Chapter 5

Week 4
[Lecture 4]
The Time Value
of Money: Effective
Annual Rate, Annuities
& Perpetuities
 Learning Objectives

1. Understand annuities.
2. Understand amortization
3. Understand perpetuities.
4. Compute non-annual compounding
frequency.

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 ANNUITIES

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 Annuity

An annuity is a series of equal dollar

payments for a specified number of years.

Ordinary annuity payments occur at the end

of each period.

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 FV of Annuity

Compound Annuity
Depositing or investing an equal sum of
money at the end of each year for a certain
number of years and allowing it to grow.

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 FV Annuity - Example

What will be the FV of a 5-year, $500 annuity

compounded at 6%?
FV5 = $500 (1 + 0.06)4 + $500 (1 + 0.06)3
+ $500(1 + 0.06)2 + $500 (1 + 0.06) + $500
= $500 (1.262) + $500 (1.191) + $500
(1.124)
+ $500 (1.090) + $500
= $631.00 + $595.50 + $562.00 + $530.00 +
$500
= $2,818.50

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 FV of an Annuity
Using the Mathematical Formulas

FVn = PMT {(1 + r)n 1/r}

FV n = the future of an annuity at the end of
the nth year
PMT = the annuity payment deposited or
received at the end of each year
r = the annual interest (or discount) rate
n = the number of years

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 FV of an Annuity
Using the Mathematical Formulas
What will $500 deposited in the bank every
year for 5 years at 6% be worth?

FV = PMT ([(1 + r)n 1]/r)

= $500 (5.637)
= $2,818.50

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 FV of Annuity:
Changing PMT, N, and r
1. What will $5,000 deposited annually for 50
years be worth at 7%?
FV = $2,032,644
Contribution = $250,000 (= 5000*50)
2. Change PMT = $6,000 for 50 years at 7%
FV = $2,439,173
Contribution= $300,000 (= 6000*50)

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 FV of Annuity:
Changing PMT, N, and r

3. Change time = 60 years, $6,000 at 7%

FV = $4,881,122
Contribution = $360,000 (= 6000*60)
4. Change r = 9%, 60 years, $6,000
FV = $11,668,753
Contribution = $360,000 (= 6000*60)

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 Present Value of an Annuity

Pensions, insurance obligations, and interest

owed on bonds are all annuities. To
compare these three types of investments
we need to know the present value (PV) of
each.

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 PV of Annuity
Using the Mathematical Formulas

PV of Annuity = PMT {[1 (1 + r)5]}/r

= 500 (4.212)
= $2,106

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 Annuities Due

Annuities due are ordinary annuities in

which all payments have been shifted
forward by one time period. Thus, with
annuity due, each annuity payment occurs
at the beginning of the period rather than at
the end of the period.

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 Annuities Due

Continuing the same example: If we assume

that $500 invested every year for 5 years at
6% to be annuity due, the future value will
increase due to compounding for one
additional year.
FV5 (annuity due) = PMT {[(1 + r)n 1]/r}
(1 + r)
= 500(5.637)(1.06)
= $2,987.61
(versus $2,818.80 for ordinary annuity)

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 Amortized Loans

Loans paid off in equal installments over

time are called amortized loans.
Example: Home mortgages, auto loans.

Reducing the balance of a loan via annuity

payments is called amortizing.

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 Amortized Loans

The periodic payment is fixed. However,

different amounts of each payment are
applied toward the principal and interest.
With each payment, you owe less toward
principal. As a result, the amount that goes
toward interest declines with every payment
(as seen in Figure 5-4).

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 Amortization Example

Example: If you want to finance a new

machinery with a purchase price of $6,000
at an interest rate of 15% over 4 years,
what will your annual payments be?

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 Finding PMT
Using the Mathematical Formulas
Finding Payment: Payment amount can be
found by solving for PMT using PV of annuity
formula.
PV of Annuity = PMT {1 (1 + r)4}/r
6,000 = PMT {1 (1 + 0.15)4}/0.15

6,000 = PMT (2.855)

PMT = 6,000/2.855
= $2,101.59

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 MAKING INTEREST
RATES COMPARABLE

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 Making Interest Rates
Comparable
We cannot compare rates with different
compounding periods. For example, 5%
compounded annually is not the same as
5% percent compounded quarterly.
To make the rates comparable, we compute
the annual percentage yield (APY) or
effective annual rate (EAR).

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 Quoted Rate versus
Effective Rate

Quoted rate could be very different from the

effective rate if compounding is not done
annually.
Example: $1 invested at 1% per month will
grow to $1.126825 (= $1.00(1.01)12) in one
year. Thus even though the interest rate
may be quoted as 12% compounded
monthly, the effective annual rate or APY is
12.68%.

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 Quoted Rate versus
Effective Rate

APY = (1 + quoted rate/m)m 1

Where m = number of compounding periods
= (1 + 0.12/12)12 1
= (1.01)12 1
= .126825 or 12.6825%

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 Finding PV and FV with
Nonannual Periods
If interest is not paid annually, we need to change
the interest rate and time period to reflect the
nonannual periods while computing PV and FV.
r = stated rate/# of compounding periods
N = # of years * # of compounding periods in a year
Example: If your investment earns 10% a year,
with quarterly compounding for 10 years, what
should we use for r and N?
r = 0.10/4 = 0.025 or 2.5%
N = 10*4 = 40 periods

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 THE PRESENT VALUE
OF AN UNEVEN STREAM
AND PERPETUITIES

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 Perpetuity

A perpetuity is an annuity that continues

forever.
The present value of a perpetuity is given by
PV = PP/r
PV = present value of the perpetuity
PP = constant dollar amount provided by
the perpetuity
r = annual interest (or discount) rate

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 Perpetuity

Example: What is the present value of

$2,000 perpetuity discounted back to the
present at 10% interest rate?
= 2000/0.10
= $20,000

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 Growing Annuities
Financial managers may also need to evaluate the
value of contracts with cash flows that increase
each year at a constant rate. These are called
growing annuities.

0 1 2 3 4 5
n
CF0(1+g) CF0(1+g)2 CF0(1+g)3 CF0(1+g)4 CF0(1+g) 5 CF0(1+g) n

Where CF0 = Cash Flow at end of period-0

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 PV of a Growing Ordinary Annuity

CF0 (1 g ) 1 g
n

PV 1
(i g ) 1 i

Where
PV = Present Value of a growing ordinary annuity with n-
periods
CF0 = Cash flow at end of period -0
i = Discount rate
g = Constant growth rate per period
Note: The PV can be calculated so long as i > g

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 Example 7
You are considering the purchase of a service station
which is located on a site that has been leased from the
state government, originally for 99 years and currently has
7 years before expiration. The service station generated
cash flow of $92,500 last year and the current owner
expects an annual growth rate of 6.5%. If the discount rate
used to evaluate such businesses is 14.5%, what is a
maximum price you would offer for the purchase of the
business based on the Present value of the future cash
flows?

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 Example 7

CF1 1 g
n

PV 1
(i g ) 1 i

$98,512.50 1.065
7

PV 1 $489,737.12
(0.145 0.065) 1.145

Given the assumptions about growth rates you

should NOT pay more than $489,737.12 for the
purchase of the service station.

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 PV of a Growing Ordinary Perpetuity

If the growing ordinary annuities go one forever for an

indefinitely long period of time then it is referred to as a growing
ordinary perpetuity

CF0 (1 g ) 1 g
n
CF0 (1 g )
PV 1
(i g ) 1 i PV
(i g )
Since g< i as n , 1 g n
0
1 i

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 Example 8
Nylex Ltd paid dividends per share of $1.80 in 2011. Its earnings and dividends
have grown at 5% a year between 2006 and 2011, and are expected to grow at the
same rate in the long term. The rate of return required by investors on stocks of
equivalent risk is 15%. How much would you pay to purchase the shares in this
company today?

Now investment in shares of a company are assumed to yield dividend income for
an indefinitely long period of time. Hence, these cash flows would constitute a
growing perpetuity. Since the cash flows occur at the end of each year it is a
growing ordinary perpetuity.

CF0 (1 g ) $1.80(1.05)
PV $18.90
(i g ) (0.15 0.05)

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 Key Terms

Amortized loan Effective annual rate

Annuity (EAR)
Annuity due Future value
Annuity future value Future value factor
factor Ordinary annuity
Annuity present value Present value
factor Present value factor
Compound annuity Perpetuity
Compound interest

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