Lecture 2

Interest Rates and

Time Value of Money

References: Villalobos, Luenberger, Faerber

 Lecture Topics
• Time Value of Money
• Simple and compound interest
• Equivalence
• Factors
• Nominal and Effective Interest
• Present Value
• Future Value
• Internal Rate of Return
 Business Decisions?
• How do you determine if purchasing a piece of equipment is the
right thing to do?
• How do you justify purchases in general?
• Is it better to buy the equipment or put the money in a CD?
• How do you know which investments to make?
• How much do you need to invest?
• Where do you invest?

• Comparison principle is the common approach in finance.

• What do you compare?

– ROI, interest, value?
– Risk?
Is there really a risk-free investment?
• What if one bank is offering loans at 7% interest while another bank
has a savings account at 8% interest?
– You could actually make money without investing any money of
your own
– This is called Arbitrage

• It is generally assumed that there is “no-arbitrage” for the purposes

of financial analysis

• We will assume this for most of our discussions as well

• However, there are companies out there that invest heavily in

computer and software development that look for these types of
opportunities in markets such as the currency markets
 Risk Aversion
• What if you had the following choice for investment:
– Put $1,000 in a 5% savings account for one year
– Loan $1,000 to a friend who promises to pay you back with 5%
interest at the end of one year

• How about the following choice:

– US treasury bond worth 3%
– Corporate stock with expected return of 3%

• How do we compare the values and the risks?

• How do we reduce the risks?

 Hedging
• Luenberger introduces this concept in Chapter 1 as a quick example of how
one might go about reducing risk

• Hedging is a process used to reduce financial risks

– Have you heard the phrase “hedge a bet”?

• Clearly insurance is a hedge where you pay fixed amounts as protection for
unexpected but severe losses
– Personal
– Business

• Bakery example where the bakery purchases wheat futures to offset the
potential fluctuations in flour prices

• Airlines and oil futures?

 Time Value of Money
• The same amount of money today is worth more than that same amount in
the future
– Potential earning?
– Inflation?
– Would you rather I give you $1000 today or one year from now?

• In other words, you could earn “interest” if you took the money today

• Interest is the cost of money

• Interest = Total Amount Accumulated – Original Investment
• Interest = Final Amount Owned – Original Loan
 Time Value of Money
• How do you determine the value of a company?
– One possible way is to sum up the profits of the company over a period
of time

• How can this be used for comparison purposes?

– If we could determine the value of these future profits today, “present
value”, then we could compare to the “present value” of other
businesses
– Basically, discount the future profits based on time value of money
– We can then sum up the discounted future profits to determine the
present value

• We will spend the next bit of time discussing this concept

 Terminology
• Principle = Original investment or loan

• Interest Rate = Interest presented as a percentage of the original amount

Interest Accrued Per Unit Time

Interest Rate =
Original Amount

• So, how much is our money in the future if invested today assuming we
know the interest rate?
 Simple Interest
• Simple interest is calculated using only the principle

• Interest money earned is not included in the calculation of future interest

money earned

F P (1 + iN )
=

• Where F is the future value, N is the number of periods and i is the

simple interest per period

Time = 0 1 2 3 n-1 n

P P(1+i) P(1+2i) P(1+3i) P[1+(n-1)i] P(1+ni)

 Compound Interest
• Compound interest is calculated using the principle plus the total amount
of interest accrued so far

F P (1 + i )
N
=

• The compounding period is the time when the interest is added to the
principle

Time = 0 1 2 3 n-1 n

P P(1+i) P(1+i)2 P(1+i)3 P(1+i)(n-1) P(1+i)n

 Examples
• If you invest $1000 at 10% per year interest, how much will you have after
3 years?

• Simple Interest
End of Year Amount Invested Interest Earned Total
0 1000 1000
1 100 1100
2 100 1200
3 100 1300

• Compounded Interest
End of Year Amount Invested Interest Earned Total
0 1000 1000
1 100 1100
2 100 1210
3 100 1331
 Simple vs Compound Interest
Same $1000 investment at 10% over 20 years
8000

7000
Simple
Compound
6000

5000

4000

3000

2000

1000

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
 Interesting Rule of Thumb
• For compounded interest we have the Seven-Ten rule!

• Seven-Ten rule: Money invested at 7% doubles in 10

years while money invested at 10% doubles in 7 years

72/i = the approximate years to double money

 Continuous Compound Interest
• What is the yearly effect of normal compounding as the number of
periods approaches infinity?
n
lim 1 + ( i n )  =
ei
n →∞

• It can also be shown that the effect over a given period of time can be
expressed as

eit
• This form is often useful with simplifying models and calculations.
 Cash Flow
• Cash Flow represents the Receipts, or income, and the Disbursements, or
costs, for an identified time interval
• Assumption that all cash flow occurs at the End of Interest Period
• Cash flow stream is a very common diagram used to represent the cash
flow

Positive Cash Flow

such as income

Time

Negative Cash Flow such

as costs and expenses
 Cash Flow Equivalence
• Equivalence occurs when different amounts of money at different
periods of time are determined to be equal in economic value

• For example:
– Interest rate is 8%
– $1000 is borrowed
– Amount accrued after one year is 1000(1 + 0.08) = $1080

• So, with an interest rate of 8%, $1000 today has the same economic value
as $1080 one year from now

• We can convert a cash flow to an equivalent cash flow at any point or

period in time
– Two cash flows are equivalent if their Present Value is the same
 Cash Flow Equivalence
• Back to one of our original questions, how can we compare
investments?

• It is common to look at cash flows at their Present Value, or

worth at time zero based on an assumed or defined interest
rate
– From the prior example, the PV for $1080 given one year
from now is $1000 today at an interest rate of 8%
 Present vs Future Values
• Let’s first look at Future Value (FV)
– Cash flow of money at each period, xo, x1, . . . , xn
FV= x0 (1 + i ) + x1 (1 + i )
n n −1
+  + xn

• Present value of a cash flow stream:

x1 x2 xn
PV = x0 + + + +
1 + i (1 + i ) 2
(1 + i )
n
 Present vs Future Values
• Another way to look at the relationship is:

FV
PV =
(1 + i )
n
 Present Value
• A more general equation for present value would include more
frequent compounding such that:
– r = annual interest rate
– m = number of equally spaced periods in a year
n
xk
PV = ∑ k
k =0   r 
1 +  m  
  
 PV Example
• With an interest rate of 6%, what is the PV of receiving $1000

– Today = $1000

– One year from now = 1000/(1+0.06) = $943

– Two years from now = 1000/(1+0.06)2 = $890

– Ten years from now = 1000/(1+0.06)10 = $558

 PV Example
• Consider the following cash flow with annual returns:
1000 2000 3000 4000 5000

10000
• If the annual interest rate is 10%

1000 2000 3000 4000 5000

−10000 +
PV = + + + + $652.59
=
1.1 (1.1) (1.1) (1.1) (1.1)
2 3 4 5

• The fact that the PV is positive is a good sign that the cash flow presented
is beneficial
• Note, a single payment at time zero of $652.59 would be equivalent to
the cash flow shown above
 PV Example
• Another look at the same example:

Year Amount Discount Factor Present Value

0 -$10,000.00 1.0000 -$10,000.00
1 $1,000.00 0.9091 $909.09
2 $2,000.00 0.8264 $1,652.89
3 $3,000.00 0.7513 $2,253.94
4 $4,000.00 0.6830 $2,732.05
5 $5,000.00 0.6209 $3,104.61
Total $5,000.00 $652.59

• The discount factor is generally referred to as a compound amount factor

represented as P/F, i, n). Tables for these values can be found in any
economics book, but are also easily calculated
 FV Example
• Let’s reconsider the prior cash flow with annual returns of:

1000 2000 3000 4000 5000

10000

• And the annual interest rate is 10%

−10000 (1.1) + 1000 (1.1) + 2000 (1.1) + 3000 (1.1) + 4000 (1.1) + 5000 =
5 4 3 2
FV = $1051

• This could have been calculated by FV = PV(F/P, 10%, 5) from the tables
or by using the equation:
FV
⇒ FV= PV (1 + i ) = 652.59 (1.1) = $1051
n 5
PV=
(1 + i )
n
 Single Payment Equivalent
• A very common question is: What is the single payment equivalent to a
series of equal payments such as annuities?
• This single payment would be the Present Value of the series of
payments
???? 5000 5000 5000 5000

• Interest rate is 5%

5000 5000 5000 5000

PV = + + + =$17, 729.75
1.05 (1.05 ) (1.05 ) (1.05 )
2 3 4
 General Annuity Equation
• It would be useful to have a generalized (simplified) equation to determine the
FV and PV for a cash flow of annuities
A A A A A

0 1 2 3 N-1 N

FV= x0 (1 + i ) + x1 (1 + i )
n n −1
• From the earlier equation: (1) +  + xn

FV =A + A (1 + i ) +  + A (1 + i ) + A (1 + i )
N −2 N −1
• Reorganize: (2)

• Multiply by (1+i): (3) FV (1 + i ) = A (1 + i ) + A (1 + i ) +  + A (1 + i ) + A (1 + i )

2 N −1 N

FV (1 + i ) − FV =− A + A (1 + i )
N
• Subtract 2 from 3: (4)
 General Annuity Equation
• Solving for FV we get:  (1 + i ) N − 1 
FV = A  
 i 

• To solve for PV at time = 0:

 (1 + i ) N − 1   1   (1 + i ) N − 1 
PV A=
  N 
A N 
 i   (1 + i )   i (1 + i ) 

• So, (F / A, i, N) presents the value at the end of year N

• And (P / A, i, N) presents the value at time equals 0

 General Annuity Equation
• We can also solve for A:

 i (1 + i ) N 
A = PV  
 (1 + i ) − 1 
N

 i 
A = FV  
 (1 + i ) − 1 
N
 Annuity Example
• Back to our original problem:

???? 5000 5000 5000 5000

 (1 + i ) N − 1   (1 + 0.05 )4 − 1 
PV A=
 N 
A = 4
$17, 729.75
 i (1 + i )   0.05 (1 + 0.05 ) 
 Annuity Example
• What is the annual worth for a present value of $20,000 if the number of
annuities is 10 and the interest rate is 8%?

 i (1 + i ) N 
A = PV  
 (1 + i ) − 1 
N

 0.08 (1 + 0.08 )10 

20000
=   $2980.59
 (1 + 0.08 ) − 1 
10

• Note: The negative of the Excel “PMT” function will produce this result
 Effective Interest Rate
• Effective rate considers the time value of money
• Nominal and effective rates are the same if the compounding period is
one year, but are different if the compounding period is less than one
year
• For example, a nominal rate of 12% for a loan that is compounded
monthly will have an effective rate of 12.68%
• If effective rate is i, nominal rate is r, and m is the number of
compounding periods per nominal period (such as 12 months per one
year), then
m
 r
1
i =+  −1
 m
 Continuous Compounding
• The effective interest rate for continuously compounding is
m
 r
i = lim 1 +  − 1 = e r − 1
m →∞
 m

• Single payment, PV based on FV can be calculated

FV= PV (1 + i ) = PV (1 + e r − 1) N= PVe rN
N

• PV is simply

PV = FVe − rN
Effective Interest Rate Example
• The nominal interest rate for a credit card is r = 12% such that the
monthly interest rate that is applied is 1%

• Effective rate is calculated as:

m 12
 r  0.12 
i = 1 +  − 1 = 1 +  − 1 = 0.1268
 m  12 

• If this were continuous compounding:

m
 r
i = lim 1 +  − 1 = e r − 1 = e0.12 − 1 = 0.1274
m →∞
 m
 Internal Rate of Return
• By now it might be clear that the Present Value is a useful number for
comparing investments or making business decisions
• However, another good concept of cash flow analysis is the Internal Rate
of Return (IRR)
• The cash flow used presents the entire cash flow including all negative and
positive entries, (or deposits and withdrawals)
• With the IRR analysis, we are basically presenting a cash flow, and solving
for the interest rate given a present value = 0

x1 x2 xn
PV =0 =x0 + + + +
1 + i (1 + i ) 2
(1 + i )
n
 Internal Rate of Return
• Another way to look at this is the PV of the initial disbursement is equal to
the PV of the receipts

Receipts

Time

Disbursement

• This can be solved in some cases using an exact formula, numerical

methods to find the roots of the function, trial and error, or trial and error
with interpolation
 Internal Rate of Return
• The IRR is determined without any reference to a defined interest rate
• It is based solely on the cash flows of the stream
• Once estimated, the IRR can also be a value to compare with other
investments or expectations
• Example from Blank and Tarquin
7000

100 100 100 100 100 100 100 100 100 100

5000

• A = 100, n=10 (note when n=10, receipt is 100 + 7000

 Internal Rate of Return
• Setting PV = 0:
7000

100 100 100 100 100 100 100 100 100 100

5000

 (1 + i )10 − 1   1 
0=
PV =−5000 + 100  10 
+ 7000  10 
 i (1 + i )   (1 + i ) 
 Internal Rate of Return
• By iteratively solving for IRR:

 (1 + i )10 − 1   1 
0=
−5000 + 100  10 
+ 7000  10 
 i (1 + i )   (1 + i ) 

Interest 0.0510 0.0511 0.0512 0.0513 0.0514 0.0515 0.0516 0.0517 0.0518 0.0519
PV 25.1161 20.6960 16.2804 11.8693 7.4626 3.0605 -1.3371 -5.7303 -10.1190 -14.5032

• IRR = 5.16%

• Note, this can be solved with an Excel function by listing cash flow in an
array (list)
 Internal Rate of Return
• To be even more precise, you can interpolate:

Interest 0.0510 0.0511 0.0512 0.0513 0.0514 0.0515 0.0516 0.0517 0.0518 0.0519
PV 25.1161 20.6960 16.2804 11.8693 7.4626 3.0605 -1.3371 -5.7303 -10.1190 -14.5032

O
i* − i1 i2 − i1
=
69.47 0 − PV1 PV2 − PV1
0

-355.19

5 5.16 6 i
 Additional Comments
• When would you use Internal Rate or Return or Present value (or Net
Present Value)?
• Read the discussion in pages 28 through 30 (2nd edition).
– I find PV easy to interpret and explain to others, such as senior
management
– IRR has the benefit of only using the cash flow stream and not
requiring an assumption on interest rate
• It depends on the problem at hand
– Because they are both easy to calculate, might be worth looking at
both when making a business decision!

• If time permits, show the Example 2.8 in Excel

 Assignments
• Read Chapter 3 from Luenberger
• The rest of Faerber