2

The time value of money:

the key to the valuation of
financial markets
Time value of money is a critical consideration in under-
standing the key areas in the economics of financial markets.
Compound interest calculations are needed to determine future
sums of money resulting from an investment. Discounting, or
the calculation of present values, a concept inversely related to
compounding, is a technique which is used to evaluate the cash
flow associated with the valuation of financial markets.

Future values – compounding

A dollar in hand today is worth more than a dollar to be received
tomorrow because of the interest it could earn from putting it in
a savings account. This process of earning interest on money is
known as compounding. Compounding interest means that
interest earns interest. In order to appreciate the concepts of
compounding and time value we need some definitions:
Fn = future value
= the amount of money at the end of year n
P = principal
i = annual interest rate
n = number of years
Then,
F1 = the amount of money at the end of year 1
= principal and interest = P + iP = P(1 + i)
F2 = the amount of money at the end of year 2
= F1(1 + i) = P(1 + i) (1 + i) = P(1 + i)2
34 Economics for Financial Markets

The future value of an investment compounded annually at

rate i for n years is given by equation (2.1)
Fn = P(1 + i)n = P·FVIFi,n (2.1)
where FVIFi,n is the future value interest factor for $1. This can
be found in Table 2.1.

Table 2.1 Compounded future value of $1 (FVIF)

Years 1% 2% 3% 4% 5% 6% 7% 8% 9%
Hence

1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090

2 1.020 1.040 1.061 1.082 1.102 1.124 1.145 1.166 1.188
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
7 1.072 1.149 1.230 1.316 1.407 1.504 1.605 1.714 1.828
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367

Example 2.1
Nadia placed $1000 in a savings account earning 8 per cent
interest compounded annually. How much money will she have
in the account at the end of 4 years?
Fn = P(1 + i)n
F4 = $1000(1 + 0.08)4 = $1000·FVIF8,4
From Table 2.1 the FVIF for 4 years at 8 per cent is 1.360.
Therefore,
F4 = $1000(1.360) = $1360.

Present values – discounting

Present value is the present worth of future sums of money. The
process of calculating present values, or discounting, is actu-
ally the opposite of finding the compounded future value. In
The time value of money: the key to the valuation of financial markets 35

connection with present value calculations, the interest rate i is

called the discount rate.
Recall that
Fn = P(1 + i)n
Therefore

 (1 + i)  = F ·PVIF
Fn 1
P = n
= F n n i,n (2.2)
(1 + i)

where PVIFi,n represents the present value interest factor for $1.
This can be found in Table 2.2.

Table 2.2 Present value of $1 (PVIF)

Years 1% 2% 4% 5% 6% 8% 10% 12% 15%

Hence

1 0.990 0.980 0.962 0.952 0.943 0.926 0.909 0.893 0.870

2 0.980 0.961 0.925 0.907 0.890 0.857 0.826 0.797 0.756
3 0.971 0.942 0.889 0.864 0.840 0.794 0.751 0.712 0.658
4 0.961 0.924 0.855 0.823 0.792 0.735 0.683 0.636 0.572
5 0.951 0.906 0.822 0.784 0.747 0.681 0.621 0.567 0.497
6 0.942 0.888 0.790 0.746 0.705 0.630 0.564 0.501 0.432
7 0.933 0.871 0.760 0.711 0.665 0.583 0.513 0.452 0.376
8 0.923 0.853 0.731 0.677 0.627 0.540 0.467 0.404 0.327
9 0.914 0.837 0.703 0.645 0.592 0.500 0.424 0.361 0.284
10 0.905 0.820 0.676 0.614 0.558 0.463 0.386 0.322 0.247

Example 2.2
Nadia has been given an opportunity to receive $20 000 six
years from now. If she can earn 10 per cent on investing it, what
is the most she should pay for this opportunity? To answer this
question, one must compute the present value of $20 000 to be
received six years from now at a 10 per cent rate of discount. F6
is $20 000, i is 10 per cent, which equals 0.1, and n is six years.
PVIF10,6 from Table 2.2 is 0.564.

 (1 + 0.1) 
1
P = $20 000 6

= $20 000(PVIF10,6 ) = $20 000(0.564) = $11 280

36 Economics for Financial Markets

This means that Nadia who can earn 10 per cent on her
investment, should be indifferent to the choice between receiv-
ing $11 280 now or $20 000 six years from now since the
amounts are time equivalent. In other words she could invest
$11 280 today at 10 per cent and have $20 000 in six years.

Bond and stock valuation

The process of determining security valuation involves finding
the present value of an asset’s expected future cash flows
using the investor’s required rate of return. Thus the basic
security valuation model can be defined mathematically as
equation (2.3):
n Ct
V =  (2.3)
t = 1 (1 + r)t
where
V = intrinsic value or present value of an asset
Ct = expected future cash flows in period t = 1, . . ., n
r = investors required rate of return.

Bond valuation
The valuation process for a bond requires a knowledge of three
basic elements: (1) the amount of the cash flows to be received
by the investor, which is equal to the periodic interest to be
received and the par value to be paid at maturity; (2) the
maturity date of the loan; and (3) the investor’s required rate of
return. The periodic interest can be received annually or semi-
annually. The value of a bond is simply the present value of
these cash flows.
If the interest payments are made annually then we derive
equation (2.4)
n I M
V =  t
+ = I(PVIFAr,n ) + M(PVIFr,n ) (2.4)
t = 1 (1 + r) (1 + r)n
where
I = interest payment each year = coupon interest
rate (par value)
M = par value, or maturity value, typically $1000
The time value of money: the key to the valuation of financial markets 37

r = investor’s required rate of return

n = number of years to maturity
PVIFA = present value interest factor of an annuity of $1
(which can be found in Table 2.3)
PVIF = present value interest factor of $1 (which can be
found in Table 2.2).

Table 2.3 Present Value of an Annuity of $1 (PVIFA)

Years 1% 2% 4% 5% 6% 8% 10%

1 0.990 0.980 0.962 0.952 0.943 0.926 0.909

2 1.970 1.942 1.886 1.859 1.833 1.783 1.736
3 2.941 2.884 2.775 2.723 2.673 2.577 2.487
4 3.902 3.808 3.630 3.546 3.465 3.312 3.170
5 4.853 4.713 4.452 4.329 4.212 3.993 3.791
6 5.795 5.601 5.242 5.076 4.917 4.623 4.355
7 6.728 6.472 6.002 5.786 5.582 5.206 4.868
8 7.652 7.325 6.733 6.463 6.210 5.747 5.335
9 8.566 8.162 7.435 7.108 6.802 6.247 5.759
10 9.471 8.983 8.111 7.722 7.360 6.710 6.145

Example 2.3

Consider a bond, maturing in 10 years and having a coupon

rate of 8 per cent. The par value is $1000. Investors consider 10
per cent to be an appropriate required rate of return in view of
the risk level associated with this bond. The annual interest
payment is $80 (8% × $1000). The present value of this bond is
given by equation (2.5):
n I M
V =  + = I(PVIFAr,n ) + M(PVIFr,n ) (2.5)
t = 1 (1 + r)t (1 + r)n
10 80 1000
=  +
t = 1 (1 = 0.1)t (1 + 0.1)10

= $80(PVIFA10%,10 ) + $1000(PVIF10%,10 )

= $80(6.145) + $1000(0.386) = $491.60 + $386.00

= $877.60
38 Economics for Financial Markets

Common stock valuation

Like bonds, the value of a common stock is the present value of
all future cash inflows expected to be received by the investor.
The cash inflows expected to be received are dividends plus the
future price at the time of the sale of the stock. For an investor
holding a common stock for only one year, the value of the stock
would be the present value of both the expected cash dividend
to be received in one year (D1 ) and the expected market price per
share of the stock at year-end (P1 ). If r represents an investor’s
required rate of return, the value of the common stock (P0 )
would be given by equation (2.6).

D1 P1
P0 = 1
+ (2.6)
(1 + r) (1 + r)1

Example 2.4

Assume an investor is considering the purchase of stock A at the

beginning of the year. The dividend at year-end is expected to be
$1.50, and the market price by the end of the year is expected to
be $40. If the investor’s required rate of return is 15 per cent,
then referring to Table 2.2 the value of the stock would be:

D1 P1 $1.50 $40
P0 = + = +
(1 + r)1 (1 + r)1 (1 + 0.15) (1 + 0.15)1

= $1.50(0.870) + $40(0.870)

= $1.31 + $34.80 = $36.11

Since common stock has no maturity date and is held for many
years, a more general, multiperiod model is needed. The general
common stock valuation model is defined as follows:
∞ Dt
P0 = 
t = 1 (1 + r)t

There are three cases of growth in dividends: zero growth,

constant growth, and supernormal growth. In the case of zero
growth, if

D0 = D1 = . . . = D
The time value of money: the key to the valuation of financial markets 39

then the valuation model becomes

 Dt
P0 =  (2.7)
t = 1 (1 + r)t

This reduces to

D1
P0 = (2.8)
r

Example 2.5
Assuming D equals $2.50 and r equals 10 per cent, then the
value of the stock is:

$2.50
P0 = = $25
0.1

In the case of constant growth, if we assume that dividends grow

at a constant rate of g every year, i.e., Dt = D0 (1 + g)t, then
equation (2.7) is simplified to:

D1
P0 = (2.9)
r–g

This formula is known as the Gordon growth model.

Example 2.6
Consider a common stock that paid a $3 dividend per share at
the end of last year and is expected to pay a cash dividend every
future year with a growth rate of 10 per cent. Assume that the
investor’s required rate of return is 12 per cent. The value of the
stock would be:
D1 = D0(1 + g) = $3(1 + 0.10) = $3.30

D1 $3.30
P0 = = = $165
r–g 0.12 – 0.10

Finally consider the case of supernormal growth. Firms typi-

cally go through life cycles, during part of which their growth is
faster than that of the economy and then falls sharply. The
value of stock during such supernormal growth can be found by
taking the following steps:
40 Economics for Financial Markets

1. compute the dividends during the period of supernormal

growth and find their present value;
2. find the price of the stock at the end of the supernormal
growth period and compute its present value; and
3. add these two present value figures to find the value (P0 ) of
the common stock.

Example 2.7

Consider a common stock whose dividends are expected to grow

at a 25 per cent rate for two years, after which the growth rate
is expected to fall to 5 per cent. The dividend paid last period
was $2. The investor desires a 12 per cent return. To find the
value of this stock, take the following steps:
1. Compute the dividends during the supernormal growth
period and find their present value. Assuming D0 is $2, g is
15 per cent and r is 12 per cent, then:
D1 = D0(1 + g) = $2(1 + 0.25) = $2.50
D2 = D0(1 + g)2 = $2(1.563) = $3.125
or D2 = D1(1 + g)) = $2.50(1.25) = $3.125

D1 D2
PV of dividends = 1
+
(1 + r) (1 + r)2
$2.50 $3.125
= +
(1 + 0.12) (1 + 0.12)2

= $2.50(PVIF12%,1 ) + $3.125(PVIF12%,2 )
= $2.50(0.893) + $3.125(0.797)
= $2.23 + $2.49 = $4.72
2. Find the price of stock at the end of the supernormal growth
period. The dividend for the third year is:
D2 = D2(1 + g), where g = 5%
= $3.125(1 + 0.05) = $3.28
The price of the stock is therefore:

D3 $3.28
P2 = = = $46.86
r – g 0.12 – 0.05
The time value of money: the key to the valuation of financial markets 41

PV of stock price = $46.86(PVIF12%,2 ) = $46.86(0.797)

= $37.35
3. Add the two PV figures obtained in steps 1 and 2 to find the
value of the stock.
P0 = $4.72 + $37.35 = $42.07

Simple interest and compound

interest
Present values and future values for financial assets are very
sensitive to the frequency with which interest is paid. In
particular it is necessary to distinguish between simple interest
and compound interest.

Simple interest
When money of value P on a given date increases in value to S
at some later date, P is called the principal, S is called the
amount or accumulated value of P, and I = S – P is called the
interest.
When only the principal earns interest for the entire life of the
transaction, the interest due at the end of the time is called
simple interest. The simple interest on a principal P for t years
at the rate r is given by
I = Prt (2.10)
and the simple interest amount is given by
S = P + I = P + Prt = P(1 + rt) (2.11)

Example 2.8
Find the simple interest on $750 at 4 per cent for six months.
What is the amount?
Here P = 750, r = 0.04, and t = 12. Then
I = Prt = 750(0.04) 12 = $15
and
S = P + I = 750 + 15 = $765
42 Economics for Financial Markets

Compound interest
If the interest due is added to the principal at the end of each
interest period and thereafter earns interest, the interest is said
to be compounded. The sum of the original principal and total
interest is called the compound amount or accumulated value.
The difference between the accumulated value and the original
principal is called the compound interest. The interest period,
the time between two successive interest computations, is also
called the conversion period.
Interest may be converted into principal annually, semi-
annually, quarterly, monthly, weekly, daily, or continuously.
The number of times interest is converted in one year, or
compounded per year, is called the frequency of conversion. The
rate of interest is usually stated as an annual interest rate,
referred to as the nominal rate of interest.
The following notation will be used :

P  original principal, or the present value of S, or the

discounted value of S
S  compound amount of P, or the accumulated value of P
n  total number of interest (or conversion) periods
involved
m  number of interest periods per year, or the frequency
of compounding
jm  nominal (yearly) interest rate which is compounded
(payable, convertible) m times per year
i  interest rate per interest period.

The interest rate per period, i, equals jm/m. For example j12 = 12
per cent means that a nominal (yearly) rate of 12 per cent is
converted (compounded, payable) 12 times per year, i = 1% =
0.01 being the interest rate per month.
Let P represent the principal at the beginning of the first
interest period and i the interest rate per conversion period. It is
necessary to calculate the accumulated values at the ends of
successive interest periods for n periods. At the end of the first
period, the interest due is Pi and the accumulated value is

P + Pi = P(1 + i)

At the end of the second period, the interest due is [P(1 + i)]i and
the accumulated value is

P(1 + i) + [P(1 + i)]i = P(1 + i)(1 + i) = P(1 + i)2

The time value of money: the key to the valuation of financial markets 43

At the end of the third period, the interest due is [P(1 + i)2]i and
the accumulated value is
P(1 + i)2 + [P(1 + i)2]i = P(1 + i)2(1 + i) = P(1 + i)2
Continuing in this manner, we see that the successive accumu-
lated values,
P(1 + i), P(1 + i)2, P(1 + i)3, . . .
form a geometric progression whose nth term is
S = P(1 + i)n (2.12)
where S is the accumulated value of P at the end of the n
interest periods.
The application of compound interest is most clearly seen by
working through some real world applications.

Example 2.9
Assume you are asked to find (a) the simple interest on $1000
for two years at 12 per cent, and (b) the compound interest on
$1000 for two years at 12 per cent compounded semi-annually
(that is, j2 = 12 per cent).
(a) I = Prt – 1000(0.12)(2) = $240
(b) Since the conversion period is six months, interest is earned
at the rate of 6 per cent per period, and there are four interest
periods in two years, the answer can be seen from Table 2.4.
The compound interest is $1262.48 – $1000 = $262.48.
Alternatively, from equation (2.12) with P = 1000, i = 0.06, and
n = 4, then
S = P(1 + i)n = 1000(1.06)4 = $1262.48
and the compound interest is S – P = $262.48.

Table 2.4 Simple interest versus Compound Interest

At the Interest Accumulated Value

End of Period

1 1000(0.06) = $60 $1060.00

2 1060(0.06) = $63.60 $123.60
3 1123.60(0.06) = $67.42 $1191.02
4 1191.02(0.06) = $71.46 $1262.48
44 Economics for Financial Markets

Example 2.10
Assume you are asked to find the compound interest on $1000
at (a) j12 = 6 per cent for five years, and (b) j12 = 15 per cent for
30 years.
(a) We have P = 1000, i = 0.06/12 = 0.005, and n = 5 × 12 = 60.
From equation (2.12),
S = P(1 + i)n = 1000(1.005)60 = $1348.85
The compound interest is S – P = $348.85.
(b) We have P = 1000, i = 0.15/12 = 0.0125, and n = 30 × 12 = 360.
From equation (2.12),
S = 1000(1.0125)360 = $87,541.00
The compound interest is S – P = $86,541.00, which is more
than 86 times the original investment of $1000. If the
investment had been at 15 per cent simple interest, the
interest earned would have been only
I = 1000(0.15)(30) = $4500
This illustrates the power of compound interest. A high rate
of interest for a long period of time generates far more than
receiving only simple interest.

Example 2.11
Assume you are asked to tabulate and graph the growth of $100
at compound interest rates j12 = 6%, 8%, 10%, 12% and for 5,
10, 15, 20, 25, 30, 35, 40, 45 and 50 years (see Table 2.5 and
Figure 2.1).

Table 2.5 The power of compound interest

Years n j12 = 6%, j12 = 8%, j12 = 10%, j12 = 12%,

i = 0·005 i = 0·08/12 i = 0·10/12 i = 0·01

5 60 134.89 148.98 164.53 181.67

10 120 181.94 221.96 270.70 330.04
15 180 245.41 330.69 445.39 599.58
20 240 331.02 492.68 732.81 1089.26
25 300 446.50 734.02 1205.69 1978.85
30 360 602.26 1093.57 1983.74 3594.96
35 420 812.36 1629.26 3263.87 6530.96
40 480 1095.75 2427.34 5370.07 11864.77
45 540 1478.00 3616.36 8835.42 21554.69
50 600 1993.60 5387.82 14536.99 39158.34
The time value of money: the key to the valuation of financial markets 45

11 000
12%
10 000
9000
10%
8000
7000
6000
$ 8%
5000
4000
3000 6%
2000
1000
0
5 10 15 20 25 30 35 40 45 50
Year
Figure 2.1 The power of compound interest.

Nominal and effective rates of

interest
The annual rates of interest with different conversion periods are
called equivalent if they yield the same compound amount at the
end of one year. Again this is best understood using examples.

Example 2.12
At the end of one year the compound amount of $100 at:
(a) 4 per cent compounded quarterly is 100(1.01)4 = $104.06
(b) 4.06 per cent compounded annually is 100(1.0406) =
$104.06.
Thus 4 per cent compounded quarterly and 4.06 per cent
compounded annually are equivalent rates.
When interest is compounded more often than once per year,
the given annual rate is called the nominal annual rate or
nominal rate. The rate of interest actually earned in one year is
called the effective annual rate of the effective rate. In Example
2.12(a), 4 per cent is a nominal rate while in 2.12(b), 4.06 per
cent is an effective rate. As noted above, 4.06 per cent is the
effective rate equivalent to a nominal rate of 4 per cent
compounded quarterly.
46 Economics for Financial Markets

Example 2.13
What is the effective rate r equivalent to the nominal rate 5 per
cent compounded monthly?
In one year 1 at r effective will amount to 1 + r and at 5 per
cent compounded monthly will amount to (1 + 0.05/12)12.
Setting
1 + r = (1 + 0.05/12)12
we find
r = (1 + 0.05/12)12 – 1
= 1.05116190 – 1 = 0.05116190
or 5.116%

Example 2.14
What is the nominal rate j compounded quarterly which is
equivalent to 5 per cent effective?
In one year 1 at j compounded quarterly will amount to
(1 + j/4)4 and at 5 per cent effective will amount to 1.05.
Setting
(1 + j/4)4 = 1.05
we find
1 + j/4 = (1.05)1/4
Then
j = 4[(1.05)1/4 – 1]
= 4(0.01227223) = 0.04908892
or 4.909%