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Because rational people prefer to receive benefits sooner than later and make sacrifices later than

sooner, money, which provides the option to buy benefits, is likewise preferred sooner to later.

If an individual prefers money sooner than later, then he/she values a dollar today more than a

dollar tomorrow or a dollar in one year from now. A dollar today is worth a dollar today:

therefore, a dollar next year must be worth less than a dollar today since it is less

preferable/valuable.

In other words, the same amount of money will be more or less valuable depending upon when it

is received. What would you prefer, $100 today or $100 in one year from today? Most people

prefer $100 today since it gives them the option to spend it today or save it and spend it in one

year. Receiving $100 in one year doesn't allow for $100 in consumption today.

For equal amounts of money, the decision when to take money --today or in the future-- is an

easy one: sooner is always better than later. But what about situations where the amounts differ?

What decision rule should be used in those situations?

For example, what is preferable? $100 today or $133.1 in three years? Simply picking the largest

number may not provide the best value. (Another way of viewing this situation is to ask: would

you pay $100 today to receive $133.1 in three years?) The answer depends upon what could be

earned with the $100 in alternative investments. Suppose that it's possible to earn 5% on the

$100. Then after three years it would accrue to $115.76. In that case, it would be better to wait

and take the $133.1. If 15% could be earned, the $100 today would grow to $152.08 and the

$100 today would be more attractive.

1

In this example, we compared future values of the alternatives (at the same point in time).

Alternatively, we could have looked at present values by asking "what are you willing to pay

today for a promise of $133.31 in three years?"

As you might infer, when choosing an investment among various alternatives it's necessary to

value each option at the same point in time (at present or in the future). That means to determine

which investment to select, compare future values in year three with futures value in year three

or compare the present values, but don't compare the present value of a cash flow with the future

value of another cash flow.

A simple example illustrates this point: If John is 24 today and Mary will be 28 in five years,

who is older?" Obviously, comparing the 24 with the 28 will lead to the erroneous conclusion

that Mary is older. This is illogical since these ages occur in different time periods. To correctly

see that John is one year older than Mary, it is necessary to add five years to his current age or

subtract five from her future age. Whatever is method is chosen, looking at either both their

future ages or both their present ages will lead to the correct answer.

The previous financial example introduced three concepts, related to the time value of money: 1)

future value ($133.1) - the amount of cash to be delivered at a subsequent date; 2) present value

($100) - the amount of cash available to invest today or the price, today, of future cash flows

($114.98 or $87.75), and 3) opportunity cost (5% or 15%) - the rate of return forsaken, with the

selection of a particular investment. The opportunity cost is the rate of return that could have

been earned on similar investments elsewhere.

2

This guide covers each of these topics in depth; however, to develop an intuitive understanding

remember:

3. The higher the opportunity cost --the more that is forsaken-- the lower the relative

value of a particular future cash flow.

Time value of money calculations provide the algorithms to find today's price of future cash

flows. By the end of this guide, you will be able to price financial instruments such as leases and

bonds and understand the basics of stock valuation. This knowledge is necessary to develop a

sound understanding of capital markets phenomena and corporation finance issues.

3

Future Value

A future value (FV) is an amount of cash to be received or paid at a subsequent date. In this

section, we will develop methods to calculate future amounts given initial investment, today. In

the next section, we will use the inverse of the future value formula to calculate the present

value of future cash flows.

Sinqle Period

Potential investments are offering a rate of return of 9% per period. Given an initial investment

of $2,000, how much cash would be available at the end of one period?

The investment would return the original $2,000 plus 9% of $2,000 or $2,180 calculated as

follows:

= 2,000 (1 + .09)

= 2,000 (1.09)

= 2,180

FV = PV (1 + r)

PV = present value

r = periodic rate of return.

4

Multi-period

Continuing the above example, what would the investment be worth after four periods assuming

that the accrued interest could be reinvested at a rate of 9%?

= 2,180 * 1.09 * 1.09 * 1.09

= 2,376.2 * 1.09 * 1.09

= 2,590.1 * 1.09

= 2,823.16

After four periods, the value of the investment would be $2,823.2. Although the above method

correctly calculates the future value, it is very inefficient since the $2,000 must be multiplied by

1.09 four times to get the correct answer (imagine if the investment was for fifty periods instead

of four!)

= 2,000 * (1.4116)

= 2,823.16

5

In general, for any multi-period problem,

or

FV = PV ( 1 + r ) t

where FV, PV, and r are defined as above and t = number of periods invested. Note that the one

period case is simply a special case of the above formula where the t = 1. Also note that the FV =

PV when 1) there are no available rates of return (r = 0) or 2) the cash is delivered today (t = 0).

calculations of future value. In the example above, the interest would have been (4 * .09 * 2,000)

or $720 if simple interest would have been calculated. Instead, since interest was earned on

interest, the total earned was $823.16.

Example: Herbert plans to retire in fifteen years. Can he afford a $250,000 condominium when

he retires if he invests $100,000 in a fifteen-year Mellon CD (certificate of deposit) which pays

7.5% interest, compounded annually?

Solution:

Yes, he could afford to purchase the condominium since he should have $295,887.74 when he

retires. $295,887.74 = $100,000 (1.075)15.

6

Practice Problem:

1. Can he afford the condo if he purchases three consecutive five-year CD’s? The current

five-year rate is 6%. Rates for the second and third five-year periods and expected to be

6.5% and 7.5%, respectively.

2. What is the future value of $26 invested for 325 years at an average rate of return of 7%?

(In this context, did the Indians make a poor decision to sell Manhattan Island to the

Dutch settlers?)

3. The Quad Corporation needs $50 million to repay a bullet loan which is due at the end of

seven years. If Quad makes the following sinking fund payments, will there be sufficient

funds available to repay the loan on schedule?

$12 million today 11%

10 million in two years 10%

8 million in four years 9%

7

4. Suppose that you start a savings plan by depositing $1,000 at the beginning of every year

into an account that offers 8% per year. If you make the first deposit today, and then three

additional ones, how much will have accumulated after four years.

Solutions:

FV = 100,000 (1.06)5(1.065)5(1.075)5

FV = 100,000 (1.3382)(1.37009)(1.43563)

FV = 100,000 (2.6322)

FV = 263,216.

2. FV = 26(1.07)325

= 9.2194 x 1010

= $92.194 billion

would have over $92 billion after 325 years.

8

3. We need future values seven years hence.

FV of the $10 million = 10(1.1 )5 = 16.1051

FV of the $8 million = 8(1.09)3 = 10.3602

FV of 2nd deposit: = 1,000(1.08)3

FV of 3rd deposit: = 1,000(1.08)2

FV of 4th deposit: = 1,000(1.08)1

Total FV: = $4,866.60

$4,866.60 will have accumulated in the account.

9

Compounding Periods

Often, available interest rates are quoted on an annual basis although interest may actually be

paid semi-annually, quarterly, monthly, daily, hourly, or even continuously. Rates such as 10%

compounded monthly or 12% compounded quarterly, are known as stated rates. They differ from

the rate actually -or effectively-- earned by the compounding effect of the interest earned on

interest within an annual period. For example, 10% compounded semi-annually does not provide

the same return as 10% compounded annually. 10% compounded semi-annually is actually 5%

per six-month period. In this case, the periodic rate is 5% and effective annual rate is above 10%.

To calculate the periodic rate, divide the stated rate by the number of periods per year:

Number of periods per year

r e = (1 + r p)n -1

where, re represents the effective annual rate, rp represents the periodic rate, and n represents the

number of periods per year.

10

One way of looking at the formula is to view what happens to an investment of $1 when a stated

interest rate of 16% is compounded quarterly. The periodic rate is 4% (16%/4). At the end of the

first quarter the dollar will grow to $1.04. After the second quarter it will be worth $1.04 * 1.04,

and by the end of the year, it will grow to 1.044 .To find the effective rate, we subtract the initial

dollar from the accumulated amount to get

(1.04)4 – 1 = 16.9858%.

Example:

What is the effective yield for a stated rate of 9% when interest is compounded semiannually?

monthly?

Solution:

So 1.092025 - 1 = 9.2025%.

(1.0075)12 - 1 = 9.3806898%

generate interest of $920.25 after one year, and one paying monthly interest of .75% would

return $938.07.

11

Later in the course, we will concentrate on calculating effective returns when stated rates are not

provided and periodic rates when effective rates are given. For single period problems we will

find these rates with the following formula: (FV/PV) -1 = effective periodic rate, and in this case,

the holding period return.

The following table provides periodic and effective information given a stated rate of 12%:

period per year rate (%) rate (%)

semiannual 2 6.0000 12.360000

quarter 4 3.0000 12.550881

month 12 1.0000 12.682503

day 365 .0328 12.747456

hour 8,760 .0014 12.749592

continuous infinite near zero 12.749685

So far, we have dealt with compounding issues for one-year projects. A natural question is, how

should we treat multiple-year projects for which interest is compounded periodically? The

answer is: similar to multi-period future value problems with one slight adjustment in the

formula:

FV = PV (1 + r p)n t .

The value FV/PV which equals (1 + r p)n t is the future value factor. Subtracting one from this

factor yields the holding period rate of return or the total return over the investment

period.

12

13

Practice Problems:

1. If you pay 1.5% per month on the outstanding balance of your Mastercard bill, what

effective annual rate are you being charged?

2. What would you prefer to earn on a money-market account: 21% compounded annually

or 20% compounded daily?

14

3. A mutual fund provides a return of 6% per quarter. An alternative investment directly in

stocks is likely to effectively yield 24% per year. What is the implied monthly rate on

both investments? Which one is preferable?

4. To find what fraction of the future value of a two-year bond can be ascribed to interest-

on-interest (or compounding), consider the following:

Two year hence the bond expires, making coupon pus fare payment of

$1200.

If the coupon one year hence is invested at 10%, what interest-on-interest is obtained at

the end of tow years? What is the future value of the bond? What fraction of the future

value is comprised of the interest-on-interest?

15

Solutions:

1. re = (1 + rp)n - 1

= (1 + 0.015)12 - 1

= (1.015)12 - 1

= 19.56%

3. Let rm be the monthly periodic rate for the mutual fund. The quarterly effective rate is

given. Hence

(1 + rm )4 = 1.06

so, by rearranging,

rm = (1.06)1/4 - 1

= 1.0196% per month.

For the stock, let rp be the monthly periodic rate. The twelve-month (annual) rate is

given; therefore,

(1 + rp )12 = 1.24

so again by rearranging,

rp = (1.24)1/12 - 1

16

4. Interest-on-interest at the end of two years = $200(0.1) or $20.

20 = 1.408%

1,420

17

Present Value

Present value (PV) calculations provide the basis for valuation analysis and most of the pricing

of financial instruments. Bonds, stocks, leases and other financial instruments are priced

according to their present values. Thus, this section provides the basis for most subsequent

analysis, especially in corporate finance.

What is a present value? It is the value today of money to be delivered --either received or paid--

at some future point in time. Since it is today's value, it is what investors will pay today for

future cash flows. (These cash flows could be for certain --risk-free-- or risky, in which case the

expected cash flows would be analyzed.)

For any amount of cash deliverable in any future period, it should be evident that the PV of the

future amount is worth less than that same amount today. Exactly how much less depends upon

the discount rate. The discount rate or opportunity cost of capital or required rate of return is the

interest rate that an individual could earn elsewhere on other similar investments (similar in the

sense of risk). Various models in corporate finance attempt to describe this risk-return

relationship.

Intuitively, as the opportunity cost increases or as the time period lengthens, the present value

will decline. This should "make sense" since this increases the opportunity cost.

18

PV calculations are the inverse of future value calculations. From the previous section:

FV = PV (1 + r)t

FV = PV (1 + r)t

(1 + r)t (1 + r)t

PV = FV/(1 + r)t.

Likewise, we can manipulate the right side to isolate the future value from the discount factor

and see that the present value factor, (1 + r)t , is the reciprocal of the future value factor. That

means, l/FV factor = PV factor.

PV = FV 1__

(1 + r)t

Notice that the PV will equal the FV when the factor equals one. This happens when r = 0 or t =

0. When r = 0 there are no alternative investments thus a dollar next year is worth a dollar today

and when t = 0 the future is today so PV = FV.

19

Example:

What is the present value of receiving $7,500 in seven years if alternative investments yield 6%?

This is equivalent to asking, what initial investment is required to have $7,500 after seven years

if the investment pays 6% per period?

Solution:

( 1.06)7 1.5036

Note the intuitiveness of the PV formula. The future cash flows are being discounted to their

present worth by dividing the cash flows by the rates that could be earned elsewhere --the

opportunity cost. This is a ratio or comparison. The cash flows of a particular investment are

being compared to what could be earned elsewhere. The more that can be earned elsewhere, the

less a particular investment is worth.

Often times, situations arise that involve a number of cash flows rather than just a single future

value. The present value of a set of cash flows, occurring at different times, is simply the

sum of the present values for the cash flows.

(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)T

T

PV = Σ CFt

t=1 (1 + r)t

20

Practice Problems:

1. A customer defaults on a $1,000,000 secured loan which was due today. The president of

the firm provides you with you with two options: repossess the collateral which has a fair

market value of $980,000 --it will take six months to sell-- or suspend principal and

interest payments for two years. At the end of two years the firm will pay the entire $1

million plus an extra $100,000 for your patience. If new loans are being booked at a 9%

rate, which option is preferable?

2. Which project, A or B, could be sold for the most money today? Project A will generate

cash flows of $400, $500, and $600 in the third, fourth, and sixth years, respectively, of

the project's life. Project B will generate cash flows of $700 in year two and $800 in year

nine. Investments similar to "A" return 10% on average while investments similar to "B"

return 11%.

21

3. The PKB Corporation plans to issue 10 year zero-coupon bonds with a face value

(maturity value) of $1,000 per bond. If bonds of similar risk are yielding 13%, how much

should PKB expect in proceeds (per bond issued)?

4. What would be the proceeds if investors expected interest rates to be 13% for the first

four years then 16% for the remaining six years? (Refer to 3 above. )

5. How much do you need to invest today to be a millionaire when you retire at age 65? Use

your own age and a realistic rate of return, say 10%.

22

Solutions:

PV = FV 980,000 = $938,669.76

(1 + r)t (1.09)1/2

PV = l,l00,000 = $925,847.99

(1.09)2

Since the PV is higher, it's better to repossess the collateral and sell it.

2. Project A:

(1.10)3

(1.10)4

(1.10)6

23

Project B:

(1.11)2

(1.11 )9

3.

Price of bond = 1000 = $294.59

(1.13)10

24

4. Price of bond in four years will be the discounted PV at that time. So,

1.166

1.166 = 1.166 = (1.13)4(1.16)6 = $251.73

(1+r)4 1.134

5.

PV = 1,000,000 = $57,308.55

(1.10)30

If you are 35, it’s necessary to invest $57,308.55 today in an account that pays 10% per

annum.

25

Perpetuities

A perpetuity is a stream of equal cash flows beginning in one period and lasting forever. What is

the future value of a perpetuity? Infinity, since cash will be generated forever. Does that imply

that the present value is of infinite worth or that since there exists an inverse relationship

between PV and FV that the PV is zero. No, neither is implied, the inverse relationship between

present value and future value exists for a single cash flow, not for multiple cash flows. In fact,

the calculation of the present value of a perpetuity is the simplest of all time value of money

calculations. The reasoning behind the calculation requires some thought, though.

Obviously, the hardest (and longest) way to find the present value of a perpetuity is to discount

each cash flow individually. This calculation would require an infinite amount of time. Luckily,

a short-cut exists.

We have already seen that the present value of any stream of cash flows can be found by

summing the discounted value of each cash flow. Mathematically this can be written:

(1+r)1 (1+r)2 (1+r)3 (1+r)T

T

PV = Σ CFt

t=1 (1 + r)t

Since a perpetuity consists of equal cash flows, we can factor the cash flow to yield:

PV = CF [ 1 + 1 + 1 + …….. + 1 ]

1 2

(1 + r) (1 + r) (1 + r)3 (1 + r)T

26

or, in shorthand,

T

PV = CF Σ 1__

t=1 (1 + r)t

where "Σ" the capital Greek letter sigma stands for summation. Thus the present value of a

perpetuity would be shown as:

α

PV = CF Σ 1

t=1 (1 + r)t

For any positive interest rate (where r > 0), as t approaches infinity (gets larger and larger),

l/(l + r)t approaches zero since the denominator grows rapidly (it's a geometric progression). This

growth causes the value of the fraction to decrease each period. Although the factor constantly

decreases, it never becomes negative nor equals zero. It does, however, become smaller and

smaller and approaches zero. The graph below shows the value of $10 discounted at 5% from 1

to 200 years.

10

9

8

7

6

5

4

3

2

1

0

1 25 50 100 150 200

27

The values are always positive but they become worth less and less. The fact that future cash

flows become less valuable as time progresses can be seen intuitively as well. What would you

pay me today if I promised to deliver a hundred billion dollars in a million years. Probably very

little since you {and most everyone else} are almost certain to be dead by then.

The graph on the previous page displays the present value of individual cash flows. The present

value of a perpetuity is the accumulation of the present values of each future cash flow for

eternity. The following is a graph that illustrates the cumulative present values when the value of

the t - period cash flow is added to the sum of the previous t -1 cash flows (t = 1 to 200). Note

that as time passes the additional value of each cash flow becomes more and more negligible, in

fact the total value will never exceed $200 (this can be shown with as the sum of a geometric

series).

200

190

180

170

160

150

140

130

120

110

100

90

80

70

60

50

40

30

20

10

0

1 25 50 100 150 200

28

Since it may seem strange that an infinite number of equal cash flows will have a finite present

value --in this case only $200-- it may be helpful to consider a non-financial example. You are

standing 20 meters from a wall. Walk half of the distance and stop. Walk half of the remaining

distance and stop. Continue this procedure until you reach the wall. How long will it take to

reach it? In fact, you will never reach it; you will walk forever, but the distances that you cover

with each step will become shorter and shorter (1/2, 1/4, 1/8, 1/16, ...). Thus you will walk

forever but never move 1111 more than 20 meters. Likewise, you may receive cash forever, but

the total present value need not be more than a finite value (usually lower than you would

expect).

first term

1 - factor

first term = CF

1+r

factor = 1

1+r

Substituting, we find:

CF

1+r

Sum = PV = 1- 1 = CF

1+r r

Please note the timing of the cash flow and present value. The first cash flow arrives at the end of

one period, not today. The present value is calculated as of today.

29

Example:

Rather than continuing its policy of refinancing 30-year treasury bonds upon maturity, the U.S.

government has decided to issue perpetuity notes which will pay interest of $80 per year. 1) If

investors can earn 6% on similar risk-free bonds, what should the government expect as proceeds

for the issuance of a single note? 2) What should it expect if interest rates increased to 7%?

1. $80/.06 = $1,333.33

2. $80/.07 = $1,142.86

The value of the perpetuity dropped by $190.47 or 14.2% as rates increased by 1%. The present

values (prices) of perpetuities are much more sensitive to interest rates than other financial

instruments. (Interest rate sensitivity issues will be covered in the Capital Markets Calculations

course.)

30

Concept Reinforcement Question:

Can you think of any standard financial instruments that would be valued as a perpetuity?

Solution:

The only financial instrument which typically provides a constant cash flow per period, without a

return of principal, is preferred stock. Thus the price of preferred stock can be modeled as next

period's dividend divided by an appropriate capitalization rate. (You may argue that some

international debt falls into this perpetuity category, also.)

Growing Perpetuities

Unlike preferred stock, the price of common stock is rarely modeled as a normal perpetuity

because usually there are growth opportunities which create non-level cash flow streams. Growth

opportunities exist when a firm retains cash to invest in projects that will return more than the

opportunity cost of capital.

Simple common stock valuation models which assume constant growth are often framed as

growing perpetuities since the cash flows --in the form of dividends-- are assumed to grow at a

fixed rate per year. Obviously, this is usually not realistic, but it does make for simple

calculation.

A growing perpetuity is an infinite stream of cash flows that increase by a constant percentage

per year. Although the periodic cash flows grow forever, the stream still has a finite present

value. In fact the present value will equal:

PV = Cl/(r - g)

31

Where C1 is the cash flow next period, r is the opportunity cost of capital per period, and g is the

growth rate in cash flows. Note that in this model, Ct+1 = Ct (1 + g).

As was previously mentioned, this formula is used in naive stock valuations models like the

Gordon Growth Model where constant growth of earnings, dividends, reinvestment, and return

on equity is assumed.

Example:

Part 1: The SameSlope Corporation expects to grow at 5%, forever. This year it earned $3.00 per

share and paid dividends $.75 per share. It expects to pay-out one quarter of earnings as

dividends for an indefinite period. If similar stocks are yielding 11%, what is SameSlope's stock

price per share?

Solution:

First, since this year's dividends were provided, we must calculate next year's dividend. This can

be done two ways:

1. Earnings will grow 5% from $3.00 to $3.15. Given a constant pay-out ratio of 1/4, the

dividend next year will be $3.15 * .25 = $.7875.

Next, apply to growing perpetuity formula given next year's cash flow of $.7875, cost of capital

of 11% and growth rate of 5%.

r -g .11 - .05 .06

32

Part 2:

Assuming that neither the discount rate nor next year's dividend has changed, if the price rose to

$39.375 per share, what happened to the growth rate?

To solve for the constant growth rate, it's necessary to first multiply both sides of the equation by

(r - g) then divide both sides by the price.

PV 39.375

If (r - g) = .02 and r = .11, the growth rate must have increased to 9%.

33

Practice Problems:

1. As you will learn when we discuss net present value (NPV), an investment's net present

value is the (net) difference between the present value of all positive cash flows (inflows)

and the present value of all negative cash flows (outflows). A firm's stock price can be

modeled as the NPV of all of the individual projects owned and operated by the firm.

Thus, the stock price represents the present value of all future cash flows of the firm

(discounted at the firm's opportunity cost of capital).

Assume that Mellon's cost of capital is 12%. Further assume that last year Mellon

eliminated 1,000 positions at an average compensation cost of $30,000 per position. If

this action had not been taken, the employees would have worked until retirement at

which time they would have been replaced by similarly paid employees. If none of the

workers was expected to be replaced after the action and each displaced employee

received a year of severance pay, what should have been the effect on the bank's market

value on the date that the lay-offs were announced?

To simplify this analysis, assume that if the jobs had continued to exist, salaries would

have been frozen forever.

2. Assume that compensation costs would have been expected to rise by 5% per year (every

year) after a one-year freeze. What is the present value of the savings now?

34

3. Eternity Financial Corporation plans to issue non-callable, non-redeemable preferred

stock. Eternity plans to pay a dividend of 12% based upon a par value of $100. If similar

preferred stock returns 13%, what will Eternity's proceeds be?

4. What rate should Eternity promise to pay to yield $110 per share?

5. PCB Corporation will be required to spend $10 million every fifty years to make certain

that their toxic waste lagoon does not leak. Given a 10% discount rate, how much should

PCB set aside today to ensure adequate funds are available?

35

Solutions:

r .12

The cost of layoffs --severance pay-- today is: $30,000 x 1,000 = $30 million

r-g .12 - .05

Cost of layoffs today = $30 million. Net Savings = $398.57 million. Stock value should

rise by $398.57.

12 = $92.31

.13

36

4. If price/share = 110, what must the yearly payment be?

110 = CF

.13

5. PV = 10 + 10 + ...

50 l00

(1.1) (1.1)

(1.1)50

1- 1

(1.1)50

= 0.085186

1 - 0.0085186

= .0859174 million

= $85,917.41

37

Annuities

An annuity is a stream of equal cash flows delivered over some finite period of time. (They are

like perpetuities which end.) Annuities are rather common occurrences in financial markets: car

loans, mortgages, leases, bonds, and interest rate swaps all have annuity components to them.

We will deal with two types of annuities: ordinary annuities and annuities due. An ordinary

annuity is a stream of equal cash flows that begin at the end of one period. An annuity due is

a stream of equal cash flows that begin today. Thus, a five period annuity due would consist of a

cash flow today and a four period ordinary annuity. This is easy to see on a time-line:

x x x x x

∗- - - - - - - - - - ∗ - - - - - - - - - - ∗ - - - - - - - - - - ∗ - - - - - - - - - - ∗ - - - - - - - - - - ∗

t=0 t=1 t=2 t=3 t=4 t=5

x x x x x

∗- - - - - - - - - - ∗ - - - - - - - - - - ∗ - - - - - - - - - - ∗ - - - - - - - - - - ∗ - - - - - - - - - - ∗

t=0 t=l t=2 t=3 t=4 t=5

Obviously the present value of an ordinary annuity is less than the present value of a similar

period annuity due. In fact, for any t-period stream of (equal) cash flows, the PV of an annuity

due will exceed the PV of an ordinary annuity by:

CF - CF

(1 + r)t

38

Both types of streams are common in real-world applications. For instance, bonds, which begin

paying interest after six months, are like ordinary annuities, and leases, which require an initial

payment at the beginning of the lease term, are like annuities due.

There are at least two ways to view the present value of an annuity. One could view it as the

difference in present value of two perpetuities which begin at different dates (one in one year,

one in t + 1 years) or as the summation of individual present value factors where the payment is

factored and the remaining discount factors are summed (see below).

We will we consider annuities as summations, first. Recall, from the perpetuity section, that the

present value of any cash flow stream can be viewed as:

(1 + r)1 (1 + r)2 (1 + r)3 (1 +r)T

T

PV = Σ CFt

t=l (1 + r)t

Again, since the cash flow is the same each period, we can factor it and sum the discount factors.

T

PV = CF Σ 1

t=l (1 + r)t

39

The present value factor of an annuity is simply this summation. If the equation is confusing, the

following example should help clarify the point. What is the PV of a four-period ordinary

annuity which pays an annual cash flow of $100 and has a discount rate of 10%:

1.1 1.21 1.331 1.4641

PV = 100 [ 1 + 1 + 1 + 1 ]

1.1 1.21 1.331 1.4641

PV = 100 (3.16986)

PV = $316.99

In this case the annuity factor is 3.16986. What about situations like mortgages where the

payment is fixed for 360 months? Is it necessary to add 360 factors to get the desired number?

No. By viewing annuities as perpetuities that end, we can develop a formula for finding their

present values without detailed calculation.

In present value terms, what's the difference between a ten-year annuity and a perpetuity? The

difference is simply the present value of all of the perpetuity's cash flows after year ten

(beginning in year eleven).

A A A A. . . . . .A

P P P P. . . . . . P P P P P P ….

∗ - - - - ∗ - - - - ∗ - - - - ∗ - - . . . . . . ∗ - - - - ∗ - - - - ∗ - - - - ∗ - - - - ∗ - - - - ∗ ….

t=0 1 2 3 4. . . . . 10 11 12 13 14 15

40

How would you calculate the excess present value of a perpetuity over an annuity? In this case,

at the end of ten years, the value of the annuity would be zero since no more cash is expected,

but the present value of the perpetuity would still be Cll/r since even after ten years, you will still

receive cash forever. The present value, today, of those distant cash flows beginning in year 11

is:

PV0 = PV10

(1 + r)10

(1+r)10 r(1+r)10

So if Cll/[r (1 + r)10 is the excess value of a perpetuity over an annuity. The value of the annuity

must be the value of the entire perpetuity minus the present value of all cash flows that come

after the annuity, in this case, after ten years. Referring to our first example, the present value of

a four-year annuity consisting of $100 discounted at 10% would be:

.1 .1(1.1)4

= 1,000 - 683.01

= 316.99

41

To generalize, the present value of any ordinary annuity is:

PV = CF [1 - 1 ]

r r(1+r)t

where CF is the periodic cash flow, r is the periodic discount rate, and t is the number of periods

(or payments).

Example 1:

She wants to borrow $15,000,000 and repay it in installments of principle and interest of

$2,500,000 per year over the next ten years. If the bank can earn 12% on new loans, should it

make the loan?

Solution:

PV = 2,500,000 [1 - 1 ]

10

.12 .12(1.12)

PV = 2,500,000 (5.650223028)

PV = 14,125,557.57

So, the loan should not be approved since the present value of the payments is less than the

amount loaned.

42

Since it's possible to calculate the present value given the amount of periodic payments, is it then

possible to calculate the payments given the present value? Of course, why else would

we ask the question?

Since

PV = CF [ 1 - 1 ]

t

r r(1 = r)

CF = ___ PV____

[ 1 - 1 ]

t

r r(1 + r)

43

****

Example 2:

You owe $20,000 on a car. If rates are .75% per month, which equates to a 9.38% effective

annual rate, what is the monthly payment for a three-year loan? four-year loan?

Solution :

For a three-year loan, the present value annuity factor would be:

PV annuity factor = 1 - 1

.0075 .0075(1.0075)36

Similarly, for a four-year loan the annuity factor would be 40.18478 and the monthly payment

would be $497.70.

An annuity is a stream of equal cash flows. A growing annuity is, a stream of unequal cash flows

where each successive term is found by multiplying the preceding term by a fixed ratio. This

ratio is always greater than one. In fact, growing annuities can be viewed as finite geometric

progressions. Applying the proper geometric progression formula yields:

PV = CF [ 1 - (1 + g) t ]

r-g (1 + r)t

44

Future Value of an Ordinary Annuity

Occasionally, the following question may arise: How much will I have to put away each period

for the next t periods, to have the amount FV assuming that it's possible to earn an interest rate of

r per period? In this situation, the future value of an ordinary annuity is the desired result. Use

the following formula to solve for the FV of an annuity:

FV = CF ( 1 + r ) t – 1

r

45

Practice Problems:

1a. What would Jeff's monthly mortgage payment be if he borrowed $80,000 for 30 years at

a twelve percent annual rate?

1b. What would his total payments be over the life of the 30-year loan? Assuming that he

pays on schedule, what would the interest expense be over the life of the loan?

1c. Again, assuming that he pays on schedule, how much will he owe after making monthly

payments for ten full years? (Can you think of two ways to solve this problem?)

46

2. Your child is ten years old. She will enter college at age eighteen. At that time, first

year's tuition is expected to be $18,000; furthermore, it is expected to increase at 6% per

year. Fortunately for you, she expects to earn a four-year degree and immediately begin

studies on a two-year MBA (to be financed by her parent(s)). Assume that all tuition is

due at the beginning of the academic year, and that you will be able to earn rates of return

of 9% in each future year. How much cash would you need today to completely pay for

her education?

(Hint: first calculate how much you would need in seven years.)

47

3. Sue plans to invest in a nuclear power plant where she can experiment with high-level

radiation and try her hand at developing fusion reactors. She can purchase the plant

outright for $600 million or she can arrange a lease transaction. If she leases the plant,

she will be required to make thirty annual payments of $75 million beginning

immediately. If Sue's opportunity cost of capital is 13%, what should she do, lease or

buy?

4. You have just signed up to make installments for the purchase of your car. Along with a

$1,000 down payment, you have agreed to monthly payments of $230 per month, for the

next four years. If your effective discount rate is 12% per year, how much does the car

cost you?

48

5. Your boat dealer offers to sell you the "Unsinkable" for $20,000. Moreover, he offers

financing at the stated rate of 15% per year. If the boat is to be paid off in five years and

your discount rate is 12%, what would it cost you to buy the boat through the financing

package?

49

Solutions:

1a. Monthly payment with $80,000 borrowed for 30 years, (30 x 12) = 360 months at 12%

annual rate. We will treat the 12% as the stated annual rate. So, the monthly rate is 1% .

PV = C [ 1 - 1 ]

t

r r(1 + r)

C [ 1 - 1 ]

360

.01 .01(1.01)

C = $822.89

b. Total payments = 360 x 822.89 = $296,240.40. Since the principal repaid = $80,000, the

rest is the interest paid

= (296,240.40 - 80,000)

= $216,240.40

822.89 [ 1 - 1 ] = $74,734.39

240

.01 .01(1.01)

50

****

2. PV at t=7 (beginning of year 7)

= C [1 - (1 + g) t ]

r–g (1 + r)t

= 18,000 [ 1 - 1.06 6 ]

0.09 - .06 1.09 6

= $92,510.04

1.097 (1.09)7

Cost of leasing = 75 + 75 [ 1 - 1 ]

29

.13 .13 * 1.13

= $635.26 million

51

4. PV of annuity = C [ 1 - 1 ]

t

r r (1 + r)

If the effective annual rate is 12%, rm , the monthly rate can be found from

(1 + rm )12 = 1.12

PV = 230 [1 - 1 ] = $8,834.13

48

.0094888 (1.009488)

5. First, calculate the payments you are being asked to make. With a 15% stated rate, the

monthly periodic rate is .15/12 = .0125. Since $20,000 is the present value of the

payments --the price of the boat-- set:

20,000 = payment [ 1 - 1 ]

60

.0125 (1.0125)

So the payment is $475.80 per month. At your discount rate of 12%, this stream of payments is

worth

PV = 475.80 [1 - 1 ]

60

.0094888 (1.0094888)

It is better to borrow elsewhere at 12% or use cash now invested in projects generating 12%.

52

Net Present Value

The concept of net present value (NPV} is the single most important concept in modern financial

theory. Wealth (and wealth creation} can be modeled in terms of NPV. This section does not

introduce any new calculations, rather it presents an important application of the basic present

value concepts.

As the term itself implies, net present value is a measure of the difference between the present

value of all cash inflows (positive values} and present value of all cash outflows (negative

values}. That is,

Thus, NPV is the value or wealth created today by deciding to invest in a project. The project

need not be "onstream" since the NPV is based upon expectations of future cash flows.

Don't confuse NPV with profit or income in an accounting sense. Profit equals revenues

-expenses, for a particular period. It's a measure of how a firm has performed on an accrual

accounting basis, not on a cash flow basis. Since profit measures do not consider opportunities

forsaken to make a particular investment --the cost of capital-- profits do not provide a relative

measure of a project's worthiness.

It's even possible to earn profits while destroying wealth. Consider a one-period project with an

initial investment of $1. Projects of similar risk yield 7%. This particular one yields 3%. In an

accounting sense, the project has a profit of $.03. Economically, the project destroys wealth

since a return of 7% could have been earned without accepting any additional risk. The present

value of $1.03 is less than $1, thus the project has a negative net present value and it should not

be funded at a cost of $1.

53

Positive net present value implies that a project creates wealth. That is, it returns more than other

similar projects of similar risk) which require the same rate of return. Negative NPV means that

there are better ways to invest funds rather than in the proposed project; thus, it should not be

attempted.

Intuitively, present values are comparisons between a project's returns (cash flows) and what

could be earned elsewhere. That's why the project's cashflows are divided by available rates in

the ratio {Ct/(l + r)t }. Net present value provides a relative evaluation of a project's viability

based upon its cash flows and risks. Wealth is only created when returns exceed the opportunity

cost of capital and this only occurs when the project has some unique capacity unavailable

elsewhere in the market place.

Thus far, we have stressed that net present value is a measure of wealth-creation which is based

upon the relative level of a project's expected cash flows compared to the expected returns from

projects of similar risk. A natural question would be what do we mean by risk and how is it

reflected in the calculations?

By risk we mean the potential variability in returns. Compensation for assuming risk is reflected

in the cost of capital. As risk increases the discount rate increases. Later in the course we will

discuss statistical measures of risk. Subsequent courses will cover cost of capital models used in

conjunction with these various risk measures. For now, it’s sufficient to remember that as risk

increases, required rates of return increase. Thus the rate used to calculate the net present value

of investing in a new K-Mart store should be different (lower) than the rate used to discount

expected cash flows from an investment in an oil exploration and drilling operation.

54

Practice Problem:

Nollem Corporation plans to build a new facility to turn garbage into energy. The facility will

cost $100 million to build and will generate cash flows of $14 million per year for fifteen years.

At the end of the facility's life Nollem must spend $25 million to convert the plant into a non-

profit museum. Given a cost of capital of 7%, should Nollem invest in the plant? Assume all the

cash comes at the end of the year.

Solution:

NPV = -100 + 14 [ 1 - 1 ] - 25

15

.07 .07(1.07) 1.0715

NPV = +18.45,

55

Illustration:

What if expected rates increased to 12%? Should the project still be funded?

Solution:

In this case, the NPV falls to -9.22; thus, the project should not be attempted. In value terms, it

loses money.

Notice the impact of higher rates on the NPV and funding decisions throughout the economy.

High nominal interest rates caused by high real rates or high inflation expectations can easily

discourage investment. Low rates (throughout the economy) stimulate investment by making

distant cash flows -- which are usually positive-- more valuable. It's easy to see how business

investment can be stymied when the Federal Reserve Board tightens money policy to drive up

interest rates.

56

Concept Reinforcement Question:

Part 1: Simplified, the efficient markets hypothesis states that all relevant public information is

impounded in (affects) a firm's stock price. Given this theory, what is the NPV of buying stocks

or bonds?

Without inside information, the net present value of buying stocks and bonds is zero. If you

agree that the price paid equals the present value of all expected future cash flows, then the cost

of the stock is equal to the benefits expected to be derived. This means no value is being created

or destroyed by purchasing the stock on the open market. Alternatively, we can view the market

price as the equilibrium point where a price increase is as likely as a price decrease which means

that there is a 50-50 chance of doing better or worse than expected.

Does that mean that there is no profit? No! Normal profits -- in the form of interest, dividends,

and capital appreciation-- still occur. It's just there is no reason to expect to earn more than the

average return for an instrument with that level of risk.

57

Part 2: What role do security analysts play within the financial markets?

In equation terms, security analysts help provide estimates of the cash flows, which appear in the

numerator, and provide measures of risk which are reflected in the cost of capital in the

denominator of the NPV calculations. Since new facts about a firm's cash flows and risks are

frequently being generated and exposed, price changes, which reflect this information, occur

often. So, analysts help to maintain efficiently priced markets by uncovering the underlying

economic conditions of publicly-traded firm and reporting this information to investors.

58

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