Week 4 Value, Time and Money

MCD2170 Foundations of Finance

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 Learning Objectives
 Define and distinguish between ordinary annuities and annuities due.
 Understand how to calculate the present value and future value of an
ordinary annuity.
 Understand how to calculate the present value and future value of an
annuity due.
 Extend this understanding to valuation of a deferred annuity.
 Explain what a perpetuity is, and understand how to calculate the value
of a perpetuity.
 Consider applications of annuities and perpetuities in real life situations.
 Annuity
 An annuity is a stream consisting of a fixed number of equal cash

flows paid at regular interval.

– Example: Business, Personal, Car and Home Loans, Insurance

Policies, etc.
– Any financial contract that calls for equally spaced and level

cash flows over a finite number of periods is called an annuity

 Types of annuity

– Ordinary annuity – cash flow at the end of the year

– Annuity Due – cash flow at the beginning of the year

 Ordinary Annuity
 Cash payments are made or received at the end of each period.
 Ordinary Annuities are also referred to as Annuity in Arrears

End of Period

0 1 2 3 4 5 6

$PMT $PMT $PMT $PMT $PMT $PMT

Note:
 In ordinary annuities, a fixed amount of money is paid or received at
fixed intervals of time for a fixed period of time
 Always assume the ordinary annuity if no clear statement regarding
the timing of cash flows
Future Value & Present Value of an Ordinary Annuity

PMT  PMT  1 
FV  (1  i ) n  1 PV  1  
i 
 
 i  n
 (1  i ) 

Where:
= the accumulated or future value of the annuity
= the discounted or present value of the annuity
= the cash flow received/paid under the annuity
= the time period over which the annuity occurs
= the per-period interest rate
Example 1: FV and PV of Ordinary Annuity
The annual cash flows from an asset are $2.3m from year 1 to year 6. The cash
flows occur at year-end and the interest rate is 10% p.a. compounded annually.
• What is the accumulated future value of this asset at the end of
year six?
• What is the present value of this asset?
0 1 2 3 4 5 6

$2.3m $2.3m $2.3m $2.3m $2.3m $2.3m

PMT = $2.3m, = 10%, and = 6
PMT  $2,300,000 
FV  (1  i ) n  1  (1.10) 6  1
i 
 
 0.10 
 

FV  $17,745,903.00

PMT  1  $2,300,000  1 
PV  1  (1  i ) n   1 6 
i   0.1  (1.1) 
 $10,017,099.61
 Annuity Due
 Cash payments are made or received at the beginning of each period
 Due Annuities are also referred to as Annuities in Advance

Pd 1 Pd 2 Pd 3 Pd (n-1) Pd n

0 1 2 3 . . . .(n-2) n-1 n

$PMT $PMT $PMT $PMT $PMT $PMT

 Ordinary annuity vs. Annuity due

Ordinary Annuity
0 1 2 3
i%

$PMT $PMT $PMT

Annuity Due
0 1 2 3
i%

$PMT $PMT $PMT

 Present and Future Value of an Annuity Due
Due
PMT  1 
PV  1 n 
 1  i 
i  (1  i) 
PMT (1  i ) n  1  (1  i )
FV 
i  

0
 Example 2: PV of Annuity Due
Kathy’s rich uncle promises her $1,000 per month, starting today, with a final
payment to be made 6 months from today. If the interest rate is 6 percent per
annum, what is the present value of the cash flows?
0 1 2 3 4 5 6

$1,00 $1,00 $1,00 $1,00 $1,00 $1,00 $1,00

0 0 0 0 0 0 0

PMT  1 
PV  1    (1  i )
i 
 (1  i ) n 

$1000  1 
 1    (1  0.005)
0.005 
 (1  0.005) 7 

 $6,896.38

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 Applications of Annuities

 A deferred annuity: an annuity for which the first cash flow occurs beyond the
end of the first period.
 Equivalent Annuities: used to evaluate projects with unequal lives

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 Deferred Annuity
0 1 2 3 4 5 6 7

$PMT $PMT $PMT $PMT

PV0 PV3

Method:
• Calculate the “PV” of the ordinary annuity in the year
immediately before the cash flow commences
• Discount this lump sum back to time T = 0

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 Example 3
Jason is to start a 6 month live-in training course in 4 months’ time (i.e. end of month 4). His father,
Sam, has promised him $200 per month as support payable at the start of each month. If the interest
rate is 12% per annum, payable monthly, how much money will Sam need today to finance Jason’s
allowance?

Month End mth4 Begin mth 5

0 1 2 3 4 5 6 7 8 9
1%
$200 $200 $200 $200 $200 $200

PV0 PV3

Given: PMT = $200, = 6, =

𝑃𝑉 3=
𝑃𝑀𝑇
𝑖
1−
(1
( 1+𝑖 )𝑛 )
=$ 1159.10 =$1125.01

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 Example 4: Equivalent Annuity
If your rich uncle includes you in his will and leaves you with the option of either
i. Receiving $60,000 each year for the next 10 years ; Or,
ii. Receiving a lump sum of $400,000 in one year
If the interest rate applicable is 14% which option will you accept?

Asset 1: Annuity Stream (ordinary)

Year 0 1 2 3 4 5 6 7 8 9 10
$60,000 $60,000 $60,000 $60,000 $60,000 $60,000 $60,000 $60,000 $60,000 $60,000

Asset 2: Lump Sum

Year 0 1 2 3 4 5 6 7 8 9 10
5
$400,000
 Example 4 (Cont.)
One way to solve this problem is to find the PV of both cash flow streams

PMT  1 
Option 1 PV  1 
i  (1  i) n 
$60,000  1 
  1  10 
 $312,966.94
0.14  (1  0.14) 

FV $400,000
Option 2 PV    $350,877.19
(1  i) n
(1.14)1

Conclusion: Since PV of option 2> PV of option 1 , then choose option

2

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 Example 4 (cont.)
An alternative solution is to find an equivalent annuity for Asset 2

Year 0 1 2 … 10
|_____|_____|_____|_____|
$EAA $EAA … $EAA

Convert the single Lump sum in

year one into an equivalent Annual
Amount (EAA) spanning over ten
Year 0 1 2 … 10 years as option 1

|_____|_____|_____|_____|
7 $400,000
 Example 4: continued

$
Hence EAA =

Conclusion: option 2 is better as EAA in Option 2 = $67267.91 >$60,000

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 Example 5: Solving for unknown interest rate
A five year ordinary annuity with payments of $100 has a
present value of $350. Calculate the discount rate.

$350=
%

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 Perpetuity
 A perpetuity is an annuity that goes on for an indefinite
period of time or forever.

 Perpetuities can also be classified as ordinary or due

perpetuity depending on when the payments commence
or start

0
 PV of an Ordinary Perpetuity
PMT
PV 
i
where
PMT = the cash flow per period
i = the interest rate per period.

Note:
 The formula values cash flows ONE period BEFORE the
first cash flow

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 Example 6: Perpetuity
Assuming an 8 per cent interest rate, calculate the present value of the
following streams of payments:

a. $1,000 per year forever, with the first payment one year from
today
b. $500 per year forever, with the first payment two years from
today Deferred (di bedakan) Annuity
c. $2,420 per year forever, with the first payment three years
from today  Deferred Annuity

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 Note: The formula
values cashflows ONE
Example 6 - continued period BEFORE the
first cashflow

Solution
(a) $1,000 per year forever, with the first payment one
year from today

Timeline
T=0 T=1 T=2 T=3 T=4 . . . T=∞

$0 $1,000 $1,000 $1,000 $1,000 $1,000

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 Note: The formula values

Example 6 (cont) cashflows ONE period

BEFORE the first cashflow

(b) $500 per year forever, with the first payment two
years from today, Deferred Perpetuity

T=0 T=1 T=2 T=3 T=4 . . . T=∞

$0 $0 $500 $500 $500 $500

PV0 =PV1/(1+i) PV1

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 Note: The formula values
Example 6 continued cashflows ONE period
BEFORE the first cashflow

(c) $2,420 per year forever, with the first payment three years
from today  Deferred Perpetuity

T=0 T=1 T=2 T=3 T=4 T=5 T=∞

$0 $0 $0 $2,420 $2,420 $2,420 $2,420

PV0 PV2

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 Annuity real life application – Loan
Loan Basics
 A major role of banks is to provide loans to household and businesses
 The term amortisation describes how the principal amount borrowed is
repaid over the life of the loan.
 With an amortising loan, each repayment is divided into two portions.
One portion represents the reduction in the principal while the other
portion indicates the interest payment.
 An amortisation schedule is simply a table that shows the balance at
the beginning and end of each period, the payment made during the
period and how much of that payment represents interest and how
much represents repayment of principal.

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 Loan Basics Example 1: Amortisation
Q: Suppose you borrowed $5,000 at an annual interest rate of 9%, and you
have to repay it over five years with equal amounts each year. What will be
the annual repayment?

Calculator steps:
= Clear the memory before any operation

5000 × 0.09 5000 [+/-] [PV]

𝑃𝑀𝑇 = = 1285.46 9 [I/Y]
1−
1
[
( 1+0.09 )5 ] 5
[PMT]
[N]

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 Loan Amortization Schedule
Year Beginning Total Interest Principal Ending
Balance Payment Paid Paid Balance
1 $5,000.00 $1,285.46 $450.00 $835.46 $4,164.54

2 $4,164.54 $1,285.46 $374.81 $910.65 $3,253.89

3 $3,253.89 $1,285.46 $292.85 $992.61 $2,261.28

4 $2,261.28 $1,285.46 $203.52 $1,081.94 $1,179.34

5 $1,179.34 $1,285.46 $106.12 $1,179.34 $0.00

Totals $6,427.30 $1,427.30 $5,000.00

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 Loan Basics Example 2: monthly repayments
Q: Suppose you borrowed $5,000 at an annual interest rate of 9% per annum,
and you have to repay it over five years with equal amounts each month. What
will be the monthly repayment? And what will be the effective rate of interest
that you pay?
Calculator steps:
= Clear the memory before any operation

5000 [+/-][PV]
=103.79 0.75 [I/YR]
60 [N]
Solve for [PMT]

12
0.09
𝐸𝐴𝑅=(1+ ) − 1=9.38 %
12

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 Loan Basics Example 3: balance left outstanding
Q: Suppose you borrowed $5,000 at an annual interest rate of 9% per annum, and
you have to repay it over five years with equal amounts each month. After three
years you come into some money and wish to pay the loan off, how much will you
have to pay to clear the balance.

The outstanding account balance at

Calculator steps
any point of time is the PV of all Clear the memory before any operation
future unpaid payments. At the end
of 3 years, there are 24 unpaid 0.75 [I/YR]
payments, hence 24 [N]
103.79 [PMT]
Solve for [PV]

0
 Summary
 An annuity is a stream consisting of a fixed number of equal cash flows paid
at regular interval. If the cash payments are made or received at the end of
each period, it is called an ordinary annuity. If the cash payments are made or
received at the beginning of each period, it is called an annuity due
 PV and FV of an ordinary annuity
PMT  1  PMT 
PV  1   FV  (1  i ) n  1
i  n i 
 

 (1  i ) 

 PV and FV of an annuity due

PMT  1  PMT (1  i ) n  1  (1  i )
PV  1  n 
 1  i  FV 
i  (1  i)  i  
 Applications of annuity – deferred annuity and equivalent annuity

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 Summary
 A perpetuity is an annuity that goes on for an indefinite period of time
or forever. If the payments start at the end of each period, it is called
ordinary perpetuity. If the payments commence at the beginning of each
period, it is due perpetuity.
 PV of an ordinary perpetuity PMT
PV 
i

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