An annuity is simply a series of regular cash flows either received or paid periodically.
Life insurance, pension payments, motor vehicle leases, property rents, are all forms of annuities.
Cash Flow Diagram
The diagram below represents an annuity of 3,000 a period for 3 periods. Notice how each receipt is the same and occurs at the end of each period. This type of annuity is sometimes referred to as a regular annuity or an ordinary annuity.
|Cash flow||3,000 ↑||3,000 ↑||3,000 ↑|
The period for an annuity can be of any length, week, month year etc. providing all periods are of the same length.
Future Value of an Annuity
Each of the cash flows can be regarded as a single lump sum cash flow and the future value can be calculated using the future value of a lump sum formula, by compounding each cash flow forward to the end of year 3.
In the above example, assuming a periodic discount rate of 5%, at the end of year 3 the future value of the annuity would be shown as follows:
FV = FV cash flow 1 + FV cash flow 2 + FV cash flow 3 FV = 3,000 x (1 + 5%)2 + 3,000 x (1 + 5%)1 + 3,000 FV = 9,457.50
The cash flow received at the end of year 1 is compounded forward 2 years to the end of year 3, likewise the cash flow received at the end of year 2 is compounded forward 1 year to the end of year 3, and finally the cash flow received at the end of year 3 does not need compounding as its value is already at the end of year 3.
Clearly this calculation can be performed for any number of periods and cash flows, however to avoid repetitive time, consuming calculations, it can be shown mathematically that the future value of an annuity is given by the formula
FV = Pmt x ( (1 + i)n - 1 ) / i
FV = Future Value
Pmt = Periodic payment
i = Discount rate
n = Number of periods
Using the above annuity as an example, the future value of the annuity at the end of year 3 can be calculated using the formula as follows:
Pmt = 3,000 i = 5% n = 3 Future value of an annuity = Pmt x ( (1 + i)n - 1 ) / i Future value of an annuity = 3,000 x ( (1 + 5%)3 - 1 ) / 5% Future value of an annuity = 9,457.50
The future value of annuity forms the basis of many time value of money calculations. The formula allows any series of regular cash flows (Pmt) to be compounded forward a number of periods (n) at a discount rate of i per period.