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H2 Annuities and Perpetuities: Present Value: Foundations of Finance

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11 views2 pages

H2 Annuities and Perpetuities: Present Value: Foundations of Finance

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beatrice.lee12138
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H2

Annuities and Perpetuities:


Present Value
Foundations of Finance
∗
Prof. Roberto Gomez Cram

I. The present value of an annuity, PV, can be written as the sum of the present values
of each component annual payment, C, as follows:

C C C
PV = + 2 + ··· + , (1)
1 + r (1 + r) (1 + r)t

where r is the single average interest rate per annum and t is the number of years the
annuity is paid. This can be simplified as follows:
 
1 1 1
PV = C + + ··· + . (2)
1 + r (1 + r)2 (1 + r)t

Using a formula for the sum of a geometric progression (as long as r > 0), we have:
1
" #
1− (1+r)t
PV = C , (3)
r

which is the same as:


 
1 1
PV = C − . (4)
r r (1 + r)t

II. Thus if you have a three-year annuity (t = 3) that pays $100 per annum (C = $100)
∗
Based on the notes of Prof. William Silber and Alexi Savov.

1
and the average annual interest rate, is r = 6%, then from equation (4), we have:
 
1 1
PV = $100 − = $267.30.
0.06 0.06 (1 + 0.06)3

You can check that this is correct by calculating as in equation (1):

$100 $100 $100


PV = + 2 + = $267.30.
1 + 0.06 (1 + 0.06) (1 + 0.06)3

III. More interesting is what happens to the present value formula when the annual pay-
ments, C, continue forever. The annuity becomes a perpetuity as t → ∞ and the
formula in (4) becomes:
 
1 1
PV = lim C − (5)
t→∞ r r (1 + r)t
C
= . (6)
r

(To get the last line, note that (1 + r)t gets bigger and bigger with t since r > 0. As
t → ∞, (1 + r)t → ∞ and so 1/ (1 + r)t → 0.)
Equation (6) is very simple. It says that the present value of an annuity of C dollars
per annum is C divided by r, where r is the average interest rate per annum. This
makes considerable sense once you provide a numerical example. Suppose C = $10 per
annum and the interest rate is 5% = 0.05. How many dollars, designated by the letter
P , would you have to put away today so that it produces $10 every year forever? The
answer is given by solving the following equation for P :

P × 0.05 = $10
$10
P = = $200.
0.05
Investing $200 at 5% generates $10 in interest per year and continues to do so forever.
Thus, if an annuity promises to pay $10 forever and the annual interest rate is 5%,
the value of that infinite stream of payments is $200. If the annuity were priced in a
competitive market its price should be $200.

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