Annuities and perpetuities are types of financial instrument, which make payments at regular intervals (parrino & kidwell, 2009). Although both perpetuities and annuities make regular payments, there is a difference in the life span of the financial instruments. Annuities have a finite lifespan while perpetuities have an infinite life span (Grinblatt & Titman, 2002). Examples of annuities are; loan repayment and lottery winning. For loan repayment, the principal and interest are repaid in regular intervals while in lottery winning the winner receives a fixed amount of the winning for fixed period. Example of perpetuity is a charity donation and a pension fund is a pension fund where an individual receives a fixed amount until death and his or her next of kin can continue receiving the pension on behalf of the deceased person.
An annuity is series of payments made on a regular basis at a specified interest rate (Greenblatt & Titman, 2002). When calculating the payment for annuity a number of factors must be taken into consideration. These factors include: the number of payment that must be made by end of life span of the annuity, the interest rate for the annuity, and present or future value of the money (Greenblatt & Titman, 2002). Each payment of an annuity is a combination of interest and a portion of the principal, the earlier payments are primarily interest with the later payments being principal.
Perpetuity is a payment stream, which lasts forever (Parrino & Kidwell, 2009). The payment is a fixed amount of payment, which an individual receives to infinity. Perpetuities are less common than annuities because of their life span. Perpetuities just like annuities take into consideration time value of money; thus, perpetuity is fixed payment, which has been adjusted for time value of money. Perpetuities can be fixed or growing. Growing perpetuities increase the amount of payment as time goes on however they require relatively higher principal than fixed perpetuities.
Investors who have less principal amount for investment would prefer to invest in annuities than perpetuities. Investors who want quick returns on investment would also prefer an annuity to perpetuity. Long-term investors who are more concerned with future cash flow would prefer to invest in perpetuities rather than annuities. Over time, investment may lose value or gain value due to the concept of time value of money. If an investor is not willing to risk the initial cash outlay, they should invest in perpetuity because the investor is assured of a fixed amount of payment rather than annuities, which vary with interest rate, and time value of money.
Time value of money influences future returns because it affects the value of money in the future (Parrino, & Kidwell, 2009). Because money may gain or loose value over time the returns on investment must be adjusted for changes in time value of money from period of investment until time investor receives returns. Time value may increase retunes in amount but largely it is just because the amount had been adjusted for aches in value of money over period of investment.
If an investor, ahs long life expectancy he or she should invest in an annuity because the returns will only flow for a fixed period. On the other hand, if an investor ahs long life expectancy he or she should invest in perpetuity because he or she will receive fixed amounts for an infinite period.
Grinblatt, M., and Titman, S. (2002). Financial markets and corporate strategy. New York: McGraw Hill Irwin.
Parrino, R., and Kidwell, D. S. (2009). Fundamentals of Corporate Finance. New Jersey: John Wiley and Sons