Time Value of Money

• Vo= value of investment now

• V1 = value of investment one year from now
• V2= value of investment two years from now
• Vt = value of investment t years from now
• r = interest rate
 Future Value of Lump Sum

• V1 = Vo (1+ r)
• V2= Vo (1+r) (1+ r)
= Vo (1+r)2
Vt = Vo (1+r )t
 95 cents today
becomes $1 after one year
• V0 (1+ r) = V1
• .95 (1+ .06)= $1.00
• $1 received one year from now is
equivalent to 95 cents today
• PV of $1 to be received one yr from now
= .95
 Annuity
Series of payments of
1) same amounts
2) same intervals
 Cash Flows for
3 year $100 Annuity

Now
100 100 100

1 2 3

PV = 100 + 100 + 100

1+r (1+r)2 (1+r)3
 Future Value of $100 Annuity
by the end of third year
• $100 received at the end of each year for three years.
• Treating it as 3 lump sum payments:
FV = 100 (1+r)2 + 100 (1+r)1 + 100

= 100 [(1+r)2 + (1+r)1 + 1 ]

= 100 x FV of $1 Annuity
 Future Value of Annuity
• FV of $1 annuity = FV of $1 Lump Sum - 1
• r
• = (1+r)n - 1
r
Where n = number of periods
FV of $100 annuity = 100 x FV of $1 annuity
 PV of $1 Lump Sum
• PV of $1 = 1/ (1+r)t

• .95 = 1/ (1+.06)1
Present Value of $1000 Lump Sum

• Vo = Vt __1__
(1+r)t

=
$1000 __1___
(1+.12)3
Excel Formula: https://www.youtube.com/watch?
v=xGY2TRoJ0qg&ab_channel=PaulKing
 PV of $100 Annuity
• $100 received at the end of each year for three years.
• Treat as 3 lump sum payments:
PV = 100 + 100 + 100
1+r (1+r)2 (1+r)3

PV = 100 [ 1 + 1 + 1 ]
1+r (1+r)2 (1+r)3

= 100 x PV of $1 Annuity
 Formula for Present Value
of $1 Annuity
• PV of $1 Annuity = 1 – PV of $1
r
= 1 - 1/(1.12)3
.12

= 2.40

If
borrow $2.40 at 12% today, one would need to
pay $1 annual installment for 3 years in order to
pay off the loan.
 PV of $100 Annuity
Use 12% as interest rate
= $100 x ?
Half use lump sum approach
Half use formula approach
= $100 x 2.40
= $240
 Which would you rather have?
(assume 12% interest rate)

• a. $100 now
• b. $40 3 year annuity

• Next : Bond Illustration

 Annual Payment to repay loan
• You borrow $1000 at 12%. How much
should be the annual payment (end-of-year)
if loan is to be paid off in 3 years.

• PV = annuity amt x PV $1 annuity

• 1000 = x x 1 - 1/(1.12)3
.12

• Practice with Excel PPT “CalculatePV”

 Monthly Installment
• You borrow same amount $1000 at 12%.
How much should be the monthly
installment if loan is to be paid off in 36
months.

• PV = annuity amt x PV $1 annuity

• 1000 = x x 1 - 1/(1.01)36
.01
 Installment Exercise

• You took out $20,000 car loan. How much

is the monthly installment to pay off the
loan in 4 years? Assume 8% interest rate.
 Value of Money to be received
far into the future

• How much is money received 30 years from

now worth today?
• What is interest rate is high?
• The transforming ratio between future and
present become very low.
• Funny dream about time value of money.
Following slides optional
Should we use before or after-tax
interest rate for discounting CF?
Cash flows should be after-tax cash flows because
this is the amount relevant to the person.
•Thus, the discount rate should be after tax interest
rate. However, in cases where there is no tax, after
tax CF is same as before tax CF and after tax interest
rate is same as before tax interest rate.
After tax interest rate =
• before tax interest rate ( 1- marginal tax rate)
U.S. Marginal Tax Rate
(for families)
Tax Brackets (stair)
 Top U.S. marginal rate used to be
70%
• Marginal Tax Rate- tax rate applied to the last
dollar earned. It affects people’s incentives to
work and invest because additional earnings
will all be taxed at the marginal rate.
Table 15.3 Top Federal Tax Rates in the
United States, 1971–2018

* Interest income is taxed as ordinary income. Until 2003, dividends were also taxed as ordinary income. The average tax
rate on equity income is an average of dividend and capital gain tax rates (consistent with a 50% dividend payout ratio
and annual realization of capital gains), where the capital gain tax rate is the long-term rate applicable to assets held
more than one year. Since 2013, some investors are also subject to an additional 3.8% net investment income tax on
both interest and equity income.
†
The corporate rate shown is for C corporations with the highest level of income. Marginal rates can be higher for lower
brackets. (For example, between 2000 and 2017, the 35% tax rate applied to income levels above $18.3 million, while the
tax rate for income levels between $100,000 and $335,000 was 39%.)
Copyright © 2020, 2017, 2014, 2011 Pearson Education, Inc. All Rights Reserved
• After tax return =
Before tax return ( 1- marginal tax rate)
= 5% ( 1 -.2) = 4%

4% is the after tax return, which is the tradeoff

between money today and money next year.
If you give up $1 today, you will have $1.04 next
year. So $1.04 a year from now is equivalent to
$1 today. That is why we use 1.04 (not 1.05) to
divide the future CF to get the PV.
 Tax rates for different countries
• https://en.wikipedia.org/wiki/
List_of_countries_by_tax_rates
 Personal (non-business) car
Zero Percent Financing
• Price of Car (personal use)= 10,000
• Option A: pay everything now (January) and get
10% discount
• Option B: pay in five annual installments (each due
in December) and get 0% financing
Money Market rate = 10%

• Tax = .2
• PV Cost of Option A vs Option B
 Dealer offer: Buy vs Lease Car
• Buy means pay now: Price= $20,000. 8% Sales Tax
• Lease: Pay 36 installments to dealer ($700 per
month). Purchase at end of lease term at $5000.
Whether buy or lease, you expect to sell at end of year
7 for $3000.
Money Market rate = 6% (all rates are annual unless otherwise specified)
Bank loan rate = 10%

Marginal Tax = .2
Do: Compare the PV Cost of Buy vs PV Cost of Lease
If you need to borrow from bank
in order to pay now,
• then you would use the bank loan rate 10%.
(rather than 6% earn from savings) to
discount future installment payments.
Loan Interest expense of 10% is not tax
deductible for consumer, only for business.
Thus, for a consumer loan, discount rate would
be 10%. If this is a business loan, the discount
rate would be 10% (1 – marginal tax rate).
 PV of $1 Annuity Due
• PV of $1 Annuity Due =
PV of $1 Annuity for n-1 periods + 1
 Cash Flows for
3 year $100 Annuity Due

Now
100 100 100 100

1 2 3

PV = 100 + 100 + 100 = 1 + PV of 2 yr ann

1+r (1+r)2

PV of Ann Due = 1 + PV of Ann with one less period