Annuities∶special situations Perpetuities.pptVIP

Chapter 12 Annuities:special situations 12.1 Perpetuities A perpetuity is an annuity whose payments continue forever. The initial amount used to establish a perpetuity is sometimes called an endowment. An ordinary perpetuity is a perpetuity with the payments are made at the end of each payment interval and continue forever. Present value of an ordinary perpetuity Because a perpetuity is an annuity with payments that continue forever, we can not calculate the future value of it. Example A chartered bank is considering the establishment in perpetuity of the visiting Professor Chair in Policy at a university. The cost would be $7500 at the end of each month. a, If money can earn 6% compounded monthly in perpetuity, what endowment would be required to fund the position? b, what monthly compounded nominal rate would an endowment of $1.25 million have to earn to fully fund the position? Solution: R=$7500 j=6% compounded monthly i=j/m=6%/12=0.5% per month payment interval=1 month p=i=0.5% A=$1,250,000 and R=$7500 per month Example Some preferred shares promise a fixed periodic dividend in perpetuity. a, what is the fair market value of a perpetual preferred share just after payment of its quarterly $0.50 dividend if the market requires a return of 7.5% compounded quarterly on preferred share issues of similar risk? b, what will be an investor’s quarterly compounded nominal rate of return if she is able to purchase these shares at $25.00 each? Solution: a, R=$0.50 j=7.5% compounded quarterly payment interval=1 quarter i=p=j/m=1.875% per quarter b, A=$25.00 R=$.05 p=i=2% m=4 j=m*i=4*2%=8% compounded quarterly Example Mrs. Paquette set up a trust fund with an initial contribution of $150,000. The funds are to be immediately invested, and the first semiannual payment of a perpetuity is to be made in 5 years. The payments are to be used for the care of her disabled son for the rest of his life and then pa