=== Summary of Section 9.2 ===
| The essential concept of chapter 9 is that loaned money
| grows with time. This leads to the notion of present
| value. To compare money at different times you have to
| multiply or divide by the appropriate growth factor.
| This concept is known as the "time value of money" (see
| "http://en.wikipedia.org/wiki/Time_value_of_money"), and it
| is the central concept of everyday mathematical finance. The
| notion of present value requires that you specify an interest
| rate and period. (That is, you must specify how the money grows
| with time.)
Present Value:
| In general, the *present value* of an amount of money A which is
| to be paid at a time T in the future is the amount of money P
| that would grow to A if we invested it now. To find this amount
| we have to divide A by the investment growth factor.
For example: assuming 25% annual yield,
the present value of $100 to be paid one year
from now is the amount P such that
$100 = P*1.25,
Solving for P, we see that the present value of $100 to be paid
after one year of 25% annual interest is the final amount divided
by the growth factor:
P = $100/1.25 = $80.
The present value of an amount A to be paid after n periods of time
with an interest rate per period k is the principal P such that
A = P*(1+k)^n.
Solving for P shows again that the present value is the final
amount divided by the growth factor:
P = A/(1+k)^n.
Annuities.
| An *annuity* is a scheduled series of regular equal payments.
| For an ordinary annuity (annuity-immediate) the payments are
| made at the *end* of each payment period (typically a month).
| To find the present value of a series of future payments we
| find the present value of each payment and add them up.
Let Y = size of payments,
let n = number of payments,
let k = interest rate per payment period,
let V_m = present value of payment m,
let V = present value of all the payments, and
let a = (1+k) = growth factor per payment period.
The present value of the m-th payment is the amount V_m
that will grow to become Y in m payment periods:
Y = V_m*a^m;
To solve for the present value we divide by the growth factor:
V_m = Y/a^m.
The present value of all the payments is
V = V_1 + V_2 + ... + V_n
= Y/a + Y/a^2 + ... + Y/a^n.
To find this sum we first need to study geometric series.
Sum of a Geometric Series
Let S by the sum of the first n powers of a growth factor a:
S = 1 + a + a^2 + ... + a^n
This is called a geometric series. The trick to find S
is to multiply by a and subtract the original equation:
a*S = a + a^2 + ... + a^n + a^(n+1)
- [ S = 1 + a + a^2 + ... + a^n ]
When you subtract these two equations, all the terms on the right
cancel except the first and the last, so you get
S*(a-1) = a^(n+1) - 1.
Solving for S gives:
S = (a^(n+1) - 1)/(a-1).
The formula on page 426 is incorrect.
(It has "n-1" instead of "n+1".) Fix it.
Observe that the sum
S = 1 + a + a^2 + ... + a^(n-1)
is given by the same formula, with n replaced by n-1:
S = (a^n - 1)/(a-1).
Present Value of an annuity (continued).
Now resume computing the present value of an annuity. Recall
V = Y/a + Y/a^2 + ... + Y/a^n.
Factoring out Y gives:
V = Y*(1/a + 1/a^2 + ... + 1/a^n).
Multiply by a^n. Get:
a^n*V = Y*(a^n/a + a^n/a^2 + ... + a^n/a^n).
Recall the general property of division of powers: a^p/a^q = a^(p-q).
So we get:
a^n*V = Y*(a^(n-1) + a^(n-2) + ... + 1).
We see a geometric series on the right.
Using the formula for the sum of a geometric series,
a^n*V = Y*(a^n-1)/(a-1)
Solving for V, we get
V = Y*(1 - 1/a^n)/(a-1).
Recall that a = 1+k. Making this substitution gives the formula
on page 428 of the book for the present value of an annuity
with payments Y, n payment dates, and an interest rate per
period k:
V = Y*(1 - 1/(1+k)^n)/k.
For example, the present value of an annuity that pays
$100 every month for 12 months relative with respect to
an interest rate of 1% per month is
V = $100*(1 - 1/1.01^12)/.01
= $1125.507747348463.
Amount of an annuity.
| The amount of an annuity is the "future value" of
| the payments at the end of the last payment period:
| Again, to determine future value an interest
| rate k and payment period t must be specified. If the
| payments are put in an account accumulating interest
| at rate k and investment period t, the money acccumulated
| in the account at the end of the last payment period
| is the amount of the annuity.
In particular, using the same variable definitions that we used
for the present value of a series of payments,
A = Y*a^(n-1) + Y*a^(n-2) + ... + Y*a^2 + Y*a + Y
= Y*(a^n-1)/(a-1)
= Y*((1+k)^n-1)/k,
in agreement with equation 9.6 on page 427.
For example, the amount of an annuity that pays
$100 every month for 12 months relative with respect to
an interest rate of 1% per month is
A = Y*((1+k)^n-1)/k,
= $100*(1.01^12-1)/.01,
= $1268.250301319698.
Recall that we previously calculated the present value
of this annuity to be
V = $1125.507747348463.
Observe that the total of all the payments is $1200.
Notice that the present value of the total payments is
less than the total payments, and the amount is more.
That should make sense to you.
| In general the present value of the annuity is the
| present value of the amount of the annuity.
Let's check that. We need that
A/(1+k)^n = V.
You can see that this is true in the formulas.
For our specific case, we have that the growth factor is
(1+k)^n = 1.01^12 = 1.12682503013197,
and $1268.250301319698/1.12682503013197 = $1125.507747348463,
as needed.