ANNUITIES AND SINKING

FUNDS

McGraw-Hill/Irwin

Chapter
Thirteen

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

LEARNING UNIT OBJECTIVES

LU13-1: Annuities: Ordinary Annuity and Annuity Due
1.
Differentiate between contingent annuities and annuities
(Find Future Value)
certain.
2.
Calculate the future value of an ordinary annuity and an
annuity
due manually
by table
LU 13-2:
Present and
Value
of anlookup.
Ordinary Annuity (Find
1.
Calculate
the present value of an ordinary annuity by
Present
Value)
table lookup and manually check the calculation.
2.
Compare the calculation of the present value of one
lump sum versus the present value of an ordinary
annuity.

LU 13-3: Sinking Funds (Find Periodic Payments)

1.
Calculate the payment made at the end of each
period by table lookup.
2.
Check table lookup by using ordinary annuity
table.

13-2

ANNUITIES
Annuities have many uses in addition to lottery payoffs. Some of these uses are insurance companies'
pension installments, Social Security payments, home mortgages, businesses paying off notes, bond
interest, and savings for a vacation trip or college education.
Example 1
What happens when you have the winning lottery ticket? You take it to the lottery headquarters. When
you turn in the ticket, do you immediately receive a check for $1 million? No. Lottery payoffs are not
usually made in lump sums. Lottery winners receive a series of payments over a period of time
usually years. This stream of payments is an annuity. By paying the winners an annuity, lotteries do
not actually spend $1 million. The lottery deposits a sum of money in a financial institution. The
continual growth of this sum through compound interest provides the lottery winner with a series of
payments.
Example 2
Many parents of small children are concerned about being able to afford to pay for their children's
college educations. Some parents start an annuity by depositing a series of payments in a financial
institution (usually of equal amounts over a period of time) from the time when the child is in diapers.
The interest on these deposits is compounded until the child is 18, when the parents withdraw the sum
of all deposits plus the interest that accumulates for college expenses.
We begin the chapter by explaining the difference between calculating the future value of an ordinary
annuity and an annuity due. Then you learn how to find the present value of an ordinary annuity. The
chapter ends with a discussion of sinking funds.
13-3

COMPOUNDING INTEREST (FUTURE

VALUE)
Annuity

Term of the annuity

A series of payments

The time from the beginning

of the first payment period to
the end of the last payment
period

Future value of annuity

The future dollar amount of a
series of payments plus
interest

Present value of an
annuity The amount of
money needed to invest today
in order to receive a stream of
payments for a given number
of years in the future
13-4

FUTURE VALUE OF AN ANNUITY

Annuity is stream of equal payments made at periodic times.

The future value of an annuity is the future dollar amount of a series of payments plus interest. The term of
the annuity is the time from the beginning of the first payment period to the end of the last payment period.
The concept of the future value of an annuity is illustrated in the following figure
At end of period 1: $1 is invested.
At end of period 2: An additional $1 is invested. The $1 from period 1 earns interest and is now worth $1.08.
The $1 invested at the end of period 2, does not earn any interest, because it was invested at the end of the
period. The $2.00 is now worth $2.08
At end of period 3: An additional $1 is invested. The $3.00 is now worth $3.25. Remember that the last dollar
invested earns no interest.

13-5

CALCULATING FUTURE VALUE OF AN

ORDINARY ANNUITY MANUALLY
Step 1. For period 1, no interest calculation is necessary, since
money is invested at the end of the period.
Step 2. For period 2, calculate interest on the balance and add
the interest to the previous balance.
Step 3. Add the additional investment at the end of period 2
to the new balance.
Step 4. Repeat Steps 2 and 3 until the end of the desired
period is reached.

13-6

CALCULATING FUTURE VALUE OF

AN ORDINARY ANNUITY MANUALLY
Find the value of an investment after 3 years for a
$3,000 ordinary annuity at 8%.

13-7

CALCULATING FUTURE VALUE OF

AN ORDINARY ANNUITY BY TABLE
LOOKUP
Step 1. Calculate the number of periods and rate per
period.
Step 2. Look up the periods and rate in an ordinary annuity
table. The intersection gives the table factor for the
future value of $1.
Step 3. Multiply the payment each period by the table
factor. This gives the future value of the annuity.
Future value of
Ordinary annuity
ordinary annuity
factor

= Annuity payment

each period

table

13-8

ORDINARY ANNUITY TABLE:

COMPOUND SUM OF AN ANNUITY OF
$1 (TABLE 13.1)

13-9

FUTURE VALUE OF
AN ORDINARY ANNUITY
Find the value of an investment after 3 years for a $3,000
ordinary annuity at 8%.
Periods (N) = 3 x 1 =
3
Rate (R) = 8%/1 =
8%
3.2464 (table factor) x $3,000$9,739.20
=

13-10

CLASSIFICATION OF ANNUITIES
Annuities are classified into two major groups: contingent
annuities and annuities certain
Contingent annuities

Annuities certain

have no fixed number of

payments but depend on an
uncertain event

have a specific stated number

of payments

Life Insurance payments

Mortgage payments
13-11

CLASSIFICATION OF ANNUITIES
we can divide each of the major annuity groups (Contingent annuities and Annuities
certain) into Ordinary annuity and Annuity due:
Ordinary annuity

Annuity due

regular deposits/payments
made at the end of the
period

regular deposits/payments
made at the beginning of the
period

Jan. 31

Monthly

Jan. 1

June 30

Quarterly

April 1

Dec. 31

Semiannually

July 1

Dec. 31

Annually

Jan. 1

13-12

CALCULATING FUTURE VALUE OF

AN
ANNUITY DUE MANUALLY
Step 1. Calculate the interest on the balance for the period and
add it to the previous balance.

Step 2. Add additional investment at the beginning of the

period to the new balance.
Step 3. Repeat Steps 1 and 2 until the end of the desired
period is reached.

13-13

CALCULATING FUTURE VALUE OF

AN ANNUITY DUE MANUALLY
Find the value of an investment after 3 years for a
$3,000 annuity due at 8%.

13-14

CALCULATING FUTURE VALUE OF

AN
ANNUITY DUE BY TABLE LOOKUP
Step 1. Calculate the number of periods and rate per
period. Add one extra period.
Step 2. Look up in an ordinary annuity table the periods
and rate. The intersection gives the table factor
for the future value of $1.
Step 3. Multiply the payment each period by the
table factor.
Step 4. Subtract 1 payment from
Step 3.

13-15

FUTURE VALUE OF AN ANNUITY

DUE
Find the value of an investment after 3 years for a
$3,000 annuity due at 8%.
Periods (N) = 3 x 1 = 3 + 1
=4
Rate (R) = 8%/1 = 8%
4.5061 (table factor) x $3,000 =
$13,518.30
$13,518.30 -- $3,000 $10,518.30
=

13-16

PRACTICE QUIZ
1-UsingTable13.1,(a)findthevalueofaninvestmentafter4yearsonanordinaryannuityof$4,000
madesemiannuallyat10%;and(b)recalculate,assuminganannuitydue.
2-WallyBeaverwonalotteryandwillreceiveacheckfor$4,000atthebeginningofeach6monthsfor
thenext5years.IfWallydepositseachcheckintoanaccountthatpays6%,howmuchwillhehaveat
theendofthe5years?

For step by step solution watch the video for LU 13-1 ( Go to: McGraw-Hills Connect; Assignment # 5; Question
1; Click the eBook & resources options drop down menu; scroll down to LU13-1 and click

13-17

PRESENT VALUE OF AN ANNUITY

Let's assume that we want to know how much money we need to invest today to receive a stream of payments for
a given number of years in the future. This is called the present value of an ordinary annuity.
Inthefollowingfigureyoucanseethatifyouwantedtowithdraw$1attheendofoneperiod,youwould
havetoinvest93centstoday.Ifattheendofeachperiodforthreeperiodsyouwantedtowithdraw$1,you
Wouldhavetoput$2.58inthebanktodayat8%interest.(Notethatwegofromthefuturebacktothe
present.)
$2.5771
$1.7833
$.925
9

Number of periods

13-18

CALCULATING PRESENT VALUE OF

AN ORDINARY ANNUITY BY TABLE
LOOKUP
Step 1. Calculate the number of periods and rate per
period.
Step 2. Look up the periods and rate in the present
value of an annuity table. The intersection gives
the table factor for the present value of $1.
Step 3. Multiply the withdrawal for each period by the
table factor. This gives the present value of an
ordinary annuity .
Present value of
=
ordinary annuity payment
table

Annuity
x
payment

Present value of
ordinary annuity

13-19

PRESENT VALUE OF AN ANNUITY OF

$1
(TABLE 13.2)

13-20

PRESENT VALUE OF AN ANNUITY

John Fitch wants to receive a $8,000
annuity in 3 years. Interest on the
annuity is 8% semiannually. John will
make withdrawals at the end of each
year. How much must John invest
today to receive a stream of payments
for 3 years.
N=3x1=3
periods
R = 8%/1 = 8%
2.5771 (table factor) x
$8,000 =
$20,616.80

Interest ==>
Payment ==>
Interest ==>
Payment ==>
Interest ==>
Payment ==>
End of Year 3 ==>

13-21

LUMP SUMS VERSUS ANNUITIES

John Sands made deposits of $200 to Floor Bank, which pays 8%
interest compounded semi annually. After 5 years, John makes no more
deposits. What will be the balance in the account 6 years after the last
deposit?
Step 1. Future value of an
N = 5 x 2 =annuity
10
periods
R = 8%/2 = 4%
12.0061 (table factor) x
$200 =
$2,401.22

Step 2. Future value of a lump

sum
N = 6 x 2 = 12
periods
R = 8%/2 = 4%
1.6010 (table factor) x
$2,401.22 =
$3,844.35

13-22

LUMP SUMS VERSUS ANNUITIES

Mel Rich decided to retire in 8 years to New Mexico. What amount
must Mel invest today so he will be able to withdraw $40,000 at
the end of each year 25 years after he retires? Assume Mel can
invest money at 5% interest compounded annually.
Step 1. Present value of an annuity
N = 25 x 1 = 25 periods
R = 5%/1 = 5%
14.0939 x $40,000 =
$563,756

Step 2. Present value of a lump

sum
N = 8 x 1 = 8 periods
R = 5%/1 = 5%
.6768 x $563,756 =
$381,550.06

13-23

PRACTICE QUIZ
1-What must you invest today to receive an $18,000 annuity for 5 years semiannually at a 10% annual rate? All
withdrawals will be made at the end of each period.
2-Rase High School wants to set up a scholarship fund to provide five $2,000 scholarships for the next 10 years. If
money can be invested at an annual rate of 9%, how much should the scholarship committee invest today?
3-Joe Wood decided to retire in 5 years in Arizona. What amount should Joe invest today so he can withdraw $60,000
at the end of each year for 30 years after he retires? Assume Joe can invest money at 6% compounded annually.

For step by step solution watch the video for LU 13-2 ( Go to: McGraw-Hills Connect;
Assignment # 5; Question 2; Click the eBook & resources options drop down menu; scroll
13-24
down to LU13-2 and click

SINKING FUNDS
(FIND PERIODIC PAYMENTS)

A sinking fund is a financial arrangement that sets aside regular periodic

payments of a particular amount of money. Compound interest
accumulates on these payments to a specific sum at a predetermined
future date.
Corporations use sinking funds to discharge bonded indebtedness, to
replace worn-out equipment, to purchase plant expansion, and so on.
A sinking fund is a different type of an annuity. In a sinking fund, you
determine the amount of periodic payments you need to achieve a given
financial goal. In the annuity, you know the amount of each payment and
must determine its future value.

Let's work with the following formula:

Sinking fund = Future x Sinking

fund
payment
value
table

13-25

SINKING FUND TABLE BASED ON $1

(Table 12.3)

13-26

SINKING FUND
To retire a bond issue, Moore Company needs $60,000 in 18 years
from today. The interest rate is 10% compounded annually. What
payment must Moore make at the end of each year? Use Table 13.3.
N = 18 x 1 = 18 periods
R = 10%/1 = 10%
0.0219 x $60,000 =
$1,314
Check
Future Value of an annuity
table
N = 18, R= 10%
$1,314 x 45.5992 =
$59,917.35*
* Off due to rounding
13-27

PRACTICE QUIZ
Today,ArrowCompanyissuedbondsthatwillmaturetoavalueof$90,000in
10years.Arrow'scontrollerisplanningtosetupasinkingfund.Interestrates
are12%compoundedsemiannually.WhatwillArrowCompanyhavetoset
asidetomeetitsobligationin10years?Checkyouranswer.Youranswerwill
beoffduetotheroundingofTable13.3.

For step by step solution watch the video for LU 13-3 ( Go to: McGraw-Hills
Connect; Assignment # 5; Question 3; Click the eBook & resources options drop
down menu; scroll down to LU13-3 and click
13-28

PROBLEM 13-13
To help you reach financial security upon retirement, you should
invest 20% of your income annually. If you automatically transferred
$3,000 at the end of each year to a retirement account earning 4%
interest compounded annually, how much would you have after 25
years? 30 years? LU 13-1(2)
Solution:
Periods = 25 years x 1 = 25
periods
Interest rate per period = 4%/1 =
4%
$3,000
x 41.6459 = $124,937.70 after 25 years
Periods = 30 years x 1 = 30 periods
Interest rate per period = 4%/1 = 4%
$3,000 x 56.0849 = $168,254.70 after 30
years
13-29

PROBLEM 13-17
Josef Company borrowed money that must be repaid in 20 years. The
company wants to make sure the loan will be repaid at the end of
year 20, so it invests $12,500 at the end of each year at 12% interest
compounded annually. What was the amount of the original loan? LU
13-1(2)
Solution:
20 periods, 12% (Table 13.1)
$12,500 X 72.0524 = $900,655

13-30

PROBLEM 13-18
Bankrate.com reported on a shocking statistic: only 54% of workers
participate in their companys retirement plan. This means that 46% do
not. With such an uncertain future for Social Security, this can leave
almost 1 in 2 individuals without proper income during retirement. Jill
Collins, 20, decided she needs to have $250,000 in her retirement
account upon retiring at 60. How much does she need to invest each
year at 5% compounded annually to meet her goal? Tip: She is setting
up a sinking fund. LU 13-3(1)
Solution:
Periods = 40 years X 1 = 40 periods
Interest rate per period = 5%/1 = 5%
$250,000 X .0083 = $2,075 each year

13-31

PROBLEM 13-23
On Joe Martins graduation from college, Joes uncle promised him a
gift of $12,000 in cash or $900 every quarter for the next 4 years
after graduation. If money could be invested at 8% compounded
quarterly, which offer is better for Joe? LU 13-1(2), LU 13-2(1)

Solution:
8 periods 8%/ 4 = 2%
$900 x 13.5777 =
$12,219.93
(Table
13.2)

or $900 x 18.6392 = $16,775.28

(Table 13.1)
x
.7284 (Table
12.3)
$12,219.11
2%, 16 periods
13-32

PROBLEM 13-25
A local Dunkin Donuts franchise must buy a new piece of equipment
in 5 years that will cost $88,000. The company is setting up a sinking
fund to finance the purchase. What will the quarterly deposit be if the
fund earns 8% interest?
LU 13-3(1)
Solution:
20 periods, 2% (Table 13.3)
.0412 X $88,000 = $3,625.60 quarterly payment

13-33

PROBLEM 13-26
Mike Macaro is selling a piece of land. Two offers are on the table.
Morton Company offered a $40,000 down payment and $35,000 a
year for the next 5 years. Flynn Company offered $25,000 down and
$38,000 a year for the next 5 years. If money can be invested at 8%
compounded annually, which offer is better for Mike? LU 13-1(2)
Solution:
Morton: 5 periods, 8% (Table 13.2)
+ $40,000$179,744.50
=
3.9927 X $35,000 $139,744.50
=
Flynn: 5 periods, 8% (Table 13.2))
3.9927 X $38,000 $151,722.60
=
+ $25,000$176,722.60
=
Mortons offer is the better deal.

13-34