Financial and Economic Models used in the Equity and Currency Markets
We often read about how electronic and software based trading is the norm in stock or equity markets as well as currency and other financial markets. Indeed, anyone who is remotely connected with the stock market or for that matter any financial market would know that there are trading systems and trading software that help […]
How are Broadcasting Rights Revenue Split Amongst Franchises?
In the previous article, we have already seen the importance of broadcasting revenue. We also know what the shortcomings of broadcasting revenue are. However, in this article, we will have a closer look at a bigger problem which is how the revenue generated by the sale of broadcasting rights should be split between various stakeholders. […]
Intermediaries to a Credit Card Transaction
In the past couple of decades, banks have started providing a new type of product called the credit card. The credit card is a revolving line of credit which is offered to customers. Customers can use the card to borrow money to make purchases. They are then offered a credit free period. If they are […]
What is Strategic Budgeting?
The budgeting process is an integral part of any business. The budgeting process is ubiquitous and underlies almost every decision in the corporate world. In fact, critics of the budgeting process argue that the process takes too much of the management’s time. The management typically spends 25% to 30% of four months of their time […]
The Use of Reference Rates in Financial Markets
Debt securities are widely issued and traded in the secondary market. Debt securities could have a fixed interest rate or a floating interest rate. When debt is taken for the short term, fixed interest rates are preferred. However, in the medium to long run, the interest rates cannot be directly fixed. This is because, as […]
We have seen that a perpetuity represents an infinite stream of future cash flows. However, we have also seen that as time passes the value of these cash flows constantly diminishes. $100 may be able to buy us quite a few goods today, but in 50 years time $100 will not be nearly as valuable as it is today. It is for this reason that receiving infinite payments is not enough. The payments must also keep growing at a certain rate. This will ensure that they are not considerable behind inflation. This is the idea behind a growing perpetuity. The same has been explained in detail in this article:
As already stated, a growing perpetuity involves payments that do not remain fixed. Instead these payments keep on growing at the same constant rate of growth. So, if the rate of growth of the payments is 7%, each payment will be 7% more than the payment received before it.
The present value of a growing perpetuity can be derived from a complex mathematical calculation. This is because a growing perpetuity is also an infinite series which has a finite sum. For our purposes, we can just remember the formula required for our calculation.
Present Value (Growing Perpetuity) = D / (R - G)
Where:
D = Expected cash flow in period 1
R = Expected rate of return
G = Rate of growth of perpetuity payments
However, we need to understand that for this formula to hold true, G must always be greater than R. If G is less than R or equal to R, the formula does not hold true. This is because, the stream of payments will cease to be an infinitely decreasing series of numbers that have a finite sum.
Examples:
Growing perpetuities are found in a variety of places in our daily lives. Some of them have been mentioned below:
The growing perpetuity, thus assumes that we will lose a small amount of the real value of money every year. Just like the perpetuity, a growing perpetuity can only be summed up because the series is infinitely decreasing. The growing perpetuity assumes that we will lose the real value of money at a slower rate as compared to an ordinary perpetuity.
Your email address will not be published. Required fields are marked *
