Relating a Uniform Series (Annuity) to Its Present and Future Equivalent

Values
Figure 4-6 shows a general cash-flow diagram involving a series of uniform (equal) receipts,
each of amount A, occurring at the end of each period for N periods with interest at i% per
period. Such a uniform series is often called an annuity. It should be noted that the formulas and
tables to be presented are derived such that A occurs at the end of each period.

The timing relationship for P, A, and F can be observed in Figure 4-6. Four formulas relating A
to F and P will be developed.

Finding F when Given A

If a cash flow in the amount of A dollars occurs at the end of each period for N periods and i% is
the interest(profit or growth) rate per period, the future equivalent value, F, at the end of the Nth
period is obtained by summing the future equivalents of each of the cash flows. Thus,
( )
F=A[ (8)

The quantity {[(1 + i)N - 1] / i} is called the uniform series compound amount factor. It is the
starting point for developing the remaining three uniform series interest factors. the functional
symbol (F/A,i%,N) is used for this factor. Hence, Equation (8) can be expressed as

F = A (F/A, i%, N)

Example 6 Future Value of a College Degree

A recent government study reported that a college degree is worth an extra $23,000 per year in
income (A) compared to what a high-school graduate makes. If the interest rate (i) is 6% per year
and you work for 40 years (N), what is the future compound amount (F) of this extra income?

Solution: The viewpoint we will use to solve this problem is that of “lending” the $23,000 of
extra annual income to a savings account (or some other investment vehicle). The future
equivalent is the amount that can be withdrawn after the 40th deposit is made.
Notice that the future equivalent occurs at the same time as the last deposit of $23,000.

F = $23,000(F/A, 6%, 40)

Finding P when Given A

Thus, Equation (9) is the relation for finding the present equivalent value (as of the beginning of
the first period) of a uniform series of end-of-period cash flows of amount A for N periods. The
quantity in brackets is called the uniform series present worth factor.
( )
P=A[ ( )
(9)

Example 7 Present Equivalent of an Annuity (Uniform Series)

A small beverage firm is considering the installation of a newly designed cold drink machine that
is used to make carbonated drinks through an innovative process. The machine will produce cold
drinks using a new technique, saving $450,000 per year over the machine’s expected life of 10
years. If the interest rate is 12% per year, how much money can the firm afford to invest in new
machine?

Solution: In the cash flow diagram below, notice that the affordable amount (i.e., the present
equivalent, P) occurs one time period (year) before the first end-of-year cash flow of $450,000.
The increase in annual cash flow is $450,000, and it continues for 10 years at 12% annual
interest. The upper limit on what the firm can afford to spend on the new system is:

P = $450,000 (P/A, 12%, 10)

Finding A when Given F

Taking Equation (8) and solving for A, we find that

A=F[( )
(10)

Thus, Equation (10) is the relation for finding the amount, A, of a uniform series of cash flows
occurring at the end of N interest periods that would be equivalent to (have the same value as) its
future value occurring at the end of the last period. The quantity in brackets is called the sinking
fund factor.

Finding A when Given P

Taking Equation (9) and solving for A, we find that

( )
A=P[( )
(11)

Thus, Equation (11) is the relation for finding the amount, A, of a uniform series of cash flows
occurring at the end of each of N interest periods that would be equivalent to, or could be traded
for, the present equivalent P, occurring at the beginning of the first period. The quantity in
brackets is called the capital recovery factor.

Example 8 Computing Your Monthly Car Payment

You borrow $15,000 from your credit union to purchase a used car. The interest rate on your
loan is 0.25% per month∗ and you will make a total of 36 monthly payments. What is your
monthly payment?

Solution: The cash-flow diagram shown below is drawn from the viewpoint of the bank. Notice
that the present amount of $15,000 occurs one month (interest period) before the first cash flow
of the uniform repayment series.
The amount of the car payment is easily calculated using functional symbol of Equation (11) .

A = $15,000(A/P, 1/4%, 36)

Finding the Number of Cash Flows in an Annuity Given A, P, and i

Sometimes we may have information about a present amount of money (P), the magnitude of an
annuity (A), and the interest rate (i). The unknown factor in this case is the number of cash flows
in the annuity (N).

Example 9 Prepaying a Loan--Finding N

Your company has a $100,000 loan for a new security system it just bought. The annual payment
is $8,880 and the interest rate is 8% per year for 30 years. Your company decides that it can
afford to pay $10,000 per year. After how many payments (years) will the loan be paid off?

Solution: Instead of paying $8,880 per year, your company is going to pay $10,000 per year.
Using Equation (9), we find

$100,000 = $10,000 (P/A, 8%, N)

(P/A, 8%, N) = 10.

We can now use the interest tables provided in Appendix to find N. Looking down the Present
Worth Factor column (P/A) of Table in Appendix, we see that

(P/A, 8%, 20) = 9.8181

and

(P/A, 8%, 21) = 10.0168.

So, if $10,000 is paid per year, the loan will be paid off after 21 years instead of 30 in case of
$8,880 per year. The exact amount of the 21st payment will be slightly less than $10,000.

Finding the Interest Rate, i, Given A, F, and N

Now let’s look at the situation in which you know the amount (A) and duration (N) of a uniform
payment series. You also know the desired future value of the series (F). What you don’t know is
the interest rate that makes them equivalent. As was the case for an unknown N, there is no
single equation to determine i. However, we can use the known relationships between i, A, F,
and N and the method of linear interpolation to approximate the interest rate.
Example 10 Finding the Interest Rate to Meet an Investment Goal

After years of being a poor, debt-encumbered college student, you decide that you want to pay
for your dream car in cash. Not having enough money now, you decide to specifically put money
away each year in a “dream car” fund. The car you want to buy will cost $60,000 in eight years.
You are going to put aside $6,000 each year (for eight years) to save for this. At what interest
rate must you invest your money to achieve your goal of having enough to purchase the car after
eight years?

Solution we can use Equation (8) to show our desired equivalence relationship.

$60,000 = $6,000 (F/A, i%, 8)

(F/A, i%, 8) = 10

Now we can use the interest tables in Appendix to help track down the unknown value of i. What
we are looking for are two interest rates, one with an (F/A, i%, 8) value greater than 10 and one
with an (F/A, i%, 8) less than 10. Thumbing through Appendix, we find

(F/A, 6%, 8) = 9.8975 and (F/A, 7%, 8) = 10.2598,

which tells us that the interest rate we are looking for is between 6% and 7% per year. we can
use linear interpolation to approximate the value of i.

i′ = 0.0628 or 6.28% per year

So if you can find an investment account that will earn at least 6.28% interest per year, you’ll
have the $60,000 you need to buy your dream car in eight years.