Overview
- find out when payments need to be made / until when a cash flow needs to be realized
- payments of equal size at fixed intervals, taking interest rate into account
- Discounting again
- often used for investments, loans, subscription cash flow calculations
- easy calculations and leverages (or requires) predictability
- a loan will be payed back predictably, so cash flows need to be predictable as well
Key Components
- Equal Payments: Payments are the same amount in each period (e.g., monthly, quarterly, annually).
- Fixed Time Period: The duration over which the annuity payments are made is predetermined.
- Interest Rate: An interest rate is used to calculate the present value of future cash flows or the future value of current investments.
Types of Annuities
- Ordinary Annuity: Payments are made at the end of each period.
- Annuity Due: Payments are made at the beginning of each period.
Applications
- Loan Repayment: Calculating monthly mortgage or loan payments.
- Investment Planning: Estimating the future value of regular savings or investments.
- Retirement Planning: Evaluating retirement income streams based on regular withdrawals over time.
Key Formulas
Present Value of Annuity:
Where:
- = Present Value
- = Payment per period
- = Interest rate per period
- = Total number of payments
Future Value of Annuity:
Where:
- = Future Value
Limitations
- Inflation Risk: Fixed payment amounts may lose purchasing power over time due to inflation.
- Lack of Flexibility: Committing to fixed payments may limit adjustment in response to changing financial situations.
Summary
The annuity method is a popular financial tool used in various economic scenarios to evaluate fixed cash flow situations. It provides a systematic approach to understanding how regular payments impact financial planning and value assessments. Further context and specific examples from your slides would enhance clarity and application of this method within your notes.