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The current value of a set of cash flows in the future, given a specified rate of

return or discount rate. The future cash flows of the annuity are discounted at the discount

rate, and the higher the discount rate, the lower the present value of the annuity.

i = Interest rate

n = Number of payments

This calculates the present value of an ordinary annuity. To calculate the present value of

an annuity due, multiply the result by (1+i). (The payments start at time zero instead of one

period into the future.)

annuity due?

The present value of an annuity due is used to derive the current value of a series of cash payments

that are expected to be made on predetermined future dates and in predetermined amounts. The

calculation is usually made to decide if you should take a lump sum payment now, or to instead

receive a series of cash payments in the future (as may be offered if you win a lottery).

The present value calculation is made with a discount rate, which roughly equates to the current rate

of return on an investment. The higher the discount rate, the lower the present value of an annuity

will be. Conversely, a low discount rate equates to a higher present value for an annuity.

The formula for calculating the present value of an annuity due (where payments occur at

the beginning of a period) is:

P = (PMT [(1 - (1 / (1 + r)n)) / r]) x (1+r)

Where:

P = The present value of the annuity stream to be paid in the future

PMT = The amount of each annuity payment

r = The interest rate

n = The number of periods over which payments are made

This is the same formula as for the present value of an ordinary annuity (where payments occur at

the end of a period), except that the far right side of the formula adds an extra payment; this

accounts for the fact that each payment essentially occurs one period sooner than under the ordinary

annuity model.

For example, ABC International is paying a third party $100,000 at the beginning of each year for the

next eight years in exchange for the rights to a key patent. What would it cost ABC if it were to pay

the entire amount immediately, assuming an interest rate of 5%? The calculation is:

P = ($100,000 [(1 - (1 / (1 + .05)8)) / .05]) x (1+.05)

P = $678,637

The factor used for the present value of an annuity due can be derived from a standard table of

present value factors that lays out the applicable factors in a matrix by time period and interest rate.

For a greater level of precision, you can use the preceding formula within an electronic spreadsheet

An annuity is a series of evenly spaced equal payments made for a certain amount of time. There are

two basic types of annuity known as ordinary annuity and annuity due. Ordinary annuity is one in

which periodic payments are made at the end of each period. Annuity due is the one in which periodic

payments are made at the beginning of each period.

The present value an annuity is the sum of the periodic payments each discounted at the given rate of

interest to reflect the time value of money. Alternatively defined, the present value of an annuity is

the amount which if invested at the start of first period at the given rate of interest will equate the

sum of the amount invested and the compound interest earned on the investment with the product of

number of the periodic payments and the face value of each payment.

Formula

Although the present value (PV) of an annuity can be calculated by discounting each periodic payment

separately to the starting point and then adding up all the discounted figures, however, it is more

convenient to use the 'one step' formulas given below.

1 (1 + i)-n

PV of an Ordinary Annuity = R

i

1 (1 + i)-n

PV of an Annuity Due = R

(1 + i)

Where,

i is the interest rate per compounding period;

n are the number of compounding periods; and

R is the fixed periodic payment.

Examples

Example 1: Calculate the present value on Jan 1, 2011 of an annuity of $500 paid at the end of each

month of the calendar year 2011. The annual interest rate is 12%.

Solution

We have,

Periodic Payment

= $500

Number of Periods

= 12

Interest Rate

= 12%/12 = 1%

Present Value

PV

= $500 (1-(1+1%)^(-12))/1%

= $500 (1-1.01^-12)/1%

$500 (1-0.88745)/1%

$500 0.11255/1%

$500 11.255

$5,627.54

Example 2: A certain amount was invested on Jan 1, 2010 such that it generated a periodic payment

of $1,000 at the beginning of each month of the calendar year 2010. The interest rate on the

investment was 13.2%. Calculate the original investment and the interest earned.

Solution

Periodic Payment

= $1,000

Number of Periods

= 12

Interest Rate

= 13.2%/12 = 1.1%

Original Investment

= $1,000 (1-(1+1.1%)^(-12))/1.1% (1+1.1%)

= $1,000 (1-1.011^-12)/0.011 1.011

$1,000 (1-0.876973)/0.011 1.011

$1,000 0.123027/0.011 1.011

$1,000 11.184289 1.011

$11,307.32

Interest Earned

$1,000 12 $11,307.32

$692.68

An annuity is a series of equal payments or receipts that occur at evenly spaced

intervals. Leases and rental payments are examples. The payments or receipts occur

at the end of each period for an ordinary annuity while they occur at

the beginning of each period.for an annuity due.

Present Value of an Ordinary Annuity

expected or promised future payments that have been discounted to a single

equivalent value today. It is extremely useful for comparing two separate cash flows

that differ in some way.

PV-oa can also be thought of as the amount you must invest today at a specific interest

rate so that when you withdraw an equal amount each period, the original principal

and all accumulated interest will be completely exhausted at the end of the annuity.

The Present Value of an Ordinary Annuity could be solved by calculating the present

value of each payment in the series using the present value formula and then summing

the results. A more direct formula is:

PVoa = PMT [(1 - (1 / (1 + i)n)) / i]

Where:

PVoa = Present Value of an Ordinary Annuity

PMT = Amount of each payment

i = Discount Rate Per Period

n = Number of Periods

Example 1: What amount must you invest today at 6% compounded annually so that

you can withdraw $5,000 at the end of each year for the next 5 years?

PMT = 5,000

i = .06

n=5

PVoa = 5,000 [(1 - (1/(1 + .06)5)) / .06] = 5,000 (4.212364) = 21,061.82

Year

Begin

Interest

21,061.82

17,325.53

13,365.06

9,166.96

4,716.98

1,263.71

1,039.53

801.90

550.02

283.02

Withdraw

End

-5,000

-5,000

-5,000

-5,000

-5,000

17,325.53

13,365.06

9,166.96

4,716.98

.00

Example 2: In practical problems, you may need to calculate both the present value

of an annuity (a stream of future periodic payments) and the present value of a single

future amount:

For example, a computer dealer offers to lease a system to you for $50 per month for

two years. At the end of two years, you have the option to buy the system for $500.

You will pay at the end of each month. He will sell the same system to you for

$1,200 cash. If the going interest rate is 12%, which is the better offer?

You can treat this as the sum of two separate calculations:

1. the present value of an ordinary annuity of 24 payments at $50

per monthly period Plus

2. the present value of $500 paid as a single amount in two

years.

PMT = 50 per period

i = .12 /12 = .01 Interest per period (12% annual rate / 12 payments per year)

n = 24 number of periods

PVoa = 50 [ (1 - ( 1/(1.01)24)) / .01] = 50 [(1- ( 1 / 1.26973)) /.01] = 1,062.17

+

FV = 500 Future value (the lease buy out)

i = .01 Interest per period

n = 24 Number of periods

PV = FV [ 1 / (1 + i)n ] = 500 ( 1 / 1.26973 ) = 393.78

The present value (cost) of the lease is $1,455.95 (1,062.17 + 393.78). So if taxes are

not considered, you would be $255.95 better off paying cash right now if you have it.

The Present Value of an Annuity Due is identical to an ordinary annuity except that

each payment occurs at the beginning of a period rather than at the end. Since each

payment occurs one period earlier, we can calculate the present value of an ordinary

annuity and then multiply the result by (1 + i).

PVad = PVoa (1+i)

Where:

PV-ad = Present Value of an Annuity Due

PV-oa = Present Value of an Ordinary Annuity

i = Discount Rate Per Period

Example: What amount must you invest today a 6% interest rate compounded

annually so that you can withdraw $5,000 at the beginning of each year for the next 5

years?

PMT = 5,000

i = .06

n=5

PVoa = 21,061.82 (1.06) = 22,325.53

Year

Begin

Interest

22,325.53

18,365.06

14,166.96

9,716.98

1,039.53

801.90

550.02

283.02

5

5,000.00

Withdraw

End

-5,000.00

-5,000.00

-5,000.00

-5,000.00

-5,000.00

18,365.06

14,166.96

9,716.98

5,000.00

.00

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