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McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Corporate Finance
Ross - Westerfield - Jaffe
Sixth Edition
4
Chapter Four
The Time Value of
Money
Prepared by

Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline
4.1 The One-Period Case
4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
4.5 What Is a Firm Worth?
4.6 Summary and Conclusions
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4.1 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).
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4.1 The One-Period Case: Future Value
In the one-period case, the formula for FV can
be written as:
FV = C
0
(1 + r)

Where C
0
is cash flow at date 0 and r is the
appropriate interest rate.
FV = $10,500
Year 0 1
C
0
= $10,000
$10,000 1.05
C
0
(1 + r)
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4.1 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.
05 . 1
000 , 10 $
81 . 523 , 9 $ =
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).
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4.1 The One-Period Case: Present Value
In the one-period case, the formula for PV can
be written as:

r
C
PV
+
=
1
1
Where C
1
is cash flow at date 1 and r is
the appropriate interest rate.
C
1
= $10,000
Year 0 1
PV = $9,523.81
$10,000/1.05
C
1
/(1 + r)
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4.1 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?
81 . 23 $
81 . 523 , 9 $ 500 , 9 $
05 . 1
000 , 10 $
500 , 9 $
=
+ =
+ =
NPV
NPV
NPV
Yes!
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4.1 The One-Period Case: Net Present Value
In the one-period case, the formula for NPV can be
written as:
PV Cost NPV + =
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.

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4.2 The Multiperiod Case: Future Value
The general formula for the future value of an
investment over many periods can be written
as:
FV = C
0
(1 + r)
T
Where
C
0
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.
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4.2 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 = C
0
(1 + r)
T

$5.92 = $1.10(1.40)
5
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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.
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Future Value and Compounding
0 1 2 3 4 5
10 . 1 $
3
) 40 . 1 ( 10 . 1 $
02 . 3 $
) 40 . 1 ( 10 . 1 $
54 . 1 $
2
) 40 . 1 ( 10 . 1 $
16 . 2 $
5
) 40 . 1 ( 10 . 1 $
92 . 5 $
4
) 40 . 1 ( 10 . 1 $
23 . 4 $
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Present Value and Compounding
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%?
0 1 2 3 4 5
$20,000 PV
5
) 15 . 1 (
000 , 20 $
53 . 943 , 9 $ =
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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?
T
r C FV ) 1 (
0
+ =
T
) 10 . 1 ( 000 , 5 $ 000 , 10 $ =
2
000 , 5 $
000 , 10 $
) 10 . 1 ( = =
T
2 ln ) 10 . 1 ln( =
T
years 27 . 7
0953 . 0
6931 . 0
) 10 . 1 ln(
2 ln
= = = T
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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%.
What Rate Is Enough?
T
r C FV ) 1 (
0
+ =
12
) 1 ( 000 , 5 $ 000 , 50 $ r + =
10
000 , 5 $
000 , 50 $
) 1 (
12
= = + r
12 1
10 ) 1 ( = +r
2115 . 1 2115 . 1 1 10
12 1
= = = r
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4.3 Compounding Periods
Compounding an investment m times a year for
T years provides for future value of wealth:
T m
m
r
C FV

|
.
|

\
|
+ = 1
0
For example, if you invest $50 for 3 years at
12% compounded semi-annually, your
investment will grow to
93 . 70 $ ) 06 . 1 ( 50 $
2
12 .
1 50 $
6
3 2
= =
|
.
|

\
|
+ =

FV
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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:
93 . 70 $ ) 06 . 1 ( 50 $ )
2
12 .
1 ( 50 $
6 3 2
= = + =

FV
93 . 70 $ ) 1 ( 50 $
3
= + EAR
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Effective Annual Interest Rates (continued)
So, investing at 12.36% compounded annually
is the same as investing at 12% compounded
semiannually.
93 . 70 $ ) 1 ( 50 $
3
= + = EAR FV
50 $
93 . 70 $
) 1 (
3
= + EAR
1236 . 1
50 $
93 . 70 $
3 1
=
|
.
|

\
|
= EAR
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Continuous Compounding (Advanced)
The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C
0
e
rT
Where
C
0
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. e
x
is a key on your calculator.
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4.4 Simplifications
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.
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Perpetuity
A constant stream of cash flows that lasts forever.
0

1
C
2
C
3
C
The formula for the present value of a perpetuity is:
+
+
+
+
+
+
=
3 2
) 1 ( ) 1 ( ) 1 ( r
C
r
C
r
C
PV
r
C
PV =
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Perpetuity: Example
What is the value of a British consol 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.
0

1
15
2
15
3
15
150
10 .
15
= = PV
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Growing Perpetuity
A growing stream of cash flows that lasts forever.
0

1
C
2
C(1+g)
3
C (1+g)
2
The formula for the present value of a growing perpetuity is:
+
+
+
+
+
+
+
+
=
3
2
2
) 1 (
) 1 (
) 1 (
) 1 (
) 1 ( r
g C
r
g C
r
C
PV
g r
C
PV

=
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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?
0

1
$1.30
2
$1.30(1.05)
3
$1.30 (1.05)
2
00 . 26 $
05 . 10 .
30 . 1 $
=

= PV
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Annuity
A constant stream of cash flows with a fixed maturity.
0 1
C
2
C
3
C
The formula for the present value of an annuity is:
T
r
C
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 ( ) 1 (
3 2
+
+
+
+
+
+
+
=
(

+
=
T
r r
C
PV
) 1 (
1
1
T
C

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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?
0
1
$400
2
$400
3
$400
59 . 954 , 12 $
) 12 07 . 1 (
1
1
12 / 07 .
400 $
36
=
(

+
= PV
36
$400

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Annuity: Canadian Mortgages
What is special about Canadian Mortgages?

Canadian banks quote the annual interest
compounded semi-annually for mortgages, although
interest is calculated (compounded) every month.

The terms of the mortgage are usually renegotiated
during the term of the mortgage. For example, the
interest of a 25-year mortgage can be negotiated 5
years after the initiation of the mortgage.
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Canadian Mortgages: Example
You have negotiated a 25-year, $100,000 mortgage at a
rate of 7.4% per year compounded semi-annually with
the Toronto-Dominion Bank. What is your monthly
payment?

To answer this question, we first have to convert the
quoted mortgage rate, to the effective interest rate
charged each month.

We have:
% 5369 . 7 075369 . 1
2
074 . 0
1
2
= =
|
.
|

\
|
+ = EAR
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We use the present value of annuity formula to find
the monthly payment (PMT):
Canadian Mortgages: Example (Continued)
The effective interest rate charged each month is
given by:
( ) % 607369 . 00607369 . 1 075369 . 0 1
12
1
= = +
(

+
=
300
) 00607369 . 1 (
1
1
00607369 .
000 , 100
PMT
28 . 725 $ = PMT
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Growing Annuity
A growing stream of cash flows with a fixed maturity.
0 1
C
The formula for the present value of a growing annuity:
T
T
r
g C
r
g C
r
C
PV
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
1
2
+
+
+ +
+
+
+
+
=

(
(

|
|
.
|

\
|
+
+

=
T
r
g
g r
C
PV
) 1 (
1
1

2
C(1+g)
3
C (1+g)
2
T
C(1+g)
T-1
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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?
0 1
$20,000
57 . 121 , 265 $
10 . 1
03 . 1
1
03 . 10 .
000 , 20 $
40
=
(
(

|
.
|

\
|

= PV

2
$20,000(1.03)
40
$20,000(1.03)
39
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4.5 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.
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4.6 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:

=
+
+ =
+
+ +
+
+
+
+ =
N
t
t N
r
C
C
r
C
r
C
r
C
C NPV
1
0
2
0
) 1 ( ) 1 ( ) 1 ( ) 1 (

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4.6 Summary and Conclusions (continued)
We presented four simplifying formulae:

r
C
PV = : Perpetuity
g r
C
PV

= : Perpetuity Growing
(

+
=
T
r r
C
PV
) 1 (
1
1 : Annuity
(
(

|
|
.
|

\
|
+
+

=
T
r
g
g r
C
PV
) 1 (
1
1 : Annuity Growing
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How do you get to Bay Street?
Practice, practice, practice.
Its easy to watch Olympic gymnasts and
convince yourself that you are a leotard
purchase away from a triple back flip.
Its also easy to watch your finance professor
do time value of money problems and
convince yourself that you can do them too.
There is no substitute for getting out the
calculator and flogging the keys until you can
do these correctly and quickly.