Investment Tools – Time Value of Money

Time Value of Money

Concepts Covered in This

Section
– Future value
– Present value
– Perpetuities
– Annuities
– Uneven Cash Flows
– Rates of return

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 Time lines show timing of cash flows.
Interest Rate

0 1 2 3
i%

CF0 CF1 CF2 CF3

Cash Flows
Tick marks at ends of periods.
• Time 0 is today; Time 1 is the end of Period 1; or the
beginning of Period 2.

90% of getting a Time Value problem correct

is setting up the timeline correctly!!!
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 Future Values
What’s the FV of an initial $100 after 3
years if i = 10%?

0 1 2 3
10%

100 FV = ?

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

compounding.
• Compounding involves earning interest on interest for
investments of more than one period.
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 Single Sum - Future & Present Value
FV3 = (1+i)3PV
FV2 = (1+i)2PV
FV1 = (1+i)PV
PV

0 1 2 3
• Assume that you can invest PV at interest rate i to receive future sum, FV
• Similar reasoning leads to Present Value of a Future sum today.

FV1 FV2 FV3

0 1 2 3
PV = FV1/(1+i)

PV = FV2/(1+i)2

PV = FV3/(1+i)3 5
 Single Sum – FV & PV Formulas

FVn = PV(1 + i )n for given PV

n
FVn  1 
PV = n = FVn  
 1+ i
1+ i
PV Calculation for $100 received in 3 years
if interest rate is 10%
 1 3
PV = $100  
 1.10 
= $100 0.7513  = $75.13.
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 Question on PV of a given FV

Ex 1. An investor wants to
have $1 million when she • This is a single payment to be
retires in 20 years. If she turned into a set future value
can earn a 10 percent FV=$1,000,000 in N=20 years
annual return, compounded time invested at r=10% interest
annually, on her rate.
investments, the lump-sum
PV =[ 1/(1+r) ]N FV
amount she would need to
invest today to reach her PV = [ 1/(1.10) ]20 $1,000,000
goal is closest to:
A. $100,000. PV10 = [0.14864]($1,000,000)

B. $117,459. PV10 = $148,644

C. $148,644.
D. $161,506.
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 Perpetuities
Perpetuity is a series of constant payments, A, each period forever.

A A A A A A A

0 1 2 3 4 5 6 7
PV1 = A/(1+r)
PV2 = A/(1+r)2
PV3 = A/(1+r)3
PV4 = A/(1+r)4
etc.
etc.

PVperpetuity = [A/(1+i)t] = A [1/(1+i)t] = A/i

Intuition:
Present Value of a perpetuity is the amount that must invested today at the
interest rate i to yield a payment of A each year without affecting the value
of the initial investment.
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 Annuities

• Regular or ordinary annuity is a finite set of

sequential cash flows, all with the same value A,
which has a first cash flow that occurs one period
from now.
• An annuity due is a finite set of sequential cash
flows, all with the same value A, which has a first
cash flow that is paid immediately.
immediately

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 Ordinary Annuity Timeline

Time line for an ordinary annuity of $100 for 3 years.

0 1 2 3
i%

$100 $100 $100

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 Ordinary Annuity vs. Annuity Due
Difference between an ordinary annuity and an
annuity due?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

PV FV 11
 Annuity Formula and Perpetuities
1. Perpetuity of A per period in Period 0 -- PV1 = A/i
A A A A A A A A A A A A A A

0 2 4 6 8 10 12 14

2. Perpetuity of A per period in Period 8 -- PV8 = [1/(1+i)]8 x (A/i)

A A A A A A

0 2 4 6 8 10 12 14
3. Annuity of A for 8 periods -- PV = PV1 – PV8 = (A/i) x { 1 – [1/(1+i)]8 }
A A A A A A A A

0 2 4 6 8 10 12 14

Intuition: Formula for a N-period annuity of A is:

PV of a Perpetuity of A today minus PV of a Perpetuity of A in period N 12
 Annuities & Perpetuities Again
• Rather than memorize the
annuity formula, it is easier
to calculate it as the
difference between two
perpetuities with the same
payment.
• PV of an N-period annuity
of $A per period is:
PVN =
(A/i) x { 1 – [1/(1+i)]N}
• Calculating the PV of an
annuity has 3 steps:
1. Calculate (A/i)
– PV of a Perpetuity with
payments of $A per
period.
2. Calculate [1/(1+i)]N
– Discount factor
associated with end of
the annuity.
3. Calculate PVN =
(A/i) x { 1 - [1/(1 + i)]N }
– I think this is easier
under pressure than
memorizing the formula.
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 Question on FV of Annuity Due
Ex 2.An individual deposits • This is an annuity due of A=$10,000
$10,000 at the beginning for N=10 years at i=9% interest rate.
• Annuity due must be adjusted by (1+i)
of each of the next 10 to reflect payment is made at
years, starting today, into beginning rather than end of period.
an account paying 9 • Also must adjust PV formula by (1+i)N
for FV of annuity.
percent interest
compounded annually. The PVN = (1+i)N(1+i)[(A/i) { 1 – [1/(1+i)]N}]
amount of money in the
PV10 = (1.09)11 ($10K/.09) {1 – [1/1.09]10}
account at the end of 10
years will be closest to: PV10 = (2.58)($111,111){1 – [0.42]}
PV10 = $165,601
A.$109,000.
B.$143,200.
C.$151,900.
D. $165,600.

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 Uneven Cash Flows

Time line for uneven CFs: $100 at end

of Year 1 (t = 1), $200 at t=2, and$300 at
the end of Year 3.

0 1 2 3
i%

$100 $200 $300

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 Question on Uneven Cash Flows
Ex 3.An investment promises to
• This is a set of unequal cash flows.
pay $100 one year from You could do it as a sum of annuities
today, $200 two years from but it is easier to calculate it directly
in this case.
today, and $300 three years
• Interest rate is i =14%.
from today. If the required
rate of return is 14 percent, PV =  [ 1/(1+i) ]t FVt
compounded annually, the PV = $100/(1.14) + $200/(1.14)2 +
value of this investment $300/(1.14)3
today is closest to: PV = $87.72 + $153.89 + $202.49
A. $404. PV = $444.10
B. $444.
C. $462.
D. $516.

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 Uneven Cash Flows
1. Uneven cash Flows over 10 periods – PV = PV10 + PV45

$100 $100 $100 $100 $100 $500 $500 $500 $500 $100

0 2 4 6 8 10 12 14

2. Annuity of $100 per period for 10 periods -- PV10 = { 1 - [1/(1+i)]10 } x (A/i)

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100

0 2 4 6 8 10 12 14
3. Annuity of $400 per period for 4 periods from period 5
-- PV45 = [1/(1+i)]5 x [ (A/i) x { 1 – [1/(1+i)]4 } ]
$400 $400 $400 $400

0 2 4 6 8 10 12 14

Intuition: PV of uneven cash flows is equal to the sum of the PV’s of regular cash
flows that sum to the uneven cash flows.
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 Comparison of Compounding Periods

0 1 2 3
10%

100 133.10
Annually: FV3 = $100(1.10)3 = $133.10.
0 1 2 3
0 1 2 3 4 5 6
5%

100 134.01
Semiannually: FV6 = $100(1.05)6 = $134.01.
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 Questions on Time Value
• Develop an approach to problems on Time Value.
1. Draw the Time line for the cash flows.
2. Put in the cash flows from the problem.
3. Identify if single payment, annuity, annuity due, or
perpetuity.
If uneven cash flows can you break it into sums of annuities?

4. Identify what is to be calculated – PV, FV, N or i ?

5. Write out the appropriate formula, put in values for the
variables, and calculate.

• Best Study Tip: Do the problems, and then do some

more and then do some more!! Practice using your
calculator!!

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 Possible Time Value Questions
• Present Value Formula
1. Given FVN, i, N – solve for PVN N
 1 
2. Given PVN , i, N – solve for FVN PVN    FVN
3. Given PVN, FVN, N – solve for i 1  i 
4. Given PVN, FVN, i – solve for N
• Perpetuity Formula
A
1. Given A, i – solve for PVper PVPerpetuity 
2. Given PVper, i – solve for A i
3. Given PVper, A – solve for i
• Annuity Formula
A 1 
1. Given A, i, N – solve for PV PV Annuity
 1  
i   1 i 
N N
2. Given A, i, N – solve for FV
 
3. Given PV, i, N – solve for A 20
Bonds and Their Valuation

• Key features of bonds

• Bond valuation
• Measuring yield
• Assessing risk

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 Key Features of a Bond

1. Par value: Face amount; paid at maturity.

Assume $1,000.
2. Coupon interest rate: Stated interest rate. Multiply
by par value to get dollars of interest.
Often fixed but can float with market rate.
3. Maturity: Years until bond must be repaid.
Declines.
4. Issue date: Date when bond was issued.
5. Default risk: Risk that issuer will not make interest or
principal payments.

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 Valuing a 5-Period Bond

Face Value, FV
Coupon Interest, CP
Time = 0

1 2 3 4 5 6 7
Discounted Cash Flow Approach
Bond Price, P B
t • Current Bond Price = Present
value of all future Cash Flows
(Interest & Principal) at required
return,
5
kB.
CPt  i FV
Pt B  PV  CF    
 1  kB   1  kB 
i 5
i 1

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 The Right Discount Factor

• The discount rate (ki) is the opportunity cost of

capital, i.e., the rate that could be earned on
alternative investments of equal risk.

ki = k* + IP + DRP + MRP + LP
k* = Real rate of interest
IP = Inflation risk premium
DRP = Default risk premium
MRP = Maturity premium
LP = Liquidity risk premium
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 Bond Valuation Example
What’s the value of a 10-year, 10%
coupon bond if kd = 10%?
0 1 2 10
10%
...
VB = ? $100 $100 $100 + $1,000

$100 $100 $1,000

VB  1 + . . . + 10 + 10
(1+ k d ) (1+ k d ) (1+ k d )

= $90.91 + . . . + $38.55 + $385.54

= $1,000.
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 Stocks and Their Valuation
• Features of common stock
• Determining common stock
values

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 Features of Common Stock

• Represents ownership.
• Ownership implies control.
• Stockholders elect directors.
• Directors hire management.
• Management’s goal: Maximize stock price.

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 Valuing Common Stock

Uncertain Dividends, Dt+i

Time = 0

1 2 3 4 5 6 7
Dividend Discount Model
• Current Stock Price = Present value
of all future Expected Cash Flows
Stock Price, PSt
(Dividends) at required return, kS.


Dte i
Pt s  PV  CF e   
 1  ks 
i
i 1

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 Stock Value = PV of Dividends

  D1 D2 D3 D
P   . . .
0
1  k  1  k  1  k 
s
1
s
2
s
3
1  k 
s


Constant Growth stock

• One whose dividends are expected to grow forever at
a constant rate, g.
• Can link this to earnings by assuming that firm pays
out a fixed percentage of earnings as dividends
• i.e. Dt = k x Et where k equals payout ratio

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