Introduction

Financial Markets and Time value of Money

Define these markets

• Markets in general
Place where buyers and sellers can meet and exchange goods/services, directly or via
an intermediary

• Markets for physical assets

Assets that are physical in nature and can be employed for consumption or revenue
generation

• Markets for financial assets

Assets that are financial (providing contractual right or ownership) in nature and have
a cash flow stream attached.
• What do we call the price, or cost, of debt capital?

The interest rate

• What do we call the price, or cost, of equity capital?

Required Dividend Capital

return = yield + gain .
What four factors affect the cost of money?

• Production opportunities
• Time preferences for consumption
• Risk
• Expected inflation
Today, you invest 7 lakh to receive 8 lakh after 5 years. Are you at a
benefit or loss? Interest rate = 10%
Today, you invest 7 lakh to receive 8 lakh after 5 years. Are you at a
benefit or loss? Interest rate = 10%

Answer:
1. bring 8 lakh to present value.
2. Compare it with the 7 lakh investment.
8/(1+0.1)^5 = 4.96 lakh
You have just won a lottery for 10 lakh. You are given 3 options:
• 1. Take 7.5 lakh today
• 2. Take 0 today, 5 lakh after 2 years, and the remaining 5 lakh after 4
years
• 3. Take the entire 10 lakh after 4 years
You have just won a lottery for 10 lakh. You are given 3 options:
• 1. Take 7.5 lakh today
• 2. Take 0 today, 5 lakh after 2 years, and the remaining 5 lakh after 4
years
• 0+[5/(1+0.1)^2]+ [5/(1+0.1)^4]
• 0 + 4.132 + 3.415 = 7.547 lakh
• 3. Take the entire 10 lakh after 4 years
• 10 / (1+0.1)^4 = 6.83 lakh
 Timelines show the timing of cash flows.

0 1 2 3
i%

CF0 CF1 CF2 CF3

Tick marks at ends of periods, so Time 0

is today; Time 1 is the end of Period 1;
or the beginning of Period 2.
Timeline for a $100 lump sum due at the
end of Year 2.

0 1 2 Year
i%

100
Types of Cash Flows
• One shot payment – PV at time 0 and FV at time t
• Cash Flow stream – Equal cash flow from time 1 to time t is called as
Ordinary Annuity – Cash flow from the end of the time period
• Cash Flow stream – Equal cash flow from time 0 to time t is called as
Annuity Due – Cash flows at the beginning of the time period
Types of Cash Flows
• Cash Flow Stream – Different cash flow in every time period starting
time 1 to time t called as mixed cash flow stream (NPV)

• Cash Flow Stream – Same cash flow forever starting time 1 to time
infinity called as Perpetuity.

• Cash Flow Stream – Constantly increasing cash flow forever starting

time 1 to time infinity called as Growing Perpetuity.
Timeline for an ordinary annuity of $100
for 3 years.

0 1 2 3
i%

100 100 100

Timeline for uneven CFs: -$50 at t = 0 and $100,
$75, and $50 at the end of Years 1 through 3.

0 1 2 3
i%

-50 100 75 50
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.
After 1 year:
FV1 = PV + INT1 = PV + PV (i)
= PV(1 + i)
= $100(1.10)
= $110.00.
After 2 years:
FV2 = PV(1 + i)2
= $100(1.10)2
= $121.00.
After 3 years:
FV3 = PV(1 + i)3
= $100(1.10)3
= $133.10.

In general,

FVn = PV(1 + i)n.

 Three Ways to Find FVs

• Solve the equation with a regular calculator.

• Use a financial calculator.
• Use a spreadsheet.
What’s the PV of $100 due in 3 years if
i = 10%?

Finding PVs is discounting, and it’s

the reverse of compounding.

0 1 2 3
10%

PV = ? 100
Solve FVn = PV(1 + i )n for PV:
F
%"F ! & $
!"## $ ## F # $ #%"F # &
" &' (%
(&' ()

3
æ 1 ö
PV = $100ç ÷
è 1.10 ø
= $100 (0.7513 ) = $75.13.
 Finding the Time to Double
0 20%
1 2 ?

-1 2
FV = PV(1 + i)n
$2 = $1(1 + 0.20)n
(1.2)n = $2/$1 = 2
nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)
n = 0.693/0.182 = 3.8.
What’s the 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
What’s the FV of a 3-year ordinary
annuity of $100 at 10%?

0 1 2 3
10%

100 100 100

110
121
FV = 331
What’s the PV of this ordinary annuity?

0 1 2 3
10%

100 100 100

90.91
82.64
75.13
248.69 = PV
 Spreadsheet Solution

A B C D
1 0 1 2 3
2 100 100 100
3 248.69
Excel Formula in cell A3:
Syntax: PV(rate, nper, pmt, [fv], [type])
 Special Function for Annuities

For ordinary annuities, this formula in cell A3 gives

248.96:

=PV(10%,3,-100)

A similar function gives a future value of 331.00:

=FV(10%,3,-100)
Find the FV and PV if the
annuity were an annuity due.

0 1 2 3
10%

100 100 100

 Excel Function for Annuities Due

Change the formula to:

=PV(10%,3,-100,0,1)
The fourth term, 0, tells the function that there are
no other cash flows. The fifth term tells the function
that it is an annuity due. A similar function gives
the future value of an annuity due:
=FV(10%,3,-100,0,1)
What is the PV of this uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
 Spreadsheet Solution

A B C D E
1 0 1 2 3 4
2 100 300 300 -50
3 530.09
Excel Formula in cell A3:
=NPV(10%,B2:E2)
What interest rate would cause $100
to grow to $125.97 in 3 years?
$100(1 + i )3 = $125.97.
(1 + i)3 = $125.97/$100 = 1.2597
1+i = (1.2597)1/3 = 1.08
i = 8%.
Will the FV of a lump sum be larger or smaller
if we compound more often, holding the
stated I% constant? Why?

LARGER! If compounding is more

frequent than once a year--for
example, semiannually, quarterly,
or daily--interest is earned on interest
more often.
 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.
We will deal with 3 different
rates:

iNom = nominal, or stated, or

quoted, rate per year.
iPer = periodic rate.

EAR = effective annual. rate

• iNom is stated in contracts. Periods per year (m)
must also be given.
• Examples:
 8%; Quarterly
 8%, Daily interest (365 days)
• Periodic rate = iPer = iNom/m, where m is number of
compounding periods per year. m = 4 for quarterly, 12
for monthly, and 360 or 365 for daily compounding.
• Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 = 0.021918%.
• Effective Annual Rate (EAR):
The annual rate that causes PV to grow to the same FV as under
multi-period compounding.

Example: EAR% for 10%, semiannual:

FV = (1 + iNom/m)m
= (1.05)2 = 1.1025.
EAR% = 10.25% because (1.1025)1 = 1.1025.

Any PV would grow to the same FV at 10.25% annually or 10%

semiannually.
• An investment with monthly payments is different from one with
quarterly payments. Must put on EAR% basis to compare rates of
return.
• Use EAR% only for comparisons.
• Banks say “interest paid daily.” Same as compounded daily.
How do we find EAR% for a nominal rate of
10%, compounded semiannually?

( iNom
) -1
m

EAR% = 1 +
m

= (1 + 0.10) - 1.0
2

2
= (1.05)2 - 1.0
= 0.1025 = 10.25%.
EAR of 10%

EARAnnual = 10%.

EARQ = (1 + 0.10/4)4 - 1 = 10.38%.

EARM = (1 + 0.10/12)12 - 1 = 10.47%.

EARD(360) = (1 + 0.10/360)360 - 1 = 10.52%.

FV of $100 after 3 years under 10%
semiannual compounding? Quarterly?

mn
æ iNom ö
FVn = PVç 1 + ÷ .
è m ø
2x3
æ 0.10ö
FV3S = $100ç 1 + ÷
è 2 ø
= $100(1.05)6 = $134.01.
FV3Q = $100(1.025)12 = $134.49.
 Can the effective rate ever be equal
to the nominal rate?
• Yes, but only if annual compounding is used, i.e., if
m = 1.
• If m > 1, EAR% will always be greater than the
nominal rate.
When is each rate used?

iNom: Written into contracts, quoted by

banks and brokers. Not used in
calculations or shown
on time lines.
iPer: Used in calculations, shown on
time lines.

If iNom has annual compounding,

then iPer = iNom/1 = iNom.
 EAR: Used to compare returns on
investments with different
payments per year.

(Used for calculations if and only if dealing with

annuities where payments don’t match interest
compounding periods.)
What’s the value at the end of Year 3 of the
following CF stream if the quoted interest rate
is 10%, compounded semiannually?

0 1 2 3 4 5 6 6-mos.
5% periods

100 100 100

• Payments occur annually, but compounding occurs each 6
months.
• So we can’t use normal annuity valuation techniques.
1st Method: Compound Each CF
0 1 2 3 4 5 6
5%

100 100 100.00

110.25
121.55
331.80

FVA3 = $100(1.05)4 + $100(1.05)2 + $100

= $331.80.
 2nd Method: Treat as an Annuity

Could you find the FV with EAR?

Yes, by following these steps:

a. Find the EAR for the quoted rate:

( ) - 1 = 10.25%.
2
0.10
EAR = 1+ 2
b. Use EAR = 10.25% as the annual rate in your formula:
What’s the PV of this stream?

0 1 2 3
5%

100 100 100

90.70
82.27
74.62
247.59
On January 1 you deposit $100 in an account
that pays a quoted interest rate of 11.33463%,
with daily compounding (365 days).

How much will you have on October 1, or after

9 months (273 days)? (Days given.)
 iPer = 11.33463%/365
= 0.031054% per day.
0 1 2 273
0.031054%

-100 FV=?

FV273 = $100(1.00031054 )
273

= $100(1.08846) = $108.85.

Note: % in calculator, decimal in equation.

Now suppose you leave your money
in the bank for 21 months, which is
1.75 years or 273 + 365 = 638 days.
How much will be in your account at
maturity?
Answer: Override N = 273 with N =
638. FV = $121.91.
 iPer = 0.031054% per day.

0 365 638 days

-100 FV = 121.91

FV = $100(1 + 0.1133463/365)638
= $100(1.00031054)638
= $100(1.2191)
= $121.91.
You are offered a note that pays $1,000 in 15 months (or 456
days) for $850. You have $850 in a bank, which pays a
6.76649% nominal rate, with 365 daily compounding, which is
a daily rate of 0.018538%. You plan to leave the money in the
bank if you don’t buy the note. The note is riskless.

Should you buy it?

 iPer =0.018538% per day.

0 365 456 days

-850 1,000

3 Ways to Solve:

1. Greatest future wealth: FV

2. Greatest wealth today: PV
3. Highest rate of return: Highest EAR%
1. Greatest Future Wealth
Find FV of $850 left in bank for
15 months and compare with
note’s FV = $1,000.

FVBank = $850(1.00018538)456
= $924.97 in bank.

Buy the note: $1,000 > $924.97.

2. Greatest Present Wealth

Find PV of note, and compare

with its $850 cost:

PV = $1,000/(1.00018538)456
= $918.95.
3. Rate of Return

Find the EAR% on note and

compare with EAR% bank pays,
which is your opportunity cost of
capital:
FVn = PV(1 + i)n
$1,000 = $850(1 + i)456

Now we must solve for i.

Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.

EAR % = (1.00035646)365 - 1
= 13.89%.
Using interest conversion:

P/YR = 365
NOM% = 0.035646(365) = 13.01
EAR% = 13.89

Since 13.89% > 7.0% opportunity cost,

buy the note.
Problems on TVM
• James have just bought a scratch lottery ticket and won 10,000. He
wants to finance the future study of his newly born daughter and
invests this money in a fund with a maturity of 18 years offering a
promising yearly return of 6%. What is the amount available on the
18th birthday of his daughter? (28,543.39)
• Hari will retire in 20 years. This year he wants to fund an amount
equivalent of 15,000 to become available in 20 years. How much does
he have to deposit into a pension plan earning 7% annually?
(3876.29)
Problems on TVM
• The NPS scheme promises a monthly 0.75% return if you deposit
1000 per month for 15 consecutive years. What amount will be
accumulated after those 15 years?(378,405.77)
• Saavi has just bought a house. She estimates that the roof will have to
be renewed at a cost of 25,00,000 after 20 years. To cover these
costs, she intends to save an equal amount of money at the end of
each year, earning 6% annual interest rate. How much is such a yearly
annuity? (67,961.39)
Problems on TVM
• Prasad considers buying a house. Currently, he rents a place for
10,000 a month. The current monthly interest rate on mortgages is
0.75%. His planning period is 20 years. If he doesn’t want to increase
his housing costs, what amount of mortgage is available for his
purchase? (Neglect any tax effects here) (11,11,449.54)
• Philips Ltd has just paid a dividend per share of 1.20. Shares are
valued only on the basis of expected dividends. An annual sustainable
growth of dividends of 4% is assumed. The appropriate discount rate
is 10% per year. The planning horizon is limited to 20 years. Compute
the share value. (PV = PMT x [{1 – (1+g/1+i)^n}/(i-g)]) (14.03)
Problems on TVM
• Compute the share value of a company paying a dividend of 3.60 per
year over infinite maturity, with expected zero growth. The discount
rate is assumed to be 12% yearly. (30)
• BITS Pilani has established an endowment fund to further welfare and
education. From this fund, only the interest revenue is allowed to be
spent, in order to keep the principal unattached. Assume the fund has
a value of 100 crores and market interest rate is 6% annually. What
would be the present value of the fund endowed to the society?
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 of interest.
Generally fixed.
3. Maturity: Years until the bond
must be repaid. Declines.

4. Issue date: Date when bond

was issued.

5. Default risk: Risk that the issuer will not

make interest or principal payments.
Financial Asset Valuation

0 1 2 n
k
...
Value CF1 CF2 CFn

CF1 CF2 CFn

PV = + + ... + .
(1+ k) 1
(1+ k) 2
(1+ k) n
• 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 + LP + MRP + DRP

for debt securities.

What’s the value of a 10-year, 10%
coupon bond if kd = 10%?
0 1 2 10
10%
...
V=? 100 100 100 + 1,000

$100 $100 $1,000

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

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

= $1,000.
What would happen if expected inflation rose by 3%,
causing k = 13%?
When kd rises, above the coupon rate, the bond’s value falls below par, so
it sells at a discount.

What would happen if inflation fell, and kd declined to

7%? If coupon rate > kd, price rises above par, and bond sells at a premium.

Suppose the bond was issued 20 years ago and now has 10
years to maturity. What would happen to its value over time if the
required rate of return remained at 10%, or at 13%, or at 7%?
Bond Value ($)
1,372 kd = 7%.
1,211

kd = 10%. M
1,000

837
kd = 13%.
775

30 25 20 15 10 5 0

Years remaining to Maturity

• At maturity, the value of any bond must equal its par
value.
• The value of a premium bond would decrease to $1,000.
• The value of a discount bond would increase to $1,000.
• A par bond stays at $1,000 if kd remains constant.
Find YTM if price were $1,134.20.

INPUTS 10 -1134.2 90 1000

N I/YR PV PMT FV
OUTPUT 7.08

Sells at a premium.
Because coupon = 9% > kd = 7.08%,
bond’s value > par.
 Definitions

Current yield = Annual coupon pmt

Current price

Capital gains yield = Change in price

Beginning price

Exp total Exp Exp cap

= YTM = +
return Curr yld gains yld
Find current yield and capital gains yield for a 9%, 10-year
bond when the bond sells for $887 and YTM = 10.91%.

$90
Current yield = $887 = 0.1015 = 10.15%.

YTM = Current yield + Capital gains yield.

Cap gains yield = YTM - Current yield

= 10.91% - 10.15%
= 0.76%.
Semiannual Bonds
1. Multiply years by 2 to get periods = 2n.
2. Divide nominal rate by 2 to get periodic
rate = kd/2.
3. Divide annual INT by 2 to get PMT =
INT/2.

INPUTS 2n kd/2 OK INT/2 OK

N I/YR PV PMT FV
OUTPUT
If $1,000 is the proper price for the semiannual bond,
what is the proper price for the annual payment bond?

• Semiannual bond has kNom = 10%, with EAR% = 10.25%.

Should earn same EAR% on annual payment bond, so:

INPUTS 10 10.25 100 1000

N I/YR PV PMT FV
OUTPUT -984.80

• At a price of $984.80, the annual and semiannual bonds

would be in equilibrium because investors would earn
EAR% = 10.25% on either bond.
A 10-year, 10% semiannual coupon, $1,000 par value
bond is selling for $1,135.90 with an 8% yield to maturity.
It can be called after 5 years at $1,050.
What’s the bond’s nominal yield to call (YTC)?

INPUTS 10 -1135.9 50 1050

N I/YR PV PMT FV
OUTPUT 3.765 x 2 = 7.53%
kNom = 7.53% is the rate brokers would quote. Could
also calculate EAR% to call:

EAR% = (1.03765)2 - 1 = 7.672%.

This rate could be compared to monthly mortgages,

and so on.
Would you be more likely to earn YTM or
YTC if you bought bonds?
• Coupon rate = 10% vs. YTC = kd = 7.53%. Could raise money by
selling new bonds, which pay 7.53%.
• Thus, bonds that pay $100/year could be replaced with bonds
that pay only $75.30/year.
• Investors should expect a call; hence, YTC = 7.5%, not YTM = 8%.
• In general, if a bond sells at a premium, then (1) coupon > kd,
so (2) a call is likely.
• So, expect to earn:
• YTC on premium bonds.
• YTM on par & discount bonds.
Amortization

Construct an amortization schedule

for a $1,000, 10% annual rate loan
with 3 equal payments.
 Step 1: Find the required payments.

0 1 2 3
10%

-1,000 PMT PMT PMT

Step 2: Find interest charge for Year 1.

INTt = Beg balt (i)

INT1 = $1,000(0.10) = $100.

Step 3: Find repayment of principal in

Year 1.
Repmt = PMT - INT
= $402.11 - $100
= $302.11.
Step 4: Find ending balance after Year 1.

End bal = Beg bal - Repmt

= $1,000 - $302.11 = $697.89.

Repeat these steps for Years 2 and 3

to complete the amortization table.
 BEG PRIN END
YR BAL PMT INT PMT BAL

1 $1,000 $402 $100 $302 $698

2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000

Interest declines.
 $
402.11
Interest

302.11

Principal Payments

0 1 2 3
Level payments. Interest declines because
outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.
• Amortization tables are widely used--for home mortgages,
auto loans, business loans, retirement plans, and so on.
They are very important!
• Financial calculators (and spreadsheets) are great for setting
up amortization tables.