M.Sc.

 Finance 
M.Sc. Investment & Finance 
M.Sc. International Banking & Finance 
and 
M.Sc. International Accounting & Finance 
 
2011/2012 
 
40901 – Finance I 
 
FINANCIAL AND INVESTMENT DECISIONS: 
The Time Cost of Money 
 
J R Davies 
 
 
 
 
In this chapter we will consider the basic elements of financial
decision taking. Central to the analysis developed in this chapter is
the notion of the time value of money – the recognition that a pound
today is more valuable than a pound to be made available at some
point of time in the future, even if the delivery of the pound in the
future is absolutely certain and there is no inflation to erode its
purchasing power. The time value of money reflects the opportunities
available to earn interest on capital by placing it in a savings account
or some other interest-earning investment.

We will start our analysis by evaluating how a pound invested today

will grow over time when the interest income is reinvested. The sum
to which the pound will grow in the future is referred to as its future
value. Such a future value defines the equivalent value to a pound
today. We will also determine the equivalent value today of a sum to
be received in the future, and this will be referred to as the present
value. The use of these concepts will be demonstrated in an analysis
of some investment decisions. An investment generally involves the
acceptance a cost in the present in return for benefits expected in the
future. The quantitative analysis developed in this chapter will allow
costs and benefits spread out over time to be evaluated in a
systematic way to determine which investment proposals are
profitable.

While investments can take many forms, they all involve a

commitment of resources in the expectation of receiving benefits in
the future. Real investments are differentiated from financial
investments: real investments involve the use of real productive
resources, such as a machinery used to manufacture a product,,
whereas financial investments involve the purchase of paper
claims, such as shares or bonds. Some real investments may be
tangible whilst others are intangible: the purchase of a new building
is classified as a real tangible investment whereas the funding of an
advertising campaign is perceived as an intangible but real
investment. Further distinctions could be developed, but we will find
that the same general principles are employed in the evaluation of all
sorts of investments. We will also find that the same approach should
be employed in decisions concerned with the raising of funds to
finance a company’s activities e. g. for financing proposals the timing
of costs and benefits is the reverse of those for an investment: a
financing arrangement usually involves the receipt of funds today in
return for a commitment to bear the interest costs and make
repayments in the future.

Objectives
After completing the chapter you should be able to:
ƒ define and interpret the notion of compound interest
ƒ calculate the future value of a current sum

ƒ determine and interpret the net terminal value of investment

proposals

ƒ calculate the present value of future cash flows

ƒ determine and interpret the net present value of investment

proposals

ƒ explain the concept of discounted rate of return (internal rate of

return, or yield), and

ƒ calculate the rate of return for different types of proposals.

1 The time cost of money
As suggested above, most investment and financing decisions require
an evaluation of costs and benefits spread out over time. Investments You should read chapter four in
usually require a commitment of funds today in the expectation of Hillier et al in conjunction with
receiving benefits in the future. The timing of costs and benefits are this unit.
reversed for financing proposals such as borrowing from a bank –
cash is received today on the understanding that payments will be
made to cover the repayment of the loan and interest charges in
future time periods. The difference in timing of the costs and benefits
for an investment implies that it is not possible to determine its
profitability by simply adding up the various costs and benefits. The
timing of the costs and benefits has to be taken into account as money
has a time cost – a pound today is worth more than a pound at some
point in time in the future. This time cost stems from the ability of
money to earn interest over time (see the figure on page 32).

Anyone studying for an MBA degree has

already taken a major investment
decision (see figure). Some costs have
been incurred and others are being
absorbed day by day, while the expected
benefits stretch well into the future.
There are some explicit out-of-pocket
costs, such as the course fees that have been paid and the incremental
costs of accommodation and/or travelling. There is also the cost of the
salary forgone over the time taken to complete the course, although
for some MBA students these costs will be borne by their employers.
There are also less explicit costs associated with having to give up
some leisure activities as a result of the pressure of work! In return,
candidates anticipate the benefits of higher salaries and more
interesting employment opportunities over decades to come.
There are numerous rates of interest quoted in the market that reflect
the varying risks of different financial investments. Any market rate
of interest can be thought of as consisting of three components – the
first is always present while the other two will depend on the macro-
economic environment and the nature of the investment respectively:
ƒ the real rate of interest

ƒ a premium for inflation

ƒ a premium for risk.

For example, if in the absence of inflation a government can borrow in

its own currency at 4 per cent we can refer to this as the real and
riskless rate of interest. But if inflation is running at 3 per cent, the
government will have to offer investors a premium of 3 per cent or so
to compensate them for the fall in the purchasing power of their funds
by the end of the investment period. This implies a rate of interest of
about 7 per cent. At the same time, a company may have to pay an
interest rate of 9 per cent, the difference between the government’s
rate of 7 and the 9 per cent being a risk premium necessary to induce
lenders to accept the possibility that the company will default on
future payments. To keep our analysis manageable, we will assume
initially, that there is one rate of interest. We will set aside the
problems posed by risk and inflation for the moment and will presume
that we are dealing with risk-free investments in a world
characterised by constant prices.

The interest rate can be viewed as the price that balances the supply
and demand for loans, and is illustrated in the figure below. The
supply of loans stems from the savings of individuals and companies,
and to keep our analysis simple we
will assume that all savings end up
as deposits in banks. The higher the
rate of interest, the greater the level
of savings, and, all else being equal,
the higher the level of deposits
placed in banks, the greater the
funds at the disposal of the banks to
make loans. Savings become the
basis of the supply of loans. The
demand stems from companies
wishing to invest in productive
opportunities. The lower the cost of
borrowing, the more such
opportunities will be profitable for firms to undertake and the greater
their demand for loans.
The interest rate or the time value of money plays a key role in most
financial decisions, including the evaluation of capital expenditure
proposals, the assessment of the different forms of funding employed
by companies, and the valuation of securities such as bonds and
shares. Indeed, it permeates all aspects of finance. This chapter
considers how the time value of money can be systematically
incorporated into decision taking. It deals with what is often
described as financial arithmetic, and, while the subject matter is not
very exciting, it provides the basis of much of the analysis covered in
subsequent chapters, and it is essential that you master the basic
principles. (The more mathematically inclined will find the
quantitative analysis very straightforward, but those of you with a
more limited exposure to mathematics may find some of the analysis
demanding at first. But the maths employed is simply high school
maths, and you will find that with a little practice it poses far fewer
problems than it might have done the first time around.)

A simple example will illustrate the advantages of taking a

systematic approach to investment and financing decisions. An
investment project requires an outlay of £1,000 and is expected to
produce a single cash inflow of £1,100 one year from today. Is this a
worthwhile investment? Before we can answer this question, we need
to know how much interest income would be forgone by tying up
money in the project. If the prevailing interest rate is 5 per cent, the
£1,000 required by the project could be placed in a deposit account to
produce £1,050 by the end of the year. This implies that using the
funds for the investment is more productive than placing them in a
bank account. But if the interest rate is 12 per cent, a deposit account
would grow to £1,120 by the end of the year and the project is not now
an attractive use of the funds. Even though the project will allow the
recovery of the initial outlay (£1,000) and produce a surplus of £100, it
does not constitute a sufficiently profitable use of funds and should be
rejected.
The decision requires the comparison of a cost and benefit that occur
at different points in time. To allow such a comparison to be made, we
can either express the cost in terms of its equivalent value at the end
of the year, so that it can be compared to the benefit expected at that
time, or the benefit needs to be expressed in terms of its equivalent
value today so that it can be compared with the outlay required.
Given an interest rate of 12 per cent, the equivalent value at the end
of the year to £1,000 today is £1,120, the benefit forgone by not
placing the funds in a bank account, and this can be compared to the
cash flow of £1,100 expected from the investment. In terms of money
valued at the end of the year, the investment registers a net loss of
£20 and should be rejected. Alternatively, we could determine the
amount that we would have had to deposit in a bank account paying
interest at 12 per cent to produce the £1,100 promised by the project.
This turns out to be approximately £982, and this sum can be
compared with the project cost of £1,000 to determine the net benefit
or loss of the investment: the net loss in terms of today’s money is
£18. It is again clear that the investment does not constitute a good
use of funds if the interest is 12 per cent.
2 Compound interest and future values
We will now demonstrate how these types of calculation can be
undertaken on a more systematic basis, as will be needed for the
evaluation of more complex investment proposals. We begin by
determining the equivalent future value of a sum available today.
Extending the analysis for more than one period requires an
understanding of compound interest, the term used to describe the
implications of earning interest on the reinvestment of interest.

In developing the analysis we will make some simplifying

assumptions:
ƒ costs and benefits are interpreted as cash outflows (negative) and
cash inflows (positive) respectively

ƒ cash flows occur at the end of the period in which they are
expected to arise

ƒ the interest rate is constant over time, and

ƒ all cash flows are certain and prices are constant.

Consider an individual who has £1,000 available to invest. This can

be placed in a risk-free investment (eg treasury bills or a bank
deposit) to earn 10 per cent per annum. By the end of the first year,
the individual’s funds will have grown to £1,100 as a result of the
interest income of £100 (ie 10 per cent of £1,000). On this basis we can
say that, given the rate of interest of 10 per cent, £1,100 is the
equivalent value in one year’s time of £1,000 today. This implies that
an investor would be indifferent to the receipt of £1,000 today and
£1,100 at the end of the year. If the initial deposit and the interest
earned in the first year are reinvested for a second year, the sum will
grow to £1,210: the deposit of £1,100 at the start of the year plus the
interest of £110 (ie 10 per cent of £1,100). As £1,000 deposited in a
bank account will grow to £1,210 by the end of Year 2, we can say that
these are equivalent values: once again, an individual, in principle,
will be indifferent to £1,000 today and £1,210 at the end of Year 2
when the interest rate is 10 per cent. The interest received in the
second year will be greater than that of the first year as the result of
the ability to earn interest on the interest income generated in the
first year and reinvested. The interest effects are compounded, hence
the term compound interest referred to above. The calculations can be
set out more formally. For this purpose let us define the following
terms:
V0 = the sum available at the time period zero (today), and this
may also be referred to as the principal amount or
present value

Vt = the value of a sum at the end of period t

r = the interest rate given in decimal form, ie 10 per cent = 0.1

(l + r )t = the interest factor for t years given an interest rate of r.

As we have seen, a deposit of £1,000 will grow to £1,100 by the end of

a year if the interest rate is 10 per cent:
V1 = 1,000 +1,000 × 0.10
= 1,000 (1+ 0.10)
= £1,100

and by reinvesting the £1,100, the sum will grow to £1,210 by the end
of Year 2:
V2 = 1,100 +1,100× 0.10
= 1,100 (1+ 0.10 )
= £1,210

By substituting the expression 1,000 (1+ 0.10) for 1,100, the term
V2 can be written as:

V2 = 1,000 (1 + 0.10 )x (1 + 0.10 )

= 1,000 (1 + 0.10 )2
= 1,000(1.210 )
= £1,210

where (1+ 0.10 )2 is the compound or future value interest factor for
two years at an interest rate of 10 per cent.

We derive the value at the end of Year 2 by multiplying the initial

sum by the interest factor for each of the two years, ie the interest
factor squared. It will come as no surprise that the value at the end of
Year 3 is given by multiplying the initial value by the interest factor
raised to the power three:

V3 = 1,000 (1+ 0.10)3 =1,000 (1.331)

= £1,331

The interest earned in the first year is £100, in the second year £110,
and in the third £121 (see figure). The interest income in the first
year is simply the interest on the initial investment, but in the second
and third year it includes some interest
earned on the reinvested interest income
of the previous year(s). The additional
interest income of £10 expected in Year 2,
for example, is the interest on the first
year’s reinvested interest income of £100.
£1000 has the same real value as
£1100 at the end of the first year,
£1210 after two years, £1331 after
three years and £1464.10 after
four years – given an interest rate
of 10 per cent.

To see the role played by compound interest we will

consider an investment of £1,000 at an interest of 20
per cent. The interest on the initial investment of
£1,000 is £200 per annum, but after the first year
interest will also be earned on interest. In year two
£200 of interest will again be earned on the initial
investment, but a further £40 of interest will be
earned on the interest received at the end of the first
year and reinvested. Interest income will continue to
grow year by year as the sum invested grows with the
re-investment of interest. By Year 5 more interest is
being earned on re-invested interest than on the
initial capital. The growth of capital and interest
income when the interest rate is 20
per cent and interest earnings are re-invested is set
out in Table 2.1 and illustrated here.

A sum of £1000 invested at 20 per

cent will grow to £4300 by the end
of Year 8:

Original capital £1000

Interest on capital £1600
Interest on interest £1700
We will next set out the analysis in a more general algebraic form.
Let us assume that the sum available for investment today is V0 .
Over the course of the next year, this sum will earn interest of r times
V0 . Adding the interest to the initial sum produces the expected value
of the investment at the end of the year:

V1 =V0 + V0r

and this can be written

=V0 (1+ r )

Table 2.1 Bank deposit with interest at 20 per cent reinvested – compound interest at work

Years Balance at the Interest Interest on Interest on Balance at

beginning of the initial earlier the end of
the year deposit interest the year
1 1,000.00 200.00 200.00 0.00 1,200.00
2 1,200.00 240.00 200.00 40.00 1,440.00
3 1,440.00 288.00 200.00 88.00 1,728.00
4 1,728.00 345.60 200.00 145.60 2,073.60
5 2,073.60 414.72 200.00 214.72 2,488.32
6 2,488.32 497.66 200.00 297.66 2,985.98
7 2,985.98 597.20 200.00 397.20 3,583.18
8 3,583.18 716.64 200.00 516.64 4,299.82

This sum will be available for investment in the second year, and by
the end of the second year the investment will have grown to V2 .

V2 =V1 + V1r
=V1 (1+ r )

Substituting V0 (1+ r ) for V1 allows the expected value at the end of

Year 2 to be expressed in terms of the capital available today and the
interest rate:
V2 =V0 (1+ r )(1+ r )
=V0 (1+ r )2

Each additional year added to the time period under consideration

requires the multiplication by a further interest factor, and we can
write the general form of the future value equation as:

Vn =V0 (1+ r )n
This is the basic equation of compound interest calculations, and all
the other expressions used in the analysis of the time value of money
can be derived from it.

Tables for the expression (1+ r )n are available

for different values of r and n. As we can see
from Table 2.2, for a given number of time
periods, the higher the interest rate is, the
higher is the future value factor (reading along
the row), and for a given interest rate, the
longer the time period is the higher is the
future value factor (reading down a column).
As illustrated in the figure to the right, the
future value or compound interest factors do
not increase linearly with time but at an
increasing rate, reflecting the impact of the
compounding process.

Table 2.2 Compound interest factors

Years Interest rates

1% 5% 10% 15% 20% 25%
1 1.0100 1.0500 1.1000 1.1500 1.2000 1.2500
2 1.0201 1.1025 1.2100 1.3225 1.4400 1.5625
3 1.0303 1.1576 1.3310 1.5209 1.7280 1.9531
4 1.0406 1.2155 1.4641 1.7490 2.0736 2.4414
5 1.0510 1.2763 1.6105 2.0114 2.4883 3.0518
6 1.0615 1.3401 1.7716 2.3131 2.9860 3.8147
7 1.0721 1.4071 1.9487 2.6600 3.5832 4.7684
8 1.0829 1.4775 2.1436 3.0590 4.2998 5.9605
9 1.0937 1.5513 2.3579 3.5179 5.1598 7.4506
10 1.1046 1.6289 2.5937 4.0456 6.1917 9.3132
20 1.2202 2.6533 6.7275 16.3665 38.3376 86.7362
25 1.2824 3.3864 10.8347 32.9190 95.3962 264.6978
40 1.4889 7.0400 45.2593 267.8635 1469.7716 7523.1638
50 1.6446 11.4674 117.3909 1083.6574 9100.4382 70064.9232
To illustrate the use of the future value factor, let us determine the
equivalent value at the end of Year 7 of £1,000 available today if the
rate of interest is 8 per cent:

V7 =V0 (1+ r )7
= 1,000 (1+ 0.08)7
= 1,000 (1.714 )
= £1,714

A sum of £1,000 invested today for seven years at an interest rate of 8

per cent will produce a sum of £1,714.
2.1 You place £500 in a bank account yielding an interest rate of
6 per cent. Assuming the interest income is reinvested in the
account, how much will the bank account grow to by the end of
Year 5?

Whilst tables are available to give the values of the interest factors it
is generally more convenient to use a calculator to determine their
( )
value . You do this simply by employing the power function y x . The
value for y is given by the interest factor (1+ r ) , and the value for x is
given by the number of time periods. To obtain the interest factor or
future value factor for 5 years at 8 per cent, simply enter 1.08, press
y x , enter 5, and the value of 1.4693 will appear. (Financial
calculators provide a range of functions that are useful, but such
calculators are not required for this unit and cannot be used in
examinations.)

Spreadsheets also provide functions that will undertake many

financial calculations, including future values. The formula, found by
pressing the function wizard button ( f X ) , is given by:

FV (Rate, Nper, Pmt, Pv)

where Rate stands for the interest rate, entered in decimal form

Nper is the number of time periods

Pmt is the payment in each time period

Pv is the present value.

To calculate the (future) value after six years of an investment of

£1,000 (today) at an interest rate of 8 per cent requires the following
steps:

ƒ click on the function button ( f X )

ƒ choose the financial category

ƒ click on function FV

ƒ enter Rate at 0.08

ƒ enter Nper as 6 – the number of time periods

ƒ enter Pv, the sum available today of £1,000, as –1,000 (an

investment or outlay)
and the result will be given as £1586.87. This takes the pain out of
the calculation!

Compound interest factors can also be

employed to determine the future value
of cash flows that occur at points in time
later than the present, as shown in this
figure. The value at the end of Period 2 of
a cash flow expected at the end of Period
1 is derived by multiplying the expected
cash flow by the interest factor for one
period:
V2 =V1 (1+ r )

and, more generally, the future value at time t of a cash flow expected
at the end of period n will be given by

Vt =Vn (1+ r )t − n

ie the sum (Vn ) will be invested to earn interest for t minus n years.

Given a value at a point in time, it is possible to determine its

equivalent value at any subsequent point in time by multiplying by
the appropriate compound interest factor.

You expect to receive £250 the end of Year

3. Determine the equivalent value four
years later at the end of Year 7 if the
interest rate is 16 per cent.
250(1.16 )4 = 250(1.8106 )= £452.66

2.2 What is the equivalent value at the end of Year 8 of £3,000

expected at the end of year 5 if the interest rate is 5 per cent? (Use
your calculator or the tables.)

Before leaving the calculation of future values, we can consider one

further example to underline the importance of compounding and to
provide some indication of the average returns available on financial
investments.
For a number of years a company now owned by Barclays Bank has
produced data on the returns on different forms of investment in the
UK (Barclays Capital ‘Equity Gilt Study’). The 1998 study estimated
that the average annual return on equities over the period 1919–97,
79 years, was 12.2 per cent. Assuming that the returns each year
were invested, how much would an investment of £1,000 at the start
of the period have grown to by the end of 1997?

£1,000 (1 + 0.122 )79 = £1000(8900 .9364 ) = £8,900,936

The average rate of inflation during this period was 4.1 per cent, so
this sum overstates the growth in real purchasing power produced by
the investment. Using 8 per cent as an approximation of the real
return gives a more modest value of:

£1,000 (1 + 0.08 )79 = £1000 x (436.9952) = £436,995

How much would have been accumulated if the money had been
placed in a bank deposit to earn interest? The rate of interest, without
any adjustment for inflation, averaged 5.4 per cent over the period:

£1,000 (1 + 0.054 )79 = £1000 x (63.7394 ) = £63,739

After allowing for inflation, the real return on a bank deposit would
have been about 1.3 per cent;

£1,000 (1 + 0.013 )79 = £1000 x (2.7743) = £2,774

Not such a grand sum!

Simple interest
We have not yet considered the concept of simple interest as it is of
limited applicability, but a short discussion might be worthwhile.

Simple interest is paid on the initial capital sum and is a constant

sum in each time period. If simple interest is paid at the rate of r for n
periods, the initial sum V0 will grow by the end of period n to:
Vn = V0 + rV0 n = V0 (1 + rn )

Some financial contracts employ simple interest (although the market

will generally value these arrangements on a compound interest
basis!). For example, with bonds paying interest on a periodic basis
the interest due to a seller of a bond since the last interest payment is
usually calculated using simple interest. A daily rate is determined by
dividing the rate for the period by the number of days in the period,
and it is then assumed that the seller is due a payment based on the
daily rate times the number of days since the last payment date.
Compound interest and investment decisions: some illustrations
We have recognised that an evaluation of an investment proposal
requires that an allowance is made for the time cost of money, and
this can be done using compound interest factors. Costs and benefits
anticipated in different time periods can be valued in terms of their
equivalent cash flow at some common point in time in the future, the
most convenient being the terminal date for the investment.
An investment project promising a single cash inflow of £220 after
two years requires an outlay of £200. If the interest rate is 10 per
cent, is this a profitable use of funds? To evaluate this simple proposal
we need to determine the equivalent value at the end of year two of
the £200 outlay required by the investment:

V2 = 200(1+ 0.10 )2
= 200(1.21)
= £242

We can compare this sum with the cash flow of £220 promised by the
investment, and this leads to the conclusion that the cost exceeds the
benefit and the project should be rejected. Clearly, if £200 can be
placed in a bank account to produce £242 at the end of Year 2, this is
a better use of funds than an investment promising to produce £220.
The £242 can be thought of as the real or opportunity cost of the
investment specified in Year 2 cash flows.

Let us consider another example. Should a firm invest in a project

requiring an outlay of £200 today if it is expected to generate a cash
flow of £100 after one year and £140 at the end of two years, and the
rate of interest is 10 per cent?

We have already seen that if £200 is placed in a bank account for two
years it will grow to £242 by the end of Year 2. The project’s expected
cash flows and the cash flows associated with the alternative of
placing the funds in a bank account can be set out as follows:

Time 0 1 2
Project (200) 100 140
Bank account (200) 242
To allow the alternatives to be compared, the project’s expected cash
flow at the end of Year 1 can be specified in terms of its equivalent
value at the end of Year 2. The cash flow generated by the project in
Year 1 could be placed in the bank to earn interest in the second year,
growing to £110 by the end of the year:
V2 =V1 (1+ r )
V2 = 100(1+ 0.10)
= £110
Adding this to the expected cash flows at the end of the second year
gives £250, a sum that can be compared with the cash flow
anticipated from placing £200 in a bank account. This allows us to
restate the expected cash flows in the following way:

Time 0 1 2
Project (200) - 250
Bank account (200) 242
This project is seen to be a better use of funds than the bank account
and should be accepted.

A project requires an initial outlay of £1,200, is expected to produce a

net cash flow of £500 at the end of each of the next three years, and
the interest rate is 10 per cent. To evaluate the project we will
determine the value of each of the cash flows at the end of the
project’s life. This requires the calculation of the future value (Year 3
values) of all of the cash flows:

Time Net cash flow FVF (10%) FV (10%)

0 (1200) 1.331 (1597.2)
1 500 1.210 605
2 500 1.100 550
3 500 1.100 500
NTV(3) = 57.8
The project is worthwhile as it is shown to produce a surplus at the
end of Year 3. The surplus or deficit expected at the end of an
investment’s life is generally referred to as the net terminal value
(NTV). A positive net terminal value implies that:

ƒ the outlay will be recovered

ƒ the interest cost will be covered, and

ƒ a surplus will be generated (the NTV).

The interpretation of a positive net terminal value can be brought

quite clearly if we analyse the implications of using a loan at an
interest rate of 10 per cent to finance the project, the loan being
repaid as the project generates cash flows:
 Time Loan at the Interest due at Loan plus Net cash flow
period beginning of the end of the interest and
the period period (10%) charge repayment
1 1200 120 1320 500
2 820 82 902 500
3 402 40.2 442.2 442.2
Surplus =
57.8
The analysis of the loan results in the same terminal surplus as the
evaluation using future value factors presented above. (This is not
surprising as it is simply another way of arranging the arithmetic!)

This calculation can also be undertaken

using Excel’s built-in functions. This
calculation can be done using Excel’s
future value function:
ƒ enter Rate at 0.1

ƒ enter Nper as 3

ƒ enter Pmt as -500

ƒ enter Pv as 1,200 (the outlay)

and the answer is given as £57.80. The entries require the opposite
signs to those corresponding to the investment’s net cash flows. The
Excel function was not designed for this particular purpose and the
inputs have to be amended to allow it to be employed to calculate net
terminal values. In this context we can think of the net cash flows
being given up to allow the recovery of the outlay (1,200) and the
generation of the net terminal surplus.

Compound interest and growth

The mathematical basis of compound interest is the same as that for
all compound growth processes. A compound growth factor is simply a
more general interpretation of the compound interest factor, with the
growth rate substituted for the interest rate. We will find that growth
factors play an important role in a number of financial decisions. In
some circumstances a company’s assets can be expected to grow at the
constant rate, for example, and one of the most widely used models of
share valuation is based on the assumption of a constant rate of
growth of dividends over time.

Porth plc paid a dividend per share of 16p in 2001, and it is

anticipated that dividends will grow at 6 per cent per annum for the
next five years. This implies a dividend in 2006 of 21.41p:

16(1.06 ) = 16 × 1.3382 = 21.41 p

5
 2.3 The population of Newtown is 160,000 and has been growing
at 20 per cent per annum. What will be the size of the population if
this rate of growth is sustained for the next five years?

2.4 The average level of wages in Valtia is £4,500 per annum.

This is expected to increase at 15 per cent per annum over the next
four years. Determine the average wage that can be anticipated at
the end of the four-year period.

2.5 Prices have been increasing at 30 per cent per annum in

Dyfed despite the Government’s deflationary policies. A pint of
beer now costs 285 shillings. What is it likely to cost three years
from now if prices continue to increase at the rate of 30 per cent
per annum?

Investing in Manhattan: the power of compound interest

One example often quoted in US finance textbooks to illustrate the
dramatic effects of compound interest over a long period of time is the
growth that would have occurred in the capital sum used to buy
Manhattan Island in 1626 if this had been deposited in a bank
account instead. Peter Minuit bought the island from the Indians
living there for some trinkets worth $24 dollars. Given the current
value of Manhattan Island’s real estate this has been perceived as one
of the great bargains of history. The finance textbook view is
somewhat different, arguing that the Indians did not do too badly. If
the sale proceeds had been placed in a bank deposit account at 6 per
cent this would have grown by 2011 to almost $137 billion:

V2000 = V1626 (1 + 0.06)

385

= 24(1 + 0.06) = 24 x (5530420159)

385

= $132,730,083,800
Quite an attractive sum. (A comparison of this sum with the value of
Manhattan today is, however, a little misleading. If the Indians had
retained the ownership of the land, not only would they have the land
today but they would have had the use of it since 1626. The sum that
is comparable to the value of the bank deposit would be the current
value of the land today plus the accumulated value, with interest, of
the rents earned on the land over the last 385 years, less the cost of
the investments necessary to develop the real estate. One of the
dangers of financial reasoning is that calculations put forward with
confidence are often accepted without question. The underlying
assumptions of all calculations and reasoning should always be
scrutinised carefully.
2.6 Using compound interest factors

(a) Determine the value of £1,000 at the end of five years if the
rate of interest is: (i) 10 per cent; (ii) 20 per cent; (iii) 30 per cent:

Time Sum Interest Compound Future

invested rate interest factor value
(V0 ) (r ) (1+ r )t (Vt )
1-5
1-5
1-5

(b) If the rate of interest is 20 per cent, would you prefer £1,000
today or £5,000 to be received ten years from now?

(c) You estimate that you will need £5,000 for a major
expenditure in five years’ time. How much would you have to
deposit in a bank account today to accumulate this amount if the
rate of interest on deposits is 10 per cent?
3 Discounting and present values
We have seen that it is possible to allow for the time cost of money in
the evaluation of an investment proposal by converting all its net cash
flows into their equivalent values at the end of the terminal period of
the investment. Alternatively, the various costs and benefits of an
investment occurring at different points in time can be expressed in
terms of their equivalent values today, their present values. Whereas
the point in time at which terminal values are calculated is likely to
vary from project to project, making simple and direct comparisons
between projects difficult, present values provide a common basis.
Working with present values also has the advantage of dealing with
sums that we can relate to other financial magnitudes that we are
familiar with on a day-by-day basis.

To derive present values simply requires the reversal of the

compounding process and is generally referred to as discounting. We
have seen that by using the compounding equation it is a simple
matter to determine the equivalent value in n years’ time (Vn ) of a
sum of money available today (V0 ) given a rate of interest of r .It is
equally simple to determine the equivalent value today of some sum
promised in the future. To derive the value today (V0 ) of the sum (Vn )
expected at the end of period n requires the division of both sides of
the future value equation by the interest factor (1+ r )n

Given:

Vn =V0 (1+ r )n

it follows that:
Vn 1
V0 = =Vn
(1+ r )n
(1+ r )n
In this context r is referred to as the discount rate, and (1/(1 + r)n),
the reciprocal of the compound interest factor, as the discount
factor (DF) or present value factor (PVF).

In practice, the terms ‘discount factor’ and‘ present value factor’ ) are
used interchangeably. Similarly, the terms ‘present value’ and the
‘discounted cash flow’ mean the same and are also used
interchangeably. Both these terms refer to the net cash flows adjusted
for the time value of money, ie the net cash flows multiplied by the
appropriate present value factors.

The discount rate may be interpreted as the opportunity cost of funds.

For a firm, the discount rate is often referred to as the cost of capital
or the required rate of return. (The determination of the cost of
capital will be considered in later, and it will be found to depend on
the risk-free rate plus a risk premium. For the moment we will
continue to assume away the problem of risk and uncertainty, and the
discount rate can be thought of as being equivalent to the risk-free
rate of interest.)
Tables are available to determine the value of present value factors
for different interest rates and time periods, and a section from such
tables is reproduced in Table 2.3. below.
What is the present value of £1,000 expected one year from now if the
interest rate is 10 per cent? From the table it can be seen that the
present value factor for one year at 10 per cent is 0.9091. Multiplying
the £1,000 by this factor gives the equivalent value today:
1
V0 = £1000 × = £1000 x 0.9091 = £909.10
(1 + 0.10)
An individual able to borrow or lend at a rate of interest of 10 per cent
will be indifferent to £909 today or £1,000 in one
year’s time in a world of certainty. The sum of
£909 invested at 10 per cent for one year will
produce interest income of £91, which, together
with the initial sum, adds up to £1,000. (See this
figure and ignore the minor rounding error!)

On the same basis, £1,000 expected at the end of Year 2 has a present
value of £826.
1
V0 = £1000 ×
(1 + 0.10 )2
= £1000 × 0.8264 = £826.45
Table 2.3 Present value factors
Years Interest rates
1% 5% 10% 15% 20% 25%
1 0.9901 0.9524 0.9091 0.8696 0.8333 0.8000
2 0.9803 0.9070 0.8264 0.7561 0.6944 0.6400
3 0.9706 0.8638 0.7513 0.6575 0.5787 0.5120
4 0.9610 0.8227 0.6830 0.5718 0.4823 0.4096
5 0.9515 0.7835 0.6209 0.4972 0.4019 0.3277
6 0.9420 0.7462 0.5645 0.4323 0.3349 0.2621
7 0.9327 0.7107 0.5132 0.3759 0.2791 0.2097
8 0.9235 0.6768 0.4665 0.3269 0.2326 0.1678
9 0.9143 0.6446 0.4241 0.2843 0.1938 0.1342
10 0.9053 0.6139 0.3855 0.2472 0.1615 0.1074
20 0.8195 0.3769 0.1486 0.0611 0.0261 0.0115
25 0.7798 0.2953 0.0923 0.0304 0.0105 0.0038
40 0.6717 0.1420 0.0221 0.0037 0.0007 0.0001
50 0.6080 0.0872 0.0085 0.0009 0.0001 0.0000

This sum, placed in a deposit account

offering an interest rate of 10 per cent, will
grow to £1,000 by the end of Year 2.

It is clear from Table 2.3 that as the

discount rate increases and the time period
lengthens, the value of the discount factor
falls. If the discount rate is relatively high,
the sums expected in the distant future
have a relatively low value today. This is
illustrated in this figure, which gives the
present value of £1 to be received at
various interest rates. This figure also
reveals that the value of the discount factor
falls as the period of time under consideration is extended. The value
of any discount factor approaches zero if a sufficiently long period of
time is considered.

The time value of money implies that the promise of a sum well into
the future is worth very little today. How far into the future depends
on the rate of interest. To consider this issue, let us see how far into
the future we have to go for £100 to be worth no more than £1 today.
The relevant equation is given below, where r will take on various
values and we will determine the value of n .
 1
£100 x = £1
(1 + r )n
Solving for n , we will find the following values of n for different
values for the interest or discount rate:
log 100
n=
log (1+ r )

Interest rate Number of time years for

present value to fall to 1 per
cent of future value of £100
0.02 233
0.05 94
0.10 48
0.15 33
0.20 25
0.25 21

It is difficult to predict the benefits that can be anticipated from an

investment in distant time periods. But as the contribution that these
benefits will make to the present value of the investment will be
relatively small, we need not become too concerned about the errors in
our predictions.
2.7 Calculating present values

(a) What is the present value of £1,000 to be received in five

years from now if the rate of interest is 10 per cent?
1
PV =1000
(1+ 0.10)5
Time Cash flow PVF (10%) PV
5 1,000

(b) What is the present value of £1,000 to be received in five

years from now if the rate of interest is 20 per cent?
1
PV =1000
(1+ 0.20)5
Time Cash flow PVF (20%) PV
5 1,000
(c) What is the present value of £1,000 to be received after one
year plus another £500 to be received after five years if the
relevant rate is 10 per cent?

Time Cash flow PVF (10%) PV

1 1,000
5 500
PV =

(d) What is the total value of three payments of £100 to be

received at the end of each of the next three years, if the rate of
interest is 10 per cent?
Time Cash flow PVF (10%) PV
1 100
2 100
3 100
PV =
4 Net present value as an investment criterion
Once the net cash flows expected from an investment are expressed in
terms of their present values, they can be summed to determine its
profitability. The sum is referred to as the net present value (NPV)
and indicates whether the investment is expected to produce a
surplus, a deficit or just to break even.
As earlier, let C0 , C1 , etc, stand for the net cash flows expected from
an investment, with the subscripts indicating the relevant time
period. The net present value (NPV) of a project can then be specified
as follows:
1 1 1
NPV = − C0 + C1 + C2 + K + Cn
(1+ r ) (1+ r )2
(1+ r )n
or
n 1
NPV = − C0 + Σ Ct
t =1 (1+ r )t
The net present value represents the surplus or deficit expected to be
generated by an investment expressed in today’s money. If the NPV is
positive, the investment should be accepted, and if it is negative it
should be rejected.
Consider the investment proposal considered earlier (page 36). Is an
investment of £200 in a project that is expected to generate cash flows
of £100 at the end of the first year and £140 at the end of the second
year profitable if the rate of interest is 10 per cent?
1 1
NPV = − 200 +100 +140
(1+ 0.10) (1+ 0.10)2
= − 200 +100 × 0.909 +140 × 0.826 = 6.55

The NPV is positive and therefore the investment proposal should be

accepted.
For practical problems it is easier to set the calculations out in the
form of a table:
Time Cash flow PVF (10%) PV
0 -200 1.000 -200.00
1 100 0.909 90.91
2 140 0.826 115.64
NPV = 6.55
The net present value is a surplus in terms of today’s values. Given
this project, a firm could afford to borrow £206.55, invest £200 in the
project and distribute £6.55 to shareholders, knowing that the future
cash flows would be sufficient to repay a loan plus the interest
charges that would be incurred.

To consider the interpretation of the net present value, we will

consider the investment proposal that we analysed earlier: an
investment of £1,200 promising three cash flows of £500 at the end of
Years 1, 2 and 3. Given a rate of interest of 10 per cent, this
investment has a NPV of £43:
Time NCF PVF (10%) PV
0 -1,200 1.000 -1,200
1 500 0.909 454.5
2 500 0.826 413.0
3 500 0.751 375.5
NPV = 43
To illustrate that the NPV of £43 implies that the initial outlay can be
recovered, the interest charges covered and a
surplus generated, we will analyse the cash flows
of a loan used to finance the project. It is
assumed that the loan will be for £1,243,
allowing £1,200 to be spent on the project and
£43 to be made available to the investment’s
promoters. It is demonstrated that the loan can be repaid with
interest from the project’s cash flows – equivalent to recovering the
capital, covering the interest charges and producing a surplus.

Time Loan at the Interest due at Loan Repayment

period beginning of the end of the
the period period
1 1,243.00 124.30 1367.30 500
2 867.30 86.73 954.03 500
3 454.03 45.43 500.00* 500
* rounded up!
Excel also allows net present values to be calculated, but,
unfortunately, for some unknown reason it specifies net present value
as if all the cash flows are delayed by one year! The net cash flows
from the example we have just considered are used to illustrate the
use of the NPV function. The formula is:
NPV (Rate, Value1, Value2, Value3, Value4, etc)

where the values refer to net cash flows.

ƒ enter Rate as 0.1

ƒ enter values (net cash flows) in
sequence: –1,200, 500, 500, 500

and the NPV specified is £39.48 as shown,

but we know that the NPV for the
investment is close to £43. All the cash
flows occur one year earlier than is
implicitly assumed by Excel, so it is
necessary to multiply the specified NPV
by the interest factor for one year to
determine the actual NPV: 39.48 (1 + 0.1)
is approximately equal to £43.

This sort of calculation is also

very easily undertaken in a
spreadsheet without relying on
the built-in functions, as shown
in this figure. Enter the
following headings in cells B3
to E3: YEAR, NCF, PVF(10%)
and DCF. Next, enter in the B
column cells 4 to 7 the time
periods (years) 0, 1, 2, 3, and in
the adjacent C column the
associated net cash flows –
1,200, 500, 500, 500. In cell D4
insert the present value factor
at 10 per cent for period 0 as:
=1/(1.1ˆB4). (In Excel, exponentiation, eg 32, is expressed by using the
caret symbol; 3ˆ2.) As the value of B4 is 0, this will return a value of
1, because a number raised to the power of 0 is equal to that number
divided by itself and therefore equal to 1. This cell can now be copied
to D5–D7, producing the present value factors (0.9091, 0.8264 and
0.7513). Finally, multiply cash flows in column C by the present value
factors in column D to give the discounted cash flows in column E, by
inserting in cell E4: =C4 × D4 and copying this entry to E5–E7. The
NPV figure is derived in cell E8 by summing the entries E4–E7, using
the summation function (Σ). Finally, enter NPV = in cell D8.
Net present values
A positive NPV implies that a project’s cash flows will:

ƒ allow the recovery of the funds invested in the project

ƒ cover any interest costs, and

ƒ generate a surplus, given by the value of the net present value.

These are similar implications to those identified in our discussion of

the net terminal value, the only difference being the units of
measurement for the surplus, today’s values being used for NPVs
rather than the future values at the end of the project’s life for NTVs.
There is a simple relationship between the NPV and NTV(n):
NPV (1 + r ) n = NTV ( n)
1
NPV = NTV (n)
(1 + r ) n

2.8 When we used future values to assess the investment with

cash flows of –1,200, 500, 500 and 500, we found that the net
terminal value was £57.8 and the net present value was £43. What
is the relationship between the net terminal value and the net
present value?

2.9 Net present value and investment decisions

(a) The ABC Company is considering investing in a machine that
is expected to reduce the firm’s production costs by £2,000 in the
first year and by £3,000 per annum in the following four years. If
the purchase price of the machine is £10,000 and the rate of
interest is 10 per cent, is this a desirable investment?
Time Cash flow PVF (10%) PV
0 –10,000
1 2,000
2 3,000
3 3,000
4 3,000
5 3,000
NPV =
(b) A new product can be manufactured with an investment of
£14,000 and is expected to produce net cash flows of £4,000 in Year
1, £5,000 in Year 2 and £6,000 in Year 3, after which it would be
withdrawn from the market. Is it a worthwhile investment if the
appropriate discount rate is 8 per cent?
5 Valuation of constant cash flows: annuities
Many financial and investment decisions involve a series of equal
payments or receipts at regular intervals. For example, some
financial investments, such as government bonds, produce constant
interest receipts every year. Such series of constant cash flows are
known as annuities. The projected cash flows for some investment
projects may be assumed to be constant even though some variation is
anticipated from period to period. If we have no good basis on which
to forecast these deviations, it is simplest to assume for purposes of
analysis that the same net cash flow will occur in each time period
(assume a constant expected value for the annual cash flows). Whilst
the present value of an annuity can be found by determining the
present value of each cash flow individually and summing the
outcomes, it is possible to reduce the amount of tedious calculation by
the use of what are known as annuity factors.
The following example illustrates how those factors are derived.
Consider the present value of an annual payment of £100 for five
years when the rate of interest is 10 per cent.
Year Sum Discount Present
received (£) factor value (£)
1 100 0.909 90.9
2 100 0.826 82.6
3 100 0.751 75.1
4 100 0.683 68.3
5 100 0.621 62.1
PV = £379.0
This calculation could have been set out as follows:
PV = (100 × 0.909 )+ (100 × 0.826 )+ (100 × 0.751)+ (100 × 0.683)+ (100 × 0.621)
=100(0.909 + 0.826 + 0.751+ 0.683 + 0.621)
=100(3.790)
= £379.0
The value in the brackets is simply the sum of the discount factors,
and this is the present value annuity factor for five years at 10 per
cent. The present value annuity factor for n years at rate of interest
r , with the first cash flow occurring at the end of the first period is
given by:
n
PVAF n / r = Σ PVF t / r
t =1

Fortunately, tables of annuity factors are available, eliminating the

need to carry out these summations. A section from a table of present
value annuity factors is illustrated in
Table 2.4 opposite. This table indicates
how present value annuity factors
increase with the number of time periods
but at a decreasing rate. As we shall see
in a moment, they converge to some
limiting value as the number of time
periods approaches infinity. The figure
here illustrates how the value of annuity
factors increases with the number of time
periods.
It can be shown mathematically that the
value of a present value annuity factor,
the sum of the present value factors for
each year over the life of the annuity, is
given by one minus the present value
factor for the last year of the life of the
annuity, all divided by the interest rate (expressed in decimal form).
(The derivations of Present Value Annuity Factors and Future Value
Annuity Factors are provided on page 53 for information purposes
only.)
PVAFn / r = [1− PVFn / r ]/ r
⎡ 1 ⎤ 1⎡ 1 ⎤
= ⎢1− n⎥
/ r = ⎢1− ⎥
⎣⎢ (1+ r ) ⎦⎥ r ⎣⎢ (1+ r )n ⎦⎥
Table 2.4 Present value annuity factors (PVAFn / r )

Years Interest rates

5% 10% 15% 20%
1 0.9524 0.9091 0.8696 0.8333
2 1.8594 1.7355 1.6257 1.5278
3 2.7232 2.4869 2.2832 2.1065
4 3.5460 3.1699 2.8550 2.5887
5 4.3295 3.7908 3.3522 2.9906
6 5.0757 4.3553 3.7845 3.3255
7 5.7864 4.8684 4.1604 3.6046
8 6.4632 5.3349 4.4873 3.8372
9 7.1078 5.7590 4.7716 4.0310
10 7.7217 6.1446 5.0188 4.1925
11 8.3064 6.4951 5.2337 4.3271
12 8.8633 6.8137 5.4206 4.4392
13 9.3936 7.1034 5.5831 4.5327
14 9.8986 7.3667 5.7245 4.6106
15 10.3797 7.6061 5.8474 4.6755
16 10.8378 7.8237 5.9542 4.7296
17 11.2741 8.0216 6.0472 4.7746
18 11.6896 8.2014 6.1280 4.8122
19 12.0853 8.3649 6.1982 4.8435
20 12.4622 8.5136 6.2593 4.8696
40 17.1591 9.7791 6.6418 4.9966
There are tables available to provide the values of these factors, as
illustrated in Table 2.4, but the factors can also be produced using
your calculator:

ƒ derive the interest factor for interest rate r and year n

ƒ deduct one from the interest factor

ƒ divide the result by r , and this results in the FVAFn|r.

ƒ divide the outcome by (1 + r ) n to give the PVAFn|r.

 CHAPTER 2: FINANCIAL AND INVESTMENT DECISIONS: THE TIME COST OF MONEY │ 53

Present value annuity factors Future value annuity factors

The equation for a present value annuity factor is Future value annuity factors can be derived in a
simply derived. We know that the annuity factor is similar way as the present value annuity factors by
the sum of a series of discount factors: summing the appropriate series of future value
factors. If a constant amount is invested at the end of
1 1 1
PVAFn / r = + +K+ each year from Year 1 through to Year N, the sum
(1+ r ) (1+ r )2 (1+ r )n available at Year N will be made up of the sum of the
future values of each investment. The amount
This is a geometric progression, and there is a invested at the end of the first year will earn interest
standard procedure for simplifying the expression. for n –1 years, the amount invested at the end of
Year 2 will earn interest for n –2 years, and so on,
Multiplying both sides of the equation by (1+ r ) to
with the amount invested in the final period earning
give:
no interest. If the value of the annual investment is
X, the future value will be given by:
PVAFn / r (1+ r ) =1+
1 1 1
+ +K+
(1+ r ) (1+ r )2 (1+ r )n −1 Vn = Χ(1+ r )n −1 + Χ (1+ r )n − 2 + K + Χ (1 + r )+ Χ

Alternatively, we can write the last term in the series

Next we take the first equation away from the as Χ (1+ r ) , as (1+ r ) is equal to 1:
0 0

second. This implies taking the terms on the left-

Vn = Χ(1+ r )n −1 + Χ(1+ r )n − 2 + K + Χ(1 + r )+ Χ(1+ r )0
hand side of the first equation from those on the left-
hand side of the second equation, then repeating the
exercise for the right-hand sides of the equations. All
[
= Χ (1 + r )n −1 + (1 + r )n −2 + K + (1 + r ) + (1 + r )0 ]
but two of the terms on the right-hand sides of the
Letting Χ =1 :
equations cancel out to leave:

1 (1) FVAFn / r = (1+ r )n −1 + (1+ r )n − 2 + K + (1+ r )+ (1+ r )0

PVAFn / r × r = 1 −
(1+ r )n n −1
FVAFn / r = Σ (1 + r )
t
t =0

Dividing both sides by r gives: Multiply both sides of equation 1 by (1+ r ) :

1⎡
PVAFn / r = ⎢1−
1 ⎤ (2) FVAFn / r (1+ r )= (1+ r )n + (1+ r )n −1 + K + (1+ r )2 + (1+ r )1
⎥
r ⎣⎢ (1+ r )n ⎦⎥ Take Equation (1) away from Equation (2):
FVAF n / r × r = (1+ r )n −1

Dividing both sides by r gives:

FVAFn / r =
(1+ r )n −1
r
54 │ FINANCE AND FINANCIAL MANAGEMENT

Alternatively, values can be obtained by

using the function wizard in Excel. Using the
PV function, enter the Rate (r), the number
of years, Nper (n), the payment, Pmt (–1),
and finally specify the Type as zero (0). This
then gives you the present value of an
annuity of 1, which is, of course, the same as
the value of the annuity factor. (If you simply
want to derive the present value of a given
series of cash flows and are not interested in
the value of PVAFn / r , enter the value of the cash flow as the value for
Pmt.) This figure illustrates the entries to derive the present value
annuity factor for three years at 10 per cent.
The present value annuity factors considered so far are referred to as
ordinary annuities – constant periodic cash flows with the initial
cash flow in the series occurring at the end of the first period. If the
first cash flow occurs immediately, rather than at the end of the first
period, the series is referred to as an annuity due, and the relevant
annuity factor is simply the factor for an ordinary annuity plus one.

Example using annuity factors

A machine costing £50,000 is expected to lower costs by £6,000 for
each of the next ten years. Is this a profitable investment if the rate of
interest is 10 per cent?
Time Cash flow PVF(10%) PV
0 -50,000 1.000 –50,000
1→10 6,000 6.145* 36,870
NPV = –13,130
* annuity factor at 10 per cent for ten years taken from Table 2.4.

The project should be rejected as it has a negative NPV.

2.10 Determine the value of a bond with a nominal value of £1,000
that pays interest of 12 per cent on an annual basis- that is £120
per annum. It has six years to run to its redemption date and the
interest rate (the required rate of return) has fallen to 8 per cent
since the bond was issued.

Future value annuity factors

The future value annuity factor to be used to determine the future
value of a series of constant cash flows is defined by the following
expression:
 CHAPTER 2: FINANCIAL AND INVESTMENT DECISIONS: THE TIME COST OF MONEY │ 55

FVAFn / r =
(1+ r )n − 1
r

This can be derived by multiplying the present value annuity factor

by the appropriate future value factor. Let V0 be the present value of
an annuity of £1 per annum for n years (this is equal to the present
value annuity factor). Its future value Vn is derived by multiplying V0
by the future value factor:

1⎡ 1 ⎤ n (1 + r ) − 1
n
Vn = V0 (1 + r )n = ⎢1 − ⎥ x (1 + r ) =
r ⎢⎣ (1 + r )n ⎥⎦ r

Vn in this context is the future value of a series of £1 per annum for n

years and is equal to the future value annuity factor.

Example using future value factors

Annual savings of £2,000 are to be deposited in a bank account at the
end of each of the next eight years. What will be the value of the sum
in the account at the end of Year 8, immediately after the last deposit,
if the bank pays interest at 6 per cent?

⎡ (1+ 0.06)8 −1 ⎤
V8 = 2,000 ⎢ ⎥ = 2,000 × 9.8975 = £19,795
⎢⎣ 0.06 ⎥⎦

The future value function available on

spreadsheets can be used to determine the
future value of an annuity. To illustrate
this, consider the future value of six
annual payments of £1,300 with an
interest rate of 0.08:

ƒ enter 0.08 as the Rate

ƒ enter 6 as Nper
ƒ enter –1,300 as Pmt

and the answer is given as £9,536.71.

Evaluating perpetuities
A series of constant cash flows expected to occur at the end of each
year for ever and ever into the future is known as a perpetuity. As it
is convenient in a number of theoretical contexts to assume that the
cash flows occur in perpetuity, the development of an appropriate
valuation equation proves to be quite useful. There are also practical
uses for such a valuation equation: for example, some securities
issued by the UK government offer fixed interest payments but
specify no redemption date. For these securities issued at very low
56 │ FINANCE AND FINANCIAL MANAGEMENT

interest rates it can be quite reasonably assumed that they will never
be redeemed and can therefore be analysed as perpetuities. To redeem
the bonds the Government will probably need to issue bonds at the
higher prevailing interest rate – resulting in a higher annual interest
bill. The present value perpetuity factor can be specified as follows:
∞ 1
PVAF∞ / r = Σ PVFt / r =
t =1 r

This is simply a special case of the more general present value

annuity factor:

n 1⎡ 1 ⎤
PVAFn / r = Σ PVFt / r = ⎢1 − ⎥
t =1 r ⎢⎣ (1 + r )n ⎥⎦

where the term 1 / (1+ r )n goes to zero as the value of n goes to infinity
(∞ ) . The annuity factor for a perpetuity when the interest rate is 5
per cent is:
1 1
= = 20.0
0.05 1 / 20

and when the interest rate is 10 per cent:

1 1
= =10.0
0.10 1 / 10

and when the interest rate is 20 per cent:

1 1
= = 5.0
0.20 1 / 5

The value of a perpetuity of £100 if the appropriate interest rate is 20

per cent is therefore quite simply £100 times 5 = £500

Summary of compounding and discounting factors

We have now looked at various interest factors used to adjust cash
flows for the time cost of money, and it may be helpful to summarise
the definitions and uses of these factors:

Compound interest factor (1+ r ) t

used to determine the equivalent value in the future of a sum
available today

⎡ 1 ⎤
Present value factor ⎢ n⎥
⎢⎣ (1 + r ) ⎥⎦
used to derive the value today of a future cash flow

Future value annuity factor [ (1 + r ) t − 1] / r

to project forward the value of a series of constant cash flows
 CHAPTER 2: FINANCIAL AND INVESTMENT DECISIONS: THE TIME COST OF MONEY │ 57

⎡ 1 ⎤
Present value annuity factor ⎢1 − ⎥/r
⎣⎢ (1 + r )
t
⎦⎥
to derive the value today of a series of constant cash flows.

2.11 Some undated UK government bonds issued many years ago

pay interest at 2.5 per cent per annum. These bonds are most
unlikely to be redeemed. The interest rate on bonds of similar risk
and expected life if they were issued today would be 4 per cent.
Provide an estimate of the market value of the bonds that have a
nominal value of £100. What would happen to the market value of
these bonds if the interest rate increased from 4 to 5 per cent?
What does this suggest about the relationship between the price of
fixed interest bonds and the market rate of interest?

Investment decisions: Looking for shortcuts!

Is it profitable to invest in a project requiring an outlay of £10 million
if it is expected to produce net cash flows of £0.4 million for each of
the next 60 years and the rate of interest is 5 per cent?

Assume that the project has an infinite life – this simplifies the
calculation, and if the project is found to be unprofitable on this basis
it will be unprofitable when evaluated over the shorter period of 60
years:
NPV = − 10m + 0.04m PVAF∞ / 0.05
= − 10m + 0.04m × 20.0 = − £2.0m

We can conclude that the project is unprofitable. Of course, if the NPV

had turned out to be positive, we would not have been able to
conclude that the project was necessarily profitable as the cash flows
have been exaggerated and an analysis based on the 60-year life
would have been necessary.

Using interest factors

One of the difficulties encountered in financial decision taking stems from a failure to identify
correctly the distribution of costs and benefits over time. To illustrate these problems, consider the
following pension planning problem. Mr Maxwell has accumulated £60,000 in a pension fund and
plans to invest £8,000 in the pension fund annually for the next ten years. He intends retiring after
ten years and would like to know how much he can afford to spend on an annual basis over a 20-
year retirement period while retaining a balance of £50,000 at the end of this period to cover the
possibility of a longer retirement period. The pension fund promises to pay interest at 7 per cent.
With problems of this nature, it is useful to identify one point in time
to be used as a base for the calculations. Often today is the simplest
base to employ so that the various net cash flows can be specified in
present value terms. However, the focus in this example is likely to be
58 │ FINANCE AND FINANCIAL MANAGEMENT

the start of the retirement period, and we will employ this as the
base.
Money is always linked to time,
whether the accounting for pasFirst of
all we can calculate the value of the
capital expected to be available in ten
years. This implies taking the future
value (the value ten years from now) of
the £60,000 already accumulated – this
is £118,029. Next, we need to
determine the value in Year 10 of the
annual investment of £8,000 in the
pension fund. This is given by
multiplying the £8,000 by the future
value annuity factor for ten years at 7
per cent (FVAF10 / 0.07 =13.8164) and
amounts to £110,532. This gives an
overall sum of £228,561.
To meet the requirement that £50,000
should be available at the end of the
retirement period, this can be deducted
from the capital sum, leaving
£178,561. The £50,000 will produce
annual interest of £3,500 (ie 0.07 times
£50,000) if left in the pension fund.
Finally, we can determine the value of the annual payment for 20
years that has an equivalent present value to the capital sum. This is
derived by dividing the capital value of £178,561 by the present value
annuity factor for 20 years at 7 per cent, 10.5940, which gives a sum
of £16,855. Adding to this the annual interest of £3,500 on the
£50,000 being set aside gives £20,355, the maximum amount that Mr
Maxwell can afford to spend each year.

Using annuities in the analysis of loans

When loans are repaid in the form of a series of equal instalments
they are often referred to as amortised loans and the series of
payments to the lender as the amortisation schedule. For example,
a company borrows £1 million at an interest rate of 15 per cent and
will service the debt by making equal payments at the end of each of
the subsequent five years. The payments are made up of interest and
the repayment of the principal, and interest is charged on the
outstanding balance of the loan. To determine the appropriate annual
payments simply requires the calculation of a five-year annuity (a
constant cash flow), with the same present value as the loan:
V0 = annuity × the annuity factor
 CHAPTER 2: FINANCIAL AND INVESTMENT DECISIONS: THE TIME COST OF MONEY │ 59

1m = A × PVAF5/0.15 = A × 3.3522
A = 1m/3.3522 = £298,316

The reciprocal of the annuity factor in this context may be referred to

as a loan recovery factor.

The detailed loan repayment calculations may be checked as follows:

Year Loan at the Interest Loan at the Debt

beginning of year end of year service

1 1,000,000.00 150,000.00 1,150,000.00 298,315.55

2 851,684.45 127,752.67 979,437.11 298,315.55
3 681,121.56 102,168.23 783,289.80 298,315.55
4 484,974.24 72,746.14 557,720.38 298,315.55
5 259,404.83 38,910.72 298,315.55 298,315.55

Interest accounts for a relatively high proportion of the

repayments to begin with, but for less and less as more
and more of the loan is repaid. In of instalment the
example, interest in the first year, £150,000, accounts for
more than 50 per cent of the initial payment, whereas the
interest in the fifth year, £38,910, accounts for only 13 per
cent of the final payment. This is illustrated in this
figure, which breaks down the instalments into interest
charges and the repayment of principal.

2.12 Dealing with annuities

(a) What is the present value of an annuity of £1,000

for five years if the rate of interest is 10 per cent?
(i) Time Cash flow PVAF (10%) DCF
1 1,000 0.909
2 1,000 0.826
3 1,000 0.751
4 1,000 0.683
5 1,000 0.621
PV =
(ii) Time Cash flow PVAF (10%) DCF
1→5 1,000

(b) What is the net present value of a project costing £1,000 that
is expected to generate a stream of benefits of £150 per year for
ever into the future if the rate of interest is 5 per cent?
60 │ FINANCE AND FINANCIAL MANAGEMENT

Time Cash flow PVAF (5%) DCF

NPV =
 CHAPTER 2: FINANCIAL AND INVESTMENT DECISIONS: THE TIME COST OF MONEY │ 61

6 Discounted rate of return

The profitability of an investment proposal can also be assessed by
determining its rate of return. The discounted rate of return, also
known as the internal rate of return and the yield, is the discount
rate that equates the present value of the expected cash outflows with
the present value of the expected cash inflows. It can also be viewed
as the rate at which the NPV of an investment is equal to zero.
Mathematically it is the solution rate of discount (i) in the following
equation:
1 1 1
NPV = 0 = − C0 + C1 + C2 + K + Cn
((1+ i ) (1+ i )2
(1+ i )n
n 1
0 = Σ Ct −C0
t =1 (1+ i ) t
n 1
C0 = Σ Ct
t =1 (1+ i )t
When determining the NPV of an investment, it is assumed that we
know the values of the cash flows (C0 , C1,K, Cn ) and the value of the
discount rate (r ) , and thereby the values of the appropriate discount
( )
factors 1 / (1+ r )n . It is then possible to solve the equation for the
unknown value of the NPV. In the rate of return equation, the cash
flows are again assumed to be known, the NPV is set equal to zero,
leaving the discount rate (i ) as the unknown.

For investments characterised by an outlay followed by cash inflows,

the NPV will be a decreasing function of the discount rate. If the
investment is made today and the benefits are expected in the future,
increasing the discount rate will reduce the present value of the
benefits while the present value of the investment is unchanged. This
will inevitably push down the NPV. But this will also be true even if
the outlay is spread over a number of time periods as long as all the
negative cash flows precede the positive cash flows. Increasing the
62 │ FINANCE AND FINANCIAL MANAGEMENT

discount rate decreases the value of the discount factor, and the
proportionate fall in this value increases the further into the future
the time period for which the discount factor is being calculated. This
implies that increasing the discount rate will have more of an impact
on the later positive cash flows than on the earlier negative cash
flows, and this will push down the NPV.

The NPV is shown as a declining

function of the discount rate in this
figure: the DCF rate of return is given
by the point where the function cuts
the horizontal axis and the NPV is
zero.

The discounted cash flow rate of return

may be interpreted as the highest rate
of interest that a firm could afford to
pay on a loan used to finance a project
and still expect to break even.
This can be demonstrated by using an
investment proposal that we have already analysed: an outlay of
£1,200 followed by three net cash flows of £500. This investment has a
rate of return of approximately 12 per cent. (We will discuss how this
rate of return was derived below.) An analysis of a loan at an interest
rate of 12 per cent indicates that the loan can just be repaid from the
project’s net cash flows:
Period Loan at the Interest Loan at the Repayment
beginning of (12%) end of
period period
1 1,200 144 1,344 500
2 844 101 945 500
3 445 55* 500 500
* the true figure is a little less than £55 as the rate of return is slightly higher than 12
per cent (12.045 per cent), and the investment would produce a very small surplus at
12 per cent rather than break even.

If the internal rate of return is greater than the discount rate, an

investment should be accepted. Clearly, if the rate of interest that a
firm can afford to pay, and still break even, is greater than the rate
that it has to pay for its funds, an investment can be expected to be
profitable.
 CHAPTER 2: FINANCIAL AND INVESTMENT DECISIONS: THE TIME COST OF MONEY │ 63

Calculating the discounted rate of return

One period investment

For a one period investment, but only for a one period investment, the
yield is simply the ratio of the investment’s profit to the initial outlay:

Rate of return (i )=
profit
investment
where the profit is defined as the difference between the outlay and
cash inflow.

The derivation is quite straightforward:

C1
NPV = 0 = − C0 +
(1 + i )
C1
C0 =
(1 + i )
C0 (1 + i ) = C1

(1 + i ) = C1
C0
C C − C0 profit
i = 1 −1 = 1 =
C0 C0 investment

What is the rate of return on an investment of £1,000 that is expected

to yield a payoff of £1,300 at the end of one year?

Profit = 1,300 − 1,000 = £300

300
Rate of return = = 30 per cent
1,000

One payoff investment

The rate of return on a project expected to produce a single future
cash flow at the end of a period other than the first is also easily
calculated. Assuming the cash inflow occurs in year n :
1
NPV = 0 = − C0 + Cn
(1+ i )n
= (1+ i )n
Cn
C0

Given the values of C0 +, Cn and n , it is possible to solve for i by

taking the n th root of both sides of this equation:
64 │ FINANCE AND FINANCIAL MANAGEMENT

n n
Cn
= (1 + i )n = (1 + i )
C0
n Cn
i= −1
C0

For example, if a project requires an outlay of £500 and is expected to

produce a single net cash flow of £1,245 at the end of Year 5, the rate
of return is 20 per cent:
5
1245
i= −1
500
= 5 2.49 − 1 = 0.20

Annuities
For annuities it is not possible to calculate the internal rate of return
on a simple mathematical basis, but it can be determined by using the
tables for the present value annuity factors. We normally use the
tables to identify the value of an annuity factor, given the interest
rate and the number of years for which the annuity is expected to run.
But if we know the annuity’s life and the value of the annuity factor,
we can equally well use the tables to determine the interest rate. As
demonstrated below, we can use an investment’s cash flows to
identify the value of the annuity factor that is consistent with a zero
NPV and the internal rate of return. Once we know this value, all we
have to do is to read along the row of annuity factors for the relevant
year until the particular value is found, and the column in which the
factor is located will indicate the relevant interest rate.

When you have access to a spreadsheet

the problems of determining the rate of
return disappears. If you are dealing with
an annuity, you can use the financial
function RATE. This is illustrated in this
figure. The Nper is the number of
periods, Pmt the annual cash flow and
PV is the outlay, specified as a negative
cash flow. To determine the rate of return
on the three-year project we have been
considering (–1,200, 500, 500, 500), the
entries will be 3, 500, –1,200 and the
internal rate of return is given as 12%.
Alternatively, we can use the IRR
function. This simply requires the
identification of the investment net cash
flows in a series of cells in the
 CHAPTER 2: FINANCIAL AND INVESTMENT DECISIONS: THE TIME COST OF MONEY │ 65

spreadsheet. The result is illustrated in this next figure, once again

for the simple project considered above. For the insertion of the values
required by the IRR function, highlight the cells with the net cash
flows of -1200, 500, 500. It is not necessary to enter a guess for the
IRR in the case of simple investments. This approach can be utilised
for any investment and is particularly convenient for dealing with
investments with irregular net cash flows.

Conclusion
This chapter has considered the role of the time cost of money in
financial decision taking. We have seen that compound interest
factors, also referred to as future value factors, can be employed to
identify the equivalent value at a point in time into the future of a
sum available today. The factors do so by recognising that a sum
available now can generate interest income, and this interest income
can be reinvested to earn further income.

It was also demonstrated that the equivalent value today of a future

sum can be determined by using present value factors. These factors
reverse the process of compounding to allow for the interest lost by
having to wait until some time in the future to receive the sum in
question. The future and present values of a series of constant cash
flows were also considered. The chapter also provided an introduction
to the evaluation of investment decisions and explained the role of the
net present value and internal rate of return decision rules. You
should now be able to analyse decisions involving cash flows spread
out over time. Taking a corporate finance perspective, it should allow
you to appreciate the way investment decisions need to be taken and
the results interpreted. From a security analysis viewpoint, it
suggests that financial investment, such as the purchase of shares
and bonds, can be evaluated using the discounted cash flow approach.
Above all, the chapter provides some building blocks to be used in
virtually all the subsequent chapters. It should also have convinced
those with less quantitative backgrounds that basic financial analysis
in decision taking does not require complex mathematics and is a tool
that can be readily understood and employed by all managers.