Types of Fixed Income Securities
When the term “fixed income securities” is mentioned, investors immediately conjure up images of bonds in their heads. However, this is a generalization on the part of the investors. In reality, fixed income securities can refer to many different types of securities. As an investor, one must be aware of the wide range of securities […]
Conflict of Interest in Investment Banking
Investment banking institutions are engaged in multimillion-dollar transactions. This means that if an investment bank is perceived to be operating in a conflict of interest situation, it could severely damage the reputation of the bank. This lost reputation could end up becoming a financial loss is no time. There have been several instances where conflict […]
Advantages of Non-Interest Income
Over the years, corporate banking has become a very important part of the overall banking system. This is because of the fact that banks derive a bulk of their profits from their commercial or corporate banking divisions. Now, the reason that banks derive a larger than usual percentage of their revenue from their commercial banking […]
Categorizing Behavioral Biases
The field of behavioral finance has become fairly developed over the years. There have been many psychologists as well as economists who have been spending a lot of time trying to obtain more information about how behavioral finance impacts decision making. This is the reason that in the past few articles, we have come across […]
What is Cost of Equity? – Meaning, Concept and Formula
Theoretical Concept The cost of equity concept is very important when it comes to valuing shares on the stock market. Equity, like all other investment classes expects a compensation to be paid to its investors. The problem however is that unlike debt and other classes the cost of equity is never really straightforward. You can […]
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.
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