4-1

Chapter Four
The Time Value
Money
of Finance
Corporate
Ross Westerfield Jaffe
  4
Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline

4.1 The One-Period Case

4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
4.5 What Is a Firm Worth?
4.6 Summary and Conclusions

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4.1 The One-Period Case: Future Value

• If you were to invest $10,000 at 5-percent interest for
one year, your investment would grow to $10,500

$500 would be interest ($10,000 × .05)

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

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4.1 The One-Period Case: Future Value

• In the one-period case, the formula for FV can
be written as:
FV = C0×(1 + r)

Where C0 is cash flow at date 0 and r is the

appropriate interest rate.
C0×(1 + r)
C0 = $10,000 FV = $10,500
$10,000  1.05

Year 0 1
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4.1 The One-Period Case: Present Value

• If you were to be promised $10,000 due in one year
when interest rates are at 5-percent, 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 call the Present Value (PV) of
$10,000.
Note that $10,000 = $9,523.81×(1.05).
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4.1 The One-Period Case: Present Value

• In the one-period case, the formula for PV can
be written as:
C1
PV 
1 r
Where C1 is cash flow at date 1 and r is the
appropriate interest rate.

C1/(1 + r)
PV = $9,523.81 C1 = $10,000
$10,000/1.05

Year 0 1
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4.1 The One-Period Case: Net Present Value

• The Net Present Value (NPV) of an investment
is the present value of the expected cash flows,
less the cost of the investment.
• 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
buy? $10,000
NPV  $9,500 
1.05
NPV  $9,500  $9,523.81
NPV  $23.81 Yes!
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4.1 The One-Period Case: Net Present Value

In the one-period case, the formula for NPV can be
written as:
NPV  Cost  PV
If we had not undertaken the positive NPV project
considered on the last slide, and instead invested our
$9,500 elsewhere at 5-percent, our FV would be less
than the $10,000 the investment promised and we
would be unambiguously worse off in FV terms as
well:
$9,500×(1.05) = $9,975 < $10,000.

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4.2 The Multiperiod Case: Future Value

• The general formula for the future value of an
investment over many periods can be written
as:
FV = C0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.

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4.2 The Multiperiod Case: Future Value

• Suppose that Jay Ritter invested in the initial

public offering of the Modigliani company.
Modigliani pays a current dividend of $1.10,
which is expected to grow at 40-percent per
year for the next five years.
• What will the dividend be in five years?

FV = C0×(1 + r)T

$5.92 = $1.10×(1.40)5
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Future Value and Compounding

• Notice that the dividend in year five, $5.92,

is considerably higher than the sum of the
original dividend plus five increases of 40-
percent on the original $1.10 dividend:

$5.92 > $1.10 + 5×[$1.10×.40] = $3.30

This is due to compounding.

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Future Value and Compounding

5
$1.10  (1.40)
$1.10  (1.40) 4
$1.10  (1.40) 3
$1.10  (1.40) 2
$1.10  (1.40)

$1.10 $1.54 $2.16 $3.02 $4.23 $5.92

0 1 2 3 4 5
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Present Value and Compounding

• 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
$20,000
$9,943.53 
(1.15) 5
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How Long is the Wait?

If we deposit $5,000 today in an account paying 10%,

how long does it take to grow to $10,000?
T T
FV  C0  (1  r ) $10,000  $5,000  (1.10)

T $10,000
(1.10)  2
$5,000
ln(1.10)T  ln 2

ln 2 0.6931
T   7.27 years
ln(1.10) 0.0953
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What Rate Is Enough?
Assume the total cost of a university education will be
$50,000 when your child enters university in 12 years.
You have $5,000 to invest today. What rate of interest
must you earn on your investment to cover the cost of
your child’s education? About 21.15%.
T
FV  C0  (1  r ) $50,000  $5,000  (1  r )12

$50,000
12
(1  r )   10 (1  r )  101 12
$5,000
1 12
r  10  1  1.2115  1  .2115
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4.3 Compounding Periods

Compounding an investment m times a year for
T years provides for future value of wealth:
mT
 r
FV  C0  1  
 m
For example, if you invest $50 for 3 years at
12% compounded semi-annually, your
investment will grow to
23
 .12 
FV  $50  1    $50  (1.06) 6  $70.93
 2 
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Effective Annual Interest Rates

A reasonable question to ask in the above
example is what is the effective annual rate of
interest on that investment?
.12 23
FV  $50  (1  )  $50  (1.06) 6  $70.93
2
The Effective Annual Interest Rate (EAR) is
the annual rate that would give us the same
end-of-investment wealth after 3 years:
$50  (1  EAR) 3  $70.93

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Effective Annual Interest Rates (continued)

3
FV  $50  (1  EAR)  $70.93

3 $70.93
(1  EAR ) 
$50
13
 $70.93 
EAR     1  .1236
 $50 
So, investing at 12.36% compounded annually
is the same as investing at 12% compounded
semiannually.
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Continuous Compounding (Advanced)

• The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = 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 transcendental number approximately equal
to 2.718. ex is a key on your calculator.
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4.4 Simplifications
• Perpetuity
– A constant stream of cash flows that lasts forever.
• Growing perpetuity
– A stream of cash flows that grows at a constant rate
forever.
• Annuity
– A stream of constant cash flows that lasts for a fixed
number of periods.
• Growing annuity
– A stream of cash flows that grows at a constant rate for a
fixed number of periods.
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Perpetuity
A constant stream of cash flows that lasts forever.
C C C
…
0 1 2 3
C C C
PV   2
 3

(1  r ) (1  r ) (1  r )
The formula for the present value of a perpetuity is:
C
PV 
r © 2003 McGraw–Hill Ryerson Limited
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Perpetuity: Example
What is the value of a British consol that promises to
pay £15 each year, every year until the sun turns
into a red giant and burns the planet to a crisp?
The interest rate is 10-percent.

£15 £15 £15

…
0 1 2 3

£15
PV   £150
.10
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Growing Perpetuity
A growing stream of cash flows that lasts forever.
C C×(1+g) C ×(1+g)2
…
0 1 2 3
2
C C  (1  g ) C  (1  g )
PV   2
 3

(1  r ) (1  r ) (1  r )
The formula for the present value of a growing perpetuity is:
C
PV 
rg
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Growing Perpetuity: Example

The expected dividend next year is $1.30 and
dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this
promised dividend stream?
$1.30 $1.30×(1.05) $1.30 ×(1.05)2
…
0 1 2 3

$1.30
PV   $26.00
.10  .05
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Annuity
A constant stream of cash flows with a fixed maturity.
C C C C

0 1 2 3 T

C C C C
PV   2
 3
 T
(1  r ) (1  r ) (1  r ) (1  r )
The formula for the present value of an annuity is:

C 1 
PV  1  T 
r  (1  r )  © 2003 McGraw–Hill Ryerson Limited
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Annuity: Example
If you can afford a $400 monthly car payment, how much
car can you afford if interest rates are 7% on 36-month
loans?

$400 $400 $400 $400


0 1 2 3 36

$400  1 
PV  1  36 
 $12,954.59
.07 / 12  (1  .07 12) 

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Annuity: Canadian Mortgages

What is special about Canadian Mortgages?

• Canadian banks quote the annual interest

compounded semi-annually for mortgages, although
interest is calculated (compounded) every month.

• The terms of the mortgage are usually renegotiated

during the term of the mortgage. For example, the
interest of a 25-year mortgage can be negotiated 5
years after the initiation of the mortgage.

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Canadian Mortgages: Example

You have negotiated a 25-year, $100,000 mortgage at
a rate of 7.4% per year compounded semi-annually
with the Toronto-Dominion Bank. What is your
monthly payment?

To answer this question, we first have to convert the

quoted mortgage rate, to the effective interest rate
charged each month.

We have: 2
 0.074 
EAR  1    1  .075369  7.5369%
 2 
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Canadian Mortgages: Example (Continued)

The effective interest rate charged each month is
given by:

1  0.075369
1
12  1  .00607369  .607369%

We use the present value of annuity formula to find

the monthly payment (PMT):
PMT  1 
100,000  1 300 
.00607369  (1  .00607369) 

PMT  $725.28
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Growing Annuity
A growing stream of cash flows with a fixed maturity.
C C×(1+g) C ×(1+g)2 C×(1+g)T-1

0 1 2 3 T
C C  (1  g ) C  (1  g )T 1
PV   2
 T
(1  r ) (1  r ) (1  r )
The formula for the present value of a growing annuity:

C   1 g  
T

PV  1    
r  g   (1  r )  

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Growing Annuity
A retirement plan offers to pay $20,000 per year for
40 years and increase the annual payment by 3-
percent each year. What is the present value at
retirement if the discount rate is 10-percent?

$20,000 $20,000×(1.03) $20,000×(1.03)39


0 1 2 40

$20,000   1.03  
40

PV  1      $265,121.57
.10  .03   1.10  
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4.5 What Is a Firm Worth?

• Conceptually, a firm should be worth the

present value of the firm’s cash flows.
• The tricky part is determining the size,
timing, and risk of those cash flows.

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4.6 Summary and Conclusions

• Two basic concepts, future value and present value
are introduced in this chapter.
• Interest rates are commonly expressed on an annual
basis, but semi-annual, quarterly, monthly and even
continuously compounded interest rate
arrangements exist.
• The formula for the net present value of an
investment that pays $C for N periods is:
C C C N
C
NPV  C0   2
 N
 C0   t
(1  r ) (1  r ) (1  r ) t 1 (1  r )

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4.6 Summary and Conclusions (continued)

• We presented four simplifying formulae:
C
Perpetuity : PV 
r
C
Growing Perpetuity : PV 
rg
C 1 
Annuity : PV  1 
r  (1  r )T 

C   1 g  
T

Growing Annuity : PV  1    
r  g   (1  r )  
 
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How do you get to Bay Street?

• Practice, practice, practice.
• It’s easy to watch Olympic gymnasts and
convince yourself that you are a leotard
purchase away from a triple back flip.
• It’s also easy to watch your finance professor
do time value of money problems and
convince yourself that you can do them too.
• There is no substitute for getting out the
calculator and flogging the keys until you can
do these correctly and quickly.
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