Tutorial 2 Questions – Time Value of
Money
Ordinary Annuity vs Annuity Due
1. Ordinary Annuity:
- Payments are made at the **end** of each period.
- Example: If you make monthly payments on a loan, the payment is made at the end of
each month.
2. Annuity Due:
- Payments are made at the **beginning** of each period.
- Example: Rent payments or insurance premiums are often paid at the beginning of each
period.
Because an annuity due involves earlier payments (compared to an ordinary annuity), the
present value and future value of an annuity due will typically be higher than those of an
ordinary annuity, assuming the same payment amounts and interest rates.
***Always assume you are dealing with an ordinary annuity unless stated otherwise
Effective Annual Rate
If interest is compounded at different intervals – monthly/quarterly – it means that interest is
added more frequently than once a year. The quoted per annum rate is the quoted rate while
the true return in annual terms is higher if the number of compounding periods is more than
once a year – this is called the effective annual rate.
When is it calculated?
Example 1: You take out a 5-year investment and agree to make annual payments at an
interest rate of 5% p.a. There is no need to calculate the EAR as the compounding periods
match the frequency of payments, i.e. annual payments and compounding.
Example 2: You take out a 5-year investment and agree to make monthly payments at an
interest rate of 5% p.a. You need to calculate the EAR because compounding and payment
frequency do not match.
Question 1
You have just graduated and started working at a commercial bank. Your first day of work
coincides with your 25th birthday. The bank has a mandatory retirement age of 65 years. On
your first day of work you decide to supplement the bank’s pension scheme by signing up for
a retirement annuity requiring you to invest R2 000 per annum, commencing on your 26th
birthday and continuing until you reach the age of 65. Your return will be 9% per annum,
compounded monthly, for the duration of the investment.
(a) Calculate the value of the retirement annuity when you retire.
(b) Assume the same quoted return of 9% per annum compounded monthly. If you decide to
wait until your 35th birthday to begin making annual payments towards the investment,
calculate the size of the annual payment you will have to make to achieve the same
retirement value as calculated in (a) above. Note: you make the first payment upfront on
your 35th birthday, and the last payment upon retirement.
Question 2
You have a choice of two investment accounts. Investment A is a 10-year annuity featuring
end–of–month payments of R1 000, and interest earned is 12% per annum compounded
monthly. Investment B is a lump-sum 10-year investment, earning 9% per annum
compounded daily.
Calculate the lump sum of money you would need to invest in B today, so that in ten years’
time it will be worth the same as investment A ten years from now.
Note: Assume a 360-day year and round off all values to the nearest rand.
Question 3
A group of friends have R500 between them. They are thinking about using the money to buy
burgers, which currently cost R20 each. If they invested their money, they could earn a
nominal return of 9.2% at the bank. Inflation is forecast at 5% for the coming year.
Use the example to calculate the real rate of return, in terms of the number of burgers the
friends could buy at the end of the year, if they choose not to buy them now but invest their
money for the year instead. Note: A % rate of return is required.
Question 4
You are a bond portfolio manager. You paid R90 705 for a government bond, with a nominal
value of R100 000, a 10% coupon rate (coupons paid semi-annually) and 7 years to maturity.
Calculate the yield to maturity (YTM) at the time of purchase.
Question 5
You have started a small manufacturing company. You have bought a machine in terms of a
suspensive sales agreement whereby you are required to make equal monthly instalments
from today, 1 April 2x08, to 1 March 2x13. The cash price of the machine is R220 000.
Finance charges are linked to the prime overdraft rate. The bank will charge you a premium
of 1% above the prime rate which is currently 11%.
(a) Determine the equal monthly instalment amount required to purchase the machine over
five years.
(b) If the prime rate increases to 14% today, before your first instalment payment, what will
be the increase in your monthly instalment amount?
(c) The bank offers to give you a three-month ‘holiday’ so that you acquire the machine today
but the monthly repayments begin on 1 July 2x08. The last payment is still on 1 March 2x13.
What will your monthly instalment be if the prime rate is currently 11%?
Question 6
Earlier this year, Senzo Khuzwayo matched all 6 numbers in the Powerball jackpot, winning
the prize of R18.15 million. Powerball pays out its jackpot winnings in one of two ways: as
an annuity over time, or an immediate lump-sum payment.
If Senzo selected the annuity option, his jackpot prize of R18.15 million would be paid out to
him in 25 equal annual instalments, starting one year from the time of his win.
If he selected the cash option, Powerball would pay him a lump sum of R10 million
immediately.
At the time of his win, investment rates were expected to average 5% per annum for the next
25 years.
(a) Calculate which of the two payout options would have been more beneficial to Senzo.