Prof.

Vaidya Nathan
Corporate Finance−I (Cfin-1)
Term 3, August 2022
Time Value of Money: An Introduction
Prof. Vaidya Nathan
Corporate Finance−I (Cfin-1)
Term 3, August 2022
Questions

What is Arbitrage? Can/Do they exist?

What is Law of One Price?
How to value cash flows at different points in time?
What are the rules?
How by depositing money, we convert money today
into money in the future?
How by borrowing money, we exchange money in the
future for money today?
Outline

Law of One Price

Time Value of Money
Three rules of time travel of cash flows
Market Prices and Valuation Principle

There can be only one competitive price for a Good

– Law of One Price
▪ In competitive markets, securities that produce exactly the
same cash flows must have the same price.
– Arbitrage
▪ The practice of buying and selling equivalent goods to take
advantage of a price difference.
– Arbitrage Opportunity
▪ Any situation in which it is possible to make a profit
without taking any risk or making any investment.
Time Value of Money

The Time Value of Money and Interest Rates

– In general, a Rupee today is worth more than a Rupee
tomorrow.
– If I have ₹1 today and I can deposit it in a bank at 10%,
I’ll have ₹1.10 at the end of one year.
– The difference in value between money today and money
in future is the time value of money.
Converting between USD/INR or Rupees
in n years
x Exchange rate ($/₹)

US Dollar Today

÷ Exchange rate ($/₹)

USD/INR Exchange rate $/₹=0.0127 or ₹/$=79

Rupees Today

x (1+r)n

Rupees in n Years

÷ (1+r)n
Time Value of Money

The Interest Rate: Converting Cash across Time

– By depositing money, we convert money today into money
in the future.
– By borrowing money, we exchange money in the future
for money today.
Time Value of Money

The Interest Rate: Converting Cash across Time

– Interest Rate (r)
▪ The rate at which money can be borrowed or lent over a
given period.
– Interest Rate Factor (1 + r)n
▪ It is the rate of exchange between rupees today and rupees
in the future.
▪ It has units of “₹ in n year/₹ today.”
Time Value of Money

The Interest Rate: Converting Cash across Time

– Discount Factors and Rates
▪ Money in the future is worth less today so its price reflects
a discount.
▪ Discount Rate
– The appropriate rate to discount a cash flow to determine its
value at an earlier time.
▪ Discount Factor
– The value today of a rupee received later.
1
– The n-year discount factor is expressed as
1+𝑟 𝑛
Valuing Cash Flows across time

Rule 1: Comparing and Combining Values

– It is only possible to compare or combine values at the
same point in time.
Valuing Cash Flows across time

Rule 2: Compounding
– To calculate a cash flow’s future value, we must compound
it.

₹ ₹ ₹
Valuing Cash Flows across time

Rule 2: Compounding
– Compound Interest
▪ The effect of earning “interest on interest”
▪ Future Value of a Cash Flow

𝐹𝑉𝑛 = 𝐶 × 1 + 𝑟 × 1 + 𝑟 × ⋯ × 1 + 𝑟 = 𝐶 1 + 𝑟 𝑛

𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑛 𝑡𝑖𝑚𝑒𝑠
Valuing Cash Flows across time

Rule 3: Discounting
– To calculate the value of a future cash flow at an earlier
point in time, we must discount it.

₹ ₹ ₹

Present Value of a Cash Flow

𝑛
𝐶
𝑃𝑉 = 𝐶 ÷ 1 + 𝑟 = 𝑛
1+𝑟
Three Rules of time travel in finance

The Three Rules of Valuing Cash Flows

Rule Formula
1: Only values at the same point in None
time can be compared or combined.
2: To calculate a cash flow’s future Future value of a cash flow:
value, we must compound it.
𝑛
𝐹𝑉𝑛 = 𝐶 1 + 𝑟

3: To calculate the present value of a Present value of a cash flow:

future cash flow, we must discount it. 𝐶
𝑃𝑉 =
1+𝑟 𝑛
Key Learnings

Learnt about comparing and combining cash flows at

different points in time.
Assessed the effect of interest rates on today’s value of
future cash flows.
Learnt how to calculate the value of distant cash flows
in the present (discounting) and of current cash flows in
the future (compounding).
Valuing Cash Flow Streams
Prof. Vaidya Nathan
Corporate Finance−I (Cfin-1)
Term 3, August 2022
Questions

How to value Cash Flows from a Corporation because

they don’t have any definite life?
How to value cash flows from loan?
How to value Cash Flows from a Corporation when
they are growing for an infinite amount of time?
How to value cash flows from loan when the interest
payments grow with time?
Outline

Valuing a Stream of Cash Flows

➢Perpetuities
➢Annuities
➢Growing Perpetuities
➢Growing Annuities
Valuing a Stream of Cash Flows

Rules developed so far:

– Rule 1: Only values at the same point in time can be
compared or combined.
– Rule 2: To calculate a cash flow’s future value, we must
compound it.
FV𝑛 = 𝐶 1 + 𝑟 𝑛
– Rule 3: To calculate the present value of a future cash
flow, we must discount it.
𝑛
𝐶
PV = 𝐶 ÷ 1 + 𝑟 =
1+𝑟 𝑛
Valuing a Stream of Cash Flows

Consider a stream of cash flows: C0 at date 0, C1 at

date 1, and so on, up to CN at date N.

We compute the present value of this cash flow stream

in two steps.
First, compute the present value of each individual cash
flow.
Valuing a Stream of Cash Flows

Then combine the present values:

This timeline provides the general formula for the

present value of a cash flow stream:
𝐶1 𝐶2 𝐶𝑛
PV = 𝐶0 + + 2
+ ⋯+ 𝑛
1+𝑟 1+𝑟 1+𝑟
Perpetuities

Perpetuities
– A perpetuity is a stream of equal cash flows that occur at
regular intervals and last forever.
– Here is the timeline for a perpetuity:

– the first cash flow does not occur immediately; it arrives

at the end of the first period.
Perpetuities

Using the formula for present value, the present value

of a perpetuity with payment C and interest rate r is
given by:
𝐶 𝐶 𝐶
PV = + + ⋯+ +⋯
1+𝑟 1+𝑟 2 1+𝑟 𝑛

Notice that all the cash flows are the same.

Also, the first cash flow starts at time 1 (there is no cash
flow at time 0).
Perpetuities

To generalize, suppose we invest an amount P at an

interest rate r.
Every year we can withdraw the interest we earned, C
= r × P, leaving P in the bank.
Because the cost to create the perpetuity is the
investment of principal, P, the value of receiving C in
perpetuity is the upfront cost, P.
Rearranging C = r × P to solve for P, we have:
𝐶
𝑃=
𝑟
Perpetuities

Present Value of Perpetuity (PVP)

𝐶
PVP =
𝑟
Annuities

Annuities
– An annuity is a stream consisting of a fixed number of
equal cash flows paid at regular interval.

– The difference between an annuity and a perpetuity is

that an annuity ends after some fixed number of
payments.
Annuities

Present Value of an Annuity (PVA)

Note that, just as with the perpetuity, we assume the
first payment takes place one period from today.
𝐶 𝐶 𝐶
PVA = + 2
+ ⋯+ 𝑛
1+𝑟 1+𝑟 1+𝑟

To find a simpler formula, use the same approach as we

did with a perpetuity: create your own annuity.
Annuities

In general:

Present Value of Annuity (PVA) of C for n periods =

𝐶 1
PVA = 1−
𝑟 1+𝑟 𝑛
Annuities

Future Value of an Annuity (FVA)

𝐶 1 𝑛
FVA = 1 − 𝑛
1+𝑟
𝑟 1+𝑟

𝐶 𝑛
FVA = 1+𝑟 −1
𝑟
Growing Cash Flows

Present Value of a Growing Perpetuity (PVGP)

𝐶
PVGP =
𝑟−𝑔
Growing Cash Flows

Present Value of a Growing Annuity

A growing annuity is a stream of N growing cash flows,
paid at regular intervals.
It is a growing perpetuity that eventually comes to an
end.
Growing Cash Flows

The following timeline shows a growing annuity with initial

cash flow C, growing at a rate of g every period until period
N:
Growing Cash Flows

Present Value of a Growing Annuity (PVGA):

𝐶 1+𝑔 𝑛
PVGA = 1− 𝑛
𝑟−𝑔 1+𝑟
Key Learnings

Value a perpetual series of regular cash flows called a

perpetuity.
Value a common set of regular cash flows called an annuity.
Value both perpetuities and annuities when the cash flows
grow at a constant rate.