Financial Management
MBA ZG 521
BITS Pilani Krishnamurthy Bindumadhavan, CFA, FRM
Associate Professor, Management - Finance
Pilani Campus
Email:
[email protected] BITS Pilani
Pilani|Dubai|Goa|Hyderabad
Time Value of Money
- Part 2
Annuity
• Annuity: finite set of sequential CF’s, all of the same value
• Two types of annuities:
– Ordinary annuity
– Annuity due:
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Annuities
• Regular or ordinary annuity is a finite set of
sequential cash flows, all with the same value A,
which has a first cash flow that occurs one period
from now.
• An annuity due is a finite set of sequential cash
flows, all with the same value A, which has a first
cash flow that is paid immediately.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Ordinary Annuity Timeline
Time line for an ordinary annuity of $100 for 3 years.
0 1 2 3
i%
$100 $100 $100
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Ordinary Annuity vs. Annuity Due
Difference between an ordinary annuity and an annuity
due?
Ordinary Annuity
0 1 2 3
i%
PMT PMT PMT
Annuity Due
0 1 2 3
i%
PMT PMT PMT
PV FV
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Annuity calculations
• Ordinary Annuity - Equal CF’s
FV = A [ (1+r)^N -1]/ r
PV = A[(1 – 1/(1+r)^N]/ r
• Annuity Due: treat the 1st CF as one component of PV and for the
remaining CF’s use the above formula and sum the two components
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
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Perpetuities
Perpetuity is a series of constant payments, A, each period forever.
A A A A A A A
0 1 2 3 4 5 6 7
PV1 = A/(1+r)
PV2 = A/(1+r)2
PV3 = A/(1+r)3
PV4 = A/(1+r)4
etc.
etc.
PVperpetuity = [A/(1+i)t] = A [1/(1+i)t] = A/i
Intuition:
Present Value of a perpetuity is the amount that must invested today at the
interest rate i to yield a payment of A each year without affecting the value
of the initial investment.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Annuity can be viewed as a combination
of two perpetuities
1. We can view an annuity as the difference between 2 perpetuities with
different starting dates
2. PV of a series of unequal CF’s = Sum of the PV’s of the individual
CF’s
3. Use the appropriate formula (PV/ FV) to solve for other unknowns
including: rates, # of periods or size of annuity payments
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
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Annuity Formula and Perpetuities
1. Perpetuity of A per period in Period 0 -- PV1 = A/i
A A A A A A A A A A A A A A
0 2 4 6 8 10 12 14
2. Perpetuity of A per period in Period 8 -- PV8 = [1/(1+i)]8 x (A/i)
A A A A A A
0 2 4 6 8 10 12 14
3. Annuity of A for 8 periods -- PV = PV1 – PV8 = (A/i) x { 1 – [1/(1+i)]8 }
A A A A A A A A
0 2 4 6 8 10 12 14
Intuition: Formula for a N-period annuity of A is:
PV of a Perpetuity of A today minus PV of a Perpetuity of A in period N
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Annuities & Perpetuities Again
• Rather than memorize the • Calculating the PV of an
annuity formula it may be annuity has 3 steps:
easier to calculate it as 1. Calculate (A/i)
– PV of a Perpetuity with
the difference between payments of $A per
two perpetuities with the period.
same payment. 2. Calculate [1/(1+i)]N
– Discount factor
• PV of an N-period annuity associated with end of
the annuity.
of $A per period is:
3. Calculate PVN =
PVN = (A/i) x { 1 - [1/(1 + i)]N }
(A/i) x { 1 – [1/(1+i)]N} – I think this is easier under
pressure than
memorizing the formula.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Question on FV of Annuity Due
Ex 2.An individual deposits
$10,000 at the beginning of
each of the next 10 years,
starting today, into an
account paying 9 percent
interest compounded
annually. The amount of
money in the account at the
end of 10 years will be
closest to:
A. $109,000.
B. $143,200.
C. $151,900.
D. $165,600.
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Question on FV of Annuity Due
Ex 2.An individual deposits • This is an annuity due of
$10,000 at the beginning of A=$10,000 for N=10 years at
each of the next 10 years, i=9% interest rate.
starting today, into an • Annuity due must be adjusted by
account paying 9 percent (1+i) to reflect payment is made at
interest compounded beginning rather than end of
period.
annually. The amount of
• Also must adjust PV formula by
money in the account at the
(1+i)N for FV of annuity.
end of 10 years will be
closest to: PVN = (1+i)N(1+i)[(A/i) { 1 – [1/(1+i)]N}]
A. $109,000.
PV10 = (1.09)11 ($10K/.09) {1 – [1/1.09]10}
B. $143,200.
PV10 = (2.58)($111,111){1 – [0.42]}
C. $151,900.
D. $165,600. PV10 = $165,601
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Application of Annuities
• Loan or lease payments
• Calculating EMI’s
BITS Pilani, Deemed to be University under Section 3 of UGC Act, 1956
Thank You
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