SKEMA BUSINESS SCHOOL

Lecture 2
The time value of money and net present
value
 READING REQUIREMENTS

Chapter 4 Discounted cash flow valuation

Corporate Finance, European edition,
by Hillier, Ross, Westerfield, Jaffe and Jordan,
McGraw-Hill ed., 4th.
Get access to the book @ https://k2.skema.edu
in the course Corporate Finance

Lecture 2: The time value of money and net present value

 OUTLINES

• Capitalisation
• Discounting
• Present value and net present value of a financial security
• The NPV decision rule
• What does net value depend on ?
• Annuity and perpetuity

Lecture 2: The time value of money and net present value

 CAPITALISATION

When
• There is more than one period
• Several cash flows
=> Compound Interest
The interest earned by the principal after one period are
added to the initial principal to make a new beginning
principal for the following year
Interests are said to be compounded or capitalized

Lecture 2: The time value of money and net present value

 CAPITALISATION - COMPOUNDING
Example : €10,000 invested at 10% per year,
interest + principal to be redeemed after 3 years
• Interests for the first year
• 10,000 x 10% = €1,000
• Interests are added to the initial principal, to start with a
new beginning principal for the second year: 10,000 +
1,000 = €11,000
• Interests for the second year
• 11,000 x 10% = €1,100
• New beginning principal for the third year: €12,100
• Interests for the third year
• 12,100 x 10% = €1,210
• After 3 years the borrower must repay
10,000 + 1,000 + 1,100 + 1,210 = €13,310

Lecture 2: The time value of money and net present value

 CAPITALISATION - COMPOUNDING
• I invest V0 for n years at interest rate r per year
• At the end of the year 1
• I have V1 = V0 x (1 + r) which is my beginning principal for
year 2
• At the end of the year 2, I will have V2
• V2 = V1(1+r) = V0 (1+r)(1+r) = V0 (1+r)2
•…
• At the end of the year n, I will have Vn
• Vn = Vn-1(1+r) = V0 (1+r)(1+r)…(1+r) = V0 (1+r)n
• The future value Vn of principal V0 , at the end of n years is
Vn = V0 (1+r)n

Lecture 2: The time value of money and net present value

 CAPITALISATION - COMPOUNDING

To calculate returns over a period greater than one year, we cannot

simply compare the end return to the initial outlay and divide by
the number of years. This is erroneous reasoning
Capitalising income means foregoing receipt of it. It then
becomes capital and itself begins to produce interest during
the following periods.
Capitalisation formula :
Vn = Future value of investment
V0 = Initial value of investment

Vn = V0 ´ (1+ r) n
r = Interest rate of return
n = Duration of the investment

Lecture 2: The time value of money and net present value

 CAPITALISATION - COMPOUNDING

This is also called the power of capitalisation

Lecture 2: The time value of money and net present value

 CAPITALISATION - COMPOUNDING

V0 = Initial value of investment

Vn = V0 ´ (1+ r) n r = Interest rate of return

n = Duration of the investment

In such a formula the unknown component can be :

Vn
V0
R
n

Lecture 2: The time value of money and net present value

 DISCOUNTING

Discounting converts a future value into a present value. This is the

opposite result of capitalisation
Discounting makes it possible to compare sums received or paid
out at different dates

Discounting Formula

Vn Vn = Future value of investment

V0 = n
V0 = Initial value of investment

(1+ r ) r = Interest rate of return

n = Duration of the investment

Lecture 2: The time value of money and net present value

 DISCOUNTING

Capitalisation and Discounting : the two sides

of the same coin
Vn = V0 ´ (1+ r )n

V0 = Present value Vn = Future value

Time

Vn
V0 =
(1+ r )n

Lecture 2: The time value of money and net present value

 PRESENT VALUE AND NET PRESENT VALUE
OF A FINANCIAL SECURITY

The present value (PV) of a security is the sum of its discounted cash
flows :

N
Fn
PV = å
Fn = Cash flows generated by the security
n r = Applied discounting rate
n=1 (1+ r ) n = Number of years for the security

Lecture 2: The time value of money and net present value

 PRESENT VALUE AND NET PRESENT VALUE
OF A FINANCIAL SECURITY

The net present value (NPV) is the difference between present value
and market value :

N Fn = Cash flows generated by the security

Fn
NPV = å n
-V0 r = Applied discounting rate

n=1 (1+ r ) n = Number of years for the security

V0 = Market value of the security

In an efficient, fairly valued market, net present values are zero, i.e.
market value is equal to present value

Lecture 2: The time value of money and net present value

 PRESENT VALUE AND NET PRESENT VALUE
OF A FINANCIAL SECURITY

• The concept of net present value can be interpreted in three

different ways :

- The value created by an investment

- The maximum additional amount that the investor is willing to

pay to make the investment

- The difference between the present value of the investment

and its market value

Lecture 2: The time value of money and net present value

 THE NPV DECISION RULE

There are two steps to calculate the NPV :

1. Write down the net cash flows that the investment will
generate over its life
2. Discount these cash flows at an interest rate that reflects the
degree of risk inherent to the project

The NPV decision rule is easy :

NPV > 0  INVEST
NPV < 0  DO NOT INVEST

Lecture 2: The time value of money and net present value

 WHAT DOES NET VALUE DEPEND ON ?

The higher the discounting rate, the more the future cash flow is
depreciated and, therefore, the lower is the present value. Net
present value declines in inverse proportion to the discounting
rate.

Lecture 2: The time value of money and net present value

 ANNUITY AND PERPETUITY

Value of an annuity F over N years beginning in year 1

If constant annuities : same cash flow F at each interval

F é 1 ù
F = Amount of the annuity

PV = ´ ê1- Nú
r = Interest rate of return
r ë (1+ r ) û N = Number of annuity

𝐹 𝑁
𝐹𝑉 = 1+𝑟 −1
𝑟
This is a very useful formula for credit.

Lecture 2: The time value of money and net present value

 ANNUITY AND PERPETUITY

Some examples of simplification of present value calculations

(without CF rise at different rate)

Value of a perpetuity F beginning in year 1.

F F = Amount of the perpetuity

PV =
r r = Interest rate of return

The easiest formula in Finance.

Lecture 2: The time value of money and net present value

 Annuity and perpetuity
Some examples of simplification of present value calculations
(without CF rise at different rate)

Value of a perpetuity that grows at rate g (also called a

growing perpetuity)

F0 = Amount of the perpetuity today

F0 ´ (1+ g) F1
PV = = r = Interest rate of return
r -g r -g g = Growth rate

The easiest formula in Finance.

Lecture 2: The time value of money and net present value