CORPORATE FINANCE

CHAPTER 2
THE TIME VALUE OF MONEY

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 Chapter 2: THE TIME VALUE OF
MONEY
• Main Contents:
1. Future values and Compound interest
2. Present values
3. Multiple cash flow
4. Level cash flow: Perpetuities and
Annuities
5. Inflation and the time value of money
6. Effective annual interest rate

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I. Future values and Compound
interest
Interest = interest rate x initial investment

Capital after the 1st year = initial investment x (1 + interest rate)

Capital after the 2nd year = capital after the 1st year x (1 + interest rate)
= initial investment x (1 + interest rate)2

Capital after the t year = initial investment x (1 + interest rate)t

Present value
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Future value
 I. Future values and Compound
interest (cont’d)
Future value after the t year = Present value x (1 + interest rate)t

+ $6 + $6.36 + $6.74
r = 6% $106 $112.36 $119.10

0 1 2 3

Saving

Present value
Future value

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I. Future values and Compound
interest (cont’d)

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I. Future values and Compound
interest (cont’d)

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I. Future values and Compound
interest (cont’d)
Compound interest …earning interest on interest

Accumulated
Original interest
Interest investme over
= nt + periods
x

Simple interest …interest only from the original investment

Accumulated
Accu ed
interest over
Original nter
Interest investme periods
er
= nt + s
x
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I. Future values and Compound
interest (cont’d)
Do you know 111

MANHATTAN Island

1626, bo
ug ht with
24 $

Peter Minuit

??? How much equivalent in 2006 value ?

The average standard of interest rate is 3.5%

outstanding
24(1+3.5%)380 = 11,427,000 USD successful deal!!!
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I. Future values and Compound
interest (cont’d)

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 II. Present Values
Now!!!! At the
offered year-end!!
$100,000 offered
$100,000
•A dollar today is worth
more than 1 dollar tomorrow

Time value of money

Time
0 1 2 3 4 5 t
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 II. Present Values (cont’d)

Original
Receiving
investme
value
nt
(Future
(Present Int 1 Int 2 Int 3 Value)
Value)
+ + +
Time
0 1 2 3 t

FV

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II. Present Values (cont’d)

How much do we need to invest now in order to

produce $106 at the end of the year with

interest rate of 6%?

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 II. Present Values (cont’d)

$3,000

$2,600 Strategy 1:
Save money in 1 year, interest rate 8%

Strategy 2:
•Which strategy should he select ?
Save money in 2 year, interest rate 8%

•Calculate PV of each strategy, and compare with his 15

suggestion
available fund If PV < available fund: select the strategy
II. Present Values (cont’d)

The longer the time before you must make a payment,

the less you need to invest today
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 II. Present Values (cont’d)
Discount factor

PV = FV 1
r
(1+ )
t

Discount factor
To measure the PV of $1 received
in year n

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 II. Present Values (cont’d)
Finding the value of free credit

$20,000
•Down payment: $8,000

•The 2nd pay out: $12,000 No free credit provided

Free credit provider
Discount $1,000
•Which company should you select ?

•PV = 20,000 – 1,000

= $19,000

Choose Toyota
for cheaper
purchasing 18
 II. Present Values (cont’d)
Finding the interest rate

issue

•Repay $1,000
•How much is the interest rate ?
1 •…paid at the end of 25 years
PV = FV t
(1+ ) •Price of IOU: $129.20
⇒r =. r
..

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 III. Multiple Cash Flow

We have considered problems involving only a single cash

flow.
Investments will involve many cash flows overtime. When
there are many payments, it refers to a stream of cash
flows
 III. Multiple Cash Flow (cont’d)
Future Value of multiple cash flow

2 years later

+ Year 1: deposit $1.200

+ Year 2: deposit $1.400
+ r = 8%
How much will he spend on
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a laptop after 2 years?
III. Multiple Cash Flow (cont’d)

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 III. Multiple Cash Flow (cont’d)
Present Value of multiple cash flow
2
drawing 2 strategies
Installment plan

•Down payment: $8,000

$16,000 •Year 1: $4,000

1
Pay $15,500 at once •Year 2: $4,000
(deducted $500) r = 8%

•Which strategy should be chosen ?

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 III. Multiple Cash Flow (cont'd)
Present Value of multiple cash flow (cont'd)

< $15,500

The strategy 2 of installment plan should be chosen 24

 III. Multiple Cash Flow (cont'd)
Present Value of multiple cash flow (cont'd)

Characteristics of PV of a stream of future cash flows

…is the amount that needs to be invested today to generate the

stream of future cash flows.

Total future cash flow: - $16,000

Available cash: $15,133.06

Don’t worry
Total of PV of future cash flow = 25
available cash = $15,133.06
 III. Multiple Cash Flow (cont'd)
Present Value of multiple cash flow (cont'd)

…to prove this:

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IV. Level Cash flows: Perpetuity
and Annuity

Iphone5
$x $x $x $x

0 1 2 3 4
Annuity

$x $x $x $x ….

0 1 2 3 4 ….
Perpetuity
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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
What is an annuity and a perpetuity ?

Annuity

…sequence of equal cash flow with a determined last period

Perpetuity

…sequence of equal cash flows that never end

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value perpetuity

issue

Bank of England Consols

Cash flow of 1 Consol

$10 $10 $10 $10 ….

0 1 2 3 4 ….
Market interest rate: 10%
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Value of the consol = PV of the endless cash flow
 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value perpetuity (cont'd)

Cash flow of 1 Consol

$10 $10 $10 $10 ….

0 1 2 3 4 ….
Market interest rate: 10%

Cash payment from perpetuity = interest rate x PV

C = r x PV

C
PV =
r 30
 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value perpetuity (cont'd)

Endow in finance

$100,000 per year, forever

Generous man r= 10%

How much is the amount that the man must set aside today ?

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value perpetuity (cont'd)

Market interest rate: 10%

Generous man
$100,000 $100,000 ….

0 1 2 3 4 5 ….

PV

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value perpetuity (cont'd)

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value annuities

PV = PMT X

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value annuities (cont'd)

Kangaroo Autos offer a payment scheme of $4,000 a year at the end

of each of the next 3 years, r = 10%

$4,000 $4,000 $4,000

0 1 2 3

PV = PMT X

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value annuities (cont'd)

•Receive equally installments

each year: $11.828 mio.
•Total year: 25.
•Interest rate: 5.9%

Lottery winner of $295.7 mio

$11.828 $11.828 … $11.828

0 1 2 … 25

Does he accept the proposal ? Why ?

It is a fair trade ?
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What is a solution ?
 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value annuities (cont'd)

•If he could live more 30 years, how much could

Bill Gates spend yearly as taking his $46bio ?
•His money is invested to earn 9%.

Bill Gates
the richest man of
$46 bio

PV = $46 bio $? $? … $?

0 1 2 … 30

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value annuities (cont'd)

Price: $125,000

Pay down 20%

•Lending 80%

•r= 1% per month

What is the monthly mortgage payment ?
•t= 30 years

PV = $100,000 $? $? … $?
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0 1 2 … 360
 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value annuities (cont'd)

DETAIL OF THE MONTHLY DEBT PAYMENT

Months of Beginning Interest Amortization Month- End of

repayment of month of loan end month
balance payment balance

1 $100,000 $1,000 $28.61 $1,028.61 $99,971.39

2 $99,971.39 $999.71 $28.9 $1,028.61 $99,942.49
…
360

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
How to value annuities (cont'd)

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
Annuities Due

…value of a stream of cash payments starts immediately (at the

beginning of a period).
PV = PMT

Future value of an annuity

FV
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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
Future value of an annuity (cont'd)

r= 8%
$13,000

$3,000 $3,000 $3,000 $3,000

0 1 2 3 4

Can you buy this red car at the end of year

4?

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
Future value of an annuity (cont'd)
…in 50 more years

$500,000
r= 10%

…will be retired

How much could she save each year from this year ?

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 IV. Level Cash flows: Perpetuity
and Annuity (cont'd)
Annuities due
FV

…in 50 more years

$500,000 r= 10%

…will be retired
If she save the money at the beginning of each year, how much should
she deposit?
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FV = ??? Compare outcome with the previous FV annuity
any conclusion about this?
 V. SUMMARY
• Annuity (at the beginning of the period)
• FV
• Annuity (at the ending of the period)
• FV
 V. SUMMARY

• Present value of annuity (at the ending of

the period)
PV

• Present value of Annuity (at the beginning

of the period)
PV
 EXAMPLES

Example 1: Mr B deposits at the beginning within 4 years with the

amount 100, 150, 200 and 150 million VND per period. Compute
the total value Mr B will receive at the end of fourth year, interest
rate is 8% per year.
Example 2: Mr B deposits at the ending within 4 years with the
amount 100, 150, 200 and 150 million VND per period. Compute
the total value Mr B will receive at the end of fourth year, interest
rate is 8% per year.
 EXAMPLES

Example 3: A firm buy on credit with the payment as follows: 300,

200, 150, 100 million VND per month at the end of the term. If
firm pays at once, compute the total value with the interest rate is
10% per term.
Example 4: A firm buy on credit with the payment as follows: 300,
200, 150, 100 million VND per month at the beginning of the term.
If firm pays at once, compute the total value with the interest rate is
10% per term.
 V. INFLATION AND THE TIME
VALUE OF MONEY

Investment Inflation
return 10%
6%

…value of money is 45
eroded
 V. INFLATION AND THE TIME
VALUE OF MONEY (cont'd)
Real versus Nominal Cash flow

What can be used for measuring the inflation

rate ?
…CPI used for measuring the inflation rate.

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont'd)
Real versus Nominal Cash flow (cont'd)

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont'd)
Real versus Nominal Cash flow (cont'd)

What is the nominal dollar ?

…refer to the actual number of dollars

What is the real dollar ?

…refer to the amount of purchasing power

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont'd)
Real versus Nominal Cash flow (cont'd)

buy

In 1990

pr
ov
id
Pay e
lo
monthly an Year CPI
$800 for 30
years 1990 133.8

2007 210

??? What is the real monthly payment of 2007 compared with real 1990 49
dollar ?
 V. INFLATION AND THE TIME
VALUE OF MONEY (cont'd)
Inflation and interest rate

investment(1 + nominal interest rate)

Real FV of investment =
1 + inflation rate

1 + nominal interest rate

1 + Real interest rate =
1 + inflation rate

What is the nominal interest rate ?

…rate at which money invested growths

…interest rate board of commercial

banks
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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont'd)
Inflation and interest rate (cont'd)

Attention!!!

In reality, if nominal interest rate and inflation rate are small, the real interest rate
will be…

Real interest rate = nominal interest rate – inflation rate

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 V. INFLATION AND THE TIME
VALUE OF MONEY (cont'd)
Inflation and interest rate (cont'd)

…compare the nominal and real values of investment under the inflation rate of 7%
and nominal interest rate of 10%

Nominal Real

Interest rate 10% 2.8%

FV (after 1 year) $100 $93.46

PV $90.91 $90.91

Nominal PV and Real PV are equal to each other 54

 V. INFLATION AND THE TIME
VALUE OF MONEY (cont'd)
Inflation and interest rate (cont'd)

His total assets: $46 bio.

Spend $4.5 bio per year, in 30 years

•Interest rate = 9%
•Inflation rate = 5%

I would like to
ensure the
same power of
purchasing of
2042 as in 2012
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 VI. EFFECTIVE ANNUAL
INTEREST RATE (cont'd)
0 1

$100 $112.68

How much is the equivalent interest rate? •12.68%

Effective annual interest rate

1 + effective annual interest rate = (1 + monthly rate)12

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 VI. EFFECTIVE ANNUAL
INTEREST RATE (cont'd)
Method to convert to effective annual interest rate from an annual
percentage rates (APRs)

•APRs: annualized by multiplying the rate per period by the number of period in a year.

Steps to convert to effective annual interest rate

1 Take the quoted APR divided by the number of compounded

period in a year

•Monthly interest: APR / 12

•Quarterly interest: APR / 4
•Semi-annually interest: APR / 2
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 VI. EFFECTIVE ANNUAL
INTEREST RATE (cont'd)
Steps to convert to effective annual interest rate (cont’d)

2 Convert to effective annual interest rate

1 + effective annual interest rate = (1 + monthly rate)12

1 + effective annual interest rate = (1 + quarterly rate)4

1 + effective annual interest rate = (1 + semi-annually rate)2

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 VI. EFFECTIVE ANNUAL
INTEREST RATE (cont'd)

Why do we use the effective annual interest rate ?

•To measure the actual income of the depositors or expense of the borrowers

LAST SELF TEST

A car loan requiring quarterly payments carries an ARP of 8 percent.
What is the effective annual rate of interest ?

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