Math Problem Statement

A security pays $800 every 8 years forever. The appropriate discount rate discount rate is 6% (EAR). What is the value of the security if the first payment occurs 2 years from now?

Solution

To calculate the value of the security that pays $800 every 8 years forever with a discount rate of 6%, where the first payment is 2 years from now, we will use the perpetuity formula adjusted for a delayed first payment and periodic payments.

Step-by-Step Solution:

  1. Determine the Present Value (PV) of Perpetuity:

    The present value of a perpetuity with periodic payments is given by:

    PV=CrPV = \frac{C}{r}

    where:

    • CC = payment per period ($800)
    • rr = discount rate per period
  2. Convert Annual Effective Discount Rate to 8-Year Rate:

    Since the payments are every 8 years, we need to find the equivalent 8-year discount rate based on the 6% EAR (Effective Annual Rate).

    The formula to convert the annual rate to an 8-year rate is:

    r8=(1+rannual)n1r_{8} = (1 + r_{annual})^n - 1

    where rannual=6%=0.06r_{annual} = 6\% = 0.06 and n=8n = 8.

    Let's calculate r8r_8.

  3. Adjust for the Payment Delay:

    The first payment is 2 years from now, but the perpetuity calculation assumes the first payment is at time zero. To adjust for this, we need to discount the present value we calculated to account for the 2-year delay. The discount factor is based on the annual rate of 6%.

    Adjusted PV=PV×1(1+0.06)2\text{Adjusted PV} = PV \times \frac{1}{(1 + 0.06)^2}

Let’s proceed with the calculations.The value of the security, considering the first payment occurs 2 years from now, is approximately $1,198.96.

Would you like further details on any step? Here are 5 related questions to deepen your understanding:

  1. How does delaying the first payment affect the present value of a perpetuity?
  2. Why do we convert the annual discount rate to an 8-year rate?
  3. What happens to the present value if the payments occur more frequently?
  4. How would the calculation change if the discount rate were compounded monthly instead of annually?
  5. What is the significance of the Effective Annual Rate (EAR) in this problem?

Tip: Understanding how to adjust for delayed payments is crucial for dealing with perpetuities and annuities. Always account for the time shift when payments don't start immediately.

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Math Problem Analysis

Mathematical Concepts

Perpetuity
Discount Rate
Present Value
Time Value of Money

Formulas

PV = C / r
r_8 = (1 + r_annual)^n - 1
Adjusted PV = PV / (1 + 0.06)^2

Theorems

Perpetuity Formula
Effective Annual Rate (EAR)

Suitable Grade Level

Undergraduate Finance or Economics