4-1

Lecture
2
Time value of money

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2

Chapter Outline
1 The One-Period Case
2 The Multiperiod Case
3 Compounding Periods
4 Simplifications
5 What Is a Firm Worth?
6 Summary and Conclusions

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3

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 call
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 today (time zero) and

r is the appropriate interest rate.

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5

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 be worth $9,523.81 in today’s dollars.
$ 1 0 ,0 0 0
$ 9 ,5 2 3 . 8 1 
1 .0 5
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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6

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.

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7

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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8

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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2 The Multiperiod Case: Future Value
Year Beginning Interest Ending balance
balance
1 C0 C0*r C0*(1+r)

2 C0*(1+r) C0*(1+r)*r C0*(1+r)2

……. ………… ………. …………….

t C0*(1+r)t-1 C0*(1+r)t-1*r C0*(1+r)t

Initial investment is C0.

The interest rate is r.
FV: The future value.
10

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
C 0 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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11

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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12

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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13

Future Value and Compounding

$ 1 .10  (1 .40 ) 5
$ 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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14

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
$ 2 0 ,0 0 0
$ 9 ,9 4 3 . 5 3 
(1 . 1 5 ) 5

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15

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?
F V  C 0  (1  r ) T $ 1 0 , 0 0 0  $ 5 , 0 0 0  (1 . 1 0 ) T

$ 1 0 ,0 0 0
(1 . 1 0 ) T  2
$ 5 ,0 0 0
ln ( 1 . 1 0 ) T  ln 2

ln 2 0 .6 9 3 1
T    7 . 2 7 years
ln( 1 . 1 0 ) 0 . 0 9 5 3
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16

What Rate Is Enough?

Assume the total cost of a college education
will be $50,000 when your child enters
college 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%.

F V  C 0  (1  r ) T $ 50 ,000  $ 5,000  (1  r )12

$50,000
(1  r ) 
12
 10 (1  r )  101 12
$5,000

r  10 1 1 2  1  1 . 2115  1  . 2115
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17

3 Compounding Periods
Compounding an investment m times a year for T
years provides for future value of wealth:
m T
 r 
F V  C 0  1  
 m
For example, if you invest $50 for 3
years at 12% compounded semi-
annually, your investment will grow to
2 3
 .1 2 
F V  $50  1    $ 5 0  (1 . 0 6 ) 6  $ 7 0 . 9 3
 2 
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18

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?
.1 2 23
F V  $ 5 0  (1  )  $ 5 0  (1 . 0 6 ) 6  $ 7 0 . 9 3
2
The Effective Annual Interest Rate (EAR) is
the annual rate that would give us the same
end-of-investment wealth after 3 years:
$ 5 0  (1  E A R )  $ 7 0 . 9 3
3

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19

Effective Annual Interest Rates

(continued)
F V  $ 5 0  (1  E A R )  $ 7 0 . 9 3
3

$ 70 . 93
(1  E A R ) 
3

$ 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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20

Effective Annual Interest Rates

(continued)
Find the Effective Annual Rate (EAR) of an 18%
APR loan that is compounded monthly.
What we have is a loan with a monthly interest rate
rate of 1½ percent.
This is equivalent to a loan with an annual interest
rate of 19.56 percent
m 12
 r  .18 
 1    1   1    1  (1 . 015 )12
 1  19.56%
 m  12 
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21

Effective annual rate

Example: The bank A is lending money at the rate of
12%, compounded semi-annually. The bank intends
to move to a new plan where the interest is
compounded quarterly. Find the new interest rate that
the bank will apply?.

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22

Continuous Compounding (Advanced)

The general formula for the future value of an investment
compounded continuously over many periods can be written as:
FV = C 0×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. e x is a
key on your calculator.

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23

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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 How to get to the formula of annuity
Geometric progression: Cấp số nhân
q (công bội): quotient
Sum of a geometric progression
Sn = U1+ U1*q + U1*q2+….+U1*qn-1
We want to get a formula for Sn
Sn*q = U1*q + U1*q2+….+U1*qn-1+U1*qn
Sn = U1+ U1*q + U1*q2+….+U1*qn-1
Sn(q-1) = U1(qn-1)
n is a finite number (n là một số xác định)
q=1: Sn = n*U1
6-24
q≠1: Sn = U1*(qn-1)/(q-1)
 How to get to the formula of annuity
n  +∞
q=1: Sn =n*U1 +∞
q>1: qn  +∞; Sn =U1*(qn-1)/(q-1) +∞
q<1: qn  0; Sn = U1/(1-q)

Apply the above formulas to prove the formulas of

annuity and perpetuity

6-25
Perpetuity
A constant stream of cash flows that lasts forever.
C C C
…
0 1 2 3
𝐶 𝐶
𝑃𝑉 = +
(1 + 𝑟 ) ¿¿
𝐶 𝐶
1+𝑟 1+𝑟 𝐶
𝑃𝑉 = = =
1 𝑟 𝑟
1−
1+𝑟 1+𝑟
The formula for the present value of a perpetuity is:

𝐶
4- 𝑃𝑉 =
26 𝑟
27

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
.1 0
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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
C C  (1  g ) C  (1  g ) 2
PV    
(1  r ) (1  r ) 2
(1  r ) 3

(r>g) 𝐶 𝐶
1+𝑟 1+𝑟 𝐶
𝑃𝑉 = = =
1+ 𝑔 𝑟 −𝑔 𝑟 −𝑔
1−
1+𝑟 1+𝑟
The formula for the present value of a growing perpetuity is:

C
PV  (Condition : r  g)
4-
28 rg
29

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 .3 0
PV   $ 2 6 .0 0
.1 0  .0 5
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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
𝑃𝑉 = +
(1 + 𝑟 ) ¿¿

𝐶
𝑃𝑉 = ¿¿
1 +𝑟
The formula for the present value of an annuity is:
𝐶
𝑃𝑉 = ¿
𝑟
4-
30
31

Annuity Intuition
C C C C

0 1 2 3 T
An annuity is valued as the difference between two
perpetuities:
one perpetuity that starts at time 1
less a perpetuity that starts at time T + 1
C 
 
C r
PV     T
r (1  r )
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32

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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33

What is the present value of a four-year annuity of

$100 per year that makes its first payment two years from today if
the discount rate is 9%?
4
$ 100 $ 100 $ 100 $ 100 $ 100
PV1   t
 1
 2
 3
 4
 $ 323 .97
t 1 (1 . 09 ) (1 .09 ) (1 .09 ) (1 .09 ) (1 .09 )

$297.22 $323.97 $100 $100 $100 $100

0 1 2 3 4 5
$ 323 .97
PV   $ 297 .22
0 1 .09
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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 T 1
C C  (1  g ) C  (1  g )
PV   
(1  r ) (1  r ) 2
(1  r ) T

(r = g) q=1: PV = T*C/(1+r)

(r ≠g) 𝐶 1+𝑔
[( ) ] [( ) ]
𝑇 𝑇
𝐶 1+𝑔
−1 −1
1+𝑟 1+ 𝑟 1+𝑟 1+ 𝑟
[ ( )
𝑇
𝐶 1+𝑔
𝑃𝑉 = = = 1−
1+𝑔 𝑔−𝑟 𝑟 −𝑔 1+𝑟
−1
1+𝑟 1+𝑟
The formula for the present value of a growing annuity:

( ( ))
𝑇
𝐶 1+𝑔
𝑃𝑉 = 1− (Condition : r ≠ g)
4-
34 𝑟 −𝑔 1+𝑟
35

PV of Growing Annuity
You are evaluating an income property that is providing
increasing rents. Net rent is received at the end of each year.
The first year's rent is expected to be $8,500 and rent is
expected to increase 7% each year. Each payment occur at the
end of the year. What is the present value of the estimated
income stream over the first 5 years if the discount rate is
12%?
$ 8 , 5 0 0  (1 . 0 7 ) 2  $ 8 , 5 0 0  (1 . 0 7 ) 4 
$ 8 ,5 0 0  (1 . 0 7 )  $ 8 , 5 0 0  (1 . 0 7 ) 3 
$ 8 , 5 0 0 $9,095 $ 9 , 7 3 1 . 6 5 $ 1 0 , 4 1 2 . 8 7 $ 1 1 , 1 4 1 . 7 7

0 1 2 3 4 5
$34,706.26
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 Growing Annuity: Example
A defined-benefit retirement plan offers to pay $20,000
per year for 40 years and increase the annual payment
by three-percent each year.
1. What is the present value at retirement if the discount
rate is 10 percent?
2. Assume that you will retire at the age of 60 and you
are 30 years old now, how much you will pay for this
plan now?
3. Assume that you will not pay a lump sum payment
and you will pay by annuity from the age of 31 to 60.
How much you will pay each year.

$20,000   1.03  
40

PV  1      $265,121.57
6-36
.10  .03   1.10  
 Growing Annuity: Example
A defined-benefit retirement plan offers to pay $20,000
per year for 40 years and increase the annual payment
by ten-percent each year.
1. What is the present value at retirement if the discount
rate is 10 percent?
2. Assume that you will retire at the age of 60 and you
are 30 years old now, how much you will pay for this
plan now?
3. Assume that you will not pay a lump sum payment
and you will pay by annuity from the age of 31 to 60.
How much you will pay each year.

$20,000
PV  40 *  $727,272.72
1  10%
6-37
38

PV of a delayed growing perpetuity

Your firm is about to make its initial public offering of stock and
your job is to estimate the correct offering price. Forecast
dividends are as follows.

Year: 1 2 3 4

Dividends per $1.50 $1.65 $1.82 5% growth

share thereafter

If investors demand a 10% return on investments of

this risk level, what price will they be willing to pay?

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39

PV of a delayed growing annuity

Year 0 1 2 3 4
…
Cash $1.50 $1.65 $1.82 $1.82×1.05
flow

The first step is to draw a timeline.

The second step is to decide on what
we know and what it is we are trying
to find.

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40

PV of a delayed growing perpetuity

Year 0 1 2 3

Cash $1.50 $1.65 $1.82 dividend + P3

flow
= $1.82 + $38.22

PV $32.8
of 1 1 .8 2  1 .0 5
P3   $ 3 8 .2 2
cash .1 0  .0 5
flow
$1.50 $1.65 $1.82  $38.22
P0   2
 3
 $32.81
(1.10) (1.10) (1.10)
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41

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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How to remember four formulas?
Start from the formula for the present value of a growing annuity:

( ( ))
𝑇
𝐶 1+𝑔
𝑃𝑉 = 1− (Condition : r ≠ g)
𝑟 −𝑔 1+𝑟

( ( ))
𝑇
𝐶 1
Annuity: g=0: 𝑃𝑉 =
𝑟
1−
1+𝑟
Perpetuity: g=0 and T+ ∞ so 1/(1+r)T 0
𝐶
𝑃𝑉 =
𝑟
Growing Perpetuity: T+ ∞ and r > g so

( )
𝑇
1+𝑔 𝐶
→ 0 𝑠𝑜 𝑃𝑉 =
1+ 𝑟 𝑟 −𝑔 4-42
43

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:
N
C C C C
N PV  C 0  
(1  r ) (1  r ) 2
 
(1  r ) N
 C0  
t 1 (1  r ) t
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44

6 Summary and Conclusions (continued)

We presented four simplifying formulae:
C
P erp etuity : P V 
r
C
G ro w ing P erp etuity : P V 
rg
C  1 
A nnuity : P V  1  (1  r ) T 
r  
C  1 g  
T

Growing Annuity : PV  1    
r  g   1  r  
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