Time Value of Money &

Net Present Value

Philippe Henrotte
HEC Paris

© Copyright 2023, Philippe Henrotte. All rights reserved

Topic 2: TVM & NPV

v Time Value of Money (TVM)

v Future Value and Present Value
v Net Present Value (NPV)
f Perpetuity, Growing Perpetuity, Annuity
v Internal Rate of Return (IRR)
v Asset Pricing and the Discount Rate

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Topic 2: Roadmap

v How do you compare dollars to be received at different times? Do they simply

add up?
v How do we price: perpetuities, annuities, growing perpetuities, growing
annuities?
v How do you value and compare two different streams of cash flows? How do
you choose among projects?
v What is the link between valuing a security and finding its expected return?

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 1l Time Value of Money
2l Future Value & Present Value
3l Net Present Value
4l Internal Rate of Return
5l Asset Pricing & Discount Rate
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Time Value of Money

v Most investment decisions involve trade-offs over time

v Within a project, trade-off between
f Payoff now, or
f Invest now and receive payoff later
v Across projects
f Investment 1, which involves a stream of payoffs
f Investment 2, with a different stream of payoffs
v How do we quantitatively compare cash flows that occur at different times?
f We need a way to compare future cash flows with present cash flows ⇒ Time Value of
Money

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Time Value of Money

v Suppose you are asked if you are interested to

f Invest $1 today, and
f Receive $1 one year from now
v Typically you should NOT do it. You need to be compensated for waiting: if
you receive $1.05 one year from now, you might be interested
v It depends whether the payoff $1.05 is safe or risky
v If the payoff is safe, the return 5% is the Time Value of Money (TVM)
v If the payoff is risky, you might need a higher expected return, say 7%, the
extra 2% is the risk premium

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 1l Time Value of Money
2l Future Value & Present Value
3l Net Present Value
4l Internal Rate of Return
5l Asset Pricing & Discount Rate
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Future Value and Present Value
v Suppose you invest $1 today at a safe return of 5% annually compounded.
How much do you receive in one year, two or three years?
f After one year: $1.05
f After 2 years: $1.05 × 1.05 = $1.1025 = $1 × (1.05)2
f After 3 years: $1.1025 × 1.05 = $1.157625 = $1 × (1.05)3

v More generally, the Future Value of a cash flow of C dollars in t years invested
at an annually compounded rate of return r is
FV(C) = C × (1 + r)t

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Future Value and Present Value
v Let us now flip the story: how much is $1 to be received in 3 years worth to
us today?
v Answer: it is worth today the amount we should invest today so as to receive
$1 in 3 years
v If the interest rate is 5%, we say that the Present Value of $1 to be received in
3 years is $1 / (1 + 5%)3 = $0.864
v In general, the Present Value of C dollars to be received in t years, when the
interest rate is r, is
PV(C) = C / (1 + r)t

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Future Value and Present Value

v Example:
Example You have to choose between receiving
f (A) $10 million in 5 years, or
f (B) $15 million in 15 years
v Which is better if r = 5%?
v Solution: Compute the respective present values
Solution

v We conclude that opportunity A is worth more than B

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 1l Time Value of Money
2l Future Value & Present Value
3l Net Present Value
4l Internal Rate of Return
5l Asset Pricing & Discount Rate
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Net Present Value
v Example:
Example Consider a firm thinking of acquiring a new computer system that
will enhance productivity for five years to come
v This computer system project
f Requires an initial investment of $1 million today
f Yields the following sequence of cash inflows in the future, as a result from the enhanced
productivity:
Year Cash Flow
1 $100,000
2, 3 and 4 $300,000
5 $100,000

f Discount rate is 5%

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Net Present Value

v Solution:
Solution To assess the computer system project, we calculate the Net
Present Value (NPV), which is the sum of the PV of the future cash inflows
minus the initial investment
v The discount rate r is the expected return on an equivalent investment
opportunity, here r = 5%. It is also called the (opportunity) cost of capital
v This is the rate of return r that we could obtain with an equivalent investment
opportunity, equivalent in terms of timing and risk
v The NPV should be the same as the market value

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Net Present Value
v We obtain

v The net present value is negative: NPV < 0

v The present value of the future cash inflows ($951,662) is less than the initial
investment ($1M)
v The market value is also negative and the computer system project is
therefore not worthwhile
v It is not worthwhile to forego the equivalent investment opportunity

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Net Present Value
v More generally, consider a project involving a series of (net) cash flows C0,
C1, C2, …, CT occurring in 0, 1, 2, …, T years (positive for inflows, negative
for outflows)
v The NPV of the project is

v The project is worthwhile whenever the NPV is positive

v Taking positive NPV projects increases the value of a firm by the amount of
the NPV
v Taking negative NPV projects decreases the value of a firm by the amount of
the NPV

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 Valuation Techniques

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Geometric Series Formula

v Sum of n terms, starting with a, growing with x

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2 Useful Valuation Methods

v Method 1:
1 Sum of the Parts
f if a stream of cash flows can be decomposed as the sum of two streams of cash flows,
then its value must be the sum of the values of the two streams
v Method 2:
2 Choice of Valuation Time
f If the value of a stream of cash flow is V2 at time t2
f Then its value at time t1 is obtained by discounting V2 between t1 and t2

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 Perpetuity

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Perpetuity

v A perpetuity is a constant stream of cash flows, C, that occur every unit

period (say year) and continues forever
v Examples
f Long-term coupon bonds
f Console bonds (UK)
f Preferred stock
f Some specific projects (e.g., rental agreements)
v The Present Value (PV) of a perpetuity is

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 Perpetuity
Cash Flows C C C C C C

Years 0 1 2 3 4 … t t+1 …

v Constant cash flow C

f Starting in Year 1
f Every year to infinity
v Annually compounded rate r
v Today is Year 0
v Value today of the perpetuity is V0

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Perpetuity
Cash C C C C C C
Flows
Perpetuity
Years 0 1 2 3 4 … t t+1 …
=
Cash C C C C C
Flows
Perpetuity starting
in Year 2 Years 0 1 2 3 4 … t t+1 …

+
Cash C
Flows
Single cash flow C
in Year 1
Years 0 1 2 3 4 … t t+1 …

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Perpetuity
Cash C C C C C C
Flows
V0
Years 0 1 2 3 4 … t t+1 …
=
Cash C C C C C
Flows
V0 / (1 + r)
Years 0 1 2 3 4 … t t+1 …

+
Cash C
Flows
C / (1 + r)
Years 0 1 2 3 4 … t t+1 …

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 Perpetuity
Cash Flows C C C C C C

Years 0 1 2 3 4 … t t+1 …

v 0 = +
v 1+ 0 = 0 +
v 0 =
v 0 =

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Perpetuity
v Example:
Example Suppose you own a plot of land. You have an agreement to rent out
the property (which is otherwise worthless) each year for $1,000
v The city offers to buy the land from you for $17,000
v Should you accept the offer if the interest rate remains at 5% per annum
forever?
v Solution: The value of continuing the rental agreement is obtained by applying
the perpetuity formula

v You should not accept since the city only offers $17,000

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Perpetuity

v What if the interest rate goes up to 7% per annum in two years from now, and
stays there forever?
v The value of renting the property out to the city becomes

v Here, given that the city is offering $17,000, you should accept

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 Growing Perpetuity

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Growing Perpetuity
v A growing perpetuity is a stream of cash flows that grow at a constant rate g
(say per year) forever
v The price of a growing perpetuity is given by

v This formula only works for g < r. The case g ≥ r is not economically
meaningful
v If C is the dividend paid by a company, this formula becomes the Gordon
growth formula

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 Growing Perpetuity
Cash Flows C C(1+g) C(1+g)2 C(1+g)3 C(1+g)t-1 C(1+g)t

Years 0 1 2 3 4 … t t+1 …

v Initial cash flow C in Year 1

f Growing at the annual rate g
f Every year to infinity
v Annually compounded rate r
v Today is Year 0
v Value today of the growing perpetuity is V0

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Growing Perpetuity
Cash C C(1+g) C(1+g)2 C(1+g)3 C(1+g)t-1 C(1+g)t
Flows
Growing perpetuity
Years 0 1 2 3 4 … t t+1 …
=
Cash C(1+g) C(1+g)2 C(1+g)3 C(1+g)t-1 C(1+g)t
Flows
Growing perpetuity
starting in Year 2 Years 0 1 2 3 4 … t t+1 …

+
Cash C
Flows
Single cash flow C
in Year 1
Years 0 1 2 3 4 … t t+1 …

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Growing Perpetuity
Cash C C(1+g) C(1+g)2 C(1+g)3 C(1+g)t-1 C(1+g)t
Flows
V0
Years 0 1 2 3 4 … t t+1 …
=
Cash C(1+g) C(1+g)2 C(1+g)3 C(1+g)t-1 C(1+g)t
Flows
V0 (1 + g) / (1 + r)
Years 0 1 2 3 4 … t t+1 …

+
Cash C
Flows
C / (1 + r)
Years 0 1 2 3 4 … t t+1 …

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 Growing Perpetuity
Cash Flows C C(1+g) C(1+g)2 C(1+g)3 C(1+g)t-1 C(1+g)t

Years 0 1 2 3 4 … t t+1 …

( )
v 0 = +
v 1+ 0 = (1 + ) 0 +
v ( − ) 0 =
v 0 =

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Growing Perpetuity

v Example:
Example Suppose your contract with the city specifies that the rent you can
charge for the land is allowed to grow by 2% each year in order to cover
rising costs
v What is the value of your land assuming the interest rate is again r = 5%
forever?
v Solution:
Solution Applying the growing perpetuity formula, we obtain that the plot of
land is now worth

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 Annuity

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Annuity

v An annuity is a constant stream of cash flows C that occur every year up to

maturity T years
v Its Present Value can be computed as the PV of a perpetuity issued today
minus the PV of another perpetuity issued T years from now

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 Annuity
Cash Flows C C C C C C

Years 0 1 2 3 4 … T-1 T

v Constant cash flow C

f Starting in Year 1
f Every year up to T
v Annually compounded rate r
v Today is Year 0
v Value today of the annuity is V0

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Annuity
Cash C C C C
Flows
Annuity
Years 0 1 2 … T-1 T
=
Cash C C C C C C
Flows
Perpetuity starting
at Year 1 Years 0 1 2 … T-1 T T+1 T+2 …

-
Cash C C
Flows
Perpetuity starting
at Year T+1
Years 0 1 2 … T-1 T T+1 T+2 …

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Annuity
Cash C C C C
Flows
V0
Years 0 1 2 … T-1 T
=
Cash C C C C C C
Flows

Years 0 1 2 … T-1 T T+1 T+2 …

-
Cash C C
Flows

1+ Years 0 1 2 … T-1 T T+1 T+2 …

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 Annuity
Cash Flows C C C C C C

Years 0 1 2 3 4 … T-1 T

v 0 = −

v 0 = 1 − 1/(1 + )

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Annuity

v Example:
Example Suppose your daughter will enter college next year and you would
like to put enough money into the bank to afford her $10,000 tuition for each
of the next 4 years, assuming r = 5%
v You essentially would like to buy a security that pays her $10,000 every year,
for 4 years
v Solution:
Solution The fair price you will have to pay the bank today for this annuity is

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Growing Annuity

v General formula for a growing annuity,

annuity first cash flow in one year C, annual
growth rate g, discount rate r, for T years

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 1l Time Value of Money
2l Future Value & Present Value
3l Net Present Value
4l Internal Rate of Return
5l Asset Pricing & Discount Rate
© Copyright 2023, Philippe Henrotte. All rights reserved
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Internal Rate of Return
v The Internal Rate of Return (IRR) is the discounting rate that makes the NPV
equal to zero
f Also called Yield to Maturity for the cash flows of a security
f Used for capital expenditures, venture capital and private equity
v The IRR is calculated using the same formula as the NPV, except that the rate
r is unknown

v where I0 is the initial investment in the project

f The IRR is the rate r for which the initial investment is equal to the present value of the
future cash flows from the investment
f It can be found using a math solver, or just trial and error

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IRR & Net Present Value

v Consider a project which costs $250 million and which is expected to

generate cash flows of $35 million per year, starting at the end of the first year
and lasting forever
v The NPV of the project is a function of the discount rate r

v IRR rule: invest if the IRR is greater than r

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NPV Profile
If the cost of capital is 10%, the NPV is $100 million and you should undertake
the investment

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IRR & Net Present Value

v The IRR Investment Rule will give the same answer as the NPV rule in many,
but not all, situations
v In general, the IRR rule works for a project if all of the negative cash flows of
the project precede its positive cash flows
v In other cases, the IRR rule may disagree with the NPV rule and thus be
incorrect
f Delayed Investments
f Multiple IRRs
f Nonexistent IRR

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Delayed Investments

v Assume you have just retired as the CEO of a successful company

v A major publisher has offered you a book deal. The publisher will pay you $1
million upfront if you agree to write a book about your experiences
v You estimate that it will take three years to write the book. The time you spend
writing will cause you to give up speaking engagements amounting to
$500,000 per year
v You estimate your opportunity cost to be 10%. Should you accept the deal?

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Delayed Investments
v You compute the NPV

v Since the NPV is negative, you should reject the deal

v However the IRR is 23.38%, larger than the discount rate

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Multiple IRRs
v The publisher offers now $550,000 advance and $1,000,000 in four years when the book is
published. Should you accept the new offer?
v The NPV is now

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Nonexistent IRR
v Finally the publisher increases his advance to $750,000, in addition to the $1 million when
the book is published in four years
v With these cash flows, no IRR exists; there is no discount rate that makes NPV equal to zero

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 1l Time Value of Money
2l Future Value & Present Value
3l Net Present Value
4l Internal Rate of Return
5l Asset Pricing & Discount Rate
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Asset Pricing and Discount Rate
v What happens with risky future cash flows? How to value an asset with uncertain future cash flows
Ct+1, Ct+2,...?
v We start with the definition of gross return

v Taking expectations and flipping we get

v So the price today is the total expected payoff over the next period, divided by

discount rate r = asset expected return

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Asset Pricing and Discount Rate
v Assume that is constant over time
v Since

v By successive substitution we obtain

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Asset Pricing and Discount Rate

v At the limit we obtain

v If we know the expected return, we know the discount rate and we can value
the asset
v This is the main goal of the Capital Asset Pricing Model

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