ACADEMY OF FINANCE

DEPARMENT OF CORPORATE FINANCE

Chapter 2
THE TIME VALUE OF MONEY

1
 Learning objectives

• Interpret the time value of money.

• Calculate the future value (FV) and the present value (PV) of a single

cash flow, a cash flow stream, an annuity, a growing annuity due, a

perpetuity and a growing perpetuity (PV only)

• Interpret different types of interest rate; solve time value of money

problems for different frequencies of compounding.

• Apply the principle of the time value of money in making financial

decisions in practice.
 Contents

2.1. The timeline and the time value of money

2.2. The future value

2.3. The present value

2.4. Perpetuity and Annuity

2.5. Interest Rates

2.6. The application of the time value of money

5.3
2.1. The timeline and the time value of money
2.1.1. The timeline

Cash flows

Cash inflows Cash outflows

A timeline shows when cash flows occur and they are cash inflows
or cash outflows.
????? How to draw a timeline
 2.1.1. The timeline

Example 2.1. Mr. Nam has VND 1, 000 million today. He lend
this money to his friend - Ms. Hoa. Ms. Hoa will have to pay
VND 600 million one year later and VND 700 million in the
second year.

5.5
 2.1.1. The timeline

Today
0 1 2 Timeline

- VND 1,000 million

+ VND 600 million + VND 700 million

Mr. Nam to Ms. Hoa Ms. Hoa to Mr. Nam

 2.1. The timeline and the time value of money
2.1.2. The time value of money

Example 2.2. Mr. Nam has VND 1million today. He deposits this amount of
money to the bank. During a course of one year, an investment of VND 1
million would grow to VND 1.2 million.
Hence, VND 1 million today is equivalent to VND 1.2 million one year later.

The time value of money means a specific amount of money we

have today is more valuable than the same amount we receive at any point
in the future because of the impacts of interest rate, inflation and risk.
 2.2. The future value

The future value

The future value of a The future value of a

single cash flow cash flow stream
 2.2. The future value
2.2.1. The future value of a single cash flow

Example 2.3. Mr. Nam puts VND 1,000 million in a saving account in a bank
at the annual interest rate of 10%. The bank calculates interest once a year.
How much money will he receive after three years?

10%

0 1 2 3 timeline
Deposit
The future value
- VND 1,000 million ????
2.2.1. The future value of a single cash flow

The future value depends on

The way to calculate the interest

The compound
The simple
interest
interest
calculation or
calculation
compounding
 2.2.1. The future value of a single cash flow

According to the simple interest calculation, the interest is calculated on the

initial value (the principal at the beginning) with a particular interest rate.

10%

0 1 2 3 timeline

Deposit Interest = VND 1,000 m.*10% = VND 100 m.

- VND 1,000 million Total amount of money

 2.2.1. The future value of a single cash flow

In general, the formula for the simple interest is found:

The future value after n period is:

 2.2.1. The future value of a single cash flow

✓ According to the compound interest calculation or compounding, the initial

principal value and the cumulative interest of previous periods will be

reinvested, and it is considered as a new single of cash flow or a lump-sum

investment.

✓ The compound interest at period t is calculated on this lump-sum.

 2.2.1. The future value of a single cash flow

✓ According to the compound interest calculation or compounding

Unit of measure: VND million
Lump sum after (t-1)
Interest
period
The
Y The initial cumulative Interest on Interset on Future value (FV)
the initial interest
interest
(1) (2) (3) = (1) * 10% (4) = (2) * 10%

1 1,000 0 100 0

2 1,000 100 100 10

3 1,000 210 100 21

 2.2.1. The future value of a single cash flow

The difference between simple interest and compound interest calculation

Unit of measure: VND million

Y Simple interest Compound interest The difference

FV Interest FV Interest FV Interest
1 1,100 100 1,100 100 0 0
2 1,200 100 1,210 110 10 10
3 1,300 100 1,321 121 21 21

✓ Simple interest calculation: FV =

✓ Compound interest calculation: FV=

✓ The difference is which is the result of compounding.

2.2.1. The future value of a single cash flow

In general, the formula for the compounding interest is found:

The future value after n period is:

(1 + r )n ✓ The future value interest factor or FVF (r, n)

✓ The value of VND1 after n periods at the interest rate r
 2.2. The future value
2.2.2. The future value of a cash flow stream

A cash flow stream is defined as a collection of the sequent amount of money

in several periods or a series of cash flows occur in several periods.

Example 2.4. Mr. Nam invests VND 1,000million in year 1, VND 2,000million in year
2. If the interest rate is 10% per year, how much money will he have in his investment
account after two years?
 2.2. The future value
2.2.2. The future value of a cash flow stream

Example 2.4. Mr. Nam invests VND 1,000million in year 1, VND 2,000million in year
2. If the interest rate is 10% per year, how much money will he have in his investment
account after two years?

FV1 = VND1,000m*(1+10%)1 = VND1,100m

Future value
FV2 = VND 2,000m*(1+10%)0 = FV1+ FV2
= VND 2,000m = VND3,100m

0 1 2 time line
- VND 1,000 m. - VND 2,000 m.
 2.2.2. The future value of a cash flow stream

The future value of a cash flow stream over particular periods is the
sum of the future value of each individual cash flow.
Other speaking, it is the total amount of money the holder/investor will
receive after some periods when investing into assets.

✓ If we use CFt to denote the CF at the end of the period t, the CF stream as:

CF1 CF2 CFn-1 CFn

… timeline
0 1 2 n-1 n

FVn
Future value (FV)
FVn-1
…

FV2
FV1
 2.2.2. The future value of a cash flow stream

The future value of a cash flow stream over particular periods is the
sum of the future value of each individual cash flow.
Other speaking, it is the total amount of money the holder/investor will
receive after some periods when investing into assets.

✓ If we use CFt to denote the CF at the beginning of the period t, the CF stream as:
CF1 CF2 CFn

… timeline
0 1 2 n-1 n

FVn Future value (FV)

…

FV2
FV1
2.3. The present value

The present value

The present value of The present value of

a single cash flow a cash flow stream
 2.3. The present value
2.3.1. The present value of a single cash flow

Example 2.3. Mr. Nam puts VND 1,000million in a saving account in a bank
at the annual interest rate of 10%. The bank calculates interest once a year.
How much money will he receive after three years?

✓ Back to the slide 14, after 3 years, VND 1,000 m becomes VND 1,321 m

 If you want to get VND 1,321 m after 3 years, you have to invest VND 1,000 m

✓ Finding the present value of the money is to answer:

✓ This process is named discounting

 2.3.1. The present value of a single cash flow

PV = FV / (1+r)n FV
… timeline
0 1 2 n-1 n
Today Future

From the equation of the future value: the present value is:

✓ The discount factor or PVF (r,n) at the rate r

✓ How much you have to invest to get VND 1 after n periods
 2.3.2. The present value of a cash flow stream

Example 2.5. Mr. Nam is considering an investment which can bring in VND
1,000million at year 1, and VND 2,000 million at year 2. If the interest rate is
10% per year. How much money does he have to invest today to receive these
cash flows?
 2.3.2. The present value of a cash flow stream
The present value of a cash flow stream is the sum of the present value
of each amount of money.
Other speaking, it is the cost the investor/holder has to pay to receive the
same cash flow stream in the future .

✓ If we use CFt to denote the CF at the end of the period t, the CF stream as:
CF1 CF2 CFn-1 CFn

1 … timeline
0 2 n-1 n

Present value PV1

PV2
PVn-1
PVn
 2.3.2. The present value of a cash flow stream
The present value of a cash flow stream is the sum of the present value
of each amount of money.
Other speaking, it is the cost the investor/holder has to pay to receive the
same cash flow stream in the future .

✓ If we use CFt to denote the CF at the beginning of the period t, the CF stream as:

CF1 CF2 CFn

0 1 … timeline
2 n-1 n
Present value
PV1
PV2
PVn
 2.4. Perpetuity and Annuity

Cash flow stream

Growing Growing
Perpetuity Annuity
Perpetuity Annuity
 2.4. Perpetuity and Annuity
2.4.1. Perpetuity

Perpetuity is a set of identical payments ocurring each period in an infinite future.

✓ In general, the present value of a perpetuity is:

✓ When CFt = A and r is kept constant, the PV of the perpetuity is:

CF1 CF2 CFn-1 CFn CFn+T timeline

… …
0 1 2 n-1 n n + T … Forever

PV1
PV2
…
PV PVn-1
PVn
…
PVn+T
…
 2.4. Perpetuity and Annuity
2.4.1. Perpetuity

Example 2.6. If you have a perpetuity with an annual payment VND

100 million at the end of each year and 10% of annual interest rate?
What is the present value of perpetuity. …
 2.4. Perpetuity and Annuity
2.4.2. Growing perpetuity
Growing perpetuity is the perpetuity in which the payment at the end
of each period increases by instant rate g.
CF1 CF1(1+g) CF1(1+g)n-2 CF1(1+g)n-1 CF1(1+g)n+T-1

0 1 … n-1 n+T …
2 n
timeline
PV1
PV2 …
PV PVn-1
PVn
…
PVn+T
…

✓ In general, the present value of a perpetuity is:

✓ When CFt = A and r is kept constant, the PV of the perpetuity is:

(with r > g)
 2.4. Perpetuity and Annuity
2.4.2. Growing perpetuity

Example 2.7. Mr. Nam receives an offer from your bank about the collection of
the future cash flow. He will get VND 2 million in one year, the endless
payment will continuously increase by 7%. The interest rate is 12%. How much
money is Mr. Nam willing to pay the bank today to get this offer?
 2.4. Perpetuity and Annuity
2.4.3. Annuity
An annuity is a set of equal cash flows occurs in a particular fini number of periods.

The ordinary annuity A A A

A

… timeline
0 1 2 n-1 n
The annuity due
A A A

… timeline
0 1 2 n-1 n

The ordinary annuity The annuity due

✓ FV= ✓ FV=

✓ PV= ✓ PV=
 2.4. Perpetuity and Annuity
2.4.3. Annuity

Example 2.8. Ms. Lan won a local lottery with two payout options. The first
option is to get VND 150 million immediately. The other option is the lottery
company will pay her VND 20 million at the end of each year in 20 years.
Which offer should she choose today if the interest of the Treasury Bond is at
10%?
 2.4. Perpetuity and Annuity
2.4.4. Growing annuity
• Growing annuity is the ordinary annuity which the payment increases by
instant rate g in each period

When:
✓ All the payments are equal to A
✓ The interest rate r is kept at constant
✓ The discount rate (r) is higher than the growing rate (g)

The present value of the annuity is:

The future value of the annuity is:

 2.4. Perpetuity and Annuity
2.4.4. Growing annuity

Example 2.9. Ms. Lan asks Mr. Nam for his investment into her cafeteria.
She promises to pay him VND 10 million in year 1, and the growth rate at
8%. The first payment occurs at the end of year 1. The payments last 15
years. The interest rate is 12%. What is the present value of this planned
investment?
 2.5. Interest Rate
2.5.1. Effective Annual Rate and Nominal Interest Rate
✓ Nominal interest rate (stated annual interest rate) is a rate of interest based
on the face value of the security.
✓ Effective annual rate is the rate at which a unit of currency will grow in a year
with interest on interest included.

Where m is the times of compounding in a year.

✓ When the compounding interval becomes smaller, the is higher EAR
but NIR is unchanged.
 2.5. Interest Rate
2.5.1. Effective Annual Rate and Nominal Interest Rate
Quoted interval: the length of the period during which interest is
calculated.
✓ Period: days, weeks, months, 6 months, years…
✓ Each period has consistent numbers of payments a year:

Interval Numbers of payment

Monthly 12
Quarterly 4
Half year 2
 2.5. Interest Rate
2.5.1. Effective Annual Rate and Nominal Interest Rate

If today you invest VND 1 million in 10 years at the annual rate of 15%.

You will get:

✓ By annual compounding: VND 1 m (1+15%)10 = VND 4.046 million

✓ By quarter compounding: VND 1 m (1+15%/4)10*4 = VND 4.360 million.

✓ By daily compounding: VND 1 *(1+15%/360)10*360 = VND 4.480 million

 2.5. Interest Rate
2.5.1. Effective Annual Rate and Nominal Interest Rate

✓ By continuous compounding, the EAR = er – 1 (with e = 2.71828)

✓ The future value of the initial investment PV at the end of year n with
continuously compounding at constant yearly interest rate r is:

✓ The present value of the continuously compounding is:

 2.5. Interest Rate
2.5.1. Effective Annual Rate and Nominal Interest Rate

If today you invest VND100 million at the annual rate of 15%.

What will you have after ten years with continuous compounding?
 2.5. Interest Rate
2.5.1. Effective Annual Rate and Nominal Interest Rate

✓ The financial institutions can use effective rate for a specific

period (rk) less than one year. The effective annual rate for a

year is:

(m is the times of calulating interest in a year)

✓ The future value of the initial investment PV at the periodic interest rate rk

after n years is:

 2.5. Interest Rate
2.5.1. Effective Annual Rate and Nominal Interest Rate

If you put VND 1 million in the bank at the interest of 5% for 6

months, compounding semiannually. How much of money will you

get after ten years?

 2.5. Interest Rate
2.5.2. Inflation rate and the real interest rate

The relationship between the nominal interest rate, the real interest rate, and

the inflation rate is found:

(1+the nominal rate) = (1+the real interest rate)*(1+the inflation rate)

(Fisher, 1930)

Remember:

✓ The nominal cash flows in the future should be discounted at the nominal rate

✓ The real cash flows should be discounted at the real interest rate
 2.5. Interest Rate
2.5.2. Inflation rate and the real interest rate

Example 2.12. Ms. Lan wants to receive VND 10 million in

one year so she decides to put her money in a saving account

to get an interest rate of 10% per year. The projected inflation

rate for the next year is 6%. What is the real interest rate?

How much money should she put in the saving account today

to receive VND 10 million in one year?

 2.5. Interest Rate
2.5.2. Inflation rate and the real interest rate
VND 10 million in one year is nominal cash flow 10% is nominal interest
rate, 6% is inflation rate.

The real value of VND 10 million is:

The real interest rate is:

In this case, we can calculate the money she put in the saving account
today to receive VND 10 million in one year in two ways:

(1) PV =

(2) PV =
 2.6. The application of the time value of money
2.6.1. Calculating the discounted interest rate

Example 2.13. ABC Company is considering two offers from a

manufacturer for a new processing machine. The supplier requires

VND 1,000 million payment immediately after receiving the new

machine. The supplier also allows ABC Company to pay VND 191.8

million after receiving the machine and 180 million VND at the end of

each year in the next 8 years. What is the discounted rate of the

deferred payment method?

 2.6. The application of the time value of money

2.6.1. Calculating the discounted interest rate

Example 2.13

Option 1:
Pay VND 1,000m at t = 0
ABC Company
is going to
invest in a new Discount
processing rate?
machine Option 2:
+ Pay VND 191.8m at t = 0
+ Pay VND 180m at the end
of the next 8 years
2.6. The application of the time value of money
2.6.1. Calculating the discounted interest rate
 2.6. The application of the time value of money
2.6.2. Calculating the number of periods

Example 2.14. Ms. Lan deposits VND 100 million in a saving account in a bank
at the annual interest rate of 10%. The bank calculates interest once a year. How
long does it take for her money to grow to VND 161.05 million?
 2.6. The application of the time value of money

2.6.3. Calculating the payment in the future

If ABC Company in Example 2.13 choose option 1. It will borrow VND
1,000m from Vietinbank for 5 years. ABC Company has to pay a fixed amount
of money at the end of each year. The borrowing interest rate is 12% per year.

=> Make payment plan for ABC.

✓ First, we calculate the fixed payment each year for ABC company.

✓ Then, we make the payment plan as the table in the next slide
 2.6. The application of the time value of money

2.6.3. Calculating the payment in the future

Unit of measure: VND million

Period Beginning Periodic payment Ending

Balance Balance
Total Principal Interest

1
2
3
4
5
 2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

Where

✓ PV is the present value of the expected cash flows in the future

✓ CFt is the cash flow occurring at the time t in the future

✓ r is the discount rate of the model

DCF model can be used for Capital Budgeting or Valuing the securities
 2.6.The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

✓ Capital budgeting
Example 2.16. An investment project will produce the following cash flows:

Unit of measure: VND million

t 1 2 3 4 5 6
1,000 1,200 1,300 1,300 1,250 1,150
CFt

Today cost is VND 6,000 million to conduct the project. If the discounted
interest rate is kept at 10% per period in six periods, is this investment
valuable?
 2.6.The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

✓ Capital budgeting

✓ The present value of the future cash flows from this investment is:

✓ Compare to the cost of an investment, the net present value is:

 2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)
✓ Security Valuing

Example 2.17. A bond promises to pay the following cash flows:

Unit of measure: VND 1,000

t 1 2 3 4 5
Dt 100 100 100 100 1,100

rt 6% 6% 6% 6% 6%

What is the price of this bond?

 2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)
✓ Security Valuing

The bond price is the present value of the future CF:

 2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

Example 2.18. ABC Company will pay VND 20,000 of dividend next year

and its dividen increases 6% per year. If the required rate of return is 15%.

What is the current price of one ABC Company’s stock?

2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)
 Key terms
Timeline Perpetuity
Cash flow Growing Perpetuity
A cash flow stream The ordinary annuity
The time value of money The annuity due
The future value Growing annuity
Compounding Effective annual rate
Compound interest Nominal interest rate
Simple interest The real interest rate
The present value The inflation rate
Discounting
 Summary
• Using timeline to solve the issues relating to the time value of money
✓ When the cash flow occur
✓ Cash outflow or inflow

• The future value (FV) is the total value of money brought to the investor/holder
after particular periods. FV = PV * (1+r)n
✓ FV of a single CF
✓ FV of a stream of CF is the sum of FV of a single CF
• The present value (PV) answers the question of how much money invested today
to get a particular money in the future. PV = FV / ( 1+r)n
✓ PV of a single CF
✓ PV of a stream of CF is the sum of PV of a single CF
• Perpetuity is a set of identical payments occurring each period in an infinite future
✓ The PV of perpetuity = A /r
✓ The PV of growing perpetuity = A / (r-g)
 Summary
• Annuity is a set of fixed payments occurs in a particular finite number of periods
✓ Ordinary annuity: the first CF occurs after one period from today
✓ Annuity due: the first CF occurs immediately

✓ FV of an ordinary annuity = ✓ FV of an annuity due =

✓ PV of an ordinary annuity = ✓ PV of an annuity due =

• The growing annuity is an ordinary annuity which the payment increases by instant rate g
in each period
𝑛 𝑛
1+𝑟 − 1+𝑔
PV = 𝐹𝑉 = 𝐴 ∗
𝑟−𝑔
• The stated annual interest rate or nominal interest rate (NIR) is the annual rate without
information on compounding. The effective annual interest rate (EAR) refers to the compounding

✓ EAR =
• The relation between NIR, the real interest rate, and the inflation rate is:
(1+ NIR ) = (1+ the real interest rate)*(1+the inflation rate)

• Use the time value of money to solve the actual problems when making financial decision