ENGINEERING ECONOMICS 2021

TOPIC 4: ANNUITIES

An annuity is a series of payments made at equal intervals. Examples of

annuities are regular deposits to a savings account, monthly home mortgage
payments, monthly insurance payments and pension payments. Annuities can be
classified by the frequency of payment dates.

ORDINARY ANNUITY

An ordinary annuity is a series of equal payments made at the end of consecutive

periods over a fixed length of time. While the payments in an ordinary annuity can be
made as frequently as every week, in practice they are generally made monthly,
quarterly, semi-annually, or annually. An ordinary annuity makes (or requires)
payments at the end of each period. For example, bonds generally pay interest at
the end of every six months.

UNIFORM SERIES PRESENT WORTH FACTOR AND CAPITAL RECOVERY FACTOR (P/A AND
A/P)

The equivalent present worth P of a uniform series A of end-of-period cash flows

(investments) is shown in the figure below. An expression for the present worth can be
determined by considering each A value as a future worth F, calculating its present
worth.

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Where

P = value or sum of money at present

F = value or sum of money at some future time
A = a series of periodic, equal amounts of money
n = number of interest periods
i = interest rate per interest period

The term in brackets in equation above is the conversion factor referred to as

the uniform series present worth factor (USPWF). It is the P/A factor used to calculate
the equivalent P value in year 0 for a uniform end-of-period series of A values
beginning at the end of period 1 and extending for n periods.

To reverse the situation, the present worth P is known and the equivalent
uniform series amount A is sought (shown in the figure below). The first A value occurs
at the end of period 1, that is, one period after P occurs.

The term in brackets is called the capital recovery factor (CRF), or A_P factor.
It calculates the equivalent uniform annual worth A over n years for a given P in year
0, when the interest rate is i.

The P/A and A/P factors are derived with the present worth P and the first
uniform annual amount A one year (period) apart. That is, the present worth P must
always be located one period prior to the first A.

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Summary of formulas

Illustrative Problems

1. How much money should you be willing to pay now for a guaranteed Php 30
000.00 per year for 9 years starting next year, at a rate of return of 16% per
year?

A = 30 000
i = 16%
n=9
P=?

(1 + 𝑖) − 1
𝑃=𝐴
𝑖(1 + 𝑖)

(1 + 0.16) − 1
𝑃 = 30 000
0.16(1 + 0.16)

𝑷 = 𝑷𝒉𝒑 𝟏𝟑𝟖, 𝟏𝟗𝟔. 𝟑𝟏𝟔𝟑

2. An engineer who is about to retire has accumulated Php 2, 500, 000.00 in a

savings account that pays 6% per year, compounded annually. Suppose that
the engineer wishes to withdraw a fixed sum of money at the end of each
year for 10 years. What is the maximum amount that can be withdrawn?

A=?
i = 6%
n = 10
P = 2, 500, 000

𝑖(1 + 𝑖)
𝐴=𝑃
(1 + 𝑖) − 1

0.06(1 + 0.06)
𝐴 = 2 500 000
(1 + 0.06) − 1

𝑨 = 𝑷𝒉𝒑 𝟑𝟑𝟗, 𝟔𝟔𝟗. 𝟖𝟗𝟓𝟔

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3. A man paid 10% down payment of Php 200, 000 for a house and lot and
agreed to pay the balance on monthly installments for “x” years at an interest
rate of 15% compounded monthly. If the monthly installment was Php 42,
821.87, find the value of “x”.

Solution

Solve for the total cost of the house and lot given the down payment which is
10% of the total cost.

200, 000
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = = 𝑃ℎ𝑝 2, 000, 000
0.1

Since the man has initially paid 200 000, the amount that will be paid monthly
is
𝐴𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑏𝑒 𝑝𝑎𝑖𝑑 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 = 2, 000, 000 − 200, 000 = 𝑃ℎ𝑝 1, 800, 000

0.15
𝑖= = 0.0125 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ
12

𝐴 = 𝑃ℎ𝑝 42, 821.87

(1 + 𝑖) − 1
𝑃=𝐴
𝑖(1 + 𝑖)

(1 + 0.0125) − 1
1, 800, 000 = 42, 821.87
0.0125(1 + 0.0125)

𝑛 = 60 𝑚𝑜𝑛𝑡ℎ𝑠

60 𝑚𝑜𝑛𝑡ℎ𝑠
𝑥=
12 𝑚𝑜𝑛𝑡ℎ𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

𝒙 = 𝟓 𝒚𝒆𝒂𝒓𝒔

SINKING FUND FACTOR AND UNIFORM SERIES COMPOUND AMOUNT FACTOR (A/F
AND F/A)

The expression in brackets in equation above is the A/F or sinking fund factor. It
determines the uniform annual series A that is equivalent to a given future amount F.
This is shown graphically in in the figure below where A is a uniform annual
investment.

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NOTE: The uniform series A begins at the end of year (period) 1 and continues
through the year of the given F. The last A value and F occur at the same
time.

The term in brackets is called the uniform series compound amount factor (USCAF),
or F/A factor. When multiplied by the given uniform annual amount A, it yields the
future worth of the uniform series. It is important to remember that the future amount
F occurs in the same period as the last A.

Summary of formulas

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Illustrative Problems

1. The president of Sarao Motor Company wants to know the equivalent future
worth of a Php 50, 000.00 capital investment each year for 8 years, starting 1
year from now. Sarao capital earns at a rate of 14% per year.

The cash flow diagram below shows the annual investments starting at the end of
year 1 and ending in the year the future worth is desired.

(1 + 𝑖) − 1
𝐹=𝐴
𝑖

(1 + 0.14) − 1
𝐹 = 50 000
0.14

𝑭 = 𝑷𝒉𝒑 𝟔𝟔𝟏, 𝟔𝟑𝟖. 𝟎𝟎𝟕𝟗

2. Mr. Franklin wants to save for new sports car that he expects will cost Php 1,
900, 000.00 four years from now. How much money will he have to save each
year and deposit in a savings account that pays 6.25% per year,
compounded annually, to buy the car in four years?

Below is the cash flow diagram. We are to solve the yearly deposit A.

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𝑖
𝑨=𝐹
(1 + 𝑖) − 1

0.0625
𝐴 = 1, 900, 000
(1 + 0.0625) − 1

𝑨 = 𝑷𝒉𝒑 𝟒𝟑𝟐, 𝟕𝟏𝟔. 𝟏𝟓𝟐𝟑

3. The purchaser of a tractor paid Php 10, 000 cash and agreed to pay
Php 3000 at the end of 6 months for 10 years. He failed to make the first
5 payments of Php 3, 000 each. At the end of 3 years, he desires to pay
the tractor by a single payment which will cancel both his
accumulated liabilities and his future liabilities. What must he pay if
money is worth 6% per annum compounded semi-annually?

Solution

The situation for problem 3 is illustrated by the cash flow diagram below. The single
payment is equal to the sum of the future worth (F) of the 5 failed payments (plus the
payment on the end of third year which is the 6th payment) and the present worth
(P) of the remaining future payments.

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Solve for F,

0.06
𝑖= = 0.03 𝑒𝑣𝑒𝑟𝑦 6 𝑚𝑜𝑛𝑡ℎ𝑠 (𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙)
2

(1 + 𝑖) − 1
𝐹=𝐴
𝑖

(1 + 0.03) − 1
𝐹 = 3000
0.03

𝐹 = 𝑃ℎ𝑝 19, 405.23

Solve for P,

(1 + 𝑖) − 1
𝑃=𝐴
𝑖(1 + 𝑖)

(1 + 0.03) − 1
𝑃 = 3000
0.03(1 + 0.03)

𝑃 = 𝑃ℎ𝑝 33, 888.22

Solve for X,

𝑋 = 𝐹+𝑃

𝑋 = 19, 405.23 + 33, 888.22

𝑿 = 𝑷𝒉𝒑 𝟓𝟑, 𝟐𝟗𝟑. 𝟒𝟓

Compounding Occurs at a Different Rate than that at which Payments are Made

When calculating equivalent values, we need to identify both the interest period
and the payment period. If the time interval for compounding is different from the
time interval for cash transaction (or payment), we need to find the effective interest
rate that covers the payment period.

The computational procedure for dealing with compounding periods and payment
periods that cannot be compared is as follows:

1. Identify the number of compounding periods per year, the number of

payment periods per year, and the number of interest periods per payment
period.
2. Compute effective interest rate per payment period.
3. Find the total number of payment periods.
4. Use i and n in the appropriate formulas.

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Illustrative Problems

1. Suppose you make equal quarterly deposits of Php 50, 000 into a fund
that pays interest at a rate of 12% compounded monthly. Find the
balance at the end of year 3.

 Identify the number of compounding periods per year, the number of

payment periods per year, and the number of interest periods per payment
period.
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 12

𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 4

 Compute effective interest rate per payment period. Equate the effective
rate of interest of both conditions.
0.12
(1 + 𝑖) − 1 = 1 + −1
12

𝑖 = 0.030301 (𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟)

Or

𝑖 0.12
1+ −1 = 1+ −1
4 12

𝑖 = 0.121204 (𝑝𝑒𝑟 𝑦𝑒𝑎𝑟)

0.121204 (𝑝𝑒𝑟 𝑦𝑒𝑎𝑟)

𝑖=
4
𝑖 = 0.030301 (𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟)

 Find the total number of payment periods.

𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 (4 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑓𝑜𝑟 3 𝑦𝑒𝑎𝑟𝑠) = 12

 Use i and n in the appropriate formulas.

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(1 + 0.030301) −1
𝐹 = 50, 000
0.030301

𝑭 = 𝑷𝒉𝒑 𝟕𝟏𝟎, 𝟖𝟏𝟔. 𝟏𝟏𝟕𝟔

2. What is the present worth of Php 500.00 deposited at the end of every three
months for 6 years if the interest rate is 12% compounded semiannually?

The problem can be treated as an annuity since the deposits are given
uniformly at the end of three months (or quarterly) for 6 years. The given
interest rate is compounded semiannually and needs to be converted to an
equivalent interest every quarter.

0.12
(1 + 𝑖) − 1 = 1 + −1
2

𝑖 = 0.029563

(1 + 𝑖) − 1
𝑃=𝐴
𝑖(1 + 𝑖)

(1 + 0.02956) − 1
𝑃 = 500
0.029563(1 + 0.029563)

𝑷 = 𝑷𝒉𝒑 𝟖, 𝟓𝟎𝟔. 𝟓𝟖𝟖

3. A computer engineer wishes to set up a special fund by making uniform

semiannual end-of-period deposits for 20 years. The fund is to provide Php
100, 000.00 at the end of each of the last five years of the 20-year period. If
interest is 8% compounded semi-annually, what is the required semiannual
deposit to be made?

Cash flow for semi-annual deposits

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Cash flow for annual withdrawals for the last five years

To solve for the semi-annual deposits, the value of the two cash flows should be the
same. The concept of equivalence will be applied. The equation of value requires a
focal point where all computations are anchored. For this problem, let us choose the
end of the last year as the focal point.

Determine the rate of interest for semi-annual payment

8%
𝑖= = 4%
2

Determine also the effective rate of interest to be used as the rate of interest for the
annual withdrawal on the last five years.

0.08
𝑖 = 1+ − 1 = 0.0816 𝑜𝑟 8.16%
2

Equate the value of the two cash flows using the end of the 20th year as the focal
point.

(1 + 0.04) −1 (1 + 0.0816) − 1
𝐴 = 100 000
0.04 0.0816

𝑨 = 𝑷𝒉𝒑 𝟔, 𝟏𝟗𝟑. 𝟒𝟑𝟖

ANNUITY DUE

Annuity due refers to a series of equal payments made at the same interval at the
beginning of each period. Periods can be monthly, quarterly, semi-annually,
annually, or any other defined period. Examples of annuity due payments include
rentals, leases, and insurance payments, which are made to cover services provided
in the period following the payment.

The annuity due can be illustrated as follows:

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A small modification in the formula for annuity (ordinary annuity) will give us the
following formulas for annuity due.

(𝟏 + 𝒊)𝒏 𝟏 − 𝟏
𝑷=𝑨 +𝑨
𝒊(𝟏 + 𝒊)𝒏 𝟏

(𝟏 + 𝒊)𝒏 𝟏
−𝟏
𝑭=𝑨 −𝑨
𝒊

Annuity Due vs. Ordinary Annuity

Payments

The major difference between annuity due and the more popular ordinary
annuity is that payments for an ordinary annuity are made at the end of the
period, as opposed to annuity due payments made at the start of each
period/interval. Ordinary annuity payments include loan
repayments, mortgage payments, bond interest payments, and dividend
payments.

Present value

Another difference is that the present value of an annuity due is higher than
one for an ordinary annuity. It is a result of the time value of money principle,
as annuity due payments are received earlier.

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Hence, if you are set to make ordinary annuity payments, you will benefit from
getting an ordinary annuity by holding onto your money longer (for the
interval). Conversely, if you are set to receive annuity due payments, you will
benefit, as you will be able to receive your money (value) sooner. In any
annuity due, each payment is discounted one less period in contrast to a
similar ordinary annuity.

Future Value

The last difference is on future value. An annuity due’s future value is also
higher than that of an ordinary annuity by a factor of one plus the periodic
interest rate. Each cash flow is compounded for one additional period
compared to an ordinary annuity.

Illustrative Problems

1. Engr. Mason borrows Php 100, 000 at 10% interest compounded

monthly. He must pay back the loan over 30 years with uniform monthly
payments due on the first day of each month. What does Engr. Mason
pay each month?

Solution:

𝑛 = 30 𝑦𝑒𝑎𝑟𝑠 (12 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟) = 360

0.1
𝑖= = 0.00833 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
12

𝑃 = 100, 000

(1 + 𝑖) −1
𝑃=𝐴 +𝐴
𝑖(1 + 𝑖)

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(1 + 0.00833) −1
100, 000 = 𝐴 +𝐴
0.00833(1 + 0.00833)

𝑨 = 𝑷𝒉𝒑 𝟖𝟕𝟎. 𝟎𝟐𝟗

2. Under a factory savings plan, a workman deposits Php 25 at the

beginning of each month for 4 years, and the management
guarantees accumulation at 6% compounded monthly. How much
stands to the work man’s credit at the end of 4 years?

𝑛 = 4 𝑦𝑒𝑎𝑟𝑠 (12 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟) = 48

0.06
𝑖= = 0.005 𝑚𝑜𝑛𝑡ℎ𝑙𝑦 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
12

𝐴 = 𝑃ℎ𝑝 25

(1 + 𝑖) −1
𝐹=𝐴 −𝐴
𝑖

(1 + 0.005) −1
𝐹 = 25 − 25
0.005

𝑭 = 𝑷𝒉𝒑 𝟏, 𝟑𝟓𝟗. 𝟐𝟏

DEFERRED ANNUITY

A deferred annuity is one where the first payment is made several periods
after the beginning of the annuity. The formulas below were derived using the
concept of equivalence or equation of value.

Finding P when A is given

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(𝟏 + 𝒊)𝒏 − 𝟏 𝒎
𝑷=𝑨 (𝟏 + 𝒊)
𝒊(𝟏 + 𝒊)𝒏

Finding F when A is given

(𝟏 + 𝒊)𝒏 − 𝟏
𝑭=𝑨 (𝟏 + 𝒊)𝒎
𝒊

Illustrative Problems

1. On the day his grandson was born, a man deposited to a trust company a
sufficient amount of money so that the boy could receive five annual
payments of Php 10, 000.00 each for his college tuition fees, starting with his
18th birthday. Interest at the rate of 12% per annum was to be paid on all
amounts on deposit. There was also a provision that the grandson could elect
to withdraw no annual payments and receive a single lump amount on his
25th birthday. The grandson chose this option.

a. How much did the boy receive as the single payment?

b. How much did the grandfather deposit?
a. How much did the boy receive as the single payment?

Let X be the single payment received on the 25th year and P the amount the
grandfather deposited when the grandson was born.

We are going to apply the concept of equivalence or the equation of value. That is,
we are going to assign a focal point where the computations are reckoned. Let us
choose year 22 as our focal point. Then,

(1 + 𝑖) − 1
𝑋(1 + 𝑖) =𝐴
𝑖
(1 + 0.12) − 1
𝑋(1 + 0.12) = 10 000
0.12

𝑿 = 𝑷𝒉𝒑 𝟖𝟗, 𝟐𝟓𝟐. 𝟗𝟑𝟏

We can also use the concept of deferred annuity.

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(𝟏 + 𝒊)𝒏 − 𝟏
𝑭=𝑨 (𝟏 + 𝒊)𝒎
𝒊

(1 + 0.12) − 1
𝐹 = 10 000 (1 + 0.12)
0.12

𝑿 = 𝑷𝒉𝒑 𝟖𝟗, 𝟐𝟓𝟐. 𝟗𝟑𝟏

b. How much did the grandfather deposit?

Using year 17 as our focal point. The equation would be

(1 + 𝑖) − 1
𝑃=𝐴 (1 + 𝑖)
𝑖(1 + 𝑖)
(1 + 0.12) − 1
𝑃 = 10 000 (1 + 0.12)
0.12(1 + 0.12)

𝑷 = 𝑷𝒉𝒑 𝟓, 𝟐𝟓𝟎. 𝟏𝟓𝟑

Using year 22 as our focal point. The equation would be

(1 + 𝑖) − 1
𝑃=𝐴 (1 + 𝑖)
𝑖

(1 + 0.12) − 1
𝑃 = 10 000 (1 + 0.12)
0.12

𝑷 = 𝑷𝒉𝒑 𝟓, 𝟐𝟓𝟎. 𝟏𝟓𝟑

We can also use the future amount X to solve for the deposit P.

𝑃 = 𝐹(1 + 𝑖)

𝑃 = 𝑋(1 + 𝑖)

𝑃 = 89, 252.931(1 + 0.12)

𝑷 = 𝑷𝒉𝒑 𝟓, 𝟐𝟓𝟎. 𝟏𝟓𝟑

2. If Php 10, 000 is deposited each year for 9 years, how much annuity can a
person get annually from the bank every year for 8 years starting 1 year after
the 9th deposit is made. Cost of money is 14%.

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We can use the end of 9th year or the last year of the depositing as our focal point.
The equation of value would now be

(1 + 𝑖) − 1 (1 + 𝑖) − 1
𝐴 =𝐴
𝑖 𝑖(1 + 𝑖)

(1 + 0.14) − 1 (1 + 0.14) − 1
10 000 =𝐴
0.14 0.14(1 + 0.14)

𝑨 = 𝑷𝒉𝒑 𝟑𝟒, 𝟔𝟕𝟓. 𝟏𝟖𝟓

We can also use the beginning of the deposits or year zero for the deposits as focal
point. The equation would be

(1 + 𝑖) − 1 (1 + 𝑖) − 1
𝐴 =𝐴 (1 + 𝑖)
𝑖(1 + 𝑖) 𝑖(1 + 𝑖)

(1 + 0.14) − 1 (1 + 0.14) − 1
(10 000) =𝐴 (1 + 0.14)
0.14(1 + 0.14) 0.14(1 + 0.14)

𝑨 = 𝑷𝒉𝒑 𝟑𝟒, 𝟔𝟕𝟓. 𝟏𝟖𝟓

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EXERCISES 05
Direction: Solve the following problems. Show complete and neat solution. Show
illustrations (cash flow diagrams) if necessary.

1. Mr. Smith is planning his retirement. He has decided that he needs to

withdraw Php 60, 000.00 per year from his bank account to supplement his
other income from Social Security and a private pension plan. How much
money should he plan to have in the bank at the start of his retirement, if the
bank pays 10% per year, compounded annually, and if he wants money to
last for a 12-year retirement period? (Ans. Php 408, 821.509)

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2. A series of 10 annual payments of Php 100, 000.00 is equivalent to two equal

payments, one at the end of 15 years and the other at the end of 20 years.
The interest rate is 8%, compounded annually. What is the amount of the two
equal payments? (Ans. Php 1, 266, 555.15)

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3. Engr. Valdez loaned an amount of Php 100, 000 at a local commercial bank
at 10% compounded annually. How much is his monthly payment if he is
required to pay at the beginning of the first day of the monthly for a period of
30 years? (ans. Php 839.19)

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