CHAPTER

II. TIME VALUE OF MONEY

AND APPLICATION
CHAPTER STRUCTURE

1) What is time value of money?

2) Simple versus compound interest
3) Present value and Future value
4) Time value of money application
1) WHAT IS TIME VALUE OF MONEY?

u Time value of money refers to the fact that money in hand today is
worth more than the expectation of the same amount to be received
in the future.
u 3 reasons:
u Inflation: The purchasing power of money would decrease over time
due to inflation.
u Uncertainty: Money expected to receive in the future is uncertain.
u Opportunity cost: You can invest money today, earn interest, and end
up with more in the future.
u Why do we need to study time value of money?
u To make better financial decisions!
2) SIMPLE VERSUS COMPOUND INTEREST

u Interest is the price demanded by the lender from the borrower for
the use of borrowed money
u A fee paid by the borrower to the lender on borrowed cash as a
compensation for forgoing the opportunity of earning income from
other investments that could have been made with the loaned cash.
u Why do lenders charge interest on loans?
u Compensation for inflation.
u Compensation for default risk – the probability of borrwer will not pay
back the loan.
u Compensation for opportunity cost of wating to spend money.
2) SIMPLE VERSUS COMPOUND INTEREST

u Simple interest: the interest on the original principal

u Compound interest: the interest earned on the interest already paid
u Example: You put $100 to a bank at an interest of 5% for 2 years.

u The $5 interest earned each period on the $100 original investment is

known as simple interest
u The extra $0.25 at the end of Year 2 is the interest earned on the Year 1
interest of $5 that is reinvested.
2) SIMPLE VERSUS COMPOUND INTEREST

u When the question does not specify whether interest rate is single or
compounding, we assume that is compounding interest rate.
u Example: Mike deposits $10,000 into a bank account with interest rate of 10%
annually for 3 years. Calculate the amount Mike would receive at the end of 3
years in case of :
u Single interest
u Compounding interest
THE FREQUENCY OF COMPOUNDING

u Interest rate on loans and saving accounts are usually stated in form of an
annual percentage rate (APR). However, frequency of compounding can differ.
u Example: Mike deposits $10,000 into a bank account with APR of 12%
compounded monthly (This means that interest is credited to Mike’s account
every month at 1/12th the stated APR. The true interest rate is actually 1% per
month). Calculate the amount Mike would receive at the end of 3 years.
u To compare interest rate with different frequency of compounding, we can use
effective annual rate (EAR) – the equivalent interest rate if compounding
were only once per year.
THE FREQUENCY OF COMPOUNDING

u To compare interest rate with different frequency of compounding, we can use

effective annual rate (EAR) – the equivalent interest rate if compounding
were only once per year.
𝒎
𝑨𝑷𝑹
𝑬𝑨𝑹 𝑨𝑷𝑹, 𝒎 = 𝟏 + −𝟏
𝒎
u Example: Mike take out a loan at an APR of 12% with quarterly compounding.
What is effective annual rate (EAR) on the loan?
THE FREQUENCY OF COMPOUNDING

u What happen if the number of compounding periods per year becomes

infinite? Interest is said to compounding continuously.
𝑬𝑨𝑹 𝑨𝑷𝑹, 𝒄𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒊𝒏𝒈 𝒄𝒐𝒏𝒕𝒊𝒏𝒖𝒐𝒖𝒔𝒍𝒚 = 𝒆𝑨𝑷𝑹 − 𝟏
u Example: Complete the table below.

APR Frequency EAR

8% Annual
8% Semiannual
8% Quarterly
8% Monthly
8% Daily
8% Continuously
3) CALCULATING FUTURE VALUE AND PRESENT VALUE

u Types of cash flow:

u Single Cash Flow
u Uneven Cash Flows
u Annuity: a finite set of level sequential cash flows
u An Ordinary Annuity has a first cash flow that occurs one period from
now (indexed at t = 1).
u An Annuity Due has a first cash flow that occurs immediately (indexed at
t = 0).
u Perpetuity is a perpetual annuity, or a set of level never-ending sequential
cash flows, with the first cash flow occurring one period from now.
u Growing Perpetuities is a set of level never-ending sequential cash flows,
with the first cash flow occurring one period from now, and increasing at a
constant rate.
SINGLE CASH FLOW

u Future value:

𝑭𝑽𝒏 = 𝑷𝑽 × (𝟏 + 𝒊)𝒏
u Example: 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 percent 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 five years if your money
remains invested at 7 percent for five years with no withdrawals?
SINGLE CASH FLOW

u Present value:
𝑭𝑽𝒏
𝑷𝑽 =
(𝟏 + 𝒊)𝒏
u Example: An insurance company has issued a Guaranteed Investment Contract
(GIC) that promises to pay $100,000 in six years with an 8 percent return rate.
What amount of money must the insurer invest today at 8 percent for six years to
make the promised payment?
UNEVEN CASH FLOWS

u Future value: Future value of a series of unequal cash flows can be calculated
by compounding the cash flows one at a time

u Present value: Present value of a series of unequal cash flows can be

calculated by discounting the cash flows one at a time

u Example: Calculate present value (at t = 0) and future value (at t = 5) of the
following cash flow?

Time 1 2 3 4 5
Cash flow 1,000 2,000 4,000 5,000 6,000
ORDINARY ANNUITY

u Future value:
𝟏+𝐢 𝐧−𝟏
𝐅𝐕𝐧 = 𝐀×
𝐢
u Example: Suppose your company’s defined contribution retirement plan
allows you to invest up to €20,000 per year. You plan to invest €20,000 per
year in a stock index fund for the next 30 years. Historically, this fund has
earned 9 percent per year on average. Assuming that you actually earn 9
percent a year, how much money will you have available for retirement after
making the last payment?
ORDINARY ANNUITY

u Present value:
𝐀 𝟏
𝐏𝐕 = × 𝟏 − 𝐧
𝐢 𝟏+𝐢
u Example: Suppose you are considering purchasing a financial asset that
promises to pay €1,000 per year for five years, with the first payment one
year from now. The required rate of return is 12 percent per year. How much
should you pay for this asset?
ANNUITY DUE

u Future value:
(𝟏 + 𝐢)𝐧 −𝟏
𝐅𝐕𝐧 = 𝐀 × 𝟏 + 𝐢 ×[ ]
𝐢
u Example: You plan to save for future by investing $10,000 per year in 10
years. The first investment amount starts now. Suppose the interest rate is 8%
per year compounded annually?
ANNUITY DUE

u Present value:
𝐀 𝟏
𝐏𝐕 = × 𝟏 − 𝐧 × (𝟏 + 𝐢)
𝐢 𝟏+𝐢
u Example: You are retiring today and must choose to take your retirement
benefits either as a lump sum or as an annuity. Your company’s benefits officer
presents you with two alternatives: an immediate lump sum of $2 million or an
annuity with 20 payments of $200,000 a year with the first payment starting
today. The interest rate at your bank is 7 percent per year compounded annually.
Which option has the greater present value?
PERPETUITY

u Present value:
A𝟏
𝐏𝐕 =
𝐢
u Where: A% the first cash flow occurring one period from now.

u Example: 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 percent?
GROWING PERPETUITY

u Present value:
𝐀𝟏
𝐏𝐕 =
𝐢−𝐠
u Where: A% the first cash flow occurring one period from now; g is growth rate of
cash flows

u What if i ≤ g?

u Example: Suppose you are considering investing in a project that promises to

pay €1,000 per year indefinitely and increase 5 percent each year, with the first
payment one year from now. The required rate of return is 12 percent per year.
How much should you pay for this project?
4) TIME VALUE OF MONEY APPLICATION
u Rule of 72
u Installment Loans Calculation
u Net Present Value – NPV
u Internal Rate of Return – IRR
u Payback period
u Pricing Financial Assets
RULE OF 72

u Rule of 72: The number of year it takes for a sum of money to double in vaue
(the “doubling time”) is approximately equal to the number of 72 divided by the
interest rate expressed in percent per year:

𝟕𝟐
𝐃𝐨𝐮𝐛𝐥𝐢𝐧𝐠 𝐓𝐢𝐦𝐞 =
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞

u What if we change the above formula to:

𝟕𝟐
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞 =
𝐃𝐨𝐮𝐛𝐥𝐢𝐧𝐠 𝐓𝐢𝐦𝐞

u Example: Use rule of 72, calculate the number of year it takes for a sum of
money to double if the interest rate is 10 percent per year.
INSTALLMENT LOANS CALCULATION

u Installment loans: Many loans, such as home mortgage and car loans, are
repaid in equal preodic installments. Part of each payment is interest on the
outstanding balance of the loan and part is repayment of principal.

u What is the type of cash flow of the equal preodict installments from an
installment loan?

u Example: You are considering take a new $1,000 iPhone 12 and pay by
installments in 12 months. Suppose that the interest rate is 4% per month. How
much would you need to pay at the end of each month?
INSTALLMENT LOANS CALCULATION

u In reality: Go to a phones-selling website and try to buy a phone by paying in

installments to see how much do you need to pay at the end of each month.
Compare installments from the website with installments from annuity
formula.

u Equated Monthly Installment: Reducing Balance Method and Flat Rate

Method!

u In Vietnam, there is another method?

NET PRESENT VALUE – NPV

u The net present value of an investment is the present value of its cash inflows
minus the present value of its cash outflows.
NPV = PV (Cash Inflows) – PV (Cash Outflows)
u The steps in computing NPV and applying the NPV rule:
u (1) Identify all cash flows associated with the investment – all inflows and
outflows:
u A sunk cost is one that has already been incurred and therefore should be excluded.
u Cash flows are based on opportunity costs. What are the incremental cash flows
that occur with an investment compared to what they would have been without the
investment?
u Cash flows are analyzed on an after-tax basis
u Financing costs are ignored
NET PRESENT VALUE – NPV

u The steps in computing NPV and applying the NPV rule:

u (2) Determine the appropriate discount rate or opportunity cost, r, for the
investment project. Other terms: Required rate of return, cost of capital,
opportunity cost of capital
u (3) Using that discount rate, find the present value of each cash flow. (Inflows
have a positive sign and increase NPV; outflows have a negative sign and
decrease NPV.)

u (4) Sum all present values. The sum of the present values of all cash flows
(inflows and outflows) is the investment’s net present value.
NET PRESENT VALUE – NPV

u (5) Apply the NPV rule:

u If the investment’s NPV is positive, an investor should undertake it;
u if the NPV is negative, the investor should not undertake it.
u If an investor has two candidates for investment but can only invest in one
(i.e., mutually exclusive projects), the investor should choose the
candidate with the higher positive NPV.
NET PRESENT VALUE – NPV

u Example: Assume that Gerhardt Corporation is considering an investment of

€400 million in a capital project that will return after-tax cash flows of €100,
€150, €150, and €200 respectively from year 1 to year 4 . The required rate of
return is 10 percent. Calculate NPV.

Time 0 1 2 3 4
Cash flow -400 100 150 150 200
NPV PROFILE

u The NPV profile shows a project’s NPV graphed as a function of various discount
rates.

u Typically, the NPV is graphed vertically (on the y-axis), and the discount rates
are graphed horizontally (on the x-axis)

u Example: Use Microsoft Excel to create a NPV profile of a project.

INTERNAL RATE OF RETURN – IRR

u The internal rate of return is the discount rate that makes net present value
equal to zero.

u The rate is “internal” because it depends only on the cash flows of the
investment; no external data are needed.

u The decision rule for the IRR is to invest if the IRR exceeds the required rate of
return for a project or opportunity cost of capital:

u IRR > r: Invest

u IRR<r: Do not invest

INTERNAL RATE OF RETURN – IRR

u How to calculate IRR?

u Trial and error method

u Linear interpolation

u Financial calculator

u Excel Spreadsheet

u Example: Calculate IRR for a project with the following cash flows.

Time 0 1 2 3 4
Cash flow -400 100 150 150 200
INTERNAL RATE OF RETURN – IRR
PROBLEMS WITH THE IRR RULE

u The Multiple IRR Problem

u The No IRR Problem

u Ranking Conflicts between NPV and IRR

u Differing Cash Flow Patterns

u Differing Project Scale

THE MULTIPLE IRR PROBLEM
u We can illustrate this problem with the following Nonconventional Cash Flow
pattern: Time 0 1 2
Cash flow -1,000 5,000 -6,000
THE NO IRR PROBLEM
u We can illustrate this problem with the following Nonconventional Cash Flow
pattern: Time 0 1 2
Cash flow 100 -300 250
RANKING CONFLICTS BETWEEN NPV AND IRR

u Differing Cash Flow Patterns:

u Example: Projects A and B have similar outlays but different patterns of future
cash flows. Project A realizes most of its cash payoffs earlier than Project B. The
cash flows, as well as the NPV and IRR for the two projects, are shown in table
below. For both projects, the required rate of return is 10 percent.

Time 0 1 2 3 4 NPV IRR

Project A -200 80 80 80 80
Project B -200 0 0 0 400
DIFFERING CASH FLOW PATTERNS
RANKING CONFLICTS BETWEEN NPV AND IRR

u Differing Project Scale:

u Example: Projects A and B have similar outlays but different patterns of future
cash flows. Project A realizes most of its cash payoffs earlier than Project B. The
cash flows, as well as the NPV and IRR for the two projects, are shown in table
below. For both projects, the required rate of return is 10 percent.

Time 0 1 2 3 4 NPV IRR

Project A -100 50 50 50 50
Project B -400 170 170 170 170
DIFFERING PROJECT SCALE
PAYBACK PERIOD

u The payback period is the number of years required to recover the original
investment in a project

u Example: If you invest $10 million in a project, how long will it be until you
recover the full original investment.

Time 0 1 2 3 4 5
Cash flow -10,000 2,500 2,500 3,000 3,000 3,000
Cummulative -10,000 -7,500 -5,000 -2,000 1,000 4,000
PAYBACK PERIOD

u Advantages of payback period:

u Very easy to calculate and to explain

u Can be used as an indicator of project liquidity

u Drawbacks of payback period:

u Ignores the time value of money

u Ignores the risk of the project

u Ignores cash flows after the payback period is reached

u Comment on why the payback period provides misleading information about
the following: Project A, Project B versus Project C, Project D versus Project E,
and Project D versus Project F
 DISCOUNTED PAYBACK PERIOD
u The discounted payback period is the number of years it takes for the
cumulative discounted cash flows from a project to equal the original
investment
u The discounted payback period partially addresses the weaknesses of the
payback period

Time 0 1 2 3 4 5
Cash flow -5,000 1,500 1,500 1,500 1,500 1,500
Cummulative -5,000 -3,500 -2,000 -500 1,000 2,500
Discounted CF -5,000 1,363.64 1,239.67 1,126.97 1,024.52 931.38
Cummulative
-5,000 -3,636.36 -2,396.69 -1,269.72 -245.20 686.18
Disounted CF
PRICING FINANCIAL ASSETS

u Review: What are financial assets?

u Pricing financial assets is literally discounting all the expected future cash
flow(s) to present!

u Example: A bond is a contractual agreement between the issuer and the

bondholders in which issuers promise to pay preodic coupons and the principal
(par value) on maturity date. A 5 – year bond with par value of $100, coupon
rate of 10% which are made annually. Pricing the bond?

𝐂𝐨𝐮𝐩𝐨𝐧 𝟏 𝐏𝐚𝐫
𝐁𝐨𝐧𝐝 𝐩𝐫𝐢𝐜𝐞 = ´ [1 - 𝐧 ]+
𝐢 (𝟏 + 𝐢) (𝟏 + 𝐢)𝐧