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Sir i do not understand the difference between growing perpetuity and perpetuity where there is inflation…why we cannot use the formula of growing perpetuity when there is inflation
Like the r can be money cost of capital
And g will be inflationYou can either do as you have written and use the growth formula.
Alternatively you can discount the current price flow at the real cost of capital.
Both ways give exactly the same answer and both are fine in the exam.
Sir there’s a question
3000 received in one year’s time then growing by 2% per year in perpetuity.
By the growing perpetuity method the answer is 37500[3000/(.1-.02)]
By the other method we calculate real cost of capital which is 1.1/1.02=1.0784 i.e. 7.84%
The answer of perpetuity will be 3000/0.0784
= 38265 which is considerably differentBoth approaches always give exactly the same answer as I wrote before.
Using the growth formula the answer is 3,000 / (0.10 – 0.02) = 37,500.
When discounting at the real rate it is the current price flow that is discounted. The current price of 3,000 in 1 years time is 3,000/1.02. Discounting this at the real rate of 7.84% gives
3,000 / 1.02 / 0.0784 = 37,515. The difference is purely due to rounding which is as always irrelevant in the exam.Yet again, this is all explained in my free lectures.
GOT IT SIR!!!!!
Also one more question
3000 received immediately and growing at 2% per year thereafter and discount rate is 10%.
By growing perpetuity formula we will calculate as
3000+(3060/.08) right????Also sir i have two questions
First is from bpp
1)Am co will receive in perpetuity starting in two years time 100000 per year,increasing by inflation of 2%
Calculate the present value assuming money rate of return of 10.2%.
Second is from kaplan
2)Received a perpetuity of 2000 starting in six years time ,growing at 3% per year. Assume cost of capital of 10%.
What i don’t understand is how to distinguish between whether the question has given cash flow in current or real terms…in first question they assumed the 10000 is in current terms as they have calculated and used real cost of capital to find present value.
While in the second question they directly used the growing perpetuity formula meaning they assumed 2000 is in nominal terms…Assuming that in both cases you have copied the entire question exactly as it was printed, then I can’t distinguish between them either.
Also I would be interested in seeing the Kaplan answer (I have the BPP Revision Kit bit not the Kaplan Kit) because as I wrote before you can always use either approach. In the case of the Kaplan question then even if the 2,000 was in current prices they could still use the growth formula but would then have to adjust the numerator in the formula and also discount the answer from the formula.
I don’t particularly have problem in solving once i know whether it is at current terms or nominal terms…..
It’s just that they should state in which terms they are givenThe thing is in first bpp question they assumes 10000 in real terms
And in second question from kaplan study text they assumed it to be in nominal termsIn the first question, the cash flow of $10,000 per year increasing by inflation is assumed to be in current terms.
The present value is calculated using the real cost of capital because the question specifies a money rate of return of 10.2%. This means that the cash flows are discounted at a rate that accounts for inflation.In the second question, the perpetuity of $2,000 starting in six years time and growing at 3% per year is assumed to be in nominal terms. The question does not mention actual inflation it says it’s growing at and doesn’t specify a real cost of capital. Therefore, the growing perpetuity formula is used directly to calculate the present value.
So sir how do we ascertain what assumption is in the question
1)Am co will receive in perpetuity starting in two years time 10000 per year,increasing by inflation of 2%
Calculate the present value assuming money rate of return of 10.2%.
In this question why they have assumed 10000 is in real terms? Or what line or word is used for this assumption?I have answered this above and in my previous comments on the various questions that you ask.
I have said, if you use two different books from two different publishers……. this is the problem you will come across.Not all questions are past exam questions, even if they are, they may have been modified by the writer, books are written by various writers who may have written the questions from scratch in their style.
So this means they will be worded slightly different, the requirements may differ etc.
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