Chapter 4

The Time Value

of Money
Ziwei Wang
Wuhan University
 Apple Inc’s Expenditure on R&D
• In 2016 Apple signi cantly increased R&D
spending, topping $10 billion per year for
the rst time.

• Apple’s R&D expenditures represent

signi cant upfront costs.

• Executives hope these investments will

translate into revenues that will occur many
years or even decades in the future.

• In this chapter, we study how managers

compare costs and bene ts that occur over
many years.

2
fi
fi
fi
fi
Apple Inc’s Expenditure on R&D

Source: Statista 2023

3
The Timeline
• We can represent a stream of cash ows on a timeline, a linear representation
of the timing of the expected cash ows.

• Date 0 represents the present.

• Date n is n years later and represents the end of the n-th year.

4
fl
fl
The Timeline
• A bene t is represented by a positive number, while a cost a negative one.
• The label of the timeline can be adjusted. E.g. we can use “month” as one
unit of time.

• Drawing the timeline whenever possible helps us make correct nancial

decisions and avoid mistakes.

5
fi
fi
 Three Rules of Time Travel
• Rule 1: It is only possible to compare or combine values at the same point in
time.

• A dollar today and a dollar in one year are not equivalent.

• To compare or combine cash ows that occur at di erent points in time, you
rst need to move them to the same point in time.

6
fi
fl
ff
Three Rules of Time Travel
• Rule 2: To move a cash ow forward in time, you must compound it.
• To take a cash ow C forward n periods into the future, we must compound it
by the factor 1 + r to the power n. That is,
n
FVn = C × (1 + r) .

7
fl
fl
Three Rules of Time Travel
• For example, suppose we want to know how much the $1000 is worth in two
years’ time, while the market interest rate is 10%. We convert as:
2
$1000 × (1 + 10%) = $1210.
• The di erence in value between money today and money in the future
represents the time value of money.

• Note that we earn interest on interest, which is known as compound interest.

8
ff
Three Rules of Time Travel

• You’ll be a millionaire in 75 years! ($1,271,895.37)

9
Three Rules of Time Travel
• Rule 3: To move a cash ow back in time, you must discount it.
• To move a cash ow C backward n periods, we must discount it by the factor
1
to the power n. That is,
1+r
C
PV = .
(1 + r) n

10
fl
fl
Applying the Rules of Time Travel
• Suppose we plan to save $1000 today, and $1000 at the end of each of the
next two years.

• If we earn a xed 10% interest rate on our savings, how much will we have
three years from today?

• We start with a timeline:

11
fi
Applying the Rules of Time Travel
• We can think about this problem as if we’re looking at our savings at the end
of each year.

12
Applying the Rules of Time Travel
• Another approach is to compute the future value in year 3 of each cash ow
separately, and then combine them.

13

fl
Valuing a Stream of Cash Flows
• Consider a stream of cash ows: C0 at date 0, C1 at date 1, and so on, up to
CN at date N.
• We represent this cash ow stream on a timeline as follows:

14
fl
fl
Valuing a Stream of Cash Flows
• It is easier to rst compute the present value of each individual cash ows.
• Then, once the cash ows are in dollars today, we combine them.

15
fi
fl
fl
Valuing a Stream of Cash Flows
• Therefore, the standard formula for computing the present value of a stream
of cash ows is
C1 C2 CN
PV = C0 + + + ⋯ + .
(1 + r) (1 + r) 2 (1 + r) N

• This simpli es to
N
Cn
∑ (1 + r)n
PV = .
n=0
n
• To compute the future value of this stream, use FVn = PV × (1 + r) .

16
fl
fi
Calculating the NPV
• Recall that
NPV = PV(bene ts) − PV(costs) .
• But the bene ts are just cash in ows and the costs are just cash out ows.
• This means NPV is the present value of the stream of cash ows of the
investment opportunity

NPV = PV(stream of bene ts and costs) .

fi
fi
17
fi
fl
fl
fl
Calculating the NPV
Problem (Example 4.6 in textbook)

You have been o ered the following investment opportunity: If you invest $1000
ff
today, you will receive $500 at the end of each of the next three years. If you
could otherwise earn 10% per year on your money, should you undertake the
investment opportunity?

18
Perpetuities (永续年⾦)
• A perpetuity is a stream of equal cash ows
that occur at regular intervals and last forever.

• One example is the British government bond

called a consol (or perpetual bond). Consol
bonds promise the owner a xed cash ow
every year, forever.

• As a convention, the rst cash ow arrives at

the end of the rst period:

19
fi
fi
fi
fl
fl
fl
Perpetuities (永续年⾦)
• Using the formula for the present value, we discount each xed payment
separately and sum them up
∞
C C C C
∑ (1 + r)n
PV = + + + ⋯ = .
(1 + r) (1 + r)2 (1 + r)3 n=1

• As long as r > 0, this is a converging series and we have

C
PV(perpetuity) = .
r

20

fi
Perpetuities (永续年⾦)
• Let us verify this equation by considering an example.
• Suppose a perpetuity pays you $5 at the end of each year, and the interest
rate is 5% forever. What is its fair price (i.e. present value)?

• Consider the “do-it-yourself” investment that generates this perpetuity:

• By Law of One Price, the fair price is the cost of this investment: $100.

21
A Perpetuity that Still Pays Interest
• The oldest perpetuities that are still making interest payments were issued in
1624 by the Hoogheemraadschap Lekdijk Bovendams, a water board
composed of landowners and leading citizens that managed dikes, canals,
and a 20-mile stretch of the lower Rhine in Holland called the Lek.

• Two nance professors at Yale University, William Goetzmann and Geert

Rouwenhorst, purchased one of these bonds in July 2003, and collected 26
years of back interest.

• According to its original terms, the bond would pay 5% interest in perpetuity.
(The interest rate was reduced to 3.5% and then 2.5% during the
17th century.)

22
fi
A Perpetuity that Still Pays Interest

23
A Perpetuity that Still Pays Interest
• According the water authority, Yale’s bond is one of ve known to exist.
• “Yale’s bond is an extremely early example of a security that was issued
without maturity and still pays interest. One ought to be astounded that such
a thing exists,” says Rouwenhorst.

• Source: https://news.yale.edu/2015/09/22/living-artifact-dutch-golden-age-
yale-s-367-year-old-water-bond-still-pays-interest

24

fi
Annuities (年⾦)
• An annuity is a stream of N equal cash ows paid at regular intervals.
• The di erence between an annuity and a perpetuity is that an annuity ends
after some xed number of payments.

• Most car loans, mortgages, and some bonds are annuities.

25
ff
fi
fl
Annuities (年⾦)
• Using the formula for the present value again, we discount each xed
payment separately and sum them up
N
C C C C
∑
PV = + + ⋯ + = .
(1 + r) (1 + r) 2 (1 + r)N
n=1
(1 + r)n

• It is easy to simplify this equation to

( (1 + r) )
C 1
PV(annuity) = 1− .
r N

26

fi
Annuities (年⾦)
• Let us again verify this equation by considering an example.
• Suppose an annuity pays you $5 at the end of each year for 20 years, and the
interest rate is 5%. What is its fair price (i.e. present value)?

• Consider the “do-it-yourself” investment that generates this annuity:

$100
By Law of One Price, the fair price is $100 − .
• (1.05)20

27
Growing Perpetuity
• A growing perpetuity is a stream of cash ows that occur at regular intervals
and grow at a constant rate forever.

• We use the convention that the rst payment does not include growth.
• That is, the cash ow in period n undergoes only n − 1 periods of growth.
• The timeline is as below:

28
fl
fi
fl
Growing Perpetuity
• Substituting the cash ows from the preceding timeline into the general
formula for the present value of a cash ow stream gives
2 ∞ n−1
C C(1 + g) C(1 + g) C(1 + g)
∑
PV = + + + ⋯ = .
(1 + r) (1 + r) 2 (1 + r) 3
n=1
(1 + r) n

• This series diverges if g ≥ r. That is, the present value would be in nite.
• If g < r, the series converges to
C
PV(growing perpetuity) = .
r−g

29
fl
fl
fi
Growing Perpetuity
• Let us again consider an example.
• Suppose a perpetuity pays you $3 at the end of rst year, and then starts to
grow by 2% every year. The interest rate is 5%. What is its fair price?

• Consider the “do-it-yourself” investment that generates this perpetuity:

30
fi
Growing Annuity
• A growing annuity is a stream of N growing cash ows, paid at regular
intervals.

• Following our previous convention, the rst cash ow does not grow, which
means the last cash ow re ects only N − 1 periods of growth.

31
fl
fl
fi
fl
fl
Growing Annuity
• Substituting the cash ows from the preceding timeline into the general
formula for the present value of a cash ow stream gives
N−1 N n−1
C C(1 + g) C(1 + g) C(1 + g)
∑ (1 + r)n
PV = + + ⋯ + = .
(1 + r) (1 + r) 2 (1 + r) N
n=1

• Note that it is okay now to have g ≥ r.

• The summation can be simpli ed to

(1+r) )
N

r−g (
C 1+g
PV(growing annuity) = 1− .

32
fl
fi
fl
Growing Annuity
Problem (Example 4.11 in textbook)

Ellen is 35 years old, and she has decided it is time to plan seriously for her
retirement. Although $10,000 is the most she can save at the end of the first year, she expects her salary to
increase each year so that she will be able to increase
her savings by 5% per year. With this plan, if she earns 10% per year on her
savings, how much will Ellen have saved at (the beginning of) age 65?

33