SCHOOL OF BUSINESS ADMINISTRATION BUS 106 WINTER 2011

UNIVERSITY OF CALIFORNIA AT RIVERSIDE AVINASH VERMA

TEACHING NOTE: PERPETUITIES, ANNUITIES, AND GROWING

ANNUITIES
Please make sure you read Homework 3 at the end of this note. The
homework is due on February 1, 2011.

A perpetuity is a stream of constant cash flows every period that

goes on for ever. Suppose you have $50,000 and you deposit it in a
bank account that pays interest at 6% a year for all time to come.
Then you, and, after you, your heirs, will get $3000 [$50,000 times
6%] every year in perpetuity. You have therefore exchanged
$50,000 now at t=0 for $3000 every year in perpetuity staring at
t=1. Since both you and the bank entered into the transaction
voluntarily, it must be the case that the value today of that perpetual
stream of payments is $50,000. Suppose we now want to find out
what amount of deposit would generate annual cash flows of
$12,000 in perpetuity. We shall arrive at the answer by following in
reverse the steps by which we arrived at the amount of annual
interest. That is, we shall divide the targeted cash flow of $12,000
by the annual interest rate of 6%, and get the answer as $200,000.

To recapitulate, when we want to find out the annual (per period)

interest payment, denoted C, we multiply the amount deposited at
t=0 by the interest rate per year (period). Therefore, when we are
given the annual cash flow and the annual interest rate and want to
work out the amount of deposit that would generate those cash
flows, or, in other words, the present value of those cash flows, we
shall of course have to reverse the process. It thus follows that:

PV ( $C every period in perpetuity )=C

r

Notice that we have used no algebra for arriving at this result.1 The
important thing to remember about this very simple result is that the
point of valuation is one period before the point in time when the
first cash flow occurs. The economic intuition is obvious: our
deposit has to have been in the bank for one period before any
interest on it can be accrued and paid.
1
The result does have both an origin and a foundation in algebra:
C C C
PV ( $C every period in perpetuity )= + + +... ∞
(1 + r ) (1 + r ) 2 (1 + r ) 3
is an infinite geometric progression that converges for r > 0 . The formula for
sum of an infinite geometric progression is Σka*fk = a/(1 – f) where a is the first
term of the series, f (<1) is the factor by which terms in the series increase, and
k is an index that runs from 0 to ∞. In our case, the first term is a = C/(1+r), and
the factor by which the terms increase is f = 1/(1+r). Substituting these in the
formula, we get the same result.

Page 1 of 6 Teaching Note and Homework 2

SCHOOL OF BUSINESS ADMINISTRATION BUS 106 WINTER 2011
UNIVERSITY OF CALIFORNIA AT RIVERSIDE AVINASH VERMA

Now, let us define an annuity as a perpetuity with a finite life. In

other words, an annuity is a stream of constant cash flows of $C
every period that goes on for a finite length of time. It can be
represented on the time line as:
C C … C
| | | |
0 1 2 … n

In order to work out the present value of an annuity that goes on for
n periods, we shall represent it as difference between two
perpetuities: one starting at t=1 and the other at t=n+1. Because
both streams are perpetuities, each has a value of C/r. Now, it is a
cardinal principle of financial economics that two cash flows
cannot be compared with, equated to, added to, or subtracted
from, one another unless they are evaluated at the same point in
time. Therefore, in order to work out the present value of an
annuity, we shall have to make sure that the two perpetuities that it
represents the difference between, are evaluated at the same point in
time. Since the first perpetuity starts at t=1, its value at t=0 is C/r.
the second perpetuity has a value of C/r one period before its first
cash flow, or t=n. Its value at t=0 is C/r multiplied by the n-period
1
discount factor, DF n ≡ . Taking the difference between the
(1 + r ) n
two, we get that the present value of an annuity is:2

 
PV ( $C every period for n periods ) = C 1 − 1

r  (1 + r ) n


Similar to the formula for the present value of a perpetuity, when

we use the present value of an annuity formula, the point of
valuation is one period before the point in time when the first cash
flow occurs.

Now, a growing annuity is a finite stream of cash flows growing

at a constant rate. If we denote the constant growth rate as g, then
the cash flow in any given period will be higher than the preceding

2
Again, here we motivated this formula entirely on the basis of financial
economics. Just as the perpetuity formula is a sum of an infinite geometric
progression, the annuity formula is a sum of a finite geometric progression.
The formula for sum of a finite geometric progression is Σka*fk = a (1– fn+1) /(1 –
f) where a is the first term of the series, f (≠1) is the factor by which terms in the
series increase, and k is an index that runs from 0 to n. In our case, the first term
is a = C/(1+r), and the factor by which the terms increase is f = 1/(1+r).
Substituting these in the formula, we get the same result.

Page 2 of 6 Teaching Note and Homework 2

SCHOOL OF BUSINESS ADMINISTRATION BUS 106 WINTER 2011
UNIVERSITY OF CALIFORNIA AT RIVERSIDE AVINASH VERMA

cash flow by a factor of (1+g). Thus, the general term in the

growing annuity, say, the kth term, is given by:

S k = S k −1 (1 + g ) for k = 2, 3, .... n.

It might be a good idea to consider growing annuities in the context

of a numerical example. Suppose today [t=0 ] is December 31 2010.
Your annual income in calendar year 2010 was $100,000. You
expect your income to be growing at a constant rate of 6% over the
remaining 30 years of your working life. Thus, in 2011 you expect
to earn $100,000*1.06 = $106,000, and in 2012 $106,000*1.06 =
$112,360, and so on. Now, assume that up to this point in time, you
have been spending everything you earned, and your accumulated
savings are zero. From 2011 onwards, you plan to save a constant
proportion, say 10%, of your income every year and invest it in an
account yielding a return of 12% per year. Because both the growth
rate and the rate of return are given to us in per year terms, for
computational ease, we shall assume that your yearly income is paid
to you in a lump sum at the end of the year. Thus, the first inflow in
your savings account will be $10,600 [10% of $106,000] deposited
on December 31 2011, the second inflow $11236 on December 31
2012, and so on. On the time line, for n=30 (which we assume is the
length of your working life), your future savings can be represented
as:

S1=$10600 S2=$11236 … Sn=$57435

| | | |
0 1 2 … n

We are given the task of computing the present value, that is value
on December 31, 2010, of your future savings. One way in which it
is possible to evaluate the stream of your savings is to use our
fundamental valuation equation, which calls for evaluating the
present value of each of the 30 items in the stream, and then adding
them up. Thus, denoting the present value of the savings as V, we
get:

10600 10600 (1.06 ) 10600 (1.06 ) 2 10600 (1.06 ) 29

V = + + +...+
112
. . 2
112 . 3
112 . 30
112
Since we shall come across growing annuities in finance frequently,
we want to spare ourselves the drudgery involved in calculating the
present value of each cash flow in the stream. In other words, we
want to evolve a formula for valuing growing annuities. We shall do

Page 3 of 6 Teaching Note and Homework 2

SCHOOL OF BUSINESS ADMINISTRATION BUS 106 WINTER 2011
UNIVERSITY OF CALIFORNIA AT RIVERSIDE AVINASH VERMA

this by representing the growing annuity in terms of the stream we

are already familiar with, the flat annuity.
Let us define a number S0 such that:
S1 ≡ S 0 (1 + g )

Note that because we saved nothing in the year 2007, S 0 is NOT a

cash flow occurring at t=0. It is just an artificial but useful
construct. It is useful for simplifying the calculations because now
each term in the growing annuity can be represented as:
S1 = S 0 (1 + g )
S 2 = S1 (1 + g ) = S 0 (1 + g ) 2
S 3 = S 2 (1 + g ) = S 0 (1 + g ) 3 , and so on until:
S n = S 0 (1 + g ) n

Now, by the fundamental valuation equation, and given a discount

rate of r, the present value, V, of the growing annuity is:
S1 S2 Sn
V = + +.......+ .
(1 + r ) (1 + r ) 2
(1 + r ) n

Representing each cash flow in terms of S 0 , we get:

S 0 (1 + g ) S 0 (1 + g ) 2 S 0 (1 + g ) n
V = + +.......+ .
(1 + r ) (1 + r ) 2 (1 + r ) n

Let us now define another artificial construct, a number q, such that:

1 (1 + g )
≡ , which is to say tha t:
(1 + q ) (1 + r )

(r − g )
q≡
(1 + g )
We can now represent the present value, V, in terms of S 0 and q
as:

S 0 (1 + g ) S 0 (1 + g ) 2 S 0 (1 + g ) n
V = + +.......+
(1 + r ) (1 + r ) 2 (1 + r ) n
S0 S0 S0
= + +.......+ .
(1 + q ) (1 + q ) 2
(1 + q ) n

Page 4 of 6 Teaching Note and Homework 2

SCHOOL OF BUSINESS ADMINISTRATION BUS 106 WINTER 2011
UNIVERSITY OF CALIFORNIA AT RIVERSIDE AVINASH VERMA

This last equation is simply the present value of a flat annuity of

S 0 dollars every period using a flat discount rate of q per period.
We can therefore apply the familiar formula for flat annuities to get:

S0  1 
V = 1 − .
q  (1 + q ) n 

Now, if we want to get rid of the two artificial constructs, S 0 , and

q, and express the formula only in terms of what we are given, then:

S1   1 + g  n 
V = 1 −   
r − g   1 + r  

Next, we apply this formula to our current problem:

S1   1 + g  n 
V = 1 −   
r − g   1 + r  

10600   1.06  30 
= 1 −   
0.12 − 0.06   112.  
= $142 ,798 .65

This amount represents the present value of your savings, that is the
value of your savings at t=0, which we defined to be December 31,
2007. If you want to find out how much you will have in your bank
when you retire on December 31, 2037, you need to multiply this by
1.1230 to get $4,278,236.13.

HOMEWORK 3: DUE FEB 1, 2011

This is Summer 2011, and you want to work out whether going to
graduate school for your MBA, an otherwise desirable proposition
in every respect, is a financially sound decision. You have been
offered a job that pays $117,000 per year starting September 1,
2011, and you plan to take it up if you do not go for an MBA. If you
do go for an MBA, you will:

(a): have to pay $54,000 each on September 1, 2011, and

September 1, 2012 toward the cost of education, and

(b): start earning only upon graduation, with your post-MBA job
starting on September 1, 2013.

Page 5 of 6 Teaching Note and Homework 2

SCHOOL OF BUSINESS ADMINISTRATION BUS 106 WINTER 2011
UNIVERSITY OF CALIFORNIA AT RIVERSIDE AVINASH VERMA

For computational simplicity, assume that you are paid your annual
salary in a lump sum at the end of each working year. You plan to
retire on August 31, 2043 whether or not you go for an MBA in
2011. For the purposes of this problem you find it reasonable to
assume that the term structure is flat at 5%.

(i): Assuming that your income remains constant over time with
or without an MBA, that your starting salary after MBA is
$144,000, and that you save a constant 15% of your
income over your working life, work out the amount you
would have saved on retirement (a) if you go for an MBA,
and (b) if you do not go for an MBA.

(ii): Answer (i) above assuming that your income grows at the
rate of 4.5% per year without an MBA, and 6.75% a year
with an MBA.

Page 6 of 6 Teaching Note and Homework 2