TOPIC 3: Annuity

Estimated Time: 3 hours

Topic Outcomes:
At the end of the topic, you are expected to:
1. Differentiate the difference between a compound amount and an annuity;
2. Calculate and analyze the future value of types of annuity by using the formula or the table for annuities; and
3. Evaluate yourself in the assessment activity.

Topic Contents:
Annuity (A) is defined as a series of equal payments “A” occurring at equal intervals of time. When an annuity
has a fixed time span, it is known as annuity certain.
Instances where annuities occur:
 Payment of a debt by a series of equal payments at equal intervals of time.
 Accumulation of a certain amount by setting the amount periodically.
 Substitution of a series of equal amounts periodically in lieu of a lump sum.

Classification of Annuity:
1. Simple annuity- payment period is the same as the interest period. If the payments are made monthly then
the conversion of money also occurs monthly.
2. General annuity- payment period is not the same as the interest period however it can be converted to a
simple annuity by making the payment period the same as the compounding period by the concept of
effective rates.

Types of Annuities:
1. Ordinary annuity- one where equal payments is made at the end of each payment period starting from the
first period.

From the cash flow diagram above, the future amount F is the sum of payments starting from
the end of the first period to the end of the nth period. Observe that the total number of payments is n
and the total number of compounding periods is also n. Thus, the ordinary annuity, the number of
payments and, the number of compounding periods are equal.

Future Amount of Ordinary Annuity, (F):

Where;
𝑨[(𝟏 + 𝒊)𝒏 − 𝟏] A= Annual payment
𝑭=
𝒊 P= Present worth or amount
F= Future worth or amount
Present Amount of Ordinary Annuity, (P): n= number of payment period
i= interest rate per period
𝑭 𝑨[(𝟏 + 𝒊)𝒏 − 𝟏]
𝑷= =
(𝟏 + 𝒊)𝒏 (𝟏 + 𝒊)𝒏 𝒊

But, if the interest rate is compounded the formula will be;

𝒊 𝒏𝒎 𝒊 𝒏𝒎
𝑨 [(𝟏 + 𝒎) − 𝟏] 𝑭 𝑨 [(𝟏 + 𝒎) − 𝟏]
𝑭= 𝑷= =
𝒊 𝒊 𝒏𝒎 𝒊 𝒏𝒎 𝒊
𝒎 (𝟏 + 𝒎) (𝟏 + 𝒎) 𝒎
Example 1: How much money must be deposited today in order to withdraw ₱2,000 annually for 10 years if the
interest rate is 9%? How about your future amount?

Given: A= ₱2,000 Req’d: P & F

n= 10 years Solution:
𝐴[(1+𝑖)𝑛 −1] ₱2,000[(1+0.09)10 −1]
i= 9%= 0.09 𝑃= = = ₱𝟏𝟐, 𝟖𝟑𝟓. 𝟑𝟐
(1+𝑖)𝑛 𝑖 (1+0.09)10 (0.09)

𝐴[(1+𝑖)𝑛 −1] ₱2,000[(1+0.09)10 −1]

𝐹= = = ₱𝟑𝟎, 𝟑𝟖𝟓. 𝟖𝟔
𝑖 0.09

Example 2: What is the accumulated amount of the five-year annuity paying ₱6,000 at the end of each year
with interest at 15% compounded annually?

Given: A= ₱6,000 Req’d: F=?

n= 5 years Solution:
𝐴[(1+𝑖)𝑛 −1] ₱6,000[(1+0.15)5 −1]
i= 15%= 0.15 𝐹= = = ₱𝟒𝟎, 𝟒𝟓𝟒. 𝟐𝟗
𝑖 0.15

Try to solve: A piece of property is purchased for ₱20,000. The purchaser makes a down payment of ₱5,000
and agrees to pay the balance at 4% in twelve equal annual installments. Solve the amount of each installment.
Ans: ₱1,598.28

2. Annuity due- In annuity due, equal payments are made at the beginning of each compounding period
starting from the first period. The diagram below shows the cash flow in an annuity due.

As indicated in the figure above, F1 is the sum of ordinary annuity of n payments. The future amount F of
annuity due at the end of nth period is one compounding period away from F1. In symbol, F = F1(1 + i).

Future Amount of Annuity Due, (F):

𝑨[(𝟏 + 𝒊)𝒏 − 𝟏] Where;

𝑭 = 𝑭𝟏 (𝟏 + 𝒊) = (𝟏 + 𝒊)
𝒊 A= Annual payment
P= Present worth or amount
F= Futu ;re worth or amount
F1= Future amount of Ordinary Annuity
Present Amount of Annuity Due, (P):
n= number of payment period
i= interest rate per period
𝑭 𝑨[(𝟏 + 𝒊)𝒏 − 𝟏]
𝑷= = (𝟏 + 𝒊)
(𝟏 + 𝒊)𝒏 (𝟏 + 𝒊)𝒏 𝒊

But, if the interest rate is compounded the formula will be;

𝒊 𝒏𝒎
𝒊 𝑨 [(𝟏 + 𝒎) − 𝟏] 𝒊
𝑭 = 𝑭𝟏 (𝟏 + ) = (𝟏 + )
𝒎 𝒊 𝒎
𝒎

𝒊 𝒏𝒎
𝑭 𝑨 [(𝟏 + 𝒎) − 𝟏] 𝒊
𝑷= = (𝟏 + )
𝒊 𝒏𝒎 𝒊 𝒏𝒎 𝒊 𝒎
(𝟏 + 𝒎) (𝟏 + 𝒎) 𝒎
 Example 3: An 8-year annuity due has a future value of ₱1,000. If the interest rate is 5 percent, the amount of
each annuity payment.

Given: F= ₱1,000 Req’d: P=?

n= 8 years Solution:
𝑭𝒊 (₱𝟏,𝟎𝟎𝟎)(𝟎.𝟎𝟓)
i= 5%= 0.05 𝑨 = [(𝟏+𝒊)𝒏 −𝟏](𝟏+𝒊) = [(𝟏+𝟎.𝟎𝟓)𝟖 −𝟏](𝟏+𝟎.𝟎𝟓) = ₱𝟗𝟗. 𝟕𝟒

Example 4: What is the present value of an annuity due that makes 6 annual payments of ₱500 each if the
discount rate is 9%.

Given: A= ₱500 Req’d: P=?

n= 6 Solution:
𝑑 0.09
d= 9%= 0.09 𝑖 = 1−𝑑 = 1−0.09 = 0.0989 = 9.89%
Rate of discount- is the discount on one
unit of principal per unit time. If “d” is the 𝐴[(1 + 𝑖)𝑛 − 1]
𝑃= (1 + 𝑖)
rate of discount, then (1 + 𝑖)𝑛 𝑖
₱500[(1 + 0.0989)6 − 1]
𝒊 𝒅 𝑃= (1 + 0.0989)
𝒅= 𝑜𝑟 𝒊= (1 + 0.0989)6 (0.0989)
𝟏+𝒊 𝟏−𝒅 𝑷 = ₱𝟐, 𝟒𝟎𝟎. 𝟕𝟑

3. Deferred annuity- is one where the payment of the first amount is deferred a certain number of periods
after the first.

a. Accumulation Stage. A single payment is allowed to earn interest for a specified duration. There are no annuity
payments during this period of time, which is commonly referred to as the period of deferral.

b. Payments Stage. The annuity takes the form of any of the four annuity types and starts at the beginning of this
stage as per the financial contract. Note that the maturity value of the accumulation stage is the same as the
principal for the payments stage.

Where;
Future Amount of Deferred Annuity, (F): A= Annual payment
P= Present worth or amount
𝑨[(𝟏 + 𝒊)𝒏 − 𝟏] F= Future worth or amount
𝑭= n= number of payment period
𝒊 k= number of periods before the first annuity
i= interest rate per period
Present Amount of Deferred Annuity, (P):

𝑭 𝑨[(𝟏 + 𝒊)𝒏 − 𝟏]
𝑷= =
(𝟏 + 𝒊)𝒌+𝒏 (𝟏 + 𝒊)𝒌+𝒏 𝒊
 But, if the interest rate is compounded the formula will be;

𝒊 𝒏𝒎 𝒊 𝒏𝒎
𝑨 [(𝟏 + 𝒎) − 𝟏] 𝑨 [(𝟏 + 𝒎) − 𝟏]
𝑭= 𝑷=
𝒊
𝒎 𝒊 𝒌+𝒏(𝒎) 𝒊
(𝟏 + 𝒎) 𝒎

Example 5: John got a deal to ₱ lend today, and in return, he will receive twenty-five annual payments of
₱6,000 each. The annuity will start five years from now, and the rate of interest will be 6%. What is the present
value of 25 annual payments?

Given: P=₱10,000 Req’d: P=?

A= ₱6,000 Solution:
𝐴[(1+𝑖)𝑛 −1] ₱6,000[(1+0.06)25 −1]
n=25 𝑃= = = ₱57,314.40
(1+𝑖)𝑘+𝑛 𝑖 (1+0.06)30 (0.06)
k=5
𝐴[(1+𝑖)𝑛 −1] ₱6,000[(1+0.06)25 −1]
𝐹= = = ₱329,187.07
𝑖 0.06

𝐹
𝑃 = (1+𝑖)𝑘+𝑛 𝐹 = 𝑃(1 + 𝑖)𝑘+𝑛 = ₱57,314.40(1 + 0.06)30 = ₱329,187.07

Example 6: A man invests ₱10,000 now for the college education of his 2-year old son. If the fund earns a 14%
interest rate, how much will the son get each year starting from his 18th to the 22nd birthday?

Given:
P= ₱10,000 Req’d: A=?
n= 5 years (18th to 22nd) Solution:
𝐴[(1+𝑖)𝑛 −1]
k= 15 𝑃 = (1+𝑖)𝑘+𝑛 𝑖
𝐴[(1+0.14)5 −1]
i= 14% ₱10,000 = (1+0.14)15+5 (0.14)

4. Perpetuity or Perpetual Annuity- annuity where the payment periods extend to forever or in which the
periodic payments continue indefinitely. There is no definite future in perpetuity, thus, there is no formula for
the future amount.

Present Amount of Perpetuity, (P):

For perpetuity where the periodic payments are each equal to A, the present value is
Future amount is infinite

𝑨
𝑨[(𝟏 + 𝒊)𝒏 − 𝟏] 𝑷=
𝑷= 𝒊
(𝟏 + 𝒊)𝒏 𝒊
But, if the interest rate is compounded the formula will be;

𝑨
𝑷= 𝒊
𝒎
Example 7: The ABC Company is able to deliver a net income every year of ₱250. Assuming that this is
perpetuity - a never-ending income - the value of this cash flow and the value of the company with a discount
rate of 10% can be calculated to,

Given: A= ₱250 Req’d: P=?

n=∞ Solution:
𝑑 0.10
d= 10% 𝑖 = 1−𝑑 = 1−0.10 = 0.111 = 11.1%
𝐴 ₱250
𝑃= = = ₱𝟐, 𝟐𝟓𝟐. 𝟐𝟐
𝑖 0.111

Example 8: In his will, a man wishes to establish a perpetual trust to provide for the maintenance of a small
local park. If the annual maintenance is ₱7,500 per year and trust account can earn 5% interest rate, how much
money must be aside in the trust fund?

Given: A= ₱7,500 Req’d: P=?

n=∞ Solution:
𝐴 ₱7,500
i= 5% =0.05 𝑃= = = ₱𝟏𝟓𝟎, 𝟎𝟎𝟎
𝑖 0.05

Different Compound and Annuity Factors:

Annuity Factors Description

(1 + 𝑖)𝑛 − 1 Equal-payment (uniform) series compound-amount
𝑖 factor
(1 + 𝑖)𝑛 − 1 Equal-payment series present worth factor
(1 + 𝑖)𝑛 𝑖
𝑖 Equal-payment series sinking fund factor
(1 + 𝑖)𝑛 𝑖
(1 + 𝑖)𝑛 𝑖 Equal-payment series capital recovery factor
(1 + 𝑖)𝑛 − 1

𝑒 𝑖𝑛 Continuous Compounding Compound Amount Factor

(1 + 𝑖)𝑛 Single Payment Compound Amount Factor

𝑒 𝑖𝑛 − 1 Continuous Compounding Future Worth Amount Factor

𝑒𝑖 − 1
𝑒 𝑖𝑛 − 1 Continuous Compounding Present Worth Amount Factor
𝑒 𝑖𝑛 (𝑒 𝑖 − 1)
𝑒𝑖 − 1 Continuous Compounding Annual Worth Amount Factor
𝑒 𝑖𝑛 − 1

Example 9: Using the 9 different factors, determine the value of each of the following compound and annuity
factors in a given principal amount with interest rate of 14.5% in 7 years.

Given: i=14.5%=0.145 n= 7 yrs.

a. Equal-payment (uniform) series compound-amount factor

(1 + 𝑖)𝑛 − 1 (1 + 0.145)7 − 1
= = 𝟏𝟎. 𝟗𝟎
𝑖 0.145

b. Equal-payment series present worth factor

(1 + 𝑖)𝑛 − 1 (1 + 0.145)7 − 1
= = 𝟒. 𝟐𝟐
(1 + 𝑖)𝑛 𝑖 (1 + 0.145)7 (0.145)

c. Equal-payment series sinking fund factor

𝑖 0.145
= = 𝟎. 𝟑𝟖𝟖
(1 + 𝑖)𝑛 𝑖 (1 + 0.145)7 (0.145)

d. Equal-payment series capital recovery factor

(1 + 𝑖)𝑛 𝑖 (1 + 0.145)7 (0.145)
= = 𝟎. 𝟐𝟑𝟕
(1 + 𝑖)𝑛 − 1 (1 + 0.145)7 − 1
e. Continuous Compounding Compound Amount Factor
𝑒 𝑖𝑛 = 𝑒 (0.145)(7) = 𝟐. 𝟕𝟓𝟗

f. Single Payment Compound Amount Factor

(1 + 𝑖)𝑛 = (1 + 0.145)7 = 𝟐. 𝟓𝟖𝟎

g. Continuous Compounding Future Worth Amount Factor

𝑒 𝑖𝑛 − 1 𝑒 (0.145)(7) − 1
= (0.145) = 𝟏𝟏. 𝟐𝟕𝟓
𝑒𝑖 − 1 𝑒 −1

h. Continuous Compounding Present Worth Amount Factor

𝑒 𝑖𝑛 − 1 𝑒 (0.145)(7) − 1
= = 𝟒. 𝟎𝟖𝟔
𝑒 𝑖𝑛 (𝑒 𝑖 − 1) 𝑒 (0.145)(7) (𝑒 (0.145) − 1)

i. Continuous Compounding Annual Worth Amount Factor

𝑒𝑖 − 1 𝑒 (0.145) − 1
= = 𝟎. 𝟎𝟖𝟗
𝑒 𝑖𝑛 − 1 𝑒 (0.145)(7) − 1