2.

The Value of Time

Copyright 2022 Alex Stomper, Humboldt University, Berlin

We start by focusing on the first function of the financial system, i.e. its functioning as an
economic "time machine" which can be used to exchange cash flows that occur at different
points in time. To analyze the effect of a cash flow's timing on its value (market price), we
abstract from all kinds of risk by assuming that all changes in the economy are perfectly
predictable. Moreover, we simplify the analysis by assuming that financial markets are
perfect.

Definition: Perfect financial markets

There are no taxes, and no transactions costs. The transactions of each individual market
participant will not move prices (given a finite transaction volume).
All market participants have the same information and the same expectations regarding
future price changes.

For now, we also ignore inflation.

Agenda
Basics of valuation
Cash flows, prices, and rates of return
Compounding, discounting, and combining cash flows BD 3.2, 4.2
Net present value and the internal rate of return BD 3.3, 4.3, 4.4
The law of one price (LOOP) and value additivity BD 3.4, 3.5
Foreign currency cash flows
Valuation of annuities and perpetuities BD 4.5
Constant annuities and perpetuities
Growing (or shrinking) annuities and perpetuities*
Summary/Economic intuition

2.1. Basics of valuation

2.1.1. Cash flows, prices, and rates of return
While most fields of economics focus on market prices, finance focuses on changes in
market prices, i.e. returns. Returns consist of two components:

a component due to cash payments,

a component due to capital gains or losses.

We start with a motivating example regarding a time deposit, i.e. a safe investment which
yields cash flows a prespecified times.

Suppose that you deposit $ 100 for 2 years. The deposit generates 2 cash flows:
 CF1 = 100R after 1 year, (1)

CF2 = 100(1 + R) after 2 years. (2)

Suppose you sell your time deposit contract after 1 year, at a price of P.

What's your return by the end of the first year? Compute the cash-component and the capital
gain/loss component.

Answer 2.1:

CF1 + P − 100 CF1 P − 100 P − 100

R1 = = + = R + .
100 100 100 100

Open questions:

What's the price P at which the deposit can be sold after 1 year?
How can we measure the return over 2 years?

2.1.2. Compounding, discounting, and combining

cash flows
Compounding cash flows
You first deposit $ 100 for 1 year, and then deposit the proceeds for another year. What's your
final payoff if the per-annum interest rate is 1\%?

Answer 2.2:

We first compute the final payoff, given the proceeds you obtain after the first year:

CF2 = P1 (1 + 0.01).

Next, we compute the amount you have after the first year:

P1 = 100(1 + 0.01).

Therefore,

2
CF2 = 100(1 + 0.01) .

Future value
Definition: an amount I invested for n years has a future value of
n
F Vn = I (1 + R) .

The future value results from compounding the initial amount I.

Discounting cash flows

Suppose that you are offered a risk-less cash flow of $ 100 in n years, in return for a payment
of I now. What is the maximum value of I for which you would accept the offer?

Answer 2.3:

You need to take into account that, by paying I, you reduce the capital you can invest in
other ways. As a consequence, you forego returns associated with alternative investments.

To value a risk-less cash flow, we need to know the return of risk-free alternative
investments, e.g. a bank deposit. If you put I into a bank deposit, you obtain the following
future value:
n
F Vn = I (1 + R) ,

where R is the bank deposit's interest rate.

Is this future value higher than the $ 100 that have been offered to you? If so, you should
decline the offer. The offer is only acceptable if the required investment is sufficient small:

100
I ≤ .
n
(1 + R)

Present value
Definition: a cash flow CF to be received in n years has a present value of

CF
PV = .
n
(1 + R)

The present value results from discounting the cash flow. Discounting is a way to account
for the opportunity cost of capital associated with capital being tied up until the cash flow
CF is received.

The present value is the value of an investment which has an opportunity cost of capital that
can just be covered by means of the cash flow CF . This can be seen in a particularly easy
way by considering the case in which capital is tied up for one year, so that n = 1 :

CF
PV = ⇔ P V (1 + R) = CF .
1 + R

In the last equation, the left-hand side can be interpreted as the sum of two kinds of
investments that are both required in order to receive the cash flow CF :

An investment amounting to the present value P V .

An investment amounting to the cost of capital being tied up, i.e. the product of P V
and the return R that the capital would have yielded had it not been tied up.

DCF valuation
Our approach to the valuation of cash flows is commonly referred to as DCF valuation,
where DCF is short-hand for "discounted cash flow".
The (present) value of cash flows depends on the discount rate R. This discount rate is the
expected return of investment opportunities that yield returns similar to the return implied
by the cash flow we want to value.

For now, we just distinguish between risk-free cash flows/returns that occur at different
points in time.
In the future, we will compare cash flows/returns not only in terms of timing, but also in
terms of riskiness.

Combining cash flows

Suppose you are offered a choice between $ 200 in 1 year and ($ 100 now and $ 100 in 1
year). How should you choose?

Answer 2.4:

By choosing the second option, you can earn interest on the first $ 100, so that your final
payoff is

100(1 + R) + 100 > 200.

Notice: it would have been wrong to compare the two options by simply adding the cash
flows. Never simply add cash flows that occur at different points in time. Instead
compare two cash flow streams either in terms of their present values or in terms of future
values.

In our example, the two options' present values are:

200 100
vs. 100 + .
1 + R 1 + R

2.1.3. Net present value and internal rate of return

Definition: the net present value (NPV) of an investment opportunity is the difference
between the present values of the positive and the negative cash flows resulting from the
investment opportunity. If you'd have to invest I now in order to get a cash flow CF in n
years, the net present value of the investment opportunity is:

CF
N P V = −I + .
n
(1 + R)

A positive net present value implies that an investment opportunity is a good deal.
Stay away from negative NPV investments!

Opportunity cost of capital as a hurdle rate of return on

investment
Consider a simple investment opportunity, i.e. an investment which yields a single payoff CF.
The profitability of the investment opportunity can be measured in terms of the return on
investment (ROI):
 CF − I
ROI = .
I

Given the ROI, we can compute the NPV of the investment opportunity:

CF I (1 + ROI )
N P V = −I + = −I + .
1 + R 1 + R

The NPV is positive if the ROI exceeds the discount rate R, and it will equal zero if the ROI is
equal to R.

The ROI is the return of the investment opportunity that we consider.

The discount rate R is the return of an alternative investment opportunity with similar
characteristics.

Measuring the ROI (with multiple cash flows)

How can we measure the ROI? Idea: We could view the NPV as a function of an unknown
discount rate Y and solve for the value of Y that would yield an NPV of zero.

CF
−I + = 0 ⇔ Y = ROI .
1 + Y

This way of measuring the return on an investment can be used more generally: Given a
stream of cash flows, we can solve for the discount rate that implies an NPV of zero. This
discount rate is referred to as the internal rate of return.

The internal rate of return*

Definition: The internal rate of return (IRR) is the discount rate Y for which the NPV of a
stream of cash flows equals zero.

T
CFt
−I + ∑ = 0.
t
(1 + Y )
t=1

An investment opportunity is a good deal if its IRR exceeds the opportunity cost of capital.

Notice: The IRR should only be used in order to measure the profitability of investments that
cause a stream of cash flows in which negative cash flows are followed by positive cash
flows.

2.1.4. The law of one price

The law of one price: In a perfect financial market, the prices of equivalent streams of cash
flows must be equal. In practice, any price differences must be due to transactions costs.
Streams of cash flows are equivalent if they are proportional to each other across all future
times and possible future events.

The LOOP is a consequence of the presence of investors standing ready to profit from
arbitrage opportunities.
Definition: arbitrage opportunities are investment opportunities...

which cannot generate losses,

which may generate gains, and
which require no initial net investment.

The existence of arbitrage opportunities is not consistent with markets being in an

equilibrium in which supply equals demand: The portfolios that harvest arbitrage
opportunities would be in (infinte) demand.

Arbitrage trading
Arbitrage trades typically combine long positions in under-priced assets with short positions
in over-priced assets which are equivalent to the over-priced assets. Short positions are
positions established by

borrowing an asset (e.g., a bond) from someone who owns this asset, and
selling the asset. This requires that the short seller promises to compensate the owner
of the asset for all the cash flows the owner would have received had the asset not been
borrowed by the short seller.

In reality, the LOOP is never perfectly satisfied. The reason are "limits to arbitrage", such as
transactions costs.

Short-selling "money"
The simplest type of short-selling is a loan.

A government bond will generate a cash flow $ 100 one year from now. The price of the bond
is $ 97. Should you invest in the bond or would it be better to put the money into a bank
deposit? The interest rate of the bank deposit would be 2% per annum.

Follow-up question: Suppose that you can borrow money at 2\% per annum in order to finance
your investment into the government bond. How many bonds should you buy?

Answer 2.5:

No.

97(1 + 0.02) = 98.9 < 100.

Is it possible that we obtain different returns from similar risk-free investments?

Answer to the follow-up question: There is no finite optimum. By buying 1 bond, you obtain
a cash flow that can be used to repay a loan of $ 98.04:

100
= 98, 04.
1.02

Given that the bond price equals $ 97, you can pocket $ 1.04 per bond bought.
Given that there is an infinite demand for the bond at the price of $ 97, the bond's price will
be pushed up and/or the loan rate will be pushed up until the return on the bond equals the
loan rate (or until the difference is so small that transactions costs exceed the profit of the
trade described above).

Value additivity
The LOOP also applies to the (un-)bundling of cash flows. In this application, the LOOP is
referred to as "value additivity".

Value additivity: The value of a stream of cash flows must equal the sum of the present
values of all cash flows.

Example: In bond markets, it is common to "unbundle" the stream of cash flows generated
by a government bond: Investment banks buy bonds and sell claims to the cash flows of the
bonds. Value additivity says that the price of a bond equals the sum of the prices of all
claims to the bond´s cash flows. If a bond price were higher (lower), traders would short-sell
(buy) the bond, buy (sell) claims to all of its cash flows, and pocket a profit (since the short-
selling would generate more revenue that the cost of the long position).

2.1.3. Foreign currency cash flows

If DFC valuation is use to value a foreign currency cash flow, this cash flow must be
discounted at a rate which measures the opportunity cost of capital in the foreign currency.
The result will be a present value in terms of the foreign currency. To obtain a local currency
value, we need to use the current exchange rate.

What is the value of GBP 100 to be received in 1 year? The GBP trades at $ 0.8 and the British
per-annum interest rate is 2\%.

Answer 2.6:

The GBP 100 can be used to finance a loan of GBP 98.04:

100
= 98.04.
1.02

GBP 98.04 correspond to $ 78.43.

2.2. Valuation of annuities and perpetuities

Definition: An annuity is a stream of cash flows. The cash flows occur regularly (e.g. every
year) and show some pattern (e.g. growth at a constant rate). An annuity without a specified
end time is referred to as a perpetuity.

The term "annuity" suggests that we are thinking about annual cash flows. In fact, the period
between two cash flows may differ from 1 year.

2.2.1. Constant annuities and perpetuities

Starting in 1751 the Bank of England issued bonds promising investors a steady stream of
interest payments forever, - a perpetuity. These bonds came to be known as consol bonds.

What maximum price would you be willing to pay in order to receive an annual cash flow of
X?

Answer 2.7:

The maximum price is the amount you would have to depost so that the interest on this
deposit equals X. Given an interest rate of R per annum, the maximum price is:

X
P = .
R

This is the present value of a perpetuity.

But what's the "present" time associated with this present value?

Answer 2.7a:

That's the time you'd have to deposit the amount P so that the deposit generates a cash
flow of X at the same time as the perpetuity's first cash flow. If we are talking about an
annual perpetuity, the deposit will be made one year before it first generates an interest
payment. More generally, the present value of a perpetuity is its value one period before the
first cash flow!

Constant annuities and perpetuties

Definition: A constant annuity is a stream of n periodic cash flows of equal value X. If n is
infinite, the stream of cash flows is a constant perpetuity. The present value of a constant
annuity is given by:

X 1
PV = (1 − ).
R (1 + R)
n

We now prove the above-stated result in two ways. The first proof shows that the above-
stated present value is the amount required in order to replicate the annuity/perpetuity. The
second proof shows that the above-stated result is implied by the law of one price (LOOP).

The replication approach

Suppose that you deposit an amount P for 1 period. Then, you'd earn P(1+R). If you re-
deposit the amount P for another period, you can obtain a cash flow of P(1+R)-P=PR.
Repeat for n periods. After the final period, you'd get the usual cash flow PR plus the initial
deposit P. The NPV of the stream of cash flows equals zero if the following condition holds:

P
P = PV of the n cash flows of P R + ,
n
(1 + R)

1
PV of the n cash flows of P R = P (1 − ). (3)
n
(1 + R)
To replicate an annuity of X, we must choose P so that PR=X. If we rewrite the above-stated
expression in order to replace P by X/R, we obtain the above-stated expression for the
present value of an annuity/perpetuity.

The LOOP approach

An annuity is a difference between two perpetuities: To obtain an n-period stream of annual
cash flows of X, you could buy a perpetual cash flow of X and sell a perpetual cash flow of X,
starting in period n+1.

How can we use the law of one price (LOOP) to compute the present value of a constant
annuity?

Answer 2.8:

The law of one price implies value additivity, so that the market price of the annuity equals
the difference between the value of the first perpetuity (cash flows to be received) and that
of the second perpetuity (cash flows to be paid).

X X 1
P = − .
R R (1 + R)n

The first term on the right-hand side is the value of the perpetuity that you buy (cash flows
to be received), while the second term is the value of the perpetuity that you sell (cash flows
to be paid). We can add these two values because we properly discount the value of the
second perpetuity.

2.2.2. Growing (or shrinking) annuities and perpetuities*

We next consider a growing perpetuity with a growth rate G and an initial cash flow X.

Can you generate such a perpetuity using a bank deposit?

Answer 2.9:

The deposited amount has to grow at the rate G. Suppose that the initial deposit is P.

After the first period, you can walk away with a cash flow of

P (1 + R) − P (1 + G) = P (R − G).

After the second period, you get

P (1 + G)(R − G).

And so on...

The first cash flow should equal X. As a consequence, the required initial deposit is given by:

X
P = .
R − G

This is the present value of the growing perpetuity.

So, what if R is smaller than G? Will the present value be negative?

Answer 2.9a:

No. If R is smaller than G, it is simply impossible to use a finite bank deposit in order to
generate the perpetuity because it grows too fast. In this case, the value of the perpetuity is
infinite.

Growing (or shrinking) annuities and perpetuities

Definition: a growing annuity is a stream of periodic cash flows that grow at a rate G for n
periods and then stops. If n is infinite, the stream of cash flows is a growing perpetuity.
Given an initial cash flow X, the present value of a growing annuity is given by:
n
X 1 + G
PV = (1 − ( ) ).
R − G 1 + R

The present value is the product of X with the annuity PV factor.

Can we again derive this result as a consequence of the law of one price (LOOP)?

Answer 2.10:

Yes! The growing annuity is the equivalent of two growing perpetuities, one bought and one
sold. The first cash flow of the perpetuity bought is X. The first cash flow of the perpetuity
sold is
n
Xn = X(1 + G) .

This cash flow equals the period n cash flow of the perpetuity bought. And, with equal
growth rates, the two perpetuities' cash flows will offset each other in any period after
period n.

Given value additivity, the value of the finite annuity is given by the difference:

X Xn 1
− .
n
R − G R − G (1 + R)

Substituting for X yields the above-stated expression for the value of growing annuity.
n

2.2.3. Summary/Economic intuition

Valuation of Perpetuities
The price of a growing perpetuity is given by

X
P = .
R − G

To recall this result, remember the following equation:

P R = P G + X.
The left-hand side of this equation is the profit that an investor must earn in order to break
even on the opportunity cost of tying up capital by buying the perpetuity for a price P. The
equation says that the investor's profit must result from a capital gain and a cash flow: The
capital gain equals PG and the cash flow equals X.

If a growing perpetuity grows too fast, it cannot be replicated based on a finite initial
investment. The value of the perpetuity is infinitely high.

A growth rate G > R is possible, but only during a finite period.