FINA 2303 HKUST

Financial Management
FINA2303
Time Value of Money:
An Introduction
Goyal: HKUST

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Course Overview
Corporate Finance
Financial Management Overview Ch. 1

Valuation Discount Rates

(Ch. 3 to 9) (Ch. 11 to 13)

Risk and Return

Valuation of: Ch. 11
Fundamentals of • Bonds Ch. 6
Projects Systematic Risk
Valuation • Stocks Ch. 7 and 10 Risk Premium
Ch. 12
Present Values and Investment Decisions Ch. 8
Future Value Ch. 3 Cost of Capital
Financial Statement Ch. 13
NPV Analysis Ch. 2
Valuation of
Perpetuities and Payback
Annuities Ch. 4 Capital Budgeting
ROI
Ch. 9
Interest Rates IRR • Identify incremental cash flows
Ch. 5 • Sunk Costs, Opportunity Costs
• Incidental Effects, Overheads
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Market Prices and the Valuation

Principle
• Opportunity: A manufacturer of breakfast cereals
is offered an opportunity to purchase barley at
$3.00 a bushel for 10,000 bushels if it also buys
5,000 bushels of wheat at $16.00 per bushel.
• The current market price of barley is $3.80 per
bushel and that of wheat is $15.80 per bushel.

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Market Prices and the Valuation Principle:

Breakfast Cereal
Question

The manufacturer does not use any barley in its products, and currently
needs 20,000 bushels of wheat. Should this opportunity be taken, and
why?

A. Because the company has no need of barley, the opportunity should

not be taken.

B. Because the opportunity does not meet the company's need for
wheat, the opportunity should not be taken.

C. Because the value of the opportunity is positive, the opportunity

should be taken.

D. Because the value of the opportunity is negative, the opportunity

should not be taken.

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Cost-Benefit Analysis
• Does the decision increase the value of the
company?
• Do the benefits exceed the costs?
• Quantifying benefits and costs:
Cost = Investment today
How do we quantify the benefits?
• They must be in terms of $s today.
• We can only compare benefits and costs if they
are in the same currency and measured at the
same time.
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Cost-Benefit Analysis
Market Prices:
• Alaska North Slope Crude Oil (ANS) $71.75/bbl
• West Texas Intermediate Crude Oil (WTI) $73.06/bbl

• Background: You can produce $76 worth of unleaded gasoline from one
barrel of Alaska North Slope (ANS) crude oil as an oil refiner. However,
you can produce $77 worth of unleaded gasoline from one barrel of West
Texas Intermediate (WTI) crude, given its lower sulfur content,

• Trade: Another oil refiner is offering to trade you 10,150 bbl. of Alaska
North Slope (ANS) crude oil for 10,000 bbl. of West Texas Intermediate
(WTI) crude oil.

Assume you currently have 10,000 bbl. of WTI crude.

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Market Prices and the Valuation Principle:

ANS or WTI
What should you do?

A. Do nothing; refine the 10,000 bbl. of WTI crude.

B. Trade the 10,000 bbl. WTI crude with the other refiner and refine the
10,150 bbl. of ANS crude.

C. Trade the 10,000 bbl. WTI crude with the other refiner and then sell the
10,150 bbl. of ANS crude.

D. Sell 10,000 bbl. WTI crude on the market and use the proceeds to
purchase and refine ANS crude.

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Present Value
The Mother of All Finance

• Time Value of Money (TVM)

• Money today is more valuable than the same amount
of money in the future.
• $1 today is better than $1 next year
• Why?

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Dealing with Cash Flows at

Different Points in Time
• Cash flows at different dates are like different
currencies.
$1 today and $1 next year

€1 + ₹1 = ?? 2
• It cannot be compared or combined.
• Translate all cash flows –inflows and outflows –
to the same point.
• Often, we translate them into equivalent present
values.

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Deciding Which Projects to Take

On
• Decisions about which project to take depend on
the following:
• The amount of investment and cash inflows from
projects
• The points in time they arrive
• Cash flows that occur earlier are more valuable.
• The risk those cash flows
• Risky cash flows are worth less than safe cash flows.
• We focus on time first and then bring in
uncertainty later.

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Timelines
• Invest $300 million in a new plant that lasts
three years.
• Cash inflows are:
• $100 million in the first year.
• $150 million in the second year.
• $225 million in the third year.
0 1 2 3

-$300 $100 $150 $225

End of year 1 End of year 2

Today Beginning of year 2 Beginning of year 3

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Present and Future Values

Key Idea: We can move cash flows through time by looking at market
interest rates.
0 ... t

PV0 FVt

Compounding

Discounting

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Future Value of Money

• Compounding: Moving cash flows forward in
time.
• How much money will you receive at the end of year 1
if the rate of return is 20%.

r = 20%
0 1 FV1 = PV × (1+r)
or
$100 FV1=? FV1 = $100 × (1+20%)
= $120
FV = Future value (in $)

$120 next year is the future value (FV) of $100 today.

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Compounding and Future Value

• Suppose you want to keep your money in the
account for two years.
• You can earn the same 20% a year in the second year,
and you reinvest all your money for another year.
• What is your two-year rate of return?

Is that 20% + 20% =40%?

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Future Value
0 1 2

$100 $120 $144

×1.20 ×1.20

FV2 = $100 × (1+20%)2 = $144

$@AAB$@CC
Two-year rate of return = = 44%
$@CC

Simple interest = ?

Interest-on-interest = ?

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Future Value: Continued

• Suppose you invest for 3 years.
𝐹𝑉F = $100×(1 + 20%)F= $172.8

[email protected]$@CC
Three-year rate of return = = 72.8%
$@CC

Taking a cash flow PV forward t periods:

𝐹𝑉G = 𝑃𝑉× 1 + 𝑟 × 1 + 𝑟 × ⋯×(1 + 𝑟)

t times
Or

𝐹𝑉G = 𝑃𝑉×(1 + 𝑟)G

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Future Value: Using Excel

• In a cell, type =FV( to bring up the formula as
follows:

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Compounding
• Suppose you deposit $1,000 at 10% a year for 20
years.

FV20 =
• What is your 20-year rate of return?

r20-years =

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Equivalent n-period Discount

Rate
I
Equivalent 𝑛 − period Discount Rate = 1 + r −1
where r is one-period discount rate

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Compounding: Short Periods to

Long Periods
• The 1-month interest rate is 1%. What is the 1-
year rate?

• The 1-day rate is 0.02%. What is the 7-day

(weekly) rate?

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Uncompounding
• What constant two 1-year interest rates will give
you a two-year rate of return of 50%?
• Is the answer 25%?

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Uncompounding
O
1 + 𝑟JKKLMN = (1 + 𝑟OPQMR )

𝑟JKKLMN = (1 + 𝑟OPQMR )S/O −1

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Compounding and Uncompounding

• The annual interest rate is 14%. What is the daily
rate?

Question: One-year rate is 5%. What is the equivalent 3-year rate?

Question: One-year rate is 5%. What is the equivalent quarterly rate?

Question: One-year rate is 5%. What is the equivalent monthly rate?

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Original deposit (PV) = $1,000

r = 10%
N = 20 years

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Present Value
Translating future money into today’s money.

0 1 2 … t

CFt

Present Value
=
?

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Present Value: Example

What is the Present Value (PV) of $500 What would $500 in 2 periods be
to be received next year if the interest worth today?
rate is 10%?

$500 = PV × (1+r)

0 1
0 1 2
PV $500
= $413.2 $454.5 $500
$454.54 ÷(1+0.10) ÷(1+0.10)

Or,
$500
$OCC 𝑃𝑉 = = $413.2
PV = = $454.54 (1 + 10%)I
(@P@C%)

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Present Value
0 1 2 … t

PV CFt

𝐶𝐹G
𝑃𝑉 =
(1 + 𝑟)G

1
is known as the “Discount Factor”
(1 + 𝑟)G

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Takeaways
• Evaluating a decision requires:
• Comparing incremental costs and benefits associated
with that decision.
• All cost and benefits must be in common terms, typically in
cash today (in the same currency).
• The decision increases market value of the firm if the value
of benefits today exceeds the value of the costs today.
• Time Value of Money
• Money today ≠ Money tomorrow
• Exchange rate between money today and money tomorrow
depends on market interest rates.
• Draw timelines

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Takeaways Continued
• Three rules of time travel:
• Only cash flows that occur at the same point in time
can be compared or combined.
• To calculate a cash flow’s future value, compound it.
• To calculate a cash flow’s present value, discount it.
• Future value in t years of a cash flow C is:
𝐹𝑉l = 𝐶×(1 + 𝑟)l
• Present value today of a cash flow C received in t
years is: 𝐶l
𝑃𝑉 =
(1 + 𝑟)l
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Supplementary Slides

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Valuing Cash Flows at Different

Points in Time
• Suppose you invest $800 in an account paying
2% interest per year.
a. What is the balance in the account after 3 years?
How much of this balance corresponds to “interest-
on-interest”?
b. What is the balance in the account after 25 years?
How much of this balance corresponds to “interest-
on-interest”?

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Finding the Interest Rate, r

• You have access to an account that triples your
money in 8 years. What implied interest rate is
the account offering?

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Finding the Number of Years, t

• Suppose you now have $400,000 and the interest
rate is 4.5%. How long will it take to grow to $1
million?
𝐹𝑉l = 𝑃𝑉×(1 + 𝑟)l

t=?
l
$1,000,000 = $400,000 ×(1 + 0.045) Solve for t.

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Doubling Your Money:

Rule of 72
• Suppose interest rates are 9% a year.
• How long will it take to double your money?
𝐹𝑉l = 𝑃𝑉×(1 + 𝑟)l t=?
l Solve for t.
$2 = $1 ×(1 + 0.09)

• Or use the Rule of 72.

• Years to double ≈ 72 ÷ r

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Quadrupling Your Money

• If the interest rates are 7% a year, how long will
it take to quadruple your money?

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Valuing Cash Flows at Different

Points in Time
• Your mom is thinking of retiring. Her retirement
plan will be either $100,000 immediately on
retirement or $140,000 five years after her
retirement date. Which alternative should she
choose if the interest rates are:
a. 0% per year
b. 8% per year
c. 20% per year

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Valuing Cash Flows at Different

Points in Time
• Your grandfather put some money in an account
for you on the day you were born. You are now
18 years old and are allowed to withdraw money
for the first time. The account currently has
$4,200 in it and pays a 12% interest rate.
• How much money would be there if you left the
money there until your 25th birthday?
• What if you left the money until your 65th birthday?
• How much money did your grandfather originally put
in the account?

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