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Exactly What may be the Present Value of an Annuity Formula and What are Annuities?
In the event that you currently recognize the very idea of Perpetuities, the concept of Annuities is incredibly easy. It is extremely similar to Perpetuities, just that the payments are not forever. As opposed to forever, these types of payments come in just for a set period of time.
Let’s say I provided you a sheet of paper or even certificate, and it promised that I might pay you $10 each year for specifically 12 years, and then I would stop paying you instantly after that. Is this still a “perpetuity”? It even now consists of standard payments of equivalent quantities, much like a perpetuity, but it is not necessarily forever; it has a limited time period. Therefore in this case, it’s not referred to as a perpetuity, but an “annuity”.
Now, just like within the case of a perpetuity, an important question now is… precisely how much are you prepared to pay me for that sheet of paper? Simply how much are you willing to pay for this kind of “annuity”?
For this, you would make use of the Present Value of an Annuity Formula. For general managers, there is no need to know the actual step-by-step process upon calculating this, as it could easily end up being done by accountants or by totally free calculators on the web in addition to smartphone apps. Nevertheless, if you need to learn the process yourself, you may watch a great deal of free online tutorial video clips from numerous websites as well as Youtube.
Let’s imagine you are offered to invest your own severance pay (or retirement pay, or similar large sum) of $10,000 with a pension company or even investment company, and they promise to pay you $600/year for thirty years. A regular individual may think it is a good deal because $600/year x 3 decades = $18,000, which is much more than the first $10,000 investment.
However, utilizing the Present Value of an Annuity Formula, you will recognize that the “fair value” of this particular annuity is in fact only $9,223 in the event that rates of interest are generally at 5%… and that you therefore are “overpaying” if you pay anything at all more than $9,223. Put simply, if you pay anything more than $9,223, then you are just as good and even far better off placing your hard earned money in the bank as an alternative, and earning interest from the bank (or any other “risk-free” investment). At $9,223, the rate of return of your investment/pension is going to be precisely equal to the rate of return of putting your money within the bank. If you shell out greater than $9,223 for your investment, then your current investment’s rate of return may end up being less than the return from the bank.