Annuity Due

Definition

An annuity due is a series of equal payments made at the beginning of each period over a specified time frame. This payment structure affects the present value and future value calculations, as the earlier timing of payments leads to a higher total value compared to ordinary annuities, which pay at the end of each period. The unique cash flow timing is crucial in evaluating investment options and planning for financial goals.

5 Must Know Facts For Your Next Test

1. The formula for calculating the present value of an annuity due is different from that of an ordinary annuity, as it incorporates an additional compounding period for each payment.
2. To find the future value of an annuity due, you can multiply the future value of an ordinary annuity by (1 + r), where r is the interest rate per period.
3. Annuities due are often found in lease agreements, insurance premiums, and retirement plans where payments are due at the start of each period.
4. The total value received from an annuity due will always be higher than that of an equivalent ordinary annuity due to the time value of money.
5. Financial calculators often have specific functions for computing values related to both ordinary annuities and annuities due, making it easier to perform these calculations.

Review Questions

• How does the payment timing in an annuity due affect its present value compared to an ordinary annuity?
  • In an annuity due, payments occur at the beginning of each period, which means they are invested for longer and accrue interest sooner than in an ordinary annuity. This results in a higher present value for an annuity due since each payment is discounted less when calculated back to today. Consequently, when comparing both types of annuities, the present value of an annuity due will always be greater than that of an ordinary annuity for the same series of payments.
• Discuss how you would calculate the future value of an annuity due and why it's important in financial planning.
  • To calculate the future value of an annuity due, first compute the future value of an ordinary annuity using the standard formula and then multiply that result by (1 + r), where r is the interest rate per period. This adjustment accounts for the fact that each payment is made at the beginning rather than the end of each period. Understanding this calculation is essential for financial planning because it helps determine how much money will accumulate over time with regular investments or contributions made at the start of each period.
• Evaluate the significance of understanding annuities due in terms of retirement planning and cash flow management.
  • Understanding annuities due is crucial for effective retirement planning and cash flow management because many retirement accounts require contributions at the start of each period. By grasping how these payments accumulate interest more quickly, individuals can better assess how much they need to save to achieve their retirement goals. Moreover, evaluating different investment options that use annuities due can lead to improved financial strategies, allowing for more efficient use of resources and enhanced control over one's financial future.

Related terms

Ordinary Annuity: An ordinary annuity is a sequence of equal payments made at the end of each period, in contrast to an annuity due which makes payments at the beginning.

Present Value: Present value refers to the current worth of a future sum of money or stream of cash flows, discounted at a specific interest rate.

Future Value: Future value is the value of a current asset or cash flow at a specified date in the future based on an assumed rate of growth or interest.