Economic Study

Methods
Lecture 9

Dr. Lory Liza D. Bulay-og, PECE

Professor 1
Economic Study Methods
A. Ordinary Annuity
B. Annuity Due
C. Perpetuity
D. Differed Annuity
E. Annuity with Continuous Compounding of
Interest
Learning Objectives

1. Distinguish between an ordinary annuity

and an annuity due, and calculate present
and future values of each.
2. Calculate the present value of a level
perpetuity and a growing perpetuity.
3. Calculate the present and future value of
complex cash flow streams.
ANNUITIES AND AMORTIZATION
An annuity consists of a series of equal payments made at equal intervals of time. There are five types
of annuity- ordinary annuity, deferred annuity, annuity due, perpetuity and annuity with Continuous
Compounding of Interest.
1. ORDINARY ANNUITY
An ordinary annuity is the one where the equal payments are made at the end of each payment period
starting from the first period.
2. DEFERRED ANNUITY
Deferred annuity is also an ordinary annuity but the payment of the first amount is deferred a certain number
of periods after the first.
3. ANNUITY DUE
An annuity due is one where the payments are made at the start of each period, beginning from the first
period.
4. PERPETUITY
A type of annuity where the payment period extend forever or in which the periodic payment continues
indefinitely
5. ANNUITY WITH CONTINUOUS COMPOUNDING OF INTEREST
ORDINARY ANNUITY
Formula:

1+𝑖 𝑛−1
𝐹𝑉 = 𝑃𝑀𝑇 → 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑜𝑟 FV of annuity at the end of nth period
𝑖

−𝑛
1− 1+𝑖
𝑃𝑉 = 𝑃𝑀𝑇 → 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑜𝑟 PV of annuity
𝑖

Where:
PMT= payments or amortization or annuity payment deposited or received at the end of each period
n= number of periods for which annuity will last
i = interest rate per period
 Examples
1 How much money will you accumulate by the end of year 10 if you deposit $3,000
each for the next ten years in a savings account that earns 5% per year?
Given:
n=10 years
i = 5% = 0.05
PMT =$3,000
Required:
FV=?
Solution:
1+𝑖 𝑛−1
𝐹𝑉 = 𝑃𝑀𝑇
𝑖
1 + 0.05 10 − 1
𝐹𝑉 = 3000
0.05
𝐹𝑉 = $37,733.70
The Future Value of an Ordinary Annuity
• Using an Excel Spreadsheet

• FV of Annuity
– = FV(rate, nper,pmt, pv)
– =FV(.05,10,-3000,0)
– = $37,733.68
Solving for PMT in an Ordinary Annuity
• Instead of figuring out how much money
you will accumulate (i.e. FV), you may like
to know how much you need to save each
period (i.e. PMT) in order to accumulate a
certain amount at the end of n years.
• In this case, we know the values of n, i,
and FVn in the equation and we need to
determine the value of PMT.
Solving for PMT in an Ordinary Annuity
2. Suppose you would like to have $25,000
saved 6 years from now to pay towards
your down payment on a new house. If you
are going to make equal annual end-of-year
payments to an investment account that
pays 7 percent, how big do these annual
payments need to be?
Solving for PMT in an Ordinary Annuity
(cont.)
1+𝑖 𝑛−1
𝐹𝑉 = 𝑃𝑀𝑇
𝑖

• Here we know, FVn =$25,000; n = 6; and

i=7% and we need to determine PMT.
Solving for Interest Rate in an Ordinary
Annuity
3. In 20 years, you are hoping to have
saved $100,000 towards your child’s college
education. If you are able to save $2,500 at
the end of each year for the next 20 years,
what rate of return must you earn on your
investments in order to achieve your goal?
 Solving for Interest Rate in an Ordinary
Annuity (cont.)
• Using a Financial Calculator
• Enter
– N = 20
– PMT = -$2,500
– FV = $100,000
– PV = $0
– i = 6.77
Solving for the Number of Periods in an
Ordinary Annuity
• You may want to calculate the number of
periods it will take for an annuity to reach
a certain future value, given interest rate.

• It is easier to solve for number of periods

using financial calculator or excel, rather
than mathematical formula.
Solving for the Number of Periods in an
Ordinary Annuity (cont.)
4. Suppose you are investing
$6,000 at the end of each year in an account
that pays 5%. How long will it take before
the account is worth $50,000?
The Present Value of an Ordinary Annuity
• The present value of an ordinary annuity
measures the value today of a stream of
cash flows occurring in the future.
• For example, we will compute the PV of
ordinary annuity if we wish to answer the
question: what is the value today or lump
sum equivalent of receiving $3,000 every
year for the next 30 years if the interest
rate is 5%?
 The Present Value of an Ordinary
Annuity (cont.)
• Figure 6-2 shows the lump sum equivalent
($2,106.18) of receiving $500 per year for
the next five years at an interest rate of
6%.
The Present Value of an Ordinary
Annuity (cont.)
1− 1+𝑖 −𝑛
𝑃𝑉 = 𝑃𝑀𝑇
𝑖

• PMT = annuity payment deposited or

received at the end of each period.
• i = discount rate (or interest rate) on a
per period basis.
• n = number of periods for which the
annuity will last.
THANKS
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