Chapter 3

Chapter 3,4
Time Value
of Money
Copyright © 2012 Pearson Prentice Hall. All rights reserved.

Chapter Outline
3.1 Valuing an single cashflow

3.2 Valuing a Stream of Cash Flows
3.3 Perpetuities
3.4 Annuities
3.5 Growing Cash Flows
3.6 Solving for Variables Other Than Present Value
or Future Value
Copyright © 2012 Pearson Prentice Hall. All rights reserved. 4-2

Question
Time value of money- Why???

• Present Value: PV
• Future Value: FV
• R: interest rate/discount rate
• N: periods of time

3.1 Valuing a simple cashflow
• Timelines
– Constructing a Timeline
– Identifying Dates on a Timeline
• Date 0 is today, the beginning of the first year
• Date 1 is the end of the first year

• Timelines
– Distinguishing Cash Inflows from Outflows
– Representing Various Time Periods

• Just change the label from “Year” to “Month” if
monthly

Some rules to remember
• Rule 1: Comparing and Combining Values

– It is only possible to compare or combine
values at the same point in time

• Rule 2: Compounding
– To calculate a cash flow’s future value, you
must compound it

• Rule 2: Compounding
– Compound Interest
• The effect of earning “interest on interest”

Figure 3.2 The Composition of Interest
over Time

• Rule 3: Discounting
– To calculate the value of a future cash flow at
an earlier point in time, we must discount it.

Example
• If $826.45 is invested today for two years

at 10% interest, the future value will be
$1000

Example
• If $1000 were three years away, the

present value, if the interest rate is 10%,
will be $751.31

Example: Present Value of a Single
Future Cash Flow
Problem:
• You are considering investing in a savings bond that will pay
$15,000 in ten years. If the competitive market interest
rate is fixed at 6% per year, what is the bond worth today?

Example: Present Value of a Single
Future Cash Flow
Problem:
• XYZ Company expects to receive a cash flow of $2 million in
five years. If the competitive market interest rate is fixed at
4% per year, how much can they borrow today in order to
be able to repay the loan in its entirety with that cash flow?

Applying the Rules of Valuing Cash Flows

• Suppose we plan to save $1,000 today, and
$1,000 at the end of each of the next two years.
• If we earn a fixed 10% interest rate on our
savings, how much will we have three years from
today?

• We can do this in several ways.

• First, take the deposit at date 0 and move it
forward to date 1.
• Combine those two amounts and move the
combined total forward to date 2.

• Continuing in the same fashion, we can solve the

problem as follows:

• Another approach is to compute the future value

in year 3 of each cash flow separately.
• Once all amounts are in year 3 dollars, combine
them.

• Consider a stream of cash flows: C0 at

date 0, C1 at date 1, and so on, up to CN at
date N.
• We compute the present value of this cash

flow stream in two steps.

• First, compute the present value of each cash

flow.
• Then combine the present values.

Problem:
• You have just graduated and need money to buy a new car.
• Your rich Uncle Henry will lend you the money so long as
you agree to pay him back within four years.
• You offer to pay him the rate of interest that he would
otherwise get by putting his money in a savings account.

Problem:
• Based on your earnings and living expenses, you think you
will be able to pay him $5000 in one year, and then $8000
each year for the next three years.
• If Uncle Henry would otherwise earn 6% per year on his
savings, how much can you borrow from him?

You have been offered a unique
investment opportunity. If you invest
$10,000 today, you will receive $500 one
year from now, $1500 two years from
now, and $10,000 ten years from now.
If the interest rate is 6% per year,
should you take the opportunity?

Marian Plunket owns her own business and is
considering an investment. If she undertakes
the investment, it will pay $4000 at the end of
each of the next three years. The opportunity
requires an initial investment of $1000 plus an
additional investment at the end of the second
year of $5000. If the interest rate is 2% per
year? Should Marian take it?

3.3 Perpetuities
• The formulas we have developed so far allow us

to compute the present or future value of any
cash flow stream.
• Now we will consider two types of cash flow
streams:
– Perpetuities
– Annuities

3.3 Perpetuities
Perpetuities
– A perpetuity is a stream of equal cash flows
that occur at regular intervals and last forever.
– Here is the timeline for a perpetuity:
– the first cash flow does not occur immediately;

it arrives at the end of the first period

3.3 Perpetuities
• Using the formula for present value, the

present value of a perpetuity with
payment C and interest rate r is given by:
C C C
PV=    ......
(1  r) (1  r) (1  r)
2 3
• Notice that all the cash flows are the

same.
• Also, the first cash flow starts at time 1.

3.3 Perpetuities
• Let’s derive a shortcut by creating our own

perpetuity.
• Suppose you can invest $100 in a bank
account paying 5% interest per year
forever.
• At the end of the year you’ll have $105 in
the bank – your original $100 plus $5 in
interest.

3.3 Perpetuities
• Suppose you withdraw the $5 and reinvest

the $100 for another year.
• By doing this year after year, you can
withdraw $5 every year in perpetuity:

3.3 Perpetuities
• To generalize, suppose we invest an

amount P at an interest rate r.
• Every year we can withdraw the interest
we earned, C=r × P, leaving P in the bank.
• Because the cost to create the perpetuity
is the investment of principal, P, the value
of receiving C in perpetuity is the upfront
cost, P.

3.3 Perpetuities
Present Value of a Perpetuity
C
PV (C in perpetuity)  (Eq. 4.4)
r

Example:
Endowing a Perpetuity
Problem:
• You want to endow an annual graduation party. You want
the event to be a memorable one, so you budget $30,000
per year forever for the party.
• If the university earns 8% per year on its investments, and
if the first party is in one year’s time, how much will you
need to donate to endow the party?

3.4Annuities
• Annuities
– An annuity is a stream of N equal cash flows
paid at regular intervals.
– The difference between an annuity and

a perpetuity is that an annuity ends after
some fixed number of payments

3.4 Annuities
Present Value of An Annuity

• Note that, just as with the perpetuity, we
assume the first payment takes place one
period from today.
C C C C
PV=    ......
(1  r) (1  r) (1  r)
2 3
(1  r) N

4.3 Annuities
• In general:
1 1 
PV (annuity of C for N periods with interest rate r)  C  1  
r  (1  r)N 

Example
Present Value of a Lottery Prize
Annuity
Problem:
• You are the lucky winner of the $30 million state lottery.
• You can take your prize money either as (a) 30 payments of
$1 million per year (starting today), or (b) $15 million paid
today.
• If the interest rate is 8%, which option should you take?

Example
Present Value of an Annuity
Problem:
• Your parents have made you an offer you can’t refuse.
• They’re planning to give you part of your inheritance
early.
• They’ve given you a choice.
• They’ll pay you $10,000 per year for each of the next
seven years (beginning today) or they’ll give you their
2007 BMW M6 Convertible, which you can sell for
$61,000 (guaranteed) today.
• If you can earn 7% annually on your investments,
which should you choose?

3.4 Annuities
Future Value of an Annuity
FV (annuity)  PV  (1  r)N
(Eq. 4.6)
C  1 
  1  N 
  (1  r ) N
r  (1  r ) 
1
 C  ((1  r ) N  1)
r

Example
Retirement Savings Plan Annuity
Problem:
• Ellen is 35 years old, and she has decided it is time to plan
seriously for her retirement.
• At the end of each year until she is 65, she will save
$10,000 in a retirement account.
• If the account earns 10% per year, how much will Ellen
have saved at age 65?

Example
Retirement Savings Plan Annuity
Problem:
• Adam is 25 years old, and he has decided it is time to plan
seriously for his retirement.
• He will save $10,000 in a retirement account at the end of
each year until he is 45.
• At that time, he will stop paying into the account, though he
does not plan to retire until he is 65.
• If the account earns 10% per year, how much will Adam
have saved at age 65?

• A growing perpetuity is a stream of cash

flows that occur at regular intervals and
grow at a constant rate forever.
• For example, a growing perpetuity with a
first payment of $100 that grows at a rate
of 3% has the following timeline:

Example
Endowing a Growing Perpetuity
Problem:
• You planned to donate money to your alma mater to fund
an annual $30,000 graduation party.
• Given an interest rate of 8% per year, the required donation
was the present value of PV=$30,000/0.08=$375,000.
• Before accepting the money, however, the student
association has asked that you increase the donation to
account for the effect of inflation on the cost of the party in
future years.
• Although $30,000 is adequate for next year’s party, the
students estimate that the party’s cost will rise by 4% per
year thereafter.
• To satisfy their request, how much do you need to donate
now?

Present Value of a Growing

Perpetuity
C
PV (growing perpetuity)  (Eq. 4.7)
rg

Present Value of a Growing Annuity

• A growing annuity is a stream of N
growing cash flows, paid at regular
intervals
• It is a growing perpetuity that eventually
comes to an end.

• The following timeline shows a growing

annuity with initial cash flow C, growing at
a rate of g every period until period N:

• Present Value of a Growing Annuity:
1  1 g  
N
PV= C  1    
r - g   1 r  

Example
Retirement Savings with a Growing
Annuity
Problem:
• Ellen considered saving $10,000 per year for her
retirement. Although $10,000 is the most she can save in
the first year, she expects her salary to increase each year
so that she will be able to increase her savings by 5% per
year. With this plan, if she earns 10% per year on her
savings, how much will Ellen have saved at age 65?

3.6 Solving for Variables Other Than
Present Value or Future Value
• In some situations, we use the present
and/or future values as inputs, and solve
for the variable we are interested in.
• We examine several special cases in this
section.

Solving for Cash Flows
P
C (Eq. 4.8)
1 1 
 1 N
r (1  r) 

Example
Computing a Loan Payment
Problem:
• Your firm plans to buy a warehouse for $100,000.
• The bank offers you a 30-year loan with equal annual
payments and an interest rate of 8% per year.
• The bank requires that your firm pay 20% of the purchase
price as a down payment, so you can borrow only $80,000.
• What is the annual loan payment?

• Rate of Return
– The rate of return is the rate at which the
present value of the benefits exactly offsets the
cost.

• Suppose you have an investment
opportunity that requires a $1000
investment today and will pay $2000 in six
years.
• What interest rate, r, would you need so
that the present value of what you get is
exactly equal to the present value of what
you give up?
2000
1000 
(1  r) 6

• Rearranging:
1000  (1  r)  2000 6
 2000  6
1 r   
 1000 
 1.1225,or
r  12.25%

• Suppose your firm needs to purchase a
new forklift.
• The dealer gives you two options:
– A price for the forklift if you pay cash
($40,000)
– The annual payments if you take out a loan
from the dealer (no money down and four
annual payments of $15,000).

• Setting the present value of the cash flows
equal to zero requires that the present
value of the payments equals the purchase
price:
1 1 
40,000  15,000  1 
r  (1  r) 4 
• The solution for r is the interest rate
charged by the dealer, which you can
compare to the rate charged by your bank.

• There is no simple way to solve for the
interest rate.
• The only way to solve this equation is to
guess at values for r until you find the
right one.
• An easier solution is to use a financial
calculator or a spreadsheet.

Example
Computing the Rate of Return with a
Financial Calculator
Problem:
• Let’s return to the lottery example (Example 4.4).
• How high of a rate of return do you need to earn investing
on your own in order to prefer the $15 million payout?

• Solving for the Number of Periods
– 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.
– In this case, the interest rate, present value,
and future value are all known.
– We need to compute how long it will take for
the present value to grow to the future value.

Example
Solving for the Number of Periods in a
Savings Plan
Problem:
• Imagine that some time has passed and you have
$10,050 saved already, and you can now afford
to save $5,000 per year at the end of each year.
• Also, interest rates have increased so that you
now earn 7.25% per year on your savings.
• How long will it take you to get to your goal of
$60,000?

Homework
• 13,17,22- Chap 4

Chapter 3

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Chapter 3,4

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

3.1 Valuing an single cashflow

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Time value of money- Why???

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– Representing Various Time Periods

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• Rule 1: Comparing and Combining Values

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• If $826.45 is invested today for two years

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• If $1000 were three years away, the

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Applying the Rules of Valuing Cash Flows

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• We can do this in several ways.

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• Continuing in the same fashion, we can solve the

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• Another approach is to compute the future value

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• Consider a stream of cash flows: C0 at

• We compute the present value of this cash

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• First, compute the present value of each cash

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• The formulas we have developed so far allow us

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– the first cash flow does not occur immediately;

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• Using the formula for present value, the

• Notice that all the cash flows are the

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• Let’s derive a shortcut by creating our own

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• Suppose you withdraw the $5 and reinvest

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• To generalize, suppose we invest an

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Present Value of a Perpetuity

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– The difference between an annuity and

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Present Value of An Annuity

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Future Value of an Annuity