Time Value of Money

Chapter II- Corporate Finance (I)

Structure
• Future Values
• Present Values
• Multiple Cash flows
• Perpetuities and Annuities
• Effective annual interest rates
• Inflation
Future Values
Future Value - Amount to which an investment will
grow after earning interest.

Compound Interest - Interest earned on interest.

Simple Interest - Interest earned only on the original

investment.
Future Values

Example - Simple Interest

Interest earned at a rate of 6% for five years on a
principal balance of $100.

Interest Earned Per Year = 100 x .06 = $ 6

Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years

1 2 3 4 5
Interest Earned 6 6 6 6 6
106 112 118 124 130
Value 100

Value at the end of Year 5 = $130

Future Values

Example - Compound Interest

Interest earned at a rate of 6% for five years on the
previous year’s balance.

Interest Earned Per Year =Prior Year Balance x .06

Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on the
previous year’s balance.

Today Future Years

1 2 3 4 5
6 6.36 6.74 7.15 7.57
Interest Earned 106 112.36 119.10 126.25 133.82
Value 100

Value at the end of Year 5 = $133.82

Future Values
Future Value of $100 = FV

t
FV  $100  (1  r )
Future Values

t
FV  $100  (1  r )

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?

5
FV  $100  (1  .06 )  $133 .82
Future Values with Compounding

1800
1600 0%
1400 5%
10%
1200
FV of $100

15%
1000
Interest Rates
800
600
400
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
Compounding Periods
 For example, if you invest $50 for 3 years at 12%
compounded semi-annually, your investment will
grow to

23
 .12 
FV  $50  1    $50  (1.06) 6  $70.93
 2 
Present Values
Present Value Discount Factor
Value today of a Present value of
future cash a $1 future
flow. payment.

Discount Rate
Interest rate used
to compute
present values of
future cash flows.
Present Values

Present Value = PV

Future Value after t periods

PV = (1+r) t
Present Values
Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on your
money, how much money should you set aside today in order
to make the payment when due in two years?

PV  3000
(1.08) 2
 $2,572
Present Values
Discount Factor = DF = PV of $1

DF  1
(1 r ) t

• Discount Factors can be used to compute the present

value of any cash flow.
Time Value of Money
(applications)
• The PV formula has many applications. Given any
variables in the equation, you can solve for the
remaining variable.

PV  FV  1
(1 r ) t
Present Values with Compounding

120
Interest Rates
100
0%

80 5%
PV of $100

10%
60 15%

40

20

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
PV of Multiple Cash Flows
Example
Your auto dealer gives you the choice to pay $15,500 cash
now, or make three payments: $8,000 now and $4,000 at
the end of the following two years. If your cost of money is
8%, which do you prefer?

Immediatepayment 8,000.00
4 , 000
PV1  (1.08)1
 3,703.70
4 , 000
PV2  (1.08) 2
 3,429.36
Total PV  $15,133.06
Present Values
$8,000

$4,000 $ 4,000

Present Value Year

0 1 2
Year 0
$8,000
4000/1.08 = $3,703.70
4000/1.082 = $3,429.36
Total = $15,133.06
Net Present Value
• The Net Present Value (NPV) of an investment is the
present value of the expected cash flows, less the cost
of the investment.
• Suppose an investment that promises to pay $10,000
in one year is offered for sale for $9,500. Your interest
rate is 5%. Should you buy?
Net Present Value

$10,000
NPV  $9,500 
1.05
NPV  $9,500  $9,523.81
NPV  $23.81
The present value of the cash inflow is greater
than the cost. In other words, the Net Present
Value is positive, so the investment should be
purchased.
Net Present Value

In the one-period case, the formula for NPV can be

written as:
NPV = –Cost + PV

If we had not undertaken the positive NPV project

considered on the last slide, and instead invested our
$9,500 elsewhere at 5 percent, our FV would be less
than the $10,000 the investment promised, and we
would be worse off in FV terms :

$9,500×(1.05) = $9,975 < $10,000

How Long is the Wait?
If we deposit $5,000 today in an account paying 10%,
how long does it take to grow to $10,000?
T T
FV  C 0  (1  r ) $10,000  $5,000  (1.10)
$10,000
T
(1.10)  2
$5,000
ln( 1.10)T  ln( 2)

ln( 2) 0.6931
T   7.27 years
ln( 1.10) 0.0953
What Rate Is Enough?
Assume the total cost of a college education will be
$50,000 when your child enters college in 12 years.
You have $5,000 to invest today. What rate of interest
must you earn on your investment to cover the cost
of your child’s education? About 21.15%.
T
FV  C 0  (1  r ) 12
$50,000  $5,000  (1  r )

12 $50,000
(1  r )   10 (1  r )  101 12
$5,000
1 12
r  10  1  1.2115  1  .2115
Multiple Cash Flows
• Consider an investment that pays $200 one year from
now, with cash flows increasing by $200 per year
through year 4. If the interest rate is 12%, what is the
present value of this stream of cash flows?
• If the issuer offers this investment for $1,500, should
you purchase it?
Multiple Cash Flows
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93
Present Value < Cost → Do Not Purchase
Perpetuities & Annuities

Finding the present value of multiple cash flows by using a spreadsheet

Time until CF Cash flow Present value Formula in Column C

0 8000 $8,000.00 =PV($B$11,A4,0,-B4)
1 4000 $3,703.70 =PV($B$11,A5,0,-B5)
2 4000 $3,429.36 =PV($B$11,A6,0,-B6)

SUM: $15,133.06 =SUM(C4:C6)

Discount rate: 0.08

PV of Multiple Cash Flows
• PVs can be added together to evaluate multiple cash
flows.

C1 C2
PV  ( 1 r ) 1  (1 r ) 2 ....
4.4 Simplifications
• Perpetuity
• A constant stream of cash flows that lasts forever
• Growing perpetuity
• A stream of cash flows that grows at a constant rate
forever
• Annuity
• A stream of constant cash flows that lasts for a fixed
number of periods
• Growing annuity
• A stream of cash flows that grows at a constant rate for a
fixed number of periods
Perpetuity
A constant stream of cash flows that lasts forever
C C C
…
0 1 2 3

C C C
PV   2
 3

(1  r ) (1  r ) (1  r )
C
PV 
r
Perpetuity: Example

What is the value of a British consol that promises to

pay £15 every year for ever?
The interest rate is 10-percent.

£15 £15 £15

…
0 1 2 3

£15
PV   £150
.10
Growing Perpetuity

A growing stream of cash flows that lasts forever

C C×(1+g) C ×(1+g)2
…
0 1 2 3
2
C C  (1  g ) C  (1  g )
PV   2
 3

(1  r ) (1  r ) (1  r )

C
PV 
rg
Growing Perpetuity: Example

The expected dividend next year is $1.30, and

dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this
promised dividend stream?
$1.30 $1.30×(1.05) $1.30 ×(1.05)2
…
0 1 2 3

$1.30
PV   $26.00
.10  .05
Annuity
A constant stream of cash flows with a fixed maturity
C C C C

0 1 2 3 T

C C C C
PV   2
 3
 T
(1  r ) (1  r ) (1  r ) (1  r )
C 1 
PV  1  T 
r  (1  r ) 
Annuity: Example

If you can afford a $400 monthly car payment, how

much car can you afford if interest rates are 7% on 36-
month loans?
$400 $400 $400 $400

0 1 2 3 36

$400  1 
PV  1  36 
 $12,954.59
.07 / 12  (1  .07 12) 
 What is the present value of a four-year annuity of $100
per year that makes its first payment two years from today if the
discount rate is 9%?

  4
$100 $100 $100 $100 $100
PV1   t
 1
 2
 3
 4
 $323.97
t 1 (1.09) (1.09) (1.09) (1.09) (1.09)

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5
$327 .97
PV   $297 .22
0 1.09
Growing Annuity
A growing stream of cash flows with a fixed maturity
C C×(1+g) C ×(1+g)2 C×(1+g)T-1

0 1 2 3 T
C C  (1  g ) C  (1  g )T 1
PV   2
 T
(1  r ) (1  r ) (1  r )
C   1 g  
T

PV  1    
r  g   (1  r )  

Growing Annuity: Example

A defined-benefit retirement plan offers to pay $20,000 per

year for 40 years and increase the annual payment by three-
percent each year. What is the present value at retirement if
the discount rate is 10 percent?

$20,000 $20,000×(1.03) $20,000×(1.03)39


0 1 2 40

$20,000   1.03  
40

PV  1      $265,121.57
.10  .03   1.10  
Growing Annuity: Example
You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?
$8,500  (1.07 ) 2  $8,500  (1.07) 4 
$8,500  (1.07 )  $8,500  (1.07) 3 
$8,500 $9,095 $9,731.65 $10,412.87 $11,141.77

0 1 2 3 4 5
$34,706.26
4.5 What Is a Firm Worth?
• Conceptually, a firm should be worth the present
value of the firm’s cash flows.
• The tricky part is determining the size, timing and risk
of those cash flows.
Effective Interest Rates

Effective Annual Interest Rate - Interest rate

that is annualized using compound interest.

Annual Percentage Rate - Interest rate that is

annualized using simple interest.
Effective Interest Rates
example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual Percentage
Rate (APR)?

EAR = (1 + .01)12 - 1 = r
12
EAR = (1 + .01) - 1 = .1268 or 12.68%

APR = .01 x 12 = .12 or 12.00%

Inflation

Inflation - Rate at which prices as a whole are

increasing.

Nominal Interest Rate - Rate at which money invested

grows.

Real Interest Rate - Rate at which the purchasing

power of an investment increases.
 Inflation

1+ nominal interest rate

1  real interest rate = 1+inflation rate

approximation formula

Real int. rate  nominal int. rate - inflation rate

Inflation
Example
If the interest rate on one year govt. bonds is 6.0%
and the inflation rate is 2.0%, what is the real
interest rate?
1+.06
1  real interest rate = 1+.02 Savings

1  real interest rate = 1.039 Bond

real interest rate = .039or 3.9%

Approximation = .06 - .02 = .04 or 4.0%

Thanks