What is Perpetuity? | Definition, Working, Advantages vs Disadvantages

The term ‘perpetuity’ means what the word suggests – a never-ending cash flow of a certain amount that goes on for an unspecified or unending period. It is, in essence, a kind of annuity with periodic payments that begin at a certain time and then last perpetually.

The calculation of the present value of perpetuity depends on various factors. The formula used to calculate the current value of a perpetuity is:

​P =C _(1+r)1 + C_(1+r)2 + C_(1+r)3 … = C_r

Here, ‘P’ refers to the present value of the amount, ‘C’ represents the cash flow, and ‘r’ is the discounted rate.​

Key Takeaways

1. Perpetuity is a financial concept representing a stream of indefinite cash flows.
2. Perpetuities are used in finance to calculate the present value of an asset with infinite cash flows.
3. The present value of infinity can be calculated using the formula PV = C / r, where PV is the present value, C is the cash flow per period, and r is the discount rate.

Understanding what perpetuity is

The basic concept, as already understood, is security yielding a never-ending cash flow. To comprehend this better, we will look at the components of perpetuity and some examples.

1. A good example is the British bonds known as ‘consols’, which were redeemed in 2015. By purchasing a console, a person was entitled to receive regular yearly payments without a specific time limit.
2. An opportunity like this seems highly lucrative, but at the same time, it is not. How the amount is calculated factors in the time value of the money, so each instalment can be just a fraction of the previous. The payments may go on forever, but the amount paid never amounts to too much.
3. Other common examples include scholarships granted from a particular endowment fund or permanently invested and irredeemable money.
4. The basic nature and concept of perpetuity are used in several financial theories. A few instances include calculations of the Dividend Discount Model and valuation of financial assets or real estate finances.
5. The perpetuity formula is also commonly used to determine the cash flow in a business’s ‘terminal year’.

Advantages of a perpetuity

1. The benefits of perpetuity can be realized shortly, which is one of the major advantages of perpetuity over annuities or other bonds.
2. An assured cash flow (regardless of the amount) allows better investments and a backup financing option for future expenditures and purchases.
3. Risks regarding fluctuations in the capital market may be effectively avoided. Costs and interest rates may become higher in the future, and this serves as a mode of safe investment and regular yields.
4. Perpetuities are highly useful for scholarship payments or charities as they ensure a regular cash flow in specific intervals.

Disadvantages of a perpetuity

1. It isn’t easy to calculate the face value of perpetuity because it goes on indefinitely into the future.
2. Since amounts are likely to reduce in the future, it is not a good option for retiring people to rely on.
3. Investing in such a bond may not be viable in the long run since the money cannot be withdrawn. Thus, regardless of your financial situation, it will stay tied up in perpetuity even if it is not yielding satisfactory results.

References

1. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2755252
2. https://www.tandfonline.com/doi/abs/10.1080/03461238.1990.10413872