A Primer on the Time Value of Money

Panos N. Patatoukas

Associate Professor | The L.H. Penney Chair in Accounting | Berkeley Haas

The objective of this pre-reading is to help you refresh concepts related to the time value of
money, discounting, and present value calculations.

The basics of discounting

Before we introduce any formulas, consider the following hypothetical question. Would you
prefer a dollar today or the same dollar but ten years from today? The “present value” of a
dollar received ten years from now should be “discounted” relative to the value of a dollar
received today for a few reasons.

• First, there is opportunity cost in waiting for a future payment since a dollar today
can be invested and generate income.

• Second, inflation decreases the purchasing power of money over time and a dollar in
the future will buy you less than a dollar today.

• Third, there is risk in waiting for a future payment since a dollar in the future, even if
promised, may not be delivered. Therefore, I would choose a dollar today over the
same dollar ten years from now.

Indeed, the present value of a dollar in the future should decrease the further into the future
it is and the more uncertain you feel about getting it. The process of discounting converts
future cash flows into cash flows in today’s terms and enables us to compare cash flows at
different points in time.

Present value of a simple cash flow

Let us start from the simple case of a single cash flow. The present value of a single cash flow
that we expect to receive 𝑡 years from now is computed as follows:

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑡
(1 + 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒)𝑡

To illustrate, with a discount rate of 8%, the present value of a dollar that we expect to
receive 10 years from now is equal to

$1
= $0.46
(1 + 8%)10
Present value of a finite stream of cash flows

The present value of a stream of annual cash flows that we expect to receive over a specified
period of time, say 𝑇 years, is given by the following expression

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤1 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤2 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑇

1
+ 2
+⋯+
(1 + 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒) (1 + 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒) (1 + 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒)𝑇

To illustrate, with a discount rate of 8%, the present value of a stream of constant annual
cash flows of $1 over a five-year period is equal to

$1 $1 $1 $1 $1
1
+ 2
+ 3
+ 4
+ = $3.99
(1 + 8%) (1 + 8%) (1 + 8%) (1 + 8%) (1 + 8%)5

Present value of a perpetuity

The present value of a perpetuity, i.e., a constant stream of annual cash flows that is expected
to go on forever, is computed by dividing the annual cash flow by the discount rate

𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒
To illustrate, with a discount rate of 8%, the present value of a perpetual bond (i.e., a bond
with no maturity date) that pays a $1 coupon every year is equal to

$1
= $12.5
8%

Present value of a growing perpetuity

A growing perpetuity is a perpetual stream of cash flows that is expected to grow at a

constant rate forever from the first year onwards. The present value of a growing perpetuity
is computed as follows

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛 𝐹𝑖𝑟𝑠𝑡 𝑌𝑒𝑎𝑟

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒

To illustrate, let us go back to the example of the perpetual bond above and further assume
that the coupon payment of $1 expected in the first year will grow in perpetuity at a constant
rate of 4% per year. The present value of this bond is equal to

$1
= $25
8% − 4%

2
 Application 1

Suppose you invest $100 today in a project that will generate cash flow of $10 in the first
year and the first-year cash flow is expected to grow by 3% a year in perpetuity. Let’s address
the following questions using an 8% discount rate.

What is the value of the project?

The value of the project is $200 and can be computed as a growing perpetuity

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛 𝐹𝑖𝑟𝑠𝑡 𝑌𝑒𝑎𝑟 $10

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = = = $200
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 8% − 3%

What is the cost of the initial investment in the project?

The cost of the initial investment is $100.

What is the Net Present Value of the project?

The Net Present Value (NPV) of the project is $100, which is equal to the value of the project
minus the cost of the initial investment

𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 (𝑁𝑃𝑉) = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑠 – 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
= $200 − $100 = $100

Effectively, the project’s NPV is a measure of the expected value of the project over the cost
of the initial investment.

What is the Internal Rate of Return of the project?

The internal rate of return (IRR) of a project is the rate of return that would set the present
value of expected future cash flows equal to the cost of the initial investment. In other words,
the IRR is the rate of return that would set the project’s NPV equal to zero.

𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑖𝑛 𝐹𝑖𝑟𝑠𝑡 𝑌𝑒𝑎𝑟

− 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 0
𝑰𝑹𝑹 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒

or,

$10
− $100 = $0
𝑰𝑹𝑹 − 3%

Solving for 𝐼𝑅𝑅 in the above expression we get that the internal rate of return of the project
is 13%, which is higher than the 8% discount rate. All positive NPV projects generate an IRR
that is higher than the discount rate.

3
 Application 2

Suppose you invest $150 today in a project that will generate cash flow of $50 per year for
the next five years.

1. What is the value of the project?

2. What is the cost of the initial investment in the project?

3. What is the Net Present Value of the project?

4. What is the Internal Rate of Return of the project?