If you currently know the idea of Perpetuities, the idea of Annuities is very simple. It’s really similar to Perpetuities, only that the payments are not forever. Instead of forever, these payments come in only for a fixed time period.

Let’s say I gave you a piece of paper or certificate, and it promised that I would spend you $ 10 per year for precisely 12 years, and then I would stop paying you right away soon after that. Is this still a “perpetuity”? It nonetheless consists of typical payments of equal amounts, just like a perpetuity, but it is not forever it has a restricted time period. So in this case, it really is not called a perpetuity, but an “annuity.”

So now, just like in the case of a perpetuity, an important question now is… how considerably are you willing to pay me for that piece of paper? How a lot are you willing to spend for this “annuity”?

For this, you would use the Present Value of an Annuity Formula. For common managers, there is no want to know the actual step by step process on calculating this, as it can easily be accomplished by accountants or by free calculators on the web as well as smartphone apps. Nevertheless, if you need to learn the procedure your self, you can watch tons of cost-free on-line tutorial videos from several diverse web sites as properly as YouTube.

Real-Life Application

Let’s say you are offered to invest your severance pay (or retirement pay, or comparable lump sum) of $ ten,000 with a pension business or investment organization, and they promise to pay you $ 600/year for 30 years. An ordinary individual may possibly assume it is a excellent deal since $ 600/year x 30 years = $ 18,000, which will be a lot far more than the original $ 10,000 investment.

However, employing the Present Worth of an Annuity Formula, you will discover that the “fair value” of this annuity is actually only $ 9,223 if interest rates are at five%… and that you are consequently “overpaying” if you pay anything far more than $ 9,223. In other words, if you spend anything much more than $ 9,223, then you’re just as great or even greater off putting your funds in the bank rather, and earning interest from the bank (or other “threat-free of charge” investment). At $ 9,223, the rate of return of your investment/pension will be specifically equal to the rate of return of putting your funds in the bank. If you pay a lot more than $ 9,223 for your investment, then your investment’s rate of return will be lower than your return from the bank.