3.

The Present Value of Money

How do we decide if an investment is worth implementing? Revenues and expenditures occur
at different times, and as a result, we have to take account of the time value of Money. In the
previous chapter, we saw that it is essential to take into consideration the time value of Money
in financial decisions. The time value of Money depends on several influencing factors, such
as:
- the interest rate,
- the time interval,
- the amount of the principal.
In our decision, we take the time value of Money into account; this
means that we have to determine the value of Money for the same time
Picture 6.
period (year, month, week, etc.). Considering that we make decisions in
respect of the investment at the present moment, we calculate the current
time value of money.

3.1. The present value of a lump sum amount

In the previous chapter (Chapter 2), we calculated the future value of 100 000 EUR for one year
at a 6% annual interest rate and saw that the investment will grow to 1.06 ∙ 100 000 𝐸𝑈𝑅 =
106 000 𝐸𝑈𝑅 (Chapter 2.2). We will receive 106 000 EUR after one year; however, we know
that the present value of 106 000 EUR is 100 000 EUR. We can calculate the present value of
106 000 EUR (at a 6 percent rate) as the following:

Year 0 Year 1
106 000/1.06
100 000 EUR 106 000 EUR

106 000
PV = 1.06
= 100 000 EUR.
The present value of C1 one year from now equals:
1C
PV = (1+r) 1.

The present value of a future payment can be determined by multiplying the payment by the
1
discount factor (1+r):
1
PV = C1 ∙ (1+r)1.
The present value of C2 two years from now equals:
C2
PV = .
(1+r)2
The present value of Cn n years from now equals:
 n C
PV = (1+r) n.

We discount the expected payment in the n-th year by the discount rate (r) to determine the
present value of Cn .

Present value of a lump sum amount

To determine the present value of a future amount, we discount the future payment by the
interest rate. The present value of a future lump-sum amount which becomes due at the
end of n year can be calculated as the following:
Cn
PV = (1+r) n.

The discount rate is called the opportunity cost of capital because it is the return foregone by
investing in the project rather than investing in securities (Brealey – Myers, 2005).
Suppose that you lend your friend (John) 1 000 EUR, and the yearly interest rate is 5 percent.
According to your agreement, John will repay 1 200 EUR in three years. Calculate the present
value of 1 200 EUR.
The present value of 1 200 EUR 3 years from now equals:

1 200
PV = = 1 036.6 EUR.
1.053

3.2. The present value of a stream of future cash flows

3.2.1. Present value and the net present value of a stream of future cash
flows at a constant discount rate

To determine the present value of a stream of future cash flows, we add the present values of
all future payments. The present value (PV) of the future cash flows (C1 … Cn ) of an investment
is the following, assuming that the discount rate (r ) is constant over time:

C C C C C
1
PV = (1+r) 2 3 n
1 + (1+r)2 + (1+r)3 + ⋯ + (1+r)n =
∑ni i
.
(1+r)i

If we suppose the initial investment expenditure occurs now, the net present value is equal to
the difference between the present value of future cash flows and the required initial investment
C0 .

C C C C C
1
NPV = C0 + PV = C0 + (1+r) 2 3 n
1 + (1+r)2 + (1+r)3 + ⋯ + (1+r)n = C0 +
∑ni i
.
(1+r)i

Discount cash flow method (DCF formula)

The discounted cash flow method is used to evaluate the value of an investment
possibility:
Ci
PV = ∑ni i. (1+r)
Example 3.1:
Consider the cash flows shown in the following table:
Revenues minus
Year Expenditures
(million HUF)
0 -50
1 12
2 18
3 23
4 20
5 20

Suppose you would like to invest 50 000 000 HUF in a project now, and the annual difference
between the future revenues and the expenditures of your project can be found in the table
above. The discount rate is 12 percent. Determine the value of your project.
The present value of the stream of future cash flows is the following (million HUF):

12 18 23 20 20
PV = 1.12 + 1.122 + 1.123 + 1.124 + 1.125 = 65.5.
We get the net present value of the cash flows if we add the initial cost of the investment to the
present value of future cash flows (million HUF):

12 18 23 20 20
NPV = −50 + 1.12 + 1.122 + 1.123 + 1.124 + 1.125 = 15.5.
The result shows us that the investment is profitable because it yields a 15.5 million HUF profit.

3.2.2. Present value and the net present value of a stream of future cash
flows at a changing discount rate

We have assumed that the opportunity cost of capital is constant. Now, we ignore the condition
of the constant discount rate, and we assume that the rate changes over time.
Suppose that the discount rates are r1 , r2 ,...,, rn and future cash flows are C1 … Cn in period 1,
2,...,n.
Year Discount rate (%) Cash flow
1 r1 C1
2 r2 C2
3 r3 C3
. . .
. . .
. . .
n rn Cn
Determine the present value of the future cash flows step by step. The present value of cash
flow C1 is the following:

C
PV = (1+r1 )1.
1
If we want to determine the first-year value of C2 occurring in year 2, we have to determine the
discounted value of C2 using the second year discount rate r2 :

C
C2 value in year 1 = (1+r2 ).
2
To give the present value of the cash flow in year 2, we have to discount the value in year 1 by
the discount rate r1 . The present value of the cash flow C2 is the following:

C2
PV = (1+r .
1 )∙(1+r2 )
The present value (PV) of the future cash flows (C1 … Cn ) of an investment is the following,
assuming that the discount rate (r ) changes over time.

C1 C2 C3 Cn
PV = + +( +⋯+( .
(1+r1 )1 (1+r1 )∙(1+r2 ) 1+r1 )∙(1+r2)∙(1+r3) 1+r1 )∙(1+r2 )∙…∙(1+rn )

Example 3.2:
Calculate the present value and net present value of the investment examined in Example 3.1
under the changing interest rate condition. The interest rates in different years are shown in the
following table.
Revenue-
Interest rate
Year Expenditure
(%)
(million HUF)
0 -50
1 12 4
2 18 5
3 23 4
4 20 6
5 20 3

Determine the value of your project.

The present value of the stream of future cash flows is the following (million HUF):

12 18 23 20 20
PV = 1.04 + 1.04∙1.05 + 1.04∙1.05∙1.04 + 1.042 ∙1.05∙1.06 + 1.042 ∙1.05∙1.06∙1.03 = 81.02.
We get the net present value of the cash flows if we add the initial cost of the investment to the
present value of future cash flows (million HUF):

12 18 23 20 20
NPV = −50 + 1.04 + 1.04∙1.05 + 1.04∙1.05∙1.04 + 1.042 ∙1.05∙1.06 + 1.042 ∙1.05∙1.06∙1.03 = 31.02.
The result shows us that the investment is profitable because it yields a 31.02 million HUF
profit.
3.2.3. The present value of annuity cash flows

In this subsection, we examine the present value of annuity cash flows.

“An annuity is an asset that pays a fixed sum each year for a specified number of years. The
equal-payment house mortgage or instalment credit agreements are common examples of
annuities” (Brealey – Myers, 2005).
An annuity is a series of constant cash flows that occurs at the beginning or at the end of each
period. Let us assume you get 1 000 EUR at the end of each of the next five years. What is the
present value of these future cash flows?
Firstly, we determine the general form of the present value of an annuity. Suppose that we have
to pay, or we receive, the fixed sum (C) at the end of each of the next n years.

Year Cash flow

1 C
2 C
3 C
. C
. C
. C
n C

The present value of the constant cash-flow streams for n years is the following:

C C C C
PV = (1+r)1 + (1+r)2 + (1+r)3 + ⋯ + (1+r)n.
Let us try to determine the sum of the cash-flow streams. If we look carefully at the addend
terms of the present value, the addend terms represent the elements of a geometrical series. The
sum of a finite geometric series (Sn ) is the following:

qn −1
Sn = a1 ∙ ,
q−1
where a1 is the first element of the geometric series and q is the quotient of the series. Substitute
the suitable elements into the formula:

1 n 1 n
C ( ) −1 C ( ) −1 C 1
1+r 1+r
PV = (1+r)1 ∙ 1 = (1+r)1 ∙ −r = r ∙ (1 − (1+r)n ).
−1 1+r
1+r
The present value of an annuity can be written as follows:

C 1
PV = r ∙ (1 − (1+r)n ),
or
 1 1
= C ∙ ( r − r∙(1+r)n ),
1 1
where the expression in brackets is the annuity factor (r − r∙(1+r)n) which is the present value
at a discount rate r of an annuity of 1 HUF paid at the end of each of n periods.
We can determine the present value of the constant cash flows that occur at the end of each year
in other ways. Earlier, we analysed the future value of an ordinary annuity. If the payments of
equal amounts occur at the end of each period, the annuity is called an ordinary annuity.
The future value of an ordinary annuity in year n is the following:

(1+r)n−1
FVn = C ∙ .
r

The present value of an amount that is due in year n (Cn ) can be calculated as the following:

n C
PV = (1+r) n.

Apply the present formula for the future value of an ordinary annuity:

(1+r)n −1
C∙ C (1+r)n −1 C 1
r
PV = =r∙ = r ∙ (1 − (1+r)n ).
(1+r)n (1+r)n

If the constant series of cash flows occur at the beginning of each year instead of at the end of
each year, we have to multiply the present value equation by (1+r). The present value of
constant cash flows occurring at the beginning of each year is:

C 1
PV = r ∙ (1 + r) ∙ (1 − (1+r)n ).

Example 3.3:
Assume that you would like to purchase a new car, which costs 5 000 000 HUF. You get a
favourable offer. According to the offer, you have to repay the price in 60 equal annual
instalments of 150 000 HUF. The offer is equivalent to a loan that you have to pay over 5 years,
and the monthly instalment is 150 000 HUF. Determine the present value of your future
payments if the monthly interest rate is 2%.
You have to pay the instalments at the end of each month. The present value of your constant
series of payments is the following:

C 1 150 000 1
PV = r ∙ (1 − (1+r)n) = ∙ (1 − 1.0260) = 5 214 133 HUF.
0.02
If you pay the price of the car in cash instead of as a loan, you have to pay 214 133 HUF less.
3.3. Terms and Questions
annuity,
changing discount rate,
constant discount rate,
discount factor,
discount rate,
discounted cash flow method
net present value,
opportunity cost of capital,
present value,
present value of an annuity cash flows,
present value of a lump-sum amount,
present value of a stream of future cash flows,
series of payments.

Problems

Theoretical questions

1. What is the difference between the present value calculation and future value calculation?

2. Explain the discounted cash flow method.

3. How can we calculate the present value of an annuity?

4. How can we calculate the net present value of an investment possibility?

5. What is the difference between the opportunity cost of capital and the interest rate?

6. Explain what the relationship is between the present value of cash flows and the interest
rate.

7. What is the difference between annuity cash flows and a constant series of cash flows?
Give an example of each.
 8. Give the main influencing factors of the present value of a stream of future cash flows.

9. Give an example of an annuity cash flow.

10. Give the definition of an annuity.

11. How can we calculate the present value of a lump sum amount?

12. How can we calculate the present value of a stream of future cash flows?

13. What is the opportunity cost of capital?

14. What is the discount factor?

Calculation exercise

1.
Suppose that the annual interest rate is 4 percent, and investment produces the following cash
flows (million HUF):

Year Cash flow

0 -30
1 12
2 14
3 15.5
4 16
a) Calculate the present value of the investment opportunity.
b) Calculate the net present value of the investment opportunity.

2.
Determine the present value of 1 000 EUR due four years from today, under the following
conditions:

a) 10 percent interest rate compounded annually.

b) 8 percent interest rate compounded semi-annually.
 c) 2 percent interest rate compounded quarterly.

3.
Suppose that you pay 12 000 EUR at the beginning of each year for the next 10 years. The
annual interest rate is 6 percent.

a) Determine the future value of this stream of payments.

b) Determine the present value of this stream of payments.

4.
Calculate the present value of the following cash flow streams (million HUF):

Year Cash flow

0 25
1 30
2 40
3 60

a) The annual interest rate is 10 percent.

b) The annual interest rate is 1 percent.

5.
Suppose that you pay 5 000 EUR at the end of each month for the next 5 years. The monthly
interest rate is 0.8 percent.

a) Determine the future value of this stream of payments.

b) Determine the present value of this stream of payments.

6.
Consider the following information.

Time period
Present value Future value
(years)
1 200 2 326.533 4
5 600 11 263.6 5
6 000 6 756.975 6
12 000 13 230 2

a) Determine the annual interest rate.

 7.
Suppose that you have borrowed 5 000 EUR in student loans at a monthly interest rate of 1
percent. The loan requires monthly payments. If you repay 200 EUR per month, how long will
it take you to repay the loan?

8.
Suppose that the interest rate varies yearly. Consider the following information about an
investment opportunity:

Annual
Cash flow
Year interest rate
(million HUF)
(percent)
0 -150
1 50 12
2 50 13
3 60 14
4 60 15

a) Calculate the present value of the given investment opportunity.

b) Calculate the net present value of the given investment opportunity.

9.
You pay a five-year ordinary annuity of 150 EUR. The annual interest rate is 12 percent.
a) What is the present value of the annuity?
b) What is the future value of the annuity?
c) How can we determine the future value of the annuity from its present value?
d) What would the future value be if the annuity were an annuity due?
e) What would the present value be if the annuity were an annuity due?

10.
You have agreed to pay 5 500 HUF per month for 2.5 years for a mobile phone.

a) What is the equivalent price of this mobile phone, if the interest rate is an annual 1.2 percent?
b) What is the equivalent price of this mobile phone, if the interest rate is 0.5 percent monthly?

11.
 You are saving to purchase a car at the end of six years. If the car costs 16 000 EUR and you
can earn 8 percent a year on your savings, how much do you need to put aside over the six
years?

12.
Suppose you are on holiday in a very elegant hotel and you win a competition organised by the
hotel. As a winner, you can choose one of the following prizes:
a) 15 000 EUR now.
b) 10 000 EUR now and 6 000 EUR at the end of three years.
c) 20 000 EUR at the end of four years.
d) 1 500 EUR annually, forever.
e) 1 600 EUR for each of the next eight years.
Which one would you choose? The annual interest rate is 10 percent.

13.
Assume an investor offers you an investment possibility. According to the investor’s
information, you will realise 15 000 EUR annually for the next six years. The opportunity cost
of capital is 8 percent.

a) What is the maximum amount you would pay for the investment?

14.
Assume that you get 1 000 EUR at the end of each subsequent year for five years. The first cash
flow will be paid out four years from today. The annual interest rate is 10 percent.

a) Determine the present value of this stream of cash flow.

15.
Your uncle John is going to transfer 100 000 HUF at the end of the next three months to your
account. The monthly interest rate is 2 percent.

a) What is the value at the end of three months of this cash flow?
b) What is the present value of this cash flow?

16.
Try to determine the present value of a perpetuity of 1 000 EUR per year. The discount rate is
5 percent.