Lecture 2 - FINM7006.pptVIP

* * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * 2.4.1 Present Value of Annuities Annuity Due Example The present value of an annuity due comprising 10 annual cash flows of $500 each is calculated as follows given an interest rate of 10% p.a. : When we compare this with the present value of the ordinary annuity from Slide 29, we see the present value of the annuity due is higher. Why? * 2.4.1 Present Value of Annuities 3) Deferred Annuity Recall that a deferred annuity is simply an annuity that commences as some time in the future. To calculate the present value of a deferred annuity that commences in m periods and comprises n cash flows of $F, we use the following: * 2.4.1 Present Value of Annuities Deferred Annuity Example The present value of a deferred annuity commencing in 5 years that comprises 10 annual cash flows of $500 each is calculated as follows given an interest rate of 10% p.a. : What about if there are an infinite number of cash flows? * 2.4.2 Present Value of Perpetuities A perpetuity is a series of equally spaced cash flows of same dollar value that continues on forever. As with annuities, perpetuities can be broken into three types based on the time until the first cash flow occurs, namely: Ordinary Perpetuities; Perpetuities Due; and, Deferred Perpetuities. * 2.4.2 Present Value of Perpetuities 1) Ordinary Perpetuity Ordinary Perpetuity: The time between now and the first cash flow is the same as the time separating subsequent cash flows. The only difference between an ordinary perpetuity and an ordinary annuity is that, in the case of the ordinary perpetuity, cash flows continue forever. The present value of an ordinary perpetuity comprising individual cash flows of $F is calculated as: * 2.4.2 Present Value of Perpetuities Ordinary Perpetuity Example The present value of an ordinary perpetuity that comprises annual cash flows of $500 each is calculated as follows given an interest rate of 1