Treasury Management Services
The role of commercial banks is to act as trusted partners to their corporate associates. Over the years, the degree of trust has been steadily increasing. As a result, many corporations across the world are outsourcing critical parts of their business to banks. In the previous articles, we have already seen how certain payment functions […]
Sustainable Growth Rate: Concept
We have studied the various discounted cash flow valuation models in this module. These different models need to be applied in different situations. We have studied these situations as well. However, regardless of which model is being applied, one thing remains constant. In the end, the growth rate of the company plateaus down at a […]
Assumptions in Pension Fund Accounting
Accounting for pension funds is considered to be much more complex than standard accounting. This is because a lot of the payments being made in the pension funds are to be done in the distant future. Hence, as an accountant, provisions have to be made to account for these expenses as well as incomes that […]
Strategic Finance and Sustainability
The concept of strategic finance relates to making decisions that help the firm increase its cash flow in the long run. Strategic finance is about changing the focus from short-term profits to long-term value creation. On the other hand, sustainability is about including more stakeholders in the value creation process. For instance, in the past, […]
Availability Bias in Behavioural Investing
All of us have seen movies or have read novels wherein there are several witnesses who are describing the same crime scene. However, each of them describes the scene in different ways. This is because their experiences are colored with their own thought processes. This makes different people look at the same situation in different […]
An annuity, just like a perpetuity, is a shortcut used while making present value calculations. Unlike the perpetuity, which is very difficult to find in real life, we find examples of annuity all around us. The monthly mortgage payments we make, the car loan or student loan that we pay off are all annuities. Annuities play a very important role in corporate finance. They form the basis for valuation of bonds and other financial instruments. This article provides more information about the concept of an annuity:
Finite Stream: The first and foremost difference between an annuity and a perpetuity is the fact that an annuity has a finite life. Unlike perpetuities, annuities do not go on forever. It is for this reason that we they are conceptually more intuitive and easy to understand.
Equal Amounts: A stream of payments can be called an annuity, if and only if, all the payments in that stream of future cash flows is of equal amounts. For instance, if the future cash flows for 4 consecutive years from now are $100 in each year, then this stream is called an annuity. On the other hand, if the future cash flows for the next 3 years are $100 and the 4th year is $110, then this stream of cash flows cannot be called an annuity. (It is an annuity if you consider years 1 to 3)
Equal Time Lag: Every payment in the stream of cash flows should be equally spaced. This means that if payments are being made on a monthly basis, all payments should be made on a monthly basis. If the time lag when payments are made is changing, then the cash flow schedule cannot be classified as an annuity. This is because the annuity formula assumes that the cash flows are evenly spaced out.
Same Interest Rate: A stream of cash flows can be called an annuity, if the interest rate being charged throughout the period is same. For instance, if the rate of interest across the entire duration of a 10 year loan is 10%, then the stream of payments can be classified as an annuity. On the other hand, if the rate of interest keeps varying from year to year, then it cannot be valued as an annuity because the annuity calculation formula assumes the same interest rate.
Amortization Concept: The payments in an annuity represent amortization of a lump sum amount. This means that although the amount paid in installments is constant, its internal components are changing.
Let’s understand this, with the help of an example. Let’s say that there is a $100 payment per month for the next 5 years. Now, the $100 amount will remain constant for the next 5 years, however the internal components will change. The first payment may represent an $80 interest charge and $20 repayment of principal while the last payment may only represent $10 interest and $90 repayment of principal. This is called amortization.
The first few payments in an annuity have very high interest components. With the passage of time, the interest component becomes smaller and smaller and repayment of principal amounts becomes larger and larger.
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