Time Value of

Money
LECTURE 7-9
Learning Objectives
The Time Value of Money Bond Valuation
1. Calculate future values and understand 8. Understand basic bond terminology and
compounding apply the time value of money equation in
pricing bonds
2. Calculate present values and
understanding discounting 9. Understand the difference between annual
and semiannual bonds and note the key
3. Apply the time value of money equation features of zero-coupon bonds
using formula, calculator and spreadsheet.
10. Explain the relationship between the
4. Determine the future value of multiple cash coupon rate and the yield to maturity
flows
Stock Valuation
5. Determine the future value of an annuity
11. Calculate the value of a stock given a
6. Build and analyze amortization schedules history of payments,
7. Compute the effective annual rate on a
loan and investment
Financial Decisions
▫ Costs and benefits being spread out over time
▫ The values of sums of money at different dates
▫ The same amounts of money at different dates have
different values.
▫ Virtually every decision involves TIME and UNCERTAINTY
Time Value of Money
“MONEY HAS A TIME VALUE”

Suppose your parents opened a savings account on the day you

were born in your name for a college education with a $15,000
deposit.
The account was set to grow at 5% per year, and you are eligible
to withdraw the money on your eighteenth birthday.
On your 18th birthday, the account hat about --------------- in it, more
than the original account. How did that happen?
Time Value of Money
The time value of money refers to a
dollar in hand today being worth more
than a dollar received in the future,
because you can invest today’s dollar
in an interest-bearing account that
grows in value over time.
 Time lines

Time 0 is today Time is the end of the

first period (year, month,
day) or the beginning of
the second period
Drawing time lines
Example:
A lump sum:- a one-time payment for the total or partial value of
an asset.
A lump sum due in 4 years

0 1 2 3 4

$ 100
Cash Flow signs
INVESTING $ TODAY BORROWING $ TODAY

• Invest (Expense) $ today in Borrow (Inflow) $ today in

present to earn greater return in present to use now, then repay
the future. with interest in the future.
• Earn interest (revenue), plus • Pay interest (expense), plus
principal principal
• PV = (-) • PV = +
• FV = + • FV = (-)
Future Value and
Compounding
• Future value (FV)
• Simple interest: the interest on the original principal
• Compound interest: the interest on the interest (interest
accumulates = compounding)

Future value is the cash value of an asset in the future that is

equivalent to a specific amount today.
Future Value
The Single-Period Scenario
How much money will you have one year from today if
you put $100 in a savings account that promises to pay
you 5% over the coming year?
 The answer is $105.
interest earned = principal times interest rates (100 x 0.05 = 5$)
This one-time payment of money at a future date is a
lump-sum payment.
Future Value
The Multiple-Period Scenario
What if you were willing to wait two years for
your lump-sum payment?
What will the future value of the deposit be
after two years?
FV of an initial $100 after
two years (i = 5%)
i=5%

$100

Finding FVs (moving to the right on a time line) is called

compounding.
 One year:
FV = 100 (1+ 5%) = 105 (USD)
Second year:

Future Value and FV = 105(1 + 5%) = 105 + 105.5% = 110.25 (USD)

Compounding =100.(1+5%).(1+5%) =100. (1 + 5%)2

Suppose you invest

$1000 in a savings
account that pays 10% 110.25 = 100 + 5 + 5 + 0.25
per year. How much will
you have in one year?
Two years? Three
years? Four years? Interest Interest
(Assume the interest FV
rate does not change) Principal earned in earned
(Y2)
year 1v in year 2
Future Value
Future value = deposit x (1 +r) x (1+r)
FV = future value
PV = present value
r = interest rate
n = the number of time periods

𝐧
FV = 𝐏𝐕. (𝟏 + 𝐫)
Future Value
three years: FV = $100 x 1.053 = $ 100 x 1.1576 = $115.76
ten years: FV =
thirty years: FV =
Each year, the earned interest in preceding years earns
interest along with the initial deposits, which in return
accelerates the growth of the account.
Methods of Solving Future Value
Method 1: The equation
30
FV = 100 x 1 + 0.05
Method 2: The spreadsheet
Future Value
Problem:
John and Jane Smith are in the market for a vacation place. They
find a small but pleasant condo in Bali listed at $400,000.
They decide that now is not the right time to buy and that they will
wait six years. The condos in Bali appreciate each year 3% and
the Smiths want to know what a similar condo will sell for in six
years. Can you help them?
Present Value and
Discounting
Almost all problems in finance involve
finding the value today of one or more
future cash flows
– E.g., in order to reach a target amount
of money at a future date, how much
should we invest today?
Present Value
The Single-Period Scenario
Problem:
You want to buy a new laptop next year, and
the one you have in mind should be selling for
$1,000 a year from now. How much do you
need to put away today at 5% interest to have
$1,000 a year from now?
In another words, you are trying to determine
how much $1,000 on year from now is worth
today at 5% interest over the year.
Present Value
The Single-Period Scenario
To find a present value, we reverse the growth
concept and discount the future value back to
the current period.
 bringing the money back in time with the
interest rate (we call it the discount rate)
Present Value
The Single-Period Scenario
We turn FV = 𝐏𝐕. (𝟏 + 𝐫)𝐧 into:

𝟏
PV = FV x
(𝟏+𝒓)𝒏
Present Value
The Single-Period Scenario
The amount you need to deposit today to reach $1,000 in a year
(n = 1) at 5% interest is

𝟏
◦PV = $1,000 x = $952.38
(𝟏+𝟎.𝟎𝟓)𝟏
Present Value
The Multiple-Period Scenario
Problem:
Donna wants to buy a savings bond for her newborn niece. The
face value of the savings bond is $500, the amount the niece
would receive in twenty years (future value). The government is
currently paying 4% per year on savings bonds. How much will it
cost Donna today to buy this savings bond?
Present Value
The Multiple-Period Scenario
Solution:
$500 face value = future value
Number of years = n (the years that the owner of the savings bond
must wait to get this face value is 20 years)
The interest rate is 4.0% = the discount rate for the savings bond.

PV = ?
Methods of Solving Present Value
Method 1: The equation
Method 2: The spreadsheet
Calculate the Interest Rate/Yield/Discount
rate/Growth rate
◦ What is the discount rate on my future cash?
◦ At what rate is my money growing over time?

𝐹𝑉 1/𝑛
◦ r =( ) -1
𝑃𝑉
Problem
If you deposit $250 in the bank today and five years will get back
$400, what is your growth rate?

r=?
Calculation of the time period
The time period is the waiting time for a present value to mature
into a desired value.

𝐹𝑉
ln( )
𝑃𝑉
n=
ln(1+𝑟)
Application
Saving for retirement (present value)
1. Your retirement goal is $2,000,000. The bank is offering you a
certificate of deposit that is good for forty years at 6%. What initial
deposit do you need to make today to reach your $2,000,000 goal
at the end of forty years?
Application
In 1867, Secretary of State W.H purchased Alaska from Russia for
the sum of $7,200,000 or about two cent per acre.
What would it cost today if the land were in exactly the same
condition as it was 149 years ago and prevailing interest rate over
this time were 4%?
Application
1. John, a college student, needs to borrow $5,000 today for his
tuition bill. He agrees to pay back the loan in a lump-sum payment
five years from now, after he is out of college. The bank states that
the payment will need to be $7,012.76.
If John borrows the $5,000 from the bank, what interest rate is he
paying for his loan?
VALUING A
STREAM OF
CASH FLOWS
Future Value of Multiple
Payment Streams
Suppose you plan to put away some years to build up a nest egg
to use as a down payment on a house. You start off by putting
away $2,000 today, and over the next three years you are able to
put away $3,000 at the end of the first year, $4,000 at the end of
the second year, and $5,000 at the end of the third year.
How much will you have saved by the end of the third year if your
investment rate is 5% per year?
Solution

$4,000 $5,000
$3,000 $4,000x(1.05)2

$3,000 x (1.05)2
$2,000

$2,000 x (1.05)3
Present Value of a Stream
of Cash Flow
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, and you offer to pay him the rate
of interest that he would otherwise get by putting his money in a
savings account. 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?
Solution
How much money should Uncle Henry be willing to give you today
in return for your promise of these payments?
He should be willing to give you an amount that is equivalent to
these payments in present value terms.
The cash flows you can promise U.Henry are as follows:
Solution
Uncle Henry should be willing to lend you
……………………………in exchange for your
promised payments. This amount is
……………………….than the total you will pay
him ($5000+$8000+$8000+$8000 = $29,000)
due to the time value of money.
Three Rules of Time Travel
Annuities and
Perpetuities
Future Value of an Annuity Stream
Say you decide to put away $1,000 at the end of every year for
the next five year. If you can earn 6% on the account, what is the
value of the account at the end of the five year?
• Unlike the previous problem, you do not put away any money
away today.
• The first deposit is at the end of the first year.
Future Value of an Annuity Stream
FV of payment 1 = $1,000 x 1.064 = $ 1,262.48
FV of payment 2 = $1,000 x 1.063 = $ 1,191.02
FV of payment 3 =
FV of payment 4 =
FV of payment 5 =
Total = $5,637.10
Future Value of an Annuity Stream
•An annuity is a stream of N equal cash flows paid at regular
intervals. Most car loans, mortgages, and some bonds are
annuities.
•FV = 𝐶𝐹1 𝑥 (1 + 𝑟)4 +𝐶𝐹1 𝑥 (1 + 𝑟)3 +𝐶𝐹1 𝑥 (1 + 𝑟)2
+𝐶𝐹1 𝑥 (1 + 𝑟)1 +𝐶𝐹1 𝑥 (1 + 𝑟)0
•FV = CF x [(1 + 𝑟)4 +(1 + 𝑟)3 +(1 + 𝑟)2 +(1 + 𝑟)1 +(1 + 𝑟)0 ]

(1+ 𝑟)5 −1
•𝐹𝑉 = 𝐶𝐹 𝑥 ( )
𝑟
Future Value of an Annuity Stream
𝑛
(1+ 𝑟) −1
𝐹𝑉 = 𝑃𝑀𝑇 𝑥 ( )
𝑟
Future Value of an Annuity Stream
An Application
Kitty and Red put $1,500 into a college fund every year for their
son, Eric, on his birthday, with the first deposit one year from his
birth (at his very first birthday). The college fund has a guaranteed
annual growth or interest rate of 7%. At his eighteenth birthday,
they will pay the last $1,500 into the fund. How much will be in the
college fund for Eric immediately following this last payment?

Solution:
FV (rate, nper, Pmt, pv, Type, Fv)
FV (0.07,18,-$1500,0,0)
Present Value of an Annuity
Problem
You are the lucky winner of the $30 million state lottery. You can
take your prize money either as (1) 30 payments of $1 million per
year (starting today), or (2) $15 million paid today. If the interest
rate is 8%, which option should you take?
Present Value of an Annuity
Solution
Option 1:

Option 2: $15,000,000
Present Value of an Annuity
Because the first payment starts today, the last payment will occur
in 29 years (for a total of 30 payments).
The $1 million at date 0 is already stated in present value terms,
but we need to compute the present value of the remaining
payments.
Present Value of an Annuity
1
𝑃𝑉1 = $1,000,000 𝑥
(1+0.08) 1
1
𝑃𝑉2 = $1,000,000 𝑥
(1+0.08) 2
1
𝑃𝑉3 = $1,000,000 𝑥
(1+0.08) 3
1
𝑃𝑉𝑛 = 𝐹𝑉𝑛 𝑥
(1+0.08) 𝑛

𝟏 𝟏
PV= PMT 𝒙 (𝟏 − 𝒏 )
𝒓 𝟏+𝒓
Present Value of an Annuity
Present Value of an Annuity
Option (2) $15 million upfront, is more valuable—even though the
total amount of money paid is half that of option (1).
The reason for the difference is the time value of money.
 If you have the $15 million today, you can use $1 million
immediately and invest the remaining $14 million at an 8% interest
rate. This strategy will give you $14 million * 8% = $1.12 million
per year in perpetuity!
Future Value of an Annuity
Annuity Payment
Your biotech firm plans to buy a new DNA sequencer for
$500,000. The seller requires that you pay 20% of the purchase
price as a down payment, but is willing to finance the remainder
by offering a 48-month loan with equal monthly payments and an
interest rate of 0.5% per month.
What is the monthly loan payment?
Annuity Payment
Annuity Payment
Solution

Loan payment C as follows

Perpetuities
You want to endow an annual MBA graduation party at your alma
mater. 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?
Perpetuities
A perpetuity is a stream of equal cash flows that occur at regular
intervals and last forever.
One example is the British government bond called a consol (or
perpetual bond). Consol bonds promise the owner a fixed cash
flow every year, forever.
Present Value of A Perpetuity
A perpetuity with payment C and interest rate r:
Present Value of A Perpetuity
Application: Growing Cash Flows

Growing Perpetuity
Growing Annuity
Growing Perpetuity
A growing perpetuity is a stream of cash flows that occur at
regular intervals and grow at a constant rate forever.
Growing Perpetuity
You planned to donate money to your alma mater to fund an
annual $30,000 MBA graduation party. Given an interest rate of
8% per year, the required donation was the present value of
………………………………………………today
Before accepting the money, however, the MBA 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 Growing Perpetuity
(Suppose g ≥ r)
Cash flow C, growing at rate g every period until period N
Solution
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.
Growing Annuity
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?
Growing Annuity
Solution
Present Value of a Growing Annuity
Present Value of a Growing Annuity
Ellen’s proposed savings plan is equivalent to having ………..in
the bank today.

# Pleast try to determine the amount Ellen will have at age 65!
Interest Rate
Annual and Periodic Interest Rate
Let’s assume that you purchase a CD for
$500 with a promised annual percentage
rate (APR) of 5%.
The annual percentage rate (APR) is
the yearly rate that you earn by investing
or charge for borrowing.
Annual and Periodic Interest Rate
However the financial institution quotes 5% interest
rate on an annual basis, these institutions in fact often
pay interest quarterly, monthly or even daily.
The period in which the financial institution applies
interest or the frequency of times at which it adds
interest to an account each year is the compounding
period or compounding periods per year (C/Y)
Annual and Periodic Interest Rate
For example,
If the number of compounding periods per year is twelve (monthly
compounding), we will have (C/Y = 12)
If it is quarterly compounding, we will have (C/Y = 4) and so on
Periodic interest rate
What happens to the $500 CD with an
annual percentage rate of 5% if we
compound it on annual, quarterly,
monthly or even daily?
We must convert the annual percentage
rate (APR) into a periodic interest rate.
Periodic interest rate

𝐴𝑃𝑅
Periodic interest rate =
𝑚
 Periodic interest rate
$500 CD with 5% APR, Compounded Quarterly at 1.25%
Date Beginning Interest Earned Ending
Balance balance
1/1-3/31 $500 $500x0.0125 = $6.25 $506.25

4/1-6/30 $506.25 $506.25x0.0125 =$6.33 $512.58

7/1-9/30

10/1- $525.47
12/31
Effective annual rate (EAR)
With quarterly compounding, you receive 1.25% interest on the
new balance each quarter and over the year you will receive
$25.47.
So you effectively earned 5.094% on your CD ($25.47/$500 =
0.05094)

The effective annual rate (EAR) is the rate of

interest that the financial institution actually
pays or that you earn per year and depends
on the number of compounding periods.
Effective annual rate (EAR)

𝐴𝑃𝑅 𝑚
EAR = (1+ ) -1
𝑚
Application
ABC Company has just signed on the dotted line to buy a building
worth $200,000 to house its operations. ABC paid $10,000 down
and must borrow the remaining $90,000.
The bank will loan the firm money at 8% APR but ABC has an
option to make annual payments or monthly payments on the
loan. Both options have thirty-year payment schedule.
What are the mortgage payments under the two different plans?

PMT = (2/3%, 360, (190,000), 0, 0)

Application
How much does John need to save each period to become a
millionaire by age sixty-five? Let’s assume John is now 35 years
old and has thirty years to saving toward his one-million-dollar
goal. She anticipates an APR of 9% on her investments.
How much does she need to save if she puts money away
annually?
How much does she need to save if she puts money away
monthly?
Solution

𝐹𝑉
PMT = (1+𝑟)𝑛 −1
𝑟
𝑃𝑉
PMT = 1 −[1/(1+𝑟)𝑛 ]
𝑟
PRESENT VALUE
AND THE NPV
DECISION RULE
Net Present Value (NPV)
When we compute the value of a cost or benefit in terms of cash
today, we refer to it as the present value (PV). Similarly, we define
the net present value (NPV) of a project or investment as the
difference between the present value of its benefits and the
present value of its costs:

NPV = PV(Benefits) - PV(Costs)

Net Present Value (NPV)
Let’s consider a simple example. Suppose your firm is offered the
following investment opportunity: In exchange for $500 today, you
will receive $550 in one year with certainty.
If the risk-free interest rate is 8% per year then:
PV (Benefit) = ($550 in one year)/ (1.08 $ in one year/$ today)
= $509.26 today
Once the costs and benefits are in present value terms, we can
compute the investment’s NPV:
NPV = $509.26 - $500 = $9.26 today
Net Present Value (NPV)
As long as the NPV is positive, the
decision increases the value of the
firm and is a good decision
regardless of your current cash
needs or preferences regarding
when to spend the money.
The NPV Decision Rule
When making an investment
decision, take the alternative
with the highest NPV.
Choosing this alternative is
equivalent to receiving its NPV in
cash today.
Choosing among
alternative Plans
Problem
Suppose you started a Web site hosting business and then decided to return to school. Now that
you are back in school, you are considering selling the business within the next year. An investor
has offered to buy the business for $200,000 whenever you are ready. If the interest rate is 10%,
which of the following three alternatives is the best choice?
1. Sell the business now.
2. Scale back the business and continue running it while you are in school for one more year,
and then sell the business (requiring you to spend $30,000 on expenses now, but generating
$50,000 in profit at the end of the year).
3. Hire someone to manage the business while you are in school for one more year, and
then sell the business (requiring you to spend $50,000 on expenses now, but generating
$100,000 in profit at the end of the year).
Choosing among
alternative Plans
Internal Rate of Return
This interest rate is called the
internal rate of return (IRR),
defined as the interest rate that sets
the net present value of the cash
flows equal to zero.
Internal Rate of Return
For example, suppose that you have an investment opportunity
that requires a $1000 investment today and will have a $2000
payoff in six years.
Internal Rate of Return
r = 12.25%
This rate is the IRR of this
investment opportunity.
Making this investment is like
earning 12.25% per year on your
money for six years.
Application of the Time
Value of Money

BOND PRICING
Bond Pricing
Bond Pricing
Column 1. Type
Column 2. Issuer
Column 3. Price = it is the price someone is willing to pay for bond in today’s
market.
Column 4. Coupon Rate = Annual Rate of each bond
Column 5. Maturity date = date on which the coorpration pays the final
interest installment and repays the principal.
Column 6. Yield to Maturity = the yield or investment return that you would
receive if you purchased the bond today at the price listed in Column 3 and if
you held the bond to maturity. It will be the discount rate in the bond
pricing formula.
Column 7. Current Yield = is the annual coupon payment divided by the
current price
Column 8. Rating = the bond rating, a grade indicating credit quality
Pricing a Bond in Steps
Merrill Lynch As of 15-Jul-2008
Overview
Price (% of par) 109.13
Coupon rate 6.50%
Maturity date 15-Jul-2018
Yield to Maturity 5.30%
Current Yield 5.96%
Fitch Ratings AA
Coupon payment frequency Annual
First coupon date 15-Jul-2009
Type Corporate
Pricing a Bond in 4 Steps
Step 1: Lay out the timing and amount of the future cash flows
Annual coupon or interest payment = $1,000x 0,065 = $65.00
To = presents the original issue date of July 15th, 2008
T1= is the first annual coupon payment date of July 15th, 2009.
T10 = is the last payment on July 15,2018.
The coupon payments constitute an annuity stream.
The principal or par value of $1,000 pays out at the maturity.
Pricing a Bond in 4 Steps
Step 2: To determine the appropriate discount rate for this cash
flow.
- Use the yield to maturity as discount rate
Pricing a Bond in 4 Steps
Step 3: Find the present value of the cash flow
Present value of coupon stream
𝟏 𝟏
PV = PMT 𝒙 (𝟏 − )
𝒓 𝟏+𝒓 𝒏
𝟏 𝟏
= 65 𝒙 (𝟏 − ) = $494.68
𝟎.𝟎𝟓𝟑 𝟏+𝟎.𝟎𝟓𝟑 𝟏𝟎

Present Value of par value

𝟏
PV = FV x
𝟏+𝒓 𝒏
𝟏
= 65 x = $ 596.65
𝟏+𝟎.𝟎𝟓𝟑 𝟏𝟎
Pricing a Bond in 4 Steps
Step 4: is to add these two present value to get the price or value
of the bond
Bond price = $594.68 + $596.65 = $1091.33

𝟏 𝟏 𝟏
Bond price = par value * + coupon * (𝟏 − )
𝟏+𝒓 𝒏 𝒓 𝟏+𝒓 𝒏

Bond sold for $1091.33 on July 15, 2008. The price is displayed
as a percentage of the par value, so we have the displayed price
as ($1,091.33/$1000) = 109.13%
Application
A zero-coupon bond – a bond that paid zero coupon.
Bonds are difficult to value when:
▫ The principal repayment is not certain (for example, bonds with
embedded options)
▫ The coupon payments are not certain (for example, floating rate
bonds)
▫ The bond is exchangeable for another security (for example,
convertible bonds)
STOCK VALUATION
The dividend discount model
The dividend discount model (DDM) implies that share prices are
only determined by the expected future level of dividends and the
systematic risk of the future dividend flow
• The model argues that the sale price the current investor
receives will depend on the dividends some future investors
expect.
Therefore, for all present and future investors in total, expected
cash flows must be based in expected future dividends.
Example
For the next three years, the annual dividends of a stock are
expected to be $1.00, $1.10 and $1.20. The stock price is
expected to be $32.00 at the end of three years. If the required
rate of return on the shares is 10%, what is the estimated value of
a share?
The dividend discount model
The dividend discount model requires the forecast of all future
dividends. The following dividend growth rate assumptions
simplify the valuation process
▫ No growth
▫ Constant growth
▫ Differential growth
Case 1: Zero Growth
Case 1: Zero Growth
• Assume that dividends will remain at the
same level forever – constant dividends
Case 2: Constant Growth
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
Reading
BMC, Chapter 4-6; 8-9