What does perpetuity mean in business?
In the corporate and investing world, the term perpetuity generally means indefinitely, forever. It’s basically saying “eternal,” but with a financial connotation. In finance, perpetuity means cash flow payments that continue indefinitely or an annuity that has no end.
Perpetuity – Does It Really Mean Forever?
Browsing through financial-related literature, you will sometimes meet the word “perpetuity.”
Understanding what perpetuity is can help corporate decision-makers or investors when it comes to a better understanding of how money flows.
Perpetuity – What Is it And Importance
In the financial world, perpetuity is commonly used by companies to place value on certain investments like real estate, stocks, and bonds. However, it’s very widely used on annuities. In theory, receiving payments from such investment doesn’t end. Thus, you can consider it as perpetual.
However, what is usually considered as perpetuity investment is when a firm or individual buys a perpetuity-based investment and expect to receive payment indefinitely. Generally, such kind of investment will require an upfront payment either in a lump sum or paid over some time.
For example, an investor purchases a stock that gives the shareholders a handsome dividend. If the company is already mature and announces that they will be paying dividends regularly onwards, then you can consider it theoretically perpetual.
The same idea can be applied to real estate investors. For example, an investor buys a property and rents it out, he or she can receive payments indefinitely. Of course, this is assuming that the investor will maintain the property, so there will be willing renters.
Annuities – The Most Common Perpetuity Investment
When you talk about perpetuity investment, most people would assume you are talking about annuities. The reason for this is because annuities are modeled to pay the investor a specific amount of money indefinitely once the investor has paid his or her part of the bargain.
It’s the reason why annuities are a common financial term in the realm of retirement planning. What happens is an investor pays the insurance company upfront. In return, the insurance company will pay the investor with regular payments that will go on indefinitely. And yet, despite being popularly considered as a perpetuity investment, not all annuities can be considered as such. This is because some are annuities are not indefinite.
The Formula – Perpetuity calculation
While the term perpetuity denotes an investment that lasts indefinitely, there’s a formula that can be used for some investment to determine it’s present value. The formula is very simple:
Present Value = Dividend Or Payments / Discount Rate
When to use the perpetuity formula? For example, if a bond pays $10 per year indefinitely and it has a discount rate of 5%. Your calculation would like like this – $10 / 0.05 = $200.
With this calculation, the bond’s present value is $200.
Is It Really Forever?
What does the perpetuity period mean?
When hearing about receiving payments forever, it sounds too good to be true. Hence, you may ask if it is truly indefinite.
The short answer is yes. However, it’s not all that great. Keep in mind that, in most cases, the amount you receive is fixed. As time moves forward, inflation will start chewing through the amount of money you receive. In other words, you will still receive the same amount, but it’s buying power is slowly diminishing because of inflation.
Having said that, there’s a form of perpetuity that counterbalances the effect of inflation, and its called growing perpetuity. With such kind of perpetuity, you will not receive a fixed amount indefinitely. Instead, it will be growing to counteract the effects of inflation. Keep in mind that growing perpetuity is primarily designed to offset inflation. And, that does not mean that the buying power of the money you receive will also increase.
Like most things in the investment world, there’s no such thing as a free lunch. With growing perpetuity, it is typical that the money you receive will be lesser when compared to traditional perpetuity. However, you will enjoy the benefit of inflation protection. With traditional perpetuity investment, the early years will have a high payment. However, the value of payments will gradually deteriorate due to inflation.
Wrapping It All Up
Perpetuity in the financial world is a term that denotes an investment that will give payments until the end of time. However, this is only theoretical as real-world perpetuity investments will typically come with a clause that triggers the end of the payments. Even if it is a true perpetuity investment that will pay forever, inflation would still slowly deteriorate the value of the received payments.
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