History of Derivatives
Derivatives may have found their way into the media in very recent times. However, they have been used by mankind for a very long time. Since the inception of time, humans have not liked the idea of uncertainty. More so, they did not like the idea of economic uncertainty. Hence, the need to offset this […]
Subscription-Based Corporate Banking Business
Banking services in general and corporate banking, in particular, have witnessed a lot of innovation in the past few years. Innovations have touched almost every area of banking except the way the products and services are priced. The commercial banking pricing still seems to be anchored to old business models. However, since commercial banks are […]
What is Litigation Funding?, Its Advantages and Disadvantages
Legal costs have long been a deterrent for people wanting to file lawsuits. In a country like America, the legal fees can be significant. A lot of good lawyers charge hourly fees. Many plaintiffs believe that in an hourly fee system, the lawyer is incentivized to drag the case for as long as possible. This […]
Why Do Start-ups Fail After Receiving Funding?
It is common knowledge in the investing world that almost 90% of the start-up companies which come into existence shut down within the first couple of years. However, it is also assumed that if a company is able to gain funding from professional investors, its chances of surviving become astronomically high. This is because it […]
Why the Xiaomi IPO Failed?
Xiaomi is considered to be one of the most valuable startup firms in the world now. This firm, which has Chinese origins, has become truly global in nature. It sells world-class products at rock bottom prices all over the world. This firm completely dominates the Indian smartphone market. Given the fact, that India is poised […]
In the articles on present value, we learnt that the value of a dollar today is not the same as it will be 10 years from now. Then, we came across annuities which are a powerful mechanism that ensure that the nominal value of the payments remain the same throughout the years whereas its internal components i.e. interest and principal keep on changing. Annuities, therefore give a very useful way to work with a schedule of payments. There are various types of payment schedules possible while working with an annuity. Here are some of the important types:
Annuities can convert a lump sum payment today into a series of future cash flows which will have the exact same value as of today. This is useful in business because usually the outlays required have to be done immediately in a lump sum whereas the benefits arrive at a later date and they arrive in installments. Annuities therefore enable us to draw a comparison between these values and decide if they are beneficial to us.
Example: Assuming a 12% rate of return for the next 5 years, an annual payment of $27.74 has the same present value as a $100 payment today. So we can choose between making a $100 payment upfront or choose a 5 year annuity of $27.74
The reverse of the above calculation is also true. Annuities help us to take a series of future equal payments that will be made at equal periodic intervals and come up with a lump sum present value that is equal to those payments. This too is very useful. Let’s say that you are scheduled to make mortgage payments for the next 5 years. But instead you choose to pay upfront and close the loan. What is the amount that you should pay to the lender? Annuity calculations will help us come up with that amount.
Example: Assuming a 14% interest rate for the next 5 years and an annual payment of $100, the present value of this stream of payments is $343.31
Now, in the above cases we were converting lump sums into equal payments or equal annuity payments into lump sums. Annuity calculations can be used to arrive at the calculation of the two as well. The payment maybe partially made in equal installments and partially paid in a lump sum. For instance, if you owed the bank $500, you could pay $200 upfront and convert the balance into an annuity.
Annuity calculations allow you to convert any lump sum or stream of cash flows into any other lump sum or stream of cash flows or a combination of both. These calculations form the backbone of finance and it is difficult to imagine the financial world without them.
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