Handout - Chapter 5 6 - Time Value of Money

Chapter 5 & 6
Time Value of Money

Discounted cash flow
 PhD, Phan Hong Mai

 School of Banking and Finance
 National Economics University
 hongmai@neu.edu.vn
5-1
Key Concepts and Skills
 Be able to compute the future value of an

investment made today/ of multiple cash flows
 Be able to compute the present value of cash to
be received at some future date
 Be able to compute the return on an investment
 Be able to compute loan payments
 Be able to find the interest rate on a loan
5-2
Chapter Outline
5.1 Time Value of Money

5.2 Future Value
5.3 Present Value
5.4 Stated rates and EAR
5.5 Types of Loans
5-3
 Time value of money is the concept

that the value of $1 to be received in
future is less than the value of $1 on
hand today.
 In other words, time value of money
principle says that the value of given sum
of money to be received on a particular
date is more than same sum of money to
be received on a later date.
5-4
 1rst reason is that money received today

can be invested thus generating more
money.
 2nd reason is that when a person decides
to receive a sum of money in future rather
than today (for example, by lending his
money), there are risks involved in lending
(such as default risk and inflation). That
makes the value of money in future is less
than today.
5-5
 Time lines: A horizontal line that is used

to represent time, with the past towards
the left and the future towards the right.
 Show the timing of cash flows.
5-6
0 1 2 3
r%
CF0 CF1 CF2 CF3

Cash flow
received/invested
Cash flows received/invested in future
today
 Tick marks occur at the end of periods, so

Time 0 is today; Time 1 is the end of the first
period or the beginning of the second period.
5-7
5.2 Future value
 The amount of money an investment will

grow to over some period of times at
some given interest rate.
 What cash flows are worth in the future.
 Later money on a time line.
5-8
5.2.1 FV of a single cash amount invested
at r % per period for t periods
 Suppose you invest $1,000 for one year at

5% per year.
 What is the future value in one year?
0 1
r = 5%
$1,000
FV = ?
5-9
 Interest = $1,000 x 5% = $50

 Value in one year = principal + interest
= $1,000 + 50
= $1,050
 Future Value (FV) = $1,000 x (1 + 5%)
= $1,050
5-10
 Suppose you leave the money in for another

year. How much will you have two years
from now?
0 1 2
r = 5%
$1,000
$1,050
FV = ?
5-11
 Interest = $1,050 x 5% = $52.5

 Value in one next year = $1,050 + 52.5
= $1,102.5
 FV = $1,000 x (1 + 5%) x (1 + 5%)
= $1,000 x (1 + 5%)2
= $1,102.5
-> The process of accumulating interest over time

(to earn more money) is called “Compounding”
5-12
FV = C x (1 + r)t
 FV: future value
 C : cash amount
 r : period interest rate, expressed as a decimal
(“exchange rate” between earlier money and
later money, also can be called as Discount rate,
Cost of capital, Opportunity cost of capital,
Required return)
 t : number of periods
-> (1 + r)t : Future value interest factor, FVIF(r,t)
5-13
 Example 5.1
 Suppose you locate a two-year investment that
pays 14 percent per year. If you invest $300, how
much will you have at the end of the two years?
How much of this is simple interest? How much
is compound interest?
5-14
5.2.2 FV of multiple cash flows invested
 Suppose you invest $1,000; $1,250 and $2,324

from now for two years at 5% per year.
 How much will you have for two years ?
0 1 2
r = 5%
$1,000 $1,250 $2,324

FV = ?
5-15
 Firstly, calculate the FV of each cash flow

 Then, add them up.
0 1 2
r = 5%
$1,000 $1,250 $2,324

$1,102.5
$ 1,312.5
$ 4,739
5-16
 Example 5.2
 If you deposit $150 in one year, $200 in two
years, and $320 in three years, assume a 7
percent interest rate throughout. The cash
flows occur at the end of each year.
 Showing the cash flows on the time line? How
much will you have in three years? How much
will you have in five years if you don’t add
additional amounts?
5-17
5.2.3 FV of annuity cash flows
invested at r % per period for t periods
 A series of constant or level cash flows that

occur each period for some fixed periods is
called an annuity.
 An annuity for which the cash flows occur at the
end of the period is called an original annuity.
 An annuity for which the cash flows occur at the
beginning of the period is called an annuity due.
5-18
 Suppose you invest $1,000 at the end of each

year for three years at 5% per year.
 How much will you have for three years ?
0 1 2 3
r = 5%
$1,000 $1,000 $1,000

FV = ?
5-19
FV of original annuity cash flows:
5-20
 Suppose you invest $1,000 at the beginning of

each year for three years at 5% per year.
 How much will you have for three years ?
0 1 2 3
r = 5%
$1,000 $1,000 $1,000

FV = ?
5-21
FV of annuity due cash flows:
5-22
CONCEPT QUESTION 5.2
 What do we mean by the future value of an

investment?
 In general, what is the future value of $1
invested at r per period for t periods?
 Describe how to calculate the future value of
a series of multiple or annuity cash flows?
5-23
5.3 Present value
 The current value of future cash flows

discounted at the appropriate discount
rate.
 What future cash flows are worth today.
 Earlier money on a time line.
5-24
5.3.1 PV of a single cash amount to be
received in t periods at r % per year
 Suppose you need to have $1,050 in one

years, and you can earn 5% on your money.
 How much do you have to invest today to
reach your goal?
0 1
r = 5%
$ 1,050
PV = ?
5-25
 Suppose you need $1,102.5 in two years.

You can earn 5% on your money.
 How much do you have to invest today?
0 1 2
r = 5%
$ 1,102.5
PV = ?
5-26
 Based on your knowledge of FV, you know

the amount invest must grow to $1,050 over
one year.
 $1,050 = C x (1 + 5%)1
C = $1,050 / (1 + 5%)1
C = $1,000
5-27
 Suppose you need $1,102.5 in two years.

You can earn 5% on your money.
 How much do you have to invest today?
0 1 2
r = 5%
$ 1,102.5
PV = ?
5-28
 $1,102.5 = C x (1 + 5%)2
C = $1,102.5 / (1 + 5%)2
C = $1,000
-> The process of calculating the present value of a

future cash flow (to determine its value today) is
called “Discounting”
5-29
PV = C / (1 + r)t
 PV: present value
 C : cash amount
 r : period interest rate, expressed as a decimal
(“exchange rate” between earlier money and
later money, also can be called as Discount rate,
Cost of capital, Opportunity cost of capital,
Required return)
 t : number of periods
-> 1/(1 + r)t : Present value interest factor, PVIF(r,t)
5-30
5.3.2 PV of multiple cash flows to be
received in t periods at r % per period
 Suppose you need $1,050 in one year and

$1,102.5 more in two years.
 If you can earn 5% on your money. How much
do you have to put up today to exactly cover
these amounts in the future?
0 1 2
r = 5%
PV = ? $1,050 $1,102.5
5-31
5.3.2 PV of multiple cash flows to be
 Firstly, calculate the PV of each cash flow

 Then, add them up.
0 1 2
r = 5%
$1,050 $1,102.5
$1,000
$1,000
$ 2,000
5-32
5.3.3 PV of annuity cash flows to be received in
t periods at r % per period
 Suppose we are examining an asset that

promised to pay $500 at the end of each of the
next three years.
 If we want to earn 5% on our money, how much
would we offer for this annuity?
0 r = 5% 1 2 3
PV = ? $500 $500 $500
5-33
5.3.3 PV of annuity cash flows to be
received in t period at r % per period
 PV of original annuity cash flows:
5-34
5.3.3 PV of annuity cash flows to be
received in t period at r % per period
 Example 5.4
 You are offered an investment that will make
three $300 payments. The first payment will
occur four years from today. The second will
occur in five years, and the third will follow in
six years. You can earn 11 percent on very
similar investments.
 Showing the cash flows on the time line?
what is the most this investment is worth
today?
5-35
5.3.4 PV of growing annuity cash flows to be
 A growing annuity is an annuity where the

payments grow at a particular rate.
 Suppose we are looking at a lottery payout a 4-year
period. The first payment, made one year from now,
will be $500. Every year thereafter, the payment will
grow by 10%.
 What is the present value if the discount rate is 5%?
5-36
0 1 2 3 4
r = 5%
PV = ? $500
$500 x (1 + 10%)
$500 x (1 + 10%) x (1 + 10%)
$500 x (1 + 10%) x (1 + 10%) x (1 + 10%)

5-37
0 1 2 3 4
r = 5%
PV = ? $500
$500 x (1 + 10%)1
$500 x (1 + 10%)2
$500 x (1 + 10%)3
5-38
 1 g  t

1 -   
  1  r  
PV  C x
 rg 
 
 
5-39
5.3.5 PV of perpetuity cash flows to be
received at r % per period
 Perpetuity is an important case of an annuity

arises when the level stream of cash flows
continues forever.
 Because a perpetuity has an infinite number of
cash flows, we can’t compute its value by
discounting each one. However, PV of a perpetuity
is simply: PV = C/r
 Preferred stock is an important example of a
perpetuity. The preferred stockholders are
promised a fixed dividend every period forever.
5-40
5.3.5 PV of perpetuity cash flows to be
 Suppose the Dewey Co. wants to sell preferred

stock and promises to pay preferred dividend of
$12 per share of stock. A similar issue of preferred
stock already outstanding has a price of $150 and
offers a dividend of $10.5 every year.
 What price should Dewey offer today if the
preferred stock is sold?
5-41
5.3.6 PV of growing perpetuity cash flows to be
 A growing perpetuity is an perpetuity where the

payments grow at a particular rate.
 Based on the formula for PV of growing annuity, we
can compute PV of growing perpetuity.
PV = C/(r – g)
5-42
5.3.6 PV of growing perpetuity cash flows to be
 Suppose the Bilbo Co. wants to sell preferred

stock and promises to pay preferred dividend of
$12 per share of stock at the end of first year.
Every year thereafter, the payment will grow by
3%.
 If the required return rate for preferred stock is
7%, what price should Bilbo offer today?
5-43
 What do we mean by the present value of an

investment?
 The process of discounting a future amount
back to the present is the opposite of doing
what?
 In general, what is the present value of $1 to be
received in t periods, assuming a discount rate
of r per period?
5-44
 Stated rate (quoted rate) is the interest rate

expressed in terms of the interest payment
made each period (daily, monthly, quarterly
or annually…).
 Stated rate is stated in contracts. Periods
must also be given, e.g. 8% quarterly or 8%
daily interest.
5-45
 Effective annual rate (EAR) is the interest rate

expressed as if it were compounded once per
year. It is actually the rate that you will earn.
 To compare different investments of interest
rates, we will need to convert to EAR
 EAR = (1 + Stated rate/m)m – 1
 m: number of compounding periods per year.
5-46
 How much will we earn from $1 for one year

at the interest rate of 5% per year but
compounded daily, monthly, quarterly and
annually?
 What is EAR of each stated rate?
5-47
 What’s the FV of a 3-year $100 annuity,

if the quoted interest rate is 10%,
compounded semiannually?
5-48
 If an interest rate is given as 12% compounded

daily, what do we call this rate?
 Which is the stated rate or EAR more relevant
for financial decisions?
5-49
5.5 Types of Loans
The borrower receives money today but he can:

 Pure discount loan: repay a single lump
sum at sometime in the future.
0 1
5%
Borrows $10 Repays $10.05
5-50
5.5 Types of Loans
 Interest-only loan: pay interest each

period but repay the principal at some
point in the future.
0 5% 1 2
Borrows Interest paid Interest paid $0.5

$10 $0.5 Principal repaid $10
5-51
5.5 Types of Loans
 Amortized loan:
- pay equal payments (including interest
paid and principal repaid)
- repay equal principals, interest paid
depends on the beginning balance of each
period.
-> Use amortization tables to compute annual

payments
5-52
5.5 Types of Loans
 Suppose a business takes out a $5,000, five-

year loan at 9% percent. The loan agreement
calls for the borrower to make a single, fixed
payment every year.
 How will the amortization schedule look?
5-53
5.5 Types of Loans
 Step 1: Find the required annual payment

Dxr
Annual payment 
1
1-
(1  r) n
 D: the loan amount

 Step 2: Find the interest paid in year 1 by
multiplying the beginning balance by the interest
rate.
5-54
5.5 Types of Loans
 Step 3: Find the principal in year 1 by

subtracting the interest paid from the annual
payment.
 Step 4: Find the balance at the end of year
1 by subtracting the amount paid toward
principal from the beginning balance.
 Step 5: Construct the amortization schedule
by repeating steps 1-4 until end of loan.
5-55
5.5 Types of Loans
 Suppose a business takes out a $5,000, five-

year loan at 9% percent. The loan agreement
calls for the borrower to pay the interest on
the loan balance each year and to reduce the
loan balance each year by $1,000.
 Construct the amortization schedule?
5-56
 What is a pure discount loan?

 What is an interest-only loan?
 What does it mean to amortized loan?
5-57
SUMMARY and CONCLUSIONS
 Time value of money is the concept that the value

$1 on hand today is more than the value of $1 in
future.
 Four components of the basic present value
equation are: PV, FV, r, t.
 Interest rates can be quoted in a various ways.
For financial decisions, it is important to convert
to EAR.
 The process of providing for a loan to be paid
off gradually is called amortizing loan.
5-58
HOMEWORKS
Concepts review:
Chapter 5: 1, 2, 3, 4.
Chapter 6: 1, 2, 3, 11.
Question and Problems:

Chapter 5: 1, 2, 3, 4, 5, 6, 7, 16.
Chapter 6: 1, 2, 3, 4, 10, 11, 12, 13, 16, 17,
37, 55, 56.
5-59

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Chapter 5 & 6

Time Value of Money

 PhD, Phan Hong Mai

 Be able to compute the future value of an

5.1 Time Value of Money

 Time value of money is the concept

 1rst reason is that money received today

 Time lines: A horizontal line that is used

CF0 CF1 CF2 CF3

 Tick marks occur at the end of periods, so

 The amount of money an investment will

 Suppose you invest $1,000 for one year at

 Interest = $1,000 x 5% = $50

 Suppose you leave the money in for another

 Interest = $1,050 x 5% = $52.5

-> The process of accumulating interest over time

 Suppose you invest $1,000; $1,250 and $2,324

$1,000 $1,250 $2,324

 Firstly, calculate the FV of each cash flow

$1,000 $1,250 $2,324

 A series of constant or level cash flows that

 Suppose you invest $1,000 at the end of each

$1,000 $1,000 $1,000

FV of original annuity cash flows:

 Suppose you invest $1,000 at the beginning of

$1,000 $1,000 $1,000

FV of annuity due cash flows:

 What do we mean by the future value of an

 The current value of future cash flows

 Suppose you need to have $1,050 in one

 Suppose you need $1,102.5 in two years.

 Based on your knowledge of FV, you know

 Suppose you need $1,102.5 in two years.

-> The process of calculating the present value of a

 Suppose you need $1,050 in one year and

 Firstly, calculate the PV of each cash flow

 Suppose we are examining an asset that

PV = ? $500 $500 $500

 PV of original annuity cash flows:

 A growing annuity is an annuity where the

$500 x (1 + 10%) x (1 + 10%)

$500 x (1 + 10%) x (1 + 10%) x (1 + 10%)

 Perpetuity is an important case of an annuity

 Suppose the Dewey Co. wants to sell preferred

 A growing perpetuity is an perpetuity where the

 Suppose the Bilbo Co. wants to sell preferred

 What do we mean by the present value of an

 Stated rate (quoted rate) is the interest rate

 Effective annual rate (EAR) is the interest rate

 How much will we earn from $1 for one year

 What’s the FV of a 3-year $100 annuity,

 If an interest rate is given as 12% compounded

The borrower receives money today but he can:

Borrows $10 Repays $10.05

 Interest-only loan: pay interest each

Borrows Interest paid Interest paid $0.5

-> Use amortization tables to compute annual

 Suppose a business takes out a $5,000, five-

 Step 1: Find the required annual payment

 D: the loan amount

 Step 3: Find the principal in year 1 by

 Suppose a business takes out a $5,000, five-

 What is a pure discount loan?