Corporate Finance

Lecture 02: the Time Value of Money

Powerball

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).

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 = $10,000

Year

C0(1 + r)
$10,000 1.05

FV = $10,500

,$9,523.8.5
$
1
0

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 todays dollars.

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).

C
1r
P
V
1

The One-Period Case: Present Value

In the one-period case, the formula for PV can be written as:

Where C1 is cash flow at date 1 and r is the

appropriate interest rate.
PV = $9,523.81

Year

C1/(1 + r)

$10,000/1.05

C1 = $10,000

$
1
0
,
N
P
V

$239.,85109.25381

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?

Yes!

N
P
VC
ostP
V

The One-Period Case: Net Present Value

In the one-period case, the formula for NPV can be
written as:

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.

2. The Multi-period 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.

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

Use a Spreadsheet: Future Value

The formula for computing FV in Excel is
=FV (rate,nper,pmt,pv)

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.

$
1
.
0

(
1
.
4
0
)
.$1.0(405)($
$
1
42
).1
$3.02$4.23$5.92
6
5
4
3
2

Future Value and Compounding

,$9,43.5(1.5)5
$
2
0

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
0

$20,000

Use a Spreadsheet: Present Value

The formula for computing PV in Excel is
=PV (rate,nper,pmt,fv)

Compounding and Discounting

F
V
C
(T011..r2)l00nT(T.)06T$5915301,ln7.22$5y,e0ars(1.0)T

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?

Spreadsheet: No. of Periods

The formula for computing number of periods in Excel is
=NPER (rate,pmt,pv,fv)

F
V
C
(r110r)1.2$505,(1r.$2)5,105(1r)

T
1
2
0
,(1r)121012
$
5
0
1
2
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 childs education?
About 21.15%.

Spreadsheet: Rate
The formula for computing the required rate in Excel is
=RATE (nper,pmt,pv,fv)

r
F
V
F
V

$50
m

.12
$50(1.6)$70.93

T
02
36

3 Compounding Periods

Compounding an investment m times a year for T years

provides for future value of wealth:

For example, if you invest $50 for 3 years at

12% compounded semi-annually, your
investment will grow to

.F
1
2
2

3
6
V
$50$(50(1
)E
(A

.R
$
))3$70.93$70.93
5
0

1
6

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?

The Effective Annual Interest Rate (EAR) is

the annual rate that would give us the same
end-of-investment wealth after 3 years:

3
(E
F
V

$
5
0

E
A
R
)

$
7
0
.
9
3
3
5
1
.R
$
7
0
9
3
A
5 1.236

Effective Annual Interest Rates

(continued)

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

investing at 12% compounded semiannually.

Continuous Compounding (Advanced)

The general formula for the future value of an

investment compounded continuously over many

periods can be written as:
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. ex is a key
on your calculator.

4 Special Cases
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.

C
C
C
P
V
P

2
3
(1V
r
)(1r)(1r)
Perpetuity

A constant stream of cash flows that lasts forever.

C
C
C

The formula for the present value of a perpetuity is:

Perpetuity: Example
What is the value of a console 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

$15
PV
$150
.10

C
C

(
1

g
)
C

(
1

g
)
P
V
(1P

rV
)
rgr

2
23

Growing Perpetuity

A growing stream of cash flows that lasts forever.

C
C(1+g) C (1+g)2

The formula for the present value of a growing perpetuity is:

.P
$
1
3
0
V
5$26.0

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)
2

$1.30 (1.05)2


C
C
C
C
P
V
(P

1V
r
)(1
r)(1r)(1r)

2T3T

Annuity

A constant stream of cash flows with a fixed maturity.

C
C
C
C
0

The formula for the present value of an annuity is:


P
V
$
4
0
1
.7/21(.072)$12,954.
36

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

36

Use a Spreadsheet: Annuity

The formula for computing annuity value in Excel is
=PV (rate,nper,pmt,fv)


C
C

(
1

g
)
C

(
1

g
)
P
V
(1P

rV)rC
rg (1gr) r

1
2T

Growing Annuity

A growing stream of cash flows with a fixed maturity.

C(1+g)

C (1+g)2

C(1+g)T-1

The formula for the present value of a growing annuity:


V
,P
$
2
0
.13 1.03 $265,1.7
40

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
2

40

5 What Is a Firm Worth?

Conceptually, a firm should be worth the present value of

the firms cash flows.

The tricky part is determining the size, timing, and risk of

those cash flows.

6 Loan Amortization
Suppose a business takes out a $5,000, five-year loan at
9 percent.

Option 1: Equal Principle Repayment

6 Loan Amortization
Option 2: Fixed Repayment Each Period
First, we need to use the formula to compute the annuity
value

C
1
$5000
1

0.09
(1 0.09)5

That gives us
C $1,285.46

6 Loan Amortization

N
C
C
C
C
N
P
V
C

0
0
2
N
(1r)(1r)(1r)t1(1r)t
7 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:

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iroow
p
:w
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r
C
ruitnyg:A
n
g
P
e
pV
tnu
uityC
iry:P
:
P
V

rV

g
(
1
rC
T
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6 Summary and Conclusions
(continued)

We presented four simplifying formulae: