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Annuity Due: Definition, Calculation, Formula, and Examples

Written by admin. Posted in A, Financial Terms Dictionary

Annuity Due: Definition, Calculation, Formula, and Examples

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What Is Annuity Due?

An annuity due is an annuity whose payment is due immediately at the beginning of each period. A common example of an annuity due payment is rent, as landlords often require payment upon the start of a new month as opposed to collecting it after the renter has enjoyed the benefits of the apartment for an entire month.

Key Takeaways

  • Annuity due is an annuity whose payment is due immediately at the beginning of each period.
  • Annuity due can be contrasted with an ordinary annuity where payments are made at the end of each period.
  • A common example of an annuity due payment is rent paid at the beginning of each month.
  • An example of an ordinary annuity includes loans, such as mortgages.
  • The present and future value formulas for an annuity due differ slightly from those for an ordinary annuity as they account for the differences in when payments are made.

How Annuity Due Works

An annuity due requires payments made at the beginning, as opposed to the end, of each annuity period. Annuity due payments received by an individual legally represent an asset. Meanwhile, the individual paying the annuity due has a legal debt liability requiring periodic payments.

Because a series of annuity due payments reflect a number of future cash inflows or outflows, the payer or recipient of the funds may wish to calculate the entire value of the annuity while factoring in the time value of money. One can accomplish this by using present value calculations.

A present value table for an annuity due has the projected interest rate across the top of the table and the number of periods as the left-most column. The intersecting cell between the appropriate interest rate and the number of periods represents the present value multiplier. Finding the product between one annuity due payment and the present value multiplier yields the present value of the cash flow.

A whole life annuity due is a financial product sold by insurance companies that require annuity payments at the beginning of each monthly, quarterly, or annual period, as opposed to at the end of the period. This is a type of annuity that will provide the holder with payments during the distribution period for as long as they live. After the annuitant passes on, the insurance company retains any funds remaining.

Income payments from an annuity are taxed as ordinary income.

Annuity Due vs. Ordinary Annuity

An annuity due payment is a recurring issuance of money upon the beginning of a period. Alternatively, an ordinary annuity payment is a recurring issuance of money at the end of a period. Contracts and business agreements outline this payment, and it is based on when the benefit is received. When paying for an expense, the beneficiary pays an annuity due payment before receiving the benefit, while the beneficiary makes ordinary due payments after the benefit has occurred.

The timing of an annuity payment is critical based on opportunity costs. The collector of the payment may invest an annuity due payment collected at the beginning of the month to generate interest or capital gains. This is why an annuity due is more beneficial for the recipient as they have the potential to use funds faster. Alternatively, individuals paying an annuity due lose out on the opportunity to use the funds for an entire period. Those paying annuities thus tend to prefer ordinary annuities.

Examples of Annuity Due

An annuity due may arise due to any recurring obligation. Many monthly bills, such as rent, car payments, and cellphone payments, are annuities due because the beneficiary must pay at the beginning of the billing period. Insurance expenses are typically annuities due as the insurer requires payment at the start of each coverage period. Annuity due situations also typically arise relating to saving for retirement or putting money aside for a specific purpose.

How to Calculate the Value of an Annuity Due

The present and future values of an annuity due can be calculated using slight modifications to the present value and future value of an ordinary annuity.

Present Value of an Annuity Due

The present value of an annuity due tells us the current value of a series of expected annuity payments. In other words, it shows what the future total to be paid is worth now.

Calculating the present value of an annuity due is similar to calculating the present value of an ordinary annuity. However, there are subtle differences to account for when annuity payments are due. For an annuity due, payments are made at the beginning of the interval, and for an ordinary annuity, payments are made at the end of a period. The formula for the present value of an annuity due is:

Present Value of Annuity Due.
Investopedia 

With:

  • C = Cash flows per period
  • i = interest rate
  • n = number of payments

Let’s look at an example of the present value of an annuity due. Suppose you are a beneficiary designated to immediately receive $1000 each year for 10 years, earning an annual interest rate of 3%. You want to know how much the stream of payments is worth to you today. Based on the present value formula, the present value is $8,786.11.

Present Value of an Annuity Due.
Investopedia 

Future Value of an Annuity Due

The future value of an annuity due shows us the end value of a series of expected payments or the value at a future date.

Just as there are differences in how the present value is calculated for an ordinary annuity and an annuity due, there are also differences in how the future value of money is calculated for an ordinary annuity and an annuity due. The future value of an annuity due is calculated as:

Future Value of an Annuity Due.
 Investopedia

Using the same example, we calculate that the future value of the stream of income payments to be $11,807.80.

Future Value of an Annuity Due.
Investopedia

Annuity Due FAQs

Which Is Better, Ordinary Annuity or Annuity Due?

Whether an ordinary annuity or an annuity due is better depends on whether you are the payee or payer. As a payee, an annuity due is often preferred because you receive payment up front for a specific term, allowing you to use the funds immediately and enjoy a higher present value than that of an ordinary annuity. As a payer, an ordinary annuity might be favorable as you make your payment at the end of the term, rather than the beginning. You are able to use those funds for the entire period before paying.

Often, you are not afforded the option to choose. For example, insurance premiums are an example of an annuity due, with premium payments due at the beginning of the covered period. A car payment is an example of an ordinary annuity, with payments due at the end of the covered period.

What Is an Immediate Annuity?

An immediate annuity is an account, funded with a lump sum deposit, that generates an immediate stream of income payments. The income can be for a stated amount (e.g., $1,000/month), a stated period (e.g., 10 years), or a lifetime.

How Do You Calculate the Future Value of an Annuity Due?

The future value of an annuity due is calculated using the formula:

Future Value of an Annuity Due.
 Investopedia

where

  • C = cash flows per period
  • i = interest rate
  • n = number of payments

What Does Annuity Mean?

An annuity is an insurance product designed to generate payments immediately or in the future to the annuity owner or a designated payee. The account holder either makes a lump sum payment or a series of payments into the annuity and can either receive an immediate stream of income or defer receiving payments until some time in the future, usually after an accumulation period where the account earns interest tax-deferred.

What Happens When an Annuity Expires?

Once an annuity expires, the contract terminates and no future payments are made. The contractual obligation is fulfilled, with no further duties owed from either party.

The Bottom Line

An annuity due is an annuity with payment due or made at the beginning of the payment interval. In contrast, an ordinary annuity generates payments at the end of the period. As a result, the method for calculating the present and future values differ. A common example of an annuity due is rent payments made to a landlord, and a common example of an ordinary annuity includes mortgage payments made to a lender. Depending on whether you are the payer or payee, the annuity due might be a better option.

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Average Daily Balance Method: Definition and Calculation

Written by admin. Posted in A, Financial Terms Dictionary

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What is the Average Daily Balance Method?

The average daily balance is a common accounting method that calculates interest charges by considering the balance invested or owed at the end of each day of the billing period, rather than the balance invested or owed at the end of the week, month, or year.

Key Takeaways

  • Interest charges are calculated using the total amount due at the end of each day.
  • The average daily balance credits a customer’s account from the day the credit card company receives a payment.
  • Interest charges using the average daily balance method should be lower than the previous balance method and higher than the less common adjusted balance method.

Understanding the Average Daily Balance Method

The federal Truth-In-Lending-Act (TILA) requires lenders to disclose their method of calculating finance charges, as well as annual percentage rates (APR), fees, and other terms, in their terms and conditions statement. Providing these details makes it easier to compare different credit cards.

TILA permits the interest owed on credit card balances to be calculated in various different ways. The most common methods are:

  • Average daily balance method: Uses the balance on each day of the billing cycle, rather than an average balance throughout the billing cycle, to calculate finance charges.
  • Previous balance method: Interest charges are based on the amount owed at the beginning of the previous month’s billing cycle.
  • Adjusted balance method: Bases finance charges on the amount(s) owed at the end of the current billing cycle after credits and payments have been posted.

Important

An investor must understand how an institution’s choice of accounting methods used to calculate interest affect the amount of interest deposited into his or her account.

How the Average Daily Balance Method Works

The average daily balance totals each day’s balance for the billing cycle and divides by the total number of days in the billing cycle. Then, the balance is multiplied by the monthly interest rate to assess the customer’s finance charge—dividing the cardholder’s APR by 12 calculates the monthly interest rate. However, if the lender or card issuer uses a method that compounds interest daily, the interest associated with the day’s ending balance gets added to the next day’s beginning balance. This will result in higher interest charges and the reader should confirm which method is being used.

The average daily balance credits a customer’s account from the day the credit card company receives a payment. To assess the balance due, the credit card issuer sums the beginning balance for each day in the billing period and subtracts any payments as they arrive and any credits made to the customer’s account that day.

Cash advances are usually included in the average daily balance. The total balance due may fluctuate daily because of payments and purchases.

Average Daily Balance Method Example

A credit card has a monthly interest rate of 1.5 percent, and the previous balance is $500. On the 15th day of a billing cycle, the credit card company receives and credits a customer’s payment of $300. On the 18th day, the customer makes a $100 purchase.

The average daily balance is ((14 x 500) + (3 x 200) + (13 x 300)) / 30 = (7,000 + 600 + 3,900) / 30 = 383.33. The bigger the payment a customer pays and the earlier in the billing cycle the customer makes a payment, the lower the finance charges assessed. The denominator, 30 in this example, will vary based on the number of days in the billing cycle for a given month.

Average Daily Balance Method Vs. Adjusted Balance Method Vs. Previous Balance Method

Interest charges using the average daily balance method should be lower than the previous balance method, which charges interest based on the amount of debt carried over from the previous billing cycle to the new billing cycle. On the other hand, the average daily balance method will likely incur higher interest charges than the adjusted balance method because the latter bases finance charges on the current billing period’s ending balance.

Card issuers use the adjusted balance method much less frequently than either the average daily balance method or the previous balance method.

Special Considerations

Some credit card companies previously used the double-cycle billing method, assessing a customer’s average daily balance over the last two billing cycles.

Double-cycle billing can add a significant amount of interest charges to customers whose average balance varies greatly from month to month. The Credit CARD Act of 2009 banned double-cycle billing on credit cards.

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Accounting Rate of Return (ARR): Definition, How to Calculate, and Example

Written by admin. Posted in A, Financial Terms Dictionary

Accounting Rate of Return (ARR): Definition, How to Calculate, and Example

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What Is the Accounting Rate of Return (ARR)?

The accounting rate of return (ARR) is a formula that reflects the percentage rate of return expected on an investment or asset, compared to the initial investment’s cost. The ARR formula divides an asset’s average revenue by the company’s initial investment to derive the ratio or return that one may expect over the lifetime of an asset or project. ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining a business.

Key Takeaways

  • The accounting rate of return (ARR) formula is helpful in determining the annual percentage rate of return of a project.
  • ARR is calculated as average annual profit / initial investment.
  • ARR is commonly used when considering multiple projects, as it provides the expected rate of return from each project.
  • One of the limitations of ARR is that it does not differentiate between investments that yield different cash flows over the lifetime of the project.
  • ARR is different than the required rate of return (RRR), which is the minimum return an investor would accept for an investment or project that compensates them for a given level of risk.

Understanding the Accounting Rate of Return (ARR)

The accounting rate of return is a capital budgeting metric that’s useful if you want to calculate an investment’s profitability quickly. Businesses use ARR primarily to compare multiple projects to determine the expected rate of return of each project, or to help decide on an investment or an acquisition.

ARR factors in any possible annual expenses, including depreciation, associated with the project. Depreciation is a helpful accounting convention whereby the cost of a fixed asset is spread out, or expensed, annually during the useful life of the asset. This lets the company earn a profit from the asset right away, even in its first year of service.

The Formula for ARR

The formula for the accounting rate of return is as follows:


A R R = A v e r a g e A n n u a l P r o f i t I n i t i a l I n v e s t m e n t ARR = \frac{Average\, Annual\, Profit}{Initial\, Investment}
ARR=InitialInvestmentAverageAnnualProfit

How to Calculate the Accounting Rate of Return (ARR)

  1. Calculate the annual net profit from the investment, which could include revenue minus any annual costs or expenses of implementing the project or investment.
  2. If the investment is a fixed asset such as property, plant, and equipment (PP&E), subtract any depreciation expense from the annual revenue to achieve the annual net profit.
  3. Divide the annual net profit by the initial cost of the asset or investment. The result of the calculation will yield a decimal. Multiply the result by 100 to show the percentage return as a whole number.

Example of the Accounting Rate of Return (ARR)

As an example, a business is considering a project that has an initial investment of $250,000 and forecasts that it would generate revenue for the next five years. Here’s how the company could calculate the ARR:

  • Initial investment: $250,000
  • Expected revenue per year: $70,000
  • Time frame: 5 years
  • ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
  • ARR = 0.28 or 28%

Accounting Rate of Return vs. Required Rate of Return

The ARR is the annual percentage return from an investment based on its initial outlay of cash. Another accounting tool, the required rate of return (RRR), also known as the hurdle rate, is the minimum return an investor would accept for an investment or project that compensates them for a given level of risk.

The required rate of return (RRR) can be calculated by using either the dividend discount model or the capital asset pricing model.

The RRR can vary between investors as they each have a different tolerance for risk. For example, a risk-averse investor likely would require a higher rate of return to compensate for any risk from the investment. It’s important to utilize multiple financial metrics including ARR and RRR to determine if an investment would be worthwhile based on your level of risk tolerance.

Advantages and Disadvantages of the Accounting Rate of Return (ARR)

Advantages

The accounting rate of return is a simple calculation that does not require complex math and is helpful in determining a project’s annual percentage rate of return. Through this, it allows managers to easily compare ARR to the minimum required return. For example, if the minimum required return of a project is 12% and ARR is 9%, a manager will know not to proceed with the project.

ARR comes in handy when investors or managers need to quickly compare the return of a project without needing to consider the time frame or payment schedule but rather just the profitability or lack thereof.

Disadvantages

Despite its advantages, ARR has its limitations. It doesn’t consider the time value of money. The time value of money is the concept that money available at the present time is worth more than an identical sum in the future because of its potential earning capacity.

In other words, two investments might yield uneven annual revenue streams. If one project returns more revenue in the early years and the other project returns revenue in the later years, ARR does not assign a higher value to the project that returns profits sooner, which could be reinvested to earn more money.

The time value of money is the main concept of the discounted cash flow model, which better determines the value of an investment as it seeks to determine the present value of future cash flows.

The accounting rate of return does not consider the increased risk of long-term projects and the increased uncertainty associated with long periods.

Also, ARR does not take into account the impact of cash flow timing. Let’s say an investor is considering a five-year investment with an initial cash outlay of $50,000, but the investment doesn’t yield any revenue until the fourth and fifth years.

In this case, the ARR calculation would not factor in the lack of cash flow in the first three years, while in reality, the investor would need to be able to withstand the first three years without any positive cash flow from the project.

Pros

  • Determines a project’s annual rate of return

  • Simple comparison to minimum rate of return

  • Ease of use/Simple Calculation

  • Provides clear profitability

Cons

  • Does not consider the time value of money

  • Does not factor in long-term risk

  • Does not account for cash flow timing

How Does Depreciation Affect the Accounting Rate of Return?

Depreciation will reduce the accounting rate of return. Depreciation is a direct cost and reduces the value of an asset or profit of a company. As such, it will reduce the return of an investment or project like any other cost.

What Are the Decision Rules for Accounting Rate of Return?

When a company is presented with the option of multiple projects to invest in, the decision rule states that a company should accept the project with the highest accounting rate of return as long as the return is at least equal to the cost of capital.

What Is the Difference Between ARR and IRR?

The main difference between ARR and IRR is that IRR is a discounted cash flow formula while ARR is a non-discounted cash flow formula. A non-discounted cash flow formula does not take into consideration the present value of future cash flows that will be generated by an asset or project. In this regard, ARR does not include the time value of money whereby the value of a dollar is worth more today than tomorrow because it can be invested.

The Bottom Line

The accounting rate of return (ARR) is a simple formula that allows investors and managers to determine the profitability of an asset or project. Because of its ease of use and determination of profitability, it is a handy tool in making decisions. However, the formula does not take into consideration the cash flows of an investment or project, the overall timeline of return, and other costs, which help determine the true value of an investment or project.

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Assessed Value: Definition, How It’s Calculated, and Example

Written by admin. Posted in A, Financial Terms Dictionary

Assessed Value: Definition, How It's Calculated, and Example

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Assessed value is the dollar value assigned to a home or other piece of real estate for property tax purposes. It takes into account the value of comparable properties in the area, among other factors. In many cases, the assessed value is calculated as a percentage of the fair market value of the property.

Key Takeaways

  • Assessed value is the dollar value assigned to a home or other piece of real estate for property tax purposes.
  • It takes into consideration comparable home sales, location, and other factors.
  • Assessed value is not the same as fair market value (what the property could sell for) but is often based on a percentage of it.
  • Some states also tax personal property, such as cars and boats, and assign an assessed value to those as well.

Understanding Assessed Value

The assessed value of real estate or other property is only used for determining the applicable property tax, also known as an ad valorem tax. A government assessor is responsible for assigning the assessed value and for updating it periodically.

Government assessors are usually designated by specified tax districts, and each district may have different procedures for calculating assessed value. However, the basic process is largely the same.

Assessed value takes into account the overall quality and condition of the property, local property values, square footage, home features, and market conditions. Many of these judgments are based on computerized real estate data for that neighborhood and the surrounding area.

Depending on the state and locality, assessors may be required to personally visit properties periodically for assessment purposes. Owners who want to dispute the assessed value placed on their property can request a reassessment, which is a second evaluation of the property.

Assessed value may be lower for a property if you are an owner-occupant as opposed to a landlord (this is sometimes called a homestead exemption). That doesn’t affect the market value of the property but can reduce your property tax bill.

How Is Assessed Value Determined?

In most states and municipalities, assessed value is calculated as a percentage of the property’s fair market value. That percentage can vary considerably from one place to another.

Mississippi, for example, has one of the lowest ratios in the nation for owner-occupied single-family homes, at 10%. Massachusetts has one of the highest assessment ratios, at 100%.

How Are Property Taxes Calculated?

The assessed value of your home is only one factor used to determine your property taxes.

To calculate property tax, most assessors use an equation like the following, which typically includes a millage rate, or tax rate:

Fair Market Value × Assessment Ratio × Millage Rate = Effective Property Tax

The millage rate is the tax rate applied to the assessed value of the property. Millage rates are typically expressed per $1,000, with one mill representing $1 in tax for every $1,000 of assessed value.

So, for example, a house with a fair market value of $300,000 in an area that uses a 50% assessment ratio and a mill rate of 20 mills would have an annual property tax of $3,000 ($300,000 × 0.50 = $150,000; $150,000 × 0.02 = $3,000).

In addition to real estate, many states impose a tax on certain personal property, which is also usually based on the property’s assessed value. That can include mobile homes, cars, motorcycles, and boats. Those rates can vary widely as well, depending on where you live.

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