Time Value of Money

The main principle of the time
value of money (TVM)
Financial Management [MJJV.10.055]

Valuation concepts:
Time Value of Money. Valuation of securities.
The value of money today is worth more

than the value of money tomorrow.
Kaia Kask, PhD

Researcher in Finance
University of Tartu
tel: 7 376 336, room: A307
e-mail: kaia.kask@ut.ee
3/3/2015
FINANCIAL MANAGEMENT (Kaia Kask)
Relevant terms:
Price the amount asked, offered, or paid for
the property; price is a fact.
1000 invested at 7% interest for 100

years will become 1 000 000,
at which time it will be worth absolutely
nothing to you!
Value expresses an economic concept and is

not a fact, but a subjective opinion of
the worth of an asset.
Cost the amount required to acquire or
create an asset; cost is more a fact than
a subjective opinion.
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Abbrevations
Types of interest rates (1)
Present value (PV): an initial value at the beginning

of a period of time.
Future value (FV): a final value at the end of a
period of time.
Number of periods (n): the number of periods
(years) in the total time period.
Periodic interest rate (i): the rate of return earned
during each period n; may also be called the rate of
return (r), or the yield (y).
Growth rate (g) of cash flows, usually constant
growth rate during the cash flow projection period.
Simple interest linear growth; interest earned
A bird in the hand is worth two in the bush
3/3/2015
only on the original investment
FV = PV [1 + (i n )]
Compound interest geometric growth;
interest earned on interest
FV = PV (1 + i)
Continuous compounding exponential growth
( )
FV = PV ein
5
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Figure 1. Calculation of future value of

money graphically
The basic rule of compounding:

The more frequently interest is
compounded, the higher the future
value
20
EUR
16
12
8
4
0
1
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
Years
10% - compound interest
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10% - simple interest
10% - continuous compounding
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Types of interest rates (2)
...rental price for money.

...the time value of consumption.
...opportunity cost.
...expressed in terms of annual rate.
As with any price, interest rates serve to
allocate funds to alternative uses.
9
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the actual rate of interest earned (paid) after

adjusting the nominal rate for factors such as
the number of compounding periods per year.
EARANNUAL
EARQUARTERLY
EARMONTHLY
EARDAILY (365)
= EAR = 1 + nom 1
m
10
10.00%
10.38%
10.47%
10.52%
If m > 1, EAR will always be greater than the

nominal rate and vice versa.
iNOM nominal interest rate

m frequency of calculation of interest per year
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Values of interest rates at various

compounding levels:
Effective annual interest rate, EAR
ieffective
Interest rate is...
Nominal interest rate frequency of interest

calculation is one time per year; stated in
contracts, and quoted by banks and brokers
Effective interest rate frequency of interest
calculation is more than one time per year;
takes account compounding within a year
Real interest rate nominal interest rate
corrected by inflation rate
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11
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12
Case 1 (EAR)
Effective interest rate in case of continuous
compounding of interest
m
EAR = lim 1 + nom 1 = einom 1

m
m
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13
Suppose, you are investing 10 000 USD for two

years with nominal interest rate 10,5% per year.
The interest is calculated four times per year
(quarterly).
1. What is the effective annual interest rate of such
kind of investment?
2. How the answer will change in case, when the
interest is calculated only one time only during
the two-years investment horizon?
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1 + inom
1
ireal =
1
+
i
infl
ireal inom iinfl
Ordinary cash flow

(cash flows in every single period differ from
each other)
Annuity
(ordinary annuity and annuity due or rent
annuity)
Growing annuity
Perpetuity
Growing perpetuity
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15
Ordinary annuity payments or receipts occur at

the end of each period.
Annuity due payments or receipts occur at the
beginning of each period.
A perpetuity is a constant cash flow at regular

intervals lasting forever.
At a given time period the higher is the interest rate

(or discount rate), the smaller is present value and vice
versa, the smaller is the interest rate (or discount rate),
the bigger is the present value.
What is the value of 500 after 5 years in case the interest
rate (or discount rate) is 10%? 15?
Interest rate = 10% PV = 500 / (1.1)5 = 310.46
Interest rate = 15% PV = 500 / (1.15)5 = 248.58
At a given interest rate the longer the time period,

the smaller the present value and vice versa, the
shorter the time period, the bigger the present value.
What ise the value of 500 after 5 years? 10 years? in case
the interest rate (or discount rate) is 10% in both cases?
A growing perpetuity is a constant cash flow
5 years: PV = 500 / (1.1)5 = 310.46

10 years: PV = 500 / (1.1)10 = 192.77
that is expected to grow at a constant rate forever.

16
Important relations:
An annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.
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14
Cash flow models
Calculation basis of real interest rate, rreal
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17
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18
The basic assumptions in calculations

In case there is not said otherwise, then:
1) all cash flows are assumed to appear at the end of
each period (i.e, a year, half-year, quarter, month,
day);
2) there is used only nominal interest rate in the
time value of money interest factor formulas (NB!
with some minor exceptions!);
3) all calculations must be based on comparable and
equivalent input data.
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19
Future value of money.
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Future value interest factor, FVIF
FVIFi,n = (1 + i)
Case 2 (future value, FV)
In 1626 Peter Minuit, a Dutchman, purchased

Manhattan Island from Native Americans for 24 USD
worth of trinkets, beads and knives. Suppose the
deal was made in cash and the same Indians invested this money with interest rate 8% per year. What
would be the value of the invested sum today?
FVn = CF(1+i)n
FV380 = 24 (1.08)380 = 120 trillion USD
nm
i
FVIFi,n = 1 +
m
[( )]
FVIFi,n = e in
i nominal interest rate

n number of years
m frequency of calculation of interest per year
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With interest rate 6% the value would be today:

FV380 = 24 (1.06)380 = 99 trillion USD
21
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Case 3 (future value, FV)
22
Solution (future value, FV)
Suppose that you are planning to deposit the

money as follows: one year from now 100 EUR,
two years from now 200 EUR, three years from now
300 EUR, four years from now 400 EUR and five
years from now 500 EUR. What ise the sum of the
money accumulated to the deposit during the five
years in case the bank deposit interest rate is 5%
during the whole period and the interest is
compounded annually?
3/3/2015
20
23
5%
100 (1,05)4
200 (1,05)3 300 (1,05)2 400 (1,05)1 500

420.00
330.75
+
231.53
121.55
= 1603.83
3/3/2015
24
Future value interest factor of an

annuity, FVIFA
Future value interest factor of growing

annuity, FVIFGA
(1 + i)n 1
FVIFAi,n =
FVIFGA i,n, g
= n(1 + i)
i
SFFi,n =
(1 + i)n 1
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(1 + i)n (1 + g )n
=
, if i g
ig
n 1
] , if i = g
g growth rate
25
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26
Theory of discounting
Exponential (E) discounting model of compound
interest
1
FVn
FV
PVo =
= FVn
i = n n 1
n
n
PVo
(1 + i)
(1 + i)
Present value of money.
Hyperbolic (H) discounting model of simple

interest
FVn
1
FVn
PV
PVo =
i= o
n
1
(1 + i n)
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27
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28
Case 4 (present value)
Present value interest factor, PVIF
Suppose that your 5-year old daughter has just announced

her desire to attend a college. After some research, you
determine that you will need about 100 000 EUR on her 18th
birthday to pay for four years of college.
If you can earn 8% per year on your investments, how much
do you need to invest today to achieve your goal?
1
PVIFi, n =
n
(1 + i)
Solution
PVo =
i interest, discount rate, cost of capital or required rate of return
n number of years
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PVo =
29
3/3/2015
CFn
(1 + i)n
100 000
(1 + 0.08)13
= 36 769,79 EUR
30
Solution (present value)

0.
Suppose, you are considering investment with cash

flows as follows: first year 200 USD, second year
400 USD, third year 600 USD and fourth year 800
USD.
In case your, as an investor, required rate of return
from that investment is 12%, what would be the
maximum amount of money what you are willing to
pay today for such cash flow?
1.
2.
3.
4.
200
400
600
800
12%
178.57
318.88
427.07
508.41
1432.93
3/3/2015
31
3/3/2015

A friend offers you an investment opportunity, where
investing today 100 USD, you will receive one year from now
40 USD and for two years from now 75 USD. In case, the
required rate of return according to the risk of the
investment is 15%, will you accept the offer?
Solution:
32
Case 7 (present value of annuity)

Suppose you are receiving 800 EUR at the end of
each month during the next four years. What is
the present value of such cash flow in case the
investors effective required rate of return is 12%
(EAR) and the interest is calculated monthly?
Calculate the present value of expected future cash flows:

PVo = 40/(1.15) + 75/(1.15)2 = 91.49 USD
Compare the present value of cash flow with initial investment
offering.
Decision?
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33
34
Change the effective interest rate to nominal:
iNOM =
Present value in terms of continuously

compounded interest rate
Solution (present value of annuity)
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12
1 + 0,12 1 12 = 0,00948879 12 = 11,39%
PVo =
Present value of ordinary annuity:
1 (1 + 0,009488 )48
PVA o = 800
0,009488
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= 800 38,41184 = 30 729,47 EUR
35
e = lim 1 +
m
m
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FVn
ein
mn
= 2.71828
36
The graph of loan amortization with

equal payments
Case 8 (loan amortization)

You are willing to take bank loan 300 000 EUR
with nominal interest rate 4%. Loan term will
be five years and during this time, the loan
will amortize totally with equal payments.
How much interest (in dollars) you must to
pay during the whole loan term?
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37
The graph of loan amortization with

equal payments of initial loan sum
1.
2.
3.
4.
5.
PVA o =
1.
2.
3.
4.
5.
Algjk Laenumakse Intress Phisumma Lppjk

300 000
67 388
12 000
55 388
244 612
244 612
67 388
9 784
57 604
187 008
187 008
67 388
7 480
59 908
127 100
127 100
67 388
5 084
62 304
64 796
64 796
67 388
2 592
64 796
0
36 941
3/3/2015
38
Present value interest factor of an

annuity, PVIFA
Algjk Phisumma Intress Laenumakse Lppjk

300 000
60 000
12 000
72 000
240 000
240 000
60 000
9 600
69 600
180 000
180 000
60 000
7 200
67 200
120 000
120 000
60 000
4 800
64 800
60 000
60 000
60 000
2 400
62 400
0
36 000
3/3/2015
Loan value
300 000
=
= 67 388 EUR
PVIFA5y,4% 4,451822
39
1 (1 + i)n 1
1
=
PVIFAi,n =
n
i
i i (1 + i)
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Present value interest factor of growing

annuity, PVIFGA
40
Present value of perpetuity, PVP
1 + g n

1
1
1 1+g 1+i
PVIFGA i,n, g =
, if i g
=
ig
i g i g 1 + i
n
=
, if i = g
1 + r
PVPo =
CF
i
CF cash flow of perpetuity

g growth rate
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41
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42
Present value of growing perpetuity,

PVGP
Case 9 (present value of perpetuity)

Consider the perpetuity of one dollar every
period your friend promises to pay you.
The interest rate or discount rate is 8.5%.
PVGPo =
Solution
PVo =
3/3/2015
1 USD
= 11.765 USD
0,085
CF1 cash flow of perpetuity at period 1

g growth rate
43
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Case 10
(present value of growing perpetuity)
PVGPo =
45
3/3/2015
46
Suppose you have been offered an investment

opportunity that allows you to double the invested
sum after 6 years. You have currently available to
invest 10 000 EUR.
FV
1
PV
400
400
=
= 57 234,50 EUR
0,009488 0,0025 0,006988
Case 11 (discount rate)
What would be the annual interest rate on the

investment?
FV
ln
PV
n=
ln(1 + i)
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44
Present value of growing perpetuity:
Formulas for finding the interest rate

and number of periods
i=n
Solution
Suppose you are receiving at the end of each

month 400 EUR and which grows every
month per 0,25%. What is the present value
of the cash flow with investors effective
interest rate 12%, compounded monthly?
3/3/2015
CFo (1 + g ) CF1
=
ig
ig
i = (FV / PV)1/n 1 = (20,000 / 10,000)1/6 1 =

0.122462 = 12.25%
47
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48
Case 12 (time value of money)

You are planning the consumption for your retirement and
you will find that you could need another 700 EUR in
addition to government pension. Suppose you will retire
at the age of 65 and you hope to get the pension at least
for 20 years. For that purpose you are going to save the
certain amount of money, starting from the age of 25. The
nominal interest rate of your deposited money is 10% per
year, compounded monthly. Let assume, for simplicity,
that there is no taxes and inflation.
Valuation of bonds.
Please find, what is the amount of money you should

deposit every month during these 40 years to your savings
account in order to allow yourself such additional
consumption plan during the retirement (assuming also
monthly withdrawing)?
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49
Possible components of the investors

required rate of return
Classification of bonds...
...according to term:
...according to issuance:
Commercial bonds
Govenrmental bonds
Municipal bonds
...according to interest payments:

Fixed interest rate
Variable interest rate
0-coupon bond
...according to collateral:
Secured bond
Unsecured bond
51
3/3/2015
52
Valuation formula of the bond
Bond characteristics/attributes:
The value of the bond derives from the sum of the

present value of bonds periodical interest
payments and its nominal value at the end of the
term.
Nominal value
Coupon rate
Term
Important relations:
In case the bonds coupon rate = market interest rate,

the bond is sold on a market near its nominal value.
In case the bonds coupon rate < market interest rate,
the bond is sold on the market under its nominal value
(i.e., with discount).
In case the bonds coupon rate > market interest rate,
the bond is sold on the market above its nominal value
(i.e., with premium).
3/3/2015
50
Short-term (money market instruments)

Long-term (capital market instruments)
Risk-free rate (compensation for postponing the

consumption and decreasing purchasing power)
Real risk free rate
Inflation premium
Risk premium (compensation for risktaking)
Size of the risk
Investors risk tolerance
Premium to cover the taxes and trading costs
3/3/2015
3/3/2015
53
INTt
Mn
+
t
(1 + YTM)n
t =1 (1 + YTM)
Vb =
Vb
INTt
Mn
t
n
YTM
3/3/2015
value of the bond

interest payments at the year t
nominal value of the bond
number of periods from 1 up to n
bonds term to maturity
yield to maturity, market rate of return
54
Case 13 (bond valuation)
Macaulay duration, MD
n
The required rate of return of the investor is 15% per year.

There are four different types of bonds described as follows:
Bond A without the term, carries only coupon interest
payments 120 per year.
Bond B term to maturity is 5-years, the nominal value is
1200, no interest payments.
Bond C 0-coupon bond (no interest payments) with
nominal value 1000 and term to maturity 6 years.
Bond D term to maturity 2 years, nominal value 1000,
interest payments 50, twice per year.
Please find: (1) what ise the maximum amount of price an
investor is willing to pay for above-described bond-types; (2)
rank the bonds according to their duration (from shorter to
longer).
t CFt
(1 + YTM)
D=
t =1
n
CFt
(1 + YTM)
t =1
CFt cash flow at period t

YTM discount rate
t
time weighting from 1 up to n
3/3/2015
55
3/3/2015
56
Type of shares
Common stock confirms the ownership of the
company, gives the owner the right to vote for
decisions in shareholders general meeting of the
company, gives the right to get a share from the
profit (dividends).
Preferred stock ownership confirming hybid-type
of security (bond + common share), a share
without the voting right, gives the privilege in
getting dividend payments and in distribution of
assets after the companys activity
Valuation of shares.
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57
Types of values of shares
58
Valuation models of the common shares
Nominal value
Accounting value
Market value ( market price, usually)
Fair value (= market value, usually; an accounting
term)
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59
Value of the common share derives from the

future cash flows from the share investment,
mainly from the dividends.
There are three main valuation models:
Dividends are not growing
Dividend growth is constant
Dividend growth is variable
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60
10
Valuation of common shares (1)
No dividend growth (similar to preferred stock):
Vo =
Common share with constant dividend growth (Gordons

dividend growth model):
Do
Ke
Vo =
V0 value of common share

D0 dividend per year
Ke investors required rate of return (discount rate)
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D1 expected (next year) dividend payment per year

Ke investors required rate of return (discount rate)
g constant dividend growth rate per year
61
Common stock with variable growth of dividends

(multiple period model):
Dt
t
t =1 (1 + K e )
Vo =
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In case the required rate of return of the investor is

10% per year and the last dividend payment (Do) of the
company was 2 USD per share, what will be the market
value of one share of the company?
63
3/3/2015
Solution (1)
D1
D2
D3
D4
(1 + K e ) (1 + K e )2 (1 + K e )3 (1 + K e )4
D5
Ke g
+
(1 + K e )4
V0 =
D 4 (1 + g 3 )
D 0 (1 + g 1 ) D1 (1 + g1 ) D 2 (1 + g 2 ) D 3 (1 + g 2 )
Ke g
V0 =
+
+
+
+
(1 + K e ) (1 + K e )2 (1 + K e )3 (1 + K e )4 (1 + K e )4
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64
Solution (2)
Solution formula:
V0 =
62
The growth of the companies income at first 2 years is

negative, i.e., 5% per year, thereafter the next 2 years
the growth will be 0% and since the 5th year, there
would be expected 6% per year in perpetuity.
D n+1
K g
+ e
(1 + K e )n
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Case 14 (valuation of common stock with

variable growth of dividends)
D1
D (1 + g)
= o
Ke g
Ke g
65
2(1 0.05) 1,90(1 0.05) 1.805(1 + 0 ) 1.805(1 + 0 )

+
+
+
+
(1.1)
(1.1)2
(1.1)3
(1.1)4
1.805(1 + 0.06 )
0.1 0.06 =
(1.1)4
1.9133
1.90 1.805 1.805 1.805
0.04 =
+
+
+
+
1.1
1.12
1.13
1.14
1.14
= 1,7273 + 1.4917 + 1.3561 + 1.2328 + 32.67 = 38.47 USD
3/3/2015
66
11
Solution (3)
Valuation of preferred stock
Graphically expressed solution:

0
g = 5%
D0=2.00
g = 5%
D1=1.90
D2=1.805
0.9091
g=0
g=0
D3=1.805
0.8264
0.7513
gn = 6%
D4=1.805
5
D5=1.913
Vp =
0.6830
1.727
1.492
1.356
1.233
P4 =
1.913
= 47.825
0.10 0.06
P0 = 38.47 USD
Kp
Vp value of preferred stock

Dp dividend per year (constant cash flow)
Kp investors required rate of return (discount rate)
32.665
3/3/2015
Dp
67
3/3/2015
68
12

Time Value of Money

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Time Value of Money

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The main principle of the time

value of money (TVM)

Financial Management [MJJV.10.055]

The value of money today is worth more

Kaia Kask, PhD

FINANCIAL MANAGEMENT (Kaia Kask)

1000 invested at 7% interest for 100

Value expresses an economic concept and is

FINANCIAL MANAGEMENT (Kaia Kask)

FINANCIAL MANAGEMENT (Kaia Kask)

Types of interest rates (1)

Present value (PV): an initial value at the beginning

Simple interest linear growth; interest earned

A bird in the hand is worth two in the bush

FINANCIAL MANAGEMENT (Kaia Kask)

only on the original investment

Compound interest geometric growth;

interest earned on interest

Continuous compounding exponential growth

FINANCIAL MANAGEMENT (Kaia Kask)

Figure 1. Calculation of future value of

The basic rule of compounding:

10% - compound interest

10% - simple interest

10% - continuous compounding

FINANCIAL MANAGEMENT (Kaia Kask)

Types of interest rates (2)

FINANCIAL MANAGEMENT (Kaia Kask)

...rental price for money.

the actual rate of interest earned (paid) after

FINANCIAL MANAGEMENT (Kaia Kask)

If m > 1, EAR will always be greater than the

iNOM nominal interest rate

FINANCIAL MANAGEMENT (Kaia Kask)

Values of interest rates at various

Effective annual interest rate, EAR

Interest rate is...

Nominal interest rate frequency of interest

FINANCIAL MANAGEMENT (Kaia Kask)

FINANCIAL MANAGEMENT (Kaia Kask)

EAR = lim 1 + nom 1 = einom 1

FINANCIAL MANAGEMENT (Kaia Kask)

Suppose, you are investing 10 000 USD for two

ireal inom iinfl

Ordinary cash flow

FINANCIAL MANAGEMENT (Kaia Kask)

FINANCIAL MANAGEMENT (Kaia Kask)

Ordinary annuity payments or receipts occur at

A perpetuity is a constant cash flow at regular

At a given time period the higher is the interest rate

At a given interest rate the longer the time period,

A growing perpetuity is a constant cash flow

5 years: PV = 500 / (1.1)5 = 310.46

that is expected to grow at a constant rate forever.

An annuity represents a series of equal

Cash flow models

Calculation basis of real interest rate, rreal

FINANCIAL MANAGEMENT (Kaia Kask)

FINANCIAL MANAGEMENT (Kaia Kask)

The basic assumptions in calculations

FINANCIAL MANAGEMENT (Kaia Kask)

Future value of money.

FINANCIAL MANAGEMENT (Kaia Kask)

Future value interest factor, FVIF