Present Value of Annuity Formula | Calculate PV of an Annuity?

Formula to Calculate PV of an Annuity

The present value of annuity formula is calculated by determining present value which is calculated by annuity payments over the time period divided by one plus discount rate and the present value of the annuity is determined by multiplying equated monthly payments by one minus present value divided by discounting rate.

PV of an Annuity = C x [ (1 – (1+i)^-n) / i ]

Where,

C is the cash flow per period
i is the rate of interest
n is the frequency of payments

Explanation

The PV formula will determine at a given period, the present value of several future timely interval payments. The PV of annuity formula can be seen from the formula that it depends upon the time value of money concept, in which one-dollar amount of money in the current day is more worthy than the same dollar that shall be due at a date which is going to happen in future. Also, the PV of annuity formula takes care of the frequency of payment whether it’s annual, semi-annual, monthly, etc. and accordingly does calculation or say compounding.

Examples

You can download this Present Value of Annuity Formula Excel Template here – Present Value of Annuity Formula Excel Template

Example #1

Suppose that there is an annuity payment of $1,000 for the next 25 years beginning at every end of the year. You are required to compute the present value of the annuity, assuming a rate of interest is 5%.

Solution:

Here the annuities begin at the end of the year and therefore n will be 25, C is $1,000 for the next 25 years and i is 5%.

Use the following data for the calculation of the PV of an annuity.

So, the calculation of the PV of an annuity can be done as follows –

Present Value of the Annuity will be –

= $1,000 x [ (1 – (1+5%)^-25) / 0.05 ]

Present Value of an Annuity = 14,093.94

Example #2

John is currently working in an MNC where he is paid $10,000 annually. In his compensation, there is a 25% portion which is will be paid an annuity by the company. This money is deposited twice in a year, starting 1^st July and second is due on the 1^st of January and will continue till the next 30 years and at the time of redemption, it would be tax-exempt.

He was also given an option at the time of joining to take $60,000 at once but that would be subject to tax at the rate of 40%. You are required to assess whether John should take the money now or wait until 30 years to receive the same assuming he is not in the requirement of funds and the risk-free rate in the market is 6%.

Solution

Here, the annuities begin at the end of the semi-annually and therefore n will be 60 (30*2), C is $1,250 ($10,000 * 25% / 2) for next 30 years and i is 2.5% (5%/2).

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Use the following data for the calculation of the present value of an annuity.

So, the calculation of the (PV) present value of an annuity formula can be done as follows –

Present Value of the Annuity will be –

= $1,250 x [ (1 – (1+2.5%)^-60) / 0.025 ]

Present Value of an Annuity = $38,635.82

Hence, if John opts for annuity then he would receive $38,635.82.

The second option is he opts for $60,000 which is before tax and if we deduct a tax of 40% then the amount in hand will be $36,000.

Therefore, John should opt for annuity since there is a benefit for $2,635.82

Example #3

Two different retirement products are being offered to Mrs. Carmella as she is nearing retirement. Both of the products will start their cash flow at the age of 60 years and continue annuity till 80 years of age. Below are more details of the products. You are required to compute the present value of the annuity and advise which is the better product for Mrs. Carmella?

Assume Rate of interest 7%.

1) Product X

Annuity Amount = $2,500 per period. Payment frequency =Quarterly.Payment will be at the beginning of the period

2) Product Y

Annuity Amount = 5,150 per period. Payment frequency =Semi-Annually. Payment will be at the end of the period

Given,

Solution:

Here, the annuities for product x begins at the beginning of the quarter and therefore n will be 79 as the payment is made at the beginning of the annuity (20*4 less 1), C is $2,500 for the next 20 years and i is 1.75% (7%/4).

So, the calculation of the present value of an annuity for a product X can be done as follows –

Present Value of an Annuity for Product X will be –

=$2,500 x [ (1 – (1+1.75%)^-79) / 0.0175 ]

Present Value of Annuity = $106,575.83

Now we need to add $2,500 to above present value since that was received at the start of the period and hence total amount will be 1,09,075.83

The 2^nd option is paying semi-annually, hence n will be 40 (20*2), i will be 3.50% (7%/2) and C is $5,150.

So, the calculation of the PV of an annuity for a product Y can be done as follows –

Present Value of Annuity for Product Y will be –

= $5,150 x [ (1 – (1+3.50%)^-40) / 0.035 ]

Present Value of Annuity = $ 109,978.62

There is only $902.79 excess when opted for option 2, hence Mrs. Carmella should select opt 2.

Relevance and Uses

The formula is quite important not only in calculating the retirement options but this can also be used for cash outflows in case of capital budgeting, where there could be an example of rent or periodic interest paid which are mostly static hence those can be discounted back by using this annuity formula. Also, one has to be cautious while using the formula as one needs to determine if the payments are made at the beginning of the period or at the end of the period as the same can affect the values of cash flows due to compounding effects.