Seminar 2 – The Time Value of Money

1. The Three Rules of Time Travel

In order to evaluate an investment project, its costs1 and benefits2 must be compared. Usually, in a
long-term project, these costs and benefits are spread across time. Therefore, specific tools are needed
that make it possible to compare cash flows that occur over many years. These tools are summed up
by three important rules for moving cash flows to different points in time.
Rule 1: It is only possible to compare or combine values at the same point in time. To compare or
combine cash flows that occur at different points in time, you first need to move them to the same
point in time.

Rule 2: Moving cash flows forward in time. The future value of a cash flow is computed
through compounding. Taking into account periods and a constant interest rate , the formula of the
future value is:
( )

Rule 3: Moving cash flows back in time. The present value of a cash flow is computed through
discounting. Based on the same notations, the formula of the present value is:

( )
Note. In order to organize and visualize complex investment projects, it is recommended to draw a
timeline for the occurrence of cash flows.

2. Valuing a Stream of Cash Flows. Special Cases

Most investment projects do not generate a single cash flow but a stream of cash flows. Since the
analysis is done in the present, investment projects are evaluated based on the present value of
their cash flows. For the general case, the present value of a cash flow stream is given by the sum of
the present values of each cash flow:

∑
( )

However, there are special types of cash flow streams for which it is easier to compute the present
value because the cash flows follow a regular pattern:
a) A perpetuity is a stream of equal cash flows that occur at regular intervals and last forever. In
practice, perpetuities usually refer to perpetual bonds that promise investors a fixed cash flow
each year with no maturity date. The oldest perpetuities that are still paying interest were
issued in 1624 by a Dutch water board responsible for the maintenance of the local darns. The
present value of a perpetuity is given by:

1
Outflows, negative cash flows
2
Inflows, positive cash flows
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 b) An annuity is a stream of equal cash flows paid at regular intervals. The present value of an
annuity is given by:

( )

c) A growing perpetuity is a stream of cash flows that occur at regular intervals and grow at a
constant rate forever. In order to compute the value of a growing perpetuity, several
conventions are taken into account:
- The cash flow from the first interval does not include growth. Therefore, cash flows
start to grow beginning with the second interval;
- The growth rate must be smaller than the interest rate . Otherwise, the cash flows
would grow even faster than they are discounted meaning that the present value would
be infinite. This implies that it would be impossible to sustain such a growth rate
forever.
Consequently, the present value of a growing perpetuity is given by:

d) A growing annuity is a stream of growing cash flows, paid at regular intervals. The first
convention also applies here but the growth rate may be higher than the interest rate
because, in this case, it is only for a finite period of time. The present value of a growing
annuity is given by:

( )

Note. The formula of the growing annuity is the most general, comprising all the other three formulas.
In the case of perpetuities we apply the limit for , while in the case of the simple annuity and
perpetuity we consider that .

3. Non-Annual Cash Flows

Most of the time, annual intervals are considered when analyzing the cash flow stream of an
investment project. However, the same formulas apply for non-annual cash flows (i.e. monthly,
daily etc.), taking into account the following rules:
a) The interest rate will be specified according to the considered time interval;
b) The number of periods will be expressed in the considered time units.

Problem 1. It is estimated that two investment projects, denoted A and B, will generate the following
annual cash flow streams:

Year 1 2 3 4 5 6
Project A 1,500 2,000 2,300 4,100 4,700 5,400
Project B 5,400 4,700 4,100 2,300 2,000 1,500

Considering an annual interest rate of 5%, compute the present value of the cash flow streams
generated by each investment project. Solve the problem again for an annual interest rate of 8%.
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Problem 2. An investment project is expected to generate a stream of equal annual cash flows of
15,000 per year. Given that the annual interest rate is 6%, compute the present value of the cash flow
stream considering that the project will last:
a) 10 years;
b) 50 years;
c) Forever.

Problem 3. An investment project is expected to generate a cash flow of 15,000 in the first year that
will increase by 3% in each of the subsequent years. Given that the annual interest rate is 6%, compute
the present value of the cash flow stream considering that the project will last:
a) 10 years;
b) 50 years;
c) Forever.

Problem 4. A student will receive a monthly scholarship of 450 lei for the following 9 months.
Considering an annual interest rate of 2.4%, compute the present value of the monthly
scholarships.

Problems for individual study

Problem 5. Consider the following alternatives:

- 100 lei received in one year;
- 200 lei received in five years;
- 300 lei received in ten years.
Rank the alternatives from most valuable to least valuable if the interest rate is 10% per year. What is
your ranking if the interest rate is only 5% per year? What is your ranking if the interest rate is 20%
per year?

Problem 6. You are thinking of retiring. Your retirement plan will pay you either 250,000 lei
immediately on retirement or 350,000 lei five years after the date of your retirement. Which
alternative should you choose if the interest rate is:
a) 6% per year?
b) 10% per year?

Problem 7. You have invented a money machine. The main drawback of the machine is that it is slow.
It takes one year to manufacture 100 lei. However, once built, the machine will last forever and will
require no maintenance. The machine can be built immediately but it will cost 1,000 lei to build. If the
interest rate is 9.5% per year, is it worth investing the money in constructing the machine? What
would be your answer if the machine takes one year to build?

Problem 8. What is the present value of 1,000 lei paid at the end of each of the next 100 years if the
annual interest rate is 7%?

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Problem 9. You are running a successful company. Analysts predict that its earnings will grow at 30%
per year for the next five years. After that, as competition increases, earnings growth is expected to
slow to 2% per year and continue at that level forever. Your company has just announced earnings of
1,000,000 lei. What is the present value of all future earnings if the interest rate is 8%? (Assume all
cash flows occur at the end of the year.)

Problem 10. A company spends 5,000 lei every month on printing and mailing costs, sending
statements to customers. If the interest rate is 0.5% per month, what is the present value of eliminating
these costs by sending the statements electronically?

Bibliography:
1. “Corporate Finance” – third edition, Jonathan Berk and Peter DeMarzo, Pearson, 2014,
Chapter 4. The Time Value of Money, pg. 96;
2. “Financial Analysis: Tools and Techniques”, Helfert Erich, McGraw-Hill, 2001, Chapter 7.
The Time Value of Money, pg. 224.

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