What is the 'Present Value Interest Factor Of Annuity - PVIFA'
The present value interest factor of annuity (PVIFA) is a factor which can be used to calculate the present value of a series of annuities. The initial deposit earns interest at the periodic rate (r), which perfectly finances a series of (N) consecutive dollar withdrawals and may be written as the following formula:
PVIFA = (1 - (1 + r)^-N)/r
BREAKING DOWN 'Present Value Interest Factor Of Annuity - PVIFA'
The calculation of PVIFA is based around the concept of the time value of money. This idea stipulates that the value of currency received today is worth more than the value of currency received at a future date. This is because the currency received today may be invested and generate interest.
The most common values of both N and r can be found in a PVIFA table, which immediately shows the value of PVIFA. This table is a particularly useful tool for comparing different scenarios with variable N and r values. The rate is displayed across the top row of the table while the number of periods is displayed in the first column. The cell in the PVIFA table that corresponds to the appropriate row and column indicates the present value factor. This factor is multiplied against the dollar amount in question to arrive at the present value. The major drawback of a present value interest factor table is the necessity to round calculated figures which sacrifices precision.
The Usefulness of the Present Value Interest Factor of an Annuity
The present value interest factor of an annuity is useful in the determination of whether to take a lump sum payment now or accept an annuity payment in future periods. Using estimated rates of return, the value of the annuity payments may be compared to the lump sum. The present value interest factor may only be calculated if the annuity payments are for a predetermined amount spanning a predetermined range of time.
Use of the Discount Rate
The discount rate used in the present value interest factor calculation approximates the expected rate of return for future periods. It is adjusted for risk based on the duration of the annuity payments and the investment vehicle utilized. Higher interest rates result in lower net present value calculations. This is because the value of $1 today is diminished if future high returns are anticipated.
Present Value Interest Factor of Annuity Due
If annuity payments are due at the beginning of the period, the series of payments are referred to as an annuity due. To calculate the present value interest factor of an annuity due, take the calculation of the present value interest factor and multiply it by (1+r), with the variable being the discount rate.