GENERAL MATHEMATICS

BUSINESS MATHEMATICS

III. ANNUITIES

An annuity is a sequence of equal payments or deposits made at regular intervals of time. Examples include
insurance premiums, pensions, and installment purchases. There are two types of an annuity, the simple annuity
and the general annuity. Below is a comparison between the two.

ANNUITY

SIMPLE Annuity GENERAL Annuity

Payment period Payment period

IS THE SAME WITH DIFFERS FROM
compounding period compounding period

Example: Example:
Annual payments AND interest Annual payments BUT interest
is compounded annually. is compounded quarterly.

The following terms are used in the discussion of annuities.

Payment interval or period is the length of time between two successive payments.

Term (t) is the time between the Lirst payment interval and the last payment interval.

Periodic payment (R) is the size of each payment.

Future value (F) is sum of all the periodic payments and the compound interest accumulated in each payment
from the time they are made up to the end of the term.

Present value (P) is the sum of all the periodic payments and the compound interest discounted in each payment
from the time it should be made back to the beginning of the term.

term
period
Present value Future value

0 1 2 3 4 5
R R R R R
Future Value and Present Value of Simple and General Annuity

The computation for the future value and the present value of both simple and general annuities is the
same. Only, for general annuity, the equivalent rate of the given interest rate must be calculated using the formula
discussed in compound interest. The following example illustrates the derivation of the formulas for both the future
and present values.

Example 16. You plan to purchase a new cellphone in one year and have made quarterly deposits of P1,000 into a
fund that offers 12% interest, compounded every three months. How much will be available after one year to buy
the cellphone?

0 1 2 3 4
1,000 1,000 1,000 1,000 0.12 (
= 1,000(1 + )
4
0.12 &
= 1,000(1 + )
4
0.12 2
= 1,000(1 + )
4
0.12 3
= 1,000(1 + )
4

The diagram above illustrates the computation of the future value using the compound interest formula. It
shows that each deposit earns interest over time. Adding the future value of each deposit, the total future value of
the annuity is
𝐹 = 1,000 + 1,030 + 1,060.90 + 1,092.73 = 𝑷𝟒, 𝟏𝟖𝟑. 𝟔𝟑.

To shorten the solution in finding the future value of an annuity, the formula
(1 + 𝑖)! − 1
𝐹 = 𝑅h k
𝑖

can be used, which is derived from future value formula for compound interest. Applying this in the example, we
have

𝑗 "# 0.12 $(&)

(1 + 𝑖)! − 1 m1 + 𝑚p − 1 m1 + 4 p −1
𝐹 = 𝑅h k = 𝑅l q = 1,000 l q = 𝑷𝟒, 𝟏𝟖𝟑. 𝟔𝟑.
𝑖 𝑗 0.12
𝑚 4
which has the same answer as the above solution.
Example 17. You purchased a new cellphone on installment, agreeing to pay P1,000 at the end of every three
months for one year. What is the cash price of the cellphone if the interest rate is 12% compounded quarterly?
P

0 1 2 3 4
1,000 1,000 1,000 1,000
1,000
=
0.12 &
m1 + p
4
1,000
=
0.12 2
m1 + p
4
1,000
=
0.12 /
m1 + p
4
1,000
=
0.12 $
m1 + p
4

The diagram above illustrates the computation of the present value using the compound interest formula. It
shows that each installment earned interest over time. Adding the present value of each installment, the total
present value of the annuity is
𝑃 = 970.87 + 942.60 + 915.14 + 888.49 = 𝑷𝟑, 𝟕𝟏𝟕. 𝟏𝟎.

Deriving the formula of the present value of an annuity from the formula of the compound interest, we have
1 − (1 + 𝑖))!
𝑃 = 𝑅h k
𝑖

which we can derive from the formula of the present value of compound interest. Applying it in our example, we
have
# !$% &.() !*(()
&)(&*+)!" &),&* - &),&* -
$ *
𝑃 = 𝑅x y = 𝑅z # { = 1,000 z &.() { = 𝑷𝟑, 𝟕𝟏𝟕. 𝟏𝟎.
+
$ *
Example 18. Andrew makes a cash payment of P200,000 and agrees to pay P20,000 a month for 5 years to
purchase a car. If money is worth 2.25% compounded monthly, what is the total cash price of the car?
Solution:
Step 1. Compute the present value of the annuity

1 − (1 + 𝑖))!
𝑃 = 𝑅h k = ______________________ = ____________________ = 𝑷𝟏, 𝟏𝟐𝟔, 𝟗𝟐𝟖. 𝟎𝟕
𝑖

Step 2. Compute for the cash price of the car.

𝐶𝑎𝑠ℎ 𝑃𝑟𝑖𝑐𝑒 = 𝐷𝑜𝑤𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 + 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦
𝐶𝑎𝑠ℎ 𝑃𝑟𝑖𝑐𝑒 = 𝑃200,000 + 𝑃1,126,928.07 = 𝑷𝟏, 𝟑𝟐𝟔, 𝟗𝟐𝟖. 𝟎𝟕.
The cash price of the car is P1,326,928.07.

Example 19. Asher’s Construction plans to create a fund of P1,650,000 to replace a deteriorating machinery. If
money is worth 7.5% compounded semi-annually, what equal deposits should be made at the end of every six
months over the next 10 years to reach this goal?
Solution: Derive the formula of R using the formula of the future value of an annuity
(1 + 𝑖)! − 1
𝐹 = 𝑅h k
𝑖
𝑗 0.075
𝐹𝑖 𝐹 m𝑚 p 1,650,000 m 2 p
𝑅= = = = 𝑷𝟓𝟔, 𝟖𝟔𝟐. 𝟒𝟔
(1 + 𝑖 )! − 1 𝑗 "# 0(&()
m1 + p − 1 m1 + 0.075p − 1
𝑚 2
Asher’s Construction will have to deposit P56 862.46 semi-annually for 10 years to reach P1,650,000.

Example 20. Abigail wants to buy a new refrigerator worth P29,500 cash. If it can be sold at 20% down payment
and 24 equal monthly installments, what will be the size of each installment, if money is worth 12%
compounded semi-annually?
Solution:
Step 1. Since the paying period (monthly) is not the same as the compounding period (semi-annually), first find the
nominal rate compounded monthly that is equivalent to 12% compounded semi-annually by using equivalent rate
formula.
𝑤"1!#234 = 𝑤56"+)7!!87334

𝑗 " 𝑗 "
•1 + – − 1 = •1 + – − 1
𝑚 𝑚
𝑗 &0 0.12 0
•1 + – = •1 + –
12 2
𝒋 = 𝟎. 𝟏𝟏𝟕𝟏
Step 2. Derive the formula of R using the formula of the present value of an annuity.
1 − (1 + 𝑖))!
𝑃 = 𝑅h k
𝑖

Before substituting, compute the new present value by subtracting the down payment.

𝐷𝑜𝑤𝑛 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 (𝐷𝑃) = 20% 𝑜𝑓𝑃29,500 = 𝑷𝟓, 𝟗𝟎𝟎

𝑃 = 29,500 − 5,900 = 𝑷𝟐𝟑, 𝟔𝟎𝟎
𝑃𝑖
𝑅= = ____________________ = ____________________ = 𝑷𝟏, 𝟏𝟎𝟕. 𝟕𝟒
1 − (1 + 𝑖))!
Abigail needs to pay P1,107.74 every month for 24 months.

Deferred Annuity

Deferred annuity is an annuity whose term does not begin until a specified time. The period of deferral or
deferment period is the time between the present and the start of the payment period.

The diagram below shows how deferred annuity differs from a simple annuity.

Simple / General Deferred Annuity

Annuity

Start of Payout End of Payout Start of Payout End of Payout

R R R R

0 1 2 3 4 5 6
0 1 2 3 4 5 6

Deferred
Period, nd Payment
Period, np
Lump Sum Deposit
Lump Sum Deposit
P
P

Consider a lump sum amount deposited at the beginning of the term. For a simple annuity, the payout
begins immediately, at the end of the first period. In contrast, for a deferred annuity, the payout starts after a delay
which is the end of the fourth period. In both cases, the payouts end at the conclusion of the term, which is the end
of the sixth period.
The future value of a deferred annuity is similar to that of a simple annuity, only that the total number of
periods (n) is counted from the start of the payment period until the end of the term (payment period, 𝑛9 ). That is,

(1 + 𝑖)!- − 1
𝐹 = 𝑅h k
𝑖

On the other hand, the present value of a deferred annuity is computed using the formula
1 − (1 + 𝑖))!-
𝑃 = 𝑅h k (1 + 𝑖))!.
𝑖

where 𝑛: represents the deferral period.

Example 21. If money is worth 2.25% compounded monthly, what is the present value and the future value of a
sequence of 9 monthly payments of P2,300, the first payment due at the end of 4 months.
Illustration: Present value Start of payment Future
value

0 1 2 3 4 5 6 7 8 9 10 11 12

deferred periods, nd payment periods, np

Solution:
&)(&*+)!"-
Present value: 𝑃 = 𝑅x +
y (1 + 𝑖))!. = ____________________ = ____________________ = 𝑷𝟐𝟎, 𝟑𝟓𝟖. 𝟓𝟏

(&*+)"- )&
Future value: 𝐹 = 𝑅x +
y = ____________________ = ____________________ = 𝑷𝟐𝟎, 𝟖𝟕𝟑. 𝟑𝟒

Example 22. David borrows P400,000, with interest at 5%, compounded semiannually. He agrees to discharge his
obligation by making a series of equal payments, with the first due at the of two years and the last at the end of
seven years. What is the size of each semiannual payment?
Present Value Start of Payment End of Payment

P400,000 R R R R. R R R R R R R

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

deferred periods, nd payment periods, np

Solution:
&)(&*+)!"-
Step 1. Derive the formula of 𝑅 in 𝑃 = 𝑅 x +
y (1 + 𝑖))!.

Step 2. Substitute values

𝑃𝑖 (1 + 𝑖)!.
𝑅= = ______________________ = 𝑷𝟒𝟓, 𝟐𝟕𝟓. 𝟎𝟓
1 − (1 + 𝑖))!-

David must pay P45,275.05 every six months to pay the loan.