Present Value of Annuity
While calculating the present value of an annuity, a financial manager or any other individual relies on the concept of the time value of money ( Petty et al., 2017) . In this case, payments scheduled for later years in the future are worth less today because of uncertain global economic situations depending on the discount rate. Discount rates affect an annuity's present value since most companies will use these rates to account for market risks such as inflation. Other critical information to be used while determining the present value of annuity includes the dollar amount of each fixed payment and the period the payment will be made. In this case, for example, one might be offered the option of taking $10,000 or receive $1,000 for five years at a 10% discount rate. In the example present value of the annuity, the formula is applied
The five-year payment plan's present value will be worth about $3,790 in a 10% discounted rate environment for five years. In this case, the cash value would be less over time.
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Present Value of Perpetuity
While an annuity has a specific timeframe, perpetuity is an annuity that continues over time; that is, it lacks maturity. While calculating the present value of a perpetuity, financial managers divide constant payment by discount rate or payment. For example, the present value of $1,000 perpetuity discounted back at 10 percent is $1,000/0.1 = $10,000
Present Value of Growing Perpetuity
In finance, not all perpetuities contain equal cash payments; some, like common stock valuations, provide periodic cash flow to grow at a constant rate annually. For example, if the first payment of the first year is $50 and the payment grows at a rate of 5% per year, then the growth perpetuity for the second year would be $50(1.05) = $52.5
Therefore, I would prefer the present value of growing perpetuity since it does not have an ending point since it goes on forever with the cash flow growing at a constant rate year after year.
References
Petty, J. W., Titman, S., Keown, A. J., Martin, P., Martin, J. D., & Burrow, M. (2017). Financial management: Principles and applications . Pearson Higher Education AU.
