Chapter 4

Future Value, Present Value,

and Interest Rates
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 Learning Objectives
1. Compare the value of monetary payments
using present value and future value.
2. Apply present value to a stream of payments
using internal rate of return and bond
valuation.
3. Explain the difference between real and
nominal interest rates and how each is
calculated.

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 Introduction
• Credit is one of the critical mechanisms we
have for allocating resources.
• Although interest has historically been
unpopular, this comes from the failure to
appreciate the opportunity cost of lending.
• Interest rates
– Link the present to the future.
– Tell the future reward for lending today.
– Tell the cost of borrowing now and repaying later.

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Valuing Monetary Payments Now and in
the Future
• We must learn how to calculate and compare
rates on different financial instruments.
• We need a set of tools:
– Future value
– Present value

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 Future Value and Compound
Interest
• Future value is the value on some future date
of an investment made today.
– $100 invested today at 5% interest gives $105 in a
year. So the future value of $100 today at 5%
interest is $105 one year from now.
– The $100 yields $5, which is why interest rates are
sometimes called a yield.
– This is the same as a simple loan of $100 for a year
at 5% interest.

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 Future Value and Compound
Interest
• If the present value is $100 and the interest
rate is 5%, then the future value one year from
now is:
$100 + $100(0.05) = $105
• This also shows that the higher the interest
rate, the higher the future value.
• In general:
FV = PV + PV(i) = PV(1 + i)

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 Future Value and Compound
Interest
• The higher the interest rate or the higher the
amount invested, the higher the future value.
• Most financial instruments are not this simple,
so what happens when time to repayment
varies.
• When using one-year interest rates to
compute the value repaid more than one year
from now, we must consider compound
interest.
– Compound interest is the interest on the interest.
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 Future Value and Compound
Interest
• What if you leave your $100 in the bank
for two years at 5% yearly interest rate?
• The future value is:
$100 + $100(0.05) + $100(0.05) + $5(0.05) = $110.25
$100(1.05)(1.05) = $100(1.05)2

• In general
FVn = PV(1 + i)n

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Future Value and Compound
Interest
• Table 4.1: Computing the future value of
$100 at 5% annual interest

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 Future Value and Compound
Interest
• Converting n from years to months is easy, but
converting the interest rate is harder.
– If the annual interest rate is 5%, what is the
monthly rate?
• Assume im is the one-month interest rate and
n is the number of months, then a deposit
made for one year will have a future value of
$100(1 + im)12.

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 Future Value and Compound
Interest
• We know that in one year the future
value is $100(1.05) so we can solve for
im:
(1 + im)12 = (1.05)
(1 + im) = (1.05)1/12 = 1.0041
• These fractions of percentage points are
called basis points.
– A basis point is one one-hundredth of a
percentage point, 0.01 percent.

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• Invest $100 at 5% annual interest
• How long until you have $200?
• The Rule of 72:
– Divide the annual interest rate into 72
– So 72/5=14.4 years.
– 1.0514.4 = 2.02

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 Present Value
• Financial instruments promise future cash
payments, so we need to know how to
value those payments.
• Present value is the value today (in the
present) of a payment that is promised to
be made in the future.
• Or, present value is the amount that must
be invested today in order to realize a
specific amount on a given future date.

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 Present Value
• Solve the Future Value Formula for PV:

FV = PV × (1+i), so

FV
PV 
(1  i )
• This is just the future value calculation inverted.

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 Present Value
• We can generalize the process as we did
for future value.
• Present Value of payment received n
years in the future:
FVn
PV 
(1  i ) n

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 Present Value
• From the previous equation, we can see
that present value is higher:
1. The higher future value of the payment, .
2. The shorter time period until payment, n.
3. The lower the interest rate, i.

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• Risk requires compensation, but securing
proper compensation means understanding
the risks of what is purchased.
• If interest rates rise, losses on a long-term
bond are greater than losses on a short-term
bond.
– Long term bonds are more sensitive to the risk
that interest rates will change.

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• Investors might misjudge or underestimate risk
• The search for yield can bid up prices of risky
securities and depress the market compensation for
risk below a sustainable level.
• When risk comes to fruition, like when defaults
increase, the prices of riskier securities fall
disproportionately, triggering financial losses.
– During the 2007-2009 crisis, the plunge of corporate and
mortgage security prices show how markets reprice risk
when the search for yield has gone too far.

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 How Present Value Changes
• Doubling the future value of the payment,
without changing the time of the payment or
the interest rate, doubles the present value.
• The sooner a payment is to be made, the
more it is worth.

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Figure 4.1: Present Value of $100 at 5%
Interest

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Table 4.2: Present Value of $100 Payment
•Higher interest rates
are associated with
lower present values,
no matter what the
size or timing of the
payment.

•At any fixed interest

rate, an increase in
the time reduces its
present value.

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• We can turn a monthly growth rate into a
compound-annual rate using what we have
learned in this chapter.
– Investment grows 0.5% per month
– What is the compound annual rate?

FVn= PV(1 + i)n = 100×(1.005)12 = 106.17

Compound annual rate = 6.17%
(Note: 6.17 > 12 × 0.05 = 6.0)

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• We can also use this to compute the
percentage change per year when we know
how much an investment has grown over a
number of years.
– An investment has increased 20 percent over five
years: from 100 to 120.
FVn = PV(1 + i)n
120 = 100(1 + i)5
i = 0.0371

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 Internal Rate of Return
• Imagine that you run a tennis racket company
and that you are considering purchasing a new
machine.
– Machine costs $1 million and can produce 3000
rackets per year.
– You sell the rackets for $50, generating $150,000 in
revenue per year.
– Assume the machine is only input, have certainty
about the revenue, no maintenance and a 10-year
lifespan.
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 Internal Rate of Return
• If you borrow $1 million, is the revenue
enough to make the payments?
• We need to compare the internal rate of
return to the cost of buying the machine.
• The interest rate that equates the present value of
an investment with its cost.

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 Internal Rate of Return
• Balance the cost of the machine against
the revenue.
– $1 million today versus $150,000 a year for
ten years.
• To find the internal rate of return, we
take the cost of the machine and equate
it to the sum of the present value of
each of the yearly revenues.
– Solve for i - the internal rate of return.

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Internal Rate of Return: Example
• Solving for i, i = 0.0814 or 8.14%

$150,000 $150,000 $150,000 $150,000

$1,000,000  1
 2
 3
 ...... 
(1 i) (1 i ) (1 i ) (1 i)10
• So long as your interest rate at which you
borrow the money is less than 8.14%, then
you should buy the machine.

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• What is the present value of the expected
losses associated with a preventable future
disaster?
– Discount rates
– Scale of future losses

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 Bond Basics
• A bond is a promise to make a series of
payments on specific future dates.
• Bonds create obligations, and are therefore
thought of as legal contracts that:
– Require the borrower to make payments to the
lender, and
– Specify what happens if the borrower fails to do
so.

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 Bond Basics
• The most common type of bond is a coupon
bond.
– Issuer is required to make annual payments, called
coupon payments.
– The annual interest the borrower pays (ic), is the
coupon rate.
– The date on which the payments stop and the loan
is repaid (n), is the maturity date or term to
maturity.
– The final payment is the principal, face value, or par
value of the bond.
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 Coupon Bond

Called a coupon
bond as buyer
would receive a
certificate with a
number of dated
coupons attached.

Coupons

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• On average as of 2019, a four-year school
costs about $26,500 per year, or about
$106,000 for a degree.
– More than 1/3 the median 2019 house price
• Returns on investment are high
– 2010 study estimated PV of a college degree at
$500,000 for men and $300,000 for women
• Should we encourage people to borrow to go
to college? Yes, but be careful.
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 Valuing the Principal
• Assume a bond has a principle payment of $100
and its maturity date is n years in the future.
• The present value of the bond principal is:
– The higher the n, the lower the value of the
payment.
F $100
PBP  n
 n
(1 i ) (1 i )

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 Valuing the Coupon Payments
• These resemble loan payments.
• The longer the payments go, the higher their
total value.
• The higher the interest rate, the lower the
present value.
• The present value expression gives us a general
formula for the string of yearly coupon payments
made over n years.

C C C C
PCP     ...... 
(1  i ) 1
(1  i ) 2
(1  i ) 3
(1  i ) n
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 Valuing the Coupon Payments
Plus Principal
• We can just combine the previous two
equations to get:
 C C C C  F
PCB  PCP  PBP      ......  n

 (1  i ) 1
(1  i ) 2
(1  i ) 3
(1  i )  (1  i ) n

• The value of the coupon bond, PCB, rises when

– The yearly coupon payments, C, rise and
– The interest rate, i, falls.

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 Bond Pricing
• The relationship between the bond price and
interest rates is very important.
– Bonds promise fixed payments on future dates, so
the higher the interest rate, the lower their
present value.
• The value of a bond varies inversely with the
interest rate used to calculate the present
value of the promised payment.

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• Pay down your debt
– The opportunity cost of investing in a retirement
fund is the interest rate you are paying on your
mortgage, credit card, loan, etc.
– No riskless investment is likely to match the rate
you receive when you reduce the size of your debt

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 Real and Nominal Interest Rates

• Borrowers care about the resources required

to repay.
• Lenders care about the purchasing power of
the payments they received.
• Neither cares solely about the number of
dollars, they care about what the dollars buy.

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 Real and Nominal Interest Rates

• Nominal Interest Rates (i)

– The interest rate expressed in current-dollar
terms.
• Real Interest Rates (r)
– The inflation adjusted interest rate.

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 Real and Nominal Interest Rates
• The nominal interest rate you agree on (i) must be based on
expected inflation (e) over the term of the loan plus the real
interest rate you agree on (r).
i = r + e
• This is called the Fisher Equation.
• The higher expected inflation, the higher the nominal interest
rate.

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Figure 4.2: Nominal Interest Rate,
Inflation Rate and Real Interest
Rate

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• This figure shows the nominal interest rate and the inflation rate in 50 countries and the
euro area in early 2016.

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 Real and Nominal Interest Rates

• Financial markets quote nominal interest

rates.
• When people use the term interest rate, they
are referring to the nominal rate.
• We cannot directly observe the real interest
rate; we have to estimate it.
r = i - e

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