Session 1 - Exercises - Slides

Corporate Finance, Session I, Exercise: Time value of Money
Corporate Finance, Session I, Exercise: Time value of

Money
Moritz Greiwe
ESADE
November 9, 2020
Moritz Greiwe | ESADE | November 9, 2020 1 / 39

Useful formulas: Ex.5
1. The present value of a periodical payment C starting today which

lasts forever with a discount factor of (1 + i) is given by:
∞
X 1 C C (1 + i)
PV0∞ = C t
= 1
=
(1 + i) 1 − 1+i i
t=0

2. The present value of a periodical payment C starting kth next period

which lasts forever with a discount factor of (1 + i) is given by:
∞
X C C C
PVk∞ = t
= k
+ + ...
(1 + i) (1 + i) (1 + i)k+1
t=k
∞
1 C C 1 X C
= + + . . . =
(1 + i)k (1 + i)0 (1 + i)1 (1 + i)k (1 + i)t
t=0
1 (1 + i)C C
= k
=
(1 + i) i (1 + i)k−1 i

2. The present value of a periodical payment C starting kth next period

which lasts forever with a discount factor of (1 + i) is given by:
∞
X C C C
PVk∞ = t
= k
+ + ...
(1 + i) (1 + i) (1 + i)k+1
t=k
∞
1 C C 1 X C
= + + . . . =
(1 + i)k (1 + i)0 (1 + i)1 (1 + i)k (1 + i)t
t=0
1 (1 + i)C C
= k
=
(1 + i) i (1 + i)k−1 i
important special case: for k = 1, this reduces to

C
PV1∞ =
i

Useful formulas: Ex.4 , Ex.7 , Ex.8a) , Ex.12
3. The present value of a periodical payment C starting today which

lasts until period k with a discount factor of (1 + i) is given by:
k ∞ ∞
X C X C X C
PV0k = t
= t
−
(1 + i) (1 + i) (1 + i)t
t=0 t=0 t=k

C (1 + i) C C (1 + i) 1
= − = 1−
i (1 + i)k−1 i i (1 + i)k
Consequently, for the payment starting next period, the present value
is given by
C 1
PV1k = 1−
i (1 + i)k

Useful formulas: Ex.6 , Ex.8b)
4. The present value of a periodical payment C with growth factor g

starting today which lasts forever with a discount factor of (1 + i) is
given by:
∞
X 1+g 1 (1 + i)C
PV0∞ = C= 1+g
C=
1+i 1 − 1+i i −g
t=0
Consequently, for the payment starting next period, the present value
is given by
C
PV1∞ =
i −g

Exercise 1
Calculate the future value of $2,000 in

(a) five years at an interest rate of 5% per year.
(b) ten years at an interest rate of 5% per year.
(c) five years at an interest rate of 10% per year.
(d) Why is the amount of interest earned in part (a) less than half the
amount of interest earned in part (b)?

Solution
(a) FV5 = 2, 000 × 1.055 = 2, 552.56

Solution
(a) FV5 = 2, 000 × 1.055 = 2, 552.56

(b) FV10 = 2, 000 × 1.0510 = 3, 257.79

Solution
(a) FV5 = 2, 000 × 1.055 = 2, 552.56

(b) FV10 = 2, 000 × 1.0510 = 3, 257.79
(c) FV5 = 2, 000 × 1.105 = 3, 221.02

Solution
(a) FV5 = 2, 000 × 1.055 = 2, 552.56

(b) FV10 = 2, 000 × 1.0510 = 3, 257.79
(c) FV5 = 2, 000 × 1.105 = 3, 221.02
(d) Because in the last 5 years you get interest on the interest earned in
the first 5 years, as well as on the original $2000, or formally
FV10 = (2, 000 + 2, 000 × (1.055 − 1)) × 1.055

= 2, 000 + 2 × 2, 000 × (1.055 − 1) + 2, 000 × (1.055 − 1)2

Exercise 2
Consider the following alternatives:

(i) $100 received in one year
(ii) $200 received in five years
(iii) $300 received in ten year
(a) Rank the alternatives from most valuable to least valuable if the
interest rate is 10% per year.

Exercise 2

(b) What is your ranking if the interest rate is only 5% per year?

Exercise 2

(c) What is your ranking if the interest rate is 20% per year?

Exercise 2

(d) Is there an interest rate r > 0 such that the ranking is given by
Option (iii) > Option (i) > Option (ii)

Solution:
100
PV1 = = 90.91
1.1
200
PV2 = = 124.18
1.15
300
PV3 = = 115.66
1.110
So Option (ii)> Option (iii) > Option (i).

Solution:
100
PV1 = = 95.24
1.05
200
PV2 = = 156.71
1.055
300
PV3 = = 184.17
1.0510
So Option (iii) > Option (ii) > Option (i).

Solution:
100
PV1 = = 83.33
1.2
200
PV2 = = 80.38
1.25
300
PV3 = = 48.45
1.210
So Option (i) > Option (ii) > Option (iii).


Intuition: If you prefer (i) over (ii) it means, that you prefer $100
today over $100 + $100 in 4 years. If you prefer (iii) over (ii) it
means, that you prefer $200 + $100 in 5 years over $200 today,
which is a contradiction to the first statement for r > 0.


Analytically: if you prefer option (i) over option (ii), it follows that
100 200 200

> 5
⇔ 100 > (1)
1+r (1 + r ) (1 + r )4

Analytically: if you prefer option (i) over option (ii), it follows that
100 200 200

> 5
⇔ 100 > (1)
1+r (1 + r ) (1 + r )4
if you prefer option (iii) over option (ii), it follows that
300 200
10
>
(1 + r ) (1 + r )5
300
⇔ − 100 > 100
(1 + r )5
300 − 100 200 200
⇔ 5
= 5
> 100 ⇒ > 100 (2)
(1 + r ) (1 + r ) (1 + r )4
300
with the last step following from (1+r )5
− 100 > 300−100
(1+r )5
for r > 0.
Hence, Equation (1) and (2) are contradicting each other.
Exercise 3
You have just received a windfall from an investment you made in a

friend’s business. He will be paying you $10,000 at the end of this year,
$20,000 at the end of the following year, and $30,000 at the end of the
year after that (three years from today). The interest rate is 3.5% per
year.
(a) What is the present value of your windfall?

Exercise 3
You have just received a windfall from an investment you made in a

friend’s business. He will be paying you $10,000 at the end of this year,
$20,000 at the end of the following year, and $30,000 at the end of the
year after that (three years from today). The interest rate is 3.5% per
year.
(a) What is the present value of your windfall?
(b) What is the future value of your windfall in three years (on the date
of the last payment)?

Solution: First, draw the timeline of the payments:

(a) For the present value, we get
10, 000 20, 000 30, 000

PV = + + = 55, 390
1.035 1.0352 1.0353

(a) For the present value, we get
10, 000 20, 000 30, 000

PV = + + = 55, 390
1.035 1.0352 1.0353
(b) For the future value, we get
FV = PV × 1.0353 = 61, 412

Exercise 4: Formula
When you purchased your house, you took out a 30-year annual-payment
mortgage with an interest rate of 6% per year. The annual payment on
the mortgage is $12,000. You have just made a payment and have now
decided to pay the mortgage off by repaying the outstanding balance.
What is the payoff amount if
(a) You have lived in the house for 12 years (so there are 18 years left on
the mortgage)?
(b) You have lived in the house for 20 years (so there are 10 years left on
the mortgage)?
(c) You have lived in the house for 12 years (so there are 18 years left on
the mortgage) and you decide to pay off the mortgage immediately
before the twelfth payment is due?

the mortgage)?

the mortgage)?
Solution: First, we draw the timeline of the payments
So for the present value of the remaining payments, we get

12, 000 1
PV = × 1− = 129, 931.24
0.06 1.0618

the mortgage)?

the mortgage)?
Solution: Again, we draw the timeline of the payments

12, 000 1
PV = × 1− = 88, 321.04
0.06 1.0610


Solution: Again, we draw the timeline of the payments

12, 000 1
PV = 12, 000 + × 1− = 141, 931.24
0.06 1.0618

Exercise 5: Formula
Marian Plunket owns her own business and is considering an investment. If

she undertakes the investment, it will pay $4,000 at the end of each of the
next three years. The opportunity requires an initial investment of $1,000
plus an additional investment at the end of the second year of $5,000.
(a) What is the NPV of this opportunity if the interest rate is 2% per
year? Should Marian take it?

Exercise 5: Formula
Marian Plunket owns her own business and is considering an investment. If

she undertakes the investment, it will pay $4,000 at the end of each of the
next three years. The opportunity requires an initial investment of $1,000
plus an additional investment at the end of the second year of $5,000.
(b) Now, instead of running for four years, the investment runs forever,
meaning it guarantees an annual payoff of $4000 but requires a
biennial payment of $5,000. Intuitively, will the investment be still
beneficial? What is its NPV?



4, 000 1, 000 4, 000

NPV1 = −1, 000 + − + = 5, 729.69
1.02 1.022 1.023
Yes, make the investment.

meaning it guarantees an annual payoff of $4,000 but requires a

Intuition: Since the NPV of the finite investment was positive, the
NPV of repeating the finite investment infinite times will also be
positive.

Intuition: Since the NPV of the finite investment was positive, the
NPV of repeating the finite investment infinite times will also be
positive.
To calculate the NPV, we can rewrite this stream of payments as
4, 000 1, 000 4, 000 1, 000 4, 000
NPV2 = −1, 000 + − + − + − ...
1.02 1.022 1.023 1.024 1.025
NPV1 NPV1
= NPV1 + + + ...
1.024 1.028
NPV1 NPV1
= NPV1+ + + ...
1.0824 1.08242
(1 + 0.0824) × NPV1
= = 75, 235.39
0.0824
so the NPV is positive and hence, the investment is still beneficial.
Exercise 6: Formula
You are running a hot internet company. Analysts predict that its earnings
will grow at 30% per year for the next five years. After that, as competition
increases, earnings growth is expected to slow down to 2% per year and
continue at that level forever. Your company has just announced earnings
of $1,000,000. What is the present value of all future earnings if the
interest rate is 8%? (Assume all cash flows occur at the end of the year.)


the PV is given by
5 ∞
1.3 i X 1.3 5 1.02 i
X
PV = + = PVGA + PV5
1.08 1.08 1.08
i=1 i=6

So the problem consists of two parts, (i) a growing annuity for 5 years
and (ii) a growing perpetuity after 5 years

Finding the value of (i) by
5 !
1.3 1.3
PVGA = 1− = 9.02
0.08 − 0.3 1.08

5 !
1.3 1.3
PVGA = 1− = 9.02
0.08 − 0.3 1.08
Calculating the PV of (ii) by
(1.3)5 (1.02) 63.12

PV5 = = 63.12 ⇒ PV0 = = 42.96
0.08 − 0.02 1.085

5 !
1.3 1.3
PVGA = 1− = 9.02
0.08 − 0.3 1.08
Calculating the PV of (ii) by
(1.3)5 (1.02) 63.12

PV5 = = 63.12 ⇒ PV0 = = 42.96
0.08 − 0.02 1.085
Adding (i)+(ii) gives $9.02 + $42.96 = $51.98 million.

Exercise 7: Formula
You are thinking about buying a piece of art that costs $50,000. The art
dealer is proposing the following deal: He will lend you the money, and you
will repay the loan by making the same payment every two years for the
next 20 years (i.e., a total of 10 payments). If the interest rate is 4%, how
much will you have to pay every two years?

This cash flow stream is an annuity. First, draw the timeline

Then, calculate the 2-year interest rate: the 1-year rate is 4%, and $1
today will be worth (1.04)2 = 1.0816 in 2 years, so the 2-year interest
rate is 8.16%.

Then, calculate the 2-year interest rate: the 1-year rate is 4%, and $1
today will be worth (1.04)2 = 1.0816 in 2 years, so the 2-year interest
rate is 8.16%.
Using the equation for an annuity payment:

C 1
1− = 50, 000
0.0816 (1.0816)10
50, 000
⇔ C= = 7, 505.34
1 1
0.0816 1 − (1.0816)10

Exercise 8 a): Formula
(a) You are saving for retirement. To live comfortably, you decide you will
need to save $2 million by the time you are 65. Today is your 30th
birthday, and you decide, starting today and continuing on every
birthday up to and including your 65th birthday, that you will put the
same amount into a savings account. If the interest rate is 5%, how
much must you set aside each year to make sure that you will have $2
million in the account on your 65th birthday?

Solution: First, we draw the timeline

The PV of the cash flows must be equal to the PV of $2 million in 35

years. The cash flow consists of a 35-year annuity, plus the
contribution today, so the PV is

C 1
PV = 1− +C
0.05 1.0535



C 1
PV = 1− +C
0.05 1.0535
The PV of $2 million in 35 years is
2, 000, 000
= 362, 580.57
1.0535



C 1
PV = 1− +C
0.05 1.0535
The PV of $2 million in 35 years is
2, 000, 000
= 362, 580.57
1.0535
Setting these equal and solving for C gives:
362, 580.57
C= 1 1
= 20, 868.91
0.05 1 − 1.0535 + 1

Exercise 8 b): Formula
(a) You realize that the plan in Part (a) has a flaw. Because your income
will increase over your lifetime, it would be more realistic to save less
now and more later. Instead of putting the same amount aside each
year, you decide to let the amount that you set aside grow by 3% per
year. Under this plan, how much will you put into the account today?
(Recall that you are planning to make the first contribution to the
account today.)

Solution: Again, we draw the timeline

The first equation in part (a) changes to

35 !
C × (1.03) 1.03
PV = 1− +C
0.05 − 0.03 1.05

The first equation in part (a) changes to

35 !
C × (1.03) 1.03
PV = 1− +C
0.05 − 0.03 1.05
Setting this equal with the required present value PV = 362, 580.57
equals C = 13, 823.91.

Exercise 9: Formula
A local bank is running the following advertisement in the newspaper:

“For just $1,000 we will pay you $100 forever!” The fine print in the ad
says that for a $1,000 deposit, the bank will pay $100 every year in
perpetuity, starting one year after the deposit is made. What interest rate
is the bank advertising (what is the IRR of this investment)?

the payments are a perpetuity, so PV = 100/r

the payments are a perpetuity, so PV = 100/r

Setting the NPV of the cash flow stream equal to 0 and solving for r
gives the IRR:
100
NPV = 0 = − 1, 000 ⇒ r = 0.1
r
So the IRR is 10%.

Exercise 10
You have an investment opportunity that requires an initial investment of

$5,000 today and will pay $7,200 in two year. What is the IRR of this
opportunity?

Solution: IRR is the r that solves:

s
7, 200 7, 200
= 5, 000 ⇔ − 1 = 0.2
(1 + r )2 5, 000
so the IRR is 20%.

Exercise 11
Suppose you invest $2,000 today and receive $10,000 in five years.
(a) What is the IRR of this opportunity?
(b) Suppose another investment opportunity also requires $2000 upfront,
but pays an equal amount at the end of each year for the next five
years. If this investment has the same IRR as the first one, what is
the amount you will receive each year?

Solution:
(a) IRR solves 2000 = 10, 000/(1 + r )5 , so
1/5
10, 000
IRR = − 1 = 0.3797
2, 000

Solution:
(a) IRR solves 2000 = 10, 000/(1 + r )5 , so
1/5
10, 000
IRR = − 1 = 0.3797
2, 000
(b) C solves
C 1
2000 = × 1−
IRR (1 + IRR)5
so C = 949.27

Exercise 12: Formula
Your grandmother bought an annuity from Rock Solid Life Insurance

Company for $200,000 when she retired. In exchange for the $200,000,
Rock Solid will pay her $25,000 per year until she dies. The interest rate is
5%. How long must she live after the day she retired to come out ahead
(that is, to get more in value than what she paid in)?

Solution. She breaks even when the NPV of the cash flow is zero

The value of T that solves this is:

25, 000 1
NPV = −200, 000 + 1− =0
0.05 1.05T

The value of T that solves this is:

25, 000 1
NPV = −200, 000 + 1− =0
0.05 1.05T
Solving for T gives

1 − log 0.6
1.05T = ⇔ T = ≈ 10.5
0.6 log 1.05
Hence, T = 10.5, so if she lives 10.5 years or more she comes out
ahead.

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Corporate Finance, Session I, Exercise: Time value of Money

Corporate Finance, Session I, Exercise: Time value of

Moritz Greiwe | ESADE | November 9, 2020 1 / 39

Useful formulas: Ex.5

1. The present value of a periodical payment C starting today which

Moritz Greiwe | ESADE | November 9, 2020 2 / 39

Useful formulas: Ex.9

2. The present value of a periodical payment C starting kth next period

Moritz Greiwe | ESADE | November 9, 2020 3 / 39

Useful formulas: Ex.9

2. The present value of a periodical payment C starting kth next period

important special case: for k = 1, this reduces to

Moritz Greiwe | ESADE | November 9, 2020 3 / 39

Useful formulas: Ex.4 , Ex.7 , Ex.8a) , Ex.12

3. The present value of a periodical payment C starting today which

Moritz Greiwe | ESADE | November 9, 2020 4 / 39

Useful formulas: Ex.6 , Ex.8b)

4. The present value of a periodical payment C with growth factor g

Moritz Greiwe | ESADE | November 9, 2020 5 / 39

Calculate the future value of $2,000 in

Moritz Greiwe | ESADE | November 9, 2020 6 / 39

(a) FV5 = 2, 000 × 1.055 = 2, 552.56

Moritz Greiwe | ESADE | November 9, 2020 7 / 39

(a) FV5 = 2, 000 × 1.055 = 2, 552.56

Moritz Greiwe | ESADE | November 9, 2020 7 / 39

(a) FV5 = 2, 000 × 1.055 = 2, 552.56

Moritz Greiwe | ESADE | November 9, 2020 7 / 39

(a) FV5 = 2, 000 × 1.055 = 2, 552.56

FV10 = (2, 000 + 2, 000 × (1.055 − 1)) × 1.055

Moritz Greiwe | ESADE | November 9, 2020 7 / 39

Consider the following alternatives:

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Consider the following alternatives:

Moritz Greiwe | ESADE | November 9, 2020 8 / 39

Consider the following alternatives:

Moritz Greiwe | ESADE | November 9, 2020 8 / 39

Consider the following alternatives:

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100 200 200

Moritz Greiwe | ESADE | November 9, 2020 13 / 39

100 200 200

if you prefer option (iii) over option (ii), it follows that

You have just received a windfall from an investment you made in a

Moritz Greiwe | ESADE | November 9, 2020 14 / 39

You have just received a windfall from an investment you made in a

Moritz Greiwe | ESADE | November 9, 2020 14 / 39

Solution: First, draw the timeline of the payments:

Moritz Greiwe | ESADE | November 9, 2020 15 / 39

Solution: First, draw the timeline of the payments:

(a) For the present value, we get

10, 000 20, 000 30, 000

Moritz Greiwe | ESADE | November 9, 2020 15 / 39

Solution: First, draw the timeline of the payments:

(a) For the present value, we get

10, 000 20, 000 30, 000

FV = PV × 1.0353 = 61, 412

Moritz Greiwe | ESADE | November 9, 2020 15 / 39

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