INTRODUCTION TO FINANCE

Lecturer: Tran Thi Minh Tram

Email: tramttm@ftu.edu.vn

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CHAPTER 3: TIME VALUE OF
MONEY
3.1: Time value of money
3.2: Time value of money – Financial table
3.3: Application of time value of money

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CHAPTER 3.1: TIME VALUE OF
MONEY
Source:
• Bodie, Z, & Merton, R. (2000), Finance, Prentice Hall Inc.
• CFA Program curriculum – Level 1 – Volume 1
• Timothy J.G (2013), Financial Management: Principle
and practices, 6th ed, Freeload Press Publishers.

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Chapter 3.1: Time value of money

TIME VALUE OF MONEY

FUTURE VALUE AND PRESENT VALUE

FUTURE VALUE OF SOME SPECIAL CASH FLOWS

PRESENT VALUE OF SOME SPECIAL CASH FLOWS

RULE OF 72

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 TIME VALUE OF MONEY
• Example 3.1.1: If you win in a lottery
10,000 USD, will you choose:
– 1st: Receive 10,000 USD now?
– 2nd : Or receive 10,000 USD in one year?

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 Time value of money
• Example 3.1.1 (cont):
– You may think in the 2nd option, the total
amount of money you can borrow is less
than in the 1st option.
– You then may choose the 1st option.
– How can you consider like that?

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 Time value of money
• There are at least 3 reasons why this is
true:
1. You can invest it, earn interest, and end up
with more in the future.
2. The purchasing power of money can
change over time because of inflation.
3. The receipt of money expected in the
future is, in general, uncertain.

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 Time value of money
• In making financial decisions, like
investment or borrowing decisions, people
or corporations usually have to compare
value of cash payments at different dates.

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 Time value of money
• Easy decision:
- More is better than less
- Now is better than later
- More now is better than less later

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 Time value of money
• Harder decision:
- Less now vs more later
✓How much less?
✓How much later?

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 “MONEY HAS A TIME VALUE”

As people think:
“a dollar in hand today is worth more than
a dollar expected to be received in the
future”.

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 Time value of money

• Time value of money concerns

equivalence relationships between cash
flows occurring on different dates.

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 Time value of money

• Interest rate (denoted r or i) is a rate of

return that reflect the relationship
between differently dated cash flows.

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FUTURE VALUE AND PRESENT VALUE

The time value of money reflects as Future

value and Present value.

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Future value and present value
• Future value (FV)
• Present value (PV)
• Compounding
– Compounding: interpretation
• The frequency of compounding
• Continuous compounding
• Compounding summary
– Relationship between FV and PV

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 Future value (FV)
• Future value (FV) is the amount of money an
investment will grow to at some date in the
future by earning interest at some compound
rate.
Now
0 1 2 3
year

FV1 FV2 FV3

• Example: suppose you put $1,000 into an account earning an interest

rate of 10% per year. The amount you will have in 5 years, assuming you
take nothing out of the account before then, is called the Future Value
of $1,000 at an interest rate of 10% per year for 5 years.

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 Present value (PV)
• Present value (PV) is the value today of a
future cash flow.
• PV is also known as the initial investment.

0 1 2 3
year

PV FV1 FV2 FV3

• The amount of $1,000 in the previous example is called

the Present Value of the investment.
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 Timeline
• A time line helps us to keep track of the
compatibility of time units and the interest
rate per time period.
Now
t=0 t=1 t=2 t=3 ….. t=n
year

PV FV1 FV2 FV3 FVn=PV(1+i)n

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Relationship between FV and PV
• There is a close relationship between the
Present Value and its Future Value.
– Principle to find FV: compound the value of
money today (PV) to have its Future Value.
– Principle to find PV: discount the value of FV
to its today value.

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Relationship between FV and PV
• There is a close relationship between the
Present Value and its Future Value.
– Principle to find FV: compound the value of
money today to have its Future Value.
– Principle to find PV: discount the value of FV
The process where the value of an
to its today value.
investment increases because the
earnings on an investment, both
capital gains and interest, earn
interest as time passes.

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Relationship between FV and PV
• There is a close relationship between the
Present
To cut its Value andonits
value based howFuture Value.
much time passes before the
– Principle toisfind
money paid FV: compound the value of
money today to have its Future Value.
– Principle to find PV: discount the value of FV
to its today value.

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 Compounding
• Example 3.1.2:
– Suppose you put $1,000 (the PV) into an
account earning compound interest rate of
10% per year.
– The amount you will have in 5 years,
assuming you take nothing out of the
account before then, is called the future
value of $1,000 at an interest rate of 10%
per year for 5 years.

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 Compounding
Example 3.1.2:
Future value and compound interest
Year Beginning Interest Ending
amount earned amount
1 $1,000.00 $100.00 $1,100.00
2 1,100.00 110.00 1,210.00
3 1,210.00 121.00 1,331.00
4 1,331.00 133.10 1,464.10
5 1,464.10 146.41 1,610.51
Accrued interest earned $610.51

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 Compounding
• The future value FV2= $1,210 could be
break into 3 components:
Beginning amount (principal) $1,000
Interest for 1st year based on principal 100
(1,000*0.1)
Interest for 2nd year based on principal 100
(1,000*0.1)
Interest for 2nd year based on interest earned 10
in the 1st year (100*0.1)
Total of principal and interest after year 2 $1,210
(100*(1+0,1)*(1+0,1))
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Relationship between FV and PV
• We have:
FV1 = PV + PV*i
FV1 = PV*(1+i)
FV2 = FV1*(1+i) = PV*(1+i)2
....
FVn = PV*(1+i)n

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 Calculate FV
• More generally, if i is the interest rate
and n is the number of years, the Future
Value of the beginning value PV is given
by the formula:

FV=PV*(1+i)n (3.1)
• Note:
– i and n must be compatible, i.e. both variables must
be defined in the same time unit.
– Example: if n is stated in months, then i should be
the one-month interest rate, not annual rate.
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 Calculate FV
• Example 3.1.3: Future Value of a Lump Sum
– Your bank offers a CD with an interest rate of 3%
for a 5 year investment.
– You wish to invest $1,500 for 5 years,
– How much will your investment be worth?

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 Calculate PV
FV = PV∗(1 + i)n
Divide both sides by (1 + i)n to obtain:
FV −n
PV = = FV∗(1 + i) (3.1.2)
(1 + i)n

To cut its value based

on how much time
passes before the
money is paid

Principle to find PV: you discount the

value of FV to its today value.

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 Calculate PV

• Example 3.1.4: Present Value of a Lump Sum

– You have been offered $40,000 for your printing
business, payable in 2 years.
– Given the risk, you require a return of 8%.
– What is the present value of the offer?

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 Calculate i and n
• You have solved a present value and a future
value of a lump sum. There remains two
other variables that may be solved for:
– interest, i
– number of periods, n

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 Calculate i
FV = PV ∗ (1 + i)n
FV
= (1 + i)n
PV
n FV
(1 + i) =
PV
n FV
i= −1 (3.1.3)
PV

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 Calculate i

• Example 3.1.5: Interest Rate on a Lump

Sum Investment
– If you invest $15,000 for 10 years, you receive
$30,000. What is your annual return?

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 Review of Logarithms
• The next three slides are a quick review of
logarithms
– I know that you probably learned this in eighth
grade, but those of us who do not use them
frequently forget the basic rules

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 Review of Logarithms
– Logarithms are important in finance because
growth is related to the exponential, and the
exponential is the inverse function of the
logarithm
– Logarithms may have different bases, but in
finance we need only the natural logarithm,
that is the logarithm of base e.
• The e is the irrational number that may be
approximated as 2.718281828. It is easy to
remember because it starts to repeat, but don’t be
fooled, it doesn't, and it is irrational
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 Review of Logarithms
• The basic properties of logarithms that are
used by finance are:
eln( x ) = x, x0
ln(e ) = x
x

ln( x * y ) = ln( x) + ln( y )

ln( x y ) = y ln( x)

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 Review of Logarithms
• The following properties are easy to prove
from the last ones, and are useful in finance

ln( x / y ) = ln( x) − ln( y )

ln( x * y * z ) = ln( x) + ln( y ) + ln( z )
ln( x + y )  ln( x) * ln( y )

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 Calculate n
FV = PV∗(1 + i)n
FV
= (1 + i)n
PV
FV
ln = ln (1 + i)n = n∗ln 1 + i
PV
FV
ln ln FV − ln PV
PV
n= = (3.1.4)
ln 1 + i ln 1 + i

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 Calculate n

• Example 3.1.6: Investment period on a

Lump Sum Investment
– If you invest $15,000 and expect to receive
$30,000 at annual rate of 10%. How long do
you need to take that investment?

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The frequency of compounding

• Interest of investments can be paid more

than once a year.

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The frequency of compounding
• Example 3.1.7:
• You have a credit card that carries a rate
of interest of 18% per year compounded
monthly. If you borrowed $1 with the
card, what would you owe at the end of a
year?

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The frequency of compounding
• The year is the macroperiod, and the month is
the microperiod
• In this case there are 12 microperiods in one
macroperiod.
• If the interest rate is 18% annually, then the
monthly interest rate is 18%/12=1.5%.
• The bank charges interest on principal and
interest on monthly basis at the rate of 1.5%.

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The frequency of compounding
• With more than one compounding period
per year, the Future Value formula can be
expressed as:

FVn =PV*(1+i/m)m*n (3.2)

• Where:
– i is stated annual interest rate
– m is the number of compounding periods per
year
– n is the number of years
– i/m is the periodic interest used; (m*n) is the
total number of compounding periods
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The frequency of compounding
• We have:
FV1 = PV + PV*(i/m)
FV1 = PV*(1+i/m)
FV2 = FV1*(1+i/m) = PV*(1+i/m)2
....
FVm*n = PV*(1+i/m)m*n

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 Continuous compounding
• If the number of compounding periods
per year becomes infinite, then interest is
said to compound continuously.
• The formula for future value of a sum in
n years with continuous compounding is:
FVn =PV*ei*n (3.3)

where: e ~ 2.7182818

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 Continuous compounding
• We have:
FVn =PV*(1+i/m)m*n
• When m-> ∞ then:
m
 i 
lim m −  1 +  = e i
 m

• Then the formula for future value in the

continuous compounding is:

FVn =PV*ei*n
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 Continuous compounding
Example 3.1.8:
• Suppose a $10,000 investment will earn
8% compounded continuously for two
years. How much is its Future Value when
it comes to due?

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 Compounding summary
If stated Annual interest rate is 8% but the
frequency of compounding is different, the result
for Future Value of $1 investing is as below:
Frequency r/m m*n Future value of $1
Annual 8%/1=8% 1x1=1 $1.00(1.08)=$1.08
Semiannual 8%/2=4% 2x1=2 $1.00(1.04)2 =$1.081600
Quarterly 8%/4=2% 4x1=4 $1.00(1.02)4 =$1.082432
Monthly 8%/12=0.6667% 12x1=12 $1.00(1.006667)12
=$1.083000
Daily 8%/365=0.0219% 365x1=365 $1.00(1.000219)365
=$1.083278
Continuously $1.00(e)0.08(1) =$1.083287

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 SOME SPECIAL CASH FLOWS
• Cash flow reflects incomings and outgoings of cash,
i.e. the movement of money into or out of a business,
project, or financial product.
– Cash inflows usually arise from one of three activities:
financing, operations or investing, although this also
occurs as a result of donations or gifts in the case of
personal finance.
– Cash outflows result from expenses or investments.
➢ This holds true for both business and personal
finance.
• Some special cash flow:
– Single cash flow
– Multiple equal cash flow
✓ Ordinary annuity
✓ Annuity due
✓ Perpetual annuity
✓ Perpetual growth
– Multiple unequal cash flow

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Some special cash flows – Timelines
Single CF

Ordinary
annuity

Annuity
due

Perpetual … …
annuity

Perpetual …
growth

Unequal
CF

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 Single cash flow
• A single cash flow, also called a lump-sum
investment.
– Lump-sum is an amount paid or received at a
single point of time.
• Example: You buy a CD (Certificate of
Deposit) from a bank with an interest rate of
3% for a period of 6 month investment.
– You can not withdraw money during the period
of 6 month investment.
– You are not paid any money (principal or
interest) during this 6 month investment.
– Principal and interest will both be paid at the
end of this 6 month investment.

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 Multiple cash flows
• Multiple cash flows is series of cash
flows, the cash flows could be even or
uneven.
– Multiple equal cash flows
– Multiple unequal cash flows
• Future Value of multiple cash flows is the
Future Value of series of cash flows.
• Present Value of multiple cash flows is
the Present Value of series of cash flows.

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 Multiple equal cash flows
• Annuity: is a finite set of level sequential
cash flows.
– It is the regular payments, normally fixed to a
particular amount, then the cash flows would
be equal.
• Example: you receive a $500 USD annual
payment.
Now
t=0 t=1 t=2 t=3 ….. t=n
year

$500 $500 $500 $500

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 Multiple equal cash flows
• 4 different types :
– Ordinary annuity: has a first cash flow that
occurs one period from now (indexed at t=1).
– Annuity due: has a first cash flow that occurs
immediately (indexed at t=0).
– Perpetual annuity/ Perpetuity: is a set of level
never-ending sequential cash flows (a stream of
cash flows that lasts forever), with the first cash
flow occurring one period from now (indexed at
t=1).
– Perpetual growth: is a set of never-ending
sequential cash flows, with the cash flows
growing year by year.

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 Multiple equal cash flows
• Annuity:
– Payments must be equal and regular
✓Equal amounts
✓Occurring in each period
– Annuity due: beginning of period
– Ordinary annuity: end of period

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 Multiple equal cash flows
• Perpetuity:
– Payments must be equal and regular
✓Equal amounts
✓Occurring in each period
✓Occurring forever (no maturity date)
– Most preferred stock does not have a maturity
date and has a fixed dividend payment.

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 Multiple equal cash flows
• Perpetual growth
– Payment:
✓Amount grow at instant growth rate
✓Occurring in each period
✓Occurring forever (no maturity date)

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 Multiple unequal cash flow
• Multiple unequal cash flow: Any series of
cash flows that doesn’t conform to the
definition of an annuity is considered to be
an uneven cash flow stream.
• Example: one may receive the following
annual payments over a 5 year period:
Now
t=0 t=1 t=2 t=3 t=4 t=5
year

$500 $300 $400 $250 $750

• Unequal cash flow is more popular in

corporate finance (firm’s expenses,
revenues…)
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FUTURE VALUE OF SOME SPECIAL
CASH FLOWS
• Principle to find FV: You compound the
value of money today to have its Future
Value.
• FV of some special cash flows:
– Single cash flow
– Multiple unequal cash flow
– Multiple equal cash flow
✓Ordinary annuity
✓Annuity due
• FV of perpetuity/perpetual growth can
not be computed because it is infinite.
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 FV of a single cash flow
Example 3.1.9:
• Suppose you decide to invest the initial
$100 for 2 years with interest earned and
credited to your account annually
(annual compounding). Interest rate is
5% per year.
• How much money you suppose to have
by the end of year 1? Year 2?

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 FV of a single cash flow
Example 3.1.10:
• You are the lucky winner of your state’s
lottery of $5 million after taxes. You
invest your winnings in a five-year
certificate of deposit (CD) at a local
financial institution. The CD promises to
pay 7% per year compounded annually.
This institution also lets you reinvest the
interest at that rate for the duration of
the CD. How much will you have at the
end of 5 years if your money remains
invested at 7% for 5 years with no
withdrawals?
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 FV of a single cash flow
• General formula relates PV and FV of a
single cash flow:

FVn =PV*(1+i)n (3.1)

• In which:
– PV: present value of the investment
– FVn : future value of the investment n
periods from today
– i=rate of interest per period
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 FV of a single cash flow
Example 3.1.11:
• Continuing with the CD example,
suppose your bank offers you a CD with a
two-year maturity, a stated annual
interest rate of 8% compounded
quarterly, and a feature allowing
reinvestment of the interest at the same
interest rate. You decide to invest
$10,000. What will the CD be worth at
maturity?

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 FV of a single cash flow
• Frequency of compounding

FVn =PV*(1+i/m)m*n (3.2)

• Where:
– i is stated annual interest rate
– m is the number of compounding periods
per year
– n is the number of years
– i/m is the periodic interest used; (m*n) is
the total number of compounding periods
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FV of a multiple unequal cash flow
• Example 3.1.12:
• Consider unequal cash flow streams,
paying 5% annually. Suppose we have
five separate deposits of $1,000; $2,000;
$3,000; $4,000; $5,000 occurring at
equally intervals from year 1 to year 5
respectively (at the end of each year).
• Our goal is to find Future Value of these
cash flows at t=5

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FV of a multiple unequal cash flow
• General formula to define the Future Value
of an unequal cash flow:
n
FVn =  C t (1 + i) n −t

t =1 (3.4)

• In which:
– FV is the future value
– Ct is the amount of money invested at year t
– i is the interest rate
– n is the number of years
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 FV of an ordinary annuity
• Example 3.1.13: Consider an ordinary
annuity paying 5% annually. Suppose we
have 5 separate deposits of $1,000
occurring at equally spaced intervals of
one year, with the 1st payment occurring
at t=1.
• Our goal is to find the future value of this
ordinary annuity after the last deposit at
t=5.

66
 FV of an ordinary annuity
• General formula to define the future value of an
ordinary annuity:
FV = A * (1 + i ) 
n −1 n−2 n −3
n + (1 + i) + (1 + i) + ..... + (1 + i) + (1 + i)
1 0

• Which simplify to:


FVn = * (1 + i ) − 1
A
i
n
 (3.5)

• In which:
– FVn is the future value
– A is the annuity amount
– i is the interest rate per period
– n is the number of payment periods
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 FV of an ordinary annuity
• We have:
• Multiply with (1+i)


FVn = A * (1 + i )
n −1

+ (1 + i ) n − 2 + (1 + i ) n −3 + ..... + (1 + i )1 + (1 + i ) 0 (1)

FVn (1 + i ) = A * (1 + i ) + (1 + i ) n −1 + (1 + i ) n − 2 + ..... + (1 + i ) 2 + (1 + i )1 (2)
n

(2) − (1) = FV (1 + i − 1) = A(1 + i ) − (1 + i ) ) 
n 0
n

(1 + i ) n − 1  (1 + i ) n − 1
FVn = A * = A*  
(1 + i ) − 1  i 

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 FV of an annuity due
• Example 3.1.14: Consider an annuity due
paying 5% annually. Suppose we have 5
separate deposits of $1,000 occurring at
equally spaced intervals of one year, with
the 1st payment occurring at t=0.
• Our goal is to find the Future Value of
this annuity due after the last deposit at
t=5.

69
 FV of an annuity due
• General formula to define the future value of an
annuity due:


FVn = A * (1 + i ) + (1 + i) n−1 + (1 + i) n−2 + ..... + (1 + i) 2 + (1 + i)1
n

• Which simplify to:
A
i
n

FVn = * (1 + i ) − 1 * (1 + i) (3.6)

(annuity due can be considered 1 period before ordinary annuity)

• In which:
– FVn is the future value
– A is the annuity amount
– i is the interest rate per period
– n is the number of payment periods
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 FV of an annuity due
• We have:


FVn = A * (1 + i ) + (1 + i ) n −1 + (1 + i ) n − 2 + ..... + (1 + i ) 2 + (1 + i )1
n

= A * (1 + i ) 
n −1
FVn + (1 + i ) n − 2 + (1 + i ) n −3 + ..... + (1 + i )1 + (1 + i ) 0 * (1 + i )
 (1 + i ) n − 1
FVn = A *   (1 + i )
 i 

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FV of an ordinary FV of an annuity
annuity due

A
i
 n

FVn = * (1 + i ) − 1
A
i
 n

FVn = * (1 + i ) − 1 * (1 + i)

72
PRESENT VALUE OF SOME SPECIAL
CASH FLOWS
• Principle to find PV: you discount the
value of FV to its today value.
• PV of some special cash flows:
– Single cash flow
– Multiple unequal cash flow
– Multiple equal cash flow
✓Ordinary annuity
✓Annuity due
✓Perpetual annuity
✓Perpetual growth
73
 PV of a single cash flow
• Example 3.1.15: How much do you have
to invest today to generate a future
payoff of $110 in 5 years, suppose you
can earn 5% interest per year?
Year 0 1 2 3 4 5

PV? $110

74
 PV of a single cash flow
• From the formula (3.1) we have:
FVn =PV*(1+i)n
• Therefore, we can compute the Present
Value of a single cash flow as below:
PV = FVn / (1+i)n (3.7)
• In which:
– PV: the initial investment (present value)
– FVn : future value of the investment n periods
from today
– i: rate of interest per period
75
 PV of a single cash flow
• Example 3.1.16:
• The manager of a Canadian pension fund
knows that the fund must make a lump-
sum payment of C$5 million 10 years
from now. She wants to invest an amount
today in a GIC so that it will grow to the
required amount. The current interest
rate on GICs is 6% a year, compounded
monthly. How much should she invest
today in the GIC?

76
 PV of a single cash flow
• Frequency of compounding:
• From the formula (3.2), we have:
FVn
PV = m*n
(3.8)
 i 
1 + 
 m
• Where:
– m=number of compounding periods per
year
– i=quoted annual interest rate
– n=number of years
77
PV of multiple unequal cash flow
• Example 3.1.17:
• Consider unequal cash flow streams,
paying 5% annually. Suppose we have 5
separate deposits of $1,000; $2,000;
$3,000; $4,000; $5,000 occurring at
equally intervals from year 1 to year 5
respectively.
• Our goal is to find Present Value of these
cash flows at t=0.

78
PV of multiple unequal cash flow
• General formula to define the future
value of unequal cash flow:
n
Ct
PV = 
t=1(1 + i )t
(3.9)

• In which:
– PV is the Present value
– Ct is the amount of money invested at year t
– i is the interest rate
– n is the number of years
79
 PV of ordinary annuity
• Example 3.1.18:
• Suppose you are considering purchasing
a financial asset that promise to pay
$1,000 per year for 5 years, with the first
payment one year from now. The
required rate of return is 5% per year.
How much should you pay for this asset?

80
 PV of ordinary annuity
• Present value of an ordinary annuity is
the sum of the present values of each
individual annuity payment, as follows:
A A A A A
PV = + + + ..... + +
(1 + i ) (1 + i ) 2 (1 + i ) 3 (1 + i ) n −1 (1 + i ) n

• Which can be simplified as:

 1 
1 − (1 + i ) n 
PV = A *  
 i 
 

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 PV of ordinary annuity
• General formula for present value of
ordinary annuity cash flows:

A  1 
PV = * 1 − (3.10)
i  (1 + i) n 

• Where:
– A= the annuity amount
– i= the interest rate per period corresponding to
the frequency of annuity payments (e.g.,
annual, quarterly or monthly…)
– n= the number of annuity payments
82
 PV of ordinary annuity
• We have:
A A A A A
PV = + + + ..... + n −1
+
(1 + i ) (1 + i ) (1 + i )
2 3
(1 + i ) (1 + i ) n
• α=1/(1+i) then
• Divide with α then
• (2)-(1)

83
 PV of annuity due
• Example 3.1.19:
• Suppose you are considering purchasing
a financial asset that promise to pay
$1,000 per year for 5 years, with the first
payment starting from now. The required
rate of return is 5% per year. How much
should you pay for this asset?
➢The same as example 3.1.17 but you
receive the first payment right now.

84
 PV of annuity due
• Present value of an annuity due is the
sum of the present values of each
individual annuity payment, as follows:
A A A A
PV = A + + + ..... + n−2
+
(1 + i ) (1 + i ) 2
(1 + i ) (1 + i ) n −1

• Which can be simplified as:

 1   1 
1 − (1 + i) n -1  1 − (1 + i) n 
PV = A *  + 1 = A *   * (1 + i)
 i   i 
   

85
 PV of annuity due
• General formula for present value of annuity due cash
flows:

 1 
1 −
 (1 + i) n  A  1 
PV = A *   * (1 + i) = * 1 − n 
* (1 + i) (3.11)
 i  i  (1 + i) 
 
(annuity due can be considered 1 period before ordinary annuity)

• Where:
– A= the annuity amount
– i= the interest rate per period corresponding to the
frequency of annuity payments (e.g., annual, quarterly or
monthly…)
– n= the number of annuity payments
86
 PV of annuity due
• We have:
A A A A
PV = A + + + ..... + n−2
+
(1 + i ) (1 + i ) 2
(1 + i ) (1 + i ) n −1
• α=1/(1+i) then
• Divide with α then
• (2)-(1)

87
PV of an ordinary PV of an annuity
annuity due

A  1  A  1 
PV = * 1 − PV = * 1 − * (1 + i)
i  (1 + i) n  n 
i  (1 + i) 

88
 PV of perpetuity
• Example 3.1.20:
• The British government once issued a
type of security called a consol bond,
which promised to pay a level cash flow
indefinitely. If a consol bond paid ₤100
per year in perpetuity, what would it be
worth today if the required rate of return
were 5%?

89
 PV of perpetuity
• Present value of a perpetuity is the sum of the
present values of each individual annuity
payment, as follows:
A A A A
PV = A + + + + ..... + n −1
+ ...
(1 + i ) (1 + i ) 2
(1 + i ) 3
(1 + i )
• Which can be simplified as:
 1 
1 −
 (1 + i ) n 
PV = A *  
 i 
 
• When n -> ∞ then:
PV = A/i
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 PV of perpetuity
• General formula for Present value of a
perpetuity:

PV = A/i (3.12)

• Where:
– A= the annuity amount
– i= the interest rate per period corresponding
to the frequency of annuity payments (e.g.,
annual, quarterly or monthly…)

91
PV of perpetuity

92
 PV of perpetuity growth
• Example 3.1.21:
• Your company plan to finance a
scholarship for a school. The scholarship
will pay annual cash flow of $1,000 that
will continue indefinitely. This cash flow is
expected to grow at 5% per year to
compensate for the increase in school fees
and inflation.
• Your company intend to put an amount of
money in investment with fixed required
return 10%.
• How much does your company need to
put in that investment now?
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 PV of perpetuity growth
• Present Value of a perpetuity growth is the
sum of the present values of each
individual annuity growth payment, as
follows:
A A(1 + g ) A(1 + g ) 2 A(1 + g ) n−2 A(1 + g ) n−1
PV = + + + ..... + n −1
+
(1 + i) (1 + i) 2
(1 + i) 3
(1 + i) (1 + i) n
• Which can be simplified as:
A
PV =
i−g

94
 PV of perpetuity growth
• General formula for present value of perpetuity
growth cash flows:
A
PV = (3.13)
i−g
• Where:
– PV is the present value
– A is the amount of money investment in period 1 (the
1st period’s cash flow)
– i is the interest rate
– g is the growth rate

95
PV of perpetuity growth

96
 PV of perpetuity growth
• We have

• If α=C1 /(1+i) và x=(1+g)/(1+i) then:

• With x<1 then xn ~0 when n->∞

• Then:

97
 RULE OF 72
• This rule says that:
• The number of years it takes for a sum of
money to double in value (the “doubling
time”) is approximately equal to the
number 72 divided by the interest rate
expressed in percent per year.
72
Doubling time = (3.14)
Interest rate
98
 Rule of 72
• Estimates:
– How long does it take to double your money
given a rate of return?
– What rate of return must you earn to double
your money given a holding period?

99
 Rule of 72
• Formula:
n x i = 72

72
n=
i

72
i=
n

100
 Rule of 72
• Example 3.1.22:
• If an investment has expected interest rate of
10% per year, it should take approximately 7.2
years to double the money.
72
Doubling time = = 7.2
10
• If you start with $1,000, you will have $2,000
after 7.2 years, $4,000 after 14.4 years, $8,000
after 21.6 years, and so on.
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Inflation and time value of money
• Example 3.1.23:
• Let’s consider the issue of saving for retirement. At age 20,
you save $100 and invest it at a dollar interest rate of 8%
per year.
– The good news is that at age 65 your $100 investment will have
grown to $3,192.
– The bad news is that it will cost a lot more to buy the same things
you buy today.
– For example, if the prices of all the goods and services you want to
buy go up at 8% per year for the next 45 years, then your $3,192
will buy no more than your $100 will buy today.
– In a “real” sense, you will not have earned any interest at all.
– Thus, to make truly meaningful long-run savings decisions, you
must take account of inflation as well as interest.

102
Inflation and time value of money
• To take account of both interest and inflation, we
distinguish between nominal and real interest rate:
– The nominal interest rate is the rate denominated in
dollars or in some other currency.
– The real interest rate is denominated in units of
consumer goods.
• The general formula:
1 + Nominal Interest Rate
1 + Real Rate =
1 + Rate of Inflation
Nominal Interest Rate - Rate of Inflation
= Real Rate =
1 + Rate of Inflation

103
Inflation and time value of money
• Example 3.1.24:
• You are investing $10,000 for the next year. You
face a choice between a conventional, one-year CD
paying an interest rate of 8% or a CD that will pay
you an interest rate of 3% per year plus the rate of
inflation. We will call the former a nominal CD and
the latter a real CD. Which one will you choose?

104
 Exchange Rates and Time Value of
Money

• Example 3.1.25:
• You are considering the choice:
– Investing $10,000 in dollar-denominated bonds
offering 10% / year
– Investing $10,000 in yen-denominated bonds
offering 3% / year
• Assume an exchange rate of 0.01
Financial Decision in an International
Context
• International currency investors borrow
and lend in
– Their own currency
– The currency of countries with which they do
business but wish to hedge
– Currencies that appear to offer a better deal
• Exchange rate fluctuations can result in
unexpected gains and losses
Some notes in Time value of money
• In any time value of money calculation, the cash flows
and interest rate must be denominated in the same
currency.
– To compute the PV of cash flows denominated in yen, you
must discount using the yen interest rate.
– To compute the PV of cash flows denominated in dollar, you
must discount using the dollar interest rate.
– …
• Never use a nominal interest rate when discounting real
cash flows or a real interest rate when discounting
nominal cash flows (or: When comparing investment
alternatives, never compare a real rate of return to a
nominal opportunity cost of money)
– Nominal interest rate = Real interest rate + Expected inflation.
• Invest so as to maximize the net present value of your
after-tax cash flows (not the same as investing so as to
minimize the taxes you pay).
– After-tax Interest rate = (1-Tax rate)*Before-tax Interest rate

107
 Summary
• The time value of money reflects as Future
value (FV) and Present value (PV).
• Basic formula: FV=PV*(1+i)n
• From this formula, we can build up many
other formulas to calculate FV and PV of
different cash flows.
• Inflation and international context (foreign
exchange) should be taken into account when
we calculate time value of money.

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PRACTICE

109