Present Value of Money

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).

The One-Period Case:

Future Value
In

the one-period case, the formula for FV

can be written as:
FV = C0(1 + r)
Where C0 is cash flow today (time zero) and
r is the appropriate interest rate.

,$9,523.8.5
$
1
0

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.

The amount that you would need to set aside today to

to able to meet the promised payment of $10,000 in
one year is called the Present Value (PV) of $10,000.
Note that $10,000 = $9,523.81(1.05).

C
P
V
11r

The One-Period Case:

Present Value

In the one-period case, the formula for PV can be

written as:

Where C1 is cash flow at date 1 and

r is the appropriate interest rate.

The Multiperiod Case:

Future Value
The

general formula for the future value of an

investment over many periods can be written
as:
FV = C0(1 + r)T

Where
C0 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.

The Multiperiod Case:

Future Value
Suppose

that you invested in the initial public

offering of a company. The company 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 = C0(1 + r)T
$5.92 = $1.10(1.40)5

5
.$1.05(24$
02
$
().31
1
)6

4
4$
3.02$4.3$5.92

Future Value and Compounding

$
,(1
2
0
$
9
,4
3
.5

.5
)5

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%?
PV
0

$20,000

N
C
1
C
2
C
N
C
t
N
P
V
C

0
0
(1r)(1r)(1r)t1(1r)

The Multi-Period Case: Net Present

Value

Ct is the net cash inflow at time t

F
VC
(T01.r.2Tl)n0T(1T.0)$T6$591,5300l1,n7.22$5y,e0ars(1.0)T

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?

((1r)120$5110,1r2)T1.2$505,(1r.$2)5,0512(1r)12
F
V

What Rate Is Enough?

Assume that you will need $50,000 in 12

years. You have $5,000 to invest today.
What rate of interest must you earn on
your investment to get $50,000 in 12
years?

About 21.15%.

r
F
V
C
1m

T
0
2

3
.V
1
2
F
$50 $50(1.6)6$70.93

Compounding Periods

Compounding an investment m times a year for T

years provides for future value of wealth:

For example, if you invest $50 for 3

years at 12% compounded semiannually, your investment will grow to

Continuous Compounding

The general formula for the future value of an investment

compounded continuously over many periods can be written
as:
FV = C0erT

Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years over which the cash is invested,
and
e is a transcendental number approximately equal to 2.718

Common Cash Flow Streams

Perpetuity

Growing perpetuity

A stream of cash flows that grows at a constant rate forever.

Annuity

A constant stream of cash flows that lasts forever.

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.

C
C
C
P
V
(1r)P

2
3
(V
1
rC
)(1r)
Perpetuity

A constant stream of cash flows that lasts forever.

The formula for the present value of a perpetuity is:


1
5
P
V
.00

Perpetuity: Example

What is the value of a British consol that promises

to pay 15 each year, every year forever?
The interest rate is 10-percent.

15

15

15

2
C

(
1

g
)
C

(
1

g
)
P
V
(1r)P

2
3
rV
r
C
rg

Growing Perpetuity

A growing stream of cash flows that lasts forever.

C(1+g)

C (1+g)2

The formula for the present value of a growing

perpetuity is:

.P
$
1
3
0
V
5$26.0

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?

$1.30
0

$1.30(1.05)
2

$1.30 (1.05)2


C
C
C
C
P
V
(1r)PV(1Crr)((11r)r)
(1r)

2T3T

Annuity

A constant stream of cash flows with a fixed maturity.

The formula for the present value of an annuity is:

C
0

C
P
V
r
(1
C
r)T

Annuity Intuition
C

An annuity is valued as the difference between

two perpetuities:
one perpetuity that starts at time 1
less a perpetuity that starts at time T + 1

C
T


P
V
$
4
0
1
.7/21(.072)$12,954.
Annuity: Example

36

If you can afford a $400 monthly car payment, what

priced car can you afford if annual interest rates are
7% on 36-month loans?

$400

$400

$400

$400

36

$
1
0
$
1
0
$
1
0
$
1
0
$
1
0
P
V

$
3
2
.
9
7
(.9)(.9)(.9)(.9)(.9)

.P
$
3
2
9
7
V

$
2
9
7
.
010

4
1t1t1234

What is the present value of a four-year annuity of $100

per year that makes its first payment two years from today if
the discount rate is 9%?

$297.22

$323.97

$100

$100

$100

$100

(
1

g
)
C

(
1

g
)
P
V
(1r)r
r

1
2
T
P
C
1

g
V
rg r

Growing Annuity

A growing stream of cash flows with a fixed maturity.

C

C(1+g) C (1+g)2
2

C(1+g)T-1
T

The formula for the present value of a growing annuity:

$8,590(1.$$789),,5031.6(1.$78),52042(18.$78)$3,501,4(1.7.7)4
PV of Growing Annuity

You are evaluating an income property that is providing

increasing rents. Net rent is received at the end of each year.
The first year's rent is expected to be $8,500 and rent is
expected to increase 7% each year. Each payment occurs at
the end of the year. What is the present value of the estimated
income stream over the first 5 years if the discount rate is
12%?

0
1
$34,706.26

,P
$
2
0
1
.
0
3

.1

$
2
6
5
,1.5
7

3
Growing Annuity

4
0

A retirement plan offers to make payments for 40 years after

retirement with a payment of $20,000 at the end of the first
year and an increase in the annual payment by threepercent each year. What is the present value at retirement if
the discount rate is 10 percent?

$20,000 $20,000(1.03)
0

$20,000(1.03)39
40

Loan Amortization
Loan

servicing

Principal repayment

Interest payment

Interest on outstanding principal amount

Different

cash flows possible

Principal equally repaid over life of loan

Interest payment will vary

Total payment will vary

Loan Amortization (contd.)

Equal

total payment over life of loan

Principal repayment will increase over time

Interest payments will decrease over time

Balloon

or Bullet payment

A large part of principal repaid at the end of

the life of loan

What is a Firm Worth?

Conceptually,

a firm should be worth the

present value of the firms future cash
flows.
The tricky part is determining the size,
timing and risk of those future cash flows.