Financial Institutions

and markets
The Time Value of Money (Part I)
Prof. Dr. Alain Praet
1. A primer on TVM problems

1.1. Basic problem

1.2. General problem

1. 3. The classical problems

1. 4. Exercises

2
1.1. Basic Problem
• Consider the following valuation problem
(which you could call a standardized
transaction):
o
What is the value K1 at time 1 of a cash flow of
size K that will be exchanged at time 0 ?
or equivalently
o What is the value K at time 0 of a cash flow of size

K1 that will be exchanged at time 1 ?

• Well, ..., WE DON’T KNOW, we must agree
on an assumption. Quite obvious that this
assumption will be of key importance!
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Basic Problem
• What is the value of € 100 in 1 year if you
invest it at an annual rate of return of 10%?

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Key assumption
• Key assumption:
•  
𝐾 1=𝐾 ⋅(1+𝑟)
or equivalently

•  
𝐾 =𝐾 1⋅ ¿
• Cash flows connected by these formulae are
called equivalent at the given real rate of
return r, i.e. they have
5
equal value.
 Diagrammatic representation
• There is a very useful diagrammatic
representation of this key assumption, it
looks like:
K
time
0

x (1+r )

K1
time

6 1
 Diagrammatic representation (2)
• ... which is equivalent to:

K
time
0

/ (1+r)
or x (1+r)-1
K1
time

7
1
 Diagrammatic representation (3)
• An alternative way is to include both cash
flows in the same diagram, this looks like:
x (1+r )
K K1
time
0 1
x (1+r )-1
K K1
time
0 1
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1.2. General Problem
• Consider the following valuation problem
(which you could call a standardised
transaction):
o What is the value K at time t of a cash flow of size
K’ that will be exchanged at time t’ ?
or equivalently
o What is the value K’ at time t’ of a cash flow of

size K that will be exchanged at time t ?

• Well, ..., WE DON’T KNOW, we must agree
on an assumption. Quite obvious that this
assumption will be of key importance!
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General Problem
• What is the value of € 100 in 2 year if you
invest it at an annual rate of return of 10%?

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 Key assumption (2)
• Key assumption:
t 't
K '  K  (1  r )
or equivalently
 (t 't )
K  K '(1  r )
• Cash flows connected by these formulae are
called equivalent at the given real rate of
return r, i.e. they have
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equal value.
 Key assumption (3)
• The quantities involved are:
o the timing of the cash flows, viz. t and t’. Observe
that
• only the time interval t’-t matters, not the points in time as
such.
• the dependency is not linear!
o the size of the cash flows, viz. K and K’ . Observe
that the dependency here is indeed linear.
o some mysterious quantity denoted r, which we will
call henceforth the real rate of return applicable in
this exchange of cash flows.
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 Key assumption (4)
• The quantity r is unique to the exchange and
includes all other elements that are not
included in the passing of time or the size of
the cash flows involved.
• Therefore, it is the most concise way of
including the effects of
o currency
o trustworthiness of counterparty
o value of collateral guarantees
o ...
i.e. all other factors affecting the value both
parties attach to the passing of time.
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 Key assumption (5)
• An extremely important technical point relates
to the units in which the points in time and the
quantity r are denoted.
• For the time being, we will assume that the
key assumption only makes sense if
1.the time interval t’-t is measured in years
AND
2. the quantity r also refers to some rate of return on
an annual basis, expressed as a number between
zero and one.

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 Diagrammatic representation
• There is a very useful diagrammatic
representation of this key assumption, it
looks like:
K
time
t

x (1+r )(t'-t )

K'
time

15 t'
 Diagrammatic representation (2)
• ... which is equivalent to:

K
time
t

x (1+r )-(t'-t )

K'
time

16
t'
 Diagrammatic representation (3)
• An alternative way is to include both cash
flows in the same diagram, this looks like:
x (1+r )(t'-t )
K K'
time
t t'
x (1+r )-(t'-t )
K K'
time
t t'
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 1.3. The classical problems
• The key assumption:
t 't
K '  K  (1  r )
can be considered as an equation linking the
quantities t, t’, K, K’ and r. In such an
equation, as soon as four of the five quantities
are given, the fifth can be solved from the
equation.
• We will solve all five of these classical
problems.
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 The classical problems (2)
• Example 1: What is the value one year from
now of a cash flow of 1000 euro today if you
work with a real rate of return of 12%?

t 0

t’ 1

K 1000

K’ unknown

r 0.12
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 The classical problems (3)
• Example 1: What is the value one year from
now of a cash flow of 1000 euro today if you
work with a real rate of return of 12%?

• The equivalent cash flow is _____ euro,

probably what you expected intuitively.
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 The classical problems (4)
• Example 2: What is the value 18 months from
now of a cash flow that is valued at 1200 USD
42 months from now if you work with a real
rate of return of 8%?
t
t’
K
K’
r
21
 The classical problems (5)

• The equivalent cash flow is 1,028.81 USD,

which may differ from what you expected.

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 The classical problems (6)
• Example 3: A cash flow of 1900 GBP and one
of 3600 GBP later on are supposed to be
equivalent. Working with a real rate of return of
6.25%, how far apart are both cash flows?
t
t’
K
K’
r
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 The classical problems (7)

• The equivalent cash flows are _____ years

apart.

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 The classical problems (8)
• Example 4: Suppose you invested 12.500
ZAR some time ago at a real rate of return of
12.75%. This investment is worth 20.375 ZAR
today. When did you invest?
t
t’
K
K’
r
25
 The classical problems (9)

• You invested _____ years ago, i.e. ___ years

and almost ___ month ago.

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 The classical problems (10)
• Example 5: If cash flows of 16.814.500 USD
nine months from now and of 21.325.475 USD
18 months from now are equivalent, what real
rate of return are we working with?
t
t’
K
K’
r
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 The classical problems (11)

• The real rate of return in this problem is _____

%.

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 1.4. Exercises
1. The population of East Euclid was 15 000 on December 31, 1980. During the
period 1980 to 1990 the town grew at a rate of 2% per annum. Assuming the rate
of growth remains constant, estimate
(a) the population on December 31, 2000; (22 289.21)
(b) the increase in population in the year 1998. (420.07)
2. The management of a company must decide between two proposals, on the
basis of the following information:

Investment Net Cash Inflow at the End of

Proposal Now Year 1 Year 2 Year 3

A 80 000 95 400 39 000 12 000

B 100 000 35 000 58 000 80 000
Advise management regarding the proposal that should be selected, assuming
that on projects of this type the company can earn r = 14%.
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 Exercises (2)
3. Find today’s value of $2800 due in 3 years 7 months if money is worth 10%
effective. (10% effective means r = 10%). ($1 989.91)
4. In 1988 the earnings per share of common stock of a company was $4.71. By
1993 it was $9.38. What is the annual rate of increase in the earnings per share
in this five-year period? (annual rate of increase = r). (14.7721%)
5. Jackie invested $1000 for one year at r = 10%. The annual inflation rate for
that year was 4%.
(a) What was the real annual rate of return on her investment? (5.7692%)
(b) What was her real annual after-tax return, if she paid tax at a 40%
marginal rate? (1.9231%)
6. In 1492, Queen Isabella sponsored Christopher Columbus’ journey by giving
him $10 000. If she had placed this money in a bank account at an annual rate r
= 3%, how much money would have been in the account in 1992? ($26.219b)
7. The XYZ Company has had an increase in sales of 4% per annum. If sales in
1993 are $680 000, what would be the estimated sales for 1998?
($827 323.97)
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 Exercises (3)
8. A bank pays 12% per annum on its savings accounts. At the end of every three
years, a 2% bonus is paid on the balance at that time. Find the (annual) real rate
of return earned by an investor, if the deposit is withdrawn
(a) after 2 years, (12%)
(b) after 3 years, (12.7417%)
(c) after 4 years. (12.5558%)
9. At what real rate of return (= r) will money triple in 15 years? (7.5990%)
10. If the cost of living rises 8% a year, how long will it take for the purchasing
power of $1 to fall to $0.60? (6.6375 years)
11. A noninterest-bearing note of amount $X is due in 3 months. A finance
company calculates the value of the note today to be $3825. Find X if the annual
effective interest rate (= r) is 9%.($3 908.30)
12. A debt of $5000 is due at the end of 5 years. It is proposed that $X be paid
now with another $X paid in 10 years to liquidate the debt. Calculate the value of
X if the annual effective interest rate (= r) is 12% for the first 6 years and 8% for
the next 4 years. ($2067.30) 31
 2. The choice of the
compounding period

2.1. A straightforward generalization

2.2. Equivalence of rates

2.3. Exercises

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 2.1. A straightforward
generalization
 Up until now, we focussed on the so called real
rate of return, r, which by convention is a rate
of return per year – or on an annual basis – and
will appear in the literature under different
names:
 real rate of return
 internal rate of return (or IRR)
 effective annual rate (or EAR)
 annualised rate
 internal yield
 ...
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 A straightforward
generalization (2)
 As a matter of fact, in many real life problems,
the natural periodicity that comes up, is not
annual, but rather
 semestrial or half-yearly (i.e. on a six months basis)
 trimestrial or quarterly (i.e. on a three month basis)
 bimensual (i.e. on a two month basis)
 or monthly
 As long as you pay attention to the central
consistency of the key assumption (for time
value of money), you can easily deal with these
different periodicities.
 Let’s first do this for
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a monthly periodicity.
 A straightforward
generalization (3)
 We can generalise the key assumption
t 't
K '  K  (1  r )
t 't
to K '  K  (1  r1 12 )
 provided we use it consistently, i.e.
1. t’-t is measured in months
IF the time interval
2. THEN the quantity r1/12 also refers to some rate of
return on an monthly basis, expressed as a number
between zero and one.
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 A straightforward
generalization (4)
 or even more generally
1. IF the time interval t’-t is measured in m-ths of a
year (i.e. month/trimester/semester)
2. THEN the quantity r1/m also refers to a rate of return
per m-th part of a year (i.e. again
month/trimester/semester), expressed as a number
between zero and one.
 So: when solving a problem, make sure to use
the correct periodicity.
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 A straightforward
generalization (5)
 Example 1: What is the value 18 months
from now of a cash flow that is valued at
1200 USD 42 months from now if you work
with a monthly rate of return of 0.5%?
t 18

t’ 42

K unknown

K’ 1200

r1/12 0.005
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 A straightforward
generalization (6)
 Example 1: What is the value 18 months
from now of a cash flow that is valued at
1200 USD 42 months from now if you work
with a monthly rate of return of 0.5%?

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 A straightforward
generalization (7)
 Example 2: If cash flows of 16.814.500 ECV
nine months from now and of 21.325.475
ECV 18 months from now are equivalent,
what trimestrial return are we working with?
t
t’
K
K’
r1/4
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 A straightforward
generalization (8)
 Example 2: If cash flows of 16.814.500 ECV
nine months from now and of 21.325.475
ECV 18 months from now are equivalent,
what trimestrial return are we working with?

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 2.2. Equivalence of rates
 Introductory example: Imagine you have the
choice between depositing your money at a
trimestrial rate of 1% and depositing it at an
annual rate of 4%. What is the best choice?

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 Equivalence of rates (2)
 Solution:
 We must agree on the meaning of “best”. Let’s say
that by “best” we mean “makes you the richest at the
end of one year”. This implies this choice will also
make you the richest at the end of any investment
period.
 Because a year counts four trimesters a rate of 1%

per trimester comes down do an investment result of

1 x 1.014=1.0406
at the end of a year per unit invested. This is more than
the 1.04 you would get from the alternative deposit.

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 Equivalence of rates (3)
 Another example: Francesca deposits 500 000
INR in a savings account that yields 4.0% per
semester during the first year, 3.5% per
semester during the next two years and 2.5%
per semester during the final three years.
(a) What is the balance of Francesca’s account at the
end of the sixth year?
(b) What “average” rate did Francesca earn on her six
year savings account investment?
 It should be clear to everyone that the
specification “per semester” does matter.
 It’s less clear what is meant by “average”.
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 Equivalence of rates (3)
(a) Six years are the same as twelve semesters for
all of which we know the rate of return. So we
compound in the normal way to obtain the
terminal value of the investment
FV = 500 000 x 1.04² x 1.0354 x 1.0256
= 500 000 x 1.439366
= 719 683.05
(b) The growth factor for the full six years is
1.439366. We can compute the “average”
annual rate r which would have yielded the
same result by solving the equation
1  r  6
 1.439366
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 r  6.258%
 Equivalence of rates (4)
 Technically, this annual rate is a kind of
geometric average of the semestrial rates used.
 Using that averaging approach also makes
comparing rates with different periodicity
possible.
 The following definition for equivalence is used:
Two rates with different compounding
periodicity are called equivalent if they yield the
same accumulated value at the end of one year
(and therefore at the end of any number of
years), i.e. if they are equivalent to the same
(annual) real rate 45of return.
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 Equivalence of rates (5)
 The APR is the ‘Annual Percentage Rate’
 It is the annual cost of borrowing without
compounding

So: r1/m * m = APR

47
 Equivalence of rates (6)
 Example 1: What is the real rate of return that
corresponds to a monthly rate of 0.6% and
what is the APR?
 Solution:
 A unit invested at this monthly rate grows to
1 x 1.00612 = 1.0744 at the end of 12 months.
 The equivalent real rate of return is 7.44%.
 The APR = 0.006*12 = 0.072 = 7.20%

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 Equivalence of rates (7)
 Example 2: What is the quarterly rate that is
equivalent to a semestrial rate of 4.3%?
 Solution:
 A unit invested at this semi-annual rate yields
1 x 1.0432 = 1.0878 at the end of 2 semesters.
 The equivalent real rate of return is 8.78%.

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 Equivalence of rates (8)
 Solution (continued):
 To compute the corresponding quarterly rate we
proceed the other way around. A real rate of return
of 8.78% is equivalent to a trimestrial rate of
r = 1.08781/4 - 1 = 2.13%
 In everyday language we would say: 4.3% per half
year is equivalent to 2.13% per quarter and to
8.78% per year.
 More formally we say: a semestrial rate of 4.3% is
equivalent to a quarterly rate of 2.13% because both
are equivalent to a real rate of return of 8.78% or

r 0.5  4.3%  r0.25  2.13%  r1  r  8.78%

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