CH 4

Chapter 4
The Time Value

of Money
Copyright 2011 Pearson Prentice Hall. All rights reserved.
Chapter Outline
4.1 The Timeline
4.2 The Three Rules of Time Travel
4.3 Valuing a Stream of Cash Flows
4.4 Calculating the Net Present Value
4.5
Perpetuities, Annuities, and Other S
pecial Cases
4-2
Chapter Outline (contd)

4.6
Solving Problems with a Spreadshee
t Program
4.7
Solving for Variables Other Than Pre
sent Value or Future Value
4-3
Learning Objectives
1. Draw a timeline illustrating a given set of
cash flows.
2. List and describe the three rules of time
travel.
3. Calculate the future value of:
4. A single sum.
5. An uneven stream of cash flows, starting
either now or sometime in the future.
6. An annuity, starting either now or sometime
in the future.
4-4
Learning Objectives
7. Several cash flows occurring at regular
intervals that grow at a constant rate each
period.
8. Calculate the present value of:
9. A single sum.
10. An uneven stream of cash flows, starting
either now or sometime in the future.
11. An infinite stream of identical cash flows.
12. An annuity, starting either now or sometime
in the future.
4-5
Learning Objectives
13.
14.
15.
Given four out of the following five inputs for

an annuity, compute the fifth: (a) present
value, (b) future value, (c) number of periods,
(d) periodic interest rate, (e) periodic payment.
Given three out of the following four inputs for
a single sum, compute the fourth: (a) present
value, (b) future value, (c) number of periods,
(d) periodic interest rate.
Given cash flows and present or future value,
compute the internal rate of return for a series
of cash flows.
4-6
4.1 The Timeline

A timeline is a linear representation of the
timing of potential cash flows.
Drawing a timeline of the cash flows will
help you visualize the financial problem.
4-7
4.1 The Timeline (contd)

Assume that you made a loan to a friend.
You will be repaid in two payments, one at
the end of each year over the next two
years.
4-8

Differentiate between two types of cash
flows
Inflows are positive cash flows.
Outflows are negative cash flows, which are
indicated with a (minus) sign.
4-9

Assume that you are lending $10,000 today and that the
loan will be repaid in two annual $6,000 payments.
The first cash flow at date 0 (today) is represented as a

negative sum because it is an outflow.
Timelines can represent cash flows that take place at the
end of any time period a month, a week, a day, etc.
4-10
Textbook Example 4.1
4-11
Textbook Example 4.1 (contd)
4-12
4.2 Three Rules of Time Travel

Financial decisions often require combining
cash flows or comparing values. Three
rules govern these processes.
Table 4.1 The Three Rules of Time Travel
4-13
The 1st Rule of Time Travel

A dollar today and a dollar in one year are
not equivalent.
It is only possible to compare or combine
values at the same point in time.
Which would you prefer: A gift of $1,000 today
or $1,210 at a later date?
To answer this, you will have to compare the
alternatives to decide which is worth more. One
factor to consider: How long is later?
4-14
The 2nd Rule of Time Travel

To move a cash flow forward in time, you
must compound it.
Suppose you have a choice between receiving
$1,000 today or $1,210 in two years. You
believe you can earn 10% on the $1,000 today,
but want to know what the $1,000 will be
worth in two years. The time line looks like
this:
4-15
The 2nd Rule of Time Travel (contd)
Future Value of a Cash Flow

FVn C (1 r ) (1 r ) L (1 r ) C (1 r ) n
1 4 4 4 4 4 42 4 4 4 4 4 43
n times
4-16
Using a Financial Calculator: The

Basics
HP 10BII
Future Value
FV
Present Value
PV
I/YR
I/Y R
Interest Rate per Year

Interest is entered as a percent, not a decimal
For 10%, enter 10, NOT .10
4-17
Using a Financial Calculator:

The Basics (contd)
HP 10BII
Number of Periods
Periods per Year
Gold C All
N
P /Y R
G o ld
Clears out all TVM registers

Should do between all problems
4-18
Using a Financial Calculator:

Setting the keys
HP 10BII
Gold C All (Hold down [C] button)
Check P/YR
G o ld
# Gold P/YR
Sets Periods per Year to #
Gold DISP #
Gold and [=] button
Sets display to # decimal places
G o ld
G o ld
D IS P
P /Y R
4-19
Using a Financial Calculator

HP 10BII
Cash flows moving in opposite directions must
have opposite signs.
4-20
Financial Calculator Solution

Inputs:
N=2
I = 10
PV = 1,000
Output:
FV = 1,210
2
10
1,000
I/YR
PV
PMT
FV
-1,210
4-21
Figure 4.1 The Composition of Interest

Over Time
4-22
4-23
4-24

Financial Calculator Solution for n=7 years
Inputs:
N=7
I = 10
PV = 1,000
Output:
FV = 1,948.72
10
1,000
I/YR
PV
PMT
FV
-1,948.72
4-25
Alternative Example 4.2

Problem
Suppose you have a choice between receiving
$5,000 today or $10,000 in five years. You
believe you can earn 10% on the $5,000 today,
but want to know what the $5,000 will be
worth in five years.
4-26
Alternative Example 4.2 (contd)

Solution
The time line looks like this:
1
$ 5 ,0 0 0
x 1.10
$5, 500
x 1.10
$6,050
x 1 .10
$ 6 ,6 5 5
x 1.10
$ 7 ,3 2 1
x 1.10
$ 8 ,0 5 3
In five years, the $5,000 will grow to:

$5,000 (1.10)5 = $8,053
The future value of $5,000 at 10% for five years
is $8,053.
You would be better off forgoing the gift of $5,000 today
and taking the $10,000 in five years.
4-27

Inputs:
N=5
I = 10
PV = 5,000
Output:
FV = 8,052.55
5
10
5,0 0 0
I/Y R
PV
PM T
FV
-8,0 5 2 .5 5
4-28
The 3rd Rule of Time Travel

To move a cash flow backward in time, we
must discount it.
Present Value of a Cash Flow
(1 )
(1 )
4-29
4-30
4-31

Inputs:
N = 10
I=6
FV = 15,000
Output:
PV = 8,375.92
10
I/YR
15,000
PV
PMT
FV
-8,375.92
4-32

Problem
Suppose you are offered an investment that
pays $10,000 in five years. If you expect to
earn a 10% return, what is the value of this
investment today?
4-33

Solution
The $10,000 is worth:
$10,000 (1.10)5 = $6,209
4-34
Alternative Example 4.3:

Inputs:
N=5
I = 10
FV = 10,000
Output:
PV = 6,209.21
5
10
I/Y R
1 0,0 0 0
PV
PM T
FV
-6 ,2 0 9.2 1
4-35
Applying the Rules of Time Travel

Recall the 1st rule: It is only possible to
compare or combine values at the same
point in time. So far weve only looked at
comparing.
Suppose we plan to save $1000 today, and
$1000 at the end of each of the next two years.
If we can earn a fixed 10% interest rate on our
savings, how much will we have three years
from today?
4-36

(cont'd)
The time line would look like this:
4-37

(cont'd)
4-38

(cont'd)
4-39

(cont'd)
4-40

Table 4.1 The Three Rules of Time Travel
4-41
4-42
4-43

1,000
CFj
1,000
CFj
1,000
CFj
10
I/YR
Gold
NPV
2,735.54
4-44

Problem
Assume that an investment will pay you $5,000
now and $10,000 in five years.
The time line would like this:
0
$5,000
$10,000
4-45
Alternative Example 4.4 (cont'd)

Solution
You can calculate the present value of the combined cash
flows by adding their values today.
0
$5,000
$ 6,209
$11,209
1 .10 5
$10,000
The present value of both cash flows is $11,209.
4-46

Solution
You can calculate the future value of the

combined cash flows by adding their values
in Year 5.
1
$5 , 0 0 0
x 1.10 5
$1 0 , 0 0 0
$ 8 ,0 5 3
$1 8 , 0 5 3
The future value of both cash flows is $18,053.

4-47

Present
Value
0
$11,209
$18,053
1 .10 5
$11,209
x 1 .10
Future
Value
5
$18,053
4-48
4.3 Valuing a Stream of Cash Flows

Based on the first rule of time travel we
can derive a general formula for valuing a
stream of cash flows: if we want to find
the present value of a stream of cash
flows, we simply add up the present values
of each.
4-49
4.3 Valuing a Stream

of Cash Flows (contd)
Present Value of a Cash Flow Stream
( )
(1 )
4-50
4-51
4-52

0
CFj
5,000
CFj
8,000
CFj
8,000
CFj
8,000
CFj
I/YR
Gold
NPV
24,890.65
4-53
Future Value of Cash Flow Stream

Future Value of a Cash Flow Stream with a Present Value of
PV
(1 )
4-54

Problem
What is the future value in three years of the
following cash flows if the compounding rate
is 5%?
0
$ 2 ,0 0 0
$ 2 ,0 0 0
$ 2 ,0 0 0
4-55

Solution
1
$2 ,0 0 0
x 1. 05
x 1. 05
x 1 .05
x 1. 05
x 1 .05
$2 ,0 0 0
Or
$ 2 ,2 0 5
$ 2 ,0 0 0
$2 , 0 0 0
$2 ,0 0 0
$2 ,1 0 0
$ 4 ,1 0 0
$2 , 0 0 0
x 1. 05
x 1. 05
x 1 .05
$ 2 ,1 0 0
$ 6 ,6 2 0
3
$4 , 3 0 5
$ 6 ,3 0 5
x 1. 05
$ 2 ,3 1 5
$ 6 ,6 2 0
4-56
4.4 Calculating the Net Present

Value
Calculating the NPV of future cash flows
allows us to evaluate an investment
decision.
Net Present Value compares the present
value of cash inflows (benefits) to the
present value of cash outflows (costs).
4-57
4-58
Textbook Example 4.6 (cont'd)
4-59

-1,000
CFj
500
CFj
500
CFj
500
CFj
10
I/YR
Gold
NPV
243.43
4-60

Problem
Would you be willing to pay $5,000 for the
following stream of cash flows if the discount
rate is 7%?
0
$ 3 ,0 0 0
$ 2 ,0 0 0
$1 , 0 0 0
4-61

Solution
The present value of the benefits is:
3000 / (1.05) + 2000 / (1.05)2 + 1000 / (1.05)3 =
5366.91
The present value of the cost is $5,000,

because it occurs now.
The NPV = PV(benefits) PV(cost)
= 5366.91 5000 = 366.91
4-62

-5,000
CFj
3,000
CFj
2,000
CFj
1,000
CFj
I/YR
Gold
NPV
On a present value
basis, the benefits
exceed the costs by
$366.91.
366.91
4-63
4.5 Perpetuities, Annuities,

and Other Special Cases
When a constant cash flow will occur at
regular intervals forever it is called a
perpetuity.
4-64
4.5 Perpetuities, Annuities,

and Other Special Cases (contd)
The value of a perpetuity is simply the
cash flow divided by the interest rate.
Present Value of a Perpetuity
( in perpetuity)
4-65
4-66
4-67

Problem
You want to endow a chair for a female
professor of finance at your alma mater. Youd
like to attract a prestigious faculty member, so
youd like the endowment to add $100,000 per
year to the faculty members resources (salary,
travel, databases, etc.) If you expect to earn a
rate of return of 4% annually on the
endowment, how much will you need to donate
to fund the chair?
4-68

Solution
The timeline of the cash flows looks like this:
This is a perpetuity of $100,000 per year. The

funding you would need to give is the present
value of that perpetuity. From the formula:
PV
C $100,000
$2,500,000
r
.04
You would need to donate $2.5 million to endow

the chair.
4-69
Annuities
When a constant cash flow will occur at
regular intervals for a finite number of N
periods, it is called an annuity.
Present Value of an Annuity
N
C
C
C
C
C
PV
...
( 1 r ) ( 1 r )2 ( 1 r )3
( 1 r )N n1 ( 1 r )n
4-70

To find a simpler formula, suppose you
invest $100 in a bank account paying 5%
interest. As with the perpetuity, suppose
you withdraw the interest each year.
Instead of leaving the $100 in forever, you
close the account and withdraw the
principal in 20 years.
4-71
Present Value of an Annuity (contd)

You have created a 20-year annuity of $5
per year, plus you will receive your $100
back in 20 years. So:
$100 PV (20 year annuity of $5 per year) PV ($100 in 20 years)
Re-arranging terms:
PV (20 year annuity of $5 per year) $100 PV ($100 in 20 years)
100
100
$62.31
20
(1.05)
4-72

For the general formula, substitute P for
the principal value and:
PV(annuity of Cfor N periods)
P PV(Pin period N)
P
1
P
P 1
N
N
(1 r)
(1
r)
4-73
4-74
4-75

Since the payments begin today, this is an
Annuity Due.
First:
Gold
BEG/END
4-76
Textbook Example 4.8 Financial

Calculator Solution (contd)
Then:
30
I/YR
1,000,000
PV
PMT
FV
-12,158,406
$15 million > $12.16 million, so take the lump sum.
4-77
Future Value of an Annuity

Future Value of an Annuity
FV (annuity) = PV (1 + r ) N
C
1
=
1
r
(1 + r ) N
1
N
= C
(1
+
r
)
(1
+
r
)
4-78
4-79
4-80

Since the payments begin in one year, this
is an Ordinary Annuity.
Be sure to put the calculator back on End
mode:
Gold BEG/END
4-81
Textbook Example 4.9 Financial

Calculator Solution (contd)
Then:
30
10
I/YR
10,000
PV
PMT
FV
-1,644,940
4-82
Growing Perpetuities
Assume you expect the amount of your
perpetual payment to increase at a
constant rate, g.
Present Value of a Growing Perpetuity
(growing perpetuity)

4-83
4-84
4-85

Problem
In Alternative Example 4.7, you planned to
donate money to endow a chair at your alma
mater to supplement the salary of a qualified
individual by $100,000 per year. Given an
interest rate of 4% per year, the required
donation was $2.5 million. The University has
asked you to increase the donation to account
for the effect of inflation, which is expected to
be 2% per year. How much will you need to
donate to satisfy that request?
4-86

Solution
The timeline of the cash flows looks like this:
The cost of the endowment will start at $100,000,

and increase by 2% each year. This is a growing
perpetuity. From the formula:
PV
C $100,000
$5,000,000
r .04 .02
You would need to donate $5.0 million to endow the

chair.
4-87
Growing Annuities
The present value of a growing annuity
with the initial cash flow c, growth rate g,
and interest rate r is defined as:
Present Value of a Growing Annuity
1
1
1
( )
(1 )
4-88
4-89
4-90
4.6 Solving Problems with a

Spreadsheet Program
Spreadsheets simplify the calculations of
TVM problems
NPER
RATE
PV
PMT
FV
These functions all solve the problem:

V
1
1

(1 )
(1 )
4-91
4-92
4-93
4-94
4-95
4.7 Solving for Variables Other Than

Present Values or Future Values
Sometimes we know the present value or
future value, but do not know one of the
variables we have previously been given as
an input. For 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.
4-96
4-97
4-98

Present Values or Future Values (contd)
In some situations, you know the present
value and cash flows of an investment
opportunity but you do not know the
internal rate of return (IRR), the
interest rate that sets the net present
value of the cash flows equal to zero.
4-99
4-100
4-101
4-102
4-103

Present Values or Future Values (contd)
In addition to solving for cash flows or the
interest rate, we can solve for the amount
of time it will take a sum of money to grow
to a known value.
4-104
4-105
4-106
Discussion of Data Case Key Topic

Would your answer change if the
certification job would require her to stay
in Seattle but an MBA would allow her to
move to New York City, where Natasha has
always wanted to live?
Hint: Consider the cost of living differences
between Seattle and New York. Would her
salary be different in Seattle versus New York?
http://cgi.money.cnn.
com/tools/costofliving/costofliving.html
4-107
Chapter Quiz
1. Can you compare or combine cash flows at
different times?
2. How do you calculate the present value of a cash
flow stream?
3. What benefit does a firm receive when it accepts
a project with a positive NPV?
4. How do you calculate the present value of a
a.
b.
c.
d.
Perpetuity?
Annuity?
Growing perpetuity?
Growing annuity?
4-108

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CH 4

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Chapter 4

The Time Value

Copyright 2011 Pearson Prentice Hall. All rights reserved.

Chapter Outline (contd)

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Given four out of the following five inputs for

Copyright 2011 Pearson Prentice Hall. All rights reserved.

4.1 The Timeline

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4.1 The Timeline (contd)

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4.1 The Timeline (contd)

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4.1 The Timeline (contd)

The first cash flow at date 0 (today) is represented as a

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Textbook Example 4.1

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Textbook Example 4.1 (contd)

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4.2 Three Rules of Time Travel

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The 1st Rule of Time Travel

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The 2nd Rule of Time Travel

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The 2nd Rule of Time Travel (contd)

Future Value of a Cash Flow

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Using a Financial Calculator: The

Interest Rate per Year

Using a Financial Calculator:

Clears out all TVM registers

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Using a Financial Calculator:

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Using a Financial Calculator

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Financial Calculator Solution

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Figure 4.1 The Composition of Interest

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Textbook Example 4.2

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Textbook Example 4.2 (contd)

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Textbook Example 4.2

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Alternative Example 4.2

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Alternative Example 4.2 (contd)

In five years, the $5,000 will grow to:

Alternative Example 4.2

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The 3rd Rule of Time Travel

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Textbook Example 4.3

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Textbook Example 4.3

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Textbook Example 4.3

Alternative Example 4.3

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