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Chapter 3: Future value of an annuity 1

Chapter 3: Future value of an annuity.

Learning Objectives:

1. Understanding the concept of a geometric series, including the first

term, common ratio, and the number of terms involved in the series.

2. Learning to calculate the future value of an ordinary annuity,

considering factors such as payment amounts, interest rates, periods
per year, and the time frame in years.

3. Distinguishing between annuity-due and ordinary annuity and

understanding how their payment timings impact future value
calculations.

4. Applying formulas for calculating the future value of annuities due and
ordinary annuities due, and understanding the practical implications of
these calculations in financial contexts.

5. Exploring the concept of a sinking fund and understanding how to

calculate the required periodic deposits to accumulate a specific
amount over a given period.

6. Gaining practical knowledge through examples and exercises that

illustrate the application of formulas and concepts related to ordinary
annuities and their future value in real-life scenarios.
 .Chapter 3: Future value of an annuity 2

Ordinary Annuity
An ordinary annuity involves a sequence of regular payments made at equal
intervals of time into an account. This section focuses on developing a
formula to determine the value of such annuities. In simpler terms, when a
fixed amount is deposited or paid at regular intervals, it constitutes an annuity,
forming the basis of our discussion.

To establish a formula for calculating the value of an annuity, we'll draw upon
the formula for the sum of a geometric series. A geometric series takes the
form:
2 3 n
a+ ax +a x + a x + …+a x (1)

In a geometric series, each subsequent term is derived by multiplying the

preceding term by a constant, known as the common ratio. Understanding a
geometric series requires knowledge of its first term, common ratio, and the
number of terms.

In Equation (1), the first term of the series is denoted as a, the common ratio
as x, and the number of terms as n+1. Several examples of geometric series
illustrate this concept:

3 + 6 + 12 + 24 + 48

This series has a=3 and x=2.

2 + 6 + 18 + 54 + 162

Here, a=2 and x=3.

37 + 3.7 + 0.37 + 0.037 + 0.0037

This series involves a=35 and x=0.1.

In previous algebra classes, you may have derived a formula for the sum of a
geometric series, often using r to symbolize the ratio. However, in this context,
we use x because r is already employed to represent the interest rate. The
formula for the sum of the terms in a geometric series with first term a,
common ratio x, and last term ax n is given by:
 .Chapter 3: Future value of an annuity 3

n +1
x −1
a( )
x −1

Example:

Suppose a monthly deposit of $500 is made at the end of each month into an
account that earns 8% interest compounded monthly. What will be the final
amount after five years?

Solution:

A total of 60 deposits are made into this account. The first payment remains in
the account for 59 months, the second for 58 months, the third for 57 months,
and so forth.

The accumulation of the first payment of $500 is given by

$500(1+0.08 /12)59

The second payment of $500 accumulates to $500(1+0.08 /12)58

The third payment accumulates to $500(1+0.08 /12)57

The fourth payment accumulates to $500(1+0.08 /12)56

And so on...

The penultimate (59th) payment accumulates to $500(1+0.08 /12)1

The final payment is withdrawn at the same time it is made and does not
accrue any interest.

To calculate the total amount in five years, we need to sum up the

accumulated values of these sixty payments.

In other words, we need to find the sum of the following series.

$500(1+0.08 /12)59 + $500(1+0.08 /12)58 + $500(1+0.08 /12)57 + … + $500

Reversed, this series is represented as

$500 + $500(1 + 0.08/12) + $500(1+0.08 /12)2 + …+ $500(1+0.08 /12)59

 .Chapter 3: Future value of an annuity 4

This forms a geometric series with a = $500, r = (1 + 0.08/12), and n = 59. The sum
is calculated as

( ) −1]
60
0.08
$ 500 [ 1+
Sum = 12 = $500(73.47686) = $36,738.43
0.08 /12

When payments are made at the end of each period, as opposed to the
beginning, it is referred to as an ordinary annuity.

Future Value.
Understanding the concept of Future Value (FV) in financial contexts is crucial
for individuals and investors alike. FV represents the projected worth of an
investment or a series of payments at a specified point in the future,
accounting for factors such as interest rates, payment amounts, and the
duration of the investment. In the realm of annuities, which involve a series of
fixed payments at regular intervals, distinguishing between annuity-due and
ordinary annuity is essential, as their payment timings significantly impact FV
calculations.

Key Points:

 Calculating FV involves considering the payment amount, interest rate,

number of periods per year, and the time frame in years.
 Annuity-due and ordinary annuity differ in the timing of their first and
last payments, leading to distinct future values.
 Specific formulas are employed for annuities due and ordinary
annuities due to these timing variations.

Key Terms:

 Annuity-due: An investment featuring fixed payments paid at the

beginning of each period.
 Ordinary annuity: An investment with fixed payments occurring at the
end of each period.

The future value of an annuity is determined by the sum of its individual future
values. While manually computing FV for each payment is possible, it
becomes impractical with an increasing number of payments.
 .Chapter 3: Future value of an annuity 5

Explicitly defining the annuity's inception and termination is critical for

accurate manual FV calculations. In annuity-due, payments commence at the
annuity's inception, with the last payment occurring one period before
termination. Conversely, in an ordinary annuity, the first payment is one period
after the start, with the last payment at the termination. Distinct FV
calculations apply to annuities due and ordinary annuities based on when the
first and last payments occur.

Formulas simplify FV calculations for both annuities. Knowledge of the

payment amount (m or pmt or p), interest rate (r or i), periods per year (n),
and time in years (t) is fundamental.

Formulas:

The formula for an ordinary annuity is:

A=m¿ ¿

where m is the payment amount, r is the interest rate, n is the periods per
year, and t is the time in years.

Example:

John makes quarterly deposits of $300 into her savings account. With the
account earning 5.75% interest compounded quarterly, the total amount after
4 years can be determined using the formula provided.

The future value of this annuity is calculated as:

A=300 ¿ ¿

Therefore, if John consistently deposits $300 into a savings account with a

5.75% quarterly compounding interest rate for a period of 4 years, she will
accumulate $5,353.89 by the end of that period.
 .Chapter 3: Future value of an annuity 6

Sinking Fund

A sinking fund is established when a business regularly deposits money into

an account to accumulate funds for a future equipment purchase. The
calculation of the sinking fund deposit involves employing the same method
as described in the preceding problem.

Example:

A business is aiming to accumulate $450,000 in five years. To achieve this, a

quarterly deposit into a sinking fund earning 9% compounded quarterly is
required. Let's denote the quarterly deposit as m.

The relationship to achieve a future value of $450,000 after five years is

expressed by the equation:

m ¿ ¿ = $450,000

Solving m: m (24.9115) = 450,000;

m= $18,063.93

In contrast, the formula for an annuity-due is:

A=m¿ ¿

Given knowledge of m, r, n, and t, these formulas facilitate the determination

of the future value (FV) of an annuity.

Example:

If a monthly deposit of $500 is made into an account that compounds interest

at a rate of 8%, the final amount after five years can be determined by
considering 60 deposits. Each deposit remains in the account for a
decreasing number of months (60 months for the first deposit, 59 months for
the second, and so on).

The accumulation of each payment is calculated using the formula

n
$ 500(1+0.08 /12) , where n represents the number of months the payment
stays in the account.
 .Chapter 3: Future value of an annuity 7

To find the total amount after five years, the sum of this series is computed:

$500(1+0.08 /12)60 + $500(1+0.08 /12)59 + $500(1+0.08 /12)58 + … +

$500(1+0.08/12)

Rearranging the series, we have:

$500(1+0.08/12) + $500(1+0.08 /12)2 + … + $500(1+0.08 /12)60

By adding $500 to this series, and then subtracting $500 later, the overall value
remains unchanged:

$500 + $500(1+0.08/12) + $500(1+0.08 /12)2 + … + $500(1+0.08 /12)60 - $500

Considering this as a geometric series with a = $500, r = (1 + 0.08/12), and n = 60

(except for the last term), the sum is calculated as:

( ) −1] −$ 500
61
0.08
$ 500[ 1+
12
A=
0.08/12

A = $36983.35.

Exercises.
Exercise 1.
 .Chapter 3: Future value of an annuity 8

What would be the future value, ten years from now, of an annuity making 10
annual payments of Rs. 5,000 each, with a quarterly compounded interest
rate of 7% per year?

Solution:

( )
10∗4
0.07
1+ −1
4
5 , 000[ ]
0.07
4

Rs. 286,170.67

Exercise 2.

Consider initiating a savings plan where you contribute Rs. 1,000 at the
commencement of each year into an account yielding an 8% annual interest
rate. If you make the initial deposit today and three more subsequent
deposits, what will be the total accumulation after four years?

Solution:

Rs. 4,863.60

Exercise 3.
 .Chapter 3: Future value of an annuity 9

If an annuity consists of 25 annual payments of Rs. 1,000, with the initial

payment made today, what would be the future value 25 years from now,
given an interest rate of 9%?

Solution:

Rs. 92,323.98

Exercise 4.

If you invest Rs. 100 in the market at the end of each year for 20 years at a
rate of 10%,

a) what will be the total amount accumulated?

b) How would the outcome differ if you invested Rs. 100 at the beginning of
each year instead?

Solution:

a)

Rs. 5,727.50

b)

Rs. 6,300.25

Exercise 5.
 .Chapter 3: Future value of an annuity 10

You opt to work for the next 20 years before considering early retirement. For
your post-retirement period, you intend to contribute Rs. 1,000 monthly to a
retirement account with a 12% annual interest rate compounded monthly. The
initial deposit will be made one month from today. What would be the balance
in your account at the end of the 20-year period?

Solution:

Rs. 572,749.99