FINA1027 Lecture 3 Time Value of Money

Lecture 3:
Time Value of Money
Panagiotis Panagiotou
FINA1027 Finance
Department of Accounting, Finance, and Economics
Greenwich Business School
October 11, 2022

p.panagiotou@greewich.ac.uk
Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 1 / 58

Learning Objectives
By the end of this session, you will be able to:
Develop an understanding of the time value of money.
Understand future value and compounding.
Understand present value discounting.
Value a perpetual series of regular cash flows called a perpetuity.
Value a common set of regular cash flows called an annuity.

Outline
1 Interest rates
2 Simple and Compound interest
3 Future Value
4 Present Value
5 Quoted and Effective interest rates
6 Annuities
7 Perpetuities
8 Real and Nominal interest rates

Question
Which would you prefer:
£1,000 today
or
£1,000 in 1 year?

Question
Which would you prefer:
£1,000 today
or
£1,000 in 1 year?
Obviously, £1,000 TODAY!

Time Value of Money
The time value of money is the concept that a unit of currency received
today is worth more than the same unit of currency received at a future
point.
Why is TIME such an important element in your decision?
There are 3 reasons why a pound tomorrow is worth less than a pound today:
1 Time allows you the opportunity to postpone consumption, to invest and

start earning interest immediately.
2 There is inflation, which reduces a currency’s purchasing power over

time. The greater the inflation, the greater the difference in value
between a pound today and a pound tomorrow.
3 If there is any uncertainty associated with the cash flow in the future,
the less that cash flow will be valued.
Uses of Time Value of Money
Time value of money quantifies the value of a pound through time.
Time value of money is a concept that is used in all aspects of finance:
Bond valuation
Stock valuation
Investment appraisal
Financial analysis
and many others!

Interest Rates
If you are a saver or lender, the interest rate tells you how much money
will be paid into your account as a percentage of your savings or lending.
- you demand interest as you cannot instantly spend the money you have
lent on consumption goods
- the less trustworthy person/company you lend money to, the higher the
interest rate you require as you’re less confident that you’ll get your money
back.
If you are a borrower, the interest rate tells you the amount charged for
borrowing money, expressed as a percentage of the borrowed amount.
- the higher the interest rate, the more you have to pay back
- the higher your credit risk, the higher the interest rate
Bank rate: the key interest rate in the UK, determined by the Bank of
England (BoE). It influences many other interest rates in the economy.
Interest Calculation
We must distinguish between two varieties of interest calculation: simple and

compound interest.
Assume a fixed, one-period interest rate of r and an initial balance of X.
1 Simple Interest: the interest earned or paid is just the original balance
of the deposit/loan times the interest rate.
2 Compounded Interest: interest must be paid on previously charged /

earned interest.

Example #1: simple interest calculation
Scenario: Assume you deposit £1,000 in a savings account, earning 10%

p.a. simple interest for 3 years. What amount will you have in your account at
the end of that time period?
- the interest earned in year 1 is: £1, 000 × 10% = £100;
- the total interest earned is £100 × 3 years = £300;
- and the total balance at the end of that time period would be equal to:
Original Deposit + Interest earned = £1,000 + £300 = £1,300;
or, alternatively, £1, 000 × (1 + 10% × 3) = £1, 300;
- So over T periods, the total balance of your deposit / debt will grow to be:
X + (r × X ) × T = X + rXT = X (1 + rT ).

Example #2: compound interest calculation
Scenario: Assume you deposit £1,000 in a savings account, earning 10%
p.a. compound interest for 3 years. What amount will you have in your
account at the end of that time period?
- the total interest earned is £100 + £110 + £121 = £331;
- and the total balance at the end of that time period would be equal to:
Original Deposit + Interest earned = £1,000 + £331 = £1,331;
or, alternatively, £1, 000 × (1 + 10%)3 = £1, 331;
- So over T periods, the total balance of your deposit / debt will grow to be:
X (1 + r )T .
- Note that £1,000 × 1.1 × 1.1 × 1.1 = £1,000 ×1.13 = £1,331.

Compound vs Simple Interest
Assume a fixed interest rate of 10%.
Clearly: compound interest is good for savers but worrying for borrowers.

Future Value of a Cash Flow
Question: we are given a cash flow of X today (we denote the present value
of that cash flow X today by PV). What value will this cash flow grow to if
invested at interest rate r for T periods?
FV = PV × (1 + r )T
This amount is called the future value (FV) of X, assuming an interest rate of r
and an investment period of T.
Note the use of compound interest
Obviously the future value is larger if r is larger
The future value is obviously also greater when T is greater or when X

(i.e., PV) is greater.

Example #3: calculating future values
Scenario: 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 annual interest rate 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?
The baseline answer, assuming a 5% rate, and then the sensitivity analysis
are given below;
FV(5%,10y) = X × (1 + r )T = 100, 000 × (1 + 0.05)10 = £162, 889.46
FV(2%,10y) = X × (1 + r )T = 100, 000 × (1 + 0.02)10 = £121, 899.44
FV(10%,10y) = X × (1 + r )T = 100, 000 × (1 + 0.10)10 = £259, 374.25

Present Values
Intuition:
Assume that you’re due to receive a payment of X in T years.
What current cashflow is equivalent to that future cash flow?

- Compute the amount that you would have to place in a bank today such
that it would grow to be exactly worth X in T years.
- Equivalently, how much would a bank lend you today if you promise to give
them a repayment of X in T years.
This is called the Present Value (PV) of X. We compute it as:
FV
FV = PV × (1 + r )T ⇒ PV =
(1 + r )T
Note: if you took exactly this present value and banked it for T years at
rate r you would end up with: PV (r , T ) × (1 + r )T = FV
Present Value Computations

Discount Rates
A discount rate is the rate of return used to discount future cash flows
back to their present value.
It is the reward that investors demand for accepting delayed rather the
immediate gratification.
We will also call the discount rate the interest rate or required rate of
return or opportunity cost of capital.
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.
Discount rates also account for the riskiness of an investment and can
be adjusted to better reflect the uncertainties about reassessments
through time of the future values from an investment.
Discount Factors
When computing present values we often make use of an object called a
discount factor.
A discount factor is just the present value of £1.
Discount factors vary with the interest rate and with the investment
horizon.
We calculate a discount factor (DF) as:

1
DF =
(1 + r )T
Higher interest rates lead to lower discount factors and longer
investment periods lead to lower discount factors.
Present values and discount factors: using the definition of the discount
factor we can rewrite the present value as;
1
PV = DF × FV = × FV
(1 + r )T
Example #4: calculating present values
Scenario: 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 assuming the current annual
interest rate of 1%?
Sensitivity analysis: how would your answer change if interest rates turn
out to be 5% per year?
The baseline answer and then the sensitivity analysis are given below;
1
PV(1%, 2y) = 5, 000, 000 × (1+0.01)2
= £4, 901, 480.25
1
PV(5%, 2y) = 5, 000, 000 × (1+0.05)2
= £4, 535, 147.39
Clearly, even over short horizons, with reasonably high interest rates, PV’s
can be much smaller than actual future CF’s.

calculating present values (cont.)
The PV of a cash flow can be calculated in any one of several ways: the computations
could be done by hand, by calculator, by spreadsheet, or with the help of a table of
present value factors.
This table presents the present value of £1 at the end of T periods.
The table is used by locating the appropriate interest rate on the horizontal and the
appropriate number of periods on the vertical.

calculating present values (cont.)
Recall that:
1
PV = DF × FV = × FV
(1 + r )T
PV(1%, 2y) = 5, 000, 000 × 0.980 = £4, 900, 000
PV(5%, 2y) = 5, 000, 000 × 0.907 = £4, 535, 000

PV of streams of CF’s
Problem:
Until now we’ve thought about single CF’s (current or future) only.
Most investments involve multiple CFs received and paid at different
points in time.
Positive CFs are receipts and negative CFs are payments.
How do you compute present values for these more complicated
streams of money?
Solution:
Take each individual CF and compute its present value.

Sum present values across all of the CFs.
This is called the Net Present Value or NPV.
Receipts will contribute positively to NPV and payments will contribute
negatively.
Net Present Value (NPV)
Calculating NPV: assume a constant interest rate of r per period. Assume a
investment project which will deliver a cashflow of CF1 at the end of 1 period,
CF2 at the end of two periods, continuing until it finishes by delivering a
cashflow of CFT after T periods. The NPV is:
T
X CFt
NPV =
(1 + r )t
t=1
CF1 CF2 CFT

= + + ... +
(1 + r )1 (1 + r )2 (1 + r )T
1 1 1
= CF1 × + CF2 × + ... + CFT ×
(1 + r )1 (1 + r )2 (1 + r )T
| {z } | {z } | {z }
DF DF DF
Again, note that some of the CFt might be negative (if they are payments not
receipts).
Example #5: calculating the PV of a stream of CFs
Scenario: I promise to give you £10,000 at the end of each of the next 3
years.
How much are you willing to pay me now in order to benefit from these future
payments? Assume a fixed annual interest rate of 6% and that I’m completely
trustworthy.
Solution: compute the NPV of the promised cashflow stream. This is;
10, 000 10, 000 10, 000

NPV = + + = £26, 730.12
(1 + 0.06)1 (1 + 0.06)2 (1 + 0.06)3
So the CFs I have promised you are worth £26,730.12 in current terms.
Thus, you should be willing to pay me up to this amount (and no more) if I

promise you £10,000 for each of the next 3 years.

calculating the PV of a stream of CFs (cont.)
Assumption: Fixed cash flows.

calculating the PV of a stream of CFs (cont.)
10, 000 10, 000 10, 000

NPV = + +
(1 + 0.06)1 (1 + 0.06)2 (1 + 0.06)3
1 1 1
= 10, 000 × + 10, 000 × + 10, 000 ×
(1 + 0.06)1 (1 + 0.06)2 (1 + 0.06)T
| {z } | {z } | {z }
DF DF DF
= 10, 000 × 0.943 + 10, 000 × 0.890 + 10, 000 × 0.840
= 10, 000 × (0.943 + 0.890 + 0.840)
= 10,000 × 2.673
= 26, 730

Compounding Periods
Convention:
So far, we have assumed that compounding and discounting occur

yearly.
Whenever we talk about interest rates we tend to scale them up or down

so that they cover a period of exactly one year.
The way in which this is done varies across financial instruments and
markets.
In this course we will adopt the convention below (which is also fairly
common in real markets).

Quoted Interest Rates
Assume that you have an interest rate, r , for a given period and that there are
N of these periods in a year.
Then the quoted Annual Percentage Rate (APR) is Nr.
Implication: if someone quotes you an interest rate of 6% on a 1-month

deposit, this means that you will receive a rate of 0.5% on your initial
balance at the end of the month.
Why? Because 0.5% × 12 = 6%.
The APR is the annual interest rate without consideration of

compounding. Banks and other financial institutions may use other
names for the APR.
APR: interest is compounded once per year or annually AND ignores

compounding.
Effective Annual Rate (EAR)
The Effective Annual Rate (EAR) is the actual interest you would receive on a
deposit (or pay on a loan) on an annual basis, expressed as a percentage.
Example:
Take the situation above, where one is quoted a rate of 6% on a 1-month

deposit.
You make such deposit of £1 and at the end of every month re-invest the
balance at the 1-month rate.
At the end of 12 months you have:

£1 × (1 + r )12 = £1 × (1 + 0.005)12 = £1.0617
So, your effective annual interest rate is 6.17%.
The EAR > APR when the compounding period is less than a year.

APR and EAR
With m compounding periods per year, the EAR is:
m
APR
EAR = 1+ −1
m
Example:
If a bank pays 5% interest semi-annually, customers receive 2.5% of
their deposit every 6 months.
5% 2

The bank deposit really earns 1 + 2 −1 = 5.0625%
APR is meaningless without its compounding frequency.
One common reference point is continuous compounding:
as m → ∞ ⇒ EAR → eAPR − 1

Example #6: EAR calculation
Scenario: Calculate the EAR if the Annual Percentage Rate (APR) is 12%
and interest is paid quarterly.

Scenario: Calculate the EAR if the Annual Percentage Rate (APR) is 12%
and interest is paid quarterly.
Answer:
m
APR
EAR =1+ −1
m
4
12%
= 1+ −1
4
= 0.1255 or 12.55%

Scenario: What is the end-of-year wealth if Alex Marsh receives an APR of

24% compounded monthly on a £10 investment?

Scenario: What is the end-of-year wealth if Alex Marsh receives an APR of

24% compounded monthly on a £10 investment?
Answer:
m
APR
End-of-year wealth = X × 1 +
m
12
24%
= £10 × 1 +
12
= £12.68

Compounding Frequency and Effective Annual Rates
Compounding Compounding
Frequency Periods APR EAR
(m)
0.05 1
Annual 1 5.00% (1 + 1 ) − 1 = 5.00%
0.05 2
Semi-annual 2 5.00% (1 + 2 ) − 1 = 5.0625%
0.05 4
Quarterly 4 5.00% (1 + 4 ) − 1 = 5.0945%
0.05 12
Monthly 12 5.00% (1 + 12 ) − 1 = 5.1162%
0.05 52
Weekly 52 5.00% (1 + 52 ) − 1 = 5.1246%
0.05 365
Daily 365 5.00% (1 + 365 ) − 1 = 5.1267%
Continuous ∞ 5.00% e0.05 = 5.1271%

Compounding over many years
The FV equation applies for an investment over one year with annual
compounding.
FV = PV × (1 + r )T
For an investment over one or more years and less than annual
compounding, the FV formula becomes:
r mT
FV = PV × (1 + )
m

Example #8: multi-year compounding
Scenario: Richard Smith is investing £5,000 at an annual percentage rate of

12% per year, compounded quarterly, for five years. What is his wealth at the
end of five years?

Example #8: multi-year compounding
Scenario: Richard Smith is investing £5,000 at an annual percentage rate of

12% per year, compounded quarterly, for five years. What is his wealth at the
end of five years?
Answer:
r mT
FV = PV × (1 + )
m
12% 4×5
= £5, 000 × (1 + )
4
= £5, 000 × (1.03)20
= £5, 000 × 1.8061
= £9, 030.50

Continuous Compounding I
The previous discussion shows that we can compound much more

frequently than once a year.
We could compound semiannually, quarterly, monthly, daily, hourly, each

minute, or even more often.
The limiting case would be to compound every infinitesimal instant,

which is commonly called continuous compounding.
Surprisingly, banks and other financial institutions sometimes quote

continuously compounded rates, which is why we study them.

Continuous Compounding II
Fix a deposit size of X and an (annual) quoted interest rate of r. If there are m periods
per year then, at the end of the year, the balance of one’s investment is:
m
r
X 1+
m
As the number of periods per year tends to infinity we get;

m
r
lim X 1 + = X × er
m→∞ m
We call this continuous compounding and r would be described as the continuously

compounded interest rate.
An investment for T years at continuously compounded rate r would grow to X × e rT

by the end of the holding period.
The number e is a constant and is approximately equal to 2.718.

Example #9: continuous compounding
Scenario: Linda Evans invested £1,000 at a continuously compounded rate

of 10% for one year. What is the value of her wealth at the end of one year?
What is the value of her wealth at the end of two years?

Example #9: continuous compounding
Scenario: Linda Evans invested £1,000 at a continuously compounded rate

of 10% for one year. What is the value of her wealth at the end of one year?
What is the value of her wealth at the end of two years?
Answer:
FV at the end of year 1 = PV × erT

= £1,000 × e10%×1
= £1,000 × 1.1052
= £1, 105.20
FV at the end of year 2 = £1,000 × e10%×2 = £1, 221.40

Discounting in Continuous Time
You will receive a cashflow of X in T years.
You want to compute the present value of the cashflow.
If you are told that the continuously-compounded interest rate is r then the
present value is:
FV 1
PV = = FV × rt = FV × e−rT
erT e

Example #10: PV with continuous compounding
Scenario: The State Lottery is going to pay you £100,000 at the end of four
years. If the annual continuously compounded rate of interest is 8%, what is
the present value of this payment?

Example #10: PV with continuous compounding
Scenario: The State Lottery is going to pay you £100,000 at the end of four
years. If the annual continuously compounded rate of interest is 8%, what is
the present value of this payment?
Answer:
1
PV = FV ×
ert
1
= £100, 000 ×
e8%×4
1
= £100, 000 ×
1.3771
= £72, 616.37

Valuing long-lived projects or securities
Often the cashflow streams that we are interested in are comprised of
multiple payments/receipts e.g.:
Stocks pay dividends on a regular basis

Bonds make regular interest payments (known as coupon payments)
After making a loan to a friend you expect monthly repayments
We can use PV techniques to arrive at a total value for these cashflow

streams.
We can also use some shortcuts in certain cases to make our lives easier.
Examples of these are:
Annuities (with and without growth)
Perpetuities (with and without growth)

Perpetuities
Consider an asset that promises a fixed nominal cashflow at the end of every
period from now until the end of time. This is a perpetuity.
Call the fixed cashflow C and assume that the 1-period interest rate is fixed at
r. Then the PV of the perpetuity is:
∞ ∞
X C X 1
PVp = t
= C×
(1 + r ) (1 + r )t
t=1 t=1
It can be shown that this infinite sum can be written as: Proof
Present Value of a Perpetuity:
C
PVp =
r

Example #11: valuing perpetuities
Scenario: If interest rates are at 5% per annum and someone promises you
£100 per year forever, that cashflow stream is worth:
C 100
PVp = r = 0.05 = £2,000 in present value terms.

Example #12: undated UK government debt
War loans: in late 2014 and early 2015 the UK government repaid undated
(perpetual) bonds that had been issued by previous UK governments to
finance, amongst other things, the First World War.
Details: the WW1 debt was, in total around £1.9 billion with a 3.5% annual
interest rate. The debt was perpetual and was originally issued in 1932.
Replacement: the undated debt was replaced with standard fixed lifetime
gilts issued at relatively low interest rates (given current economic
conditions). Plans were made and executed to take all undated UK bonds
and replace them in the same way. Some of these other undated bonds were
first issued in the 18th century.
Links:
https://www.gov.uk/government/news/chancellor-to-repay-the-nations-first-world-war-debt
https://www.ft.com/content/94653f60-60e8-11e4-894b-00144feabdc0
https://www.theguardian.com/money/2014/dec/03/treasury-repay-war-debts-bonds-uk

Annuities
These are more common cashflow streams, consisting of the payment of a
fixed nominal cashflow, once per period but only for a known, finite number of
periods.
Example: I promise to pay my mortgage company £10,000 per year at the

end of each year for the next 25 years.
Present Value of an Annuity:

1 1
PVA = C −
r r (1 + r )T
The intuition is simple. Take the example above;

1 Consider a perpetuity paying £10,000 per year and with the first payment 1 year
from now.
2 Consider a perpetuity paying £10,000 per year where the first payment is 26
years from now.
3 Subtract (2) from (1): you’re left with a 25 year annuity. Proof

Example #13: valuing annuities I
Scenario: A recent retiree wants to use some of her savings to buy an

annuity product. This product will deliver an annual income of £25,000 per
year for the next 15 years.
Assuming that all payments are made at year end, and the annual interest
rate is fixed at 3%, how much should she expect to pay to the annuity
provider today?
Solution: the annual payment (C) is £25,000, the constant interest rate (r ) is
3%, and the term (T ) is 15 years. So:

1 1 1 1
PVA = C − = 25, 000 − = £298,448.38
r r (1 + r )T 0.03 0.03(1 + 0.03)15

Example #14: valuing annuities II
Scenario: In May 1998 a retired couple paid £1 to buy a Powerball lottery
ticket and won a record £194 million. This sum was to be paid in 25 equal
annual instalments.
If the first instalment was received immediately and the interest rate was 9%,
how much was the prize worth? Assume that payments are made at the end
of the year.
Solution: the annual payment (C) is £194 million divided by 25 years = £7.76
million, the constant interest rate (r ) is 9%, and the term (T ) is 25 years. So:

1 1 1 1
PVA = C − = 7.76 − = £76.23m
r r (1 + r )T 0.09 0.09(1 + 0.09)25
But payments are actually beginning of year so the PV of the cashflows is;
PVA × (1 + r ) = 76.23 × 1.09 = 83.08m

Perpetuities with growth
Another infinitely-lived stream of cashflows.
At the end of one period one is promised a cash flow of C and at the end of
each subsequent period, the cashflow promised grows at rate g.
Thus the second cash ow is C(1 + g), the third is C(1 + g)2 , and so on...
Again, if we assume that the constant one-period interest rate is r , then the
present value of a Perpetuity with growth: is;
∞
X C(1 + g)t−1 C
PVp = = Proof
(1 + r )t r −g
t=1
Clearly we need r to be greater than g to make the answer to this infinite

present value sensible.
If g is larger than r then the cashflows grow more quickly than the discount
factors and thus the sum is infinite.
Annuities with growth
Consider a cashflow stream such that at the end of one period, one is
promised a cashflow of C and at the end of each subsequent period, the
cashflow promised grows at rate g. However, the cashflow stream terminates
after T payments. This is an annuity with growth.
Valuation: use exactly the same trick as when valuing a no-growth annuity
1 Value a perpetuity with growth where the first payment is made one period from
now.
2 Value a perpetuity with growth where the first payment is made T + 1 periods
from now.
3 The cash flows from the annuity with growth equal the cashflows from (1) minus
the cashflows from (2).
4 Thus the PV of the annuity with growth is the PV of (1) minus the PV of (2).

Annuities with growth II
If the first cashflow is C, the cashflows grow at rate g and the one-period
discount rate is r then the PV of the growing annuity is;
Present Value of an Annuity with growth:

T
C 1+g
PVA = 1−
(r − g) 1+r

Real and Nominal Interest Rates I
Consider the following three rates:
Inflation rate: the (usually annual) rate at which the level of prices in the
economy grows. 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.
Comments:
Up to now we’ve worked entirely in nominal terms.

If you’re given nominal cashflows, you should discount them at the
nominal rate.
If you’re given real cashflows, you should discount them at the real rate.
Real and Nominal Interest Rates II
Real Interest Rate: we define the real interest rate to be;
(1 + r )
(1 + i) =
(1 + π)
Approximate real interest rate: we have;
(1 + r ) = (1 + i) × (1 + π) ⇒ (1 + r ) = 1 + i + π + iπ
When rates are low, iπ will be very small. Thus we ignore it and obtain;
(1 + r ) ≈ 1 + i + π ⇒ i ≈ r − π

Real and Nominal Interest Rates III
Comments:
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.
- 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.

Key Points
Assets can be seen as sequences of cashflows.
Date t cashflows are different from date (t+k) cashflows.
PV and FV allows us to value sequences of cashflows.
Be aware of the compounding frequency.
Special cashflows: perpetuities and annuities.
Inflation and interest rates.

Before you go
Required reading: Corporate Finance (Hillier et al.), Chapter 4.
Tutorial and support session questions can be found on Moodle.
Prepare tutorial and support session questions before attending the

actual session.
Post any questions on Q&A Forum or send email at:

p.panagiotou@greewich.ac.uk
What’s next? Investment Appraisal I
See you all next week!

APPENDIX

PV of a Perpetuity: Proof
1
Define x to be (1+r ) . Then the PV of the perpetuity is:
∞
X ∞
X
t t
PVp = C x = Cx 1 + x
t=1 t=1
Thus,
∞
X ∞
X
t
xPVp = Cx x + x = Cx xt
t=2 t=1
Combining these two equations gives:

∞
X ∞
X
t
PVp − xPVp = Cx 1 + x − Cx x t = Cx
t=1 t=1
and therefore;
x C
PVp = C =
1−x r
Back

PV of an Annuity: Proof
Assume a T year annuity, paying C per year and an annual interest rate of r.
The value of a perpetuity, paying C per year with the first payment in 1 year is;
C
PV1 =
r
The value of a perpetuity paying C per year and with a first payment in T+1
years is:
1 C
PV2 =
(1 + r )T r
The T year annuity has value equal to PV1 minus PV2. So;

C 1 C 1 1
PVA = PV1 − PV2 = − = C −
r (1 + r )T r r r (1 + r )T
Back

PV of a Perpetuity with growth: Proof
Start with the infinite sum again;
∞ ∞ t ∞
C(1 + g)t−1

X C X 1+g C X
t
PVp = = 1+ = 1+ x
(1 + r )t 1+r 1+r 1+r
t=1 t=1 t=1
(1+g)
where x = (1+r ) . This implies that:
∞ ∞
C X C X t
xPVp = x+ xt = x
1+r 1+r
t=2 t=1
Subtracting the result of this second equation from that of the first we get;
∞ ∞
C X C X t C
PVp − xPVp = 1+ xt − x =
1+r 1+r (1 + r )
t=1 t=1
And finally;
1 C (1 + r ) C C
PVp = = =
1 − r )1 + r ) (r − g) (1 + r ) r −g
Back

FINA1027 Lecture 3 Time Value of Money

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Lecture 3:

Time Value of Money

October 11, 2022

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 1 / 58

By the end of this session, you will be able to:

Develop an understanding of the time value of money.

Understand future value and compounding.

Understand present value discounting.

Value a perpetual series of regular cash flows called a perpetuity.

Value a common set of regular cash flows called an annuity.

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 2 / 58

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 3 / 58

Which would you prefer:

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 4 / 58

Which would you prefer:

Obviously, £1,000 TODAY!

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 4 / 58

Why is TIME such an important element in your decision?

1 Time allows you the opportunity to postpone consumption, to invest and

2 There is inflation, which reduces a currency’s purchasing power over

Time value of money quantifies the value of a pound through time.

Time value of money is a concept that is used in all aspects of finance:

and many others!

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 6 / 58

We must distinguish between two varieties of interest calculation: simple and

Assume a fixed, one-period interest rate of r and an initial balance of X.

2 Compounded Interest: interest must be paid on previously charged /

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 8 / 58

Scenario: Assume you deposit £1,000 in a savings account, earning 10%

- the interest earned in year 1 is: £1, 000 × 10% = £100;

- the interest earned in year 2 is: £1, 000 × 10% = £100;

- the interest earned in year 3 is: £1, 000 × 10% = £100;

- the total interest earned is £100 × 3 years = £300;

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 9 / 58

- the interest earned in year 1 is: £1, 000 × 10% = £100;

- the interest earned in year 2 is: £1, 100 × 10% = £110;

- the interest earned in year 3 is: £1, 210 × 10% = £121;

- the total interest earned is £100 + £110 + £121 = £331;

- Note that £1,000 × 1.1 × 1.1 × 1.1 = £1,000 ×1.13 = £1,331.

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 10 / 58

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 11 / 58

Note the use of compound interest

Obviously the future value is larger if r is larger

The future value is obviously also greater when T is greater or when X

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 12 / 58

How much will you be able to contribute to her house purchase

FV(5%,10y) = X × (1 + r )T = 100, 000 × (1 + 0.05)10 = £162, 889.46

FV(2%,10y) = X × (1 + r )T = 100, 000 × (1 + 0.02)10 = £121, 899.44

FV(10%,10y) = X × (1 + r )T = 100, 000 × (1 + 0.10)10 = £259, 374.25

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 13 / 58

What current cashflow is equivalent to that future cash flow?

This is called the Present Value (PV) of X. We compute it as:

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 15 / 58

The discount rate is also called opportunity cost of capital because it is

A discount factor is just the present value of £1.

We calculate a discount factor (DF) as:

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 18 / 58

This table presents the present value of £1 at the end of T periods.

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 19 / 58

PV(1%, 2y) = 5, 000, 000 × 0.980 = £4, 900, 000

PV(5%, 2y) = 5, 000, 000 × 0.907 = £4, 535, 000

Panagiotis Panagiotou (Greenwich) Time Value of Money FINA1027 (Term 1) 20 / 58

Take each individual CF and compute its present value.