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An annuity is a series of nominally equal payments equally spaced in time Annuities are very common:
Rent Mortgage payments Car payment Pension income
1 i
! 1 i
1 i
1 i
Pmt t Pmt 1 Pmt 2
t 1 2 t !1
Pmt N
N
. . 110 110
100
2
100 . 110
3
100 . 110
4
100 . 110
5
! 379.08
100 0 1
100 2
100 3
100 4
100 5
1 i
Pmt t
t !1
1 1 N 1 i ! Pmt i
This equation works for all regular annuities, regardless of the number of payments
Pmt 1 i
t t !1
Nt
! Pmt 1 1 i
N 1
Pmt 2 1 i
N 2
Pmt N
100 0 1
100 2
100 3
100 4
100 5
= 610.51 at year 5
Pmt 1 i
t t !1
Nt
1 i N 1 ! Pmt i
This equation works for all regular annuities, regardless of the number of payments
The term within brackets is the compound value factor for an annuity of Re 1, which we shall refer as CVFA.
n
= v CVFA n, i
Example
Suppose that a firm deposits Rs 5,000 at the end of each year for four years at 6 per cent rate of interest. How much would this annuity accumulate at the end of the fourth year? We first find CVFA which is 4.3746. If we multiply 4.375 by Rs 5,000, we obtain a compound value of Rs 21,875:
F4 ! 5,000(CVFA 4, 0.06 ) ! 5,000 v 4.3746 ! Rs 21,873
Sinking Fund
Sinking fund is a fund, which is created out of fixed payments each period to accumulate to a future sum after a specified period. For example, companies generally create sinking funds to retire bonds (debentures) on maturity. The factor used to calculate the annuity for a given future sum is called the sinking fund factor (SFF). i A = Fn (1 i )n 1
The reciprocal of the present value annuity factor is called the capital recovery factor (CRF).
A= C Fn,i
Annuities Due
Thus far, the annuities that we have looked at begin their payments at the end of period 1; these are referred to as regular/ordinary annuities A annuity due is the same as a regular annuity, except that its cash flows occur at the beginning of the period rather than at the end
100 5-period Annuity Due 5-period Regular Annuity 0 100 100 1 100 100 2 100 100 3 100 100 4
100 5
1 1 N 1 1 i Pmt ! Pmt i
PVAD
Note that this is higher than the PV of the, otherwise equivalent, regular annuity
Pmt 0
Pmt 1
FVAD
Note that this is higher than the future value of the, otherwise equivalent, regular annuity
Deferred Annuities
A deferred annuity is the same as any other annuity, except that its payments do not begin until some later period The timeline shows a five-period deferred annuity
100 0 1 2 3 100 4 100 5 100 6 100 7
PV of a Deferred Annuity
We can find the present value of a deferred annuity in the same way as any other annuity, with an extra step required Before we can do this however, there is an important rule to understand: When using the PVA equation, the resulting PV is always one period before the first payment occurs
Step 1:
Step 2:
PV0 !
379.08 . 110
2
! 313.29
FV of a Deferred Annuity
The future value of a deferred annuity is calculated in exactly the same way as any other annuity There are no extra steps at all
200
2
300
3 4 5
PV !
100
1
1.07 1.07
200
2
300
1.07
! 513.04
500
2
700
3
1
Non-annual Compounding
So far we have assumed that the time period is equal to a year However, there is no reason that a time period cant be any other length of time We could assume that interest is earned semiannually, quarterly, monthly, daily, or any other length of time The only change that must be made is to make sure that the rate of interest is adjusted to the period length
! 1,104.71
365
! 1,10516 .
Multi-Period Compounding
If compounding is done more than once a year, the actual annualised rate of interest would be higher than the nominal interest rate and it is called the effective interest rate.
i EIR = 1 m
nv m
Continuous Compounding
There is no reason why we need to stop increasing the compounding frequency at daily We could compound every hour, minute, or second We can also compound every instant (i.e., continuously): rt
F ! Pe
Here, F is the future value, P is the present value, r is the annual rate of interest, t is the total number of years, and e is a constant equal to about 2.718
F ! 1,000 e
0 .10 1
! 1,105.17
This is even better than daily compounding The basic rule of compounding is: The more frequently interest is compounded, the higher the future value
F ! 1,000e
0 .10 5
! 1,648.72
Continuous Compounding
The continuous compounding function takes the form of the following formula:
Fn ! v eiv n ! v ex