Handout 1

Mathematical models of Corporate finance

January/February 2009, AIMS
Maciej Capi
nski

Time value of money

1.1

Introduction

To an economist thinking about money is not thinking about a piece of paper

on which its value is written. Printed money is there. Once we have it does not
change. One hundred dollars remains one hundred no matter what happens.
One might find oneself though in a situation in which one reaches for a suit
which has not been worn for the last twenty of years and find forgotten hundred
dollars in it. Looking back in time to when it was put inside of the pocket
one realizes that it was actually worth much more than it is now. This should
start us thinking. What is money? Surely it is not as static as a piece of paper
which we have in mind when we first think of it. To an economist money is not
about paper. Money is something which changes hands and most importantly
changes value. If an investor stars off with one million dollars at the beginning
of the year and at the end of the year finds that he still he has one million at
his disposal, then he is doing something very wrong. One might argue that he
has not lost any money, since he has the same amount, but this is not the case!
Had the investor deposited his one million in a bank account he would end up
with one million plus interest. He would have been better off. Also if one takes
into account inflation, one million is now worth slightly less than it was one year
ago. By not making money the investor has actually lost.
To an economist money is something that should grow in time. It should
grow at least as fast as investments into a bank account (for if it does not, then
what good is making business when one could just as well sit back and keep
the money in the bank?). Bank accounts are a good starting point to describe
how money changes value and are a useful benchmark, so here is where we will
begin our story.
We start with a seemingly trivial question. How much money will we have
in the future if we deposit it in the bank? As such, the question is very vague.
To add meaning we need to specify a number of things
1. How much money have we invested? This initial capital we will usually
denote as P V (standing for present value).

2. For how long do we intend to keep the money in the bank account? This
we will refer to as the terminal date and denote it by T .
3. What is the interest rate that the bank offers? We will denote interest
rate by r.
Now we can pose a more meaningful question:
Example 1 How much money will we have in a one year time (T = 1) if
we deposit one hundred dollars in a bank (P V = 100) and the interest is four
percent (r = 4%). It does not take a rocket scientist to guess that the answer
is 104. Let us write this in a form of an equation, where F V stands for future
value,
F V = P V (1 + r)
= 100(1 + 4%).

(1)

Things seem as simple as they could get so let us stir things up a bit.
Example 2 Let us first ask how much money will we have if T = 21 , P V = 100
and r = 4%? If we keep one hundred dollars for half a year at four percent then,
once again, it does not take a rocket scientist to guess that the answer should be
102. We can even put this in a form of an equation
F V = P V (1 + rT ).
Now that half a year has passed we have our 102 dollars and can do something
with it. Let us invest it once again for half a year at the same interest rate.
What we will end up with is
1
F V = 102(1 + 4% ) = 104. 04.
2

(2)

Something is very wrong! in both Examples we have considered an investment of P V = 100, for a duration of one year T = 1, with the same interest
rate r = 4%, yet in (1) and (2) we obtain different results. We are missing one
important factor in our story. This is compounding.
Compounding determines how often money obtained from interest rate is
reinvested. We have various types of compounding. Most common are:
Simple compounding. In this case interest is not reinvested. This is
sometimes encountered in some types of debts (when imposing interest on
interest is not permitted). The most common example is what happens
on our bank account throughout a duration of a single month. We pay
in/out money at different periods, but the overall interest on our deposit is
computed using simple compounding. (At the end of a month the interest
is reinvested, so simple compounding is no longer valid).
Annual compounding. In this case interest is added at the end of each
year.
2

 Semi-annual compounding. Interest is added at the end of every six

months.
Quarterly compounding. Interest is added at the end of every three
months.
Monthly compounding. Interest is added every month.

Continuous compounding. This is obtained by passing to a limit in

frequency of compounding. In such case the investment is compounded
continuously throughout time. This notion, even though somewhat abstract at first glance, is quite simple and will be discussed in the next
section.
When discussing time value of money we will need to specify all:
Amount invested (P V ), terminal date (T ), interest rate (r) and compounding.

1.2

Present and future value

In case of simple compounding the formula for future value is

F V = P V (1 + T r).
The more time we wait the larger the interest acquired. Since there is no
compounding the growth rate in time is linear.
Considering examples of Section 1.1 it is quite natural to write out the
formula for future value in the case of annual compounding
F V = P V (1 + r)T .

(3)

In the most natural cases T is usually a natural number (but this does not
always need to be case as we will see later on). From 3 one immediately obtains
P V = F V (1 + r)T .

(4)

This, though quite trivial, does answer an important question: How much
money should we invest at time zero to receive F V at time T when compounding
is annual?.
Formulas for future and present value can be seen as ways of travelling in
time. We can look at this in the following way. The money in question is
always the same, it simply changes value throughout time. Let us consider an
example which will clarify this idea.
Example 3 We can invest our money with interest r = 5%, and annual compounding. We wish to have 1000$ in two years (T = 2). How much money
should we have at time t1 = 12 and t0 = 0 to achieve this?
The first approach could be to compute the amount needed at t1 . This would
be
P Vt1 = F V (1 + r)(T t1 ) = 1000(1.05)1.5 = 929. 43.
(5)
3

Then we can compute the value needed at time zero

P Vt0 = P Vt1 (1 + r)(t1 t0 ) = 907. 03.

(6)

Above we have travelled back in time from T = 2 to t1 and then once again
back in time from t1 to t0 .
Let us note that P Vt0 could just as well be accomplished by travelling back
from T to t0 directly.
P Vt0 = F V (1 + r)(T t0 ) = 907. 03.

(7)

The result of this is just the same as (6) by no accident. From (5) we have
P Vt0 = P Vt1 (1 + r)(t1 t0 )
= F V (1 + r)(T t1 ) (1 + r)(t1 t0 )
= F V (1 + r)(T t0 ) .
Travelling back for two years is the same as travelling back for one and a half
year and then half a year back more. This is the same money, only seen at
different times.
The terms (1 + r)T and (1 + r)T are often referred to as growth factor and
discount factor respectively.
For different types of compounding we obtain similar formulas to (3) and
(4). Looking at Example 2 it is not difficult to figure out that in the case of
semi-annual compounding we should have
!
r "2T
FV = PV 1 +
2
!
r "2T
PV = FV 1 +
.
2
This can easily be generalized to different types of compounding
!
r "mT
FV = PV 1 +
,
m
!
r "mT
PV = FV 1 +
,
m

(8)

where m is the number of compounding periods in a single year.

compounding
annual
semi-annual
quarterly
monthly

m
1
2
4
12

Example 4 It is not unheard of having m smaller than one. If interest is added

every two years then this means that m = 12 . If interest is added every seventeen
months (not a very typical scenario) then m = 12
17 .
4

Now is a good time to precisely specify how the interest rate r used in (8)
should be understood. The rate is annual, but expressed in nominal terms. This
means that for a single compounding period the rate is r/m. In our lectures we
will keep to the convention that rates will always be expressed in annual terms.
This means that if we make 105$ in half a year from investing 100$ at time zero
then our rate is r = 10% with semi-annual compounding.
In theory we can consider compounding as frequent as we wish. Passing
with m to infinity we obtain a formulas for continuous compounding
F V = P V erT ,
P V = F V erT .

1.3

Effective interest rate

It is evident that the growth factor depends on compounding. The more frequent
compounding, is the higher the growth factor. The question which we are
going to answer here is how rates with different compounding compare to one
another. The starting point in such discussion is usually finding an interest rate
with annual compounding re , which is called the effective rate, for which the
growth factor is the same as for a given nominal rate r with compounding m.
This gives the following relation

or after rearranging

!
r "mT
(1 + re )T = 1 +
,
m

!
r "m
re = 1 +
1.
(9)
m
Let us see how the rate re is related to r. If we invest P V at either of the
two rates re or r then the future outcome will be the same, no matter what
terminal date T we choose
F V = P V (1 + re )T = P V (1 +

r mT
) .
m

(10)

This means that investments with interest rates r and re are equivalent. We
will call such rates equivalent.
Remark 5 It is very important to take note that the formula (10) works for
any T, and not only for integers. If one is aware of this then one can exploit
this fact to simplify many computations. Here is an example.
Consider that at your local bank you are offered a bank account with monthly
compounding, and you are told that the effective rate for that account is re = 5%
(This is a quite common scenario. Quite often we are given effective rather than
nominal rates). Let us assume that we are interested in how much money we
will have on our bank account in ten months if we deposit 500$ today. The first
approach could be to compute r using (9) and then to apply (8) with m = 12.

But if one is aware that (10) works for any time T then one can just as well
compute
F V = P V (1 + re )T
= 500(1.05)10/12
= 520. 75.
There is no need to compute r at all! If we pay attention to and exploit such
properties then this will simplify a lot of computations in the future.
Now we can come to the question of how to compare different rates with
different compounding. The task is simple. If we have two nominal rates r1 and
r2 , then the one for which we have bigger growth factors is the one that has a
higher effective rate. We say that two nominal rates r1 and r2 are equivalent
if their respective effective rates re1 , re2 are equal re1 = re2 .

1.4

Annuities

Annuities are fixed payments at given time periods. This section deals with
their valuation. All formulas follow from simple sums of a geometric sequence.
In these notes though we will focus on derivation of annuities using time value
of money, or economic arguments. The main purpose of this is to acquaint
ourselves with this type of reasoning. (Mathematical derivation of present values
of annuities will be dealt with during exercises.)
For simplicity of notation we will focus on the case of annual compounding. The general case of arbitrary compounding will also be dealt with during
exercises.
1.4.1

Perpetuity

Consider a dream. How beautiful would it be to inherit P V = 10 000 000$,

deposit it in a bank and live off interest! A natural question to ask is how much
money would we have each year to spend (We assume that we have annual
compounding. We take out a lump of cash at the beginning of each year and
spend it throughout the year). If we wish to live off interest only, and deposit
the money in a bank at an interest rate r with annual compounding, then we
can spend
C = rP V
each year. This is because if at the end of each year we take out interest
C = rP V then the amount left on our deposit is P V, and we can repeat this
procedure every year. This leads to the formula for present value of a perpetuity
PV =

C
,
r

(11)

where by a (fixed) perpetuity we mean an infinite sequence of constant payments of C each year.
6

Someone should (wisely) spot one weakness in our plan. If we adopt the
above procedure then we will receive our first payment one year after we inherit
the money! If one is not patient then one would prefer to be able to spend some
of the money right now. In such a case one should pay out somewhat less each
year. How much? There are at least two ways of obtaining the answer. The
first is by time value of money argument. In this argument we notice that an
infinite sequence of payments of C which starts from time t = 1 is worth P V
0
PV

1
C

2
C

3
C

...

What we would like is for this sequence to start at time zero. Nothing easier!
We only need to shift each of the payments one year back in time. This is done
by discounting
0
PV

C(1 + r)1

1
C
C(1 + r)1

2
C

C(1 + r)1

3
C
C(1 + r)1

...
#

This means that by starting our payments at time zero we can constantly pay
out
rP V
C = C(1 + r)1 =
.
1+r
This gives a formula for a (fixed) perpetuity up-front
PV =

C
(1 + r).
r

(12)

Another argument leading to the same formula is the following. If we pay

out C now then we will be left with P V C on our deposit. What we will pay
hence
out in one years time is interest equal to r(P V C)

C = r(P V C),

which when solved for P V gives (12). Do not be fooled! The second solution
is not simpler. Once you become familiar with time value of money, it will not
only seem very natural, but also prove to be a handy tool at valuation of a wide
range of instruments.
Let us return to the discussion where first C was paid out at the end of the
first year. The discussion has missed one key issue. If we start paying out C
each year, then by the time we grow old this will not be worth as much as it
is today. In particularwe need to take into account inflation. In reality what
we would truly wish for is to be able to pay out somewhat more each year. We
could for example wish to pay out a fraction g more (or less; in which case g
would be smaller than zero) each year. To sum up we would like to ensure a
sequence of payments
0

1
C

2
3
C(1 + g) C(1 + g)2
7

...

the question is the value of C which we can afford if we invest P V at time zero.
The solution is as follows. We should be able to cover C from interest at time
one. If we wish to pay out C(1 + g) from interest at year two, then at year one
we need to leave on our account P V (1 + g), which is a fraction g more than we
started with. If we keep successively increasing the amount left on our deposit
then this will ensure that we can pay out more each year. This means that
P V (1 + r) C = P V (1 + g)

which gives

C
.
(13)
rg
This is the present value of a perpetuity with a growth rate g. Analogous
formulas to (13) can be derived using time value of money or geometric series
types of arguments. This will be covered in exercises. Also in exercises we will
derive formulas for a perpetuity with a growth rate up-front.
PV =

1.4.2

Fixed annuities.

A fixed annuity consists of a sequence of payments (coupons) C at regular

time intervals. In this section we will deal with annual annuities, which means
that coupons are paid out every year. To compute the present value of an
annuity which has a first payment at time one and last payment at time N we
can proceed as follows. We can notice that this annuity is a difference of two
perpetuities, one of which starts at time 1 (and its P V is therefore at time
zero) and the other starts at time n + 1 (its P V is therefore at time n)
0
(P V =?)

1
C

2
C

...
...

n
C

...

n+1

=
#
!

P V1 =

C
r

P V2 (1 + r)

"

...

P V2 =

C
r

...

...

We can now compute the present value of our annuity as

n

which gives a formula

P V = P V1 P V2 (1 + r)

C
C

.
(14)
r
r(1 + r)n
The above derivation is a nice example of how time value of money based computations can be performed. One could have derived this using a finite sum of a
geometric sequence, but such derivation is somewhat more time laborious (left
as an exercise).
PV =

1.4.3

Annuities with growth

Consider now an annuity with a first payout of C at time one, with payments
which grow at a rate g in time. The last payment made is at time n with a
coupon of C(1 + g)n1 . To value such an annuity consider two perpetuities. The
first is a perpetuity starting at time one with growth g and first payment of C.
The value at time zero of this perpetuity is (13)
P V1 =

C
.
rg

The second perpetuity will have the first payment at time n + 1 with a coupon
of C(1 + g)n . Its value at time n is
P V2 =

C(1 + g)n
.
rg

Note that our annuity is the difference between the two perpetuities.
0

1
C

2
...
C(1 + g)
...
=
C(1 + g)

n
C(1 + g)n1
C(1 + g)n1

...

n+1

C(1 + g)n

...

C(1 + g)n

...

This gives us the present value of our annuity as

n

P V = P V1 P V2 (1 + r)

C(1 + g)n
C
n

(1 + r)
rg
rg
%
%
&n &
C
1+g
=
1
.
rg
1+r

Formulas for annuities with with growth for different compounding and also
for annuities up front with growth can be derived similarly. This is left as an
exercise.