Rates and Time Value of Money - Basic

Tools of Finance

Would you rather receive 100 € today or in 1 year from now ?

=> If you answered today, this means that for you to postpone consuming today, you need to be
compensated with a larger amount of consumption in the future. Hence €1 today is worth more to
you than €1 in a year, and inversely €1 in one year is worth less than €1 today.

The basic idea: Money has what we call TIME value -> this explains why interest rates exist.

Arbitraging --or finding equivalency -- between two amounts of money received in two different
periods, depends on the rate of interest.

There are 2 sources for the existence of interest rates in the economy:
1. Impatience (Lenders)

2. Economic Productivity (Borrowers)

Lenders: are willing to sacrifice $1 worth of current consumption against $ (1+i) they’ll receive in the
future. Where i is the interest rate. Borrowers: want to consume today. They borrow against future
income. Future income is expected to rise with economic productivity.

Check the Excel file for numerical applications (numbered).

Main Concepts

Two basic mechanisms

• Simple interests : interests payment received are not reinvested (period < 1 year)

• Compound interests : interest payments received are reinvested (this is the mechanism that
is more commonly used).

Two important concepts

• Compounding : it's to help find the future value of an amount of money invested.

• Discounting : is the mirror image of compounding. Here we look for the present value of an
amount of money to be received in the future.

1. Simple interests

Key idea : Interests receipts are not reinvested

 Mechanism mostly used for investments with a time horizon < 1 year

Example to get how this works

You invest 100 euros for 5 months, the monthly interest rate is 1% (simple interests)

• End of Month 1 : you get 100 + 100 × 0.01 = 101 (the amount invested plus the interest
payments received)

• End of Month 2 : 101 + 100 × 0.01 = 102 (the amount invested in the second month plus the
interest received on the INITIAL investment)

• …

• End of Month 5 : 104 + 100 × 0.01 = 105

The key idea for simple interests is to imagine that each month, you spend the interests your receive
on consumption (food, restaurants, etc...) instead of reinvesting them.
2. Compound Interests

Mechanism used for multiperiod investments (usually greater than 1 year)

Key idea : interests payments ARE reinvested (so that your principal invested grows exponentially
because interests are also paid on cumulated past interests)
 2.1 Compounding

1 - With compounding we are looking for a single future value Cn. Here the graph shows what happens for various future
dates: n=1, n=2, etc...

Example to illustrate how this works :

You invest 100 euros for 5 years, the annual interest rate is 10% (compound interest rates)

• End of year1 : you get 100 + 100 × 0.10 = 110

• End of year 2 : 110 + 110 × 0.10 = 121 (the amount you got end of year 1 plus the interests
earned on the investment including past interests, in year 2)

• End of year 3 : 121 + 121 × 0.10 = 133.1

• End of year 4 : 133.1 + 133.1 × 0.10 = 146.41

• End of year 5 : 146.41 + 146.41 x 0.10 = 161.051

Application 1 : What is the future value of 1 000 €, in 3 years from now, invested at a rate of
5%? (euros, two decimal places. WATCH OUT: this is a French Excel, so decimal places are with
"commas" not "dots")

One is looking for the future value C0 = 1000*(1+5%)^3 = 1157,63

Answers use "commas" in the french Excel version. But Remember that in all tests your
answers must use the English notation for decimal places: the dot "."
Compounded Interest Rates, Peter Minnewit and the Indians

According to the legend, Peter Minwitt purchased the Isle of Manhattan on May 24, 1626 Manhattes
indians. He bought it for a bunch of glass trinkets and other small items for an amount worth 60
florins (dutch currency) which is equivalent to $24.

This seemed like a bad deal for the indians at the time. Unless they had invested this money for 394
years …

Here is what they would have earned (figure right). You will notice the exponential effect of
compound interests, small differences in rates produce big changes in the final accumulated wealth
(going from 3% to 5%, we go from almost 3 millions to about 5 billions ; to give you an element of
comparison, 1 million seconds is 11.6 days, et 1 billion seconds is ... 31.7 years.

2 - At a rate of 7%, the value of the reinvested money would have been worth $9 trillion today. By comparison the US GDP
est de 21 trillion dollars en 2019 (around 1/4 of world GDP).

2.2 Discounting

3 - Discounting: one is looking to calculate Co

 Application 2 : What is the Present Value of an investment giving 100 € in 3 years from now
when the interest rate is 5%? (euros, two décimal places). WATCH OUT: this is a French Excel, so
decimal places are with "commas" not "dots".
That is: how much do you need to invest today to get 100 € in 3 years at an interest rate of 5%?

We are looking for the Present Value C0 = 100*(1+5%)^-3 = 100/(1+5%)^3 = 86,38

2.3 Formulas (compounding and discounting) with 4 variables. If you are given numerical values for 3
of them, you can deduce the 4th one!

1/ Given an interest rate of 3%, what will the value of 50 000 € be in 10 years ? (euros, two
decimal places)

2/ How much do you need to have on your savings account right now, earning a rate of
2,5%/year, to get 100 000 € in 8 years ? (euros, two decimal places)

3/ What is the time needed to triple your investment if you earn 2,5%/year ? (one decimal
place) (optional)

4/ At what rate must you invest your capital so that it doubles in value after 7 years ? (two
decimal places)

3. Annual Percentage Rates vs Effective Annual Rates and Periodic

Rates
If the period considered is other than yearly (one period = 1 year), it is necessary to find the periodic
rate of interest from the given annual rate. We distinguish two sorts of yearly rates. 1) the Annnual
Percentage Rate (APR) is the one that is usually quoted in all loans applications. 2) The Effective
Annual Rate (EAR) is the yearly rate that you actually pay on a yearly basis. The periodic rate is used
for instance to compute the monthly payments of a loan, the bi-annual interest coupons on a
savings bond, etc...
There are two ways to compute a periodic interest rate. One is based on the APR and the other on
the EAR. Most of the time the periodic rate is obtained easily from the APR. The reason is simple.
The APR is the quoted rate for a loan. It is calculated as APR = the periodic rate x the number of
periods in one year. So to calculate the periodic rate you only have to divide the APR by the number
of payment periods in one year. The EAR is defined as the compounded rate, which indicates the
actual interest rate that you pay when you make periodic payments (period < 1 year). The reason
that it is the actual rate is because banks charge you compound interest rates and not simple
interest rates. Below is explains how to get the periodic rate in each case.
4. Multiple Cash Flows
This part is based solely on COMPOUND interests

So far we have worked with only one amount of money (also called lump-sum amount) that we
were trying to compound to the future or discount back to the present. But in most cases, there are
multiple cash flows.

For instance. An investment project earns $10 millions the first year, 20 the second year... How
much is that project worth? Or, you invest 100 euros each month over a 20 year period. How much
money have you accumulated after 20 years?

A Time Line is a representation of the timing of cash flows (money amounts). We already used time
lines above, when we calculated the discounted present value of a single cash flow or its future
value. In prior examples we did show the starting cash flow and the final cash flow (after discounting
or compounding). Below is a representation of several cash flows that we may be receiving (or
paying) over time.

1st Case : Cash flows are not constant. We must then discount (or compound) each one of them
independently.

Take for example a project which gives $3 million the first year (t=1), and $5 millions the second
year (t=2). The interest (or discount) rate is 6%.

If we are looking for the Present Value of this project (at t=0) then we need to bring back all the cash
flows to date t=0. Hence, we need to discount the first cash flow by (1+0.06) and discount the
second cash flow by (1+ 0.06)² as it is in two years from now.

Thus one calculates the Present Value of the project as PV = $3 / (1+0.06) + $5 / (1+ 0.06) ²= $7.280
 Application 3 : at a rate of 5%, what is the present value of the following series of cash flows?

One is looking for the Present Value C0 = B4/(1+5%)+C4/(1+5%)^2+D4/(1+5%)^3+E4/(1+5%)^4

In a similar fashion, when we are looking for the future value, we must compound each cash flow at
5%, while taking into account how many periods are remaining till the future (or end) period we are
focusing on.

2nd Case : the cash flows are constant over time

This part and its formulas are recommended for you (but not mandatory)
Advice: this part is to be known for students interested in going into the Finance Major

When the cash flows are contant in each period, we can use some formulas that make the
calculations not as time consuming (you don't have to discount each cash flow separately).
a. Discounting

Application 4 : Given that you took a bank loan for 75 000 € with an annual rate of 3,5%, and
constant annual payments (called annuities) to reimburse your loan in 4 years, what is the
amount of your annuity payment ? (euros, two decimal places)

We are looking for the annuity payment that will be made in each of the next 4 years

= (75000*3,5%)/(1-(1+3,5%)^-4)

b. Compounding

Application 5 : You want to buy an appartment 10 years from now, and you want to make down
payment of 500 000 € on the house then, how much money should you be saving each year
(assuming that you invest the same amount every year) if the interest rate you earn is 2% ?
(euros, two decimal places)

One is looking for the annuity payment to be made every year to reach the goal of having 500000
euros in 10 years
Present Value, Net Present Value and Internal Rate of Return

Present Value (PV)

In finance and in practice, the value of an asset comes from all the cash flows that this asset is
expected to earn for the owner of this asset in the future.

We have already seen above examples of Present Value calculations. The Present Value (PV) is the
computed sum of cash flows (one or several, constant or not) that are discounted back to time t=0,
or today -- that's why it is called the Present Value. The Present value can be positive or negative
depending on whether cash flows are positive (gains) or negative (payments or losses).

See the example of application 3 .

This principle is generalizable to any type of asset that generates cash flows (may they be positive
or negative) : for instance one can evaluate a business based on the cash flows it will generate, a
commercial buidling based on the rental income it will bring to the owners, ...

Application : An investment brings 85 thousand euros the first year and 65 thousand the second,
what is the PV of the investment knowing that the hurdle rate is 4%?

We are looking for the Present Value. Two ways to do it

We can write out the formula =B5/(1,04)+C5/(1,04)^2 = 141,83
Or use the PV formula in (french) Excel =VAN(4%;B5:C5) = 141,83

Answers use "commas" in the french Excel version. But Remember that in all tests your answers
must use the English notation for decimal places: the dot "."
Net Present Value
Here is another concept you need to master : the Net Present Value.

The Net Present Value (NPV) of an asset is equal to the Present Value minus the monetary value of
the initial investment. The word "Net" is used because we take into account the initial investment.

When applied to a new project, the Net Present Value is the value of the income generated by the
project in excess of the initial investement (or cost of the project).

The NPV is the most used criterion in investment decisions.

Decision rule :

• A positive NPV means that the present value of the stream of income from the investment is
greater than its cost => we accept the investment.

• A negative NPV signifies that the cost of investement is greater than the stream of income
received from the investment => we reject the investment.

Application : An investment costs 120 thousand euros. It brings 85 thousand euros the first year
and 65 thousand the second, what is the NPV of the investment knowing that the hurdle rate is
4%?

One is looking for the Net Present Value:

VAN = -120 + (85/1,04) + (65/1,04²) = 21,83

NPV Excel formula (french): VAN(4%;C4:D4)+B4 = 21,83

NOTE that we are NOT doing VAN(4%;B4:D4) this is because the french NPV (VAN) formula
considers that the first cash flow happens ONE period in the future, which is not the case here.

Once we vary the discount rate this is what happens:

 NPV and the discount rate

The NPV being a sum of discounted cash flows, it is easy to show that the higher the discount rate is,
the smaller the NPV is. Inversely, the smaller the discount rate is and the larger the NPV will be
(everything else held constant).

A cash flow of 10, received at t=1 and discounted at 1%, has a present value = 10 / (1.01) = 9,90 at
t=0.

A cash flow of 10, received at t=1 and discounted at 10%, has a present value = 10 / (1.10) = 9.09 at
t=0.

A cash flow of 10, received at t=1 and discounted at 20%, has a present value = 10 / (1.20) = 8.33 at
t=0.

As you can see the PV falls as the discount rate increases.

How to read the graph:

1. You will see the NPV calculated at the rate of 4% (see preceding NPV application)

2. The curve tracing the relationship between NPV and rate allows us to see clearly that the
higher the rate the lower the NPV.

3. The graph is based on these calculations. The rate is measured on the x-axis and the NPV on
the y-axis.

4. The higher the rate, the lower the NPV. There is a rate for which the NPV = 0, and beyond
that rate the NPV becomes negative. Here when the rate is almost equal to 17% the NPV
reaches 0, and for rates higher than 17%, the NPV becomes negative.
The Internal Rate of Return
The internal rate of return (IRR) is the rate at which the NPV is zero. This is when the project is at a
break-even point. Expected cash flows cover exactly the cost of the project. (This perspective of
the break-even point considers the time value of money.)

Application : An investment costs 120 thousand euros. It brings 85 thousand euros the first year
and 65 thousand the second, what is the IRR ?

One is looking to the IRR which is the rate that makes the NPV=0
You can calculate it using the IRR formula (french Excel) =TRI(B4:D4) = 17,09%

Note : In the french version of Excel the Internal Rate of Return is calculated using the TRI fonction. In
the English version it is the IRR (internal rate of return).

Example of an investment project

Compute 1) the NPV and 2) the IRR.

We are looking for the Present Value at t=0, thus you need to discount each cash flow at the
discount rate R. For the IRR, this is the rate that solves NPV = 0, given the cash flows.

Here are the formulas to use:

In the example, the project generates an NPV of 52.07. Because the NPV is positive, the project is
profitable and thus the rule is to accept the project.

Decision rule : the IRR must be compared to the disount rate that is applied to the specific project.
The discount rate is often referred to in that case as the required return or "hurdle rate".

Go ahead with the investment when the IRR > Discount Rate.

In the example, the IRR= 9.49% > 7%

Then the project is green lighted. It is accepted as the project gives more income than its cost.

Clarification: in the case of investment projects, we speak of required return rather than discount
rates, to highlight that this return is demanded by investors. This notion will be covered in more
details in chapter 5, which is about the weighted average cost of capital.

The comparison between the required return and the IRR must be understood as follows: a project
will be undertaken as long as the project brings more money than it costs. Similarly, the same
decision is reached when the NPV of the project is positive. In that case, the sum of discounted cash
flows, discounted at the rate required by investors, does create a positive value for the company.