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Present Value Of An Annuity'

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.

C = Cash flow per period


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.)

What is the formula for the present value of an


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

Present Value of an Annuity


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

= PV of annuity due on Jan 1, 2010


= $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

Present Value of Annuities


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

The Present Value of an Ordinary Annuity (PVoa) is the value of a stream of


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.

Present Value of an Annuity Due (PVad)

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