Valuation AND Annuity MATH PDF

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BFF1001

Pre-load: Valuation and Annuity Math Please join the active FLUX session upon entering class.

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Key Topic Aspects being introduced …

1. Annuities 2. Growth Annuities 3. Annuity Applications 4. Perpetuities

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Learning Objectives 1. Describe how to calculate the present value of an ordinary annuity and it differs from an annuity due. 2. Understand the methodology of valuing Deferred Annuities and Annuities of Unequal lives. 3. Discuss growing annuities and perpetuities, as well as their application in business, and be able to calculate their value.

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Annuity Learning Map

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Financial Math Review §

So far, we have discussed the PV and FV of single cash flows and multiple cash flows of an asset/liability.

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Annuities § In finance we commonly encounter situations which calls for

payments of equal amount of cash at regular intervals of time over several time periods.

§ Example:

Business, Personal, Insurance Policies, etc.

Car

and

Home

Loans,

§ Any financial contract that calls for equally spaced and level

cash flows over a finite number of periods is called an annuity.

§ When valuing annuities, rather than discount/compound each

cash flow individually, as each cash flow is the same and equally spaced over time, a single formula can be applied for ease of understanding and calculation.

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Ordinary Annuities Ordinary Annuities: § Most annuities are structured so that cash payments are paid or received at the end of each period. As this is the most common structure, these annuities are called ordinary. Annuity starts today:

Payments at the end of the period

§

A fixed amount of money is paid/received at fixed intervals of time for a fixed period of time.

§

Ordinary Annuities are also called… Annuity in Arrears.

§

If nothing is said about the cash flows, always assume it is an ordinary annuity. 1st cash flow occurs 1 period after the start of the annuity

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Ordinary Annuity Valuation

Where …

Annuity definition = equal payments, made regularly, over a fixed time.

•

FV = the future value of the annuity

•

PV = present value of the annuity

•

PMT = the regular, equal cash flow received/paid each period

•

n = the number of payments

•

i = the per-payment discount rate (PV) or compound rate (FV). i and r are used interchangeably.

Important note: PV of Ordinary annuities, is for the time period before the 1st payment. business.monash.edu

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Ordinary Annuity Timelines Self-study: •

Be able to draw time lines which show ordinary annuity valuation. Be able to understand the following time line examples that illustrate how PV and FV of annuities are calculated. Attempt to calculate the answers for the PV and FV below:

What is the present value of an investment that pays $50 at the end of each year for 4 years?

What value is accumulated for an investment that pays $50 in arrears each year for 4 years?

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Annuity Learning Map Annuity definition = equal payments, made regularly, over a fixed time.

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Annuity Due § Annuity where the equal payments are paid or received at the start of each period. Annuity starts today:

Payments at the beginning of the period

§ Annuity Dues are also called… Annuities in Advance. § 1st cash flow occurs at the start of the annuity.

(FLUX Q1) business.monash.edu

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Annuity Due Valuation

Where …

Annuity definition = equal payments, made regularly, over a fixed time.

•

FV = the future value of the annuity

•

PV = present value of the annuity

•

PMT = the regular, equal cash flow received/paid each period

•

n = the number of payments

•

i = the per-payment interest rate

Important note: PV of Annuity Due, is for the time period of the 1st payment. (FLUX Q2) business.monash.edu

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Annuity Due Timelines Self-study: •

Be able to draw time lines which show annuity due valuation. Be able to understand the following time line examples that illustrate how PV and FV of annuities are calculated. Attempt to calculate the answers for the PV and FV below:

What is the present value of an investment that pays $50 at the beginning of each year for 4 years?

What value is accumulated for an investment that pays $50 at the start of each year for 4 years?

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Annuity Learning Map

Annuity definition = equal payments, made regularly, over a fixed time.

Self-study: •

Be clear on the key defining characteristics between ordinary and annuity dues …

•

When do cash flows start for both? When PVing either what time period is the PV for?

•

Attempt to find examples of financial instruments/securities that provide annuity payments.

•

In the Workshop, we shall practice applying these formula in annuity math.

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Growth Annuities Our original definition of an annuity was a fixed payment, at equal intervals over time. We now expand that concept to allow for the fixed payment to grow at a constant rate over time. § Growth annuities: where the cash flow increases each period at a constant growth rate.

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Growth Annuity Formula The original annuity formula are expanded to the following: Ordinary Growth Annuity

𝑃𝑉 =

𝐶𝐹 1+𝑔 1 − 1+𝑖 (𝑖 − 𝑔)

Growth Annuity Due

1+𝑔 1− 1+𝑖 𝑃𝑉 = 𝐶𝐹 + 𝐶𝐹 (1 + 𝑔) 𝑖−𝑔

!

Where

!"#

In this topic, we only do PV of Growth Annuities. FVs will be introduced in Topic 5.

§

CF = the first cash flow received

§

i = interest rate per payment, note i & r are used interchangeably

§

g = constant growth rate per payment

§

n = number of payments (FLUX Q3)

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Growth Annuity Timelines Self-study: •

Be able to draw time lines which show growth annuity valuation. Be able to understand the following time line examples that illustrate how PV and FV of annuities are calculated. Attempt to calculate the answers for the PV and FV below:

An investment pays an initial $50 (at end of the year) which grows by 5% each payment after. The investment runs for 4 years, what is the PV?

An investment pays an initial $50 (at the start of the year) which grows by 5% each payment after. The investment runs for 4 years, what is the PV?

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Perpetuity

An annuity where the cash flow continues for an indefinite period. § n=∞ Ordinary Perpetuity

𝑃𝑉 =

!"# $

Perpetuity Due

𝑃𝑉 = 𝑃𝑀𝑇 +

!"# $

Where §

PMT = the regular, equal cash flow received per period

§

i = interest rate per payment

§

As with annuities, the ordinary perpetuity formula establishes PV one period before the first cash flow. The perpetuity due formula establishes PV at the same period as the first cash flow.

§

Perpetuities can also be deferred as with annuities. (FLUX Q4 & 5)

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Growth Perpetuity Formula A growth perpetuity is where the cash flow increases each period at a constant rate for infinity. Ordinary Growth Perpetuity

𝑃𝑉 =

𝐶𝐹 (𝑖 − 𝑔)

Growth Perpetuity Due

𝐶𝐹 (1 + 𝑖) 𝑃𝑉 = 𝑖 −𝑔

Where §

CF = the first cash flow received.

§

i = interest rate per period, note i & r are used interchangeably

§

g = constant growth rate per period Perpetuities have no FV as payments continue forever.

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Full Annuity Learning Map

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Growth Annuities & Perpetuity Self-study: •

In preparation for this Topic’s workshop, make sure you are also comfortable with the prior Topics Workshop FLUX and PBL questions.

•

Be practiced at drawing time lines, applying formula and establishing the correct n and i under various investment or liability scenarios.

•

If unclear, see staff in consultation to make sure you understand the last topic as well as possible.

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Next…Self-study for Topic 3

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