CHAPTER 3

THE TIME VALUE OF MONEY

Outline
1. Draw a timeline illustrating a given set of cash flows.
2. List and define three rules of time travel.
3. Calculate the future value of
4. Calculate the present value of
a. A single sum.
b. An uneven stream of cash flows, starting either now or
sometime in the future.
c. An infinite stream of identical cash flows.
d. An annuity, starting either now or sometime in the future.
e. A growing perpetuity
f. A growing annuity.
 The Timeline
• A timeline is a linear representation of the timing of
potential cash flows.
• Drawing a timeline of the cash flows will help you
visualize the financial problem.
The Timeline
• Assume that you made a loan to a friend. You will
be repaid in two payments, one at the end of each
year over the next two years.
The Timeline
• Differentiate between two types of cash flows
• Inflows are positive cash flows.
• Outflows are negative cash flows, which are indicated
with a – (minus) sign.
The Timeline
• Assume that you are lending $10,000 today and that the
loan will be repaid in two annual $6,000 payments.

• The first cash flow at date 0 (today) is represented as a

negative sum because it is an outflow.
• Timelines can represent cash flows that take place at the
end of any time period – a month, a week, a day, etc.
The Timeline- Example
Three Rules of Time Travel
• Financial decisions often require combining cash
flows or comparing values. Three rules govern these
processes.

The Three Rules of Time Travel

The 1st Rule of Time Travel
• A dollar today and a dollar in one year are not
equivalent.
• It is only possible to compare or combine values at
the same point in time.
• Which would you prefer: A gift of $1,000 today or $1,210
at a later date?
• To answer this, you will have to compare the alternatives
to decide which is worth more. One factor to consider:
How long is “later?”
The 2nd Rule of Time Travel
• To move a cash flow forward in time, you must
compound it.
• Suppose you have a choice between receiving $1,000
today or $1,210 in two years. You believe you can earn
10% on the $1,000 today but want to know what the
$1,000 will be worth in two years. The time-line looks
like this:
The 2nd Rule of Time Travel

• Future Value of a Cash Flow

Example
Problem
• Suppose you have a choice between receiving $5,000
today or $10,000 in five years. You believe you can earn
10% on the $5,000 today, but want to know what the
$5,000 will be worth in five years.
The 3rd Rule of Time Travel
• To move a cash flow backward in time, we must
discount it.
• Present Value of a Cash Flow
C
PV  C  (1  r ) n 
(1  r ) n
Example
Problem
• Suppose you are offered an investment that pays
$10,000 in five years. If you expect to earn a 10% return,
what is the value of this investment today?
Applying the Rules of Time
Travel
• Recall the 1st rule: It is only possible to compare or
combine values at the same point in time. So far
we’ve only looked at comparing.
• Suppose we plan to save $1000 today, and $1000 at the
end of each of the next two years. If we can earn a fixed
10% interest rate on our savings, how much will we have
three years from today?
Applying the Rules of Time
Travel (cont'd)
• The timeline would look like this:
Applying the Rules of Time
Travel (cont'd)
Applying the Rules of Time
Travel (cont'd)
Applying the Rules of Time
Travel (cont'd)
The Three Rules of Time Travel
Example
Problem
• Assume that an investment will pay you
$5,000 now and $10,000 in five years.
• The-time line would like this:

0 1 2 3 4 5

$5,000 $10,000
Valuing a Stream of Cash Flows
• Based on the first rule of time travel we can derive a
general formula for valuing a stream of cash flows:
if we want to find the present value of a stream of
cash flows, we simply add up the present values of
each.
Valuing a Stream of Cash Flows

• Present Value of a Cash Flow Stream

N N
Cn
PV  
n  0
PV (Cn )  
n  0 (1  r ) n
Textbook Example
Alternative Example
• Problem
• What is the future value in three years of the
following cash flows if the compounding rate
is 5%?

0 1 2 3

$2,000 $2,000 $2,000

Future Value of Cash Flow
Stream
• Future Value of a Cash Flow Stream with a Present
Value of PV
FVn  PV  (1  r ) n
Calculating the Net Present
Value
• Calculating the NPV of future cash flows allows us
to evaluate an investment decision.
• Net Present Value compares the present value of
cash inflows (benefits) to the present value of cash
outflows (costs).
Textbook Example
Problem
• Would you be willing to pay $5,000 for the following
stream of cash flows if the discount rate is 7%?

0 1 2 3

$3,000 $2,000 $1,000

Perpetuities and Annuities
• Perpetuities
• When a constant cash flow will occur at regular intervals
forever it is called a perpetuity.
Perpetuities and Annuities
• The value of a perpetuity is simply the cash flow
divided by the interest rate.
• Present Value of a Perpetuity
C
PV (C in perpetuity) 
r
Example
Alternative Example
• Problem
• You want to endow a chair for a female professor of
finance at your alma mater. You’d like to attract a
prestigious faculty member, so you’d like the
endowment to add $100,000 per year to the faculty
member’s resources (salary, travel, databases, etc.) If
you expect to earn a rate of return of 4% annually on the
endowment, how much will you need to donate to fund
the chair?
Perpetuities and Annuities
• Annuities
• When a constant cash flow will occur at regular intervals
for a finite number of N periods, it is called an annuity.

• Present Value of an Annuity

C C C C N C
PV     ...   
(1 r ) (1 r ) (1 r )
2 3
(1 r ) N
n 1 ( 1  r )
n
Present Value of an Annuity
• To find a simpler formula, suppose you invest $100
in a bank account paying 5% interest. As with the
perpetuity, suppose you withdraw the interest each
year. Instead of leaving the $100 in forever, you
close the account and withdraw the principal in 20
years.
Present Value of an Annuity
• You have created a 20-year annuity of $5 per year,
plus you will receive your $100 back in 20 years. So:

$100  PV (20  year annuity of $5 per year)  PV ($100 in 20 years)

• Re-arranging terms:

PV (20  year annuity of $5 per year)  $100  PV ($100 in 20 years)

100
 100  20
 $62.31
(1.05)
Present Value of an Annuity
• For the general formula, substitute P for the
principal value and:
PV(annuity of Cfor N periods)
 P  PV(Pin period N)
P  1 
P  P 1 
 (1  r) N 
(1  r) N  
Textbook Example
Future Value of an Annuity
• Future Value of an Annuity

FV (annuity)  PV  (1  r ) N
C  1 
  1    (1  r )
N

r  (1  r ) N 
1
 C 
r
 (1  r ) N  1
Example
Growing Cash Flows
• Growing Perpetuity
• Assume you expect the amount of your perpetual
payment to increase at a constant rate, g.

• Present Value of a Growing Perpetuity

C
PV (growing perpetuity) 
r  g
Textbook Example
Problem
In Alternative Example 4.7, you planned to donate money
to endow a chair at your alma mater to supplement the
salary of a qualified individual by $100,000 per year.
Given an interest rate of 4% per year, the required
donation was $2.5 million. The University has asked you
to increase the donation to account for the effect of
inflation, which is expected to be 2% per year. How much
will you need to donate to satisfy that request?
Growing Cash Flows
• Growing Annuity
• The present value of a growing annuity with the initial
cash flow c, growth rate g, and interest rate r is defined
as:
• Present Value of a Growing Annuity

1   1  g  
N

PV  C  1    

(r  g )   (1  r )  
Textbook Example 4.11
Alternative Example 4.11
• Problem
• You want to begin saving for your retirement. You plan
to contribute $12,000 to the account at the end of this
year. You anticipate you will be able to increase your
annual contributions by 3% each year for the next 45
years. If your expected annual return is 8%, how much
do you expect to have in your retirement account when
you retire in 45 years?
Textbook Example 4.12
Textbook Example 4.13
Non-Annual Cash Flows
• The same time value of money concepts apply if
the cash flows occur at intervals other than
annually.
• The interest and number of periods must be
adjusted to reflect the new time period.
Textbook Example
Solving for the Cash Payments
• Sometimes we know the present value or future
value, but do not know one of the variables we
have previously been given as an input.
Solving for the Cash Payments
• For example, when you take out a loan you may
know the amount you would like to borrow, but
may not know the loan payments that will be
required to repay it.
Textbook Example
The Internal Rate of Return
• In some situations, you know the present value and
cash flows of an investment opportunity but you do
not know the internal rate of return (IRR), the
interest rate that sets the net present value of the
cash flows equal to zero.
Textbook Example
Textbook Example
Problem 1

• You must pay a creditors $6.000 one year from now, $5000 two years
from now, $4000 three years from now, $2000 four years from now
and a final $1000 five years from now. You would like to restructure
the loan into five equal annual payments due at the end of each year.
If the agreed interest rate is 6% compounded annually, what is the
payment?
Problem 2
• Your favorite grandfather wants to make a single deposit today in an
account from which you will withdraw $10.000 one year from today;
$20.000 two years from today; and $30.000 per year forever thereafter,
with your first $30.000 withdrawal three years from today. The account
will earn interest at rate of 10% per year compounded annually, forever.
• Assuming that you will indeed live forever, how much your grandfather
deposit in the account today?
• Suppose your grandfather does not expect you to live forever. Instead, he
wants to deposit enough today to enable you to make just 40 annual
withdrawals of $30.000, starting three years from today, in addition to
the $10.000 withdrawal one year from today and the $20.000 withdrawal
two years from today. How large must his single deposit today be?
• End of Chapter 3