Introduction to Finance

Lecture 3

Blair Robertson
 Lecture 3: The Time Value of Money
• We will develop tools that can be used to compute Net Present Value (NPV)
– Time Value of Money (TVM)
– Discounted Cash Flow Analysis (DCF) (simplified)

• The tools we develop will also be used later on to value stocks, bonds, and capital
investment projects

• Will cover the one-period and multi-period cases

• Compounding within year:

Interest Rate Conversions, Compounding Periods & Payment Frequency
– APR: Annual Percentage Rate or “Quoted” Rate
– EAR: Effective Annual Rate

• Administrative Items
– Readings: Chapter 5.1, 5.2 and 5.3
– Textbook Practice Problems: Examples 5.1 – 5.13, 5.20 – 5.22
2
The One-Period Case: Future Value
• If you were to invest $10,000 at 5% interest for one
year, how much would you have at the end of the
year?

3
The One-Period Case: Future Value
• If you were to invest $10,000 at 5% interest for one year, your
investment would grow to $10,500

$10,000 is the principal repayment ($10,000 × 1)

$500 would be interest ($10,000 × .05)
$10,500 is the total due. It can be calculated as:

$10,500 = $10,000×(1+.05)

The total amount due at the end of the investment is called the
Future Value (FV). What is the formula?

FV = PV0 x (1+r)

4
The One-Period Case: Present Value
• If you were promised $10,000, due in one year, when
interest rates are 5%, how much would your investment
be worth today?

5
The One-Period Case: Present Value
• If you were promised $10,000, due in one year, when
interest rates are 5%, your investment would be worth
$9,523.81 in today’s dollars
$10,000
$9,523.81 
1.05
The amount that a borrower would need to set aside today to be able to
meet the promised payment of $10,000 in one year is called the Present
Value (PV) of $10,000.
Note that $10,000 = $9,523.81×(1.05) FV
PV 
What is the one period formula? (1  r )

6
Recall: The Net Present Value

• The Net Present Value (NPV)  of an investment is the present

value of the expected (future) cash flows, less the cost of
the investment.

Note: this is the simplified formula for a one period example

• Q: Suppose an investment that promises to pay $10,000 in one

year is offered for sale for $9,500. Your interest rate is 5%. Should
you invest?

7
Recall: The Net Present Value

• The Net Present Value (NPV) of  an investment is the present

value of the expected (future) cash flows, less the cost of the
investment.

Q: Suppose an investment that promises to pay $10,000 in one year is

offered for sale for $9,500. Your interest rate is 5%. Should you invest?

A: Yes!

• We say that your “interest rate” is your required rate of return

8
The Multiperiod Case: Future Value
• Example: You have $100 to invest in a bank account that
pays an interest rate r = 6% per year.

• Future value of investment in year 1?

• Future value of investment in year 2?

9
The Multiperiod Case: Future Value
• Example: You have $100 to invest in a bank account that pays an
interest rate r = 6% per year.
• Future value of investment in year 1:
– Interest earned = Initial investment × interest rate = $100 × 0.06 = $6
• Future value of investment in year 2:
= $100 + $100 × 0.06 + $100 × 0.06 + $100 × 0.06 × 0.06
Principle; Interest (on Principle) in Y1; Interest (on Principle) in Year 2;Interest (on Interest) in Year 2

= $100 + $6 + $6 + $0.36 = $112.36

FV = (PV) × (1 + r) × (1 + r)
FV = (PV) × (1 + r) 2

Generalized for time T

FVT  C0  1  r 
FVT = Future Value at time T, or Cash at time T (C T)
T C0 = Cash to be invested at date 0, or Present Vale (PV)
r = interest rate per period
T = the number of periods over which the cash is invested
10
Future Value and Compounding
• Notice that the interest in year two, $6.36, is higher than the interest in year 1:

• Notice that the interest earned in year two, $6.36, is higher than the interest in
year 1, $6.00.
– If you extended this out to interest that would be earned in:
• 3 Years: $6.74
• 10 Years: $10.14
• 30 Years: $32.51
• 100 Years: $1,920.57

• This is due to compounding:

– You earn interest on both the initial $100 investment and also on the $6 interest that you
earned in the first year
– This interest earned on interest is called compounded interest

11
 Future Values with Compounding
  
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”

―Albert Einstein

12
Future Values with Compounding

7000

6000 0%
5%
5000 10%
FV of $100

4000 15%

3000

2000

1000

Number of Years

13
Future Values with Compounding

14
Historical Asset Class Performance: 80 Years
Wealth Multiples for US Asset Classes and Inflation
December 1925 – December 2005

Asset Class Multiple

Inflation 11 x
Treasury Bills 18 x
Corporate Bonds 100 x
Large Cap Stocks 2,658 x
Small Cap Stocks 13,706 x

Source: Ibbotson Associates, Stocks, Bonds, Bills and Inflation 2006 Year Book.
Performance of Small Cap Equities
in the Great Depression
 While these returns look great, don’t forget about
risk!
Wealth Multiples for Small Capitalization US Equities
November 1928 – June 1932

Date Multiple
November 30, 1928 1.00 x
December 31, 1929 0.46 x
December 31, 1930 0.29 x
December 31, 1931 0.14 x
June 30, 1932 0.10 x

Source: Ibbotson Associates, Stocks, Bonds, Bills and Inflation 2006 Year Book.
It Took People a Long Time
to Trust the Markets Again…
“It’s ridiculous that stocks are called securities,
they should be called insecurities”

─ paraphrased quote from the Saturday Evening Post, April 3, 1937

A Contemporary Example:
Remember Japan…

Source: www.finance.yahoo.com
The Multiperiod Case:
Present Value and Discounting

• How much would an investor have to set

aside today in order to have $20,000 five
years from now if the current rate is 15%?

PV $20,000

0 1 2 3 4 5

19
Present Value Formula
CT PV = Present Value, or Cash at date 0 (C 0)

PV  CT = Cash at time period T, or Future Value at time period T (FV T)

1  r 
r = interest rate per period
T T = the number of periods over which the cash is invested

Discount Factor = DF = PV of $1
1
DF 
1  r  T

 These discount factors can be used to

compute the present value of any cash flow

20
How Long is the Wait?
If we deposit $5,000 today in an account paying 10%,
how long does it take to double your money?

21
How Long is the Wait Continued
Recall that the Present Value formula is:

We can rearrange the Present Value formula to solve for

“T”:
 
T = the number of periods over which the cash is invested
FVT = Future Value at time period T, or Cash at time period T (C T)
PV = Present Value, or Cash at date 0 (C 0)
r = interest rate per period

22
How Long is the Wait Continued
By utilizing the rearranged Present Value formula:

We can solve for “T”:

T = log($10,000/$5,000)
log(1+0.1)
T = log 2 / log 1.10
T = 7.27 years
23
The Manhattan Example

• In 1626 Dutch Settlers who were representatives of a publically traded

company, the West India Company, purchased the Island Manhattes from
the Indians for a value of 60 guilders or $24 dollars in the exchange rate of
the time. According to Bloomberg, commercial and residential properties in
Manhattan for 2020 is approximately $483.6 billion. What was the rate of
return on this purchase?
24
What Rate Is Enough?
Recall that the Present Value formula is:

We can rearrange the Present Value formula to solve for

“r”:
r = interest rate per period
T FVT = Future Value at time period T, or Cash at time period T (CT)
PV = Present Value, or Cash at date 0 (C0)
T = the number of periods over which the cash is invested

25
What Rate Is Enough Continued
By utilizing the rearranged Present Value formula:

We can solve for “r”:

r = ($483,600,000,000/$24)(1/394) -1

r = 6.21%

Was this a good deal?

26
Extension to Multiple Cash Flows

C1
PV of cash flow in year 1 PV 
1  r 


C2
PV of cash flow in year 2 PV 
1  r  2


 PV of a series of cash flows in years 1 to T is

therefore:
C1 C2 C3 CT
PV      
1  r  1  r  2 1  r  3 1  r  T
T
Ct
PV  
t 1  1  r  t

27
Multiple Cash Flows
• Consider an investment that pays $200 one
year from now, with cash flows increasing by
$200 per year through year 3. If the interest
rate is 12%, what is the present value of this
stream of cash flows?
$200 $400 $600

0 1 2 3

PV  ?
28
Compounding (within) Periods
• We have implicitly assumed that interest is paid once a year but
what if interest was paid more than once a year?
• Wealth from investing for T years, compounding an investment
m times a year with a stated/nominal rate of r:

mT
 r
FVT  C0  1  
 m

FVT = Future Value at time period T, or Cash at time period T (CT)

C0 = Cash at date 0 (C0), or Present Value (PV)

r = nominal interest rate per period (i.e. year), sometimes referred to as the QR (Quoted Rate) or
the APR (Annual Percentage Rate) – it does not take compounding into account
m = the number of times per period (i.e. year) the investment is compounded
T = the number of periods (i.e. years) over which the cash is invested

29
Compounding (within) Periods - Example
If you invest $50 for 1 year at 12% compounded semi-annually,
what will your investment grow to?
Recall that:
mT
 r
FVT  C0  1  
 m
2∗1
0.12  
(
𝐹𝑉 =$ 50 ∗ 1+
2 ) 2
=$ 50∗ ( 1.06 ) =$ 56.18

30
APR vs. EAR
• Annual Percentage Rate (APR) is the stated or quoted annual
interest rate without consideration of compounding. This is
sometimes referred to as the Quoted Rate (QR)
• APR is computed by simply multiplying the periodic rate by the
number of periods in a year
– e.g. An investment pays 3% per quarter with quarterly compounding. The APR
will be 12% per year whereas the EAR will be 12.5509% (rounded)

• Effective Annual Rate (EAR) is the interest rate that is annualized

using compound interest
m
 r
mT
 r
(1  EAR)  1   EAR  1   1
T in a single year

 m  m
r = percentage/nominal interest rate per period (i.e. year) ), sometimes referred to
as the Quoted Rate or the APR (Annual Percentage Rate) – it does not take
compounding into account
m = the number of times per period (i.e. year) the investment is compounded
T = the number of payments per period (i.e. year) 31
Effective Annual Interest Rates
What is the effective annual rate of interest on our earlier
investment? (Recall: If you invest $50 for 1 year at 12%
compounded semi-annually)
 

So, investing at 12.36% compounded annually is the same as

investing at 12% compounded semiannually

32
APR vs. EAR
• Effective Annual Rate (EAR) is the interest rate that is annualized
using compound interest (12.36% in the previous example)
• Annual Percentage Rate (APR) is the stated or quoted annual
interest rate without consideration of compounding (12% in the
previous example)
• APR is computed by simply multiplying the periodic rate by the
number of periods in a year
– e.g. An investment pays 6% interest semi-annually.
• APR: 6% x 2 = 12%
• EAR: (1+0.12/2)2 – 1 = 12.36%
– e.g. Note this is different than 6% compounded semi-annually.
• APR: 6%
• EAR: (1+0.06/2)2 – 1 = 6.09%

33
Effective Annual Interest Rate: Example
What is the Effective Annual Rate (EAR) of your credit
card balance if the annual percentage rate (APR) is
18% compounded monthly?
What we have is a loan with a monthly interest rate
of 1½ percent (18% / 12 = 1.5%)
This is equivalent to a loan with an effective annual
interest rate of 19.56%

m 12
 r  .18 
EAR  1    1  1    1  (1.015)  1  1.19561817 1  19.56%
12

 m  12 

34
Compounding Frequency and Effective Annual Rates

Compounding Period # Of Times Effective Annual Rate

Compounded

Year 1 10.00000%
Quarter 4 10.38129%
Month 12 10.47131%
Week 52 10.50648%
Day 365 10.51558%
Hour 8,760 10.51703%
Minute 525,600 10.51709%

Continuous Infinite 10.52%

35
Continuous Compounding
• The general formula for the future value of an investment
compounded continuously over many periods can be
written as:

FVT = C0×erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of periods over which the cash is invested, and
e is a mathematical constant approximately equal to 2.718. ex is
the exponential function and also a key on your calculator.

36
Lecture 3: Knowledge Checks
• You should be able:
 To compare cash flows that occur at different points in
time
 To determine economically equivalent future values
from values that occur in previous periods through
compounding
 To determine economically equivalent present values
from cash flows that occur in the future through
discounting
 To determine effective annual rates (EAR) of return
from quoted interest rates (APR)
• Readings: Chapter 5.1, 5.2 and 5.3
37