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Calculating the Yield of an Annuity
The yield of an annuity is commonly found using either the percent change in the value from PV to FV, or the internal rate of return.
Learning Objective

Calculate the yield of an annuity using the internal rate of return method
Key Points

The yield of an annuity may be found by discounting to find the PV, and then finding the percentage change from the PV to the FV.

The Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment equals 0.

The IRR calculates an annualized yield of an annuity.
Terms

yield
In finance, the term yield describes the amount in cash that returns to the owners of a security. Normally it does not include the price variations, at the difference of the total return. Yield applies to various stated rates of return on stocks (common and preferred, and convertible), fixed income instruments (bonds, notes, bills, strips, zero coupon), and some other investment type insurance products

Internal Rate of Return (IRR)
The discount rate that will cause the NPV of an investment to equal 0.

Net Present Value (NPV)
The present value of a project or an investment decision determined by summing the discounted incoming and outgoing future cash flows resulting from the decision.
Full Text
The yield of annuity can be calculated in similar ways to the yield for a single payment, but two methods are most common.
The first is the standard percentagechange method. Just as for a single payment, this method calculated the percentage difference between the FV and the PV. Since annuities include multiple payments over the lifetime of the investment, the PV (or V_{1} in is the present value of the entire investment, not just the first payment.
The second popular method is called the internal rate of return (IRR). The IRR is the interest rate (or discount rate) that causes the Net Present Value (NPV) of the annuity to equal 0. That means that the PV of the cash outflows equals the PV of the cash inflows. The higher the IRR, the more desirable is the investment. In theory, you should make investment with an IRR greater than the cost of capital.
Let's take an example investment: It is not technically an annuity because the payments vary, but still is a good example for how to find IRR:
Suppose you have a potential investment that would require you to make a $4,000 investment today, but would return cash flows of $1,200, $1,410, $1,875, and $1,050 in the four successive years. This investment has an implicit rate of return, but you don't know what it is. You plug the numbers into the NPV formula and set NPV equal to 0. You then solve for r, which is your IRR (it's not easy to solve this problem by hand. You will likely need to use a business calculator or Excel). When r = 14.3%, NPV = 0, so therefore the IRR of the investment is 14.3%.
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Key Term Reference
 Interest
 Appears in this related concepts: Times Interest Earned Ratio, Interest Compounded Continuously, and Tax Considerations
 annuity
 Appears in this related concepts: Future Value, Multiple Flows, Impact of Payment Frequency on Bond Prices, and Applications and ProblemSolving
 capital
 Appears in this related concepts: Types of Businesses, Issuing Stock, and Architecture
 cash flow
 Appears in this related concepts: Defining the Cash Flow Cycle, The Imperative of Liquidity, and Interpreting Overall Cash Flow
 cash inflow
 Appears in this related concepts: Reporting Financing Activities, Defining NPV, and Calculating the Payback Period
 cash outflow
 Appears in this related concepts: Managing Disbursements, Advantages of the NPV method, and Selected Financial Ratios and Analyses
 cost of capital
 Appears in this related concepts: Evaluating Interest Rates, Advantages of the IRR Method, and Cost of capital
 discount
 Appears in this related concepts: The Discount Rate, Par Value at Maturity, and Present Value, Multiple Flows
 discount rate
 Appears in this related concepts: The Discount Rate, Present Value of Payments, and Factors Affecting the Price of a Bond
 discounting
 Appears in this related concepts: Overview of Merchandising Operations, The Relationship Between Present and Future Value, and ShortTerm Approach
 interest rate
 Appears in this related concepts: SinglePeriod Investment, Why is it Important?, and The Equilibrium Interest Rate
 investment
 Appears in this related concepts: Functions of Corporate Finance, Defining Finance, and Agencies
 net present value
 Appears in this related concepts: Other Considerations in Capital Budgeting, The Role of Financial Managers, and CostBenefit Analysis
 present value
 Appears in this related concepts: Capital Leases versus Operating Leases, Calculating Values for Different Durations of Compounding Periods, and Present Value and the Time Value of Money
 return
 Appears in this related concepts: Dollar Returns, Finance, Economics, and Accounting: Differences and Commonalities, and Disadvantages of the Payback Method
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Cite This Source
Source: Boundless. “Calculating the Yield of an Annuity.” Boundless Finance. Boundless, 20 Jan. 2015. Retrieved 25 Mar. 2015 from https://www.boundless.com/finance/textbooks/boundlessfinancetextbook/thetimevalueofmoney5/yield60/calculatingtheyieldofanannuity2787559/