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Assume two annuities will each provide $500 annual cash flows for 5 years. One is an...

Assume two annuities will each provide $500 annual cash flows for 5 years. One is an ordinary annuity and the other is an annuity due. Which statement concerning these annuities is correct?

Multiple Choice

The ordinary annuity will have the highest value at the end of Year 4.

The annuity due is more valuable than the ordinary annuity.

The ordinary annuity will pay on the first day of each time period.

The annuity due will pay one more payment than the ordinary annuity.

Both annuities are of equal value given any positive discount rate.

Solutions

Expert Solution

  • ?Ordinary annuity is one in which the inflow or outflow of cash fall due for payment at the end of each period. Appropriate for payments
    example: Housing loan, payment of mortgage, coupon bearing bonds, etc.
  • Annuity due is described as the series of cash flows occurring at the beginning of each period.Appropriate for receipts
    example: Rental lease payments, life insurance premium, etc.
  • Since payments are made sooner with an annuity due than with an ordinary annuity, an annuity due typically has a higher present value than an ordinary annuity. Hence option 2 is correct "The annuity due is more valuable than the ordinary annuity".
  • Above reason applies for option 5 as well
  • Option 4 is wrong, as the only difference between ordinary annuity and annuity due is when the payment is made and hence both have equal number of payments.
  • Option 3 is wrong. The ordinary annuity will pay on the end of each period.

jeff jeffy answered 2 years ago
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