Lecture 1

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

Acknowledgements
Some of these slides have been adapted from previous FM212

slides, in particular the slides produced by Professor Richard
Payne.
All errors remain my own.

Key Topics
Discount Rates
Present Value
Future Value
Simple Interest Vs. Compound Interest
Discount Factors
Net Present Value (NPV)
Nominal and Real Interest Rates

Lecture 1 - Time Value of Money I
Time Value of Money
Discount Rate
Interest rate used to compute the present
value of future cash flows
Present Value Future Value

Value today of Amount to which an
future cash flows investment will grow to
after earning interest
Discount Factor
Present value of a £1 future payment

Discount Rates
A discount rate is the reward that investors demand for accepting delayed
rather than immediate gratification.
We will also call the discount rate the interest rate or required rate of return
or opportunity cost of capital.
If you lend someone money for a year, you demand interest as you cannot
instantly spend the money you have lent on consumption goods.
If you lend money to a less trustworthy person/company, you require a

greater interest rate as you’re less confident that you’ll get your money back.

Discount Rates
The discount rate is also called opportunity cost of capital because it is the
return foregone by investing in a capital project rather than investing in freely-
available securities.
The higher the risk of an investment the higher the higher the return required
by a risk-averse investor.
Later, in the course we will look at asset pricing models and see how we can
define risk and how it relates to the return required by an investor.

Present Value – One Time Period
Discounting
t=0 t=1
Interest rate = 10%
£100 £100
= £90.91
1.1
The present value (PV) is the value today of future cash flows.
With the relevant interest rate for the cash flow at t=1 of 10%, £100 received at
t=1 is equivalent to £90.91 today.
In other words we can generate the £100 at t=1 by investing £90.91 today at an
interest rate of 10% i.e. £90.91(1.10)=£100.
Future Value – One Time Period
Accumulating
t=0 t=1
Interest rate = 10%
£90.91 £90.91(1.1) = £100

The future value (FV) is the amount an investment will grow to after earning
interest.
An investment of £90.91 today, t=0, is worth more than £90.91 at t=1 i.e.
£90.91(1.10)=£100.
Due to the time value of money i.e. positive discount rates, before we can add
cash flows together to make decisions we need to accumulate/discount cash
flows to the same point in time.
Simple Interest
Simple interest only pays interest on the original principal (principal is the term
used for the original amount of money invested).
Example
If the original amount invested is £100 at t=0 and the annual simple interest rate
is 10% then the year end total amounts up to year 3 are:
+ £100 ( 0.1)
Year 1: £100

£100 + £10 = £110
Principal
Interest year 1
+ £100
Year 2: £100 ( 0.1) + £100 ( 0.1)

£100 + £10 + £10 = £120
Principal
Interest year 1 Interest year 2
+ £100
£100
Year 3: Principal ( 0.1) + £100 ( 0.1) + £100 ( 0.1)
£100 + £10 + £10 + £10 = £130
Interest year 1 Interest year 2 Interest year 3

Compound Interest
Compound interest pays interest not only on the original principal but also on
accumulated interest.
Example
If the original amount invested is £100 at t=0 and the annual compounded
interest rate is 10% then the year end total amounts up to year 3 are:
Year 1: + £100
£100 ( 0.1)
£100 (1 + r ) £100 (1.1) = £110
Principal
Interest
£100 (1 + r )(1 + r ) = £100 (1 + r )

2
Year 2:
£100 (1 + r ) = £100 (1 + 2r + r 2 ) = £100 + £100 ( 2 × 0.1) + £100 ( 0.12 )

2
+
£100 £20
+ £1
= £121
Principal Interest on principal Interest on interest
Year 3: £100 (1 + r )(1 + r )(1 + r ) = £100 (1 + r )

3
£100 (1 + r ) = £100 (1 + 3r + 3r 2 + r 3 ) = £100 1 + ( 3 × 0.1) + ( 3 × 0.12 ) + ( 0.13 ) 

3
+
£100 £30
+ £3.1
= £133.1
Principal Interest on principal Interest on interest
With compound interest since we also earn interest on interest the terminal
wealth at the end of three years is greater than with simple interest
(£133.1>£130).
This may not seem like a significant difference but over longer periods of time the
impact can be huge as shown in the graph on the next slide.
Over 20 years the terminal wealth using compound interest of 10% is more than
double that when using simple interest of 10% (£672.75>£300) with the huge
difference due to earning interest on interest with compound interest.
The green curve shows with

compound interest the amount of
money increases exponentially, with
700
the amount on money in Year n
600 The red line shows with simple equal to £100(1+r)n.
500
interest the amount of money
Amount in £'s
increases linearly, with the

400
amount of money in Year n
300
equal to £100(1+rn).
200
100
0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Year 11
Year 12
Year 13
Year 14
Year 15
Year 16
Year 17
Year 18
Year 19
Year 20
Principal Interest on principal (simple interest) Interest on interest
Suppose your bank pays interest monthly with an effective compounded

monthly rate of 0.5%.
How can we state this as an annual rate?
1. Stated annual interest rate1

2. Effective annual rate (EAR)
What is the stated annual interest rate?
The simplest way to convert an effective monthly rate to an annual figure is to

multiply the effective monthly rate by 12 (12 monthly periods in a year).
1The stated annual interest rate is also known in the U.S. as the annual percentage rate (APR).

The stated annual interest rate is 6% with monthly compounding.
12 ( 0.005 ) = 0.06
The stated annual interest rate indicates the amount of simple interest earned in
a year and does not take into consideration interest earned on interest through
compounding. Therefore we do not discount with stated annual interest rates1.
When accumulating or discounting cash flows to calculate present values or
future values we always use compound interest. Quoting the annual rate with
simple interest only is simply a convention.
If a stated annual interest rate is quoted then the number of compounding

periods per year also has to be stated. We use the term the number of
compounding periods but remember the stated annual interest rate uses simple
interest and not compound interest.
1Technically one exception for annual cash flows is the stated annual interest rate with annual compounding since this is equal to the EAR.

What is the EAR?
The effective annual rate (EAR) indicates the actual amount of interest that will
be earned at the end of the year after taking into consideration compounding
i.e. interest on interest.
If your bank pays interest monthly with an effective compounded monthly rate
of 0.5% then the EAR is:
(1.005)12 − 1 = 0.0617
The EAR is 6.17%.

Converting a Stated Annual Interest Rate to an EAR
Define k as the number of compounding periods in a year:
k
 Stated annual interest rate 
1 + EAR = 1 + 
 k 
The greater the number of compounding periods in a year, k, the larger the EAR
will be holding the stated annual interest rate constant as you are earning
interest on interest more frequently (see the example on the next slide).
The stated annual interest rate in the above formula has to be the stated annual
interest rate that is for k compounding periods per year.

Example
If the stated annual interest rate is quoted as 5% with the compounding

frequencies as below the EAR’s are:
1
 0.05 
Annual compounding 1 +  − 1 = 0.05
 1 
4
 0.05 
Quarterly compounding 1 +  − 1 = 0.0509
 4 
12
 0.05 
Monthly compounding 1 +  − 1 = 0.05116
 12 
365
 0.05 
Daily compounding 1 +  − 1 = 0.051268
 365 
Effective rate Effective rate
Equivalent n time period effective discount rate = (1 + r ) − 1

n
r is the effective rate for the time period
Example
If the effective monthly rate is 1% then the effective rate for 2 months is:
(1.01)2 − 1 = 0.0201
Effective rate Stated annual interest rate
r (k )
r is the effective rate for k is the number of time

the time period periods in a year
Example
If the effective monthly rate is 1% the stated annual interest rate with monthly
compounding is:
0.01(12) = 0.12
Stated annual interest rate Effective rate
The stated annual interest rate must

relate to time period k e.g. if k is 12 If n=k in this formula then the right
then it must be the stated annual hand side is the effective annual
interest rate with monthly rate (EAR).
compounding.
n
 Stated annual interest rate 
1 + k 

− 1 = Effective rate for n periods
The individual time period will
Example
be defined by k.
If the stated annual interest rate is 12% with monthly compounding the effective
6 month rate is: 6
 0.12 
1 + 12  − 1 = 0.0615
Simple Interest Vs. Compound Interest Examples
If the stated annual interest rate is 12% with semi-annual compounding what is
the effective rate for 6 months?
0.12
= 0.06
2
The effective rate for 6 months is 6%.
If stated annual interest rate is 12% with semi-annual compounding what is the
effective monthly rate?
1/ 6
 0.12 
1 +  − 1 = 0.0098
 2 
The effective monthly rate is 0.98%.

If the EAR is 12% what is the effective quarterly rate?
(1.12)1/ 4 − 1 = 0.0287
The effective quarterly rate is 2.87%.
If the effective monthly rate is 1% what is the stated annual interest rate with
monthly compounding ?
0.01(12) = 0.12
The stated annual interest rate is 12% with monthly compounding.

If the annual interest rate is 8% what is EAR?
0.08
The EAR is 8%. Note that although it just says annual interest rate, it cannot be
a stated annual interest rate as it does not use the term stated and no level of
compounding is given. Thus, by default it must be the EAR.
If the annual interest rate is 8% what is effective rate for 6 months?
(1.08 ) − 1 = 0.0392
1/2
The effective rate for 6 months is 0.0392. Again note that since it does not use
the term stated and no level of compounding is given in the question the annual
rate here of 8% is the EAR.
Future Value – Multiple Time Periods
t=0 t=T
If we are given a cash flow of C today it’s future value at time T is given by
FV = C (1 + r )
T
where T is the number of time periods and r is the effective rate for the time
period and constant over time.
Note the use of compound interest.
Obviously the future value is larger if r or C or T is larger, ceteris paribus.

Future Value – Multiple Time Periods Example
t=0 t=10
£100, 000
You inherit £100,000 today and decide to place it in a bank account for
10 years. At the end of that 10 year period you’ll withdraw the funds and use
the money to help buy your daughter a house.
How much will you be able to contribute to her house purchase assuming
that the effective annual interest rate (EAR) is 5% for the next 10 years?
Sensitivity analysis: how would your answer change if interest rates turn out
to be 2% per year or 10% per year?
Future Value – Multiple Time Periods Example
If the effective annual interest rate is 5% then the future value is:
£100, 000 (1.05 ) = £162,889.46

10
£100, 000 (1.02 ) = £121,899.44

10
£100, 000 (1.10 ) = £259,374.25

10

Present Value – Multiple Time Periods
t=0 t=T
Assume that you’re due to receive a payment of C at time T. The current cash
flow today that is equivalent to the future cash flow at time T is given by
C
PV =
(1 + r )
T
Note the use of compound interest.
Obviously the present value is smaller, if C is smaller, or r or T is larger, ceteris

paribus.
Present Value – Multiple Time Periods Example
t=0 t=2
£5, 000, 000
You are a supplier of aircraft parts to Boeing. In 2 years you are due to
receive £5,000,000 as payment for components you have supplied.
How much is this worth in current terms today assuming the effective annual
interest rate is 1%?
Sensitivity analysis: how would your answer change if interest rates turn out
to be 5% per year?

Present Value – Multiple Time Periods Example
The PV if the effective annual interest rate is 1% is:
£5, 000, 000

= £4,901, 480.25
(1.01)
2
The PV if the effective annual interest rate is 5% is:
£5, 000, 000

= £4,535,147.39
(1.05)
2
Clearly, even over short horizons, with reasonably high interest rates, present
values can be much smaller than actual future cash flows.

Present Value – Multiple Time Periods and Cash Flows Example
t=0 t=1 t=2
£100 £200
What is the PV of the future cash flows in the diagram if time is measured in
years and the effective annual interest rate is 7%?
£100 £200
PV = + = £268.15
1.07 (1.07 ) 2

Present Value – Multiple Time Periods and Cash Flows Example
The present value of the future cash flows is £268.15. This means that the future
cash flows are equivalent to £268.15 today. In other words with £268.15 today
you can exactly replicate the future cash flows of £100 at t=1 and £200 at t=2.
t=0 t=1 t=2
£268.15 Value: £268.15 (1.07 ) = £286.92

Payout: £100
Residual: £286.92 − £100 = £186.92
Value: £186.92 (1.07 ) = £200

Payout: £200
Residual: £200 − £200 = £0
Discount Factors
When computing present values we can also make use of discount factors.
A discount factor is just the present value of £1.
Discount factors vary with the interest rate and with the investment horizon.
We can calculate a T period discount factor denoted by dT from
1
dT =
(1 + r )
T
Higher interest rates and longer investment periods lead to lower discount
factors.
Discount Factors Example
t=0 t=1 t=2
£100 £200
PV = d1 ( £100 ) + d 2 ( £200 )
1 1
Where d1 = = 0.93458 and d2 = = 0.87344
(1.07 )
2
1.07
PV = 0.93458 ( £100 ) + 0.87344 ( £200 ) = £268.15

Net Present Value
Most investments or applications involve multiple cash flows received and paid
at different points in time.
Positive cash flows are receipts and negative cash flows are payments.
How do you compute present values for these more complicated streams of
money?
Take each individual cash flow and compute its present value.
Sum present values across all of the cash flows.
This is called the Net Present Value or NPV.
Receipts will contribute positively to NPV and payments will contribute
negatively.

Net Present Value
Calculating NPV
Assume a constant EAR of r per period. Also assume an investment project

which has a cash flow C0 today, a cash flow of C1 at the end of period one, C2 at
the end of period two, continuing until it finishes by delivering a cash flow of CT
after T periods.
The NPV is:
T
Ct C1 C2 CT
NPV = ∑ = C0 + + + .........
t =0 (1 + r )
t
(1 + r ) (1 + r ) 2
( )
1 + r
T
Again, note that some of the cash flows might be negative, in particular C0.
Richard
Net Present Value
NPV Rule
Consider an investment project for which you have calculated the NPV.
If the NPV is positive you should invest in the project.

If the NPV is negative, you should turn down the investment opportunity.
The discount rate used in the NPV calculation should reflect the project’s
risk. More risky projects require a greater return and so you should use a
larger discount rate.
If you don’t know the cash flows associated with the project precisely, use the
expected value of each cash flow instead.

Net Present Value Example
A building company is considering buying a plot of land costing £2,000,000

today. It plans to build 5 houses on the plot. Construction will take 2
years to complete, with each house’s building costs comprising £75,000 in one
year and £40,000 in two years. If the company expects to sell each house for
£600,000 two years from now and the interest rate is 8% per annum, should the
project be taken on?
First compute the NPV of the cash flow stream:
5 ( £75, 000 ) 5 ( £600, 000 − £40, 000 )

NPV = −£2, 000, 000 − + = £53,326.47
(1.08 )
2
1.08
As the NPV is positive, the company should go ahead with the project. The
building company has increased its wealth today by £53,326.47, which is the
NPV.
The Optimality of the NPV Rule
Why should I trust the NPV rule? Why is it optimal for individuals to invest in
projects with positive NPV and discard projects with negative NPV?
It turns out that NPV is optimal (under some assumptions) in the sense that
use of the rule leads to investors maximising their expected wealth.
This is true regardless of how patient or impatient an investor is, and thus
the rule can be used for all investors (they will all agree on which investments
to choose and which to discard).

Consider two investors Anne and George:
George wants to consume now (he is impatient).
Anne wants to wait (she is patient).
Both have current income of £185,000 today and expect zero income in a
year. This is a simple two period model, today and one year’s time.
Each can invest in an opportunity costing £185,000 now and returning a

guaranteed £210,000 at the end of the year.
They also have access to a risk-free bank where the borrowing and lending
rate is 5% per annum.
Both should choose to undertake the investment.

Pounds (£)
Next Year
£210,000 Possible spending
patterns if invest in the capital
£194,250 market.
Possible spending
patterns if invest in the
investment project.
£185,000 £200,000 Pounds (£) Now

Pounds (£)
Anne invests £185,000 now and
Next Year
consumes £210,000 next year
£210,000
£194,250
George invest £185,000

now, borrows £200,000
and consumes now
£185,000 £200,000 Pounds (£) Now

Analysis of Anne’s situation:
Anne wants to consume at the end of the year.
If she took her original wealth, invested in the risk-free asset and consumed
the proceeds, she would have £194,250 to consume.
Instead, if she invests in the project she has £210,000 to consume at the end
of the year.
She is better off investing in the project.

Analysis of George’s situation:
George wants to consume today.

He could just consume his original wealth, of £185,000.
Instead, he could do the following:
He invests in the project, meaning that he has £210,000 in income at the
end of the year.
He borrows the present value of £210,000 from the bank today. At 5%
interest, this gives him £200,000 today.
He consumes the £200,000 today and in one year uses the proceeds of the
investment to repay the bank.
He is better off investing in the project and using the capital market (i.e.
borrowing and lending) to arrive at his desired consumption pattern.
George and Anne together:
Outcome: both George and Anne end up investing in the project as they are
both better off if they do so.
Why? It’s because the project has a positive NPV.
They should exploit the positive NPV opportunity and then borrow/lend to
move income through time and arrive at an optimal consumption pattern.
Implications:
Everyone, regardless of their preferences, should use the NPV rule to decide
on which projects to invest in.
The decision as to which projects to invest in can be separated from the

decision regarding when to consume.
Inflation Rate
The rate (usually annual) at which the level of prices in the economy increases.
Denote it by π.
Nominal Interest Rate
The rate at which the balance of a deposit grows in cash terms. Denote it by r .
Real Interest Rate
The rate at which the balance of a deposit grows in purchasing power terms.
Denote it by i.

Up to now we’ve worked entirely in nominal terms.
If you’re given nominal cash flows, you should discount them at the nominal
rate. If you’re given real cash flows, you should discount them at the real rate.
The relationship between the real interest rate, the nominal interest rate and
the inflation rate is:
Growth of Money
Growth in purchasing power =
Growth of Prices
(1+ r )
(1 + i ) =
(1 + π )

Example
What is the annual real interest rate if the annual nominal interest rate is 2%
and annual inflation is 2%
i=
(1+ r )
−1 i=
(1.02 )
−1 = 0
(1 + π ) (1.02 )
The annual real interest rate is 0 which makes sense as if prices grow at the
same rate as the balance of a deposit in cash terms you can still only buy the
same amount of goods at the end of the period as at the start of the period.

Approximation for Real Interest Rate
(1 + r ) = (1 + i )(1 + π )
Multiply out the brackets on the right-hand side of the equation:
(1 + r ) = 1 + i + π + iπ
When rates are low the interaction term iπ will be very small. Therefore we can
ignore it and obtain:
(1 + r ) ≈ 1 + i + π
r ≈ i +π

If the nominal interest rate is below the inflation rate, then a deposit is losing
money in purchasing power terms. On the flipside, a debt will shrink in real
terms if r < π .
Inflation rates can be substantial, implying that the difference between real
and nominal rates can be large.
Example
Assume nominal rates are 12% and inflation is running at 8%. The approximate
real rate is 4%. The precise real rate is 3.7%.
Note the larger are rates, the bigger the approximation error in the approximate
real rate calculation above.

U.S. Interest Rates and Inflation Rates, 1962–2012
Source: Berk and DeMarzo, Corporate Finance, Fourth Edition.

Summary of Key Topics
Discount Rates
Present Value
Future Value
Discount Factors
Net Present Value (NPV)

Lecture 1 - Appendix
Continuous Compounding
As we have seen the effective annual rate 1 + (EAR) can be calculated from
k
 Stated annual interest rate 
1 + EAR = 1 + 
 k 
where k is the number of compounding periods per year.
Remember the stated annual interest rate uses simple interest whereas the EAR
includes interest on interest.

For simplicity in the equation define the stated annual interest with k
compounding periods a year as ρ. We can rewrite this equation as follows:
k
ρ
  k
  
ρ
 1 
 
1 + EAR =  1 + 
  k   
   ρ   
 
ρ
k
k
If we define n=
ρ
we can rewrite the equation as follows:
ρ
  k
  
ρ
 1 
 

1 + EAR =  1 + 
  k   
   ρ   
 
ρ
 1  n

1 + EAR =  1 +  
  n  
For a given ρ when the number of compounding periods in the year k increases
so does n: k
n=
ρ
At the limit when n approaches infinity we have instantaneous/continuous
compounding:
ρ
 1  n

1 + EAR =  1 +  
  n  
n
 1
e = lim 1 +  = 2.718............
n →∞
 n
1 + EAR = e ρ
Where ρ is the annual continuously compounded rate.
If we are compounding over T annual periods (e.g. T =1/2, 2 or 3 etc) then
(1 + EAR )
T
= e ( ) ρ T
= e ρT

Example
If the effective annual rate (EAR) is 10% what is the equivalent annual
continuously compounded rate ρ?
1 + EAR = e ρ
1.1 = e ρ
Take the natural log of both sides:
ln (1.1) = ln e ρ ( )
Using log rules:
ln (1.1) = ρ ln e
ln e = log e e = 1
ln (1.1) = ρ ≈ 0.09531
An annual continuously compounded rate of 9.531% is equivalent to an EAR of

10%.

Lecture 1

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FM212 - Principles of Finance

Lecture 1 – Time Value of Money I

James Clark FM212 - Principles of Finance 1

Some of these slides have been adapted from previous FM212

All errors remain my own.

James Clark FM212 - Principles of Finance 2

Simple Interest Vs. Compound Interest

Net Present Value (NPV)

Nominal and Real Interest Rates

James Clark FM212 - Principles of Finance 3

Time Value of Money

Present Value Future Value

James Clark FM212 - Principles of Finance 4

If you lend money to a less trustworthy person/company, you require a

James Clark FM212 - Principles of Finance 5

James Clark FM212 - Principles of Finance 6

Present Value – One Time Period

Future Value – One Time Period

£90.91 £90.91(1.1) = £100

Simple Interest Vs. Compound Interest

James Clark FM212 - Principles of Finance 9

Simple Interest Vs. Compound Interest

£100 (1 + r )(1 + r ) = £100 (1 + r )

£100 (1 + r ) = £100 (1 + 2r + r 2 ) = £100 + £100 ( 2 × 0.1) + £100 ( 0.12 )

Simple Interest Vs. Compound Interest

Year 3: £100 (1 + r )(1 + r )(1 + r ) = £100 (1 + r )

£100 (1 + r ) = £100 (1 + 3r + 3r 2 + r 3 ) = £100 1 + ( 3 × 0.1) + ( 3 × 0.12 ) + ( 0.13 ) 

Simple Interest Vs. Compound Interest

The green curve shows with

increases linearly, with the

Simple Interest Vs. Compound Interest

Suppose your bank pays interest monthly with an effective compounded

How can we state this as an annual rate?

1. Stated annual interest rate1

What is the stated annual interest rate?

The simplest way to convert an effective monthly rate to an annual figure is to

James Clark FM212 - Principles of Finance 13

Simple Interest Vs. Compound Interest

The stated annual interest rate is 6% with monthly compounding.

If a stated annual interest rate is quoted then the number of compounding

James Clark FM212 - Principles of Finance 14

Simple Interest Vs. Compound Interest

What is the EAR?

The EAR is 6.17%.

James Clark FM212 - Principles of Finance 15

Simple Interest Vs. Compound Interest

Converting a Stated Annual Interest Rate to an EAR

Define k as the number of compounding periods in a year:

James Clark FM212 - Principles of Finance 16

Simple Interest Vs. Compound Interest

If the stated annual interest rate is quoted as 5% with the compounding

Simple Interest Vs. Compound Interest

Effective rate Effective rate

Equivalent n time period effective discount rate = (1 + r ) − 1

r is the effective rate for the time period

Simple Interest Vs. Compound Interest

Effective rate Stated annual interest rate

r is the effective rate for k is the number of time

Simple Interest Vs. Compound Interest

Stated annual interest rate Effective rate

The stated annual interest rate must

Simple Interest Vs. Compound Interest Examples

The effective rate for 6 months is 6%.