What are annuities, and why is it necessary to calculate their present value?
What are annuities, and why is it necessary to calculate their present value? Why is the calculation of the present value of any future amount important? Why is the present value of any future amount greater when the discount rate is lower? Explain your
It is necessary to calculate their present value for the same reason that medical interns and residents still put in an ungodly number of hours on duty in a hospital – because everyone who has gotten an accounting or a finance or an economics degree before you had to do it and they don’t think it would be fair for someone to enter the profession without having to be tortured just as they were tortured.
I’m a straight-A student, and you would not believe the amount of tutoring I had to get just to get through the unit on time value of money. My daughter was engaged to be married at the time and we were going through the wedding planning process, and that time value of money gave me more headaches and heartaches and gray hair than her entire wedding did.
(PS – I know there are lots of people around here who know the theory and can answer your question. I hope the time value of money problems make more sense to you than they do to me. “Torture” doesn’t begin to cover it.)
Annuity is an amount of money given to you at fixed interval for an infinite amount of time (assuming you lived that long).
Well, the discount rate is closely linked to two factors: normal interest rate and inflation rate.
So an amount in the future, say $100, a year from now with an inflation rate of 10%, when discounted to the present, would just be about $90. (e.g 100 bucks in the future can only buy an equivalent 90 bucks of goods now) So you can imagine if the discount rate is 5%, the present value would be about $95.
The calculation of present value is important because it provides for a basis of comparison of money at different times. Say $1000 in 20 years time is definitely not the same as $1000 now. So by discounting the amount to its present value, we could then differentiate their worth.
Hope this helps.