Introduction to Finance

Lecture 4

Blair Robertson
Lecture 4: The Time Value of Money Continued
• Time Value of Money Simplifications (which reduce the #
calculations)
- Perpetuities – we use this a lot in finance to value equity
- Annuities – we use this a lot in finance to value bonds

• Readings: Chapter 5.4 & 5.5

• Textbook Practice Problems: Examples 5.20 – 5.23; 5.26; 5.28

– 5.32

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Simplifications
$$$ $$$ $$$

0 1 2 3
Perpetuity
• A constant stream of cash flows that continues forever
Growing perpetuity
• A stream of cash flows that grows at a constant rate forever
Annuity
• A stream of constant cash flows that lasts for a fixed number
of periods
Growing annuity
• A stream of cash flows that grows at a constant rate for a
fixed number of periods
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Simplifications: Perpetuities

• A constant stream of cash flows that continues forever

$C $C $C

…∞
0 1 2 3

C
PV  T+1

r
T

* Note that the formula values C as of one period prior to the first period, or,
said another way, the cash is assumed to be received one full period hence
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Perpetuity: Example
What is the value of a British consol (a British government
security without a maturity date, i.e. a perpetual stream of
future cash flows) that promises to pay $15 each year forever?
The interest rate is 10-percent.

$15 $15 $15

…
0 1 2 3
PV = ?
C=?
r=?

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Simplifications: Growing Perpetuities
• A stream of cash flows that grows at a constant rate forever

$C $C(1+g) $C(1+g)(1+g)

…∞
0 1 2 3

C
PV  T+1

T
rg
* Note that the formula values C as of one period prior to the first period, or,
said another way, the cash is assumed to be received one full period hence
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Growing Perpetuity: Example
The expected dividend next year is $1.30 and
dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this
promised dividend stream?

$1.30 $1.30×(1.05) $1.30 ×(1.05)2

…
0 1 2 3

PV = ?
c=?
g=?
r=?

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Simplifications: Growing Perpetuity
The expected dividend next year is $1.30 and dividends are
expected to grow at 5% forever
If the discount rate is 10%, what is the value of this promised
dividend stream?
$1.30 $1.30×(1.05) $1.30 ×(1.05)2

…
0 1 2 3
C $1.30
PV  T+1
PV   $26.00
rg .10  .05
T

* Note that the formula values C as of one period prior to the first period, or,
said another way, the cash is assumed to be received one full period hence

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 Annuity
A constant stream of cash flows with a fixed maturity:
C C C C


0 1 2 3 T

C C C C
PV    
(1  r ) (1  r ) (1  r )
2 3
(1  r ) T

C 1 
The formula for the present PV  1  T 
value of an annuity is:
*Note that in the formula C is assumed to be received in one
r  (1  r ) 
full period (e.g., at the end of the first period)
**All our time value of money formulas give the PV one period
before the cash flows start. 9
Annuity: A Note on the “Annuity Factor”

C 1 
PV  1  T 
r  (1  r ) 

1 1 
PV  C   T 
 C  Ar
T

 r r (1  r ) 
A is called the “annuity factor”
*(similar ‘exchange rate’ over time idea as
the discount factor but for annuities, i.e.)

* Note that the formula values C as of one period prior to the first period, or,
said another way, the cash is assumed to be received one full period hence
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Present Value of an Ordinary Annuity
You have just won a lottery and have two options. You can take
$1,000,000 at the end of each year for 25 years or a lump sum of
$10,000,000 today. If the appropriate discount rate is 10%, what
should you do?

$1,000,000  1 
PV  1  25 
 $9,077,040.02
0.10  (1  0.1) 

Take the $10,000,000 today!

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Annuity: Mortgage Example
If you can afford a $4,000 monthly mortgage payment, what
is the size of the mortgage you can afford if the interest rate is
7% (compounded monthly) on a 30 year (360 month) loan?

$4000 $4000 $4000 $4000


0 1 2 3 360

PV = ?
c=?
r=?
T=?

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Annuity: Mortgage Example
To answer this question, we should put everything into monthly
terms. In order to do this, since the 7% mortgage is compounded
monthly, we can simply divide “r” by 12 to get the monthly interest
rate (.07 / 12) = 0.005833 (or 0.5833%).
$4000 $4000 $4000 $4000


0 1 2 3 360

$4000  1 
PV  1 360 
 $601,230.27
.07 / 12  (1  .07 12) 

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Annuity: A Note on Canadian Mortgages
• Two Complicated Features
• Canadian banks quote mortgage rates using semi-annual compounding
but interest is actually calculated (i.e. compounded ) monthly

• The terms of the mortgage are usually renegotiated during the life of
the mortgage. For example, the interest of a 25-year mortgage can be
negotiated 5 years after the initiation of the mortgage.

• For simplicity we will use international convention where

mortgages rates are quoted as APR and compounded
monthly.

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FV of an Annuity
Intuitive Formula (on formula sheet):
FVT  PVAnnuity  (1  r ) T

Complicated Formula (NOT on formula sheet):

1 1   (1  r )T 1 
FVT  PVAnnuity  (1  r )  C  
T
T 
 (1  r )  C 
T
 
 r r (1  r )   r r

 (1  r )T 1 
FV  C   
T
 r r

* Note that the PV Annuity formula values C as of one period prior to the
first period, or, said another way, the cash is assumed to be received one
full period hence
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Annuity Due (Annuity in Advance)
• The perpetuity and annuity formulas assume that the
first payment occurs at the end of the period

• Sometimes payments start immediately

• A level stream of payments starting immediately is

known as an annuity due

PVAnnuityDue  PVAnnuity  (1  r )

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Difference Between Annuity Types

Ordinary Annuity
0 1 2 3

$100 $100 $100

Annuity Due
0 1 2 3

$100 $100 $100 $100

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 Example: Annuity Due
• Your aunt left you the sum of $5,000 a year for ten years with
payments starting immediately. Given an interest rate of 4%,
what is the PV of the inheritance?

$5,000  1 
PV  1  10 
(1  0.04)  $42,176.7
0.04  1  0.04  

PV = ?
c=?
r=?
T=?
C 1 
PV  1 
r  (1  r )T 

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Growing Annuity
A growing stream of cash flows with a fixed maturity:
C C×(1+g) C ×(1+g)2 C×(1+g)T-1


0 1 2 3 T

T 1
C C  (1  g ) C  (1  g )
PV   
(1  r ) (1  r ) 2
(1  r ) T

The formula for the present C  1 g  

T

PV  1    
value of a growing annuity: r  g   1  r  
* Note that the formula values C as of one period prior to the first period, or,
said another way, the cash is assumed to be received one full period hence
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 Growing Annuity: Example
A retirement plan will payout $20,000 at the end of the first
year of your retirement. Annual payments will then increase
by 3% every year for 40 years. What is the present value of
this investment when you retire if the discount rate is 10%?

$20,000 $20,000×(1.03) $20,000×(1.03)39


0 1 2 40
PV = ?
c=?
g=?
r=?
T=?
C   1  g T 
PV  1    
rg   1  r   20
 Growing Annuity: Example
A retirement plan will payout $20,000 at the end of the first
year of your retirement. Annual payments will then increase
by 3% every year for 40 years. What is the present value of
this investment when you retire if the discount rate is 10%?

$20,000 $20,000×(1.03) $20,000×(1.03)39


0 1 2 40
PV = ?
c=?
$20,000   1.03  
40
g=?
r=? PV  1      $265,121.57
T=? .10  .03   1.10  
C   1  g T 
PV  1    
rg   1  r   21
FV of a Growing Annuity

FVT  PVGrowing _ annuity  (1  r ) T

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Notes on Growing Cash Flows
• C is the initial cash flow that occurs in one period’s
time
• The discount rate “r” must be greater than the growth
rate “g” for the growing perpetuity formula

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Delayed Cash Flows
What is the present value of a four-year $100 annuity that makes its
first payment two years from today if the discount rate is 9%?

$100 $100 $100 $100

0 1 2 3 4 5

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Delayed Cash Flows
What is the present value of a four-year $100 annuity that makes
its first payment two years from today if the discount rate is 9%?
C 1 
PV  1 
r  (1  r )T 
You can calculate this using the PV Annuity formula:

PV = ?
c=?
r=?
T=?
$323.97 $100 $100 $100 $100

0 1 2 3 4 5

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Delayed Cash Flows
What is the present value of a four-year $100 annuity that makes
its first payment two years from today if the discount rate is 9%?

$323.97
PV   $297.22
0 1.09

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5

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 Delayed Cash Flows: Example
Your firm is about to make its initial public offering of stock and
your job is to estimate the correct offering price. Forecast
dividends are as follows.
Year: 1 2 3 4
Dividends per $1.50 $1.65 $1.82 5% growth
share thereafter

If investors demand a 10% return on investments of this risk level,

what price will they be willing to pay?

Year 1 2 3 4
0

$1.50 $1.65 $1.8 $1.82*(1.05

2 )
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PV of a Delayed Growing Perpetuity

D3

  2= 1.82
𝑃 =36.40
Year 0 1 2 0.10 −0.05

Cash $1.50 $1.65

flow $36.40

  0 = 1.50 + 1. 65 + 36.40 =32.81

𝑃
(1.10) (1.10)2 (1.10)2

PV of cash flows is
$32.81
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Tips for Solving Time Value of Money Problems

1. Draw a time line that precisely identifies when cash

flows occur
2. Find an anchor – either the present value or future value
of the cash flow stream
3. Make sure that your discount rate matches the
compounding and payment frequencies
– Do not confuse EAR with APR
– Maintain consistency between the interest rate and the
number of periods
4. Be careful: The perpetuity and annuity(1) formulas
assume that the first payment occurs at the end of the
first period
Note (1): The “annuity due” formula adjusts for this.

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Additional Example: More Complicated Cash Flows
• You can value any complicated stream of cash flows by
splitting that stream into separate cash flows, annuities,
and perpetuities

• Example: You are planning to buy a property. You think

that you can sell it in six years for $4,000,000. You also
expect to earn rent of $200,000 per year for the first 3
years and $250,000 per year for the following 3 years. The
interest rate is 8%. How much are would you be willing to
pay for it today?

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Answer
• You are ready to pay the PV of two annuities (one of
200,000 and one of 250,000 but delayed 3 years) plus
the PV of 4M. This is equal to:

$200,000  1 
PV  1  3

0.08  1  0.08 
$250,000  1  1 4,000,000
 1  3

0.08  1  0.08  1  0.08 3
1  0.08 6

PV  $3,547,543.57

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Lecture 4: Knowledge Checks
• You should be able:
 To compare cash flows that occur at different points in
time
 To determine economically equivalent future values
from values that occur in previous periods through
compounding
 To determine economically equivalent present values
from cash flows that occur in the future through
discounting
 To find present value of perpetuities and growing
perpetuities
 To find present value and future values of annuities
and growing annuities
• Readings: Chapter 5.4 & 5.5
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