Corporate Finance

Perpetuities
 Perpetuities

A perpetuity is a series of constant cash-flows

occurring at the end of each period that goes on
forever.

$1000 $1000 $1000 $1000

T=0 1 2 3 4 …etc. →
Present Value of a Perpetuity

➢ What is the present value of a perpetuity paying $1,000

per year, if the interest rate is 8% p.a.?
Present Value of a Perpetuity

$1000 $1000 $1000

…etc. →
T=0 1 2 3
𝐶1 𝐶2 𝐶3
𝑃𝑉 = 1
+ 2
+ 3
+⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)
1000 1000 1000
𝑃𝑉 = 1
+ 2
+ 3
+⋯
(1 + 0.08) (1 + 0.08) (1 + 0.08)
 Present Value of a Perpetuity

❑ Calculating the Present Value of a perpetuity the

“short” way:

𝐶
𝑃𝑉𝑃 =
𝑟
➢ What is the Present Value of a perpetuity paying $1000
per year, if the interest rate is 8% p.a.?
𝐶
𝑃𝑉𝑃 =
𝑟
1000
𝑃𝑉𝑃 =
0.08
𝑃𝑉𝑃 = $12,500
Present Value of a Perpetuity

➢ What is the value of an unbreakable promise to receive

$100 a year forever, beginning next year, if the interest
rate is 5% per year?

𝐶
𝑃𝑉𝑃 =
𝑟
100
𝑃𝑉𝑃 =
0.05
𝑃𝑉𝑃 = $2,000
Present Value of a Perpetuity

➢ What is the value of an unbreakable promise to receive

$100 a month forever, beginning next month, if the
interest rate is 6% per year, compounding monthly?

𝐶
𝑃𝑉𝑃 =
𝑟
100
𝑃𝑉𝑃 =
0.005
𝑃𝑉𝑃 = $20,000
Future Value of Perpetuities

❑ The future value of a perpetuity cannot be

calculated as the cash flows are infinite. The
future end point does not exist.
Corporate Finance
Annuities
Annuities

❑ An Annuity is a series of constant/fixed cash-

flows occurring at regular intervals, for a number
of periods.

$1000 $1000 $1000

T=0 1 2 3
 Future value of an Annuity

❑ Future value of an ordinary annuity:

$1000 $1000 $1000

T=0 1 2 3

𝐹𝑉𝑛 = 𝑃𝑉 × (1 + 𝑟)𝑛
𝐹𝑉3 = 1000 × (1.10)2+ 1000 × (1.10)1 + 1000 = $3,310
Future value of an Annuity

❑ Future value of an ordinary annuity:

(1 + r)𝑛 −1
FVA𝑛 = C ×
𝑟
❑ The formula gives the future value at the time the last
payment is made.
Future value of an Annuity

$1000 $1000 $1000

T=0 1 2 3

(1+r)𝑛 −1
▪ FVA𝑛 = C
𝑟
(1+0.10)3 −1
▪ FVA3 = 1000
0.10
▪ FVA3 = $3,310
Future Value of an Annuity

➢ If you invest $2,500 at the end of each of the next four

years at 2.4% p.a., how much will you have after 4
years?

(1+r)𝑛 −1
▪ FVA𝑛 = C
𝑟
(1+0.024)4 −1
▪ FVA4 = 2500
0.024
▪ FVA4 = $10,365.79
Future Value of an Annuity

➢ If you deposit at least $100 every month, your bank

promises to pay an interest of 1.5% p.a., compounding
monthly. How much will there be in the account if you
deposit $100 per month for three years?

(1+r)𝑛 −1
▪ FVA𝑛 = C
𝑟
(1+0.00125)36 −1
▪ FVA36 = 100
0.00125
▪ FVA36 = $3,679.88
Corporate Finance
Present Value of an Annuity
 Present value of an Annuity

$1000 $1000 $1000

T=0 1 2 3
❑ Present value of an annuity:

1 − (1 + r)−𝑛
𝑃𝑉𝐴 = C
𝑟
❑ The formula gives the Present Value one period before
the first payment occurs.
Present Value of an Annuity

➢ What is the PV of receiving $1,000 at the end of each of

the next 10 years if the current interest rate is 8% p.a.?

1−(1+r)−𝑛
❑ 𝑃𝑉𝐴 = C
𝑟
1−(1+0.08)−10
❑ 𝑃𝑉𝐴 = 1000
0.08

❑ 𝑃𝑉𝐴 = $6,710.08
Present Value of an Annuity

➢ Your company has just signed a 10-year lease for its CBD
offices, at a yearly rent of $500,000. What is the PV of this
deal if the interest rate is 3.5% p.a.?

1−(1+r)−𝑛
▪ 𝑃𝑉𝐴 = C
𝑟
1−(1+0.035)−10
▪ 𝑃𝑉𝐴 = 500,000
0.035

▪ 𝑃𝑉𝐴 = $4,158,303
Annuities: Unknown C

❑ Finding an unknown C
❑ Just as with the Single Sum cash flows, we can
also use the formulas for the PV and the FV to
find another missing variable.
Annuities: Unknown C

➢ You aim to save $20,000 within the next 5 years. The

interest rate is 1.1% p.a.. How much will you have to
save every year?

(1+r)𝑛 −1
❑ FVA𝑛 = C
𝑟

(1+0.011)5 −1
❑ 20,000 = C
0.011

❑ 20,000 = C × 5.111
❑ C = $3,912.96
Corporate Finance
Mixed Cash Flows and Time Variations
➢ Consider an annuity that will make five yearly payments of
$1,000. The first payment will occur three years from now, so
the last payment will be seven years from now. What is the
present value of this annuity if the discount rate is 10%?

1000 1000 1000 1000 1000

T=0 1 2 3 4 5 6 7

❑ The annuity formula calculates the present value

one period before the first payment.
1−(1+r)−𝑛
❑ 𝑃𝑉𝐴 = C
𝑟
 1000 1000 1000 1000 1000

T=0 1 2 3 4 5 6 7
1 − (1 + r)−𝑛
𝑃𝑉𝐴 = C
𝑟
1 − (1.10)−5
𝑃𝑉𝐴2 = 1000
0.10
𝑃𝑉𝐴2 = 3790.79
𝐹𝑉𝑛
𝑃𝑉 =
(1 + 𝑟)𝑛
3790.79
𝑃𝑉𝐴0 = 2
= $3,132.88
(1.10)
 Mixed Cash Flows and Time Variations

➢ You are planning to put $100 a year in a savings account over

the next four years. How much will there be in the account
eight years from now if it pays an interest of 2% per year?

(Remember, the formula for the FV of an annuity gives the FV at the time
the last payment is made: Draw a timeline)

(1 + r)𝑛 −1
FVA𝑛 = C ×
𝑟
(1.02)4 −1
FVA4 = 100 × = 412.16
0.02
𝐹𝑉𝑛 = 𝑃𝑉 × (1 + 𝑟)𝑛
FVA8 = 412.16 × (1.02)4 = $446.14
 Mixed Cash Flows and Time Variations

➢ What is the Present Value of 5 yearly payments of

$1,000, if the first payment will be made 1 second from
now, the following payment 1 year from now, etc?
Assume an opportunity cost of 5% p.a.

$1000 $1000 $1000 $1000 $1000

T=0 1 2 3 4 5
1−(1+r)−𝑛
▪ PV = 1000 + C
𝑟
1−(1.05)−4
▪ PV = 1000 + 1000
0.05
▪ PV = $4,545.95
 Mixed Cash Flows and Time Variations

➢ What is the Present Value of 3 yearly payments of $100,

if the first payment will be made 1 second from now,
and the second payment 1 year from now? Assume an
opportunity cost of 10%.

$100 $100 $100

T=0 1 2 3
1−(1+r)−𝑛
▪ PV = 100 + C
𝑟
1−(1.10)−2
▪ PV = 100 + 100
0.10
▪ PV = $273.55
 ➢ You are considering an investment scheme that has the
following payoff: three years from now it pays $1,000, after
the forth year it pays $1,400, the following six years after
that it pays $2,000, and from then on it will pay $5,000
indefinitely. What is the present value of this stream of
cash flows if the interest rate is 10%?

1000 1400 2000 2000 2000 2000 2000 2000 5000

…etc. →
T=0 1 2 3 4 5 6 7 8 9 10 11

❑ This cash flow stream is a combination of single sum

payments, an annuity and a perpetuity.
 1000 1400 2000 2000 2000 2000 2000 2000 5000
…etc. →
T=0 1 2 3 4 5 6 7 8 9 10 11

𝐹𝑉𝑛
❑ Single sums: 𝑃𝑉 =
(1+𝑟)𝑛
1000 1400
𝑃𝑉 = 3
+ 4
= 1707.53
(1.10) (1.10)
1−(1+r)−𝑛
❑ Annuity: 𝑃𝑉𝐴 = C
𝑟
1− (1.10)−6
𝑃𝑉𝐴4 = 2000 = 8710.52
0.10
8710.52
𝑃𝑉𝐴0 = 4
= 5949.40
(1.10)
 1000 1400 2000 2000 2000 2000 2000 2000 5000
…etc. →
T=0 1 2 3 4 5 6 7 8 9 10 11

𝐶
❑ Perpetuity: 𝑃𝑉 =
𝑟
5000
𝑃𝑉10 = = 50,000
0.10
50,000
𝑃𝑉0 = 10
= 19,277.16
(1.10)

❑ Present Value of the Investment Scheme:

𝑃𝑉0 = 1707.53 + 5949.40 + 19,277.16 = $26,934.09

 ➢ You are considering an investment scheme that has the following
payoff: two years from now it pays $500, at the end of year three it
pays $1,100, just as in the three following years after that. At the end
of year 8 it pays $2,000, and from then onwards it will pay $1,000
indefinitely. What is the present value of this stream of cash flows if
the interest rate is 10%?

500 1100 1100 1100 1100 2000 1000

…etc. →
T=0 1 2 3 4 5 6 7 8 9
 𝐹𝑉𝑛
❑ Single sums: 𝑃𝑉 =
(1+𝑟)𝑛
500 2000
𝑃𝑉 = + = 1346.24
(1.10)2 (1.10)8
1−(1+r)−𝑛
❑ Annuity: 𝑃𝑉𝐴 = C 𝑟
−4
1 − (1.10)
𝑃𝑉𝐴2 = 1100 = 3486.85
0.10
3486.85
𝑃𝑉𝐴0 = = 2881.70
(1.10)2
𝐶
❑ Perpetuity: 𝑃𝑉 = 𝑟
1000
𝑃𝑉8 = = 10,000
0.10
10,000
𝑃𝑉0 = = 4665.07
(1.10)8
❑ Present Value of the Investment Scheme:
𝑃𝑉0 = 1346.24 + 2881.70 + 4665.07 = $8,893.01