FINANCIAL CONTROLLERSHIP
Calculating Present and Future Value of Annuities
WEEK 11
Module 8
Calculating Present and Future Value of Annuities
At the end of this module, you are expected t0:
1. Explain how to calculate different kind of Annuities
2. Understand the amortization loan
First, differentiate between a normal annuity and an annuity due
Most people have had the encounter of creating a sequences of steady premium over a period.—
like rent or car premiums—or receiving a sequence of premiums for a period, like interest from a
bond or certificate of deposit (CD). These reappear or continuous premiums are technically
mentioned as "annuities" (not to be baffled with the financial merchandise called an annuity,
even though the two are associated).
There are various ways to test the cost of creating specific premiums or what they're eventually
value. Here's what you wish to understand about computing the present value (PV) or future
value (FV) of an annuity.
MAJOR UPSHOT
Recurring payments, like the rent on an apartment or interest on a security, are frequently
mentioned as "annuities."
In normal annuities, premiums are created at the end of every period. With annuities due, they're
created at the starting of the period.The future value of an annuity is the complete of premiums at
a particular point in time.The present value is how much money would be necessary now to
supply those forthcoming premiums.
Two Types of Annuities
Annuities, in this matter, break down into two fundamental types: ordinary annuities and
annuities due.
Ordinary annuities: An ordinary annuity creates (or needs) premiums at the end of every period.
For instance, bonds mostly compensate interest at the end of every 6 months.
Annuities due: With an annuity due, by contradiction, premiums come at the starting of every
period. Rent, which landlords usually demand at the starting of every month, is a normal
instance.
You can compute the present or future value for an ordinary annuity or an annuity due utilizing
the subsequent formulas.
Computing the Future Value of an Ordinary Annuity
Future value (FV) could be assess of how much a sequence of ordinary premiums will be value
at any time point in the forthcoming, given a stated interest rate. So, for instance, if you intend to
invest a definite value every month or year, it'll tell you how much you will have accrued as of a
forthcoming date. If you are creating ordinary premiums on a loan, the future value is beneficial
in deciding the entire cost of the loan.
Consider, as an example, a sequence of five $1,000 premiums create at ordinary intervals.
Since of the time amount of money—the idea that any given sum is value more now than it'll be
in the forthcoming because it may be invested in the interim—the first $1,000 premium is value
more than the next, and so on. So, let's consider that you simply invest $1,000 each year for the
next five years, at five percent interest. Below is how much you'd have at the term of the five-
year period.
Instead of computing every premium separately and then adding all of them up, nonetheless,
you'll use the subsequent formula, which is able to tell you how much cash you'd have within the
end:
FVOrdinary Annuity =C×[i(1+i)n−1 ]where:C=cash flow per period i=interest rate n=number of
payments
Using the instance above, here's how it might work:
FVOrdinary Annuity =$1,000×[0.05(1+0.05)5−1 ]=$1,000×5.53=$5,525.63
Notice that the one-cent variation in these outcomes, $5,525.64 vs. $5,525.63, is because of
rounding within the first computation.
Calculating the Present Value of an Ordinary Annuity
In comparison to the future value computation, a present value (PV) computation tells you how
much money would be necessary now to generate a sequence of premiums in the forthcoming,
again presumptuous a series interest rate.
Utilizing the same instance of five $1,000 premiums created over a period of 5 years, here is how
a present value computation would show. It displays that $4,329.58, invested at five percent
interest, would be enough to generate those five $1,000 premiums.
This is the appropriate formula:
PVOrdinary Annuity =C×[i1−(1+i)−n ]
If we clog the same figures as above into the equation, here is the outcome:
PVOrdinary Annuity =$1,000×[0.051−(1+0.05)−5 ]=$1,000×4.33=$4,329.48
Calculating the Future Value of an Annuity Due
An annuity due, you'll remember, vary from an ordinary annuity in that the annuity due's
premiums are created at the starting, instead the end, of every period.
To account for premiums appear at the starting of every period, it necessary a modest adjustment
to the formula accustomed compute the future value of an ordinary annuity and leads to greater
amounts, as displayed below.
The sense the amounts are greater is that premiums created at the start of the period have longer
to earn interest. As an example, if the $1,000 was invested on January 1 instead of January 31 it'd
have a further month to increase.
The formula for the future value of an annuity due is as observes:
FVAnnuity Due =C×[i(1+i)n−1 ]×(1+i)
Here, we use the identical figurers, as in our earlier examples:
FVAnnuity Due =$1,000×[0.05(1+0.05)5−1 ]×(1+0.05)=$1,000×5.53×1.05=$5,801.91
In addition, please notice that the one-cent variation in these outcomes, $5,801.92 vs. $5,801.91,
is because of rounding in the first computation.
Calculating the Present Value of an Annuity Due
Similarly, the formula for calculating the present value of an annuity due takes into account the
fact that payments are made at the beginning rather than the end of each period.
For example, you could use this formula to calculate the present value of your future rent
payments as specified in your lease. Let's say you pay $1,000 a month in rent. Below, we can see
what the next five months would cost you, in terms of present value, assuming you kept your
money in an account earning 5% interest.
This is the formula for calculating the present value of an annuity due:
PVAnnuity Due=C×[i1−(1+i)−n]×(1+i)
So, in this example:
PVAnnuity Due=$1,000×[0.05(1−(1+0.05)−5]×(1+0.05)=$1,000×4.33×1.05=$4,545.95
Calculating the Present Value of an Annuity Due
Particularly, the formula for computing the present value of an annuity due takes into account the
matter that premiums are created at the start instead of the end of every period.
For instance, you'll use this formula to compute the present value of your forthcoming rent
premiums as stated in your lease. To illustrates, you pay $1,000 a month in rent. Below, we will
see what the next 5 months would cost you, in conditions of present value, presumptuous you
kept your money in an account gaining five percent interest.
This is the formula for computing the present value of an annuity due:
PVAnnuity Due =C×[i1−(1+i)−n ]×(1+i)
So, in this example:
PVAnnuity Due =$1,000×[0.05(1−(1+0.05)−5 ]×(1+0.05)=$1,000×4.33×1.05=$4,545.95
The Efficient Annual Interest Rate
What Does the Efficient Annual Interest Rate?
A bank certificate of deposit, a savings account, or a loan proposal is also publicized with its
nominal interest rate as well as its effective annual interest rate. The nominal interest rate doesn't
get reflect the results of compounding interest or match the bills that appear with these financial
merchandises. The efficient annual interest rate is the actual return.
MAJOR UPSHOTS
A savings account or a loan could also be publicized with both a nominal interest rate and an
efficient annual interest rate.
The efficient annual interest rate is the actual return compensated on savings or the actual cost of
a loan as it gets into account the results of compounding and any bills charged.
The more constant the compounding cycles, the higher the return.
That's why the efficient annual interest rate is a crucial financial idea to know. You'll be able to
compare different offers correctly as long as you recognize the efficient annual interest rates of
each.
Example of Efficient Annual Interest Rate
As an example, consider these two offers: Investment A compensates ten percent interest,
compounded monthly. Investment B compensate 10.1% compounded semi-annually.
Which is the excelling offer?
In both cases, the posted interest rate is the nominal interest rate. The efficient annual interest
rate is computed by correcting the nominal interest rate for the figure of compounding cycles the
financial commodities will encounter in a period. In this situation, that cycle is one year. The
formula and computations are as follows:
Effective annual interest rate = (1 + (nominal rate / number of compounding periods)) ^ (number
of compounding periods) - 1
For investment A, this may be: 10.47% = (1 + (10% / 12)) ^ 12 - 1
And for investment B, it might be: 10.36% = (1 + (10.1% / 2)) ^ 2 - 1
Investment B features a higher offer nominal interest rate, but the efficient annual interest rate is
less than the efficient rate for investment A. This is often Investment B compounds fewer times
over the progress of the year.
If a financier were to set, say, $5,000,000 into one in all these assets, the incorrect decision
would cost quite $5,800 for each year.
More Frequent Compounding Equals Greater Returns
As the figure of compounding cycles raises, so does the efficient annual interest rate. Quarterly
compounding generates greater returns than semi-annual compounding, monthly compounding
more than quarterly, and daily compounding more than monthly. Below is an analysis of the
outcomes of these various compound periods with a ten percent nominal interest rate:
Semi-annual = 10.250%
Quarterly = 10.381%
Monthly = 10.471%
Daily = 10.516%
The Limits to Compounding
There is a maximum to the compounding episode. Whether or not compounding appears a
limitless value of times—not just each second or microsecond but frequently—the limit of
compounding is attained.
With ten percent, the frequently compounded efficient annual interest rate is 10.517%. The
frequent rate is computed by increasing the figure "e" (almost equal to 2.71828) to the ability of
the interest rate and subtracting one. In this instance, it might be 2.171828 ^ (0.1) - 1.
What Is an Amortized Loan?
An amortized loan is a kind of loan with due, periodic premiums that are used to both the loan's
principal value and the interest accrued. An amortized loan premium first compensates off the
compatible interest expense for the cycle, after which the balance of the premium is put toward
decreasing the principal value. Ordinary amortized loans involve car loans, house loans, and
private loans from a bank for small programs or debt unification.
MAJOR UPSHOT
An amortized loan is a kind of loan that needs the borrower to create due, periodic premiums
that are used to both the principal and interest.
An amortized loan payment first compensates off the interest expense for the cycle; any
balance amount is put towards decreasing the principal amount.
As the interest percentage of the premiums for an amortization loan is cut down, the principal
percent increases.
How an Amortized Loan Works
The interest on an amortized loan is computed to establish the most current ending balance of the
loan; the interest amount overdue reduces as premiums are created. This is because any premium
in extreme of the interest value decreases the principal, which in turn, decreases the balance on
which the interest is computed. As the interest percent of an amortized loan reduces, the
principal percent of the premium increases. Accordingly, interest and principal have an opposite
connection within the premiums throughout the amortized loan.
An amortized loan is the outcome of a sequence of computations. First, the actual balance of the
loan is multiplied by the interest rate derivable to the present period to seek out the interest due
to the cycle. (Annual interest rates could also be divided by 12 to search out a monthly rate.)
Subtracting the interest due for the period from the whole monthly premium leads to the dollar
value of the principal compensated within the cycle.
The amount of principal compensated in the cycle is used to the pending balance of the loan.
Accordingly, the actual balance of the loan, minus the value of the principal compensated in the
cycle, results in the new pending balance of the loan. This new pending balance is employed to
compute the interest for the subsequent period.
Amortized Loans vs. Balloon Loans vs. Revolving Debt (Credit Cards)
While amortized loans, balloon loans, and revolving debt–particularly credit cards–are related,
they have vital distinctions that customers should remember before signing up for one.
Amortized Loans
Amortized loans are mainly compensated off over a drawn-out period, with equal values
compensated for every premium period. Nonetheless, there's always the choice to compensate
more, and hence, further, decrease the principal overdue.
Balloon Loans
Balloon loans usually have a comparatively short term, and only a percent of the loan's principal
balance is amortized over that course. At the end of the course, the outstanding balance is due as
a last compensation, which is mostly large (somewhat twice the value of previous premiums).
Revolving Debt (Credit Cards)
Credit cards are the most recognized kind of revolving debt. With revolving debt, you borrow
opposite to a settled credit limit. As long as you haven't attained your credit limit, you'll keep
borrowing. Credit cards are varied than amortized loans because they do not have set premium
values or a stable loan value.
Amortized loans apply every premium to both interest and principal, originally repay more
interest than principal until finally that ratio is turned.
Example of an Amortization Loan Table
The computations of an amortized loan may be shown in an amortization table. The table lists
appropriate balances and dollar values for every period. In the instance below, every period is a
row in the table. The columns involve the premium date, principal percent of the premium,
interest percent of the premium, full interest compensated to date, and ending overdue balance.
The subsequent table portion is for the first year of a thirty years loan agreement in the value of
$165,000 with an annual interest rate of 4.5%.
References and Supplementary Materials
Books and Journals
1. Marlon Oyzon Flores,INTEGRATED COST ACCOUNTING (PRINCIPLES
AND APPLICATION), Rex Bookstore
2. Bragg, Steven, Controllership: The Work of the Managerial Accountant, Solely distributed by
C&E Publishing, (1672 Quezon Ave, South Triangle, QC
3. McGraw-Hill. 2007, Fundamentals of Corporate Finance, 5th Edition. Solely distributed by
C&E Publishing, (1672 Quezon Ave, South Triangle, QC)
Online Supplementary Reading Materials
https://corporatefinanceinstitute.com/resources/ebooks/
https://www.investopedia.com/retirement/calculating-present-and-future-
value-of-annuities/
1. Kellison, Stephen G. (1970). The Theory of Interest. Homewood, Illinois: Richard D.
Irwin, Inc. p. 45
2. ^ Lasher, William (2008). Practical financial management. Mason, Ohio: Thomson
South-Western. p. 230. ISBN 0-324-42262-8..
3. ^ Jordan, Bradford D.; Ross, Stephen David; Westerfield, Randolph
(2000). Fundamentals of corporate finance. Boston: Irwin/McGraw-Hill. p. 175. ISBN 0-
07-231289-0.
Samuel A. Broverman (2010). Mathematics of Investment and Credit, 5th Edition. ACTEX
Academic Series. ACTEX Publications. ISBN 978-1-56698-767-7.
Stephen Kellison (2008). Theory of Interest, 3rd Edition. McGraw-Hill/Irwin. ISBN 978-0-
07-338244-9.
