.04. This means $1000 is multiplied by 1.02 five times, once for each of the remaining sixmonth


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1 Questio 1: What is a ordiary auity? Let s look at a ordiary auity that is certai ad simple. By this, we mea a auity over a fixed term whose paymet period matches the iterest coversio period. Additioally, the paymets to the auity are made at the ed of the paymet period. Suppose a paymet of $1000 is made semiaually to the auity over a term of three years. If the auity ears % per year compouded semiaually, the paymet made at the ed of the first sixmoth period will accumulate This meas $1000 is multiplied by 1.0 five times, oce for each of the remaiig sixmoth periods. The ext paymet also ears iterest, but over sixmoth periods. This paymet has a future value of This process cotiues util we have the future value for each paymet. First paymet period Secod paymet period Third paymet period Fourth paymet period Fifth paymet period Sixth paymet period $ $ $1000 grows to 5 $1000 grows to $ $108.3 $1000 grows to 3 $ $ $1000 grows to $ $100.0 $ $ $1000 grows to 1 $1000
2 The last paymet occurs at the ed of the last period ad ears o iterest. Examiig each expressio for the future value, it appears that there is a patter to the idividual future values. Each future value forms a umber correspodig to a geometric sequece. A geometric sequece is a ifiite list of umbers with the form aarar ar ar 3,,,,,, The amouts above correspod to the first six umbers i the geometric sequece , , , , , , I this case, a 1000 ad r 1.0. The umbers i the geometric sequece are called terms. For this geometric sequece, we ca umber the terms to make them easy to refer to First term Secod term Third term Fourth term Fifth term Sixth term I this geometric sequece, each term is 1.0 times larger tha the term before it. I fact, the ratio of ay two adjacet terms is 1.0. For istace, the ratio of the fourth ad fifth terms is Similarly, the ratio of the first ad secod terms is
3 I a geometric series, dividig a term by the precedig oe should results i the same umber. This umber is called the commo ratio for the geometric sequece ad correspods to r. Notice that the power o the 1.0 factor is oe less tha the term umber. This patter holds i geeral ad leads us to the followig patter. For ay 1, the th term of a geometric sequece is 1 ar. It might seem as though this geeral expressio might ot apply to the first term. I this case, 1, so the first term is or Other terms may be idetified as log as the values for a, r, ad are kow. Example 1 Terms of a Geometric Sequece Fid the fourth ad teth terms of the geometric sequece with a first term 500 ad r Solutio If the first term is 500, the a 500. The fourth term ( ) i the geometric sequece is 3 ar or This is equal to The teth term is Let s cotiue to look at the future value of a paymet of $1000 made semiaually to a auity over a term of three years. The future value of the auity is the sum of the future values of each paymet ad correspodig iterest is
4 This sum represets the future value of the auity. For a sum with few terms, it is easy to add these amouts to give a future value of about $ This icludes six paymets of $1000 ad iterest of $ We ca fid the same amout usig a alterate strategy. Start by multiplyig both sides of the expressio for the sum by 1.0 to yield Subtract the sides of this equatio ad the previous equatio: Each equatio cotais idetical terms that are highlighted i red. Whe those terms are subtracted, may terms drop out leavig us with Each side of this equatio may be divided by 0.0 ad simplified to yield This expressio yields the same amout as addig the terms directly, $ If the paymets to the auity icrease i frequecy or take place over a loger period of time, it is ot coveiet to add all of the terms directly. This strategy allows us to fid the sum of ay umber of terms of a geometric sequece. 5
5 I the terms of the geometric sequece we have bee examiig, we ca recogize the paymet PMT ad iterest rate per period i. If the paymets are paid at the ed of periods, the sum of the accumulated amout of each paymet is 3 PMTPMT 1i PMT 1i PMT 1i PMT 1i Usig the strategy, this sum may be writte i a simplified form. Future Value of a Ordiary Auity If equal paymets of PMT are made ito a ordiary auity for periods at a iterest rate of i per period, the future value of the auity is 1 i 1 PMT i We use this expressio to calculate the sum whe there are ay umber of terms. Example Fid the Future Value of the Auity A ivestor deposits $500 i a simple auity at the ed of each sixmoth paymet period. This auity ears 10% per year, compouded semiaually. a. Fid the future value if paymets are made for three years. Solutio Fid the future value of this ordiary auity usig 1i 1 PMT. I this case, PMT 500, i 0.05, ad 6. i This gives 6
6 We could also fid this same amout by addig the terms directly, The six paymets of $500 have eared $ $300 or $00.96 i iterest over the life of the auity. b. Fid the future value if paymets are made for 30 years. Solutio I this ordiary auity, the term is much loger. The geometric series would have 30 terms ad it would ot be practical to add the terms directly. However, if we set R 500, i 0.05, ad 60 i the formula for the future value of a auity, we get , c. How much iterest is eared over the 30 year term i part b? Solutio Over the term of the auity, sixty paymets of $500 are made for a total of $30,000. This yields $176, $30,000 or $16, i iterest. The future value of a ordiary auity formula assumes that the auity starts out with a balace of zero. However, the auity may have a existig balace ad the paymets are added to that amout. I this case, the balace grows accordig to the compoud iterest formula. The paymets grow accordig to the future value of the auity. The sum of these amouts is the future value of both ivestmets combied. 7
7 Example 3 Fid the Future Value of a Retiremet Accout A employee s retiremet accout curretly has a balace of $61,000. Suppose the employee cotributes $33 at the ed of each moth. If the accout ears a retur of 5% compouded mothly, what will the future value of the accout i 15 years? Solutio The origial balace grows accordig to the compoud iterest formula, PV 1 i. The origial amout is PV 600, the iterest rate per period is years is i, ad the umber of periods over The future value of the paymets ito the auity grow accordig to 1i 1 PMT i ad yields. For this accout, the paymet is PMT The sum of future value for the compouded amout ad the future value of the auity is $,181,
8 We ca combie the two amouts ito a sigle formula that accouts for paymets ito a existig accout that has some balace. I this cotext, the balace is called the preset value. It correspods to the value of the accout at the time the paymets commece. Future Value of a Ordiary Auity Whose Preset Value Is Not Zero If paymets PMT are made to a ordiary auity whose preset value is PV, the future value is 1 i 1 PV1i PMT i If paymets PMT are made from a ordiary auity whose preset value is PV, the future value is 1 i 1 PV1i PMT i We could have used the first formula to calculate the future value i Example 3, ,181, I Examples ad 5, four of the five values i the future value formula for a ordiary auity are kow. This allows us to solve for the remaiig value. 9
9 Example Fid the Amout Needed to Establish a Trust Fud A wealthy idividual wishes to create a trust fud for his gradso so that he may withdraw $5000 at the ed of every quarter for te years. At the ed of te years, the gradso will receive the rest of the trust which cotais $50,000. If the trust ears 8% iterest compouded quarterly, how much should be put ito the trust iitially? Solutio I this problem, the amout i the auity is decreasig sice withdrawals are beig made. However, we wish the future value of the auity to be $50,000 i te years. This meas that a larger amout must be placed i the trust ow so that paymet may be made from it Substitute 50000, PMT 5000, i 0.0, ad 10 0 ito 1 i 1 PV1i PMT i to give PV Now solve this equatio for the preset value PV PV PV The trust must be established with a iitial deposit of $159,
10 Example 5 Fid the Paymet from a Auity A savvy ivestor has accumulated $1,000,000 i a ordiary auity. The auity ears % iterest compouded quarterly. She wishes to receive paymets from the auity each quarter for the ext 30 years. a. If the auity will ed up with o moey i 30 years, what paymet should she receive? Solutio Sice the paymets are made from a ordiary auity, we ll start from the future value of a ordiary auity formula, 1 i 1 PV1i PMT i The auity curretly cotais $1,000,000, so PV 1,000,000. The ivestor wats the value of the auity to be $0 i 30 years. This meas 0 0. Substitute these values, the iterest rate per period i, ad the umber of periods 30 to yield ,000,0001 PMT 0 To solve for the paymet PMT, simplify ad isolate the paymet: ,000, PMT PMT 1,000, PMT 1,000, PMT 1, Multiply both sides by the reciprocal of the fractio i brackets The quarterly paymet is $1,
11 The paymet has bee rouded dow to isure all of the paymets are equal. This will leave a small amout of moey i the auity at the ed of 30 years. However, you could also roud up if you realize the last paymet might be differet from the earlier paymets. b. The ivestor wishes to leave a balace i the auity to leave to her heirs. If the auity is to ed cotai $100,000 i 30 years, what paymet should she receive? Solutio I this case, she wishes 100, 000. Chage the future value to this amout a solve for the paymet i ,000 1,000, PMT PMT 1,000, ,000 PMT 1,000, , PMT 13, Reducig the paymet by $3.71 isures that the auity will cotai $100,000 i 30 years. 1
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