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8.5 Annuities Present Value

The document discusses present value of annuities, including formulas and examples. It provides information on calculating the present value required to fund regular future payments at a given interest rate. Several example problems are included to demonstrate calculating the present value, payment amounts, and interest savings for different annuity scenarios.

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80 views3 pages

8.5 Annuities Present Value

The document discusses present value of annuities, including formulas and examples. It provides information on calculating the present value required to fund regular future payments at a given interest rate. Several example problems are included to demonstrate calculating the present value, payment amounts, and interest savings for different annuity scenarios.

Uploaded by

anzt888
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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MCR3U – 8.

5 Annuities: Present Value

Present value is today’s value of money from some point in the future.

If you deposit enough money today, the money can go to work earning compound interest and allow
you to withdraw regular equal payments that end up totaling more than the money you initially
invested.

Present Value of an Annuity


• The amount of money that must be invested today at a given interest rate in order to provide
a number of equal payments for a specified time period
• It is the value at the beginning of the term of an annuity
• The sum of all the present value of the payments

A variation of this type of annuity is a loan. A sum of money is borrowed upfront and the borrower
will make regular equal payments to pay off the loan. The lender will charge interest on the amount
borrowed. Thus, the amount paid back over the term of the loan is equal to more than the original
value of the loan.

1. Suppose your parents have promised to pay your way through University. Your parents wish to
deposit enough money today in an annuity paying 8% per annum compounded annually, so that
you will receive equal payments of $18,000 each year for the next 4 years, beginning one year
from now. How much money should mom and dad need to invest today?
MCR3U – 8.5 Annuities: Present Value

𝐴
For Present Value: 𝐴 = 𝑃(1 + 𝑖)𝑛 → 𝑃 = (1+𝑖)𝑛

Present Value of an Ordinary Annuity


• The sum of the present values of each of the individual pay amounts
𝑅 𝑅 𝑅 𝑅
𝑃𝑉 = + 2
+ 3
+ ⋯+
1 + 𝑖 (1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛

Annuities are basically a Geometric Series:

𝑎(𝑟 𝑛 −1)
𝑆𝑛 = Start with the formula for the sum of a geometric series
𝑟−1

Present Value of an Substitute


Ordinary Annuity 𝑆𝑛 = 𝑃𝑉 (present amount of an ordinary annuity)
Formula: 𝑅
𝑎 = (1+𝑖) = 𝑅(1 + 𝑖)−1 (regular payments or
withdrawals)

1
𝑟 = 1+𝑖 = (1 + 𝑖)−1 (interest per compounding period)

𝑛 is the number of compounding periods //payments or


withdrawals)

𝑅[1 − (1 + 𝑖)−𝑛 ]
Present Value of an Ordinary Annuity Formula: 𝑃𝑉 =
𝑖
• Formula can only be used when:
o The payment interval is the same as the compounding period
o A payment is made at the end of each compounding period

2. How much would you need to invest now at 8.3%/a, compounded annually to provide $500 per
year for the next 10 years?
MCR3U – 8.5 Annuities: Present Value

3. You have just won $2,000,000 in the lottery. You decide rather than going on a huge spending
spree, you want your winnings to provide an income for the next 60 years. You buy an annuity at
6.5% per annum compounded annually. The annuity will provide enough annual payments.
Determine the amount of each payment.

4. Claire has just won the lottery. She is offered two prize options: $125 000 cash today or payments
of $1000 each at the end of each month for 20 years. Claire expects a return of 9%/𝑎,
compounded monthly, if she invests the cash prize. Which option should Claire choose?

5. The Lee family purchase a motor home. They borrow $30 000 at 9.6%/a, compounded monthly,
and they will make payment at the end of each month. They have two choices for the term: seven
years or ten years.
a) Find the monthly payment under each term.

b) How much would they save in interest by selecting the shorter term?

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