School of economics

CHAPTER 2
TIME VALUE OF MONEY AND ITS APPLICATION

8/2022

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 TIME VALUE OF MONEY

VALUING COMMON STOCKS

Content
VALUING BONDS

VALUING BUSINESS

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 Reading materials
• Bodie, Merton, & Cleeton (2012) – Chapter 7+8+9
• Brealey, Mayers & Allen (2011) – Chapter 2

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 1. Time value of money
Question:

Would you take $1000 today or $1000 one year from now?

Would you take $1000 today or $1005 one year from now?

Would you take $1000 today or $1500 one year from now?

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 1. Time value of money
Definition
Value of money is measured not only by amount of
money but also by the time that money appears.

1 million VND in the last 10 years ≠ 1 million VND today ≠

1 million VND in the next 10 years

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 1. Time value of money
Future value and present value

Future Value
Amount to which an investment will
grow after earning interest

Present Value
Value today of a future cash flow.

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 1. Time value of money
Future value

Example 1 - FV
What is the future value of $100 if interest is compounded annually
at a rate of 10% for one year? For 2 years? For 10 years?

C0 = 100
T = 1,2,10,…
r = 10%/ year
FV = ?

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 1. Time value of money
Future value

0 1 2 3 T
Unit: $
100
r=10%/year, T=10
year 1: 100.(1+10%)=100.(1+10%)1 =
year 2: 100.(1+10%)1(1+10%)=100.(1+10%)2 =
year 3: 100.(1+10%)2(1+10%)=100.(1+10%)3 =
...
year 10: 100.(1+10%)9(1+10%)= 100.(1+10%)10 = 8
 1. Time value of money
Future value

• The general formula for the future value of an investment over many
periods can be written as:

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. 9

 1. Time value of money
Future value and present value
1800
1600 0%
1400 5%
10%
1200
FV of $100

15%
1000
800
600
400
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
10
 1. Time value of money
Present value
𝐹𝑉
𝑃𝑉 =
(1 + 𝑟)𝑛

𝑃𝑉 = 𝐷𝐹𝑛 × 𝐹𝑉𝑛
Example 2 - PV
How much should you deposit to the bank today to receive $114.49 after
2 years if interest is compounded annually at a rate of 7%/ year?

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 1. Time value of money
Net present value - NPV
Example 3 – Valuing an office building
Step 1: Forecast cash flows
Cost of building = C0 = 405,000
Sale price in Year 1 = C1 = 420,000

Step 2: Estimate the opportunity cost of capital

If equally risky investments in the capital market offer a return of 5%, then

Cost of capital = r = 5%
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 1. Time value of money
Step 3: Discount future cash flows

𝑃𝑉 =?

Step 4: Go ahead if PV of payoff exceeds investment and vice versa

𝑁𝑃𝑉 =?

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 1. Time value of money
Net present value

NPV = PV− required investment

𝐶1
NPV = C0 +
1+𝑟

Accept investments that have positive net present value and vice versa

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 1. Time value of money
0 1 2 T-1 T

𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝑻−𝟏 𝑪𝑻

𝑪𝟏 × (𝟏 + 𝒓)−𝟏

𝑪𝟐 × (𝟏 + 𝒓)−𝟐

𝑪𝑻−𝟏 × (𝟏 + 𝒓)−(𝑻−𝟏)

𝑪𝑻 × (𝟏 + 𝒓)−𝑻 15
 1. Time value of money
Multiple cash flows

For multiple periods we have the Discounted Cash Flow (DCF) formula

PV0 = C1
(1 + r ) 1 + C2
(1 + r ) 2 + .... + Ct
(1 + r ) t

T
NPV 0 = C 0 +  Ct
(1 + r ) t
t =1
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 1. Time value of money
Multiple cash flows
• Perpetuity
• A constant stream of cash flows that lasts forever
• Growing perpetuity
• A stream of cash flows that grows at a constant rate forever
• 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
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 1. Time value of money
Multiple cash flows – ANNUITY
A constant stream of cash flows with a fixed maturity

C C C C

0 1 2 3 T
𝐶 𝐶 𝐶 𝐶
𝑃𝑉 = + 2
+ 3
+⋯
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑇

C 1 
PV = 1 − T 
r  (1 + r ) 
 1. Time value of money
Multiple cash flows – ANNUITY
Example 4: If you can afford a $400 monthly car payment, how much
car can you afford if interest rates are 7%/year on 36-month loans?

$400 $400 $400 $400


0 1 2 3 36
 1. Time value of money
Multiple cash flows - ANNUITY
Example 5:
The state lottery advertises a jackpot prize of $295.7 million, paid in 25
installments over 25 years of $11.828 million per year, at the end of each
year. If interest rates are 5.9%/year what is the true value of the lottery
prize?

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 1. Time value of money
Multiple cash flows – GROWING ANNUITY
A growing stream of cash flows with a fixed maturity
C C×(1+g) C ×(1+g)2 C×(1+g)T-1

0 1 2 3 T
𝐶 𝐶 × (1 + 𝑔) 𝐶 × (1 + 𝑔)𝑇−1
𝑃𝑉 = + 2
+ ⋯ +
(1 + 𝑟) (1 + 𝑟) (1 + 𝑟)𝑇

C   1+ g  
T

PV = 1 −   
r − g   (1 + r )  
 
 1. Time value of money
Multiple cash flows – GROWING ANNUITY
Example 6: A defined-benefit retirement plan offers to pay $20,000 per year for
40 years and increase the annual payment by 3% each year. What is the
present value at retirement if the discount rate is 10%?

$20,000 $20,000×(1.03) $20,000×(1.03)39


0 1 2 40
 1. Time value of money
Multiple cash flows – ANNUITY
Example 7: You are evaluating an income generating property. 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. What is the
present value of the estimated income stream over the first 5 years if the
discount rate is 12%?
 1. Time value of money
Multiple cash flows – PERPETUITY
A constant stream of cash flows that lasts forever

C C C
…
0 1 2 3
C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3

C
PV =
r
 1. Time value of money
Multiple cash flows – PERPETUITY
Example 8: What is the value of a British consol that promises to pay £15 every
year forever?
The interest rate is 10%.
£15 £15 £15 …

0 1 2 3
 1. Time value of money
Multiple cash flows – GROWING PERPETUITY
A growing stream of cash flows that lasts forever

C C×(1+g) C ×(1+g)2
…
0 1 2 3
C C  (1 + g ) C  (1 + g ) 2
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

C
PV =
r−g
 1. Time value of money
Multiple cash flows – GROWING PERPETUITY
Example 9: 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 $1.30×(1.05) $1.30 ×(1.05)2
…
0 1 2 3
 1. Time value of money
Multiple cash flows - ANNUITY

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 1. Time value of money
Effective annual rate and percentage rate

Effective Annual Interest Rate - Interest rate that is annualized using

compound interest.

Annual Percentage Rate - Interest rate that is annualized using simple

interest.
 1. Time value of money
Effective annual rate and percentage rate

Example 10
Given a monthly rate of 1%, what is the Effective Annual Rate(EAR)? What
is the Annual Percentage Rate (APR)?

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EAR = (1 + .01) -1 = r
EAR = (1 + .01)12 - 1 = .1268 or 12.68%

APR = .01 x 12 = .12 or 12.00%

 Exercise
1. What is the present value annuity factor at a discount rate of 11% for 8
years?

2. What is the present value annuity factor at an interest rate of 9% for 6

years?

3. What is the present value of $1000 per year annuity for five years at an
interest rate of 12%?

4. What is the present value of $5000 per year annuity at a discount rate
of 10% for 6 years?
 Exercise
5. After retirement, you expect to live for 25 years. You would like to have $75,000
income each year. How much should you have saved in the retirement to receive
this income, if the interest is 9% per year (assume that the payments start one
year after the retirement)?

6. What is the present value annuity factor at an interest rate of 12% for 9 years?

7. What is the future value of $1000 per year annuity for five years at an interest
rate of 12%?
8. What is the present value of $2000 per year annuity at a discount rate of 12%
for 8 years?
 2. Bond valuation
Sometimes firms can retain and accumulate earnings to cover the cost of
investment, but often they need to raise extra cash from investors.
→ If they choose not to sell additional shares of common stock, the cash
has to come from borrowing.
→ If cash is needed for only a short while, firms may borrow from a bank.
→ If they need cash for long-term investments, they generally issue bonds,
which are simply long-term loans.
 2. Bond valuation
Bond is a security that confirms that an institution owes the
bondholder. The institution (issuer) has to pay the holder an amount of
money during a duration of time.

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 2. Bond valuation
➢ The First Bond Ever… Circa 2400 B.C.

➢ 1100s: Venetians Create Advanced Bond Markets

➢ 1693: government bond - Bank of England

➢ 1917: The first U.S. Treasury bonds

➢ 1929: Treasuries Become Safe Haven During the Great Depression

2. Bond valuation
2. Bond valuation
2. Bond valuation
 2. Bond valuation
Example 10: French government bonds pay interest and principal in euros
(€). Suppose that in January 2019 you decide to buy €100 face value of the
8.5% maturing in January 2023. In January 2019, other medium-term
French government bonds offered a return of about 3%/ year
➢ What is the value of your bond?
 2. Bond valuation

C1 C2 000 + C N
1,FV
PV = + + ... +
(1 + r ) 1
(1 + r ) 2
(1 + r ) N

PV: bond’s price

Cn Coupon payment
FV: face value
r: discount rate
 2. Bond valuation
Example 11
If today is October 1, 2010, what is the value of the following bond? An
IBM Bond pays $115 every September 30 for 5 years. In September 2015
it pays an additional $1000 and retires the bond. The annual interest rate
is 7.5%)
 2. Bond valuation
Example 12 - Japan
In July 2010 you purchase 200 Yen of bonds in Japan which pay a 8% coupon
every year. If the bond matures in 2015 and the YTM is 4.5%, what is the
value of the bond?
 2. Bond valuation
Example 13 - USA
In February 2009 you purchase a 3 year US Government bond. The bond has
an annual coupon rate of 4.875%, paid semi-annually. If investors demand a
3% semiannual return, what is the price of the bond?
 3. Stock valuation
• Why should we care of stock value?

• Could we look up the stock price in the newspaper?

Stock board
3. Stock valuation
 3. Stock valuation
The value of any stock is the present value of its future cash flows. This
reflects the DCF formula. Dividends represent the future cash flows of the
firm.

PV(stock) = PV(expected future dividends)

 3. Stock valuation
The price of any share of stock can be thought of as the present value of
the futures cash flows. For a stock the future cash flows are dividends
and the ultimate sales price of the stock.

Div1 + P1
Price = P0 =
1+ r
 3. Stock valuation
Dividend Discount Model - Computation of today’s stock price which
states that share value equals the present value of all expected
future dividends.

Div1 Div 2 Div H + PH

P0 = + + ...+
(1 + r ) 1
(1 + r ) 2
(1 + r ) H

H
Divt PH
P0 =  +
t =1 (1 + r ) t
(1 + r ) H

H - Time horizon for your investment.

 3. Stock valuation
Example 14:
Fledgling Electronics is forecasted to pay a $5.00 dividend at the end
of year one and a $5.50 dividend at the end of year two. At the end
of the second year the stock will be sold for $121. If the discount
rate is 15%, what is the price of the stock?
 3. Stock valuation
Example 15:
Current forecasts are for XYZ Company to pay dividends of $3,
$3.24, and $3.50 over the next three years, respectively. At the end
of three years you anticipate selling your stock at a market price of
$94.48. What is the price of the stock given a 12% expected return?
 3. Stock valuation
• Valuing Non-Constant Growth

Div1 Div 2 Div H PH

PV = + + ... + +
(1 + r ) (1 + r )
1 2
(1 + r ) H
(1 + r ) H

DivH +1
PH =
r−g
 3. Stock valuation
Example 16 – Phoenix produces dividends in three consecutive years of 0, .31,
and .65, respectively. The dividend in year four is estimated to be .67 and
should grow in perpetuity at 4%. Given a discount rate of 10%, what is the
price of the stock??

0 .31 .65  1 .67 

PV = + + + 
(1 + .1) (1 + .1)
1 2
(1 + .1)  (1 + .1) (.10 − .04) 
3 3

= 9.13
 3. Stock valuation
Example 17:
Casino Inc. is expected to pay a dividend of $3 per share at the end of year-
1 (D1) and these dividends are expected to grow at a constant rate of 6%
per year forever. If the required rate of return on the stock is 18%, what is
current value of the stock today?
 3. Stock valuation
Example 18:
ABC Corporation has just paid a dividend of $0.50 per share. The dividends
are expected to grow at 15% per year for the next two years and at 8% per
year thereafter. If the required rate of return in the stock is 10%, calculate
the current value of the stock?
 3. Stock valuation
Example 19:
Otobai Motor Company is currently paying a dividend of $1.40 per year.
The dividends are expected to grow at a rate of 18% for the next three
years and then a constant rate of 5% thereafter. What is the expected
dividend per share in year 5?
 3. Stock valuation
Example 20:
Consider the following three stocks:
a. Stock A is expected to provide a dividend of $10 a share forever.
b. Stock B is expected to pay a dividend of $5 next year. Thereafter,
dividend growth is expected to be 4% a year forever.
c. Stock C is expected to pay a dividend of $5 next year. Thereafter,
dividend growth is expected to be 20% a year for five years (i.e., until year
6) and zero thereafter.
 3. Stock valuation
Cost of equity capital

Div1
Restated P0 =
r−g
Div1
r= +g
P0

Div 1 (g) expected rate of

Dividend Yield =
P0 growth in dividends
 3. Stock valuation
Dividend Growth Rate can also be derived from applying the return
on equity to the percentage of earnings plowed back into
operations.

g = return on equity X plowback ratio

Return on Equity = ROE

EPS
ROE =
Book Equity Per Share
 3. Stock valuation
Example 21:
Ocean Co. has paid a dividend $2 per share out of earnings of $4 per share.
If the book value per share is $25, what is the expected growth rate in
dividends (g)?
 3. Stock valuation
Example 22
Northwest Natural Gas stock was selling for $42.45 per share at the start of
2009. Dividend payments for the next year were expected to be $1.68 a
share. What is the cost of capital, assuming no growth?

Northwest Natural Gas stock was selling for $42.45 per share at the start of
2009. Dividend payments for the next year were expected to be $1.68 a
share. What is the cost of capital, assuming a growth rate of 6.1%?
 3. Stock valuation
If a firm elects to pay a lower dividend, and reinvest the funds, the stock
price may increase because future dividends may be higher.

Payout Ratio - Fraction of earnings paid out as dividends

Plowback Ratio - Fraction of earnings retained by the firm
 3. Stock valuation
Example 23:
Our company forecasts to pay a $8.33 dividend next year, which represents
100% of its earnings. This will provide investors with a 15% expected return.
Instead, we decide to plowback 40% of the earnings at the firm’s current return
on equity of 25%. What is the value of the stock before and after the plowback
decision?
 3. Stock valuation
Example 24
Our company forecasts to pay a $8.33 dividend next year, which
represents 100% of its earnings. This will provide investors with a
15% expected return. Instead, we decide to plowback 40% of the
earnings at the firm’s current return on equity of 25%. What is the
value of the stock before and after the plowback decision?
No Growth With Growth

8.33 g = .25  .40 = .10

P0 = = $55.56
.15
5.00
P0 = = $100.00
.15 − .10
 3. Stock valuation
Example 24 - continued
If the company did not plowback some earnings, the stock price would
remain at $55.56. With the plowback, the price rose to $100.00.
The difference between these two numbers is called the Present Value of
Growth Opportunities (PVGO).

PVGO = 100.00 − 55.56 = $44.44

 3. Stock valuation
Present Value of Growth Opportunities (PVGO) - Net present value of a
firm’s future investments.

Sustainable Growth Rate - Steady rate at which a firm can grow: plowback
ratio X return on equity.
 3. Business valuation
Valuing a Business or Project
The value of a business or Project is usually computed as the
discounted value of FCF out to a valuation horizon (H).
The valuation horizon is sometimes called the terminal value and is
calculated like PVGO.

FCF1 FCF2 FCFH PV H

PV = + + ... + +
(1 + r ) (1 + r )
1 2
(1 + r ) H
(1 + r ) H

PV (free cash flows) PV (horizon value)

 3. Business valuation
Example 25
Given the cash flows for Concatenator Manufacturing Division, calculate
the PV of near term cash flows, PV (horizon value), and the total value
of the firm. r=10% and g= 6%
Year
1 2 3 4 5 6 7 8 9 10
Asset Value 10.00 12.00 14.40 17.28 20.74 23.43 26.47 28.05 29.73 31.51
Earnings 1.20 1.44 1.73 2.07 2.49 2.81 3.18 3.36 3.57 3.78
Investment 2.00 2.40 2.88 3.46 2.69 3.04 1.59 1.68 1.78 1.89
Free Cash Flow - .80 - .96 - 1.15 - 1.39 - .20 - .23 1.59 1.68 1.79 1.89
.EPS growth (%) 20 20 20 20 20 13 13 6 6 6
 3. Business valuation
Example 25 - continued

1  1.59 
PV(horizon value) = 6   = 22.4
(1.1)  .10 − .06 
.80 .96 1.15 1.39 .20 .23
PV(FCF) = - − − − − −
1.1 (1.1) (1.1) (1.1) (1.1) (1.1)6
2 3 4 5

= − 3 .6
PV(busines s) = PV(FCF) + PV(horizon value)
= -3.6 + 22.4
= $18.8
WORK TO DO
✓ Làm bài tập Brealey,
Mayers & Allen (2011)
– Chapter 2

✓ Đọc Bodie et al. (2012)

– 10, 11, 12, 13

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