Department of Business and Economics Western University
Annuities
CHAPTER
5
ESSENTIAL NOTES
DEFINITIONS USED
1 Annuity
An annuity is a series of payments (usually equal) made at certain equal
intervals of time.
2 Examples of Annuity
Rental, insurance premium, installment payments, lease, housing loan
payments.
3 Payment Interval
It refers to time interval between the first payment and another.
4 Term of Annuity
The term of annuity, indicates the time between the first payment
interval and the end of last payment interval.
5 Cost of Annuity
The cost of annuity is the present value of an annuity at the beginning
of the term.
They separated an annuity into two types:
6 Simple Annuity or Annuity Certain
A simple annuity is annuity in which payment interval and interest
period coincide.
It refers to the term which clearly specifics the dates of the first and the
last payments. The dates are fixed.
7 General Annuity or Contingent Annuity
A general annuity is annuity in which payment interval and interest do
not coincide.
If the term of an annuity is not certain or specified, the annuity is a
contingent annuity. The payment of life insurance premium ceases,
after the death of the insured.
Page 1 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
Notation Used
R = Regular payment per payment interval
i = Rate of interest
PV = Present Value
FV = Accumulated amount of an annuity
n = Number of payment
Simple Annuity or Annuity Certain
a- Ordinary Annuity
Payments made at the ends of payment intervals.
First payment starts here Last payment ends here
R R R R R R R R
0 1 2 3 4 5 10 11 12
PV FV
- Present Value of Ordinary annuity
Formula for Present Value
[1 - (1 + i) –n]
PV = R --------------------
i
WORKED EXAMPLES
QUESTION 1
Find the cost of annuity of $200 per year for 6 years if money is
worth 7.5% per annum and the first payment starts at the end of
the first year.
Page 2 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
SOLUTION
PV = cost of annuity or Present Value R = $200
i = 7.5% n=6
$200 $200 $200 $200 $200 $200
0 1 2 3 4 5 6
1 - (1 + i) -n
PV = R -----------------
i
$200 [1 - (1 + 0.075) -6]
= -------------------------------
0.075
= $938.77
QUESTION 2
Find the present value of an annuity of $300 per quarter for 8
years, 9 months, if money is worth 12% per annum compounded
quarterly and the first payment starts at the end of the first
quarter.
SOLUTION
PV = Present Value R = $300 per payment
i = 12% / 4 = 3% per quarter n = (8 x 4) + 9 / 3 = 35
$300 $300 $300 $300
0 1 2 34 35
1 - (1 + i) -n
PV = R -----------------
i
$300 [1 - (1 + 0.03) -35]
= -------------------------------
0.03
= $6,446.17
Page 3 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
- The Accumulated amount of an Ordinary annuity
Formula for Accumulated amount
[(1 + i) n – 1]
FV = R ------------------
i
WORKED EXAMPLES
QUESTION 3
Find the accumulated amount of an annuity of $500 per month
for 25 moths if money is worth 4% per month and the first
payment starts at the end of first month.
SOLUTION
S = accumulated amount R = $500 per month
i = 4% per month n = 25
$500 $500 $500 $500
0 1 2 24 25
R [(1 + i) –n – 1]
S = ------------------------
i
$500 [(1+0.04) 25 – 1]
= ------------------------------
0.04
= $20,822.95
Page 4 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
QUESTION 4
A man deposits $150 in his bank account at the end of each
month for five year pays interest at 15% per annum compounded
monthly, find the total amount of the deposit at the end of five
years.
SOLUTION
S = Total amount R = $150 per month
i = 15% / 12 = 1.25% per month n = 5 x 12 = 60
$150 $150 $150 $150
0 1 2 59 60
R [(1 + i) –n – 1]
S = ------------------------
i
$150 [(1+0.0125) 60 – 1]
= ------------------------------
0.0125
= $13,286.18
b- Annuity Due
Payment made at the start of payment intervals.
The first payment starts at the beginning of the first interest period
and last payment at the beginning of last payment period but the
term of annuity ends at the end of the last interest period.
First payment starts here Last payment ends here
R R R R R R R R
0 1 2 3 4 5 10 11 12
n
PV FV
The periodic payment is made at the beginning of each payment period.
Page 5 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
- Present Value of Annuity Due
Formula for Present Value
[1 - (1 + i) –n+]
PV = R -------------------- (1 + i)
i
WORKED EXAMPLES
QUESTION 5
If the monthly payment for an installment is $20 (paid in
advance), find the annual installments which is equivalent to a
rate of 15% compounded monthly (paid in advance).
SOLUTION
PV = Present Value R = $20
i = 15 / 12 % per month = 1.25% n = 12
$20 $20 $20 $20
0 1 2 11 12
R [1 – (1 + i) –n]
PV = -------------------------- (1+ i)
i
$20 [1 – (1 + 0.125) -12 ]
= ---------------------------------- (1 + 0.125)
0.125
= $224.36
Page 6 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
- The Accumulated amount of an Annuity Due
Formula for Accumulated amount
[(1 + i) n – 1]
FV = R ---------------------- (1 + i)
i
WORKED EXAMPLES
QUESTION 6
A man invested $2,000 at the beginning of each year for ten
years. If the investment earned 10% interest compounded
annually, what would be the total investment at the end of ten
years?
SOLUTION
FV = Total investment R = $2,000 per year
i = 10% p.a n = 10
$2,000 $2,000 $2,000 $2,000
0 1 2 9 10
R [(1 + i) n - 1]
FV = ------------------------ (1+ i)
i
$2,000 [(1 + 0.1) 12 - 1 ]
= ---------------------------------- (1 + 0.1)
0.1
= $35,062.33
QUESTION
Page 7 of 16
7 CHEA Sopheap, MBA
Department of Business and Economics Western University
(a) An accountant bought an annuity of $10,000 per year for 15
years. The first payment started at the beginning of the first
year. Assuming a compound interest of 7% per annum, how
much was paid for the annuity?
(b) Find the accumulated amount of the annuity at the end of 15
years.
SOLUTION
(a) PV = amount paid for the annuity R = $10,000
i = 7% p.a n = 15
R [1 - (1 + i) -n ]
PV = ------------------------- (1+ i)
i
$10,000 [1 - (1 + 0.07) -15]
= ------------------------------------- (1 + 0.07)
0.07
= $97,453.61
(a) FV = accumulated amount R = $10,000
i = 7% p.a n = 15
R [(1 + i) n - 1]
FV = ------------------------- (1+ i)
i
$10,000 [(1 + 0.07) 15 - 1]
= ------------------------------------- (1 + 0.07)
0.07
= $268,880.54
$10,000 $10,000 $10,000 $10,000
0 1 2 14 15
c- PERPETUITIES
Page 8 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
1- When the payments of an annuity is at infinity, the payments continue
into the future without an end, the annuity is termed perpetuity.
2- Since there is no end to the term of an annuity, the accumulated amount
of perpetuity is not practical to calculate.
3- The present value of a perpetuity PV, is given as follows:
R
PV = --------
i
WORKED EXAMPLES
QUESTION 8
Calculated the present value or the discounted value of an
ordinary simple perpetuity of $600 a month at 101/2%
compounded monthly.
SOLUTION
PV = Present Value R = $600 per month
i = 101/2 / 12 % = 0.875% per month
R
PV = --------
i
$600
= ----------
0.1
= $6,857.14
QUESTION 9
Page 9 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
A very philanthropist decides to establish an Educational
Research Fund is able to contribute $4,500 annually. Calculate
the amount of money needed to establish such a fund if the fund
earns interest at 12% per annum and the first payment starts at
(a) the end of the first year,
(b) the beginning of the first year,
(c) 3 years from now.
SOLUTION
PV = Present Value R = $4,500
i = 12% p.a
R $4,500
(a) PV = -------- = -----------
i 0.12
= $37,500
R $4,500
(b) PV = -------- (1 + i) = ----------- (1 + 0.12)
i 0.12
= $42,000
R
(c) PV = -------- (1 + i) (1 + i) -n where n = 3
i
$4,500
= ----------- (1 + 0.12) (1 + 0.12) -3
0.12
= $29,894.77
QUESTION 10
A man invested a sum of $100,000 which earns interest at 15%
compounded quarterly. If quarterly income is needed for his
children’s education indefinitely. Calculate the sum of the
quarterly income if the first income starts
(a) at the beginning at the first quarterly
Page 10 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
(b) at the end of first quarterly
(c) 2 years from now
SOLUTION
PV = $100,000 R = quarterly income
i = 15 / 4 % = 3.75% per quarter
R
(a) PV = -------- = (1 + i)
i
PV . i
R = ----------
1+i
$100,000 x 0.0375
= --------------------------
1 + 0.0375
= $3,614.46
R
(b) PV = --------
i
R = PV . i
= $100,000 x 0.0375
= $3,750
R
(c) PV = -------- (1 + i) (1 + i) -n
i
R (1 + i)
i.e PV = ---------------
i (1 + i) n
A (1 + i) n i
R = ----------------------
(1 + i)
$100,000 (1 + 0.0375) 8 (0.0375)
= -------------------------------------------
Page 11 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
(1 + 0.0375)
= $4,852.30
QUESTION 11
On 1 March 1985, a scholarship fund of $1,000,000 was
established and in order to ensure the payment of $50,000 at the
end year indefinitely, the fund of $1,000,000 was invested at a
certain rate of compound interest. Find the rate of compound
interest earned on the fund.
SOLUTION
PV = $1,000,000 R = $50,000 per year
i = rate of interest per year
R
Since PV = ------
i
R
i = -------
PV
50,000
= -----------------
1,000,000
= 0.05 = 5%
General Annuity or Contingent Annuity
A general annuity is an annuity in which the payment period or interval is
different from the interest period (frequency of compounding).
Amortization of the principal and interest can be made by six methods :
Page 12 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
1- Balloon Amortization
QUESTION 12
Loan amount 100,000
Yearly interest rate 20%
Repayment Yearly
Duration 5 years
Loan open 01-01-2000
Amortization Balloon
No Date Outstanding Interest Paid Principal Paid Annuity
0 - 100,000.00 0.00 0.00 0.00
1 01-01-01 100,000.00 20,000.00 0.00 20,000.00
2 01-01-02 100,000.00 20,000.00 0.00 20,000.00
3 01-01-03 100,000.00 20,000.00 0.00 20,000.00
4 01-01-04 100,000.00 20,000.00 0.00 20,000.00
5 01-01-05 0.00 20,000.00 100,000.00 120,000.00
2- Declining Amortization
QUESTION 13
Loan amount 100,000
Yearly interest rate 20%
Repayment Yearly
Duration 5 years
Loan open 01-01-2000
Amortization Declining
No Date Outstanding Interest Paid Principal Paid Annuity
0 - $100,000.00 0.00 0.00 0.00
1 01-01-01 $80,000.00 $20,000.00 $20,000.00 $40,000.00
2 01-01-02 $60,000.00 $16,000.00 $20,000.00 $36,000.00
3 01-01-03 $40,000.00 $12,000.00 $20,000.00 $32,000.00
4 01-01-04 $20,000.00 $8,000.00 $20,000.00 $28,000.00
5 01-01-05 $0.00 $4,000.00 $20,000.00 $24,000.00
3- Flat Amortization
QUESTION 14
Page 13 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
Loan amount 100,000
Yearly interest rate 20%
Repayment Yearly
Duration 5 years
Loan open 01-01-2000
Amortization Flat
No Date Outstanding Interest Paid Principal Paid Annuity
0 - 100,000.00 0.00 0.00 0.00
1 01-01-01 80,000.00 20,000.00 20, 000.00 40,000.00
2 01-01-02 60,000.00 20,000.00 20,000.00 40,000.00
3 01-01-03 40,000.00 20,000.00 20,000.00 40,000.00
4 01-01-04 20,000.00 20,000.00 20,000.00 40,000.00
5 01-01-05 0.00 20,000.00 20,000.00 40,000.00
4- Constant Amortization or International Standard Flat.
QUESTION 15
Loan amount 100,000
Yearly interest rate 20%
Repayment Yearly
Duration 5 years
Loan open 01-01-2000
Amortization Constant
No Date Outstanding Interest Paid Principal Paid Annuity
0 - $100,000.00 0.00 0.00 0.00
1 01-01-01 $86,562.03 $20,000.00 $13,437.97 $33,437.97
2 01-01-02 $70,436.47 $17,312.41 $16,125.56 $33,437.97
3 01-01-03 $51,085.79 $14,087.29 $19,350.68 $33,437.97
4 01-02-04 $27,864.98 $10,217.16 $23,220.81 $33,437.97
5 01-01-05 $0.00 $5,573.00 $27,864.98 $33,437.98
5- Progressive geometry Annuity
QUESTION 16
Page 14 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
Loan amount 100,000
Yearly interest rate 20%
Repayment Yearly
Duration 5 years
Loan open 01-01-2000
Amortization Progressive geometry Annuity
i = Interest Rate
r = Increase Rate
A = Total Payment
K = Principle
K (i r )
A1 A2 A1(1 r ) An A1(1 r ) n 1
1 r n
1 ( )
1 i A2 = A1(1+ r)1
A3 = A1(1+ r)2
-
-
An = A1(1+r)n-1
No Date Outstanding Interest Paid Principal Paid Annuity
0 - $100,000.00 0.00 0.00 0.00
1 01-01-01 $89,204.94 $20,000.00 $10,795.06 $30,795.06
2 01-01-02 $74,711.11 $17,840.99 $14,493.83 $32,334.82
3 01-01-03 $55,701.77 $14,942.22 $19,009.34 $33,951.56
4 01-01-04 $31,192.99 $11,140.35 $24,508.78 $35,649.13
5 01-01-05 $0.00 $6,238.60 $31,192.99 $37,431.59
6- Differed Annuity
QUESTION 17
Loan amount 1,500
Yearly interest rate 24%
Repayment Monthly
Duration 12 years
Loan open 22-08-2002
Amortization Differed Annuity
Grace period 3 months
No Date Outstanding Interest Paid Principal Paid Annuity
0 22-08-2002 1,500.00 - - -
1 22-09-2002 1,530.00 30.00 - -
2 22-10-2002 1,560.60 30.60 - -
3 22-11-2002 1,591.81 31.21 - -
Page 15 of 16 CHEA Sopheap, MBA
Department of Business and Economics Western University
4 22-12-2002 1,473.13 31.84 118.68 150.52
5 22-01-2003 1,352.07 29.46 121.06 150.52
6 22-02-2003 1,228.59 27.04 123.48 150.52
7 22-03-2003 1,102.64 24.57 125.95 150.52
8 22-04-2003 974.17 22.05 128.47 150.52
9 22-05-2003 843.13 19.48 131.04 150.52
10 22-06-2003 709.47 16.86 133.66 150.52
11 22-07-2003 573.08 14.19 136.33 150.52
12 22-08-2003 434.08 11.46 139.06 150.52
13 22-09-2003 292.24 8.68 141.84 150.52
14 22-10-2003 147.57 5.84 144.68 150.52
15 22-11-2003 0.00 2.95 147.57 150.52
Total 306.24 1,500 -
ssssssssssssssssssss
Page 16 of 16 CHEA Sopheap, MBA
