Topic #1

Time Value of Money

Period
0 1 2 3 4
|_______|______|_______|_______|
100 100 100 100
Cash Flows
• In the figure t=0 refers to the present time. A cash flow
that occurs at time 0 does not need to be adjusted for
time value.
• Here we have cash flows at the end of periods 1, 2, 3
and 4. We will consistently follow the convention that
the end of period 1 is the same as the beginning of period 2.
• These cash flows occur at different points in time which
means that they do not have equivalent value. $100 in
one year (t = 1) should be worth less than $100 today (t
= 0) but more than $100 in two years (t = 2) provided….?
(Provided that the interest rate is greater than 0%!!)
Period
0 1 2 3 4
|_______|______|_______|_______|
100 100 100 100
Cash Flow

Is there any difference between the cash flows represented in

the two figures? If you had the choice, which would you
choose to receive?

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1. Compounding – given an interest rate r, the future

value of a cash flow deposited at time t = 0 (denoted
as C0), at time t (denoted as FVt) will be:

FV = C (1 + r )
t 0
t

Compounding is moving cash flows to a future date. In

the equation above, (1 + r) is called the compounding
t

factor.

Example# 1: Suppose you invest $1,000 today at an

interest rate of 5%. How much would you receive at
the end of two years?

Period
0 1 2
|_______|______|
-1000 ? ??
Cash Flows

1,000*(1+0.05) = 1050.00 at the end of year 1

1,050*(1+0.05) = 1102.50 at the end of year 2

Please note that:

1,000*(1+0.05)*(1+0.05) = 1,000*(1+0.05)2 = 1102.50

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A B
1
2 rate 0.05
3 nper 2
4 Payment 0
5 Present Value -$1000
6
7 FV $1102.50

In excel, put the cursor on Cell B7

Then click the function wizard ( f x ), Financial, FV and
OK.
- Rate: enter B2 or 0.05
- Nper: enter B3 or 2
- Pmt: enter B4 or 0
- PV: enter B5 or (-)1,000
Then, click OK; you get the answer, $1102.50

Financial calculator Using HP-10B:

The downward arrow pink key is denoted as ▀ and the
sign-change key is denoted as (+/-).

1. ▀ Clear All: (you enter ▀, clear all): It clears your old

calculations.
2. 1▀ P/YR : (you enter 1, ▀, P/YR): It sets P/YR to 1
i.e. # of payments per year = 1. We have annual
compounding here. Therefore, P/YR=1.
3. 1000 (+/-) PV (you enter 1000, (+/-), PV): It enters initial
cash flow PV = -$1000.
4. N=2
5. I/YR = 5
6. FV =? And you get your answer $1102.50

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Period
0 1 2 3 4
|_______|______|_______|_______|
100 0 0 0 0
Cash Flows
Example# 2:
We have a cash flow of $100 at t=0. We need to find the
FV of that amount at t=4, given that r = 10%.

Using HP-10B: Always remember that you must:

1. ▀ Clear All: (you enter ▀, clear all): It clears your old
calculations).
2. 1▀ P/YR : (you enter 1, ▀, P/YR): It sets P/YR to 1
i.e. # of payments per year = 1). We have annual
compounding here. Therefore, P/YR=1.
N=4, I/YR=10, PV=-100, FV=?
Answer: + $146.41

Using the formula: FV = 100(1 + 0.10 ) = $146.41

4

In excel, click on the function wizard ( f x ),

Choose: Financial, FV and OK.
- Rate: enter 0.10 or 10%
- Nper: enter 4
- Pmt: enter 0
- PV: enter -100
Then, click OK; you get the answer, $146.41

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Example# 3: In 1626, Peter Minuit bought the entire

Manhattan Island from the Native Americans for
about $24 in goods. Suppose they had sold the goods
and invested $ 24 at 8%. What would it be worth 396
years later?
(a) $ 71 million
(b) $ 71 billion
(c) $ 71 trillion
(d) More!

In excel,
A B
1
2 rate 0.08
3 nper 396
4 Payment 0
5 Present Value -$24
6
7 FV $???

Using HP-10B: Always remember that you must:

1. ▀ Clear All: (you enter ▀, clear all): It clears your old

calculations).
2. 1▀ P/YR: (you enter 1, ▀, P/YR): It sets P/YR to 1
i.e. # of payments per year = 1). We have annual
compounding here. Therefore, P/YR=1.

N=396, I/YR=8, PV=-24, FV=?

Answer: + $???

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2. Discounting – computing the present value of a cash

flow:
CF
PV = t

(1 + r ) t

Discounting is moving future cash flows to a present date

1
is called the discount factor.
(1 + r) t

Note: compounding factor = 1/ (discount factor)

There is reciprocity between the two factors.

Example# 4: Suppose you do a consulting project in

return for $50,000 to be received after one year. What
is the present value of this contract for you? (Assume
a discount rate of 5%):

50,000
Using the formula: PV= = 47619.05
(1 + 0.05)1

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Using HP-10B: Always remember that you must:

1. ▀ Clear All: (you enter ▀, clear all): It clears your old
calculations).
2. 1▀ P/YR : (you enter 1, ▀, P/YR): It sets P/YR to 1
i.e. # of payments per year = 1). We have annual
compounding here. Therefore, P/YR=1.

N=1, I/YR=5, FV=+50,000, PV=?

Answer: - $47,619.05

In excel, click on the function wizard ( f x ),

Choose: Financial, PV and OK.
- Rate: enter 0.05 or 5%
- Nper: enter 1
- Pmt: enter 0
- FV: enter 50,000
Then, click OK; you get the answer, -$47,619.05

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3. Perpetuities

Perpetuity is a constant cash flow at regular intervals

forever.

Does it ever happen? Yes:

- Consol bonds in the UK
- Preferred Stock valuation!

For Cash Flows to be called a Perpetuity, the cash

flows should be:
 Fixed ($ amount)
 Infinite number of periods
 Periodic (periodicity of cash flows must
match that of the interest rates)
Present value of a Perpetuity at t = 0:
𝐶𝐶1
𝑃𝑃𝑉𝑉0 =
𝑟𝑟
𝐶𝐶 1
𝑃𝑃𝑉𝑉0 (𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃) = (𝑟𝑟−𝑔𝑔)

In a growing perpetuity, the growth rate must be less than

the discount rate, for a finite present value.

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4. Annuities

An annuity is a series of constant cash flows that

occur at the end of each time period for a fixed
number of periods.

For Cash Flows to be called an annuity, they

should be:
 Fixed ($ amount)
 Finite (number of periods)
 Periodic (periodicity of cash flows must
match that of the interest rates)

|____ |____ |____ |.........................|____ |

0 1 2 3 n-1 n
C C C C C

Present value of an end-of-period annuity:

𝑃𝑃𝑉𝑉0 (Annuity) = 𝐶𝐶1𝑟𝑟 �1 − (1+𝑟𝑟)
𝑡𝑡
1
�

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Example# 5: Many sports compensation contracts are

structured as annuities. How much is LeBron James’
$97 million, 2-yr contract ($48.5m per year for 2 years)
worth in present value terms, assuming a 4% discount
rate?

Cash Flow (C) = $48.5m per year

r = 4% per year
Present value of the annuity =?

Using HP-10B: Always remember that you must:

1. ▀ Clear All: (you enter ▀, clear all): It clears your old
calculations).
2. 1▀ P/YR: (you enter 1, ▀, P/YR): It sets P/YR to 1 i.e.
# of payments per year = 1. We have annual compounding
here. Therefore, P/YR=1.

N=2, I/YR=4, PMT=48.5, PV=?

Answer: - $??

In excel, click on the function wizard ( f x ),

Choose: Financial, PV and OK.
- Rate: enter 0.04 or 4%
- Nper: enter 2
- Pmt: enter 48.5
- FV: enter 0
Then, click OK; you get the answer, -$???

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Example# 6: What would be the monthly mortgage payment

on a 7¾% (0.0775), 15 year fixed mortgage for a $250,000
house with a 10% down payment?

Loan amount = (0.90) * 250,000 = 225,000

(Please note that $225,000 is the present value of the loan,
received at t = 0).

Monthly rate = 0.0775/12 = 0.0065 per month

Number of months = 15 * 12 = 180 months
Monthly payment =???

Using HP-10B: Always remember that you must:

1. ▀ Clear All: (you enter ▀, clear all): It clears your
old calculations).
2. 12▀ P/YR: (you enter 12, ▀, P/YR): It sets P/YR to
12 i.e. # of payments per year = 12. We have
monthly compounding here. Therefore, P/YR=12.
3. First you enter 15 N. Then you enter ▀xP/YR. The
display will show you that there are 180 periods (15
years at 12 payments per year gives us 180 periods).
I/YR=7.75%, PV=-$225,000, PMT=??
Answer: $??

In excel, click on the function wizard ( f x ),

Choose: Financial, PMT and OK.
- Rate: enter (0.0775/12)
- Nper: enter 180
- PV: enter -225000
- FV: enter 0
Then, click OK; you get the answer, -$???

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Period
0 1 2 3 4
|_______|______|_______|_______|
100 100 100 100
Cash Flows

• Do the cash flows in the figure represent an annuity?

• If the discount rate is 10%, what will be the present
value of these cash flows?
• If the discount rate is 10%, what will be the future
value of these cash flows?

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Example # 7: Retirement Accounts (IRAs). What would be

the value of your account at age 70, if you contribute $10,000
at the end of each year from age 30 onwards? The annual
return is 8%.

Using HP-10B: Always remember that you must:

1. ▀ Clear All: (you enter ▀, clear all): It clears your old
calculations).
2. 1▀ P/YR: (you enter 1, ▀, P/YR): It sets P/YR to 1 i.e. #
of payments per year = 1. We have annual compounding
here. Therefore, P/YR=1.

N=40, I/YR=8%, PMT= $10,000, FV=?

Answer: $??

In excel, click on the function wizard ( f x ),

Choose: Financial, FV and OK.
- Rate: enter 0.08 or 8%
- Nper: enter 40
- PMT: enter 10000
- PV: enter 0
Then, click OK; you get the answer, -$???

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Example# 8: Sinking fund provision for a bond. How

much would a company need to set aside each year for
bonds with a face value of $100 m, coming due in 10
years, assuming an 8% p.a. return?

Hint: Does the $100 m represent PV or FV?

In excel, click on the function wizard ( f x ),

Choose: Financial, PMT and OK.
- Rate: enter 0.08 or 8%
- Nper: enter 10
- PV enter 0
- FV: enter 100

Then, click OK; you get the answer, -$???

Period 0 1 2 3 4 5 6 7 8 9 10
PMT 0 X X X X X X X X X X
($)

In words: There are 10 payments, deposited at the end of the

next 10 periods. They accumulate interest at 8%. The FV of
these payments at the end of year 10 must be $100m. We
need to find the payments (X).

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An end-of-period annuity

|____ |____ |____ |.........................|____ |

0 1 2 3 n-1 n
C C C C C

A beginning-of-the-period annuity

|____ |____ |____ |.........................|____ |

0 1 2 3 n-1 n
C C C C C

An end-of-period annuity

Period
0 1 2 3 4
|_______|______|_______|_______|
100 100 100 100

A beginning-of-the-period annuity

Period
0 1 2 3 4
|_______|______|_______|_______|
100 100 100 100

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An end-of-period annuity

Period
0 1 2 3 4
|_______|______|_______|_______|
100 100 100 100
Cash Flows

A beginning-of-the-period annuity

Period
0 1 2 3 4
|_______|______|_______|_______|
100 100 100 100
Cash Flow

Do we really need to know the formulae for the

beginning-of-the-period annuities, given that we already
know those for the end-of-period annuities?

To solve as a beginning-of-the-period annuity (r = 8%)

Choose: Financial, PV and OK.

- Rate: enter 0.08 or 8%
- Nper: enter 4
- PMT enter 100
- FV: enter 0
- Type enter 1 (for beginning of period PMT)

Then, click OK; you get the answer, -$357.71

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To solve as an end-of-the-period annuity (r = 8%)

Choose: Financial, PV and OK.

- Rate: enter 0.08 or 8%
- Nper: enter 4
- PMT enter 100
- FV: enter 0
- Type enter 0 (or leave blank)

Then, click OK; you get the answer, -$331.21

Now, to get the beginning-of-the-period annuity answer:

(End-of-the-period annuity) *(1+ r) = -331.21*(1.08) = -$357.71

Please note that the answer $331.21 has been found at

t=-1. To get the answer at t=0, we need to multiply
that answer by (1+r).

Rule of Thumb:
To either get the PV or the FV of a beginning-of-the-
period annuity, solve it as an end-of-period annuity and
then multiply your answer by (1 + r).

PV (beginning-of-the-period annuity) = PV (end-of-period annuity) (1 + r)

FV (beginning-of-the-period annuity) = FV (end-of-period annuity) (1 + r)

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A beginning-of-the-period annuity

Period
0 1 2 3 4
|_______|______|_______|_______|
100 100 100 100
Cash Flow

Alternate Method:
 Please note that the first payment of $100 is already at t=0.
It does not need to be discounted.
 The remaining three payments look like an ordinary
annuity.

Choose: Financial, PV and OK.

- Rate: enter 0.08 or 8%
- Nper: enter 3
- PMT enter 100
- FV: enter 0
- Type enter 0 (or leave blank)

Then, click OK; you get the answer, -$257.71.

Add to this the first payment of $100 which is already at t=0 to

get your answer $357.71.

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Growing Annuities

A cash flow that grows at a constant rate for a specified

period of time is called a growing annuity.

C (1 + g )  (1 + g )  t

PV (Growing Annuity ) = 0
1−

(r − g )  (1 + r )  t

where g is the constant growth rate in cash flows.

Please note that C0 (1 + g) = C1

where C1 is the cash flow at the end of Period 1.

Thus we have:

C  (1 + g )  t

PV (Growing Annuity ) = 1
1−
(r − g )  (1 + r ) 
t

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Example# 9: Suppose you have rights to a gold mine for

the next 20 years, over which you plan to extract 5000
ounces of gold every year. The current price per ounce
is $1750 but is expected to increase at 3% per year. If
the discount rate is 6%, how much should you be
willing to pay for these rights?

1750∗1.03∗5000 1.03 20
PV= .06−.03
∗ �1 − �1.06� �

Why did we use (1750*1.03) *5000???

 $1750 is the price is the current price (at t=0).

 The price will increase at 3% per year. Therefore,
next year’s price will be 1750*(1.03).
 In year 1, 5000 ounces of gold will be sold at
1750*(1.03). Therefore, the cash flow in year 1, will
be 1750*(1.03) *5000.
 As before, to find the answer at t=0, we must use the
cash flow at t=1.
 Please remember that whenever any annuity
formula is used, the answer is always found in the
period preceding the first cash flow.

If g=r, PV=???

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A simple but a very useful idea:

Example 10: If the rate per period is 4%, then what

interest rate will we get over 4 periods i.e. a four-
period rate?
It will be (1 + 0.04)4 – 1 = 0.169859 or 16.9859%

To see if that is true, check the following:

We start with a deposit of $1000 at t=0.
Then, at t=1 we get: 1000*(1 + 0.04) = 1040
at t=2 we get: 1040*(1 + 0.04) = 1081.60
at t=3 we get: 1081.60*(1+ 0.04) = 1124.864
at t=4 we get: 1124.864*(1 + 0.04) = 1169.859*
*Please note that this is the same as 1000*(1 + 0.04)4
The interest received is: 169.859/1000 = 0.169859 or
16.9859%!!
This is exactly what we had figured out above:
Using 4% per period over 4 periods gave us a four-
period rate of 16.9859%. Thus $1000 deposited at
4% for 4 periods gives us:
1000*(1 + 0.169859) = 1169. 859*
*Please note that this is the same as 1000*(1 + 0.04)4

Thus, if we know the rate per period, we can find

the n period rate.

In general, the n period rate is:

(1 + r) n - 1 = rate of interest for n periods where r is
the rate per period.

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Effective Annual Rate (EAR):

Effective Annual Rate (EAR):

-the actual annual interest rate earned or paid
 r 
m

- EAR = 1 +  − 1,nom

 m
where
rnom = Nominal, or stated, or quoted rate per year
m = number of compounding periods per year

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Example 11: rnom = 12%, compounded semi-annually

(m=2), then
2
 0.12 
 − 1 = (1.06 ) − 1 = 0.1236 = 12.36%
2
EAR = 1 +
 2 

Note that 12% semi-annual for 1 year is the same as 6% per

period for 2 periods.

Using HP-10B:
1. ▀ Clear All: (you enter ▀, clear all): It clears your old
calculations). Remember that ▀ stands for the shift
key.
2. 2▀ P/YR : (you enter 2, ▀, P/YR): It sets P/YR to 2
i.e. # of payments per year = 2). We have semi- annual
compounding here. Therefore, P/YR=2.

Step 3: 12 ▀ NOM%: Puts the nominal rate at 12%

Step 4: ▀ EFF%
Answer: 12.36%

In excel, click on the function wizard ( f x ),

Choose: Financial, EFFECT and OK.
- Nominal_Rate: enter 0.12 or 12%
- Npery: enter 2

Then, click OK; you get the answer, 0.1236

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Example# 12: MonthComp bank charges 8%, compounded

monthly, while SemiComp bank charges 8 18 % compounded
semi-annually. Which bank would you go to for a new loan?

Using the formula:

MonthComp:
12
 0.08 
 − 1 = (1.006667 ) − 1 = 0.083 = 8.30%
12
EAR = 1 +
 12 
SemiComp:
2
 0.08125 
 − 1 = (1.040625) − 1 = 0.0829 = 8.29%
2
EAR = 1 +
 2 
Using HP-10B: Enter in this order (for MonthComp)
Step 1: 12 ▀ P/YR: Sets it up for monthly compounding
Step 2: 8 ▀ NOM%
Step3: ▀ EFF%
Answer: 8.29995%

For SemiComp: In excel, click on the function wizard ( f x ),

Choose: Financial, EFFECT and OK.
- Nominal_Rate: enter 0.08125 or 8.125%
- Npery: enter 2

Then, click OK; you get the answer, 0.0829

General Rule:
 Two banks can charge the same nominal rate, but their EARs may be quite
different depending upon compounding frequency.
 The higher the nominal rate, more is the effect of increasing
compounding frequency.

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Example# 13: What is the rate of interest that you are paying
on your mortgage if the monthly payment is $2117.87? It is a
15-year fixed mortgage for a $250,000 house with a 10% down
payment.

Loan amount = (0.90) * 250,000 = 225,000

(Your equity contribution is 10% of the value of the
house or $25,000. Please note that $225,000 is the present
value of the loan, received at t = 0.).

Monthly payment = $2117.87 per month

Number of months = 15 * 12 = 180 months
Monthly payment =???

In excel, click on the function wizard ( f x ),

Choose: Financial, RATE and OK.
- Nper: enter 180
- PMT: enter 2117.87
- PV: enter -225000
- FV: enter 0
Then, click OK; you get the answer, 0.64583%

This is the monthly rate. Your nominal annual rate will be:
Nominal rate = 0.0064583*12 = 0.0775 or 7.75%. This is what
we had for example # 6 (on Page 11) .

 The effective annual rate (EAR) will be???

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 Extreme Case: Continuous Compounding

Limiting case is to compound every infinitesimal

instant (banks and financial institutions use this rate
very often!). In this case,
EAR = e − 1, e=2.718 (approx.)
nom

Example 14: What will be the effective interest rate

when a 6% annual rate is compounded continuously?

EAR = e0.06 − 1 = 6.18%

Using HP-10B: Enter in this order

Step 1: 0.06 ▀ e : Sets it up for continuous compounding
x

(You will get 1.061837).

Step 2: Subtract 1 from 1.061837
Answer: 0.061837 or 6.1837%

In excel, input in a cell

=exp(0.06) (then hit enter), you will get 1.061837
Subtract 1 from 1.061837 and you get the answer, 0.061837

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Example# 15: What will be the value of $1000 in 3 years

if it earns an 8% continuously compounded rate?

Using HP-10B: Enter in this order

Step 1: 0.08 ▀ e : Sets it up for continuous compounding
x

(You will get 1.083287).

Step 2: 1000*(1.083287)3 = 1000*(1.271249)
Answer: $1271.249

Note: Essentially, we first find the effective annual rate

(1.083287-1) or 0.083287. Then we use our old familiar formula
for finding the future value: FVt = C0 (1 + r )t where C0 = 1000
and r = 0.083287.

In excel, input in a cell

= (exp (0.08) ^3) *1000 (then hit enter), you will get
1271.249

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Example # 16: Stock Valuation – Johnson & Johnson

(JNJ) paid a dividend of $1.13 cents in the most recent
quarter. Their earnings and dividends are expected to
grow at 6% per year in the long run. If their average
cost of capital is 8.5%, what is the value of the stock?

Recognize that we have a growing perpetuity!

Next quarter’s dividend = 1.13* (1.015)

1.13∗(1.015) 1.147
Price of the stock = 0.02125−0.015 = 0.00625 = $183.512

Notice again, that to find the price of the stock at t=0,

we first found the cash flow starting at t=1.

 Please remember that whenever any annuity or a

perpetuity formula is used, the answer is always
found in the period preceding the first cash flow.

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Example# 17: Disneyland generated $100 million in

cash flows for Disney last year. The discount rate that
Disney would use to analyze these cash flows is 12%
and the expected inflation rate is 3%. Disney believes
that it can keep increasing the ticket prices at the
inflation rate. What would be the PV of the cash flows
if:
 Disney can keep generating these cash flows for a
very long period of time?
 We assumed a 50-year life for the park?

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Example #18:

How much money must the parents deposit in an account each

year to fund their daughter’s 4-year-college education?

Input data:
• College expense = $30,000 per year per child for 4 years
• annual interest rate is 14%
• college expenses start 18 years from now
• parents start making deposits one year from now
• parents will make last payment on year 17

Let’s visualize the cash flows:

t 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Pay 30 30 30 30
Deposit X X X X X X X X X X X X X X X X X

Let’s determine the present value today for those cash flows:

We have an annuity. The present value given by the formula of an

annuity is for the year prior to the first payment, hence year 17.

Using Excel:
Choose: Financial, PV and OK.
- Rate: enter 0.14 or 14%
- Nper: enter 4
- PMT enter 30
- FV: enter 0
- Type enter 0 (or leave blank)
Then, click OK; you get the answer, -$87411.369

Consequently, the deposits the parents will make over the years
should have generated at year 17 an amount equal to $87,411.37 to
be able to pay for their daughter’s college.
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Business Finance FIN3403H
 Topic #1

Let’s calculate how much it represents today (t = 0):

PV (0) = $87,411.37 / (1+0.14)17 = $9,422.91

Let’s now determine the value of each of 17 deposits the parents

have to make up to year 17 (first deposit at t = 1):

Using Excel:
Choose: Financial, PMT and OK.
- Rate: enter 0.14 or 14%
- Nper: enter 17
- PV enter -9422.91
- FV: enter 0
- Type enter 0 (or leave blank)
Then, click OK; you get the answer, -$1478.60

Conclusion: if the parents deposit $1,478.60 each year up to 17

years from now (t = 17), her 4 years of college will be paid for.

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Business Finance FIN3403H
 Topic #1

Next question: Instead of depositing the same amount each year,

what if the amount deposited each year increased at 4%. Then what
would be the amount of the first deposit?

Please notice that the difference from the solution above is that
now we have a growing annuity whose PV is $9,422.91. We know
how to set up the PV of a growing annuity.

C (1 + g )  (1 + g )  t

PV (Growing Annuity ) = 0
1−
(r − g )  (1 + r )  t

The only unknown in the problem is the size of the first payment.

PV = $9,422.91
r = 14%
g = 4%
t = 17
We need to find C1

C1  (1.04)17 
9422.91 = 1−
0.14 − 0.04  (1.14)17 


Solving for C1 we get: C1 = $1,192.78

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Business Finance FIN3403H