Chapter 4

The Time Value

of Money

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Chapter Outline

1.The Timeline
2.The Three Rules of Time Travel
3.Valuing a Stream of Cash Flows
4.Calculating the Net Present Value
Perpetuities, Annuities, and Other
5.Special Cases

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Chapter Outline (cont’d)

6. Solving Problems with a Spreadsheet

Program
7. Solving for Variables Other Than
Present Value or Future Value

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4.5 Perpetuities, Annuities,
and Other Special Cases
• When a constant cash flow will occur at
regular intervals forever it is called a
perpetuity.

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4.5 Perpetuities, Annuities,
and Other Special Cases
• Using the formula for the present value,
the present value of a perpetuity with
payment C and interest rate r is given
by

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4.5 Perpetuities, Annuities,
and Other Special Cases
• Example: You invest $100 in a bank account paying
5% interest per year. Suppose you withdraw the $5
interest every year and reinvest the $100 for the
next year year. By doing this year after year, you can
withdraw $5 every year in perpetuity:

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4.5 Perpetuities, Annuities,
and Other Special Cases (cont’d)
• The value of a perpetuity is simply the
cash flow divided by the interest rate.

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4.5 Perpetuities, Annuities,
and Other Special Cases (cont’d)
• 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

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Practical Example
You want to endow an annual MBA graduation
party at your old school. 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?

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Solution

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Practical Example
Your buddy in mechanical engineering has invented
a money machine. The main drawback of the
machine is that it is slow. It takes one year to
manufacture $100. However, once built, the
machine will last forever and will require no
maintenance. The machine can be built
immediately, but it will cost $1000 to build. Your
buddy wants to know if he should invest the money
to construct it. If the interest rate is 9.5% per year,
what should your buddy do?

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Solution

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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

C C C C N
C
PV     ...
( 1  r ) ( 1  r )2 ( 1  r )3 ( 1  r )  n1
( 1  r )
N n

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Present Value of an Annuity

• Example: 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.

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Present Value of an Annuity (cont’d)

• 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($100 in 20 years)

• Re-arranging terms:
PV(20  year annuity of $5 per year)  $100  PV($100 in 20 years)
100
 100  $62.31
 (1.05) 20

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Present Value of an Annuity

•  For the general formula, substitute P for the

principal value and:
PV (annuity of C for N periods)
= P - PV(P in period N)
=

Because
=> PV(annuity of C for N periods)=

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Textbook Example 4.8

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Textbook Example 4.8

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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 
r (1  r) N 

1
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Textbook Example 4.9

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Textbook Example 4.9 (cont’d)

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Growing Perpetuities

• 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
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Textbook Example 4.10

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Textbook Example 4.10 (cont’d)

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Growing Annuities

• 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 
N

PV  C   1  g  
(r  g) 1
   
 
  (1  r) 

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Textbook Example 4.11

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Textbook Example 4.11

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4.7 Solving for Variables Other Than
Present Values or Future Values
• Sometimes we know the present value or
future value, but do not know one of the
variables we have previously been given
as an input. 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.

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Textbook Example 4.14

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Textbook Example 4.14 (cont’d)

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