Time Value of Money:

Single Cash Flows

Financial Management
Banikanta Mishra
Xavier Institute of Management,
Bhubaneswar (XUB)
 Real Rate
Even in the absence of inflation,
Even assets without risk
(say a guaranteed bank deposit)
Give a return (say the “interest rate”)

Why?

What does this “real rate” depend upon?

07/24/21 Professor Banikanta Mishra 2

 Computing Real Rate
t=0 Real Rate t=1
Lend Get back
25 Apples = (26-25) / 25 26 Apples

= 4.00%
People prefer
current consumption to future consumption
and, therefore,
demand a compensation for postponing consumption.
THAT REFLECTS IN THE REAL RATE (OF 4% HERE)
07/24/21 Professor Banikanta Mishra 3
 Nominal Rate
$0.80 Price Per Apple $0.80

t=0 t=1
Lend Get back
$20 Nominal Rate = ??

20.80 – 20.00
------------------
20.00
This buys Should be able
25 apples = 4.00% to buy 26 apples
=> Need
$20.80 (=$0.80 x 26)
07/24/21 Professor Banikanta Mishra 4
 Inflation and Nominal Rate
$0.80 Price Per Apple $0.83

t=0 t=1
Lend Get back
$20 Nominal Rate = ??

21.58 – 20.00
------------------
20.00
This buys Should be able
25 apples = 7.90% to buy 26 apples
=> $0.83 x 26
= $21.58
07/24/21 Professor Banikanta Mishra 5
 Nominal Rate: Fisher Effect
Nominal Rate =

[(1+Real Rate) x (1+ Expected Inflation)] – 1*

Using notation, R = [ (1+r) (1+h) – 1]

Here, R = [(1+4.00%) *( 1+3.75%)] – 1 = 7.90%

R, a benchmark, is referred to as Nominal Risk-free Rate (or Rf )

Expected Inflation (in Apple Price)= (0.83 – 0.80) / 0.80 = 3.75%

[*Nominal Rate Approximately Equals Real Rate + Inflation Premium]

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 Risk Free Rate
Risk-free Rate is what we expect to earn
on a Risk-free Asset (asset that would never default)

Technically, only securities issued or guaranteed

by governments (federal, state, city, municipal)
are deemed to be risk-free

Treasury Securities (Treasury Bills, Notes, Bonds)

are the standard risk-free assets

Bank-deposits, to the extent guaranteed,

can also be taken as risk-free assets

07/24/21 Professor Banikanta Mishra 7

FUTURE VALUE: ONE PERIOD
Given Investment ( I ) and Expected Rate of Return (ERR),
find Future Value (FV1)
ERR = 8% (Let us take it as given)
t =0 t=1
Invest Receive
I FV1 = I x ( 1 + ERR )
= I + (I x ERR)
100 100 x (1 + 8%) = 108
[= 100 + (100 x 8%)]
(I is the PV or Present Value here)

07/24/21 Professor Banikanta Mishra 8

 Risk and ERR
ERR for a “fairly priced” asset
depends upon its risk.
Higher the risk, higher the ERR.
ERR = Riskfree Rate + Risk Premium
= Rf + RP
For a Riskfree Asset, ERR = Rf
For a Risky Asset, ERR > Rf

07/24/21 Professor Banikanta Mishra 9

FV1 for a Risky Investment
It is given that, ERR = Rf + RP = 8% + 6% = 14%
t =0 t=1
Invest Receive
I FV1 = I x ( 1 + ERR )
= I + (I x ERR)
100 100 x (1 + 14%) = 114
[= 100 + (100 x 14%)]

07/24/21 Professor Banikanta Mishra 10

 Where does the $114 FV1 come from?
t=0 t=1
I CF1
½
102
100
½ 126
FV1 = Average of CF1 (Cash Flow at t=1) = (½ * 102) + (½ * 126) = $114

½ 2%
I
½ 26%

ERR = Average of Actual Returns (over t=0 and t=1) = (½*2%) + (½*26%)]= 14%

It’d give 2% in some years and 26% in others => averaging 14%, 6% more than 8% Rf
07/24/21 Professor Banikanta Mishra 11
 Deriving ERR
Given I and FV1, derive ERR
(If a $100 investment would become $108 at the end of one period,
what is the ERR?)

t =0 t=1
I FV1
100 108
Ending Inflow – Beginning Outflow FV1 - I
ERR = ---------------------------------------------- = --------------
Beginning Outflow I

=> ERR = [ (108 – 100) / 100 ] = 8.00%

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 FV in a Two-period Context
t=0 t=1 t=2
R01 = 8% R12 = 10%

I = 100 FV1 = 108 FV2 = 118.80

= I x (1+ R01) x (1+ R12)

= 100 (1+8%) (1+10%)

= 108 (1 + 10%)
Would FV2 be different if R01 = 10% and R12 = 8%?

07/24/21 Professor Banikanta Mishra 13

Two-period FV with Constant Rates
R01 = R12 = R
t=0 t=1 t=2
R01 = 8% R12 = 8%

I = 100 FV2 = 116.64

= I x (1+ R01) x (1+ R12)

= I (1+R) (1+R)

= I (1 + R)2 = 100 (1+8%)2

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 Contribution of Compounding
FV under Simple Interest would have given as follows:

Principal [1 + (Rate per Period x Number of Periods)]

= 100 [1 + (8% x 2)] = 100 x 1.16 = 116.00

FV under Compounding gives as follows

Principal [ (1 + Rate per Period)Number of Periods ]

= 100 [ (1+8%)2 ] = 116.64

FV is $116.64 – $116.00 = $0.64 extra

07/24/21 Professor Banikanta Mishra 15
 Interest: Simple and Compound
Simple Interest =

Principal x [Rate per Period x Number of Periods]

= 100 x [8% x 2] = 100 x 16% = $16.00

Compound Interest =

Principal x [(1 + Rate per Period)Number of Periods – 1]

= 100 x [(1+8%)2 - 1] = 100 x 16.64% = $16.64

So, Interest is $16.64 – $16.00 = $0.64 extra

07/24/21 Professor Banikanta Mishra 16
 t=0 t=1 t=2

100 100 * 1.08 = 108 100 * 1.082 = 116.64

Principal
100 100 100

Interest 8

8 8

0.64
Interest on Interest

CONCEPT OF COMPOUNDING

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 Compounding and EAR
Let us take each PERIOD as SIX MONTHS.

If the rate is 8% per period (i.e. six-months),

what is the correct RATE Per Year?

16.64% [ = (1+8%)2 – 1], as A Year = Two Periods

This is the EAR: Effective Annual Rate,
and is based on Compounding Interest principle

It differs from APR (Annual Percentage Rate)

or SAR (Stated Annual Rate) = 8% x 2 = 16%,
which is based on the Simple Interest principle.

07/24/21 Professor Banikanta Mishra 18

 FV in a Multi-period Context
t=0 t=1 t=2 . . . t=T

I FV1=I (1+ERR)
100 = 108

I FV2= I (1+ERR)2
100 = 116.64

I FVT= I (1+ERR)T
100 = 100 (1+8%)T

07/24/21 Professor Banikanta Mishra 19

 FVIF: Future Value Interest Factor
(1+ERR)T , or more generally, (1+R)T
is called the FVIFR,T ,
the Future Value Interest Factor
(or Future Value Factor)
for T periods and a rate of R per period

$1 invested now would grow to this value

at the end of T periods,
if it earns a rate of R per period
For example, FVIF8%,2 = (1+8%)2 = 1.1664
$1 invested now @8% per period would grow to
$1.1664 at the end of 2 periods (sounds familiar?)
07/24/21 Professor Banikanta Mishra 20
 Present Value
A bank promises to give you
$214 at t=1 (end of the first period)
If you deposit $200 now.

Would you accept the offer, if you can earn 8% elsewhere?

Question: How much is the future $214 worth today?

Why do you care? Because, you pay $200 TODAY.

Worth today is the PRESENT VALUE.

07/24/21 Professor Banikanta Mishra 21

 Concept of Present Value
How much do I need to invest today to get $214 at t=1?

t =0 t=1
I 214

We know that, @ERR=8%

I becomes I x (1+8%)
For I x (1 + 8%) to equal 214,
we require I = 214 / (1+8%) = 198.15

That is, we need to invest $198.15 today to get $214.00 at t=1

=> $198.15 is worth today or present-value of $214 at t=1

07/24/21 Professor Banikanta Mishra 22

 Computing PV (Present Value)
214
PV = ------------------------
1 + 8%

CF1
PV = ------------------------
1 + RRR

(CF1 is Cash Flow at t=1, RRR is Required Rate of Return)

RRR = ERR on the Next Best Investment of Same Risk

07/24/21 Professor Banikanta Mishra 23
 Discount Rate and Factor
1
----------
1 + RRR

is the Discount Factor

RRR is the Discount Rate

So, PV is also a “Discounted Value”

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 Why Discount by RRR?
Discounting by RRR ensures that
IF we set the Price of the asset equal to
the Discounted (or Present) Value
THEN the ERR becomes equal to RRR,
=>
the ERR on the asset becomes
equal to the ERR on the next best investment
Previous example: IF we set Price = $198.15,
THEN ERR becomes equal to RRR = 8%,
which is also ERR on next best investment
07/24/21 Professor Banikanta Mishra 25
 The Verdict
Since PV = $198.15

AND

Investment (or Deposit Required) = $200

Do not invest

RULE: DO NOT INVEST IF PV < I

07/24/21 Professor Banikanta Mishra 26

 Is the Decision Right?
Yes.

If we invest $200 elsewhere,

our ERR = 8%

So, we would end up with

 FV1 = $200 x (1+8%) = $216

So, $214 at t=1 is NOT acceptable?

07/24/21 Professor Banikanta Mishra 27

 Evaluating Decision using IRR
IRR is that DR (Discount Rate) that makes
DVCI (Discounted Value of Cash Inflows) = I

t=0 t=1

200 214

I = 200 DVCI = 214/(1+DR)

200 = 214 / (1+DR) => DR = 7% => IRR = 7%
As wee see, in this context, IRR equals ERR.

Since IRR < RRR, do NOT invest

07/24/21 Professor Banikanta Mishra 28

 PV of CF after Two Periods
You need $605 at the end of two years.
Toward that,
you want to deposit enough money in the bank today.
How much need you deposit,
if the bank gives a rate of 10% per year?
t=0 t=1y t=2y
605
605
PV = ---------- = 500
(1 + 10%)2

07/24/21 Professor Banikanta Mishra 29

 The Discounting Formulae
t=0 t=1 t=2 t=3 … t=T

PV CF1
= CF1 / (1+RRR)

PV CF2
= CF2 / (1+RRR)2

PV CF3
= CF3 / (1+RRR)3

PV CFT
=07/24/21
CFT / (1+RRR)T Professor Banikanta Mishra 30
 Discounting Examples
t=0 t=1 t=2 ... t=T
PV CF1
= CF1 / (1+RRR)
PV 108
=108 /(1+8%)
=100
PV CF2
= CF2 / (1+RRR)2
PV 233.28
=233.28 / (1+8%)2 = 200
PV CFT
= CFT / (1+RRR)T
07/24/21 Professor Banikanta Mishra 31
 Time Value of Money
Discounting implies that
$1 received on a future-date is worth less than $1 today
For a given amount,
as the future-date moves farther and farther away,
the worth today (or present value) becomes less and less
(as shown below for RRR = 8%)

t=0 t=1 t=2 t=3 … t=10

0.93 1
0.86 1
0.79 1
0.46 1
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PVIF: Present Value Interest Factor
1/(1+RRR)T, or more generally, 1/(1+R)T
is called the PVIFR,T ,
the Present Value Interest Factor
(or Present Value Factor)
for T periods and a rate of R per period

$1 to be received at t=T has this value today (or PV)

if the rate per period is R
For example, PVIF7%,25 = (1+7%)25 = 0.1842
[ 25 N; 7 I/Y; 1 FV; CPT PV -> -0.1842 ]

To receive $1 at t=25, we need to invest today $0.1842,

if the rate is 7% per period
07/24/21 Professor Banikanta Mishra 33
 Solving for the Unknown
The FV Equation: FVT = I (1 + ERR)T
CFT
The PV Equation: PV = ------------
(1 + RRR)T

COMMON FORM: FVT = PV (1 + R)T

FOUR variables: FVT , PV, R, T

Given any THREE, solve for the FOURTH

07/24/21 Professor Banikanta Mishra 34
SOLVING FOR FVT AND T
t=0 t=1 t=2 . . . t=T
PV FVT = PV (1 + R)T

If $100 is invested @8%, how much is received at end of 9 periods?

0 T=9
@ERR= 8%
100 FVT = 100 (1 + 8% )9 = 199.90

If $100 is invested @8%, how much time it takes to double?

0 T=?
@ERR= 8%
100 FVT = 100 (1 + 8% )T = 200.00
=> T = Ln (200/100) / Ln (1.08) = 9.006 years
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 SOLVING FOR R (RRR or ERR) AND PV (or I)

At what rate should $100 be invested to give $200 at end of 9 years?

0 T=9
@ERR = ?
100 FVT = 100 (1 + ERR)9 = 200.00
=> ERR = (200 / 100)1/9 – 1 = 8.006%

How much needs to be invested @8% to give $200 at end of 9 years?

0 T=9
@ERR=8%
I =? FVT = I (1 + 8%)9 = 200.00
=> PV or I = 200 / (1.089) = 100.05

07/24/21 Professor Banikanta Mishra 36