Chapter 6

The Time Value

of Money
Annuities and
Other Topics

Slide Contents
Principles Applied in This Chapter
1. Annuities
2. Perpetuities
3. Complex Cash Flow Streams

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-2

6.1 ANNUITIES

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-3

Ordinary Annuities
An annuity is a series of equal dollar
payments that are made at the end of
equidistant points in time, such as monthly,
quarterly, or annually. If payments are made
at the end of each period, the annuity is
referred to as ordinary annuity.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-4

Ordinary Annuities (cont.)

Example How much money will you
accumulate by the end of year 10 if you
deposit $3,000 each year for the next ten
years in a savings account that earns 5%
per year?
Determine the answer by using the equation
for computing the FV of an ordinary annuity.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-5

The Future Value of an

Ordinary Annuity

FVn = FV of annuity at the end of nth period.

PMT = annuity payment deposited or
received at the end of each period
i = interest rate per period
n= number of periods for which annuity will
last

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-6

The Future Value of an

Ordinary Annuity (cont.)
Using equation 6-1c,
FV = $3000 {[ (1+.05)10 - 1] (.05)}
= $3,000 { [0.63] (.05) }
= $3,000 {12.58}
= $37,740

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-7

Figure 6.1 Future Value of a FiveYear AnnuitySaving for Grad

School

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-8

Solving for the PMT in an

Ordinary Annuity
You may like to know how much you need to
save each period (i.e. PMT) in order to
accumulate a certain amount at the end of n
years.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-9

The Present Value of an

Ordinary Annuity
(cont.)

PMT = annuity payment deposited or

received
i = discount rate (or interest rate)
n = number of periods

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-10

Amortized Loans
An amortized loan is a loan paid off in equal
payments consequently, the loan payments
are an annuity. Examples: Home mortgage
loans, Auto loans

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-11

Amortized Loans (cont.)

Example You plan to obtain a $6,000 loan
from a furniture dealer at 15% annual interest
rate that you will pay off in annual payments
over four years. Determine the annual
payments on this loan and complete the
amortization table.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-12

Amortized Loans (cont.)

Using a Financial Calculator

N=4
i/y = 15.0
PV = 6000
FV = 0
PMT = -$2,101.59

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-13

The Loan Amortization Schedule

Table 6.1 The Loan Amortization Schedule for a $6,000
Loan at 15% to Be Repaid in Four Years

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-14

Amortized Loans with

Monthly Payments
Many loans such as auto and home loans
require monthly payments. This requires
converting n to number of months and
computing the monthly interest rate.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-15

Annuities Due
Annuity due is an annuity in which all the
cash flows occur at the beginning of each
period. For example, rent payments on
apartments are typically annuities due
because the payment for the months rent
occurs at the beginning of the month.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-16

Annuities Due: Future Value

Computation of future value of an annuity due
requires compounding the cash flows for one
additional period, beyond an ordinary annuity.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-17

Annuities Due: Present Value

Since with annuity due, each cash flow is
received one year earlier, its present value will
be discounted back for one less period.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-18

6.2 PERPETUITIES

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-19

Perpetuities
A perpetuity is an annuity that continues
forever or has no maturity. For example, a
dividend stream on a share of preferred stock.
There are two basic types of perpetuities:
Growing perpetuity in which cash flows grow
at a constant rate from period to period over
time.
Level perpetuity in which the payments are
constant over time.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-20

Calculating the Present Value

of a Level Perpetuity

PV = the present value of a level perpetuity

PMT = the constant dollar amount provided by
the perpetuity
i = the interest (or discount) rate per period

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-21

Present Value of a
Growing Perpetuity
In growing perpetuities, the periodic cash
flows grow at a constant rate each period.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-22

6.3 COMPLEX CASH FLOW

STREAMS

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-23

Complex Cash Flow Streams

The cash flows streams in the business world
may not always involve one type of cash
flows. The cash flows may have a mixed
pattern of cash inflows and outflows, single
and annuity cash flows. Figure 6-4
summarizes the complex cash flow stream for
Marriott.

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-24

Figure 6-4 Present Value of Single

Cash Flows and an Annuity ($
value in millions)

Copyright 2014 Pearson Education, Inc. All rights reserved.

6-25