Time Value of Money

1
 Time Value of Money
• Incremental cash flows in earlier years are more
valuable than incremental cash flows in later
years.
– Why?
– Exactly how much?

2
 Present Value / Future Value
• Cash flows across time cannot be added up. They have
to be brought back to the same point in time before we
aggregate them.
• The process of moving cash flows in time is:
– Discounting, if future cash flows are brought to the present
• Present Value of Cash Flows
– Compounding, if present cash flows are taken to the future
• Future Value of Cash Flows

3
 Time Line

$100 $100 $100 $100

0 1 2 3 4

10% 10% 10% 10%

• This time line represents a cash flow stream of $100 at

the end of each of the next 4 periods.
• The period discount rate is 10% for each period.

4
 Discount Rate
• Why to discount the future cash flows?
– Individuals prefer present consumption to future
consumption,
– Monetary inflation,
– Uncertainty about future cash flows.

5
 Types of Cash Flows
➢Simple cash flows
➢Annuities
➢Growing annuities
➢Perpetuities
➢Growing perpetuities

➢Note: Any other type of cash flow can be represented by

a combination of the above…
6
 Notation

Notation Stands for:

PV Present Value
FV Future Value
CFt Cash flow at the end of period t
A Annuity
r Discount Rate
g Expected Growth Rate
n Number of years

7
 Compounding a Simple Cash Flow

• A simple cash flow is a single cash flow at a

specified time.
CF0 FVt

0 t

8
 Discounting a Simple Cash Flow

• A simple cash flow is a single cash flow at a

specified time.
PV CFt

0 t

9
 Example
• Assume that you own Infosoft, a small software firm. You
are currently leasing your office space, and expect to make a
lump sum payment to the owner of the real estate of
$500,000 ten years from now. Assume that an appropriate
discount rate for this cash flow is 10%. The present value of
this cash flow can then be estimated as:

10
Discount Rates and Present Values –
Negative Relationship

11
 Present Value of Annuities
• An annuity is a constant cash flow that occurs
at regular intervals for a fixed period of time.

$100 $100 $100 $100

0 1 2 3 4

12
 Example: Budget decision

• Assume that you are the owner of Infosoft, and that you
have the following two alternative:
– Buying a copier for $10,000 cash down or
– Paying $ 3,000 a year for 5 years for the same copier.
• If the opportunity cost is 12%, which would you rather do?

13
 5
3,000 3,000 3,000 3,000 3,000 3,000
+ + + + = 
1.12 1.12 2 1.12 3 1.12 4 1.12 5 i =1 1.12 i
where the general formula is :
n
CF
PV =  i = 1,2,..., n
i =1 (1 + r ) i

Or use the annuity formula…

14
14
 Future Value of Annuities
FV=?

$100 $100 $100 $100

0 1 2 3 4

15
 Example

• An individual sets aside $2,000 at the end of every

year for three years.
• She expects to make 8% a year on her investments.
The expected value of the account on the end of
the 3 years:

2,000 + 2,000 *1.08 + 2,000 *1.08 2

where the general formula is :
n
FV =  CF (1 + r )i i = 1,2,..., n
i =1

16
16
 Example

• An individual sets aside $2,000 at the end of every

year, starting when she is 25 years old, for an
expected retirement at the age of 65.
• She expects to make 8% a year on her investments.
The expected value of the account on her
retirement date would be:

17
17
 Annuity due example
• You are going to rent an apartment for a year. You
have 2 choices: (1) pay the monthly rent, $500, at the
beginning of the month, or (2) pay the entire year’s
rent, $5,000, today. Suppose that you can earn 1%
every month. Which is the better choice?
• Annuity due PV = ordinary PV  (1 + i) = $5,627.5387
 1.01 = $5,683.8141.
• You would want to pay $5,000 today if you can.
 Present Value of Growing Annuities
• A growing annuity is a cash flow that grows at a
constant rate for a specified period of time.
A(1+g) A(1+g)2 A(1+g)3 A(1+g)n

0 1 2 3 ………. n

19
 Growing annuity example
• Emily has just been offered a job at $80,000 a
year. She anticipates her salary increasing by 9%
a year until her retirement in 40 years. Given an
interest rate of 20%, what is the present value
of her lifetime salary?
PV = C (1+g) × { [ 1 – ((1 + g) / (1 + i))N ] / (i – g) }
= $80,000 ×(1+9%) × { [ 1 – ((1 + 9%) / (1 + 20%))^40 ] /(20% – 9%) }
= $775,786.5
 Present Value of a Perpetuity
• A perpetuity is a constant cash flow at regular
intervals forever.

21
 Example
• A console bond is a bond that has no maturity and pays
a fixed coupon. Assume that you have a $60 coupon
console bond. The value of this bond, if the interest
rate is 9%, would be:

22
 Present Value of a Growing Perpetuity
• A growing perpetuity is a cash flow that is
expected to grow at a constant rate forever.

23
 Example
• Valuing a Stock with Stable Growth in Dividends
– In 1992, Southwestern Bell paid dividends per share of
$2.73. Its earnings and dividends had grown at 6% a year
between 1988 and 1992 and were expected to grow at the
same rate in the long term. The rate of return required by
investors on stocks of equivalent risk was 12.23%. What
is the value of this stock?

24