ANNUITIES
An annuity is a sequence of payments paid or received at equal time intervals. The payments
could be yearly, quarterly, monthly e.t.c or as a lump sum. Some examples are:
1.A sequence of equal monthly payments (the annuity) for a life cover policy at Botswana
Life Insurance Company.
2.A sequence of equal monthly payments (the annuity) to payoff a home mortgage.
3.A lump sum invested at BIFM by a pensioner after retirement.
4.A sequence of quarterly payments at Stanbic Bank for a child education policy.
5. A monthly payment towards a pension fund during the employment period.
Annuities serve as retirement planning tool because they can provide a steady income after
retirement. The time period between successive annuity payments is called the payment
period or payment interval for the annuity.
TIME VALUE FOR MONEY (PRESENT VALUE AND FUTURE VALUE OF AN
ANNUITY)
Present Value of an annuity (PV) – this refers to how much money would be needed to fund
a series of future annuity payments, i.e the amount of cash that would be paid presently to
generate a particular income in the future. It could be paid as a lump sum or as a series of
payments (monthly, quarterly, yearly e.t.c) for the lifetime of the investment.
Future Value of an annuity (FV) – this is the sum of the future value of each payment of an
annuity.
FUTURE VALUE AND PRESENT VALUE OF A LUMP SUM OF AN ANNUITY
Since we have already dealt with Compound interest, we are familiar with the formula
/ , now with Future Value and Present Value of an annuity, the
formula is presented as:
/
Where FV - Future Value of an annuity
PV - Present Value of an annuity
R - annual interest rate expressed in decimal form / annual discount rate
m/t - number of times interest is calculated in one year
n – number of years
Exercise
1. Neo bought a house cash, valued at P350 000. Calculate its value after 6 years if it
appreciates at a rate of 5% per annum.
2. Ms Tau retired from her employment as a teacher and received a lump sum of P2000
000, of which she wanted to invest a portion of her money to raise P1000 000 in 10
years. How much should she invest now as a lump sum if the insurance company
offers 5% per annum compounded monthly?
3. Puso wants to save money for his child ‘s tertiary tuition for 12 years. A bank offered
a savings account that pays 3.5% per annum compounded quarterly. How much lump
sum should he deposit in the account now to be able to raise P150 000 he intends to
accumulate in the 12 years?
4. Find the present value of P4000 receivable in 2 years at a discount rate of 5% per
annum.
5. Find the present value of P6750 receivable in 3 years given a discount rate of 10% per
annum compounded quarterly?
FUTURE VALUE AND PRESENT VALUE OF A SERIES OF PAYMENTS:
ORDINARY ANNUITY AND ANNUITY DUE
When payments are due at the end of the payment periods, the annuity is called ordinary
annuity, e.g stock dividends or bond dividends. This is the most common type of annuity in
households. When payments are due at the beginning of the payment periods, the annuity is
called annuity due, e.g rental or lease payments.
Ordinary annuity
Future Value of an Annuity (FVA)
where FVA - Future Value of an annuity
PMT - Periodic Payment
r - interest rate per period expressed in decimal form
n – number of periods
Present Value of an Annuity (PVA)
where PVA - Future Value of an annuity
PMT - Periodic Payment
r - interest rate per period expressed in decimal form
n – number of periods
Exercise/Examples
[Link] the end of each month, P100 is invested in a savings account paying 6% compounded
monthly. What is the Future Value of this ordinary annuity just after the fifth payment.
= 100 + 100.500 + 101.0025 + 101.5075 + 102.0151
= P505.03
If the above was computed for many months it won’t be practical, hence the application of
the formula.
= P505.03
2. To save for a child’s education, a family decides to invest P300 at the end of each 6-month period
in a fund paying 8% compounded semi-annually. Find the amount of the investment at the end of 18
years.
FVA = P23 279.49.
[Link] retirement, a couple wants to make a lump sum investment paying 8% compounded annually so
that they can receive annuity payments of P10 000 at the end of each year for the following 5 years.
How much must they invest?
= 9259.2593 + 8573.3882 + 7938.3224 + 7350.2985 + 6805.8320
= P39 927.10
Alternatively, the formula can be used as follows:
= P39 927.10
[Link] needs to have P4000 in 18 months to pay part of her college tuition. How much should
she deposit into her savings account at the end of each month if interest is 9 % compounded
monthly.
5.A firm anticipates a capital expenditure of P10 000 for new equipment needed in 5 years.
How much should be deposited quarterly in a sinking fund earning 10% compounded
quarterly to provide for the purchase.
6. What is the present value of an ordinary annuity with 20 quarterly payments of P100 each if the
interest is 8% compounded quarterly?
7. A developer purchases a piece of land for P10000 to be amortized over 2 years at 9% compounded
monthly. How much will each monthly payment be?
[Link] the Present Value of the following ordinary annuities:
a) P1000 per year for 5 years at 7% compounded annually.
b) P500 per quarter for 10 years at 8% compounded quarterly.
c) P4000 every 6 months for 15 years at 5 % compounded semi-annually.
d) P40 per month for 5 years at 6% compounded monthly.
[Link] the Future Value of the following ordinary annuities:
a) P1000 per year for 5 years at 7% compounded annually.
b) P500 per quarter for 10 years at 8% compounded quarterly.
c) P4000 every 6 months for 15 years at 5 % compounded semi-annually.
d) P40 per month for 5 years at 6% compounded monthly.
Annuity Due
Future Value of an Annuity ( )
) (1+r)
Where - Future Value of an annuity
PMT - Periodic Payment
r - interest rate per period expressed in decimal form
n – number of periods
Present Value of an Annuity ( )
) (1+r)
Where - Future Value of an annuity
PMT - Periodic Payment
r - interest rate per period expressed in decimal form
n – number of periods
Exercise/Examples
1.A four-year lease agreement requires payments of $10,000 at the beginning of every
year. If the interest rate is 6% compounded monthly, what is the cash value of the
lease?
) (1+r)
) (1+0.005)
= P543 683.21
2. What deposit made at the beginning of each month will accumulate to $120,000 at
8% compounded semi-annually at the end of 10 years?
) (1+r)
) (1+0.04)
PMT =P3874.82
3. Laura wants to accumulate P150,000 in her bank account by depositing P1000 at the
beginning of each month. If interest on the account is 5% compounded quarterly, for
how long does Laura have to deposit the money?
4. James deposited P150 at the beginning of each month for two years into his savings
account. For the next four years he did not make any more deposits, leaving the
money in the account. The bank charges 4% interest compounded monthly. What
will the balance be after 12 years?
