Ordinary annuity

Example 1: Calculate the present value on Jan 1, 2011 of an annuity of $500 paid at the
end of each month of the calendar year 2011. The annual interest rate is 12%.
Solution

We have,
Periodic Payment R = $500
Number of Periods n = 12
Interest Rate i = 12%/12 = 1%
Present Value PV = $500 × (1-(1+1%)^(-12))/1%
= $500 × (1-1.01^-12)/1%
≈ $500 × (1-0.88745)/1%
≈ $500 × 0.11255/1%
≈ $500 × 11.255
≈ $5,627.54
Example 2: A certain amount was invested on Jan 1, 2010 such that it generated a periodic
payment of $1,000 at the beginning of each month of the calendar year 2010. The interest
rate on the investment was 13.2%. Calculate the original investment and the interest
earned.
Solution
Periodic Payment R = $1,000
Number of Periods n = 12
Interest Rate i = 13.2%/12 = 1.1%
Original Investment = PV of annuity due on Jan 1, 2010
= $1,000 × (1-(1+1.1%)^(-12))/1.1% ×
(1+1.1%)
= $1,000 × (1-1.011^-12)/0.011 × 1.011
≈ $1,000 × (1-0.876973)/0.011 × 1.011
≈ $1,000 × 0.123027/0.011 × 1.011
≈ $1,000 × 11.184289 × 1.011
≈ $11,307.32
Interest Earned ≈ $1,000 × 12 − $11,307.32
≈ $692.68

Deffered annuity

Identify the type of annuity (based on the periodic payment date), deferral period, annuity period, and
number of payments in Problems 1 and 2:

1. Investments: a. $500 is deposited into a savings account at the end of each month for three years and
the first deposit is made five months from now. b. $500 is deposited into a savings account at the
beginning of every six months for 5 years and 6 months and the first deposit is made 2 years from now.
 2. Payments: a. A certain amount is deposited into an RRSP that pays $2000 at the end of every month
for ten years. The first payment is received seven years from now. b. A certain amount is deposited into
a GIC today and payments of $10,000 are withdrawn at the beginning of every quarter for five years.
The first payment is received two years from now.

3. How much would a business have to invest in a high-growth fund to receive $10,000 at the end of
every quarter for five years? The first payment is received two years from now and the investment has
an interest rate of 12% compounded quarterly.

4. What amount would a company have to borrow from a bank to be able to repay $2800 at the end of
every month for ten years, with receipt of the first payment two years from now, if the bank charges an
interest rate of 6% compounded monthly?

5. Keira is planning to retire in seven years and would like to receive $3000 from her RRSP at the end of
every month for ten years during her retirement. She would like to receive her first periodic payment on
the day she retires. How much would she have to invest in an RRSP that has an interest rate of 8%
compounded quarterly?

6. Tasty Pastries Inc. wants to purchase a deferred annuity that would provide the company annuity
payments of $20,000 at the end of every six months for seven years. Calculate the purchase price of the
deferred annuity if the deferral period is two years and the interest rate is 6% compounded monthly.

7. Calculate the amount of money an investment banker would have to deposit in an investment fund
that would provide him $1000 at the beginning of every month for 10 years if his payments were
deferred by 3 years and 6 months and the interest rate is 6% compounded monthly.

8. A restaurant owner wants to invest in GICs that have an interest rate of 3.25% compounded semi-
annually. Calculate the amount he should invest in order to receive annuity payments of $2000 at the
beginning of every 6 months for a period of 5 years. He wants his annuity to begin 2 years and 6 months
from now.

9. On the day Cecilia was born, her grandmother made an investment in a fund that was growing at
6.75% compounded quarterly. How much was invested in the fund to enable annual withdrawals of
$10,000 for five years starting from Cecilia's 18th birthday?

10. Jemi purchased a deferred annuity with his 2010 earnings. If it pays him $1200 at the beginning of
every month for five years and the payment period is deferred by one year, calculate the purchase price
of the deferred annuity. Assume an interest rate of 8% compounded semi-annually.

11. Yuan invested $10,000 in a fund earning 8% compounded monthly. He withdraws $800 from the
fund at the end of every quarter with the first withdrawal being made three years from now. How long
will it take for the fund to be depleted?
 12. How long will it take Ardiana to settle a $280,000 business loan if she makes equal month-end
payments of $1500, making her first payment six months from now? The interest rate on the mortgage
is 3.45% compounded semiannually.

13. Russ Inc. invested its annual net profits of $25,000 into a fund at 8% compounded quarterly. The
company wants to withdraw $2500 at the beginning of every six months, with the first withdrawal being
made two years from now. For how long can withdrawals be made?

14. Samantha deposited her sales commission of $15,500 in an investment that was growing at 7%
compounded monthly. If she wanted to withdraw $2500 at the beginning of every quarter, with the first
withdrawal being made four years from now, how long will she be able to make withdrawals?

15. Jehona took an $8000 loan to purchase equipment for her hair salon. If the interest rate charged on
the loan is 11% compounded quarterly, what month-end payments of equal amounts will settle the loan
in 5 years if she made her first payment 1 year and 4 months from now?

16. A small business invested its profits of $20,850 in an annuity that pays equal amounts at the end of
every quarter for five years, receiving the first payment two years from now. Calculate the size of the
payments if the annuity has an interest rate of 8% compounded monthly.

17. A software company took a loan of $85,000 from a bank and was required to pay equal payment
amounts at the beginning of every month for ten years, with the first payment being made one year
from now. The interest rate charged is 8.5% compounded semi-annually. a. What will be the size of the
monthly payments? b. What will be the total interest charged?

18. Amanda obtained a student loan of $55,000 for her two-year MBA program. The loan agreement
states that she would have to make equal payments at the beginning of each month to settle the loan
over ten years after she graduates two years from now. The interest rate on the loan is 6% compounded
quarterly. a. What will be the size of the monthly payments? b. What will be the total interest charged?

19. Leigha invested $35,000 in a retirement fund and withdrew equal amounts at the end of each month
for 20 years. She made her first withdrawal 5 years after she made the initial investment. Calculate the
size of the withdrawals if the fund was earning 9.5% compounded quarterly during the deferral period
and 8% compounded quarterly during the annuity period.

20. Five years ago, a bank offered an interest rate of 4% compounded semi-annually on an investment of
$20,000. Now, a month before the first withdrawal will be made, the rate will be changing to 4%
compounded quarterly. Calculate the size of the equal withdrawals at the end of each month that would
ensure that the investment lasts for ten years.

21. A company invested $380,000 in a fixed deposit at 5.75% compounded quarterly. After a deferral
period, it wants to withdraw $11,100.21 at the beginning of the month for four years. How long is the
deferral period? Express your answer in years rounded to two decimal places.
22. Beyonce received a student loan of $56,000 at 6.55% compounded semi-annually. She was required
to settle the loan by making payments of $1409.07 at the beginning of every month for a period of five
years from the date of graduation. How long is the deferral period? Express your answer in years
rounded to two decimal places.

23. Ada is planning to retire in 15 years and would like to receive $2500 from her RRSP at the end of
every month for 20 years during her retirement. At the end of this 20-year period she would like to have
$20,000 in the RRSP after receiving her last payment. If she receives the first periodic payment one
month after she retires, how much would she have to invest in an RRSP that has an interest rate of 4.5%
compounded semi-annually?

24. A company purchased a deferred annuity that provided it with annuity payments of $15,000 at the
end of every three months for ten years. At the end of this ten-year period, the account would have a
balance of $10,000 after the last payment has been withdrawn. Calculate the purchase price of the
deferred annuity if the period of deferment is four years and the interest rate is 5.75% compounded
monthly

1. Congrats! You just won the $64 million Florida lottery. Now the Surely Company is
offering you $30 million in exchange for the 20 installments on your winnings. If
your opportunity cost of funds is 8%, should you agree to this deal?

Given:

CF = $64,000,000 / 20 = $3,200,000

N = 20

i = 8%

Annuity due

PV = $33,931,517.44

No: the annuity is worth almost $34 million to you, but Surely is offering only $30.

2. Carol Calc plans on retiring on her 60th birthday. She wants to put the same amount of funds
aside each year for the next twenty years -- starting next year -- so that she will be able to
withdraw $50,000 per year for twenty years once she retires, with the first withdrawal on her
61st birthday. Carol is 20 years old today. How much must she set aside each year for her
retirement if she can earn 10% on her funds?

PV60 = $50,000 (PV annuity factor for N=20, i=10%)

PV60 = $50,000 (8.5136)

 PV60 = $425,678.19

Because she will stop making payments on her 40th birthday (first is on her 21st birthday, last is
on her 40th birthday), we must calculate the balance in the account on her 40th birthday:

PV40 = PV60 / (1 + 0.10)20 = $63,274.35

Then, we need to calculate the deposits necessary to reach the goal:

FV40 = PV40 = $63,274.35

N = 20

i = 10%

FV = CF (FV annuity factor for N=20, i=10%)

$63,274.35 = CF (FV annuity factor for N=20, i=10%)

$63,274.35 = CF (57.2750)

CF =payment = $1,104.75 per year

3. Have I got a deal for you! If you lend me $100,000 today, I promise to pay you back in twenty-
five annual installments of $5,000, starting five years from today (that is, my first payment to
you is five years from today). You can earn 6% on your investments. Will you lend me the
money?

This is a deferred annuity problem

CF = $5,000

N = 25

i = 6%

PV4 = $5,000 (PV annuity factor for N=25 and i=6%)

PV4 = $5,000 (12.7834)

PV4 = $63,916.78

PV0 = $63,916.78 / (1 + 0.06)4 = $50,628.08

You probably shouldn't lend the money under these terms. If you lend me $100,000,
I am repaying you using terms such that the value of my repayment is $50,628.08.

4. You have choice when subscribing to our magazine: you can

a. pay $100 now for a four year subscription,
b. pay $28 at the beginning of each year for four years, or
 c. pay $54 today and $54 again two years from today.

Which is the best deal for you, the subscriber, if your opportunity cost of funds is 10%?

(a): PV = $100

(b) PV = PV of a 4-payment annuity due = $97.63

(c) PV = $54 + $54 / (1+0.10)2 = $54 + 44.63 = $98.63

The best deal is to pay $28 at the beginning of each of the four years.

5. The Trust Worthy loan company is willing to lend you $10,000 today if you promise to repay the
loan in six monthly payments of $2,000 each, beginning today. What is the effective annual
interest rate on Trust Worthy's loan terms?

Use the present value of an annuity due to approach this problem (because the first
payment is today).

PV = $10,000

CF = $2,000

N=6

PV annuity due = CF (PV annuity factor for N=6, i=?)(1 + i)

$10,000 = $2,000 (PV annuity factor for N=6, i=?)(1 + i)

5 = (PV annuity factor for N=6, i=?)(1 + i)

Through trial error using the tables for N=6 such that the factor multiplied by 1+ i is
equal to 5,

i = 8%

precise answer for i= 7.9308%

EAR = (1 + 0.079308)12 - 1 = 149.89%

Want an easier way to do this problem? OK, if TW lends you $10,000 and you repay
$2,000 immediatly, you are really only borrowing $10,000 - 2,000 = $8,000. Therefore,
you can use the ordinary annuity approach, modifying the PV and N:

PV = $8,000

CF = $2,000

N=5
 Solve for i for an ordinary annuity:

PV = CF (PV annuity factor for N=5, i = ?)

$8,000 = $2,000 (PV annuity factor for N=5, i = ?)

4.000 = PV annuity factor

Using the tables, i = 8% (factor is 3.9927)

Using a calculator, i = 7.9308%

Perpetuity

Example:
Alan wants to retire and receive $3,000 a month. He wants to pass this monthly
payment to future generations after his death. He can earn an interest of 8%
compounded annually. How much will he need to set aside to achieve his perpetuity
goal?

Solution: R = $3,000

i = 0.08/12 or 0.00667

Substituting these values in the above formula, we get

$3000
A ∞ = ———
0.00667

= $449,775

If he wanted the payments to start today, we must increase the size of the funds to
handle the first payment. This is achieved by depositing $452,775 which provides the
immediate payment of $3,000 and leaves $449,775 in the fund to provide the future
$3,000 payments.
1. A 5-year ordinary annuity has a present value of $1,000. If the interest rate is 8
percent, the amount of each annuity payment is closest to which of the following?
A. $250.44
B. $231.91
C. $181.62
D. $184.08
E. $170.44

2. An 8-year annuity due has a present value of $1,000. If the interest rate is 5
percent, the amount of each annuity payment is closest to which of the following?
A. $154.73
B. $147.36
C. $109.39
D. $104.72
E. $ 99.74

3. A 5-year ordinary annuity has a future value of $1,000. If the interest rate is 8
percent, the amount of each annuity payment is closest to which of the following?
A. $250.44
B. $231.91
C. $184.08
D. $181.62
E. $170.44

4. An 8-year annuity due has a future value of $1,000. If the interest rate is 5
percent, the amount of each annuity payment is closest to which of the following?
A. $104.72
B. $109.39
C. $147.36
D. $154.73
E. $ 99.74

5. Which of the following statements is TRUE? (Assume that the yearly cash flows
are identical for both annuities and that the common interest rate is greater than zero.)
A. The present value of an annuity due is greater than the present value of
an ordinary
 annuity.
B. The present value of an ordinary annuity is greater than the present value of
an annuity
due.
C. The future value of an ordinary annuity is greater than the future value of
an annuity
due.
D. Both B and C are correct.

6. A 5-year ordinary annuity has periodic cash flows of $100 each year. If the
interest rate is 8 percent, the present value of this annuity is closest to which of the
following?
A. $331.20
B. $399.30
C. $431.24
D. $486.65
E. $586.70

7. A 5-year annuity due has periodic cash flows of $100 each year. If the interest
rate is 8 percent, the future value of this annuity is closest to which of the following
equations?
A. ($100)(FVIFA at 8% for 5 periods)
B. ($100)(FVIFA at 8% for 4 periods)(1.08)
C. ($100)(FVIFA at 8% for 5 periods)(1.08)
D. ($100)(FVIFA at 8% for 5 periods) + $100
E. ($100)(FVIFA at 8% for 4 periods) + $100

8. A 5-year annuity due has periodic cash flows of $100 each year. If the interest
rate is 8 percent, the present value of this annuity is closest to which of the following
equations?
A. ($100)(PVIFA at 8% for 4 periods) + $100
B. ($100)(PVIFA at 8% for 4 periods)(1.08)
C. ($100)(PVIFA at 8% for 5 periods)(1.08)
D. ($100)(PVIFA at 8% for 6 periods) - $100
E. Both A and C
9. Study the time line and accompanying 5-period cash-flow pattern below.
0 1 2 3 4 5 6 Time line
|--------|--------|--------|--------|--------|--------|
$10 $10 $10 $10 $10 Cash flows
¦ ¦
A B
The present value of the 5-period annuity shown above as of Point A is the present
value of a 5-period ______________ , whereas the future value of the same annuity as
of Point B is the future value of a 5-period ______________ .
A. ordinary annuity; ordinary annuity.
B. ordinary annuity; annuity due.
C. annuity due; annuity due.
D. annuity due; ordinary annuity.

10.Study the time line and accompanying 5-period cash-flow pattern below.
0 1 2 3 4 5 6 Time line
|--------|--------|--------|--------|--------|--------|
$10 $10 $10 $10 $10 ¦ Cash flows
¦ ¦
A B
The present value of the 5-period annuity shown above as of Point A is the present
value of a 5-period ______________ , whereas the future value of the same annuity as
of Point B is the future value of a 5-period ______________ .
A. ordinary annuity; ordinary annuity.
B. ordinary annuity; annuity due.
C. annuity due; annuity due.
D. annuity due; ordinary annuity.