Time Value of Money

P.V. Viswanath
 Key Concepts

 Be able to compute the future value of an

investment made today
 Be able to compute the present value of cash to be
received at some future date
 Be able to compute the return on an investment

P.V. Viswanath 2
 Chapter Outline

 Future Value and Compounding

 Present Value and Discounting
 More on Present and Future Values

P.V. Viswanath 3
 Present and Future Value
 Present Value – earlier money on a time line
 Future Value – later money on a time line
100 100 100 100 100 100

0 1 2 3 4 5 6
 If a project yields $100 a year for 6 years, we may want to know the
value of those flows as of year 1; then the year 1 value would be a
present value.
 If we want to know the value of those flows as of year 6, that year 6
value would be a future value.
 If we wanted to know the value of the year 4 payment of $100 as of
year 2, then we are thinking of the year 4 money as future value, and
the year 2 dollars as present value.

P.V. Viswanath 4
 Rates and Prices

 A rate is a “price” used to convert earlier money into later

money, and vice-versa.
 If $1 of today’s money is equal in value to $1.05 of next
period’s money, then the conversion rate is 0.05 or 5%.
 Equivalently, the price of today’s dollar in terms of next
period money is 1.05. The excess of next period’s monetary
value over this period’s value (1.05 – 1.00 or 0.05) is often
referred to, as interest.
 The price of next period’s money in terms of today’s money
would be 1/1.05 or 95.24 cents.

P.V. Viswanath 5
 Rate Terminology
 Interest rate – “exchange rate” between earlier money and later
money (normally the later money is certain).
 Discount Rate – rate used to convert future value to present value.
 Compounding rate – rate used to convert present value to future
value.
 Cost of capital – the rate at which the firm obtains funds for
investment.
 Opportunity cost of capital – the rate that the firm has to pay
investors in order to obtain an additional $ of funds.
 Required rate of return – the rate of return that investors demand
for providing the firm with funds for investment.

P.V. Viswanath 6
 Relation between rates

 If capital markets are in equilibrium, the rate that

the firm has to pay to obtain additional funds will
be equal to the rate that investors will demand for
providing those funds. This will be “the” market
rate.
 Hence this is the rate that should be used to convert
future values to present values and vice-versa.
 Hence this should be the discount rate used to
convert future project (or security) cashflows into
present values.

P.V. Viswanath 7
 Discount Rates and Risk

 In reality there is no single discount rate that can be

used to evaluate all future cashflows.
 The reason is that future cashflows differ not only
in terms of when they occur, but also in terms of
riskiness.
 Hence, one needs to either convert future risky
cashflows into certainty-equivalent cashflows, or,
as is more commonly done, add a risk premium to
the “certain-future-cashflows” discount rate to get
the discount rate appropriate for risky-future-
cashflows.
P.V. Viswanath 8
 Future Values
 Suppose you invest $1000 for one year at 5% per year. What is the future
value in one year?
 The compounding rate is given as 5%. Hence the value of current dollars in
terms of future dollars is 1.05 future dollars per current dollar.
 Hence the future value is 1000(1.05) = $1050.
 Suppose you leave the money in for another year. How much will you have
two years from now?
 Now think of money next year as present value and the money in two years as
future value. Hence the price of one-year-from-now money in terms of two-
years-from-now money is 1.05.
 Hence 1050 of one-year-from-now dollars in terms of two years-from-now
dollars is 1050(1.05) = 1000 (1.05)(1.05) = 1000(1.05)2 = 1102.50

P.V. Viswanath 9
 Future Values: General Formula

 FV = PV(1 + r)t
 FV = future value
 PV = present value
 r = period interest rate, expressed as a decimal
 T = number of periods
 Future value interest factor = (1 + r)t

P.V. Viswanath 10
 Effects of Compounding

 Simple interest
 Compound interest
 The notion of compound interest is relevant when money is
invested for more than one period.
 After one period, the original amount increases by the
amount of the interest paid for the use of the money over
that period.
 After two periods, the borrower has the use of both the
original amount invested and the interest accrued for the
first period. Hence interest is paid on both quantities.

P.V. Viswanath 11
Figure 4.1

P.V. Viswanath 12
Figure 4.2

P.V. Viswanath 13
 Future Values – Example 2

 Suppose you invest the $1000 from the previous

example for 5 years. How much would you have?
 FV = 1000(1.05)5 = 1276.28
 The effect of compounding is small for a small
number of periods, but increases as the number of
periods increases. (Simple interest would have a
future value of $1250, for a difference of $26.28.)

P.V. Viswanath 14
 Future Values – Example 3

 Suppose you had a relative deposit $10 at 5.5%

interest 200 years ago. How much would the
investment be worth today?
 FV = 10(1.055)200 = 447,189.84
 What is the effect of compounding?
 Without compounding the future value would have been
the original $10 plus the accrued interest of 10(0.055)
(200), or 10 + 110 = $120.
 Compounding caused the future value to be higher by an
amount of $447,069.84!

P.V. Viswanath 15
 Future Value as a General Growth
Formula
 Suppose your company expects to increase unit
sales of books by 15% per year for the next 5 years.
If you currently sell 3 million books in one year,
how many books do you expect to sell in 5 years?
 FV = 3,000,000(1.15)5 = 6,034,072

P.V. Viswanath 16
 Present Values

 How much do I have to invest today to have some

amount in the future?
 FV = PV(1 + r)t
 Rearrange to solve for PV = FV / (1 + r)t
 When we talk about discounting, we mean finding
the present value of some future amount.
 When we talk about the “value” of something, we
are talking about the present value unless we
specifically indicate that we want the future value.

P.V. Viswanath 17
 PV – One Period Example

 Suppose you need $10,000 in one year for the down

payment on a new car. If you can earn 7% annually,
how much do you need to invest today?
 PV = 10,000 / (1.07)1 = 9345.79

P.V. Viswanath 18
 Present Values – Example 2

 You want to begin saving for your daughter’s

college education and you estimate that she will
need $150,000 in 17 years. If you feel confident
that you can earn 8% per year, how much do you
need to invest today?
 PV = 150,000 / (1.08)17 = 40,540.34

P.V. Viswanath 19
 Present Values – Example 3

 Your parents set up a trust fund for you 10 years

ago that is now worth $19,671.51. If the fund
earned 7% per year, how much did your parents
invest?
 PV = 19,671.51 / (1.07)10 = 10,000

P.V. Viswanath 20
 PV – Important Relationship I

 For a given interest rate – the longer the time

period, the lower the present value
 What is the present value of $500 to be received in 5
years? 10 years? The discount rate is 10%
 5 years: PV = 500 / (1.1)5 = 310.46
 10 years: PV = 500 / (1.1)10 = 192.77

P.V. Viswanath 21
 PV – Important Relationship II

 For a given time period – the higher the interest

rate, the smaller the present value
 What is the present value of $500 received in 5 years if
the interest rate is 10%? 15%?
 Rate = 10%: PV = 500 / (1.1)5 = 310.46
 Rate = 15%; PV = 500 / (1.15)5 = 248.58

P.V. Viswanath 22
 Quick Quiz

 What is the relationship between present value and

future value?
 Suppose you need $15,000 in 3 years. If you can
earn 6% annually, how much do you need to invest
today?
 If you could invest the money at 8%, would you
have to invest more or less than at 6%? How much?

P.V. Viswanath 23
Figure 4.3

P.V. Viswanath 24
 The Basic PV Equation - Refresher

 PV = FV / (1 + r)t
 There are four parts to this equation
 PV, FV, r and t
 If we know any three, we can solve for the fourth
 FV = PV(1+r) t
r = (FV/PV)-t – 1
t = ln(FV/PV)  ln(1+r)

P.V. Viswanath 25
 Discount Rate – Example 1

 You are looking at an investment that will pay

$1200 in 5 years if you invest $1000 today. What
is the implied rate of interest?
 r = (1200 / 1000)1/5 – 1 = .03714 = 3.714%

P.V. Viswanath 26
 Discount Rate – Example 2

 Suppose you are offered an investment that will

allow you to double your money in 6 years. You
have $10,000 to invest. What is the implied rate of
interest?
 r = (20,000 / 10,000)1/6 – 1 = .122462 = 12.25%

P.V. Viswanath 27
 Discount Rate – Example 3

 Suppose you have a 1-year old son and you want to

provide $75,000 in 17 years towards his college
education. You currently have $5000 to invest.
What interest rate must you earn to have the
$75,000 when you need it?
 r = (75,000 / 5,000)1/17 – 1 = .172688 = 17.27%

P.V. Viswanath 28
 Quick Quiz: Part 3

 What are some situations where you might want to

compute the implied interest rate?
 Suppose you are offered the following investment
choices:
 You can invest $500 today and receive $600 in 5 years.
The investment is considered low risk.
 You can invest the $500 in a bank account paying 4%.
 What is the implied interest rate for the first choice and
which investment should you choose?

P.V. Viswanath 29
 Finding the Number of Periods

 Start with basic equation and solve for t (remember

your logs)
 FV = PV(1 + r)t
 t = ln(FV / PV) / ln(1 + r)

P.V. Viswanath 30
 Number of Periods – Example 1

 You want to purchase a new car and you are willing

to pay $20,000. If you can invest at 10% per year
and you currently have $15,000, how long will it be
before you have enough money to pay cash for the
car?
 t = ln(20,000/15,000) / ln(1.1) = 3.02 years

P.V. Viswanath 31
 Number of Periods – Example 2

 Suppose you want to buy a new house. You

currently have $15,000 and you figure you need to
have a 10% down payment plus an additional 5% in
closing costs. If the type of house you want costs
about $150,000 and you can earn 7.5% per year,
how long will it be before you have enough money
for the down payment and closing costs?

P.V. Viswanath 32
 Example 2 Continued

 How much do you need to have in the future?

 Down payment = .1(150,000) = 15,000
 Closing costs = .05(150,000 – 15,000) = 6,750

 Total needed = 15,000 + 6,750 = 21,750

 Using the formula

 t = ln(21,750/15,000) / ln(1.075) = 5.14 years

P.V. Viswanath 33
Basic Formulas Refresher

P.V. Viswanath 34
 Quick Quiz: Part 4

 When might you want to compute the number of

periods?
 Suppose you want to buy some new furniture for
your family room. You currently have $500 and the
furniture you want costs $600. If you can earn 6%,
how long will you have to wait if you don’t add any
additional money?

P.V. Viswanath 35
 The Frequency of Compounding
 Banks frequently refer to interest rates on loans and deposits
in the form of an annual percentage rate (APR) with a
certain frequency of compounding.
 For example, a loan might carry an APR of 18% per annum
with monthly compounding.
 This actually means that the loan will carry a monthly rate
of interest of 18/12 = 1.5% per month.
 The APR is also called the stated rate of interest in contrast
to the Effective Rate of Interest, which is effectively the
additional dollars the borrower will have to pay if the loan is
repaid at the end of a year, over and above the initial
principal, assuming no interim repayments.

P.V. Viswanath 36
 The Frequency of Compounding

 The frequency of compounding affects the future

and present values of cash flows. The stated interest
rate can deviate significantly from the true interest
rate –
 For instance, a 10% annual interest rate, if there is
semiannual compounding, works out to-
Effective Interest Rate = 1.052 - 1 = .10125 or 10.25%
 The general formula is
Effective Annualized Rate = (1+r/m)m – 1
where m is the frequency of compounding (# times per year), and
r is the stated interest rate (or annualized percentage rate (APR) per
year

P.V. Viswanath 37
 The Frequency of Compounding

Effective Annual
Frequency Rate t Formula Rate
Annual 10% 1 r 10.00%

Semi-Annual 10% 2 (1+r/2)2-1 10.25%

Monthly 10% 12 (1+r/12)12-1 10.47%

Daily 10% 365 (1+r/365)365-1 10.52%

Continuous 10%   er-1 10.52%

P.V. Viswanath 38
 Present Value of an Annuity

 The present value of an annuity can be calculated

by taking each cash flow and discounting it back to
the present, and adding up the present values.
Alternatively, there is a short cut that can be used in
the calculation [A = Annuity; r = Discount Rate; n
= Number of years]

A 1 
PV
ofan PV
Annuity(A,r,n) 1 n
r  (1r) 

P.V. Viswanath 39
 Example: PV of an Annuity

 The present value of an annuity of $1,000 at the end

of each year for the next five years, assuming a
discount rate of 10% is -
1 - 1 
5
 (1.10) 
PV of $1000 each year for next 5 years = $1000  $3,791
 .10 
 

P.V. Viswanath 40
 Annuity, given Present Value

 The reverse of this problem, is when the present

value is known and the annuity is to be estimated -
A(PV,r,n).
 
 r 
Annuity given Present Value = A(PV, r,n) = PV
1 - 1 
 (1 + r)n 

P.V. Viswanath 41
 Computing Monthly Payment on a
Mortgage
 Suppose you borrow $200,000 to buy a house on a
30-year mortgage with monthly payments. The
annual percentage rate on the loan is 8%.
 The monthly payments on this loan, with the
payments occurring at the end of each month, can
be calculated using this equation:
 Monthly interest rate on loan = APR/12 = 0.08/12 =
0.0067  
 0.0067 
Monthly Payment on Mortgage = $200,000 1  $1473.11
1 - 
 (1.0067)360 

P.V. Viswanath 42
 Future Value of an Annuity

 The future value of an end-of-the-period annuity

can also be calculated as follows-

(1 + r)n - 1 
FV of an Annuity = FV(A,r,n) = A  
 r 

P.V. Viswanath 43
 An Example

 Thus, the future value of $1,000 at the end of each

year for the next five years, at the end of the fifth
year is (assuming a 10% discount rate) -
(1.10)5 - 1 
FV of $1,000 each year for next 5 years = $1000 = $6,105

 .10 


P.V. Viswanath 44
 Annuity, given Future Value

 If you are given the future value and you are

looking for an annuity, you can use the following
formula:
 r 
Annuity given Future Value = A(FV, r,n) = FV 
(1+ r)n - 1 


Note, however, that the two formulas, Annuity, given

Future Value and Present Value, given annuity can be
derived from each other, quite easily. You may want
to simply work with a single formula.

P.V. Viswanath 45
 Application : Saving for College
Tuition
 Assume that you want to send your newborn child to a private college
(when he gets to be 18 years old). The tuition costs are $16000/year now
and that these costs are expected to rise 5% a year for the next 18 years.
Assume that you can invest, after taxes, at 8%.
 Expected tuition cost/year 18 years from now = 16000*(1.05)18 = $38,506
 PV of four years of tuition costs at $38,506/year = $38,506 * PV(A ,8%,4
years) = $127,537
 If you need to set aside a lump sum now, the amount you would need to
set aside would be -
 Amount one needs to set apart now = $127,357/(1.08)18 = $31,916
 If set aside as an annuity each year, starting one year from now -
 If set apart as an annuity = $127,537 * A(FV,8%,18 years) = $3,405

P.V. Viswanath 46
 Valuing a Straight Bond
 You are trying to value a straight bond with a fifteen year maturity
and a 10.75% coupon rate. The current interest rate on bonds of this
risk level is 8.5%.
PV of cash flows on bond = 107.50* PV(A,8.5%,15 years) + 1000/1.08515 = $
1186.85
 If interest rates rise to 10%,
PV of cash flows on bond = 107.50* PV(A,10%,15 years)+ 1000/1.1015 =
$1,057.05
Percentage change in price = -10.94%
 If interest rate fall to 7%,
PV of cash flows on bond = 107.50* PV(A,7%,15 years)+ 1000/1.0715 = $1,341.55
Percentage change in price = +13.03%

P.V. Viswanath 47
 III. Growing Annuity

 A growing annuity is a cash flow growing at a

constant rate for a specified period of time. If A is
the current cash flow, and g is the expected growth
rate, the time line for a growing annuity looks as
follows –
Figure 3.8: A Growing Annuity

A(1+g) A(1+g)2 A(1+g)3 A(1+g)n

0 1 2 3 ........... n

P.V. Viswanath 48
 Present Value of a Growing Annuity

 The present value of a growing annuity can be estimated in all

cases, but one - where the growth rate is equal to the discount
rate, using the following model:
 (1+ g)
n 
1 - 
 (1+ r) 
n
PV of an Annuity = PV(A,r,g,n) = A(1 +g)  
 (r - g) 

 


 In that specific case, the present value is equal to the nominal

sums of the annuities over the period, without the growth
effect.

P.V. Viswanath 49
 The Value of a Gold Mine

 Consider the example of a gold mine, where you have

the rights to the mine for the next 20 years, over which
period you plan to extract 5,000 ounces of gold every
year. The price per ounce is $300 currently, but it is
expected to increase 3% a year. The appropriate
discount rate is 10%. The present value of the gold that
will be extracted from this mine can be estimated as
follows –
 (1.03)20 
1 -
 (1.10) 
20
PV of extracted gold = $300* 5000 * (1.03)  $16,145,980
 .10 - .03 

 


P.V. Viswanath 50
 IV. Perpetuity

 A perpetuity is a constant cash flow at regular

intervals forever. The present value of a perpetuity
is-
A
PV of Perpetuity =
r

P.V. Viswanath 51
 Valuing a Consol Bond

 A consol bond is a bond that has no maturity and

pays a fixed coupon. Assume that you have a 6%
coupon console bond. The value of this bond, if the
interest rate is 9%, is as follows -
Value of Consol Bond = $60 / .09 = $667

P.V. Viswanath 52
 V. Growing Perpetuities

 A growing perpetuity is a cash flow that is expected to grow

at a constant rate forever. The present value of a growing
perpetuity is -
CF1
PV of Growing Perpetuity =
(r - g)

where
 CF1 is the expected cash flow next year,
 g is the constant growth rate and
 r is the discount rate.

P.V. Viswanath 53