Corporate Finance: Theory &

Practice
Time value of money

Prof. Marta Degl’Innocenti

Learning objectives

• Calculate the future value to which money invested at a

given interest rate will grow.
• Calculate the present value of a future payment and multiple
cash flows.
• Calculate present and future values of annuities.
• Calculate present value of perpetuities.
• Calculate the effective annual interest rate and the annual
percentage rate
• Explain the difference between real and nominal cash flows
and between real and nominal interest rates.
• Calculate the present value of bonds and equities.
Learning objectives (cont’d)
• Calculate the Net Present Value of an investment.
• Use the NPV rule to choose between projects.
• Explain alternative decision rules (i.e. IRR, payback rule,
profitability index) and their advantages and drawbacks.
• Calculate the profitability index and use it to choose between
projects when funds are limited.
• Distinguish between nominal cash flows and real cash flows,
and use the right discount rate to calculate NPV.
 Time Value of Money

Assuming the situation that you won a lottery, and the lottery
company gives you two options for the payoff:

(a): The company will pay you $10, 000 right here right now.
(b): The company will pay you $15, 000 in 2 years time.
What are your choices?

1
Time Value of Money

• Money has a time value. It can be expressed in multiple

ways:
• If $1 today held in savings will grow. The value of $1 today
is worth more than $1 tomorrow.
• $1 received in a year is not worth as much as $1 received
today.
• The Interest rate (r) : Converting cash across time
• By depositing money, we convert money today into money
in the future
• By borrowing money, we exchange money today for
money in the future

2
 Future Value (FV)

• Future Value: Amount to which an investment will grow after

earning interest.
• Simple Interest – Interest only on original investment.

Interest earned at a rate of 7% for 5 years on a principal of $100.

Example - Simple Interest:

Today Future Years

1 2 3 4 5
Interest Earned 7 7 7 7 7
Principal+Interest 107 114 121 128 135
Value at the end of Year 5: $135
3
Future Value (FV) (cont’d)

• Compound Interest – Earning interest on interest

• Compound Interest: Example

Interest earned at a rate of 7% for 5 years.

Example - Compound Interest
Today Future Years
1 2 3 4 5
Interest Earned 7 7.49 8.01 8.58 9.18
Principal+Interest 107 114.49 122.50 131.08 140.26
Value at the end of Year 5 = £ 140.26
4
Simple Vs. Compound Interest
Interest earned at a rate of 7% for the first forty years on the
£100 invested using simple and compound interest.

5
Composition of interest over time

6
How to calculate future value?
• Future of $1 invested for t periods at a rate of interest r per
year is
FV  1 pound  (1  r )t
• is called the future value interest factor.
Manhattan island was sold for $24 in 1626 to Peter Minuit. Consider
an interest rate of 3.5% per year, how much is it worth in 2017?
(i) Using simple interest rate
(ii) Using annually compounded interest rate
(i) The annual interest payment is 24*3.5% = $0.84. This payment
is received for (2017 - 1626) = 391 years, giving a total interest
payment of 391*0.84 = $328.4, and plus the principal it will be
328.4 + 24 = $352.4
(ii) 24 *(1+3.5%)391 = $16,668,173.44
The Power of Compounding

8
Factors Affect FV

FV  1 pound  (1  r )t

• The relationship between FV and r is positive. As r increases,

FV increases and the opposite also holds.
• The relationship between FV and t is positive. As t increases,
FV increases and the opposite also holds.

9
Present Value
• Calculate present value:
• The current value of a future sum of money or stream of cash
flows discounted at a certain rate of interest.
• For example, how much investment today will grow to
$1,000 at 10% per year in 2 years?

1, 000  PV  (1  10%) 2
1, 000
therefore, PV 
(1  10%) 2
10
Present Value (cont’d)
• The present value of $1 after t period in the future at the
interest rate r.
1
PV  FV 
(1  r )t
• Discount factor:
1
(1  r )t

• The relationship between PV and r is inverse. As r increases,

PV decreases and the opposite also holds.
• The relationship between PV and t is inverse. As t increases,
PV decreases and the opposite also holds.

11
Present Values: Changing Discount Rates

12
 Present Value: Example

Always ahead of the game, Tommy, at 8 years old, believes he will

need $100,000 to pay for college 10 years later. If he can invest at a
rate of 7% per year, how much money should he ask his rich Uncle
GQ to give him now?

FV  100,000 t  10 r  7%
1 100,000
PV  FV  t
 10
=50,835
(1  r ) (1  7%)

13
 Periodic Compounding

Suppose a principal amount of $1,500 is deposited in a bank paying

an annual interest rate of 4.3%, compounded quarterly. Then the
balance after 6 years should be?

PV  1,500 t  6 r  4.3%
FV  1,500  (1  4.3%)6 =1,931

4.3% 64
FV  1,500  (1  ) =1,938.84
4
r nt
FV  PV  (1  )
n
n: compouding frequency
t: overall length of time the interest is applied 14
Continuous Compounding
• Interests compound every infinitesimal instant, which is
called continuous compounding.

C0  e rT
• How do we have this?
r nT
Let FV  PV  (1  )
n
r nT
thus, FV  lim ( PV  (1  ) )
n  n
r n T
 PV  [lim(1  ) ]
n  n
 PV  e rT 15
 PV of a stream of cash flows
Your auto dealer gives you the choice to pay $15,500 cash now or
make three payments: $8,000 now and $4,000 at the end of the
following two years. If your cost of money (discount rate) is 8%,
which do you prefer?

Initial Payment  $8, 000.00

4, 000
PV of C1   $3, 703.70
1  0.08
4, 000
PV of C2  2
 $3, 429.36
(1  0.08)
Total PV  $15,133.06

16
 PV of a stream of cash flows
• The present value of multiple cash flows can be calculated

Let:
C1 = The cash flow in year 1
C2 = The cash flow in year 2
C t = The cash flow in year t (with any number of cash flows in between)
C1 C2 Ct
so we have, PV  1
 2

(1  r ) (1  r ) (1  r )t

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Annuities
• A series of constant cash flows for some fixed number of
periods.
• Annuities are very common in the financial market.
Examples, car loan, most mortgage loan, etc.
• Present Value of an Annuity:
Let:
C = yearly cash payment
r = interest rate
t = number of years
1 1 
so we have, PV  C    t 
 r r  (1  r ) 
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 Annuities: Example
You are purchasing a house which costs you $125,000. You have
$25,000 in deposit and need to borrow $100,000 from the bank.
Suppose the bank allows you to make 30 annual instalments with
an interest rate of 5% to repay the loan, how much you have to pay
every year?

PV=100,000 C ? r  5% t  30
1 1   1 1 
PV  C    t 
C  30 
 100, 000
 r r  (1  r )   5% 5%  (1  5%) 
C  6,505.14

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Future Value of Annuities
You are setting aside $3,000 at the end of every year. If your
savings earn interest of 8% a year, how much will they be
worth at the end of 4 years?

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Future Value of Annuities (cont’d)
• A shortcut method to calculate the future value of an annuity
is to first calculate the present value of the annuity and then
multiply it by
• FV of an annuity:

1 1  t
FV  C    t
 (1  r )
 r r  (1  r ) 
 (1  r )t  1 
C 
 r 

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Future Value of Annuities: Example
You plan to save $4,000 every year for 20 years and then retire.
Given a 10% rate of interest, how much will you have saved by
the time you retire?

1 1  t
FV  C    t 
 (1  r )
 r r  (1  r ) 
 (1  10%) 20  1 
 4,000    =229,100
 10% 

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Perpetuities
• An annuity in which its cash flow continues forever (the cash
flow will be received at the end of that year), e.g. Consols
bonds.
Suppose you could invest $100 at an interest rate of 10%. Every year you
earn an interest of $10 and withdraw this amount without running
down your balance. In other words, a $100 investment could provide a
perpetuity of $10 per year.

Let: C = yearly cash payment

r = interest rate
t = number of years
 1 1  C
so we have, PV= lim C    t   
t 
  r r  (1  r )   r
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Perpetuities: Example
In order to create an endowment, which pays $185,000 per year
forever, how much money must be set aside today if the rate of
interest is 8%?
C  185,000 r  8%
185,000
PV  =2,312,500
8%
What if the first payment won’t be received until 3 years from
today, how much money needs to be set aside today?
FV  2,312,500 r  8% t  3  1  2
2,312,500
PV  2
=1,982,596
(1  8%)
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Growing Perpetuities
Suppose an apartment building where cash flows to the landlord after
expenses will be $100,000 next year. These cash flows are expected to
risk at 5% per year. If one assumes that this rise will continue
indefinitely, and the discount rate is 11%, and the present value can be
given as,

100, 000 100, 000(1.05) 100, 000(1.05) 2 100, 000(1.05)t 1

PV   2
 3
 ... 
1.11 1.11 1.11 1.11t
100, 000   1  0.05 t  100, 000
so we have, PV= lim 1    
0.11  0.05 t 
  1  0.10   0.11  0.05
Let C = yearly cash payment, r = interest rate, g=annual growth rate,
C
PV= ,  g<r
rg
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Interest Rates: EAR & APR
• Effective Annual Interest Rate (EAR), also known as annually
compounded rate, is the rate at which your money grows, allowing for
the effect of compounding. If RP is the periodic interest rate for each
month, we have
• Эффективная годовая процентная ставка (EAR), также известная
как годовая сложная ставка, - это скорость, с которой ваши деньги
растут с учетом эффекта начисления сложных процентов. Если RP -
периодическая процентная ставка для каждого месяца, мы имеем

EAR  (1  RP)12  1
• Annual Percentage Rate (APR): short-term rates annualized by
multiplying the rate per period by the number of periods in a year.
Годовая процентная ставка (APR): краткосрочные ставки в годовом
выражении путем умножения ставки за период на количество
периодов в году.
APR  RP  12 26
EAR and APR: Example
Given a quarterly rate of 3%, what is the Effective Annual
Rate(EAR)? What is the Annual Percentage Rate (APR)?

EAR  (1  RP) 4  1
 (1  3%) 4  1  12.55%

APR  RP  n
 3%  4  12%

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Nominal & Real Interest Rates
• What is the rate of inflation?
• It measures the increases in the level of prices across the
economy.
• Why does it matter?
• It reduces the buying power of money. Suppose good X cost
$1.00 per unit in 2010 and in 2014 the same good X cost $1.20
per unit. The value of the $ has fallen due to rising prices.
• The return of your investment may be offset by increase of
prices of goods.

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Nominal & Real Interest Rates (cont’d)

• How can we measure the general trends in prices?

• We examine changes in the consumer price index, or CPI. CPI
measures the cost of purchasing a representative bundle of
goods. e.g. food, clothing, fuel, leisure goods
• The inflation rate is measured by the rate of increase of the CPI.
• The interest rate reported is usually the nominal interest
rate. Nominal interest rate does not adjust for the inflation
rate.
• Real interest rate is adjusted for the inflation rate. It is the
rate above the inflation rate.

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Nominal & Real Interest Rates (cont’d)

1  nominal interest rate

1  real interest rate 
1  inflation rate
If the nominal interest rate on your interest-bearing savings
account is 2.0% and the inflation rate is 3.0%, what is the real
interest rate?

1  nominal interest rate

1  real interest rate 
1  inflation rate
1  nominal interest rate
real interest rate  -1
1  inflation rate
1  2%
  1  0.97%
1  3%
30
Nominal & Real Interest Rates (cont’d)
If the nominal interest rate is 10%, how much do you need to
invest now to produce £100 in a year’s time?
100
PV of 100   90.91
1.10
If the inflation will be 7% over the next year, what is the real value
of that £100 (receive in a year’s time) in today’s value?
100
Real value of 100   93.46
1.07
1.10
Also, the Real Rate   1  2.8%
1.07
93.46
PV of the Real value:  90.91
1.028 31
Nominal & Real Interest Rates (cont’d)
You are now 60 years old with a fortune of $3 million and are
considering early retirement. How much can you spend each year
for the next 30 years? Assume that spending is stable in real terms.
The nominal interest rate is 10%, and the inflation rate is 5%.

1.10
Real Rate   1  4.8%
1.05

1 1   1 1 
PV  C    t
 C    30 
 3,000,000
 r r  (1  r )   4.8% 4.8%  (1  4.8%) 
C  190,728

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Valuation in practice: Bond
• What is a bond?
• A bond is a certificate showing that a borrower owes a specified sum. To repay
the money, the borrower has agree to make interest and principal payments on
designated dates. Залог - это сертификат, подтверждающий, что заемщик должен
определенную сумму. Чтобы вернуть деньги, заемщик соглашается уплатить проценты и
основную сумму в установленные сроки.
Company SHU Inc. just issued 100,000 bonds for $10,000 each,
where the bonds have a coupon rate of 5% and a maturity of 2
years. Interest is to be paid yearly.

• This means:
• $1 billion (=100,000*$10,000) has been borrowed by SHU Inc.
• The firm must pay interest of $50 million (=$1 billion*5%) at the end of every
year for the following 2 years.
• The firm must pay both $50 million of interest and $1 billion of principal at the
end of 2 years. 33
Valuation in practice: Bond

34
Bond types
• Terminology:
• Maturity (T): The date when the issue of the bond makes the last payment is
called the maturity date of the bond.
• Срок погашения (T): дата, когда выпуск облигации производит последний
платеж, называется датой погашения облигации.
• Face/par value (F): The payment at the maturity is termed the bond’s face/par
value. Номинальная / номинальная стоимость (F): платеж по истечении
срока погашения называется номинальной / номинальной стоимостью
облигации.
• Bond types:
• Pure discount bond / Zero coupon bond.
• Coupon bonds.

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Bond valuation
• Pure discount bond / Zero coupon bond.
F
PV 
(1  R)T

Suppose that the interest rate is 10%. Consider a bond with a face
value of $1 million that matures in 20 years.

$1 million
PV  20
 $148, 644
(1  10%)

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Bond valuation (cont’d)
• Coupon bond:
C C CF
PV  1
 2
 ... 
(1  R) (1  R) (1  R)T

Company GlaxoSmithKline issued bonds in December 2014. The

coupon is 1.375% and the face value is £10,000. Assume that the
coupon is paid annually each December. The face value is paid out
in December 2019 (5 years from the issue date). If the annual
interest rate is 1.48%. What is the present value of the bond?
10, 000 1.375% 10, 000 1.375% 10, 000 1.375%  10, 000
PV  1
 2
 ... 
(1  1.48%) (1  1.48%) (1  1.48%)5
 £9,950.1
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Bond valuation (cont’d)
• Coupon bond:
C C CF
PV  1
 2
 ... 
(1  R) (1  R) (1  R)T
Company GlaxoSmithKline issued bonds in December 2014. The
coupon is 1.375% and the face value is £10,000. Assume that the
coupon is paid annually each December. The face value is paid out
in December 2019 (5 years from the issue date). If the annual
interest rate is 1.48%. What is the present value of the bond?
• Terminology (Cont’d):
• Yield to maturity (R or formally YTM): It is the discount rate that equates the
price of the bond with the discounted value of the coupons and face value.

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Equity valuation
• Which of the following is the value of equity?
• The discounted present value of the sum of next period’s dividend plus next
period’s share price.
• The discounted present value of all future dividends.

Div1 P1 Div2 P2
P0   P1  
1 R 1 R 1 R 1 R
Div1 Div2 P2
Substituting P1 with P2 givens: P0   
1  R (1  R) 2 (1  R) 2
Substituting Pt 1 with Pt givens,
Div1 Div2 Div3
P0   2
 3
+...
1  R (1  R ) (1  R)

Divt
= t
t 1 (1  R ) 39
Valuations of equities types
• Zero growth: Value of equity with constant dividend.
Div Div Div
P0   2
 3
+...
1  R (1  R ) (1  R)

Div
= t
t 1 (1  R )
Div
=
R
• Constant growth: Dividends grow at rate g:

40
Valuations of equities types
• Zero growth: Value of equity with constant dividend.
Div Div Div
P0   2
 2
+...
1  R (1  R ) (1  R)

Div
= t
t 1 (1  R )
Div
=
R
• Constant growth: Dividends grow at rate g:

Div1 Div1 (1  g ) Div1 (1  g ) 2 Div1 (1  g )3 Div1

P0     +...=
1 R (1  R ) 2 (1  R)3 (1  R ) 4 Rg

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Additional Exercises
• 1. Would you rather receive $1,000 a year for 10 years or
$800 a year for 15 years if
• a. the interest rate is 5%?
• b. the interest rate is 20%?
• c. Why do your answers to (a) and (b) differ?
a. You should compare the present values of the two annuities.
 1 1 
PV  £1,000    10 
 £7,721.73
 0.05 0.05  (1.05) 
 1 1 
PV  £800    15 
 £8,303.73
 0.05 0.05  (1.05) 

42
Additional Exercises (cont’d)
• b.
 1 1 
PV  £1,000    10 
 £4,192.47
 0.20 0.20  (1.20) 

 1 1 
PV  £800    15 
 £3,740.38
 0.20 0.20  (1.20) 

• c. When the interest rate is low, as in part (a), the longer

(i.e., 15-year) but smaller annuity is more valuable because
the impact of discounting on the present value of future
payments is less significant.

43
Additional Exercises (cont’d)
• 2. A local bank advertises the following deal: “Pay us $100 a year for 10
years and then we will pay you (or your beneficiaries) $100 a year
forever. ” Is this a good deal if the interest rate available on other
deposits is 6%?
• The present value of your payments to the bank equals:
 1 1 
£100    10 
 £736.01
 0.06 0.06  (1.06) 
• The present value of your receipts is the value of a $100 perpetuity
deferred for 10 years:

100 1
 10
 £930.66
0.06 (1.06)

44
Additional Exercises (cont’d)
• 3. Suppose you can borrow money at 8.6% per year (APR) compounded
semiannually or 8.4% per year (APR) compounded monthly. Which is the
better deal?
• Semiannual compounding means that the 8.6% loan really carries
interest of 4.3 percent per half year. Similarly, the 8.4% loan has a
monthly rate of 0.7%.
Compounding
APR Effective annual rate
period
     
6 months
8.6% 1.0432  1 = 0.0878 = 8.78%
(m = 2/yr)
1 month
8.4% 1.00712  1 = 0.0873 = 8.73%
(m = 12/yr)

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