Ahram Canadian University, School of Business Administration Future Annuity

Dr. Ramy ALdallal Math II Lecture Notes 3.1

ANNUITIES
Definition:
An Annuity is a series (sequence) of periodic payments at equal periods
of time that earns compound interest.

In the discussion that follows the following assumption are made:

All payments are equal.
All payments are made at the end of a compounding period (called
ordinary annuity).
Interest is compounded at the time of each payment. Annual
payments earns interest compounded annually, quarterly payments
earns interest compounded quarterly and so forth.

We will be studying two types of Annuities, namely: the Future

Value of an Annuity and the Present value of an Annuity

Future Value of an Annuity

In this type of problems a series of periodic and equal payments

(deposits) are made in an account which earns compound interest so as
to have a lump sum in the future.

Examples of this type of annuity are: Sinking Funds, Pension Funds,

and Education Funds.

A sinking fund is generally used by businesses or governments to

accumulate money to pay off an anticipated debt, but we will use the
term to refer to any account into which you make periodic payments.

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Ahram Canadian University, School of Business Administration Future Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.1

Ex1
Mike deposits $1000 at the end of each year in an account that pays 10%
compounded annually. What will the final amount be after 5 years?

Solution:
There are 5 deposits made in this account. Each deposit earns compound
interest so we can find the final value in the account using the compound
interest formula studied in the previous section.

The first payment stays in the account for 4 years, so the final amount
will be = 1000(1+ 0.1)4 = $1464.1
The second payment stays in the account for 3 years, so the final amount
will be = 1000(1+ 0.1)3 = $1331
The third payment stays in the account for 2 years, so the final amount
will be = 1000(1+ 0.1)2 = $1210
The fourth payment stays in the account for 1 year, so the final amount
will be = 1000(1+ 0.1) = $1100
The fifth and last payment will not earn any interest so it will stay=
$1000
The total amount after 5 years will thus be the sum of the above values,
thus the Future value of the annuity will be = $6105.1

Now suppose that payments were made monthly for 5 years. It means
that we will have 60 payments and if we use the above approach to find
the future value of the annuity the work will be too long and tedious.
Fortunately it can be shown that the above summation is that for a
geometric series for which we have a well known formula.
The formulae for the future value of an annuity (or simply Sinking
Fund) are:
r mt
(1 i ) n 1 (1 m ) 1
FV PMT
Or FV PMT
i r

m
I FV PMT (n) Or I FV PMT (mt )

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Ahram Canadian University, School of Business Administration Future Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.1

Where:
FV = the future value of an annuity in $.
PMT = the payment (deposit) made at the end of each period in $.
All other parameters are the same as before.

Solve the above problem directly using the above formula and see that
you will get the same answer as before.

Ex2: Future Value of an Ordinary Annuity

A corporation wants to establish a Sinking Fund at the end of this
year. Annual deposits of $2,000 will be made each year. The deposits
are expected to earn interest at the rate of 8.5%% compounded
annually.

a) What is the value of the annuity at the end of 20 years?

b) How much of this value is interest?

Solution:

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Ahram Canadian University, School of Business Administration Future Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.1

Ex3: Education Fund

Tony and Maria have just had a son. They establish an account to
accumulate money for his college education, in which they would like
to have $100,000 after 17 years. If the account pays 4% interest per
year compounded quarterly, and they make deposits at the end of
every quarter, how large must each deposit be for them to reach their
goal? What is the total interest earned by the couple over the 17
years-period?

Solution

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Ahram Canadian University, School of Business Administration Future Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.1

Ex4: Computing the Payment for a Sinking Fund

A company estimates that it will have to replace a piece of equipment at
a cost of $800,000 in 5 years. To have this money available in 5 years, a
sinking fund is established by making equal monthly payments into an
account paying 6.6% compounded monthly.
a) How much should each payment be?
b) How much interest is earned during the last year?

Solution

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Ahram Canadian University, School of Business Administration Future Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.1

Ex5: Growth in an IRA

Jane deposits $2,000 annually into a Roth IRA that earns 6.85%
compounded annually. The interest earned by Roth IRA is tax free. Due
to a change in employment, these deposits stop after 10 years, but the
account continues to earn interest until Jane retires 25 years after the last
deposit was made. How much is in the account when Jane retires?

Solution:

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Ahram Canadian University, School of Business Administration Future Annuity
Dr. Ramy ALdallal Math II Lecture Notes 3.1

Ex6: Time required to achieve a goal

John wants to accumulate $30,000 to buy a new car. He decided to
start saving by depositing $2,000 every 3 months in an account that
earns interest at a rate of 8% per year compounded quarterly. How
long will it be until he can achieve his goal?

Solution:

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