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Section 5.4a MOF 5th April

- An annuity is a series of regular payments made over a fixed period of time at fixed intervals. - The present value of an ordinary annuity is the sum of the present values of each payment in the annuity. This can be calculated using a formula that takes into account the payment amount, interest rate, and number of periods. - An annuity due is where payments are made at the beginning of each period rather than the end. This shifts the payments one period ahead and the present value formula is slightly different to account for the extra period of interest earned.

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33 views33 pages

Section 5.4a MOF 5th April

- An annuity is a series of regular payments made over a fixed period of time at fixed intervals. - The present value of an ordinary annuity is the sum of the present values of each payment in the annuity. This can be calculated using a formula that takes into account the payment amount, interest rate, and number of periods. - An annuity due is where payments are made at the beginning of each period rather than the end. This shifts the payments one period ahead and the present value formula is slightly different to account for the extra period of interest earned.

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muaz
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© © All Rights Reserved
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Section 5.

4a
Mathematics of Finance
• Definitions:
• Annuity: An annuity is any finite sequence of
payments made at fixed time periods over a given
time interval.
• Payment period: Length of the fixed time period.
These time periods are of equal length.
• Term of an annuity. Given total time/interval.
Definitions:

• Payments: Consider payments of equal value denoted


by R.
• Ordinary Annuity: Payments are made at the end of
each time period. e.g Wages
• r: periodic interest rate.
• 
 Present Value of an annuity (denoted by A): Sum of
the present values of all n payments.
• ( Consider n payments or n time intervals, payments
are made at time period 1,2,…n).
• Also called the amount invested now to purchase all
n of the payments.
Time line for an annuity
Consider an annuity of 1000 dollars for 5 years with r =0.05
Annuities
• A stream of equal cash flows.
• Occur at equal time intervals.
• Cash flow is at the end of the compounding period.
0 1 2 3 n-1 n

R R R R R

• R is the fixed cash flow.


• n is the number of cash flows.
• In many instances, we want to know the PV or FV of
annuities.
Present Value of Annuities
0 1 2 3 n-1 n

R R R R R
R(1+r)-1

R(1+r)-2

R(1+r)-n

PV of Annuity = R(1 + r)-1 + R(1 + r)-2 + ... + R(1 + r)-n.


This is a geometric series of n terms with first term R(1 + r)-1 and
common ratio (1 +r)-1. Simplifying this series gives us the
following:
Derivation ( Not to be memorized !)
•  In general , take payment as R and n payments with periodic interest
rate as r .
• On adding up all n terms we get the geometric series

• On using the formula for sum of a finite geometric series and


simplifying we get
Present Value of an Annuity
• 
• The present value A of an ordinary annuity R
per payment period for n periods at the interest
rate of r per period is:
Example 1

1.Find the present value of an annuity of $100


per month for 3.5 years at an interest rate of
6% compounded monthly.
Here R=100, n = 3.5 x 12=42,
r = 0.06/12=0.005
Cont’d

• 
Example 2
• 
If $10000 is used to purchase an annuity
consisting of equal payments at the end of each
year for the next 4 years and the interest rate is
6% compounded annually find the amount of
each payment?
Cont’d
• 
• Here A=10000, n =4 x 1=4, r = 0.06, R = ?
Example 3

Given interest rate of 5% compounded annually, find the PV


of a generalized annuity of $2000 due at the end of each
year for 3 years and $5000 due thereafter at the end of
each year for the next 4 years.
• Solution : Payment =$2000 for 3 years,
• then Payment = $5000 for the next 4 years
• We cannot use the formula directly as in the formula payment is the same
throughout
 Method 1 using
• 

• This method is not suitable for a large


number of payments. So we use the formula
discussed.
 Method II : Using

•  • We can assume all payments are worth 5000 dollars and then we subtract
the sum of present values of excess payments for the first 3 months:
• A= PV of an annuity with each payment as 5000 for 7 months minus PV of
excess payments for the first 3 months.
• =PV ( R =5000, n = 7 , r = 0.05) –PV of (R=3000, n = 3 , r = 0.05)
Annuity Due

 Annuity Due: Payments are made at the beginning of


each time period. e. g rent.
Timeline for annuity due: Payment =1000,
 r=0.05 and 5 payments are made
Annuity Due
• An annuity where payments are made at the beginning
of the period.

0 1 2 3 n-1 n

R R R R R

• The number of payments in the stream does not change.


• All payments shift one period ahead, starting from t = 0
and ending at n – 1.
• Interest is earned for one extra period for annuity due as
compared to an ordinary annuity.
Annuity Due
• Present value of an annuity Due: Payments are made at time periods
0,1,2,…n-1
  − 𝑛+1
1 − ( 1+𝑟 )
𝐴=𝑅+ 𝑅 ( 𝑟 )
Annuity Due (Payments are made in advance/
at the beginning of each time period)
4. The premiums on an insurance policy are $50 per
quarter payable at the beginning of each quarter. If
the policy holder wants to pay one year’s premiums
in advance, how much should be paid if the interest
rate is 4% compounded quarterly?
Example 4: R = 50 n =4 , r= 0.01
• 
• PV of an annuity due
•=
Qs 18 Section 5.4

•18. A company wishes to lease an office space for 6 months.


The rental fee is $1500 a month and is payable in advance.
Suppose that the company wants to make a lump sum payment
at the beginning of the rental period to cover all the rental fee
due over the 6 month period. If the interest rate is worth 9%
compounded monthly, how much should the payment be?
Solution
••  
R = 1500, r =0.09/12, A = ?, n = 6;
•Annuity Due
 Present value of an annuity Due:
Additional Questions
1. An annuity consisting of equal payments at the end of each quarter for three years is to
be purchased for $15,000. If the interest rate is 4% compounded quarterly, how much is
each payment?

2. Find the present value of an annuity of $ 500 per month for 2 years at an interest rate of
6% compounded monthly.

3. For an interest rate of 4% compounded monthly, find the present value of an annuity of
$150 at the end of each month for eight months and $175 thereafter at the end of each
month for a further two years.

4. The beneficiary of an insurance policy has the option of receiving a lump sum payment of
$275000 or 10 equal yearly payments where the first payment is due at once. If the interest
rate is 3.5% compounded annually find the yearly payment?
Additional Questions
•1.  An annuity consisting of equal payments at the end of each quarter
for three years is to be purchased for $15,000. If the interest rate is
4% compounded quarterly, how much is each payment?

Here
•  15000

• R = 15000/11.2551=1332.73 dollars
Additional Questions
2. Find the present value of an annuity of $ 500 per month for 2 years
at an interest rate of 6% compounded monthly.

Here R=500,
n = 2 x 12=24,
r = 0.06/12=0.005
Cont’d
• 
3. Generalized Annuity
• 
For an interest rate of 4% compounded monthly, find the present value
of an annuity of $150 at the end of each month for eight months and
$175 thereafter at the end of each month for a further two years.

Total time span =8 months + 2 years = 8months + 24 months = 32


months
n = 32
r=, First Payment = 5
Method:

• Assume all payments are worth 175 for n = 32, r =0.04/12


• From this
• Subtract sum of present values of excess payments for the first 8
months.
• Excess payment = 175-150=25, n = 8 , r = 0.04/12
Solution
•• Present
  value = (A with n_2 = 32, r = 0.04/12)
• minus (A with n = 8, r = 0.04/12)
Question 4
The beneficiary of an insurance policy has the option of receiving a lump sum
payment of $275000 or 10 equal yearly payments where the first payment is
due at once. If the interest rate is 3.5% compounded annually find the yearly
payment?

• A = 275000
• n = 10
• r=0.035
• R=?
• Annuity Due
− 𝑛+1
1 − ( 1 +𝑟 )
  𝐴=𝑅+ 𝑅 ( 𝑟 )
• 

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