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CORPORATE FINANCE
Lecture 2: The time value of money
LECTURE 2

3/25/2019 2
 Learning objectives

• Interpret the time value of money.

• Calculate the future value (FV) and the present value (PV) of a single cash
flow, a cash flow stream, an annuity, a growing annuity due, a perpetuity
and a growing perpetuity (PV only)
• Interpret different types of interest rate; solve time value of money
problems for different frequencies of compounding.
• Apply the principle of the time value of money in making financial
decisions in practice.
 Contents

2.1. The time value of money

2.2. The future value

2.3. The present value

2.4. Perpetuity and Annuity

2.5. Interest Rates

2.6. The application of the time value of money

5.4
 Terminology
 Time value of money  Annuities  Annually

 Interest  Perpetuities  Semi – annually

 Interest rate  Cash Flows  Quarterly

 Simple interest  Effective Annual Rate (EAR)  Monthly

 Compound interest  Nominal Interest Rate (NIR)

 Principal  Payment
 Future Value (FV)

 Present Value (PV)

4.5
2.1. The time value of money
What is the time value of money?

If you are guaranteed payment, would you

rather receive VND 100 million today or VND
100 million in one year’s time? Why?

6
What is the time value of money?
2.1.1. Simple interest
Simple interest:

Formula

 I : the amount of interest earned from the n period

 Po: original capital
 r : interest rate / period
n : Number of Time Period
Example: A person deposits 100 million at the bank for 3
years with the interest rate of 10%/year.
How much interest does he or she receive after 3 years?
Answer:
 2.2.2. Compound interest
Compound interest:
Example:
A depositor opens a saving in the bank, the amount of 100 million for 3
years at an interest rate of 10% per year. How much interest will he get
after 3 years?
Simple interest & Compound interest

Simple interest Compound interest

The difference between simple interest & compound interest is:

Causes:
2.2. The future value

The future value

The future value of a The future value of a

single cash flow cash flow stream
2.2. The future value
2.2.1. The future value of a single cash flow

Example: Mr. Nam puts VND 100 million in a saving account in a bank at the annual interest
rate of 10%. The bank calculates interest once a year.
How much money will he receive after three years?
10%

0 1 2 3 timeline
Deposit
The future value
- VND 100 million ???? The total value of money the
holder/investor can receive
after particular periods.
2.2. The future value
2.2.1. The future value of a single cash flow

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2.2. Future value and Present value
2.2.1. Future value
Formula

• FVn : future value at the end of period n

• PV: Initial investment
• r: annual rate of interest paid
• n: number of investment period
2.2.1. Future value
Example: Mr Lam deposits VND 500 million into an account earning
6% interest rate compounded annually. If no withdrawals are made, what
would be the value Mr Lam will have after 5 years?
Call future value is “ FV” we have:
2.2. The future value
2.2.2. The future value of a cash flow stream

A cash flow stream is defined as a collection of the sequent amount of

money in several periods or a series of cash flows occur in several periods.

Example 2.4. Mr. Nam invests VND 1,000million in year 1, VND 2,000million in year
2. If the interest rate is 10% per year, how much money will he have in his investment
account after two years?
2.2. The future value
2.2.2. The future value of a cash flow stream

Example: Mr. Nam invests VND 1,000million in year 1, VND 2,000million in year 2. If
the interest rate is 10% per year, how much money will he have in his investment
account after two years?
2.2.2. The future value of a cash flow stream

The future value of a cash flow stream over particular periods is the sum of the future value of
each individual cash flow.
Other speaking, it is the total amount of money the holder/investor will receive after some periods
when investing into assets.

 If we use CFt to denote the CF at the end of the period t, the CF stream as:
CF1 CF2 CFn-1 CFn

… timeline
0 1 2 n-1 n

FVn
Future value (FV)
FVn-1

…
FV2
FV1
 2.2.2. The future value of a cash flow stream

The future value of a cash flow stream over particular periods is the sum of the future value of
each individual cash flow.
Other speaking, it is the total amount of money the holder/investor will receive after some periods
when investing into assets.

 If we use CFt to denote the CF at the beginning of the period t, the CF stream as:
CF1 CF2 CFn

… timeline
0 1 2 n-1 n

FVn Future value (FV)

…
FV2
FV1
2.3. The present value

The present value

The present value of a The present value of a

single cash flow cash flow stream
2.3. The present value
2.3.1. The present value of a single cash flow

Example: Mr. Nam puts VND 1,000million in a saving account in a bank at

the annual interest rate of 10%. The bank calculates interest once a year.
How much money will he receive after three years?
 2.3.1. The present value of a single cash flow

PV = FV / (1+r)n FV
… timeline
0 1 2 n-1 n
Today Future

From the equation of the future value: the present value is:

 The discount factor or PVF (r,n) at the rate r

 How much you have to invest to get VND 1 after n periods
 2.3.2. The present value of a cash flow stream

Example: Mr. Nam wants to have VND 1,000million in one year, VND 2,000million in
two years. If the interest rate is 10% per year. How much money does he have to invest
today to receive these cash flows?
+VND 1,000m +VND 2,000m

0 1 2 timeline
 2.3.2. The present value of a cash flow stream

The present value of a cash flow stream is the sum of the present value of each amount of money.
Other speaking, it is the cost the investor/holder has to pay to receive the same cash flows in the future .

 If we use CFt to denote the CF at the end of the period t, the CF stream as:
CF1 CF2 CFn-1 CFn

1 … timeline
0 2 n-1 n

Present value PV1

PV2
PVn-1
PVn
 2.3.2. The present value of a cash flow stream

The present value of a cash flow stream is the sum of the present value of each amount of money.
Other speaking, it is the cost the investor/holder has to pay to receive the same cash flows in the
future .

 If we use CFt to denote the CF at the beginning of the period t, the CF stream as:

CF1 CF2 CFn

0 1 … timeline
2 n-1 n
Present value
PV1
PV2
PVn
 2.4. Perpetuity and Annuity

Cash flow stream

Growing
Perpetuity Annuity Growing Annuity
Perpetuity
2.4. Perpetuity and Annuity
2.4.1. Perpetuity

Perpetuity is a set of identical payments ocurring each period in an infinite future.

 In general, the present value of a perpetuity is:

 When CFt = A and r is kept constant, the PV of the perpetuity is:

CF1 CF2 CFn-1 CFn CFn+T timeline

1 … n+T …
0 2 n-1 n
…
Forever
PV1
PV2
…
PV PVn-1
PVn
…
PVn+T

…
2.4. Perpetuity and Annuity
2.4.1. Perpetuity

Example: If you have a perpetuity with an annual payment VND 100 million at the end
of each year and 10% of annual interest rate? What is the present value of perpetuity.
2.4. Perpetuity and Annuity
2.4.2. Growing perpetuity
Growing perpetuity is the perpetuity in which the payment at the end
of each period increases by instant rate g.
CF1 CF1(1+g) CF1(1+g)n-2 CF1(1+g)n-1 CF1(1+g)n+T-1

0 1 2 … n-1 n n+T …
timeline
PV1
PV2 …
PV PVn-1
PVn
…
PVn+T
…
 In general, the present value of a perpetuity is:
 When CFt = A and r is kept constant, the PV of the perpetuity is:
2.4. Perpetuity and Annuity
2.4.2. Growing perpetuity

Example: Mr. Nam receives an offer from your bank about the collection of the future
cash flow. He will get VND 2 million in one year, the endless payment will continuously
increase by 7%. The interest rate is 12%. How much money is Mr. Nam willing to pay
the bank today to get this offer?
2.4. Perpetuity and Annuity
2.4.3. Annuity

An annuity is a set of equal cash flows occurs in a particular finite number of periods.
The ordinary annuity A A A
A

… timeline
0 1 2 n-1 n
The annuity due
A A A

… timeline
0 1 2 n-1 n

The ordinary annuity The annuity due

2.4. Perpetuity and Annuity
2.4.3. Annuity

Example: Ms. Lan won a local lottery with two offers. The first option is to get VND
150 million immediately. The other option is the lottery company will pay her VND 20
million at the end of each year in 20 years. Which offer should she choose today if the
interest of the Treasury Bond is at 10%?
2.4. Perpetuity and Annuity
2.4.4. Growing annuity

When:
 All the payments are equal to A
 The interest rate r is kept at constant
 The discount rate (r) is higher than the growing rate (g)

The present value of the annuity is:

The future value of the annuity is:

2.4. Perpetuity and Annuity
2.4.4. Growing annuity

Example: Ms. Lan asks Mr. Nam for his investment into her cafeteria. She
promises to pay him VND 10 million in year 1, and the growth rate at 8%. The first
payment occurs at the end of year 1. The payments last 15 years. The interest rate is
12%. What is the present value of this planned investment?
2.5. Interest Rate
Effective Annual Rate and Nominal Interest Rate

 Nominal interest rate (stated annual interest rate) is a rate of interest based
on the face value of the security.
 Effective annual rate is the rate at which a unit of currency will grow in a year
with interest on interest included.

Where m is the times of compounding in a year.

 When the compounding interval becomes smaller, the is higher EAR
but NIR is unchanged.
2.5. Interest Rate
Effective Annual Rate and Nominal Interest Rate

Quoted interval: the length of the period during which interest is

calculated.
 Period: days, weeks, months, 6 months, years…
 Each period has consistent numbers of payments a year:

Interval Numbers of payment

Monthly 12
Quarterly 4
Half year 2
2.5. Interest Rate
Effective Annual Rate and Nominal Interest Rate

If today you invest VND 1 million in 10 years at the annual rate of 15%.

You will get:

 By annual compounding:

 By quarter compounding:

 By daily compounding:
2.5. Interest Rate
Effective Annual Rate and Nominal Interest Rate

 The financial institutions can use effective rate for a specific period (rk) less than one

year. The effective annual rate for a year is:

(m is the times of calulating interest in a year)

 The future value of the initial investment PV at the periodic interest rate rk after n years is:
2.5. Interest Rate
Effective Annual Rate and Nominal Interest Rate

If you put VND 1 million in the bank with an offer that the interest rate for 6 months is 5%

and the interest is compounded semiannually. How much of money will you get after ten

years?
2.6. The application of the time value of money
2.6.1. Calculating the discounted interest rate

Example: ABC Company is considering two offers from a manufacturer for a

new processing machine. The supplier requires VND 1,000 million payment

immediately after receiving the new machine. The supplier also allows ABC

Company to pay VND 191.8 million after receiving the machine and 180

million VND at the end of each year in the next 8 years. What is the discounted

rate of the deferred payment method?

2.6. The application of the time value of money
2.6.1. Calculating the discounted interest rate

Option 1:

ABC Company is
going to invest in a
new processing Discount rate?
machine

Option 2:
2.6. The application of the time value of money
2.6.1. Calculating the discounted interest rate

At the discount rate r, the present value of two offers are equivalent.
2.6. The application of the time value of money
2.6.2. Calculating the number of periods

Example: Ms. Lan deposits VND 100 million in a saving account in a bank at the annual
interest rate of 10%. The bank calculates interest once a year. How long does it take for
her money to grow to VND 161.05 million?
2.6. The application of the time value of money
2.6.3. Calculating the payment in the future

If ABC Company in Example above choose option 1. It will borrow VND 1,000m from
Vietinbank for 5 years. ABC Company has to pay a fixed amount of money at the end
of each year. The borrowing interest rate is 12% per year.

=> Make payment plan for ABC.

2.6. The application of the time value of money
2.6.3. Calculating the payment in the future

Unit of measure: VND million

Period Beginning Periodic payment Ending

Balance Balance
Total Principal Interest

1
2
3
4
5
2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

Where

 PV is the present value of the expected cash flows in the future

 CFt is the cash flow occurring at the time t in the future

 r is the discount rate of the model

DCF model can be used for Capital Budgeting or Valuing the securities
2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

 Capital budgeting
Example: An investment project will produce the following cash flows:

Unit of measure: VND million

t 1 2 3 4 5 6

CFt 1,000 1,200 1,300 1,300 1,250 1,150

Today cost is VND 6,000 million to conduct the project. If the discounted interest
rate is kept at 10% per period in six periods, is this investment valuable?
2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

 Capital budgeting
2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

 Security Valuing

Example: A bond promises to pay the following cash flows:

Unit of measure: VND 1,000
t 1 2 3 4 5
Dt 100 100 100 100 1,100
rt 6% 6% 6% 6% 6%

What is the price of this bond?

2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

 Security Valuing
2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)

Example: ABC Company will pay VND 20,000 of dividend next year

and its dividen increases 6% per year. If the required of return is 15%.

What is the current price of one ABC Company’s stock?

2.6. The application of the time value of money
2.6.4. Discounted cash flow model (DCF)