FINA1003/FINA1310 CORPORATE FINANCE

Faculty of Economics and Finance

University of Hong Kong

Dr. Shiyang Huang

Lecture 2: The Time Value of Money

Course Overview
• Introduction

• Part I: Valuation
• Time Value of Money, Discounted Cash Flow
Valuation, Bond and Stock Valuation.

• Part II: Risk and Return

• Historical Risk and Return Relationships, CAPM.

• Part III: Capital Budgeting

• Real Investment Decisions, Cost of Capital.

• Part IV: Financing Decisions

• Raising Capital, Tradeoff between Equity and Debt.
Key Takeaways

• Cash Flows and Assets

• Future Value (FV) and Compounding

𝑡
FV = PV 1 + 𝑟

• Present Value (PV) and Discounting

• Interest Rate

• Number of Periods

Reading: Chapter 5
Goal of Today
• Understand the Time Value of Money
• Draw timeline under each context

• Understand the power of compounding

• Calculate compound interest and simple interest

• Be able to quantitatively link FV (future value), PV (present

value), r (interest rate) and T (number of periods)
• Given three of them, be able to compute the fourth

• Focus on cases with single and known cash flows

Key Takeaways
• Cash Flows and Assets
• Future Value (FV) and Compounding
• Present Value (PV) and Discounting
• Interest Rate
• Number of Periods

Reading: Chapter 5
 Timeline

CF1 CF2 CF3 CF4

• Unless otherwise stated, t=0 represents today

• Unless otherwise stated, cash flows occur at the end of a time interval
• Cash inflow are treated as positive amounts, while cash outflows are
treated as negative amounts.
 Basic Definitions

• Present Value: earlier money on a timeline

• Future Value: later money on a timeline
• Interest rate: “exchange rate” between earlier money and the later money
• Discount rate
• Cost of Capital
• Opportunity cost of capital
• Required return
What is Time Value of Money?

• Your choice:
• 1,000,000 (A) vs. 1,050,000, (B)?
What is Time Value of Money?
• This question is essentially about the comparing an early
money (1,000,000) and a late money (1,050,000).

• There is one challenge in this question.

• Money occurs at different time

• How to solve this question?

• We can convert the early money to the future value.
What is Time Value of Money?
Future Values and Interest Rate
• Future Value: later money on a timeline. Amount to
which an investment will grow after earning interest.

• Simple Interest: Interest paid (earned) on only the

original amount, or principal, borrowed (lent).

• Compound Interest: interest paid (earned) on any

previous interest earned, as well as on the principal
borrowed (lent).
Simple Interest
• Simple Interest: Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
Future Value: Simple Interest

Formula

Future value using simple interest rate

= P0 (1 + t*i)

P0: Deposit today (t=0)

i: Interest Rate per Period
t: Number of Time Periods
Simple Interest – Example 1

• Assume that you deposit $1,000 in an account

earning 5% simple interest for 2 years. What is the
account balance at the end of the 2nd year?
• A 1,050

• B 1,100
• C 1,102.5
• D 1,125
Simple Interest – Example 1

• Assume that you deposit $1,000 in an account

earning 5% simple interest for 2 years. What is the
account balance at the end of the 2nd year?

Future value using simple interest rate

= P0(1 + t * i)
= $1,000(1 + 2*0.05)
= $1100
Compound Interest
• Compound Interest: interest paid (earned) on any previous
interest earned, as well as on the principal borrowed (lent).
Future Value – General Formula
• $1 today should be worth more than $1 in the future.
• Suppose the interest rate is 𝑟:
• $1 in Year 0 = $1 × 1 + 𝑟 in Year 1
2
• $1 in Year 0 = $1 × 1 + 𝑟 in Year 2
• ⁞
𝑇
• $1 in Year 0 = $1 × 1 + 𝑟 in Year T

• $1 today and any single choice on the right-hand side are

equivalent
• The choices on the right are Futures Values of $1 today
Future Value: Compound Interest

Formula

Future value using simple interest rate

= P0 *(1 + i)t

P0: Deposit today (t=0)

i: Interest Rate per Period
t: Number of Time Periods
Compound Interest – Example 1

• Assume that you deposit $1,000 in an account

earning 5% compound interest for 2 years. What is
the account balance at the end of the 2nd year?
• A 1,050

• B 1,100
• C 1,102.5
• D 1,125
Compound Interest – Example 1

• Assume that you deposit $1,000 in an account

earning 5% compound interest for 2 years. What is
the account balance at the end of the 2nd year?

Future value using compound interest rate

= P0 *(1 + i)t
= $1,000*(1 + 0.05)2
= $1102.5
The Effect of Compound
• Simple Interest

• FV with simple interest = 1000 + 50 + 50 = 1100

• Compound Interest

• FV with compound interest = 1102.5

• What is the Effect of Compounding?

• The extra 0.25 comes from the interest of 0.05(50) = 2.5

earned on the first interest payment
Future Values – Example 2
• Suppose you invest the $1000 from the previous example

(interest rate=5%) for 5 years. How much would you have?

• FV with simple interest = ?

• FV with compound interest = ?

Future Values – Example 2
• Suppose you invest the $1000 from the previous example
(interest rate=5%) for 5 years. How much would you have?
• FV with simple interest = ?
• Answer: FV=1000×(1+5%×5)=1250

• FV with compound interest = ?

• Answer: FV=1000 ×(1+5%)5 =1276.30

• Difference = 1276.30 – 1250 = 26.30

• One finding: the effect of compounding is small for a small
number of periods but increases as the number of periods
increases.
Future Value – General Formula
• Future value with compound interest PV FV
• FV = PV 1 + 𝑟 𝑡

• Future Value Interest Factor

0 t
The “Exchange Rate” between a dollar today and the dollar at time t

= (1 + r)t
• Future value with simple interest
• FV = PV (1 + 𝑟 × 𝑡)
Comparative Statics
• For a given interest rate – the longer the time period, the
future value is higher or lower?
• Answer: higher (A) vs. lower (B)?

• For a given time period – the higher the interest rate, the
future value is higher or lower?
• Answer: higher (A) vs. lower (B)?
Different Periods and Interest Rates
Key Takeaways
• Cash Flows and Assets
• Future Value (FV) and Compounding
• Present Value (PV) and Discounting
• Interest Rate
• Number of Periods

Reading: Chapter 5
 Present Value
• $1 today compounded at 10% interest is worth $1.1 next year

• What is the present value of $1.1 next year?

• What is the present value of $1 next year?

• $1 today is equivalent to $1×(1+𝑟)𝑡 in t years

• $1 in t years is equivalent to ____ Today?

• Answer:
 Present Value
• Remember Exchange Rate from PV to FV
$𝒕
= 𝟏+𝒓 𝒕
$𝟎
• What is the Exchange Rate from FV to PV? PV FV
$𝟎 𝟏
=
$𝒕 𝟏+𝒓 𝒕
0 t
• The Basic PV Equation
𝑭𝑽
𝑷𝑽 = 𝒕
𝟏+𝒓

• When we talk about discounting, we mean finding the present value of

some future amount
• When we talk about the “value” of something, we are talking about the
present value unless we specifically indicate that we want the future value
 Present Value – Example 1
• Suppose you need $10,000 in one year for the down payment on
a new car. If you can earn 7% annually on a ETF ABC, how
much do you need to invest today?
• A 10,700

• B 10,000

• C 9,345

• D 9,000

• E 8,000

PV = 10,000 / (1.07)1 = 9,345.79

 Present Value – Example 2
• Your parents set up a trust fund for you 10 years ago
that is now worth $19,671.51. If the fund earned 7% per
year, how much did your parents invest?

PV = 19,671.51 / (1.07)10 =10,000

 Present Value – Example 3
• Your neighbor wants to begin saving for her daughter’s
college education and you estimate that she will need
HK$180,000 in 17 years. The interest rate is 8% per
year, how much does your neighbor need to invest
today?

PV = 180,000 / (1.08)17 = 48,648.41

 Different Periods and Interest Rates
• For a given interest rate – the longer the time period, the
present value is higher or lower?
• Answer: higher (A) vs. lower (B)?

• For a given time period – the higher the interest rate, the
present value is higher or lower?
• Answer: higher (A) vs. lower (B)?

𝑭𝑽
𝑷𝑽 = 𝒕
𝟏+𝒓
Different Periods and Interest Rates
Key Takeaways
• Cash Flows and Assets
• Future Value (FV) and Compounding
• Present Value (PV) and Discounting
• Interest Rate
• Number of Periods

Reading: Chapter 5
The Basic FV Equation

• 𝐹𝑉 = 𝑃𝑉 1 + 𝑟 𝑡

• There are four parts to this equation

• PV, FV, r and t

• If we know any three, we can solve for the fourth

Interest Rate
• Many names: Interest Rate, Discount Rate, Cost of
Capital, Opportunity Cost of Capital, Required Return…

• We often will want to know the “implied rate of interest” of

an investment

• Rearrange the basic PV equation and solve for r

• FV = PV(1 + r)t
• r = (FV / PV)1/t – 1
Interest Rate – Example 1

• We are looking at an investment that will pay $1,200

in 5 years if we invest $1,000 today. What is the
implied rate of interest?

• r = (FV / PV)1/t – 1
• r = (1,200 / 1,000)1/5 – 1 = .03714 = 3.714%
Interest Rate – Example 2

• Suppose we are offered an investment that will allow

us to double our money in 6 years. What is the
implied rate of interest?

• r = (FV / PV)1/t – 1
• r = (2/1)1/6 – 1 = 12.25%
Key Takeaways
• Cash Flows and Assets
• Future Value (FV) and Compounding
• Present Value (PV) and Discounting
• Interest Rate
• Number of Periods

Reading: Chapter 5
Number of Periods

• Start with the basic equation and solve for t

(remember your logs)

• 𝐹𝑉 = 𝑃𝑉 1 + 𝑟 𝑡

• t = ln(FV / PV) / ln(1 + r)

Number of Periods – Example 1

• You want to purchase a new car and you are willing

to pay $20,000. If you can invest at 10% per year and
you currently have $15,000, how long will it be before
you have enough money to pay cash for the car?

• t = ln(FV / PV) / ln(1 + r)

• t = ln(20,000 / 15,000) / ln(1 + 0.1) =3.02 years

Double Your Money!!!

Quick! How long does it take to double $5,000 at a

compound rate of 12% per year (approx.)?

We will use the “Rule-of-72”.

ln 2 0.72
𝑇= ≈
ln(1 + 𝑟) 𝑟
Rule of 72

• Question 1: The economy of Hong Kong grew by 2.4% in

2014. If this growth rate continues, how long will it take
for the Hong Kong economy to double in size?
Answer: A (30 years) vs. B (20 years) vs. C (40 years)?

• Question 2: The value of your friend’s house doubled in the

past twenty years. What was the approximate value of the
growth rate in house price per year?
Answer: A (2%) vs. B (3.5%) vs. C (4%)?
Key Takeaways
• Cash Flows and Assets
• Future Value (FV) and Compounding
• Present Value (PV) and Discounting
• Interest Rate
• Number of Periods

FV = PV 1 + 𝑟 𝑡

• How about an extension with multiple cash flows?

Reading: Chapter 6
PV and FV of Multiple Cash Flows
• PV Multiple Cash Flows

0 1 2 3

C1 C2 Ct
PV(C1)
PV(C2)
PV(C3)
PV(Ct)

PV(Total CF)
 PV and FV of Multiple Cash Flows
Dividend History Ex-Div. Date Amount Type Yield Change Decl. Date Rec. Date Pay. Date Details

for Apple, Inc. 11/3/2016 $0.57 Quarter 2.1% N/A 10/25/2016 11/7/2016 11/10/2016 Details

(AAPL)
8/4/2016 $0.57 Quarter 2.2% N/A 7/26/2016 8/8/2016 8/11/2016 Details

5/5/2016 $0.57 Quarter 2.4% +9.6% 4/26/2016 5/9/2016 5/12/2016 Details

Ticker | Expand Research on AAPL
Price: 120.08 | Annualized 2/4/2016 $0.52 Quarter 2.2% N/A 1/26/2016 2/8/2016 2/11/2016 Details
Dividend: $2.28 | Dividend
11/5/2015 $0.52 Quarter 1.7% N/A 10/27/2015 11/9/2015 11/12/2015 Details
Yield: 1.9%
8/6/2015 $0.52 Quarter 1.8% N/A 7/21/2015 8/10/2015 8/13/2015 Details

5/7/2015 $0.52 Quarter 1.7% +10.6% 4/27/2015 5/11/2015 5/14/2015 Details

2/5/2015 $0.47 Quarter 1.6% N/A 1/27/2015 2/9/2015 2/12/2015 Details

11/6/2014 $0.47 Quarter 1.7% N/A 10/20/2014 11/10/2014 11/13/2014 Details

8/7/2014 $0.47 Quarter 2% N/A 7/22/2014 8/11/2014 8/14/2014 Details

5/8/2014 $3.29 Quarter 11% +7.9% 4/23/2014 5/12/2014 5/15/2014 Details

2/6/2014 $3.05 Quarter 2.4% N/A 1/27/2014 2/10/2014 2/13/2014 Details

11/6/2013 $3.05 Quarter 2.3% N/A 10/28/2013 11/11/2013 11/14/2013 Details

8/8/2013 $3.05 Quarter 2.6% N/A 7/23/2013 8/12/2013 8/15/2013 Details

5/9/2013 $3.05 Quarter 2.7% +15.1% 4/23/2013 5/13/2013 5/16/2013 Details

2/7/2013 $2.65 Quarter 2.3% N/A 1/23/2013 2/11/2013 2/14/2013 Details

11/7/2012 $2.65 Quarter 1.9% N/A 10/25/2012 11/12/2012 11/15/2012 Details

8/9/2012 $2.65 Quarter 1.7% N/A 7/24/2012 8/13/2012 8/16/2012 Details

PV and FV of Multiple Cash Flows
• FV Multiple Cash Flows
FV of Multiple Cash Flows
• Suppose you invest $500 in a mutual fund today and $600 in
one year. If the fund earns 9% annually, how much will you
have in 2 years?
FV of Multiple Cash Flows
• Suppose you invest $500 in a mutual fund today and $600 in
one year. If the fund earns 9% annually, how much will you
have in 2 years?

𝐹𝑉2 500 = $500 × 1.092 = $594.05

𝐹𝑉2 600 = $600 × 1.09 = $654
𝐹𝑉2 𝑡𝑜𝑡𝑎𝑙 = $594.05 + $654 = $1248.05
Key Takeaways
• FV = PV(1 + r)t

𝐹𝑉
• 𝑃𝑉 =
1+𝑟 𝑡

• r = (FV / PV)1/t – 1

• t = ln(FV / PV) / ln(1 + r)

Reading for Next Lecture: Chapter 6