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Web Extension 28B

Derivation of Annuity Formulas

In this extension, we give derivations for annuity formulas. It is actually easier to

start with the formula for a perpetuity. First, consider the following geometric progression, where A is a positive constant that is less than 1 and X is the sum of the
geometric progression:

X 5 A t

(28B1)

t51

At first blush, it might seem that X must equal infinity, since the sum goes to
infinity. But notice that as t gets large, the term At gets very small, because A is less
than 1. For example, suppose that A is equal to 1/2. Then the sum is
X = 1/2 + 1/4 + 1/8 + 1/16 +
Notice that, as we continue to add terms, X approaches but never exceeds 1. From
an algebra or calculus course you may recall that the sum of a geometric progression actually has a solution:

X 5 A t 5
t51

A
12A

(28B2)

For example, in the case of A = 1/2, the sum is

CHE-BRIGHAM-11-0504-WEB EXTN-028B.indd 1

X 5 (1 / 2)t 5
t51

1/2
51
12 (1 / 2)

(28B3)

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28WB-2

Web Extension 28B

Derivation of Annuity Formulas

Now consider a perpetuity with a constant payment of PMT and an interest rate
of I. The present value of this perpetuity is

PMT
(
1
1 I )t
t51

PV 5

(28B4)

This can be written as a geometric progression:

t

PV 5 PMT 1 t 5 PMT 1
1
I
1

(
)
1
1
I
t51
t51

(28B5)

Because 1 + I is positive and greater than 1 for reasonable values of I, the summation in Equation 28B-5 is a geometric progression with A = 1/(1 + I). Therefore,
using Equation 28B-2, we can write the summation in Equation 28B-5 as
1
t

1
11I

11I 5 5 1I
t51
1
12

11I

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(28B6)

Substituting this result into Equation 28B-4 gives us the present value of a perpetuity:
PV 5

(28B7)

PMT
I

Now consider the time lines for a perpetuity that starts at time 1 and a perpetuity that starts at time N + 1:
0

N+1

N+2

N+3

PMT PMT
1

PMT PMT PMT PMT

N+1

N+2

N+3

PMT PMT PMT

Observe that, by subtracting the second time line from the first, we get the time line
for an ordinary annuity with N payments:
0

PMT PMT

PMT

Therefore, the present value of an ordinary annuity is equal to the present value of
the first time line minus the present value of the second time line. The present value
of the first time line, which is a perpetuity, is given by Equation 28B-7 as follows:
(28B8)

CHE-BRIGHAM-11-0504-WEB EXTN-028B.indd 2

PV of first time line =

PMT
I

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Web Extension 28B

Derivation of Annuity Formulas

28WB-3

If we apply Equation 28B-7 to the second time line, it gives the value of the
payments discounted back to time N (because if we look at the time line just from N
on, it is an ordinary annuity that starts at time N + 1). To find the present value of
the second time line, we just discount this perpetuity value back to time 0:
PMT 1

PV of second time line =

I (11I)N

(28B9)

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Subtracting Equation 28B-9 from 28B-8 gives the present value of an ordinary annuity, PVA:

PVA 5 PMT 2 PMT 1 N

I I (11I)

(28B10)

PVA 5 PMT 1 2 1 N
I I(11I)

(28B11)

This can be rewritten as

The future value of an ordinary annuity is equal to the present value compounded out to N periods:

1
1 (11I)N
FVA = PVA (1+1)N 5 PMT 2

I I(11I)N

(28B12)

This can be rewritten as

CHE-BRIGHAM-11-0504-WEB EXTN-028B.indd 3

FVA 5 PMT (11I) 21
I I

(28B13)

21/03/12 9:36 PM