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+
=
+
+ +
+
+
+
+
+
=
=
N
1 n
n N 3 2
) r 1 (
C
) r 1 (
C
...
) r 1 (
C
) r 1 (
C
) r 1 (
C
PV
4-42
Present Value of an Annuity
To find a simpler formula, suppose you invest
$100 in a bank account paying 5% interest. As
with the perpetuity, suppose you withdraw the
interest each year. Instead of leaving the $100 in
forever, you close the account and withdraw the
principal in 20 years.
4-43
Present Value of an Annuity (contd)
You have created a 20-year annuity of $5
per year, plus you will receive your $100
back in 20 years. So:
Re-arranging terms:
) years 20 in 100 ($ PV ) year per 5 $ of annuity year 20 ( PV 100 $ + =
31 . 62 $
) 05 . 1 (
100
100
) years 20 in 100 ($ PV 100 $ ) year per 5 $ of annuity year 20 ( PV
20
= =
=
4-44
Present Value of an Annuity
For the general formula, substitute P for the
principal value and:
|
|
.
|
\
|
+
=
N
r) 1 (
1
1
r
1
C r) rate interest with periods N for C of PV(annuity
N N
PV(annuityof Cfor Nperiods)
P PV(Pinperiod N)
P 1
P P 1
(1 r) (1 r)
=
| |
= =
|
+ +
\ .
C/ r P =
4-45
Textbook Example 4.8
4-46
Future Value of an Annuity
Future Value of an Annuity
( )
(annuity) V (1 )
1
1 (1 )
(1 )
1
(1 ) 1
= +
| |
= +
|
+
\ .
= +
N
N
N
N
FV P r
C
r
r r
C r
r
4-47
Textbook Example 4.9
4-48
Growing Cash Flows
Growing Perpetuities
Assume you expect the amount of your
perpetual payment to increase at a constant
rate, g.
Present Value of a Growing Perpetuity
(g<r)
(growing perpetuity)
=
C
PV
r g
4-49
Textbook Example 4.10
4-50
Alternative Example 4.10
Problem
In Alternative Example 4.7, you planned to
donate money to endow a chair at your alma
mater to supplement the salary of a qualified
individual by $100,000 per year. Given an
interest rate of 4% per year, the required
donation was $2.5 million. The University has
asked you to increase the donation to account
for the effect of inflation, which is expected to
be 2% per year. How much will you need to
donate to satisfy that request?
4-51
Alternative Example 4.10 (contd)
The timeline of the cash flows looks like this:
The cost of the endowment will start at $100,000,
and increase by 2% each year. This is a growing
perpetuity. From the formula:
C $100, 000
PV $5, 000, 000
r .04 .02
= = =
\
|
+
=
N
r r
P
C
) 1 (
1
1
1
4-58
Textbook Example 4.15
4-59
4.9 The Internal Rate of Return
In some situations, you know the present
value and cash flows of an investment
opportunity but you do not know the
internal rate of return (IRR), the
interest rate that sets the net present
value of the cash flows equal to zero.
4-60
Textbook Example 4.16
4-61
Textbook Example 4.17