Class 8: Perpetuities, Canadian Mortgages

COMM 298 Introduction to Finance

Complete Notes
Cornelia Kullmann

Objectives
K Be able to define and work with Perpetuities.
Understand how to calculate PV, CF, or r for a Perpetuity.

K Deepen understanding of relationship between cash flow frequency and

interest rate needed to discount the cash flows.
K The next major goal is to understand how Canadian Mortgages work.
We will:

Determine the monthly payment for a given amount borrowed (PV0)

Calculate the principal outstanding at any given time.
Look at what happens when we refinance a mortgage.
Compute how much of any given payment goes towards payment of interest
and how much is repayment of principal.

Present Value of an Annuity

K For an interest rate r, the present value at t = 0 of an annuity with n
level cash flows A that start at the end of the first period is equal to:
Timeline:
0
1
2
3
4 .
n1 n
Periods
----|------|------|------|------|-------------------------|------|-----A
A
A A
A A
Cash Flows

PV0 =

A
A
A
A
A
+
+
+..........................
+
+
(1+ r)1 (1+ r)2 (1+ r)3
(1+ r)n!1 (1+ r)n

" 1! (1+ r) % A
!n
PV0 = A $
1!
1+
r
=
'
( ) =A
r
#
& r
!n

1
1! ( 1+r
)

) = A "$1! "$
r $#

1 %
'
# 1+ r &

%
''
&

Perpetuities
K A perpetuity is an annuity that is paid in perpetuity, i.e. forever.
K

Timeline:
0
1
2
3
4
5
.
-----|-------|-------|-------|-------|-------|-------|-------|---A
A
A
A
A
.

Periods
Cash Flows

Perpetuity ! n " #

A%
1 (
PV0 (n-year Annuity) = '1$
n*
r & (1+ r) )

1
Then as n " #,
" 0 and
n
(1+ r)
A
PVPerp =
r

Present Value of a Perpetuity

K The present value of an infinite stream of cash flows A that are
made at the end of each period is equal to

A
PV0 =
r
K where r is the effective per period interest rate.
K Another way of seeing this:
By depositing PV0 in the bank today, you can withdraw the Interest
earned at the end of each period (A = PV0*r), leaving the amount
originally invested (PV0) in the bank.

Aside: Preferred Stock

K Preferred Stock
Typically no voting rights.
K Unless corporation has not paid preferred dividends for some time.
Preferential treatment regarding payment of dividends and in case of
liquidation (relative to common stock).
Fixed-Rate Preferred Stock pays a fixed cash dividend each period.

K Preferred Stock is often treated (and valued) as a perpetuity.

Perpetuity Example
K You want to endow an annual graduation party at your university.
You would like to budget $50,000 per year in perpetuity. If the
university earns 5% on its investments and the first party is going to
be one year from now, how much money will you have to donate
today?
K Timeline:
K
0
1
2
3

Periods
K -----|----------|----------|----------|--------------K
50k
50k
50k .
Cash Flows

50, 000
PV 0 =
= $1, 000, 000
0.05
7

iClicker Example: Perpetuity Due

K You want to endow an annual graduation party at your university.
Suppose you want the event to be memorable, so you would like to
budget $50,000 per year in perpetuity. If the university earns 5% on
its investments and the first party is going to be today, how much
money will you have to donate today?
a)
b)
c)
d)
e)

$1,000,000.00
$1,050,000.00
$ 952,380.95
$1,100,000.00
None of the above

Correct answer is b)

50, 000
50, 000
PV0 =
(1+ 0.05) = 50, 000 +
= $1, 050, 000
0.05
0.05
8

In General: PV of a Perpetuity Due

K What is the present value of an infinite stream of cash flows A that
are made at the beginning of each period (i.e. they start
immediately)?
Timeline:
0
1
2
3
4
5 . Periods
-----|------|------|------|------|------|-----A
A
A
A A
A Cash Flows

A
A rA A
PV0 = + A = +
= (1+ r)
r
r r
r

K The last formula shows the same pattern we observed for annuities.
The value of an annuity due is (1+r)*(Value of regular annuity).
Because interest is earned/paid one period sooner than for a regular
annuity.

Perpetuity vs. Long Annuity

K Consider a perpetuity that pays $1,000 at the end of each period
forever.
When r = 10%, the PV of this perpetuity is equal to

1,000
= 10,000
0.1
K Compare this to the present value of a 99-year annuity of $1,000 per
year (first payment at the end of the year).
PV =

For r = 10%, the present value is equal to

1 1.1199
= $9999.20
PV = 1,000 *
0.1

The difference is only $0.80!

K Thats because the interest rate is pretty high.
What happens if the interest rate is 1% instead of 10%?
$100,000 vs. $62,659.17
10

Cash Flow Frequency and Compounding Frequency

K The annuity cash flow frequency determines the effective interest
rate you have to use for compounding or discounting.
If we have annual cash flows, we need to use an effective annual
interest rate (EAR) rYr.
If we have semi-annual cash flows, we have to use an effective semiannual interest rate rsemi.
With monthly cash flows, we would need an effective monthly interest
rate rmo.

K The annuity cash flow frequency also determines the units that n is
in (i.e. the length of one period).
With semi-annual cash flow, n has to be equal to the number of sixmonths periods over which the annuity is paid, which is equal to the
number of cash flows of the annuity. .
With monthly cash flows, n has to be equal to the number of months
over which the annuity is paid, which again equals the number of
annuity payments.
11

Exercise: Matching Interest Rates to Cash Flows

Consider the following four annuities:

PV0 =

A
1! (1+ r)!n )
(
r

a) Annuity of $100 per year for four years starting at the end of this year. The
interest rate is 10% per year compounded annually.
A = 100

ryr = 10%,

n=4

rsemi = 5% => ryr = 10.25%

n=4

ryr = 10% => rsemi = 4.88%

n=8

rsemi = 5%

n=8

PV0 = $316.99

b) Annuity of $100 per year for four years starting at the end of this year. The
interest rate is 10% per year compounded semi-annually.
A = 100

c)

PV0 = $315.28

Annuity of $50 every six months for four years starting at the end of the first
period. The interest rate is 10% per year.
A = 50

PV0 = $324.73

d) Annuity of $50 every six months for four years starting at the end of the first
period. Interest rate is 10% compounded semi-annually.
A = 50

PV0 = $323.16
12

Matching Interest Rates to Cash Flows

a)

b)

c)

d)

A = 100
rYr = 10%,
n=4
PV0 = $316.99
0
1
2
3
4
Years
--|--------------------|--------------------|--------------------|--------------------|--100
100
100
100
A = 100
isemi = 10% (=> rYr = 10.25%)
n=4
PV0 = $315.28
0
1
2
3
4
Years
--|--------------------|--------------------|--------------------|--------------------|--100
100
100
100
CFs
A = 50
rYr = 10% => rsemi = 4.88%
n=8
PV0= $324.73
0
1
2
3
4
5
6
7
8
Periods
--|----------|----------|----------|----------|----------|----------|----------|----------|--- (6-months)
50
50
50
50
50
50
50
50
CFs
A = 50
isemi = 10% => rsemi = 5%
n=8
PV0= $323.16
0
1
2
3
4
5
6
7
8
Periods
--|----------|----------|----------|----------|----------|----------|----------|----------|--- (6-months)
50
50
50
50
50
50
50
50
CFs
13

Matching Interest Rates to Cash Flows (a)

K

Annuity of $100 per year for four years starting at the end of this year.
Interest rate is 10% compounded annually.
Timeline:
0
1
2
3
4
Years
--------|------------|------------|------------|------------|------100
100
100
100 CFs

" 1! (1+ r)!n %

PV0 = A $
' where A = 100, n = 4, r = 10%
r
#
&
" 1! (1.1)!4 %
( PV0 = 100 $
' = 316.99
# 0.1 &

14

Matching Interest Rates to Cash Flows (b)

(b) Annuity of $100 per year for four years starting at the end of this year.
Interest rate is 10% compounded semi-annually.
Timeline:
0
1
2
3
4
Years
--------|------------|------------|------------|------------|------100
100
100
100

1 (1 + r ) n
where A = 100, n = 4, r = ?
PV0 = A
r

rYr = (1 + rsemi ) 1 = 10.25%

1 (1.1025) 4
= 315.28
PV0 = 100
0.1025
15

Matching Interest Rates to Cash Flows (c)

(c) Annuity of $50 every 6 months for four years starting at the end of the
first period
Interest rate is 10% compounded annually.
Timeline: 0 1
2
3
4
5
6
7
8 Periods
0
1
2
3
4
Years
--------|------|------|------|------|------|------|------|------|------50 50 50 50 50 50 50 50

1 (1 + r ) n
where A = 50, n = 8, r = ?
PV0 = A
r

1
2

rsemi = (1 + rYr ) 1 = 4.88%

1 (1.0488) 8
= 324.73
PV0 = 50
0.0488

16

Matching Interest Rates to Cash Flows (d)

(d) Annuity of $50 every 6 months for four years starting at the end of the
first period
Interest rate is 10% compounded semi-annually.
Timeline: 0 1
2
3
4
5
6
7
8 Periods
0
1
2
3
4
Years
--------|------|------|------|------|------|------|------|------|------50 50 50 50 50 50 50 50

1 (1 + r ) n
where A = 50, n = 8, r = ?
PV0 = A
r

10%
= 5%
isemi = 10% rsemi =
2
1 (1.05) 8
= 323.16
PV0 = 50
0.05

17

Canadian Mortgages

COMM 298 Introduction to Finance

Cornelia Kullmann

18

Canadian Mortgages
K A typical mortgage in Canada is a closed 5-year fixed rate mortgage
with an amortization period of 25 years.
K Mortgage payments are typically monthly, so there are 300 payments.
K Canadian financial regulations require mortgage rates to be quoted
with semi-annual compounding.
Mortgage rates are APRs (i.e. isemi)

19

Canadian Mortgages Continued

K Explanation of terms:
Open vs. Closed Mortgage:
K With a closed mortgage, you pay a penalty when you want to
terminate your mortgage early (if you want to sell, for example).
K Open mortgages can be repaid any time.
Mortgage Term: Period over which payments are fixed.
K A fixed rate mortgage is one in which the interest rate is fixed for the
term of mortgage.
K A flexible rate mortgage also has fixed payments, but when market
interest rates change, more or less of each payment goes to interest
payments while the remainder reduces the mortgage principal
outstanding.
Amortization Period: Period over which mortgage is assumed to be paid
off (in Canada typically longer than the term of the mortgage).
K You calculate the payments by using the interest rate that is fixed for 5
years, but pretending that it is amortized (paid down) over 25 years.
20