1-0

Quantitative Methods
for Business
COMM5005
Lecture 3

Shengyu Li
 1-1
1

Topics
3-1

In this lecture we will see how some of the important

concepts in financial mathematics are used:
• Ordinary annuities
• Annuity Due
• Amortization of Loans
• Perpetuities
 1-2
2

Readings
3-2

Sections of Haeussler Paul and Wood 14th ed. will help

you to understand this week’s topics more clearly.
Chapter Name Pages
5.4-5.6 Annuities, Amortization of Loans, 222-237
Perpetuities
 1-3
3

1. Annuities
3-3

• An annuity is a sequence of equal payments made at

regular intervals.
Examples: rent payments, mortgage payments,
wages, insurance premiums, sinking fund.

Time
 1-4
4

Can you distinguish? 3-4

• Payments of $1000 are made each month for two

years.
à This is an annuity.

• Payments of $200, $1000 and $800 are made for

three consecutive months.
à This is not an annuity.
 1-5
5

Ordinary Annuities & Annuity Due

3-5

• An ordinary annuity has payments made at the end

of each period.
0 1 2 3 4 5
Time
R R R R R

• An annuity due has payments made at the

beginning of each period.

0 1 2 3 4 5
Time
R R R R R
 1-6
6

Future or present value?

3-6

• To find an amount at the end of a series of payments,

we look for the future value.

• Future values are needed where we wish to know how

much superannuation a person will have put aside
when they retire, or how much a person will have
saved for their holiday when they are ready to depart.

• With loans or mortgages, on the other hand, we focus

on the amount borrowed at the beginning of the series
of payments, which is a present value.
 1-7
7

Future or present value?

3-7

Can you distinguish?

a) Linda’s grandparents save $200 per month to send
her to study art in France in 5 years time. How much
is available for her studies when she commences?

b) Her course and living expenses will require that she

spends $5000 per half year for 2 years. Have they
saved enough?
 1-8
8

3-8

Do you use future value or present value?

1. Present for (a) Future for (b)

2. Future for both
3. Future for (a) Present for (b)
4. Present for both
 1-9
9

Timeline of payments
3-9

Year 1 Year 2 Year 3 Year 4 Year 5

0 00 00 00
20 2 2 2
……………………… 0 0 00 00
20 20 2 2
Linda starts
the art
. course in
France
How much
is saved by
this time?
 1-
10 1
Timeline of payments 0

3-
1
0

Year 1 Year 2
5000 5000 5000 5000
Linda starts
the art
course in
France
How much is
needed by
this time?
 1-
11 1
2. Future value of an ordinary annuity 1

3-
1
1

• Imagine that Sam is saving $250 at the end of each

month to go on a mountain bike holiday in New Zealand.

• His savings account’s interest rate is

2.4% per annum compounded monthly,
how much does he have after a year?
 1-
12 1
2

3-
1
• Each deposit is R = 250 2
!.!#$
• Interest per period is 𝑟 = %# = 0.002

R R R R R R R R R R R R
𝑅
1 2 3 4 5 6 7 8 9 1 1 1 𝑅 1+𝑟
0 1 2 𝑅 1+𝑟 !
"
𝑅 1+𝑟

#$
𝑅 1+𝑟
##
𝑅 1+𝑟
 1-
13 1
Future value of an ordinary annuity 3

3-
1
The final value of all deposits that Sam has is: 3

𝑆 = 𝑆% + 𝑆# + ⋯ + 𝑆%% + 𝑆%#
𝑆 = 250 1.002 %% + 250 1.002 %! + ⋯ + 250 1.002 + 250
𝑆 = 250 1.002%% + 1.002%! + ⋯ + 1.002 + 1
This is a geometric series with a = 250 as the first term of the
series and the common ratio b = 1.002. Its sum is, therefore

𝑏& − 1 1.002%# − 1
S=a = 250 = $3033.22
𝑏−1 1.002 − 1
 1-
14 1
Future value of an ordinary annuity 4

3-
1
In general, the future value formula for an ordinary annuity is 4

𝑆 = 𝑆% + 𝑆# + ⋯ + 𝑆&'% + 𝑆&
𝑆 =𝑅 1+𝑟 &'% +𝑅 1+𝑟 &'# + ⋯+ 𝑅 1 + 𝑟 + 𝑅

(𝟏 + 𝒓)𝒏−𝟏
𝑺=𝐑
𝒓
where
R is the regular payment
r is interest per period
n is the number of periods
 1-
15 1
Example 1 5

3-
1
5

A company has a coal mining lease and is required to

stabilise soil at the site and replace native plants at the
expiration of the lease in 24 years.
If the company sets aside $285,000 in a sinking fund at
the end of each half-year and interest is 4.8% p.a.
compounded half yearly, how much is available when
the restoration begins?
 1-
16 1
3. Present value of an ordinary annuity 6

3-
1
6

• To find the present value of a series of n payments of $R

each, we discount each payment for the appropriate
number of periods then add all the discounted amounts.

0 1 2 3 4

R R R R
%#
𝑅 1+𝑟
%!
𝑅 1+𝑟
𝑅 1+𝑟 %"

%&
𝑅 1+𝑟
 1-
17 1
Present value of an ordinary annuity 7

3-
1
'% '# '& 7
A=𝑅 1+𝑟 +𝑅 1+𝑟 + ⋯+ 𝑅 1 + 𝑟
This also represents a geometric series with the first
term 𝑎 = 𝑅 1 + 𝑟 '% and the common ratio 𝑏 = 1 + 𝑟 '% .

𝑏! − 1 "#
1+𝑟 "!
−1
A=a =𝑅 1+𝑟 "# − 1
𝑏−1 1+𝑟

1 + 𝑟 "! − 1
=𝑅
1− 1+𝑟
 1-
18 1
Present value of an ordinary annuity 8

3-
1
8
The formula for the present value of an ordinary annuity
is therefore:

𝟏− 𝟏+𝒓 6𝒏
𝐀=𝑹
𝒓
where
R is the regular payment
r is interest per period
n is the number of periods

How this is related to the future value?

 1-
19 1
Example 2 9

3-
1
Kate purchases a house with an initial down payment of 9

$60,000 and then makes monthly payments of $2000 at

the end of each month for 20 years.
Given an interest rate of 7.5%
compounded monthly, find the present
value of the payments and the list price of
the house.
 1-
20 2
4. Future value of an annuity due 0

3-
2
0
• To derive the formula for the future value of an annuity due
consider that the first payment is made immediately. We
find its future value by compounding for n periods.
• Subsequent payments are each compounded for one less
period. The last payment is made at the beginning of the
last period so is compounded for one period.
• Then we add all these individual future values to find S.
 1-
21 2
Future value of an annuity due 1

3-
2
1
The future value in period n of an annuity due with regular
payments R and interest per period, r, is
& &'%
S=𝑅 1+𝑟 +𝑅 1+𝑟 + ⋯+ 𝑅 1 + 𝑟 (3)
Compare this with the series we had for an ordinary annuity

S=𝑅 1+𝑟 &'% +𝑅 1+𝑟 &'# + ⋯+ 𝑅 1 + 𝑟 + 𝑅 (4)

It can be seen that
(3) = 1 + 𝑟 ∗ (4)
 1-
22 2
Future value formula 2

3-
2
2

So the formula for the future value of an annuity due can

be obtained by multiplying the ordinary annuity formula for
future value by 1 + 𝑟

𝟏+𝒓 𝒏−𝟏
𝑺=𝑹 𝟏+𝒓
𝒓
 1-
23
Example 3 2
3

3-
2
3

Ted and Alice are new grandparents. On the day their new
granddaughter Sophie is born they set up a trust account
and deposit $2500 in it. $2500 will be deposited on each
birthday until she reaches 20 then she will receive the total
amount in the account on her 21st birthday.
a) Assuming an interest rate of 2.6% compounded annually
applies, how much will Sophie receive?
b) How would this differ if they deposited nothing at her
birth but $2500 on each birthday from her 1st to her 21st?
 1-
24 2
5. Present Value of an Annuity Due 4

3-
2
4
• If we wish to find the present value of an annuity due we
discount the value of each of the payments.
• As the first payment R is made immediately, it is already a
present value and needs no adjustment.
• The second payment needs to be discounted for one
period, the third for two periods and so on.
 1-
25 2
Present Value of an Annuity Due 5

3-
2
5
The present value of an annuity due is
A=𝑅+𝑅 1+𝑟 '% +𝑅 1+𝑟 '# + ⋯+ 𝑅 1 + 𝑟 '(&'%) (6)
Comparing with the ordinary annuity present value
A=𝑅 1+𝑟 '% +𝑅 1+𝑟 '# + ⋯+ 𝑅 1 + 𝑟 '& (7)

We can see that

(6) = 1 + 𝑟 ∗ (7)
 1-
26 2
Present value formula 6

3-
2
6

So the formula for the present value of an annuity due

can be obtained by multiplying the ordinary annuity
formula for present value by 1 + 𝑟

𝟏− 𝟏+𝒓 6𝒏
𝑨=𝑹 𝟏+𝒓
𝒓
 1-
27 2
Quick guide to annuities 7

3-
2
7
!"
1− 1+𝑟
PV = 𝑅
𝑟
Ordinary
annuity 1+𝑟 "−1
FV = 𝑅
𝑟

1− 1+𝑟 !"
PV = 𝑅 1+𝑟
Annuity 𝑟
due 1+𝑟 "−1
FV = 𝑅 1+𝑟
𝑟
 1-
28 2
6. Finding the payment 8

3-
2
In order to find the payment or repayment for an annuity, 8

we need to rearrange the appropriate formula which

shows the future or present value of the annuity, making
R the subject. Eg., for a loan with an ordinary annuity,
where we have the present value,
1− 1+𝑟 !"
A=𝑅
𝑟
then
𝑨𝒓
𝑹= !𝒏
𝟏− 𝟏+𝒓
 1-
29 2
Example 4 9

3-
2
This car lease is an arrangement where a financier buys a 9
$40,000 car and rents it to you for a monthly payment, with
the first payment made immediately. At the end of the three
years lease you can purchase the car for a residual of
$12,000. The interest rate is 6.6% p.a. compounded monthly.
a) What is the present value of the residual?
b) How much is the monthly payment?
c) Alternatively, the same car can be purchased
using a loan which has payments of $950 made at the
end of each month for 3 years plus a lump sum paid
immediately. How much should the lump sum be?
 1-
30 3
Example 5 0

3-
3
0
On her 35th birthday, Angela decides to make
superannuation contributions at the end of each month until
retirement. She and her employer together contribute $580 a
month. Her superannuation fund earns interest on
contributions of 5.2% per annum compounded monthly.
When Angela retires on her 65th birthday, the day of the last
payment, she chooses to take her superannuation
entitlement in the form of equal monthly pension payments
until she reaches her 80th birthday.
If payments begin one month after she turns 65, how much
is each payment? Assume the same interest rate applies in
the pension phase.
 1-
31 3
Time line representing Angela’s payments 1

3-
3
1

How much is each pension payment?

A. $846.32 B. $1843.12
C. $4013.95 D. Something else
 1-
32 3
7. Amortisation of loans 2

3-
3
2
• A loan with a fixed rate of interest is said to be
amortised if both the principal and interest are paid by a
sequence of equal payments made over equal periods
of time.
• We will examine how to
construct an amortisation table
by working through Example 6.
 1-
33 3
Example 6 3

3-
3
3

A personal loan of $20,000 is to be repaid over 5 years

with interest of 12% p.a. compounded annually. Payments
are made at the end of each year. Set up an amortisation
table for this loan.
 1-
34 3
Step 1 4

3-
3
4
• Since compounding is annual, each period will be 1 year.
• Interest is r = 0.12
• Since $20,000 is a present value and this is an ordinary
annuity. We re-arrange the appropriate formula to find R,
the regular payment made in each period.
𝐴𝑟
𝑅= '&
1− 1+𝑟
20,000 ∗ 0.12
𝑅= = 5548.19
1 − 1 + 0.12 '*
 1-
35 3
Step 2 5

3-
3
Consider period 1: 5

• Principal outstanding at the beginning is $20,000

• Interest charged = 20,000 ×0.12 = $2400
• Payment is $5548.19
• Principal repaid is $5548.19 –$2400.00 = $3148.19
• Principal outstanding at beginning of period 2 is
$20,000 –3,148.19 = $16,851.81
• Continuing the process for the other years allows us to
set up an amortisation table.
 1-
36 3
Amortisation Table 6

3-
3
6
Principal Principal
Year outstanding at start Interest paid Payment repaid

y1 20000 2400 5548.195 3148.195

y2 16851.81 2022.217 5548.195 3525.978

y3 13325.83 1599.099 5548.195 3949.095

y4 9376.732 1125.208 5548.195 4422.987

y5 4953.745 594.4494 5548.195 4953.745

 1-
37 3
Principal outstanding 7

3-
3
Sometimes we wish to calculate the principal outstanding 7

on a loan without setting up a whole amortisation table.

The simplest way to do so is to find the present value of
the payments yet to be made. For an ordinary annuity, if
there are still p payments left to be made
*𝒑
𝟏− 𝟏+𝒓
𝑷. 𝑶. = 𝑹
𝒓
 1-
38 3
Example 7 8

3-
3
A commercial loan of $275,000 is being repaid over 10 8
years with equal payments at the end of each quarter.
Interest is charged at 8.8% compounded quarterly.
a) How much money is outstanding at the beginning of
the fifth year?
b) How much interest is paid in the 17th payment?
A. $3644.77 B. $7812.5
C. $4234.61 D. Other amount
 1-
39 3
8. Changes of interest for savings 9

3-
3
9

We have seen in the previous example that by

calculating the principal outstanding we can deal with
changes in the interest rates for loans. It is not correct to
use that approach though for savings where future values
are concerned.
 1-
40 4
Finding the new payment amounts 0

3-
4
• In the case of savings, the original payments 𝑅% are found. 0
The future value of these payments 𝑆% is found at the time
the interest rate changes (𝑛% ).

• This amount goes on earning compound interest at the new

rate and has a final value of 𝑆# at period 𝑛# .

• If the total amount required to be saved at 𝑛# is 𝑆, then the

missing amount is 𝑆+ = 𝑆 − 𝑆# .

• The payments for the remainder of the period can be

calculated using the new interest rate and the future value 𝑆+ .
 1-
41 4
Example 8 1

3-
4
1

A company puts aside $10,000 at the end of each month in an

investment account to refurbish its offices two years from now.
a) If the interest rate is initially 5.4% per annum compounded
monthly, how much will the investment be worth after two
years?
b) If the interest rate drops to 4.8% p.a. after six months what
will the new deposits need to be to meet the original
investment target on time?
 1-
42 4
9. Perpetuities 2

3-
4
• Perpetuities are perpetual annuities. 2

• Examples are endowments for scholarships or prizes

which pay out money indefinitely
• They have no future value – we are always interested in
the present value or the amount needed to set them up.
• The present value can be shown to be

𝑹
𝑨=
𝒓
How is this formula related to present value of ordinary
annuity?
 1-
43 4
Example 9 3

3-
4
3
You have made a fortune and love classical music. You decide to
set up a prize for a piano competition to be held in Sydney each
year, indefinitely. If money in the fund can be invested at an interest
rate of 5% p.a. compounded annually,
a) how much do you need to contribute if the annual prize will
be $15,000 and is first awarded one year from now?
b) How much will be in the fund immediately before and after
the first payment?
c) How much will be in the fund immediately before and after
the 50th payment?
A. Same answer as for (b)
B. Different from answer (b)
 1-
44 4
So far we have learned 4

3-
4
4
• Simple interest: No interest on interest is earned.
• Compound interest
• Present value and Future value
• NPV and IRR
• Annuities
• Ordinary annuities/ Due annuities
• Future value and Present value of annuities
• Loan amortisation
• Savings and change of interest rate
• Perpetuities
 1-
45 4
5

3-
4
• This concludes our financial mathematics topic. Try 5
sufficient questions from the reference books to
understand how to apply formulas correctly.

• Using present versus future value appropriately is one

of the hardest choices for students to get right.

• Be very careful with rounding as the computer

demands accuracy.

• Next, calculus! We measure rates of change when

there is one independent variable or more than one.
 1-
46 4
Notices 6

3-
4
6

• Online Quiz 1 will be available on Moodle. It will cover material up

to and including this lecture. Access it on the Assessments page
of the course website. You will have multiple attempts. (Note that
mid term assessment and final exam do not have multiple
attempts.)