AF 3313 – Business Finance

Lecture 2
Time Value of Money
Basic Definitions
❑ Present Value – “earlier” money on a time line
❑ Future Value – “later” money on a time line
❑ Interest rate – “exchange rate” between earlier money and
later money
❑ Other names for interest rate
1. Discount rate
2. Cost of capital
3. Opportunity cost of capital
4. Required return

2
Table 5.4

3
Help: Time Line
❑To help make things clear, drawing a time line could be a
helpful step.
Cash Flow at period 2
discounting compounding

C0 C1 C2

t=0 1 2 ….
Convention:

Discounting and compounding Positive → cash inflow

are done with interest rate (r).
Negative → cash outflow

4
Present and Future Values Formula
FV
PV = This is the relationship
(1 + r )T
where between PV and FV,
❑ FV = future value but there are still issues
❑ PV = present value to be dealt with.
❑ r = period interest rate, expressed as a decimal
❑ T = number of periods
❑ Future value interest factor = (1 + r)T
1
❑ Present value interest factor = (1 + r )T

5
Future Values
❑Suppose you invest $1000 for one year at 5% per year.
What is the future value in one year?
❑Interest = 1000(.05) = 50
❑Value in one year = principal + interest = 1000 + 50 = 1050
❑Future Value (FV) = 1000(1 + .05) = 1050
❑Suppose you leave the money in for another year. How
much will you have two years from now?
❑FV = 1000(1.05)(1.05) = 1000(1.05)2 = 1102.50

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Effects of Compounding
❑Simple interest
❑Interests calculated are on principal only.
❑Compound interest
❑Interests on interest payments are also included.
❑Consider the previous example
❑FV with simple interest = 1000 + 50 + 50 = 1100
❑FV with compound interest = 1102.50
❑The extra 2.50 comes from the interest of .05(50) = 2.50
earned on the first interest payment, this is usually called
interest on interest.

7
Present Values
❑How much do I have to invest today to have some
amount in the future?
❑FV = PV(1 + r)t
❑Rearrange to solve for PV = FV / (1 + r)t
❑When we talk about discounting, we mean finding the
present value of some future amount.
❑When we talk about the “value” of something, we are
talking about the present value unless we specifically
indicate that we want the future value.

8
 Present Values – An Example
❑You want to begin saving for your daughter’s college
education and you estimate that she will need $150,000
in 17 years. If you feel confident that you can earn 8%
per year, how much do you need to invest today?
❑PV = 150,000 / (1.08)17 = 40,540.34

40,540.34 150,000

17 years @ 8% per year

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Discount Rate
❑Often we will want to know what the implied interest
rate is in an investment
❑Why do we need to find the rate?
❑Since we can treat the implied rate of return as a profitability
measure of the project.
❑Rearrange the basic PV equation and solve for r
❑FV = PV(1 + r)t
❑r = (FV / PV)1/t – 1

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 Finding the Number of Periods
❑No. of periods can be seen as another variable you want to
calculate.
❑The is the number of periods required to achieve certain
level of profitability.
❑Start with basic equation and solve for t (remember your
logs)
❑FV = PV(1 + r)t
❑ln(FV / PV) = t * ln(1 + r)
❑t = ln(FV / PV) / ln(1 + r)

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Table 5.4

12
Multiple Cash Flows –
Future Value
❑Find the value at year 3 of the following cash flows if
interest rate per year is 8% and find the value at the end of
year 4.
❑CFs: $7000 (time 0 = present), $4000 (time 1 – 3)

0 1 2 3

7k 4k 4k 4k

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Multiple Cash Flows –
Future Value
❑Today (year 0): FV = 7000(1.08)3 = 8,817.98
❑Year 1: FV = 4,000(1.08)2 = 4,665.60
❑Year 2: FV = 4,000(1.08) = 4,320
❑Year 3: Value = 4,000
❑Total value in 3 years = 8817.98 + 4665.60 + 4320 + 4000
= 21,803.58
❑ Therefore, Value at year 4 = 21,803.58(1.08) = 23,547.87

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Multiple Cash Flows –
Price that you are willing to pay
❑You are considering an investment that will pay you
$1000 in one year, $2000 in two years and $3000 in
three years. If you want to earn 10% on your money,
how much would you be willing to pay?
❑PV = 1000 / (1.1)1 = 909.09
❑PV = 2000 / (1.1)2 = 1652.89
❑PV = 3000 / (1.1)3 = 2253.94
❑PV = 909.09 + 1652.89 + 2253.94 = 4815.92

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Simplifications
❑ When certain assumptions are met, we may be
able to use some formula to help us calculate
the present value.
CF: C0 C1 C2 C3 CN

Time: 0 1 2 3 N ∞
Forever
1. Timing (Forever or stop at time T) Stop sometime
Constant
2. Cash Flow (Constant or growing at rate g)
Growing

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 Simplifications
After understanding the concept of Present Value, you could have
some simplifications if some assumptions are met.
1. Perpetuity
❑ Constant Cash flows that last forever
2. Growing perpetuity
❑ Cash flows that grow at a constant rate and last forever
3. Annuity (also called ordinary or simple annuity)
❑ A stream of constant cash flows that lasts for a fixed number
of periods
4. 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 Perpetuity is a constant stream of cash flows without end
❑ Cash flows are the same in every period.
❑ PV of Perpetuity formula: PVt = Ct+1 / r
100 100 100 …. forever (r = 10%)

0 1 2 3 …. forever
❑ PV0 = 100 / 0.1 = 1000
❑ Example: The British consol bond

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Growing Perpetuity
❑ A growing perpetuity is a stream of cash flows that grows at
a constant rate (g) forever. (r = 10%)
PV of Growing Perpetuity formula : PVt = Ct+1 / (r - g)
100 102 104.04 …. forever (g= 2%)

0 1 2 3 …. forever (r = 10%)
❑ PV0 = 100 /(0.1-0.02) = 1250

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 Annuity
(also called ordinary or simple annuity)

❑Annuity – A stream of constant cash flows that lasts

for a fixed number of periods
❑ If the first payment occurs at the end of the period, it is
called an ordinary annuity
❑ Example: Salary

❑ If the first payment occurs at the beginning of the period, it

is called an annuity due
❑ Example: rental
payment
Annuity
❑ If the first payment occurs at the end of the period, it is called
an ordinary annuity
1 1 
Simplification: PVt = Ct +1  − T 
r r (1 + r ) 
 (1 + r )T 1 
FVt +T = Ct +1  − 
 r r
An example: Assume that $100 occurs at the end of the period, it
is called an ordinary annuity. (r = 10%)
$100 $100 $100  1 1 
PV0 = 100  − 3
= 249
 0.1 0.1(1.1) 
0 1 2 3  (1.1) 3 1 
FV3 = 100  −  = 331
 0.1 0.1

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Annuity
❑ If the first payment occurs at the end of the period, it is called
an ordinary annuity The term is called the annuity present
1 1  value factor
Simplification: PVt = Ct +1  − T 
r r (1 + r ) 
The term is called the annuity future
 (1 + r )T 1  value factor
FVt +T = Ct +1  − 
 r r
An example: Assume that $100 occurs at the end of the period, it
is called an ordinary annuity. (r = 10%)
$100 $100 $100  1 1 
PV0 = 100  − 3
= 249
 0.1 0.1(1.1) 
0 1 2 3  (1.1) 3 1 
FV3 = 100  −  = 331
 0.1 0.1

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Table 6.2

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Present Value Factor for an Ordinary Annuity

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Future Value Factor for an Ordinary Annuity

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 PV of Annuity: Example
What is the present (today) 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
P V1 = 
t =1 (1 . 0 9 ) t
= 1
+
(1 . 0 9 ) (1 . 0 9 ) 2
+ 3
+
(1 . 0 9 ) (1 . 0 9 ) 4
= $ 3 2 3 .9 7

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

0 1 2 3 4 5
$32𝟑. 97
𝑃𝑉0 = = $297.22
1.09

2-26
Buying a House
❑You are ready to buy a house and you have $20,000 for
a down payment. You have an annual salary of $36,000
and the bank is willing to allow your monthly mortgage
payment to be equal to 28% of your monthly income.
The interest rate on the loan is 6% per year with monthly
compounding (.5% per month) for a 30-year fixed-rate
loan. How much can you afford to pay for a house?
❑Today house price = down payment + total PV of 360
monthly payments

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Buying a House - Continued
❑Bank loan
❑Monthly income = 36,000 / 12 = 3,000
❑Maximum payment = .28(3,000) = 840
❑PV = 840[1 – 1/1.005360] / .005 = 140,105
❑Total Price
❑Down payment = 20,000
❑Affordable price = 140,105 + 20,000 = 160,105

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Finding the Payment
❑Suppose you want to borrow $20,000 for a new
car. You can borrow at 8% per year, compounded
monthly (8/12 = .66667% per month). If you take
a 4 year loan, what is your monthly payment?
❑20,000 = C[1 – 1 / 1.006666748] / .0066667
❑C = 488.26

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Finding the Number of Payments
❑You ran a little short on your spring break
vacation, so you put $1000 on your credit card.
You can only afford to make the minimum
payment of $20 per month. The interest rate on
the credit card is 1.5 percent per month. How
long will you need to pay off the $1,000?

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Finding the Number of Payments
❑Start with the equation and remember your logs.
❑1000 = 20(1 – 1/1.015t) / .015
❑.75 = 1 – 1 / 1.015t
❑1 / 1.015t = .25
❑1 / .25 = 1.015t
❑t = ln(1/.25) / ln(1.015) = 93.111 months = 7.76
years
❑And this is only if you don’t charge anything
more on the card!

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Annuity Due
An annuity due is an annuity for which the cash
flows occur at the beginning of each period.

6F-32
Annuity Due

Where:
A = The amount of each annuity payment
i = The interest rate
n = The number of periods over which payments are to be made

AF 3311 - Finance - Lecture 2 33

PV of Annuity Due: Example
❑ Assume that you have $50,423 in your savings account. You will need to
draw upon this amount for your university education in four equal annual
payments. You would like to have the first payment now. Assume that the
interest rate is 8 percent compounded annually. How large will each of the
payment be?

6F-34
FV of Annuity Due
Example: The treasurer of ABC Imports expects to invest $50,000
of the firm's funds in a long-term investment vehicle at the
beginning of each year for the next five years. He expects that the
company will earn 6% interest that will compound annually.
The value that these payments should have at the end of the five-
year period is calculated as:

FVA = ($50,000 [((1 + .06)5 - 1) / .06])(1 + .06)

FVA = $298,765.90

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Growing Annuity
(Growing ordinary 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 = + + +
(1 + r ) (1 + r ) 2
(1 + r ) T
C   1+ g  
T

PV = 1 −   
r − g   (1 + r )  
 
Growing Annuity
(Growing ordinary annuity)
❑A growing annuity is a stream of cash flows that
grows at a constant rate over a fixed number of
periods.

❑ An example:
$100 $102 $104.04 (r=10%, g= 2%)

 1 1  1.02  
3
0 1 2 3 PV0 = 100  −    = 253
 0.08 0.08  1.1  

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Table 6.2

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Annual Percentage Rate

❑This is the annual rate that is quoted by most banks

❑By definition APR = period rate times the number of
periods per year
❑Consequently, to get the period rate we rearrange the
APR equation:
❑Period rate = APR / number of periods per year

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Computing APRs
❑What is the APR if the monthly rate is .5%?
❑.5(12) = 6% (we call this rate 6% compounded
monthly)
❑What is the APR if the semiannual rate is .5%?
❑.5(2) = 1%
❑What is the monthly rate if the APR is 12% with
monthly compounding?
❑12 / 12 = 1%

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Things to Remember
❑You ALWAYS need to make sure that the interest rate
and the time period match.
❑If you are looking at annual periods, you need an annual
rate.
❑If you are looking at monthly periods, you need a monthly
rate.

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Effective Annual Rate (EAR)
❑This is the actual rate paid (or received) after accounting
for compounding that occurs during the year.

❑If you want to compare two alternative investments with

different compounding periods you need to compute the
EAR and use that for comparison.

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EAR - Formula

m
 APR 
EAR = 1 +  −1
 m 

Remember that the APR is the quoted rate

m is the number of compounding periods per year

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Computing EARs - Example
❑ Suppose you can earn 1% per month on $1 invested today.
❑What is the APR? 1%(12) = 12%
❑How much are you effectively earning?
❑FV = 1(1.01)12 = 1.1268
❑Rate = (1.1268 – 1) = .1268 = 12.68%
❑ Suppose if you put it in another account, you earn 3% per quarter.
❑What is the APR? 3%(4) = 12%
❑How much are you effectively earning?
❑FV = 1(1.03)4 = 1.1255
❑Rate = (1.1255 – 1) = .1255 = 12.55%

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Computing APRs from EARs
❑If you have an effective rate, how can you
compute the APR? Rearrange the EAR equation
and you get:

APR = m (1 + EAR) m - 1
 1

 

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APR - Example
❑ Suppose you want to earn an effective rate of 12% and you are
looking at an account that compounds on a monthly basis. What
APR must they pay?

 
APR = 12 (1 + .12)1/12 − 1 = .1138655152
or 11.39%

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Computing Payments with APRs
❑ Suppose you want to buy a new computer system and the
store is willing to sell it to allow you to make monthly
payments. The entire computer system costs $3500. The loan
period is for 2 years and the interest rate is 16.9% with
monthly compounding. What is your monthly payment?
❑Monthly rate = .169 / 12 = .01408333333
❑Number of months = 2(12) = 24
❑3500 = C[1 – 1 / 1.01408333333)24] / .01408333333
❑C = 172.88

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Future Values with Monthly
Compounding
❑Suppose you deposit $50 a month into an
account that has an APR of 9%, based on
monthly compounding. How much will you have
in the account in 35 years?
❑Monthly rate = .09 / 12 = .0075
❑Number of months = 35(12) = 420
❑FV = 50[1.0075420 – 1] / .0075 = 147,089.22

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Present Value with
Daily Compounding
❑You need $15,000 in 3 years for a new car. If
you can deposit money into an account that pays
an APR of 5.5% based on daily compounding,
how much would you need to deposit?
❑Daily rate = .055 / 365 = .00015068493
❑Number of days = 3(365) = 1095
❑PV = 15,000 / (1.00015068493)1095 = 12,718.56

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Summary
1. Time value of Money
a. Present Value
b. Future Value
2. Discount Cash Flow
a. Annuity
b. Growing Annuity
c. Perpetuity
d. Growing Perpetuity
3. Annual Percentage Rate (APR)
4. Effective Annual Rate (EAR)

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