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Annuity factors are used to calculate present values of annuities, and equated instalments.
The simplest type of annuity is a finite series of identical future cash flows, starting exactly one period into the future.
Present value calculations
An annuity factor can be used to calculate the total present value of a simple fixed annuity.
The Annuity Factor is the sum of the discount factors for maturities 1 to n inclusive, when the cost of capital is the same for all relevant maturities.
Commonly abbreviated as AF(n,r) or AFn,r
Sometimes also known as the Present Value Interest Factor of an Annuity (PVIFA).
The present value of the annuity is calculated from the Annuity Factor (AF) as:
= AF x Time 1 cash flow.
Example 1: Present value calculation
Annuity factor = 1.833.
Time 1 cash flow = $10m.
Present value is:
= AF x Time 1 cash flow
= 1.833 x 10
Annuity factor calculation
The annuity factor for 'n' periods at a periodic yield of 'r' is calculated as:
AF(n,r) = (1 - (1 + r)-n ) / r
n = number of periods
periodic cost of capital.
Example 2: Annuity factor calculation
When the periodic cost of capital (r) = 6%,
and the number of periods in the total time under review (n) = 2.
Annuity factor is:
= (1 - (1 + r)-n ) / r
= (1 - 1.06-2 ) / r
This figure is also the sum of the related Discount Factors (DF):
AF2 = DF1 + DF2
= 1.06-1 + 1.06-2
= 0.9434 + 0.8900
Annuity factors are also used to calculate equated loan instalments.
For a loan drawn down in full at the start, the equated loan instalment is given by:
Instalment = Principal/Annuity factor
Example 3: Loan instalment
$20m is borrowed at an annual interest rate of 6%.
The loan is to be repaid in two equal annual instalments, starting one year from now.
The annuity factor is 1.833 (as before).
The loan instalment is:
20 / 1.833
The Annuity Factor is sometimes also known as the Annuity formula.
An annuity factor is a special case of a cumulative discount factor (CumDF).
Ever decreasing circles - using annuity factors to unlock circularity in loan instalments, The Treasurer