51.1
1. How is it possible that a perpetuity, a perpetual
stream of cash flows, can have a finite value? That is,
explain how it can be that at 4% interest rates, $375,000 would
be enough to set-up a scholarship that
would pay $15,000 per year forever. (1 pt)
In order to get full credit, you had to make it clear that you understand how a perpetuity works and why the PV of a perpetuity is what it is. One way to do that is to explain that because you can earn interest on your investment every year, you can use your initial principal to create a stream of interest that recurs every year. That is, the interest is a new cash flow every year forever. For example, you put the $375,000 into an account bearing 4% interest, and every year, that account will generate .04(375,000) = $15,000 in interest. It is this newly generated interest that will be the annual cash flow in your perpetual scholarship. As long as you don't draw down the principal, you will get $15,000 in interest every year forever.