Chapter 5: The Time Value

of Money

&

Chapter 2: How to
Calculate Present Values
 Topics Covered
• Time Value of Money
• Future Values (FV) and Present Values (PV)
– Compute the future value of an investment made today
– Compute the present value of cash to be received at some
future date
– Compute the number of periods that equates a present value
and a future value given an interest rate
– Compute required interest rate to reach a certain amount in a
certain period
• Looking for Shortcuts—Perpetuities and Annuities
• More Shortcuts—Growing Perpetuities and Annuities
• How Interest Is Paid and Quoted
 Time Value of Money
10% risk-free interest rate
Now 1 Year 2 Years
100TL 108TL 120TL

Which of these would you want assuming you

do not need cash urgently?
 Time Value of Money
10% risk-free interest rate
Now 1 Year 2 Years
100TL 108TL 120TL

Which of these would you want assuming you do not

need cash urgently?

Now 1 Year 2 Years

100TL +10TL 110TL +11TL 121TL
 Time Value of Money
Money has a time value. It can be expressed in
multiple ways:
• When you get your money is important

• A TL today held in savings will grow.

• A TL received in a year is not worth as much as a TL

received today.

5-5
 Present Value and Future Value
• Future Value
– Amount to which an investment will grow after
earning interest
• Present Value
– Value today of a future cash flow
 Basic Definitions
• Present Value – earlier money on a
time line

• Future Value – later money on a time line

• Interest rate – “exchange rate” between earlier money

and later money
 Discount rate
 Cost of capital
 Opportunity cost of capital
 Required return
USING TIMELINES TO VISUALIZE
CASHFLOWS
Using Timelines to Visualize Cash flows

• A timeline identifies the timing and amount of

a stream of payments – both cash received
and cash spent - along with the interest rate
earned.

• A timeline is typically expressed in years, but

it could also be expressed as months, days or
any other unit of time.
 Time Line

0 1 2 3 4

Time Periods
Time Value of Money-Time Line

0 1 2 3 4

CF0 CF1 CF2 CF3 CF4

Cash Flows

Can we add these cash flows?

 Time Value of Money-Intuition
• Different Currencies
• How do you add them?
• Common currency
• Time units like different currencies
• Common unit
• Tools
– Time Line
– Discount Factor
 Time Line Example
i=10%

Years 0 1 2 3 4

Cash flow -$100$30 $20 -$10 $50

The 4-year timeline illustrates the following:

– The interest rate is 10%.

– A cash outflow of $100 occurs at the beginning of the first year
(at time 0), followed by cash inflows of $30 and $20 in years 1
and 2, a cash outflow of $10 in year 3 and cash inflow of $50 in
year 4.
FUTURE VALUE and
COMPOUNDING
 Future Value: FV
Investing for a Single Period

If I deposit $100 in a bank account that pays 10%, how much will I
have after 1 year?

$100 FV=?

r =10%
0 1

$100+(.10)(100) = $110 or $100(1+.10) = $110

15
FV (Investing for More than One
Period)
After 2 years? $110+(.10)(110) = $121
or
$100(1+.10)(1.10) = $100(1.10)2 = $121

After 30 years? $100(1.10)30 = $1,744.94

After t years? $100(1.10)t = FV

Why do we raise to a power? COMPOUNDING - interest on

interest
16
 Future Values

Future Value of $100

FV  $ 100  (1  r ) t
 Future Value and Compounding
• Future Value: The amount an investment is
worth after one or more periods

• Compounding: The process of accumulating

interest on an investment over time to earn
more interest

• Equation: FV = PV (1+ r)t

 Future Values Continued
FV  $100  (1  r) t

Example: FV
What is the future value of $100 if interest is
compounded annually at a rate of 7% for two
years?
FV =$100 ´ (1.07) ´ (1.07) =$114.49
2
FV =$100 ´ (1+.07) =$114.49
 Future Value and Compounding

Time value of money calculations involve Present

value (what a cash flow would be worth to you
today) and Future value (what a cash flow will be
worth in the future).
Time Value of Money-Compounding

0 1 2 3 4

CF0 CF1 CF2 CF3 CF4

CF3 *(1+r)1
CF2 *(1+r)2
CF1 *(1+r)3
CF0 *(1+r)4

Compounding moves cash flows forward in time

Can add cash flows at time t=4

 Future Value

0 1 2 3 4

CF0 CF1 CF2 CF3 CF4

FV4(CF3)=CF3 *(1+r)1
FV4(CF2)=CF2 *(1+r)2
FV4(CF1)=CF1 *(1+r)3
FV4(CF0)=CF0 *(1+r)4

Future values of cash flows as of year 4.

 Compound Interest and Time

Example: Suppose that you deposited $500 in

your savings account that earns 5% annual
interest. How much will you have in your
account after two years? After five years?

•FV2 = PV(1+i)n = 500(1.05)2 = $551.25

 Compound Interest and Time
YEAR PV or Interest Earned (5%) FV or
Beginning Value Ending
Value
1 $500.00
2
3
4
5
 Compound Interest and Time
YEAR PV or Interest Earned (5%) FV or
Beginning Value Ending
Value
1 $500.00 $500*.05 = $25 $525
2 $525.00 $525*.05 = $26.25 $551.25
3 $551.25 $551.25*.05 =$27.56 $578.81
4 $578.81 $578.81*.05=$28.94 $607.75
5 $607.75 $607.75*.05=$30.39 $638.14

FV2 = PV(1+i)n = 500(1.05)2 = $551.25

Using Equation FV = PV(1+i)n

= 500(1.05)5 =
$638.14
Figure 2.1 Future Values with Compounding
Applying Compounding to Things Other Than
Money

Example A DVD rental firm is currently renting

8,000 DVDs per year. How many DVDs will the
firm be renting in 10 years if the demand for
DVD rentals is expected to increase by 7% per
year?

Using Equation,
– FV = 8000(1.07)10 = 15,737.21 DVDs
 CHECK YOURSELF

Calculating the FV of a Cash Flow

What is the FV of $10,000 compounded at
12% annually for 20 years?
 Step 1: Picture the Problem
i=12%
0 1 2… 20
Years

Cash flow -$10,000 Future

Value=?
 Step 2: Decide on a Solution Strategy
This is a simple future value problem. We can
find the future value using Equation.
 Step 3: Solve

Solve Using a Mathematical Formula

FV = $10,000(1.12)20
= $10,000(9.6463)
= $96,462.93
 Step 3: Solve (cont.)
Solve Using a Solve Using an Excel
Financial Calculator Spreadsheet
N = 20
I/Y = 12% =FV(rate,nper,pmt, pv)
PV = -10,000 =FV(0.12,20, 0,-10000)
PMT = 0
= $96,462.93
FV = $96,462.93
 Step 4: Analyze
If you invest $10,000 at 12%, it will grow to
$96,462.93 in 20 years.
 Example Savings
How much money will we have four years from
today if we save $100 a year, beginning today,
for the next three years, assuming we earn 5%
per annum?
 Example Savings

0 1 2 3 4

100 100 100 100 ?

100 *(1+0,05)1
100 *(1+0,05)2
100 *(1+0,05)3
100 *(1+0,05)4

Compounding moves cash flows forward in time

Can add cash flows at time t=4

 Example Savings

0 1 2 3 4

100 100 100 100 452.564

105
110.25
115.763
121.551

Compounding moves cash flows forward in time

Can add cash flows at time t=4

 Example Savings

0 1 2 3 4

100 100 100 100 452.564

105
110.25
115.763
121.551

The future value four years from today of saving $100 starting today
for the next three years at 5% per annum is $452.56.
 Example Savings
Show that we are going to have $452.56 at the
end of four years if we save $100 starting today
for the next three years and our money earns
5% per annum.
Year Interest Pre- Deposit Post-
Deposit Deposit
Balance Balance
0 $100 $100
 Example Savings
Show that we are going to have $452.56 at the
end of four years if we save $100 starting today
for the next three years and our money earns
5% per annum.
Year Interest Pre- Deposit Post-
Deposit Deposit
Balance Balance
0 $100 $100
1 5 105 100 205.00
2 10.25 215.25 100 315.25
3 15.76 331.01 100 431.01
4 21.55 452.56 0 452.56
 Compound Interest with Shorter
Compounding Periods

Banks frequently offer savings account that compound

interest every day, month, or quarter.

More frequent compounding will generate higher interest

income and lead to higher future values.
The Value of $100 Compounded at Various Non-Annual Periods
and Various Rates
 CHECK YOURSELF
Calculating Future Values Using
Non-Annual Compounding Periods
If you deposit $50,000 in an account that pays an annual
interest rate of 10% compounded monthly, what will
your account balance be in 10 years?
 Step 1: Picture the Problem

i=10%
0 1 2… 120
Months

Cash flow -$50,000 FV of $50,000

Compounded for
120 months
@ 10%/12
 Step 2: Decide on a Solution Strategy

This involves solving for future value of $50,000.

Since the interest is compounded monthly, we
will modify the following equation by replacing
years with months .
 Step 3: Solve
Using a Mathematical Formula Using a Financial Calculator

FV = PV (1+i/12)m*12 N = 120
= $50,000 (1+0.10/12)10*12 I/Y = .833%
= $50,000 (2.7070) PV = -50,000
= $135,352.07 PMT = 0

FV = $135,352
 Step 4: Analyze
• More frequent compounding leads to a higher
FV as you are earning interest more often on
interest you have previously earned.

• If the interest was compounded annually, the

FV would have been equal to only $129,687.12

– $50,000 (1.10)10 = $129,687.12

DISCOUNTING AND PRESENT VALUE
 The Key Question
• What is value today of cash flow to be received in the
future?

• The answer to this question requires computing the

present value (PV) i.e. the value today of a future cash flow,
and the process of discounting, determining the present
value of an expected future cash flow.
 Present Value: PV

Now let’s reverse the problem. How much will I pay today to receive $110 one
year from today if I require a 10% return on my money?

P0 = PV=? 110

r =10%
0 1

$110
P0  PV   $100
(110
. )
49
 PV (Cont’d)
What about PV of $121 in 2 years?

P0 = PV=? 121
$121
PV  2  $100
r =10%
(110
. )
0 2

$1,000 in t years?

P0 = PV=? 1000
$1,000
PV  t
r =10%
(1.10)
0 N
50
 Present Value and Discounting
Present value = PV
PV = FV / (1+r)t

PV = discount factor  C1

• Discount rate (factor): The rate used to calculate the

present value of future cash flows.
 Present Value Continued
Discount factor = DF = PV of $1

DF  1
(1  r ) t

Discount factors can be used to compute the

present value of any cash flow
 Present Value Concluded
• The PV formula has many applications. Given
any variables in the equation, you can solve
for the remaining variable. Also, you can
reverse the prior example.

PV =DF2 ´ C2
PV = (1+.07)
1
2 ´ $114.49 =$100
 The Mechanics of Discounting Future Cash
Flows

• The term in the bracket is known as the Present Value

Interest Factor (PVIF).

• PV = FVn × PVIF
 Present Value
PV(t): Discounted value of cash flows as of time t.

0 1 2 3 4

CF0 CF1 CF2 CF3 CF4

CF1 /(1+r)1
CF2 /(1+r)2
CF3 /(1+r)3
CF4 /(1+r)4

Present Values of future cash flows as of today.

 Time Value of Money-Discounting
Cash flows occur at the end of the period
0 1 2 3 4

CF0 CF1 CF2 CF3 CF4

PV0(CF1)=CF1 /(1+r)1
PV0(CF2)=CF2 /(1+r)2
PV0(CF3)=CF3 /(1+r)3
PV0(CF4)=CF4 /(1+r)4
Once we discount, we can add these cash flows.

Assume r is constant over time.

 CHECK YOURSELF

Solving for the PV of a Future Cash Flow

What is the present value of $100,000 to be
received at the end of 25 years given a 5%
discount rate?
 Step 1: Picture the Problem
i=5%
0 1 2… 25
Years

Cash flow $100,000

Present
Value =?
 Step 2: Decide on a Solution Strategy

Here we are solving for the present value (PV) of

$100,000 to be received at the end of 25 years
using a 5% interest rate. We can solve using
equation
 Step 3: Solve
Using a Mathematical Formula Using a Financial
Calculator
PV N = 25
= $100,000 [1/(1.05)25) I/Y = 5
= $100,000 [0.2953] PMT = 0
= $29,530 FV = 100,000

PV = -$29,530
 Step 4: Analyze
Once you’ve found the present value, it can be
compared to other present values. Present value
computation makes cash flows that occur in
different time periods comparable so that we
can make good decisions.
 Present Value: Example

Always ahead of the game, Tommy, at 8 years old, believes

he will need $100,000 to pay for college. He goes to college
at 18. If he can invest at a rate of 7% per year, how much
money should he ask his rich Uncle to give him?

F V  $100, 000 t  10 yrs r  7%

1
PV  FV   $100, 000  1
 $50,835
(1  r ) t (1.07)10

Note: Ignore inflation/taxes 62

 Present Value: Example 2
•How
  much money would you accept now instead of
30,500TL by the end of fourth year? Interest rate is
6%.

t = 4 r = %6 PV = ?

= 24,158.86TL
 Example-Savings
How much do you have to deposit today to
withdraw $100 at the end of each of the next
four years if you can earn 5% annually?
 Example Savings

0 1 2 3 4

? 100 100 100 100

100 /(1+0,05)1
100 /(1+0,05)2
100 /(1+0,05)3
100 /(1+0,05)4

Present Values of future cash flows as of today.

 Example Savings

0 1 2 3 4

354,60 100 100 100 100

95,238
90,703
86,384
82,270
The present value of $100 received at the end of each of the next four years is
$354,60.
 Example Savings
Show that when you deposit $354,60 now, you
are going to be able to withdraw $100 for the
Year Interest Pre-Withdrawal Withdrawal Post-Withdrawal
following four years.
Balance Balance

0• $354,60
1
2
3
4 $0.00
 Example Savings
Show that when you deposit $354,60 now, you
are going to be able to withdraw $100 for the
Year Interest Pre-Withdrawal Withdrawal Post-Withdrawal
following four years.
Balance Balance

0• $354,60
1 $17.73 $372.32 $100.00 $272.32

2 $13.62 $285.94 $100.00 $185.94

3 $9.30 $195.24 $100.00 $95.24

4 $4.76 $100.00 $100.00 $0.00

 Relationship between Present Value
and Interest Rate

• Your aunt promises to give you $100 in 10 years.

– If the interest rate you could earn is 5% per
year, what is the promise worth in today’s
terms?
– If the interest rate you could earn is 10% per
year, what is the promise worth in today’s
terms?

69
Figure 2.2 Present Values with Compounding
 Two Additional Types of Discounting
Problems

Solving for: (1) Number of Periods; and

(2) Rate of Interest

(1): How long will it take to accumulate a specific amount in

the future?
• It is easier to solve for “n” using the financial
calculator or Excel rather than mathematical formula.
 Step 1: Picture the Problem
How many years does it take for your $10.000
investment to become $200.000 if the interest rate is
15%.
i=15%

Years 0 1 2… N =?

Cash flow -$10,000 $200,000

We know FV,
PV, and i and
are solving for
N
 Step 2: Decide on a Solution Strategy

In this problem, we are solving for “n”. We know

the interest rate, the present value and the
future value. We can calculate “n” using a
financial calculator or an Excel spreadsheet.
 Step 3: Solve
• Using a Financial • Using an Excel
Calculator Spreadsheet
I/Y = 15
PMT = 0 N = NPER(rate,pmt,pv,fv)
PV = -10,000 = NPER(.15,0,-10000,200000)

FV = 200,000
= 21.4 years

N = 21.4 years
 Step 4: Analyze
It will take 21.4 years for $10,000 to grow to
$200,000 at an annual interest rate of 15%.
 Number of Years Example
• With
  15% interest after how many years will it
take for 80,000 TL be 160,000 TL?

PV=80,000 FV=160,000 r=0.15 t=?

Remember:
Change of base formula

/
 Solving for the Rate of Interest
(2): What rate of interest will allow your
investment to grow to a desired future value?

We can determine the rate of interest using

mathematical equation, the financial calculator
or the Excel spread sheet.
 CHECK YOURSELF

Solving for the Interest Rate, i

At what rate will $50,000 have to grow
to reach $1,000,000 in 30 years?
 Step 1: Picture the Problem
i=?%

Years 0 1 2… 30

Cash flow-$50,000 $1,000,000

We know FV, PV
and N and are Solving
for “interest rate”
 Step 2: Decide on a Solution Strategy

Here we are solving for the interest rate. The

number of years, the present value, the future
value are known. We can compute the interest
rate using mathematical formula, a financial
calculator or an Excel spreadsheet.
 Step 3: Solve
Using a Mathematical Using an Excel
Formula Spreadsheet
r = (FV/PV)1/n - 1
= (1,000,000/50,000)1/30 - 1 =Rate (nper, pmt, pv, fv)
= (20)0.0333 - 1 =Rate(30,0,-50000,1000000)
= 1.1050 - 1 =10.50%
= .1050 or 10.50%
 Step 4: Analyze
You will have to earn an annual interest rate of
10.50 percent for 30 years to increase the value
of investment from $50,000 to $1,000,000.
 Interest Rate Example
•What
  is the interest rate if 25,000 TL that you
invest grows to 32,000 TL in three years?

• PV = 25,000 FV = 32,000 t = 3 r=?

• -18.58%
Valuing an Investment Opportunity
You own a small company and want to construct a suburban office
building. The cost of buying the land and constructing the building is
$700.000. You can sell the office building next year for $800.000.
(Assume that $800.000 next year is a sure thing)

Step 1: Forecast cash flows

Cost of building = C0 = 700,000
Sale price in Year 1 = C1 = 800,000

Step 2: Estimate opportunity cost of capital

If equally risky investments in the capital market
offer a return of 7%, then
Cost of capital = r = 7%
 Valuing an Investment Opportunity
Continued

Step 3: Discount future cash flows

C1
PV  (1 r )  800 , 000
(1 .07 )  747 ,664
Step 4: Go ahead if PV of payoff exceeds investment

NPV  747 ,664  700 ,000

 47 ,664
 Net Present Value

NPV = PV – required investment

C1
NPV = C0 +
1+ r
Figure 2.4 NPV Calculation
 Risk and Present Value
PV1
of
C $800,000
at
12%
800,000

PV 714
,286
1
.12

PV of C1  $800,000 at 7%
800,000
PV   747 ,664
1  .07
 Risk and Net Present Value

NPV = PV – required investment

NPV = 714,286 – 700,000

= $14,286
 Net Present Value Rule
• Accept investments that have positive net
present value
Example
Use the original example. Should we accept
the project given a 10% expected return?

800,000
NPV = –700,000 + =$27,273
1.10
 Rate of Return Rule
• Accept investments that offer rates of return
in excess of their opportunity cost of capital
Example
In the project listed below, the foregone
investment opportunity is 12%. Should we do
the project?
profit 800,000  700,000
Return    .143 or 14.3%
investment 700,000
Calculating Net Present Value When There
Are Multiple Cash Flows

For multiple periods we have the discounted

cash flow (DCF) formula
C1 C2 Ct
PV = (1+r )1 + (1+r )2 +...+ (1+r )T

T
NPV =C0 + å Ct
(1+r )t
t=1
• What is the NPV of this building project if you
can rent out the building for two years at
$30.000 a year and predict that you can sell
the building for $840.000 at the end of second
year?
(Assume that equally risky investments offer a
return of 12%)
Figure 2.5 NPV Calculation
PERPETUITIES AND ANNUITIES
 How to Value Perpetuities
• Sometimes there are shortcuts that make it
very easy to calculate the present value of an
asset that pays off in different periods.
• These tools allow us to cut through the
calculations quickly.
• A perpetuity is an infinite sequence of equal
cash flows
– i.e. $1 per year forever
 Shortcuts
Perpetuity: Financial concept in which a cash
flow is theoretically received forever.

cash flow
Return 
present value
C
r
PV
 Shortcuts Continued
Perpetuity: Financial concept in which a cash
flow is theoretically received forever.

cash flow
PV of cash flow =
discount rate
C
PV =
r
 Examples of Perpetuities

• preferred stock dividends: amount of dividend

is fixed and occurs on a regular basis,
presumably continuing forever

• perpetual bond (consol): bond issued (by

British government) that pays interest forever

99
Perpetuity Formula Derivation
1 1 1
1) x     ...
1  r 1  r  2
1  r  3

1 1
2) x(1  r )  1    ...
1  r 1  r  2

Subtract 1) from 2) and solve for x :

x(1  r )  x  1
x  xr  x  1; xr  1
1
 x 
r
100
 Present Values
Example
What is the present value of $1 billion every
year, for all eternity, if you estimate the
perpetual discount rate to be 10%?

PV  $1 bil
0.10  $10 billion
 Present Values Continued
Example continued
What if the investment does not start making
money for 3 years?

PV  $1 bil
0 . 10   1
1.10 3
  $ 7 .51 billion
 How to Value Annuities
Annuity: An asset that pays a fixed sum each
year for a specified number of years

1 1 
PV of annuity  C    t
 r r 1  r  
 Perpetuities & Annuities
PV Annuity Factor (PVAF): The present value of
$1 a year for each of t years

é
PVAF =ër -
1 1 ù
r (1+r ) t û
Figure 2.7 Annuity
 Example: Costing an Installment Plan

• Tiburon Autos offers you “easy payments”

of $5,000 per year, at the end of each year
for five years. If interest rates are 7% per
year, what is the cost of the car?
Figure 2.8 Costing an Installment Plan
 Valuing Annuities Due
Annuity due: Level stream of cash flows starting immediately

How does it differ from an ordinary annuity?

PVAnnuity due  PVAnnuity  (1  r )

How does the future value differ from an ordinary annuity?

FVAnnuity due  FVAnnuity  (1  r )

Example 2.3 Paying off a Bank Loan
Suppose that you take out a four-year loan of $1,000. What
would be the annual loan payment amount if the bank
requires you to repay the loan evenly over the four years if the
interest rate is 10%?
Table 2.1 Amortizing Loan Example
An example of an amortizing loan. If you borrow $1,000 at an
interest rate of 10%, you would need to make an annual
payment of $315.47 over four years to repay that loan with
interest.
 FV of an annuity
How much would be in your bank account if you deposit $100 at the end of
every year for the next 4 years, and your account earns 10% a year?
FV=?
$100 $100 $100 $100

r=10% 1 2 3 4
0

. ) 3  100(110
100(110 . ) 2  100(110
. ) 1  100(110
. )0

 100 (110
. ) 3  (110
. ) 2  (110 . )0 
. )1  (110

 100 4.6410

 $464.10 111
FV of an Annuity- Formula Derivation
Future value of $1 annuity for t years:

112
 Future Value of an Annuity
Future Value of an Annuity: The future value of an
asset that pays a fixed sum each year for a specified
number of years.

 1  r   1  t
FV of annuity  C   
 r 
 Future Value of an Annuity -Example
Example
What is the future value of $20,000 paid at the end of each of
the following 5 years, assuming your investment returns 8% per
year?

 1  .08 5  1
FV  20,000   
 .08 
 $117 ,332
 Summary: Annuity Formula Notes
The PVr,t formula is constructed to discount all the annuity payments back to 1
period before the 1st cash flow!

PV CF CF CF CF

0 1 2 3 N
The FVr,t formula is constructed to compound all the annuity payments forward
to the day of the last cash flow!

FV

CF CF CF CF

0 1 2 3 N
Remember these rules!
115
 Summary: Ordinary Annuity
Payments or receipts occur at the end of each
period.

End of End of End of

Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
 Summary: Annuity Due
Payments or receipts occur at the beginning of
each period.

Beginning of Beginning of Beginning of

Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
 Annuity Due: Example
Assuming a 10% discount rate, how much would you pay for a 5-year
$100 annuity that begins by making the first payment today?
“Due”
means
payments
$100 $100 $100 $100 $100 arrive at
the
beginning
r=10% 1 2 3 4 of the
-1 0
period!

If we treat it as a regular annuity, each cash flow is discounted 1 too many

times. So, we need a second step that brings the cash flows forward 1
period.

PV(Annuity Due) = (PV (of regular annuity) 10%,5)(1.10)

118
 1) Discount each cash flow individually:

 1 1 1 1 
PV(AnnuityDue)  1001   2  3  4
 (110
. ) (110
. ) (110
. ) (110
. ) 
2) Now factor out (1+r)

 1 1 1 1 1 
 100(110
. )  2  3  4  5
 (110
. ) (110
. ) (110
. ) (110
. ) (110
. ) 
=(1.10)(PV (of regular annuity) 10%,5) = $416.99

In general
PV(Annuity Due)=
(1+r)(PV(of regular annuity)r,t)
119
Delayed Annuity: Example
How much would you pay to receive $100 every year for 4 years but the
payments don’t start for 3 years? (assume you require a 10% return on your
investment?

P0=? $100 $100 $100 $100

0 1 2 3 4 5 6

Step 1: Lump the cash flows

1 1 1 
PV 2  CF   
 r r (1  r ) t

 1 1 1 
 100  
 . 10 . 10 (1 . 10 ) 4 
 100 ( 3 . 1699 )  316 . 99
120
 Step 2: Move the “lump” to t=0

1
PV0  PV2 2
 316.99(0.8264)
(1.10)
 261.98
Alternatively, we could “lump” the cash flows at t=6 and move them from t=6 to
t=0!
 (1  r ) t  1  1
FV 6  100   PV0  FV6
 r  (1.10) 6
 (1.10 ) 4  1   464.10(0.5645)
 100  
 . 10   261.98
 100 ( 4.6410 )  464 .10 121
 Growing Perpetuities
Present value of growing perpetuity

C1
PV0 
rg
g = the annual growth rate of the cash flow
 Growth Perpetuity Example
Example
What is the present value of $1 billion paid at the end of
every year in perpetuity, assuming a rate of return of
10% and a constant growth rate of 4%?

1
PV 0 
. 10  . 04
 $ 16 . 667 billion
INTEREST RATE
 What’s in an interest rate?
• Forgone consumption
– All else equal, I would prefer to have it now rather
than wait for a year.
• Inflation
– Things will cost more in the future
• Risk
– How bad is the downside?

125
 Simple vs. Compound interest

Pay attention to the difference between simple

interest and compound interest!!!
Future Value: Amount to which an investment will
grow after earning interest.

Let r = annual interest rate

Let t = # of years

Simple Interest Compound Interest

FVSimple = Initial investment  (1  r  t ) FVCompound = Initial investment  (1  r )t
126
 Simple Interest: Example

Interest earned at a rate of 7% for five years on a

principal balance of $100.

Example - Simple Interest

Today Future Years
1 2 3 4 5
Interest Earned 7 7 7 7 7
Value 100 107 114 121 128 135
Value at the end of Year 5: $135
127
 Compound Interest: Example

Interest earned at a rate of 7% for five years on the

previous year’s balance.

Example - Compound Interest

Today Future Years
1 2 3 4 5
Interest Earned 7 7.49 8.01 8.58 9.18
Value 100 107 114.49 122.50 131.08 140.26
Value at the end of Year 5 = $140.26

128
 The Power of Compounding
Interest earned at a rate of 7% for the first forty years on the $100 invested
using simple and compound interest.
$1,600

$1,400

$1,200
Simple Interest
$1,000
Compound Interest
Future Value

$800

$600

$400

$200

$0
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
Year

129
 How Interest is Paid and Quoted
Annual Percentage Rate: Interest rate that
is annualized using simple interest

Effective Annual Interest Rate: Interest

rate that is annualized using compound
interest
 EAR & APR Formulas
Annual Percentage Rate (APR):
APR =MR ´ 12
Effective Annual Interest Rate (EAR):

EAR  (1  MR )  112

*where MR = monthly interest rate

 Effective Interest Rates
Example:
Given a monthly rate of 1%, what is the effective
annual rate (EAR)? What is the annual
percentage rate (APR)?
12
EAR = (1 + .01) -1 = r
EAR = (1 + .01)12 -1 = .1268 or 12.68%

APR = .01  12 = .12 or 12.00%

 Translating Stated Rates into Effective
Rates
• A stated rate of 12% with monthly compounding
means you pay 1% a month for twelve months!

0 1 2 3 12 months
1% 1-year

From the stated rate (APR), the only thing useful is

the periodic rate:

rStated .12
rPeriodic   .01
N 12
# of compounding periods 133
 EAR vs APR
m
 APR 
EAR ( EffectiveAnnualRate)  1   1
 m 

m: number of compounding periods in a year

134
 10% Stated rate:
Compounding N Formula Effective
Annual
.1
rate
01
Annual 1 (1 ) 1 10%
1
.102
Semiannual 2 (1 ) 1 10.25%
2
.1012
Monthly 12 (1 )  1 10.47%
1 2
.
1 03
Daily 365 (
1  ) 65
1 10.52%
365
Continuous  e .10  1 10.52% 135
Real vs. Nominal Interest Rate

136
 Inflation
Inflation - Rate at which prices as a whole are
increasing.

Nominal Interest Rate - Rate at which money

invested grows.

Real Interest Rate - Rate at which the

purchasing power of an investment increases.

137
 Nominal vs. Real Returns
• nominal return:
– raw % return, not adjusted for inflation
• real return: nominal return less inflation

• e.g. You invested in a CD for one year that earned

you a total of 5.5% on your investment. If prices of
goods and services went up by 3% over the same
period, your real return is about 2.5%.
138
 Nominal vs. Real Returns (cont.)
•  
(1  no min al int erest rate)
1  real int erest rate 
(1  inf lation)

• Approximately ;
Real interest rate

• e.g. Suppose that you invest your funds at an interest rate of 8%.
What will be your real interets if the inflation is zero? What if it is 5%?

Answer: 1+real interest rate= (1+8%) / (1+0) => real interest rate : 8 %
1+real interest rate= (1+8%) / (1+5%) =>
real interest rate : 2.857%
139
 Formulas: Nominal vs. Real
•  
 

 
 Inflation: Example
If the nominal interest rate on your interest-bearing savings
account is 2.0% and the inflation rate is 3.0%, what is the
real interest rate?
1+.02
1  real interest rate = 1+.03

1  real interest rate = 0.9903

real interest rate = -.0097 or -.97%

Approximation = .02-.03 =  .01  1%

141
 Example
• How much would you invest today to earn $100 in a year if
the discount rate is 10%?
– Answer= 100 / 1.1 = $90.91

• How would your answer change if the inflation rate is 7%?

– The real value of $100 will be 100/1.07= $93.46
– The real interest rate = 2.8%
– Answer = 93.46/ 1.028 = $90.91

– Nominal cash flows must be discounted by the nominal interest

rate and real cash flows must discounted by the real interest rate!

142