Lecture 2

FM212 - Principles of Finance
Asset Pricing
Lecture 2 – Time Value of Money II
James Clark FM212 - Principles of Finance 1

Key Topics
Shortcut Formulas
Annuity with Growth
Annuity
Perpetuity with Growth
Perpetuity
Shortcut Formulas – Cash Flows Occur at the Beginning of the Period
Future Value using Shortcut Formulas
Mortgage Example
Lecture 2 - Time Value of Money II
Valuing Long-Lived Projects or Securities
Often the cash flow streams that we are interested in are comprised of multiple
payments/receipts. For example:
Stocks pay dividends on a regular basis

Bonds make regular interest payments
We can use PV techniques to arrive at a total value today for these cash flow
streams.
We can also use some shortcut formulas in certain cases to make our lives easier.
The shortcut formulas we will use include:
Annuity Perpetuity
Annuity with growth Perpetuity with growth
Before we look at the four shortcut formulas we will look at the mathematics
behind their derivations.
Mathematical Aside: Sequences and Series
The sum of terms in a sequence is called a series, denoted by Sn:
S n = u1 + u2 + u3 + .......... + un
1st term in sequence nth term in sequence
Example
S n = 1 + 2 + 4 + 8 + 16 + ........

Geometric series
A geometric series is the sum of n terms where the first term is denoted by a
and each new term after the first term is obtained by multiplying the preceding
term by a constant factor x:
1st term 2nd term nth term
a + ax + ax 2 + .......ax n − 2 + ax n −1
n terms in series

Sum of first n terms in a geometric series where n is finite
Define the sum of the first n terms as Sn :
Sn = a + ax + ax 2 + ....... + ax n − 2 + ax n −1 Equation 1
Multiply both sides of the equation by x: Common terms
S n . ( x ) = ax + ax 2 + ax3 + ....... + ax n −1 + ax n Equation 2

Equation 1 – Equation 2
Common terms cancel
S n = a + ax + ax 2 + ..... + ax n − 2 + ax n −1 Equation 1
Sn . ( x ) = ax + ax 2 + ..... + ax n − 2 + ax n −1 + ax n Equation 2
Sn − Sn . ( x ) = a − ax n
Therefore S n − S n . ( x ) = a − ax n

Factor left hand side by Sn and right hand side by a and rearrange to make Sn the
subject of the equation:
a (1 − x n )
Sn =
(1 − x )
The formula derived above enables us to calculate quickly the series we originally
defined:
S n = a + ax + ax 2 + ....... + ax n − 2 + ax n −1
It is important to recognise that if the first term was defined as ax rather than a
or if there were (n+1) terms for example rather than n, then the formula derived
above would have to be modified.

Sum to infinity of a geometric series
Previously we have looked at the sum of a geometric series where n is finite.
If n now tends towards infinity
a (1 − x n )
Sn = where n→∞
(1 − x )
and if x satisfies the following −1 < x < 1 i.e. x < 1 then the sum to
infinity of a geometric series can be calculated from
a
S∞ =
1− x

Annuity with Growth
The diagram below depicts an annuity with growth:
t=0 t=1 t=2 t=3 t=n-1 t=n
PV C C(1+g) C(1+g)2 C(1+g)n-2 C(1+g)n-1
C (1 + g ) C (1 + g ) C (1 + g )
n−2 n −1
C
PV = + ......... + +
(1 + r ) (1 + r ) 2
( )
1 + r
n −1
( )
1 + r
n

Annuity with Growth
From the diagram and PV equation on the previous slide what are the key
characteristics of an annuity with growth?
1. The first cash flow occurs at the end of the 1st period and is denoted by C.
2. The cash flows must grow at a constant rate each period denoted by g.
3. The timing of the cash flows occur at constant intervals.
2.4. The
Thefirst
discount rateoccurs
cash flow is theateffective
the end ofrate
the for the time
1st period andperiod in between
is denoted by C. cash
flows and is constant over time and denoted by r.
5. There are n time periods between cash flows where n is finite.
6. The PV valuation point is one period before the first cash flow.

Annuity with Growth
Derivation of the Annuity with Growth Formula
Define C 1+ g
a= x= .
1+ r 1+ r
The PV calculation for an annuity with growth can therefore be rewritten as
PV = a + ax + ax 2 + ............ + ax n − 2 + ax n −1.
Geometric series

Annuity with Growth
Using the formula for a geometric series:
1 − x n 
PV = a  
 1 − x 
Plug in for a and x as defined on the previous slide:
  1 + g n 
1 −   
C   1+ r  
PV =
1+ r  1− 1+ g 
 1 + r 
 
Simplify the denominator:
Annuity with Growth
  1+ g 
n

 1−   
 1 + r 
PV = C  
 (1 + r )(1 + g ) 
1 + r − 1+ r 
 
  1 + g n 
1 −   
  1+ r  
PV = C
 r−g 
 
 
Note r cannot equal g in this formula.
Annuity with Growth Example
You work for a pharmaceutical company that has developed a new drug. The
patent on the drug will last 17 years. You expect that the new drug will generate
a cash inflow of £4 million in its first year (assume the cash flow occurs at the
end of the year, t=1) and that this amount will grow at a rate of 6% every year
until the patent expires. Once the patent expires assume cash flows after this
point are zero. What is the present value of the new drug if the interest rate is
8% per year?
t=0 t=1 t=2 t=3 t=16 t=17
PV £4m £4m(1.06) £4m(1.06)2 £4m(1.06)15 £4m(1.06)16
These cash flows are an annuity with growth.

t=0 t=1 t=2 t=3 t=16 t=17
PV £4m £4m(1.06) £4m(1.06)2 £4m(1.06)15 £4m(1.06)16
Yes, £4m.
2. The cash flows must grow at a constant rate each period denoted by g. Yes,
6% per year.
2.3. The
Thefirst
timing
cashof theoccurs
flow cash at
flows occur
the end at constant
of the 1st periodintervals. Yes, by
and is denoted yearly.
C.
4. The discount rate is the effective rate for the time period in between cash
flows and is constant over time and denoted by r. Yes, the EAR is 8%.
5. There are n time periods between cash flows where n is finite. Yes, 17 years.
6. The PV valuation point is one period before the first cash flow. Yes.

  1 + g n 
1 −   
1+ r  
PV = C  
 r−g 
 
 
  1.06 17 
1 −   
PV = £4m  
1.08  
= £54, 445, 424.54
 0.08 − 0.06 
 
 
The present value of the drug is £54,445,424.54.

Annuity
The diagram below depicts an annuity:
t=0 t=1 t=2 t=3 t=n-1 t=n
PV C C C C C
C C C C
PV = + ......... + +
(1 + r ) (1 + r )2 ( )
1 + r
n −1
( )
1 + r
n

Annuity
characteristics of an annuity?
2. The cash flow C must be constant each period.
2.4. The
Thefirst
discount rate
cash flow is the
occurs at effective
the end ofrate
the 1for the time
st period and period in between
flows and is constant over time and is denoted by r.
5. There are n time periods between cash flows where n is finite.

Annuity
Derivation of the Annuity Formula
We could apply the same method as with the derivation for the annuity with
growth where we would define
C 1
a= x=
1+ r 1+ r
and use the formula for a geometric series (try this method for homework).
We looked at the annuity with growth first, as once we have the annuity with
growth formula we can easily and quickly derive the other three shortcut
formulas.

Annuity

t=0 t=1 t=2 t=3 t=n-1 t=n
PV C C C C C
We can view the cash flows of an annuity as the same as an annuity with
growth but with the growth rate equal to zero.
We can use the growing annuity formula again to derive the annuity formula by
setting the growth rate to zero.

Annuity

n is a finite number
Set the growth rate g
 (1 + g )n 
to zero 1 − 
 ( + )
n
1 r 
PV = C  
r−g
 
 
 
 1 
 1 − 
( )+
n
1 r
PV = C  
 r 
 
 

Annuity Example
You have won the lottery! You can chose between £7 million today or you can
receive monthly payments of £40,000 at the end of every month for 30 years
starting today i.e. first payment in one month’s time. The annual stated interest
rate is 6% with semi-annual compounding. What option do you choose?
The value of taking £7million today is £7 million.

The second option where time t is measured in months is depicted below.
t=0 t=1 t=2 t=3 t= 359 t =360
PV £40,000 £40,000 £40,000 £40,000 £40,000
These cash flows are an annuity.

Annuity Example
The relevant discount rate to use in the annuity formula is the effective rate in
between the cash flows i.e. monthly effective rate.
Since the stated annual interest rate is quoted with semi-annual compounding
k = 2.
Stated annual interest rate 0.06
= = 0.03
k 2
3% is the effective rate for 6 months.

(1.03)1/ 6 − 1 = 0.00494
The monthly effective rate to use in the annuity formula is 0.494%.

Annuity Example
t=0 t=1 t=2 t=3 t= 359 t =360
PV £40,000 £40,000 £40,000 £40,000 £40,000
1. The first cash flow occurs at the end of the 1st period and is denoted by C. Yes, C is
£40,000.
2. The cash flow C must be constant each period. Yes, £40,000.
3. The timing of the cash flows occur at constant intervals, at the end of each
period. Yes, monthly.
4. The discount rate is the effective rate for the time period in between cash flows and is
constant over time and is denoted by r. Yes, 0.494%.
5. There are n time periods between cash flows where n is finite. Yes, 360 monthly
periods.

Annuity Example
 1 
 1 − 
( + )
n
1 r
PV = C  
 r 
 
 
 1 
1 − 1.00494 360 
PV = £40, 000 
( )  = £6, 724, 684.78
 0.00494 
 
 
Therefore take the £7 million today as its PV is higher.

The diagram below depicts a perpetuity with growth:
t=0 t=1 t=2 t=3 t= 4 t=n→∞
PV C C(1+g) C(1+g)2 C(1+g)3
C (1 + g ) C (1 + g ) C (1 + g )
2 3
C
PV = + + + + ...............
(1 + r ) (1 + r ) 2
(1 + r )
3
(1 + r )
4

characteristics of a perpetuity with growth?
2. The cash flows must grow at a constant rate each period denoted by g.
4. The discount rate is the effective rate for the period in between cash flows
andfirst
2. The is constant
cash flow over
occurstime and
at the is of
end denoted by r. and is denoted by C.
the 1st period
5. n the number of periods tends to infinity.
7. The discount rate for the period in between cash flows has to be greater
than the growth rate between cash flows i.e. r > g.

Derivation of the Perpetuity with Growth Formula
C 1+ g
a= x=
1+ r 1+ r
and use the formula for the sum to infinity of a geometric series (try this
method for homework).
We looked at the annuity with growth first, as once we have that formula we
can easily and quickly derive the other three shortcut formulas.


t=0 t=1 t=2 t=3 t= 4 t=n→∞
PV C C(1+g) C(1+g)2 C(1+g)3
A perpetuity with growth is defined in the same manner as an annuity with

growth but for the perpetuity with growth n the number of time period tends
to infinity.
We can use the annuity with growth formula again to derive the perpetuity with
growth formula by letting n tend to infinity.
(1 + g )
n
As n tends to infinity tends to zero if r > g.

(1 + r )
n


Tends to zero as n→∞
if r > g i.e. the
modulus of (1+g)/(1+r)
 (1 + g )n  is less than 1 which will
1 − 
 (1 + r )
n
 be the case if we use a
PV = C   positive discount rate
r−g
  and a suitable growth
  rate.
 
C
PV =
r−g

Perpetuity with Growth Example
A rich relative has bequeathed you a growing perpetuity. The first payment will
occur in one year and will be £2000. Each year after that you will receive a
payment that is 8% larger than the previous payment. This pattern of payments
will go on forever. If the interest rate is 15% per year what is today’s value of the
bequest?
t=0 t=1 t=2 t=3 t=4 t=n→∞
PV £2000 £2000(1.08) £2000(1.08)2 £2000(1.08)3
The series of cash flows above represents a perpetuity with growth.

Yes, C is £2000.
2. The cash flows must grow at a constant rate each period denoted by g. Yes,
8% per year.
3. The timing of the cash flows occur at constant intervals. Yes, yearly.
2.4. The
Thefirst
discount rate
cash flow is the
occurs ateffective
the end ofrate
the for the time
1st period andperiod in between
flows and is constant over time and is denoted by r. Yes, the EAR is 15%.
5. n the number of periods tends to infinity. Yes.
7. The discount rate for the period in between cash flows has to be greater
than the growth rate between cash flows i.e. r > g. Yes, 15% > 8%.

C
PV =
r−g
£2000
PV = = £28,571.43
0.15 − 0.08
The PV of the bequest is £28,571.43.

Perpetuity
The diagram below depicts a perpetuity:
t=0 t=1 t=2 t=3 t= 4 t=n→∞
PV C C C C
C C C C
PV = + + + + ...............
(1 + r ) (1 + r ) (1 + r ) (1 + r )
2 3 4

Perpetuity
characteristics of a perpetuity?
2. The cash flow C must be constant each period.
2.4. The
Thefirst
discount rate
cash flow is the
occurs ateffective
the end ofrate
the for the period
1st period and is in between
denoted by C.cash flows
and is constant over time and is denoted by r.
5. n the number of periods tends to infinity.

Perpetuity
Derivation of the Perpetuity Formula
C 1
a= x=
1+ r 1+ r
and use the formula for the sum to infinity of a geometric series (try this
method for homework).
We looked at the annuity with growth first, as once we have that formula we
can easily and quickly derive the other three shortcut formulas.

Perpetuity
t=0 t=1 t=2 t=3 t= 4 t=n→∞
PV C C(1+g) C(1+g)2 C(1+g)3
A perpetuity is defined in the same manner as an annuity with growth but for
the perpetuity with growth n the number of time periods tends to infinity and
the growth rate is zero.
We can use the annuity with growth formula again to derive the perpetuity with
growth formula by letting n tend to infinity and setting the growth rate g to
zero.

Perpetuity
Tends to zero as n→∞

Set the growth rate to if r > g i.e. the
 (1 + g )n  modulus of (1+g)/(1+r)
zero 1 − 
 ( + )
n
1 r  is less than 1 which will
PV = C   be the case if we use a
r−g
  positive discount rate
  and a growth rate of
 
zero.
C
PV =
r

Perpetuity Example
You are going to enter into a contract to receive cash flows of £50 every year
forever with the first cash flow starting at t=3. What is the present value of these
cash flows today, t=0 if the stated annual interest rate is 6% with semi-annual
compounding?
t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=n→∞
PV £50 £50 £50 £50

The series of cash flows above represents a perpetuity.
What is the relevant effective rate needed to discount the cash flows?
k 2
 Stated annual interest Rate   0.06 
EAR = 1 +  − 1 = 1 +  − 1 = 0.0609
 k   2 
The EAR is the relevant effective rate to discount the cash flows and is 6.09%.
Perpetuity Example
Perpetuity
The first cash flow C of £50 occurs at t=3. This makes the 1st period the
3rd year. This makes t=2 the valuation point for the perpetuity formula.
2. The cash flow C must be constant each period. Yes £50.
3. The timing of the cash flows occur at constant intervals. Yes, every year.
4. The discount rate is the effective rate for the time period in between cash
2. The firstand
cashisflow occursover
at thetime
end and
of the st period and is denoted by C.
flows constant is1denoted by r. The cash flows are
annual so the relevant discount rate is the EAR which is 6.09%.
5. n the number of periods tends to infinity. Yes, n tends to infinity.
6. The PV valuation point is one period before the first cash flow. PV
valuation point will be t=2. We must therefore discount the PV from the
perpetuity formula from t=2 back to t=0.

Perpetuity Example
t=0 t=1 t=2 t=3 t=4 t=5 t=6 t=n→∞
PV0 PV2 £50 £50 £50 £50
C £50
PV2 = = = £821.02
r 0.0609
1  £50 
PV0 = 2   = £729.46
(1.0609 )  0.0609 
The PV of the cash flows at t = 0 is £729.46.

In the four shortcut formulas we have derived the cash flows occur at the end of
each period. For example the first cash flow C occurs at the end of the first
period i.e. one period after the PV point.
We could derive four new shortcut formulas where the cash flows occur at the
beginning of each period. Fortunately we can use our knowledge of our original
four shortcut formulas and some intuition to answer these types of questions.
For an example we will look at an annuity, with n periods, where the cash flows
occur at the beginning of each period. This is known as an annuity due. The
logic that follows for the annuity can be applied to all of the shortcut formulas.

Annuity Due Example

t=0 t=1 t=2 t=3 t=n-1 t=n
C C C C C
PV
C C C C
PV = C + + ......... + +
(1 + r ) (1 + r )2 (1 + r )
n−2
(1 + r )
n −1

Shortcut Formulas – First Cash Flow at the Beginning of the Period
Annuity Due Example

t=0 t=1 t=2 t=3 t=n-1 t=n
C C C C C
PV
We can calculate the PV of these cash flows using
The PV of C at t=0 is
the annuity formula where the number of cash flows
simply just C.
at the end of each period is n-1.
 1 
 1 − n −1 
PV = C + C 
(1 + r ) 
 r 
 
 
Shortcut Formulas – Future Values
Although we have calculated the PV for the shortcut formulas we could also
calculate the future value. The logic that follows for the annuity can be applied
to all of the shortcut formulas.
Annuity Example
t=0 t=1 t=2 t=3 t=n-1 t=n
C C C C C
FV
FVn = C (1 + r ) + C (1 + r ) ........ + C (1 + r ) + C
n −1 n−2

Shortcut Formulas – Future Values
Factor out on the right hand side of the equation (1+r)n.
 C C C C 
FVn = (1 + r ) + ........ + +
n
 n 
1 + r (1 + r ) (1 + r ) (1 + r ) 
2 n −1
PV of an annuity
 1 
 1 − 
(1 + r )  (1 + r )n − 1 
n
FVn = (1 + r ) C   =C
n

 r   r 
 
 

Mortgage Example
Assume a world where annual interest rates are expected to be constant at 3%

for the foreseeable future. You wish to buy a flat and a mortgage company
agrees to lend you £950,000 today. The mortgage has a term of 25 years. You
promise the mortgage company a fixed repayment at the end of each of the
next 25 years. What is the fair repayment?
t=0 t=1 t=2 t=3 t= 24 t =25
£950,000 C C C C C
These cash flows are an annuity.

Mortgage Example
 1 
 1 − 
( + )
n
1 r
PV = C  
 r 
 
 
£950, 000
C= = £54,556.48
 1 
 1 − 25 
 ( 1.03 ) 
 0.03 
 
 
The fair yearly mortgage repayment is £54,556.48.

Mortgage Example
Time (Years) Payment Number Beginning of Period Loan Balance Mortgage Payment Interest Repayment of Principal End of Period Loan Balance
1 1 £950,000 £54,556.48 £28,500.00 £26,056.48 £923,943.52

2 2 £923,943.52 £54,556.48 £27,718.31 £26,838.17 £897,105.35
3 3 £897,105.35 £54,556.48 £26,913.16 £27,643.32 £869,462.03
4 4 £869,462.03 £54,556.48 £26,083.86 £28,472.62 £840,989.42
5 5 £840,989.42 £54,556.48 £25,229.68 £29,326.79 £811,662.62
6 6 £811,662.62 £54,556.48 £24,349.88 £30,206.60 £781,456.02
7 7 £781,456.02 £54,556.48 £23,443.68 £31,112.80 £750,343.23
8 8 £750,343.23 £54,556.48 £22,510.30 £32,046.18 £718,297.05
9 9 £718,297.05 £54,556.48 £21,548.91 £33,007.57 £685,289.48
10 10 £685,289.48 £54,556.48 £20,558.68 £33,997.79 £651,291.69
11 11 £651,291.69 £54,556.48 £19,538.75 £35,017.73 £616,273.96
12 12 £616,273.96 £54,556.48 £18,488.22 £36,068.26 £580,205.70
13 13 £580,205.70 £54,556.48 £17,406.17 £37,150.31 £543,055.39
14 14 £543,055.39 £54,556.48 £16,291.66 £38,264.82 £504,790.58
15 15 £504,790.58 £54,556.48 £15,143.72 £39,412.76 £465,377.82
16 16 £465,377.82 £54,556.48 £13,961.33 £40,595.14 £424,782.68
17 17 £424,782.68 £54,556.48 £12,743.48 £41,813.00 £382,969.68
18 18 £382,969.68 £54,556.48 £11,489.09 £43,067.39 £339,902.29
19 19 £339,902.29 £54,556.48 £10,197.07 £44,359.41 £295,542.88
20 20 £295,542.88 £54,556.48 £8,866.29 £45,690.19 £249,852.69
21 21 £249,852.69 £54,556.48 £7,495.58 £47,060.90 £202,791.80
22 22 £202,791.80 £54,556.48 £6,083.75 £48,472.72 £154,319.07
23 23 £154,319.07 £54,556.48 £4,629.57 £49,926.91 £104,392.17
24 24 £104,392.17 £54,556.48 £3,131.76 £51,424.71 £52,967.45
25 25 £52,967.45 £54,556.48 £1,589.02 £52,967.45 -£0.00

Mortgage Example
Mortgage Schedule
£60,000.00
£50,000.00
£40,000.00
Mortage Payment
£30,000.00
Repyment of Principle
Interest
£20,000.00
£10,000.00
£0.00
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Payment Number

Summary Key Topics
Shortcut Formulas
Annuity with Growth
Annuity
Perpetuity
Future Value using Shortcut Formulas
Mortgage Example

Lecture 2

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FM212 - Principles of Finance

Lecture 2 – Time Value of Money II

James Clark FM212 - Principles of Finance 1

Annuity with Growth

Perpetuity with Growth

Shortcut Formulas – Cash Flows Occur at the Beginning of the Period

Future Value using Shortcut Formulas

Valuing Long-Lived Projects or Securities

Stocks pay dividends on a regular basis

The sum of terms in a sequence is called a series, denoted by Sn:

1st term in sequence nth term in sequence

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1st term 2nd term nth term

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Sum of first n terms in a geometric series where n is finite

Define the sum of the first n terms as Sn :

Multiply both sides of the equation by x: Common terms

S n . ( x ) = ax + ax 2 + ax3 + ....... + ax n −1 + ax n Equation 2

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Sum of first n terms in a geometric series where n is finite

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Sum of first n terms in a geometric series where n is finite

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Sum to infinity of a geometric series

Previously we have looked at the sum of a geometric series where n is finite.

If n now tends towards infinity

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Annuity with Growth

The diagram below depicts an annuity with growth:

t=0 t=1 t=2 t=3 t=n-1 t=n

PV C C(1+g) C(1+g)2 C(1+g)n-2 C(1+g)n-1

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Annuity with Growth

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Annuity with Growth

Derivation of the Annuity with Growth Formula

The PV calculation for an annuity with growth can therefore be rewritten as

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Annuity with Growth

Derivation of the Annuity with Growth Formula

Using the formula for a geometric series:

Annuity with Growth

Derivation of the Annuity with Growth Formula

Annuity with Growth Example

t=0 t=1 t=2 t=3 t=16 t=17

PV £4m £4m(1.06) £4m(1.06)2 £4m(1.06)15 £4m(1.06)16

These cash flows are an annuity with growth.

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Annuity with Growth Example

t=0 t=1 t=2 t=3 t=16 t=17

PV £4m £4m(1.06) £4m(1.06)2 £4m(1.06)15 £4m(1.06)16

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Annuity with Growth Example

The present value of the drug is £54,445,424.54.

The diagram below depicts an annuity:

t=0 t=1 t=2 t=3 t=n-1 t=n

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Derivation of the Annuity Formula

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Derivation of the Annuity Formula

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Derivation of the Annuity Formula