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Understanding Annuity Cash Flows

This document defines and explains different types of annuities. It begins by stating that an annuity is a financial product that provides equal cash flows at regular time intervals through a contract between an individual and an insurance company. It then defines ordinary annuities and annuities due, and provides the key formulas for calculating the present and future values of these annuity types. Ordinary annuities make payments at the end of each period, while annuity due payments are made at the beginning of each period. The document also defines rent in the context of annuities as the payments received from an annuity contract during retirement.

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Shoaib Amin
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13 views7 pages

Understanding Annuity Cash Flows

This document defines and explains different types of annuities. It begins by stating that an annuity is a financial product that provides equal cash flows at regular time intervals through a contract between an individual and an insurance company. It then defines ordinary annuities and annuities due, and provides the key formulas for calculating the present and future values of these annuity types. Ordinary annuities make payments at the end of each period, while annuity due payments are made at the beginning of each period. The document also defines rent in the context of annuities as the payments received from an annuity contract during retirement.

Uploaded by

Shoaib Amin
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Chapter No.

9
INTRODUCTION:
At its core, an annuity is a contract between you and an insurance company in which the company
promises to make periodic payments to you, starting immediately or at some future time.
Some annuity contracts provide a way to save for retirement. Others can turn your savings into a
stream of retirement income.
ANNUITY:

An annuity is a financial product that provides certain cash flows at equal time intervals. Annuities
are created by financial institutions, primarily life insurance companies, to provide regular income to
a client.
Definition:
An equal receipts or payments over a specific period of time called annuity.
t=0 t=1 t=2 t=3 t=4 t=5

0 1000 1000 1000 1000 1000

Amount
Of
Annuity

=1000{( 1.10^5 ) – 1} / 1.10- 1 = 6106.1

Equal Cash Flow

Specific time interval

Types of Annuity :

1. Ordinary Annuity

2. Annuity Due
What Is an Ordinary Annuity?

An ordinary annuity is a series of equal payments made at the end of consecutive periods over a fixed length
of time. While the payments in an ordinary annuity can be made as frequently as every week, in practice
they are generally made monthly, quarterly, semi-annually, or annually.

Definition:
An equal receipts or payments occurring at the end of each period called Ordinary annuity.
Formula For:

Present Value = FvA=

For example, if an ordinary annuity pays $50,000 per year for five years and the interest rate is 7%, the
present value would be:
PMT=P= $50,000
Time=n= 5 Years
Rate=r=7%
Present Value =
=$50,000 x ((1 - (1 + 0.07) ^ -5) / 0.07)
= $205,010
Formula for Future Value of Ordinary Annuity :

FvAn =

For example, if an ordinary annuity pays $50,000 per year for five years and the interest rate is 7%, the future value
would be:
PMT=P= $50,000
Time=n= 5 Years
Rate=r=7%

FvAn= 50,000[{(1+0.07)^5} -1] / 0.07


=287,536.95
_______________________

What Is Annuity Due?

Annuity due is an annuity whose payment is due immediately at the beginning of each period. A common example of an
annuity due payment is rent, as landlords often require payment upon the start of a new month as opposed to collecting
it after the renter has enjoyed the benefits of the apartment for an entire month.

IMPORTANT:
An ordinary annuity will have a lower present value than an annuity due, all else being equal.
Definition:
An equal receipts or payments occurring at the beginning of each period called Annuity Due.
Formula For Future Value of Annuity Due:

For example, if an annuity due pays $50,000 per year for five years and the interest rate is 7%, the future value
would be:
PMT=P= $50,000
Time=n= 5 Years
Rate=r=7%
FvADn= (1+0.07)x50,000[{(1+0.07)^5}} – 1] / 0.07
=(1.07)x50000{(1.40255-1)/0.07}
= 1.07x50000x5.750
=307,664.537
Formula For Present Value of Annuity Due:

PvADo=

For example, if an annuity due pays $50,000 per year for five years and the interest rate is 7%, the present value would be:
PMT=P= $50,000
Time=n= 5 Years
Rate=r=7%

PvADo= 50,000x[{ 1- (1/(1+r)^n)}/r]x (1+r)


=219,360.5628

Rent of an annuity?
A payment made to an annuitant from his/her annuity.

For example, if one purchases an annuity and begins receiving payments after age 65, then those payments in retirement
are called the annuity rent.
When S is Known: When P is Known:
R= R=

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