Handout - FIN300 - Chapter 5 6 - 2024

Chapter 5 & 6
Time Value of Money

Discounted cash flow
 PhD, Phan Hong Mai

 School of Banking and Finance
 National Economics University
 [email protected]
5-1
Chapter Outline
5.1 Time Value of Money

5.2 Future Value
5.3 Present Value
5.4 Stated rates and EAR
5.5 Types of Loans
5-2
 Time value of money is the concept

that the value of $1 to be received in
future is less than the value of $1 on
hand today.
 In other words, time value of money
principle says that the value of given sum
of money to be received on a particular
date is more than same sum of money
to be received on a later date.
5-3
 1rst reason is that money received today

can be invested thus generating more
money.
 2nd reason is that when a person decides
to receive a sum of money in future rather
than today (for example, by lending his
money), there are risks involved in lending
(such as default risk and inflation). That
makes the value of money in future is less
than today.
5-4
 Time lines: A horizontal line that is used

to represent time, with the past towards
the left and the future towards the right.
 Show the timing of cash flows.
5-5
0 1 2 3
r%
CF0 CF1 CF2 CF3

Cash flow
received/invested
Cash flows received/invested in future
today
 Tick marks occur at the end of periods, so

Time 0 is today; Time 1 is the end of the first
period or the beginning of the second period.
5-6
$100 lump sum due in 2 years

0 1 2
r%
100
3 year $100 ordinary annuity
0 1 2 3
r%
100 100 100

5-7
Uneven cash flow stream

0 1 2 3
r%
-50 100 75 50
Cash
Outflow 5-8
5.2 Future value
 Future value: The amount of money that

an investment will grow to over some period
of times at the given interest rate.
 What cash flows are worth in the future.
 Later money on a time line.
5-9
5.2 Future value
a single cash
amount multiple
FV cash flows
of finite ordinary
cash flows annuity annuity
cash cash flows
flows
annuity
due cash
flows
5.2.1 FV of a single cash amount invested
at r % per period for t periods
 Suppose you invest $1,000 for one year at

5% per year.
 What is the future value in one year?
0 1
r = 5%
$1,000
FV = ?
5-11
 Interest = $1,000 x 5% = $50

 Value in one year = principal + interest
= $1,000 + 50
= $1,050
 Future Value (FV) = $1,000 x (1 + 5%)
= $1,050
5-12
 Suppose you leave the money in for another

year. How much will you have two years
from now?
0 1 2
r = 5%
$1,000
$1,050
FV = ?
5-13
 Interest = $1,050 x 5% = $52.5

 Value in one next year = $1,050 + 52.5
= $1,102.5
 FV = $1,000 x (1 + 5%) x (1 + 5%)
= $1,000 x (1 + 5%)2
= $1,102.5
5-14
 FV = $1,000 x (1 + 5%) x (1 + 5%)

= $1,000 x (1 + 5%)2 = $1,102.5
a cash
r %/period t periods
amount
-> The process of accumulating interest over time

(to earn more money) is called “Compounding”
5-15
FV = C x (1 + r)t
 FV: future value
 C : cash amount
 r : period interest rate, expressed as a decimal
(“exchange rate” between earlier money and
later money, can be also called as Discount rate,
Cost of capital, Opportunity cost of capital,
Required return)
 t : number of periods
-> (1 + r)t : Future value interest factor, FVIF(r,t)
5-16
 Example 5.1
 Suppose you locate a two-year investment that
pays 14 percent per year. If you invest $300, how
much will you have at the end of the two years?
How much of this is simple interest? How much
is compound interest?
5-17
5.2.2 FV of multiple cash flows invested
 Multiple cash flows: a series of different cash

flows that occur each period for some fixed
periods.
 Suppose you invest $1,000; $1,250 and $2,324
from now for two years at 5% per year.
 How much will you have for two years ?
0 1 2
r = 5%
$1,000 $1,250 $2,324

FV = ? 5-18
 Firstly, calculate the FV of each cash flow

 Then, add them up.
0 1 2
r = 5%
$1,000 $1,250 $2,324

$1,102.5
$ 1,312.5
$ 4,739
5-19
 Example 5.2
 Suppose you deposit $150, $200, $320 at the
end of each year for three years, assume a 7
percent interest rate throughout.
 Showing the cash flows on the time line? How
much will you have in three years? How much
will you have in five years if you don’t add
additional amounts?
5-20
5.2.3 FV of annuity cash flows
invested at r % per period for t periods
 Annuity cash flows: a series of constant or

level cash flows that occur each period for some
fixed periods.
 Ordinary annuity: an annuity for which the
cash flows occur at the end of the period.
 Annuity due: an annuity for which the cash
flows occur at the beginning of the period.
5-21
 Suppose you invest $1,000 at the end of each

year for three years at 5% per year.
 How much will you have for three years ?
0 1 2 3
r = 5%
$1,000 $1,000 $1,000

FV = ?
5-22
0 1 2 3
r = 5%
$1,000 $1,000 $1,000

$1,102.5
$ 1,050
$ 3,152.5
FV = $3,152.5 = $1,000 x {[(1 + 5%)3–1]/ 5%}

5-23
FV of ordinary annuity cash flows:
5-24
 Suppose you invest $1,000 at the beginning

of each year for three years at 5% per year.
 How much will you have for three years ?
0 1 2 3
r = 5%
$1,000 $1,000 $1,000

FV = ?
5-25
0 1 2 3
r = 5%
$1,000 $1,000 $1,000

$1,050.0
$ 1,102.5
$ 1,157.625
$ 3,310.152
FV = $1,000 x {[(1 + 5%)3–1]/ 5%} x (1 + 5%)
5-26
FV of annuity due cash flows:
-> FV of annuity due cash flows = FV of same

ordinary cash flows x (1 + r)
5-27
5.3 Present value
 Present value: the current value of future

cash flows discounted at the appropriate
discount rate.
 What future cash flows are worth today.
 Earlier money on a time line.
5-28
5.3 Present value
multiple
cash flows
a single cash
amount annuity
cash flows
PV growing
of finite annuity cash
flows
cash flows
perpetuity
cash flows
infinite
cash flows growing
perpetuity
cash flows
5.3.1 PV of a single cash amount to be
received in t periods at r % per period
 Suppose you need to have $1,050 in one

years, and you can earn 5% on your money.
 How much do you have to invest today to
reach your goal?
0 1
r = 5%
$ 1,050
PV = ?
5-30
 Based on your knowledge of FV, you know

the amount invest must grow to $1,050 over
one year.
 $1,050 = C x (1 + 5%)1
C = $1,050 / (1 + 5%)1
C = $1,000
5-31
 Suppose you need $1,102.5 in two years.

You can earn 5% on your money.
 How much do you have to invest today?
0 1 2
r = 5%
$ 1,102.5
PV = ?
5-32
 $1,102.5 = C x (1 + 5%)2
C = $1,102.5 / (1 + 5%)2 = $1,000
a cash
r %/period t periods
amount
-> The process of calculating the present value of a

future cash flow (to determine its value today) is
called “Discounting”
5-33
PV = C / (1 + r)t
 PV: present value
 C : cash amount
 r : period interest rate, expressed as a decimal
(“exchange rate” between earlier money and
later money, also can be called as Discount rate,
Cost of capital, Opportunity cost of capital,
Required return)
 t : number of periods
-> 1/(1 + r)t : Present value interest factor, PVIF(r,t)
5-34
5.3.2 PV of multiple cash flows to be
 Suppose you need $1,050 in one year and

$1,102.5 more in two years.
 If you can earn 5% on your money. How much
do you have to put up today to exactly cover
these amounts in the future?
0 1 2
r = 5%
PV = ? $1,050 $1,102.5
5-35
 Firstly, calculate the PV of each cash flow

 Then, add them up.
0 1 2
r = 5%
$1,050 $1,102.5
$1,000
$1,000
$ 2,000
5-36
 Example 5.3
 You are offered an investment that will pay
you $210 in the first year, $400 the next year,
$630 the next year, and $700 at the end of
the fourth year. You can earn 12 percent on
very similar investments.
 Showing the cash flows on the time line?
What is the most you should pay for this one?
5-37
5.3.3 PV of annuity cash flows to be
 Suppose we are examining an asset that

promised to pay $500 at the end of each of the
next three years.
 If we want to earn 5% on our money, how much
would we offer for this annuity?
0 r = 5% 1 2 3
PV = ? $500 $500 $500
5-38
received in t period at r % per period
0 1 2 3
r = 5%
$500 $500 $500

$476.19
$453.51
$431.92
$1,361.62
PV = $1,361.62 = $500 x {[1 – 1/(1 + 5%)3]/ 5%}

5-39
 PV of ordinary annuity cash flows:
5-40
 Example 5.4
 You are offered an investment that will make
three $300 payments. The first payment will
occur four years from today. The second will
occur in five years, and the third will follow in
six years. You can earn 11 percent on very
similar investments.
 Showing the cash flows on the time line?
what is the most this investment is worth
today? (solve in 2 ways)
5-41
5.3.4 PV of growing annuity cash flows to be
 A growing annuity is an annuity where the

payments grow at a particular rate.
 Suppose we are looking at a lottery payout a 4-year
period. The first payment, made one year from now,
will be $500. Every year thereafter, the payment will
grow by 10%.
 What is the present value if the discount rate is 5%?
5-42
0 1 2 3 4
r = 5%
PV = ? $500
$500 x (1 + 10%)
$500 x (1 + 10%) x (1 + 10%)
$500 x (1 + 10%) x (1 + 10%) x (1 + 10%)

5-43
0 1 2 3 4
r = 5%
PV = ? $500
$500 x (1 + 10%)1
$500 x (1 + 10%)2
$500 x (1 + 10%)3
5-44
0 r = 5% 1 2 3 4
$500 $550 $605 $665.5

$476.19
$498.87
$522.62
$547.51
$2,045.19 5-45
  1  10%  4 
1 -   
  1  5%  
PV  $2,045.19  $500 x
 5%  10% 
 
 
5-46
 1 g  t

1 -   
  1  r  
PV  C x
 rg 
 
 
5-47
5.3.5 PV of perpetuity cash flows to be
received at r % per period
 Perpetuity is an important case of an annuity

arises when the level stream of cash flows
continues forever.
 Because a perpetuity has an infinite number of
cash flows, we can’t compute its value by
discounting each one. However, PV of a perpetuity
is simple: PV = C/r
 Preferred stock is an important example of a
perpetuity. The preferred stockholders are
promised a fixed dividend every period forever.
5-48
5.3.5 PV of perpetuity cash flows to be
 Example 5.5
 Suppose the Dewey Co. wants to sell preferred
stock and promises to pay preferred dividend of
$12 per share of stock. A similar issue of preferred
stock already outstanding has a price of $150 and
offers a dividend of $10.5 every year.
 What price should Dewey offer today if the
preferred stock is sold?
5-49
5.3.6 PV of growing perpetuity cash flows to be
 A growing perpetuity is an perpetuity where

the payments grow at a particular rate.
 Based on the formula for PV of growing annuity, we
can compute PV of growing perpetuity.
PV = C/(r – g)
5-50
5.3.6 PV of growing perpetuity cash flows to be
 Example 5.6
 Suppose the Bilbo Co. wants to sell preferred
stock and promises to pay preferred dividend of
$12 per share of stock at the end of first year.
Every year thereafter, the payment will grow by
3%.
 If the required return rate for preferred stock is
7%, what price should Bilbo offer today?
5-51
 Stated rate (quoted rate) is the interest rate

expressed in terms of the interest payment made
each period (daily, monthly, quarterly or annually…).
Stated rate is stated in contracts, e.g. 8% annually,
2% quarterly, 0.6% monthly or 0.02% daily
interest.
 Sometimes, Stated rate is also expressed in term of
annual term but note the number of compounding
period per year, e.g. 1% compounded weekly, 5%
compounded monthly, 6% compounded quarterly.
5-52
 Effective annual rate (EAR) is the interest rate

expressed as if it were compounded once per
year. It is actually the rate that you will earn.
 To compare different investments of interest
rates, we will need to convert to EAR.
5-53
 How much will we earn from $1 for one year

at the interest rate of 5% per year but
compounded daily, monthly, quarterly and
annually?
 What is EAR of each stated rate?
5-54
Accumulated interest for 365 days principal
 FV at interest rate of 5% compounded daily:

FV = $1 x (1 + 5%/365)365 = $1.05127
EAR = ($1.05127 – 1) / 1 = 0.05127 = 5.127%
 FV at interest rate of 5% compounded monthly:
FV = $1 x (1 + 5%/12)12 = $1.05116
EAR = ($1.05116 – 1)/1 = 0.05116 = 5.116%
5-55
 FV at interest rate of 5% compounded quarterly:

FV = $1 x (1 + 5%/4)4 = $1.05095
EAR = ($1.05095 – 1)/1 = 0.05095 = 5.095%
 FV at interest rate of 5% compounded annually:
FV = $1 x (1 + 5%/1)1 = $1.05
EAR = ($1.05 – 1)/1 = 0.05 = 5%
5-56
Stated rate Number of EAR

compounding times
5% 365 5.127%
5% 12 5.116%
5% 4 5.095%
5% 1 5.000%
 EAR = (1 + Stated rate/m)m – 1

 m: number of compounding periods per year.
5-57
 First, the highest quoted rate is not

necessarily the best.
 Second, compounding during the year can
lead to a significant difference between
the quoted rate and the effective rate.
-> Remember that the EAR is what you

actually get or what you pay.
5-58
5.5 Types of Loans
The borrower receives money today but he can:

 Pure discount loan: repay a single lump
sum at some time in the future.
0 1
5%
Borrows $10 Repays $10.05
5-59
5.5 Types of Loans
 Interest-only loan: pay interest each

period but repay the principal at some
point in the future.
0 5% 1 2
Borrows Interest paid Interest paid $0.5

$10 $0.5 Principal repaid $10
5-60
5.5 Types of Loans
 Amortized loan:
- pay equal payments (including interest
paid and principal repaid)
- repay equal principals, interest paid
depends on the beginning balance of each
period.
-> Use amortization tables to compute annual

payments
5-61
5.5 Types of Loans
 Suppose a business takes out a $5,000, five-

year loan at 9% per year. The loan agreement
calls for the borrower to make a single, fixed
payment every year.
 How will the amortization schedule look?
5-62
5.5 Types of Loans
 Step 1: Find the required annual payment

Dxr
Annual payment 
1
1-
(1  r) n
D: the loan amount PV of annuity CFs
Required annual payment =

($5,000 x 9%) / [1 – 1/(1+9%)5]= $1,285.46
5-63
5.5 Types of Loans
 Step 2: Find the interest paid in year 1 by

multiplying the beginning balance by the
interest rate.
Interest paid in Y1 = $5,000 x 9% = $450
 Step 3: Find the principal in year 1 by
subtracting the interest paid from the annual
payment.
Principal repaid in Y1 = $1,285.46 – 450
= $835.46
5-64
5.5 Types of Loans
 Step 4: Find the balance at the end of year

1 by subtracting the amount paid toward
principal from the beginning balance.
Ending balance in Y1 = $5,000 – 835.46

= $4,164.54
-> The ending balance in year 1 is also the

beginning balance in year 2
5-65
5.5 Types of Loans
 Step 5: Construct the amortization schedule

by repeating steps 1-4 until end of loan.
5-66
5.5 Types of Loans
 Example 5.7
 Suppose a business takes out a $5,000, five-
year loan at 9% percent. The loan agreement
calls for the borrower to pay the interest on
the loan balance each year and to reduce the
loan balance each year by $1,000.
 Construct the amortization schedule?
5-67
SUMMARY and CONCLUSIONS
 Time value of money is the concept that the value

$1 on hand today is more than the value of $1 in
future.
 Four components of the basic present value
equation are: PV, FV, r, t.
 Interest rates can be quoted in a various ways.
For financial decisions, it is important to convert
to EAR.
 The process of providing for a loan to be paid
off gradually is called amortizing loan.
5-68
HOMEWORKS
Concepts review:
Chapter 5: 1, 2, 3, 4.
Chapter 6: 1, 2, 3, 11.
Question and Problems:

Chapter 5: 1, 2, 3, 4, 5, 6, 7, 16.
Chapter 6: 1, 2, 3, 4, 10, 11, 12, 13, 16, 17,
37, 55, 56.
5-69

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Chapter 5 & 6

Time Value of Money

 PhD, Phan Hong Mai

5.1 Time Value of Money

 Time value of money is the concept

 1rst reason is that money received today

 Time lines: A horizontal line that is used

CF0 CF1 CF2 CF3

 Tick marks occur at the end of periods, so

$100 lump sum due in 2 years

100 100 100

Uneven cash flow stream

 Future value: The amount of money that

 Suppose you invest $1,000 for one year at

 Interest = $1,000 x 5% = $50

 Suppose you leave the money in for another

 Interest = $1,050 x 5% = $52.5

 FV = $1,000 x (1 + 5%) x (1 + 5%)

-> The process of accumulating interest over time

 Multiple cash flows: a series of different cash

$1,000 $1,250 $2,324

 Firstly, calculate the FV of each cash flow

$1,000 $1,250 $2,324

 Annuity cash flows: a series of constant or

 Suppose you invest $1,000 at the end of each

$1,000 $1,000 $1,000

$1,000 $1,000 $1,000

FV = $3,152.5 = $1,000 x {[(1 + 5%)3–1]/ 5%}

FV of ordinary annuity cash flows:

 Suppose you invest $1,000 at the beginning

$1,000 $1,000 $1,000

$1,000 $1,000 $1,000

FV of annuity due cash flows:

-> FV of annuity due cash flows = FV of same

 Present value: the current value of future

 Suppose you need to have $1,050 in one

 Based on your knowledge of FV, you know

 Suppose you need $1,102.5 in two years.

-> The process of calculating the present value of a

 Suppose you need $1,050 in one year and

 Firstly, calculate the PV of each cash flow

 Suppose we are examining an asset that

PV = ? $500 $500 $500

$500 $500 $500

PV = $1,361.62 = $500 x {[1 – 1/(1 + 5%)3]/ 5%}

 PV of ordinary annuity cash flows:

 A growing annuity is an annuity where the

$500 x (1 + 10%) x (1 + 10%)

$500 x (1 + 10%) x (1 + 10%) x (1 + 10%)

$500 $550 $605 $665.5

 Perpetuity is an important case of an annuity

 A growing perpetuity is an perpetuity where

 Stated rate (quoted rate) is the interest rate

 Effective annual rate (EAR) is the interest rate

 How much will we earn from $1 for one year

Accumulated interest for 365 days principal

 FV at interest rate of 5% compounded daily:

 FV at interest rate of 5% compounded quarterly:

Stated rate Number of EAR

 EAR = (1 + Stated rate/m)m – 1