Derivation of Useful Shortcuts

Introduction to Corporate Finance

Professor Michael R. Roberts

There are several approaches to deriving the formulas for the present values of an annuity,
growing annuity, perpetuity, and growing perpetuity. I am going to derive the result for a
growing annuity and show that the other three follow immediately from this result. These
derivations are not needed to excel in the course. They are only presented for completeness and
in response to student requests.

Growing Annuity

Recall that a growing annuity is defined as a finite stream of cash flows that grow at a constant
rate g. This stream can be represented visually as follows:

The present value is:

CF (1+ g ) CF (1+ g ) CF (1+ g )

2 T −1
CF
PV = + 2 + + ... + (1)
(1+ R ) (1+ R ) (1+ R ) 3
(1+ R )T
Multiply both sides of equation (1) by (1+R) and move the first cash flow, CF, to the left side of
the equation.

CF (1+ g ) CF (1+ g ) CF (1+ g )

2 T −1

PV (1+ R ) − CF = + + ... + (2)

(1+ R ) (1+ R )2
(1+ R )T −1
Divide both sides by CF and use summation notation to get

PV (1+ R ) − CF T −1 ⎛ 1+ g ⎞
t

= ∑⎜ ⎟⎠ (3)
CF ⎝
t =1 1+ R

The right hand side of equation (3) is a partial sum of a geometric series that can be represented
more generally as:

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 N

∑a i (4)
i =1

where

ai = a1r i −1 (5)

Most calculus texts will show that the partial sum defined by (4) and (5) equals

⎛ 1− r N ⎞
a1 ⎜ (6)
⎝ 1− r ⎟⎠

In our setting,

⎛ 1+ g ⎞ ⎛ 1+ g ⎞
N = T − 1, a1 = ⎜ ⎟ ,r = ⎜ (7)
⎝ 1+ R ⎠ ⎝ 1+ R ⎟⎠

Substituting these assumptions into equation (6) yields

⎛ ⎛ 1+ g ⎞ T −1 ⎞
1− ⎜ ⎟
⎛ 1+ g ⎞ ⎜ ⎝ 1+ R ⎠ ⎟
⎜⎝ ⎟ ⎜ ⎟ (8)
1+ R ⎠ ⎜ ⎛ 1+ g ⎞ ⎟
⎜⎝ 1− ⎜⎝ 1+ R ⎟⎠ ⎟⎠

We can simplify this expression with a little algebra to get

T −1
⎛ 1+ g ⎞ ⎛ ⎛ 1+ g ⎞ ⎞
⎜⎝ R − g ⎟⎠ ⎜ ⎜⎝ 1+ R ⎟⎠ ⎟
1− (9)
⎝ ⎠

Substituting equation (9) for the expression on the right hand side of equation (3) give us

PV (1+ R ) − CF ⎛ 1+ g ⎞ ⎛ ⎛ 1+ g ⎞ ⎞
T −1

=⎜ 1− ⎜ ⎟ (10)
CF ⎝ R − g ⎟⎠ ⎜⎝ ⎝ 1+ R ⎠ ⎟⎠

Solving equation (10) for PV and doing a little algebra (see bottom of this note) to simplify
things leads to the formula we presented in a class:
−T
CF ⎛ ⎛ 1+ g ⎞ ⎞ CF ⎛ ⎛ 1+ R ⎞ ⎞
T

PV = 1− ⎜ ⎟ = ⎜ 1− ⎟ (11)
R − g ⎜⎝ ⎝ 1+ R ⎠ ⎟⎠ R − g ⎝ ⎜⎝ 1+ g ⎟⎠ ⎠

Note: Equation (11) is valid R > g and when R < g. It is not defined when R = g. When R = g, the
present value of the annuity is simply:

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 T
PV = CF × (12)
(1+ R )
When R = g, the growth and discounting cancel. I.e., the cash flows are growing at the same rate
at which we are discounting them.

Annuity

For a non-growing annuity, set g = 0 in equation (11) to get

⎛ ⎛ 1 ⎞ T ⎞ CF
PV =
CF
R ⎝ ⎠
(
⎜ 1− ⎜⎝ 1+ R ⎟⎠ ⎟ = R 1− (1+ R )
−T
) (13)

Growing Perpetuity

For a growing perpetuity, let Tà ∞ in equation (11) to get

CF
PV = (14)
R−g

Perpetuity

Finally, for a non-growing perpetuity, set g = 0 in equation (14) to get

CF
PV = (15)
R

For those of you who don’t see the algebra needed to move from equation (10) to (11), here is a
tedious but hopefully somewhat clear step-by-step derivation. (I’m not shooting for elegance
here, only ease of understanding for those whose math skills are a little rusty.)

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 PV (1+ R ) − CF ⎛ 1+ g ⎞ ⎛ ⎛ 1+ g ⎞ ⎞
T −1

=⎜ 1− ⎜ ⎟
CF ⎝ R − g ⎟⎠ ⎜⎝ ⎝ 1+ R ⎠ ⎟⎠
T −1
CF CF ⎛ 1+ g ⎞ ⎛ ⎛ 1+ g ⎞ ⎞
PV = + ⎜ ⎟ 1− ⎜ ⎟
1+ R R − g ⎝ 1+ R ⎠ ⎜⎝ ⎝ 1+ R ⎠ ⎟⎠

CF ⎛ ⎛ 1+ g ⎞ ⎛ 1+ g ⎞ ⎞
T
CF
PV = + ⎜ ⎟ −⎜ ⎟
1+ R R − g ⎜⎝ ⎝ 1+ R ⎠ ⎝ 1+ R ⎠ ⎟⎠
T
CF CF ⎛ 1+ g ⎞ CF ⎛ 1+ g ⎞ CF CF
PV = + ⎜⎝ ⎟⎠ − ⎜⎝ ⎟⎠ + −
1+ R R − g 1+ R R − g 1+ R R−g R−g
CF ⎛ ⎛ 1+ g ⎞ ⎞ CF
T
CF ⎛ 1+ g ⎞ CF
PV = ⎜ 1− ⎜ ⎟⎠ ⎟ + + ⎜⎝ ⎟⎠ −
R−g⎝ ⎝ 1+ R ⎠ 1+ R R − g 1+ R R−g

CF ⎛ ⎛ 1+ g ⎞ ⎞ ⎛ 1 1 ⎞
T
1+ g
PV = ⎜ 1− ⎜ ⎟ ⎟ + CF ⎜ + −
R − g ⎝ ⎝ 1+ R ⎠ ⎠ ⎝ 1+ R (R − g ) (1+ R ) R − g ⎟⎠
CF ⎛ ⎛ 1+ g ⎞ ⎞ ⎛ ⎞
T
R−g 1+ g 1+ R
PV = ⎜ 1− ⎜⎝ ⎟⎠ ⎟ + CF ⎜ + −
R−g⎝ 1+ R ⎠ ⎝ (1+ R ) (R − g ) (R − g ) (1+ R ) (R − g ) (1+ R ) ⎟⎠
CF ⎛ ⎛ 1+ g ⎞ ⎞ ⎛ R − g + 1+ g − 1− R ⎞
T

PV = 1− ⎜ ⎟ + CF
R − g ⎜⎝ ⎝ 1+ R ⎠ ⎟⎠ ⎜⎝ (1+ R ) (R − g ) ⎟⎠

CF ⎛ ⎛ 1+ g ⎞ ⎞ ⎛ ⎞
T
0
PV = ⎜ 1− ⎜ ⎟ ⎟ + CF ⎜
R − g ⎝ ⎝ 1+ R ⎠ ⎠ ⎝ (1+ R ) (R − g ) ⎟⎠
CF ⎛ ⎛ 1+ g ⎞ ⎞
T

PV = 1− ⎜ ⎟
R − g ⎜⎝ ⎝ 1+ R ⎠ ⎟⎠

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