Time Value of Money

 Introduction
 Present and future values
 Present and future value factors
 Compounding
 Growing income streams

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 Introduction
 Time has a value
• If we owe, we would prefer to pay money later
• If we are owed, we would prefer to receive
money sooner
• The longer the term of a single-payment loan,
the higher the amount the borrower must repay

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 Time Value of Money
 Money has a time value
because it can earn more
money over time (earning
power).
 Money has a time value
because its purchasing power
changes over time (inflation).
 Time value of money is
measured in terms of interest
rate.
 Interest is the cost of money—
a cost to the borrower and an
earning to the lender
 Decision Dilemma—Take a Lump Sum or
Annual Installments

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Delaying Consumption
 Account Value Cost of Refrigerator

Case 1: N = 0 $100 N = 0 $100

Inflation
exceeds N = 1 $106 N = 1 $108
earning power
(earning rate =6%) (inflation rate = 8%)
Case 2: N = 0 $100 N = 0 $100
Earning power
exceeds N = 1 $106 N = 1 $104
inflation
(earning rate =6%) (inflation rate = 4%)
$
 Present and Future Values
 Basic time value of money relationships:
PV  FV  DF
FV  PV  CF
where PV = present value;
FV = future value;
DF = discount factor = 1/(1  R )t
CF = compounding factor = (1  R )t
R = interest rate per period; and
t = time in periods
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 Present and Future Values
(cont’d)
 A present value is the discounted value of
one or more future cash flows
 A future value is the compounded value of
a present value
 The discount factor is the present value of a
rupee invested in the future
 The compounding factor is the future value
of a rupee invested today
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 Present and Future Values
(cont’d)
 Why is a rupee today worth more than a
rupee tomorrow?
• The discount factor:
– Decreases as time increases
• The farther away a cash flow is, the more we discount it
– Decreases as interest rates increase
• When interest rates are high, a rupee today is worth much
more than that same rupee will be in the future

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 Present and Future Values
(cont’d)
 Situations:
• Know the future value and the discount factor
– Like solving for the theoretical price of a bond
• Know the future value and present value
– Like finding the yield to maturity on a bond
• Know the present value and the discount rate
– Like solving for an account balance in the future

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 Present and Future Value
Factors
 Single sum factors
 How we get present and future value tables
 Ordinary annuities and annuities due

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 Single Sum Factors
 Present value interest factor and future
value interest factor:
PV  FV  PVIF
FV  PV  FVIF
where
1
PVIF 
(1  R)t
FVIF  (1  R)t
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 Single Sum Factors (cont’d)
Example

You just invested RS.2,000 in a three-year bank

certificate of deposit (CD) with a 9 percent interest rate.

How much will you receive at maturity?

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 Single Sum Factors (cont’d)
Example (cont’d)

Solution: Solve for the future value:

FV  $2, 000 1.093

 $2, 000 1.2950
 $2,590

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 How We Get Present and
Future Value Tables
 Standard time value of money tables
present factors for:
• Present value of a single sum
• Present value of an annuity
• Future value of a single sum
• Future value of an annuity

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 How We Get Present and
Future Value Tables (cont’d)
 Relationships:
• You can use the present value of a single sum
to obtain:
– The present value of an annuity factor (a running
total of the single sum factors)

– The future value of a single sum factor (the inverse

of the present value of a single sum factor)

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 Ordinary Annuities
and Annuities Due
 An annuity is a series of payments at equal
time intervals

 An ordinary annuity assumes the first

payment occurs at the end of the first year

 An annuity due assumes the first payment

occurs at the beginning of the first year
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 Ordinary Annuities
and Annuities Due (cont’d)
Example

You have just won the lottery! You will receive RS.1 million
in ten installments of RS.100,000 each. You think you can
invest the RS.1 million at an 8 percent interest rate.

What is the present value of the RS.1 million if the first

RS.100,000 payment occurs one year from today? What is
the present value if the first payment occurs today?

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 Ordinary Annuities
and Annuities Due (cont’d)
Example (cont’d)

Solution: These questions treat the cash flows as an

ordinary annuity and an annuity due, respectively:

PV of ordinary annuity  $100, 000  6.7100  $671, 000

PV of annuity due  $100, 000  ($100, 000  6.2468)  $724, 680

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 Compounding
 Definition
 Discrete versus continuous intervals
 Nominal versus effective yields

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 Definition
 Compounding refers to the frequency with
which interest is computed and added to the
principal balance
• The more frequent the compounding, the higher
the interest earned

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 Discrete Versus
Continuous Intervals
 Discrete compounding means we can count the
number of compounding periods per year
• E.g., once a year, twice a year, quarterly, monthly, or
daily

 Continuous compounding results when there is

an infinite number of compounding periods

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 Discrete Versus
Continuous Intervals (cont’d)
 Mathematical adjustment for discrete
compounding:
FV  PV (1  R / m) mt

R  annual interest rate

m  number of compounding periods per year
t  time in years
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 Discrete Versus
Continuous Intervals (cont’d)
 Mathematical equation for continuous
compounding:

FV  PVe Rt

e  2.71828

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 Discrete Versus
Continuous Intervals (cont’d)
Example

Your bank pays you 3 percent per year on your savings

account. You just deposited RS.100.00 in your savings
account.

What is the future value of the RS.100.00 in one year if

interest is compounded quarterly? If interest is
compounded continuously?
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 Discrete Versus
Continuous Intervals (cont’d)
Example (cont’d)

Solution: For quarterly compounding:

FV  PV (1  R / m) mt
 $100.00(1  0.03 / 4) 4
 $103.03

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 Discrete Versus
Continuous Intervals (cont’d)
Example (cont’d)

Solution (cont’d): For continuous compounding:

FV  PVe Rt

 $100.00  e0.03
 $103.05
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 Nominal Versus
Effective Yields
 The stated rate of interest is the simple rate or
nominal rate
• 3.00% in the example
 The interest rate that relates present and future
values is the effective rate
• RS.3.03/RS.100 = 3.03% for quarterly compounding
• RS.3.05/RS.100 = 3.05% for continuous
compounding

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 Growing Income Streams
 Definition
 Growing annuity
 Growing perpetuity

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 Definition
 A growing stream is one in which each
successive cash flow is larger than the
previous one
• A common problem is one in which the cash
flows grow by some fixed percentage

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 Growing Annuity
 A growing annuity is an annuity in which
the cash flows grow at a constant rate g:

C C (1  g ) C (1  g ) 2 C (1  g ) n
PV     ... 
(1  R ) (1  R ) 2
(1  R) 3
(1  R) n 1
C1   1 g  
N

 1    
R  g   1  R  

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 Growing Perpetuity
 A growing perpetuity is an annuity where
the cash flows continue indefinitely:

C C (1  g ) C (1  g ) 2 C (1  g ) 
PV     ... 
(1  R ) (1  R ) 2
(1  R ) 3
(1  R) 

Ct (1  g )t 1 C1
 
t 1 (1  R) t
Rg

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 Safe RS. s and Risky RS. s
 Introduction
 Choosing among risky alternatives
 Defining risk

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 Introduction
 A safe rupee is worth more than a risky
rupee
• Investing in the stock market is exchanging
bird-in-the-hand safe Rs. for a chance at a
higher number of Rs. in the future.

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 Introduction (cont’d)
 Most investors are risk averse
• People will take a risk only if they expect to be
adequately rewarded for taking it

 People have different degrees of risk

aversion
• Some people are more willing to take a chance
than others
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 Choosing Among
Risky Alternatives
Example

You have won the right to spin a lottery wheel one time.
The wheel contains numbers 1 through 100, and a pointer
selects one number when the wheel stops. The payoff
alternatives are on the next slide.

Which alternative would you choose?

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 Choosing Among
Risky Alternatives (cont’d)
A B C D

1-50 RS.110 1-50 RS.200 1-90 RS.50 1-99 RS.1000

51-100 RS.90 51-100 RS.0 91-100 RS.550 100 -RS.89,000

Avg.
payoff RS.100 RS.100 RS.100 RS.100

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 Choosing Among
Risky Alternatives (cont’d)
Example (cont’d)
Solution:
 Most people would think Choice A is “safe.”
 Choice B has an opportunity cost of RS.90
relative to Choice A.
 People who get utility from playing a game pick
Choice C.
 People who cannot tolerate the chance of any
loss would avoid Choice D.

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 Choosing Among
Risky Alternatives (cont’d)
Example (cont’d)

Solution (cont’d):
 Choice A is like buying shares of a utility stock.
 Choice B is like purchasing a stock option.
 Choice C is like a convertible bond.
 Choice D is like writing out-of-the-money call
options.

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 Defining Risk
 Risk versus uncertainty
 Dispersion and chance of loss
 Types of risk

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 Risk Versus Uncertainty
 Uncertainty involves a doubtful outcome
• What you will get for your birthday
• If a particular horse will win at the track

 Risk involves the chance of loss

• If a particular horse will win at the track if you
made a bet

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Dispersion and Chance of Loss
 There are two material factors we use in
judging risk:
• The average outcome

• The scattering of the other possibilities around

the average

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Dispersion and Chance of Loss
(cont’d)
Investment value

Investment A
Investment B

Time
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Dispersion and Chance of Loss
(cont’d)
 Investments A and B have the same
arithmetic mean

 Investment B is riskier than Investment A

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 Types of Risk
 Total risk refers to the overall variability of
the returns of financial assets

 Undiversifiable risk is risk that must be

borne by virtue of being in the market
• Arises from systematic factors that affect all
securities of a particular type

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 Types of Risk (cont’d)
 Diversifiable risk can be removed by
proper portfolio diversification
• The ups and down of individual securities due
to company-specific events will cancel each
other out
• The only return variability that remains will be
due to economic events affecting all stocks

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Relationship Between Risk and
Return
 Direct relationship
 Concept of utility
 Diminishing marginal utility of money
 St. Petersburg paradox
 Fair bets
 The consumption decision
 Other considerations
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 Direct Relationship
 The more risk someone bears, the higher
the expected return
 The appropriate discount rate depends on
the risk level of the investment
 The risk-less rate of interest can be earned
without bearing any risk

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Direct Relationship (cont’d)
Expected return

Rf

0 Risk 50
 Direct Relationship (cont’d)
 The expected return is the weighted average
of all possible returns
• The weights reflect the relative likelihood of
each possible return

 The risk is undiversifiable risk

• A person is not rewarded for bearing risk that
could have been diversified away
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 Concept of Utility
 Utility measures the satisfaction people get
out of something
• Different individuals get different amounts of
utility from the same source
– Casino gambling
– Pizza parties
– CDs
– Sports.

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 Diminishing Marginal
Utility of Money
 Rational people prefer more money to less
• Money provides utility

• Diminishing marginal utility of money

– The relationship between more money and added
utility is not linear

– “I hate to lose more than I like to win”

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 Diminishing Marginal
Utility of Money (cont’d)
Utility

RS.
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 St. Petersburg Paradox
 Assume the following game:
• A coin is flipped until a head appears
• The payoff is based on the number of tails
observed (n) before the first head
• The payoff is calculated as RS.2n

 What is the expected payoff?

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 St. Petersburg Paradox
(cont’d)
Number of Tails
Before First Probability
Head Probability Payoff x Payoff
0 (1/2)1 = 1/2 RS.1 RS.0.50
1 (1/2)2 = 1/4 RS.2 RS.0.50
2 (1/2)3 = 1/8 RS.4 RS.0.50
3 (1/2)4 = 1/16 RS.8 RS.0.50
4 (1/2)5 = 1/32 RS.16 RS.0.50
n (1/2)n + 1 RS.2n RS.0.50
Total 1.00 
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 St. Petersburg Paradox
(cont’d)
 In the limit, the expected payoff is infinite

 How much would you be willing to play the

game?
• Most people would only pay a couple of RS. s
• The marginal utility for each additional RS.0.50
declines

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 Fair Bets
 A fair bet is a lottery in which the expected
payoff is equal to the cost of playing
• E.g., matching quarters
• E.g., matching serial numbers on RS.100 bills

 Most people will not take a fair bet unless

the rupee amount involved is small
• Utility lost is greater than utility gained
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 The Consumption Decision
 The consumption decision is the choice to
save or to borrow
• If interest rates are high, we are inclined to save
– E.g., open a new savings account

• If interest rates are low, borrowing looks

attractive
– E.g., a higher home mortgage

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 The Consumption
Decision (cont’d)
 The equilibrium interest rate causes savers
to deposit a sufficient amount of money to
satisfy the borrowing needs of the economy

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 Other Considerations
 Psychic return
 Price risk versus convenience risk

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 Psychic Return
 Psychic return comes from an individual
disposition about something
• People get utility from more expensive things,
even if the quality is not higher than cheaper
alternatives
– E.g., Rolex watches, designer jeans

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 Price Risk Versus
Convenience Risk
 Price risk refers to the possibility of adverse
changes in the value of an investment due to:
• A change in market conditions
• A change in the financial situation
• A change in public attitude

 E.g., rising interest rates and stock prices, a

change in the price of gold and the value of the
rupee

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 Price Risk Versus
Convenience Risk (cont’d)
 Convenience risk refers to a loss of
managerial time rather than a loss of RS. s
• E.g., a bond’s call provision
– Allows the issuer to call in the debt early, meaning
the investor has to look for other investments

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