12-1

Special
12
Annuities

Special

Situations

Chapter 12
McGraw-Hill
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 12-2
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12 Learning Objectives
Annuities

After completing this chapter, you will be able to:

Calculate the

LO 1. Present Value of a perpetuity or

deferred perpetuity

LO 2. Present Value and Future Value

of an annuity whose payment size
grows at a constant rate

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12
Calculation of
Annuities

Perpetuity
or
Deferred
Perpetuity
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12 Ordinary Perpetuities
Annuities

A $100,000 bequest is made to Seneca

A College to establish a
perpetual bursary fund.
perpetuity If the college invests the funds to earn
is an 6% compounded annually,
the maximum amount that can be paid
annuity out on each anniversary
whose of the bequest is

payments $100,000 * 0.06 = $6,000

continue If more than this was to be paid out,
a loss of principal would result.
forever.
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12 Ordinary Perpetuities
Annuities

Present Value of:

Formula PV = PMT / i
If the payment interval Otherwise
equals it is an
the compounding interval, ordinary
the perpetuity is an general
ordinary simple perpetuity annuity

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12 What endowment is required to establish a
Annuities perpetuity with an ongoing cost of $6,000 at
the end of each month if interest is 6.0%
compounded monthly in perpetuity?

Formula PV = PMT / i
= 6000 / (.06/12)
= $1,200,000

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12 What monthly compounded nominal rate of
Annuities return must an endowment of $1 million
earn to fully fund a perpetuity with an ongoing
cost of $4,000 at the end of each month?
Reorganize
to find i
Formula PV = PMT/ i
i = PMT / PV
i = 4000 / 1 000 000
= 0.004
= 0.4% per month
The required nominal rate of return is:
12 * 0.4% = 4.8% compounded monthly
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 12-8
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12 What endowment is required to establish a
Annuities perpetuity with an ongoing cost of
$6,000 at the end of each month if interest is
6.0% compounded annually in perpetuity?

Since this is a general perpetuity, we need to determine c and i2

number of compoundings per year 1 = .0833
C = number of payments per year =
12
i2 = (1+i)c - 1
= (1.06)0.0833-1
= 0.00486755
PV = 6000 / 0.00486755
= $ 1,232,652.83
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12
Annuities

Calculating initial endowment

for a
General Perpetuity

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12 What amount must be placed in a perpetual
Annuities fund today if it earns 4.0% compounded
semi-annually and monthly payments of $700
in perpetuity are to start 1 month from now?

Since this is a general perpetuity, we need to determine c and i2

number of compoundings per year 2 = .1667
C = number of payments per year =
12
i2 = (1+i)c - 1
= (1.02)0.1667-1
= 0.00330589
PV = 700 / 0.00486755
= $ 211,743.26
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 12-11
Special
12 What amount must be placed in a perpetual
Annuities fund today if it earns 4.0% compounded
semi-annually and monthly payments of $700
in perpetuity are to start 1 YEAR from now?

We have already determined the value

at the beginning of the payments
This is the value
PV = $ 211,743.26 11 months from
now
- n
Formula PV = FV(1 + i)

PV = 211743.26 (1 + 0.00330589)-11

= $204,193.83 This is the value

now
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12
Annuities
LO 2.

Constant Growth
Annuities

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12
Constant Growth
Annuities Annuities

Annuities in which the

payments change by
the same percentage
from one payment to another

Let g = rate of growth in payment size

between successive payments

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12
Constant Growth
Annuities Annuities
The following formulae will be used:

(1+ i)n - (1+g)n

Formula FV = PMT [ ]
i-g

Formula PV = PMT [ 1- (1+g)n(1+ i)-n ]

i-g

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12
Constant Growth
Annuities Annuities

You intend to make RRSP contributions on Feb.28

of each year. You plan to contribute $2,000 in the
first year and increase the contribution
by 4% every year thereafter.
a) How much will you have in your RRSP at the time
of your 20th contribution if the plan earns 7.5%
compounded annually?
b) What will be the amount of your
last contribution?
Extract necessary data...
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 12-16
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12 a) How much will you have in your RRSP at the
Annuities time of your 20th contribution if the plan earns
7.5% compounded annually?

PMT = $2000 i = 0.075 n = 20

You intend to make
g = 4% PV = 0 FV = ?
RRSP contributions
on Feb.28 of each
Solve
year. You plan to
contribute $2000 in FV = PMT [
(1+ i) n - (1+g)n

i-g
]
the first year and
increase the
contribution
FV = 2000 [
(1.075) 20 - (1.04)20

0.075 - 0.04
]
by 4% every year
thereafter. Solve
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 12-17
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12
PMT = $2000 i = 0.075 n = 20
Annuities
g = 4% PV = 0 FV = ?

Amount in the
Solve
RRSP at the time
117,527.31
2.0567
4.2479
2.1911 of the 20th
contribution

1.04 20

1.075 20
0.035 2000

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 12-18
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12 (b) What will be the amount
of
Annuities your last contribution?

The final payment will be the

You intend to make Future Value of $2000
RRSP contributions after
on Feb.28 of each
year. You plan to
19 compoundings at 4%
contribute $2000 in
the first year and Formula FV = PV(1 + i)n
increase the
= 2000( 1+ 0.04)19
contribution
by 4% every year = $4,213.70
thereafter.
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12
Constant Growth
Annuities Annuities

How much will it cost to purchase a

25-year ordinary annuity
making semiannual payments
that grow at the rate of 3%
compounded semiannually?
The first payment is $10,000
and the funds used
to purchase the annuity
earn 5% compounded semiannually.

Solution
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Constant Growth
Annuities Annuities
The cost will be the PV of the payments.
How much
will it cost to Extract necessary data...
purchase a 25-year
ordinary annuity PMT = $10000 i = 0.05/2 = 0.025
making semiannual
payments that grow at n = 50 g = 3%/2 = 0.015 PV = ?
the rate of 3%
compounded Solve
semiannually?
The first payment is
$10,000
PV = PMT [ i-g ]
1- (1+ g)n(1+ i)-n

and the funds used

to purchase the
annuity
PV = 10000 [ 1- (1.015) 50(1.025)-50
.025 .015 ]
earn 5% compounded
semiannually. Solve
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12
Annuities
PV = 10000 [
1- (1.015) 50(1.025)-50
.025 .015 ]
How much
will it cost to Cost of the
purchase a 25-year 387,496.12
-0.3875
0.6125
2.1052
0.2909 annuity
ordinary annuity
making semiannual
payments that grow at 1.025 50
the rate of 3%
compounded 1.015
semiannually?
The first payment is 50
$10,000
and the funds used 1
to purchase the
annuity 0.01 10000
earn 5% compounded
semiannually.
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12
Annuities

This completes Chapter 12

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