Time Value of

Money S2
Alexei Alvarez Drobush, CFA
Time Value of Money

Which one is worth more: one sol today or one tomorrow? Why?
Time Value of Money
❖ “Today, I have 1000 soles in my wallet that I do not expect to spend
during the year. So, I decide to put this money in a 1 yr time
deposit in a bank. The bank offers to pay me a 5.0% interest rate a
year. If I decide to invest in the 1yr time deposit, how much money
will I have in one year?
Time Value of Money
❖ “Today, I have 1000 soles in my wallet that I do not expect to spend
during the year. So, I decide to put this money in a 1 yr time
deposit in a bank. The bank offers to pay me a 5.0% interest rate a
year. If I decide to invest in the 1yr time deposit, how much money
will I have in one year?
• Interest = 5.0% * 1000 = 50
• Investment = 1000
• Value of investment after 1 year: 1000 * ( 1 + 5.0% ) = 1050

1000 1050

Today 1 year
Present Future
Value Value
Negative Interest Rates?

Do they really exist?

Future Value with Simple Interest
FVN = PV(1 + r * N)
❖ Where:
❖ FVN = Future Value of Investment N periods from today

❖ PV = Present Value (Principal of the Investment)

❖ r = Stated (quoted) interest rate per period

❖ N = Number of periods

❖ IMPORTANT:

❖ Stated interest rate (r) and the number of periods (N) must be
defined in the same time units
Simple vs. Compound Interest
❖ Simple Interest: When you only earn interest on your initial investment
(principal)

FV = PV*(1+ r*n)
❖ Compound interest: When you earn interest on the principal and on the
reinvested interest

FV = PV*(1+r)n
❖ Example:
How much money will I have in 3 years if I invest 1000 soles today…
❖ Option A: ….at a simple interest rate of 10%?
❖ Option B: … at a compound interest rate of 10%?
Compounding
❖ In the previous example, we note that:

❖ I will end up with more money if I have a compound interest

(1,331) rather than a simple interest (1,300)

❖ The difference is due to the “interest on interest”

Today Year 1 Year 2 Year 3

Future Value with Compound
Interest

❖ Where:
❖ FVN = Future Value of Investment N periods from today

❖ PV = Present Value (Principal of the Investment)

❖ r = Stated (quoted) interest rate per period

❖ N = Number of compounding periods

❖ IMPORTANT:

❖ Stated interest rate (r) and the number of compounding periods (N)
must be defined in the same time units
Future Value
❖ Unless otherwise stated, compounding should always be assumed

❖ Logical relations:
❖ For a given interest rate (r), FV increases with the number of periods (N)

❖ For a given number of periods (N), FV increases with the interest rate (r)

❖ How much would I have in the future if I invest 1,000 soles at…
• 2.5% for 1 year?
• 5.0% for 2 years?
• 10.0% for 10 years?
Compounding
Interest Rates
❖ Interest can be expressed in different dimensions:

❖ Simple

r ❖ Compound
Frequency of Compounding
❖ So far we have assumed annual interest rates with annual
compounding. But, if an investment pays interest more than once a
year, interests have to be compounded more frequently.

❖ For example:
❖ A time deposit that pays 8% interest compounded monthly
❖ A time deposit that pays a 4% interest compunded quarterly

❖ A time deposit that pays a 6% interest semi-anually

Effective Annual Rate (EAR)

❖ Calculate the EAR for a:

A. 7.0% interest rate compounded weekly
B. 15.0% interest rate compounded semianually

❖ Equivalent rates: Calculate the interest rate compounded semianually

that is equivalent to a 10% interest rate compounded quarterly
Continuous Compounding
❖ What if m --> ∞?
Interest Rates
❖ Interest can have different dimensions:

❖ Daily ❖ Simple

❖ Monthly
r ❖ Compound

❖ Annual IMPORTANT: Do not confuse the quotation of the

rate with its compounding period (for instance, a rate
could be expressed in monthly terms, yet the
compounding could occur daily)
❖ …?
Unless stated otherwise, rates can be assumed to be
quoted in annual terms
Day Count Convention
❖ A day count convention determines how interest is calculated,
determining the days between two payments.
❖ It is expressed as number of days between payments over the
number of days in a year, as agreed per convention.
❖ Many different conventions may exist within a market, so it’s
important to understand which one is being used while calculating
the EAR.
❖ For example, for commercial loans in the US and in Peru, banks
will express their “Effective Rate” using ACT / 360 (actual days
between dates over a 360-day year). This increases the actual
amount charge to clients over a year and does not represent the
true EAR.
❖ For the purposes of this class, Actual/365 will be assumed.
Interest Rates
❖ Interest can have different dimensions:

❖ Daily ❖ Simple

❖ Monthly
r ❖ Compound

❖ Annual ❖ ACT / 360

❖ ACT / 365 (aka ACT / ACT)

❖ …? ❖ 30 / 360
❖ …?
Present Value
❖ How much should I invest today at a interest rate of “r” to recieve
a certain amount “FV” in a “N” period of time?

Example: How much is worth today, 15,000 soles that I will recibe in 5
years? Annual interest rate is 5.0%
Present Value
❖ When calculating the PV of a series of Cash Flows it’s important to
understand whether the CFs are being received at the end of the
period…

S/. 50 S/. 50 S/. 50 S/. 50 S/. 50

0 1 2 3 4 5

P1 P3 P5
P2 P4
Present Value
❖ …or at the beginning of it

S/. 50 S/. 50 S/. 50 S/. 50 S/. 50

0 1 2 3 4 5

P1 P3 P5
P2 P4
Present Value
❖ Examples:

❖ How much are worth these payments to be received in the future?

1. 1,000 soles to be received in one year

2. 2,000 soles to be received in three years

❖ How much is worth a series of 3 payments to be received at the

beginning of the next three years, starting the next one?
Additivity Principle
❖ IMPORTANT: Amounts of money indexed at the same
point in time are additive
Annuity
❖ An Annuity is a finite set of level sequential cash flows.

❖ Ordinary Annuity:
CF CF CF

Today Year 1 … Year “n”

Where A is the regular Cash Flow in any period.

❖ What about an Annuity that starts today (annuity due)?

Annuity: Examples
❖ You decided to buy a car on credit. The bank offered you a loan in which you will
have to pay $ 4,800 annually at a 7% interest rate for 3 years. How much did
you pay for the car?
Annuity: Examples
❖ You decided to buy a car on credit. The bank offered you a loan in which you will
have to pay $ 4,800 annually at a 7% interest rate for 3 years. How much did
you pay for the car?

PV = cost of car
A= 4,800
r= 7%
N= 3

Numerator 0.183702123
PV = 12,596.72
Annuity: Examples
❖ Yesterday you bought a flat and have agreed to pay $ 400 per month at a 7.2%
interest rate compounded monthly for 3 years. How much was the downpayment
if the flat cost you $ 15,000?
Annuity: Examples
❖ Yesterday you bought a flat and have agreed to pay $ 400 per month at a 7.2%
interest rate compounded monthly for 3 years. How much was the downpayment
if the flat cost you $ 15,000?

PV = loan for apt

1 A= 400
1− 𝑟 𝑚𝑁 r/m = 0.60%
(1 + ) mxN = 36
𝑃𝑉 = 𝐴 𝑚
𝑟
𝑚 Numerator 0.193744493
PV = 12,916.30
Value of apt = 27,916.30
Annuity: Application to loans
❖ Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and the
loan (including interest) has to be canceled in 3 years with yearly payments.
Please, write down the loan’s payment schedule.
Annuity: Application to loans
❖ Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and the
loan (including interest) has to be canceled in 3 years with yearly payments.
Please, write down the loan’s payment schedule.

𝑟
𝐴 = 𝑃𝑉
1
1−
(1 + 𝑟)𝑁

Debt
Period Outstanding Payment Interest Capital New Debt
1 200,000 83,270 24,000 59,270 140,730
2 140,730 83,270 16,888 66,382 74,348
3 74,348 83,270 8,922 74,348 0
Annuity: Application to loans
❖ Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and the
loan (including interest) has to be canceled in 3 years with semi-annual
payments. Please, write down the loan’s payment schedule.
Annuity: Application to loans
❖ Imagine you borrowed $ 200,000 from a bank at a 12.0% interest rate and the
loan (including interest) has to be canceled in 3 years with semi-annual
payments. Please, write down the loan’s payment schedule.

𝑟
𝐴 = 𝑃𝑉 𝑚
1
1− 𝑟 𝑚𝑁
(1 + )
𝑚

Semester Debt Outstanding Payment Interest Capital Remaining Debt

1 200,000 40,673 12,000.00 28,673 171,327
2 171,327 40,673 10,279.65 30,393 140,935
3 140,935 40,673 8,456.08 32,216 108,718
4 108,718 40,673 6,523.09 34,149 74,569
5 74,569 40,673 4,474.12 36,198 38,370
6 38,370 40,673 2,302.22 38,370 0
Growing Annuity

CF CF*(1+g) CF*(1+g)n-1

Today Year 1 … Year “n”

1 (1+𝑔)𝑡
PV of a growing annuity= 𝐴 × 𝑟−𝑔
× 1− (1+𝑟)𝑡

1
FV of a growing annuity= 𝐴 × × (1 + 𝑟)𝑡 −(1 + 𝑔)𝑡
𝑟−𝑔

❖ Where: g= growth rate

Growing Annuities: Examples
❖ A retirement plan offers an annual payment of $ 40,000 for 20 years. This
payment will increase at a 2% rate every year. Please, calculate the
Present Value of the retirement plan if the discount rate is 10.0%

PV = value today of flows

A= 40,000
1 (1+𝑔)𝑡 r= 10%
PV= 𝐴 × 𝑟−𝑔 × 1 − (1+𝑟)𝑡 N= 20
g= 2%

PV = 389,561.69
Perpetuity
❖ An ordinary annuity that extends indefinitely

Example: UK Consol Bonds, some types of preferred stock

❖ PV of a ordinary annuity = Difference between PVs of Perpetuities

❖ A growing perpetuity at a rate of “g”:

PV = A / (r – g)
Perpetuities: Examples
❖ What is the PV of a perpetual Disney bond that pays $ 10 yearly
and its discount rate is 5.0%?
Perpetuities: Examples
❖ What is the PV of a perpetual Disney bond that pays $ 10 yearly
and its discount rate is 5.0%?

A= 10
r= 5%

PV = 200
Perpetuities: Examples
❖ Many analysts expect Coca Cola’s next year dividend to be $1.30
and they believe that dividends will grow at a constant rate of
5.0% in perpetuity. If the discount rate is 10%, calculate the present
value of the future dividends.
Perpetuities: Examples
❖ Many analysts expect Coca Cola’s next year dividend to be $1.30
and they believe that dividends will grow at a constant rate of
5.0% in perpetuity. If the discount rate is 10%, calculate the present
value of the future dividends.

A= 1.3
r= 10%
PV = A / (r – g) g= 5%

PV = 26.0
Perpetuities: Examples
❖ Given a 5% discount rate, find the present value of a three-year
ordinary annuity of $1000 per year starting in Year 1 as the
difference between two level perpetuities
Perpetuities: Examples
❖ Given a 5% discount rate, find the present value of a three-year
ordinary annuity of $1000 per year starting in Year 1 as the
difference between two level perpetuities

Year 1 2 3 4 5 …
Perpetuity 1 1,000 1,000 1,000 1,000 1,000 1,000
Perpetuity 2 1,000 1,000 1,000

Value of Perpetuity 1 20,000

Value of Perpetuity 2 17,277
Perpetuity 1 - Perpetuity 2 2,723.25
Solving for…
❖ Rates

❖ Number of Periods

❖ Size of Annuity Payments