INTRODUCTION TO

FINANCE
PhD. Tran Thu Ha
0944505868
tranthuha1985@gmail.com

Monday A1104, Tuesday A1105, Wednesday A1104

1
Session 4 - 6: 09:20 - 11:45
Course schedule

1. Chapter 1: Overview of Finance

2. Chapter 2: Financial markets and Interest rate
3. Chapter 3: Risk and Return
4. Chapter 4: The Time Value of Money
5. Chapter 5: Capital Budgeting
6. Chapter 6: Understanding Financial Statements
7. Chapter 7: The cost of capital

2
 CHAPTER 4
The time value of
money
CHAPTER 4
The time value of money
u 4.1. Compound interest, future value and present value
u 4.2. Annuities
u 4.3. Making interest rates comparable
u 4.4. The present value of an uneven stream and perpetuities
 4.1. Compound
interest, future value
and present value
USING TIMELINES TO VISUALIZE CASH FLOWS

u A timeline identifies the timing and amount of a stream of cash flows—both cash
received, and cash spent—along with the interest rate it earns.
u Timelines are a critical first step used by financial analysts to solve financial
problems.

u Time periods are identified on the top of the timeline, measured in years.
u Time period 0 is both today and the beginning of the first year.
u The dollar amount of the cash flow received or spent at each time period is shown
below the timeline.
u Positive values represent cash inflows. Negative values represent cash outflows.
USING TIMELINES TO VISUALIZE CASH
FLOWS
u If I offered to give you $100, would you say yes?
u Then, if I asked you if you wanted the $100 today or one year from
today, what would you say?
u The phrase time value of money refers to the fact that a dollar in
hand today is worth more than a dollar promised at some time in the
future.
u On a practical level, one reason for this is that you could earn interest
while you waited; so a dollar today would grow to more than a dollar
later.
u The trade-off between money now and money later thus depends on,
among other things, the rate you can earn by investing.
USING TIMELINES TO VISUALIZE CASH
FLOWS

u Timelines are used to identify when cash inflows and outflows will
occur so that an accurate financial assessment can be made.
u Because money has a time value, it gives rise to the concept of
interest.
u Interest can be thought of as rent for the use of money.
u The size of the rental rate or user fee is the interest rate.
Future Value and
Compounding
Future Value and Compounding

Investing for a Investing for more

single period than one period
Future Value and Compounding

u What is future value?

u Future value (FV) refers to the amount of money an investment
will grow to over some period of time at some given interest rate.
u Put another way, Future value is the cash value of an investment
at some time in the future.
a. Investing for a single period

u Suppose you invest $100 in a savings account that pays 10% interest
per year. How much will you have in one year?
u You will have $110 = original principal of $100 + $10 in interest earnt.
u è $110 is the future value of $100 invested for one year at 10%,
meaning that $100 today is worth $110 in one year, given that 10% is
the interest rate.
u In general, if you invest for one period at an interest rate of r, your
investment will grow to (1 + r) per dollar invested.
u Ex: r = 10%
u à investment growth: 1+0,1 = 1,1 dollars per dollar invested
u à 100$ invested x 1,1 = $110
b. Investing for more than one period

u Going back to our $100 investment, what will you have

after two years, assuming the interest rate doesn’t
change (10%)?
u If you leave the entire $110 in the bank,
u Earn $110 x 0.10 = $11 in interest during the second year
u à a total of $110 + 11 = $121.
u This $121 is the future value of $100 in two years at 10%.
b. Investing for more than one period

u Going back to our $100 investment, what will you have after
two years, assuming the interest rate doesn’t change (10%)?
u If you leave the entire $110 in the bank,
u Earn $110 x 0.10 = $11 in interest during the second year
u à a total of $110 + 11 = $121.
u This $121 is the future value of $100 in two years at 10%.
u This $121 has four parts.
u The first part is the $100 original principal.
u The second part is the $10 in interest you earned in the first year
u The third part is another $10 you earn in the second year, for a total of
$120.
u The fourth part is the last $1 which is interest you earn in the 2nd year on
the interest paid in the first year: $10 x 0.10 = $1.
b. Investing for more than one period

u Compounding: The process of accumulating interest on an investment

over time to earn more interest.
u Compounding the interest means earning interest on interest, so we
call the result compound interest.
u With simple interest, the interest is not reinvested, so interest is
earned each period only on the original principal.
b. Investing for more than one period

u Example 1. Interest on Interest

u Suppose you locate a two-year investment that pays 14 percent per year.
If you invest $325, how much will you have at the end of the two years?
How much of this is simple interest? How much is compound interest?
u At the end of the 1st year: $325 x (1 + 0.14) = $370.50
u If you invest this entire amount and thereby, compound the interest:
$370.50 x 1.14 = $422.37 at the end of 2nd year.
u Total interest you earn = $422.37 - $325 = $97.37
u Your $325 original principal earns $325 x 0.14 = $45.50 in interest each
year à for a two-year total of $91 in simple interest.
u The remaining $97.37 - 91 = $6.37 results from compounding (interest on
interest.
b. Investing for more than one period

u Future value = Present value x (1+r)t (4-1)

u FV = PV * (1+r)t
u The expression (1 + r)t is sometimes called the future value interest factor (or
just future value factor) for $1 invested at r percent for t periods and can be
abbreviated as FVIF(r, t).
u In our example, what would your $100 be worth after five years? We can first
compute the relevant future value factor as follows:
u (1+r)t =(1 + 0.10)5 =1.15 =1.6105
u Your $100 will thus grow to: $100 x 1.6105 = $161.05
The interest earned in each year is equal to the beginning
amount multiplied by the interest rate of 10%.

b. Investing for more than one period

 Future Value of $1 for Different Periods and Rates

b. Investing for more than one period

b. Investing for more than one period

u Example 2: Compound Interest

u You’ve located an investment that pays 12 percent per year. That rate
sounds good to you, so you invest $400.
u How much will you have in three years?
u How much will you have in seven years?
u At the end of seven years, how much interest will you have earned?
u How much of that interest results from compounding?
b. Investing for more than one period

u Example 2: Compound Interest

u You’ve located an investment that pays 12% per year. That rate sounds good to
you, so you invest $400.
u How much will you have in three years?
u Future value factor for 12% and 3 years = (1+r)t = 1.123 = 1.4049
u Your $400 thus grow to: $400 x 1.4049 = $561.97
u How much will you have in seven years?
u $400 x 1,127 = $400 x 2.2107 = $ 884.27
b. Investing for more than one period

u Example 2: Compound Interest

u You’ve located an investment that pays 12% per year. That rate sounds good to
you, so you invest $400.
u At the end of 7 years, how much interest will you have earned?
u You invested $400, the interest in the $884.27 future value is $884.27 - 400 =
$484.27
u How much of that interest results from compounding?
u At 12%, your $400 investment earns $400 x 0.12 = $48 in simple interest every year.
u Over 7 years, the simple interest thus totals 7 x $48 = $336.
u The other $484.27 - $336 = $148.27 is from compounding.
b. Investing for more than one period

u Example 3: Dividend growth

u The TICO Corporation currently pays a cash dividend of $5 per share. You believe the divi-
dend will be increased by 4 percent each year indefinitely. How big will the dividend be in
eight years?
u Future value = $5 x 1.048 = $5 x 1.3686 = $6.84
 Present Value
and Discounting
2. Present Value and Discounting

u When we discuss future value, we are thinking of questions like:

u What will my $2,000 investment grow to if it earns a 6.5% return every
year for the next six years?
u The answer to this question is what we call the future value of $2,000
invested at 6.5% for six years ~ $2,918.
u Another type of question that comes up even more often in financial
management is obviously related to future value.
u Suppose you need to have $10,000 in 10 years, and you can earn 6.5% on
your money.
u How much do you have to invest today to reach your goal?
2. Present Value and Discounting

u The Single-period case

u Present values for multiple periods
2.1. The Single-period case

u Future value = Present value x (1+r)t

(4-2)

u Present value is just the reverse of future value. Instead of

compounding the money forward into the future, we discount it back
to the present.
2.1. The Single-period case

u Example 4. Single Period PV

u Suppose you need $400 to buy textbooks next year. You can earn 7% on your
money. How much do you have to put up today?
u We need to know the PV of $400 in one year at 7%. Proceeding as in the
previous example:
u Present value x 1.07 = $400
u Present value = $400 x (1/1.07) = $373.83
u à $373.83 is the present value.
2.2. Present values for multiple periods

u Suppose you need to have $1,000 in two years. If you can earn 7%, how much
do you have to invest to make sure you have the $1,000 when you need it? In
other words, what is the present value of $1,000 in two years if the relevant
rate is 7%?
u The amount invested must grow to $1,000 over the two years:
$1,000 = PV x 1.07 x 1.07 = PV x 1.072 = PV x 1.1449
u Present value = $1,000 / 1.1449 = $873.44
à $873.44 is the amount you must invest to achieve your goal.
2.2. Present values for multiple periods

u 1/(1+r)t is called discount factor or discount rate

u The quantity in brackets is also called the present value interest factor (or
just present value factor) for $1 at r percent for t periods and is sometimes
abbreviated as PVIF(r, t).
u Calculating the present value of a future cash flow to determine its worth
today is commonly called discounted cash flow (DCF) valuation.
2.2. Present values for multiple periods

u PV = $1 x [1/(1+r)t] = $1/(1+r)t
u Suppose you need $1,000 in three years. You can earn 15 percent on your
money. How much do you have to invest today?
u The discount factor is: 1/(1 + 0.15)3 = 1/1.5209 = 0.6575
u The amount you must invest is thus: $1,000 x 0.6575 = $657.50
u We say that $657.50 is the present or discounted value of $1,000 to be
received in three years at 15%.
2.2. Present values for multiple periods

Present Value of $1 for Different Periods and Rates

PRACTICE

u Calculating Interest Rates: Assume the total cost of a college

education will be $290,000 when your child enters college in 18
years. You presently have $55,000 to invest. What annual rate
of interest must you earn on your investment to cover the cost
of your child’s college education?
u Calculating the Number of Periods: At 7 percent interest, how
long does it take to double your money? To quadruple it?
u Calculating Interest Rates: In January 2023, the average house
price in the United States was $314,600. In January 2016, the
average price was $200,300. What was the annual increase in
selling price?
4.2. ANNUITIES
4.2.1. ANNUITIES

u An annuity is a series of equal dollar payments for a specified number of

years.
u With an ordinary annuity, the payments occur at the end of each period.
Because annuities occur frequently in finance— for example, as bond interest
payments.
 a. COMPOUND ANNUITIES
u A compound annuity involves depositing or investing an equal sum of money
at the end of each year for a certain number of years and allowing it to
grow.
u For example: if to provide for a college education we are going to deposit
$500 at the end of each year for the next 5 years in a bank where it will earn
6% interest, how much will we have at the end of 5 years?
a. COMPOUND ANNUITIES

u Future value of an annuity:

(4-3)
u PMT: Annuity
u Annuity future value factor:
a. COMPOUND ANNUITIES
u For example: if we know that we need $10,000 for college in 8 years, how
much must we deposit in the bank at the end of each year at 6% interest to
have the college money ready?
u Using equation (4-3), we know the values of n = 8, r = 6%, and FVn = $10,000;
what we do not know is the value of PMT:

(4-3)

u Thus, we must deposit $1,010.36 in the bank at the end of each year for 8
years at 6% interest to accumulate $10,000 at the end of 8 years.
a. COMPOUND ANNUITIES
u For example: How much must we deposit in an 8% savings account at the end
to accumulate $5,000 at the end of 10 years?
u Using equation (4-3), we know the values of n = 10, r = 8%, and FVn = $5,000;
what we do not know is the value of PMT:

u Thus, we must deposit $345.15 in the bank per year for 10 years at 8% to
accumulate $5,000.
b. THE PRESENT VALUE OF AN ANNUITY

u Pension payments, insurance obligations, and the interest owed on bonds all
involve annuities.
u To compare these three types of investments we need to know the present
value of each.
u For example, if we wish to know what $500 received at the end of each of the
next 5 years is worth today given a discount rate of 6%?
u We can simply substitute the appropriate values into equation (4-2):
THE PRESENT VALUE OF AN ANNUITY

u Present value of an annuity:

(4-4)

u The annuity present value factor:

THE PRESENT VALUE OF AN ANNUITY

u Ex 1. What is the present value of a 10-year $1,000 annuity discounted back

to the present at 5%?
u Ex2. If we have $5,000 in an account earning 8% interest, how large of an
annuity can we draw out each year if we want nothing left at the end of 5
years?
4.2.2. ANNUITIES DUE

u Annuities due are really just ordinary annuities in which all the annuity
payments have been shifted forward by 1 year.
u With an annuity due, each annuity payment occurs at the beginning of each
period rather than at the end of the period.
4.2.2. ANNUITIES DUE

u FUTURE VALUE OF AN ANNUITY DUE

u Because an annuity due merely shifts the payments from the end of the year
to the beginning of the year, we now compound the cash flows for one
additional year.

(4-5)
4.2.2. ANNUITIES DUE

u FUTURE VALUE OF AN ANNUITY DUE

u Ex: In an earlier example on saving for college, we calculated the value of a
5-year ordinary annuity of $500 invested in the bank at 6% to be $2,818.50. If
we now assume this to be a 5-year annuity due, what is its future value?

(4-5)
4.2.2. ANNUITIES DUE

u PRESENT VALUE OF AN ANNUITY DUE

u Receive each cash flow 1 year earlier—that is, we receive it at the beginning
of each year rather than at the end of each year.
u Thus, because each cash flow is received 1 year earlier, it is discounted back
for one less period.
u To determine the present value of an annuity due, we merely need to find the
present value of an ordinary annuity and multiply that by (1 cancels out 1+ r),
which in effect year’s discounting.

(4-6)
4.2.2. ANNUITIES DUE

u PRESENT VALUE OF AN ANNUITY DUE

u Ex: Re-examining the earlier college saving example in which we calculated
the present value of a 5-year ordinary annuity of $500 given a discount rate of
6%, we now find that if it is an annuity due rather than an ordinary annuity,
how much is the present value of an annuity due?

(4-6)
4.2.3. AMORTIZED LOANS
u An amortized loan is a type of loan with
scheduled, periodic payments that are
applied to both the loan's principal amount The Amortization Process
and the interest accrued.
u An amortized loan payment first pays off the
relevant interest expense for the period,
after which the remainder of the payment is
put toward reducing the principal amount.
u Although the payments are fixed, different
amounts of each payment are applied
toward the principal and the interest.
u With each payment, you owe a bit less
toward the principal. As a result, the
amount that has to go toward the interest
payment declines with each payment,
whereas the portion of each payment that
goes toward the principal increases.
u Common amortized loans include auto loans,
home loans, and personal loans from a
bank for small projects or debt
consolidation.
4.2.3. AMORTIZED LOANS

u Ex: Suppose a firm wants to purchase a piece of machinery. To do this, it

borrows $6,000 to be repaid in four equal payments at the end of each of the
next 4 years, and the interest rate that is paid to the lender is 15% on the
outstanding portion of the loan. What is the annual payments associated with
the repayment of this debt?
 4.2.3. AMORTIZED LOANS
u Ex: Suppose a firm wants to purchase a piece of machinery. To do this, it
borrows $6,000 to be repaid in four equal payments at the end of each of the
next 4 years, and the interest rate that is paid to the lender is 15% on the
outstanding portion of the loan. What is the annual payments associated with
the repayment of this debt?
u Use equation (4-4) and solve for the value of PMT, the annual annuity:
u PV, the present value of the annuity, is $6,000;
u r, the annual interest rate, is 15%;
u and n, the number of years for which the annuity will last, is 4 years.
u PMT, the annuity payment received (by the lender and paid by the firm) at the end
of each year, is unknown.

u To repay the principal and interest on the outstanding loan in 4 years, the annual
payments would be $2,101.59.
 4.2.3. AMORTIZED LOANS
u Ex: Suppose a firm wants to purchase a piece of machinery. To do this, it
borrows $6,000 to be repaid in four equal payments at the end of each of the
next 4 years, and the interest rate that is paid to the lender is 15% on the
outstanding portion of the loan. What is the annual payments associated with
the repayment of this debt?
u To repay the principal and interest on the outstanding loan in 4 years, the annual
payments would be $2,101.59.

Loan Amortization Schedule Involving a $6,000 Loan at 15% to Be Repaid in 4 Years

 4.3. MAKING
INTEREST RATES
COMPARABLE
Effective annual rate (EAR)
u Effective annual rate (EAR): the annual compound rate that produces the
same return as the nominal, or quoted, rate when something is compounded
on a nonannual basis. In effect, the EAR provides the true rate of return.
u Ex: You are considering borrowing money from a bank at 12% compounded
monthly. If you borrow $1 at 1% per month for 12 months you’d owe:
u $1.00(1.01)12 = $1.126825
u In effect, you are borrowing at 12.6825% rather than just by 12% à the EAR
for 12% compounded monthly is 12.6825.
u It tells us the annual rate that would produce the same loan payments as the
nominal rate.
u In other words, you’ll end up with the same monthly payments if you borrow at
12.6825% compounded annually or 12% compounded monthly.

where EAR is the effective annual rate

m is the number of compounding periods within a year
Finding Present and Future Values with
Nonannual Periods
The future value of an investment for which interest is compounded in non-annual periods:
Finding Present and Future Values with
Nonannual Periods
u Example 1: You’ve been house shopping and aren’t sure how big a house you
can afford. You figure you can handle monthly mortgage payments of $1,250
and you can get a 30-year loan at 6.5%. How big of a mortgage can you
afford?
u Example 2: If we place $100 in a savings account that yields 12% compounded
quarterly, what will our investment grow to at the end of 5 years?
u Example 3: In 2023, the average UK household owed about $10,000 in credit
card debt, and the average interest rate on credit card debt was 13.0%. On
many credit cards the minimum monthly payment is 4% of the debt balance. If
the average household paid off 4% of the initial amount it owed each month,
that is, made payments of $400 each month, how many months would it take
to repay this credit card debt?
The Present Value of an Uneven
Stream and Perpetuities
u Although some projects will involve a single cash flow and some will involve
annuities, many projects will involve uneven cash flows over several years.
u For example, if we wished to find the present value of the following cash
flows given a 6% discount rate, we would merely discount the flows back to
the present and total them by adding in the positive flows and subtracting the
negative ones. However, this problem is complicated by the annuity of $500
that runs from years 4 through 10.

u
Perpetuities – Dòng tiền đều vô hạn
u A perpetuity is an annuity that continues forever; that is, every year following
its establishment this investment pays the same dollar amount.
u An example of a perpetuity is preferred stock that pays a constant dollar
dividend infinitely.
u Determining the present value of a perpetuity is delightfully simple; we
merely need to divide the constant flow by the discount rate.
Perpetuities – Dòng tiền đều vô hạn
u What is the present value of a $500 perpetuity discounted back to the present
at 8 percent?

Thus, the present value of this perpetuity is $6,250.

Summary of Time Value of Money equations
PRACTICE

u 1. Peter hit 47 home runs in 2023. If his home-run output grew at a rate of 12% per
year, what would it have been over the following 5 years?
u 2. If you were offered $1,079.50 for 10 years from now in return for an investment of
$500 currently, what annual rate of interest would you earn if you took the offer?
u 3. You lend a friend $10,000, for which your friend will repay you $27,027 at the end of
5 years. What interest rate are you charging your “friend”?
u 4. You are offered $1,000 today, $10,000 in 12 years, or $25,000 in 25 years. Assuming
that you can earn 11% on your money, which should you choose?
PRACTICE

u 5. Adam Smith, who has been married for 23 years, would like to buy his wife
an expensive diamond ring with a platinum setting on their 30-year wedding
anniversary. Assume that the cost of the ring will be $12,000 in 7 years. Adam
currently has $4,510 to invest. What annual rate of return must Adam earn on
his investment to accumulate enough money to pay for the ring?
u 6. Mary and Anna are twins and both work at the Springfield DMV. Mary and
Anna decide to save for retirement, which is 35 years away. They’ll both
receive an 8% annual return on their investment over the next 35 years. Anna
invests $2,000 per year at the end of each year only for the first 10 years of
the 35-year period—for a total of $20,000 saved. Marry doesn’t start saving
for 10 years and then saves $2,000 per year at the end of each year for the
remaining 25 years—for a total of $50,000 saved. How much will each of them
have when they retire?
PRACTICE
u 7. (ANNUITY) DAVIDSON, a sophomore mechanical engineering student,
receives a call from an insurance agent, who believes that Davidson is an
older woman ready to retire from teaching. He talks to her about several
annuities that she could buy that would guarantee her an annual fixed
income. The annuities are as follows:

If Nicki could earn 11 percent on her money by placing it in a savings account,

should she place it instead in any of the annuities? Which ones, if any? Why?
u 8. (Loan amortization) Mr. Peterson purchased a new house for $80,000. He
paid $20,000 down and agreed to pay the rest over the next 25 years in 25
equal end-of-year payments plus 9% compound interest on the unpaid
balance. What will these equal payments be?
u 9. (Solving for PMT of an annuity) To pay for your child’s education, you wish
to have accumulated $15,000 at the end of 15 years. To do this you plan on
depositing an equal amount into the bank at the end of each year. If the bank
is willing to pay 6% compounded annually, how much must you deposit each
year to reach your goal?