FINA2010 Financial Management

Lecture 3: Time Value of Money

Instructor: Prof. Si Cheng

CUHK Business School

1
 Last Lecture
• Financial Statements: Balance Sheet, Income
Statement, and Statement of Cash Flows
• Ratio Analysis: liquidity, long-term solvency,
asset management, profitability, and market
value ratios
• The Du Pont Identity: ROE = PM × TAT × EM

2
 Lecture Outline
• Basic Definitions and Concepts
• Future Value and Compounding
• Present Value and Discounting
• Multiple Cash Flows
• Annuity and Perpetuity
• Annual Percentage Rate and Effective Annual
Rate

3
 Learning Objectives
• Be able to compute the future value of an
investment made today
• Be able to compute the present value of cash to
be received at some future date
• Be able to draw and explain the use of a timeline
• Be able to solve time value of money problems
• Be able to explain what is an amortized loan and
calculate the periodic payments of such a loan

4
 Which is a Better Deal?
• You would like to buy a car that costs $20,000
today. The car dealer A offers you a 20%
discount, while the car dealer B offers you the
car for ‘free’, i.e., you can receive a
government bond that pays you $20,000 after
20 years. The annual interest rate is 10%.
• Which offer would you take?

5
 Time Value Analysis
• Cash is crucial in financial valuation.
• Determine what value we should place on
prospective cash profits
• Cash flows: amount, time, and uncertainty
• For now we will assume away uncertainty and
concentrate on how to devise techniques for
evaluating the worth of certain cash flows that
will come in at various dates in the future.

6
What is the Time Value of Money?
• The main insight to start with: $1 paid today is
worth more than $1 paid tomorrow.
• Why?
– Lost earnings: can invest the money to earn
interest
– Loss of purchasing power: because of the
presence of inflation
– Trade-off depends on the rate of return.

7
 Timelines
• Drawing timelines can be helpful in
understanding time value of money problems.
Year 0 Year 1 Year 2

End of End of
Today
Year 1 Year 2

Beginning Beginning Beginning

of Year 1 of Year 2 of Year 3

Year
0 1 2 3 4 5

8
 Basic Definition: PV and FV
• Present Value (PV): the value of something today. On a
timeline 𝑡 = 0. Present value is also referred to as the
market value of a cash flow to be received in the
future.
– Translating a value that comes at some point in the future
to its value in the present is referred to as discounting.
• Future Value (FV): the value of a cash flow sometime in
the future. On a timeline 𝑡 > 0.
– Translating a value to the future is referred to as
compounding.

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 Example: PV and FV

Year 0 • You invest $100 at 10%

• Your money grows

Year 1 to 100 + 100 × 0.1
= $110

10
 Example: PV and FV

• Receive $100, interest rate

Year 1 is 10%

• What is the Year 0

equivalent value
Year 0 of $100 received
in Year 1?
• 100/1.1 = $90.9

11
 Basic Definitions: Annuity and Perpetuity

• Annuity: a series of cash flows in which the

same cash flow or payment takes place each
period for a set number of periods.
– Ordinary Annuity: the first cash flow occurs one
period from now (end of the period 1).
– Annuity Due: the first cash flow occurs
immediately (at the beginning of period 1).
• Perpetuity: a set of equal payments that are
paid forever.
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 More Definitions
• The principal in a loan context is the original
amount borrowed.
• Interest is the compensation for the opportunity
cost of funds and the uncertainty of repayment of
the amount borrowed. Sometimes, referred to as:
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return

13
 More Timelines
• General timeline
0 1 2 3 4 5 Year

CF0 CF1 CF2 CF3 CF4 CF5

• Timeline for a $100 lump sum due at the end of Year

2
0 1 2 3 4 5 Year

100

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 More Timelines
• Timeline for an ordinary annuity of $100 for 5 years
0 1 2 3 4 5 Year

100 100 100 100 100

• Timeline for uneven CFs: −$50 at t = 0 and $100, $30,

$75, and $50 at the end of Years 1 through 4
0 1 2 3 4 5 Year

−50 100 30 75 50
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 Back to Future Values
• Future value: an amount to which an
investment will grow after earning interest
• Simple Interest: interest earned only on the
original investment.
• Compound Interest: in addition to interest
earned on the original investment, interest is
also earned on interest previously received (on
the original investment).

16
Savings Example: Simple Interest

• Deposit $100
Year 0 at 10%

• 100 + 100 × 0.1

Year 1 = $110

• 110 + 100 × 0.1

Year 2 = $120

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Savings Example: Compound Interest

• Deposit $100
Year 0 at 10%

• 100 + 100 × 0.1

Year 1 = $110

• 110 + 110 × 0.1 =

$121
Year 2 • 100 × 1.1 × 1.1 =
100 × 1.12 = $121

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Simple VS. Compound Interest

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 Another Compounding Example
• Suppose one of your ancestors deposited $10
at 5.5% interest 200 years ago. How much
would the investment be worth today?
• Under compound interest: FV = 10 × (1.055)200
= $447,189.84
• Under simple interest: FV = 10 + 200 × 10 ×
0.055 = $120.00
• Compounding added $447,069.84 to the value
of the investment!
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 Future Values: General Formula
• 𝐹𝑉𝑡 = 𝑃𝑉(1 + 𝑟)𝑡
– where 𝐹𝑉𝑡 is the future value after 𝑡 periods
– 𝑃𝑉 is the present value
– 𝑟 is the period interest rate, expressed as a
decimal (e.g., 5% = 0.05)
– 𝑡 is the number of periods
– (1 + 𝑟)𝑡 is the future value interest factor FVIF (or
future value factor)

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Future Value of $1 for Different
Periods and Rates
𝐹𝑉𝑡 = 𝑃𝑉(1 + 𝑟)𝑡

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 Example: Share Price Growth
• You invested in HSBC stocks at $46 per share
in the year end of 2015. You believe that the
share price will increase by 10 percent every
year indefinitely. How big will the share price
be in 2021?
• 𝐹𝑉𝑡 = 𝑃𝑉(1 + 𝑟)𝑡 = 46 × (1 + 0.1)6 =
$81.49

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 Financial Calculator Solution
• 𝐹𝑉𝑡 = 𝑃𝑉(1 + 𝑟)𝑡
• There are 4 variables. If 3
are known, the calculator
will solve for the 4th.
– N: number of periods
– I/Y: interest rate per period
– PV: present value
– PMT: payment per period
– FV: future value

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 Financial Calculator Solution

Inputs 6 10 −46 0
N I/Y PV PMT FV
Compute 81.49
• N: 6 periods (enter as 6)
• I/Y: 10% interest rate per period (enter as 10 NOT 0.1)
• PV: −46 (you pay $46 per share)
• PMT: not relevant in this situation (enter as 0)
• FV: compute (resulting answer is positive)

25
Financial Calculator Solution
• Press:
6 N
10 I/Y
−46 PV
0 PMT
CPT FV

26
 Back to Car Promotion
• You would like to buy a car that costs $20,000
today. The car dealer A offers you a 20%
discount, while the car dealer B offers you the
car for ‘free’, i.e., you can receive a
government bond that pays you $20,000 after
20 years. The annual interest rate is 10%.
Which offer would you take?
• Answer: PVA = 20,000 × (1 − 0.2) = $16,000
• PVB = 20,000 − 20,000/1.120 = $17,027.13

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 Quick Review MCQ
• Both Andy and Bob deposited $3,000 this morning into
an account that pays 5 percent interest, compounded
annually. Andy will withdraw his interest earnings and
spend it as soon as possible. Bob will reinvest the
interest earnings into his account. Given this, which
one of the following statements is true?
A. Bob will earn more interest the first year than Andy will.
B. Andy will earn more interest in year three than Bob will.
C. Bob will earn interest on interest.
D. After five years, Andy and Bob will both have earned the
same amount of interest.
E. Andy will earn compound interest.

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 Present Values: General Formula
• We re-arrange 𝐹𝑉𝑡 = 𝑃𝑉(1 + 𝑟)𝑡 to solve for
𝐹𝑉𝑡
𝑃𝑉 =
(1 + 𝑟)𝑡
– where 𝐹𝑉𝑡 is the future value after 𝑡 periods
– 𝑃𝑉 is the present value
– 𝑟 is the period interest rate, expressed as a decimal
(e.g., 5% = 0.05)
– 𝑡 is the number of periods
1
– is the present value interest factor PVIF (present
(1+𝑟)𝑡
value factor)

29
 Things to Remember
• When we talk about discounting, we mean
finding the present value of some future
amount. Present value is inversely related to
future value (compounding).
• When we simply talk about the “value” of
something, we are talking about the present
value. If we want future value, we specifically
indicate that we want the future value.

30
 Example: Saving Up
• You would like to buy a new automobile. You
have $50,000, but the car costs $68,500. If you
can earn 9 percent per year, how much do you
have to invest today to buy the car in two years?
Do you have enough? Assume the price will stay
the same.
𝐹𝑉𝑡 68,500
• 𝑃𝑉 = = = $57,655.08
(1+𝑟)𝑡 (1+0.09)2
• You’re still about $7,655 short, even if you’re
willing to wait two years.

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 Financial Calculator Solution

Inputs 2 9 0 68,500
N I/Y PV PMT FV
Compute −57,655.08
• N: 2 periods (enter as 2)
• I/Y: 9% interest rate per period (enter as 9 NOT 0.09)
• PMT: not relevant in this situation (enter as 0)
• FV: 68,500
• PV: compute (resulting answer is negative)

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 Present Value: Important Relationship
𝐹𝑉𝑡
• 𝑃𝑉 =
(1+𝑟)𝑡
• For a given amount to be received in the future
and for a given interest rate available, the longer
into the future that amount is to be received, the
lower the present value of that amount.
• For a given amount to be received at a given time
period in the future, the higher the interest rate,
the smaller the present value of that amount.

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Implied Discount Rate

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 Implied Discount Rate
• We can re-arrange the basic PV and FV
equations and then solve for the implied
interest rate r.
• 𝐹𝑉𝑡 = 𝑃𝑉(1 + 𝑟)𝑡
𝐹𝑉𝑡 1/𝑡
• 𝑟= −1
𝑃𝑉

35
 Example: Implied Discount Rate
• You are looking at an investment that will pay
$1,200 in 5 years if you invest $1,000 today.
What is the implied rate of interest?
1
𝐹𝑉𝑡 1/𝑡 1,200 5
• 𝑟= −1= − 1 = 3.71%
𝑃𝑉 1,000

Inputs 5 −1,000 0 1,200

N I/Y PV PMT FV
Compute 3.71
36
Example: FV of Multiple Cash Flows
• Consider the future value of $2,000 invested
at the end of each of the next five years. The
current balance is zero, and the rate of return
is 10 percent. Find the FV at the end of Year 5.

FV = ?

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Example: FV of Multiple Cash Flows
• Future value calculated by compounding each cash
flow separately

38
 Example: PV of Multiple Cash Flows
• You are offered an investment that will pay you $200
in one year, $400 the next year, $600 the next year,
and $800 at the end of the fourth year. You can earn
12 percent on very similar investments. What is the
most you should pay for this investment?

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 Annuity VS. Annuity Due
• Ordinary Annuity
0 r 1 2 3 4 5 Year

PMT PMT PMT PMT PMT

• Annuity Due
0 r 1 2 3 4 5 Year

PMT PMT PMT PMT PMT

PV FV
40
 Example: PV of an Ordinary Annuity
• Suppose we are examining an asset that promises
to pay $500 at the end of each of the next three
years. If we want to earn 10 percent per year on
our money, how much would we offer for this
asset?
0 10% 1 2 3 Year

PV = ? 500 500 500

• PV = 500/1.1 + 500/1.12 + 500/1.13 = $1,243.43

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 Financial Calculator Solution

Inputs 3 10 500 0
N I/Y PV PMT FV
Compute −1,243.43
• N: 3 periods (enter as 3)
• I/Y: 10% interest rate per period (enter as 10 NOT 0.1)
• PMT: 500 annuity (enter as 500)
• FV: 0 (no lump sum FV)
• PV: compute (resulting answer is negative)

42
 PV of Annuity: General Formula
• The present value of an annuity of $C (or any
other currency) per period for t periods when the
rate of return (or interest rate) is r is given by:
1−𝑃𝑉 𝑓𝑎𝑐𝑡𝑜𝑟
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = 𝐶 ×
𝑟
1− 1/(1+𝑟)𝑡
=𝐶×
𝑟
1 1
=𝐶× −
𝑟 𝑟(1+𝑟)𝑡
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒 𝑃𝑉 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 × (1 + 𝑟)
43
 Example: How Much Can You Afford?
• After carefully going over your budget, you have
determined you can afford to pay $600 per
month toward a new sports car (starting from
next month). You call your local bank and find out
that the going rate is 1 percent per month for 4
years. How much can you borrow?
1− 1/(1+𝑟)𝑡
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = 𝐶 ×
𝑟
1− 1/(1+0.01)4×12
= 600 × = $22,784.38
0.01

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 Example: How Much Can You Afford?

Inputs 48 1 −600 0
N I/Y PV PMT FV
Compute 22,784.38

• N: 48 (number of month to pay back)

• I/Y: 1 (interest rate per month)
• PMT: −600 (you pay $600 per month)
• PV: compute (resulting answer is positive)
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 FV of Annuity: General Formula
𝐹𝑉 𝑓𝑎𝑐𝑡𝑜𝑟−1
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑉 = 𝐶 ×
𝑟
(1+𝑟)𝑡 −1
=𝐶×
𝑟
(1+𝑟)𝑡 1
=𝐶× −
𝑟 𝑟
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐷𝑢𝑒 𝐹𝑉 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑉 × (1 + 𝑟)

46
 Perpetuity Revisited
• Recall that a perpetuity is a set of equal
payments that are paid forever.
• If the periodic payment is $C, and rate of
return is r, then the present value of the
perpetuity is:
𝐶
𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑃𝑉 =
𝑟

47
 Example: Preferred Stock
• When a corporation sells preferred stock, the
buyer is promised a fixed cash dividend every
period (usually every quarter) forever.
• Suppose the Fellini Co. wants to sell preferred
stock at $100 per share. A similar issue of
preferred stock already outstanding has a price of
$40 per share and offers a dividend of $1 every
quarter. What dividend will Fellini have to offer to
make the preferred stock attractive?

48
 Example: Preferred Stock
• The issue already out: Perpetuity PV = 40 = 1/r
→r = 2.5%
• To be competitive, the new Fellini issue will
also have to offer 2.5 percent per quarter.
• If the present value is to be $100, the dividend
must be such that: Perpetuity PV = 100 =
C/0.025
→C = $2.5 (per quarter)
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 Annual Percentage Rate (APR)
• This is the annual rate that is quoted by law. Also
known as nominal annual rate or quoted rate or
stated rate.
• APR = Period rate × Number of periods per year
• What is the APR if the semiannual rate is 4%?
• 4% × 2 = 8%
• What is the monthly rate if the APR is 12%?
• 12%/12 = 1%

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 Things to Remember
• You ALWAYS need to make sure that the
interest rate and the time period match.
– If you are looking at annual periods, you need an
annual rate.
– If you are looking at monthly periods, you need a
monthly rate.

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 Effective Annual Rate (EAR)
• Effective Annual Rate: the actual rate paid (or
received) after taking into consideration of any
compounding that may occur during the year.
• 𝐸𝐴𝑅 = 1 + 𝑄𝑢𝑜𝑡𝑒𝑑 𝑟𝑎𝑡𝑒/𝑚 𝑚 − 1
– where quoted rate is the interest rate expressed in terms
of the interest payment made each period, also known as
APR or nominal rate or stated rate
– m is the compounding frequency per year
• If you want to compare two alternative investments
with different compounding periods, you need to
compute the EAR and use that for comparison.

52
Example: Comparing Savings Accounts
• You are looking at two savings accounts. One pays
5.25%, with daily compounding. The other pays
5.3% with semi-annual compounding. Which
account should you use and why?
• First account: EAR = [1 + (Quoted rate/m)]m − 1
= (1 + 0.0525/365)365 – 1 = 5.39%
• Second account: EAR = [1 + (Quoted rate/m)]m − 1
= (1 + 0.053/2)2 – 1 = 5.37%

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 Example: Effective Annual Rates
• APR = 10% at different compounding intervals

= (1 + 0.1/4)4 − 1
= (1 + 0.1/12)12 − 1

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 Amortized Loan
• Amortized loan: the borrower will repay parts
of the loan amount over time.
• The process of providing for a loan to be paid
off by making regular principal reductions is
called amortizing the loan.
• Almost all consumer loans (such as car loans)
and mortgages have fixed equal payments.
• Each equal payment covers the interest
expense plus principal reduction.
55
 Example: Amortized Loan
• Suppose a five-year, 9 percent, $5,000 loan is
amortized with fixed equal payments. The first
payment will occur one year later.
• We first need to determine the payment.
1− 1/(1+𝑟)𝑡
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = 𝐶 ×
𝑟
1− 1/(1+0.09)5
• 5,000 = 𝐶 ×
0.09
• 𝐶 = $1,285.46
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 Example: Amortized Loan
• Fixed payment amortization schedule

• Year 1 Interest Paid = 5,000 × 9% = $450

• Year 1 Principal Paid = 1,285.46 − 450 = $835.46
• Year 1 Ending Balance = 5,000 − 835.46 = $4,164.54

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Amortized Loan with Fixed Equal Payments

• Use Mortgage Calculator:

• https://www.bankrate.com/calculators/mortgages/mortgag
e-calculator.aspx
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 Summary
• Future Value and Present Value (Single CF): 𝐹𝑉𝑡 = 𝑃𝑉(1 + 𝑟)𝑡
• Annuity (Multiple CFs):
1 1
– 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = 𝐶 × −
𝑟 𝑟(1+𝑟)𝑡
(1+𝑟)𝑡 1
– 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑉 = 𝐶 × −
𝑟 𝑟
𝐶
• Perpetuity: 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 𝑃𝑉 =
𝑟
• Effective Annual Rate: 𝐸𝐴𝑅 = 1 + 𝑄𝑢𝑜𝑡𝑒𝑑 𝑟𝑎𝑡𝑒/𝑚 𝑚 −1

59
Appendix (Not Examinable)

60
 Appendix: Derive PV of Annuity
• Recall sum of a geometric series:
1−𝑏𝑛
• σ𝑛−1
𝑘=0 𝑎𝑏 𝑘 2
= 𝑎 + 𝑎𝑏 + 𝑎𝑏 + ⋯ + 𝑎𝑏 𝑛−1
= 𝑎
1−𝑏
– where 𝑎 is the first term, 𝑏 is the common ratio, 𝑛 is the
number of terms
𝐶 𝐶 𝐶
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = + + ⋯+
1+𝑟 (1+𝑟)2 1+𝑟 𝑡
𝐶 1
• In this case, 𝑎 = ,𝑏 = ,𝑛=𝑡
1+𝑟 1+𝑟
1 𝑡
𝐶 1− 1+𝑟 1− 1/(1+𝑟)𝑡
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑃𝑉 = × 1 =𝐶×
1+𝑟 1−1+𝑟 𝑟

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 Appendix: Derive FV of Annuity
• Similarly,
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑉 = 𝐶 + 𝐶 1 + 𝑟 + ⋯ +
𝐶(1 + 𝑟)𝑡−1
• In this case, 𝑎 = 𝐶, 𝑏 = 1 + 𝑟, 𝑛 = 𝑡
1− 1+𝑟 𝑡 (1+𝑟)𝑡 −1
• 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝐹𝑉 = 𝐶 × =𝐶×
1−(1+𝑟) 𝑟

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