An Annuity is a method in which structured payments or equal payments are made regularly, like every month or every week.
Let’s say you are given a choice between getting $ 1,000,000 now in one lump sum, or in structured payments of $ 50,000 a year for the next 22 years. The million dollars up front may sound enticing but so does the other option if you do some basic math, so which do you take?
Money is generally worth less in the future. So the $50,000 payment you get in 22 years is not going to be worth as much as it is today. So first, we need to guess an interest rate, in this case, the rate of inflation for the next 22 years. Lets say 4% as an example. Now, we have to figure out the present value of the $50,000 times 22 years discounted by 4% and then compare it with the million bucks.
We’ll use a financial calculator to calculate the present value (PV) of an annuity for this scenario:
1. Enter n (the number of compounding periods – in this case the number of years). Press 22 and then push the N button.
2. Enter i (the interest rate per period – in this case the number of years). Press 4 and then push the i button.
3. Enter FV (the future value). It is zero. You want to know the Present Value, not the future value, right? Push 0 and then push the FV button.
4. Enter PMT (the payment). You are not making a payment, you are getting one. So you have to show a negative number. Press 50000, then the CHS (change sign button), then push the PMT button.
5. Push the PV (present value) button.
6. Answer = $722,555. This means 22 annual structured payments of 50,000 each is worth only $722,555 of today’s dollars. So you should take the million bucks in one lump sum
It is understood that money today is worth more than money tomorrow. Why? Because money today is a certainty, money tomorrow carries some risk. $100 today can be invested. Money tomorrow just sits until it is today. Time Value of Money (TVM) is an important concept in financial management. It can be used to compare many different types of investment alternatives.