5

MATHEMATICS
OF FINANCE

Copyright Cengage Learning. All rights reserved.

5.2

Annuities

Copyright Cengage Learning. All rights reserved.

Future Value of an Annuity

Future Value of an Annuity

An annuity is a sequence of payments made at regular time
intervals.
The time period in which these payments are made is
called the term of the annuity.
Depending on whether the term is given by a fixed time
interval, a time interval that begins at a definite date but
extends indefinitely, or one that is not fixed in advance, an
annuity is called an annuity certain, a perpetuity, or a
contingent annuity, respectively.
4

Future Value of an Annuity

In general, the payments in an annuity need not be equal,
but in many important applications they are equal. Annuities
are also classified by payment dates.
An annuity in which the payments are made at the end of
each payment period is called an ordinary annuity, whereas
an annuity in which the payments are made at the beginning
of each period is called an annuity due.
Furthermore, an annuity in which the payment period
coincides with the interest conversion period is called a
simple annuity, whereas an annuity in which the payment
period differs from the interest conversion period is called a
complex annuity.
5

Future Value of an Annuity

In other words, we study annuities that are subject to the
following conditions:
1. The terms are given by fixed time intervals.
2. The periodic payments are equal in size.
3. The payments are made at the end of the payment
periods.
4. The payment periods coincide with the interest
conversion periods.
6

Future Value of an Annuity

To find a general formula for the accumulated amount S of
an annuity, suppose that a sum of $R is paid into an
account at the end of each period for n periods and that the
account earns interest at the rate of i per period.
Then, proceeding as we did with the numerical example,
we obtain
S = R + R(1 + i ) + R(1 + i )2 + + R(1 + i )(n 1)
(9)
7

Future Value of an Annuity

The expression inside the brackets is commonly denoted
by
(read s angle n at i) and is called the
compound-amount factor.
In terms of the compound-amount factor,
(10)

Future Value of an Annuity

The quantity S in Equations (9) and (10) is realizable at
some future date and is accordingly called the future value
of an annuity.

Example 1
Find the amount of an ordinary annuity consisting of
12 monthly payments of $100 that earn interest at 12% per
year compounded monthly.
Solution:
Since i is the interest rate per period and since interest is
compounded monthly in this case, we have i =
= 0.01.
Using Formula (9) with R = 100, n = 12, and i = 0.01, we
have

10

Example 1 Solution
1268.25

contd
Use a calculator.

or $1268.25.
The same result is obtained by observing that
S=
= 100(12.6825)
= 1268.25

Use Table 1 from CourseMate.

11

Present Value of an Annuity

12

Present Value of an Annuity

To derive a formula for determining the present value P of
an annuity, we may argue as follows.
The amount P invested now and earning interest at the rate
of i per period will have an accumulated value of P(1 + i )n at
the end of n periods.
But this must be equal to the future value of the annuity S
given by Formula (9).

13

Present Value of an Annuity

Therefore, equating the two expressions, we have
P(1 + i )n =

Multiplying both sides of this equation by (1 + i )n gives

P=

14

Present Value of an Annuity

(1+ i )n(1+ i )n = 1

where the factor

(read a angle n at i) represents the
expression inside the brackets.
15

Present Value of an Annuity

16

Example 2
Find the present value of an ordinary annuity consisting of
24 monthly payments of $100 each and earning interest at
9% per year compounded monthly.
Solution:
Here, R = 100,
so by

= 0.0075, and n = 24,

we have

2188.91 or $2188.91.

17

Example 2 Solution

contd

The same result may be obtained by using Table 1 from the

CourseMate site. Thus,
P =
= 100(21.8891)
= 2188.91

18

Present Value of an Annuity

One important application of annuities arises in the area of
tax planning.
During the 1980s, Congress created many tax-sheltered
retirement savings plans, such as Individual Retirement
Accounts (IRAs), Keogh plans, and Simplified Employee
Pension (SEP) plans.
These plans are examples of annuities in which the
individual is allowed to make contributions (which are often
tax deductible) to an investment account.
19

Present Value of an Annuity

Suppose, for example, you are eligible to make a fully
deductible contribution to an IRA and you are in a marginal
tax bracket of 28%.
Additionally, suppose you receive a year-end bonus of
$2000 from your employer and have the option of
depositing the $2000 into either an IRA or a regular savings
account, where both accounts earn interest at an effective
annual rate of 8% per year.

20

Present Value of an Annuity

If you choose to invest your bonus in a regular savings
account, you will first have to pay taxes on the $2000,
leaving $1440 to invest.
At the end of 1 year, you will also have to pay taxes on the
interest earned, leaving you with

or $1522.94.
21

Present Value of an Annuity

On the other hand, if you put the money into the IRA, the
entire sum will earn interest, and at the end of 1 year you
will have (1.08)($2000), or $2160, in your account.
Of course, you will still have to pay taxes on this money
when you withdraw it, but you will have gained the
advantage of tax-free growth of the larger principal over the
years.
The disadvantage of this option is that if you withdraw the
money before you reach the age of
, you will be liable
for taxes on both your contributions and the interest
earned, and you will also have to pay a 10% penalty.

22

Present Value of an Annuity

Note:
In practice, the size of the contributions an individual might
make to the various retirement plans might vary from year
to year.
Also, he or she might make the contributions at different
payment periods.
To simplify our discussion, we will consider example in
which fixed payments are made at regular intervals.

23

Applied Example 5 IRAs

Caroline is planning to make a contribution of $2000 on
January 31 of each year into a traditional IRA earning
interest at an effective rate of 5% per year.
a. After she makes her 25th payment on January 31 of the
year following her retirement at age 65, how much will
she have in her IRA?
b. Suppose that Caroline withdraws all of her money from
her traditional IRA after she makes her 25th payment in
the year following her retirement at age 65 and that her
investment is subjected to a tax of 28% at that time. How
much money will she end up with after taxes?

24

Applied Example 5 Solution

a. The amount of money Caroline will have after her 25th
payment into her account is found by using Formula (9)
with R = 2000, r = 0.05, m = 1, and t = 25, so that
i = = 0.05 and n = mt = 25.
The required amount is given by

95,454.20
or $95,454.20.
25

Applied Example 5 Solution

contd

b. If she withdraws the entire amount from her account, she

will end up with
(1 0.28)(95,454.20) 68,727.02
that is, she will have approximately $68,727.02 after
paying taxes.

26

Applied Example 5 Solution

contd

After-tax-deferred annuities are another type of investment

vehicle that allows an individual to build assets for
retirement, college funds, or other future needs.
The advantage gained in this type of investment is that the
tax on the accumulated interest is deferred to a later date.
Note that in this type of investment, the contributions
themselves are not tax deductible.
At first glance, the advantage thus gained may seem to be
relatively inconsequential, but its true effect is illustrated by
the next example.
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Applied Example 6 Investment Analysis

Both Clark and Colby are salaried individuals, 45 years of
age, who are saving for their retirement 20 years from now.
Both Clark and Colby are also in the 28% marginal tax
bracket. Clark makes a $1000 contribution annually on
December 31 into a savings account earning an effective
rate of 8% per year.
At the same time, Colby makes a $1000 annual payment to
an insurance company for an after-tax-deferred annuity. The
annuity also earns interest at an effective rate of 8%
per year. (Assume that both men remain in the same tax
bracket throughout this period, and disregard state income
taxes.)
28

Applied Example 6 Investment Analysis

contd

a. Calculate how much each man will have in his

investment account at the end of 20 years.
b. Compute the interest earned on each account.
c. Show that even if the interest on Colbys investment
were subjected to a tax of 28% upon withdrawal of his
investment at the end of 20 years, the net accumulated
amount of his investment would still be greater than that
of Clarks.

29

Applied Example 6 Solution

a. Because Clark is in the 28% marginal tax bracket, the
net yield for his investment is (0.72)(8), or 5.76%, per
year.
Using Formula (9) with R = 1000, r = 0.0576, m = 1, and
t = 20, so that i = 0.0576 and n = mt = 20, we see that
Clarks investment will be worth

35,850.49
or $35,850.49 at his retirement.
30

Applied Example 6 Solution

contd

Colby has a tax-sheltered investment with an effective

yield of 8% per year. Using Formula (9) with R = 1000,
r = 0.08, m = 1, and t = 20, so that i = 0.08 and
n = mt = 20, we see that Colbys investment will be worth

45,761.96
or $45,761.96 at his retirement.
31

Applied Example 6 Solution

contd

b. Each man will have paid 20(1000), or $20,000, into his

account. Therefore, the total interest earned in Clarks
account will be (35,850.49 20,000), or $15,850.49,
whereas the total interest earned in Colbys account will
be (45,761.96 20,000), or $25,761.96 .
c. From part (b) we see that the total interest earned in
Colbys account will be $25,761.96. If it were taxed at
28%, he would still end up with (0.72)(25,761.96), or
$18,548.61. This is larger than the total interest of
$15,850.49 earned by Clark.
32