Annuities and Sinking Funds Chapter 13 Annuities and Sinking Funds McGraw-Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved.

Annuities and Sinking Funds #13 Annuities and Sinking Funds Learning Unit Objectives LU13.1 Annuities: Ordinary Annuity and Annuity Due (Find Future Value) Differentiate between contingent annuities and annuities certain Calculate the future value of an ordinary annuity and an annuity due manually and by table lookup

Compounding Interest (Future Value) Term of the annuity - the time from the beginning of the first payment period to the end of the last payment period. Annuity - A series of payments Present value of an annuity - the amount of money needed to invest today in order to receive a stream of payments for a given number of years in the future Future value of annuity - the future dollar amount of a series of payments plus interest

Figure 13.1 Future value of an annuity of $1 at 8% $1.00 End of period

Figure 13.1 Future value of an annuity of $1 at 8% $2.08 $1.00 End of period

Figure 13.1 Future value of an annuity of $1 at 8% $3.25 $2.08 $1.00 End of period

Classification of Annuities Contingent Annuities - have no fixed number of payments but depend on an uncertain event Annuities certain - have a specific stated number of payments Life Insurance payments Mortgage payments

Classification of Annuities Annuity due - regular deposits/payments made at the beginning of the period Ordinary annuity - regular deposits/payments made at the end of the period Jan. 31 Monthly Jan. 1 June 30 Quarterly April 1 Dec. 31 Semiannually July 1 Dec. 31 Annually Jan. 1

Tools for Calculating Compound Interest Rate for each period (R) Annual interest rate divided by the number of times the interest is compounded per year Number of periods (N) Number of years times the number of times the interest is compounded per year If you compounded $100 each year for 3 years at 6% annually, semiannually, or quarterly What is N and R? Periods Rate Annually: 6% / 1 = 6% Semiannually: 6% / 2 = 3% Quarterly: 6% / 4 = 1.5% Annually: 3 x 1 = 3 Semiannually: 3 x 2 = 6 Quarterly: 3 x 4 = 12

Calculating Future Value of an Ordinary Annuity by Table Lookup Step 3. Multiply the payment each period by the table factor. This gives the future value of the annuity Step 2. Lookup the periods and rate in an ordinary annuity table. The intersection gives the table factor for the future value of $1 Step 1. Calculate the number of periods and rate per period

Table 13.1 Ordinary annuity table: Compound sum of an annuity of $1

Future Value of an Ordinary Annuity Find the value of an investment after 5 years for a $2,000 ordinary annuity at 9% N = 5 x 1 = 5 R = 9%/1 = 9% 5.9847 x $2,000 $11,969.40

Future Value of an Ordinary Annuity Find the value of an investment after 5 years for a $2,000 ordinary annuity at 9% N = 5 x 1 = 5 R = 9%/1 = 9% 5.9847 x $2,000 $11,969.40

Future Value of an Ordinary Annuity Find the value of an investment after 5 years for a $2,000 ordinary annuity at 9% N = 5 x 1 = 5 R = 9%/1 = 9% 5.9847 x $2,000 $11,969.40

Future Value of an Ordinary Annuity Find the value of an investment after 5 years for a $2,000 ordinary annuity at 9% N = 5 x 1 = 5 R = 9%/1 = 9% 5.9847 x $2,000 $11,969.40

Future Value of an Ordinary Annuity Find the value of an investment after 5 years for a $2,000 ordinary annuity at 9% N = 5 x 1 = 5 R = 9%/1 = 9% 5.9847 x $2,000 $11,969.40

Calculating Future Value of an Annuity Due by Table Lookup Payment is made at the beginning of the period. Step 4. Subtract 1 payment from Step 3. Step 3. Multiply the payment each period by the table factor. Step 2. Look up the periods and rate in an ordinary annuity table. The intersection gives the table factor for the future value of $1 Step 1. Calculate the number of periods and rate per period. Add one extra period.

Future Value of an Annuity Due Find the value of an investment after 5 years for a $2,000 annuity due at 9% N = 5 x 1 = 5 + 1 = 6 R = 9%/1 = 9% 7.5233 x $2,000 $15,046.60 - $2,000 $13,046.60

Future Value of an Annuity Due Find the value of an investment after 5 years for a $2,000 annuity due at 9% N = 5 x 1 = 5 + 1 = 6 R = 9%/1 = 9% 7.5233 x $2,000 $15,046.60 - $2,000 $13,046.60

Future Value of an Annuity Due Find the value of an investment after 5 years for a $2,000 annuity due at 9% N = 5 x 1 = 5 + 1 = 6 R = 9%/1 = 9% 7.5233 x $2,000 $15,046.60 - $2,000 $13,046.60

Future Value of an Annuity Due Find the value of an investment after 5 years for a $2,000 annuity due at 9% N = 5 x 1 = 5 + 1 = 6 R = 9%/1 = 9% 7.5233 x $2,000 $15,046.60 - $2,000 $13,046.60

Future Value of an Annuity Due Find the value of an investment after 5 years for a $2,000 annuity due at 9% N = 5 x 1 = 5 + 1 = 6 R = 9%/1 = 9% 7.5233 x $2,000 $15,046.60 - $2,000 $13,046.60

Investing for the Future Deb has just started a new job where her employer will match contributions she makes to 401(k) retirement plan. Deb decides to invest $100 per month, with deposits made on a quarterly basis. The company investment plan compounds interest quarterly, and is currently showing a 6% yield. How much will accumulate in Deb’s account after 12 years if this is an ordinary annuity? N= 4 * 12 = 48 R = .06/4 = .015 f = 69.5649 FV = 600 * 69.5649 = 41,738.94

Investing for the Future Deb has just started a new job where her employer will match contributions she makes to 401(k) retirement plan. Deb decides to invest $100 per month, with deposits made on a quarterly basis. The company investment plan compounds interest quarterly, and is currently showing a 6% yield. How much will accumulate in Deb’s account after 12 years if this is an annuity due? N= 4 * 12 = 48 + 1 R = .06/4 = .015 f = 71.6084 FV = 600 * 71.6084 = 42,965.04 – 600 = 42,365.04

Work Drill problems 13-1 to 13-4, page 311 Assignment Read chapter 13 pages 299—305 Work Drill problems 13-1 to 13-4, page 311

Annuity Review 1 Doug Anders gets paid salary plus commission. His commission is paid at the end of each quarter, so he has decided to invest $500 in a mutual fund each quarter. The fund pays 8% interest compounded quarterly. How much will Doug have accumulated at the end of 8 years? N = 32 R= 2% Annuity factor = 44.2269 Ordinary annuity = 44.2269 x 500 = 22113.45

Annuity review 2 Nancy Smith receives a $1,250 alimony payment at the beginning of each month. She wants to save for a down payment on a home. If she can save one-half of the alimony each month, and invest it in a fund which pays 6% interest compounded monthly, how much will she have saved after 4 years? N = 48 + 1 R = .5% annuity factor = 55.3684 Annuity due = 55.3684 x 625 = 34605.25 – 625 Annuity due = 33980.25

Annuities and Sinking Funds #13 Annuities and Sinking Funds Learning Unit Objectives LU13.2 Present Value of an Ordinary Annuity (Find Present Value) Calculate the present value of an ordinary annuity by table lookup and manually check the calculation Compare the calculation of the present value of one lump sum versus the present value of an ordinary annuity

Figure 13.2 - Present value of an annuity of $1 at 8% $2.58 End of period

Figure 13.2 - Present value of an annuity of $1 at 8% $2.58 $1.78 End of period

Figure 13.2 - Present value of an annuity of $1 at 8% $2.58 $1.78 $.93 End of period

Calculating Present Value of an Ordinary Annuity by Table Lookup Step 3. Multiply the withdrawal for each period by the table factor. This gives the present value of an ordinary annuity Step 2. Look up the periods and rate in an ordinary annuity table. The intersection gives the table factor for the present value of $1 Step 1. Calculate the number of periods and rate per period

Table 13.2 - Present Value of an Annuity of $1

Present Value of an Annuity Duncan Harris wants to receive a $5,000 annuity payment each 6 months for 5 years. Interest on the annuity is 8% semiannually. Duncan will make withdrawals at the end of each year. How much must Duncan invest today to receive a stream of payments for 5 years. Interest ==> Payment ==> Payment ==> Payment ==> N = 5 x 2 = 10 R = 8%/2 = 4% 8.1109 x $5,000 $40,554.50 Payment ==> Payment ==>

Present Value of an Annuity Duncan Harris wants to receive a $5,000 annuity payment each 6 months for 5 years. Interest on the annuity is 8% semiannually. Duncan will make withdrawals at the end of each year. How much must Duncan invest today to receive a stream of payments for 5 years. Interest ==> Payment ==> Payment ==> Payment ==> N = 5 x 2 = 10 R = 8%/2 = 4% 8.1109 x $5,000 $40,554.50 Payment ==> Payment ==> End of Year 5 ==>

If I win the Lottery…

If I win the Lottery… Amanda must decide how she wishes to take her lottery winnings, which amount to $1.5 million. She may take a lump sum payment now or her second option is to take an annual payment of $50,400 each year for 20 years, less taxes. Ryan is trying to convince her to take it all now, in one lump-sum. How much would Amanda receive before tax if she follows Ryan’s advice, at a 4% investment rate, annual compounding for 20 years? N = 20 R = 4% PV = 50400 * 13.5903 = $684,951.12

Lump Sums versus Annuities Karen Jones made deposits of $1,000 to Fleet Bank, which pays 6% interest compounded annually. After 4 years, Karen makes no more deposits. What will be the balance in the account 10 years after the last deposit N = 10 x 1 = 10 R = 6%/1 = 6% 1.7908 x $4,374.60 $7,834.03 Future value of a lump sum N = 4 x 1 = 4 R = 6%/1 = 6% 4.3746 x $1,000 $4,374.60 Future value of an annuity

Work Drill problems 13-5 to 13-7, page 311 Assignment Read chapter 13 pages 306--308 Work Drill problems 13-5 to 13-7, page 311

Annuity Review 3 Susan has started a Roth IRA. She plans to deposit $400 per quarter at the end of each quarter into the fund which pays 6% interest. Tax laws permit Susan to withdraw up to $10,000 for a new home deposit after a minimum of 5 years. How much will Susan have accumulated after the 5 year period? N = 5 x 4 = 20 R = 6% / 4 = 1.5% fv = 400 x 23.1236 fv = 9249.44

Annuity review 4 John has just inherited a large sum of money. He wants to set up an educational trust for his daughter. She will start college next year, and he plans on having $5,000 available to pay her educational costs each semester for 5 years. If John can invest the money at 8% compounded semiannually, how much should he put in the trust for his daughter now? N = 10 R = 4% pv = 5000 x 8.1109 pv = 40554.50

Annuity Review 5 The YMCA has just received an endowment of $75,000 per year for 4 years, receiving it at the beginning of each year. They plan to invest this in a building fund which will yield 5% annually. At the beginning of the 5th year, they will invest the total amount in a fund for 6 more years, earning 8% quarterly. How much be available after 10 years? Annuity due: N = 4 + 1 R = 5% 75000 x 5.5256 = 414,420 – 75000 = 339,420 Lump sum: N = 24 R = 2% 339,420 x 1.6084 = 545,923.13

Annuities and Sinking Funds #13 Annuities and Sinking Funds Learning Unit Objectives LU13.3 Sinking Funds (Find Periodic Payments Calculate the payment made at the end of each period by table lookup Check table lookup by using ordinary annuity table

Sinking Funds (Find Periodic Payments) The amount of a periodic payment which must be made at regular intervals in order to accumulate a desired future amount with compound interest. Bonds Sinking Fund = Future x Sinking Fund Payment Value Table Factor

Table 13.3 - Sinking Fund Table Based on $1

Future Value of an annuity table Sinking Fund Check: To retire a bond issue, Randolph Company needs $150,000 in 10 years. The interest rate is 8% compounded annually. What payment must Randolph Co. make at the end of each year to meet its obligation? $10,350 x 14.4866 149,936.30* N = 10, R= 8% Future Value of an annuity table N = 10 x 1 = 10 R = 8%/1 = 8% 0.0690 x $150,000 $10,350 * Off due to rounding

If I win the Lottery!!! John wants his winnings spread out so he doesn’t spend it all at once. If he wins the megabucks jackpot of $5 million, how much will he receive semi-annually for 20 years, assuming a 4% compound rate? SF = 5,000,000 * f SF = 5,000,000 * .0166 SF = $83,000 before taxes

Work Drill problems 13-8 to 13-10, page 311 Assignment Read chapter 13 pages 308--309 Work Drill problems 13-8 to 13-10, page 311

Decisions, decisions, decisions … How do I know what compound interest factoring table to use for a problem?

Compound Interest to find Future Value (chapter 12) Given: a single investment amount What will $1 today grow to in the future Present value is known key words: invest today future amount at the end of X years

Compound Interest to find Present Value (chapter 12—col 2) Given: a single future amount What you need today to grow to $1 in the future Future value is known key words: how much today present value

Annuity—Future Value to find Future Value of several payments made (chapter 13) Amount of Annuity (col. 3) multiple amounts grow to one future amount What will several $1 deposits grow to in the future Given: payment amounts key words: annuity end of X years Payments, Deposits Ordinary Annuity Annuity Due

Annuity—Present Value to find amount needed today to receive several equal payments (chapter 13) Present Value of Annuity (col. 4) Given: amount of multiple payments What will you need today (single amount) if you wish to make multiple withdrawal over future periods key words: how much today original amount present value

Annuity—Sinking Fund to find amount of each equal payment (chapter 13) Sinking Fund (col. 5) How much is the payment? Given: Future amount needed key words: needed payments deposits needed sinking fund payment

Review Problem 1 John Tobn made deposit of $650 at the end of each year for 5 years. The rate if 8% compounded annually. What is the value of John’s annuity at the end of 5 years? What type of problem? Ordinary annuity N = 5 R = .08 650 x 5.8666 = 3813.29

Review Problem 2 Jim promised to pay his son $200 semiannually for 6 years. If Jim can invest his money at 8% in an ordinary annuity, how much must Jim invest today to be able to pay his son. What type of problem? Annuity—present value N = 12 R = .04 200 * 9.3851 = $1877.02

Review Problem 3 Joyce has decided to invest $500 quarterly for 5 years in an ordinary annuity at 12%. As her financial advisor, could you calculate for Joyce the total cash value of the annuity at the end of year 5? What type of problem? Ordinary annuity N = 20 R = 3% 500 * 26.8704 = 13,435.20

Review Problem 4 Jack invests $850 semiannually at 10% for 9 years at the beginning of each year. What will be the cash value of this annuity due at the end of the ninth year? What type of problem? Annuity due N = 19 R = 5% 850 * 30.5389 = $25,958.07 – 850 = 25,108.07

Review Problem 5 Moller Associates must repay $500,000 in bonds in 10 years. The company wants to set up a sinking fund to accumulate the needed amount. Assuming a rate of 10% compounded semiannually, what amount must be paid into the fund each period? What type of problem? Sinking fund N = 20 R = 5% 500,000 * .0302 = 15,100 Check it: 15100 * 33,0659 = 499,295.10

Review Problem 6 Jane’s daughter, Amanda, is now two year’s old. Jane is planning a college fund to pay tuition costs of $5000 per semester. Amanda will start college in 16 years, and Jane will pay for four years of school. Jane is planning on setting up a mutual fund which yields 7% compounded semiannually, using money she inherited. How much must Jane invest into the mutual fund to meet the needed tuition payments? What is this? Present value of an annuity and sinking fund PV annuity: 5000, 4 years, semiannual, 7% PV annuity = 5000 x 6.8739 = 34,369.50 in 16 years PV lump sum for 16 years at 7% semiannual PV = 34,369 * .3326 = 1,1431.13

Review Problem 7 Wes wants to retire as a millionaire. How much must Wes save per year for 30 years, if he can invest in a mutual fund which pays 9% compounded annually? What is this? Sinking fund SF = 1,000,000 x .0073 SF deposit = 7300 per year