Annuities

Lesson:

Many business transactions involve a temporary stream of payments. Loans, for instance, are often paid over the course of many years at a set interest rate.

This stream of equal payments is often called an annuity.

There are two types of annuities:

  • Ordinary annuities are paid at the end of each period.
  • Annuities due are paid at the beginning of each period.

A simple trick to remember the difference is that the earlier in the name you see the word annuity, the sooner in a period each payment is required.

Inputting the type of annuity, the number of periods, and the interest rate into a complicated formula yields the present value factor. Multiplying this factor by the size of a single payment provides the present value of the stream of payments.

David Co., the little-known book vendor, bought an annuity that pays $2,786.00 at the start of each year, for the next 4 years. The prevailing interest rate is 2%.

Here's what you know:

  • The present value factor for an annuity due at 2% for 4 years is 3.88388.
  • The present value factor for an ordinary annuity at 2% for 4 years is 3.80773.
What is the present value of the annuity?

Answer:

  • $10,820.50

Explanation:

  1. Because the payments occur at the start of each period, the annuity is clearly an annuity due (PV factor: 3.88388).
  2. Here's the formula to use
    PRESENT VALUE OF ANNUITY = PAYMENT * PRESENT VALUE FACTOR
  3. Let's just plug in the numbers
    $10,820.50 = $2,786.00 * 3.88388
Random FAR Random in Category Try Again