Chapter 3
Mathematics of Finance
Section 4
Present Value of an Annuity; Amortization
Present Value of an Annuity
In this section, we will address the problem of determining
the amount that should be deposited into an account now at
a given interest rate in order to be able to withdraw equal
amounts from the account in the future until no money
remains in the account.
Here is an example: How much money must you deposit
now at 6% interest compounded quarterly in order to be
able to withdraw $3,000 at the end of each quarter year for
two years?
2
Derivation of Formula
We begin by solving for P in the compound interest
formula:
A P 1 i
n
n
P A(1 i )
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Present Value of the
First Four Payments
Interest rate each period is 0.06/4=0.015
1
0.06
P1 3000 1
4
P2 3000 1.015
2
3
P3 3000(1.015)
4
P4 3000(1.015)
4
Derivation of Short Cut Formula
We could proceed to calculate the next four payments and
then simply find the total of the 8 payments. There are 8
payments since there will be 8 total withdrawals:
(2 years) (four withdrawals per year) = 8 withdrawals.
This method is tedious and time consuming so we seek a
short cut method.
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Present Value of an Ordinary Annuity
n
1 (1 i)
PV PMT
i
PV = present value of all payments
PMT = periodic payment
i = rate per period
n = number of periods
Note: Payments are made at the end of each period.
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Back to Our Original Problem
How much money must you deposit now at 6% interest
compounded quarterly in order to be able to withdraw
$3,000 at the end of each quarter year for two years?
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Back to Our Original Problem
How much money must you deposit now at 6% interest
compounded quarterly in order to be able to withdraw
$3,000 at the end of each quarter year for two years?
Solution: R = 3000, i = 0.06/4 = 0.015, n = 8
1 (1 i ) n
P R
i
1 (1.015) 8
P 3000 22, 457.78
0.015
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Interest Earned
The present value of all payments is $22,457.78. The total
amount of money withdrawn over two years is
3000(4)(2)=24,000.
Thus, the accrued interest is the difference between the
two amounts:
$24,000 – $22,457.78 =$1,542.22.
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Amortization Problem
Problem: A bank loans a customer $50,000 at 4.5%
interest per year to purchase a house. The customer agrees
to make monthly payments for the next 15 years for a total
of 180 payments. How much should the monthly payment
be if the debt is to be retired in 15 years?
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Amortization Problem
Solution
Problem: A bank loans a customer $50,000 at 4.5%
interest per year to purchase a house. The customer agrees
to make monthly payments for the next 15 years for a total
of 180 payments. How much should the monthly payment
be if the debt is to be retired in 15 years?
Solution: The bank has bought an annuity from the
customer. This annuity pays the bank a $PMT per month at
4.5% interest compounded monthly for 180 months.
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Solution
(continued)
We use the previous formula for present value of an
annuity and solve for PMT:
1 (1 i ) n
PV PMT
i
i
PMT PV n
1 (1 i )
12
Solution
(continued)
i
Care must be taken to perform PMT PV n
the correct order of operations. 1 (1 i )
1. enter 0.045 divided by 12 0.045
2. 1 + step 1 result PMT 50, 000 12 382.50
3. Raise answer to -180 power. 0.045 180
1 1
4. 1 – step 3 result 12
5. Take reciprocal (1/x) of step 4
result. Multiply by 0.045 and
divide by 12.
5. Finally, multiply that result by
50,000 to obtain 382.50
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Solution
(continued)
If the customer makes a monthly payment of $382.50 to
the bank for 180 payments, then the total amount paid to
the bank is the product of $382.50 and 180 = $68,850.
Thus, the interest earned by the bank is the difference
between $68,850 and $50,000 (original loan) = $18,850.
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Constructing an
Amortization Schedule
If you borrow $500 that you agree to repay in six
equal monthly payments at 1% interest per month
on the unpaid balance, how much of each monthly
payment is used for interest and how much is used
to reduce the unpaid balance?
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Amortization Schedule
Solution
If you borrow $500 that you agree to repay in six
equal monthly payments at 1% interest per month
on the unpaid balance, how much of each monthly
payment is used for interest and how much is used
to reduce the unpaid balance?
Solution: First, we compute the required monthly
payment using the formula i
PMT PV
1 (1 i ) n
0.01
500
1 (1.01) 6
$86.27
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Solution
(continued)
At the end of the first month, the interest due is
$500(0.01) = $5.00.
The amortization payment is divided into two parts, payment
of the interest due and reduction of the unpaid balance.
Monthly Payment Interest Due Unpaid Balance
Reduction
$86.27 = $5.00 + $81.27
The unpaid balance for the next month is
Previous Unpaid Bal Unpaid Bal Reduction New Unpaid Bal
$500.00 – $81.27 = $418.73
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Solution
(continued)
This process continues until all payments have been made
and the unpaid balance is reduced to zero. The calculations
for each month are listed in the following table, which was
done on a spreadsheet.
Payment Payment Interest Inpaid Bal Unpaid
Number Reduction Balance
In reality, the
0 $500.00 last payment
1 86.27 $5.00 $81.27 $418.73 would be
2 86.27 $4.19 $82.08 $336.65 increased by
3 86.27 $3.37 $82.90 $253.74
4 86.27 $2.54 $83.73 $170.01
$0.03, so that the
5 86.27 $1.70 $84.57 $85.44 balance is zero.
6 86.27 $0.85 $85.42 $0.03
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Strategy for Solving Mathematics
of Finance Problems
Step 1. Determine whether the problem involves a single
payment or a sequence of equal periodic payments.
• Simple and compound interest problems involve a
single present value and a single future value.
• Ordinary annuities may be concerned with a present
value or a future value but always involve a sequence
of equal periodic payments.
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Strategy
(continued)
Step 2. If a single payment is involved, determine whether
simple or compound interest is used. Simple interest is
usually used for durations of a year or less and compound
interest for longer periods.
Step 3. If a sequence of periodic payments is involved,
determine whether the payments are being made into an
account that is increasing in value -a future value problem
- or the payments are being made out of an account that is
decreasing in value - a present value problem. Remember
that amortization problems always involve the present
value of an ordinary annuity.
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