CORPORATE FINANCE

CHAPTER 2

TIME VALUE OF MONEY

 Chapter content

1. Time Value of Money

1.1. Simple interest and Compound interest

1.2. Quoted and Effective annual interest rate

2. Future Value and Present Value

2.1. Future value

2.2. Present value

3. Simplifications for different types of cashflow

4. Loan Amortization
 PART 1

TIME VALUE OF MONEY

 Cash Flow Timing

Which is the better project?

Future Cash Flows

Year Project A Project B

1 $0 $20 000

2 $10 000 $10 000

3 $20 000 $0

Total $30 000 $30 000

1-4
 Time value of money

• The idea that money available at the present time is worth more than
the same amount in the future due to its potential earning capacity.
→ it is better to have money now rather than later

?
You can do much more with the money if you have it now because over
time you can earn more interest on your money.
the most basic principle of finance:

a dollar today is
worth more than a
dollar tomorrow
 INTEREST and INTEREST RATES

• Interest in general is the cost of borrowing money.

• An interest rate is the cost stated as a percent of the
amount borrowed (principal) per period of time,
usually one year.

Interest

Simple Compound
interest interest
 INTEREST RATES:
Simple and Compound interest
Simple Interest
• Simple interest is calculated on the original principal only.
• Accumulated interest from prior periods is NOT used in calculations for
the following periods.
• Simple interest is normally used for a single period of less than a year,
such as 30 or 60 days.

Simple Interest = p * i * n
p = principal (original amount borrowed or
loaned)
i = interest rate for one period
n = number of periods
 INTEREST RATES:
Simple and Compound interest
 INTEREST RATES:
Simple and Compound interest

Compound Interest

• Compound interest is calculated each period on the original principal and all
interest accumulated during past periods.

• The compounding periods can be annual, semiannual or quarterly.

Future value = p * (1+i )n

 INTEREST RATES:
Quoted and Effective annual interest rate

The government of France and Germany pays interest on its bonds

annually.
In the United States and Britain government bonds pay interest
semiannually.
So if the interest rate on a U.S. government bond is quoted as 10%, the
investor receives interest of 5% every six months. What is the value of
the investment after one year?
 INTEREST RATES:
Quoted and Effective annual interest rate

Quoted annual interest rate Effective annual interest rate

Interest paid once a year =

Interest paid more frequently
(semiannually, quarterly, …) <
m
  r 
Effective annual interest rate = 1 +  m  −1
  
Where:
r: quoted annual interest rate
m: number of compounding periods
 PART 2
FUTURE VALUES
VS. PRESENT VALUES
 FUTURE VALUE

Future Value is the value of an asset or

cash at a specified date in the future that
is equivalent in value to a specified sum
today.
 FUTURE VALUE (cont)

Suppose you invest $100 in a bank account that pays

interest of r = 7% a year. In the first year you will earn
interest of .07 x $100 = $7 and the value of your investment
will grow to $107:

Value of investment after 1 year = $100 x (1 + 7%) = $107

→ By investing, you give up the opportunity to spend $100

today and you gain the chance to spend $107 next year.
 FUTURE VALUE (cont)

• If you leave your money in the bank for a second year,

you earn interest of .07 x $107 = $7.49 and your
investment will grow to:
$107 x (1 + 7%) = $100 x (1 + 7%)2 = $114.49

Initial
investment
→ You earn interest on both Compound interest
Previous year’s
interest
 FUTURE VALUE: formula

• The general formula for the future value of an investment over

many periods can be written as:
FV = CF0 × (1 + r)T
Where : CF0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is invested.
 FUTURE VALUE
How an investment of $100 grows with compound interest at
different interest rates.

$1,636.65

$672.75

$265.33
$100
 Example

CF0 = $10,000
CFt is the future value of CF0
r = 9%
t = 10 years
What is the future value if the interest rate is compounded annually or monthly?
 PRESENT VALUE

How much you need to

What is the present
invest today to produce
OR value (PV) of the
$114.49 at the end of
$114.49 payoff?
the second year?
PRESENT VALUE: formula

CFt
PV =
(1 + r ) t

CF1 is cash flow at date 1

CFt is cash flow at date t
r is the appropriate interest rate
t is the number of compounding periods
 1 
 (1 + r)t  = discount factor
 
 PART 3
SIMPLIFICATIONS FOR
DIFFERENT TYPES OF CASH
FLOW
 DIFFERENT KINDS OF CASHFLOW

• Annuity
• A stream of constant cash flows that lasts for a fixed number
of periods.
• Growing annuity
• A stream of cash flows that grows at a constant rate for a
fixed number of periods.
• Perpetuity
• A constant stream of cash flows that lasts forever.
• Growing perpetuity
• A stream of cash flows that grows at a constant rate forever.
 ANNUITY
A constant stream of cash flows with a fixed maturity.
CF CF CF CF

0 1 2 3 T

CF CF CF CF
PV = + + ++
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r ) T

The formula for the present value of an annuity is:

CF  1 
PV = 1 − (1 + r )T 
r  
 ANNUITY: example
If you can afford a $400 monthly car payment, how much
car can you afford if interest rates are 7% on 36-month
loans?

$400 $400 $400 $400


0 1 2 3 36
 What is the present value of a four-year annuity of $100 per year that
makes its first payment two years from today if the discount rate is 9%?

$X $Y $100 $100 $100 $100

0 1 2 3 4 5
 GROWING ANNUITY
A growing stream of cash flows with a fixed maturity.
CF CF×(1+g) CF ×(1+g)2 CF×(1+g)T-1

0 1 2 3 T
CF CF  (1 + g ) CF  (1 + g )T −1
PV = + ++
(1 + r ) (1 + r ) 2
(1 + r ) T

The formula for the present value of a growing annuity:

CF   1+ g  
T

PV = 1 −   
r − g   (1 + r )  
 
 GROWING ANNUITY: example
You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?

0 1 2 3 4 5
 PERPETUITY
A constant stream of cash flows that lasts forever.
CF CF CF
…
0 1 2 3
CF CF CF
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3

The formula for the present value of a perpetuity is:

CF
PV =
r
 PERPETUITY: example

On occasion, the British and the French have been known to disagree
and sometimes even to fight wars. At the end of some of these wars
the British consolidated the debt they had issued during the war.
The securities issued in such cases were called consols. Consols are
perpetuities. These are bonds that the government is under no
obligation to repay but that offer a fixed income for each year to
perpetuity. The British government is still paying interest on consols
issued all those years ago.
 GROWING PERPETUITY
A growing stream of cash flows that lasts forever.
CF CF×(1+g) CF×(1+g)2
…
0 1 2 3
CF CF  (1 + g ) CF  (1 + g ) 2
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

The formula for the present value of a growing perpetuity is:

CF
PV =
r−g
 GROWING PERPETUITY: example
Imagine An apartment building where cash flows to the landlord
after expenses will be $100,000. The annual interest rate is
11%. These cash flows are expected to rise at 5% per year. If
one assumes that this rise will continue indefinitely, the cash
flow stream is termed a growing perpetuity.

$100k $100k×(1.05) $100k ×(1.05)2

…
0 1 2 3
PERPETUITY & ANNUITY:
some useful shortcuts
 PART 4
LOAN AMORTIZATION
 Loan amortization

An amortized loan require the borrower to repay parts of the loan amount over
time.

The process of providing for a loan to be paid off by making regular principal
reductions is called amortizing the loan.

→ the borrower pay the interest each period plus some fixed amount.
 Loan amortization example

Example: Suppose a business takes out a $5,000, 5-year loan at 9%. The loan
agreement calls for the borrower to pay the interest on the loan balance each
year and to reduce the loan balance each year by $1,000 (it is fully paid in five
years).
 Loan amortization example

If borrower make a single, fixed payment every period?

MS Excel functions
 MS Excel functions
❖ Rate - the interest rate per period. If you make yearly payments, indicate an annual
interest rate; if you pay monthly, specify a monthly interest rate, and so on.
❖ Nper - the total number of payment periods for the length of an annuity.
❖ Pmt - the amount paid each period. If omitted, it is assumed to be 0, and the fv argument
must be included.
❖ Fv - the future value of an annuity after the last payment. If omitted, it is assumed to be 0,
and the pmt argument must be included.
❖ PV – the present value of an annuity, loan or investment based on a constant interest
rate. It can be used for a series of periodic cash flows or a single lump-sum payment.
❖ Type (optional) - when the payments are to be made:
• 0 or omitted (default) - at the end of a period (regular annuity)
• 1 - at the beginning of a period (annuity due)

Exp: You’ve been saving up to buy the Godot Company. The total cost will be $10
million. You currently have about $2.3 million. If you can earn 5% on your money,
how long will you have to wait? At 16%, how long must you wait?
 CHAPTER SUMMARY
• It is better to have money now rather than later
• Interest is the cost of borrowing money, including simple and
compound interest
• Future value is an amount to which an investment will grow after
earning interest
• Present value is value today of one or many future cash flows
• There are 4 common kinds of cash flow in finance: perpetuity,
growing perpetuity, annuity and growing annuity. Each has
shortcut to simplify calculation.
• Loan amortization means the borrower pay the interest each
period plus some fixed amount
“Live as if you are to die tomorrow,
study as if you are to live forever”
- Thomas More -