Question

Betty received $ 500,000 from a life insurance policy to be distributed to her as an annuity certain in 10 equal annual installments with the first payment made immediately. On the day she receives her third payment, she is offered a monthly perpetuity of X in lieu of the future annual payments. The first payment will be made in exactly one month. The effective annual rate of interest is 8 %. Determine the value of X.​

Answer 1

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Answer:

• annual payment: $68,995.13
• monthly payment in perpetuity: X = $2394.76

Explanation:

a) For payments made at the beginning of the period, the annuity is called an "annuity due." The formula in the first attachment tells how to compute the payment for a given present value ($500,000), number of periods (N=10), and interest rate (i=0.08).

pmt = $500,000/(1 +(1 -(1 +i)^(-N+1))/i) = $500,000/(1 +(1 -(1.08^-9))/.08)

pmt ≈ $68,995.13 . . . . annual payment

__

b) After the first payment, the account balance is ...

$500,000 -68,995.13 = $431,004.87

After subsequent payments, the account balance will be ...

$431,004.87×1.08 -68,995.13 = $396,490.13 . . . after 2nd payment

$396,490.13×1.08 -68,995.13 = $359,214.21 . . . after 3rd payment

The payment amount that can be made in perpetuity is the amount of the monthly interest on this balance:

X = $359,214.21 × (0.08/12) = $2394.76