Berk Chap 4

Chapter 4
The Time Value

of Money
Copyright © 2011 Pearson Prentice Hall. All rights reserved.

Chapter Outline
4.1 The Timeline

4.2 The Three Rules of Time Travel
4.3 Valuing a Stream of Cash Flows
4.4 Calculating the Net Present Value
4.5 Perpetuities, Annuities, and Other
Special Cases
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Chapter Outline (cont’d)
4.6 Solving Problems with a Spreadsheet

Program
4.7 Solving for Variables Other Than
Present Value or Future Value

4.1 The Timeline
• A timeline is a linear representation of the

timing of potential cash flows.
• Drawing a timeline of the cash flows will
help you visualize the financial problem.

Textbook Example 4.1

Textbook Example 4.1 (cont’d)

4.2 Three Rules of Time Travel
• Financial decisions often require combining

cash flows or comparing values. Three
rules govern these processes.
Table 4.1 The Three Rules of Time Travel

The 1st Rule of Time Travel
• A dollar today and a dollar in one year are

not equivalent.
• It is only possible to compare or combine
values at the same point in time.
– Which would you prefer: A gift of $1,000 today
or $1,210 at a later date?
– To answer this, you will have to compare the
alternatives to decide which is worth more.
One factor to consider: How long is “later?”

The 2nd Rule of Time Travel
• To move a cash flow forward in time, you

must compound it.
– Suppose you have a choice between receiving
$1,000 today or $1,210 in two years. You
believe you can earn 10% on the $1,000
today, but want to know what the $1,000 will
be worth in two years. The time line looks like
this:

The 2nd Rule of Time Travel (cont’d)
• Future Value of a Cash Flow
FVn = C × (1 + r ) × (1 + r ) ×  × (1 + r ) = C × (1 + r ) n

n times



Alternative Example 4.2
• Problem
– Suppose you have a choice between receiving
$5,000 today or $10,000 in five years. You
believe you can earn 10% on the $5,000
today, but want to know what the $5,000 will
be worth in five years.

Alternative Example 4.2 (cont’d)
• Solution
– The time line looks like this:
0 1 2 3 4 5
$5,000 x 1.10 $5, 500 x 1.10 $6,050 x 1.10 $6,655 x 1.10 $7,321 x 1.10 $8,053
– In five years, the $5,000 will grow to:
$5,000 × (1.10)5 = $8,053
– The future value of $5,000 at 10% for five years
is $8,053.
– You would be better off forgoing the gift of $5,000 today
and taking the $10,000 in five years.

The 3rd Rule of Time Travel
• To move a cash flow backward in time, we

must discount it.
• Present Value of a Cash Flow

C
PV = C ÷ (1 + r ) n
=
(1 + r ) n



• Problem
– Suppose you are offered an investment that
pays $10,000 in five years. If you expect to
earn a 10% return, what is the value of this
investment today?

• Solution
– The $10,000 is worth:
• $10,000 ÷ (1.10)5 = $6,209

Applying the Rules of Time Travel
• Recall the 1st rule: It is only possible to

compare or combine values at the same
point in time. So far we’ve only looked at
comparing.
– Suppose we plan to save $1000 today, and
$1000 at the end of each of the next two
years. If we can earn a fixed 10% interest rate
on our savings, how much will we have three
years from today?

Applying the Rules of Time Travel
(cont'd)



• Problem
– Assume that an investment will pay you $5,000
now and $10,000 in five years.
– The time line would like this:
0 1 2 3 4 5
$5,000 $10,000

Alternative Example 4.4 (cont'd)
• Solution
– You can calculate the present value of the combined cash
flows by adding their values today.
0 1 2 3 4 5
$5,000
$6,209 5
$10,000
÷ 1.10
$11,209
– The present value of both cash flows is $11,209.

• Solution
– You can calculate the future value of the
combined cash flows by adding their values
in Year 5.
0 1 2 3 4 5
$10,000
$5,000 x 1.105 $8,053
$18,053
– The future value of both cash flows is $18,053.

Present
Value
0 1 2 3 4 5
$11,209 $18,053
÷ 1.105
Future
Value
0 1 2 3 4 5
$11,209 $18,053
x 1.105

4.3 Valuing a Stream
of Cash Flows (cont’d)
• Present Value of a Cash Flow Stream

N N
Cn
=
PV
n 0=n 0
∑ PV (Cn )
= ∑ (1 + r ) n


Future Value of Cash Flow Stream
• Future Value of a Cash Flow Stream with a Present Value of

PV
FVn = PV × (1 + r ) n

• Problem
– What is the future value in three years of the
following cash flows if the compounding rate
is 5%?
0 1 2 3
$2,000 $2,000 $2,000

• Solution 0 1 2 3
$2,000 $2,315
x 1.05 x 1.05 x 1.05
$2,000 $2,205
x 1.05 x 1.05
• Or $2,000
x 1.05
$2,100
$6,620
0 1 2 3
$2,000 $2,000 $2,000

x 1.05
$2,100
$4,100
x 1.05
$4,305
$6,305
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x 1.05
4.4 Calculating the Net Present
Value
• Calculating the NPV of future cash flows
allows us to evaluate an investment
decision.
• Net Present Value compares the present
value of cash inflows (benefits) to the
present value of cash outflows (costs).


Textbook Example 4.6 (cont'd)

• Problem
– Would you be willing to pay $5,000 for the
following stream of cash flows if the discount
rate is 7%?
0 1 2 3
$3,000 $2,000 $1,000

• Solution
– The present value of the benefits is:
3000 / (1.05) + 2000 / (1.05)2 + 1000 / (1.05)3 =
5366.91
– The present value of the cost is $5,000,

because it occurs now.
– The NPV = PV(benefits) – PV(cost)
= 5366.91 – 5000 = 366.91

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

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



• Problem
– You want to endow a chair for a female
professor of finance at your alma mater. You’d
like to attract a prestigious faculty member, so
you’d like the endowment to add $100,000 per
year to the faculty member’s resources (salary,
travel, databases, etc.) If you expect to earn a
rate of return of 4% annually on the
endowment, how much will you need to donate
to fund the chair?

• Solution
– The timeline of the cash flows looks like this:
– This is a perpetuity of $100,000 per year. The

funding you would need to give is the present
value of that perpetuity. From the formula:
C $100,000
PV= = = $2,500,000
r .04
– You would need to donate $2.5 million to
endow the chair.
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 n=1 ( 1 + r )n

Present Value of an Annuity
• To find a simpler formula, 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.

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 − 20
= $62.31
(1.05)

Present Value of an Annuity
• For the general formula, substitute P for

the principal value and:
PV(annuity of Cfor N periods)
= P − PV(Pin period N)
P  1 
=
P− =
P 1 − N 
(1 + r) N
 (1 + r) 



Future Value of an Annuity
• Future Value of an Annuity

FV (annuity) = PV × (1 + r ) N
C  1 
= 1 −  × (1 + r ) N
r  (1 + r ) N

=C ×
1
r
( (1 + r ) N
− 1)



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


• Problem
– In Alternative Example 4.7, you planned to
donate money to endow a chair at your alma
mater to supplement the salary of a qualified
individual by $100,000 per year. Given an
interest rate of 4% per year, the required
donation was $2.5 million. The University has
asked you to increase the donation to account
for the effect of inflation, which is expected to
be 2% per year. How much will you need to
donate to satisfy that request?

• Solution
The timeline of the cash flows looks like this:
The cost of the endowment will start at $100,000,

and increase by 2% each year. This is a growing
perpetuity. From the formula:
C $100,000
PV= = = $5,000,000
r .04 − .02
You would need to donate $5.0 million to endow the

chair.
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   1 + g  
N
PV =
C × 1 −   
(r − g )   (1 + r )  



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.



Present Values or Future Values (cont’d)
• In some situations, you know the present

value and cash flows of an investment
opportunity but you do not know the
internal rate of return (IRR), the
interest rate that sets the net present
value of the cash flows equal to zero.







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Chapter 4

The Time Value

Copyright © 2011 Pearson Prentice Hall. All rights reserved.

4.1 The Timeline

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-2

4.6 Solving Problems with a Spreadsheet

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-3

• A timeline is a linear representation of the

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-4

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-5

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-6

• Financial decisions often require combining

Table 4.1 The Three Rules of Time Travel

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-7

• A dollar today and a dollar in one year are

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-8

• To move a cash flow forward in time, you

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-9

• Future Value of a Cash Flow

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-10

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-11

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-12

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-13

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-14

• To move a cash flow backward in time, we

• Present Value of a Cash Flow

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Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-16

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-17

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-18

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• Recall the 1st rule: It is only possible to

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Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-21

Copyright © 2011 Pearson Prentice Hall. All rights reserved. 4-22

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– The future value of both cash flows is $18,053.

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• Present Value of a Cash Flow Stream

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• Future Value of a Cash Flow Stream with a Present Value of

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$2,000 $2,000 $2,000

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$2,000 $2,000 $2,000

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$3,000 $2,000 $1,000

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– The present value of the cost is $5,000,

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– This is a perpetuity of $100,000 per year. The

• When a constant cash flow will occur at

• Present Value of an Annuity

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