Perpetuity

From Academic Kids

A perpetuity is an annuity in which the periodic payments begin on a fixed date and continue indefinitely. Fixed coupon payments on permanently invested (irredeemable) sums of money are prime examples of perpetuities. Scholarships paid perpetually from an endowment fit the definition of perpetuity.

The value of the perpetuity is finite because receipts that are anticipated far in the future have extremely low present value (today's value of the future cash flows). Additionally, because the principal is never repaid, there is no present value for the principal. The price of perpetuity is simply the coupon amount over the appropriate discount rate or yield. To give a numerical example, a 3% UK government War Loan will trade at 50 pence per pound in a yield environment of 6%, whilst at 3% yield it is trading at par.

Real Life Examples

For example, UK government bonds, called consols, that are undated and irredeemable (e.g. War Loan) pay fixed coupons (interest payments) and trade actively in the bond market. Very long dated bonds have financial characteristics that can appeal to some investors and in some circumstances, e.g. long-dated bonds have prices that change rapidly (either up or down) when yields change (fall or rise) in the financial markets.

A more current example is the convention used in real estate finance for valuing real estate with a cap rate. Using a cap rate, the value of a particular real estate asset is either the net income or the net cash flow of the property, divided by the cap rate. Effectively, the use of a cap rate to value a piece of real estate assumes that the current income from the property continues in perpetuity.

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