Time Value of Money

Time Value of Money
Removal of errors and omissions, if any, in this ppt

are your responsibility
1
Agenda
Timeline
Present Value - Future Value
One period PV, NPV
PV - different rates and time periods
FV - different rates and time periods
Multi-Period Case (incl. power of compounding)
Annuities, Perpetuities - Simplifications
Special Cases
Effective Annual Rate
APR and Loan Balance
Risk and CF
2
Timeline
Main issue is what value to place on a cash flow
▪ When or time component (early part of the

course)
▪ Uncertainty (risk-return latter part)
Importance is because we need to make

apples-to-apples comparisons
It is only possible to compare or combine
values at the same point in time
3
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
Usually cash flows are assumed to be at the end of

the period unless o/w stated
By convention, inflows are positive and outflows are

negative
4
Present Value
Key insight is that a Rupee today is worth more

than a Rupee tomorrow – the Rupee today can be
invested to earn interest which can be obtained
along with the original Rupee invested (tomorrow)
Conversely one could ask how much is it worth to

me today to have a Rupee tomorrow
or
How much do I have to put away today to get a
Rupee tomorrow
5
Present Value
The PV of a delayed payment is obtained by
multiplying the payoff by the discount factor
Consider the following example

Suppose you receive Rs.1 tomorrow and the bank
pays an interest rate of 18% (reward for waiting) ,
what is the PV? r is the rate of
X (1+r)1 = 1 return, hurdle rate,
opportunity cost of
X = 1/(1+r)1 = 1/(1.18) = 0.8475 capital
Discount factor (DF)

PV = Discount factor * payment to be received
6
Future Value
If I had a Rupee today what is it worth tomorrow?

Suppose you have Rs.1 today, the bank pays an
interest rate of 18% (rate of return), what is the FV?
1* (1+r)1 = 1*(1.18)1 = 1.18

Discount rate (also called future value factor,
compound factor)
FV = Initial payment + accumulated interest
7
PV & FV
Future Value
Present Value
Amount to which an
Value today of a
investment will grow
future cash flow
after earning interest
Discount Factor Discount Rate

Present value of a Interest rate used to
Rs.1 future compute present
payment values of future cash
flows
8
One Period: PV
Suppose you are offered an investment that pays
Rs.15,000 in four years. If you expect to earn a 15%
return, what is the value of this investment?
9
One Period: PV
John Doe wishes to find the present value of
Rs.1,800 that will be received 10 years from now;
John’s opportunity cost is 10%
10
One Period: FV
Jane Farber places Rs.1000 in a savings account
paying 6% interest compounded annually. She
wants to know how much money will be in the
account at the end of four years
11
One Period: Net Present Value (NPV)
Suppose an investment that promises to pay
Rs.15,000 in one year is offered for sale for
Rs.12,000. Your interest rate is 10%. Should you
buy?
12
One Period: Net Present Value (NPV)
In the one-period case, the formula for NPV can be
written as:
NPV = –Cost + PV
If one had not undertaken the positive NPV project

considered on the last slide, and instead invested
our Rs.12,000 elsewhere at 10-percent, the FV
would be less than the Rs.15,000 the investment
promised and one would be unambiguously worse
off in FV terms as well:
Rs.12,000×(1.10) = Rs.13,200 < Rs.15,000
13
PV- different rates and time periods
Interest rate, time period and PV
100
90
80
70
60
50
40
30
20
10
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
0% 5% 10% 15% 20%
As t increases PV decreases
As r increases PV decreases
14
FV- different rates and time periods
Interest rate, time period and FV
1000
900
800
700
600
500
400
300
200
100
0
1 3 5 7 9 11 13 15 17 19 21 23 25
0% 5% 10% 15% 20%
As t increases FV increases
As r increases FV increases
15
Multi-period Case
What happens when the number of period

increases?
FV = X* (1+r)t
PV = X/(1+r)t
FV = PV * (1+r)t or PV = FV /(1+r)t
16
Multi-period Case
Consider a simple example
Suppose r = 15% & you want to compare two plan
A: receive Rs.500, 3 years from now
B: Receive Rs.800, 10 years from now
Which one would you prefer?
17
Multi-period Case
Suppose you have a choice between receiving Rs.5,000
today or Rs.10,000 in six years. You believe you can earn
10% on the Rs.5,000 today. What should you do?
18
Multi-period Case
Suppose that Mr. Brealey invested in the initial
public offering of the Myers company. Myers pays a
current dividend of Rs.1.12, which is expected to
grow at 50% per year for the next five years. What
will the dividend be in five years?
19
Multi-period Case
Power of compounding
Notice that the dividend in year five, Rs.8.51, is

higher than the sum of the original dividend plus
five increases of 50-percent on the original Rs.1.12
dividend:
5 increases of 50% on the original dividend (simple

interest) = Rs.1.12 + 5×[Rs1.12×0.50] = Rs.3.92
This is due to compounding – earning interest on

the interest earned
20
Multi-period Case
Suppose we plan to save Rs.1000 today, and
Rs.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?
21
Multi-period Case
Consider the following example (PV case)
You have an opportunity to invest in a business that will pay
Rs.200,000 in year one, Rs.300,000 in year two, Rs.500,000
in year three and Rs.600,000 in year four. You can earn
13% per year compounded annually on a mutual fund that
has similar risk. If it costs Rs.1.1 million to start this
business, should you invest?
0 1 2 3 4
| | | | |
–1.1 mil 200K 300K 500K 600K
Discount rate = 13%
22
Multi-Period Case
In general when you have multiple cash flows C0

…..CN, the PV of those Cash flows is
23
Multi-period Case
24
PV & FV
Only values at the same point in time can be
combined or compared (time travel)
When cash flows occur at different points in time
they must be discounted or compounded
appropriately
To move cash flow forward compound it

To compound cash flows, multiply the amount by
(1 + r)n where r is the periodic interest rate and n
is the number of compounding periods
To move cash flow backward discount it

To discount cash flows, divide the amount by
(1 + r)n where r and n are as defined previously
25
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
Perpetuity - A constant stream of cash flows that

lasts forever
Growing perpetuity - A stream of cash flows that

grows at a constant rate forever.
26
Annuity - A constant stream of cash flows with a
fixed maturity
27
If you can afford a Rs.600 monthly car payment,
what is the maximum price of the car you can buy if
the interest rate is 7% per year on a 36-month loan
28
What is the present value of a four-year annuity of
Rs.100 per year that makes its first payment two
years from today if the discount rate is 9%?
29
Consider the following example (spreadsheet)

Braden Company, a small producer of plastic toys,
wants to determine the most it should pay to purchase a
particular annuity. The annuity consists of cash flows of
Rs.1000 at the end of each year for 10 years. The
required return is 9%.
30
Future Value of an Annuity
31
Ellen is 40 years old today and wants to begin saving

for retirement from next year. At the end of each year
until she is 70 she will save Rs.15,000 each year in a
retirement account. If the account earns 12% per
year how much would Ellen have saved at age 70?
32
Growing annuity - A growing stream of cash flows
with a fixed maturity
The PV of a growing annuity with the initial cash flow c, growth rate g, and
interest rate r is
33
In the Ellen example – Suppose Ellen expects to

salary to increase and so she plans to save 6% more
each year - how much will she have saved by at age
70? All other details remain the same
34
Consider the following example – PV of a lottery
You have won the Rs. 30 Million state lottery. You

have two options to claim the prize
(a) 30 payments of 1 million starting today or
(b)15 million lump-sum paid today
If the interest rate is 8% which is the option you
should choose (you are rational!)
35
In an annuity due all that happens is that the

timeline changes. So how does the value change..
An annuity due is worth (1+r) times an ordinary

annuity
Verify with the lottery example

• For option (a) recalculate the annuity for 30
years = Rs.11.26 million
• The value of this annuity due is 11.26*(1.08) =
12.16 million today!
36
Perpetuity - A constant stream of cash flows that

lasts forever
37

What is the value of a British consol that promises
to pay £20 each year, every year until the sun turns
into a red giant and burns the planet to a crisp?
The interest rate is 15-percent
38

How much would I have to deposit today in order to
withdraw Rs.3,500 each year forever if I can earn
8% on my deposit?
39
You want to endow a graduation party at IIMK. You

want the event to be memorable and plan Rs.9,000
per year for ever for the party. If IIMK can invest at
8% year and the first party is a year from now how
much will you need to donate to endow the party?
40
Growing perpetuity - A growing stream of cash flows
that lasts forever
The PV of a growing perpetuity with the initial cash flow c, growth rate g,
and interest rate r is
41
The expected dividend next year is Rs.1.50 and
dividends are expected to grow at 7% forever;
If the discount rate is 12%, what is the value of
this dividend stream?
42

If in the MBA graduation party endowment case –
you realize that the inflation rate will be 5% per
year after the first year and that will also need to be
factored in your original donation amount – what
do you now have to donate. All other details
remain the same.
43
Your firm is about to make its initial public offering
of stock and your job is to estimate the correct
offering price. Forecast dividends are as follows
Year: 1 2 3 4
Dividends per $1.60 $1.72 $1.80 6% growth

share thereafter
If investors demand a 13% return on investments for

stocks of similar risk, what price will they be willing
to pay?
44
Special Cases
So far, we have computed either the PV or the FV
of a stream of CF (unequal or equal) for a given
number of time periods and interest rate
Sometimes we know the present value or future

value, but do not know one of the other 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 45
Special Cases

Your firm plans to buy a warehouse for Rs.800,000.
The bank requires you to pay 25% down payment
and will lend Rs.600,000 to you for a 36-year time
period at 12% annual rate of interest. What is your
annual payment amount?
46
Special Cases
At times it may be necessary to compute the r (also
called IRR) – more on this later in the session but
let us do an example
Jane has just graduated and is offered a fantastic

job at ABC investment corporation. She ponders
but decides to set up her own business and asks
them for funding. ABC lends her Rs.4 million with
the agreement that she will pay back Rs.300,000 at
the end of each year for the next 30 years.
Assuming she fulfills her agreement what is the
rate at which ABC has lent Jane the money?
(spreadsheet) 47
Special Cases
Suppose ABC corporation gives Jane another

option – pay 400,000 in the first year and 5% more
in perpetuity – all other details remain the same.
What is the rate that ABC is lending at (IRR)?
48
Special Cases
Assume the total cost of a college education will be
Rs.180,000 when Ms. X’s child enters college in 10
years. She has Rs.60,000 to invest today. What
rate of interest must she must earn on her
investment to cover the cost of her child’s
education?
49
Special Cases
Calculating time T (or N)
If we deposit Rs.20,000 today in an account paying
10%, how long does it take to grow to Rs.100,000?
50
Compounding an investment m times a year for T
years provides for future value of wealth
C0 = initial investment or PV of the CF
51
You invest Rs.200 for 5 years at 14% compounded
semi-annually, what will your investment grow to at
the end of that period
52
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 5 years
53
200 x(1+EAR)5 = 393.43 (This is the future value)

(1+EAR) = (393.43/200)1/5
EAR = (….) – 1 = 0.1449 = 14.49%
So, investing at 14.49% compounded annually is

the same as investing at 14% compounded
semiannually
54
Find the Effective Annual Rate (EAR) of an 20% APR

(annual % rate) loan that is compounded monthly.
55
What is the difference between the EAR of interest

and stated rate of interest in the following cases:
Case A: Stated rate of interest is 8 percent and the
frequency of compounding is six times a year.
Case B: Stated rate of interest is 10 percent and the

frequency of compounding is four times a year.
Case C: Stated rate of interest is 12 percent and the

frequency of compounding is twelve times a year.
56
The general formula for the future value of an

investment compounded continuously over many
periods is FV = C0×erT
Where
C0 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
57
The nominal interest rate is the stated or contractual

rate of interest charged by a lender or promised by a
borrower
The effective interest rate is the rate actually paid or

earned
In general, the effective rate > nominal rate whenever

compounding occurs more than once per year
58
Example of an actual automobile loan agreement

The ad says
12 month car loans - Only 9%!
Where is the fallacy?

What is actually happening….
59
Ten years ago your firm borrowed $3 million to

purchase an office building using a loan with a
7.80% APR, and monthly payments for 30 years
• How much do you owe on the loan today
• How much interest was paid on the loan in the last
year
60
Solution steps
• Convert ARR to monthly rate
• Compute the monthly pmt or C
• Compute yearly payment (C* 12)
• PV of loan after 10 years - notice T or remaining number of
periods is 240 (20 more years to go – gives answer to part 1)
• PV of loan after 9 years (remaining number of periods T = 252)
• Difference in the two PV gives the decline in the balance amount
or principal amount
• Difference between the yearly payment and yearly (year 9- year
10) balance decline is interest payment – answer to part 2
61
Customer Lifetime Value
• CLV - it is the expected profit that you will realize

from sales to a particular customer in the future
• It uses past customer history to ‘understand’ the
customer but CLV is all about the future
• It is based, primarily, on the expected retention rate
spending rate, plus some other factors that are
easy to determine
• Some customer groups have negative CLVs –
what this means is that you would be more
profitable if you had fewer customers
62
Customer Lifetime Value
Acquisition Second Third Fourth Fifth

Year Year Year Year Year
Customers 100,000 60,000 42,000 33,600 26,880
Retention Rate 60% 70% 80% 80% 80%
Orders per Year 1.8 2.5 3 3 3
Avg Order Size $90 $95 $100 $100 $100
Total Revenue $16,200,000 $14,250,000 $12,600,000 $10,080,000 $8,064,000
Costs 70% 65% 60% 60% 60%

Cost of Sales $11,340,000 $9,262,500 $7,560,000 $6,048,000 $4,838,400
Acquisition/Mkt. Cost $55 $20 $20 $20 $20
Marketing Costs $5,500,000 $1,200,000 $840,000 $672,000 $537,600
Total Costs $16,840,000 $10,462,500 $8,400,000 $6,720,000 $5,376,000
Gross Profit ($640,000) $3,787,500 $4,200,000 $3,360,000 $2,688,000

Discount Rate 8% 8% 8% 8% 8%
Net Present Value ($640,000) $3,506,944 $3,600,823 $2,667,276 $1,975,760
Cumulative NPV Profit ($640,000) $2,866,944 $6,467,767 $9,135,044 $11,110,804
Customer LTV ($6) $29 $65 $91 $111
63
Problem Solving
Mini case – see word doc
64
Problem Solving
What are the four questions to be answered
• How much money would Ramesh need 15 years from

now?
• How much money should Ramesh save each year for
the next 15 years to be able to meet his investment
objective?
• How much money would Ramesh need when he
reaches the age of 60 to meet his donation objective?
• What is the present value of Ramesh’s life time
earnings?
65
Summary
CF
Pull (PV) Push (PV)
Non constant CF Non constant CF
Annuity Annuity
Pseudo annuity Pseudo annuity
66
Summary
Pull (PV)
Non constant CF Annuity

finite
N
Ct
PV = 
T =1 (1 + r )t Infinite
Finite
(perpetuity)
c  1  
t
C
PV = 1 −    PV =
r   1 + r   r
Pseudo annuity
Finite Infinite
C   1 + g  C
rg PV = 1−   PV =
r − g   1 − r  

r−g gr
67
Summary
In case of pseudo annuity, when r = g
0 1 2 3
C C(1+g) C(1+g)2
C (1 + g ) C (1 + g ) C (1 + g )
2 T −1
C
PV = + + + ... +
(1 + r ) (1 + r ) 2
( )
1 + r
3
( )
1 + r
T
1  C (1 + g ) C (1 + g ) C (1 + g ) 
2 T −1
= C + + + ... + T −1 
( ) 
1 + r ( )
1 + r (1 + r )
2
(1 + r ) 
1
= C + C + C + ...
(1 + r )
TC
PV =
1+ r 68
Summary
Push (FV)
Non constant Annuity Pseudo annuity
Single
PV = CF (1 + r ) Infinite Infinite
n
Finite
C Does not
FV = (1 + r ) − 1 Does
t
r   exist
not
Multiple exist
T
FV =  CT −t (1 + r )
t
t =1 Finite
C 
FV = (1 + r ) − (1 + g ) 
T T T
FV =  Ct (1 + r )
T −t
r−g  
t =1
rg
69
Summary
In case of Pseudo annuity, when r = g
0 1 2 3 T
C C(1+g) C(1+g)2 C(1+g)T-1
FV = C (1 + r ) + C (1 + g )(1 + r ) + C (1 + g )(1 + r ) + ... + C (1 + g )

T −1 T −2 T −3 T −1
When r=g
FV = C (1 + r ) + C (1 + r ) + C (1 + r )
T −1 T −1 T −1
+ ...
= TC (1 + r )
T −1
70
Risk and CF
A safe Rupee is worth more than a risky one
Generally, investors do not like risk
In order to induce the investors to invest in risky

projects, a higher rate of return is needed
Higher rate of return causes lower PVs
Consider a Lottery vs. bank deposit

71
How do you master this
Practice, practice, practice
It is also easy to watch what is done in class and

convince yourself that you can do it, if needed
There is no substitute for getting out the calculator,

paper and pen and working out many, many
problems from the book until you can do them
correctly and quickly
72
Thank you !
73

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Removal of errors and omissions, if any, in this ppt

▪ When or time component (early part of the

Importance is because we need to make

Drawing a timeline of the cash flows will help you

Usually cash flows are assumed to be at the end of

By convention, inflows are positive and outflows are

Key insight is that a Rupee today is worth more

Conversely one could ask how much is it worth to

Consider the following example

Discount factor (DF)

If I had a Rupee today what is it worth tomorrow?

Consider the following example

1* (1+r)1 = 1*(1.18)1 = 1.18

FV = Initial payment + accumulated interest

Discount Factor Discount Rate

If one had not undertaken the positive NPV project

0% 5% 10% 15% 20%

0% 5% 10% 15% 20%

What happens when the number of period

Notice that the dividend in year five, Rs.8.51, is

5 increases of 50% on the original dividend (simple

This is due to compounding – earning interest on

Discount rate = 13%

In general when you have multiple cash flows C0

To move cash flow forward compound it

To move cash flow backward discount it

Annuity - A stream of constant cash flows that lasts

Growing annuity - A stream of cash flows that grows

Perpetuity - A constant stream of cash flows that

Growing perpetuity - A stream of cash flows that

Consider the following example (spreadsheet)

Future Value of an Annuity

Consider the following example

Ellen is 40 years old today and wants to begin saving

Consider the following example

In the Ellen example – Suppose Ellen expects to

Consider the following example – PV of a lottery

You have won the Rs. 30 Million state lottery. You

In an annuity due all that happens is that the

An annuity due is worth (1+r) times an ordinary

Verify with the lottery example

Perpetuity - A constant stream of cash flows that

Consider the following example

Consider the following example

Consider the following example

You want to endow a graduation party at IIMK. You

Consider the following example

Dividends per $1.60 $1.72 $1.80 6% growth

If investors demand a 13% return on investments for

Sometimes we know the present value or future

For example, when you take out a loan you may

Consider the following example

Jane has just graduated and is offered a fantastic

Suppose ABC corporation gives Jane another

C0 = initial investment or PV of the CF

The Effective Annual Interest Rate (EAR) is the

200 x(1+EAR)5 = 393.43 (This is the future value)

So, investing at 14.49% compounded annually is

Find the Effective Annual Rate (EAR) of an 20% APR

What is the difference between the EAR of interest

Case B: Stated rate of interest is 10 percent and the

Case C: Stated rate of interest is 12 percent and the