Time Value of Money

Bodie, Chapters 4 & 5,8 & 9

Mishkin, Chapter 4
Cornett, Chapters 4 & 5

Time Value of Money 1

 Content
The Time Value of Money Bond Valuation
• 1. Calculate future values and • 8. Understand basic bond
understand compounding
terminology and apply the time
• 2. Calculate present values and value of money equation in pricing
understanding discounting
bonds
• 3. Apply the time value of money
equation using formula, calculator • 9. Understand the difference
and spreadsheet. between annual and semiannual
• 4. Determine the future value of bonds and note the key features
multiple cash flows of zero-coupon bonds
• 5. Determine the future value of • 10. Explain the relationship
an annuity
between the coupon rate and the
• 6. Build and analyze amortization yield to maturity
schedules
• 7. Compute the effective annual Stock Valuation
rate on a loan and investment
• 11. Calculate the value of a stock
given a history of payments,

Time Value of Money 2

 Financial Decisions
• Costs and benefits being spread out over time

• The values of sums of money at different dates

• The same amounts of money at different dates

have different values.

• Virtually every decision involves TIME and

UNCERTAINTY

Time Value of Money 3

 Time Value of Money
“MONEY HAS A TIME VALUE”

• Evaluating financial transactions requires

valuing uncertain future cash flows;
 determining what uncertain cash flows are
worth at different points in time.

Time Value of Money 4

 Time Value of Money

• One complication is the time value of

money: a dollar today is not worth a
dollar tomorrow or next year.
• Another complication is that any amount of
money promised in the future is
uncertain, some riskier than others.

Time Value of Money 5

 Time Value of Money

• The time value of money refers to a dollar in

hand today being worth more than a dollar
received in the future, because you can invest
today’s dollar in an interest-bearing account
that grows in value over time.

Time Value of Money 6

 Moving money through time
 finding the equivalent value to money at different points in time

Compounding

Present Future
Value Value

Discounting

Time Value of Money 7

 Of interest

• The word interest is from the

Latin word intereo, which
means “to be lost.”
• Interest developed from the
concept that lending goods
or money results in a loss to
the lender because he or
she did not have the use of
the goods or money that is
loaned.

Time Value of Money 8

 Interest
• Interest is the compensation for the
opportunity cost of funds and the uncertainty
of repayment of the amount borrowed.
• It represents both the price of time and the
price of risk.
• The riskier the investment, the higher the
interest rate.

Time Value of Money 9

 Compound Interest
• Interest is compound interest if interest is paid
on both the principal—the amount
borrowed—and any accumulated interest.
• For instance, if you borrow $1000 today for two
years and the interest is 5% compound
interest, at the end of two years you must
repay the $1000, plus interest on the $1000 for
two years and interest on interest.

Time Value of Money 10

 Computing the Future Value

• What is the future value of an initial $1000

after two years
(i = 5%)
• Finding FVs (moving to the right on a time
line) is called compounding.

Time Value of Money 11

Future Value

Time Value of Money 12

The Composition of Interest over Time

Time Value of Money 13

 Comouting a savings deposit
• Suppose you have a saving deposit
of $1000, paying 10%, annually
compounding. How much will you
have in the account in 7 years? in 20
years? in 35 years?

Time Value of Money 14

 Future Value
In the case of compound interest, the amount
repaid has three components:
1. The amount borrowed (= the principal)
2. The interest on the amount borrowed
3. The interest on interest

Time Value of Money 15

 Future Value

• We refer to translating a value today into a

value in the future as compounding, whereas
discounting is translating a future value into the
present.

• Future value = Present value + Interest

Time Value of Money 16

 Future Value
Future value = present value x (1+r) x (1+r)x..
FV = future value
PV = present value
= interest rate
n = the number of compounding periods

FV =

Time Value of Money 17

 Try it #: Savings
• Suppose you deposit $100 in an account that
earns 5% interest per year. If you do not make
any withdrawals, how much will you have in the
account at the end of 30 years?

Time Value of Money 18

 Methods of Solving Future Value
• Method 1: The equation
• FV =
• Method 2: The spreadsheet

Time Value of Money 19

 Cash Flow signs

Investing $ today Borrowing $ today

• Invest (Expense) $ • Borrow (Inflow) $ today
today in present to in present to use now,
earn greater return in then repay with interest
the future. in the future.
• Earn interest
(revenue), plus • Pay interest (expense),
principal plus principal
• PV = (-) • PV = +
• FV = + • FV = (-)
Time Value of Money 20
 Try it#: Loan Payment
• If you borrow $20,000 and the interest on the
loan is 9% per year, all payable at the end of
the loan, what is the amount that you must
repay if the loan is for four years?
• FV = 20000*(1.09)^4 = 28231.6$

Time Value of Money 21

 Exercise
• You suppose to buy a house five years from now
and want to invest enough money now to pay for it.
You have in mind a house now costs $100,000 and
the interest rate you can earn for your money is
8.5% pear year. (deposit IR)
• How much money should you invest now? If the
inflation rate is 6.5% per year.

Time Value of Money 22

 Financial Math
• Analysts often come up with estimates of
growth in revenues and earnings for publicly
traded companies. We can use these
estimates to make projections.

Time Value of Money 23

 Financial Math
• Consider the Walt Disney Company. At the end
of fiscal year 2018, analysts expected Disney’s
earnings to grow at a rate of 12.19% per year,
in the long-term.
• If Disney’s earnings for fiscal year 2018 were
$2,300 per share and if we concur with the
analysts, we can estimate the earnings per
share for fiscal years into the future.
• How much is the estimated earnings per share
for 2019? 2020?

Time Value of Money 24

 Try it#: Frequency
• If interest compounds more frequently than
once per year, you need to consider this in
any valuation problem involving compounded
interest.

Time Value of Money 25

 Some remarks
• Savings deposit IR
• Demand deposit = no maturity = customer can withdraw money
anytime that they want
• IR = 0.1%; annual percentage rate (APR) = 0.1% (365 days)
• FV = (1+i) ^n x PV (compounding Interest)  applied to savings
deposits
• But for demand deposit; the bank will simple interest for the demand
depositors
• Simple Interest = days/years * (Interest rate per day)* PV
• On the 1st day: you put 1 mill VNDs into your account;
• After 30 days, you check the total amount of money in the account:
• 1 mil VND * 30 days * 0.1%/365 days = 0.82191 VND for the months
• After 365 days, 1 mill * 365 days * 0.1%/365 = 1000 VND

Time Value of Money 26

 Try it#: Frequency
Annual percentage rate (APR)
• When an interest rate is stated in terms of a
rate per year, but interest is compounded more
frequently than once per year, the stated
annual rate is referred to as the annual
percentage rate (APR), but the actual
calculation requires using the rate per
compound period and the number of
compound periods.

Time Value of Money 27

 Try it#: Frequency
• For example, if a loan of $5,000 for three years
has an APR of 10% and interest compounds
semi-annually, the calculation of the future
value at the end of three years uses:
• i = rate per compound period
= 10% ÷ 2 = 5% per six months
• n = number of compounding periods
= 2 per year × 3 years = 6 periods
FV = ?

Time Value of Money 28

 THE POWER OF
COMPOUNDING
• Suppose you invest $1000 in an account
paying 6% for monthly compounding
interest. How much will you have in the
account in 7 years? in 20 years? in 35
years?

Time Value of Money 29

 Try it#: Frequency
• Suppose you have a choice of saving $1
million with the following terms, with interest
paid at the end of the deposit:
• 5% APR, quarterly interest
• 5.5% APR, semi-annual interest
• 6% APR, annual interest
Under which deposit terms would you have the
largest payment at the end of three years?

Time Value of Money 30

 Financial Math
• Credit card companies allow customers with
balances to pay a minimum amount, instead of the
full amount each month. What remains unpaid
accumulates interest at sometimes quite high
interest rates.
• Suppose you have charged $1,000 and choose to
pay the minimum balance of 2% at the end of each
month. And suppose your credit card company
charges 30% APR interest, with monthly
compounding.
• How much will you owe after 12 months if you
implement the strategy of paying the minimum?
• The interest will be applied on the principal after
the first monthly minimum payment.

Time Value of Money 31

 Don’t Discount Discounting
• We refer to translating a value back in time as
discounting, which requires determining what a
future amount or cash flow is worth today.
• Discounting is used in valuation because we
often want to determine the value today of
some future value or cash flow (e.g., what a
bond is worth today if it promised interest and
principal repayment in the future).

Time Value of Money 32

 Present Value
The Single-Period Scenario
• To find a present value, we reverse the growth
concept and discount the future value back to
the current period.
•  bringing the money back in time with the
interest rate (we call it the discount rate)

Time Value of Money 33

 Present Value
𝐧
• We turn FV = into:

PV = FV x

• PV=the present value (today’s value)

• FV=the future value (a value or cash flow sometime in the future)

• i=the interest rate per period

• n=the number of compounding periods

Time Value of Money 34

 Present Value
The Multiple-Period Scenario
• Suppose that you wish to have $20,000 saved by the
end of six years. And suppose you deposit funds today
in an account that pays 3% interest, compounded
monthly. How much must you deposit today to meet
your goal?
• PV = ? Of $20000
• 
•

• ∗ = 16 709.15711
Quarterly IR = 8%
PV = ( %/ ) = 12 434.42976

Time Value of Money 35

 Methods of Solving Present Value

• Method 1: The equation

• Method 2: The spreadsheet

Time Value of Money 36

 Calculate the Interest
Rate/Yield/Discount rate/Growth rate
• What is the discount rate on my future cash?
• At what rate is my money growing over time?

• =( -1

Time Value of Money 37

 Try it# Interest ratae
• If you deposit $35000 in the bank today and
five years will get back $40000, what is your
growth rate?

•i=?

Time Value of Money 38

 Calculation of the time period

• The time period is the waiting time for a

present value to mature into a desired value.

•n =

Time Value of Money 39

 Try it # Savings
• You invest $5000 in bank with APR = 1%,
compounding monthly, beginning two years
from now and $4000 beginning three years
from now, $3000 beginning four years from
now,
• Compute the present value of the amount you
receive after ten years from now.
• PV = 𝒏  PV = 𝟏𝟐𝟎 = 11 665.269

Time Value of Money 40

 Try it # Loan rate
John, a college student, needs to borrow
$25,000 today for his tuition bill. He agrees to
pay back the loan in a lump-sum payment five
years from now, after he is out of college. The
bank states that the payment will need to be
$55,015.75.
• If John borrows the $25,000 from the bank,
what interest rate is he paying for his loan?

Time Value of Money 41

 i, r, k: What is the difference?
• From now on, if you look at other books and
our documents, you will see other notations for
the interest rate, including r for return or the
required rate of return, and k for the cost of
capital.
• These really represent the same concept: the
time value of money.

Time Value of Money 42

 VALUING A
STREAM OF CASH
FLOWS

Time Value of Money 43

 Future Value of Multiple
Payment Streams
• Suppose you plan to put away some years to
build up a nest egg to use as a down payment
on a house. You start off by putting away
$2,000 today, and over the next three years
you are able to put away $3,000 at the end of
the first year, $4,000 at the end of the second
year, and $5,000 at the end of the third year.
• How much will you have saved by the end of
the third year if your investment rate is 5% per
year?

Time Value of Money 44

 Solution

$4,000 $5,000
$3,000
$4,000x(1.05)

$3,000 x
$2,000

$2,000 x

Time Value of Money 45

 Present Value of a Stream of Cash Flow
• You have just graduated and need money to
buy a new car. Your rich Uncle Henry will lend
you the money so long as you agree to pay
him back within four years, and you offer to
pay him the rate of interest that he would
otherwise get by putting his money in a savings
account. Based on your earnings and living
expenses, you think you will be able to pay him
$5000 in one year, and then $8000 each year
for the next three years.
• If Uncle Henry would otherwise earn 6% per
year on his savings, how much can you borrow
from him?

Time Value of Money 46

 Solution
• How much money should Uncle Henry be
willing to give you today in return for your
promise of these payments?
• He should be willing to give you an amount that
is equivalent to these payments in present
value terms.
• The cash flows you can promise Henry are as
follows:

Time Value of Money 47

PV =? 7183 7183 7183 7183

I = 6%

𝑪𝑭 𝟏
• PV*(1+i)^n= (
𝒓 𝟏 𝒓 𝒏

Time Value of Money 48

 Solution
• Uncle Henry should be willing to lend you
……………………………in exchange for your
promised payments. This amount is
……………………….than the total you will pay
him ($5000+$8000+$8000+$8000 = $29,000)
due to the time value of money.

Time Value of Money 49

Three Rules of Time Travel

Time Value of Money 50

Time Value of Money 51
 Annuity
• An annuity is a series of even cash flows.
Because the cash flows are the same amount,
the math is simpler 

Time Value of Money 52

 Future Value of an Annuity Stream
• Say you decide to put away $1,000 at the end
of every year for the next five year. If you can
earn 6% on the account, what is the value of
the account at the end of the five year?
• Unlike the previous problem, you do not put
any money away today.
• The first deposit is at the end of the first year.

Time Value of Money 53

 Future Value of an Annuity Stream
• An annuity is a stream of N equal cash flows
paid at regular intervals. Most car loans,
mortgages, and some bonds are annuities.
• FV = +
+ +
+
• FV = CF x [ + + +
+ ]

• )

Time Value of Money 54

 Future Value of an Annuity Stream

• )
• FV= = 115892.499 = 53680.65*(1.08^10)
.
• PV = 53680.65

Time Value of Money 55

 Try it #:
Back and Forth with Annuities
• Kitty and Red put $1,500 into a college fund every
year for their son, Eric, on his birthday, with the
first deposit one year from his birth (at his very first
birthday). The college fund has a guaranteed
annual growth or interest rate of 7%. At his
eighteenth birthday, they will pay the last $1,500
into the fund. How much will be in the college fund
for Eric immediately following this last payment?

• Solution:
• FV (rate, nper, Pmt, pv,type)
• FV (0.07,18,-$1500,0,0)

Time Value of Money 56

 Try it #:
Back and Forth with Annuities
• Ben and Donna determine that upon
retirement, they will need to withdraw $50,000
annually at the end of each year for the next
thirty years. They know that they can earn 4%
each year on their investment.
• What is the present value of this annuity? In
the other words, how much will Ben and Donna
need in their retirement account (at the
beginning of their retirement) to generate this
future cash flow?

Time Value of Money 57

 Try it #: Annuity Payment
• Your biotech firm plans to buy a new DNA
sequencer for $500,000. The seller requires
that you pay 20% of the purchase price as a
down payment,
• but is willing to finance the remainder by
offering a 48-month loan with equal monthly
payments and an interest rate of 0.5% per
month.
• What is the monthly loan payment?
• C = $9394.01

Time Value of Money 58

 Amortization schedule

• You take a loan of 2 billions VND for 20 years

with the interest rate of 9%.
• Compute the annual payment.
• How much is the loan after the third payment?

Time Value of Money

59
 Amortization schedule

You take a loan of 2 billions VND for 20

years with the interest rate of 9%.Time Value of Money
60
 Three Loan Payment Methods
1. Amortized Loan (Interest and Principal as You
Go)
 Amortization Schedules
2. Discount Loan (Interest and Principal at the
Maturity of Loan
3. Interest Only Loan
Interest as You Go
 Consols (Multiple Interest) ;
 Coupon Bond (Multiple Interest + Principal at
Maturity of Loan)

Time Value of Money 61

 Perpetuities
• Let’s look at still another example. Suppose
you are evaluating an investment that promises
$10 every year forever. This type of cash flow
stream is referred to as a perpetuity.

Time Value of Money 62

 Perpetuities
• A perpetuity is a stream of equal cash flows
that occur at regular intervals and last forever.
• One example is the British government bond
called a consol (or perpetual bond). Consol
bonds promise the owner a fixed cash flow
every year, forever.

Time Value of Money 63

 Present Value of A Perpetuity
• A perpetuity with payment C and interest rate r:

Time Value of Money 64

Present Value of A Perpetuity

Time Value of Money 65

 Financial Math: Consols
• The government of the United Kingdom has
had bonds outstanding that never mature.
These bonds are referred to as consolidated
stock, or consols, that are part of the
government debt.
• The bonds currently pay interest at a rate of
2.5% per year, paid four times a year. What is
the value of one Consolidated Stock if the
appropriate discount rate is 4%?
• Face value = 100

Time Value of Money 66

 Try it #: Perpetuities
• You want to endow an annual MBA graduation
party at your alma mater. You want the event to
be a memorable one, so you budget $30,000
per year forever for the party. If the university
earns 8% per year on its investments, and if
the first party is in one year’s time, how much
will you need to donate to endow the party?

Time Value of Money 67

 Application: Growing Cash Flows

Growing Perpetuity
Growing Annuity

Time Value of Money 68

 Growing Perpetuity

• A growing perpetuity is a stream of cash

flows that occur at regular intervals and grow at
a constant rate forever.

Time Value of Money 69

Present Value of Growing Perpetuity
(Suppose g < r)
Cash flow C, growing at rate g every period until
period N

Time Value of Money 70

 Try it #: Growing Perpetuity
• You planned to donate money to your alma mater
to fund an annual $30,000 MBA graduation party.
Given an interest rate of 8% per year, the required
donation was the present value of
• ………………………………………………today
• Before accepting the money, however, the MBA
student association has asked that you increase
the donation to account for the effect of inflation on
the cost of the party in future years.
• Although $30,000 is adequate for next year’s party,
the students estimate that the party’s cost will rise
by 4% per year thereafter. To satisfy their request,
how much do you need to donate now?

Time Value of Money 71

 Solution

Time Value of Money 72

 Growing Annuity
• A growing annuity is a stream of N growing
cash flows, paid at regular intervals. It is a
growing perpetuity that eventually comes to an
end.

Time Value of Money 73

Present Value of a Growing Annuity

Time Value of Money 74

 Try it #: Growing Annuity

• Ellen considered saving $10,000 per year for

her retirement. Although $10,000 is the most
she can save in the first year, she expects
her salary to increase each year so that she
will be able to increase her savings by 5%
per year. With this plan, if she earns 10% per
year on her savings, how much will Ellen
have saved at age 65?

Time Value of Money 75

 Growing Annuity
• Solution

Time Value of Money 76

 Present Value of a Growing
Annuity
• Ellen’s proposed savings plan is equivalent to
having ………..in the bank today.

• # Please try to determine the amount Ellen will

have at age 65!

Time Value of Money 77

Time Value of Money 78
 Annual and Periodic Interest Rate

• Let’s assume that you purchase a CD for

$500 with a promised annual percentage
rate (APR) of 5%.
• The annual percentage rate (APR) is
the yearly rate that you earn by investing
or charge for borrowing.

Time Value of Money 79

 Annual and Periodic Interest Rate
• However the financial institution quotes 5% interest
rate on an annual basis, these institutions in fact often
pay interest quarterly, monthly or even daily.
• The period in which the financial institution applies
interest or the frequency of times at which it adds
interest to an account each year is the compounding
period or compounding periods per year (C/Y)

Time Value of Money 80

 Periodic interest rate

• Periodic interest rate =

Time Value of Money 81

Effective annual rate (EAR)

•EAR = (1+ -1

Time Value of Money 82

 Try it#: APR
• Suppose your bank account pays interest
monthly with the interest rate quoted as an
effective annual rate (EAR) of 6%.
• What amount of interest rate will you earn each
month?

Time Value of Money 83

 Try it#: APR
• Suppose you borrow $1,000 using a payday
loan that has finance charges of 17.5% of the
loan for a 10-day period.
• What is the APR on this loan?

Time Value of Money 84

 Try it#: EAR
• A credit card offers a rate of 19.4% on unpaid
balances. Interest compounds daily. What is
the effective annual rate on this credit card?

Time Value of Money 85

Financial Math: Financial Leasing

Time Value of Money 86

•PRESENT VALUE
AND THE NPV
DECISION RULE

Time Value of Money 87

 Evaluating long-term cash flows
• One of the most important tools in business
and investing is evaluating an investment that
provides cash flows over a long time period.
• We refer to these types of decisions as capital
budgeting because we use capital—that is,
long-term sources of funds—and are
evaluating what we can spend now to get
these future benefits—hence, the budgeting
part

Time Value of Money 88

 Different investment:
Thing One and Thing Two

• Using a 10% cost of

capital, we can apply
the time value of
money skills to give
us a better idea of
which is better:

Time Value of Money 89

 Net Present Value (NPV)
• When we compute the value of cash today, we
refer to it as the present value (PV).
• Similarly, we define the net present value
(NPV) of a project or investment as the
difference between the present value of its
cash inflows and the present value of its cash
outflows:
• NPV = PV(Cash inflows) - PV(Cash outflows)

Time Value of Money 90

Net Present Value Decision Rule

Time Value of Money 91

 Net Present Value (NPV)
• As long as the NPV is positive, the
decision increases the value of the
firm and is a good decision
regardless of your current cash
needs or preferences regarding
when to spend the money.

Time Value of Money 92

• NPV = ?
• Initial Cost/Investment at t0 = 910;
• At the end of the first year, project generates a revenue
of 1000 and a cost $550
• At the end of the second year, project generates a
revenue of 800 and a cost $350
• Cost of the capital = 10%
• NPV1 = 1000/1.1 – 550/1.1 = 409.09
• NPV2 = (800 – 350)/1.1^2 = 371.9
• NPV = 910 – 409.09 – 371.9 = 409.09 + 371.9
– 910 = 129.01

Time Value of Money 93

 The NPV Decision Rule
• When making an investment
decision, take the alternative
with the highest NPV.
• Choosing this alternative is
equivalent to receiving its NPV in
cash today.

Time Value of Money 94

 Try it#: NPV

• Problem
Suppose you started a Web site hosting business and then decided to return to school. Now
that you are back in school, you are considering selling the business within the next year. An
investor has offered to buy the business for $200,000 whenever you are ready. If the interest
rate is 10%, which of the following three alternatives is the best choice?
1. Sell the business now.
2. Scale back the business and continue running it while you are in school for one more year,
and then sell the business (requiring you to spend $30,000 on expenses now, but generating
$50,000 in profit at the end of the year).
3. Hire someone to manage the business while you are in school for one more year, and
then sell the business (requiring you to spend $50,000 on expenses now, but generating
$100,000 in profit at the end of the year).

Time Value of Money 95

Choosing among alternative Plans

Time Value of Money 96

Exercises: n  ∞

Time Value of Money 97

 Internal Rate of Return
• Suppose you have an investment opportunity
that requires you to put up $50,000 and has
expected cash inflows of $28,809.52 after one
year and $28,809.52 after two years.

• IRR =10%

Time Value of Money 98

 Internal Rate of Return
• This interest rate is called the
internal rate of return (IRR),
defined as the interest rate that sets
the net present value of the cash
flows equal to zero.

Time Value of Money 99

 Internal Rate of Return Decision Rule
• The internal rate of return is a yield—what we
earn, on average, per year.
• How do we use it to decide which investment, if
any, to choose?
• Let’s revisit investments Thing One and Thing
Two and the IRRs that we just calculated for
each. If, for similar risk investments, owners
earn 10% per year, then both Thing One and
Thing Two are attractive investments.

Time Value of Money 100

 Internal Rate of Return Decision Rule
• The decision rule for the internal rate of return
is to invest in an investment if it provides a
return greater than the cost of capital. The cost
of capital, in the context of the IRR, is a hurdle
rate—the minimum acceptable rate of return.

Time Value of Money 101

Internal Rate of Return Decision Rule

Time Value of Money 102

 IRR and Mutually Exclusive Investment
• When evaluating mutually exclusive
investments, the one with the highest IRR may
not be the one with the best NPV.
• The IRR may give a different decision than
NPV when evaluating mutually exclusive
investments because of the reinvestment
assumption:
• NPV assumes cash flows reinvested at the
cost of capital.
• IRR assumes cash flows reinvested at the
internal rate of return.

Time Value of Money 103

 IRR and Mutually Exclusive Investment
• What if we were forced to choose between Thing
One and Thing Two because they are mutually
exclusive or there is a limit on how much we can
invest? Thing Two has a higher IRR than Thing
One—so at first glance we might want to accept
Thing Two.
• What about the NPV of these investments? What
does the NPV tell us to do? If we use the higher
IRR, it tells us to go with Thing Two.
• Choosing the investment with the higher net
present value is consistent with maximizing wealth.
Why? Because if the cost of capital is 10%, we
would calculate different NPVs and come to a
different conclusion.

Time Value of Money 104

 IRR and Mutually Exclusive Investment
This reinvestment assumption may cause
different decisions in choosing among mutually
exclusive investments when one or more of the
following apply:
• The timing of the cash flows is different among
the investments.
• There are scale differences (that is, very
different cash flow amounts).
• The investments have different useful lives.

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 IRR and Mutually Exclusive Investment
The timing of the cash flows
• With respect to the role of the timing of cash
flows in choosing between two investments:
Thing Two’s cash flows are received sooner
than Thing One’s. Part of the return on either is
from the reinvestment of its cash inflows. And
in the case of Thing Two, there is more return
from the reinvestment of cash inflows.
• The question is “What do you do with the cash
inflows when you get them?” We generally
assume that if you receive cash inflows, you’ll
reinvest those cash flows in other assets.

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Application of the Time Value of Money

BOND PRICING

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 Values tied to bonds
• A bond is a legal obligation to repay an amount
borrowed—theprincipal—along with some
compensation for the time value of money and
risk. Corporations, municipalities, states, and the
federal government issue bonds.
• Most bonds represent obligations of the borrower
to pay interest at regular intervals (usually every
six months) and to repay the principal amount of
the loan at the end of the loan period; that is, at
maturity.
• We also use the terms maturity value, face value,
par value, and redemption value to refer to this
principal

Time Value of Money 108

Bond Pricing

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 Bond Pricing
• Column 1. Type
• Column 2. Issuer
• Column 3. Price = it is the price someone is willing to pay for bond
in today’s market.
• Column 4. Coupon Rate = Annual Rate of each bond
• Column 5. Maturity date = date on which the coorpration pays the
final interest installment and repays the principal.
• Column 6. Yield to Maturity = the yield or investment return that
you would receive if you purchased the bond today at the price
listed in Column 3 and if you held the bond to maturity. It will be
the discount rate in the bond pricing formula.
• Column 7. Current Yield = is the annual coupon payment divided
by the current price
• Column 8. Rating = the bond rating, a grade indicating credit
quality

Time Value of Money 110

 Value of a bond
A bond typically has two types of cash flows:
• Interest, which is periodic
• Principal, which is a lump sum at maturity

Time Value of Money 111

 Value of a bond
• To calculate the value of a bond, we discount
the future cash flows (that is, the interest and
maturity value) at some rate that reflects both
the time value of money and the uncertainty of
receiving these future cash flows.
• We refer to this discount rate as the yield.

Time Value of Money 112

 U.S bonds vs European bonds
• Most U.S. bonds pay interest semiannually,
though European bonds often pay interest
annually.
• In Wall Street parlance, we use the term yield
to maturity (YTM) to describe an annualized
yield on a security if the security is held to
maturity.

Time Value of Money 113

 Yield to maturity

•The yield to maturity of a bond is

the discount rate that sets the
present value of the promised
bond payments equal to the
current market price of the bond.

Time Value of Money 114

 Try it#: Bond pricing
• Merrill Lynch As of 15-Jul-2008
• Coupon rate 6.50%
• Maturity date 15-Jul-2018
• Yield to Maturity 7.0%
• Fitch Ratings AA
• Coupon payment frequency: semiannual
• First coupon date 15-Jan-2009
• Type Corporate
• Price (% of par) ?

Time Value of Money 115

 Pricing a Bond in 4 Steps
• Step 1: Lay out the timing and amount of the
future cash flows
• Annual coupon or interest payment = $1,000x
0,065 = $65.00
• To = presents the original issue date of July 15th,
2008
• T1= is the first annual coupon payment date of
July 15th, 2009.
• T10 = is the last payment on July 15,2018.
• The coupon payments constitute an annuity
stream.
• The principal or par value of $1,000 pays out at the
maturity.

Time Value of Money 116

 Pricing a Bond in 4 Steps
• Step 2: To determine the appropriate discount
rate for this cash flow.
Use the yield to maturity as discount rate

Time Value of Money 117

 Pricing a Bond in 4 Steps
• Step 3: Find the present value of the cash flow

Time Value of Money 118

 Pricing a Bond in 4 Steps
• Step 4: is to add these two present value to get
the price or value of the bond

• Bond price = par value x 𝒏

𝟏 𝟏
+ coupon x
𝒓
(
𝟏 𝒓 𝒏

Time Value of Money 119

 Zero Coupon Bond
• A zero-coupon bond – a bond that paid zero
coupon.
• Bonds are difficult to value when:
• The principal repayment is not certain (for
example, bonds with embedded options)
• The coupon payments are not certain (for
example, floating rate bonds)
• The bond is exchangeable for another security
(for example, convertible bonds)

Time Value of Money 120

•STOCK VALUATION

Time Value of Money 121

 The dividend discount model
• The dividend discount model (DDM) implies
that share prices are only determined by the
expected future level of dividends and the
systematic risk of the future dividend flow
• • The model argues that the sale price the
current investor receives will depend on the
dividends some future investors expect.
• Therefore, for all present and future investors
in total, expected cash flows must be based in
expected future dividends.

Time Value of Money 122

 Example
• For the next three years, the annual dividends
of a stock are expected to be $1.00, $1.10 and
$1.20. The stock price is expected to be
$32.00 at the end of three years. If the required
rate of return on the shares is 10%, what is the
estimated value of a share?

Time Value of Money 123

 The dividend discount model
• The dividend discount model requires the
forecast of all future dividends. The following
dividend growth rate assumptions simplify the
valuation process
• ▫ No growth
• ▫ Constant growth
• ▫ Differential growth

Time Value of Money 124

 Case 1: Zero Growth

• Case 1: Zero Growth

• • Assume that dividends will remain at the
• same level forever – constant dividends

Time Value of Money 125

 Case 2: Constant Growth
• Assume that dividends will grow at a constant
rate, g, forever, i.e.,

Time Value of Money 126