ANALYSIS OF FINANCIAL FLOWS

AND INVESTMENTS II 4
Annuities
Only rarely will one encounter an investment or loan where the underlying financial arrangement is as simple
as the lump sum, single cash flow problems presented previously. Financing arrangements on real estate and
other capital will most often involve a number of costs and benefits that may occur simultaneously or at different
times, which, taken together, are referred to as a stream of cash flows. A single cash flow is the net amount of
all costs and benefits that occur during a single interval of time.

The preceding chapter introduced financial relationships which had, among others, the following characteristics:

C payments of the same amount

C payments occurring at regular intervals

In the jargon of the mathematics of finance, any stream of payments having these two characteristics is said to
be an annuity. A number of types of annuities are defined, characterized by the frequency of compounding, the
timing of the payments, and whether the compounding and payment periods are identical.

One type of annuity corresponds to that used in the illustrations and examples in the preceding chapter. This type
of annuity has the following characteristics:

C payments of equal size

C payments occurring at regular intervals
C compounding periods corresponding exactly to payment periods
C payments occurring at the end of compounding (and payment) periods

When an annuity can be characterized in this fashion, it is referred to as an ordinary simple annuity. When
analyzing ordinary simple annuities, one may use the relationship:

PV = PMT a n,j

to directly solve for any of the unknown terms. The term ordinary simple annuity is a composite of two key
features. The term simple annuity refers to any annuity where the frequency with which payments are made or
received exactly matches the frequency at which interest is charged or calculated. This is contrasted with a
general annuity where payment periods and compounding periods do not correspond. Thus, annuities are
distinguished according to the correspondence of payment and compounding periods.

Annuities are also distinguished by whether payments occur at the beginning or end of payment periods. An
ordinary annuity is any annuity where payments occur at the end of payment periods. An annuity due is an
annuity where payments occur at the beginning of payment periods.

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Chapter 4

Thus annuities (regular payments occurring at regular intervals) fall into one of four types, as shown in Table 1:

PAYMENTS OCCUR AT:
Beginning of Payment Periods
End of Payment Periods
Ordinary Simple Annuity
(Ordinary Annuity)
Table 1
Types of Annuities
COMPOUNDING PERIODS AND
PAYMENT PERIODS ARE:
Same Different
(Simple Annuities) (General Annuities)
Simple Annuity Due General Annuity Due
Ordinary General Annuity

An ordinary simple annuity is one in which the payments are due at the end of payment periods and the payment
interval is identical to the interest compounding period.

Time Diagram: Ordinary Simple Annuity

A simple annuity due is one in which the payments are due at the beginning of payment periods and the payment
interval is identical to the interest compounding period. A stream of rent payments may be considered as an
example of a simple annuity due.

Time Diagram: Simple Annuity Due

An ordinary general annuity is one in which the payments are due at the end of the payment period and the
payment period is not identical to the interest compounding period. This payment pattern conforms to that used
almost exclusively for long-term residential mortgages in Canada (i.e., mortgage loans with monthly payments
and interest is compounded semi-annually).

The vast majority of Canadian mortgage loan repayment schemes represent a form of ordinary general annuity:
payments are made at the end of payment periods (hence ordinary), the interest compounding frequency does
not match the payment frequency (hence general), and the payments occur at regular intervals and are of equal
amounts (hence annuity).

4.2
 Analysis of Financial Flows and Investments II

Time Diagram: Ordinary General Annuity

As the payment frequency does not equal the compounding frequency in a standard mortgage (or ordinary
general annuity), one cannot directly apply the present value relationship:

PV = PMT a n,j

developed for solving problems in the form of ordinary simple annuities. Rather, one must first modify the
elements of the relationship by finding the equivalent values that would exist if compounding and payment
periods were made to correspond. This procedure utilizes the analytical techniques presented in Chapter 2 and,
in effect, converts an ordinary general annuity to an equivalent ordinary simple annuity.

There are a variety of approaches to the conversion of ordinary general annuities to equivalent ordinary simple
annuities. The approach presented in this chapter is the most efficient for an analyst utilizing a financial
calculator. An alternative approach is presented in Chapter 5.

A general annuity due is one in which the payments are due at the beginning of the payment period and the
payment period is not identical to the interest compounding period.

Time Diagram: General Annuity Due

The term of an annuity is defined as the period of time from the beginning of the first payment period to the end
of the last payment period. Hence, in the case of an ordinary annuity, the term is measured from the beginning
of the period in which the first payment is made until the date of the last payment. In the case of an annuity due,
the term is from the date of the first payment until the end of the period in which the last payment is made.

4.3
Chapter 4

The analysis of cash flows associated with annuities can be used to examine a wide range of financial
arrangements, including mortgages, leases, and real estate equity investments. Often these financial arrangements
are relatively complex, involving cash flows over long periods of time. However, the basic techniques of
discounting and compounding presented previously are extended to develop an efficient means of analyzing
certain complex cash flows common in real estate.

In the previous chapter, techniques of analysis for ordinary simple annuities have been presented. In these cases,
one can use the relationship:

PV = PMT a n,jm

to determine any one of the following terms providing the others are known:

C PV, the present value of the payments at the time of the beginning of the first payment period
C PMT, the size of the regular payments which occur at the end of each and every payment (and
hence compounding) period
C N, the number of payments (and hence compounding) periods in the term of the annuity
C I/YR, the nominal interest rate (jm)
C P/YR, the number of compounding and payment periods in one year (m)

If the payment pattern does not correspond to that of an ordinary simple annuity, the analysis cannot be carried
out directly using this relationship. Methods for solving other types of annuities (i.e., ordinary general annuity,
simple annuity due, and general annuity due) are described below.

Constant Payment Mortgage Loan

The constant payment mortgage loan has equal payments throughout the life of the loan. Payments are made
on a specified day, at a specified frequency, for example, monthly, semi-monthly, bi-weekly, or weekly. Each
payment includes all interest due for that period plus some repayment of principal. While the total payment is
constant for the duration of the term, the components of interest and principal change during the loan.

By the time a constant payment mortgage loan expires, all of the principal amount has been repaid by periodic
payments. As is illustrated in Figure 1, the early payments on a fully amortized constant payment loan are
mainly interest with a little principal since the borrower must pay interest on a large outstanding principal
amount. However, as each payment is made, an increasing portion of the principal is repaid thereby reducing
the outstanding balance on which interest is charged during the next period. As a result of the decreasing
balance on which interest is charged, the interest portion of the payment gradually decreases and the principal
repayment portion increases. As the end of the loan approaches, little principal remains outstanding and
relatively little interest is due. Thus, almost all of the payment is assigned to principal repayment.

4.4
 Analysis of Financial Flows and Investments II

Figure 1
Outstanding Balance and Periodic Payments on a Constant Payment Mortgage

Constant payment loans are referred to as amortized loans (as contrasted to interest only and interest accruing
loans discussed earlier). Amortization refers to the fact that the amount owing on the loan is reduced over the
term of the loan. Constant payment loans can be classified as either fully amortized or partially amortized. A
fully amortized loan is a loan in which the entire amount of principal is repaid by periodic payments and the final
regular payment will repay the remaining principal balance and accrued interest. The interest owing at the end
of each compounding period is subtracted from the payment, the remaining amount then goes to reduction of
the debt. The last regular payment1 pays off the final amount of principal owing at the end of the last payment
period of the loan. In the case of a fully amortized loan, the amortization period and the term of the loan are
equal.

A partially amortized loan is one in which the debt is only partially repaid using the regular periodic payments
of principal and interest during the term of the loan. An additional (non-regular) payment (generally at the end
of the contractual life of the loan) is required to pay off the unamortized portion of the loan. With a partially
amortized loan, the amortization period is greater than the term of the loan (i.e., a mortgage is amortized over
25 years with a five-year contract term). In this example, the regular payments made by the borrower are based
on the amortization period of 25 years. However, the borrower makes these payments for only 5 years. At the
end of the 5 years, the principal balance which remains outstanding is repaid or refinanced by the borrower.
Since payments made early in the life of a constant payment loan are largely comprised of interest, the
outstanding balance due at the end of five years on a loan with a 25-year amortization is large. The use of
partially amortized loans permits regular payments to be based upon a long amortization period (i.e., 20-25
years) and at the same time permits lenders and borrowers to adjust the rate of interest charged on loans at the
end of the loan's contractual term.

Real estate financing mainly involves the use of constant payment mortgages. Part of this chapter reviews the
financial calculations necessary to determine loan amounts, periodic payments (monthly or otherwise),
amortization periods, and interest rates.

1
Subject to the rounding of payments discussed earlier.

4.5
Chapter 4

The Standard Canadian Mortgage Loan

Most borrowers and lenders, particularly in the residential real estate market, prefer to have loans repaid using
equal monthly payments of blended interest and principal (blended payment) rather than accrued interest or interest
only repayment plans. The use of twelve equal and relatively small payments rather than one or two large
payments during the year has budgetary appeal for both parties. The techniques of financial analysis presented in
Chapter 3 are directly applicable to mortgages with monthly payments providing a monthly interest rate is
specified. Analysis of such mortgages is very straightforward since they take the form of ordinary simple
annuities.

However, mortgage contracts which specify monthly payments and quote a monthly rate of interest are rare in
Canada. The more common situation is to have a mortgage which requires monthly payments but quotes the
rate of interest for either semi-annual or annual compounding. The Interest Act requires that all blended payment
mortgages contain a statement showing the principal amount of the loan and the rate of interest compounded
either annually or semi-annually, not in advance, that is to apply to the principal (as discussed in Chapter 2).

As a result of this requirement, most mortgage loans specify that payments be made monthly while quoting
interest rates for semi-annual compounding.2 This means that the techniques of mortgage analysis presented in
Chapter 3 cannot be directly applied to the majority of mortgage loans in Canada since these mortgages do not
satisfy the requirements of an ordinary simple annuity (i.e., they do not have matching payment and
compounding periods). In order to facilitate easy and efficient analysis of the standard Canadian mortgage loan
(one which specifies semi-annual compounding and monthly payments), it is necessary to utilize the concept of
equivalent interest rates introduced in Chapter 2.

Calculations for Constant Payment Mortgages

There are four basic financial components in all constant payment mortgage loans:

(1) The Loan Amount: The loan amount (or face value of the mortgage) is the amount the borrower agrees
to repay at the interest rate stated in the mortgage contract. In financial terms, the loan amount is the
present value of the required payments.

(2) The Nominal Rate of Interest: The frequency of compounding of the nominal interest rate must match
the frequency of the payments. For example, if a loan called for interest at 10% per annum,
compounded semi-annually with monthly payments, the equivalent nominal rate of interest with monthly
compounding would need to be calculated.

(3) The Amortization Period: The amortization period is used to calculate the size of the required
payments. The amortization period must be specified in terms of the number of payment periods, so
a loan calling for monthly payments over 25 years has 300 (25 12) payment periods.

(4) The Payment: The constant payment required to repay the loan amount over the amortization period
is calculated such that, if payments are made regularly, the last payment will repay all remaining
principal as well as interest due at the end of the final payment period.

2
The almost universal practice in Canadian mortgage financing is to express interest with semi-annual compounding rather than annual
compounding. The implications of this practice are discussed in this chapter.

4.6
 Analysis of Financial Flows and Investments II

The calculator also uses a fifth piece of information, the future value (FV). The future value, however, is equal
to zero when doing basic calculations for constant payment mortgages, because these mortgages are always
completely paid off (have a future value of zero) at the end of the amortization period.

The financial calculator used in this course is preprogrammed to calculate loan amounts (PV), future values
(FV), payments (PMT), amortization periods (N), and interest rates (I/YR). By entering any four of these
variables (PV, FV, PMT, N, and I/YR), the calculator can then determine the fifth variable.

The following conditions must occur in order to use the calculator to analyze a constant payment mortgage:

(1) The present value must occur at the beginning of the first payment/compounding period.

(2) The payments must be equal in amount, occur at regular intervals, and be made at the end of each
payment period.

(3) The rate of interest must be stated as, or converted to, a nominal rate with compounding frequency
matching the payment frequency.

Present Value Analysis and Ordinary General Annuities

An understanding of the present value relationship for ordinary general annuities, and an ability to work with
such annuities permits a wide range of financial analysis. In the context of real estate, the ordinary general
annuity has relevant applications for the appraisal of income-producing property and for real estate finance.
Applications in real estate finance include the calculation of payments, loan amounts, contract rates, amortization
periods, outstanding balances, yields, discounts, and bonuses.

The methods of converting an ordinary general annuity into an equivalent ordinary simple annuity are discussed
in the context of calculating the present value of an annuity. Once the method of conversion has been presented,
it will then be used in other real estate applications.

Illustration 4.1
A local trust company has been approached by someone seeking long term mortgage money. The borrower is
willing to pay $4,000 per month for a 15 year period.

Statement of Problem:

What is the largest loan the trust company should advance if it desires a yield of 14% compounded semi-
annually, not in advance, and the loan is to be fully amortized in 15 years?

Analysis:

Data

Payments = $4,000 = PMT

Frequency of Payments = Monthly
j2 = 14% 6 isa = 7%
N = 15 years (180 payment periods and 30 compounding periods)

4.7
Chapter 4

As the payment period does not match the frequency of compounding, the payments will not be represented by
PMT. (At this point, the $4,000 per month payment will be represented by W rather than PMT as PMT
generally applies to simple annuities).

Time Diagram

Solution:

This problem, in this particular form, is unlike any presented up to this point. When one is presented with
a financial arrangement that calls for different frequencies of compounding and payment, it is necessary
either to calculate the rate of interest per payment period that is equivalent to the stated interest rate per
compounding period, or to calculate a payment per compounding period that is equivalent to the stated
periodic payment. The first alternative is generally used for analysis carried out utilizing a financial
calculator. The second method, discussed in Chapter 5, is generally used for analysis carried out utilizing
valuation tables.

In this illustration, the lender expects a return on investment of 14% per annum compounded semi-annually,
or 7% per semi-annual compounding period. However, the borrower is to make payments on a monthly
basis. The first step in the analysis consists of calculating the nominal rate with monthly compounding that
is equivalent to a rate of 14% per annum, compounded semi-annually.

CALCULATION
Press Display Comments
14 NOM% 14 Nominal interest rate

2 P/YR 2 Number of compounding periods per year

EFF% 14.49 Effective annual interest rate

12 P/YR 12 Payment frequency

NOM% 13.6083121618 j12 (nominal rate with monthly compounding)3

12 = 1.13402601348 imo (monthly rate)

3
The nominal monthly rate (of 13.6083121618%) is now stored in the I/YR key. Equivalent interest rates should not be typed into the
calculator, rather they should be internally calculated and used directly. The reason for this approach is that the internally calculated
equivalent interest rate is more precise. While the calculator displays a rate of 13.6083121618%, it may be stored differently. That is,
the calculator carries more accuracy than it displays on the screen. Occasionally readers will arrive at an answer for a problem presented
in these chapters that is slightly different from the solution presented. A frequent cause for this type of difference is that readers may
have typed in or re-entered an interest rate rather than calculating and using it directly (in which case the calculator will use a more
precise value). On rare occasions minor errors may occur because of the different methods of handling interest rate conversions.

4.8
 Analysis of Financial Flows and Investments II

The above calculations have the effect of restating the problem presented in Illustration 4.1 in a form where
the loan amount can be determined directly using the formula for ordinary simple annuities. It is known that
the borrower is prepared to make payments of $4,000 per month, that the loan involves 180 monthly
payments (15 years, 12 payments per year), and that the equivalent rate of interest is j12 = 13.6083121618
(imo = 1.13402601348% per month).

PMT = $4,000
N = 180
j12 = 13.6083121618% or imo = 1.13402601348%
PV = ?

Having determined the equivalent monthly interest rate, the maximum loan amount to be advanced is
calculated as follows:

PV = PMT a n,j

Note that the payment is now expressed as PMT since the payments and compounding now occur at the
same frequency (i.e, an ordinary simple annuity).

PV = $4,000 a 180, j12 = 13.6083121618%

CALCULATION
(continued)
Press Display Comments
13.6083121618 Previously entered as I/YR; P/YR also entered
4000 %/& PMT -4,000 Enter payment per month

180 N 180 Enter number of monthly payments

0 FV 0 No amount owing at end of amortization

PV 306,389.050169 Present value or loan amount

Thus, the lender, desiring to earn 14% per annum, compounded semi-annually, should be willing to advance
no more than $306,389.05 in exchange for the borrower's promise to pay $4,000 per month for 180 months.

The steps in Illustration 4.1 should make it apparent that the analysis involves no new concepts. Earlier chapters
have detailed the calculation of equivalent interest rates and the determination of the present value of an ordinary
simple annuity. Illustration 4.1 serves to link these two concepts together to solve a "new" type of problem.
Calculating the equivalent rate on a basis that matches the payment frequency has the effect of reducing an
ordinary general annuity to an ordinary simple annuity. The following examples are presented as applications
of this method of analysis for handling ordinary general annuities.

4.9
Chapter 4

Example 4.1

A prospective purchaser is considering making an offer of $268,000 for a condominium unit that is listed for
sale. Financing to a maximum of 85% of the purchase price is available at an interest rate of 7% per annum,
compounded semi-annually, not in advance. The loan is to be fully amortized with monthly payments over 20
years.

Statement of Problem:

If the purchaser desires the maximum allowable loan, calculate the size of the required monthly payment
to fully amortize the loan.

Solution:

Loan = $227,800
j12 = 6.90004739713%
PMT = $1,752.49

Example 4.2

A $150,000 mortgage loan is written at an interest rate of 5.5% per annum, compounded semi-annually. The
loan calls for constant monthly payments based on a 25 year amortization period.

Statement of Problem:

Calculate the size of the monthly payment necessary to fully amortize the loan.

Solution:

j12 = 5.43801806193%
PMT = $915.59

Example 4.3

A vendor and purchaser agree that annual payments of $5,300 will be made on their agreement for sale. An
agreement for sale is a contract by which the owner of land (vendor) agrees to sell land to another (purchaser)
who agrees to purchase it. The purchaser's interest is registered in the Land Title Office as a charge against the
vendor's certificate of title.

Statement of Problem:

How many annual payments would be required if the agreement for sale is in the amount of $33,000 and
the contract rate of interest is 15% per annum compounded semi-annually?

Solution:

ia = 15.5625%
N = 24.0132738055

4.10
 Analysis of Financial Flows and Investments II

Example 4.4
A vendor is willing to provide financing to a prospective purchaser by taking a second mortgage in the amount
of $23,500. The loan is to be written at an interest rate of 10% per annum, compounded semi-annually and the
loan is to be fully amortized with monthly payments of $295.

Statement of Problem:

How many monthly payments of $295 will be required?

Solution:

j12 = 9.79781526228%
N = 129.25014997 months

Illustration 4.2
A real estate investment syndicate is contemplating the purchase of a leasehold interest in real property. There
are exactly six years left on the existing lease. Each syndicate member is to invest $130,000 and, in exchange,
is to receive $3,000 at the end of each month for the six years remaining on the lease.

Statement of Problem:

What is the annual yield, expressed with annual compounding, realized on the investment? (Ignore income
tax considerations).

Analysis:

Data

PV = $130,000
PMT = $3,000
N = 12 6 = 72
j12 = ?; imo = ?
ia = ?

Equation

PV = PMT a n,j
$130,000 = $3,000 a 72,j12

Time Diagram

4.11
Chapter 4

Solution:
CALCULATION

Press Display Comments

12 P/YR 12 Number of periods per year

130000 PV 130,000 Present value

3000 %/& PMT -3,000 Monthly payment

72 N 72 Number of monthly payments

0 FV 0

I/YR 18.4746307052 j12

The final step of the analysis is to express this rate (j12 = 18.4746307052%) as an annual equivalent rate
with annual compounding. The financial method of conversion is used.

CALCULATION
(continued)

Press Display Comments

18.4746307052 Previously entered as I/YR

12 P/YR also previously entered
EFF% 20.1221077056 j1

Thus, the syndicate investors expect an annual yield of 20.1221077056%.

Example 4.5
A $40,000 mortgage calls for monthly payments of $450 for 15 years, at which point the loan will be paid in
full. In order to satisfy the terms of the Interest Act, it is necessary to state the rate of interest charged on the
loan, expressed as a nominal rate with either annual or semi-annual compounding, not in advance.

Statement of Problem:

Calculate the required equivalent annual rates for both annual and semi-annual compounding.

Solution:

j12 = 10.8148856252%
j2 = 11.0615038771%
j1 = 11.3673960472% = ia

4.12
 Analysis of Financial Flows and Investments II

Innovative Options for Constant Payment Mortgages

Borrowers are obviously very concerned about how long they will be indebted. The simplest way to decrease
this time frame is to reduce the amortization period, which has the benefit of saving a significant amount of
interest over the loan period. However, reducing the amortization period has the effect of increasing the constant
payments to levels which may prove to be unaffordable for borrowers. In recent years, lenders have introduced
a number of innovative options which are aimed at reducing the time required to repay mortgage loans and
providing a savings on interest costs. Borrowers can choose options such as increased mortgage payments, lump
sum principal prepayments, increased payment frequency, and/or accelerated payments. Other flexible
arrangements are continually being developed by mortgage lenders as they compete for borrowers in the
residential mortgage market.

Increased Mortgage Payments/Principal Prepayments

By increasing the amount of the mortgage payment and/or making additional principal prepayments (balloon
payments), borrowers can pay off a mortgage loan much faster. Different financial institutions usually have a
number of options with varying rules and regulations which enable a borrower to benefit from an increased
mortgage payment plan. For example, one lender may allow borrowers to prepay up to 10% of the loan amount
once annually, whereas another may allow borrowers to "double-up" any given payment (pay up to double your
regular mortgage payment on any payment due date) or to increase payments by up to 15% over the current
payment once annually.

Increased Payment Frequency

Choosing a more frequent payment schedule provides significant benefits to borrowers. By increasing the
payment frequency on mortgage loans from monthly payments to semi-monthly, bi-weekly or weekly payments,
the total mortgage repayment period is reduced and interest costs are saved. As well, borrowers can make
mortgage payments which occur at the same frequency as their paycheque or income schedule. Many financial
institutions allow you to change the payment frequency without cost whenever the mortgage is up for renewal,
or during the mortgage term for a nominal fee.

Accelerated Payments

Accelerating payments is a very effective way to pay off a mortgage loan faster and to reduce interest costs.
This method of prepaying a mortgage may substantially step up the payment of the loan principal which will save
money by reducing the amount of interest paid on the loan. For example, since many people are paid every two
weeks, making accelerated bi-weekly mortgage payments is a convenient and efficient way to pay off a mortgage
loan. The accelerated bi-weekly payment is calculated as a monthly payment divided in half, and, instead of
paying once a month, one-half of the monthly payment is paid every two weeks. The effect of bi-weekly
accelerated payments is that the borrower is making the equivalent of one extra monthly payment per year, thus
paying down the principal faster and paying less interest (it should be noted that a borrower could make 26 or
27 bi-weekly payments in a given year, depending on the payment date).

Other Options

Lenders also offer other options to borrowers, such as "Cash Back" mortgages. This mortgage offer gives you
cashback in the amount of a certain percentage (usually no more than 5%) of the mortgage principal, however,
they usually apply to 5 year fixed rate mortgages and cannot be combined with other rate discounts. There are
numerous offers available and borrowers should calculate the benefits of the various options.

4.13
Chapter 4

Perpetual Annuities
In real estate investment analysis and appraisal, one frequently encounters cash flow streams that can be
reasonably expected to endure for very long periods of time. For example, given the durability of real property,
structural improvements typically stand for a considerable time. This section explores the nature of valuation
techniques for cash flow streams that the analyst expects to remain stable for many years. Due to the nature of
compound interest, it will be shown that it makes very little difference, in terms of valuation, whether a cash
flow stream is expected to continue for 100 years, 200 years, or forever (in perpetuity).

Illustration 4.3
A long term institutional investor is considering the purchase of a major office project in a large urban centre.
Analysis of the subject property, and of recent purchases of similar properties, have led the investor to believe
that the property will generate a cash flow of $3,250,000 per annum (assumed to occur at the end of each
compounding period) after all operation costs, expenses, and allowances. The investor expects that any increases
in operating expenses will be exactly offset by increases in rental income (as a result of a lease whereby tenants
must pay all increases in operating costs above a base year amount). As a result, the cash flow figure is
expected to remain constant. Further, the investor has learned that the marketplace expects investments of this
type to yield a return of 9% per annum, compounded annually.

Statement of Problem:

Calculate the present value of the expected cash flow stream if the cash flow stream remains constant:4

(a) for 50 years

(b) for 120 years
(c) for 999 years
(d) in perpetuity

Analysis:

Data

PMT = $3,250,000
jm = 9%
m = 1
(a) N = 50
(b) N = 120
(c) N = 999
(d) N = perpetuity

Equation

PV = PMT a n,j

4
Note that as the problem requires the calculation of the present value of the cash flow stream, one need not consider the present value
of the future value of the property at the end of the cash flow, reversion. Consideration of reversionary values is the topic of discussion
in the next section.

4.14
 Analysis of Financial Flows and Investments II

Solution:

(a) Calculate the present value of $3,250,000 per year for 50 years at 9% compounded annually.

Time Diagram

CALCULATION

Press Display Comments

1 P/YR 1

9 I/YR 9 9% per annum

50 N 50 50 annual payments

3250000 %/& PMT -3,250,000 Annual payment

0 FV 0 Reversionary value not considered

PV 35,625,469.4292 PV equals $35,625,469.43

(b) Calculate the present value of $3,250,000 per annum for 120 years at 9% compounded annually.

CALCULATION

Press Display Comments

1 P/YR 1

9 I/YR 9 9% per annum

120 N 120 120 annual payments

3250000 %/& PMT -3,250,000 Annual payment

0 FV 0

PV 36,109,945.7485 PV equals $36,109,945.75

4.15
Chapter 4

Having proceeded this far in the analysis, some commentary is appropriate. When the cash flow stream is
assumed to have a duration of 50 years, the present value is $35,625,469.43. Increasing the assumed
duration of the cash flow stream by an additional 70 years (to a total of 120 years) has the effect of
increasing the present value to $36,109,945.75. The present value increases by only $484,476.32 as a result
of the additional series of 70 payments of $3,250,000 per year commencing at the end of the 50th year.

This modest increase in the present value is the result of the long period of time required until the additional
70 years commence.

(c) Calculate the present value of $3,250,000 per annum for 999 years at 9% compounded annually.

CALCULATION

Press Display Comments

1 P/YR 1

9 I/YR 9 9% per annum

999 N 999 999 annual payments

3250000 %/& PMT -3,250,000 Annual payment

0 FV 0

PV 36,111,111.1111 PV equals $36,111,111.11

Note that extending the length of the cash flow by 879 years (from 120 to 999) only results in an increase
of $1,165.36 in the present value. Clearly further extensions will have little impact on the present value.

(d) Calculate the present value of $3,250,000 per annum in perpetuity at 9% compounded annually.

Since an infinitely large number (the number of compounding and payment periods) cannot be entered into
the calculator, an alternative approach must be adopted. Readers will recall that in the analysis of ordinary
simple annuities presented earlier, the term "a n,j" was introduced as a short hand representation of a
mathematical formula.

PV = PMT a n,j = PMT

(1 & (1 % i)&n)
i

As shown in Appendix 2, this formula reduces to:

PMT
PV ' Equation 4.1
i

As a result, the estimate of value of long-term cash flows is generally performed by dividing the periodic
income by the interest rate per period (expressed as a decimal), assuming a perpetual cash flow.

4.16
 Analysis of Financial Flows and Investments II

In this context, the periodic rate is referred to as the capitalization rate; an analytical concept used
extensively in the appraisal of income producing properties.

In this illustration, PMT is $3,250,000; i% is equal to 9% (or 0.09, as a decimal) and n has an infinitely
large value.

$3,250,000
PV =
.09

PV = $36,111,111.1111

The present value of an infinitely long net income stream of $3,250,000 is therefore equal to $36,111,111.

Summarizing the results of calculations in this illustration demonstrates the reasonableness of the perpetual
income assumptions which are commonly used in appraisal practice.

Case Net Income Annual Interest Number of Annual Present Value Incremental Present
per annum Rate Payments Value
(a) $3,250,000 9% 50 $35,625,469.43
(b) $3,250,000 9% 120 $36,109,945.75 $484,476.32
(c) $3,250,000 9% 999 $36,111,111.11 $1,165.36
(d) $3,250,000 9% 4 $36,111,111.11 $0

Extending the time frame under analysis to an infinite duration beyond 120 years has the effect of increasing the
present value of the entire cash flow by $1,165 or less than one percent.

The impact of an extended number of payments on the present value will obviously depend upon the number of
payments, but it also depends upon the interest rate selected. At the 9% rate used in the example, the
incremental present value that occurs by extending the term from 120 years to perpetuity is $1,165.36. If
another interest rate is used, this incremental present value would change. Consider the impact of different
discount rates on an annuity of $3,250,000 per year.

Number of Present Increment Present Increment Present Increment

Payments Value at 9% at 9% Value at 5% at 5% Value at 15% at 15%
50 $35,625,469.43 0 $59,331,757.75 0 $21,646,672.65 0
120 36,109,945.75 $484,476.32 64,813,706.60 $5,481,948.85 21,666,665.54 $19,992.89
999 36,111,111.11 1,165.36 65,000,000 186,293.40 21,666,666.67 1.13
4 36,111,111.11 0 65,000,000 0 21,666,666.67 0

At rates of interest less than 9%, the incremental present value due to the extension of the number of payments
is more significant, while at a rate of interest in excess of the 9%, the incremental present value is less
significant. In general, the higher the rate of discount, the less significant, in terms of present value, are
payments received in the future. Hence, using an assumption of a perpetual annuity to approximate the present
value of a long term annuity, involves less error at higher interest rates than at lower interest rates. In any case,
the incremental present value arising from payments beyond 100 years, at any interest rate is not significant.

4.17
Chapter 4

Example 4.6

A property is expected to generate a cash flow of $32,000 per annum for the foreseeable future. The cash flow
is set by virtue of an existing lease which remains in effect for the next 90 years, at which time there is no reason
to expect a change in the cash flow.

Statement of Problem:

Calculate the present value of the cash flow stream assuming a perpetual cash flow and payments occur at
the end of the compounding period:

(a) at 10% per annum, calculated annually

(b) at 5% per annum, calculated annually

Solution:

(a) PV = $320,000
(b) PV = $640,000

Reversionary Values and Perpetual Annuities

Using the perpetual annuity assumption, no mention is made of the value of the property at the end of the holding
period (reversionary value). The reason for this apparent omission is that this value is incorporated in the
assumption of the perpetual annuity. Consider a case where the property in Illustration 4.3 is assumed to be held
for fifty years and then sold to an investor who wishes to earn the same yield. It is necessary to forecast the
sales price assumed to be received for the building fifty years in the future, PV50:

PMT
PV50 =
.09

$3,250,000.00
=
.09

= $36,111,111.1111

For purposes of illustration, assume a sale price of $36,111,111.11 in the 50th year.

The investor today will be buying the right to receive 50 years of payments of $3,250,000 per year plus
$36,111,111.11 at the end of fifty years. The property's present value today, PV, is:

PV = $3,250,000 a 50, j1=9% + $36,111,111.11 (1+i)-50

4.18
 Analysis of Financial Flows and Investments II

CALCULATION

Press Display Comments

1 P/YR 1

9 I/YR 9 Rate per year

50 N 50 Number of periods

3250000 %/& PMT -3,250,000 Payment per period

36111111.11 %/& FV -36,111,111.11 Sales value in fifty years (reversion)

PV 36,111,111.1111 Total Present Value

Note that this present value is exactly equal to the value that would have been determined using the perpetual
annuity calculation for present value today:

$3,250,000
PV = = $36,111,111.11
.09

So long as the assumptions of a constant annual income and a constant discount rate are used, the perpetual
annuity or capitalization approach implicitly5 accounts for reversionary values.

Note that for investments involving long periods of cash flows, estimation of the reversionary value is not
generally of great concern, regardless of the method used in calculation. For example, consider the impact on
the present value (at j1 = 9%) of assuming this reversionary value in 50 years is:

(a) $26,111,111.11
(b) $36,111,111.11
(c) $46,111,111.11

Value of Reversion Change in Value of Present Value of Change in Present

Reversion Investment Value of Investment
$26,111,111.11 $35,976,625.72
$36,111,111.11 $10,000,000 $36,111,111.11 $134,485.39
$46,111,111.11 $10,000,000 $36,245,596.50 $134,485.39

5
Mathematical Proof:
PV = PMT a n,i + [
PMT
(1 + i)-n]
i
(1 & (1 % i)&n) PMT
= PMT [ ]+[ ] (1 + i)-n
i i
PMT PMT
= [ (1 - (1 + i)-n)] + [ (1 + i)-n)]
i i
PMT
= [1 - (1 + i)-n + (1 + i)-n]
i
PMT
=
i

4.19
Chapter 4

In this case, a change in the reversionary value of $10,000,000 only changed the present value of the investment
by $134,485.39 or 0.37%. A $36,111,111 variation in the expected reversionary value (a range from
$18,055,555.56 to $54,166,666.67) will result in a variation of only 1.34% in the present value of the
investment. Thus, while care must still be given to the calculation of reversionary values, when these values
occur far in the future, they will have little impact on present values.

Deferred Annuities
A deferred annuity refers to a situation where the cash flow has all the characteristics of an annuity but where
the present value is to be calculated for some point in time in advance of the beginning of the first payment
period. The approach to solving such problems is outlined in the following illustration.

Illustration 4.4

A real investment syndicate has the opportunity to finance a development which will return $10,000 per annum
for 10 years, with the first payment in five years time.

Statement of Problem:

How much should the syndicate be prepared to pay for each share if it expects a return of j1 = 6%?

Analysis:

Data
PMT = $10,000
N = 10 payments
j1 = 6%
Deferment = 5 years
PV = ?

Time Diagram

Solution: Method 1

The first approach to analyzing this problem is to find the present value of the annuity at its beginning (i.e.,
the start of the first payment period), and then discount this value back to the present time.

4.20
 Analysis of Financial Flows and Investments II

Time Diagram

The value of the annuity at the beginning of the first payment period is:

PV = PMT a n,j
= $10,000 a 10,6%
= $73,600.8705141

The present value of the investment, as of today is:

PV = FV4 (1+i)-4
= $73,600.8705141 (1+i)-4
= $58,298.783143

CALCULATION

Press Display Comments

1 P/YR 1

6 I/YR 6

10000 %/& PMT -10,000 Annuity payments

10 N 10 Number of payments

0 FV 0

PV 73,600.8705141 Value of annuity when it begins

%/& FV -73,600.8705141 Enter value of annuity as future value

4 N 4 Number of compounding periods until annuity begins

0 PMT 0 No payments during period of deferral

PV 58,298.783143 Present value of investment

4.21
Chapter 4

Thus, the syndicate should pay no more than $58,298.78 per share for the investment today.

Solution: Method 2

This approach involves the analysis of the difference in the present values of two ordinary simple annuities
which are together equivalent to the one deferred annuity under consideration. It is assumed that one
annuity will begin today and will involve 14 payments of $10,000 that are received by the investor. It is
also assumed that another annuity commences today and involves 4 payments of $10,000 that are made by
the investor. The net of those two cash flows is a 10 payment annuity with a four year deferral.

Time Diagram

As the two hypothetical annuities do not involve any deferral period, their present values can be directly
calculated. The difference between these present values will equal the present value of the deferred annuity.

PV = PMT a 14, j1=6% ! PMT a 4, j1=6%

= 10,000 a 14, j1=6% ! 10,000 a 4, j1=6%
= $92,949.8392701 ! $34,651.056127
= $58,298.7831431

4.22
 Analysis of Financial Flows and Investments II

CALCULATION

Press Display Comments

1 P/YR 1

6 I/YR 6

14 N 14 First Annuity

10000 %/& PMT -10,000

0 FV 0

PV 92,949.8392701 PV of First Annuity

6M 92,949.8392701

4 N 4 Second Annuity

PV 34,651.056127 PV of Second Annuity

%/& M% -34,651.056127

RM 58,298.7831431 PV of Deferred Annuity

Generalizing from the example presented in methods 1 and 2 above, a deferred annuity may be valued by
applying one of the following relationships:

PV = [ PMT a n,j ] (1 + i)-d (Equation 4.2)

PV = [ PMT a n+d,j ] ! [ PMT a d,j ] (Equation 4.3)

where PMT = periodic annuity payments

n = number of annuity payments
d = number of periods deferred

Note that for an ordinary simple annuity, where the first payment is made at the end of 2 periods, the annuity
is deferred only 1 period. As payments are made at the end of payment periods, the annuity actually begins at
the start of the second period (end of the first period).

4.23
Chapter 4

Example 4.7

ABC Construction wishes to borrow funds at j12 = 18% to finance the phased subdivision of a 15 acre parcel
of single detached residential property. ABC plans to repay the costly financing with the proceeds of lot sales
of the first phase of the subdivision and, as a result, promises to repay $16,000 per month for 18 months. The
first payment is due at the end of the sixth month after the funds are advanced.

Statement of Problem:

What is the largest loan ABC should be advanced under these conditions?

Solution:

$232,771.46

Annuities Due
So far, all analysis has focused on ordinary annuities where income is received (or payments are made) at the
end, rather than the beginning, of payment periods. The focus of analysis now shifts to address a class of
income streams where payments are made at the beginning of payment periods. This class of annuities is
commonly referred to as annuities due, that is, annuities where payments are due at the beginning of each
payment period. As was briefly discussed earlier, there are two classes of annuities due: simple annuities due
and general annuities due. In the case of the former, the frequency of payment matches that of compounding
and, in the latter, the payment and compounding frequencies do not match.

A simple annuity due involves a regular series of payments (hence, annuity) where the frequency of payment
equals that of compounding (simple) and where payments are made or received at the beginning of payment
periods (due) the appropriate time diagram would take the following form:

Two methods are commonly used to analyze the present value of simple annuities due. The first method
involves valuing the annuity as though "n-1" payments were made at the end of "n-1" compounding periods,
finding the present value of the "n-1" payments and, as a final step, adding to the present value the amount of
the payment made (or received) at the beginning of the first period (see Equation 4.4 below). The second
method involves valuing the income stream one period before payments actually commence and as though "n"
payments were actually made at the end of compounding periods, finding the present value of "n" payments and,
subsequently, compounding the resultant present value forward one period to account for the actual timing of
payments (see Equation 4.5 below). Both of these methods are developed and presented in the following
illustration (and in Appendix 3).

4.24
 Analysis of Financial Flows and Investments II

Illustration 4.5

A tenant in a warehouse property is considering prepaying a 5-year lease. The terms of the lease are such that
payments of $11,500 are due on the first day of each year. Rental payments, in this instance, are to be made
in advance of the period of time to which they apply.

Statement of Problem:

If the landlord is willing to discount future payments at 10% per annum, compounded annually, calculate
the amount of the appropriate prepayment.

Analysis:

Data

PMT = $11,500
j1 = 10%
N = 5
PV = ?

Time Diagram (Annuity Due)

The first valuation method involves determining the present value of the payments actually made at the end
of the first, second, third, and fourth periods. To this present value, $11,500 is added to account for the
payment due at the beginning of the first payment period. Graphically, the analysis can be presented as
follows:

PV = PMT a n,i
PV = $11,500 a 4, j1=10% = $36,453.452633
plus payment made at time zero = $11,500.00
equals Total Present Value = $47,953.452633

4.25
Chapter 4

CALCULATION
Press Display Comments

1 P/YR 1

10 I/YR 10 ia = 10%

4 N 4 Four payments in the future

11500 %/& PMT -11,500 Annual payment equals $11,500

0 FV 0

PV 36,453.452633 PV of 4 future payments

+ 11500 11,500 Payment made at time zero

= 47,953.452633 Total present value

The tenant would prepay the five-year lease for $47,953.45.

The second method of analysis involves an artificial intermediate assumption which is subsequently corrected
as the analysis continues. The present value of a five period annuity is calculated as the initial step. The
resultant present value is analytically valid one period prior to the actual commencement of the annuity (PV-1).
To correct for this valuation date, the present value is then compounded forward one period.

Time Diagram

PV-1 = PMT a n,j

PV-1 = $11,500 a 5, j1=10% = $43,594.0478482

Next, to value the annuity at time zero, the present value must be compounded forward one period:
PV-1 = $43,594.0478482
FV = ?
FV = PV-1 (1+i)1
FV = $43,594.0478482 (1.10)1
FV = $47,953.452633

4.26
 Analysis of Financial Flows and Investments II

CALCULATION
Press Display Comments
1 P/YR 1

10 I/YR 10 Discount rate per period

5 N 5 Assume five period ordinary simple annuity

0 FV 0

11500 %/& PMT -11,500 Size of payments

PV 43,594.0478482 PV of ordinary simple annuity

1 N 1 One compounding period

0 PMT 0 No payments during compounding period

FV -47,953.452633 PV of simple annuity due

Once again, the present value of the simple annuity due is found to be $47,953.45.

Generalizing from the preceding illustration, two equations may be developed to represent the valuation of
simple annuities due. From the methodology presented first:

PV = [ PMT a n-1, j ] + PMT

PV = PMT [a n-1, j + 1] (Equation 4.4)

or, based on the second method:

PV = [PMT a n, j](1 + i)1 (Equation 4.5)

Having presented the analytical basis for the valuation of simple annuities due, it is now appropriate to introduce
the pre-programmed function of the calculator for computing annuities due.

CALCULATION
Press Display Comments

BEG/END BEGIN To recognize payments are due at beginning of period

1 P/YR 1

10 I/YR 10 10% per annum

5 N 5 5 annual payments

0 FV 0

11500 %/& PMT -11,500 Periodic (annual) payment

PV 47,953.452633 PV of the simple annuity due

4.27
Chapter 4

Example 4.8

The tenant in Illustration 4.5 has been offered a rental prepayment arrangement whereby she can trade off the
five annual installments of $11,500 for a single payment of $50,000 to be made at the present time.

Statement of Problem:

Calculate the rate of interest at which the rental payments have been discounted to arrive at the figure of
$50,000, assuming payments are due at the beginning of each year.

Solution:

ia = 7.51998870969%.

Present Value of Perpetual Annuities Due

The analysis in the previous section can be extended to consider the concept of perpetual annuities due. This is
an annuity that is expect to endure indefinitely. However, the payments are assumed to occur at the beginning
of the period. In the previous section on perpetual annuities, cash flows are assumed to occur at the end of the
compounding period. However, there are some situations (i.e., leasing) where the payments may be due at the
beginning of the period and the payments are assumed to carry on for a considerable length of time. A similar
process like that used in annuities due can be applied here.

Recall that the equation for a perpetuity is the following:

PMT
PV ' (Equation 4.1)
i
and the relationship for annuities due include the following:

PV = PMT [a n-1, j + 1] (Equation 4.4)

PV = [PMT a n, j](1 + i)1 (Equation 4.5)

Substituting Equation 4.1 into Equations 4.4 and 4.5 creates the following equivalent formulas6:

Method 1:

PV = PMT + PMT (Equation 4.6)

i

Method 2:

PV = PMT (1 + i)1 (Equation 4.7)

i

6
See Appendix 4 for a proof of Equations 4.6 and 4.7.

4.28
 Analysis of Financial Flows and Investments II

Illustration 4.6

A long term institutional investor is considering the purchase of an office project. in a large urban centre.
Analysis of the subject property, and of recent purchases of similar properties, have led the investor to believe
that the property will generate a cash flow of $50,000 per annum (assumed to occur at the beginning of each
compounding period) after all operation costs, expenses, and allowances. The cash flow figure is expected to
remain constant for an indefinite period. Further, the investor has learned that the marketplace expects
investments of this type to yield a return of 10% per annum, compounded annually.

Statement of Problem:

Calculate the present value of the expected cash flow if the cash flow stream remains constant in perpetuity
and the payments are due at the beginning of the compounding period.

Analysis:

Data

PMT = $50,000
jm = 10%
m = 1
N = perpetuity

Time Diagram

Solution: Method 1

PV = PMT + PMT
i

PV = $50,000 + $50,000
.1

= $550,000

Solution: Method 2

PV = PMT (1 + i)1
i

PV = $50,000 (1.10)1
.1
PV = $500,000(1.10)

PV = $550,000

4.29
Chapter 4

Example 4.9
A property is expected to generate a cash flow of $30,000 per annum for the foreseeable future. Payments are
due at the beginning of each period. The cash flow is set by virtue of an existing lease which remains in effect
for the next 90 years, at which time there is no reason to expect a change in the cash flow.

Statement of Problem:

Calculate the present value of the cash flow stream assuming a perpetual cash flow and payments occur at
the beginning of the compounding period:

(a) at 8% per annum, calculated annually

(b) at 12% per annum, calculated annually

Solution:

(a) PV = $405,000
(b) PV = $280,000

Summary
This chapter introduces and examines the basic methods of analyzing annuities. An annuity is any stream of
equal cash flows that occur at regular intervals. An ordinary annuity has cash flows that are not in advance,
whereas an annuity due has cash flows that are made in advance. A simple annuity has the same frequencies
of cash flows and compounding, whereas a general annuity has different frequencies of cash flows and
compounding. Annuities fall into four major analytical classes: ordinary simple annuity, simple annuity due,
ordinary general annuity, and general annuity due.

The relationship for the ordinary simple annuity, introduced in the previous chapter,

PV = PMT a n,jm,

is re-visited and is expanded to introduce the concept of ordinary general annuities (situations where the payment
frequency and compounding frequency do not match. This chapter discusses the standard Canadian mortgage
loan and constant payment mortgage loans, further illustrating the concept of an ordinary general annuity.

The chapter also examines and illustrates the concept of perpetual annuities cash flow streams that are
expected to last for a very long period of time. The calculation for the present value of a perpetual cash flow
is:

PV = PMT (Equation 4.1)

i

The chapter also examines the concept of deferred annuities that refer to situations where the cash flow has all
the characteristics of an annuity but where the present value is to be calculated for some point in time in advance
of the beginning of the first payment period. Two methods of solution are provided:

PV = [ PMT a n,j ] (1 + i)-d (Equation 4.2)

PV = [ PMT a n+d,j ] ! [ PMT a d,j ] (Equation 4.3)

4.30
 Analysis of Financial Flows and Investments II

where PMT = periodic annuity payments.

The concept of annuities due is also presented where the payments are assumed to occur at the beginning of the
compounding period. Two formulas are presented to solve annuities due:

PV = PMT [a n-1, j + 1] (Equation 4.4)

PV = [PMT a n, j](1 + i)1 (Equation 4.5)

In addition, there is a pre-programmed function on the calculator that can be used for computing annuities due.

The chapter concludes with a discussion of the concept of the present value of annuities due. This is a cash flow
stream that is expected to endure for a very long period of time and the payments occur at the beginning of the
compounding period. Two methods of solution are possible:

PV = PMT + PMT (Equation 4.6)

i

PV = PMT (1 + i)1 (Equation 4.7)

i

4.31
Chapter 4

APPENDIX 1
Calculator Steps for Selected Examples

Example 4.1

CALCULATION

Press Display

7 I/YR 7

2 P/YR 2

EFF% 7.1225

12 P/YR 12

NOM% 6.90004739713

227800 PV 227,800

0 FV 0

240 N 240

PMT -1,752.48962851

Example 4.2
CALCULATION

Press Display

5.5 I/YR 5.5

2 P/YR 2

EFF% 5.575625

12 P/YR 12

NOM% 5.43801806193

150000 PV 150,000

0 FV 0

300 N 300

PMT -915.587223996

4.32
 Analysis of Financial Flows and Investments II

Example 4.3

CALCULATION

Press Display

15 I/YR 15

2 P/YR 2

EFF% 15.5625

1 P/YR 1

NOM% 15.5625

33000 PV 33,000

5,300 %/& PMT -5,300

0 FV 0

N 24.0132738055

Example 4.4

CALCULATION

Press Display

10 I/YR 10

2 P/YR 2

EFF% 10.25

12 P/YR 12

NOM% 9.79781526228

23,500 PV 23,500

295 %/& PMT -295

0 FV 0

N 129.25014997

4.33
Chapter 4

Example 4.5

CALCULATION

Press Display

12 P/YR 12

40000 PV 40,000

180 N 180

450 %/& PMT -450

0 FV 0

I/YR 10.8148856252

EFF% 11.3673960472

2 P/YR 2

NOM% 11.0615038771

Example 4.6

$32,000
(a) PV = = $320,000
.10

$32,000
(b) PV = = $640,000
.05

Example 4.7

CALCULATION

Press Display

12 P/YR 12

18 I/YR 18

18 N 18

16000 %/& PMT -16,000

0 FV 0

PV 250,760.974278

%/& FV -250,760.974278

4.34
 Analysis of Financial Flows and Investments II

5 N 5

0 PMT 0

PV 232,771.463582

Example 4.8

CALCULATION

Press Display

BEG/END BEGIN

1 P/YR 1

5 N 5

0 FV 0

11500 %/& PMT -11,500

50000 PV 50,000

I/YR 7.51998870969

Example 4.9

(a) PV = $30,000 (1.08)1 = $405,000

.08

(b) PV = $30,000 (1.12)1 = $280,000

.12

4.35
Chapter 4

APPENDIX 2
Proof of a Perpetual Annuity Formula

Calculate the present value of $3,250,000 per annum in perpetuity at 9% per annum, compounded annually.

Recall that in the analysis of ordinary simple annuities presented earlier, the term a n,j was introduced as a
short hand representation of a mathematical formula:

PV = PMT a n,j = PMT

(1 & (1 % i)&n)
i

In this illustration, the PMT is $3,250,000; i% is equal to 9% (or 0.09, as a decimal) and n has an infinitely
large value.

(1 & (1.09)&n)
PV = $3,250,000
.09

1
Recalling that (1+i)-n represents
(1 % i)n

1
1&
(1.09)n
PV = $3,250,000
0.09

At this stage, the analysis can be simplified to the point where the value of (1.09)n is identified: once this value
is known, the analysis reduces to a number of simple arithmetic operations.

Values for exponential functions such as (1.09)n can be quickly calculated where n is a known quantity. For
example, the values of (1.09)10, (1.09)100 and (1.09)1000 may be calculated as follows:

CALCULATION

Press Display Comments

1.09 1.09
y x 10 = 2.36736367459
1.09 1.09
y x 100 = 5,529.04079183
1.09 1.09
y x 1000 = 2.66991811E377
1/x 3.7454332E-38 Calculating inverse (dividing into one)

7
The calculator display of 2.66991811E37 represents 2.66991811 multiplied by 1037 or
26,699,181,100,000,000,000,000,000,000,000,000,000. Just as the value of (1.09)1000 is an extraordinarily large number, the value of
one divided by this value must be a very, very small number; that is, given that (1.09)1000 equals 2.66991811 1037, the value of
1/(1.09)1000 must equal 1/(2.66991811 1037).

4.36
 Analysis of Financial Flows and Investments II

Thus, the value of 1/(1.09)1000 (or (1.09)-1000) is 3.7454332 10 -38

or, more conventionally
0.00000000000000000000000000000000000003754332; a number very close to zero. As the value of
1/(1.09)1000 is very close to zero, it follows that the value of 1/(1.09)4, where "4" is an infinitely large number,
would be infinitely small or, effectively, zero. This reduces the mathematic formula for a n,j as follows:

1
1 &
PV = $3,250,000 (1.09)4
0.09

(1 & 0) 1
PV = $3,250,000 replacing , which is approximately zero, with zero.
.09 (1.09)4

1
PV = $3,250,000
.09

$3,250,000
PV =
.09

PV = $36,111,111.1111

The present value of an infinitely long net income stream of $3,250,000 is therefore equal to $36,111,111.

In general terms, the formula becomes:

PV = PMT a n,j = PMT

(1 & (1 % i)&n)
i

(1 & 0)
PV = PMT
i

PMT
PV ' (Equation 4.1)
i

As a result, the estimate of value of long-term cash flows is generally performed by dividing the periodic income
by the interest rate per period (expressed as a decimal), assuming a perpetual cash flow.

4.37
Chapter 4

APPENDIX 3
Annuity Due Verification of Alternative Methods

In the discussion focusing on the valuation of simple annuities due, two alternatives for analysis were presented.
The purpose of this appendix is to present a mathematical verification of the equivalency of the alternatives.

Method A Method B
PV = PMT (an-1,i + 1) PV = PMT an,i (1+i)1

(1 & (1 % i)&(n&1)) 1 & (1%i)&n

PV = PMT % 1 PV = PMT (1+i)
i i

1 & (1%i)&(n&1) i 1 & (1%i)&n

PV = PMT % PV = PMT (1+i)1
i i i

1 & (1%i)&(n&1) % i (1%i)1 1 & (1%i)1 (1%i)&n

PV = PMT PV = PMT
i i

(1%i) & (1%i)&(n&1) (1%i) & (1%i)&n%1

PV = PMT PV = PMT
i i

(1%i) & (1%i)&(n&1)

PV = PMT
i

Hence, Methods A and B reduce to the same equation.

4.38
 Analysis of Financial Flows and Investments II

APPENDIX 4
Proof of Perpetual Annuities Due

Method A:

PV = PMT (an-1,i + 1)

1 & (1 % i)&(n&1)
PV = PMT % 1
i

With n = 4, the equation becomes:

1 & (1%i)&4
PV = PMT % 1
i

1&0
PV = PMT %1
i

1
PV = PMT %1
i

PMT
PV = % PMT Equation 4.6
i

Method B:

PV = PMT an,i (1+i)1

1 & (1%i)&n
PV = PMT (1+i)1
i

With n = 4, the equation becomes:

1 & (1%i)&4
PV = PMT (1+i)1
i

1&0
PV = PMT (1+i)1
i

1
PV = PMT (1%i)1
i

PMT
PV = (1%i)1 Equation 4.7
i

4.39