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Deriving The Present-Value Formula For A Perpetuity
Deriving The Present-Value Formula For A Perpetuity
www.fbenabdelkader.com
Perpetuity formula
A perpetuity is a stream of equal cash flows that occur at regular intervals and last for ever
0 1 2 3
……
C C C
The present value of a perpetuity P with payment C and interest r is given by:
& & &
!"#!$ = *
+ +
+ +⋯
#1 + )$ #1 + )$ #1 + )$,
1 1 1
!"#!$ = C ∗ 0 *
+ +
+ + ⋯1
#1 + )$ #1 + )$ #1 + )$,
∞
1
!"#!$ = & ∗ 3
#1 + )$4
45*
You may recognize this, from Calculus classes, as a geometric progression:
∞
6 = 3 78
45*
Where Z is a positive constant that is less than 1, and X is the sum of the geometric progression
Recall that the sum of such a series actually has a closed-form solution:
∞
7
6 = 3 78 =
1−:
45*
*
The Present Value of the perpetuity can then be written as a geometric progression, where 7 = :
*;<
∞ 1
1 7 =1 + ) > 1
!"#!$ = & ∗ 3 4
=&∗ =&∗ =&∗
#1 + )$ 1−: 1 )
45* ?1 − =1 + )>
*
!"#!#$%#&'(&)$ =
$
Page 2 of 13
Fundamentals of Finance Fahmi Ben Abdelkader
www.fbenabdelkader.com
To derive the shortcut, we calculate the value of a perpetuity by creating our own perpetuity.
Suppose you could invest $100 in a bank account paying 5% interest per year forever. Suppose also you
withdraw the interest and reinvest the $100 every year. By doing this, you can create a perpetuity paying $5 per
year.
The Law of One Price: the value of the perpetuity must be the same as the cost we incurred to create the
perpetuity.
Let’s generalize: suppose we invest an amount P in the bank. Every year we can withdraw the interest,
C=r*P, leaving the principal P. The present value of receiving C in perpetuity is then the upfront cost: P=C/r.
*
!"#!#$%#&'(&)$ =
$
Page 3 of 13
Fundamentals of Finance Fahmi Ben Abdelkader
www.fbenabdelkader.com
A growing perpetuity is a stream of cash flows that occur at regular intervals and grow at a constant rate for
ever.
0 1 2 3
…
…
C*(1+g) C*(1+g)2 C*(1+g)3
The present value of a Growing Perpetuity P with payment C and interest r is given by:
∞
' '(1 + j)3k+
!"(i!) = +2
(1 + r) (1 + *)3
35-
∞
' ' (1 + j)3
!"(i!) = + ∗2
(1 + r) (1 + r) (1 + *)3
35+
7 = 2 89
35+
Where Z is a positive constant that is less than 1, and X is the sum of the geometric progression
Recall that the sum of such a series actually has a closed-form solution:
∞
8
7 = 2 89 =
1−;
35+
Page 9 of 13
Fundamentals of Finance Fahmi Ben Abdelkader
www.fbenabdelkader.com
The Present Value of the perpetuity can then be written as a geometric progression,
+<l
where 8 = and g<r
+<>
∞ 1+j
' ' 1 ' ' ?1 + * @
!"(i!) = + ∗ 2 3
= + ∗
(1 + r) (1 + r) (1 + *) (1 + r) (1 + r) 1+j
35+ A1 − ? 1 + * @
' ' (1 + j)
!"(i!) = + ∗
(1 + r) (1 + r) (* − j)
' (1 + j)
!"(i!) = ∗ A1 +
(1 + r) (* − j)
' (1 + *)
!"(i!) = ∗A
(1 + r) (* − j)
*
!"(m$OX(Rn !#$%#&'(&)) = ; oHMℎ n < *
$−n
Page 10 of 13
Fundamentals of Finance Fahmi Ben Abdelkader
www.fbenabdelkader.com
To derive the shortcut, we calculate the value of a growing perpetuity by creating our own perpetuity.
Suppose you want to create a perpetuity growing at 2%. You could invest $100 in a bank account paying 5%
interest per year forever. At the end of the first year, suppose you withdraw only $3 from the interest ($5).
You will have $102to reinvest (2% more than the initial investment). By doing this, you can create a growing
perpetuity that starts at $3 and grows 2% per year.
The Law of One Price: the value of the growing perpetuity must be the same as the cost we incurred to
create the perpetuity.
Let’s generalize: suppose we invest an amount P in the bank. If we want to increase the amout we withdraw
each year by g, then P will have to grow by the same factor g.
Every year we should reinvest !(1 + j) and withdraw ' = (*! − j!) = !(* − j)
r
The present value of the growing perpetuity is then the upfront cost: ! = .
>kl
*
!"(m$OX(Rn !#$%#&'(&)) =
$−n
Page 11 of 13
Fundamentals of Finance Fahmi Ben Abdelkader
www.fbenabdelkader.com
0 1 2 3 N
……
The present value of an N-period annuity A with payment C and interest r is given by:
( ((1 + j) ((1 + j). ((1 + j),k,
!"(i+) = + + + ⋯ +
(1 + +), (1 + +). (1 + +)/ (1 + +),
,
( ( (1 + j)7
!"(i+) = + ∗ 6
(1 + r) (1 + r) (1 + +)7
78,
You may recognize this, from Calculus classes, as a finite geometric series. The formula for the sum of such
a series is:
,
: ∗ (1 − : , )
9 = 6 :; =
(1 − =)
78,
The Present Value of the N-period annuity can then be written as a geometric progression,
,>l
where : = and g < r
,>@
1+j 1+j ,
∗ A1 − B 1 + +C
,
( ( (1 + j)7 ( ( 1++
!"(i+) = + ∗ 6 = + ∗
(1 + r) (1 + r) (1 + +)7 (1 + r) (1 + r) 1+j
78, B1 − 1 + + C
,>@
This equation can be simplified by multiplying it by which is to multiply it by 1. The formula is now
,>@
reduced to:
: <+n =
!"(m$OX(Rn QRR'(&)) = ∗ s< − U V t ; oHMℎ n < +
$−n <+$
Page 12 of 13
Fundamentals of Finance Fahmi Ben Abdelkader
www.fbenabdelkader.com
The formula for the growing annuity encompasses all of the other formulas
: <Jn =
!"(m$OX(Rn QRR'(&)
m$OX(Rn CD ∗ H< F I M
$Fn <J$
Example:
! E = ∞ ; j q $
%&l
! q 1
%&(
<&n =
! + <&$ / → D wx = → ∞
: :
! !"7m$OX(Rn !#$%#&'(&)
!#$%#&'(&)C D ∗ 7< F DC D
$kn $kn
Page 13 of 13