Time Value of Money

FINC 361 Fall 2016

Professor Mahdi Mohseni

The Time Value of Money

The Time Value of Money
o In general, a dollar today is worth more than a
dollar in one year
If you have $1 today and you can deposit it in a bank at
10%, you will have $1.10 at the end of one year

o The difference in value between money today and

money in the future is the time value of money.

The Time Value of Money

The Interest Rate: Converting Cash Across Time
o Present Value:
the value of a cost or benefit (cash flow) computed in
terms of cash today

o Future Value:
the value of a cash flow that is moved forward in time

The Time Value of Money

The Interest Rate: Converting Cash Across Time
o By depositing money, we convert money today into
money in the future
o By borrowing money, we exchange money today for
money in the future

Interest Rate (r)

The rate at which money can be borrowed or lent over a

given period

Interest Rate Factor (1 + r)

It is the rate of exchange between dollars today and dollars

in the future

The Time Value of Money

Money in the future is worth less today so its
price reflects a discount
Discount Rate
The appropriate rate to discount a cash flow to
determine its value at an earlier time

Discount Factor
The value today of a dollar received in the future,
expressed as:
1
1+ r

The Time Value of Money

Example: Evaluate a firm's investment opportunity with a cost of
$100,000 today and a benefit of $105,000 at the end of one year.
(assume interest rate is 10%)

NPV = $95,454.55 - $100,000 = -$4,545.45

The Time Value of Money

Timelines
o Constructing a Timeline
o Identifying Dates on a Timeline
Date 0 is today, the beginning of the first year
Date 1 is the end of the first year

The Time Value of Money

Timelines
o Distinguishing Cash Inflows from Outflows

o Representing Various Time Periods

Just change the label from Year to Month if monthly

Valuing Cash Flows at Different Points in Time

Rule 1: Comparing and Combining Values
o It is only possible to compare or combine values at
the same point in time

Valuing Cash Flows at Different Points in Time

Rule 2: Compounding
o To calculate a cash flows future value, you must
compound it

Valuing Cash Flows at Different Points in Time

Rule 2: Compounding
o Compound Interest
The effect of earning interest on interest

Valuing Cash Flows at Different Points in Time

Rule 3: Discounting
o To calculate the value of a future cash flow at an
earlier point in time, we must discount it.

Example 1 - Present Value of a Single Future Cash Flow

Problem:
XYZ Company expects to receive a cash flow of $2 million in five years. If
the competitive market interest rate is fixed at 4% per year, how much can
they borrow today in order to be able to repay the loan in its entirety with
that cash flow?

Example 1 - Present Value of a Single Future Cash Flow

Solution:
Plan:
First set up your timeline. The cash flows for the loan are represented by
the following timeline:

Thus, XYZ Company will be able to repay the loan with its expected $2
million cash flow in five years. To determine the value today, we compute
the present value using Eq. 3.2 and our interest rate of 4%.

The Three Rules of Valuing Cash Flows

Valuing a Stream of Cash Flows

Applying the Rules of Valuing Cash Flows
Suppose we plan to save $1,000 today, and $1,000 at the end
of each of the next two years
If we earn a fixed 10% interest rate on our savings, how much
will we have three years from today?

Valuing a Stream of Cash Flows

Consider a stream of cash flows: C0 at date 0, C1 at date 1,
and so on, up to CN at date N

We compute the present value of this cash flow stream in two

steps

Valuing a Stream of Cash Flows

First, compute the present value of each cash flow
Then combine the present values

Example 2 - Present Value of a Stream of Cash Flows

Problem:

You have just graduated and need money to pay the deposit
on an apartment. Your older sister will lend you the money so
long as you agree to pay her back within six months. You offer
to pay her the rate of interest that she would otherwise get by
putting her money in a savings account. Based on your
earnings and living expenses, you think you will be able to pay
her $70 next month, $85 in each of the next two months, and
then $90 each month for months 4 through 6. If your sister
would otherwise earn 0.5% per month on her savings, how
much can you borrow from her?

Example 2 - Present Value of a Stream of Cash Flows

Solution:
The cash flows you can promise your sister are as follows:

She should be willing to give you an amount equal to these payments in

present value terms.

Example 2 - Present Value of a Stream of Cash Flows

Solution:

We can calculate the PV as follows:

70
85
85
90
90
90
PV =
+
+
+
+
+
2
3
4
5
1.005 1.005 1.005 1.005 1.005 1.0056
=$69.65 + $84.16 + $83.74 + $88.22 + $87.78 + $87.35
= $500.90

Example 2 - Present Value of a Stream of Cash Flows

Now, suppose that your sister gives you the money, and then
deposits your payments in the bank each month.
How much will she have six months from now?

Example 2 - Present Value of a Stream of Cash Flows

We need to compute the future value of the monthly deposits.
One way is to compute the bank balance each month.

Example 2 - Present Value of a Stream of Cash Flows

To verify our answer, suppose your sister kept her $500.90 in the bank
today earning 6% interest.
In six months she would have:
FV= $500.90(1.005)6= $516.11 in 6 months

Perpetuities, Annuities,
and Other Special Cases
For specific patterns of cash flow streams,
shortcuts are given by specific formulas
1. Big advantage (time and effort) in recognizing the
patterns and applying the formulas appropriately
2. Be careful: Make sure the stream of cash flows
follows exactly the pattern that goes with the
formula
Sometimes they dont fit exactlyclassic exam trick!

1. Perpetuities
When a constant cash flow will occur at regular
intervals forever it is called a perpetuity
The stream starts one period from now
C

Time 0

Time 1

Time 2

Timeline

The PV of a perpetuity is given by a simple

formula:

C
PV (C in perpetuity) =
r

Perpetuities
The present value of a perpetuity with
payment C and interest rate r is given by:
C
C
C
PV=
+
+
+ ......
2
3
(1 + r) (1 + r) (1 + r)

Notice that all the cash flows are the same

Also, the first cash flow starts at time 1

Perpetuities
Present Value of a Perpetuity
C
C
C
PV=
+
+
+ ......
2
3
(1 + r) (1 + r) (1 + r)

Time (1+r) at both sides of the equation

(1+r)*PV = C + C/(1+r) + C/(1+r)2 + C/(1+r)3 +
(1+r)*PV = C + PV
r*PV = C

Example 3 - Endowing a Perpetuity

Problem:

You just won the lottery, and you want to endow a professorship at Texas
A&M.
You are willing to donate $4 million of your winnings for this purpose.
If the university earns 5% per year on its investments, and the professor
will be receiving her first payment in one year, how much will the
endowment pay her each year?

Example 3 - Endowing a Perpetuity

Solution:

The timeline of the cash flows you want to provide is:

=
=

= = , , . = ,

If you donate $4,000,000 today, and if the university invests it at 5% per

year forever, then the chosen professor will receive $200,000 every year.

2. Annuities
When a constant cash flow will occur at regular
intervals for N periods it is called an annuity
Very common: Examples?
The stream starts one period from now
C

Timeline
Time 0

Time 1

Time 2

Time N

Present Value of an Annuity:

1
1
PV (annuity of C for N periods with interest rate r ) =
C
1

(1 + r ) N
r

Present Value of An Annuity

Note that, just as with the perpetuity, we
assume the first payment takes place one
period from today
C
C
C
C
PV=
+
+
+ ......
2
3
(1 + r) (1 + r) (1 + r)
(1 + r) N

(Eq. 4.3)

1
1
PV (annuity of C for N periods with interest rate r ) =
C
1

(1
r
r)N

Intuition: create your own annuity from perpetuity

Example 4 - Present Value of a Lottery Prize Annuity

Problem:
You are the lucky winner of the $30 million state lottery.
You can take your prize money either as (a) 30 payments of $1 million per
year (starting today), or (b) $15 million paid today.
If the interest rate is 8%, which option should you take?

Example 4 - Present Value of a Lottery Prize Annuity

Solution:
Option (a) provides $30 million in prize money but paid over time. To
evaluate it correctly, we must convert it to a present value. Here is the
timeline:

Because the first payment starts today, the last payment will occur in 29
years (for a total of 30 payments).
The $1 million at date 0 is already stated in present value terms, but we
need to compute the present value of the remaining payments.
Fortunately, this case looks like a 29-year annuity of $1 million per year, so
we can use the annuity formula.

Example 4 - Present Value of a Lottery Prize Annuity

Solution :
Value of the annuity part is,

1
1
PV( 29-year annuity of $1million) = $1 million
1

0.08
1.0829
= $1 million 11.16
= $11.16 million today
Thus, the total present value of the cash flows is $1 million + $11.16
million = $12.16 million

Future value of annuity

Formula:

FV (annuity) =

PV (1 + r ) N

C
1
1

r
(1 + r ) N
1
(1 + r ) N
=C
(
r

N
(1
r
)

1)

Typical examples: Saving for retirement and college funds

Example 5 - Retirement Savings Plan Annuity

Problem:
Ellen is 35 years old, and she has decided it is time to plan seriously for her
retirement.
At the end of each year until she is 65, she will save $10,000 in a
retirement account.
If the account earns 10% per year, how much will Ellen have saved at age
65?

Example 5 - Retirement Savings Plan Annuity

Solution:
As always, we begin with a timeline. In this case, it is helpful to keep track
of both the dates and Ellens age:

Ellens savings plan looks like an annuity of $10,000 per year for 30 years.
(Hint: It is easy to become confused when you just look at age, rather than
at both dates and age. A common error is to think there are only 65-36=
29 payments. Writing down both dates and age avoids this problem.)
To determine the amount Ellen will have in the bank at age 65, well need
to compute the future value of this annuity.

Example 5 - Retirement Savings Plan Annuity

Solution:
1
FV = $10,000
(1.1030 1)
0.10
= $10,000 164.49
= $1.645 million at age 65

By investing $10,000 per year for 30 years (a total of

$300,000) and earning interest on those investments, the
compounding will allow her to retire with $1.645 million.

Example 6 - Retirement Savings Plan Annuity

Problem:
Adam is 25 years old, and he has decided it is time to plan seriously for his
retirement.
He will save $10,000 in a retirement account at the end of each year until
he is 45.
At that time, he will stop paying into the account, though he does not plan
to retire until he is 65.
If the account earns 10% per year, how much will Adam have saved at age
65?

Example 6 - Retirement Savings Plan Annuity

Solution:

As always, we begin with a timeline. In this case, it is helpful to keep track

of both the dates and Adams age:

Adams savings plan looks like an annuity of $10,000 per year for 20 years.
The money will then remain in the account until Adam is 65 20 more
years.
To determine the amount Adam will have in the bank at age 45, well need
to compute the future value of this annuity.
Then well compound the future value into the future 20 more years to
see how much hell have at 65.

Example 6 - Retirement Savings Plan Annuity

Solution:
PV(savings)=

+.

= $

6 = ( + . )
= $3,853,175

3. Growing Perpetuities

When a growing cash flow will occur at regular

intervals forever it is called a growing perpetuity
The stream starts one period from now
Growth rate: g

C(1+g)

C(1+g)

C(1+g)

Time 0

Time 1

Time 2

Timeline

The PV of a growing perpetuity is given by a

simple formula:
C
PV (growing perpetuity) =
r g

4. Growing Annuities
When a growing cash flow will occur at regular
intervals for N periods it is called a growing annuity
The stream starts one period from now
Growth rate: g

C(1+g)

C(1+g)(N-1)

C(1+g)

C(1+g)

Timeline

Time 0

Time 1

Time 2

Time N

PV (growing annuity) is given by a simple formula:

N

1 + g
1
1
PV =
C

(r g )
(1 + r )

Example 7 - Retirement Savings with a Growing Annuity

Problem:
In Example 5, Ellen considered saving $10,000 per year for her retirement.
Although $10,000 is the most she can save in the first year, she expects
her salary to increase each year so that she will be able to increase her
savings by 5% per year. With this plan, if she earns 10% per year on her
savings, how much will Ellen have saved at age 65?

To solve it, do it in two steps:

1. Compute the PV(growing annuity) of Ellens savings
2. From this PV -> compute FV at retirement in 30 years

Example 7 - Retirement Savings with a Growing Annuity

Solution:

Her new savings plan is represented by the following timeline:

This example involves a 30-year growing annuity with a growth

rate of 5% and an initial cash flow of $10,000. We can use Eq.
4.8 to solve for the present value of a growing annuity.

Example 7 - Retirement Savings with a Growing Annuity

Solution:
The present value of Ellens growing annuity is given by:

1.05 30
1
PV= $10,000
1

0.10 - 0.05 1.10
= $10,000 15.0463
= $150, 463today

Example 7 - Retirement Savings with a Growing Annuity

Solution:
Ellens proposed savings plan is equivalent to having $150,463
in the bank today. To determine the amount she will have at
age 65, we need to move this amount forward 30 years:

FV= $150, 463 1.1030

= $2.625 million in 30 years

Example 7 - Retirement Savings with a Growing Annuity

Solution :
Ellen will have saved $2.625 million at age 65 using the new savings plan.
This sum is almost $1 million more than she had without the additional
annual increases in savings.
Because she is increasing her savings amount each year and the interest
on the cumulative increases continues to compound, her final savings is
much greater.

Solving for variables other than

present value (PV) or future value (FV)
What if you know the present value or future
value, but not all the other inputs in the formula?
Classic 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

Example 8 - Computing a Loan Payment

Problem:
Suppose you accept your parents offer of a 2012 BMW M6 convertible,
but thats not the kind of car you want.
Instead, you sell the car for $61,000 and use that money for a down
payment on an Aston Martin V8 Vantage Roadster. You got a real bargain
at $110,000!
The bank offers you a 5-year loan with equal monthly payments and an
interest rate of 4% per year.
What will be the payment on the loan?

Example 8 - Computing a Loan Payment

Solution:
The loan amount is $110,000 $61,000 = $49,000
Note, we need to use the monthly interest rate. Since the quoted rate is
an APR, we can just divide the annual rate by 12:
r = .04/12 = .0033

Example 8 - Computing a Loan Payment

= $.

Internal rate of return (IRR)

In some situations, you know:
All cash flows of an investment opportunity
but you do not know the internal rate of return (IRR):
IRR =

Implicit interest rate that sets the net

present value (NPV) of the cash flows equal to
zero

Intuitive example of IRR

In simple cases, you can solve without a financial
calculator the problem
Imagine the following cash flows:
+$2,000

Time 0

Time 6
-1,000

The IRR of this project is found by solving:

NPV = 1000 +

2000
=0
6
(1 + r )

1000 (1 + r ) 6 = 2000
1/ 6

2000
1+ r =
= 1.1225
1000
So IRR = 12.25%

Timeline

In more complicated cases, you

need a financial calculator

Solution

No analytical way to solve the boxed equation

Manual trial and error: Painful!
Use a calculator or an Excel spreadsheet!
If you solve this equation, you get IRR=12.09%

Number of years for money to

grow by a certain amount
We have played with C and r, what about N?
Typical question: How many years will it take
for a particular investment to yield a specified
amount?

Solution

Now use a mathematical trick: Take the logs Remember : ln( x y ) = y ln( x)

Effective Annual Rate (EAR)

The Effective Annual Rate (EAR)
EAR = total amount of interest earned over one year

This is what we have used up to now in the class

Trivial example:
EAR = 5%
$100,000 invested for one year will give
$100,000(1+.05)=$105,000

Mismatch between cash flows timeline

and interest rate
What is todays value of a bond that pays an amount of
$100 (coupon) every three years forever?
Effective Annual Rate = 10%

Rule:

1. Never change the cash flows

2. Always adapt the interest rate
+$100

+$100

+$100

Time 0
Year 2
-$X

Year 4

Year 6

Timeline

Equivalent n-period discount rate:

Going from 1 year to 2 years

Suppose EAR: 5%
Example 1:

Suppose we want the equivalent interest rate over two years (n=2)
Hint: It is not 10%!
Why?
Compound interest!

(1+0.05)

(1+0.05)

Time 0

Time 0
1 year

2 years

-1,000

2 years
-1,000

$1,000(1+.05) = $1,000(1+r2 years)

r2 years = (1.05)2-1 = 10.25%

(1+r2 years)

Equivalent n-period discount rate:

Going from 1 year to six months

Suppose EAR: 5%
Example 1:

Suppose we want the equivalent interest rate over six months (n=1/2)
Hint: It is not 2.5%!

Time 0

(1+r6 months) (1+r6 months)

6 months

(1+0.05)
Time 0

1 year

-1,000

1 year
-1,000

$1,000(1+r6 months) = $1,000(1+0.05)

r6 months = (1.05)1/2-1 = 2.4695%

Solution to the initial problem

What is todays value of a bond that pays an amount of
$100 (coupon) every three years forever?
Effective Annual Rate = 10%

Compute the appropriate discount rate and it is trivial!

+$100

+$100

+$100

Time 0
Year 2
-$X

Year 4

Year 6

Timeline

Annual Percentage Rates (APR)

The annual percentage rate (APR) is a
conventional way to quote interest rates
However: APR quote is a weird way to quote a rate
Typically: APR Actual interest rate
Why?
Because it does not include the effect of compounding

Conversion of APR to EAR

APR needs to be converted to EAR
Need to know what is the corresponding effective annual rate!

Two necessary steps:

1. An APR is always quoted with the number of
compounding period (k)
APR/k = Interest rate for the compounding period

2. To get the EAR we need to compound (APR/k) for

the k periods in a year:
APR

1 + EAR =1 +

Example
APR = 6% with monthly compounding
Step 1: k=12 so 6%/12 = 0.5% per month
Step 2: Annual conversion
(1+APR/12)

Time 0

(1+APR/12)

(1+APR/12)

1m 2m 3m

(1+APR/12)

Time 0

(1+r1 year)

1 year

-1,000

1 year
-1,000

1+r1 year = (1+APR/12)12 = (1+0.06/12)12 = 1.06178

So r1 year = EAR = 6.178%

Compounding period
Most of the time, the APR is given with a
monthly compounding period
But suppose an APR is quoted at 6% with
quarterly compounding (every three months)
What is the EAR now?
Step 1:
Step 2:

More examples of conversion

EAR increases as the compounding period gets smaller. Why?

Because you get compounded interest sooner!

Revisit Example 8 - Computing a Loan Payment

Problem:
Suppose you accept your parents offer of a 2012 BMW M6 convertible,
but thats not the kind of car you want.
Instead, you sell the car for $61,000 and use that money for a down
payment on an Aston Martin V8 Vantage Roadster. You got a real bargain
at $110,000!
The bank offers you a 5-year loan with equal monthly payments and an
interest rate of 4% per year (This 4% is an APR).
What will be the payment on the loan?

Revisit Example 8 - Computing a Loan Payment

Solution:
The loan amount is $110,000 $61,000 = $49,000
Note, we need to use the monthly interest rate. Since the quoted rate is
an APR, we can just divide the annual rate by 12:
r = .04/12 = .0033

Revisit Example 8 - Computing a Loan Payment

= $.

Application: The refinancing problem

Computing the outstanding balance on a loan

Amortizing loans

You reimburse part of your loan at each payment

Hence, after X number of payments, you can ask

yourself:
How much of the loan do I still need to pay back?
Basically, how much outstanding balance is there remaining
on my loan?

The answer to this question is very valuable:

Suppose you want to get pay off your loan before maturity
You need to prepare for your meeting with your banker!

Example
Ten years ago, you borrowed $3M to purchase
an office building
Loan had APR 7.80% and monthly payments over
30 years (360 payments)
You just completed the 120th payment today
240 remaining payments starting one month from now

How much do you still owe on the loan today?

I.e. what is the outstanding balance on your loan?

Step 1
You first need to figure out what the monthly
payment are equal to in this loan.
Step 1: Timeline

Step 2: Solve for C (monthly payment)

Answer: $21,596

Step 2
We know there are 20 years to go on the loan, i.e. 240 monthly payments of $21,596
By definition, the banker will be indifferent between:
1. Getting today the amount equal to PV(all the remaining monthly payments);
2. Getting over the coming 20 years all the remaining monthly payments
Hence, the remaining balance of the loan is simply the present value of all future
cash flow you still owe the bank
Timeline:

Solution:

Answer: $2.62M

Refinancing
Interest rates have gone down in the last 10 years
Thank you the FED!

Now you can get a new loan for 20 years with a low
APR = 4% (monthly compounding)
Suppose you take a new 20 year loan with the bank
to pay down your outstanding balance of $2.62M
1. What will be your new monthly payment?
2. How does the low interest rate hurt the bank?

Solution: Timeline

Solution: Maths
APR = 4% with monthly compounding
Rmonthly =

Solve for the monthly payment:

What just happened?

The bank was expecting you to pay more than
$21K a month for the next 20 years
You made them whole on the existing loan

BUT, the banker has to put the money he received

back to worki.e. he needs to loan out the money
again
and now the interest rate environment is such
that to whomever he gives out the loan, the
monthly loan payments will be lower than before!

How much worse off is the bank?

Well, we assumed that the banker would loan out
the money to none other than you, such that you can
refinance your existing loan
We saw that your new monthly payments for the next 20
years are much lower
$15.88K << $21.59K

This is called pre-payment or refinancing risk

It can create havoc for banks!

Application: //ZW

When the costs of an investment precede the

benefits, a decrease (increase) in the interest rate
will increase (decrease) the investments NPV

. The FEDs actions promote investments. How?

Reducing interest rates by the FED could potentially

expand the set of positive NPV investment opportunities.

You can now do it all!

Given:
1. Discount rate r
2. Cash flows (CF0, CF1, CF2, etc.)

You can perform any computations you want!

In future classes, our mission will be to find:
1. The appropriate discount rate r and;
2. The relevant cash flows (CF0, CF1, CF2, etc.)