Annuity

An Annuity is a type of bond that offers a stream of periodic interest payments to the holder until the date of maturity.

Annuity

Table of Contents

How to Calculate the Present Value of an Annuity

An annuity provides periodic payments for a specific number of years until reaching maturity.

Annuities are a distinct type of financial security because of the following characteristics:

Earlier cash flows can be reinvested earlier and for a longer duration, so these cash flows carry the highest value (and vice versa for cash flows received later).

Typically, the most common types of issuers of annuities are the following:

Present Value of Annuity Formula (PV)

The present value (PV) of an annuity is the discounted value of the bond’s future payments, adjusted by an appropriate discount rate, which is necessary because of the time value of money (TVM) concept.

The formula to calculate the present value (PV) of an annuity is equal to the sum of all future annuity payments – which are divided by one plus the yield to maturity (YTM) and raised to the power of the number of periods.

Present Value of Annuity (PV) = Σ A ÷ (1 + r) ^ t

Alternatively, a simpler approach consists of the following two steps:

  1. First, the annuity payment is divided by the yield to maturity (YTM), denoted as “r” in the formula.
  2. Next, the result from the previous step is multiplied by one minus [one divided by (one + r) raised to the power of the number of periods].
Present Value (PV) of Annuity = (A ÷ r) (1 (1 ÷ (1 + r) ^ t))

Ordinary Annuity vs. Annuity Due: What is the Difference?

When calculating the present value (PV) of an annuity, one factor to consider is the timing of the payment.

The term “annuity due” means receiving the payment at the beginning of each period (e.g. monthly rent).

On the other hand, an “ordinary annuity” is more so for long-term retirement planning, as a fixed (or variable) payment is received at the end of each month (e.g. an annuity contract with an insurance company).

The trade-off with fixed annuities is that an owner could miss out on any changes in market conditions that could have been favorable in terms of returns, but fixed annuities do offer more predictability.

Present Value of an Ordinary Annuity Table (PV)

PV of Ordinary Annuity Table

Present Value of an Annuity Due Table (PV)

PV of Annuity Due Table

Present Value (PV) of Annuity Calculator

We’ll now move to a modeling exercise, which you can access by filling out the form below.

1. Annuity Bond Assumptions

In our illustrative example, we’ll calculate an annuity’s present value (PV) under two different scenarios.

  1. Ordinary Annuity
  2. Annuity Due

The assumptions listed below are to be used for the entirety of the exercise.

2. Present Value of Annuity Calculation Example (PV)

First, we will calculate the present value (PV) of the annuity given the assumptions regarding the bond.

The “PV” Excel function can be used here, as shown below.

Note: Since we have two scenarios, we’ll create a toggle to alternate between the two options – which is the “IF(Annuity Type Cell =“Ordinary,” 0,1)”.

The two present value (PV) amounts calculated on the annuity bond are the following:

3. Future Value of Annuity Calculation Example (FV)

From there, we can also calculate the future value (FV) using the formula below:

The two future value (FV) amounts calculated on the annuity bond are the following:

We’ll calculate the yield to maturity (YTM) using the “RATE” Excel function in the final step.

In conclusion, the annuity bond has a yield of 5.0% under either scenario.

Present Value of Annuity Calculator (PV)

Future Value of Annuity Calculator (FV)

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