What Is Perpetuity? A Complete Guide
When it comes to finances and accounting for your small business there can be a lot to understand and take into consideration. There are all sorts of different terms that mean different things. So how do you know which are the most important?
Perpetuity is one of the many important concepts to know when it comes to finances. It helps make it possible to value things like real estate, stocks and other types of investment opportunities. Let’s take a look into what perpetuity is and how it works.
Here’s What We’ll Cover:
What Is Perpetuity?
What is the definition of perpetuity? Basically, perpetuity within the financial system is when a series of cash flows moves forward indefinitely and at a constant rate. Perpetuity gets used to help find the present value of your company’s projected cash flow stream.
It’s also taken into account to determine the terminal value of your business. To keep things simple, perpetuity is basically a stream of cash flows that continue to get paid out year after year. And this lasts forever.
Let’s think about it in terms of real estate. If you own an apartment and then decide to rent it out to make some extra cash, you could essentially get an unlimited stream of rent payments. The rent that is generated from your apartment could get defined as perpetuity.
Why Do Perpetuities Have Finite Values?
If you’re sitting there and wondering how a series of infinite cash flows can end up having a finite valuation, you’re not the only one. It’s a little counter-intuitive, but the real value of future cash flows will continue to fall. Whereas the present values are going to be higher in the early years.
But, the payment amount gets fixed under perpetuity. So as the years go on and inflations continue to rise, the real value of any payments will continue to decrease. This is since the cash flows in the future are going to have a near-zero valuation, even though it’s never actually zero.
Formula to Valuate Perpetuity
The good news is that calculating perpetuity is simple to do. All you need is the formula and a few details and you can get started.
PV = the present value of a perpetuity
C = the amount of cash flow you receive each period
R = the required rate of return (interest rate or yield)
PV = C / R
Let’s take a look at an example.
Your business pays £2 in dividends annually and you estimate those dividends will get paid indefinitely. So, if the required rate of return is 5%, how much are investors going to be willing to pay for the dividend?
PV = 2 / 5%
PV = £40
Basically, it could be said that an investor would invest in your company if that stock price is around £40 or less.
It’s no secret that the value of your money is going to depreciate over time. That’s why a lottery winner might choose to take a lump sum over smaller payments. To help make sure that perpetuity is going to retain its value as the years go on, payouts need to do more than just show up.
As well, they need to grow at a rate that can either match or exceed any inflation. Enabling this growth helps to guarantee that the perpetuity keeps its value as the economy fluctuates. At the end of the day, this is called growing perpetuity.
When it comes to growing perpetuities, payments don’t remain fixed. They instead show a constant growth rate. So, if 10% is the payment growth rate, then every additional payment you receive can be 10% larger than any that came previously.
It can be a bit more complicated to calculate growing perpetuity since you need to choose a specific date to do the calculation.
Some of the most classic examples of perpetuity are in real estate and insurance companies. Perpetuities are also common in certain types of bonds and other investment opportunities. Another example of perpetuity is the UK’s government bond, which is known as a Consol. Essentially, bondholders receive annual fixed coupons, or interest payments, as long as they can hold the amount. And as long as the government doesn’t discontinue the Consol.
To keep things simple, perpetuity gets used to help you find the present value of your projected cash flow. And the formula used to help calculate perpetuity is super easy to use, so you can do the calculations on your own. The basic formula is broken up between present value, amount of cash flow and the required rate of return.
The perpetuity formula looks like this: PV = C / R
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