Chapter+4 +time+value+of+money

CHAPTER 4:
TIME VALUE OF MONEY
Lecturer: Truong Thi Thuy Trang

Email: truongthithuytrang.cs2@ftu.edu.vn
1
Content
• Interest Rates: Interpretation
• The Future Value of a Single Cash Flow
• The Present Value of a Single Cash Flow
• The Future Value of a Series of Cash Flows
• The Present Value of a Series of Cash Flows
• Application of time value of money in bond valuation
• Application of time value of money in stock valuation
2
Content
• Investment Decision Criteria
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
3
Financial Decisions
• Costs and benefits being spread out over time
• The values of sums of money at different dates
• The same amounts of money at different dates
have different values.
• Every decision involves time and uncertainty
4
Interest Rates: Interpretation
• An interest rate, denoted r, is a rate of return that
reflects the relationship between differently dated
cash flows.
• Interest rates can be thought of in three ways.
– First, they can be considered required rates of return -
that is, the minimum rate of return an investor must
receive in order to accept the investment.
– Second, interest rates can be considered discount rates.
– Third, interest rates can be considered opportunity costs.
5
• Economics tells us that interest rates are set in the
marketplace by the forces of supply and demand,
• Taking the perspective of investors in analyzing
market-determined interest rates, we can view an
interest rate as being composed of a real risk-free
interest rate plus a set of four premiums that are
required returns or compensation for bearing
distinct types of risk.
6
Interest rate = Real risk-free interest rate
+ Inflation premium
+ Default risk premium
+ Liquidity premium
+ Maturity premium
7
• The real risk-free interest rate is the single-
period interest rate for a completely risk-free
security if no inflation were expected.
• The inflation premium compensates investors for
expected inflation and reflects the average
inflation rate expected over the maturity of the
debt.
8
• The default risk premium compensates investors
for the possibility that the borrower will fail to make
a promised payment at the contracted time and in
the contracted amount.
• The liquidity premium compensates investors for
the risk of loss relative to an investment’s fair
value if the investment needs to be converted to
cash quickly.
9
• The maturity premium compensates investors
for the increased sensitivity of the market value of
debt to a change in market interest rates as
maturity is extended, in general (holding all else
equal).
10
The Three Rules of Time Travel
• It is only possible to compare or combine values
at the same point in time.
• To move a cash flow forward in time, you must
compound it.
• To move a cash flow back in time, we must
discount it.
11
Moving money through time
Compounding
Present Future
Value Value
Discounting
12
The Future Value of a Single Cash Flow
• Suppose you invest $100 in an interest-bearing
bank account paying 5 percent annually.
• How much will you have at the end of the 1st year?
• How much will you have at the end of the 2nd year?
• How much will you have at the end of the 3rd year?
13
FV = PV (1+i)n
Where:
PV : present value of the investment
FVn : future value of the investment n periods from
today
i: interest rate per period
14
15
• Simple interest
• Compound interest
16
Compound Interest
• Interest is compound interest if interest is paid on
both the principal—the amount borrowed—and
any accumulated interest.
• For instance, if you borrow $1,000 today for two
years and the interest is 5% compound interest, at
the end of two years you must repay the $1,000,
plus interest on the $1,000 for two years and
interest on interest.
17
Compound Interest
In the case of compound interest, the amount
repaid has three components:
1. The amount borrowed (= the principal)
2. The interest on the amount borrowed
3. The interest on interest
18
19
Example: You are 20 years old and are considering
putting $100 into an account paying 8% per year for
45 years. How much will you have in the account at
age 65? If you could find an account paying 9% per
year, how much more would you have at age 65?
20
Example: Fifty years after graduation, you get a
letter from your college notifying you that they have
just discovered that you failed to pay your last
student activities fee of $100. Because it was your
college’s oversight, it has decided to charge you an
interest rate of only 6% per year. As a loyal alumnis,
you feel obiliged to pay. How much do you have to
pay?
21
Example: You are the lucky winner of your state’s
lottery of $5 million after taxes. You invest your
winnings in a five-year certificate of deposit (CD) at
a local financial institution. The CD promises to pay
7 percent per year compounded annually. This
institution also lets you reinvest the interest at that
rate for the duration of the CD. How much will you
have at the end of five years if your money remains
invested at 7 percent for five years with no
withdrawals?
22
Example: An institution offers you the following
terms for a contract: For an investment of
¥2,500,000, the institution promises to pay you a
lump sum six years from now at an 8 percent
annual interest rate. What future amount can you
expect?
23
The Present Value of a Single Cash Flow
• PV = FV/(1+i)n
24
The Present Value of a Single Cash Flow
Example: Suppose you own a liquid financial asset
that will pay you $100,000 in 10 years from today.
You plan to study MBA four years from today, and
you want to know what the asset’s present value will
be at that time. Given an 8 percent discount rate,
what will the asset be worth four years from today?
25
Example: Bob estimates that he will inherit $10
million five years from now. He plans to invest this
amount of money on some financial assets. The
rate of return on those assets has been estimated
at 9 percent per year. What will the value of this
investment at t = 15? At t = 0?
26
Example: The rate of return on Bob’s investment
will be 10% instead of 9% as stated in the above
example. What will the value of his investment at t =
15? At t = 0?
27
• We can add amounts of money only if they are
indexed at the same point in time.
• For a given interest rate, the future value increases
with the number of periods.
• For a given number of periods, the future value
increases with the interest rate.
28
• To calculate interest rate
• To calculate number of periods
29
The Frequency of Compounding
• Rather than quote the periodic monthly interest
rate, financial institutions often quote an annual
interest rate that we refer to as the stated annual
interest rate or quoted interest rate.
– For instance, your bank might state that a particular CD
pays 8 percent compounded monthly. The stated
annual interest rate equals the monthly interest rate
multiplied by 12. In this example, the monthly interest
rate is 0.08/12 = 0.0067 or 0.67 percent.
30
With more than one compounding period per year:
Where in is stated annual interest rate, m is the

number of compounding periods per year, and n
now stands for the number of years.
31
Example: Suppose your bank offers you a CD with
a two- year maturity, a stated annual interest rate of
8 percent compounded quarterly, and a feature
allowing reinvestment of the interest at the same
interest rate. You decide to invest $10,000. What
will the CD be worth at maturity?
32
Example: An Australian bank offers to pay you 6
percent compounded monthly. You decide to invest
A$1 million for one year. What is the future value of
your investment if interest payments are reinvested
at 6 percent?
33
Continuous Compounding
If the number of compounding periods per year
becomes infinite, then interest is said to compound
continuously.
FVn= PV ein
Where:
i is stated annual interest rate
n is the number of years
e ≈ 2.7182818
34
Continuous Compounding
Example: Suppose a $10,000 investment will earn
8 percent compounded continuously for two years.
What is the future value of this investment?
35
The Effect of Compounding Frequency
on Future Value
Example: Suppose that you invest $1 with stated
annual interest rate of 8%/year. What is the future
value of your investment after one year if interest
payments are compounded:
§ Annually
§ Semiannually
§ Quarterly
§ Monthly
§ Daily
§ Continuously
36
Stated and Effective Rates
• Effective annual rate (EAR)
m is the number of compounding periods per year
• With continuous compounding, we can solve for

the effective annual rate as follows:
EAR = ei -1
37
Stated and Effective Rates
Example: You have check on the Internet and
come up with the following three rates:
Bank A: 15 percent compounded daily Bank B: 15.5
percent compounded quarterly Bank C: 16 percent
compounded annually
Which of these is the best if you are thinking of
opening a savings account? Which of these is best
if they represent loan rates?
38
The Future Value of a Series of Cash Flows
• Uneven cash flow
• Annuity
– Ordinary Annuity
– Annuity Due
• Perpetuity
39
The Future Value of a Series of Cash Flows
• An annuity is a finite set of level sequential cash flows.
• An ordinary annuity has a first cash flow that occurs one
period from now (indexed at t = 1).
• An annuity due has a first cash flow that occurs
immediately (indexed at t = 0).
• A perpetuity is a perpetual annuity, or a set of level never-
ending sequential cash flows, with the first cash flow
occurring one period from now.
40
41
The Future Value of an uneven cash flow
Example: An investor signs a 6-year contract that is
expected to return $8.25 million in the first year,
$7.75 million in the second year, $3.25 million in the
third year, $4.75 million in the fourth year, $5.25
million in the fifth year, and $6.25 million in the final
year. If 12 percent is the appropriate interest rate,
what is the total return of this investor at the end of
the contract?
42
Cash Flow signs
Investing $ today Borrowing $ today
• Invest (Expense) $ today • Borrow (Inflow) $ today

in present to earn in present to use now,
greater return in the then repay with interest
future. in the future.
• Earn interest (revenue), • Pay interest (expense),
plus principal. plus principal.
• PV = (-) • PV = +
• FV = + • FV = (-)
43
Future value of an Ordinary Annuity
Example:
Suppose that you decide to deposit $1000 at the
end of every year for the next five years. If you can
earn 5% on the account, what is the value of the
account at the end of the fifth year? Assume that
the first deposit will be one year from now.
44
45
FVA = CF(1+i)0 + CF(1+i)1 + CF(1+i)2 + CF(1+i)3 + …+ CF(1+i)n-2 + CF(1+i)n-1
FVA = CF + CF(1 + i) + CF(1 + i)2 + CF(1 + i)3 + …+ CF(1 + i)n - 2 + CF(1+i)n-1 (1)
FVA CF ! " #$!
= + CF + CF 1 + i + CF 1 + i + CF 1 + i + ⋯ + CF 1 + i
1+i 1+i
(1) – (2):
FVA CF #$% #$%
CF
FVA − = − + CF 1 + i = CF 1 + i −
1+i 1+i 1+i
1 #$%
1
FVA 1 − = CF 1 + i −
1+i 1+i
1+i 1 1+i # 1
FVA − = CF −
1+i 1+i 1+i 1+i
i 1+i #−1
FVA = CF
1+i 1+i
𝟏'𝒊
Multiply both sides by
𝒊
1+i #−1
FVA = CF
i
46
§ FVA: Future value of ordinary annuity

§ CF: Cash flow
47
Future value of an Annuity Due
Example:
Suppose that you decide to deposit $1000 at the
beginning of every year for the next five years. If
you can earn 5% on the account, what is the value
of the account at the end of the fifth year? The first
deposit is made at the beginning of the first year.
48
49
FVAD = CF(1+i)n + CF (1+i)n-1+…+CF(1+i)1
• Future value of annuity due
§ FVAD: Future value of annuity due

§ CF: Cash flow
50
Example: Chau graduated and started working on
January 2, 2020. At the end of each year, she
deposits 30 million VND into the bank at the interest
rate of 7%/year, compounded annually. As of
31/12/2027, how much will she have saved?
Assume that she will not make any withdrawal
during this period.
51
Example: Chau graduated and started working on
January 2, 2020. At the beginning of each year, she
deposits 30 million VND into the bank at the interest
rate of 7%/year, compounded annually. Her first
deposit was sent to the bank on 02/01/2020. As of
31/12/2027, how much will she have saved?
Assume that she will not make any withdrawal
during this period.
52
Example: Ellen is 35 years old, and she has
decided it is time to plan seriously for her
retirement. At the end of each year until she is 65,
she will save $10,000 in a retirement account. If the
account earns 10% per year, how much will Ellen
have saved at age 65?
53
Example: Green and Red put $1,500 into a college
fund every year for their son, Eric, on his birthday,
with the first deposit one year from his birth (at his
very first birthday). The college fund has a
guaranteed annual growth or interest rate of 7%. At
his eighteenth birthday, they will pay the last $1,500
into the fund. How much will be in the college fund
for Eric immediately following this last payment?
54
Example: Your biotech firm plans to buy a new
DNA sequencer for $500,000. The seller requires
that you pay 20% of the purchase price as a down
payment, but is willing to finance the remainder by
offering a 48-month loan with equal monthly
payments and an interest rate of 0.5% per month.
The first payment is one month after the down
payment. What is the monthly loan payment?
55
Present value of a Series of Cash Flows
• Uneven cash flow
• Annuity
– Ordinary Annuity
– Annuity Due
• Perpetuity
– Growing Perpetuity
– Growing Annuity
56
Present value of an uneven cash flow
Example: You have just graduated and need money
to buy a new car. Your rich Uncle Henry will lend you
the money so long as you agree to pay him back
within four years, and you offer to pay him the rate of
interest that he would otherwise get by putting his
money in a savings account. Based on your earnings
and living expenses, you think you will be able to pay
him $5000 in one year, and then $8000 each year for
the next three years. If Uncle Henry would otherwise
earn 6% per year on his savings, how much can you
borrow from him? 57
Present value of an Ordinary Annuity
58
• Present value of ordinary annuity
59
CF CF CF CF
PVA = !
+ "
+ #
+ ⋯+ $
1+i 1+i 1+i 1+i
1 1 CF CF CF CF
PVA = !+ "+ # + ⋯+ $
1+i 1+i 1+i 1+i 1+i 1+i
1 CF CF CF CF CF
PVA = "
+ #
+ %
+ ⋯+ $
+
1+i 1+i 1+i 1+i 1+i 1 + i $&!
(1) – (2):
1 CF CF
PVA − PVA = !
−
1+i 1+i 1 + i $&!
1 CF 1
PVA 1 − = 1− $
1+i 1+i 1+i
i CF 1
PVA = 1− $
1+i 1+i 1+i
CF 1
PVA = 1− $
i 1+i 60
Example: Suppose you are considering purchasing
a financial asset that promises to pay €1,000 per
year for five years, with the first payment one year
from now. The required rate of return is 12 percent
per year. How much should you pay for this asset?
61
Example:
• You have decided to buy a house and need to
borrow $100.000. One bank offers you a
mortgage loan to be repaid over 30 years in 360
monthly payment. If the interest rate is 12% per
year, what is the amount of the monthly payment?
• Another bank offer you a 15-year mortgage loan
with a monthly payment of $1,100. Which loan is
the better deal?
62
Present value of an Annuity Due
63
• Present value of Annuity Due
64
Example: You are retiring today and must choose
to take your retirement benefits either as a lump
sum or as an annuity. Your company’s benefits
officer presents you with two alternatives: an
immediate lump sum of $2 million or an annuity with
20 payments of $200,000 a year with the first
payment starting today. The interest rate at your
bank is 7 percent per year compounded annually.
Which option has the greater present value? (Ignore
any tax differences between the two options.)
65
Present Value of an Annuity Due
Example: You are the lucky winner of the $30
million state lottery. You can take your prize money
either as (a) 30 payments of $1 million per year
(starting today), or (b) $15 million paid today. If the
interest rate is 8%, which option should you take?
66
The Present Value of a Perpetuity
CF ⎡ 1 ⎤ CF
PVP = ⎢1− ∞⎥
=
i ⎣ (1+ i) ⎦ i
67
CF CF CF
PVP = + + +⋯
(1 + i)! (1 + i)" (1 + i)#
1 1 1
PVP = CF !
+ + +⋯
1+i (1 + i)" (1 + i)#
* *
#
1 1
PVP = CF × / # = CF × /
1+i 1+i
#)% #)%
As a geometric progression:
Where Z is a positive constant that is less than 1, and X is the sum of the
geometric progression:
The present value of the perpetuity can then be written as:
68
Example: For example, an investment offers a
perpetual cash flow of $500 every year. The return
you require on such an investment is 8 percent.
What is the value of this investment?
69
Example: You want to endow an annual MBA
graduation party at your alma mater. You want the
event to be a memorable one, so you budget
$30,000 per year forever for the party. If the
university earns 8% per year on its investments,
and if the first party is in one year’s time, what’s the
present value of your donation?
70
The Present Value of a Growing Perpetuity
• A growing perpetuity is a stream of cash flows
that occur at regular intervals and grow at a
constant rate forever.
71
• Present Value of a Growing Perpetuity
72
Example: You want to endow an annual MBA
graduation party at your alma mater. You want the
event to be a memorable one, so you budget
$30,000 per year forever for the party. Every year
thereafter, the payment will grow by 5 percent. If the
university earns 8% per year on its investments,
and if the first party is in one year’s time, what’s the
present value of your donation?
73
The Present Value of a Growing Annuity
74
The Present Value of a Growing Annuity
Example: Ellen is 35 years old and considers
saving $10,000 per year for her retirement.
Although $10,000 is the most she can save in the
first year, she expects her salary to increase each
year so that she will be able to increase her savings
by 5% per year. With this plan, if she earns 10% per
year on her savings, how much will Ellen have
saved at age 65?
75
Application of time value of money in
bond valuation
• Coupon: the stated interest payment made on a
bond.
• Face value: the principal amount of a bond that is
repaid at the end of the term. Also called par
value.
• Coupon rate: annual coupon divided by the face
value of a bond.
• Maturity: the specified date on which the principal
amount of a bond is paid.
76
bond valuation
• Yield to maturity (YTM) is the interest rate that
equates the present value of cash flow payments
received from a debt instrument with its value
today
• Yield to maturity is the rate required in the market
on a bond.
77
bond valuation
• Coupon bond
• Zero-coupon bond
• Perpetuity
78
bond valuation – Coupon bond
Example: The Xanth bond has an annual coupon of
$80. Similar bonds have a yield to maturity of 8
percent. The Xanth bond will pay $80 per year for
the next 10 years in coupon interest. In 10 years,
Xanth will pay $1,000 to the owner of the bond.
What would this bond sell for?
79
• Step 1: Lay out the timing and amount of the
future cash flows
• Step 2: To determine the appropriate discount
rate for this cash flow. Use the yield to maturity as
discount rate
• Step 3: Find the present value of the cash flow
• Step 4: Add the two present value amounts to get
the price or value of the bond
80
What if the YTM of the Xanth bond is
• 7% ?
• 9% ?
81
Example: A bond has a coupon rate of 14 percent,
then the owner will get a total of $140 per year, but
this $140 will come in two payments of $70 each.
The yield to maturity is quoted at 16 percent. What
would this bond sell for?
82
bond valuation – Zero-coupon bond
• A zero-coupon bond – a bond that paid zero
coupon.
83
bond valuation – Zero-coupon bond
Example: What is the current price of a one-year,
$1,000 Treasury bill with yield to maturity of 11.1%?
84
bond valuation – Consol bond
Example: The British government once issued a
type of security called a consol bond, which
promised to pay a level cash flow indefinitely. If a
consol bond paid £100 per year in perpetuity, what
would it be worth today if the required rate of return
were 5 percent?
85
stock valuation
• Prefered stock
• Common stock
86
stock valuation – Preferred stock
• Preferred stock (or preference stock) is an
important example of a perpetuity.
• When a corporation sells preferred stock, the
buyer is promised a fixed cash dividend every
period (usually every quarter) forever.
• This dividend must be paid before any dividend
can be paid to regular stockholders - hence the
term preferred.
87
stock valuation – Preferred stock
Example: Suppose the Fellini Co. wants to sell
preferred stock at $100 per share. A similar issue of
preferred stock already outstanding has a price of
$40 per share and offers a dividend of $1 every
quarter. What dividend will Fellini have to offer if the
preferred stock is going to sell?
88
stock valuation – Common stock
• Current price of the stock can be written as the
present value of the dividends beginning in one
period and extending out forever:
89
• Zero Growth: D1 = D2 = D3 = D = constant
• Because the dividend is always the same, the
stock can be viewed as a perpetuity with a cash
flow equal to D every period. The per-share value
is thus given by:
Where R is the required rate of return

90
Example: Suppose the Paradise Prototyping
Company has a policy of paying a $10 per share
dividend every year. If this policy is to be continued
indefinitely, what is the value of a share of stock if
the required rate of return is 20 percent?
91
• Constant Growth: If the dividend for a company
always grows at a steady rate. Call this growth
rate g. If we let D0 be the dividend just paid, then
the next dividend, D1, is:
• The dividend in two periods is:
• Dividend t periods into the future, Dt, is

92
• If we take D0 to be the dividend just paid and g to
be the constant growth rate, the value of a share
of stock can be written as:
• The present value of this series of cash flows can

be written simply as:
93
Example: The next dividend for the Gordon Growth
Company will be $4 per share. Investors require a
16 percent return on companies such as Gordon.
Gordon’s dividend increases by 6 percent every
year. Based on the dividend growth model, what is
the value of Gordon’s stock today? What is the
value in four years?
94
Investment decision criteria
• Net present value (NPV)
• Internal rate of return (IRR)
• Payback period
• Discounted payback period
• Average accounting rate of return (AAR)
• Profitability index (PI)
95
Net Present Value (NPV)
Net present value (NPV) is the difference between
the present value of cash inflows and the present
value of cash outflows over a period of time.
96
Example: Assume that GE Corporation is
considering an investment of €50 million in a capital
project that will return after-tax cash flows of €16
million per year for the next four years plus another
€20 million in Year 5. The required rate of return is
10 percent. What is NPV of GE?
97
• As long as the NPV is positive, the decision
increases the value of the firm and is a good
decision regardless of your current cash needs or
preferences regarding when to spend the money.
• When making an investment decision, take the
alternative with the highest NPV.
98
Internal Rate of Return (IRR)
IRR is the discount rate that makes the present
value of the future after-tax cash flows equal that
investment outlay. IRR can be defined as the
discount rate that makes the present values of all
cash flows sum to zero:
99
The decision rule for the IRR is to invest if the IRR
exceeds the required rate of return for a project:
• Invest if IRR > r
• Do not invest if IRR < r
The required rate of return (r) is often termed the
hurdle rate, the rate that a project’s IRR must
exceed for the project to be accepted.
100
• In the GE Corporation example, we want to find a
discount rate that makes the total present value of
all cash flows, the NPV, equal zero. In equation
form, the IRR is the discount rate that solves this
equation:
101
• In the GE Corporation example, we want to find a
discount rate that makes the total present value of
all cash flows, the NPV, equal zero. In equation
form, the IRR is the discount rate that solves this
equation:
IRR = 19.52%
102
Ranking Conflicts between NPV and IRR
• Ranking Conflict Due to Differing Cash Flow
Patterns
• Ranking Conflicts due to Differing Project Scale
103
Ranking Conflict Due to Differing Cash
Flow Patterns
Projects A and B have similar outlays but different
patterns of future cash flows. For both projects, the
required rate of return is 10 percent.
104
Flow Patterns
105
Flow Patterns
106
Ranking Conflicts due to Differing
Project Scale
Project A has a much smaller outlay than Project B,
although they have similar future cash flow patterns.
107
Project Scale
108
Project Scale
109

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CHAPTER 4:

TIME VALUE OF MONEY

Lecturer: Truong Thi Thuy Trang

• To calculate number of periods

Where in is stated annual interest rate, m is the

m is the number of compounding periods per year

• With continuous compounding, we can solve for

• Invest (Expense) $ today • Borrow (Inflow) $ today

§ FVA: Future value of ordinary annuity

• Future value of annuity due

§ FVAD: Future value of annuity due

• Present value of Annuity Due

The present value of the perpetuity can then be written as:

• Present Value of a Growing Perpetuity

Where R is the required rate of return

• The dividend in two periods is:

• Dividend t periods into the future, Dt, is

• The present value of this series of cash flows can

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