Perpetuity

What Is Perpetuity?

A perpetuity is a security that pays for an infinite amount of time. In finance, perpetuity is a constant stream of identical cash flows with no end. The concept of perpetuity is also used in several financial theories, such as in the dividend discount model (DDM).

Key Takeaways

  • Perpetuity, in finance, refers to a security that pays a never-ending cash stream.
  • The present value of a perpetuity is determined by dividing cash flows by the discount rate.
  • Examples include annuities and British consols (which were discontinued in 2015).
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Perpetuity

Understanding Perpetuity

An annuity is a stream of cash flows. A perpetuity is a type of annuity that lasts forever, into perpetuity. The stream of cash flows continues for an infinite amount of time. In finance, a person uses the perpetuity calculation in valuation methodologies to find the present value of a company's cash flows when discounted back at a certain rate.

An example of a financial instrument with perpetual cash flows is the British-issued bonds known as consols, which the Bank of England phased out in 2015. By purchasing a consol from the British government, the bondholder was entitled to receive annual interest payments forever.

Although it may seem a bit illogical, an infinite series of cash flows can have a finite present value. Because of the time value of money, each payment is only a fraction of the last.

Specifically, the perpetuity formula determines the amount of cash flows in the terminal year of operation. In valuation, a company is said to be a going concern, meaning that it goes on forever. For this reason, the terminal year is a perpetuity, and analysts use the perpetuity formula to find its value.

Perpetuity Present Value Formula

The formula to calculate the present value of a perpetuity, or security with perpetual cash flows, is as follows:

PV = C ( 1 + r ) 1 + C ( 1 + r ) 2 + C ( 1 + r ) 3 = C r where: PV = present value C = cash flow r = discount rate \begin{aligned} &\text{PV} = \frac { C }{ ( 1 + r ) ^ 1 } + \frac { C }{ ( 1 + r ) ^ 2 } + \frac { C }{ ( 1 + r ) ^ 3 } \cdots = \frac { C }{ r } \\ &\textbf{where:} \\ &\text{PV} = \text{present value} \\ &C = \text{cash flow} \\ &r = \text{discount rate} \\ \end{aligned} PV=(1+r)1C+(1+r)2C+(1+r)3C=rCwhere:PV=present valueC=cash flowr=discount rate

The basic method used to calculate a perpetuity is to divide cash flows by some discount rate. The formula used to calculate the terminal value in a stream of cash flows for valuation purposes is a bit more complicated. It is the estimate of cash flows in year 10 of the company, multiplied by one plus the company’s long-term growth rate, and then divided by the difference between the cost of capital and the growth rate.

Simply put, the terminal value is some amount of cash flows divided by some discount rate, which is the basic formula for a perpetuity.

Perpetuity Example

For example, if a company is projected to make $100,000 in year 10, and the company’s cost of capital is 8%, with a long-term growth rate of 3%, the value of the perpetuity is as follows:

= Cash Flow Year 10 × ( 1 + g ) r g = $ 100 , 000 × 1.03 0.08 0.03 = $ 103 , 000 0.05 = $ 2.06  million \begin{aligned} &= \frac{ \text{Cash Flow}_\text{Year 10} \times ( 1 + g ) }{ r - g } \\ &= \frac{ \$100,000 \times 1.03 }{ 0.08 - 0.03 } \\ &= \frac{ \$103,000 }{ 0.05 } \\ &= \$2.06 \text{ million} \\ \end{aligned} =rgCash FlowYear 10×(1+g)=0.080.03$100,000×1.03=0.05$103,000=$2.06 million

This means that $100,000 paid into a perpetuity, assuming a 3% rate of growth with an 8% cost of capital, is worth $2.06 million in 10 years. Now, a person must find the value of that $2.06 million today. To do this, analysts use another formula referred to as the present value of a perpetuity.

What Is a Perpetuity?

A perpetuity is a financial instrument that offers a stream of cash flows in perpetuity—that is, without end. Before 2015, the U.K. offered a government bond called a “consol” that was structured as a perpetuity, although these instruments have since been discontinued. Unlike other bonds, perpetuities do not have a fixed maturity date, but instead, continue paying interest indefinitely.

How Is a Perpetuity Valued?

At first glance, it may seem as though an instrument that offers an infinite stream of cash flows would be almost infinitely valuable, but this is not the case. Mathematically speaking, the value of a perpetuity is finite, and its value can be determined by discounting its future cash flows to the present using a specified discount rate. This procedure, known as discounted cash flow (DCF) analysis, is also widely used to value other types of securities, such as stocks, bonds, and real estate investments.

What Is the Difference Between a Perpetuity and an Annuity?

A perpetuity and an annuity are similar instruments in that both offer a fixed set of cash flows over time. However, the key difference between them is that annuities have a predetermined end date, known as the “maturity date,” whereas perpetuities are intended to last forever. Importantly, both annuities and perpetuities can be valued using DCF analysis.

Article Sources
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  1. Federal Reserve Bank of St. Louis. "Consols: The Never-Ending Bonds." Accessed Dec. 6, 2021.

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