Introduction to Finance: The Basics

Professor Yang Xi

Module 4: Time Value of Money

Table of Contents
Module 4: Time Value of Money ............................................................................................. 1
Lesson 4-1.1: Module 4 Overview ....................................................................................................................... 2

Lesson 4-2: Present Value and Future Value ..................................................................................... 6

Lesson 4-2.1. Present Value and Future Value .................................................................................................... 6

Lesson 4-3: Net Present Value ........................................................................................................ 16

Lesson 4-3.1. Net Present Value ........................................................................................................................ 16
Lesson 4-3.2. APR and EAR ................................................................................................................................ 27

Lesson 4-4: Perpetuity and Annuity ................................................................................................ 38

Lesson 4-4.1. Perpetuity .................................................................................................................................... 38
Lesson 4-4.2. Annuity......................................................................................................................................... 47

Lesson 4-5 Module 4 Wrap Up ........................................................................................................ 60

Lesson 4-5.1. Module 4 Wrap Up ...................................................................................................................... 60

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Lesson 4-1 Module 4 Overview

Lesson 4-1.1: Module 4 Overview

Hello. In this module, let's discuss the time value of money. First, let's think about some
important financial decisions we make in our life. For most of us, we begin our career in
our 20s and then we can see they're buying a car or even a home. During the initial
years of our job is difficult to buy a car or home since our savings would be little. One
thing we are sure of is that we can accumulate enough wealth in our lifetime through our
hard work. Yet, we wouldn't want to delay our purchases until we are old. So, what we
can do is to borrow money from a bank to finance the purchases of both car and home.
In this case, financial institutions like banks help us to shift some our future earnings to
the present, so that we can purchase a home worth hundreds of thousands of dollars.

When we have a job and receive our salary, we don't want to spend all our income. We
also want to save some money for retirement. We deposit a portion of our salary into a
savings account such as 401k plan. Some employers may also make matching
contributions. We want to allocate some of our current income to the retirement plan,
because we want to maintain our standards of living even after we retire. Making
contributions to the retirement account will help us to shift some of our current earnings
to the future so that we can retire worry-free. In addition to the retirement savings, we
also want to make some investments if we have some extra money.

There are a bunch of investment options for us to choose from, such as stocks, bonds,
money markets, and others. But our investment goal is pretty straightforward. We want
to sacrifice a part of our current consumption in exchange for greater future rewards.
From all these daily examples, you can see they have something in common. With the

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help of financial institutions, we move cash flows either from present to the future or
from future to present, so that we can smooth our consumption. If we want to know how
to allocate cash flows across time, we have to value the trade-offs between today's
dollars and future dollars. This is the time value of money.

In this module, let's get introduced to the concept of present value and future value.
How to convert the present value to future value and vice versa. How to deal with single
cash flows as well as multiple cash flows.

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And how to calculate the net present value. Next, let's study the compounding
frequency. Financial institutions may pay interest annually, semi-annually, monthly, or
daily. So, how do we compare the value of investments if we receive the different
quotes of the interest rates from various financial institutions. How do we convert a
stated annual interest rate to an effective annual interest rate?

Lastly, let's study two special categories of cash flows, perpetuity and annuity. Using
these analysis tools, we should be able to value the cash flows generated, by a lot of

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financial instruments. You can consider this module as the foundation of financial asset
valuation.

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Lesson 4-2: Present Value and Future Value

Lesson 4-2.1. Present Value and Future Value

The time value of money is an idea that a dollar today is worth more than a dollar
tomorrow. This is the case because you can earn interest on your money. Suppose I
offer you two options. One is to receive $1,000 now and another is to receive $1,000
one year later. Of course, you want the $1,000 right now because you can deposit your
money into a bank and get more than $1,000 one year later. But the question is, how
much more will you get?

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Now, let's discuss the concepts of the present value and the future value. Suppose you
invest $1,000 now and the interest rate is 5 percent. What is the investment value one
year later?

The ending value is composed of two parts. The first part is interest payments. Using
the original $1,000 times the 5 percent interest rate, you get the interest payment $50.
You'll also receive the $1,000 principal repayment. So, your investment will grow to

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1,050 in total. You can also derive the value using the original $1,000 investment times
1 plus 5 percent interest rate.

Today's investment of $1,000 is called the present value and $1,050 is called the future
value because it is expressed as future dollars.

More generally, if the interest rate is r for a given period and the present value is PV, the

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future value, FV can be calculated using the formula: future value equals to present
value times 1 plus interest rate r.

We also draw the timeline here to show you the time associated with each value.

Now, we want to ask an alternative question. Suppose you want to have $1,000 a year
from today and the interest rate is 5 percent. How much should you invest today?

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You can also solve this question by rearranging the formula we just developed. Using
the future value $1,000 divided by 1 plus the interest rate 5 percent, you get $952.38.
This is the amount of money you need to invest today to be able to achieve your
investment goal of receiving $1,000 in one year. The value $952.38 is called the present
value of 1,000.

We can also generalize this relationship as present value equals to a future value
divided by 1 plus the interest rate r.

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Suppose you know the future value, we can use this formula to derive the present
value. This process is called discounting. The interest rate r is also called the discount
rate. Until now, we analyze the one-period case, which is the simplest. But in real life,
we need to deal with multiple periods.

For example, we want to know how much our investment of 1,000 will grow to after five
years if the interest rate is5 percent.

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To answer that question, at the end of year 1, the investment will grow into $1,050
which equals to 1,000 times 1 plus 5 percent. The investment at the end of year 1,
$1,050 will be reinvested during year 2 and also earn an interest of 5 percent.
Therefore, the ending value of investment at the end of year 2 will be 1,000 times 1 plus
5 percent to the power of two. By following this process, we need to get the investment
value at the end of year 5 that equals to 1,000 times 1 plus 5 percent to the power of
five, which is $1,276.28. From the description of the investment process, you may notice
that you earn interest on your initial investment $1,000 and you will also earn interest on
the interests you earned previously. This process is called compounding.

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The general formula for the future value of an investment over multiple periods is equal
to the present value times 1 plus interest rate r to the power of T. T is the periods of
time.

If we know the future value at the period T, we can also derive that the present value
equals the future value divided by 1 plus interest rate r to the power of T.

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We want to use an example to show you how to use the formula we just developed.
Suppose you would need $100,000 for your child's college education, which is 10 years
from now. An investment opportunity promises to offer you an interest rate of 8 percent.
How much do you need to invest now so that you can achieve your goal?

In order to answer this question, we need to identify that the future value is $100,000.
The appropriate interest rate is 8 percent and the number of periods is 10 years. By

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discounting the required ending investment value of $100,000 to the present, we will
yield a present value of $46,319.35

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Lesson 4-3: Net Present Value

Lesson 4-3.1. Net Present Value

In the previous lesson, we have learned how to work on a single cash flow, such as how
to convert the cash flow from present to the future value and vice versa. Now, we want
to add a new level of reality to our analysis. We want to know how to deal with a stream
of cash flows. Suppose a project generates a stream of cash flows, $50,000 one year
from now, $60,000 at the end of year two, and $20,000 at the end of year three. If the
Interest rate is 8%, and the initial investment needed is $100,000, do you think it's
worthwhile to invest in this project?

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In order to solve this question, we cannot simply sum up all the future cash flows
directly and then compare them with the initial outlay. Cash flows and different points in
time cannot be compared directly, because their units are different. For example, you
have €10 and $12. You cannot argue that $12 is worth more than €10 because 12 is
greater than 10. You have to convert them to the same currency and then compare
which one yields more value. What we want to do here is to convert all the future values
into the same unit, the present value and then compare them. One nice thing about the
present value is that they are all expressed in current dollars, so we can add them up.
First, we convert the cash flow in year one into the present value by dividing $50,000 by
one plus the interest rate to the power of one. The present value is $46,296.30. We
repeat this process for the cash flows in year two and year three, and get the
corresponding present values. Then we sum up all these present values and deduct the
initial cost $100,000 to compute the total present value as $13,613.27. Because this
value is positive, the projects discounted cash flows are more than enough to pay its
initial cost. This project is worth taking.

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What we have done can be generalized using mathematical formulas. The present
value of a stream of future cash flows can be calculated by dividing each cash flow by
one plus interest rate R to the power of the corresponding time period. And then sum up
all the discounted cash flows. This formula is called the discounted cash flow formula,
also called DCF. DCF is a widely used tool in financial valuation.

If we take initial cash flow into consideration, we get the net present value, NPV of a
project. In most cases, the initial cash flow is negative because a company needs to

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purchase equipment, build factories, hire employees and build up inventory to start a
new project. After the project is established, positive cash flows will be generated
through making goods or providing services. Once you have the net present value
number, you can make your decision.

The decision rule is that you should accept projects with positive NPV and reject those
projects with a zero or negative NPV.

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You can think of the decision rule as a cost benefit analysis. The present value of cash
inflows can be considered as the benefits of a project. Well, the cash outflows are the
cost of a project. If the net present value is positive, it means the total benefits from the
project outweigh the costs. Projects with positive NPV increase the earnings of the
company and also create value for shareholders. So now, let's work on the Excel
spreadsheet. First, we need to label the time periods clearly. So, we label the time. So,
this is 0, 1, 2, and 3 because we have three years in total. And the second column we
enter cash flows, and the cash flow information looked like this. So, for the first year, we
have $100,000 of cash outflow. And in the second year we have $50,000 of cash inflow,
and the second year $60,000, the third year $20,000. So, we have listed all the cash
flows in the second column and we also need to enter the information of the discount
rate. So, the discount rate in this case is 8%. And in order to calculate the net present
value of this project, we can use the function called net present value. And the first
argument of the function is the discount rate 8%, and then we use comma, and then we
need to include all the cash flows from year one to year three and then parenthesis. So,
this is the net present value, but don't forget we need to add the initial outlay at the very
beginning of the project. So, this is the net present value of this project equals to
$13,613.27. So, this number matches what we have done before. And here, I also want
to bring one question to your attention. When we use the net present value function, a
lot of students put all the cash flows in the net present value function. So, they do it like
this. So, they use the net present value function and then they use the rate, and
followed by all the cash flows, and then do it like this. So, this is a wrong way to do it,
because the initial cash flow is already expressed as the present value. So, we cannot
put it in the net present value formula, okay? So, this is the right way to do it. So, this is
the right way to do it, and this is the wrong way to do it. In this example, we used
discount rate 8% but we didn't explain why we picked 8% instead of 4% or 10%.

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What is the reasoning behind it? The discount rate has other names, such as the rate of
return, hurdle rate, or opportunity cost of capital.

It is called an opportunity cost because it is the rate of return that is foregone by

investing in this project rather than investing in financial markets. In our example, the
opportunity cost is 8%. Because we could earn a return of 8% by investing the same
amount of money in other financial securities with the same level of risk involved as in
this project. This project should deliver a return of at least 8%, otherwise, it's better to

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invest in other financial instruments. This is why it is also called the hurdle rate because
it is the minimum required rate of return of this project.

Some projects are riskier, like developing new products or expanding the business into
a whole new market. There are a lot of uncertainties with the cash flows, so we need to
use a higher discount rate to adjust for the risk. Other projects are pretty safe, such as
renovating an existing facility. We should use a low discount rate for low-risk projects.
Suppose you believe the project is as risky as an investment in the stock market and
that the stock investment offers a 15% expected return.

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This time we change the discount rate from 8% to 15%, and when we change the
discount rate to 15% and the net present value will be changed automatically to around
$2,000. So, you can see that when the discount rate increases then the net present
value decreases a lot compared to our previous case. But the net present value is still
positive, meaning the project is still worthwhile to explore but is not as attractive as the
previous case.

A related concept to judge whether we should accept or reject the project is called the

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internal rate of return. Internal rate of return is the rate that makes a project's net
present value equals to zero.

Internal rate of return, IRR, can be thought of as a project's inherent growth rate. So IRR
is the discount rate that sets NPV to zero.

The decision rule of using IRR is to accept the project if the IRR is higher than the
required rate of return. This makes sense because it means that the return from this

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project is higher than the return from other available investment opportunities with the
same level of risk.

If there are multiple projects for you to choose from and you have to pick one, just pick
the one with the highest IRR. Solving for IRR manually is very tedious, but it's pretty
easy to solve the equation using Excel spreadsheet.

Let's use the previous example and solve for the projects IRR. So in this Excel

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spreadsheet let's use the previous example and solve for the projects internal rate of
return. And in this example, we list all the cash flows in the second column and we list
the time in the first column. And in order to calculate the internal rate of return, we just
use the function, internal rate of return, and then followed by all the cash flows from the
beginning to the end. And then this is the internal rate of return. So, internal rate of
return 16% is higher than the discount rate. So, we can argue that this project is a good
one and we need to go ahead with the project. Normally, the decision you made using
IRR will be the same as using the net present value. Just like in this example, both
methods are very popular among financial managers.

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Lesson 4-3.2. APR and EAR

In previous lessons, we assume that the interest is compounded yearly. But in reality,
this may not be the case. Suppose you buy a certificate of deposit from a bank. The
interest payment may occur daily, monthly, or semi-annually depending on which bank
you choose. Some banks pay continuously the compounded interest rate, which means
you earn interest at every moment.

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Let's take a look at some real-world examples and see how to deal with the
compounding frequency problem. When we apply for credit cards, there's a very
important term for us to consider, which is called the annual percentage rate, APR. Here
are some example quotes used by different credit cards.

The APR is the rate of the loan based on a person's credit history. If you have an
excellent credit score, you may get a 10 percent APR. For a person with a bad credit
score, the credit card company may charge a 25 percent APR. APR is the rate that a

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bank is required to quote on the loan it offers to borrowers. APR is a simple interest rate
without considering compounding that equals the periodic interest rate times the
number of compounding periods in a year.

How do you understand APR? Suppose you have just applied for a new credit card and
the APR is 15 percent compounded monthly, we want to investigate how much you
need to pay back one year later if you borrow $1,000 now. You cannot use $1,000 times
1 plus 15 percent and say, the final repayment is $1,150 because the APR is not
compounded annually.

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First, we need to divide 15 percent by 12 to get the monthly interest rate and then let the
$1,000 compound at that monthly rate for 12 times a year. The end of the year payment
should be $1,160.75.

In general, the end of year value can be expressed as the present value times 1 plus
the annual percentage rate, r, divided by compounding periods, m, and to the power of
m times the number of years, T.

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Let's take a look at how to use the formula to compare different loan options. Suppose
you want to apply for a three-year loan and there are three options from different
financial institutions, the first offers you an 18 percent APR compounded daily, while the
second offers you an APR of 18 percent compounded monthly, and the third offers an
APR of 18.5 percent compounded semi-annually.

Which one is the best choice for you? From the appearance, the first one and the
second one have exactly the same APR, but they are compounded differently. The third

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choice charges you a higher APR but the compounding frequency is low. Let's work on
the numbers. The first choice is 18 percent compounded daily, so you need to use 18
percent divided by 365 to get the daily interest rate and compound for each day within
three years. If you take out $100,000 loan, the ending value you need to pay back is
$171,578. As you repeat the process for option 2 and option 3, you will find that the third
choice is the cheapest option because you just need to pay back $170,031.

The lesson from this example is that you need to care about the APR as well as
compounding frequency when you take out a loan. The compounding frequency can
also make a big difference. The higher the compounding frequency, the more interest
you need to pay. That's bad news for a person who wants to borrow money, but for an
investor who wants to make investments, a higher compounding frequency is great
news because they can earn interests more frequently and their ending value will be
higher. APR is an interest rate without considering compounding. It is not convenient for
us to compare different APR offers directly. In real life, we are also interested in the real
rate of return on investment considering the effect of company interests. The concept is
called the effective annual rate, EAR, also called the effective annual yield, EAY, or
annual percentage yield, APY. Based on the EAR, we can calculate the end of the
investment values directly. The major difference between the APR and the EAR is
whether they consider compounding or not.

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If we were given the value of APR, we can convert it into EAR using the equation like
this. EAR equals to one plus the annual percentage rate r divided by the compounding
frequency, m and to the power of m minus one.

Let's use the previous three offers to see what the corresponding EAR for each option
is. The first option, 18 percent APR compounded daily is equivalent to 19.72 percent
compounded annually. Eighteen percent compounded monthly is the same as 19.56
percent annual interest rate. The third option, 18.5 percent compounded semi-annually

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is the same as 19.36 percent compounded annually. Using the relationship, you can
convert any APR into EAR and vice versa. Using the EAR, you can compare the offers
directly because all of them are annualized interest rates. Since 19.36 percent is the
lowest EAR among these three options, this is the best choice for a borrower. From
lender's perspective, the first choice is the best one because it provides the highest
return. We learned that interests can be compounded annually, quarterly, monthly and
daily.

You may ask, what is the limit of compounding frequency? Actually, the compounding
frequency can go to infinity and this is called continuous compounding. Meaning that the
interest compounds every single instant. You can also think of this situation as interest
payments evenly spread out the whole year without stopping.

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The future value of an investment after T years can be expressed as the present value
times e to the power of stated interest rate, r, times T years. E is the base of natural log,
which equals to 2.71828.

Suppose you invest $10,000 in a certificate of deposit, CD, for three years. Here, I
would like to explain a little bit about the CD. A CD works like this. You deposit a certain
amount of money for a fixed term, such as one year, three years, or five years. The
bank offers you a higher interest rate than a regular savings account, but you are

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expected to hold it until maturity. If you want to withdraw it early, you are subject to a
penalty.

This CD pays 8 percent annual interest compounded continuously. So, what would be
the value of your investment at the end of year three?

We calculate the ending value by multiplying the initial investment in CD, $10,000 with e
to the power of eight percent times three years. The CD will grow to $12,712.49 at the

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end of three years. With all else equal, continuous compounding yields the highest
return if you compare it to all the other compounding intervals.

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Lesson 4-4: Perpetuity and Annuity

Lesson 4-4.1. Perpetuity

In this lesson, we will discuss some special patterns of cash flows. If cash flows follow a
special pattern, we can use shortcut formulas that will save us a lot of work. The first
one is called perpetuity. A perpetuity is a constant stream of cash flows that last forever.

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If you pay close attention to the cash flow, you will find that the cash flows are constant.
The time interval between two cash flows is equal, and the first cash flow occurs at time
one. These characteristics can help us to identify whether a stream of cash flows is
perpetuity or not.

If a stream is perpetuity, the present value of the cash flows can be written as the sum
of each cash flow discounted to the present. Notice all the cash flows are future values.
And there's no cash flow at time zero. There are infinite terms in this geometric series.

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But the good news is that the sum is a finite number, which equals to the cash flow C
divided by interest rate r. Here, we also assume the discount rate is constant throughout
time.

To understand the meaning of this shortcut, imagine that you deposit $100 in a bank at
an interest rate of 8 percent. At the end of year 1, you will have $108 in your bank
account. You then withdraw eight dollars and reinvest the remaining $100 for another
year. At the end of each following year, you withdraw the same amount of money of
eight dollars and reinvest $100. You just create a perpetuity all by yourself. In this
example, the cash flow is eight dollars and the interest rate is 8 percent, then the
present value of all cash flows is just $100.

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To generalize the relation, suppose you deposit a fixed amount of money, c over r, in a
bank. Then the interest payment in each period will be this amount of money times the
interest rate r, which is just the amount of cash flow C.

A real-world example of a financial instrument with perpetual cash flows is the British
issued bonds called consol bonds. By investing in the consols, an investor is entitled to
receive annual interest payments from the British government forever. Investors are

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interested in perpetual bonds because they provide a steady and reliable cash flow on a
regular schedule.

Now, we want to see how to value a consol bond. Suppose the British government
issue the consol bonds that pay 50 pounds of interests each year forever with an
appropriate discount rate of 3.5 percent. What would it be the price of the consol bond?

To solve the price of the consol bond, let's use the cash flow amount, which is 50

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pounds, divided by the appropriate discount rate of 3.5 percent and derived the value,
which is 1,429 pounds.

Sometimes the cash flows of perpetuity are not all fixed. The increase at a constant rate
with time, we call this pattern of growing perpetuity.

The basic valuation rule is also the sum of all the present value of cash flows. There are

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an infinite number of cash flows in the future. But fortunately, we have a shortcut
formula for growing perpetuity.

Suppose the cash flow is C at time one that increases at a constant growth rate g, with
the appropriate discount rate r. The present value of the growing perpetuity can be
expressed as C divided by r minus g. To use the growing perpetuity formula, you have
to make sure that the discount rate is higher than the growth rate. Otherwise, the
formula will not make any sense.

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Let's look at an example of how to work with growing perpetuity. Suppose there is a
mature firm that expects to generate $1.5 million of cash flow next year, and the cash
flows are expected to grow at a rate of 5 percent each year forever. If we adopt a
discount rate of 10 percent, what is the value of this firm?

First, let's use a timeline to show the future cash flows of the firm. The first cash flow,
$1.5 million, occurs at the end of year 1. Year 2 cash flow is $1.5 million times 1 plus
the growth rate 5 percent. And the third-year cash flow is $1.5 million times 1 plus 5

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percent to the power of two, so on and so forth until infinity. We can tell that the cash
flows are growing perpetuities.

Let's use the growing perpetuity formula and then plug in the numbers. The first cash
flow, $1.5 million, divided by the discount rate, 10 percent, subtracted by 5 percent
growth rate gives us the firm value of $30 million. We can use this number as a ballpark
estimate of the value of a business. In reality, there are a lot of uncertainties we should
be aware of. For example, the next year's cash flow may not be $1.5 million. The
discount rate and growth rate may change over time and the company may not last
forever. This exercise is still helpful because some numbers are better than no number.
At least we will get a rough idea about the value of a business.

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Lesson 4-4.2. Annuity

In this lesson, let me introduce you to a new special pattern of cash flows called
annuities. An annuity is a stream of cash flows that last for a given number of periods.

This is a timeline that shows the cash flows of an annuity. We can tell that it looks a lot
like perpetuity. The only difference between the perpetuity and annuity is whether the
cash flow will stop at some point or not.

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To derive the present value of an annuity, let's start from what we have learned before.
We can see the annuity as the difference between two perpetuities. The first one,
perpetuity A is an ordinary perpetuity that starts at time one. Another one, perpetuity B
is a perpetuity that starts at time t + 1. We can also call it a delayed perpetuity. If we can
get the present value of these two perpetuities, the annuity can be valued.

The present value of perpetuity A is just the C over r. Let me explain how to deal with
perpetuity B.

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If we divide C by r, we get the value of perpetuity B at time t. We need to go one step

further to convert this value to the present value by dividing it by 1 plus r to the power of
t.

Since both of them are expressed as today's dollars, we can calculate the difference of
perpetuity A and perpetuity B and get the result for the present value of the annuity.

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The annuity formula can also be simplified into this equation. The first part is the
periodic payment C and the second part in the parenthesis is called the annuity factor.
Let's use an example to understand how annuity works.

Suppose you are looking to buy a car and applying for auto loans from your local bank.
Based on your excellent credit score, the local bank charges you an APR of 3.6 percent
compounded monthly.

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According to your income, the maximum amount you can pay is $600 per month for
three years and the payment is scheduled at the end of each month. In this case,
there's no need for a down payment. How much is the car that you can afford? The
stream of payment is an annuity.

One small thing we need to do first is to convert the APR or 3.6 percent into a monthly
interest rate of 0.3 percent. The monthly payment of $600 is the periodic cash flow. And
there are 36 payments in total because you need to pay 12 times a year for three years.

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By plugging in these values into the annuity formula, we do get the maximum cost of the
car as $20,445.

If you feel this is too much math for you, you can also try to solve the question using
Excel spreadsheet. In this example, you need to enter three values in the Excel
spreadsheet. The first one is the discount rate and for the discount rate, we need to use
the APR which is 0.036 divided by 12 months so that we can get the monthly discount
rate. So, the monthly discount rate is 0.3 percent. And the next column is the number of
periods. For the number of periods, we need to use 12 times 3 years, so the total
number of periods equals to 36. For the periodic payment, we use minus 600 because
for each month we need to pay $600. So, we have three arguments over here and using
these three arguments we can calculate the present value. And in order to calculate the
present value, we use an Excel function PV, so equals to the present value. The first
argument is the monthly discount rate and the second argument is the number of
periods of payments. And the third argument is the periodic payment and then
parenthesis, so our present value equals to $20,445. And you will find out that this value
is exactly the same as the present value of annuity we calculated before.

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Another application of annuity is to calculate the periodic payment if we know the

present value of an annuity. Let's look at this example. Suppose you would like to buy a
house that costs $350,000. You plan to make a 20 percent down payment using your
savings and take out a 30-year fixed-rate mortgage to finance the remaining part. Your
local bank charges you an APR of 4.5%, compounded monthly. How much should you
pay each month?

To solve this question, we first use the APR, 4.5% divided by 12, to determine the

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monthly interest rate, 0.375%. Then we computed the total amount of the loan, which is
80% of the house price, because you have already paid 20% as down payments.

Then we set up the annuity equation. The left-hand side is the amount of the loan,
$280,000, and the right-hand side is the annuity formula with all the numbers plugged
in. The only unknown in this equation is the monthly payment. Solving this equation, we
get the monthly payment of $1,419.

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An alternative way to solve this equation is to use an Excel spreadsheet. In this Excel
spreadsheet, we need three inputs. The first one is the monthly interest rate. Because
we have the APR over here, we need to use the APR 0.045 divided by 12 to get the
monthly interest rate. So, the discount rate equals to 0.375%. And for the number of
periods, we use 12 times 30 because there are 12 months and 30 years. So, the total
number of payments equals to 360. And the present value equals to the total value of
the house, $350,000, times 80%. The total amount of the loan equals to $280,000. And
in order to calculate the periodic payment, we use a function. So, this is our financial
function in Excel called PMT. So, using the PMT function, the first argument is the
discount rate, the monthly rate, and the second argument is the number of periods 360,
and then followed by the present value, $280,000. And then we put parenthesis over
here. So, we got a periodic payment equals to $1,419. So, remember, this is a negative
value because this is a cash outflow. And you will find out that the monthly payment
result matches our previous results.

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Now, let's talk about the growing annuity. A growing annuity looks just like growing
perpetuity, but with an ending point.

Suppose the initial cash flow at time one, is C. The cashflow grows at a constant growth
rate g. And the appropriate discount rate is r. To value the growing annuity, we discount
each cash flow to the present and then sum them up. The formula can be simplified like
this. If you want to understand it better, try to prove this formula yourself. You will need
to create two growing perpetuities. One start at time one, and the other start at time t

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Professor Yang Xi
plus one. The difference between the present value of two growing perpetuities is just
the value here.

Let's see an example of a growing annuity. Suppose you get a job offer and the starting
salary is $100,000 a year, paid at the end of each year. The salary is expected to rise
by a constant rate of 3% each year, and you are going to work for 40 years. What is the
present value of this job offer if the discount rate is 8%?

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To evaluate the job offer, we need to collect all the inputs from the question. The initial
cash flow at time one is $100,000. The growth rate is 3%, discount rate 8% and the time
horizon 40 years.

By plugging in these values into the growing annuity, we gain the present value of this
job offer as around $1.7 million. When you have multiple job offers, you can use this
method to compare them and decide which one is more attractive financially. Of course,
salary is not the only thing you need to consider. You'll also need to think about the one

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that provides more opportunities for your future growth and the one that helps to
achieve your career goals.

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Lesson 4-5 Module 4 Wrap Up

Lesson 4-5.1. Module 4 Wrap Up

In this module, we learn what time value of money is. First, we introduce two basic
concepts, present value and future value. For any cash flows, you should be able to
convert it from the present value to the future value, and vice versa. This is the basic
skill we need to master before we do any tricks.

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Based on that, we learn the net present value or project should be accepted if its net
present value is positive because it creates value for shareholders. Otherwise, we reject
the project.

An alternative criterion to judge a project is the internal rate of return. It is the return that
equates the cash inflows and cash outflows. If the internal rate of return is higher than
the opportunity cost of capital, then the investment has a positive net present value. The

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net present value and internal rate of return are basic tools for us to make financial
decisions.

We also learn the difference between the annual percentage rate and the effective
annual rate. The APR is the rate financial institutions quote. It is the rate without
considering compounding. The effective annual rate is the equivalent interest rate
compounded annually. For any APR, you need to know how to convert it to an EAR.

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The last part of the module is devoted to special patterns of cash flows, such as
perpetuity and annuity. We talked about how to identify a perpetuity, a growing
perpetuity, annuity and a growing annuity. How to compute the present values of these
cash flows, how to use the Excel spreadsheet to derive the values, and some real-world
examples. Overall, time value of money has wide applications in our daily life. You will
use time value of money when you apply for a credit card, apply for an auto loan, apply
for a mortgage, save for your child's college education, compare multiple job offers,
create your retirement plan, and make any investments. Whenever you make important
financial decisions in the future, I hope you can use what we have learned in this class
to make a better decision.

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