How to Calculate the Present Value of an Annuity

To calculate the present value of an annuity, each individual cash flow payment to the annuity’s owner has to be discounted to present value terms based on the interest rate used to discount the cash flows (inflation rate plus other risk factors) and the time period until that specific cash flow is to be realized. For example, the present value of a cash flow to be realized a month from now is higher than that of a cash flow expected to be realized in a year. In other words, less has to be invested today in order to receive a certain dollar amount in a year than would have to be invested to receive the same amount in a month.

Using the Formula by Hand

Financial calculators will do the work of discounting back multiple cash flows. However, just to understand how it works, it is good to know the simple formula. To discount a given cash flow to its present value terms, divide the cash flow by (1+discount rate)^the number of periods in the future until the cash flow is received. For example, if the cash flow will be received in 3 payment periods, the cash flow would be divided by (1+discount rate)^3.

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