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Financial Mathematics/ Lecture Notes II

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 Chapter TWO

Annuities and their Application

An annuity is a sequence of equal payment or a sequence of regular payment at

regular intervals. Payments may he made by you to an account which you may use
it taken or by an insurance company on a retirement fund for example.

The time between payment is called the payment interval, and the time which the
money is to be paid is called the term of the annuity.

Annuity Define:

1.All cash flow payment are equal in amount

2.The time between each payment is equal.

Two types of annuities:

1.Orinary annuities(all annuities are ordinary unless otherwise state)

i. Period payment is made of end of each period

ii. Example: Home Mortgage payment or car loan payment.

2.Annuity Due

An annuity due calls for payment at the beginning of each interval:

1
 i .Period payment is made of the beginning of each period.

ii. Example: lease payment.

Ordinary annuity:
The future value can be calculate by using the following formula:

2
Note that the (1cent) difference between $5,525.64 and $5,525.63 is due to
a rounding error in the first calculation.

3
Annuity due: Annuity which payments made at beginning of each
payment interval. The future value can be calculate by using the
following formula:
 R
nt

  1    1
  n  x 1  R 
FVAnnuity Due  Pmt  
R  n
n

 R
FVAnnuity Due  FVAnnuity Order *  1  
 n

Example :

Let's assume (as in Example 1) that you are receiving $1,000 every year for
the next five years, and you invested each payment at 5%. When you are
receiving or paying cash flows for an annuity due, your cash flow schedule
would appear as follows:

4
Example:
Suppose you went to save money for your child's college expenses. Let's suppose
you depots 1000$ at the beginning of each year, for (18) years. At interest rate of
5%. How much is available for your child's when he/she start school.

Solution: r=0.05/1=0.05 , N=n*t=1*18=18

 R
nt

 1    1
 n   x 1  R 
FV Annuity Due  PMT   
R  n 
n

FVAnnuity Due  1000

1  0.05 18
1  x1  0.05
0.05
FVAnnuity Due  1000( 28.132)(1.05)  29539$
Present Value of an Annuity

Business have to plan for the future. Since equipment's break down or
wears out, business owners have to have the money to replace the
equipment. In addition, money might be set aside for retirement benefits
for their employs. Individuals also plan for the future. Some may want to
set aside money now for college expenses for their children, their
retirement, future vacation or future purchases.

5
In order to have finances, a limp some of money can be set aside that will
collect interest, this amount is called the present value.

The Present Value of an Ordinary Annuity is computed by the formula:

Present Value (PV)=PMT * Discount factor

(𝟏−(𝟏+𝒓)−𝑵 )
Discount factor=[ ]
𝒓

(𝟏−(𝟏+𝒓)−𝑵 )
PV=PMT* [ ]
𝒓

Note: The Present Value of an Annuity Due is computed by the formula:

Present Value (PV)=PMT * Discount factor*(1+r)
Or

(𝟏 − (𝟏 + 𝒓)−𝑵 )
𝑷𝑽 = 𝑷𝑴𝑻 ∗ [ ] ∗ (𝟏 + 𝐫)
𝒓
Example:

Bill would like to insert some money so that he can receive a monthly retirement
supplement. How much money must be invest at 9% compounded monthly in order
to receive 500$ at the end of each month for the next 5 years?
Solution:
In this example PMT=500$ , N=5*12=60 , r=0.09/12=0.0075

(𝟏 − (𝟏 + 𝟎. 𝟎𝟎𝟕𝟓)−𝟔𝟎 )
𝑷𝑽 = 𝟓𝟎𝟎 ∗ [ ]
𝟎. 𝟎𝟎𝟕𝟓

𝑷𝑽 = 𝟓𝟎𝟎 ∗ 𝟒𝟖. 𝟏𝟕𝟑𝟑𝟕 = 𝟐𝟒𝟎𝟖𝟔. 𝟔𝟗

6
Example:
Suzan's grandmother left her 10000 $ when she died. She stipulated in
her will that the money be invested in a bank account paying 8% interest
compounded quarterly and paid out in equal installments every 3
months for a period of 10 years. How much will Suzan receive each
quarter?

Solution:

In this example PV=1000 $ , N=10*4=40 , r=0.08/4=0.02

(𝟏 − (𝟏 + 𝟎. 𝟎𝟐)−𝟒𝟎 )
𝟏𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ [ ]
𝟎. 𝟎𝟐

𝟏𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ 𝟐𝟕. 𝟑𝟓𝟓𝟒𝟖

𝟏𝟎𝟎𝟎
𝑷𝑴𝑻 = = 𝟑𝟔𝟓. 𝟓𝟔 $
𝟐𝟕. 𝟑𝟓𝟓𝟒𝟖

Example :
If you can afford to pay 250 $ at the end of each month for the next 5
years 6% compounded monthly, how much do you have today to spend
on an automobile porches?

In this example PMT=250 $ , N=12*5=60 , r=0.06/12=0.005

(𝟏 − (𝟏 + 𝟎. 𝟎𝟎𝟓)−𝟔𝟎
𝑷𝑽 = 𝟐𝟓𝟎 ∗ [ ]
𝟎. 𝟎𝟎𝟓

7
 (𝟏 − 𝟎. 𝟐𝟓𝟖𝟔𝟐𝟕𝟖𝟎𝟒)
𝑷𝑽 = 𝟐𝟓𝟎 ∗ [ ]
𝟎. 𝟎𝟎𝟓
𝑷𝑽 = 𝟐𝟓𝟎 ∗ (𝟎. 𝟕𝟒𝟏𝟑𝟕𝟐)/(𝟎. 𝟎𝟎𝟓)
𝑷𝑽 = 𝟐𝟓𝟎 ∗ 𝟓𝟏. 𝟕𝟐𝟔
𝑷𝑽 = 𝟏𝟐𝟗𝟑𝟏. 𝟑𝟗 $
Example:

If you have 500,000 $ when you retire and you plan to live for 40 year,
and you can earn 8% compounded monthly, how much can you
withdraw each month from your account?
Solution:
In this example PV=500,000 $ , N=12*40=480 , r=0.08/12=0067

(𝟏 − (𝟏 + 𝟎. 𝟎𝟎𝟔𝟕)−𝟒𝟖𝟎
𝟓𝟎𝟎, 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ [ ]
𝟎. 𝟎𝟎𝟔𝟕

𝟓𝟎𝟎, 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ 𝟏𝟒𝟑. 𝟐𝟎

𝑷𝑴𝑻 = 𝟓𝟎𝟎, 𝟎𝟎𝟎/𝟏𝟒𝟑. 𝟐𝟎
𝑷𝑴𝑻 = 𝟑𝟒𝟕𝟔. 𝟓𝟔 $

8
Example:

9
Example:

John makes a new years resolution to put 100 $ into the bank account at
the beginning of each month, beginning January 2016. If the bank pays
6% interest compounded monthly on the last day of each month, Who
much will John have one year later.

Solution:

In this example PMV=100 $ , N=1*12=12 , r=0.06/12=0.005

(𝟏 − (𝟏 + 𝒓)−𝑵 )
𝑷𝑽 = 𝑷𝑴𝑻 ∗ [ ] ∗ (𝟏 + 𝐫)
𝒓

(𝟏 − (𝟏 + 𝟎. 𝟎𝟎𝟓)−𝟏𝟐 )
𝑷𝑽 = 𝟏𝟎𝟎 ∗ [ ] ∗ (𝟏 + 𝟎. 𝟎𝟎𝟓)
𝟎. 𝟎𝟎𝟓

PV=1167.7 $

10
Chapter Three

Sinking Funds

11
The total amount of money in the fund is simply the accumulated value
(S) of an annuity. The pervious payment PMT can be computed from our
pervious formula:

(𝟏 + 𝒓)𝑵 − 𝟏
𝑺 = 𝑷𝑴𝑻 ∗ [ ]
𝒓

Country form needs to preaches a new machine to cap the milk bottles in
10 years. The estimated cost is about 9000 $. Find the Sinking Fund
Payment if the form can get 6% interest quarterly.

Solution:
S=9000 , r=0.06/4=0.015, N=4*10=40

(𝟏 + 𝒓)𝑵 − 𝟏
𝑺 = 𝑷𝑴𝑻 ∗ [ ]
𝒓
(𝟏 + 𝟎. 𝟎𝟏𝟓)𝟒𝟎 − 𝟏
𝟗𝟎𝟎 = 𝑷𝑴𝑻 ∗ [ ]
𝟎. 𝟎𝟏𝟓

PMT=165.84 quarterly.
Example:

A business sets up a sinking fund so that it will be able to pay off bonds it
has issued when they mature. If it deposits $12,000 at the end of each
quarter in an account that earns 5.2% interest, compounded quarterly,
how much will be in the sinking fund after 10 years?
Solution:
The sinking fund is an annuity, with R = 12, 000, r =0 .052/4, and n =
4(10) = 40. The future value is

12
 (𝟏 + 𝒓)𝑵 − 𝟏
𝑺 = 𝑷𝑴𝑻 ∗ [ ]
𝒓
(𝟏+𝟎.𝟎𝟏𝟑)𝟒𝟎 −𝟏
𝑺 = 𝟏𝟐, 𝟎𝟎𝟎 ∗ [ ] =624,396.81$
𝟎.𝟎𝟏𝟑

So there will be about $624,370 in the sinking fund.

Example:

A firm borrows $6 million to build a small factory. The bank requires it

to set up a $200,000 sinking fund to replace the roof after 15 years. If the
firm’s deposits earn 6% interest, compounded annually, find the
payment it should make at the end of each year into the sinking fund.
Solution:
This situation is an annuity with future value S = 200, 000, interest rate
r =0 .06, and N = 15. Solve the future-value formula for PMT:

(𝟏 + 𝒓)𝑵 − 𝟏
𝑺 = 𝑷𝑴𝑻 ∗ [ ]
𝒓

(𝟏 + 𝟎. 𝟎𝟔)𝟏𝟓 − 𝟏
𝟐𝟎𝟎, 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ [ ]
𝟎. 𝟎𝟔
𝟐𝟎𝟎, 𝟎𝟎𝟎
𝑷𝑴𝑻 = [ ] = 𝟖𝟓𝟗𝟐. 𝟓𝟓 $
𝟐𝟑. 𝟐𝟕𝟓𝟗𝟕
So the annual payment is about 8593 $.
Example:

Find the monthly amount payment you make if you want to have
1,000,000 $ in 3o years , assuming 12% annual interest, compounded
monthly.

13
Solution:

(𝟏 + 𝒓)𝑵 − 𝟏
𝑺 = 𝑷𝑴𝑻 ∗ [ ]
𝒓

(𝟏 + 𝟎. 𝟏𝟐/𝟏𝟐)𝟏𝟐∗𝟑𝟎 − 𝟏
𝟏, 𝟎𝟎𝟎, , 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ [ ]
𝟎. 𝟏𝟐/𝟏𝟐
PMT=(1,000,000)/(3494.964)=286.13 $.
Example:

Supposed we deposit 100 $ per month(of the end of each month)into an account
paying 12% interest, compounded monthly, for 2 years. How much would we have
at the end of the 2 years?

Solution:

(𝟏 + 𝒓)𝑵 − 𝟏
𝑭𝑽 = 𝑷𝑴𝑻 ∗ [ ]
𝒓

(𝟏 + 𝟎. 𝟏𝟐/𝟏𝟐)𝟏𝟐∗𝟐 − 𝟏
𝑭𝑽 = 𝟏𝟎𝟎 ∗ [ ]
𝟎. 𝟏𝟐/𝟏𝟐

𝑭𝑽 = 𝟐𝟔𝟗𝟕. 𝟑𝟓 $
Thus, at the end of two years, the account will have 2,697.35 $.
Example:
A business man borrows 15000 $ at 18% payable monthly and makes
monthly desist into a Sinking fund, so that his debt may be paid off at the
end of one year. The Sinking fund earns 9% Compounded monthly.

a)What is the monthly expense of the debt?

b)What is the book value of the debt at the end of 6 month.

14
Solution:

a. The monthly interest on the loan is compute by multiplying the

amount borrowed by the monthly interest rate.

r=0.18/12=0.015

monthly interest=0.015*15,000=225.00 $

Next we compute the amount which mast be deposited into the Sinking
Fund in order to accumulate 15000 $ in one year.

R=0.09/12=0.0075

(𝟏+𝒓)𝑵 −𝟏
𝑭𝑽 = 𝑷𝑴𝑻 ∗ [ ]
𝒓

(𝟏 + 𝟎. 𝟎𝟎𝟕𝟓)𝟏𝟐 − 𝟏
𝟏𝟓, 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ [ ]
𝟎. 𝟎𝟎𝟕𝟓

𝟏𝟓, 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ 𝟏𝟐. 𝟓𝟎𝟕𝟓𝟗

PMT=15,000/12.50759=1,199.27 $

Monthly expense=Interest on loan+ deposit into Sinking fund

Monthly expense=225.00+1,199.27=1,424.27 $.

b)What is the book value of the debt at the end of 6 month.

(𝟏 + 𝒓)𝑵 − 𝟏
𝑺 = 𝑷𝑴𝑻 ∗ [ ]
𝒓

(𝟏 + 𝟎. 𝟎𝟎𝟕𝟓)𝟔 − 𝟏
𝑺 = 𝟏, 𝟏𝟗𝟗. 𝟐𝟕 ∗ [ ]
𝟎. 𝟎𝟎𝟕𝟓

S= 𝟏, 𝟏𝟗𝟗. 𝟐𝟕 ∗ 𝟔. 𝟏𝟏𝟑𝟔𝟑 = 𝟕𝟑𝟑𝟏. 𝟖𝟗

15
Book Value=Original amount borrowed-amount in the Sinking Fund
15000-7331.89=7668.11 $.

Amortization

Congratulations! You just bought a new home—it’s lovely—and in a

good neighborhood. Only 360 more payments and it’s all yours. When
you make such a large purchase, you usually have to take out a loan that
you repay in monthly payments. The process of paying off a loan (plus
interest) by making a series of regular, equal payments is called
Amortization, and such a loan is called an Amortized loan.

Example:

A loan of 10,000 $ is to be amortized with 10 equal quarterly payments. If

the interest rate 6%, compounded quarterly, what is the periodic
payment?

𝟏−(𝟏+𝒓)−𝑵
𝑷𝑽 = 𝑷𝑴𝑻 ∗ [ ]
𝒓

PV=10,000, n=10, r=0.06/4=0.015

𝟏 − (𝟏 + 𝟎. 𝟎𝟏𝟓)−𝟒𝟎
𝟏𝟎, 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ [ ]
𝟎. 𝟎𝟏𝟓

𝟏𝟎, 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ 𝟐𝟗. 𝟗𝟐

PMT=10,000/29.92=334.225 $

Example:
Mohamed buys a car costing 19300 $. He agree to make payment at the
end of each monthly period for 5 years. He pays 6% interest compounded

16
monthly. What is the total amount of each payment? Find the total
amount of interest paid.
Solution:

𝟏 − (𝟏 + 𝒓)−𝑵
𝑷𝑽 = 𝑷𝑴𝑻 ∗ [ ]
𝒓
𝟏−(𝟏+𝟎.𝟎𝟎𝟓)−𝟔𝟎
𝟏𝟗𝟑𝟎𝟎 = 𝑷𝑴𝑻 ∗ [ ]=PMT*51.7255
𝟎.𝟎𝟎𝟓𝒓

Then the total amount of each payment is:

PMT=(19300)/( 51.7255)=373.23$ .
To Find the total amount of interest paid, we calculate
The total cost paid=373.23*60=22387.2
The total amount of interest=22387.2-19300=3087.2 $.

Example:

Mr & Mrs X went to buy a hose that costs 240,000 $. They can afford to
put a 20% down payment toward the cost of the hose but must obtain a
montage for the rest. We would like to determine how much they must
pay each month if the elect a 30 years term and the interest rate is 7.5%.

Solution:
1.find down payments
240,000*20/100=48,000 $
2.The amount of the montage is
240,000-48,000=192,000 $.

17
 3.Monthly Payment
r=0.075/12=0.00625 , N=30*12=360

𝟏 − (𝟏 + 𝒓)−𝑵
𝑷𝑽 = 𝑷𝑴𝑻 ∗ [ ]
𝒓

𝟏 − (𝟏 + 0.00625)−𝟑𝟔𝟎
192,000 = 𝑷𝑴𝑻 ∗ [ ] = 𝑷𝑴𝑻 ∗ 𝟏𝟒𝟑. 𝟎𝟏
0.00625

PMT=192,000/ 𝟏𝟒𝟑. 𝟎𝟏 = 𝟏𝟑𝟒𝟐. 𝟒𝟗 $

Example:
Find the monthly payment on auto loan of 20,000 $ to be amortized over
a 5-year period at a rate of 9%.
Solution:
There are 60 monthly payment and the monthly interest rate
r=0.09/12=0.0075.

(𝟏 − (𝟏 + 𝟎. 𝟎𝟎𝟕𝟓)−𝟔𝟎 )
𝑷𝑽 = 𝑷𝑴𝑻 ∗ [ ]
𝟎. 𝟎𝟎𝟕𝟓

𝟐𝟎, 𝟎𝟎𝟎 = 𝑷𝑴𝑻 ∗ 𝟒𝟖. 𝟏𝟕𝟑𝟑𝟕

𝟐𝟎𝟎𝟎𝟎
PMT= = 𝟒𝟏𝟓. 𝟏𝟕 $.
𝟒𝟖.𝟏𝟕𝟑𝟑𝟕

18
 Example:
Suzan porched a home for 142,000 $. She made a 20% down payment
and obtained a 9% mortgage for 30 years.

1.Find the amount of the mortgage.

2. Find the monthly payment.

3.Find the amortization for month 1.

4. Find the amortization for month 2.

Solution:

1.The amount of the mortgage is: 0.8*142,000=113,600 $

2. The monthly payment

𝟏 − (𝟏 + 0.09/12)−𝟑𝟎∗𝟏𝟐
113,600 = 𝑷𝑴𝑻 ∗ [ ] = 𝑷𝑴𝑻 ∗ 𝟏𝟐𝟒. 𝟐𝟖
0.09/12

PMT=113,600/124.28=914.05 $.

The amortization for month 1: I=PTR=113600*(1/12)*0.09=852 $.

Amount paid on the principle is: 914.05-852=62.05 $

Balance after the 1st payments is: 113600-62.05=113537.95 $.
The amortization for month 2
I=PTR=113537.95*(1/12)*0.09=851.53 $.
Amount paid on the principle is: 914.05-851.53=62.52 $
Balance after the 2nd payment is: 113600-62.52=113537.48 $.

19
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