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"Present value of an annuity" is finance jargon meaning present value with a cash flow. The cash flow may be an investment, payment or savings cash flow, or it may be an income cash flow.

The present value (PV) is what the cash flow is worth today. Thus this present value of an annuity calculator calculates today's value of a future cash flow. The annuity may be either an ordinary annuity or an annuity due (see below).

The PV will always be less than the future value, that is, the sum of the cash flows (except in the rare case when interest rates are negative).

Why?

Because there must be compensation made to the party who has to wait for the money. Think of it in reverse. Would you rather have $100 today, or $100 one year from now?

Of course, you would rather have $100 today since there is risk in not receiving the money if you wait, and further, if you receive the payment today, you can invest it today and earn a return on the capital.

The present value of an annuity calculation considers these things and discounts the cash flow. In fact, sometimes this calculator is also known by the name discounted cash flow calculator. More below


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What is present value used for?

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At a high level, there are two scenarios when you may want to know the present value of a cash-flow.

  • when someone or some entity owes you money
  • when you want to make an investment

Perhaps you have won a court settlement payable as an annuity, or maybe you've been lucky enough to win a state lottery, and you want to receive the proceeds at once. How much should you expect?

Use this PV of an annuity calculator to tell you. Since an annuity is a regular, periodic cash-flow, and because this calculator allows you to set a specific first cash-flow date, it is capable of calculating the current value for any future stream of payments or investments. The calculator is also particularly suitable for calculating the PV of a legal settlement, such as one involving alimony.

For the same reasons, this calculator can be used to calculate the PV of an investment cash-flow. Perhaps you want to invest in a mortgage? You'll need to calculate the PV of the said mortgage before you can make an offer or know if the offering price allows you to meet your investment objective.

What is the correct discount rate?

A discount rate is a personal number. That is, there is no absolute right or wrong value one can use.

When determining the discount rate, you could use several approaches. If you invest in the stock market, and for you, you earn on average 8% per year, you can use 8% for the discount rate to compare the present value with the return you earn from the market.

If you want to compare PV to something safer, you might use the US Treasury ten-year rate, which currently is at about 1.75% (August 2019).

Example

Additionally, buyers and sellers are very likely to use different discount rates. For example, a commercial building's owner is selling the property, and a tenant has ten years remaining on the lease. What is the value of the contract to the prospective buyer?

The buyer may feel that mutual funds and the lease have similar risks (mutual funds loss of value and the lessee not paying). In that case, the buyer can use their average mutual fund return rate, say 7%, to calculate the PV of the lease. After all, why would they pay more to purchase the contract if they can earn 7% in mutual funds? The buyer will always want to use the highest discount rate they can justify because the higher the discount rate, the lower the PV – or the lower the cost of the asset. In other words, for the buyer, using a higher discount rate is the more conservative approach.

On the other hand, the seller may feel the tenants are reliable, and the cash flow is safe. They'll ask themselves why take a risk and put the money into the market where there is the risk of losing principal? In that case, the seller might want to park the money in a 2% CD, so they'll use 2% as their discount rate. Lower rates result in a higher PV. Thus, for the seller, the lower rate is more conservative. They'll need to be paid a higher price so they can put the proceeds from the sale in a lower yielding CD to reduce the investment risk.

With this example, it looks as if no deal would ever get done. The buyer will want to pay to little, and the seller will want to receive too much.

However, all deals depend on each participant's perspective. Perhaps the seller thinks that they have an opportunity to reinvest the money and earn not 2% but instead 20%. In that case, the seller might be willing to sell the lease at a 10% or 12% discount to have the funds available to take advantage of the more profitable opportunity.

See how what discount rate to use is a matter of personal choice and perspective?

PV Calculator for Either Ordinary Annuity or Annuity Due

You may have heard of the terms "ordinary annuity" or "annuity due". This calculator will calculate the present value for either type of annuity.

First, what's the difference between an ordinary annuity and an annuity due? These two terms are a bit of financial jargon for an easy to understand financial concept.

An ordinary annuity will have its first cash flow scheduled for a future date. Textbooks frequently explain this concept by saying the cash flow gets paid at the end of the period.

An annuity due will have its first cash flow scheduled on the as-of-date, that is, the date for which the present value is calculated. Textbooks explain this concept by stating the cash flow gets paid at the beginning of the period.

The present value formula needs to be slightly modified depending on the annuity type.

Since this calculator prompts the user for the present value date (today's date) and the first cash flow date, it will work equally as well for either annuity type. If you set the dates to the same day, then the calculator will use the annuity due formula; otherwise, it will use the ordinary annuity formula.

Note, if you are calculating the present value for a deal that closes in the future, then you should set today's date to the day the contract is scheduled to close.

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