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Lecture # 4 FM

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Usman Dasti
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23 views19 pages

Lecture # 4 FM

Uploaded by

Usman Dasti
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Annuities 1

ANNUITIES
Annuities
2
 In previous discussion regarding time value of money, we were looking at a cash
flows through time, calculating their future and present values.
 Now we will extend these formulas to find the future and present values of a
constant/regular stream of cash flows.
 Annuity Simple Definition = A fixed or pre-decided sum of money paid to
someone each year
 Annuity Advanced Definition = We define an annuity as 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 (such as three years).
Types of Annuities
3
 Payments for an annuity can be made at either the beginning or the end of each
period.
 If payments are made at the end of each period, the annuity is often referred to
as an ordinary annuity.
 An ordinary annuity is the most common form of annuity and is oftentimes
referred to simply as an annuity.
 However, some annuities have payments that are made at the beginning of each
period, such as apartment rent. This type of annuity is called Annuity Due
 So, there are two main types of annuities
1. Ordinary annuity
2. Annuity Due
Characteristics of Ordinary Annuity
4

1. The payments are made at the end of each period


2. The periods are equidistant in time, such as monthly or annually
3. The payments are made for a finite period of time, such as three years
Ordinary Annuity (Future Value)
1. T
Ordinary Annuity (Present Value)
1. T
Annuity Due
7

1. An annuity in which all the cash flows occur at the beginning of a


period
1. For example, rent payments on apartments are typically annuities due
because the payment for the month’s rent occurs at the beginning of the
month.
2. Annuity due merely shifts the payments from the end of the period to
the beginning of the period
Annuity Due (Future Value)
8

 FVn is the future value of the annuity due.


 PMT is the annuity due payment deposited or received at the beginning of each
period.
 i is the interest (or compound) rate per period.
 n is the number of periods for which the annuity due will last.
Annuity Due (Present Value)
9

 PV is the present value of the annuity due.


 PMT is the annuity due payment deposited or received at the beginning of each
period.
 i is the discount (or interest) rate
 n is the number of periods for which the annuity due will last.
Ordinary Annuity vs. Annuity Due
Ordinary Annuity Annuity Due
In an ordinary annuity, payments payments occur at the beginning
Definition or receipts occur at the end of each of each period.
period

The amount of pensioner fund.


The amount received by pensioner Rent Paid – Rent of house or
Example after every month. Normally, commercial building is paid at the
readjusted after budget. beginning of each month
Interest received on bonds

Good for someone who want to Good for someone who want to
Appropriate
make payments receive payments
The Future Value of an Ordinary Annuity
What is the future value of a 7%, 5-year ordinary annuity that pays $300 each year?
If this were an annuity due, what would its future value be?
In Case of Future Value of Ordinary Annuity

FV5 =?; PMT = $300; n = 5; i = 7 percent or 0.07

Step # 1 FV5 = PMT x [{(1+i)n-1}/i] Step # 6 FV5 = 300 x 5.7507


Step # 2 FV5 = 300 x [{(1+0.07)5-1}/0.07] Step # 7 FV5 = 1725.22
Step # 3 FV5 = 300 x [{(1.07)5-1}/0.07]
Step # 4 FV5 = 300 x [{1.4025-1}/0.07]
Step # 5 FV5 = 300 x [0.4025/0.07]
The Future Value of an Ordinary Annuity
12
What is the future value of a 7%, 5-year ordinary annuity that pays $300 each year?
If this were an annuity due, what would its future value be?

Interpretation = The future value of an ordinary annuity, in which annual


payments (annuity payments) are made of $300 per year, having the interest rate
of 7 percent will have the future value of $ 1725 after 5 years
The Future Value of an Ordinary Due
What is the future value of a 7%, 5-year ordinary annuity that pays $300 each year?
If this were an annuity due, what would its future value be?
In Case of Future Value of Annuity Due

FV5 =?; PMT = $300; n = 5; i = 7 percent or 0.07

Step # 1 FVn = PMT x [{(1+i)n-1}/i] (1+i) Step # 7 FV5 = 300 x 5.7507 x 1.07
Step # 2 FV5 = 300 x [{(1+0.07)5-1}/0.07] (1+0.07) Step # 8 FV5 = 1845.97
Step # 3 FV5 = 300 x [{(1.07)5-1}/0.07] (1.07)
Step # 4 FV5 = 300 x [{1.4025-1}/0.07] (1.07)
Step # 5 FV5 = 300 x [0.4025/0.07] (1.07)
Step # 5 FV5 = 300 x [0.4025/0.07] (1.07)
The Future Value of an Annuity Due
14
What is the future value of a 7%, 5-year ordinary annuity that pays $300 each year?
If this were an annuity due, what would its future value be?

Interpretation = The future value of an annuity due, in which annual payments


(annuity payments) are made of $300 per year, having the interest rate of 7
percent will have the future value of $ 1845.97 after 5 years
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
percent?

PV =?; PMT = $1000; n = 10; i = 5 percent or 0.05


Step # 1 PV = PMT x [{1-1/(1+i)n}/i] Step # 6 PV = 1000 x [0.3860/0.05]
Step # 2 PV = 1000 x [{1-1/(1+0.05)10}/0.05] Step # 7 PV = 1000 x [7.7217]
Step # 3 PV = 1000 x [{1-1/(1.05)10}/0.05] Step # 8 PV = 7721.7
Step # 4 PV = 1000 x [{1-1/1.6288}/0.05]
Step # 5 PV = 1000 x[{1-0.6139}/0.05]
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
percent?

Interpretation = The present value of an annuity due, in which annual payments


(annuity payments) are made of $1000 per year for 10 years, having the interest
rate of 5 percent will have the present value of $ 7721.7
To Find The Payment to Be Made At End of Each Year
How much must you deposit at the end of each year in a savings account earning 8
percent annual interest in order to accumulate $5,000 at the end of 10 years??

i = 0.08; FV = 5000; PMT = ?; n = 10; PMT = ?

Step # 1 FVn = PMT x [{(1+i)n-1}/i] Step # 7 5000 = PMT x 14.4865


Step # 2 5000 = PMT x [{(1+0.08)10-1}/0.08] Step # 8 5000/14.4865 = PMT
Step # 3 5000 = PMT x [{(1.08)10-1}/0.08] Step # 9 345.1474 = PMT
Step # 4 5000 = PMT x [{(2.1589-1}/0.08] Step # 10 PMT = 345.1474
Step # 5 5000 = PMT x [1.1589/0.08]
Step # 6 5000 = PMT x [14.4865]
To Find The Payment to Be Made At End of Each Year
How much must you deposit at the end of each year in a savings account earning 8
percent annual interest in order to accumulate $5,000 at the end of 10 years??

Interpretation = you deposit $345 at the end of each year in a savings account
earning 8 percent annual interest in order to accumulate $5,000 at the end of 10
years
Perpetuities
 A perpetuity is simply an annuity that continues forever or has no maturity.
 It is difficult to conceptualize such a cash flow stream that goes on forever. One such
example, however, is the dividend stream on a share of preferred stock.
 In theory, this dividend stream will go on as long as the firm continues to pay dividends,
so technically the dividends on a share of preferred stock form an infinite annuity, or
perpetuity.

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