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X 5 A t
(28B1)
t51
At first blush, it might seem that X must equal infinity, since the sum goes to
infinity. But notice that as t gets large, the term At gets very small, because A is less
than 1. For example, suppose that A is equal to 1/2. Then the sum is
X = 1/2 + 1/4 + 1/8 + 1/16 +
Notice that, as we continue to add terms, X approaches but never exceeds 1. From
an algebra or calculus course you may recall that the sum of a geometric progression actually has a solution:
X 5 A t 5
t51
A
12A
(28B2)
CHE-BRIGHAM-11-0504-WEB EXTN-028B.indd 1
X 5 (1 / 2)t 5
t51
1/2
51
12 (1 / 2)
(28B3)
21/03/12 9:36 PM
28WB-2
Now consider a perpetuity with a constant payment of PMT and an interest rate
of I. The present value of this perpetuity is
PMT
(
1
1 I )t
t51
PV 5
(28B4)
PV 5 PMT 1 t 5 PMT 1
1
I
1
(
)
1
1
I
t51
t51
(28B5)
Because 1 + I is positive and greater than 1 for reasonable values of I, the summation in Equation 28B-5 is a geometric progression with A = 1/(1 + I). Therefore,
using Equation 28B-2, we can write the summation in Equation 28B-5 as
1
t
1
11I
11I 5 5 1I
t51
1
12
11I
Cengage Learning. All rights reserved. No distribution allowed without express authorization.
(28B6)
Substituting this result into Equation 28B-4 gives us the present value of a perpetuity:
PV 5
(28B7)
PMT
I
Now consider the time lines for a perpetuity that starts at time 1 and a perpetuity that starts at time N + 1:
0
N+1
N+2
N+3
PMT PMT
1
N+1
N+2
N+3
Observe that, by subtracting the second time line from the first, we get the time line
for an ordinary annuity with N payments:
0
PMT PMT
PMT
Therefore, the present value of an ordinary annuity is equal to the present value of
the first time line minus the present value of the second time line. The present value
of the first time line, which is a perpetuity, is given by Equation 28B-7 as follows:
(28B8)
CHE-BRIGHAM-11-0504-WEB EXTN-028B.indd 2
PMT
I
21/03/12 9:36 PM
28WB-3
If we apply Equation 28B-7 to the second time line, it gives the value of the
payments discounted back to time N (because if we look at the time line just from N
on, it is an ordinary annuity that starts at time N + 1). To find the present value of
the second time line, we just discount this perpetuity value back to time 0:
PMT 1
(28B9)
Cengage Learning. All rights reserved. No distribution allowed without express authorization.
Subtracting Equation 28B-9 from 28B-8 gives the present value of an ordinary annuity, PVA:
(28B10)
PVA 5 PMT 1 2 1 N
I I(11I)
(28B11)
The future value of an ordinary annuity is equal to the present value compounded out to N periods:
1
1 (11I)N
FVA = PVA (1+1)N 5 PMT 2
I I(11I)N
(28B12)
CHE-BRIGHAM-11-0504-WEB EXTN-028B.indd 3
FVA 5 PMT (11I) 21
I I
(28B13)
21/03/12 9:36 PM