Module 2

Multiple cash flows

Learning objectives
This topic expands on the multiple cash flows calculation to include the different
types of annuities. After completing this module, you should be able to:
handle situations with multiple cash flows
identify the different types of annuities
calculate present and future values of ordinary and annuity due
calculate repayments on loans
In this topic you will also be applying time lines effectively to calculate solutions
to present and future value problems.
Introduction
In the earlier module, we looked at what we should do when faced with more than
one cash flow. You do the same as you do with a single cash flow. The formula
does not change and all you need to do is to treat each cash flow separately. In
this topic we also look at how we can handle cash flows that repeat. That is, the
same dollar value occurring over regular intervals.
Recap on multiple cash flows
Activity2.1
An investment promises a return of $100 in year 1, $200 in year 2 and $300 in
year 3. If interest rate is 10% per annum compounding annually, what is the
present value of the investment?
The present value of the three cash flows can be calculated by bringing back to
time 0, the individual cash flow using the present value formula:
58 . 481
39 . 225 29 . 165 91 . 90
) 1 . 0 1 (
300
) 1 . 0 1 (
200
) 1 . 0 1 (
100
3 2 1

+ +
+
+
+
+
+
PV
Notationally:
3
3
2
2
1
1
) 1 ( ) 1 ( ) 1 ( i
CF
i
CF
i
CF
PV
+
+
+
+
+

In general:
n
n
i
CF
i
CF
i
CF
PV
) 1 (
...
) 1 ( ) 1 (
2
2
1
1
+
+ +
+
+
+

100 200 300

0 3 2 1
Annuities
In the above example, the individual cash flows were of different values. There
can be situations when the cash flow repeats itself at a regular interval of time.
We call this an annuity. An annuity is a stream of equal amounts that occur at a
regular interval in time.
Key words: Stream
Equal amounts
Regular interval
Types of annuities
Before we can find the future value or the present value of annuities, we must first
ascertain the type of annuity we are dealing with. The type of annuity depends on
when the first payment of the annuity falls in time.
There are primarily three types of annuities ordinary annuity (also called annuity
certain), annuity due and deferred annuity.
Ordinary: First payment falls at the end of the first period
Due: First payment falls at the beginning of the first period
Deferred: First payment falls after the first period
The annuities will appear on the time line as below:
Let us now look at each type of annuity in detail.
PMT PMT PMT
0 3 2 1 4 5
PMT PMT Ordinary annuity
PMT PMT PMT PMT PMT Annuity due
PMT PMT PMT PMT Deferred annuity
Ordinary annuity
The ordinary annuity is also called annuity certain. For an ordinary annuity, the
first payment starts at the beginning of the first period. Examples of ordinary
annuities include mortgage repayments, car loans and insurance premiums.
Here is an example of how we deal with an ordinary annuity.
Say, we have an annuity of $100 that starts at the end of the first year for 4 years
with i = 12% per annum. If we need to calculate the future value of the cash
flows, we can take the individual cash flow up to time 4 as follows:
93 . 477
) 12 . 1 ( 100 ) 12 . 1 ( 100 ) 12 . 1 ( 100 100
3 2 1

+ + + FV
The above problem can be interpreted as a geometric progression. Using the
formula for the sum of a geometric progression, we can summarise a formula that
is more convenient for the above problem. You do not need to know the
derivation of the formula, but you need to be able to interpret and apply the
formula. The formula for the future value of an ordinary annuity is as follows:
The accumulated value (future value):
( )
1
]
1

i
i
PMT FV
n
1 1
100 100 100
0 3 2 1 4
100
Activity2.2
To provide for the ultimate purchase of a home, a man deposits $3,000 at the end
of every 6 months at 14% p.a. compounded semi-annually. At the end of the
eighth year how much does he have to his credit?
Remember, it is always a good practice to draw a time line!
PMT =3000 n = 8 x 2 = 16 I = 0.14/2 = 0.07
(Note that because the interest is compounding semi-annually, we divide interest
by 2 and multiply n by 2).
Alternatively,
* Please read the section on setting the calculator at the end of this module.

3000 3000 3000
0 3 2 1 16
3000
( )
1
]
1

i
i
PMT FV
n
1 1
( )
16 . 664 , 83
07 . 0
1 07 . 0 1
3000
16

1
]
1

+
FV
3,000 PMT
7 I/YR
16 N
FV = -83,664.16
Annuity due
An annuity due is a stream of equal payments that starts at the beginning of the
first period. Rent is an example of an annuity due.
Finding the future value of an annuity due is similar to that of an ordinary annuity.
We use the formula for the sum of a geometric progression to arrive at the
formula.
Since the payment starts at the beginning of the first period instead of the end, the
formula for the accumulated value is slightly different to the one derived
previously. Once again, there is no need for you to learn how to derive the
formula.
The formula for the accumulated value of an annuity due is:
Activity2.3
Starting today, you wish to make quarterly deposits of $200 into an investment
that is earning 9% p.a. compounding quarterly. You intend to keep up identical
regular deposits for 5 years. What sum do you accumulate at the end of the 5
years?
PMT = 200 I = 0.09/4 = 0.025 n = 5x4 = 20
Alternatively,
( )
1
]
1

+
+
i
i
i PMT FV
n
1 1
) 1 (
200 200
200
0 19
2 1

20
200
( )
1
]
1

+
+
i
i
i PMT FV
n
1 1
) 1 (
( )
41 . 5094
0225 . 0
1 0225 . 0 1
) 0225 . 0 1 ( 200
20

1
]
1

+
+ FV
Remember, this is an annuity due, therefore your calculator has to be set in the
begin mode:
Note that your calculator will display the word Begin. It is important to make
sure that this word does not appear when you are doing the ordinary annuity
problem. To get rid of the begin mode, press the yellow button followed by the
BEG/END button. This will get rid of the word begin in your display.
Present value of an ordinary annuity
Finding the present value of an annuity is similar to finding the future value. For
present value of an annuity we have to discount each cash flow back to year 0.
For example, if we are looking for the present value of a series of four payments
of $100 starting at the end of the first period if interest rate is 12% per annum:
75 . 303
4
) 12 . 1 ( 100
3
) 12 . 1 ( 100
2
) 12 . 1 ( 100
1
) 12 . 1 ( 100

PV
If we were to use geometric progression, we would arrive at the formula:
1
]
1

i
i
PMT PV
n
) 1 ( 1
Activity2.4
YELLOW
BEG/END
200 PMT
2.25 I/YR
20 N
FV = -5094.41
100 100 100
0 3 2 1 4
100
What is the present value of a sand quarry that will yield an annual end of year
income of $30,000 for the next 16 years and then be worthless if money is worth
15% per annum compounded annually?
PMT =30000 n = 16 I = 15
Alternatively,
Activity2.5
In a contest the winner is allowed an option of $10,000 at the end of each year for
the next 20 years or $80,000 in cash now. If money is worth 13% per annum to
the contest winner, which is the greater amount?
The natural tendency is to multiply the $10,000 by 20 to get $200,000 and
compare that with the $80,000. This is wrong! Remember, we cannot add,
multiply, subtract or divide money across time. The correct way of comparing the
two sums is to bring the annuity of $10,000 to the same point in time as the
$80,000.
30000 30000 30000
0 3 2 1 16
30000
( )
1
]
1

i
i
PMT PV
n
1 1
( )
05 . 627 , 178
15 . 0
15 . 0 1 1
30000
16

1
]
1

+
PV
30,000 PMT
15 I/YR
16 N
PV = -178,627.05
0 2 1 20
80,000
Present value of 10,000 annuity
A = 10,000 i = 0.13 n = 20
Using the formula or calculator will give you:
PV = $70,247.52
Therefore, the larger amount is $80,000 today!!
Amortisation
To amortise a loan is to pay off the loan with regular equal payments so that the
loan balance is zero. Here, we know the loan amount (PV), the number of
payments needed and the interest rate. We need to calculate the payment (PMT)
that would be required to discharge the loan.
To calculate the repayment, we simply rearrange the present value formula above:
The calculator functions need for an amortisation is the similar to those we used
for the ordinary annuity calculations. We know PV, i and n, we look for PMT:
( )
( )
1
]
1

1
]
1

i
i
PV
PMT
i
i
PMT PV
n
n
1 1
1 1
10000 10000 10000
Activity2.6
A businessman has incurred a debt of $30,000 that is to be repaid monthly
payments. Find the monthly payment necessary to cancel the debt in three years
if the loan is charged at 12% p.a. compounding monthly.
PV = 30,000 I = 0.12/12=0.01 n = 3 x 12 = 36
( )
43 . 996
01 . 0
) 01 . 1 ( 1
000 , 30
1 1
36

1
]
1

1
]
1

i
i
PV
PMT
n
Activity2.7
When visiting a finance company for a loan of $5000 you may be quoted the
repayments per month over three years as $200. What is the nominal and
effective rates of interest?
PV = 5000 PMT= -200 n = 36
Unfortunately, we cannot use the formula to work out the solution to this problem
as the interest rate appears both in the numerator as well as the denominator. We
can employ interpolation but this will take too long. So, the best way to work out
the answer is to use the calculator.
Alternatively,
Thus, the interest is 2.12% per month
Nominal annual rate = 2.12 x12 = 25.44%
Effective annual rate
-200 PMT
5000 PMT
36 N
I/YR = 2.12
2863 . 0
1
12
2544 . 0
1
1 1
12

,
_

+

,
_

+
m
m
i
E
Activity2.8
You have taken out a loan for $180,000 at 6% per annum compounding daily.
The term of the loan is 25 years. What is your monthly repayment? What is your
fortnightly repayment?
First we need to work out the effective interest rate for a month:
005012 . 0
1
365
06 . 0
1
12
365

,
_

+ E
( )
33 . 1161
005012 . 0
) 005012 . 1 ( 1
000 , 180
1 1
300

1
]
1

1
]
1

i
i
PV
PMT
n
Hence, the monthly payment is 1161.33.
See if you can calculate the fortnightly payments:
Present value of an annuity due
Finding the present value of an annuity due is similar to what we have done for an
ordinary annuity. The formula for the present value of an annuity due is given
below. Remember, if you are using the calculator, make sure that you activate the
BEGIN mode for annuity due problems.
The formula is:
Activity2.9
Instead of paying $7000 a year rent at the beginning of each year for the next 10
years, a renter decides to buy a house. If money is worth 12% p.a. what would be
the cash value equivalent to 10 years rent?
PMT = 7000 I=0.12 n=10
PV = 44,297.72
( )
1
]
1

+
+

i
i
i PMT PV
n
1 1
) 1 (
( )
1
]
1

+
+

i
i
i PMT PV
n
1 1
) 1 (
Formulas covered
Future value of an ordinary annuity
Future value of an annuity due
Present value of an ordinary annuity
1
]
1

i
i
PMT PV
n
) 1 ( 1
Present value of an annuity due
Reflecting on what you have learned
Write a brief description on the following:
Ordinary annuity
Annuity Due
Amortisation
( )
1
]
1

i
i
PMT FV
n
1 1
( )
1
]
1

+
+
i
i
i PMT FV
n
1 1
) 1 (
( )
1
]
1

+
+

i
i
i PMT PV
n
1 1
) 1 (