Definition: Perpetuity is an ongoing timeline that extends into infinity. In the business world, this typically refers to a security or bond that doesn’t have a maturity date or a steady stream of reoccurring income that extends into the foreseeable future, like a royalty payment.
What Does Perpetuity Mean?
What is the definition of perpetuity? The concept of regular payments that extend indefinitely is a common principle in finance. It’s used in many different valuation theories to evaluate businesses, stock prices, and other investments.
Valuation models like the dividend discount model calculate the value of indefinite dividend payments by looking at present value of perpetuity. This model uses the future dividend cash flows and an interest rate per period to calculate what those annuity payments would be worth today. These payments are assumed to consistent or fixed even if the actual value of the security changes.
Let’s look at an example.
Let’s say Anna is the CFO of a bank and in order to generate more capital, she wants to offer bonds to the public. She offers a bond that will pay investors $7.50 annually. In order to do this, she needs to determine what purchasing price she will offer to her clients.
Currently, the discount rate is 4% because that is the highest amount of interest she could earn given her options. To calculate the bond’s value, she would divide the coupon amount of $7.50 by the discount rate of 4%, which would amount to $187.50. This means to receive the perpetuities the investors would have to pay $187.50 to receive $7.50 a year indefinitely.
If the interest rate increased, the value of the perpetuity would lower; however, payments to the investor would remain consistent. On the other hand, if the interest rates decreased the value of the perpetuity would increase yet the dividends would remain constant. The dividends aren’t affected by the changes in discount rates after the initial valuation has occurred.
Define In Perpetuity: Perpetuity means an instrument without a maturity date or an income / expense that extends indefinitely.