Perpetuities are also called annuities with an extended, or unlimited, life. Bas

Question

Perpetuities are also called annuities with an extended, or unlimited, life. Based on your understanding of perpetuities, answer the following questions. Which of the following are characteristics of a perpetuity? Check all that apply The principal amount of a perpetuity is repaid as a lump-sum amount In a perpetuity, returns-m the form of a series of identical cash flows-are earned. A perpetuity is a series of regularly timed, equal cash flows that is assumed to continue Indefinitely Into the future. A perpetuity continues for a fixed time period. A local bank's advertising reads: "Give us $40,000 today, and well pay you $200 every year forever." If you plan to live forever, what annual interest rate will you earn on your deposit? 0.50% 0.70% 0.80% 0.40% Oops ! When you went In to make your deposit, the bank representative said the amount of required deposit reported in the advertisement was Incorrect and should have read $60,000. This revision, which will the interest rate earned on your deposited funds, will adjust your earned interest rate to

Explanation / Answer

Part A)

The following 2 options are correct:

1) In a perpetuity, returns - in the form of a series of identical cash flows - are earned (which is Option B)

2) A perpetuity is a series of regularly timed, equal cash flows that is assumed to continue indefinitely into the future (which is Option C)

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Explanation:

The present value of a perpetuity is calculated with the use of following formula:

Present Value of Perpetuity = Constant Cash Flow/Opportunity Interest Rate

we can also derive the value of constant cash flow from the above formula as follows:

Constant Cash Flow = Present Value of Perpetuity*Opportunity Interest Rate

Based on above, it can be clearly concluded that in case of a perpetuity, the returns are earned in the form of a series of identical cash flows that continue to occur for an indefinite period. Therefore, Option B and Option C are correct.

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Part B)

The interest rate can be calculated with the use of following formula:

Interest Rate = Constant Cash Flow/Lump Sum Value

Using the values provided in the question, we get,

Interest Rate = 200/40,000 = .005 or .50% (which is Option A)

________

Part C)

The revised interest rate is calculated as follows:

Revised Interest Rate = 200/60,000 = .33%

______

The blanks have been filled as follows:

The revision which will "Reduce/Lower/Decrease" the interest rate earned on your deposited funds, will adjust your earned interest rate to .33%

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