Time Value of Money

MGFB Principles of Finance

Jincheng Tong
University of Toronto

January 5, 2024

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0. Course objective

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Why finance?

- valuation matters!
- what determines the value of a company’s stock? How about risks?

- should a company invest in robots/automation technology and replace workers?

- should I buy or rent a house?

- Recent development in the global economy confirms the importance of finance

- close link between the real economy and financial market

- government policies have strong impact on household/firms’ financial decisions

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Rising inflation

- The pandemic:a mismatch between supply and demand → rising price level! 4 / 51
Central banks tightens monetary policy

- Central banks raise interest rates to combat inflation

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High interest rate and asset prices

- Bond and equity prices fall as interest rates are lifted

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The impact of high interest rate on the labor market

- labor demand starts to fall as monetary policy is tightened

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Adverse effects of high interest rate start to emerge

Figure: Market Implied Future Rates Figure: Number os Rate Cuts Priced In

- As the labor market cools down, central banks shifts policy stance

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Conclusion

- Stock valuation is closely related to economic conditions

- Asset prices are sensitive to interest rate changes

- What are the relations between interest rate, fundamentals, and asset prices?

- We will start with the basic valuation principle!

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1. Introduction to concepts of time value of money

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Why Is This Important?

- Calculating how much to put aside now to buy a car

- Determining how long it will take to pay off your credit card

- Figuring out how expensive of a house you can buy

- Estimating how much to save for comfortable retirement

- Computing how much to invest to pay your kids’ education

- Creating a business plan for your start-up venture

- Deciding which investment alternative is more profitable

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Outline

1. Introduction to concepts of time value of money

- What is future value (FV), present value (PV), and compounding?

- Mathematical formulation to PV and FV

2. Annual percentage rate (APR) and effective annual rate (EAR)

- What is the difference between APR and EAR?

- How to calculate EAR

3. Finding FV and PV with multiple cash flows

- Multiple cash flows for FV and PV

- Perpetuities, growing perpetuities, annuities, and growing annuities

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Time Value of Money
- A dollar today is worth more than a dollar in a year.
- Why? If you receive $1 today, you can invest it and earn interest on it.

- Suppose you have a sequence of cash flows and you want to know their total value as of
today
- Can you simply add them?

- No, because you need to remove the element of time. Past and future cannot be combined
without first converting them

- You can obtain the value of the cash flows at any point in time as long as you can make each
cash flow comparable

- Intuition
- Cash flows at different dates are different “currencies”

- Interest rate = “exchange rate” across time

Only cash flow values at the same point in time can be compared or combined.
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Future Value (FV) of a Cash Flow

- Suppose you invest $1,000 for one year at 10% per year. How much will you receive in
one year?
Interest = $1, 000 · 0.1 = $100

Principal + Interest = $1, 000 + $100 = $1, 100

Future Value (FV ) = $1, 000 · (1 + 0.1) = $1, 100

- Suppose you leave the money (including your interest payment) in for another year. How
much will you have two years from now?
Interest = $1, 100 · 0.1 = $110

Principal + Interest = $1, 100 + $110 = $1, 210

Future Value (FV ) = $1, 100 · (1 + 0.1) = 1, 100 · (1 + 0.1)2 = $1, 210

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Future Value of a Cash Flow

0 1 2 T −1 T

C FV

FV = C · (1 + r ) · (1 + r ) · · · · · (1 + r )
| {z }
T times

FV = C · (1 + r )T

The process of calculating the FV of a cash flow is called compounding

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Future Value of a Cash Flow: Example

- Compare two investment opportunities. You can invest $10,000 today in an index fund A
that generates a 10% return per year after fees. What is your investment worth in 20
years?
FVA = $10, 000 · 1.1020 = $67, 275

- What would your investment be worth if you invested instead in an actively managed fund
B that generates 9% annually after fees?

FVB = $10, 000 · 1.0920 = $56, 044

- How much richer are you if you invested in the more cost-effective fund A rather than the
costlier fund B?
FVA − FVB = $11, 231

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The Power of Compounding
- Suppose you invest the $1,000 from our first example at 10% per year for 3 years. How
much would you have?

FV = $1, 000 · 1.13 = $1, 331

- What is the future value of your investment without reinvesting interest payments every
period?
Simple interest (interest earned only on the original principal) would only give a future value
of
FV = $1, 000 + $1, 000 · 0.1 · 3 = $1, 300

The difference is due to compounding, or the fact that interest itself earns interest

(100 · 1.12 + 100 · 1.1 + 100) − (100 + 100 + 100) = $31

| {z } | {z }
FV of compound interest FV of simple interest

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The Power of Compounding
- Peter Minuit, the director of the Dutch colony of New Netherland, bought Manhattan
Island from the Native Americans for approximately $24 in 1626. If this money could have
been invested at 6% compound annual interest until 2016 (390 years), what would this
investment be worth?

FV = $24 · 1.06390 = 177, 622, 793, 082 (nearly $178 trillion)

- What would the investment be worth in 2016 if it earned interest only on the original
principal (simple interest)?

FV = $24 + $24 · 0.06 · 390 = $585.6

The effect of compounding is small for a small number of periods, but increases as the
number of periods increases.

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Why Compounding is so Important

- Real Bond Return =1.86%, stock return = 6.57% 19 / 51

Present Value of a Cash Flow
- What is value today, of $1,000 you anticipate receiving in one year? If the current market
interest rate is 10%, you can compute this value by converting money tomorrow into
money today.

$1, 000
PV = = $909.09
1 + 0.1
To move cash flow backward in time one period, we divide it by the interest rate factor
(1 + r ), where r is the interest rate.

- Suppose you anticipate receiving $1,000 two years from today rather than in one year.
If the interest rate for both years is 10% we can deduce:

$1, 000
PV = = $826.45
(1 + 0.1)2

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Present Value of a Cash Flow

0 1 2 T −1 T

PV C

1
PV = ×C
(1 + r )T

The process of calculating the PV of a cash flow is called discounting

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Present Value of a Cash Flow: Example

- You would like to buy a new car with cash in 5 years. The car will cost $30,000 and you
are confident that any money you set aside today will earn 7% annually. How much do
you need to set aside today?

30, 000
PV = = 21, 389.6
(1 + 0.07)5

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What Rate Is Enough?

- You would like to buy a new car with cash in 5 years. The car will cost $30,000 and you
only have $15,000 to invest today. What rate of return does your investment need to earn
so you can afford the car?

30, 000
15, 000 =
(1 + r )5
⇒ r = (30, 000/15, 000)1/5 − 1 = 14.87%

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How Long Is the Wait?
- You would like to buy a new car with cash. The car will cost $30,000 and you only have
$15,000 to invest today at the rate of 7% annually. How long do you have to wait before
you can afford the new car?

30, 000
15, 000 =
(1 + 0.07)T
⇒ T = ln(30, 000/15, 000)/ ln(1.07) ≈ 10

Recall: Basic properties of logarithms

ln(xy ) = ln(x ) + ln(y )
ln(x y ) = y ln(x )
ln(x /y ) = ln(x ) − ln(y )

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Basic Time Value of Money Relation
1
PV = × FV
(1 + r )T

- There are four parts to this equation: PV , FV , r , and T

- Knowing any three allows to solve for the fourth
- Required rate of return

  T1
FV
r= −1
PV

- Number of periods

ln(FV /PV )
T =
ln(1 + r )
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Frequency of Compounding
- So far we assumed that compounding and discounting occurs yearly (i.e. interest is paid
once a year)

- In general, compounding may occur more frequently

- Compounding an investment m times a year for T years gives

 r  m ·T
FV = PV · 1 +
m
r
- is the rate per period and m · T is the number of periods
m
- We have already seen the case for when m = 1

- Does FV increase or decrease as m increases?

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Frequency of Compounding
Suppose you owe $100 on your credit card and expect to repay it only in 3 years. How much
will you have to pay in 3 years if the credit card company charges 12% compounded ...
- ... annually
0.12 1·3
 
 r  m ·T
FV = $100 · 1 + = $100 · 1 + = $140.49
m 1

- ... quarterly
0.12 4·3
 
 r  m ·T
FV = $100 · 1 + = $100 · 1 + = $142.58
m 4

- ... monthly
0.12 12·3
 
 r  m ·T
FV = $100 · 1 + = $100 · 1 + = $143.08
m 12

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2. Annual and Effective Rate

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Annual vs. effective rates

Convention is to quote interest rates on an annual basis, but compounding may be more
frequent: semi-annual, daily, etc
- E.g., “12% compounded quarterly”: 12% is the actual or stated rate

- Stated annual interest rate is called the annual percentage rate (APR)

- APR does not reflect the true amount of interest paid over one year

The effective annual rate (EAR) of interest is used to compare investments with different
compounding frequencies
- EAR basically says ’quit BS-ing me around by telling me that it’s 12% quarterly and tell
me how much I’m really paying annually’

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Effective Annual Rate
- Compounding annually at EAR gives the same FV as compounding more frequently at
the stated rate

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Effective Annual Rate
- Compounding annually at EAR gives the same FV as compounding more frequently at
the stated rate
- $100 invested for a year at 12% compounded quarterly will grow to

0.12 4
 
FV = $100 · 1 + = $112.55
4

- Thus the stated rate of 12% compounded quarterly is equivalent to investing at 12.55%
compounded annually, or EAR = 12.55%

- EAR of an investment with the stated rate r compounded m periods a year is

 r m
EAR = 1 + −1
m

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Effective Annual Rate: Examples

- Your credit card agreement quotes APR of 18%. Monthly payments are required. What is
the EAR on your credit card debt?
Based on our discussion, an APR of 18% with monthly payments is really 0.18/12=0.015 or
0.15 percent per month. The EAR is this EAR = (1 + 0.18/12)12 − 1 = 19.56%

- You are choosing between two investment opportunities. Investment A pays 10%
compounded semi-annually. Investment B pays 9.8% compounded weekly (52 times a
year). Which of these investments is better?
EARA = (1 + 0.1/2)2 − 1 = 10.25%

EARB = (1 + 0.098/52)52 − 1 = 10.29%

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Calculating Effective rates for any payment frequencies

What about effective monthly rates (EMR) or effective quarterly rates (EQR)?

Example:
A financial institution is offering a $100,000 mortgage at a stated rate of 6 percent. In
Canada, mortgage rates are quoted with semiannual compounding. Moreover, payments
towards your mortgage are monthly. What is the effective monthly rate?

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Calculating Effective rates for any payment frequencies

Once you have the EAR, you can easily find the EMR or EQR by simply doing:

(1 + EAR )1/k − 1,

where k is = 12 for EMR and 4 for EQR.

The general effective rate formula is:

APR m/k
rk = (1 + m ) −1

TIP: I find it easier to find the EAR first and then simply do (1 + EAR )1/k − 1 to find EMR
or EQR.

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3. Finding FV and PV with multiple cash flows

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Multiple Cash Flows: Example

- Consider an investment that pays $200 one year from now, with cash flows increasing by
$200 per year through year 4. If the interest rate is 12%, what is the present value of this
stream of cash flows?
0 1 2 3 4

$200 $400 $600 $800

- If the issuer offers this investment for $1,500, should you purchase it?
0 1 2 3 4

−$1, 500

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Multiple Cash Flows: Example
0 1 2 3 4

$200 $400 $600 $800

178.57
318.88
427.07
508.41

200 400 600 800

PV = + 2
+ 3
+
1.12 1.12 1.12 1.124
= 178.57 + 318.88 + 427.07 + 508.41
= 1, 432.93
Present Value < Cost ⇒ Do Not Purchase

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Present Value of Multiple Cash Flows

0 1 2 T −1 T

C1 C2 CT −1 CT
C1
(1+r )
C2
(1+r )2
..
.
CT −1
(1 + r )T −1
CT
(1+r )T

C1 C2 CT − 1 CT
PV = + +···+ +
(1 + r ) (1 + r )2 (1 + r )T −1 (1 + r )T

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Future Value of Multiple Cash Flows

0 1 2 T −1 T

C1 C2 CT − 1 CT
CT −1 · .(1 + r )
..
C2 · ( 1 + r ) T − 2
C1 · ( 1 + r ) T − 1

FVT = C1 · (1 + r )T −1 + · · · + CT −1 · (1 + r ) + CT
FVT = PV · (1 + r )T

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Special Multiple Cash Flows

- Perpetuity is constant stream of cash flows that lasts forever

- Growing perpetuity is stream of cash flows that grows at a constant rate forever

- Annuity is stream of constant cash flows that lasts for a fixed number of periods

- Growing annuity is stream of cash flows that grows at a constant rate for a fixed number
of periods

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Perpetuity
- Perpetuity pays constant cashflow C forever

- How much is an infinite cashflow of C each year worth?

0 1 2 3 4

C C C C
C C C
PV = + 2
+ +...
(1 + r ) (1 + r ) (1 + r )3
C C
(1 + r ) · PV = C + + +...
(1 + r ) (1 + r )2
r · PV = C

C
PV =
r

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Perpetuity: Example
- You want to endow an annual graduation party at your university. You want it to be
great, so you budget $30,000 for next year’s 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?
∞
$30, 000 $30, 000
∑ (1 + 0.08)t = 0.08 = $375, 000
t =1

- How much will you need to donate if the first party is this year?
∞
$30, 000 $30, 000
∑ (1 + 0.08)t = $30, 000 + 0.08 = $405, 000
t =0

- How much should you donate if the first party is in two years?

In one year the PV of the $30,000 perpetuity is $375,000. A sum of $375,000 in one year
from now is worth
$375, 000 $375, 000
= = $347.2 thousands today
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Growing Perpetuity
- Growing perpetuity pays a growing stream of cash flows forever
- How much is an infinite growing cashflow of C each year worth?
0 1 2 3 4

C C · (1 + g ) C · (1 + g )2 C · (1 + g )3
C C · (1 + g ) C · (1 + g )2
PV = + + +...
(1 + r ) (1 + r )2 (1 + r )3
(1 + r ) C C C · (1 + g )
· PV = + + +...
(1 + g ) (1 + g ) (1 + r ) (1 + r )2
 
(1 + r ) C
− 1 · PV =
(1 + g ) (1 + g )

C
PV = , r >g
r −g
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Growing Perpetuity: Example

- You still plan to donate money to your university to fund an annual graduation party. The
president of the student association estimates that although $30,000 is adequate for the
next year’s party, the costs of the party will rise by 4% per year thereafter. Given an
interest rate of 8% per year, how much will you need to donate now?
Recall that if there is no increase in the cost of the party in the future years, the required
donation
$30, 000
PV = = $375, 000 today
0.08
If the cost increases 4% per year, we have a growing perpetuity. To finance the growing cost,
you need to provide the university with

$30, 000
PV = = $750, 000 today
0.08 − 0.04

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Annuity
- Annuity pays constant cashflow C for T periods

- How can we value it?

0 1 2 3 T

C C C C
C C C
PV = + +···+
(1 + r ) (1 + r )2 (1 + r )T
C C
(1 + r ) · PV = C + +···+
(1 + r ) (1 + r )T −1
C
r · PV = C −
(1 + r )T
 
C 1
PV = 1−
r (1 + r )T

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Annuity Example: RRSP Annuity
- Your friend just turned 35 and decided that it is time to plan seriously for retirement. On
each birthday, beginning in one year and ending when she turns 65, she will save $10,000
in an RRSP account. If the account earns 10% per year, how much will she have at age
65?
In the timeline, it is helpful to keep track of both the dates and age:
35 36 37 38 65
0 1 2 3 30

$10, 000 $10, 000 $10, 000 $10, 000

To determine the amount your friend will have in the RRSP account at 65, we need to
compute the future value of this annuity
FV = PV · (1 + r )T
 
C 1
= 1− · (1 + r )T
r (1 + r )T
$10, 000 h 30 i
= · 1.1 − 1 = $1.645 million
0.1
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Annuity Example: Canadian Mortgages

What is special about Canadian Mortgages?

- Canadian banks quote the annual interest based on compounding semi-annually, although
interest is calculated (compounded) every month.

- The terms of the mortgage are usually renegotiated during the period of the mortgage.
For example, the interest of a 25-year mortgage may be renegotiated 5 years after the
initiation of the mortgage.

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Annuity Example: Canadian Mortgages

- You have negotiated a 25-year, $100,000 mortgage at a rate of 7.4% per year
compounded semi-annually with the Toronto-Dominion Bank. What is your monthly
payment?
To answer this question, we first have to convert the quoted mortgage rate, to the effective
interest rate charged each month. We can do this in two steps.
0.074 2
1. Find the EAR: EAR = (1 + ) − 1 = 0.075369 = 7.5369%
2
2. Find the monthly rate corresponding to this EAR:
(1 + rmonthly )12 − 1 = 0.075369 ⇒ rmonthly = 0.00607369 = 0.607369%

We now can use the present value of annuity formula to find the monthly payment:
 
C 1
$100, 000 = 1− ⇒ C = $725.28
0.00607369 (1 + 0.00607369)12·25

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Growing Annuity
- Growing annuity pays growing cashflow for T periods
- How can we value it?
0 1 2 3 T

C C · (1 + g ) C · (1 + g )2 C · (1 + g )T −1
C C (1 + g ) C (1 + g )T −1
PV = + + · · · +
(1 + r ) (1 + r )2 (1 + r )T
(1 + r ) C C C (1 + g )T −2
· PV = + +···+
(1 + g ) (1 + g ) (1 + r ) (1 + r )T −1

(1 + r )

C C (1 + g ) T − 1
− 1 · PV = −
(1 + g ) (1 + g ) (1 + r )T

"  #
1+g T

C
PV = 1−
r −g 1+r
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Growing Annuity: Example
- In the RRSP example, your friend 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 in her RRSP, how much will she have saved at 65?
35 36 37 38 65
0 1 2 3 30

$10, 000 $10, 000 · 1.05 $10, 000 · 1.052 $10, 000 · 1.0529

The present value of this growing annuity is given by

"  #
1.05 30

$10, 000
PV = 1− = $150, 436 today
0.1 − 0.05 1.1

We see that the proposed savings plan is equal to having $150,436 in the bank today. The
future value your friend will have at 65 is
FV = $150, 436 · 1.130 = $2.625 million in 30 years
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Summary

- Time value of money is one of the most important concepts in finance

- The basic time value of money relationship:

FV = PV · (1 + r )T

- Effective annual rate, EAR, is an important concept used to compare products with
different compounding frequencies

- EAR is the interest rate that is actually earned or paid on investment, loan or other
financial product due compounding within the year

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Summary
- Cash flow valuation shortcuts help simplify valuation
- Perpetuities and annuities

- Note that annuity and perpetuity formulas assume that the first cash flow happens in one
period (at time 1) and not now (at time 0)

- Effective rate for any period can be computed as

APR m/k
rk = (1 + ) −1
m
- m = stated compounding frequency

- k = actual payment frequency

- Special cases: in case of yearly payments (k = 1) use EAR, in case m = k use APR/m

- Time value of money techniques can be used to value any financial asset, e.g. stock, bond
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