Ahram Canadian University, School of Business Administration Present Annuity

Dr. Ramy ALdallal Math II Lecture Notes 3.2

Present Value of an Annuity

Amortization

In this type of problems, an amount of money is deposited today (at

present) earning compound interest from which periodic withdrawals
are made for retirement years or to secure college expenses etc….Or
an amount of money (lump sum) needed today as a loan to buy a car
or a house is to be repaid with its interest in a form of a series of
payments for some period of time.

Ex1
Mike wants to deposit an amount of money in an account today (at
present) so that his son can withdraw $1000 at the end of each year
for 4 years to come. If the bank pays 10% interest compounded
annually, how much should Mike deposit today so that his son
withdraws the money as planned?
Note: the last withdrawal will deplete the account completely, that
is it will draw it down to zero.

Solution:
Let us solve the problem using the compound interest formula, only this
time we have a series of withdrawals (an annuity).
The amount of money needed to be deposited today (at present) so that
Mike’s son can withdraw $1000 after 1 year is simply:
P1= 1000/ (1+ 0.1) = $909.09
Similarly, the amount of money needed to be deposited today so that
Mike’s son can withdraw $1000 after 2 years is:
P2 = 1000/ (1+ 0.1)2 = $826.45 and so on……
P3 = 1000/ (1+ 0.1)3 = $751.31
P4 = 1000/ (1+ 0.1)4 = $683.01
So the total amount that should be deposited today so that Mike’s son
withdraws $1000 every year for the coming 4 years would be simply the
sum of the above values. So
PV = 909.09+826.45+751.31+683.01 = $3169.86

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Ahram Canadian University, School of Business Administration Present Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.2

The above rationalization is the same if Mike wants to borrow an

amount of money today (at present) to buy a new car for example, and
would like to repay the loan in a form of periodic payments so that the
last payment amortizes (kills) the loan completely. In this case PV will
be the amount of the loan and the $1000 will be payments to the bank
instead of withdrawals.
It is obvious that if the withdrawals/payments are required to be every
month for 4 years (48 withdrawals/payments in total) the above method
for find the present value of the annuity will be very long and tedious.
It can be shown that the formulae to use in these types of problems are:

 r mt 
1  (1  ) 
1  (1  i ) n
 m
PV  PMT   Or PV  PMT  
 i   r 
 m 

I  PMT (n)  PV Or I  PMT (mt )  PV

Where:
 PMT = the withdrawal (payment in case of a loan), made at the
end of each period in $. The account is exhausted (equals zero) at
the time of the last withdrawal that is no money is left in the
account. Also the loan is amortized (killed) after the last payment
is made.
 All other parameters are the same as before.

Ex2: Present Value of an Annuity (Trust Fund)

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Ahram Canadian University, School of Business Administration Present Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.2

You wish to establish a trust fund from which your niece can withdraw
$200 every month for 5 years, at the end of which time the remaining
money in the trust will be depleted (reduces to zero). The trust will be
invested at 6% per year compounded monthly.

a) How large should the trust be?

b) How much interest will your niece earn during the 5-year period?

Solution

Ex3: Education Fund

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Ahram Canadian University, School of Business Administration Present Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.2

Tony and Maria, having accumulated $100,000 for their son’s college
education, would now like to make quarterly withdrawals over the
next 4 years. How much money can they withdraw each quarter in
order to draw down the account to zero at the end of the 4 years?
Assume that the account pays interest at 4% per year compounded
quarterly.

Solution

Ex4: Saving for Retirement

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Ahram Canadian University, School of Business Administration Present Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.2

Jane Q. Employee has just started her new job with Big
Conglomerate, Inc., and is already looking forward to retirement. BCI
offers her as a pension plan an annuity that is guaranteed to earn 6%
annual interest compounded monthly. She plans to work for 40 years
before retiring and would then like to be able to draw an income of
$7,000 per month for 20 years.

a) How much do she and BCI together have to deposit per month
into the fund to accomplish this?
b) How much total interest will Jane earn during the entire 60-year
process?

Solution

Ex5: Automobile Financing

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Ahram Canadian University, School of Business Administration Present Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.2

You want to purchase a pickup truck for $25,200. The dealer offers you
0% financing for 48 months or a $3,000 rebate. If you choose the rebate,
you can obtain a credit union loan for the balance at 4.5% compounded
monthly for 48 months. Which option should you choose?

Solution:

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Ahram Canadian University, School of Business Administration Present Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.2

Amortization

Amortizing a debt means killing the debt. This is done using the
present value form of an annuity, where the present value of the annuity
PV is the amount of the loan that will be returned to the bank, with
compound interest, in form of equal periodic payments PMT. Actually
the bank has bought an annuity from you. When the loan is for buying a
home the payments are usually called monthly mortgage payments.

Ex6:
A family purchased a house in 1995. The price of the house was
$80,000. The house was financed by paying 20% down payment and
amortizing the rest at 9% compounded monthly over a 30-year period.

a) How much should each monthly payment be to amortize the loan?

b) How much total interest will you pay?
c) In 2005 (after 10 years), the family decided to pay off the debt
completely. How much should they pay to the bank?

Solution

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