Corporate Finance: Fifth Edition

Corporate Finance (1 of 2)
Fifth Edition
Chapter 4
The Time Value of Money
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Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Chapter Outline (1 of 2)
4.1 The Timeline

4.2 The Three Rules of Time Travel
4.3 Valuing a Stream of Cash Flows
4.4 Calculating the Net Present Value
4.5 Perpetuities and Annuities
Chapter Outline (2 of 2)
4.6 Using an Annuity Spreadsheet or Calculator

4.7 Non-Annual Cash Flows
4.8 Solving for the Cash Payments
4.9 The Internal Rate of Return
Learning Objectives (1 of 4)
• Draw a timeline illustrating a given set of cash flows.

• List and define three rules of time travel.
• Calculate the future value of the following:
– A single sum
– An uneven stream of cash flows, starting either now or
sometime in the future
– An annuity, starting either now or sometime in the
future
– Several cash flows occurring at regular intervals, which
grow at a constant rate each period
• Calculate the present value of the following

– A single sum
– An uneven stream of cash flows, starting either now or
sometime in the future
– An infinite stream of identical cash flows
– An annuity, starting either now or sometime in the
future
– An infinite stream of cash flows that grow at a constant
rate each period
– Several cash flows occurring at regular intervals, which
grow at a constant rate each period
• Given four out of the following five inputs for an annuity,

compute the fifth: (a) present value, (b) future value, (c)
number of periods, (d) periodic interest rate, (e) periodic
payment.
• Given three out of the following four inputs for a single
sum, compute the fourth: (a) present value, (b) future
value, (c) number of periods, (d) periodic interest rate.
• Given cash flows and present or future value, compute the

internal rate of return for a series of cash flows.
4.1 The Timeline (1 of 4)
• A timeline is a linear representation of the timing of

potential cash flows.
• Drawing a timeline of the cash flows will help you visualize
the financial problem.
• Assume that you made a loan to a friend. You will be

repaid in two payments, one at the end of each year over
the next two years.
• Differentiate between two types of cash flows

– Inflows are positive cash flows.
– Outflows are negative cash flows, which are indicated
with a − (minus) sign.
• Assume that you are lending $10,000 today and that the
loan will be repaid in two annual $6,000 payments.
• The first cash flow at date 0 (today) is represented as a

negative sum because it is an outflow.
• Timelines can represent cash flows that take place at the
end of any time period—a month, a week, a day, etc.
Textbook Example 4.1 (1 of 2)
Constructing a Timeline
• Problem
– Suppose you must pay tuition of $10,000 per year for
the next two years. Your tuition payments must be
made in equal installments at the start of each
semester. What is the timeline of your tuition
payments?
Solution
• Assuming today is the start of the first semester, your first
payment occurs at date 0 (today). The remaining
payments occur at semester intervals. Using one semester
as the period length, we can construct a timeline as
follows:
Alternative Example 4.1 (1 of 2)
Problem
Suppose you can purchase a three-year bond with a $1,000
face value and a coupon rate of 4.5%, paid semi-annually.
Draw a timeline for the cash inflows of the bond.
Solution
4.2 The Three Rules of Time Travel
• Financial decisions often require combining cash flows or

comparing values. Three rules govern these processes.
Table 4.1 The Three Rules of Time Travel
Only values at the same point

Rule1 in time can be compared or blank
combined
Rule2 To move a cash flow forward in Future value of a Cash flow
time, you must compound it. FVn  C  (1  r ) n
Rule3 To move a cash flow backward Present value of a Cash flow
in time, you must discount it. PV  C  (1  r )n 
C
(1+ r ) n
Rule 1: Comparing and Combining
Values
• A dollar today and a dollar in one year are not equivalent.
• It is only possible to compare or combine values at the
same point in time.
– Which would you prefer: A gift of $1,000 today or
$1,210 at a later date?
– To answer this, you will have to compare the
alternatives to decide which is worth more. One factor
to consider: How long is “later?”
Rule 2: Moving Cash Flows Forward in
Time (1 of 2)
• To move a cash flow forward in time, you must compound
it.
– Suppose you have a choice between receiving $1,000
today or $1,210 in two years. You believe you can earn
10% on the $1,000 today but want to know what the
$1,000 will be worth in two years.
Rule 2: Moving Cash Flows Forward in
Time (2 of 2)
• Future Value of a Cash Flow
FVn = C × (1 + r ) × (1 + r ) ×L ×(1 + r ) = C × (1 + r )n (4.1)
Using a Financial Calculator: The
Basics (1 of 2)
• H P 10 BI I
– Future Value FV
‒ Present Value PV
‒ I/Y I/Y
 Interest Rate per Year

 Interest is entered as a percent, not a decimal
– For 10%, enter 10, NOT . 10
Using a Financial Calculator: The
Basics (2 of 2)
• HP 10BII
– Number of Periods
– Periods per Year
– Gold → C All
 Clears out all TVM registers

 Should do between all problems
Using a Financial Calculator: Setting
the Keys
• HP 10BII
– Gold → C All (Hold down [C] button)
 Check P/YR
– # → Gold → P/YR
 Sets Periods per Year to #
– Gold → DI S P → #
 Gold and [=] button
 Sets display to # decimal places
Using a Financial Calculator
• HP 10B II
– Cash flows moving in opposite directions must have
opposite signs.
Financial Calculator Solution
• Inputs:
– N=2
– I = 10
– PV = 1,000
• Output:
– FV = −1,210
Figure 4.1 The Composition of Interest
over Time
The Power of Compounding

• Problem
– Suppose you invest $1,000 in an account paying 10%
interest per year. How much will you have in the
account in seven years? In 20 years ? In 75 years?
Solution
• You can apply Eq. 4.1 to calculate the future value in each case
$1000 ×  1.10  = $1948.72

7
7 years :
$1000 ×  1.10 
20
20 years : = $6727.50
$1000 ×  1.10 
75
75years : = $1, 271,895.37
– Note that at 10% interest, your money will nearly double in

7years. After 20 years, it will increase almost sevenfold. And
if you invest for 75 years, you will be a millionaire!
Textbook Example 4.2: Financial
Calculator Solution for N = 7 years
• Inputs:
– N=7
– I = 10
– P V = 1,000
• Output:
– F V = −1,948.72
• Problem
– Suppose you have a choice between receiving $5,000
today or $10,000 in five years. You believe you can
earn 10% on the $5,000 today, but want to know what
the $5,000 will be worth in five years.
• Solution
– The time line looks like this:
– In five years, the $5,000 will grow to:

$5000 ×  1.10  = $8053
5
– The future value of $5,000 at 10% for five years

is $8,053.
– You would be better off forgoing the gift of $5,000 today
and taking the $10,000 in five years.
Alternative Example 4.2: Financial
Calculator Solution
• Inputs:
– N=5
– I = 10
– P V = 5,000
• Output:
– F V = −8,052.55
Rule 3: Moving Cash Flows Back in
Time
• To move a cash flow backward in time, we must discount
it.
• Present Value of a Cash Flow
C
PV = C ÷ (1 + r )n =
(1 + r )n
Present Value of a Single Future Cash Flow

• Problem
– You are considering investing in a savings bond that
will pay $15,000 in 10 years. If the competitive
– market interest rate is fixed at 6% per year, what is the
bond worth today?
Solution
• The cash flows for this bond are represented by the following
timeline:
• Thus, the bond is worth $15,000 in 10 years. To determine the

value today, we compute the present value:
15, 000
PV = 10
= $8375.92 today
1.06
• The bond is worth much less today than its final payoff because
of the time value of money.
Calculator Solution
• Inputs:
– N = 10
– I=6
– F V = 15,000
• Output:
– P V = −8,375.92
• Problem
– Suppose you are offered an investment that pays
$10,000 in five years. If you expect to earn a 10%
return, what is the value of this investment today?
• Solution
– The $10,000 is worth:
 $10, 000 ÷  1.105  = $6209
Calculator Solution
• Inputs:
– N=5
– I = 10
– F V = 10,000
• Output:
– P V = −6,209.21
Applying the Rules of Time Travel
(1 of 5)
• Recall the first rule: It is only possible to compare or
combine values at the same point in time. So far we’ve
only looked at comparing.
– Suppose we plan to save $1,000 today, and $1,000 at
the end of each of the next two years. If we can earn a
fixed 10% interest rate on our savings, how much will
we have three years from today?
(2 of 5)
• The time line would look like this:
(3 of 5)
(4 of 5)
(5 of 5)
Table 4.1 The Three Rules of Time
Travel
Only values at the same point in

Rule1 time can be compared or blank
combined.
Rule2 To move a cash flow forward in Future Value of a Cash Flow
time, you must compound it. FVn = C × (1 + r ) n
Rule3 To move a cash flow backward in Present Value of a Cash Flow

time, you must discount it. C
PV = C ÷ (1 + r ) n =
(1 + r ) n
Computing the Future Value

• Problem
– Let’s revisit the savings plan we considered earlier: we
plan to save $1,000 today and at the end of each of the
next two years. At a fixed 10% interest rate, how much
will we have in the bank three years from today?
Solution
• Let’s solve this problem in a different way than we did earlier.

First, compute the present value of the cash flows. There are
several ways to perform this calculation. Here we treat each
cash flow separately and then combine the present values.
• Saving $2,735.54 today is equivalent to saving $1,000 per

year for three years. Now let’s compute its future value in
year 3:
• This answer of $3,641 is precisely the same result we

found earlier. As long as we apply the three rules of time
travel, we will always get the correct answer.
Calculator Solution
• Problem
– Assume that an investment will pay you $5,000 now
and $10,000 in five years.
– The timeline would like this:
0 1 2 3 4 5
$5,000 $10,000
• Solution
– You can calculate the present value of the combined
cash flows by adding their values today.
– The present value of both cash flows is $11,209.
0 1 2 3 4 5
$5,000
$6,209 $10,000
÷ 1.105
$11,209
‒ The present value of both cash flows is $11,209.
• Solution
– You can calculate the future value of the combined
cash flows by adding their values
in Year 5.
0 1 2 3 4 5
$10,000
$5,000 x 1.105 $8,053
$18,053
– The future value of both cash flows is $18,053.
• Solution
Present
Value
0 1 2 3 4 5
$11,209 $18,053
÷ 1.105
Future
Value
0 1 2 3 4 5
$11,209 $18,053
x 1.105
(1 of 2)
• Based on the first rule of time travel we can derive a
general formula for valuing a stream of cash flows: if we
want to find the present value of a stream of cash flows,
we simply add up the present values of each.
(2 of 2)
• Present Value of a Cash Flow Stream

N N
Cn
PV =  PV  Cn  = 
1+ r
n
n =0 n =0
Present Value of a Stream of Cash Flows

• Problem
– You have just graduated and need money to buy a new
car. Your rich uncle Henry will lend you the money so
long as you agree to pay back within four years, and
you offer to pay him the rate of interest that he would
otherwise get by putting his money in a savings
account. Based on your earnings and living expenses,
you think you will be able to pay him $5,000 in one
year, and then $8000 each year for the next three
years. If uncle Henry would otherwise earn 6% per
year on his savings, how much can you borrow from
him? Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Solution
• The cash flows you can promise Uncle Henry are as follows:
• How much money should Uncle Henry be willing to give you today in
return for your promise of these payments? He should be willing to
give you an amount that is equivalent to these payments in present
value terms. This is the amount of money that it would take him to
produce these same cash flows, which we calculate as follows:
5000 8000 8000 8000
PV = + + +
1.06 1.062 1.063 1.064
= 4716.98+7119.97+6716.95+6336.75
= 24,890.65
• Thus, Uncle Henry should be willing to lend you $24,890.65 in

exchange for your promised payments. This amount is less than
the total you will pay him ($5,000 + $8,000 + $8,000 + $8,000 =
$29,000) due to the time value of money.
• Let’s verify our answer. If your uncle kept his $24,890.65 in the
bank today earning 6% interest, in four years he would have
FV = $24,890.65 ×  1.06  = $31, 423.87 in four years

4
• Now suppose that Uncle Henry gives you the money, and then
deposits your payments to him in the bank each year. How
much will he have four years from now? We need to compute
the future value of the annual deposits. One way to do so is to
compute the bank balance each year:
• We get the same answer both ways (within a penny, which

is because of rounding).
Calculator Solution
• Problem
– What is the future value in three years of the following
cash flows if the compounding rate is 5%?
0 1 2 3
$2,000 $2,000 $2,000
• Solution
0 1 2 3
$2,000 $2,315
x 1.05 x 1.05 x 1.05
$2,000 $2,205
x 1.05 x 1.05
$2,000 $2,100
x 1.05
$6,620
Or
0 1 2 3
$2,000 $2,000 $2,000

x 1.05
$2,100
$4,100
x 1.05
$4,305
$6,305
$6,620
x 1.05
Future Value of Cash Flow Stream
• Future Value of a Cash Flow Stream with a Present Value

of PV
FVn = PV × (1 + r ) n
4.4 Calculating the Net Present Value
• Calculating the NP V of future cash flows allows us to

evaluate an investment decision.
• Net Present Value compares the present value of cash
inflows (benefits) to the present value of cash outflows
(costs).
Net Present Value of an Investment Opportunity

• Problem
– You have been offered the following investment
opportunity: if you invest $1,000 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?
Solution
• As always, we start with a timeline. We denote the upfront
investment as a negative cash flow (because it is money
we need to spend) and the money we receive as a positive
cash flow.
• To decide whether we should accept this opportunity, we

compute the NPV by computing the present value of the
stream:
500 500 500
NPV = 1000 + + 2
+ 3
= $243.43
1.10 1.10 1.10
• Because the NPV is positive, the benefits exceed the costs

and we should make the investment. Indeed, the NPV tells
us that taking this opportunity is like getting an extra
$243.43 that you can spend today. To illustrate, suppose
you borrow $1,000 to invest in the opportunity and an extra
$243.43 to spend today. How much would you owe on the
$1,243.43 loan in three years? At 10% interest, the amount
you would owe would be
FV =  $1000 + $243.43 ×  1.10  = $1655 in three years

3
• At the same time, the investment opportunity generates

cash flows. If you put these cash flows into a bank
account, how much will you have saved three years from
now? The future value of the savings is
 
FV = $500 ×1.102 +  $500 ×1.10  + $500 = $1655 in three years
• As you see, you can use your bank savings to repay the
loan. Taking the opportunity therefore allows you to spend
$243.43 today at no extra cost.
Calculator Solution
• Problem
– Would you be willing to pay $5,000 for the following
stream of cash flows if the discount rate is 7%?
• Solution
– The present value of the benefits is:
3000 2000 1000

+ + = 5366.91
 1.05  1.05  1.05
2 3
– The present value of the cost is $5000, because it

occurs now.
– The NPV = PV (benefits) − PV (cost)
= 5,366.91 − 5,000 = 366.91
Calculator Solution
• On a present value basis, the
benefits exceed the costs by
$366.91.
4.5 Perpetuities and Annuities (1 of 2)
• Perpetuities
– When a constant cash flow will occur at regular
intervals forever it is called a perpetuity.
4.5 Perpetuities and Annuities (2 of 2)
• The value of a perpetuity is simply the cash flow divided by

the interest rate.
• Present Value of a Perpetuity
C
PV (C in perpetuity) =
r
Endowing a Perpetuity
• Problem
– You want to endow an annual M BA graduation party at
your alma mater. You want the event to be a
memorable one, so you budget $30,000 per year
forever for the party. If the university earns 8% per year
on its investments, and if the first party is in one year’s
time, how much will you need to donate to endow the
party?
Solution
• The timeline of the cash flows you want to provide is
• This is a standard perpetuity of $30,000 per year. The funding you

would need to give the university in perpetuity is the present value of
this cash flow stream. From the formula,
$30, 000
PV = C / r = = $375, 000 today
0.08
• If you donate $375,000 today, and if the university invests it at 8% per
year forever, then the M BA s will have $30,000 every year for their
graduation party.
• Problem
– You want to endow a chair for a female professor of
finance at your alma mater. You’d like to attract a
prestigious faculty member, so you’d like the
endowment to add $100,000 per year to the faculty
member’s resources (salary, travel, databases, etc.). If
you expect to earn a rate of return of 4% annually on
the endowment, how much will you need to donate to
fund the chair?
• Solution
– The timeline of the cash flows looks like this:
– This is a perpetuity of $100,000 per year. The funding you

would need to give is the present value of that perpetuity.
From the formula:
C $100, 000
PV = = = $2,500, 000
r .04
– You would need to donate $2.5 million to endow the chair.
4.5 Perpetuities and Annuities
• Annuities
– When a constant cash flow will occur at regular
intervals for a finite number of N periods, it is called an
annuity.
– Present Value of an Annuity

N
C C C C C
PV   
(1+r ) (1+r ) 2 (1+r )3
    
(1+r ) N n =1 (1+r ) n
Present Value of an Annuity (1 of 3)
• To find a simpler formula, suppose you invest $100 in a

bank account paying 5% interest. As with the perpetuity,
suppose you withdraw the interest each year. Instead of
leaving the $100 in forever, you close the account and
withdraw the principal in 20 years.
• You have created a 20-year annuity of $5 per year, plus

you will receive your $100 back in 20 years. So
$100 = PV(20  year annuity of $5 per year) + PV($100in 20 years)
• Re-arranging terms
PV(20  year annuity of $5 per year) = $100  PV($100 in 20 years)

100
= 100  20
= $62.31
(1.05)
• For the general formula, substitute P for the principal value

and
PV (annuity of C for N periods)

= P  PV ( P in period N )
P  1 
= P N
= P 1  N 
(1 + r )  (1 + r ) 
Present Value of a Lottery Prize Annuity

• Problem
– You are the lucky winner of the $30 million state lottery.
You can take your prize money either as (a) 30
payments of $1 million per year (starting today), or (b)
$15 million paid today. If the interest rate is 8%, which
option should you take?
Solution
• Option (a) provides $30 million of prize money but paid annually. In
this case, the cash flows are an annuity in which the first payment
begins immediately, sometimes called an annuity due.
• Because the first payment is paid today, the last payment will occur in
29 years (for a total of 30 payments). We can compute the present
value of the final 29 payments as a standard annuity of $1 million per
year using the annuity formula:
 million  1  1 
PV  29 yr annuity of $1  = $1 million × 1 
 yr  .08  1.0829 
= $11.16 million today
• Adding the $1 million we receive upfront, this option has a present

value of $12.16 million:
• Adding the $1 million we receive upfront, this option has a present value of
$12.16 million:
• Therefore, the present value of option (a) is only $12.16 million, and so it is
more valuable to take option (b) and receive $15 million upfront—even though
we receive only half the total cash amount. The difference, of course, is due to
the time value of money. To see that (b) really is better, if you have the $15
million today, you can use $1 million immediately and invest the remaining $14
million at an 8% interest rate. This strategy will give you $14 million × 8% =
$1.12 million per year in perpetuity! Alternatively, you can spend $15 million −
$11.16 million = $3.84 million today, and invest the remaining $11.16 million,
which will still allow you to withdraw $1 million each year for the next 29 years
before your account is depleted.
Calculator Solution (1 of 2)
• Since the payments begin today, this is an Annuity Due.
– First,
– Then
 $15 million > $12.16 million, so take the lump sum.
Future Value of an Annuity
• Future Value of an Annuity
FV (annuity) = PV × (1 + r ) N
C  1 
=  1  N 
× (1 + r ) N
r  (1 + r ) 
1

= C × (1 + r ) N  1
r

Retirement Savings Plan Annuity

• Problem
– Ellen is 35 years old, and she has decided it is time to
plan seriously for her retirement. At the end of each
year until she is 65, she will save $10,000 in a
retirement account. If the account earns 10% per year,
how much will Ellen have saved at age 65?
Solution
• As always, we begin with a timeline. In this case, it is helpful to
keep track of both the dates and Ellen’s age:
• Ellen’s savings plan looks like an annuity of $10,000 per year for
30 years. (Hint: It is easy to become confused when you just
look at age, rather than at both dates and age. A common error
is to think there are only 65 − 36 = 29 payments. Writing down
both dates and age avoids this problem.)
Solution
• To determine the amount Ellen will have in the bank at age
65, we compute the future value of this annuity:
1
FV = $10, 000 ×
0.10
1.1030  1 
= $10, 000 ×164.49
= $1.645 million at age 65
• Since the payments begin in one year, this is an Ordinary
Annuity.
– Be sure to put the calculator back on “End” mode:
– Then
Growing Cash Flows (1 of 2)
• Growing Perpetuity
– Assume you expect the amount of your perpetual
payment to increase at a constant rate, g.
• Present Value of a Growing Perpetuity
C
PV (growing perpetuity) =
rg
Endowing a Growing Perpetuity

Problem
In example 4.7, you planned to donate money to your alma mater to fund
an annual $30,000 MBA graduation party. Given an interest rate of 8%
per year , the required donation was the present value of
$30, 000
PV = = $375, 000 today
0.08
Before accepting the money, however, the M BA student association has
asked that you increase the donation to account for the effect of inflation
on the cost of the party in future years. Although $30,000 is adequate for
next year’s party, the students estimate that the party’s cost will rise by
4% per year thereafter. To satisfy their request, how much do you need
to donate now?
Solution
The cost of the party next year is $30,000, and the cost then
increases 4% per year forever. From the timeline, we
recognize the form of a growing perpetuity. To finance the
growing cost, you need to provide the present value today of
$30, 000
PV   $750, 000 today
0.08  0.04
You need to double the size of your gift!
• Problem
– In Alternative Example 4.7, you planned to donate
money to endow a chair at your alma mater to
supplement the salary of a qualified individual by
$100,000 per year. Given an interest rate of 4% per
year, the required donation was $2.5 million. The
university has asked you to increase the donation to
account for the effect of inflation, which is expected to
be 2% per year. How much will you need to donate to
satisfy that request?
Solution
The timeline of the cash flows looks like this:
The cost of the endowment will start at $100,000, and increase by

2% each year. This is a growing perpetuity. From the formula:
C $100,000
PV = = =$5,000,000
r 0.04  0.02
You would need to donate $5.0 million to endow the chair.
Growing Cash Flows (2 of 2)
• Growing Annuity
– The present value of a growing annuity with the initial
cash flow c, growth rate g, and interest rate r is defined
as:
– Present Value of a Growing Annuity
1   1+ g  
N
PV = C × 1    
(r  g )   (1 + r )  
 
Retirement Savings with a Growing Annuity

• Problem
– In Example 4.9, Ellen considered saving $10,000 per
year for her retirement. Although $10,000 is the most
she can save in the first year, she expects her salary to
increase each year so that she will 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 age 65?
Solution
• Her new savings plan is represented by the following timeline:
• This example involves a 30-year growing annuity, with a growth

rate of 5%, and an initial cash flow of $10,000. The present
value of this growing annuity is given by
1   1.05 30 
PV = $10, 000 × 1   
0.10  0.05   1.10  
= $10, 000 ×15.0463
= $150, 463 today
• Ellen’s proposed savings plan is equivalent to having

$150,463 in the bank today. To determine the amount she
will have at age 65, we need to move this amount forward
30 years:
FV = $150, 463×1.1030
= $2.625 million in 30 years
• Ellen will have saved $2.625 million at age 65 using the

new savings plan. This sum is almost $1 million more than
she had without the additional annual increases in savings.
• Problem
– You want to begin saving for your retirement. You plan
to contribute $12,000 to the account at the end of this
year. You anticipate you will be able to increase your
annual contributions by 3% each year for the next 45
years. If your expected annual return is 8%, how much
do you expect to have in your retirement account when
you retire in 45 years?
• Solution
– The present value of the series of deposits is:
1  1 + .03  
45
PV = $12, 000 × 1     = $211,567

.08  .03  1 + .08  
–The future value of the series of deposits is:
FV = $211,567 × (1.08) 45 = $6, 753,314
4.6 Using an Annuity Spreadsheet or
Calculator
• Spreadsheets simplify the calculations of T V M problems
– N PE R
– RAT E
– PV
– PM T
– FV
• These functions all solve the problem:
1  1  FV
NPV = PV + PMT ×  1  NPER 
+ NPER
=0
RATE  (1 + RATE )  (1 + RATE )
Computing the Future Value in Excel

• Problem
– Suppose you plan to invest $20,000 in an account
paying 8% interest. How much will you have in the
account in 15 years?
Solution
• We represent this problem with the following timeline:
Solution
• To compute the solution, we enter the four variables we
know (N P E R = 15, R A T E = 8%, P V = −20,000, P M T = 0)
and solve for the one we want to determine (F V ) using the
Excel function F V(R A T E, N P E R, P M T, P V ). The
spreadsheet here calculates a future value of $63,443.
Blank N PE R RATE PV PM T FV Excel Formula

Given 15 8.00% −20,000 0 Blank Blank
Solve for F Blank Blank Blank Blank = FV (0.08,15,0,
V 63,443
−20000)
• Note that we entered P V as a negative number (the

amount we are putting into the bank), and F V is shown as
a positive number (the amount we can take out of the
bank). It is important to use signs correctly to indicate the
direction in which the money is flowing when using the
spreadsheet functions.
• To check the result, we can solve this problem directly:
FV = $20, 000 ×1.0815 = $63, 443
Using the Annuity Spreadsheet

• Problem
– Suppose that you invest $20,000 in an account paying
8% interest. You plan to withdraw $2,000 at the end of
each year for 15 years. How much money will be left in
the account after 15 years?
Solution
• Again, we start with the timeline showing our initial deposit
and subsequent withdrawals:
Solution
• Note that P V is negative (money into the bank), while P M
T is positive (money out of the bank). We solve for the
final balance in the account, F V, using the annuity
spreadsheet:
N PE
Blank RATE PV PM T FV Excel Formula
R
Given 15 8.00% −20,000 2,000 Blank Blank
Solve for FV Blank Blank Blank Blank = FV(0.08,15,2000,
9139
−20000)
We will have $9,139 left in the bank after 15 years.

• We can also compute this solution directly. One approach is to
think of the deposit and the withdrawals as being separate
accounts. In the account with the $20,000 deposit, our savings
will grow to $63,443 in 15 years, as we computed in Example
4.12. Using the formula for the future value of an annuity, if we
borrow $2,000 per year for 15 years at 8%, at the end our debt
will have grown to
1
$2000 ×
0.08

1.0815  1 = $54,304 
• After paying off our debt, we will have $63,443 − $54,304 =
$9,139 remaining after 15 years.
4.7 Non-Annual Cash Flows
• The same time value of money concepts apply if the cash

flows occur at intervals other than annually.
• The interest and number of periods must be adjusted to
reflect the new time period.
Evaluating an annuity with monthly cash flows

• Problem
– You are about to purchase a new car and have two
options to pay for it. You can pay $20,000 in cash
immediately, or you can get a loan that requires you to
pay $500 each month for the next 48 months (four
years). If the monthly interest rate you earn on your
cash is 0.5%, which option should you take?
Solution
• Let’s start by writing down the timeline of the loan
payments:
• The timeline shows that the loan is a 48-period annuity.

Using the annuity formula the present value is
1  1 
PV  48  period annuity of $500  = $500 × 1 
0.005  1.00548 
= $21, 290
• Alternatively, we may use the annuity spreadsheet to solve

the problem:
Given 48 0.50% Blank 500 0 Blank

Solve for PV Blank Blank (21,290) Blank Blank = PV(0.005,48,500,0)
• Thus, taking the loan is equivalent to paying $21,290

today, which is costlier than paying cash. You should pay
cash for the car.
(1 of 2)
• Sometimes we know the present value or future value, but
we do not know one of the variables we have previously
been given as an input.
(2 of 2)
• For example, when you take out a loan you may know the
amount you would like to borrow but may not know the
loan payments that will be required to repay it.
Loan or Annuity Payment
P
C=
1 1 
1  
r  1+ r N 
 
Computing a Loan Payment

• Problem
– Your biotech firm plans to buy a new DNA sequencer
for $500,000. the seller requires that you pay 20% of
the purchase price as a down payments, but is willing
to finance the remainder by offering a 48-month loan
with equal monthly payments and an interest rate of
0.5% per month. What is the monthly loan payment?
Solution
• Given a down payment of 20% × $500,000 = $100,000,
your loan amount is $400,000. We start with the timeline
(from the seller’s perspective), where each period
represents one month:
• Using Eq. 4.14, we can solve for the loan payment, C, as

follows:
P 4000, 000
C= =
1 1  1  1 
1   1  
r  1+ r  N  0.005   1.005  
48
   
= $9394
• Using the annuity spreadsheet:
Given 48 0.50% −400,000 Blank 0 Blank

Solve for PMT Blank Blank Blank 9,394 Blank = PMT (0.005,48,
−400000,0)
• Your firm will need to pay $9,394 each month to repay the
loan.
• Problem
– You have just graduated and landed your dream job
with a nice salary. To reward yourself, you decide to
purchase a luxury automobile at a cost of $60,000. The
manufacturer is offering a special deal on financing: $0
down and 60 monthly payments with an annual interest
rate of 3%. What are the monthly payments?
• Solution
12 Gold P/YR
4.9 The Internal Rate of Return
• In some situations, you know the present value and cash

flows of an investment opportunity, but you do not know
the internal rate of return (I R R), the interest rate that
sets the net present value of the cash flows equal to zero.
Textbook Example 4.16 (1 of 2 )
Computing the I RR for a Perpetuity

• Problem
– Jessica has just graduated with her MB A. Rather than
take the job she was offered at a prestigious
investment bank—Baker, Bellingham, and Botts—she
has decided to go into business for herself. She
believes that her business will require an initial
investment of $1 million. after that, it will generate a
cash flow of $100,000 at the end of one year, and this
amount will grow by 4% per year thereafter. What is the
I RR of this investment opportunity?
Solution
The timeline is
The timeline shows that the future cash flows are a growing perpetuity with a
growth rate of 4%. Recall from Eq. 4.11 that the PV of a growing perpetuity is
C
. Thus, the NPV of this investment would equal zero if
(r - g )
1000, 000
1, 000, 000 =
r - 0.04
We can solve this equation for r
1000, 000
r= + 0.04 = 0.14
1, 000, 000
So, the IRR on this investment is 14%.

Computing the Internal Rate of return for an Annuity

• Problem
– Baker, Bellingham, and Botts, was so impressed with
Jessica that it has decided to fund her business. In
return for providing the initial capital of $1 million,
Jessica has agreed to pay them $125,000 at the end of
each year for the next 30 years. What is the internal
rate of return on Baker, Bellingham, and Botts’s
investment in Jessica’s company, assuming she fulfills
her commitment?
Solution
• Here is the timeline (from Baker, Bellingham, and Botts’s
perspective):
• The timeline shows that the future cash flows are a 30-
year annuity. Setting the NPV equal to zero requires
1 1 
1, 000, 000 = 125,× 1  
r  1+ r 
30
 
• Using the annuity spreadsheet to solve for r,
Given 30 blank −1,000,000 125,000 0 blank

Solve for Rate blank blan = RATE(30,125000 ,
12.09% blank blank
k −1000000,0)
• The I RR on this investment is 12.09%. In this case, we can

interpret the I RR of 12.09% as the effective interest rate of
the loan.
Corporate Finance (2 of 2)
Fifth Edition
Chapter 4
Appendix
Slide in this Presentation Contain Hyperlinks. JAWS users

should be able to get a list of links by using INSERT+F7
Appendix: Solving for the Number of
Periods
• In addition to solving for cash flows or the interest rate, we
can solve for the amount of time it will take a sum of
money to grow to a known value.
Textbook Example 4A.1 (1 of 3)
Solving for the number of periods in a savings plan

• Problem
– You are saving for a down payment on a house. You
have $10,050 saved already ,and you can afford to save
an additional $5,000 per year at the end of each year. If
you earn 7.25% per year on your savings, how long will it
take you to save $60,000?
Solution
• The timeline for this problem is
• We need to find N so that the future value of our current savings plus the
future value of our planned additional savings (which is an annuity) equals our
desired amount:
1
10, 050 ×1.0725 N + 5000 ×
0.0725
 
1.0725 N  1 = 60, 000
• To solve mathematically, rearrange the equation to

60, 000 × 0.0725 + 5000
1.0725 N = = 1.632
10, 050 × 0.0725 + 5000
• We can then solve for N:

In  1.632 
N  7.0 years
In  1.0725 
• It will take seven years to save the down payment. We can

also solve this problem using the annuity spreadsheet:
Given Blank 7.25% −10,050 −5,000 60,000 Blank
Solve for N = NPER(0.0725,
7.00 blank blank blank Blank
−5000, −10050,60000)
Discussion of Data Case Key Topic
• Would your answer change if the certification job would

require her to stay in Seattle but an MBA would allow her
to move to New York City, where Natasha has always
wanted to live?
– Hint: Consider the cost of living differences between
Seattle and New York. Would her salary be different in
Seattle versus New York?
– cgi.money.cnn.com
Chapter Quiz
1. Can you compare or combine cash flows at different times?

2. How do you calculate the present value of a cash flow stream?
3. What benefit does a firm receive when it accepts a project with
a positive NPV ?
4. How do you calculate the present value of a
– Perpetuity?
– Annuity?
– Growing perpetuity?
– Growing annuity?
Copyright
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any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

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Corporate Finance (1 of 2)

Slide in this Presentation Contain Hyperlinks. JAWS users

4.1 The Timeline

4.6 Using an Annuity Spreadsheet or Calculator

• Draw a timeline illustrating a given set of cash flows.

• Calculate the present value of the following

• Given four out of the following five inputs for an annuity,

• Given cash flows and present or future value, compute the

• A timeline is a linear representation of the timing of

• Assume that you made a loan to a friend. You will be

• Differentiate between two types of cash flows

• The first cash flow at date 0 (today) is represented as a

• Financial decisions often require combining cash flows or

Table 4.1 The Three Rules of Time Travel

Only values at the same point

• Future Value of a Cash Flow

FVn = C × (1 + r ) × (1 + r ) ×L ×(1 + r ) = C × (1 + r )n (4.1)

 Interest Rate per Year

– Periods per Year

 Clears out all TVM registers

The Power of Compounding

$1000 ×  1.10  = $1948.72

– Note that at 10% interest, your money will nearly double in

– In five years, the $5,000 will grow to:

– The future value of $5,000 at 10% for five years

Present Value of a Single Future Cash Flow

• Thus, the bond is worth $15,000 in 10 years. To determine the

 $10, 000 ÷  1.105  = $6209

Only values at the same point in

Rule3 To move a cash flow backward in Present Value of a Cash Flow

Computing the Future Value

• Let’s solve this problem in a different way than we did earlier.

• Saving $2,735.54 today is equivalent to saving $1,000 per

• This answer of $3,641 is precisely the same result we

‒ The present value of both cash flows is $11,209.

– The future value of both cash flows is $18,053.

• Present Value of a Cash Flow Stream

Present Value of a Stream of Cash Flows

• Thus, Uncle Henry should be willing to lend you $24,890.65 in

FV = $24,890.65 ×  1.06  = $31, 423.87 in four years

• We get the same answer both ways (within a penny, which

$2,000 $2,000 $2,000

$2,000 $2,000 $2,000

• Future Value of a Cash Flow Stream with a Present Value

• Calculating the NP V of future cash flows allows us to

Net Present Value of an Investment Opportunity

• To decide whether we should accept this opportunity, we

• Because the NPV is positive, the benefits exceed the costs

FV =  $1000 + $243.43 ×  1.10  = $1655 in three years

• At the same time, the investment opportunity generates

3000 2000 1000

– The present value of the cost is $5000, because it

• The value of a perpetuity is simply the cash flow divided by

• This is a standard perpetuity of $30,000 per year. The funding you

– This is a perpetuity of $100,000 per year. The funding you

– Present Value of an Annuity

• To find a simpler formula, suppose you invest $100 in a

• You have created a 20-year annuity of $5 per year, plus

PV(20  year annuity of $5 per year) = $100  PV($100 in 20 years)

• For the general formula, substitute P for the principal value

PV (annuity of C for N periods)

Present Value of a Lottery Prize Annuity

• Adding the $1 million we receive upfront, this option has a present