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12
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Special
Situations
Chapter 12
McGraw-Hill
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Ryerson

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Learning
Objectives

After completing this chapter, you will be able to:

Calculate the
LO1.1.
LO

Present Value of a perpetuity or

deferred perpetuity

LO2.2.
LO

Present Value and Future Value

of an annuity whose payment size
grows at a constant rate

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12-3

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Calculation of

Perpetuity
or
Deferred
Perpetuity
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12-4

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Special

Ordinary Perpetuities
Perpetuities
Ordinary

12
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perpetuity
is an
annuity
whose

payments
continue
forever.
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A $100,000 bequest is made to Seneca

College to establish a
perpetual bursary fund.
If the college invests
the funds to earn 6% compounded
annually,
the
maximum amount that can be paid out
on each anniversary
of the bequest is

$100,000 * 0.06 = $6,000

If more than this was to be paid out,

a loss of principal would result.

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Ordinary Perpetuities
Perpetuities
Ordinary

12
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Present Value of:

Formula
Formula

PV = PMT / i

If the
the payment
payment interval
interval
If

equals
equals

the
the
compounding interval
interval,,
compounding

the perpetuity
perpetuityisis an
an
the

ordinary simple
simple
ordinary
perpetuity
perpetuity

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Otherwise
an
itit isis an

ordinary
ordinary
general
general
annuity
annuity

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What endowment is required to establish a

perpetuity with an ongoing cost of $6,000 at
the end of each month if interest is 6.0%
compounded monthly in perpetuity?

Formula
Formula

PV = PMT / i
= 6000 / (.06/12)

= $1,200,000

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Reorganize
Reorganize
findii
totofind

What monthly compounded nominal rate of

return must an endowment of $1 million
earn to fully fund a perpetuity with an
ongoing cost of $4,000 at the end of each
month?

Formula
Formula

PV = PMT/ i

i = PMT / PV
i

= 4000 / 1 000 000

= 0.004
= 0.4% per month

The required nominal rate of return is:

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12 * 0.4% = 4.8% compounded

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12

What endowment is required to establish a

Annuities
Annuities
perpetuity with an ongoing cost of
$6,000 at the end of each month if interest
is 6.0% compounded annually in
perpetuity?
Since
Sincethis
thisisisaageneral
generalperpetuity,
perpetuity,we
weneed
needto
todetermine
determineccand
andii22
number of compoundings per year
1 = .0833
C=
=
number of payments per year
12

i2 = (1+i)c - 1
= (1.06)0.0833-1
= 0.00486755
PV = 6000 / 0.00486755
1,232,652.83
== $$ 1,232,652.83

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Special
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12
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Calculating initial endowment

for a
General Perpetuity

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12-9

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12
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What amount must be placed in a perpetual

fund today if it earns 4.0% compounded
semi-annually and monthly payments of
$700 in perpetuity are to start 1 month from
now?

Since
Sincethis
thisisisaageneral
generalperpetuity,
perpetuity,we
weneed
needto
todetermine
determineccand
andii22
number of compoundings per year
2 = .1667
C=
=
number of payments per year
12

i2 = (1+i)c - 1
= (1.02)0.1667-1
= 0.00330589
PV = 700 / 0.00486755
= $ 211,743.26
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12
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What amount must be placed in a perpetual

fund today if it earns 4.0% compounded
semi-annually and monthly payments of
$700 in perpetuity are to start 1 YEAR from
now?

We
Wehave
have already
already determined
determined the
the value
value
at
at the
the beginning
beginning of
of the
the
payments
paymentsThis
This isis the
the value
value
PV = $ 211,743.26
11months
months
11
from now
now
from
-n
Formula
PV
=
FV(1
+
i)
Formula
PV = 211743.26 (1 + 0.00330589)-11
= $204,193.83
McGraw-Hill Ryerson

This isis the

the value
value
This
now
now

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LO2.2.
LO

Constant Growth

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12-13

ConstantGrowth
Growth
Constant

Annuities
Annuities
Annuities in which the
payments change
by
the same percentage
from one
payment
to
another
Let g
g == rate
rate of
of growth
growth in
in payment
payment size
size
Let
between successive
successive payments
payments
between

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Special

ConstantGrowth
Growth
Constant

12
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Annuities
The following formulae will be used:

Formula
Formula

Formula
Formula

McGraw-Hill Ryerson

FV

= PMT [

(1+ i)n - (1+g)n

PV

= PMT [

1- (1+g)n(1+ i)-n

i-g

i-g

]
]

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12-15

ConstantGrowth
Growth
Constant
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Annuities

You intend to make RRSP contributions on Feb.28

of each year. You plan to contribute $2,000 in the
first year and increase the contribution
by 4% every year thereafter.
a) How much will you have in your RRSP at the time
of your 20th contribution if the plan earns 7.5%
compounded annually?
b) What will be the amount

of your
last contribution?
Extract necessary data...

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a) How much will you have in your RRSP at the

time of your 20th contribution if the plan earns
7.5% compounded annually?

PMT = $2000
Youintend
intendto
tomake
make
You
RRSPcontributions
contributions
RRSP
onFeb.28
Feb.28of
ofeach
each
on
year. You
Youplan
planto
to
year.
contribute$2000
$2000in
in
contribute
thefirst
firstyear
yearand
and
the

increase the
the
increase
contribution
contribution
by4%
4%every
every
by
yearthereafter
thereafter..
year

McGraw-Hill Ryerson

g = 4%

i = 0.075 n = 20

PV = 0

FV = ?

Solve

n
n
(1+
i)
(1+g)
FV = PMT

i-g

20
20
(1.075)
(1.04)
FV = 2000
0.075 - 0.04

Solve

12-17

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PMT = $2000 i = 0.075 n = 20

g = 4% PV = 0 FV = ?

12
Annuities
Annuities

Solve

117,527.31
2.0567
4.2479
2.1911

1.04

20

1.075

20
0.035

McGraw-Hill Ryerson

2000

Amount in
in the
the
Amount
RRSPat
at the
the time
time
RRSP
of the
the 20th
20th
of
contribution
contribution

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(b) What will be the amount

Youintend
intendto
tomake
make
You
RRSPcontributions
contributions
RRSP
onFeb.28
Feb.28of
ofeach
each
on
year. You
Youplan
planto
to
year.
contribute$2000
$2000in
in
contribute
thefirst
firstyear
yearand
and
the

increase the
the
increase
contribution
contribution
by4%
4%every
every
by
yearthereafter
thereafter..
year

McGraw-Hill Ryerson

of
your last contribution?
The final payment will be the
Future Value of $2000

after
19 compoundings
at 4%

Formula FV = PV(1 + i)n

Formula
= 2000( 1+ 0.04)19
= $4,213.70

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12-19

ConstantGrowth
Growth
Constant
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Annuities

How much will it cost to purchase a

25-year ordinary annuity
making semiannual payments
that grow at the rate of 3%
compounded semiannually?

McGraw-Hill Ryerson

The first payment is $10,000

and the funds used
to purchase the
annuity
earn 5% compounded
semiannually.
Solution
Solution

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12-20

ConstantGrowth
Growth
Constant
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Annuities
The cost
will be the PV of the payments.

Howmuch
much
How
willititcost
costto
topurchase
purchase
Extract necessary data...
will
25-yearordinary
ordinary
aa25-year
annuitymaking
making
PMT = $10000 i = 0.05/2 = 0.025
annuity
semiannualpayments
payments
semiannual
n = 50 g = 3%/2 = 0.015 PV = ?
that
grow
at
the
rate
that grow at the rate
3%compounded
compounded
ofof3%
semiannually?
Solve
semiannually?
Thefirst
first
n
-n
The
1(1+
g)
(1+
i)
paymentisis$10,000
$10,000
PV = PMT
payment
i-g
and
the
and the
funds
used
50
-50
funds used
1(1.015)
(1.025)
PV
=
10000
toto
.025 .015
purchasethe
theannuity
annuity
purchase
Solve
earn
5%
earn 5%
compounded
compounded

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Howmuch
much
How
willititcost
costto
topurchase
purchase
will
25-yearordinary
ordinary
aa25-year
annuitymaking
making
annuity
semiannualpayments
payments
semiannual
thatgrow
growat
atthe
therate
rate
that
3%compounded
compounded
ofof3%
semiannually?
semiannually?
Thefirst
first
The
paymentisis$10,000
$10,000
payment
andthe
the
and
fundsused
used
funds
toto
purchasethe
theannuity
annuity
purchase
earn5%
5%
earn
compounded
compounded

McGraw-Hill Ryerson

PV = 10000 1- (1.015)50(1.025)-50
.025 .015
387,496.12
-0.3875
0.6125
2.1052
0.2909
1.025

Costof
ofthe
the
Cost
annuity
annuity

50

1.015
50

1
0.01

10000

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This completes Chapter 12

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