Time Value of Money

 Be able to compute the future value and/or present

value of a single cash flow or series of cash flows
 Be able to compute the return on an investment
 Understand perpetuities and annuities

1
  If you were to invest $10,000 at 5-percent interest for one
year, your investment would grow to $10,500.

$500 would be interest ($10,000 × .05)

$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:

$10,500 = $10,000×(1.05)

 The total amount due at the end of the investment is call the
Future Value (FV).

 In the one-period case, the formula for FV can be

written as:
FV = C0×(1 + r)

Where C0 is cash flow today (time zero), and

r is the appropriate interest rate.

2
  If you were to be promised $10,000 due in one year
when interest rates are 5-percent, your investment
would be worth $9,523.81 in today’s dollars.
$10,000
$9,523.81 
1.05
The amount that a borrower would need to set aside
today to be able to meet the promised payment of
$10,000 in one year is called the Present Value (PV).
Note that $10,000 = $9,523.81×(1.05).

 In the one-period case, the formula for PV can be

written as:

C1
PV 
1 r
Where C1 is cash flow at date 1, and
r is the appropriate interest rate.

3
  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?

$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.

4
 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

The general formula for the future value of an

investment over many periods can be written as:
FV = C0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.

5
  Suppose a stock currently pays a dividend of $1.10,
which is expected to grow at 40% per year for the
next five years.
 What will the dividend be in five years?

FV = C0×(1 + r)T

$5.92 = $1.10×(1.40)5

10

 Notice that the dividend in year five, $5.92, is

considerably higher than the sum of the original
dividend plus five increases of 40-percent on the
original $1.10 dividend:

$5.92 > $1.10 + 5×[$1.10×.40] = $3.30

This is due to compounding.

11

6
 $1.10  (1.40) 5
$1.10  (1.40) 4
$1.10  (1.40) 3
$1.10  (1.40) 2
$1.10  (1.40)

$1.10 $1.54 $2.16 $3.02 $4.23 $5.92

0 1 2 3 4 5
Copyright © 2016 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written consent of McGraw-Hill Education.

12

 How much would an investor have to set aside today

in order to have $20,000 five years from now if the
current rate is 15%?
PV $20,000

0 1 2 3 4 5
$20,000
$9,943.53 
(1.15)5

13

7
 If we deposit $5,000 today in an account paying 10%, how
long does it take to grow to $10,000?
FV  C0  (1  r )T $10,000  $5,000  (1.10)T
$10,000
(1.10)T  2
$5,000
ln( 1.10)T  ln( 2)

ln( 2) 0.6931
T   7.27 years
ln( 1.10) 0.0953

14

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%.
FV  C0  (1  r )T $50,000  $5,000  (1  r )12

$50,000
(1  r )12   10 (1  r )  101 12
$5,000

r  101 12  1  1.2115  1  .2115

15

8
  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?

16

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

17

9
 Compounding an investment m times a year for T years
provides for future value of wealth:
mT
 r
FV  C0  1  
 m

18

 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 

19

10
 A reasonable question to ask in the above example is
“what is the effective annual rate of interest on that
investment?”
.12 23
FV  $50  (1  )  $50  (1.06) 6  $70.93
2
The Effective Annual Rate (EAR) of interest is the
annual rate that would give us the same end-of-
investment wealth after 3 years:

$50  (1  EAR)3  $70.93

20

FV  $50  (1  EAR)3  $70.93

$70.93
(1  EAR)3 
$50
13
 $70.93 
EAR     1  .1236
 $50 
So, investing at 12.36% compounded annually is the
same as investing at 12% compounded semi-annually.

21

11
  Find the Effective Annual Rate (EAR) of an 18%
APR loan that is compounded monthly.
 What we have is a loan with a monthly interest rate
rate of 1½%.
 This is equivalent to a loan with an annual interest
rate of 19.56%.
m 12
 r  .18 
 1    1    (1.015)  1.1956
12

 m  12 

22

The general formula for the future value of an

investment compounded continuously over many
periods can be written as:
FV = C0×erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years, and
e is a transcendental number approximately equal
to 2.718. ex is a key on your calculator.

23

12
  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

24

A constant stream of cash flows that lasts forever

C C C
…
0 1 2 3

C C C
PV    
(1  r ) (1  r ) 2 (1  r )3
C
PV 
r

25

13
 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

26

A growing stream of cash flows that lasts forever

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

C
PV 
rg

27

14
 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

28

A constant stream of cash flows with a fixed maturity

C C C C

0 1 2 3 T

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

29

15
 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   $12,954.59
.07 / 12  (1  .07 12)36 

30

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

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

0 1 2 3 4 5
$327 .97
PV   $297 .22
0 1.09 4-31

31

16
 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   L
(1 r) (1 r) 2 (1 r)T
C   1 g  
T

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

32

A defined-benefit retirement plan offers to pay

$20,000 per year for 40 years and increase the annual
payment by 3% each year. What is the present value at
retirement if the discount rate is 10%?
$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  

33

17
 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

34

 How is the future value of a single cash flow

computed?
 How is the present value of a series of cash flows
computed.
 What is the Net Present Value of an investment?
 What is an EAR, and how is it computed?
 What is a perpetuity? An annuity?

35

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