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An annuity is a special kind of cash flow, a special pattern of cash flow. In an annuity, the person who is the beneficiary gets a certain amount of money per year for a given period of time. This means that the person has a guaranteed cash flow for that time period.
Typically, an annuity is used as a way of financing a person's retirement.
In financial management texts, formulas for calculating the values of annuities are typically included. The formulas can tell you, for example, how much you must invest on a yearly basis to assure yourself of a given amount of cash flow from an annuity.
Annuity is fixed sum of money paid every year in at any other fixed interval shorter than a year. This annuity may be by way of return of some principal plus interest payment of against money invested or by way of payment of other dues such as pensions after retirement. In any case it represents out flow of cash from one account to in flow of cash to another account. In this way all annuities involve movements of cash or funds. Therefore all annuities are cash flows that can be suitably represented in cash flow statements.
An annuity will be represented as inflow of cash in the cash flow statement for the recipient of the annuity and out flow of cash in the cash flow statement of the person or firm paying out the annuity.
An annuity is a stream of equal annual cash flows. Annuities involve calculations based upon the regular periodic contribution or receipt of a fixed sum of money.
An example: Say Mr Banda deposits Kw 2,000 at the end of every year for 45 years in his saving account, paying 5% interest compounded annually. Determine the sum of money, he will have at the end of the 5th year.
End of Yr: Amount deposited: Nr:of yrs. compounded:
1 2,000 4
2 2,000 3
3 2,000 2
4 2,000 1
5 2,000 0
Compounded interest factor: Future Sum:
Amount at the end of the 5th year Kw 11,054
Finding the common factor of Kw 2,000
=Kw 2,000 (1.216+1.158+1.103+1.050+1.000)
=Kw 2,000 (5.527)
The above depicts that in order to find the sum of annuity, the annual amount must be multiplied by the sum of the appropriate compound interest factors. Such calculations are available for a wide range of 1 and n. To find the answer to the annuity question of illustration above, we are required to look for the 5% column and the row for five years and multiply the factor by annuity amount of Kw 2000. From the illustration we find that the sum of annuity Re. 1 deposited at the end of each year for 5 years is 5.527(IF). Thus, when multiplied by Kw 2,000 annuity (A) we find the total sum as Kw 11,054,
IF= Represents the appropriate factor for the sum of the annuity of Re.1
Sn= Represents the compound sum of annuity.
Annuity tables are great innovations in the field of investment banking as they guide the depositors and investors as to what sum amount (X) paid for the number of years,n, will accumulate to, at a stated rate of compound interest.
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