Principles of Finance

Chapter 8: Time Value of

Money II: Equal Multiple
Payments
 PERPETUITY

A perpetuity is a series of uniform discrete

payments or receipts that continue forever or
into infinity—in other words, perpetually.

•An annuity also consists of uniform discrete payments, but

these payments come to a finite end.
There are two types of
perpetuities

Constant perpetuity
which consists of fixed uniform payments

Growing perpetuity
which has payments that grow at a fixed rate
Explain how perpetuities are valued

The present value formula for a growing perpetuity is the starting

point for calculating the present value of a constant perpetuity.

The present value of a growing perpetuity

is calculated as follows:
PV = PMT / (i – g)
To determine the present value of a constant perpetuity,
equating g to zero in the above formula gives:
PV = PMT / i
Where:
PMT = payment
i = interest rate or yield
g = growth rate
EXAMPLE:

Company pays $ 3 in dividends annually and estimates that they will pay the
dividends indefinitely. How much are investors willing to pay for the dividend
with a required rate of return of 5%?

PMT = $3 i = 5% g = 2%
PV = PMT / i
PV = 3 / 0.05
PV =$60

Taking the above example, imagine if the $ 3 dividend is expected to

grow annually by 2%.

PV = PMT / (i – g)
PV = 3 / (0.05 – 0.02)
PV = 3 / 0.03
PV =$ 100
 ANOTHER EXAMPLE:

Let’s assume that our preferred stock in YOLO Corporation is expected to grow at a rate of
5% per year. Its annual dividend per share is $ 15, and its required rate of return in the
market is 8%. If this is a constant dividend stock, like most preferred stock, its price would
be expected to approximate

PMT= $15 i= 8% g= 5%
PV = PMT / i
PV = 15 / 0.08
PV = $187.5
When we factor the annual growth in the dividend, what
does the price per share become?

PV = PMT / (i – g)
PV = 15 / (0.08 – 0.05)
PV = 15 / 0.03
PV = $500
 ANNUITY

An annuity consists of fixed regular

payments into the future for a finite
period of time.
•In contrast, perpetuities have payments that don’t come to
an end but continue forever.
 Examples of annuities:

•A lottery payout consisting of uniform annual payouts for a

specified of time is a common annuity.
•Mortgage loans to fund a home purchase that are paid back
through uniform monthly installment payments—for 30
years, for example—are also annuities.
•US Treasury bonds are US government debt obligations that
promise to pay a fixed bond coupon payment for as long as
the bond is outstanding.
 The fixed coupon payments are annuities.
Distinguish between an ordinary annuity and an annuity
due

ORDINARY ANNUITY
An ordinary annuity is one where the payments are made
the end of the period
Example of an ordinary annuity:
Interest payments on loans are due at the end of the
borrowing period.

ANNUITY DUE
An annuity due is one where the payments are made at the
beginning of the period
Example of an annuity due:
Rental contracts require that rent be paid at the beginning
of the month.
 Calculate the present value of an ordinary
annuity and an annuity due

Calculation of the present value of an ordinary annuity

and an annuity due requires the use of the formula:

Where:
PMYT = Payment
r = rate
n= number of periods

The present value of an ordinary annuity:

PVa = PYMT × [1 − 1 / (1 + r)n] / r
The present value of an annuity due:
PVa = PYMT × [1 − 1 / (1 + r)n] / r × (1 + r)
The above formula is an adaptation of the PV formula for an
ordinary annuity, but with one more compounding period
added.
 Example

JKL International has committed to a legal settlement that requires it to pay $50,000 per year
at the end of each of the next ten years, assuming an interest rate of 5%?

PVa = PYMT × [1 − 1 / (1 + r)n] / r PYMT= $50,000 r= 5% or 0.05 n= 10 years

PVa = 50,000 × [1 – 1 /(1 + 0.05)10] / 0.05

PVa = 50,000 × [1 – 1 /(1.05)10] /0.05
PVa = 50,000 × (1 – 1 / 1.628895)/0.05
PVa = 50,000 × (1 – 0.613913)/0.05
PVa = 50,000 × 0.386087/0.05
PVa = 50,000 × 7.72174
PVa ≈ $386,087
 Example

JKL
WhatInternational has committed
if JKL International to payment
settle the a legal settlement
of $50,000that
perrequires it tobeginning
year at the pay $50,000 per year
of each next
at
tenthe end, of
years each of the
assuming next tenrate
an interest years. What would it cost ABC if it were to instead settle the
of 5%?
claim immediately with a single payment, assuming an interest rate of 5%?
PVa = PYMT × [1 − 1 / (1 + r) n
] / r × (1 + r) PYMT= $50,000 r= 5% or 0.05 n= 10 years
PVa = PYMT × [1 − 1 / (1 + r)n] / r PYMT= $50,000 r= 5% or 0.05 n= 10 years
PVa
PVa= =50,000 × [1 – 11//(1(1+ 0.05
50,000× [1 )10] 10
+ 0.05) / ]0.05
/ 0.05 × ( 1 + 0.05)
PVa
PVa= =50,000 × [1 – 11//(1.05
50,000× [1 )10]10/]0.05
(1.05) / 0.05 × 1.05
PVa
PVa= =50,000 × (1 – 11//1.628895
50,000× (1 1.628895) )/0.05
/ 0.05 × 1.05
PVa
PVa= =50,000 × (1 – 0.613913
50,000× (1 0.613913) )/0.05
/ 0.05 × 1.05
PVa 50,000× 0.386087
PVa= =50,000 × 0.386087/0.05 0.05 × 1.05
PVa 50,000× 7.72174
PVa= =50,000 × 7.72174× 1.05
PVa≈ ≈$405,
PVa $386,087
391.35
 Example

Alan was getting $100 for 5 years every year at an interest rate of
5%. Find the present value using the ordinary annuity formula at
the end of 5 years? 
PVa = PYMT × [1 − 1 / (1 + r)n] / r PYMT= $100 r= 5% or 0.05 n= 5 years

PVa = 100 ×[1– 1 /(1+ 0.05) 5 ]/ 0.05

PVa = 100 × [1 – 1 /(1.05) 5 ] / 0.05
PVa = 100 × (1 – 1 / 1.276282)/ 0.05
PVa = 100 × (1 – 0.783526)/ 0.05
PVa = 100 × 0.216474/ 0.05
PVa = 100 × 4.32948
PVa ≈ $432.95
 Example

Alan was getting $100 for 5 years every year at an interest rate of
5%. Find the present value using the annuity due formula at the
beginning of 5 years? 

PVa = PYMT × [1 − 1 / (1 + r)n] / r × (1 + r) PYMT= $100 r= 5% or 0.05 n= 5 years

PVa = 100 × [1 – 1 / (1 + 0.05)5] / 0.05 × ( 1 + 0.05)

PVa = 100 × [1 – 1 / (1.05)5] / 0.05 × 1.05
PVa = 100 × (1 – 1 / 1.276282) / 0.05 × 1.05
PVa = 100× (1 – 0.783526) / 0.05 × 1.05
PVa = 100 × 0.216474 / 0.05 × 1.05
PVa = 100 × 4.32948× 1.05
PVa ≈ $ 454.6
 Explain how annuities may be used in lotteries
and structured settlements

Lotteries and structured settlements make a fixed

periodic payout for a finite period of time.

● In these cases, an alternative is often presented to

the recipient that allows them to convert the
annuity into a single lump sum payment up front.
• How would you determine if the lump sum is
adequate compensation in exchange for giving up
the annuity?
o It all depends on what your assumed discount
rate is (i.e., what is an acceptable rate of return
for you)?
 Example how annuity may be used in lottery

Let’s assume you win the Lottery for $1.2million, The Lottery Commission will likely contact
you with an alternative: would you like to accept if they offer you $120,000 per year for 10 years,
beginning one year from today … or would you like to accept a lump sum of $787,000 right now
instead? Let’s use 9%. If we discount the future stream of fixed payments (an ordinary annuity,
as the payments are identical and they begin one year from now), ), we can then compare that
result to the cash lump sum that the Lottery Commission is offering you instead.
Using the present value of an ordinary annuity formula:
PVa = PYMT × [1 − 1 / (1 + r)n] / r

PYMT=  $120,000 , r= 9% , n=10

PVa = $120,000 × [1 – 1 / (1 + 0.09)10] / 0.09
PVa = $120,000 × [1 – 1 / (1.09)10] / 0.09
PVa = $120,000 × (1 – 1 / 2.367364) / 0.09
PVa =  $120,000 × 1 − 0.422411 / 0.09 
PVa =  $120,000 × 0.577589 / 0.09 
PVa =  $120,000 × 6.417656
PVa ≈ $770,118.72
All things being equal, that expected future stream of ten $120,000 payments is worth approximately $770,118.72 today.
Now you can compare like numbers, and the $787,000 cash lump sum is worth more than the discounted future payments.
Reviewing the facts, you have a choice of receiving 10 annual payments of your $1.2 million winnings,
each worth $120,000, and you discount at a rate of 9%. The only difference is that this time, you can
receive your first $120,000 right away; you don’t have to wait a year. This is now an annuity due. We
solve it just as before, except that we multiply by one additional period of interest, (1 + i):

Using the present value of an annuity due formula:

PVa = PYMT × [1 − 1 / (1 + r)n] / r × (1 + r)

PYMT=  $120,000 , r= 9% , n=10

PVa = $120,000 × [1 – 1 / (1 + 0.09)10] / 0.09 × (1 + 0.9)
PVa = $120,000 × [1 – 1 / (1.09)10] / 0.09 × 1.09
PVa = $120,000 × (1 – 1 / 2.367364) / 0.09 × 1.09
PVa = $120,000 × 1 − 0.422411/ 0.09  × 1.09
PVa = $120,000 × 0.577589 / 0.09  × 1.09
PVa = $120,000 × 6.417656 × 1.09
PVa ≈ $839,429.41
 Explain how annuities may be used in lotteries
and structured settlements

Lotteries and structured settlements make a fixed

periodic payout for a finite period of time.

● In these cases, an alternative is often presented to

the recipient that allows them to convert the
annuity into a single lump sum payment up front.
• How would you determine if the lump sum is
adequate compensation in exchange for giving up
the annuity?
o It all depends on what your assumed discount
rate is (i.e., what is an acceptable rate of return
for you)?
 Example how annuity may be used in structured settlement

If you win a $450,000 settlement for an insurance claim, the opposing party may ask you to accept an
annuity so that they can pay you in installments rather than a lump sum of cash. What would a fair cash
distribution by year mean? If you have a preferred discount rate (the percentage we all must know to
calculate the time value of money) of 6% and you expect equal distributions of $45,000 over 10 years,
beginning one year from now, you can use the present value of an ordinary annuity formula to compare the
alternatives:
PVa = PYMT × [1 − 1 / (1 + r)n] / r

PYMT=  $45,000 , r= 6% , n=10

PVa = $45,000 × [1−1 / (1 + 0.06) 10] / 0.06
PVa = $45,000 × [1−1 / (1.06) 10] / 0.06
PVa = $45,000 × (1−1 / 1.790848) / 0.06
PVa = $45,000 × 1 – 0.523977 / 0.06
PVa = $45,000 × 0.476023 / 0.06
PVa = $45,000 × 7.933717
PVa ≈ $357,017.27
What if you negotiate the first payment to be made to you immediately,
turning this ordinary annuity into an annuity due? We simply multiply by
one additional period of interest, (1 + 0.06). Repeating the last step of the
solution above and then multiplying by (1 + 0.06), we determine that
PVa = PYMT × [1 − 1 / (1 + r)n] / r × (1 + r)

PYMT=  $45,000 , r= 6% , n=10

PVa = $45,000 × [1−1 / (1 + 0.06)10] / 0.06 × (1 + 0.06)
PVa = $45,000 × [1−1 / (1.06) 10] / 0.06 × 1.06
PVa = $45,000 × (1−1 / 1.790848) / 0.06 × 1.06
PVa = $45,000 × 1 – 0.523977 / 0.06 × 1.06
PVa = $45,000 × 0.476023 / 0.06 × 1.06
PVa = $45,000 × 7.933717 × 1.06
PVa ≈ $378, 438.30
 Explain how annuities may be used in lotteries
and structured settlements

Lotteries and structured settlements make a fixed

periodic payout for a finite period of time.

● In these cases, an alternative is often presented to

the recipient that allows them to convert the
annuity into a single lump sum payment up front.
• How would you determine if the lump sum is
adequate compensation in exchange for giving up
the annuity?
o It all depends on what your assumed discount
rate is (i.e., what is an acceptable rate of return
for you?)
 Explain how annuities might be used in
retirement planning

A common scenario upon reaching retirement is that one has

to rely on drawing down on savings to fund expenses.
● This essentially is a matter of converting a lump sum into an annuity.

Assume the recipient just received $75,000. They have the chance to invest in an annuity
that will provide a distribution at the end of each of the next five years, and that annuity
contract provides interest at 3% annually. Their first receipt will be one year from now.
This is an ordinary annuity. We can also solve for the payment given the other variables,
an important aspect of financial analysis. If the person with the $75,000 windfall wants
this fund to last five years and they can earn 3%, then how much can they withdraw
from this fund each year? To solve this question, we can apply the present value of an
ordinary annuity formula. This time, the payment (PYMT) is the unknown, and we
know that the PVa, or the present value that they have at this moment, is $75,000:
PVa = PYMT × [1−1 / (1 + r)n] / r
PVa = PYMT × [1−1 / (1 + r)n] / r
PVa= $75,000 , r= 3% , n= 5
$75,000 = PYMT × [1−1 / (1 + 0.03)5] / 0.03
$75,000 = PYMT × [1−1 / (1.03)5] / 0.03
$75,000 = PYMT × (1−1 / 1.159274) / 0.03
$75,000 = PYMT × (1−0.862609) / 0.03
$75,000 = PYMT × 0.137391 / 0.03
$75,000 = PYMT × 4.5797
PYMT = $75,000 / 4.5797
PYMT = $16,376.62

The person can withdraw this amount every year beginning one year from now, and
when the final payment is withdrawn, the fund will be depleted. Interest accrues
each year on the beginning balance, and then $16,376.62 is withdrawn at the end of
each year.
 Use a financial calculator and Excel to solve
annuity problems
A financial calculator will have PMT, PV, FV, N, and I buttons.
• Set up a table identifying the independent variables and the one
dependent variable (i.e., the thing you are solving for).
• Enter the known independent variables first, leaving the unknown
variable until the end—the financial calculator will solve for the last
variable as the unknown variable.
The Excel functions work in the same way as a financial calculator does: they require PMT,
PV, FV, n, and i as inputs and will solve for a dependent variable given the input of the
independent variables.
• From the same table used earlier, independent variables are fed into the Excel function, which
then solves for the dependent variable (i.e., the thing you are solving for).
• The Excel functions are as follows:
• Solving for future value: = FV (rate, pmt, [pv], [type])
• Solving for present value: = PV (rate, pmt, [fv], [type])
• Solving for number of periods: = NPER (rate, pmt, pv, [fv], [type])
• Solving for the interest rate: = RATE(nper, pmt, pv, [fv], [type], [guess])
• The inputs in brackets are optional, and their absence will not hinder the operation of the
function.
 Distinguish between different types of loans

Loans come in different forms:

• Term loans: Borrowing a sum of money with a promise to pay it
back after a certain number of years with a given interest rate
• Revolving lines of credit: Funds that can be tapped on an as-
needed basis to fund gaps in cash flow needs; interest is paid on
the portion used
• Personal lines of credit: Loans made to individuals that, similar to
revolving lines of credit, can be tapped to fund temporary cash
flow shortfalls
• These loans are either secured (as with home equity loans) or
unsecured (as with credit card lines of credit).
• Installment loans: Loans that are paid back over time via periodic
payments
 Explain how amortization works

Amortization of an amount involves creating an equivalency

between the present value of the amount and periodic installments.

• In mathematical terms, you solve for an annuity

payment (or PYMT) given PV (the loan amount), n
(the number of periods), and r (the interest rate).
• Taking out a $300,000 mortgage for 30 years
payable in monthly installments at 3% interest
results in a monthly payment as follows:
• Solve for PYMT given PV = 300,000, n = 30 × 12 months,
and r = 0.03/12 monthly interest.
• PYMT is equal to: $1,264.81 monthly.
Taking out a $300,000 mortgage for 30 years payable in
monthly installments at 3% interest results in a
monthly payment as follows:
• Solve for PYMT given PV = $300,000, n = 30 × 12 months, and r
= .03/12 monthly interest.
• PYMT is equal to: $1,264.81 monthly.

Formula:
PVa = PYMT × [1−1 / (1 + r)n] / r
300,000 = PYMT × [1−1 / (1 + 0.0025)360] / 0.0025
300,000 = PYMT × [1−1 / (1.0025)360] / 0.0025
300,000 = PYMT × (1−1 / 2.456842) / 0.0025
300,000 = PYMT × (1−0.0407027) / 0.0025
300,000 = PYMT × 0.592973 / 0.0025
300,000 = PYMT × 237.1892
PYMT = 300,000 / 237.1892
PYMT ≈  1,264.81 MONTHLY PAYMENT
 Create an amortization schedule

An amortization schedule shows how an installment

loan is amortized over time
• If you take out a $10,000 loan to be paid in annual
installments for the next five years at 5% interest, you
would make five annual payments of $2,309.75.
• The loan would amortize as follows:

Year Beginning Annual Interest Principal Ending

Balance Payment Balance

1 10,000.00 2,309.75 500 1,809.75 8,190.25

2 8,190.25 2,309.75 409.51 1,900.24 6,290.01
3 6,290.01 2,309.75 314.50 1,995.25 4,294.76
4 4,294.76 2,309.75 214.74 2,095.01 2,199.75
5 2,199.75 2,309.75 109.99 2,199.75 zero
 • If you take out a $10,000 loan to be paid in annual
installments for the next five years at 5% interest,
you would make five annual payments of $2,309.75.

PVa = PYMT × [1−1 / (1 + r)n] / r

10,000 = PYMT × [1−1 / (1 + 0.05)5] / 0.05
10,000 = PYMT × [1−1 / (1.05)5] / 0.05
10,000 = PYMT × (1−1 / 1.276282) / 0.05
10,000 = PYMT × (1−0.783526) / 0.05
10,000 = PYMT × 0.216474 / 0.0025
10,000 = PYMT × 4.32948
PYMT = 10,000 / 4.32948
PYMT ≈  2,309.75
Year Beginning Annual Interest Principal Ending
Balance Payment Balance

1 10,000.00 2,309.75 500 1,809.75 8,190.25

2 8,190.25 2,309.75 409.51 1,900.24 6,290.01
3 6,290.01 2,309.75 314.50 1,995.25 4,294.76
4 4,294.76 2,309.75 214.74 2,095.01 2,199.75
5 2,199.75 2,309.75 109.99 2,199.75 zero
 Calculate the cost of borrowing

Given loan details such as the loan amount, installment

payments, and term of the loan, what rate of interest (or
cost of borrowing) is being paid on the loan?

• This involves solving for an r (or interest rate) given a present value
(or loan amount), PMT (periodic installment payments), and n (or
number of periods).
• The formula for calculating interest rate is:
R= PMT / PV x n
Where:
PMT= periodic installment payments
PV= present value or loan amount
n= number of period
EXAMPLE:
If you borrowed $1,000 for five years and make an annual
installment payment of $239, your cost of borrowing is:
• The givens are: PV = 1,000, n= 5 years, PMT = $239 annually.
• The unknown is the r, or interest rate, which is 4.78% in this case.

R= PMT / PV × n
R= 239 /1,000 × 5
R= 239/ 5,000
R= 0.0478 or 4.78%
ANOTHER EXAMPLE

Toasty received a profit of $200 on top of the money that he

deposited in the bank 2 months

R= PMT / PV × n
R= 239 / 1,000 × 5
R= 239 / 5,000
R= 0.0478 or 4.78%
 Explain the difference between stated and effective rates

When loans are stated in monthly terms, it is tempting to simply

take the loan rate and multiply it by 12 to arrive at an annual interest
rate.
• Multiplying by 12 will yield the stated annual loan rate, but
that stated rate will be different from the effective interest rate
when compounding is taken into account.

The formula for calculating effective interest rates is:

Effective Annual Rate= [( 1 + r / n )n]-1
Where:
n= number of periods
r= annual interest rate
For example

A stated rate of 1.5% monthly for a year is

equal to 1.5% × 12, or 18%
-When this information is input into Effective Annual Rate
formula, this will result in an effective rate of 19.6%
The formula for calculating effective interest rates is
Effective Annual Rate=
[( 1 + r / n )n]-1

n= 1 × 12 = 12
r= 1.5% × 12 = 18% or 0.18
EAR = [( 1 + r / n )n]-1
EAR = [( 1 + 0.18 / 12)]12 -1
EAR= [( 1 + 0.015)]12 -1
EAR= (1.015)12 -1
EAR= 1.1956 – 1
EAR= 0.1956 OR 19.6%
 A stated rate of 15% quarterly for a year
is equal to 15% x 4, or 60

n= 1 × 4 = 4
r= 15% × 4 = 60% or 0.6
EAR = [( 1 + r / n )n]-1
EAR = [( 1 + 0.6 / 4)]4 -1
EAR= [( 1 + 0.15)]4 -1
EAR= (1.15)4 -1
EAR= 1.749 – 1
EAR= 0.749 OR 74.9%
 Calculate the true cost of borrowing

In assessing the cost of borrowing, the effective

interest rate is the rate that matters to borrowers.
• Firms need to know their all-in cost of borrowing (i.e.,
factoring in all related costs of borrowing).
• Knowing the all-in cost of borrowing allows for better-
informed decisions regarding how to minimize this cost.
• A firm’s cost of borrowing factors into its weighted average
cost of capital.