Introduction to

Time Value of Money

Professor Jennifer L. Koski
Jan. 21, 2010

Overview*
In order to estimate the value of a firms projects and
assets, its managers must compare the benefits and
costs.
This comparison is complicated by the fact that they
occur
at different points in time
in different currencies, or
with different risks

* This material derives heavily from Berk and DeMarzo, Corporate Finance (2007)
Costs and Benefits
Example: Suppose you are offered the
following investment opportunity.
In exchange for $20,000 today, you will receive
200 shares of stock in the Coca-Cola Company today,
and
11,000 euros today.
Should you take this opportunity? Assume:
The current price of Coca-Cola is $40 and,
the current exchange rate is 0.80 euros per dollar.


Overview: Example (cont.)
Example (cont.). We need to convert the costs
and benefits to their cash values:

(200 shares Coca-Cola)x($40/sh)=$8,000 today

(11,000 euros) (0.80 euros/dollar) =$13,750 today

The net value of the opportunity is

$8,000 + 13,750 20,000 = $1,750 today.

Interest Rates
For most financial decisions, costs and
benefits occur at different points in time.
Typical investment projects incur costs upfront
and receive benefits in the future.
How do we account for this time difference when
valuing a project?

The Time Value of Money
Consider an investment opportunity with the
following cash flows:
Cost: $100,000 today
Benefit: $105,000 in one year
In general, money today is not the same as money in
one year.
If you have $1 today, you can invest it (for example, in a
bank account) and end up with more than $1 in one year.
We call the difference in value between money today
and money in the future the time value of money.
Interest Rates
By investing money at the bank, we can convert
money today into money in the future.
Similarly, by borrowing money from the bank, we can
exchange money in the future for money today.
The rate at which we can exchange money today for
money in the future by investing or borrowing is
determined by the current interest rate.
An interest rate is like an exchange rate across time.
Interest Rates
Lets evaluate the prior investment
opportunity, assuming the current annual
interest rate is 7%.
We can express both costs and benefits in
dollars one year from today:
Cost:
($100,000 today) x($1.07 in one year/dollar today) =
$107,000 in one year.
Benefit: $105,000 in one year.
Net: $105,000 107,000 = -$2000 in one year.

Interest Rates
Alternatively, we may express the value of
this investment in dollars today:
Cost: $100,000 today
Benefit: ($105,000 in one year) ($1.07 in one
year/dollar today) = $98,130.84 today
Net: $98,130.84 100,000 = -$1,869.16 today
Comparing our results, they are equivalent:
(-$1,869.16 today)($1.07 in one year/dollar
today) = -$2,000 in one year

Time Value of Money Rules

We refer to a series of cash flows lasting several
periods as a stream of cash flows.
Every stream of cash flows can be represented on a
timeline.
Financial decisions often require combining cash
flows or comparing values. To do so:
First: It is only possible to compare or combine
values at the same point in time.
A dollar today is worth more than a dollar in the future,
because you can invest it and earn interest.
Money at different points in time has distinctly different
values.

Time Value of Money Rules
Second: To move a cash flow forward in time, you
must compound it.
Example: The current interest rate is 10% per year,
and you have $1000 today to invest for 2 years.
On a timeline:


During the first year you earn $100 in interest, but
during the second year you earn more.
Compound interest: earning interest on interest.





0
$1000
2
$1210
1
$1100
1.10 1.10
Time Value of Money Rules
The value of a cash flow that is moved forward
in time is its future value (FV).
The future value (FV) of a cash flow today (C)
at an interest rate r, n periods in the future is
FV
n
=C(1+r)
n
Example: You have $500 today, and the interest rate
is 4% per year. What is the future value of this cash
flow 3 years from today?
FV
n
=C(1+r)
n
=500(1+.04)
3
=$562.43








(100)(1+.05)
190
= $1,061,614
Time Value of Money Rules
Third: To move a cash flow back in time, we
discount it.
The interest rate we use is therefore also called the
discount rate.
Suppose you anticipate receiving $1000 two years
from today, you can work backward by dividing by
(1+r) each year.

1.10
0
$826.45
2
$1000
1
$909.09
1.10
Time Value of Money Rules
In general, to move a cash flow C backward n
periods at an interest rate of r per period,
compute its present value (PV):
PV=

Example: A bond will pay $15,000 in ten
years. If the interest rate is 6% per year, what
is the bond worth today?
PV=

(1 )
n
C
r +
10
15, 000
$8375.92
(1 .06)
=
+
Valuing a Stream of Cash Flows
Consider a stream of cash flows: C
0
at date 0, C
1
at
date 1, and so on up to C
N
at date N.
We represent this cash flow stream on a timeline:


To compute the present value of this cash flow
stream, we
Compute the present value of each individual cash flow.
Once the cash flows are in common units (dollars today),
we can combine them.
N
C
N

0
C
0

2
C
2

1
C
1

Present Value, Net Present Value
The Present Value (PV) is


The Net Present Value (NPV) is


NPV Rule: If the NPV is positive, undertake
the project.


1 2
2
...
(1 ) (1 ) (1 )
N
N
C C C
PV
r r r
= + + +
+ + +
1 2
0
2
(1 ) (1 ) (1 )
N
N
C C C
NPV C
r r r
= + + + +
+ + +
Example
Suppose a project will produce $50,000 after 1
year, $10,000 after 2 years, and $210,000 after
4 years.
It costs $200,000 today to invest.
The interest rate is 9% per year.
The NPV of this project is



2 4
50, 000 10, 000 210, 000
200, 000 0 3, 057.65
1.09 (1.09) (1.09)
NPV = + + + + =
Market Prices and Arbitrage
The practice of buying and selling equivalent
goods in different markets to exploit a price
difference is called arbitrage.
If you can earn a positive profit with no net
investment and no risk, you have an arbitrage
opportunity.
Traders will react quickly to an arbitrage
opportunity, and prices will adjust.
Assets must be priced in financial markets to
rule out arbitrage (the Law of One Price).
Market Prices and Arbitrage
The market price of an asset must equal its present
value.
Example: Suppose you can borrow or lend at 10%.
Assume the market price of a one-year bond with a
FV of $110 is $98.


The price of this bond is less than its present value.
There is an arbitrage opportunity.
110
$100
(1 .10)
PV = =
+
Example (cont.)
To arbitrage this opportunity, we
1.) buy the bond
2.) borrow $100 for one year.

Example (cont.)
To arbitrage this opportunity, we
1.) buy the bond
2.) borrow $100 for one year.
The cash flows from this strategy today and at the
end of one year are:
Today One Year
Buy the bond -98 +110
Borrow $100 (1 yr) +100 -110
Net cash flow +2 0
Market Value
The only price for a bond which rules out
arbitrage is $100.
$100 is also the present value of the payoff of the
bond.
RULE: Assets must be priced in the market to
rule out arbitrage (i.e., no arbitrage)
Therefore, the present value of an asset is its market
price.

Perpetuities and Annuities
We frequently deal with projects whose cash
flows follow a special pattern:
Equal payments over a number of years.
A stream with a finite life is called an Annuity.
An infinitely lived stream is called a Perpetuity.
There are some shortcuts for evaluating the
present value of these streams of cash flows.
Perpetuities
Consider a bond that pays a fixed amount of interest
every year, forever. The principal will never be repaid.
This type of security is a Perpetuity and has been
issued by the British government.
The present value of a perpetuity is

r
C
r
C
r
C
r
C
PV
1
3
1
2
1 1
...
) 1 ( ) 1 ( ) 1 (
= +
+
+
+
+
+
=
Perpetuities
For example, the present value (today) of $100 a
year forever (starting in 1 year) when r = 10% is


Note: This formula assumes the cash flow and
interest rate are constant forever.
Also Note: This formula computes the value in one
period of cash flows that start in the next period. Be
careful with the timing.

000 , 1
10 .
100
= = PV
Perpetuities
Example: You will receive $100 per year,
starting 3 years from today and lasting forever
(r=8%).

To compute the present value today:



Note that the exponent is 2, not 3.

250 , 1
08 .
100
) 2 ( = = year PV
67 . 071 , 1
) 08 . 1 (
250 , 1
) (
2
=
+
= today PV
Growing Perpetuities
Suppose the perpetual cash flows are growing at a rate
of g% per year.
The present value is



Note: What is the reasonable range of growth rates
for this calculation?


g r
C
PV

=
1
Annuities
An Annuity is an asset that pays a fixed sum each
year, for a specified number of years.
Example: Consider an annuity that will pay $100 a
year for 10 years, starting 1 year from today.
We may think of this annuity as
a perpetuity paying $100 a year forever, starting
in 1 year, minus
a perpetuity paying $100 a year forever, starting
in 11 years.
Annuities
The value today of the first perpetuity is


The value of the second perpetuity in Year 10 is
also $1000.
The value today of the second perpetuity is


So, the PV of the annuity is 1000-385.543=614.457


1000
10 .
100
= = PV
54 . 385
) 10 . 1 (
1000
10
=
+
= PV
Annuities
To compute the present value of an annuity that
makes (constant) payments from year 1 to n:



Financial calculators and spreadsheet programs
frequently refer to annuities as PMT
(payment).

1 1 (1 )
1
(1 )
n
n
PMT r
PV PMT
r r r

| | | | +
= =
| |
+
\ . \ .
Example
You are the winner of a $30 million state lottery.
You can take your prize as either
30 payments of $1 million (starting in 1 year) or
$15 million paid today.
If the interest rate is 8% per year, which should you
choose?
To compute the present value of the annuity:


Choose the $15 million today, because the present
value is higher.
30
1 (1 .08)
$1 $11.26
.08
PV million million

| | +
= =
|
\ .
Annuities
Sometimes, we may know the present value and may
want to compute an annuity amount.
Solve the last equation for PMT.
The reciprocal of the annuity present value factor is






1 (1 )
n
r
PMT PV
r

| |
=
|
+
\ .
Example
Suppose you would like to borrow $7,000 at an
interest rate of 6% per year.
The loan plus interest are to be repaid in equal
monthly payments over 3 years.
Using r = .06/12 = .005 per month and n = 12(3)=36
months, payments are

95 . 212 $
) 005 . 1 ( 1
005 .
000 , 7 $
36
=
|
|
.
|

\
|
+

Using Financial Functions
To solve time value of money problems in
Excel or with a financial calculator, we use
five functions:
NPER, RATE, PV, PMT and FV
These functions are all based on the timeline
of an annuity.

Example
You invest $20,000 into an account paying 8% interest
per year. How much will you have in 15 years?


Use the Excel function
FV(RATE,NPER,PMT,PV)
Example: Car Loan
To compute the payment using Excel,
RATE = .005
NPER = 36
PV=7000
FV=0
Solve for the PMT:

= PMT(RATE,NPER,PV,FV)
= PMT(.005,36,7000,0) = $212.95
Mortgages
When you buy a home, you may take out a
special type of loan called a mortgage.
With a mortgage, you make equal payments that
consist of
- principal, and
- interest.
Your final principal balance at the end of the
mortgage is $0.
A mortgage payment is an annuity.
Mortgages
Suppose you have a mortgage of $100,000 for 30
years at an interest rate of 12% per year, with
monthly payments.
- n = 30(12) = 360 monthly payments.
- r = .12/12 = .01 per month.
Compute your payments:
61 . 028 , 1 $
) 01 . 1 ( 1
01 .
000 , 100
360
=
|
|
.
|

\
|
+

Mortgages
Each monthly payment of $1,028.61 is part interest
and part principal.
Month Payment Interest Principal End Balance
1 1,028.61 1,000.00 28.61 99,971.39
2 1,028.61 999.71 28.90 99,942.49
3 1,028.61 999.42 29.19 99,913.30
4 1,028.61 999.13 29.48 99,883.82

359 1,028.61 20.27 1,008.34 1,018.43

360 1,028.61 10.18 1,018.43 0.00