ĐẠI HỌC HOA SEN

Khoa Kinh tế Thương mại

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KHOA KINH TẾ THƯƠNG MẠI

CORPORATE
FINANCE
ThS. Nguyễn Tường Minh
Email: minh.nguyentuong@yahoo.com.vn

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CORPORATE FINANCE

CHAPTER 2
THE TIME VALUE OF MONEY

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 References
• Fundamentals of Corporate Finance, Brealey et al.,
McGraw Hill, 5th edition, USA, 2007.
• Foundation of Financial Management, Block & Hirt,
McGraw Hill, 12th edition,USA, 2008.
• Other relevant materials.

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 Chapter 2: THE TIME VALUE OF
MONEY
• Main Contents:
1. Future values and Compound interest
2. Present values
3. Multiple cash flow
4. Level cash flow: Perpetuities and
Annuities
5. Inflation and the time value of money
6. Effective annual interest rate

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I. Future values and Compound
interest
Interest = Interest rate x Initial investment

Capital after the 1st year = initial investment x (1 + interest rate)

Capital after the 2nd year = capital after the 1st year x (1 + interest rate)
= initial investment x (1 + interest rate) 2

Capital after the t year = initial investment x (1 + interest rate)t

Present value
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Future value
 I. Future values and Compound
interest (cont’d)
Future value after the t year = Present value x (1 + interest rate)t

+ $6 + $6.36 + $6.74
r = 6% $106 $112.36 $119.10

0 1 2 3

Saving

Present value
Why do the interest after each year higher
than the previous ones ? Future value

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I. Future values and Compound
interest (cont’d)

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I. Future values and Compound
interest (cont’d)

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 I. Future values and Compound
interest (cont’d)
Compound interest …earning interest on interest

Accumulated
Original interest
Interest investment over
= + periods
x

Simple interest …interest only from the original investment

Accumulated
Original interest
Interest investment over
= + periods
x
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 I. Future values and Compound
interest (cont’d)
Do you know ???

MANHATTAN Island

Peter Minuit

??? How much equivalent in 2019 value ?

The average standard of interest rate is 3.5%

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I. Future values and Compound
interest (cont’d)

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 II. Present Values
Now!!!! At the
offered year-end!!
$100,000 offered
$100,000
•A dollar today is worth
more than 1 dollar tomorrow

Time value of money

Time
0 1 2 3 4 5 t
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 II. Present Values (cont’d)

Original
Receiving
investment
value
(Present
(Future
Value) Int 1 Int 2 Int 3 Value)

+ + +
Time
0 1 2 3 t

FV  PV 1  r  t

FV
PV 
1  r t 14
II. Present Values (cont’d)

•How much do we need to invest now in order to produce $106 at

the end of the year with interest rate of 6% ?

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 II. Present Values (cont’d)

$3,000

$2,600 Strategy 1:
Save money in 1 year, interest rate 8%

Strategy 2:
•Which strategy should he select ?
Save money in 2 year, interest rate 8%

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II. Present Values (cont’d)

The longer the time before you must make a payment,

the less you need to invest today
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 II. Present Values (cont’d)
Discount factor

1
PV  FV
(1  r )t

Discount factor To measure the PV of $1 received

in year n

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 II. Present Values (cont’d)
Finding the value of free credit
$20,000
•Down payment: $8,000

•The 2nd pay out: $12,000 No free credit provided

Free credit provider Discount $1,000

•Which company should you select ?

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 II. Present Values (cont’d)
Finding the interest rate

issue

•Repay $1,000

•…paid at the end of 25 years

•How much is the interest rate ?
•Price of IOU: $129.20

2010
20
2016
 III. Multiple Cash Flow

A single cash flow

FV  PV 1  r t
FV
PV 
1  r t
Single CF2
Single CF1
Multiple CF
Single CF3

Single CF4

Now, we calculate the FV, PV of a Multiple Cash Flow… 21

 III. Multiple Cash Flow (cont’d)
Future Value of multiple cash flow

2 years later

•Year 1: deposit $1,200

•Year 2: deposit $1,400
•How much will he spend
•r = 8%
on a laptop after 2 years ?
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 III. Multiple Cash Flow (cont’d)
Present Value of multiple cash flow
2
drawing 2 strategies
Installment plan

•Down payment: $8,000

$16,000 •Year 1: $4,000

1
Pay $15,500 at once •Year 2: $4,000
(deducted $500)
r = 8%

•Which strategy should be chosen ?

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 III. Multiple Cash Flow (cont’d)
Present Value of multiple cash flow (cont’d)

Characteristics of PV of a stream of future cash flows

…is the amount that needs to be invested today to generate the stream of
future cash flows.

Total future cash flow: - $16,000

Available cash: $15,133.06

Don’t worry
Total of PV of future cash flow = 24
available cash = $15,133.06
 III. Multiple Cash Flow (cont’d)
Present Value of multiple cash flow (cont’d)

…to prove this:

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IV. Level Cash flows: Perpetuity
and Annuity

$x $x $x $x

0 1 2 3 4

Annuity

$x $x $x $x ….

0 1 2 3 4 ….
Perpetuity 26
 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
What is an annuity and a perpetuity ?

Annuity

…sequence of equal cash flow with a determined last period

Perpetuity

…sequence of equal cash flows that never end

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value perpetuity

issue

Bank of England Consols

Cash flow of 1 Consol

$10 $10 $10 $10 ….

0 1 2 3 4 ….
Market interest rate: 10%
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Value of the consol = PV of the endless cash flow
 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value perpetuity (cont’d)

Cash flow of 1 Consol

$10 $10 $10 $10 ….

0 1 2 3 4 ….
Market interest rate: 10%

Cash payment from perpetuity = interest rate x PV

C = r x PV

C
PV 
r 29
 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value perpetuity (cont’d)

Endow in finance

$100,000 per year, forever

Generous man r= 10%

How much is the amount that the man must set aside today ?

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value perpetuity (cont’d)

Market interest rate: 10%

Generous man

0 $100,000 $100,000 ….

1 2 3 4 5 ….

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value perpetuity (cont’d)

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value annuities

1 1 
PV  C   t 
 r r (1  r ) 
Annuity factor

1  (1  r )t 
 PV  C  
 r 
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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value annuities (cont’d)

Kangaroo Autos offer a payment scheme of $4,000 a year at the end

of each of the next 3 years, r = 10%

$4,000 $4,000 $4,000

0 1 2 3

1  (1  r )t 
PV  C  
 r 

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value annuities (cont’d)

•Receive equally installments each

year: $11.828 mio.
•Total year: 25.
•Interest rate: 5.9%

Lottery winner of $295.7 mio

$11.828 $11.828 … $11.828

0 1 2 … 25

Does he accept the proposal ? Why ?

What is a solution ? 35
 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value annuities (cont’d)

•If he could live more 30 years, how much could

Bill Gates spend yearly as taking his $46bio ?
•His money is invested to earn 9%.

Bill Gates
the richest man of $46 bio

PV = $46 bio $? $? … $?

0 1 2 … 30

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value annuities (cont’d)

Price: $125,000

Pay down 20%

•Lending 80%

•r= 1% per month

What is the monthly mortgage payment ?
•t= 30 years

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value annuities (cont’d)

DETAIL OF THE MONTHLY DEBT PAYMENT

Months of Beginning Interest Amortization Month- End of

repayment of month of loan end month
balance payment balance

1 $100,000 $1,000 $28.61 $1,028.61 $99,971.39

2 $99,971.39 $999.71 $28.9 $1,028.61 $99,942.49
…
360

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
How to value annuities (cont’d)

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
Annuities Due

…value of a stream of cash payments starts immediately (at the beginning of a period).

1  (1  r )t 
PV of an annuities due = C  (1  r )
 r 

Future value of an annuity

 (1  r )t  1
FV of an annuity = C 
 r 
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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
Future value of an annuity (cont’d)

r= 8%
$13,000

$3,000 $3,000 $3,000 $3,000

0 1 2 3 4

Can you buy this red car at the end of year 4 ?

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
Future value of an annuity (cont’d)
…in 50 more years

$500,000
r= 10%

…will be retired

How much could she save each year from this year ?

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 IV. Level Cash flows: Perpetuity
and Annuity (cont’d)
Annuities due  (1  r )t  1
FV of an annuities due = C   (1  r )
 r 

…in 50 more years

$500,000
r= 10%

…will be retired
If she save the money at the beginning of each year, how much should she deposit ?

Compare outcome with the previous FV annuity,43

C = ???
any conclusion about this?
 V. INFLATION AND THE TIME
VALUE OF MONEY

Investment return Inflation

6% 10%

…value of money is eroded 44

 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Real versus Nominal Cash flow

What can be used for measuring the inflation rate ?

…CPI used for measuring the inflation rate.

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Real versus Nominal Cash flow (cont’d)

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Real versus Nominal Cash flow (cont’d)

What is the nominal dollar ?

…refer to the actual number of dollars

What is the real dollar ?

…refer to the amount of purchasing power

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Real versus Nominal Cash flow (cont’d)

buy

In 1990

Year CPI
Pay monthly
$800 for 30 years 1990 133.8

2007 210

2020 268

??? What is the monthly payment for 2007 and 2020 expressed in real 1990 dollars48
?
 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Real versus Nominal Cash flow (cont’d)

Year CPI
1950 25
1980 86.3

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Inflation and interest rate

PV of investment (1  nominal interest rate)

Real FV of investment 
1  inflation rate

1  nominal interest rate

1  Real interest rate 
1  inflation rate

What is the nominal interest rate ?

…rate at which money invested growths

…interest rate board of commercial banks

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Inflation and interest rate (cont’d)

…invest to earn interest rate: 6%

…simultaneously, reduce the income

with inflation rate of 2%

…how much is the real interest rate ?

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Inflation and interest rate (cont’d)

Attention!!!

In reality, if nominal interest rate and inflation rate are small, the real interest rate will be…

Real interest rate = nominal interest rate – inflation rate

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Inflation and interest rate (cont’d)

…compare the nominal and real values of investment of one year under the inflation rate
of 7% and nominal interest rate of 10%

Nominal Real

Interest rate 10% ? (1)

FV (after 1 year) $100 ? (2)

PV ? (3) ? (3)

Nominal PV and Real PV are equal to each other 53

 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Inflation and interest rate (cont’d)

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Inflation and interest rate (cont’d)

His total assets: $59 bio with 9%

Can spend $5.7 bio per year, in 30 years

•Interest rate = 9%
•Inflation rate = 5%

I would like to ensure

the same power of
purchasing of 2047 as in
2017, what would I do ?

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Inflation and interest rate (cont’d)

I would like to ensure the

same power of purchasing
of 2042 as in 2012, what
would I do ?

Solution

Spend less in 2012 and then increase expenditure in line with inflation,
how much could he spend in 2012 ?

•Real interest rate: 3.8%

•Annual spending in 2012: PV = C x 30 year annuity at 3.8% => C= $3.33 56

bio
 V. INFLATION AND THE TIME
VALUE OF MONEY (cont’d)
Inflation and interest rate (cont’d)

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 VI. EFFECTIVE ANNUAL
INTEREST RATE

Borrow $100
Interest 1% per month

Putting off the

payment up to 1 year Total payment after 1 year:
100(1+1%)12= $112.68

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 VI. EFFECTIVE ANNUAL
INTEREST RATE (cont’d)
0 1

$100 $112.68

How much is the equivalent interest rate? •12.68%

Effective annual interest rate

1 + effective annual interest rate = (1 + monthly rate)12

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 VI. EFFECTIVE ANNUAL
INTEREST RATE (cont’d)
Method to convert to effective annual interest rate from an annual
percentage rates (APRs)

•APRs: annualized by multiplying the rate per period by the number of period in a year.

Steps to convert to effective annual interest rate

1 Take the quoted APR divided by the number of compounded

period in a year

•Monthly interest: APR / 12

•Quarterly interest: APR / 4
•Semi-annually interest: APR / 2
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 VI. EFFECTIVE ANNUAL
INTEREST RATE (cont’d)
Steps to convert to effective annual interest rate (cont’d)

2 Convert to effective annual interest rate

1 + effective annual interest rate = (1 + monthly rate)12

1 + effective annual interest rate = (1 + quarterly rate)4

1 + effective annual interest rate = (1 + semi-annually rate)2

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 VI. EFFECTIVE ANNUAL
INTEREST RATE (cont’d)
Why do we use the effective annual interest rate ?

•To measure the actual income of the depositors or expense of the borrowers

LAST SELF TEST

A car loan requiring quarterly payments carries an ARP of 8 percent.
What is the effective annual rate of interest ?

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Thank you for your attention !

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