ANNUITIES

ORDINARY ANNUITIES

1. If at the end of each month, a saver deposited $100 into a savings account that paid 6%
compounded monthly, how much would he have at the end of 10 years?

A = $100

r = 6% per year compounded monthly, = .5% interest per month = .005

n = 120 in 10 years.

F=100 * ((1+.005)120 -1)/.005 = $16,387.93

2. A certain amount was invested on Jan 1, 2010 such that it generated a periodic payment of
$1,000 at the beginning of each month of the calendar year 2010. The interest rate on the
investment was 13.2%. Calculate the original investment and the interest earned.

Solution

R = $1,000

n = 12

i = 13.2%/12 = 1.1%

PV = $1,000 (1-(1+1.1%)^(-12))/1.1% (1+1.1%)

= $1,000 (1-1.011^-12)/0.011 1.011

$1,000 (1-0.876973)/0.011 1.011

$1,000 0.123027/0.011 1.011

$1,000 11.184289 1.011

$11,307.32

Interest Earned $1,000 12 $11,307.32 $692.68

3.You win a $1,000,000 lottery, which is paid in annual installments of $50,000 over 20 years.
How much did you really win, assuming that you could earn 5% interest, compounded
annually?

Solution: Since you are not receiving the full $1,000,000 payment right away, but in the form
of an annuity, its actual worth is much less.

r=$50,000

n=20

i=5%

Present Value of Annuity = 50,000 * (1 - (1 + .05)-20)/.05 = $623,110.52

4. Mr A deposited $700 at the end of each month of calendar year 2010 in an investment
account of 9% annual interest rate. Calculate the future value of the annuity on Dec 31, 2011.
Compounding is done on monthly basis.

Solution

R = $700

n = 12

i = 9%/12 = 0.75%

Future Value PV = $700 {(1+0.75%)^12-1}/1%

= $700 {1.0075^12-1}/0.01

$700 (1.0938069-1)/0.01

$700 0.0938069/0.01
 $700 9.38069 $6,566.48

5. Calculate the future value of 12 monthly deposits of $1,000 if each payment is made on
the first day of the month and the interest rate per month is 1.1%. Also calculate the total
interest earned on the deposits if the whole amount is withdrawn on the last day of 12th
month.

Solution:

R = $1,000

n = 12

i = 1.1%

Future Value = $1,000 {(1+1.1%)^12-1}/1.1% (1+1.1%)

= $1,000 {1.011^12-1}/0.011 (1+0.011)

= $1,000 (1.140286-1)/0.011 1.011

$1,000 0.140286/0.011 1.011

$1,000 12.75329059 1.011

$12,893.58

Interest Earned $12,893.58 - $1,000 12 $893.58

DEFERRED ANNUITIES

1. Carol Calc plans on retiring on her 60th birthday. She wants to put the same amount of
funds aside each year for the next twenty years -- starting next year -- so that she will be
able to withdraw $50,000 per year for twenty years once she retires, with the first
withdrawal on her 61st birthday. Carol is 20 years old today. How much must she set aside
each year for her retirement if she can earn 10% on her funds?

r=$50,000
n=20

i=10%

Solution:

PV60 = $50,000 (PV annuity factor for N=20, i=10%)

PV60 = $50,000 (8.5136)

PV60 = $425,678.19

PV40 = PV60 / (1 + 0.10)20 = $63,274.35

FV40 = PV40 = $63,274.35

N = 20

i = 10%

FV = CF (FV annuity factor for N=20, i=10%)

$63,274.35 = CF (FV annuity factor for N=20, i=10%)

$63,274.35 = CF (57.2750)

CF =$1,104.75 per year

2. Have I got a deal for you! If you lend me $100,000 today, I promise to pay you back in
twenty-five annual installments of $5,000, starting five years from today (that is, my first
payment to you is five years from today). You can earn 6% on your investments. Will you
lend me the money?

CF = $5,000

N = 25

i = 6%

Solution:
PV4 = $5,000

PV4 = $5,000 (12.7834)

PV4 = $63,916.78

PV0 = $63,916.78 / (1 + 0.06)4 = $50,628.08

3. You have choice when subscribing to our magazine: you can pay $100 now for a four
year subscription, pay $28 at the beginning of each year for four years, or pay $54 today and
$54 again two years from today.

Which is the best deal for you, the subscriber, if your opportunity cost of funds is 10%?

(a): PV = $100

(b) PV = PV of a 4-payment annuity due = $97.63

(c) PV = $54 + $54 / (1+0.10)2 = $54 + 44.63 = $98.63

4. The Trust Worthy loan company is willing to lend you $10,000 today if you promise to
repay the loan in six monthly payments of $2,000 each, beginning today. What is the effective
annual interest rate on Trust Worthy's loan terms?

PV = $10,000

CF = $2,000

N=6

PV annuity due = CF (PV annuity factor for N=6, i=?)(1 + i)

$10,000 = $2,000 (PV annuity factor for N=6, i=?)(1 + i)

5 = (PV annuity factor for N=6, i=?)(1 + i)

Through trial error using the tables for N=6 such that the factor multiplied by 1+ i is equal to
5,

i = 8%

precise answer for i= 7.9308%

EAR = (1 + 0.079308)12 - 1 = 149.89%

Want an easier way to do this problem? OK, if TW lends you $10,000 and you repay $2,000
immediatly, you are really only borrowing $10,000 - 2,000 = $8,000. Therefore, you can use
the ordinary annuity approach, modifying the PV and N:

PV = $8,000

CF = $2,000

N=5

PV = CF (PV annuity factor for N=5, i = ?)

$8,000 = $2,000 (PV annuity factor for N=5, i = ?)

4.000 = PV annuity factor

Using the tables, i = 8% (factor is 3.9927)

Using a calculator, i = 7.9308%

5. A deferred annuity is purchased that will pay $10,000 per quarter for 15 years after being
deferred for 5 years. If money is worth 6% compounded quarterly, what is the present value
of this annuity?

r=$10000 Solution:

(n)=4(15) =60 A=10000(1-(1+0.015)^-60/0.015)(1.015)^-20

= $292,386.85

k=4(5)=20

i=0.06/4=0.015