APrimerontheTimeValueofMoney

Thenotionthatadollartodayispreferabletoadollarsometimeinthefutureisintuitive
enoughformostpeopletograspwithouttheuseofmodelsandmathematics.The
principlesofpresentvalueprovidemorebackingforthisstatement,however,and
enableustocalculateexactlyhowmuchadollarsometimeinthefutureisworthin
todaysdollarsandtomovecashflowacrosstime.Presentvalueisaconceptthatis
intuitivelyappealing,simpletocompute,andhasawiderangeofapplications.Itis
usefulindecisionmakingrangingfromsimplepersonaldecisionsbuyingahouse,
savingforachild'seducationandestimatingincomeinretirement,tomorecomplex
corporatefinancialdecisionspickingprojectsinwhichtoinvestaswellastheright
financingmixfortheseprojects.

TimeLinesandNotation
Dealingwithcashflowsthatareatdifferentpointsintimeismadeeasierusingatime
linethatshowsboththetimingandtheamountofeachcashflowinastream.Thus,a
cashflowstreamof$100attheendofeachofthenext4yearscanbedepictedona
timelineliketheonedepictedinFigure3.1.

Inthefigure,0referstorightnow.Acashflowthatoccursattime0isthereforealready
inpresentvaluetermsanddoesnotneedtobeadjustedfortimevalue.Adistinction
mustbemadeherebetweenaperiodoftimeandapointintime.Theportionofthetime
linebetween0and1referstoperiod1,which,inthisexample,isthefirstyear.The
cashflowthatoccursatthepointintime"1"referstothecashflowthatoccursatthe
endofperiod1.Finally,thediscountrate,whichis10%inthisexample,isspecifiedfor
eachperiodonthetimelineandmaybedifferentforeachperiod.Hadthecashflows
beenatthebeginningofeachyearinsteadofattheendofeachyear,thetimelinewould
havebeenredrawnasitappearsinFigure3.2.

Notethatinpresentvalueterms,acashflowthatoccursatthebeginningofyear2isthe
equivalentofacashflowthatoccursattheendofyear1.

Cashflowscanbeeitherpositiveornegative;positivecashflowsarecalledcash
inflowsandnegativecashflowsarecalledcashoutflows.Fornotationalpurposes,we
willassumethefollowingforthechapterthatfollows:
Notation
PV
FV
Cft
A
r
g
n

Stands for
Present Value
Future Value
Cashflowattheendofperiodt
Annuity: Constantcashflowsoverseveralperiods
Discount Rate
Expected growth rate
Numberofyearsoverwhichcashflowsarereceivedorpaid

TheIntuitiveBasisforPresentValue
Therearethreereasonswhyacashflowinthefutureisworthlessthanasimilarcash
flowtoday.
(1)Individualspreferpresentconsumptiontofutureconsumption.Peoplewould
havetobeofferedmoreinthefuturetogiveuppresentconsumption.Ifthe
preferenceforcurrentconsumptionisstrong,individualswillhavetobeoffered
muchmoreintermsoffutureconsumptiontogiveupcurrentconsumption,a
tradeoffthatiscapturedbyahigh"real"rateofreturnordiscountrate.
Conversely,whenthepreferenceforcurrentconsumptionisweaker,individuals
willsettleformuchlessintermsoffutureconsumptionand,byextension,alow
realrateofreturnordiscountrate.
(2)Whenthereismonetaryinflation,thevalueofcurrencydecreasesovertime.
Thegreatertheinflation,thegreaterthedifferenceinvaluebetweenacashflow
todayandthesamecashflowinthefuture.
(3)Apromisedcashflowmightnotbedeliveredforanumberofreasons:the
promisormightdefaultonthepayment,thepromiseemightnotbearoundto
receivepayment;orsomeothercontingencymightintervenetopreventthe
promisedpaymentortoreduceit..Anyuncertainty(risk)associatedwiththe
cashflowinthefuturereducesthevalueofthecashflow.
Theprocessbywhichfuturecashflowsareadjustedtoreflectthesefactorsiscalled
discounting,andthemagnitudeofthesefactorsisreflectedinthediscountrate.The
discountrateincorporatesalloftheabovementionedfactors.Infact,thediscountrate
canbeviewedasacompositeoftheexpectedrealreturn(reflectingconsumption
preferencesintheaggregateovertheinvestingpopulation),theexpectedinflationrate
(tocapturethedeteriorationinthepurchasingpowerofthecashflow)andthe
uncertaintyassociatedwiththecashflow.

TheMechanicsofTimeValue
Theprocessofdiscountingfuturecashflowsconvertsthemintocashflowsinpresent
valueterms.Conversely,theprocessofcompoundingconvertspresentcashflowsinto
futurecashflows.
TimeValuePrinciple1:Cashflowsatdifferentpointsintimecannotbecomparedand
aggregated.Allcashflowshavetobebroughttothesamepointintimebefore
comparisonsandaggregationscanbemade.
Therearefivetypesofcashflowssimplecashflows,annuities,growingannuities,
perpetuitiesandgrowingperpetuities,whichwediscussbelow.
SimpleCashFlows
Asimplecashflowisasinglecashflowinaspecifiedfuturetimeperiod;itcanbe
depictedonatimeline:

whereCFt=thecashflowattimet.
Thiscashflowcanbediscountedbacktothepresentusingadiscountratethatreflects
theuncertaintyofthecashflow.Concurrently,cashflowsinthepresentcanbe
compoundedtoarriveatanexpectedfuturecashflow.
I.DiscountingaSimpleCashFlow
Discountingacashflowconvertsitintopresentvaluedollarsandenablestheusertodo
severalthings.First,oncecashflowsareconvertedintopresentvaluedollars,theycan
beaggregatedandcompared.Second,ifpresentvaluesareestimatedcorrectly,theuser
shouldbeindifferentbetweenthefuturecashflowandthepresentvalueofthatcash
flow.Thepresentvalueofacashflowcanbewrittenasfollows
PresentValueofSimpleCashFlow=
where
CFt=CashFlowattheendoftimeperiodt
r=DiscountRate

Otherthingsremainingequal,thepresentvalueofacashflowwilldecreaseasthe
discountrateincreasesandcontinuetodecreasethefurtherintothefuturethecashflow
occurs.
Illustration:DiscountingaCashFlow
AssumethatyouownInfosoft,asmallsoftwarefirm.Youarecurrentlyleasingyour
officespace,andexpecttomakealumpsumpaymenttotheowneroftherealestateof
$500,000tenyearsfromnow.Assumethatanappropriatediscountrateforthiscash
flowis10%.Thepresentvalueofthiscashflowcanthenbeestimated
PresentValueofPayment=

=$192,772

Thispresentvalueisadecreasingfunctionofthediscountrate,asillustratedinFigure
3.4.

II.CompoundingaCashFlow
Currentcashflowscanbemovedtothefuturebycompoundingthecashflowatthe
appropriatediscountrate.
FutureValueofSimpleCashFlow=CF0(1+r)t
where
CF0=CashFlownow
r=Discountrate
Again,thecompoundingeffectincreaseswithboththediscountrateandthe
compoundingperiod.
4

Illustration:ThePowerofCompoundingStocks,BondsandBills
Asthelengthoftheholdingperiodisextended,smalldifferencesindiscountratescan
leadtolargedifferencesinfuturevalue.Inastudyofreturnsonstocksandbonds
between1926and1997,IbbotsonandSinquefieldfoundthatstocksontheaverage
made12.4%,treasurybondsmade5.2%,andtreasurybillsmade3.6%.Assumingthat
thesereturnscontinueintothefuture,Table3.1providesthefuturevaluesof$100
investedineachcategoryattheendofanumberofholdingperiods1year,5years,10
years,20years,30years,and40years.
Table3.1:FutureValuesofInvestmentsAssetClasses
Holding
Period
1
5
10
20
30
40

Stocks

T.
T.Bills
Bonds
$112.40 $105.20 $103.60
$179.40 $128.85 $119.34
$321.86 $166.02 $142.43
$1,035.92 $275.62 $202.86
$3,334.18 $457.59 $288.93
$10,731.30 $759.68 $411.52

Thedifferencesinfuturevaluefrominvestingatthesedifferentratesofreturnaresmall
forshortcompoundingperiods(suchas1year)butbecomelargerasthecompounding
periodisextended.Forinstance,witha40yeartimehorizon,thefuturevalueof
investinginstocks,atanaveragereturnof12.4%,ismorethan12timeslargerthanthe
futurevalueofinvestingintreasurybondsatanaveragereturnof5.2%andmorethan
25timesthefuturevalueofinvestingintreasurybillsatanaveragereturnof3.6%.
TheRuleof72:AShortCuttoestimatingtheCompoundingEffect
Inapinch,theruleof72providesanapproximateanswerthequestion"Howquickly
willthisamountdoubleinvalue?"bydividing72bythediscountorinterestrateusedin
theanalysis.Thus,acashflowgrowingat6%ayearwilldoubleinvaluein
approximately12years,whileacashflowgrowingat9%willdoubleinvaluein
approximately8years.
III.TheFrequencyofDiscountingandCompounding
Thefrequencyofcompoundingaffectsboththefutureandpresentvaluesofcashflows.
Intheexamplesabove,thecashflowswereassumedtobediscountedandcompounded
annually,i.e.,interestpaymentsandincomewerecomputedattheendofeachyear,
basedonthebalanceatthebeginningoftheyear.Insomecases,however,theinterest
maybecomputedmorefrequently,suchasonamonthlyorsemiannualbasis.Inthese
cases,thepresentandfuturevaluesmaybeverydifferentfromthosecomputedonan
annualbasis;thestatedinterestrate,onanannualbasis,candeviatesignificantlyfrom
theeffectiveortrueinterestrate.Theeffectiveinterestratecanbecomputedasfollows

EffectiveInterestRate=
where
n=numberofcompoundingperiodsduringtheyear(2=semiannual;12=monthly)
Forinstance,a10%annualinterestrate,ifthereissemiannualcompounding,worksout
toaneffectiveinterestrateof
EffectiveInterestRate=1.0521=.10125or10.25%
Ascompoundingbecomescontinuous,theeffectiveinterestratecanbecomputedas
follows
EffectiveInterestRate=expr1
where
exp=exponentialfunction
r=statedannualinterestrate
Table3.2providestheeffectiveratesasafunctionofthecompoundingfrequency.
Table3.2:EffectofCompoundingFrequencyon
EffectiveInterestRates
Frequency
Annual
Semi-annual
Monthly
Daily
Continuous

Rate t Formula
10% 1 1.10-1
10% 2 (1+.10/2)21
10% 12 (1+.10/12)121
10% 365 (1+.10/365)3651
10%
exp(.10)-1

Effective Annual Rate

10%
10.25%
10.47%
10.5156%
10.5171%

Asyoucansee,compoundingbecomesmorefrequent,theeffectiverateincreases,and
thepresentvalueoffuturecashflowsdecreases.
Annuities
Anannuityisaconstantcashflowthatoccursatregularintervalsforafixedperiodof
time.DefiningAtobetheannuity,thetimelineforanannuitymaybedrawnas
follows:

Anannuitycanoccurattheendofeachperiod,asinthistimeline,oratthebeginning
ofeachperiod.
I.PresentValueofanEndofthePeriodAnnuity
Thepresentvalueofanannuitycanbecalculatedbytakingeachcashflowand
discountingitbacktothepresentandthenaddingupthepresentvalues.Alternatively,a
formulacanbeusedinthecalculation.Inthecaseofannuitiesthatoccurattheendof
eachperiod,thisformulacanbewrittenas

where
A=Annuity
r=DiscountRate
n=Numberofyears
Accordingly,thenotationwewilluseintherestofthisbookforthepresentvalueofan
annuitywillbePV(A,r,n).
Illustration:EstimatingthePresentValueofAnnuities
AssumeagainthatyouaretheownerofInfosoft,andthatyouhaveachoiceofbuyinga
copierfor$10,000cashdownorpaying$3,000ayearfor5yearsforthesamecopier.
Iftheopportunitycostis12%,whichwouldyouratherdo?

Thepresentvalueoftheinstallmentpaymentsexceedsthecashdownprice;therefore,
youwouldwanttopaythe$10,000incashnow.
Alternatively,thepresentvaluecouldhavebeenestimatedbydiscountingeachofthe
cashflowsbacktothepresentandaggregatingthepresentvaluesasillustratedinFigure
3.5.

Illustration:PresentValueofMultipleAnnuities
SupposeyouarethepensionfundconsultanttoTheHomeDepot,andthatyouare
tryingtoestimatethepresentvalueofitsexpectedpensionobligations,whichamountin
nominaltermstothefollowing:
YearsAnnualCashFlow
15$200.0million
610$300.0million
1120$400.0million
Ifthediscountrateis10%,thepresentvalueofthesethreeannuitiescanbeestimatedas
follows:
PresentValueoffirstannuity=$200million*PV(A,10%,5)=$758million
PresentValueofsecondannuity=$300million*PV(A,10%,5)/1.105=$706million
PresentValueofthirdannuity=$400million*PV(A,10%,10)/1.1010=$948million
Thepresentvaluesofthesecondandthirdannuitiescanbeestimatedintwosteps.First,
thestandardpresentvalueoftheannuityiscomputedovertheperiodthattheannuityis
received.Second,thatpresentvalueisbroughtbacktothepresent.Thus,forthesecond
annuity,thepresentvalueof$300millioneachyearfor5yearsiscomputedtobe
$1,137million;thispresentvalueisreallyasoftheendofthefifthyear.Itisdiscounted
back5moreyearstoarriveattodayspresentvaluewhichis$706million.
CumulatedPresentValue=$758million+$706million+$948million=$2,412million
II.AmortizationFactorsAnnuitiesGivenPresentValues
Insomecases,thepresentvalueofthecashflowsisknownandtheannuityneedstobe
estimated.Thisisoftenthecasewithhomeandautomobileloans,forexample,where
theborrowerreceivestheloantodayandpaysitbackinequalmonthlyinstallmentsover

anextendedperiodoftime.Thisprocessoffindinganannuitywhenthepresentvalueis
knownisexaminedbelow

Illustration:CalculatingTheMonthlyPaymentOnAHouseLoan
Supposeyouaretryingtoborrow$200,000tobuyahouseonaconventional30year
mortgagewithmonthlypayments.Theannualpercentagerateontheloanis8%.The
monthlypaymentsonthisloancanbeestimatedusingtheannuitydueformula:
Monthlyinterestrateonloan=APR/12=0.08/12=0.0067

Thismonthlypaymentisanincreasingfunctionofinterestrates.Wheninterestrates
drop,homeownersusuallyhaveachoiceofrefinancing,thoughthereisanupfrontcost
todoingso.Weexaminethequestionofwhetherornottorefinancelaterinthischapter.
III.FutureValueOfEndOfThePeriodAnnuities
Insomecases,anindividualmayplantosetasideafixedannuityeachperiodfora
numberofperiodsandwillwanttoknowhowmuchheorshewillhaveattheendof
theperiod.Thefuturevalueofanendoftheperiodannuitycanbecalculatedas
follows:

Thus,thenotationwewillusethroughoutthisbookforthefuturevalueofanannuity
willbeFV(A,r,n).
Illustration:IndividualRetirementAccounts(IRA)
Individualretirementaccounts(IRAs)allowsometaxpayerstosetaside$2,000ayear
forretirementandexemptstheincomeearnedontheseaccountsfromtaxation.Ifan
individualstartssettingasidemoneyinanIRAearlyinherworkinglife,thevalueat
retirementcanbesubstantiallyhigherthanthenominalamountactuallyputin.For
instance,assumethatthisindividualsetsaside$2,000attheendofeveryyear,starting
whensheis25yearsold,foranexpectedretirementattheageof65,andthatshe
expectstomake8%ayearonherinvestments.Theexpectedvalueoftheaccounton
herretirementdatecanbeestimatedasfollows:

Thetaxexemptionaddssubstantiallytothevaluebecauseitallowstheinvestortokeep
thepretaxreturnof8%madeontheIRAinvestment.Iftheincomehadbeentaxedat
say40%,theaftertaxreturnwouldhavedroppedto4.8%,resultinginamuchlower
expectedvalue:

Asyoucansee,theavailablefundsatretirementdropsbymorethan55%asa
consequenceofthelossofthetaxexemption.
IV.AnnuityGivenFutureValue
Individualsorbusinesseswhohaveafixedobligationtomeetoratargettomeet(in
termsofsavings)sometimeinthefutureneedtoknowhowmuchtheyshouldsetaside
eachperiodtoreachthistarget.Ifyouaregiventhefuturevalueandarelookingforan
annuityA(FV,r,n)intermsofnotation:

Illustration:SinkingFundProvisiononaBond
Inanyballoonpaymentloan,onlyinterestpaymentsaremadeduringthelifeofthe
loan,whiletheprincipalispaidattheendoftheperiod.Companiesthatborrowmoney
usingballoonpaymentloansorconventionalbonds(whichsharethesamefeatures)
oftensetasidemoneyinsinkingfundsduringthelifeoftheloantoensurethatthey
haveenoughatmaturitytopaytheprincipalontheloanorthefacevalueofthebonds.
Thus,acompanywithbondswithafacevalueof$100millioncomingduein10years
wouldneedtosetasidethefollowingamounteachyear(assuminganinterestrateof
8%):

Thecompanywouldneedtosetaside$6.9millionattheendofeachyeartoensurethat
thereareenoughfunds($10million)toretirethebondsatmaturity.
V.EffectOfAnnuitiesAtTheBeginningOfEachYear
Theannuitiesconsideredthusfarinthischapterareendoftheperiodcashflows.Both
thepresentandfuturevalueswillbeaffectedifthecashflowsoccuratthebeginningof
eachperiodinsteadoftheend.Toillustratethiseffect,consideranannuityof$100at
theendofeachyearforthenext4years,withadiscountrateof10%.

10

Contrastthiswithanannuityof$100atthebeginningofeachyearforthenextfour
years,withthesamediscountrate.

Sincethefirstoftheseannuitiesoccursrightnow,andtheremainingcashflowstakethe
formofanendoftheperiodannuityover3years,thepresentvalueofthisannuitycan
bewrittenasfollows:

Ingeneral,thepresentvalueofabeginningoftheperiodannuityovernyearscanbe
writtenasfollows:

Thispresentvaluewillbehigherthanthepresentvalueofanequivalentannuityatthe
endofeachperiod.
Thefuturevalueofabeginningoftheperiodannuitytypicallycanbeestimatedby
allowingforoneadditionalperiodofcompoundingforeachcashflow:

Thisfuturevaluewillbehigherthanthefuturevalueofanequivalentannuityattheend
ofeachperiod.
Illustration:IRASavingAtTheBeginningOfEachPeriodInsteadOfTheEnd
Consideragaintheexampleofanindividualwhosetsaside$2,000attheendofeach
yearforthenext40yearsinanIRAaccountat8%.Thefuturevalueofthesedeposits
amountedto$518,113attheendofyear40.Ifthedepositshadbeenmadeatthe
beginningofeachyearinsteadoftheend,thefuturevaluewouldhavebeenhigher:

11

Asyoucansee,thegainsfrommakingpaymentsatthebeginningofeachperiodcanbe
substantial.
GrowingAnnuities
Agrowingannuityisacashflowthatgrowsataconstantrateforaspecifiedperiodof
time.IfAisthecurrentcashflow,andgistheexpectedgrowthrate,thetimelinefora
growingannuityappearsasfollows

Notethat,toqualifyasagrowingannuity,thegrowthrateineachperiodhastobethe
sameasthegrowthrateinthepriorperiod.
TheProcessOfDiscounting
Inmostcases,thepresentvalueofagrowingannuitycanbeestimatedbyusingthe
followingformula

Thepresentvalueofagrowingannuitycanbeestimatedinallcases,butonewhere
thegrowthrateisequaltothediscountrate.Inthatcase,thepresentvalueisequaltothe
nominalsumsoftheannuitiesovertheperiod,withoutthegrowtheffect.
PVofaGrowingAnnuityfornyears(whenr=g)=nA
Notealsothatthisformulationworksevenwhenthegrowthrateisgreaterthanthe
discountrate.
Thisspreadsheetallowsyoutoestimatethepresentvalueofagrowingannuity
Illustration:TheValueOfAGoldMine
Supposeyouhavetherightstoagoldmineforthenext20years,overwhichperiodyou
plantoextract5,000ouncesofgoldeveryyear.Thecurrentpriceperounceis$300,but
itisexpectedtoincrease3%ayear.Theappropriatediscountrateis10%.Thepresent
valueofthegoldthatwillbeextractedfromthisminecanbeestimatedasfollows:

12

Thepresentvalueofthegoldexpectedtobeextractedfromthismineis$16.146
million;itisanincreasingfunctionoftheexpectedgrowthrateingoldprices.Figure
3.6illustratesthepresentvalueasafunctionoftheexpectedgrowthrate.

ConceptCheck:Ifboththegrowthrateandthediscountrateincreaseby1%,will
thepresentvalueofthegoldtobeextractedfromthismineincreaseordecrease?Why?
Perpetuities
Aperpetuityisaconstantcashflowatregularintervalsforever.Thepresentvalueofa
perpetuitycanbewrittenas

whereAistheperpetuity.Thefuturevalueofaperpetuityisinfinite.
Illustration:ValuingaConsoleBond
Aconsolebondisabondthathasnomaturityandpaysafixedcoupon.Assumethat
youhavea6%couponconsolebond.Thevalueofthisbond,iftheinterestrateis9%,is
asfollows:
ValueofConsoleBond=$60/.09=$667
Thevalueofaconsolebondwillbeequaltoitsfacevalue(whichisusually$1000)
onlyifthecouponrateisequaltotheinterestrate.

13

GrowingPerpetuities
Agrowingperpetuityisacashflowthatisexpectedtogrowataconstantrateforever.
Thepresentvalueofagrowingperpetuitycanbewrittenas:

whereCF1istheexpectedcashflownextyear,gistheconstantgrowthrateandristhe
discountrate.
Whileagrowingperpetuityandagrowingannuityshareseveralfeatures,thefactthata
growingperpetuitylastsforeverputsconstraintsonthegrowthrate.Ithastobeless
thanthediscountrateforthisformulatowork.
Illustration:ValuingaStockwithStableGrowthinDividends
In1992,SouthwesternBellpaiddividendspershareof$2.73.Itsearningsand
dividendshadgrownat6%ayearbetween1988and1992andwereexpectedtogrowat
thesamerateinthelongterm.Therateofreturnrequiredbyinvestorsonstocksof
equivalentriskwas12.23%.
CurrentDividendspershare=$2.73
ExpectedGrowthRateinEarningsandDividends=6%
DiscountRate=12.23%
ValueofStock=$2.73*1.06/(.1223.06)=$46.45
Asaninterestingaside,thestockwasactuallytradingat$70pershare.Thispricecould
bejustifiedbyusingahighergrowthrate.Thevalueofthestockisgraphedinfigure3.7
asafunctionoftheexpectedgrowthrate.

Thegrowthratewouldhavetobeapproximately8%tojustifyapriceof$70.This
growthrateisoftenreferredtoasanimpliedgrowthrate.

14

CombinationsandUnevenCashFlows
Intherealworld,anumberofdifferenttypesofcashflowsmayexistsimultaneously,
includingannuities,simplecashflows,andsometimesperpetuities:Someexamplesare
discussedbelow.

Aconventionalbondpaysafixedcouponeveryperiodforthelifetimeofthe
bond,andthefacevalueofthebondatmaturity.Intermsofatimeline:

Sincecouponsarefixedandpaidatregularintervals,theyrepresentanannuity,
whilethefacevalueofthebondisasinglecashflowthathastobediscounted
separately.Thevalueofastraightbondcanthenbewrittenasfollows:
ValueofStraightBond=Coupon(PVofanAnnuityforthelifeofthebond)
+FaceValue(PVofaSingleCashFlow)
Illustration:TheValueofaStraightBond
Sayyouaretryingtovalueastraightbondwitha15yearmaturityanda10.75%
couponrate.Thecurrentinterestrateonbondsofthisrisklevelis8.5%.
PVofcashflowsonbond=107.50*PV(A,8.5%,15years)+1000/1.08515=$
1186.85
Ifinterestratesriseto10%,
PVofcashflowsonbond=107.50*PV(A,10%,15years)+1000/1.1015=
$1,057.05
Percentagechangeinprice=($1057.05$1186.85)/$1186.85=10.94%
Ifinterestratefallto7%,
PVofcashflowsonbond=107.50*PV(A,7%,15years)+1000/1.0715=
$1,341.55
Percentagechangeinprice=($1341.55$1186.85)/$1186.85=+13.03%
Thisasymmetricresponsetointerestratechangesiscalledconvexity.
Illustration:ContrastingShortTermVersusLongTermBonds
Nowsayyouarevaluingfourdifferentbonds1year,5year,15year,and30year
withthesamecouponrateof10.75%.Figure3.8contraststhepricechangesonthese
threebondsasafunctionofinterestratechanges.

15

BondPricingProposition1:Thelongerthematurityofabond,themoresensitiveitis
tochangesininterestrates.
Illustration:ContrastingLowCouponAndHighCouponBonds
Supposeyouarevaluingfourdifferentbonds,allwiththesamematurity15years
butdifferentcouponrates0%,5%,10.75%and12%.Figure3.9contraststheeffects
ofchanginginterestratesoneachofthesebonds.

BondPricingProposition2:Thelowerthecouponrateonthebond,themoresensitive
itistochangesininterestrates.
Inthecaseofthestockofacompany,thatexpectshighgrowthinthenearfuture
andlowerandmorestablegrowthforeverafterthat,theexpecteddividendstake
thefollowingform:

Thedividendsoverthehighgrowthperiodrepresentagrowingannuity,while
thedividendsafterthatsatisfytheconditionsofagrowingperpetuity.Thevalue
ofthestockcanthusbewrittenasthesumofthetwopresentvalues.

16

GrowingAnnuityGrowingPerpetuitydiscountedback
where
P0=PresentValueofexpecteddividends
g=Extraordinarygrowthrateforthefirstnyears(n=Highgrowthperiod)
gn=Growthrateforeverafteryearn
D0=Currentdividendspershare
Dt=Dividendspershareinyeart
r=Requiredrateofreturn>DiscountRate
Illustration:TheValueofaHighGrowthStock
In1992.EliLillyhadearningspershareof$4.50andpaiddividendspershareof$2.00.
Analystsexpectedbothtogrow9.81%ayearforthenext5years.Afterthefifthyear,
thegrowthratewasexpectedtodropto6%ayearforever,whilethepayoutratiowas
expectedtoincreaseto67.44%.TherequiredreturnonEliLillyis12.78%.
Thepriceattheendofthehighgrowthperiodcanbeestimatedusingthegrowing
perpetuityformula:
Terminalprice=DPS6/(rgn)
=EPS6*PayoutRatioinStableGrowth/(rgn)
=EPS0(1+g)5(1+gn)/(rgn)
=$4.50*1.09815*1.06*0.6744/(.1278.06)=$75.81
Thepresentvalueofdividendsandtheterminalpricecanthenbecalculatedasfollows:

ThevalueofEliLillystock,basedontheexpectedgrowthratesanddiscountrate,is
$52.74.
Therearesomecaseswhereoneannuityfollowsanother.Inthiscase,the
presentvaluewillbethesumofthepresentvaluesofthetwo(ormore)
annuities.Atimelinefortwoannuitiescanbedrawnasfollows:

Thepresentvalueofthesetwoannuitiescanbecalculatedseparatelyand
cumulatedtoarriveatthetotalpresentvalue.Thepresentvalueofthesecond
annuityhastobediscountedbacktothepresent.

Conclusion

Presentvalueremainsoneofthesimplestandmostpowerfultechniquesinfinance,
providingawiderangeofapplicationsinbothpersonalandbusinessdecisions.Cash
flowcanbemovedbacktopresentvaluetermsbydiscountingandmovedforwardby
compounding.Thediscountrateatwhichthediscountingandcompoundingaredone
reflectthreefactors:(1)thepreferenceforcurrentconsumption,(2)expectedinflation
and(3)theuncertaintyassociatedwiththecashflowsbeingdiscounted

17