Time Value of Money and Annuities

 Important concepts for laying the base of maths

of course
 Revised chapters 7 & 8 uploaded on LMS
Time Value of Money and Annuities
 Value of money depends on time
 Generally same amount of money worth less in
future
 Some reasons
 Inflation
 Foregone immediate consumption
 Intervening risk
 Future Value (FV) of money
 Let FVt be amount of money at future time t
 If you have 1,000 now and interest (rate of rate )
at end of year is 10%
 It will grow to 10000(1.10) at end of year 1, 1,000
x (1.10)2 at end of yar 2 etc.
 OR
 FV0 = 1
 FV1 = 1,100
 FV2 = 1,210
 FVt = 1,000 (1+i)t
 Example 1
Which stream of payments made to you would you
prefer at 10% RoR
i. 100 right now
ii. 112 at end of year 1
iii. 30 now, 50 at end of year 1 and 30 at end of year
2
 Present (Current) Value
 Present Value (PV) is the amount of money
required now (time 0) to accumulate to a given
amount (FV) at time t
 Or PV=FV0
 As can be easily seen
 FVt = PV (1+i)t or
 PV =

Note: The terminology of “r” is used in FINN 100 in lieu

of “i” in this course.
Accumulation & Discounting
 In order to accumulate 1 at end of year 1, you
need ( ) now, 1 at end of year 2 you need ()2 and
so on
 Another way of viewing is that 1 at end of year
1 is worth ( ) right now etc.
 It is expressed that discounted present value of
1 at end of year n is ( )n (discounted means
moving backward)
 Discounting
 Let us introduce a symbol of v for discounting such
that v = ( )
 v is the preset value (at time 0) at 1 at end of year 1
 vn is present value of 1 at end of year n (also called
discount factor)
 Let us also introduce a symbol d such that
d=()
 In other words, d is value of i expressed as fraction
of accumulated value (i is a fraction of initial value)
 Or d is the Present Value (at time 0) of
i (at time 1)
 Example 2
How much would you need to invest now to get to
2,000 in 5 years at annual interest rate of 5%?
 Example 2
Solution :
Investment at time t=0 = PV
= = = 1,567

Or PV of 2000 after 5 years at 5% ROI is 1,567

 Recap
 Rate of interest (i) is the interest paid at end of
time unit divided by amount of capital at
beginning of time unit
 Discount factor (v) is the amount of money one
needs to invest at the beginning (or t=0) to get one
unit of capital after one year (or t=1)
 Discount rate (d) is amount of money one needs to
invest at time t=0 to get to “i” at end of year (at
t=1)
 Relationship between i, v, d
 If i is known, v and d can be easily calculated
 It can be seen d = iv (or d is PV of i)
 Also, d+v=1

 ==> d = 1-v or v = 1-d

 =
 If i is given, d and v can be easily found.
 Annuity Symbols & Meaning
 | is the present value of annual payments of 1 at
end of each year for n years.
 100 a| is the present value of annual payments of
100 at the end of each year for n years
 ä| is the present value of annual payments of 1 at
the beginning of each year for n years
 1,000 ä| is the present value of annual payments
of 1,000 at the beginning of each year for n years
 Present Value of Level Annuities in
terms of i, v & d
 Immediate Annuity pays 1st payment at end of 1st
year
 Therefore, value of immediate Annuity for n years
is
 a| = v + v2 + …………+vn
 Geometric sum
 a| =
 ==> a| =
Note: Terminology of “Ordinary Annuity” in FINN
100
 Present Value of Level Annuities in
terms of i, v & d
 Annuity due pays first payment immediately
 PV of Level Annuity Due
 ä| = 1+v + v2 + …………+vn-1
 ä| = =
 It can be easily seem
 ä| = a| - vn + 1
 ä| > a|
Note: Terminology of “Immediate Annuity” in FINN 100
 Logical interpretation of Annuity
Formulae
 If you loan 1 unit of money at time 0 with following
commitments for n years
 Interest i at end of each of n years
 Return of capital of 1 at end of n years
 Present value of outgo (of loan) = 1
 Present value of interest annuity (income) = i a|
 Present value of return of loan (income) = vn
 Logical interpretation of Annuity
Formulae
 Present Value (PV) of income = PV of outgo
 1=i a| +vn
 ==>
a|=
 Same interpretation for annuity due
 1=d ä| +vn
 ==>
ä| =
 Example 3

 A loan of 2,400 is to be repaid by 20 equal instalments. The rate

of interest for the transaction is 10% per annum. Find the value
of each repayment, assuming that payments are made (i) in
areas (ii) in advance.
 Example 3

 Solution : PV of instalments must equal 2,400

i. P1 a| =2,400
ii. P2 ä| = 2,400
 Perpetuity Symbols & Meaning

 Perpetuities are payments made till infinity

 a| is the present value of payments of 1 made at end of each
year till infinity
 x a| is the present value of payments of x made at end of each
year till infinity
| is the present value of payments of 1 made at the beginning of


each year till infinity

 y a| is the present value of payments of y made at beginning of
each year till infinity
 Perpetuities
 a| = v + v2 + …………
 =
 ä| = 1+v+v2 +……… =
 ä| = 1+ a|
 a| = v ä|
 Logical interpretation is important
 Example 4

 The present value of perpetuity due with annual payments of

1,000 is 39,610.04. Find i
 Example 4

Solution :
1,000 ä| = 39,610.04
= 39,610.04
d = 2.52%
Find i from relationship d=
 Accumulated value of annuities
 s| is the accumulated value of 1 at time t=n at the
end of each year for n years
| is the accumulated value at time t=n of 1


payable at the beginning of each year for n years

Accumulated Value of level annuities

 Accumulated value of immediate annuity of 1 for n

years
 s| = (1+i)n-1 + (1+i)n-2 + ….. + (1+i)+1
=
 Accumulated value of annuity due
| = (1+i) + (1+i) + ….. + (1+i)
 n n-1

 =
 Also |= (1+i) s|

..
s
 Some Relationships
 ä| = (1+i) a| = a|

 .. | = (1+i) s| = s|
s
 ä| = a| +1
 s| = | +1
..
s
 Some Relationships Contd...
 s| = (1+i)n a|
 a| = vn s|
 ä| = 1+v ä|
 Example 5
An annuity pays 300 at end of each year for 3 years,
500 at end of year for next 3 years and 200 at end of
year for next 4 years. Find different expressions for
its present value in terms of symbols “a|“ and “vn”.
 Example 5
Option I: This can be viewed as combination of 3
annuities :
1. Annuity of 300 payable for 10 years starting at
end of year 1
2. Annuity of 200 payable for 3 years starting at
end of year 4
3. Annuity of -100 payable for 4 years starting at
end of year 7
 Example 5
300 a| + 200 v3 a| - 100 v6 a|

Note: This is not the only option

 Deferred annuity
 m/a| is Immediate annuity deferred for m years
with payment for n years having 1st payment at
time (m+1) and last payment at time (n+m)
 m/| annuity due deferred for m years with
payment of n years having 1st payment at time
(m) and last payment at time (n+m-1)
Formula for deferred annuity
Approach 1
 Annuity immediate of n years with deferred

period of m years (first payment at time (m+1))

 m/a| = vm a| = vm+1 ä|

 Annuity due of n years with deferred period of

m years (first payment at time m)
 m/ä| = vm ä| = vm-1 a|
Note: The annuity of “n” years is first valued t=m and then
the stream is discounted to t=0
Formula for deferred annuity
Approach 2
 We can add and subtract payment for 1 for the

deferral period
 As such

 m/a| = a| - a|

 m/ä| = ä| - ä|
 Example 6
Find the present value of an annuity immediate of
10 years of 100 per annum with 1st payment at end
of 6 years at 10% rate of interest
 Example 6
Solution :
100 x 5/a| = 100 x v5 6.14 = 100 x 0.621 x 614 = 381
Or 100x6/ä| = 100 xv6 6.76 =100x0.564 x 676 = 381
 Deferred Perpetuity
 m/ a| is an immediate perpetuity with m year
deferral having first payment at time (m+1)
and payments continuing forever
 m/ ä| is a perpetuity due with m year deferral
having first payment at time m and payment
continuing forever
 Formulae for deferred
Perpetuities
 Same rationale as deferred annuities
Approach 1
 m/ a| = vm a|

 m/ ä| = vm ä|
Approach 2
 m/ a| = a| - a|

 m/ ä| = ä| - ä|
 Example 7
At time 0, Paul deposits P into a fund crediting
interest at an effective annual interest rate of 8%.
No other deposits were made. At the end of each
years 6 through 20, Paul withdraws an amount of
1,000 per year. Immediately after the withdrawal at
end of year 20, the fund value is zero. Find P.
 Example 7
Solution :
PV of deferred annuity starting at end of year 6 is
10,000 v6 ä| OR 1,000 v5 a| at 8% interest
This should equal P
Or P = 1,000 v6 ä|
 Example 8
An investment requires initial payment of 10,000 and
annual payments of 1,000 at each of first 10 years. Starting
the end of 11th year, the investment returns 5 equal annual
payments of X. Determine X at annual interest rate of
10%.
 Example 8
Solution :
Advisable (but not necessary) to use comparison at end of
10th year
Accumulate Value (AV) of payments at end of 10th year is:
10,000 (1.1)10 + 1,000 | = 41,874.80
This must equal PV of returns :
X a | = 41,874.80
X = 11,046
 Example 9
Susan makes deposits of 100 at the end of each
year for 30 years. Starting at the end of the 41st
year, Susan makes annual withdrawals of X
which last forever. Assume interest rate of 10%.
Find X.
 Example 9
Solution I
At t=0
100 = Xv40
Solution II
At t=40
100 (1.1)10 = X =
 Example 10
There is a payment stream of 1 at the end of each year for 5
years. Express the value of this payment stream at end of 3 rd
year (t=3) in different forms using a| , ä| , | & |

i. without using “v” or its powers;

ii. using “v” and its powers.
 Example 10
Solution :
i. without using powers of “v”
a. | + | ; or

b. | + ä| ; or

c. | +1 + |

ii. Using powers of “v”

d. v2 |
e. (1+i)3 |
 Example 11
You are given
a. ä| = 8
b. vn + vn+1 + vn+2 = 1.8
Find |
 Example 11
Solution :
| = | + vn + vn+1 + vn+2
= (a|-1) + vn + vn+1 + vn+2
= (8-1) + 1.8
= 8.8
Increasing Annuities by Arithmetic
Progression
 Symbol (Ia)
 Immediate Annuity starting with 1 at end of 1st year

and thereafter increasing by 1 per year

 (Iä) means annuity due starting with 1 at beginning of

year & increasing by 1 each year

Examples
 100 (Ia) | means 100 payable at end of year 1; 200

payable at end of year 2, etc. …. with 500 payable at end

of year 5
 200 (Iä) | means 200 payable at beginning of year 1; 400

at beginning of year 2 and 600 at beginning of year 3

Increasing Annuities by Arithmetic
Progression
 -500 (Ia) | means -500 payable at end of year 1; -1,000
payable at end of year 2; -1,500 payable at end of year 3
and -2,000 payable at end of year 4.
 300v2(Ia)| means 300 payable at end of year 3; 600 at
end of year 4 and 900 at end of year 5.
 400v4(Iä) | means 400 payable at beginning of year 5 and
800 payable at beginning of year 6.

Note: Initial Value & “increase” per year are the same.
Arithmetically Increasing Annuities
 (Ia)| = v+2v2 + 3v3 + ….. + nvn
 (Iä)| = 1+2v+3v2+ ……… + nvn-1
It can be seen
(Ia)| = v (Iä)|
Arithmetically Increasing Annuities
 (Ia)| =
 (Iä)| =

Logical interpretation of above formulae is very

important
 Example 12
An annuity is payable in arrears for 5 years. The first payment
is 8,000 and decreases by 300 each year after that. Find the
expression for PV of annuity on basis of interest rate of 5%.
 Example 12
Solution :
This can be viewed as combination of 2 immediate annuities :
i. Level annuity of 8,000 payable for 5 years
ii. Decreasing annuity of 300 payable for 5 years with first
payment at end of year 1
PV = 8,000 a| - 300v(Ia) | at 5%
or PV = 8,000 a| -300v2(Iä)| at 5%
 Example 12 (Contd…)

Alternate approach
8,300 a| - 300(Ia)|
or (computationally easier)
8,300 a| -300v(Iä)|
 Example 13
Identify the payments associated with the following annuity :
1000 ä | - 100 v(Ia) | + 50 v3(Iä)|
 Example 13
i. 1,000 ä | is regular payments of 1,000 payable at the beginning
of years 1 to 5
ii. -100v(Ia) | is -100 payable at beginning of year 3; -200 at
beginning of year 4 & -300 at beginning of year 5
iii. 50 v3(Iä)| is 50 payable at beginning of year 4 and 100 at the
beginning of year 5
iv. Therefore, the expression represents payments of 1,000 at the
beginning of years 1 &2; 900 at the beginning of year 3, 850 at
beginning of year 4 and 800 at beginning of year 5.
 True or False
A statement is “True” if it holds for all values of n & i
“n” is finite and >0
A. As “i” increases, “d” decreases (i>0)

B. a | < ä | (i>0)

C. If i=d, a | = n (i>0)
D. a | = v(1+v) + v2 ä | (i>0)
 True or False (Answers)
A. F
B. F
C. T
D. F