Present Value of a Growing Annuity
Growing annuities are payment plans in which the payouts increase by a fixed percent each period. The present value of a growing annuity (PVGA) is the current monetary value of the annuity. For instance, suppose it is January 1, 1999 and you will receive a payment on January 1 for the next five years. Each passing year the payments increase by 2%. Your payments are thus:
Jan 1, 2000: $1250
Jan 1, 2001: $1275
Jan 1, 2002: $1300.50
Jan 1, 2003: $1326.51
Jan 1, 2004: $1353.04
Imagine you could invest each payment into an account that earns 4% interest per year, then on Jan 1, 2004 you would have
$1250(1.044) + $1275(1.043) + $1300.50(1.042) + 1326.51(1.04) + 1353.04
But if you were given $5782.88 right now, and you invested it in an account that earned 4% annually, then on Jan 1, 2004 you would also have
$5782.88(1.045) = $7035.76.
This means that $5782.88 is the present value of the annuity. Rather than work the arithmetic out by hand with large sums, you can use a more compact formula, or use the calculator above.
PVGA FormulaLet P be the amount of the initial payment, N be the number of payments, g be the growth rate (decimal), and r be the annual percentage rate (decimal). Then the future value is computed with the equation
PV = P[1 - (1+g)N(1+r)-N]/(r-g)
In case r = g, the formula is
PV = PN/(1+r)
ExampleYou will be given annual payments for the next ten years starting a year from now. The first payment will be $1000, and each passing year it will increase by 3.4%. Assuming you could invest the money in an account that bears 3.4% annual interest, what is the present value of this growing annuity?
Here we have P = 1000, N = 10, r = 0.034, and g = 0.034. Since r = g in this example, we must use the second formula. Therefore the present value of this growing annuity is
1000(10)/(1.034) = $9671.18
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