Chapter 5 FIN3414

Chapter 5 FIN3414 - 1 2 Chapter Five 3 4 TIME VALUE OF MONEY WITH AN ANNUITY 5 6 7 8 9 10 FUTURE VALUE OF AN ANNUITY Let n equal deposits of an

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1 Chapter Five 1 2 TIME VALUE OF MONEY WITH AN ANNUITY 3 4 FUTURE VALUE OF AN ANNUITY 5 6 Let n equal deposits of an amount A are made at the beginning of each year. 7 What would be the future value of this annuity if the annual rate of interest is k ? 8 9 The mathematical formula can be developed as follows: 10 11 Amount deposited A A A A A A 12 13 Beginning of year 1 2 3 4 (n - 1) n 14 15 16 By expression (4.1), at point n the future value of the first deposit of A dollars = 17 A (1 + k ) n -1 . The future value of the second deposit of A dollars = A (1 + k ) n -2. 18 19 The future value of the ( n - 1) th deposit of A dollars = A (1 + k ), and the future 20 value of the n th deposit of A dollars = A . Therefore, the future value of the annuity 21 will be: 22 23               1 2 2 1 1 1 1 1 1 1 1 n n n k k k A A k A k A k A FVA 24 25 Note that the terms in the brackets are in geometric series with common ratio of 26 (1+ k ). By our discussion in Chapter 1, this series can be simplified to: 27 28     k k A k k A FVA n n 1 1 1 1 1 1 (5.1) 29 30 Note that in these computations the future value is obtained right after the last 31 payment. Also, it does not matter whether the payments are made at the beginning 32 or at the end of each year. In expression (5.1), there are n payments, while the 33 number of the compounding period is only ( n - 1) no matter when they start. 34 35
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36 37 The future value of an annuity ( FVA ) of n deposits of $ A with an annual 38 rate of interest k is given by 39 40   k k A FVA n 1 1 41 42 43 Example 5.1 : What is the future value of an annuity of an annual $15 deposit: 44 45 (a) at the beginning of each year for three years? 46 (b) at the end of each year for three years? 47 48 Assume that the annual interest rate is 15 percent. 49 Answer : Since the numbers of payments are small, the value of the annuity can be 50 obtained either directly or by using formula (5.1). 51 The following diagram will help solve the problem. We are assuming a 52 deposit is made at the beginning of each year, and the value is calculated at the 53 beginning of the third year. 54 55 56 Amount deposited 15 15 15 57 58 Beginning of year 0 1 2 3 59 60 By calculating the results directly, we have the future value at year 3 61 62 = 15(l + .15) 2 + 15(l + .15) + 15 63 = 19.8375 + 17.25 + 15 64 = $52.0875 65 66 Alternatively, using expression (5.1): A = 15, k = .15 and n = 3. Therefore, 67 68 0875 . 52 $ 15 . 1
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This note was uploaded on 11/06/2011 for the course FIN 3414 taught by Professor Chaiyuthpadungsaksawasdi during the Fall '10 term at FIU.

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Chapter 5 FIN3414 - 1 2 Chapter Five 3 4 TIME VALUE OF MONEY WITH AN ANNUITY 5 6 7 8 9 10 FUTURE VALUE OF AN ANNUITY Let n equal deposits of an

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