What Are Annuities?

Annuities are essentially a series of fixed payments required from you, or paid to
you, at a specified frequency over the course of a fixed time period. The most
common payment frequencies are yearly, semi-annually (twice a year), quarterly
and monthly. There are two basic types of annuities: ordinary annuities and
annuities due.

 Ordinary annuity: Payments are required at the end of each period. For
example, straight bonds usually pay coupon payments at the end of every six
months until the bond's maturity date.
 Annuity due: Payments are required at the beginning of each period. Rent is
an example of annuity due. You are usually required to pay rent when you
first move in at the beginning of the month, and then on the first of each
month thereafter.

Since the present and future value calculations for ordinary annuities – and
annuities due are slightly different – we will first discuss the present and future
value calculation for ordinary annuities.

Calculating the Future Value of an Ordinary Annuity

If you know how much you can invest per period for a certain time period, the
future value (FV) of an ordinary annuity formula is useful for finding out how
much you would have in the future by investing at your given interest rate. If you
are making payments on a loan, the future value is useful in determining the total
cost of the loan.

Let's now run through Example 1. Consider the following annuity cash flow
schedule:
To calculate the future value of the annuity, we have to calculate the future value
of each cash flow. Let's assume that you are receiving $1,000 every year for the
next five years, and you invested each payment at 5%. The following diagram
shows how much you would have at the end of the five-year period:

Since we have to add the future value of each payment, you may have noticed that
if you have an ordinary annuity with many cash flows, it would take a long time to
calculate all the future values and then add them together. Fortunately,
mathematics provides a formula that serves as a shortcut for finding
the accumulated value of all cash flows received from an ordinary annuity:

where C = Cash flow per

period
 i = interest rate

n = number of payments

Using the above formula for Example 1 above, this is the result:

= $1000*[5.53]=
$5525.63

Note that the 1 cent difference between $5,525.64 and $5,525.63 is due to
a rounding error in the first calculation. Each value of the first calculation must be
rounded to the nearest penny – the more you have to round numbers in a
calculation, the more likely rounding errors will occur. So, the above formula not
only provides a shortcut to finding the FV of an ordinary annuity, but also gives a
more accurate result.

Calculating the Present Value of an Ordinary Annuity

If you would like to determine today's value of a future payment series, you need
to use the formula that calculates the present value (PV) of an ordinary annuity.
This is the formula you would use as part of a bond pricing calculation. The PV of
an ordinary annuity calculates the present value of the coupon payments that you
will receive in the future.

For Example 2, we'll use the same annuity cash flow schedule as we did in
Example 1. To obtain the total discounted value, we need to take the present value
of each future payment and, as we did in Example 1, add the cash flows together.
Again, calculating and adding all these values will take a considerable amount of
time, especially if we expect many future payments. As such, we can use a
mathematical shortcut for PV of an ordinary annuity.

where C = Cash flow per

period

i = interest rate

n = number of payments

The formula provides us with the PV in a few easy steps. Here is the calculation of
the annuity represented in the diagram for Example 2:

= $1000*[4.33]=
$4329.48
Calculating the Future Value of an Annuity Due

When you are receiving or paying cash flows for an annuity due, your cash flow
schedule would appear as follows:

Since each payment in the series is made one period sooner, we need to discount
the formula one period back. A slight modification to the FV-of-an-ordinary-
annuity formula accounts for payments occurring at the beginning of each period.
In Example 3, let's illustrate why this modification is needed when each $1,000
payment is made at the beginning of the period rather than at the end (interest rate
is still 5%):

Notice that when payments are made at the beginning of the period, each amount is
held longer at the end of the period. For example, if the $1,000 was invested on
January 1 rather than December 31 each year, the last payment before we value our
investment at the end of five years (on December 31) would have been made a year
prior (January 1) rather than the same day on which it is valued. The future value
of annuity formula would then read:
 where C = Cash flow per period

i = interest rate

n = number of payments

Therefore,

= $1000*5.53*1.05=
$5801.91

Calculating the Present Value of an Annuity Due

For the present value of an annuity due formula, we need to discount the formula
one period forward as the payments are held for a shorter amount of time. When
calculating the present value, we assume that the first payment was made today.

We could use this formula for calculating the present value of your future rent
payments as specified in a lease you sign with your landlord. Let's say for Example
4 that you make your first rent payment at the beginning of the month and are
evaluating the present value of your five-month lease on that same day. Your
present value calculation would work as follows:
Of course, we can use a formula shortcut to calculate the present value of an
annuity due:

where C = Cash flow per period

i = interest rate

n = number of payments

Therefore,

= $1000*4.33*1.05=
$4545.95

Recall that the present value of an ordinary annuity returned a value of $4,329.48.
The present value of an ordinary annuity is less than that of an annuity due because
the further back we discount a future payment, the lower its present value – each
payment or cash flow in an ordinary annuity occurs one period further into the
future.
 Fixed Interest Securities

Price of a fixed interest bond at coupon date

The price of a fixed interest security is the sum of the present value of the face
value and the present value of the coupon stream

P=C [
1−( 1+i )
i
−n
] −n
+ A ( 1+i )

Example 5:

Current corporate bond yields in the market are 8 per cent per annum. An existing
corporate bond with a face value of $100,000, paying 10 per cent per annum half-
yearly coupons, maturing 31 December 2009, would be sold on 20 May 2004 at a
price of:

Ans:
(a)

PV =$100 000 (1+ 0. 04 )

−12
face value
=$62 459 . 70
plus
(b)
1−( 1 +0 . 04 )−12
PV =$5000 [ ]
coupons 0 . 04
=$46 925 . 37
PV =$62 459 . 70 +$46 925 . 37
=$10 9385 . 07

Determining Day Count

P= C {[
1−( 1+i )
i
−n
] + A ( 1+ i )
−n
} ( 1+i )
k
To price a bond between payment periods, we must use the appropriate day-count
convention. Day count is a way of measuring the appropriate interest rate for a specific
period of time. There is actual/actual day count, which is used mainly for Treasury
securities. This method counts the exact number of days until the next payment. For
example, Current corporate bond yields in the market are 8 per cent per annum. An
existing corporate bond with a face value of $100,000, paying 10 per cent per annum
half-yearly coupons, maturing 31 December 2009, would be sold on 20 May 2004 at a
price of: Time Period = Days Counted
January 1-31 = 31 days
February 1-28 = 28 days
March 1-31 = 31 days
April 1-30 = 30 days
May 1-20 = 20 days
Total Days = 140 days

To determine the day count, we must also know the number of days in the six-month
period of the regular payment cycle. In these six months there are exactly 181 days, so
the day count of the Bond would be 140/181, which means that out of the 181 days in the
six-month period, the bond still has 140 days before the next coupon payment. In other
words, 41 days of the payment period (181 - 140) have already passed. If the bondholder
sold the bond today, he or she must be compensated for the interest accrued on the bond
over these 41 days.

(a)

PV =$100 000 (1+ 0. 04 )

−12
face value
=$62 459. 70
plus
(b)
1−(1+0 .04 )−12
PV =$5000[ ]
=$46 925. 37
PV =$62 459 .70+$46 925 . 37
=$10 9385. 07

(c )
140
P=$109 385 . 07(1 .04 )
181
=$112 754 . 27
(Note that if it is a leap year, the total number of days in a year is 366 rather than 365.)

For municipal and corporate bonds, you would use the 30/360 day count convention,
which is much simpler as there is no need to remember the actual number of days in each
year and month. This count convention assumes that a year consists of 360 days and each
month consists of 30 days. As an example, assume the above Treasury bond was actually
a semi-annual corporate bond. In this case, the next coupon payment would be in 120
days.

Time Period = Days Counted

March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
July 1 = 0 days
Total Days = 120 days

As a result, the day count convention would be 120/180, which means that 66.7% of the
coupon period remains. Notice that we end up with almost the same answer as the
actual/actual day count convention above: both day-count conventions tell us that 60 days
have passed into the payment period.

Determining Interest Accrued

Accrued interest is the fraction of the coupon payment that the bond seller earns for
holding the bond for a period of time between bond payments. The bond price's inclusion
of any interest accrued since the last payment period determines whether the bond's price
is "dirty" or "clean." Dirty bond prices include any accrued interest that has accumulated
since the last coupon payment while clean bond prices do not. In newspapers, the bond
prices quoted are often clean prices.

However, because many of the bonds traded in the secondary market are often traded in
between coupon payment dates, the bond seller must be compensated for the portion of
the coupon payment he or she earns for holding the bond since the last payment. The
amount of the coupon payment that the buyer should receive is the coupon payment
minus accrued interest. The following example will make this concept more clear.

Example 3: On March 1, 2003, Francesca is selling a corporate bond with a face value of
$1,000 and a 7% coupon paid semi-annually. The next coupon payment after March 1,
2003, is expected on June 30, 2003. What is the interest accrued on the bond?

1. Determine the Semi-Annual Coupon Payment: Because the coupon payments are semi-
annual, divide the coupon rate in half, which gives a rate of 3.5% (7% / 2). Each semi-
annual coupon payment will then be $35 ($1,000 X 0.035).

2. Determine the Number of Days Remaining in the Coupon Period: Because it is a

corporate bond, we will use the 30/360 day-count convention.

Time Period = Days Counted

March 1-30 = 30 days
April 1-30 = 30 days
May 1-30 = 30 days
June 1-30 = 30 days
Total Days = 120 days

There are 120 days remaining before the next coupon payment, but because the coupons
are paid semi-annually (two times a year), the regular payment period if the bond is 180
days, which, according to the 30/360 day count, is equal to six months. The seller,
therefore, has accumulated 60 days worth of interest (180-120).

3. Calculate the Accrued Interest: Accrued interest is the fraction of the coupon payment
that the original holder (in this case Francesca) has earned. It is calculated by the
following formula:

In this example, the interest accrued by Francesca is $11.67. If the buyer only paid her
the clean price, she would not receive the $11.67 to which she is entitled for holding the
bond for those 60 days of the 180-day coupon period.

Now you know how to calculate the price of a bond, regardless of when its next coupon
will be paid. Bond price quotes are typically the clean prices, but buyers of bonds pay the
dirty, or full price. As a result, both buyers and sellers should understand the amount for
which a bond should be sold or purchased. In addition, the tools you learned in this
section will better enable you to learn the relationship between coupon rate, required
yield and price as well as the reasons for which bond prices change in the market.
A project is expected to create operating cash flows of $30,000 a year for three years. The initial
cost of the fixed assets is $60,000. These assets will be worthless at the end of the project. An
additional $10,000 of net working capital will be required throughout the life of the project.
What is the project net present value if the required rate of return is 10%?

7 points 2. NUK company will pay an annual dividend of $2.06 a share on its common stock
next year. Last week, the company paid a dividend of $2.00 a share. The company adheres to a
constant rate of growth dividend policy. What will one share of NUK company common stock be
worth eight years from now if the applicable discount rate is 10%? 7 points