The Basics of Annuity Theory

A series of payments made at equal intervals of time is called an annuity. Common

examples are house rents, mortgage payments on homes, and installments payments
on automobiles.
An annuity where payments are guaranteed to occur for a fixed period of time is called
an annuitycertain. For example, mortgage payments on a home. The fixed period of
time for which payments are made is called term of the annuity. For example, in the case
of a home mortgage a term can be either a 15year loan or a 30year loan.
Annuities that are not certain are called contingent annuities. For example, a
pension is paid so long as the person survives. That is, regular payments are made
as long as the person is alive. Pension is an example of contingent annuity also
called life annuity.
Unless otherwise indicated, the annuitycertain is the type of annuity we will assume
in this book, and the certain will be dropped from the name.
The interval between annuity payments is called a payment period, often just
called a period. In Sections 15 through 21, we consider annuities for which the
payment period and the interest conversion period are equal. Also, payments are
of level amount, i.e. have the same fixed monetary value for each period. In
Sections 2229, we will discuss annuities for which payments are made more or
less frequently than interest is converted and annuities with varying payments.
With level annuities, we will most of the time assume payments of 1 since any other
level annuity can be obtained from this by a simple multiplication.
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 2

143
15 Present and Accumulated Values of an Annuity-
Immediate
An annuity under which payments of 1 are made at the end of each period for n periods
is called an annuityimmediate or ordinary annuity. The cash stream represented
by the annuity can be visualized on a time diagram as shown in Figure 15.1 .

Figure 15.1

The first arrow shows the beginning of the first period, at the end of which the first
payment is due under the annuity. The second arrow indicates the last payment
datejust after the payment has been made.
Let i denote the interest rate per period. The present value of the annuity at time 0 will
be denoted
by an i or simplyan . See Figure15.2.

Figure 15.2

Using the equation of value with comparison date at time t = 0, we can write

an = + 2 + + n.

That is, the present value of the annutiy is the sum of the present values of each of the
n payments. We recognize the expression on the righthand side as a geometric
progression. Thus, multiplying both sides by to obtain
an = 2 + 3 + + n + n+1.

1 i i
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 3

Subtracting this from the previous equation we find

(1 )an = (1 n).

Hence,
1 n 1 n 1 (1 + i)n
an = = = . (15.1)

Example 15.1
Calculate the present value of an annuityimmediate of amount $100 paid annually for 5
years at the rate of interest of 9 %.

Solution.
The answer is 100a5 = 1001(10..0909)5 388.97

Formula (15.1) can be rewritten as

1 = n + ian.
This last equation is the equation of value at time t = 0 of an investment of $1 for n
periods during which an interest of i is received at the end of each period and is
reinvested at the same rate i, and at the end of the n periods the original investment of
$1 is returned. Figure 15.3 describes the time diagram of this transaction.

Figure 15.3

Next,we will determine

the accumulated immediate
valueof an annuity right afterthen th payment
is made.It is denotedby sn . See Figure15.4.

Figure 15.4
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 4

Writing the equation of value at the comparison date t = n we find

sn = 1 + (1 + i) + (1 + i)2 + + (1 + i)n1.

That is, sn is the sum of the accumulated value of each of the n payments.
Using the definition of sn and the reasoning used to establish the formula for an we can
write

sn =1 + (1 + i) + (1 + i)2 + + (1 + i)n1
(1 + i)n 1 (1 + i)n 1
= = .
(1 + i) 1 i
This last equation is equivalent to

1 + isn = (1 + i)n.

This last equation is the equation of value at time t = n of an investment of $1 for n

periods during which an interest of i is received at the end of each period and is
reinvested at the same rate i, and at the end of the n periods the original investment of
$1 is returned. Figure 15.5 describes the time diagram of this transaction.

Figure 15.5

Example 15.2
Calculate the future value of an annuityimmediate of amount $100 paid annually for 5
years at the rate of interest of 9 %.

Solution.
(1.09)51

The answer is 100s5 = 100 0.09 $598.47

Example 15.3
Show that am+n = am + man
= an + nam. Interpret this result verbally.
Solution.
 15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 5

m n m m m+n m+n

We have am + man = 1i + m 1i = 1 +i = 1i = am+n.

A verbal interpretation is as follows: The present value of the first m payments of an
(m+n)year annuity immediate of 1 is am. The remaining n payments have value an at
time t = m; discounted to the present, these are worth man at time t = 0

Example 15.4
At an effective annual interest rate i, you are given
(1)the present value of an annuity immediate with annual payments of 1 for n years is 40
(2)the present value of an annuity immediate with annual payments of 1 for 3n years is 70.
Calculate the accumulated value of an annuity immediate with annual payments of 1 for
2n years.

Solution.
Using Example 15.3 we can write a3n = a2n + 2nan = an + nan + 2nan = an(1 + n + 2n).
Hence, we obtain the quadratic equation . Solving this equation we find
.
Again, using Example 15.3 we can write a3n = an +na2n which implies that na2n = 7040 =
30 and therefore a2n = 60. Finally, s2n = 2na2n = 4(60) = 240

We next establish a couple of relationships between an and sn.

Theorem 15.1
With an and sn as defined above we have
(i) sn = (1 + i)nan. That is, the accumulated value of a principal of an after n periods is just sn.
(ii) a n = s1n + i.
2

Proof.
(i) We have s n= (1+ii )n1 = (1 + i) n 1(1+i i)n = (1 + i)nan.

(ii) We have
1 i i + i(1 + i)n i i 1
+i=+i== =

2 + i1 + 2i 1 + ni
 15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 6

sn (1 + i)n 1 (1 + i)n 1 1 n an

A verbal interpretation of (ii) will be introduced when we discuss the concepts of

amortization and sinking funds.

Example 15.5
For a given interest rate i, an = 8.3064 and sn = 14.2068.
(a) Calculate i.
(b) Calculate n.

Solution.
(a) Using part (ii) of the previous theorem we find .
(b) Using part (i) of the previous theorem we find

1 sn
n = ln = 11 ln(1 + i) an

The type of annuity discussed in this section involves compound interest rate. It is
possible to define annuityimmediate not involving compound interest such as simple
interest rate, simple discount rate, and force of interest. For example, we wish to find the
present value of an nperiod annuity immediate in which each payment is invested at
simple interest rate i. The present value is equal to the sum of the present value of the
individual payments. Thus, we obtain

1 1 1
an = + + + .
The accumulated value of such an annuity is equal to the accumulated value of the
individual payments. That is,

sn = 1 + (1 + i) + (1 + 2i) + + [1 + (n 1)i].

Example 15.6
Find an expression for an assuming each payment of 1 is valued at simple discount rate d.

Solution.
The present value is the sum of the present value of individual payments. That is,
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 7

n(n + 1)
an = (1 d) + (1 2d) + + (1 nd) = n d(1 + 2 + + n) = n
d
2
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 8

Practice Problems

Problem 15.1
Consider an investment of $5,000 at 6% convertible semiannually. How much can be
withdrawn each halfyear to use up the fund exactly at the end of 20 years?

Problem 15.2
The annual payment on a house is $18,000. If payments are made for 40 years, how
much is the house worth assuming annual interest rate of 6 %?

Problem 15.3
If d = 0.05, calculate a12 .

Problem 15.4
Calculate the present value of 300 paid at the end of each year for 20 years using an
annual effective interest rate of 8 %.

Problem 15.5
If an = x and a2n = y, express d as a function of x and y.

Problem 15.6
(a) Given: a7 = 5.153, a11 = 7.036, a18 = 9.180. Find i.
(b) You are given that an = 10.00 and a3n = 24.40. Determine a4n.

Problem 15.7
Show that sm+n = sm + (1 + i)msn = sn + (1 + i)nsm. Interpret this result verbally.

Problem 15.8
A grandmother has a granddaughter entering university next year. Her granddaughter
expects to remain in school for ten years and receive a PhD. This grandmother wishes to
provide $1,000 a year to her granddaughter for entertainment expenses. Assuming a
3.5% effective annual interest rate, how much does the grandmother have to deposit
today to provide ten annual payments starting one year from now and continuing for ten
years?

Problem 15.9
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 9

In the previous problem, if the PhD student saves the income from her grandmother in an
account also paying 3.5% effective annual interest, how much will she have when she
receives the final $1,000 payment?
 15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 10

Problem
15.10
Find the present value of an annuity which pays $200 at the end of each
quarteryear for 12 years if the rate of interest is 6% convertible quarterly.

Problem 15.11
Compare the total amount of interest that would be paid on a $3,000 loan over a
6year period with an effective rate of interest of 7.5% per annum, under each of
the following repayment plans:
(a) The entire loan plus accumulated interest is paid in one lump sum at the end of 6
years.
(b) Interest is paid each year as accrued, and the principal is repaid at the end of 6
years.
(c) The loan is repaid with level payments at the end of each year over the 6-year
period.

Problem 15.12
A loan of $20,000 to purchase a car at annual rate of interest of 6% will be paid
back through monthly installments over 5 years, with 1st installment to be made 1
month after the release of the loan. What is the monthly installment?

Problem 15.13
Over the next 20 years, you deposit money into a retirement account at the end of
each year according to the following schedule:

Time Amount invested each year

1 - 5
$2000 6 -
10 $3000
11 - 20 $5000

The effective annual rate of interest is 9%. Find the accumulated value of your
account at time 20.

Problem 15.14
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 11

Problem
A family wishes to accumulate 50,000 in a college education fund by the end of 20
years. If they deposit 1,000 into the fund at the end of each of the first 10 years,
and 1,000 + X at the end of each of the second 10 years, find X to the nearest unit
if the fund earns 7% effective.

Problem 15.15
An annuity provides a payment of n at the end of each year for n years. The annual
effective interest rate is . What is the present value of the annuity?

Problem 15.16
The cash price of a new automobile is 10,000. The purchaser is willing to finance
the car at 18 % convertible monthly and to make payments of 250 at the end of
each month for 4 years. Find the down payment which will be necessary.
15.17
You have $10,000 down payment on a $20,000 car. The dealer offers you the
following two options: (a) paying the balance with endofmonth payments over
the next three years at i(12) = 0.12 ; (b) a reduction of $500 in the price of the car,
the same down payment of $10,000, and bank financing of the balance after down
payment, over 3 years with endofmonth payments at i(12) = 0.18. Which option
is better?

Problem 15.18
Nancy has 10,000 in a bank account earning 6% compounded monthly. Calculate
the amount that she can withdraw at the end of each month from the account if
she wants to have zero in the account after 12 months.

Problem 15.19
Megan purchased a new car for 18,000. She finances the entire purchase over 60
months at a nominal rate of 12% compounded monthly. Calculate Megans monthly
payment.

Problem 15.20
Seth, Janice, and Lori each borrow 5,000 for five years at a nominal interest rate of
12%, compounded semiannually. Seth has interest accumulated over the five years
 15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 12

Problem
and pays all the interest and principal in a lump sum at the end of five years.
Janice pays interest at the end of every sixmonth period as it accrues and the
principal at the end of five years. Lori repays her loan with 10 level payments at
the end of every sixmonth period.
Calculate the total amount of interest paid on all three loans.

Problem 15.21
If d(12) = 12%, calculate the accumulated value of 100 paid at the end of each
month for 12 months.

Problem 15.22
The accumulated value of an n year annuityimmediate is four times the present
value of the same annuity. Calculate the accumulated value of 100 in 2n years.

Problem 15.23
You are given the following information:
(i) The present value of a 6nyear annuityimmediate of 1 at the end of every
year is 9.7578. (ii) The present value of a 6nyear annuityimmediate of 1 at the
end of every second year is
4.760.
(iii) The present value of a 6nyear annuityimmediate of 1 at the end of every
third year is K.
Determine K assuming an annual effective interest rate of i.
15.24
Which of the following does not represent a definition of an?
(a) n h (1+ii)n1i

(b) 1in

(c) + 2 + + n
(d) 11n
sn

(e) (1+i)n1
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 13

Problem
Problem 15.25
To accumulate 8000 at the end of 3n years, deposits of 98 are made at the end of
each of the first n years and 196 at the end of each of the next 2n years. The
annual effective rate of interest is i. You are given (1 + i)n = 2.0. Determine i.

Problem 15.26
For 10,000, Kelly purchases an annuityimmediate that pays 400 quarterly for the
next 10 years. Calculate the annual nominal interest rate convertible monthly
earned by Kellys investment. Hint: Use linear interpolation.

Problem 15.27
Susan and Jeff each make deposits of 100 at the end of each year for 40 years.
Starting at the end of the 41st year, Susan makes annual withdrawals of X for 15
years and Jeff makes annual withdrawals of Y for 15 years. Both funds have a
balance of 0 after the last withdrawal. Susans fund earns an annual effective
interest rate of 8%. Jeffs fund earns an annual effective interest rate of 10%.
Calculate Y X.

Problem 15.28
A loan of 10,000 is being repaid by 10 semiannual payments, with the first
payment made onehalf year after the loan. The first 5 payments are K each, and
the final 5 are K +200 each. What is K if i(2) = 0.06 ?

Problem 15.29
Smith makes deposits of 1,000 on the last day of each month in an account
earning interest at rate i(12) = 0.12. The first deposit is January 31, 2005 and the
final deposit is December 31, 2029. The accumulated account is used to make
monthly payments of Y starting January 31, 2030 with the final one on December
31, 2054. Find Y.

Problem 15.30
A loan of $1,000 is to be repaid with annual payments at the end of each year for
the next 20 years. For the first five years the payments are k per year; the second
5 years, 2k per year; the third 5 years, 3k per year; and the fourth 5 years, 4k per
year. Find an expression for k.
15.31
 15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 14

Problem
Happy and financially astute parents decide at the birth of their daughter that they
will need to provide 50,000 at each of their daughters 18th, 19th, 20th and 21st
birthdays to fund her college education. They plan to contribute X at each of their
daughters 1st through 17th birthdays to fund the four 50,000 withdrawals. If they
anticipate earning a constant 5% annual effective rate on their contributions,
which of the following equations of value can be used to determine X, assuming
compound interest?

(A) X( + 2 + + 17) = 50,000( + 2 + 3 + 4)

(B) X[(1.05)16 + (1.05)15 + + (1.05)] = 50,000(1 + + 2 + 3)
(C) X[(1.05)17 + (1.05)16 + + (1.05) + 1] = 50,000(1 + + 2 + 3)
(D) X[(1.05)17 + (1.05)16 + + (1.05)] = 50,000(1 + + 2 + 3)
(E) X(1 + + 2 + + 17) = 50,000(18 + 19 + 20 + 21 + 22)

Problem 15.32
For time t > 0, the discount function is defined by

Consider a five-year annuity with payments of 1 at times t = 1,2,3,4,5. Consider

the following: A calculates a5 as the sum of the present value of the individual
payments. However, B accumulates the payments according to the accumulation
function

a(t) = 1 + 0.01t

and then multiplies the result by . By how much do the answers of A and B
differ?

Remark 15.1
It can be shown that the above two processes do not produce the same answers in
general for any pattern of interest other than compound interest. Thats why, it is
always recommended to avoid dealing with annuities not involving compound
interest, if possible.
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 15

Problem
Problem 15.33
Simplify the sum .

Problem 15.34
A 20 year annuity pays 100 every other year beginning at the end of the second
year, with additional payments of 300 each at the ends of years 3, 9, and 15. The
effective annual interest rate is 4 %.
Calculate the present value of the annuity.
15.35
An annuity pays 1 at the end of each 4year period for 40 years. Given a8 i = k,
find the present value of the annuity.

Problem 15.36
Smith is negotiating a price for a new car. He is willing to pay $250 at the end of
each month for 60 months using the 4.9% compounded monthly interest rate that
he qualifies for. Smith estimates that tax, title, and license for the new car will
increase the negotiated price by 10%, and he estimates that he will receive $500
tradein value for his current car. Calculate the highest negotiated price that
Smith is willing to pay for the car.

Problem 15.37
An account is credited interest using 6% simple interest rate from the date of each
deposit into the account. Annual payments of 100 are deposited into this account.
Calculate the accumulated value of the account immediately after the 20th deposit.

Problem 15.38
A homeowner signs a 30 year mortgage that requires payments of $971.27 at the
end of each month. The interest rate on the mortgage is 6% compounded monthly.
If the purchase price of the house is $180,000 then what percentage down
payment was required?

Problem 15.39
A 25yearold worker begins saving for retirement, making level annual deposits
at the end of each year. The savings are invested at an annual effective interest
rate of 8%, and are of an amount that is projected to equal 1,000,000 when the
worker is 65 (after the 40th deposit is made on that date).
 15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 16

Problem
After making five annual deposits, the worker becomes unemployed for a period of
time and, as a result, skips the next three annual deposits. Assuming that the
account earns an 8% annual effective rate in all 40 years, what amount will the
worker need to deposit in each of the remaining 32 years in order to achieve the
original goal of a 1,000,000 balance at age 65 ?

Problem 15.40
Paul lends 8000 to Peter. Peter agrees to pay it back in 10 annual installments at
7% with the first payment due in one year. After making 4 payments, Peter
renegotiates to pay off the debt with 4 additional annual payments. The new
payments are calculated so that Paul will get a 6.5% annual yield over the entire
8year period. Determine how much money Peter saved by renegotiating.

Problem 15.41
Mario deposits 100 into a fund at the end of each 2 year period for 20 years. The
fund pays interest at an annual effective rate of i. The total amount of interest
earned by the fund during the 19 th and 20th years is 250. Calculate the
accumulated amount in Marios account at the end of year 20.
15.42
Show that 1110 = s1 s10 + 1i .
10

Problem 15.43
If a4 = 3.2397 and s4 = 4.5731 what is the value of a8 ?

Problem 15.44
Smith borrows $5,000 on January 1, 2007. He repays the loan with 20 annual
payments, starting January 1, 2008. The payments in even-number year are 2X
each; the payments in odd-number years are X each. If d = 0.08, find the total
amount of all 20 payments.

Problem 15.45
(a) Show that amn = am msn where 0 < n < m.
(b) Show that smn = sm (1 + i)man where 0 < n < m.
 15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 17

Problem
Problem 15.46
Show that sn n
an.

Thus far, we have only considered annuities where the payments are made at the
end of the period, but it is possible that the circumstances may be such that the
annuity is to run for a given number of periods and a portion of a period. The
purpose of the remaining problems is to define terms such as an+k and sn+k where n
is a positive integer and 0 < k < 1.

Problem 15.47
Let k be a positive real number. Find an expression for the error involved in
approximating by the number k. Hint: Use the Taylor series expansion of (1
+ i)k around i = 0.

Problem 15.48
(a) Find the interest accrued of a principal of 1 at t = n to time t = n + k, assuming
compound interest.
(b) Show that i( + 2 + 3 + + n) + [(1 + i)k 1]n+k + n+k = 1.
(c) Let an+ 1 denote the present value of an annuity consisting of n payments of 1 at the
end of
m each period and a final payment of at the end of the th fraction
of the (n + 1) period.
1n+m1
Define a . Show that
1
n+ m
= i

" 1#
n+ 1 (1 + i)m 1
an+m1 = an + i .
m
15 PRESENT AND ACCUMULATED VALUES OF AN ANNUITY-IMMEDIATE 18

Problem
Thus, an+k is the sum of the present value of an nperiod
annuityimmediate of 1 per period, plus a final payment at time
.

Proble
m
15.49
Show
that
an+k an + kn+m1 .

Hint: Use Problems 15.47 and 15.48.

Problem 15.50
Compute a5.25 if i = 5% using the following definitions:
(a) The formula
established in
Problem 15.48.
(b)A payment of 0.25
at time 5.25. (c) A
payment of 0.25 at
time 6.

Problem 15.51
(a) Define s (1+i)n+k1. Show that
n sn+k = (1+i)ks + (1+ii)k1.
n+k = k
Thus, sn+k can be interprested as the accumulated value of an nperiod
annuityimmediate at time t = n+k with an additional payment of
at time t = n + k.
(b) Show that sn+k (1 + i)ksn + k.