FIN 3000

Chapter 6
Annuitie
s
Liuren Wu
Overview
1. Annuities

2. Perpetuities

3. Complex Cash Flow Streams

 Learning objectives
1. Distinguish between an ordinary annuity and an annuity due,
and calculate present and future values of each.
2. Calculate the present value of a level perpetuity and a growing
perpetuity.
3. Calculate the present and future value of complex cash flow
streams.

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Ordinary
Annuities
 An annuity is a series of equal dollar payments that are made
at the end of equidistant points in time such as monthly,
quarterly, or annually over a finite period of time.
 If payments are made at the end of each period, the annuity
is referred to as ordinary annuity.
 Example 6.1 How much money will you accumulate by the
end of year 10 if you deposit $3,000 each for the next ten
years in a savings account that earns 5% per year?

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The Future Value of an Ordinary
Annuity
 The time line: i=5%
Time 0 1 2… 10

Cashflow: 3000 3000 … 3000

FV [?]
 We want to know the future value of the 10 cash flows.

 We can compute the future value of each cash flow and sum
them together:

3000(1.05)9 + 3000(1.05)8 + … + 3000 = 37,733.68

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 The Future Value of an Ordinary
Annuity
Interest 5%
rate
Tm
ie 1 2 3 4 5 6 7 8 9 10
Cashflow 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00 3,000.00
Value in =3000*(1+.05)^(10-1) =3000*(1.05)^(10-8)
year 10
Value in 4,653.98 4,432.37 4,221.30 4,020.29 3,828.84 3,646.52 3,472.88 3,307.50 3,150.00 3,000.00
year 10
Total  37,733.68
The earlier cash flows have higher future values because they
have more years to earn interest.
 Year 1 cash flow can earn 9 years of interest.
 Year 10 cash flow does not earn any interest.

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The Future Value of an Ordinary
Annuity
 Since the annuity cash flow has a strong pattern, we can also
compute the future value of the annuity using a simple
formula:

 FVn = FV of annuity at the end of nth period.

 PMT = annuity payment deposited or received at the end of
each period.
 i = interest rate per period
 n = number of periods for which annuity will last.

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Example 6.1

 $3,000 for 10 years at 5% rate. Use the formula


FV = $3000 {[ (1+.05) - 1] ÷ (.05)}
10

= $3,000 { [0.63] ÷ (.05) }

= $3,000 {12.58}
= $37,733.68

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Solving for PMT in
an Ordinary
Annuity
 Instead of figuring out how much money you will accumulate
(i.e. FV), you may like to know how much you need to save
each period (i.e. PMT) in order to accumulate a certain
amount at the end of n years.

 In this case, we know the values of n, i, and FVn in the formula

FVn=PMT [((1+i)n-1)/i], and we need to determine the value of
PMT.

 PMT=FVn/[((1+i)n-1)/i].

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Examples
 Example 6.2: Suppose you would like to have $25,000 saved 6
years from now to pay towards your down payment on a new
house. If you are going to make equal annual end-of-year
payments to an investment account that pays 7%, how big do
these annual payments need to be?
 How much must you deposit in a savings account earning 8%
interest in order to accumulate $5,000 at the end of 10
years?
 If you can earn 12% on your investments, and you would like
to accumulate $100,000 for your child’s education at the end
of 18 years, how much must you invest annually to reach your
goal?
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 Verify the answers: 3494.89; 345.15;1793.73
The Present Value of an Ordinary
Annuity
 The present value of an ordinary annuity measures the value
today of a stream of cash flows occurring in the future.
 Example: What is the value today or lump sum equivalent of
receiving $3,000 every year for the next 30 years if the
interest rate is 5%?
 If I know its future value, I can compute its present value.

 PV= FVn/(1+i)n, where

= PMT[ ((1-(1+i)-n)/i]

For the example, FV=199,316.54. PV=46,117.35.

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One can also compute the PV of each cash
flow and sum them up.

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The Present and Future Values
of an Ordinary Annuity

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Checkpoint 6.2

The Present Value of an Ordinary Annuity

 Your grandmother has offered to give you $1,000 per year for the
next 10 years. What is the present value of this 10-year, $1,000
annuity discounted back to the present at 5%?

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Checkpoint 6.2

 Verify the answer:7721.73;

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Checkpoint 6.2: Check
Yourself
What is the present value of an annuity of $10,000 to be
received at the end of each year for 10 years given a 10
percent discount rate?

Answer: 61,445.67

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Amortized Loans
 An amortized loan is a loan paid off in equal payments –
consequently, the loan payments are an annuity.
 Examples: Home mortgage loans, Auto loans

 In an amortized loan, the present value can be thought of as

the amount borrowed, n is the number of periods the loan
lasts for, i is the interest rate per period, and payment is the
loan payment that is made.

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Example

 Example 6.5 Suppose you plan to get a $9,000 loan from a

furniture dealer at 18% annual interest with annual payments
that you will pay off in over five years. What will your annual
payments be on this loan?
 PMT=PV/[(1-(1+i)n)/i] =2,878.00.

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 The Loan Amortization
Schedule: Annuity Interest Repayme
Yea Amount Outstandin
rHow interest
Owed on and principal are accounted
Payment Portionfor? nt of the g Loan
Principal at (2) of the Principal Balance at
the Annuity Portion of Year end,
Beginning of (3) = (1) the After the
the Year × 18% Annuity Annuity
(1) (4) = Payment
(2) –(3) (5)
=(1) – (4)
1 $9,000 $2,878 $1,620.0 $1,258.0 $7,742.00
0 0
2 $7,742 $2,878 $1,393.5 $1,484.4 $6,257.56
6 4
3 $6257.56 $2,878 $1,126.3 $1,751.6 $4,505.92
6 4
4 $4,505.92 $2,878 $811.07 $2,066.9 $2,438.98
3
5 $2,438.98 $2,878 $439.02 $2,438.9 $0.00
8
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The Loan Amortization
Schedule
How interest and principal are accounted for?
 We can observe the following from the table:
 Size of each payment remains the same.
 However, Interest payment declines each year as the amount
owed declines and more of the principal is repaid.

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Amortized Loans with Monthly
Payments

 Many loans such as auto and home loans require monthly

payments. This requires converting n to number of months
and computing the monthly interest rate.
 Example 6.6 You have just found the perfect home. However,
in order to buy it, you will need to take out a $300,000, 30-
year mortgage at an annual rate of 6 percent. What will your
monthly mortgage payments be?
 n=30*12=360. i=6%/12=0.5%.
 PMT=300000/[(1-1.005-360)/0.005] = $1798.65

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Checkpoint 6.3

Determining the Outstanding Balance of a Loan

Let’s say that exactly ten years ago you took out a $200,000, 30- year
mortgage with an annual interest rate of 9 percent and monthly
payments of $1,609.25. But since you took out that loan, interest rates
have dropped. You now have the opportunity to refinance your loan at
an annual rate of 7 percent over 20 years. You need to know what the
outstanding balance on your current loan is so you can take out a lower-
interest-rate loan and pay it off. If you just made the 120th payment and
have 240 payments remaining, what’s your current loan balance?

What will be your new monthly payment if you can do the

refinancing?

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Checkpoint 6.3:
Analysis
 Double check the payment: PV=200,000, n=360,
i=0.09/12=0.0075.
 PMT=PV/[(1-1.0075-360)/0.0075]=1609.245

 The remaining principal can be computed as the present

value of the remaining payments under the existing interest
rate (9%).
Remaining balance=PV = 1609.245[ (1-(1.0075)-240)/(0.0075)]
=$ 178,859.49
 Now we can compute the new monthly payment on the
remaining balance with a new rate i=0.05/12= 0.00583
 PMT=178859.49/[(1-1.00583-240)/0.00583]= $1,386.69.
 A monthly saving of $222.55 (=1609.25-1386.69).
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Checkpoint 6.3: Check
Yourself
Let’s assume you took out a $300,000, 30-year mortgage with an
annual interest rate of 8%, and monthly payment of $2,201.29. Since
you have made 15 years worth of payments, there are 180 monthly
payments left before your mortgage will be totally paid off. How much
do you still owe on your mortgage?

Hint: The remaining balance is essentially the present value of

remaining payments under the existing rate.

 Verify the answer: $230,344.29

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Annuities Due
 Annuity due is an annuity in which all the cash flows occur at
the beginning of the period. For example, rent payments on
apartments are typically annuity due as rent is paid at the
beginning of the month.
 Computation of future/present value of an annuity due
requires compounding the cash flows for one additional
period, beyond an ordinary annuity.
 FV or PV (annuity due) = (FV or PV (ordinary
annuity)x(1+i)

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Examples
 Example 6.1 where we calculated the future value of 10-year
ordinary annuity of $3,000 earning 5% to be $37,734. What will be
the future value if the deposits of $3,000 were made at the
beginning of the year i.e. the cash flows were annuity due?
 Just compound the future value for the ordinary annuity for
one
more period: FV=37734 x 1.05=39,620.7

 Checkpoint 6.2 where we computed the PV of 10-year ordinary

annuity of $10,000 at a 10% discount rate to be equal to $61,446.
What will be the present value if $10,000 is received at the
beginning of each year i.e. the cash flows were annuity due?
 Just compound the PV of the ordinary annuity for one more
period: PV=61446x1.1=67,590.6
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Perpetuities

 A perpetuity is an annuity that continues forever or has no

maturity. For example, a dividend stream on a share of
preferred stock. There are two basic types of perpetuities:
 Growing perpetuity in which cash flows grow at a constant
rate, g, from period to period.
 Level perpetuity in which the payments are constant rate from
period to period.

 Even if the cash flows are infinite, present values can be finite
if the discount rate is higher than the growth rate.

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Present Value of a Level
Perpetuity
with n=infinity

= PMT/ i
 PMT = level (constant) payment per period.
 I = rate per period.

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Examples

 Example 6.6 What is the present value of $600 perpetuity at

7% discount rate?
 PV=600/0.07=8751.43.

 If you decide to rent an apartment with a fixed rent of $2,000

per month and live there forever (subletting it to your
children after you die), how much is this apartment worth if
the mortgage rate is 6% per year (Ignore tax, liquidity and
other concerns).
 The present value of paying $2000 per month forever at 6% rate
per year is: PV=2000/(0.06/12)=400,000.
 200 times your rent is about the house value.

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Checkpoint 6.4

The Present Value of a Level Perpetuity

 What is the present value of a perpetuity of $500 paid
annually discounted back to the present at 8 percent?
 What is the present value of stream of payments equal to $90,000
paid annually and discounted back to the present at 9 percent?

Verify: 6250; 1,000,000

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Present Value of a
Growing Perpetuity
 In growing perpetuities, the periodic cash flows grow at a
constant rate each period.
 The present value of a growing perpetuity can be calculated
using a simple mathematical equation:

 i -- rate per period, g—growth per period,

PMTperiod 1 – payment at the end of the first period.

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Checkpoint 6.5

The Present Value of a Growing Perpetuity

What is the present value of a perpetuity stream of cash flows that
pays $500 at the end of year one but grows at a rate of 4% per year
indefinitely? The rate of interest used to discount the cash flows is 8%.

What if the growth rate is 6%?

What if the growth rate is 9%?

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Checkpoint 6.5:
Answers
 PV=500/(.08-.04)=500/.04=12,500

 PV=500/(.08-.06)=500/.02=25,000

 When growth rate is faster than discount rate, the present

value is infinite -- You can no longer use the formula.

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Complex Cash Flow
Streams
 The cash flows streams in the business world may not always
involve one type of cash flows. The cash flows may have a
mixed pattern. For example, different cash flow amounts
mixed in with annuities.

 For example, figure 6-4 summarizes the cash flows for

Marriott.

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Complex Cash Flow Streams
(cont.)

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Complex Cash Flow
Streams
 In this case, we can find the present value of the project
by summing up all the individual cash flows by
proceeding in four steps:
1. Find the present value of individual cash flows in years 1, 2,
and 3.
2. Find the present value of ordinary annuity cash flow stream
from years 4 through 10.
3. Discount the present value of ordinary annuity (step 2)
back
three years to the present.
4. Add present values from step 1 and step 3.

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Checkpoint 6.6

The Present Value of a Complex Cash Flow Stream

What is the present value of cash flows of $500 at the end of years
through 3, a cash flow of a negative $800 at the end of year 4, and cash
flows of $800 at the end of years 5 through 10 if the appropriate
discount rate is 5%?

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Checkpoint 6.6

 PV of 3x5000=500*[(1-1.05-3)/.05]=1361.62
 PV of (-800)=-800/1.054=-658.16
 Year 4 value of 6x800= 800*[(1-1.05-6)/.05]=4060.55
 PV=4060.55/1.054=3340.63

 Total PV=1361.62-658.16+3340.63=4044.09
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Checkpoint 6.6: Check
Yourself
What is the present value of cash flows of $300 at the end of years 1
through 5, a cash flow of negative $600 at the end of year 6, and cash
flows of $800 at the end of years 7-10 if the appropriate discount rate is
10%?

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Steps
 Group the cash flow in to three types, all with i=10%
1. $300 from year 1 to 5
2. -$600 at year 6
3. $800 from year 7-10

 Find PV for each group:

1. PV=300[(1-1.1-5)/0.1]=1137.24
2. PV=-600/1.16=-338.68
3. PV={800[(1-1.1-4)/0.1]}/1.16=1431.44 (two steps
here)
 Total PV=2300.00

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