Time Value of Money

This is only a summary. Please read the text book and any assigned
readings for details. Removal of errors and omissions, if any, in this ppt are
your responsibility.

Agenda
Timeline
Present Value - Future Value
One period PV, NPV
PV - different rates and time periods
FV - different rates and time periods
Multi-Period Case (incl. power of compounding)
Annuities, Perpetuities - Simplifications
Special Cases
Effective Annual Rate
APR and Loan Balance
CLV
Risk and CF
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Timeline
Main issue is what value to place on a cash flow
When or time component (early part of the
course)
Uncertainty (risk-return latter part)

Importance is because we need to make

apples-to-apples comparisons
It is only possible to compare or combine
values at the same point in time
3

Timeline
A timeline is a linear representation of the timing of
potential cash flows
Drawing a timeline of the cash flows will help you
visualize the financial problem
Usually cash flows are assumed to be at the end of
the period unless o/w stated
By convention, inflows are positive and outflows are
negative
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Present Value
Key insight is that a Rupee today is worth more
than a Rupee tomorrow the Rupee today can be
invested to earn interest which can be obtained
along with the original Rupee invested (tomorrow)
Conversely one could ask how much is it worth to
me today to have a Rupee tomorrow
or
How much do I have to put away today to get a
Rupee tomorrow
5

Present Value
The PV of a delayed payment is obtained by
multiplying the payoff by the discount factor
Consider the following example

Suppose you receive Rs.1 tomorrow and the bank

pays an interest rate of 8% (reward for waiting) ,
what is the PV?
r is the rate of return,
1
X (1+r) = 1
hurdle rate,
X = 1/(1+r)1 = 1/(1.08) =0.926

opportunity cost of
capital

Discount factor (DF)

PV = Discount factor * payment to be received

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Future Value
If I had a Rupee today what is it worth tomorrow?
Consider the following example

Suppose you have Rs.1 today, the bank pays an

interest rate of 8% (rate of return), what is the FV?
1* (1+r)1 = 1*(1.08)1 = 1.08
Discount rate (also called future value factor,
compound factor)

FV = Initial payment + accumulated interest

7

PV & FV
Present Value
Value today of a
future cash flow

Discount Factor
Present value of a
Rs.1 future
payment
The factor by which
future cash flow
must be multiplied
to compute the
present value

Future Value
Amount to which an
investment will grow
after earning interest

Discount Rate
Interest rate used to
compute present
values of future cash
flows

One Period: PV
Consider the following example

Suppose you are offered an investment that pays

Rs.25,000 in five years. If you expect to earn a 11%
return, what is the value of this investment?

One Period: PV
Consider the following example

Mr. Ross wishes to find the present value of Rs.1,900

that will be received 9 years from now;
Mr. Rosss opportunity cost is 10%

10

One Period: FV
Consider the following example

Mr. Smith places Rs.550 in a savings account paying

6% interest compounded annually. He wants to
know how much money will be in the account at the
end of six years

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One Period: Net Present Value (NPV)

The Net Present Value (NPV) of an investment is the
present value of the expected cash flows, less the
cost of the investment.
Consider the following example

Suppose an investment that promises to pay

Rs.12,500 in one year is offered for sale for Rs.9950.
Your interest rate is 7%. Should you buy?

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PV- different rates and time periods

Interest rate, time period and PV

As t increases PV decreases
As r increases PV decreases
13

FV- different rates and time periods

Interest rate, time period and FV

As t increases FV increases
As r increases FV increases
14

Multi-period Case
What happens when the number of period
increases?
FV = X* (1+r)t
PV = X/(1+r)t
FV = PV * (1+r)t or PV = FV /(1+r)t
Consider a simple example

Suppose r = 10% & you want to compare two plan

A: receive Rs.450, 7 years from now
B: Receive Rs.750, 14 years from now

Which one would you prefer?

15

Multi-period Case
Consider the following example

Suppose you have a choice between receiving

Rs.3,500 today or Rs.8,500 in five years. You
believe you can earn 12% on the Rs.3,500 today.
What should you do?

16

Multi-period Case
Consider the following example

Suppose that Prof. Westerfield invests in the initial

public offering of the Ross company that currently
pays a dividend of Rs.3.15, which is expected to
grow at 25% per year for the next seven years.
What will the dividend be in seven years?
FV

= PV(1 + r)t
= 3.15(1.25)7
= 15.02
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Multi-period Case
Consider the following example

Suppose you plan to save Rs.2000 today, and

Rs.2000 at the end of each of the next three years.
If you can earn a fixed 8% interest rate on your
savings, how much will you have four years from
today?

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Multi-period Case
Consider the following example (PV case)

You have an opportunity to invest in a business that will pay

Rs.2,00,000 in year one, Rs.4,25,000 in year two,
Rs.5,50,000 in year three and Rs.6,15,000 in year four. You
can earn 10% per year compounded annually on a mutual
fund that has similar risk. If it costs Rs.1.25 million to start
this business, should you invest?

Discount rate = 10%

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Multi-Period Case

In general when you have multiple cash flows C0

..CN, the PV of those Cash flows is

PV

PV (C )

n 0

n 0

Cn
(1 r ) n
20

Multi-period Case

21

PV & FV
Only values at the same point in time can be
combined or compared (time travel)
When cash flows occur at different points in time
they must be discounted or compounded
appropriately
To move cash flow forward compound it
To compound cash flows, multiply the amount by
(1 + r)n where r is the periodic interest rate and n
is the number of compounding periods
To move cash flow backward discount it
To discount cash flows, divide the amount by
(1 + r)n where r and n are as defined previously
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Annuities, Perpetuities - Simplifications

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
Perpetuity - A constant stream of cash flows that
lasts forever
Growing perpetuity - A stream of cash flows that
grows at a constant rate forever.
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C
C
C
C
P
VC

2
3
T
(
1

r
)
(
1

r
)
(
1

r
)
(
1

r
)
P

1
Vr 1(1r)T

Annuities, Perpetuities - Simplifications

Annuity - A constant stream of cash flows with a
fixed maturity

The formula for the present value of an annuity is:

24

Annuities, Perpetuities - Simplifications

Consider the following example

If you can afford a Rs.550 monthly car payment,

what is the maximum price of the car you can buy if
the annual interest rates is 8% on 48-month loan

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Annuities, Perpetuities - Simplifications

Consider the following example

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

Rs.100 per year that makes its first payment two
years from today if the discount rate is 9%?

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Annuities, Perpetuities - Simplifications

Consider the following example (spreadsheet)

Jaffe Company, a small producer of plastic toys, wants

to determine the most it should pay to purchase a
particular annuity. The annuity consists of cash flows of
Rs.700 at the end of each year for 10 years. The
required return is 8%.

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Annuities, Perpetuities - Simplifications

Future Value of an Annuity

FV (annuity) PV (1 r )

C
1
N

(1 r )
1
N
r
(1 r )
1
N
C
(1

r
)
1

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Annuities, Perpetuities - Simplifications

Consider the following example

Ellen is 40 years old today and wants to begin saving

for retirement from next year. At the end of each year
until she is 65 she will save Rs.7500 each year in a
retirement account. If the account earns 12% per
year how much would Ellen have saved at age 65?

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1
C
C

(
1

g
)
C

(
1

g
)
P
V(1C

2
T

r
)
r
)
r
T

g
P
Vrg 1 (r)
Annuities, Perpetuities - Simplifications

Growing annuity - A growing stream of cash flows with

a fixed maturity

C (1+g)

C (1+g)2

C (1+g)T-1
T

The PV of a growing annuity with the initial cash flow c, growth rate g, and
interest rate r is

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Annuities, Perpetuities - Simplifications

Consider the following example

In the Ellen example Suppose Ellen expects to

salary to increase and so she plans to save 5% more
each year - how much will she have saved by at age
65? All other details remain the same

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Annuities, Perpetuities - Simplifications

Consider the following example PV of a lottery

You have won the Rs. 30 Million state lottery. You

have two options to claim the prize
(a) 30 payments of 1 million starting today or
(b)15 million lump-sum paid today
If the interest rate is 8% which is the option you
should choose (you are rational!)

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Annuities, Perpetuities - Simplifications

C
C
C
P
V(1r)C
(1r)2(1r)3
P
Vr

Perpetuity - A constant stream of cash flows that

lasts forever

The formula for the present value of a perpetuity is:

33

Annuities, Perpetuities - Simplifications

Consider the following example

What is the value of a British consol that promises

to pay 10 each year, every year until the sun turns
into a red giant and burns the planet to a crisp?
The interest rate is 9%

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Annuities, Perpetuities - Simplifications

Consider the following example

How much would I have to deposit today in order to

withdraw Rs.1,500 each year forever if I can earn
7% on my deposit?

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Annuities, Perpetuities - Simplifications

Consider the following example

How much would I have to deposit today in order to

withdraw Rs.1,500 each year forever if I can earn
7% on my deposit?
PV = 1500/.07 = Rs.21,429

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Annuities, Perpetuities - Simplifications

Consider the following example

You want to endow a graduation party at IIMK. You

want the event to be memorable and plan Rs.7,500
per year for ever for the party. If IIMK can invest at
8% year and the first party is a year from now how
much will you need to donate to endow the party?

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Annuities, Perpetuities - Simplifications

2
C
C

(
1

g
)
C

(
1

g
)
P
V(1r)Cr)2r3
P
Vrg

Growing perpetuity - A growing stream of cash flows

that lasts forever

C (1+g)

C (1+g)2

The PV of a growing perpetuity with the initial cash flow c, growth rate g,
and interest rate r is

38

Annuities, Perpetuities - Simplifications

Consider the following example

The expected dividend next year is Rs.2.25 and

dividends are expected to grow at 5% forever;
If the discount rate is 10%, what is the value of
this dividend stream?

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Annuities, Perpetuities - Simplifications

Consider the following example

If in the MBA graduation party endowment case

you realize that the inflation rate will be 4% per
year after the first year and that will also need to be
factored in in your original donation amount what
do you now have to donate. All other details
remain the same.

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Annuities, Perpetuities - Simplifications

Consider the following example

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

If investors demand a 10% return on investments for

stocks of similar risk, what price will they be willing
to pay?
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Special Cases
So far, we have computed either the PV or the FV
of a stream of CF (unequal or equal) for a given
number of time periods and interest rate
Sometimes we know the present value or future
value, but do not know one of the other variables
we have previously been given as an input
For example, when you take out a loan you may
know the amount you would like to borrow, but may
not know the loan payments that will be required to
repay it
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Special Cases
Consider the following example

Your firm plans to buy a warehouse for Rs.400,000.

The bank requires you to pay 25% down payment
and will lend the remaining to you for a 30-year
time period at 8% annual rate of interest.
Assuming you make annual payments, what is your
annual payment amount?

43

Special Cases
At times it may be necessary to compute the r (also
called IRR) more on this later in the session but
let us do an example
Jane has just graduated and is offered a fantastic
job at ABC investment corporation. She ponders
but decides to set up her own business and asks
them for funding. ABC lends her Rs.3 million with
the agreement that she will pay back Rs.250,000 at
the end of each year for the next 30 years.
Assuming she fulfills her agreement what is the
rate at which ABC has lent Jane the money?
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Special Cases
Suppose ABC corporation gives Jane another
option pay 250,000 in the first year and 4% more
in perpetuity all other details remain the same.
What is the rate that ABC is lending at (IRR)?

45

Special Cases
Consider the following example

Assume the total cost of a college education will be

Rs.150,000 when Ms. Xs child enters college in 12
years. She has Rs.30,000 to invest today. What
rate of interest must she earn on the investment to
cover the cost of her childs education?

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Special Cases
Calculating time T (or N)
If we deposit Rs.20,000 today in an account paying
10%, how long does it take to grow to Rs.200,000?

47

Effective Annual Rate

Compounding an investment m times a year for T
years provides for future value of wealth

m T

FV C 0 1
m

C0 = initial investment or PV of the CF

48

Effective Annual Rate

Consider the following example

You invest Rs.100 for 3 years at 12% compounded

semi-annually, what will your investment grow to at
the end of that period

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Effective Annual Rate

Consider the following example

You invest Rs.150 for 3 years at 10% compounded

semi-annually, what will your investment grow to at
the end of that period
rate = 0.10/2 = 0.05 (semi-annual)
m=2
nper = 3
PV = 150
FV = 150 * (1+.10/2)2*3 = Rs.201.01
w/o semi-annual compounding
FV = 150*(1.10)3 = Rs.199.65
50

Effective Annual Rate

A reasonable question to ask in the above example
is what is the effective annual rate of interest on
that investment
The Effective Annual Interest Rate (EAR) is the
annual rate that would give us the same end-ofinvestment wealth after 3 years

51

Effective Annual Rate

150 x(1+EAR)3 = 201.01 (This is the future value)
(1+EAR) = (201.01/150)1/3
EAR = (.) 1 = .1025 = 10.25%

So, investing at 10.25% compounded annually is

the same as investing at 10% compounded
semiannually

52

Effective Annual Rate

Find the Effective Annual Rate (EAR) of an 20% APR
(annual % rate) loan that is compounded monthly.

53

Effective Annual Rate

What is the difference between the EAR of interest
and stated rate of interest in the following cases:
Case A: Stated rate of interest is 8 percent and the
frequency of compounding is six times a year.
Case B: Stated rate of interest is 10 percent and the
frequency of compounding is four times a year.
Case C: Stated rate of interest is 12 percent and the
frequency of compounding is twelve times a year.
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Effective Annual Rate

The general formula for the future value of an
investment compounded continuously over many
periods is FV = C0erT
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
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Effective Annual Rate

The nominal interest rate is the stated or contractual
rate of interest charged by a lender or promised by a
borrower
The effective interest rate is the rate actually paid or
earned
In general, the effective rate > nominal rate whenever
compounding occurs more than once per year

56

APR and Loan Balance

Ten years ago your firm borrowed $3 million to
purchase an office building using a loan with a
7.80% APR, and monthly payments for 30 years
How much do you owe on the loan today
How much interest was paid on the loan in the last
year

57

Mini Case
Mini case see word doc

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Mini Case
What are the four questions to be answered
How much money would Vikas need 15 years from
now?
How much money should Vikas save each year for the
next 15 years to be able to meet his investment
objective?
How much money would Vikas need when he reaches
the age of 60 to meet his donation objective?
What is the present value of Vikas life time earnings?

59

Summary

CF

Pull (PV)

Push (PV)

Non constant
CF

Non constant CF

Annuity

Annuity
Pseudo
annuity

Pseudo annuity

60

60

Summary
Pull (PV)

Non constant CF
finite
N
Ct
PV
T 1 (1 r )t

Annuity

Finite

c
1
PV 1

r
1 r

Infinite
(perpetuity)

Finite

rg

C
1 g t
PV
1

rg
1

PV

C
r

Pseudo annuity

Infinit
e

PV

C
rg
61

gr
61

Summary
In case of pseudo annuity, when r = g
0

C(1+g)

C(1+g)2

C 1 g C 1 g
C 1 g
C
PV

...
2
3
T
1

r
1 r
1

r
1

T 1

1 r

PV

C 1 g C 1 g
C 1 g
C

...

2
T 1
1 r
1 r
1 r

T 1

1
C C C ...
1 r
TC
1 r

62

62

Summary
Push (FV)

Annuity

Non
constant
Multipl
e
T

FV CT t 1 r

t 1

FV Ct 1 r

Finit
C
t
FV e
1 r 1

Pseudo annuity

Infinite
Does not
exist

Infinite
Doe
s
not
exis
t

T t

t 1

Finite

FV

C
T
T
1 r 1 g
rg

rg
63

63

Summary
In case of Pseudo annuity, when r = g
0

FV C 1 r

T 1

C(1+g)

C 1 g 1 r

T 2

C(1+g)2

T
C(1+g)T-1

C 1 g 1 r

T 3

... C 1 g

T 1

When r=g

FV C 1 r

T 1

TC 1 r

C 1 r

T 1

C 1 r

T 1

...

T 1

64

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Risk and CF
A safe Rupee is worth more than a risky one
Generally, investors do not like risk
In order to induce the investors to invest in risky
projects, a higher rate of return is needed
Higher rate of return causes lower PVs
Consider a Lottery vs. bank deposit
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How do you master this

Practice, practice, practice
It is also easy to watch what is done in class and
convince yourself that you can do it, if needed
There is no substitute for getting out the calculator,
paper and pen and working out many, many
problems from the book until you can do them
correctly and quickly

66

Thank you !

67