Present Value of Annuity Due
An Annuity due is a stream of cash flows in which there is equal duration between different cash flows and each cash flow occurs at the start of each period. It is an annuity in which payments occur in advance instead of arrears.
Let us say you take out a 3-year auto lease that require $10,000 as down payment and $400 as monthly lease payment to be made at the start of each month. Your total outflow at the start of 1st month 1 is $10,4000 (down payment of $10,000 plus first monthly instalment of $400) and your last cash flow occur at the start of 60th month.
Annuity due differs from ordinary annuity in that periodic cash flows occur at the end of each period in an ordinary annuity.
The basic concept behind the present value of annuity due is the same as that of an (ordinary) annuity. You just need to discount cash flow to time zero.
One way to find present value is to manually discount each cash flow based on the following formula and sum all present values together:
|(1 + i)n|
But it is tedious, you can use the following formula to directly calculate the present value:
|PV of Annuity Due = PMT ×||1 - (1 + i)-n||× (1 + i)|
Where PMT is the periodic cash flows, i is the relevant periodic interest rate which equals the annual percentage rate divided by total number of payments per year, n is the total number of payments in the annuity due.
Relationship between PV of Ordinary Annuity and PV of Annuity Due
If you look closely, the component of the right-hand side is the formula for present value of an (ordinary annuity). Let us rewrite the above equation as follows:
PV of Annuity Due = PV of Ordinary Annuity × (1 + i)
Because in an annuity due each payment occurs one period closer to time 0, each payment must be discounted over one less period as compared to an identical ordinary annuity. Multiplication of the present value of an ordinary annuity with (1 + i) has the effect of shifting the cash flows one period towards time 0.
Alternatively, you can use the following formula directly to calculate present value of an annuity due:
|PV of Annuity Due = PMT + PMT ×||1 − (1 + i)-(n − 1)|
The above formula is intuitive. Since payment occurs at the start of each period, the first payment occurs at time 0 and it has no discounting effect hence the first PMT term on the right side of the above equation. The rest of the payments can be treated as an (ordinary) annuity with one less payment hence the -(n-1) term instead of just -n.
You can also use Excel PV function to calculate present value of an annuity due. PV function syntax is PV(rate, nper, pmt, [fv], [type]). Specifying 1 in [type] argument treats the cash flow stream as an annuity due.
Your company has entered a lease requiring four annual payments of $10 million in advance. The lease rate is 10%
If the payments were required at the end of each year, the present value would be:
|PV (Ordinary Annuity) = $10 million ×||1 - (1 + 10%)-4|
PV (Ordinary Annuity) = $31.70 million
To shift the present value one period closer to time 0, we need to multiply by (1+ 10%), which gets us $34.87 million.
PV (Annuity Due) = $31.70 × (1 + 10%) = $34.87 million
We can also find present value by individually discounting each cash flow as follows:
|Time||Cash Flow||Present Value Factor||Present Value|
The present value factors above are worked out based on PV of a single sum of money.
Now, let us calculate the present value using the direct formula:
|PV of Annuity Due = $10 million + $10 million ×||1 − (1 + 10%)-(4 − 1)||= $34.87 million|
If you have Excel handy, enter the following in any cell: PV(10%,4,-10000000,0,1).
by Obaidullah Jan, ACA, CFA and last modified on