Payments in Perpetuity
On the exam, you may be asked to use the discounted cash flow method to calculate the present value of a perpetuity, or the amount needed to generate a stream of payments that never ends. This is also referred to as an annuity. Such a calculation is useful when an investor wants to ensure that he or his heirs will never run out of income. It also may be used if a client wishes to give a donation to an institution in perpetuity. To calculate this amount, you divide the rate of return you can expect to earn for one payment period into the payment amount needed for that period.
An example would be an investor who wants to know how much she’d need to set aside as a nest egg if she wants to receive $10,000 per year in income off that nest egg. If she believes that she can consistently earn 5% on her nest egg, she would divide $10,000 by 0.05 (the rate of return expressed as a decimal), which would yield $200,000. In other words, $200,000 earning 5% should provide an investor with $10,000 per year indefinitely.
If the exam gets tricky and uses a monthly or quarterly amount, it’s important that you divide the annual rate of return by the payment period frequency used. For example, if the exam asks you to calculate the amount needed to provide a perpetuity of $500 per month using