LEARNING OBJECTIVES

• Determine the future value of an investment made

today.
• Determine the present value of cash to be received at a
future date.
• Find the return on an investment.
CHAPTER 5 • Calculate how long it takes for an investment to reach a
I N T R O D U C T I O N TO VA L U AT I O N : desired value.
THE TIME VALUE OF MONEY

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CHAPTER OUTLINE INTRODUCTION

• Future Value and Compounding. • One of the basic problems faced by the financial manager is
how to determine the value today of cash flows expected in
• Present Value and Discounting.
the future.
• More about Present and Future Values. • 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.

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 INVESTING FOR MORE THAN ONE
FUTURE VALUE AND COMPOUNDING
PERIOD
Future value refers to the amount an investment is worth after one or more Going back to our $100 investment, what will you have after two
periods. years, assuming the interest rate doesn’t change?
• The simplest case is a single-period investment.
• $110 x .10 = $11 in interest during the second year.
Suppose you invest $100 in a savings account that pays 10% interest per year. • Total = $110 + 11 = $121.
How much will you have in one year?
• $121 is the future value of $100 in two years at 10%.
In general, if you invest for one period at an interest rate of r, your investment
will grow to (1 + r) per dollar invested Compounding is the process of accumulating interest on an investment
• r = 10%. over time to earn more interest.
• 1 + .10 = 1.1 dollars per dollar invested. • Compounding the interest means earning interest on interest, so
• $100 x 1.1 = $110. we call the result compound interest.
• With simple interest, interest is earned only on the original principal
amount invested.
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FUTURE VALUE OF $100 AT 10

FUTURE VALUE: GENERAL FORMULA
PERCENT
• The future value of $1 invested for t periods at a rate of r per
Year Beginning Simple Interest Compound Total Ending
period is this: Amount Interest Interest Amount
Future value  $1 1  r 
t Earned
1 $100.00 $10 $ .00 $11.05 $110.00
1 r 
t
• The expression is sometimes called the future value 2 110.00 10 1.00 11.00 121.00
3 121.00 10 2.10 12.10 133.10
Interest factor (or just future value factor) for $1 invested at r
4 133.10 10 3.31 13.31 146.41
percent for t periods and can be abbreviated FVIFr ,t 5 146.41 10 4.64 14.64 161.05
Total $50 $11.05 $61.05
• Going back to our $100 investment, what will you have after
five years, assuming the interest rate doesn’t change?
1  r   1  .105   1.15  1.6105
t

• Your $100 will thus grow to $100 × 1.6105 = $161.05

© McGraw Hill © McGraw Hill
3-7 3-8
 FUTURE VALUE FACTORS CALCULATOR KEYS
Future values depend critically on the assumed interest rate, particularly for long-lived Keys of particular interest:
investments
• FV = future value.
There are several different ways of doing this:
• PV = present value.
• In our example, we could have multiplied 1.1 by itself five times, but that approach gets very
tedious for, say, a 30-year investment. • I/Y = interest rate (That is, what we have been calling r).
• Calculators generally have a key labeled “yx”; you could enter 1.1, press this key, enter 5, and • N = number of periods (That is, what we have been calling t).
press the “=“ key to get the answer.
Things you need to do only once:
• You could also use a table that contains future value factors for some common interest rates
and time periods, such as the one below: • Make sure your calculator is set to display many decimal places.
• Set calculator to assume only one payment per period or per year.
Interest Rate
• Make sure your calculator is in “end” mode.
Number of Periods 5% 10% 15% 20%
1 1.0500 1.1000 1.1500 1.2000 Things you need to do every time you work a problem:
2 1.1025 1.2100 1.3225 1.4400 • Before you start, completely clear out the calculator.
3 1.1576 1.3310 1.5209 1.7280
• Put a negative sign on cash outflows.
4 1.2155 1.4641 1.7490 2.0736
• Enter the rate correctly (That is, percent form).
5 1.2763 1.6105 2.0114 2.4883

© McGraw Hill 3-9 © McGraw Hill 3-10

EFFECT OF COMPOUNDING 1 EFFECT OF COMPOUNDING 2

Compound Interest: After seven years, you will have:

You’ve located an investment that pays 12 percent per year. That rate $400  1.127  $400  2.2107  $884.27
sounds good to you, so you invest $400. How much will you have in
three years? How much will you have in seven years? At the end of Thus, you will more than double your money over seven [Link]
seven years, how much interest will you have earned? How much of you invested $400, the interest in the $884.27 future value is $884.27
that interest results from compounding? − 400 =$484.27. At 12 percent, your $400 investment earns $400 × .12
= $48 in simple interestevery year. Over seven years, the simple
Based on our discussion, we can calculate the future value factor for
interest thus totals 7 × $48 = $336. The other $484.27 − 336 = $148.27
12 percent and three years as follows:
is from compounding.
1  r   1.123  1.4049
t

Your $400 thus grows to:

$400 × 1.4049 = $561.97

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 PRESENT VALUE:
PRESENT VALUE AND DISCOUNTING
THE SINGLE-PERIOD CASE
Present value is the current value of future cash flows Single-Period PV
discounted at the appropriate discount rate. Suppose you need $400 to buy textbooks next year. You can earn 7 percent
Present value is the reverse of future value. on your [Link] much do you have to put up today?

• Instead of compounding the money forward into the future, We need to know the PV of $400 in one year at 7 percent. Proceeding as in
the previous
we discount it back to the present.
example:
• To discount is to calculate the present value of some future
amount. Present value × 1.07 = $400
We can now solve for the present value:
• Present value of $1 to be received in one period if generally
Present value = $400 × (1/1.07) = $373.83
given as follows:
Thus, $373.83 is the present value. Again, this means that investing this
PV=$1 1 1  r    $1 1  r  amount for one year at 7 percent will give you a future value of $400.

© McGraw Hill 3-13 © McGraw Hill 3-14

PRESENT VALUES FOR MULTIPLE PERIODS 1 PRESENT VALUES FOR MULTIPLE PERIODS 2

The present value of $1 to be received t periods into the future at a discount rate of r Suppose you need $1,000 in three years. You can earn 15% on your money. How
is: much do you have to invest today? (In other words, what is the present value of
$1,000 in three years at 15%?)
PV  $1  1 1  r    $1 1  r 
t t

  • We need to discount $1,000 back three periods at 15%

As the length of time until payment grows, present values decline.
Discount factor  1 1  .15   1 1.5209  .6575
3
•
• Present values and discount rates are inversely related
• PV = $1,000 x 0.6575 = $657.52
Quantity in brackets 1 1  r  ,
t
is often called a discount factor
How do we solve this on a financial calculator?
• Discount rate is the rate used to calculate the present value of future cash flows.
• N=3
1 1  r  ,
t
Quantity in brackets, is called the present value interest factor (or just • I/Y = 15
present value factor) for $1 at r percent for t periods and is sometimes abbreviated • FV = 1,000
PVIFr ,t
• slove for PV  657.52
Calculating the present value of a future cash flow to determine its worth today is
called discounted cash flow (DCF) valuation.
© McGraw Hill 3-15 © McGraw Hill 3-16
 MORE ABOUT PRESENT AND FUTURE
EVALUATING INVESTMENTS
VALUES
• The present value factor is the reciprocal of (That is, 1 divided by) the Evaluating Investments:
future value factor: To give you an idea of how we will be using present and future values, consider the following
simple investment. Your company proposes to buy an asset for $335. This investment is very
Future value factor  1  r 
t
safe. You would sell off the asset in three years for $400. You know you could invest the $335
elsewhere at 10 percent with very little risk. What do you think of the proposed investment?
Present value factor  1 1  r  This is not a good investment. Why not? Because you can invest the $335 elsewhere at 10
t
percent. If you do, after three years it will grow to:
$335  1  r   $335  1.13
t
• If we let FVt stand for the future value after t periods, the relationship
between future value and present value can be written as one of the  $335  1.331
following:  $445.89

PV  1  r   FVt Because the proposed investment pays out only $400, it is not as good as other [Link]
t
have. Another way of seeing the same thing is to notice that the present value of $400 in three
years at 10 percent is:
PV  FVt 1  r   FVt  1 1  r  
t t
  $400  1 1  r    $400 1.13  $400 1.331  $300.53
t
 
• The (final) result above is called the basic present value equation This tells us that we have to invest only about $300 to get $400 in three years, not $335. We will
return to this type of analysis later on.
© McGraw Hill 3-17 © McGraw Hill 3-18

FINDING R FOR A SINGLE-PERIOD

DETERMINING THE DISCOUNT RATE
INVESTMENT
• We often need to determine what discount rate is implicit in You are considering a one-year investment. If you put up $1,250, you will get back
$1,350. What rate is this investment paying?
an investment, and we can do so by looking at the basic
First, in this single-period case, the answer is fairly obvious. You are getting a total of
present value equation: $100 in addition to your $1,250. The implicit rate on this investment is thus
$100/$1,250 = .08, or 8%.

PV  FVt 1  r 
t
More formally, from the basic present value equation, the present value (the amount
you must put up today) is $1,250. The future value (what the present value grows to)
is $1,350. The time involved is one period, so we have:
There are only four parts to this equation: the present value
$1.250  $1.350 1  r 
1

(PV), the future value (FVt), the discount rate (r), and the life of
1  r  $1,350 $1, 250  1.08
the investment (t).
• Given any three of these, we can always find the fourth. • r = .08, or 8%
• In this simple case, of course, there was no need to go through this calculation. But
as we describe next, it gets a little harder with more than one period.
© McGraw Hill 3-19 © McGraw Hill 3-20
 DETERMINING THE DISCOUNT RATE: AN DETERMINING THE DISCOUNT RATE: AN
EXAMPLE 1 EXAMPLE 2

Assume we are offered an investment that costs us $100 and will double our 1. Use a financial calculator.
money in eight years. To compare this to other investments, we would like to • PV = -100, FV = 200, N = 8; Solve for I/Y = 9%
know what discount rate (That is, rate of return, or return) is implicit in these
numbers. 2. Solve the equation for 1 + r by taking the eighth root of both sides.

• Here, PV = $100, FV = $200 (double our money), and an 8-year life • Because this is the same thing as raising both sides to the power of ⅛ or

.125, this is easy to do with the " yx " key on a calculator.

To calculate the return, we can write the basic present value equation as:
x
• Just enter 2, then press "y " enter .125, and press the “=” key. The eighth
PV  FVt 1  r 
t

root should be about 1.09, which implies that r is 9%.

$100  $200 1  r 
8

3. Use a future value table.

It could also be written as: • The future value factor after eight years is equal to 2.
1  r   $200 $100  2
8
• If you look across the row corresponding to eight periods in Table A.1, you will see
that a future value factor of 2 corresponds to the 9% column, again implying that
We now need to solve for r, and there are three ways to do this the return here is 9%.
© McGraw Hill 3-21 © McGraw Hill 3-22

SOLVING FOR THE DISCOUNT RATE ONLY 18,262.5 DAYS TO RETIREMENT

In his will, Benjamin Franklin gave 1,000 pounds sterling to Massachusetts and the city of You would like to retire in 50 years as a millionaire. If you have
Boston. He gave a like amount to Pennsylvania and the city of Philadelphia. After some legal
wrangling, it was agreed that the money would be paid out in 1990, 200 years after Franklin’s $10,000 today, what rate of return do you need to earn to
death. achieve your goal?
• By that time, the Pennsylvania bequest had grown to about $2 million; the Massachusetts
bequest had grown to $4.5 million. The future value is $1,000,000. The present value is $10,000,
If 1,000 pounds sterling was equivalent to $1,000, what rate of return did the and there are 50 years until payment. We need to calculate the
two states earn? unknown discount rate in the following:
$10, 000  $1, 000, 000 1  r 
50
For Pennsylvania, FV = $2 million and PV = $1,000. There are 200 years
involved, so we need to solve for r in the following:
1  r   100
50

$1, 000  $2 million 1  r 

200

1  r   2, 000
200
The future value factor is thus 100. You can verify that the
N = 200, PV = -1,000, FV = 2,000,000; Solve for I/Y = 3.87 implicit rate is about 9.65 percent.
© McGraw Hill 3-23 © McGraw Hill 3-24
 FINDING THE NUMBER OF PERIODS WAITING FOR GODOT
Suppose we are interested in purchasing an asset that costs $50,000. We currently You’ve been saving up to buy the Godot Company. The total
have $25,000. If we can earn 12 percent on this $25,000, how long until we have the
$50,000? cost will be $10 million. You currently have about $2.3 million. If
We can again manipulate the basic present value equation to solve for the number of
you can earn 5 percent on your money, how long will you have
periods: to wait? At 16 percent, how long must you wait?
• PV = $25,000, FV = $50,000, and I/Y = 12% At 5 percent, you’ll have to wait a long time. From the basic
Basic equation takes one of the following forms: present value equation:
$25,000  $50,000 1.12t $2.3million  $10 million 1.05t
$50,000 $25,000  1.12t  2
1.05t  4.35
We have a future value factor of 2 for a 12 percent rate, so we now need to solve for t
• Per Table A.1, you will see that a future value factor of 1.9738 occurs at six periods; t = 30 years
it will thus take about six years
• At 16 percent, things are a little better. Verify for yourself that
To get an exact answer, we can use our financial calculator
it will take about 10 years.
• I/Y = 12, PV = -25,000, FV = 50,000; Solve for N = 6.1163
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3-25 3-26

SUMMARY OF TIME VALUE CALCULATIONS SUMMARY OF TIME VALUE CALCULATIONS

1 2

[Link]: IV. The Basic Present Value Equation Giving the Relationship between Present Value
• PV = Present value, what future cash flows are worth today. and Future Value:
• FVt = Future value, what cash flows are worth in the future.
PV  FVt 1  r 
t
• r = Interest rate, rate of return, or discount rate per period—typically, but not •
always, one year.
• t = Number of periods—typically, but not always, the number of years.
• C = Cash amount.
II. Future Value of C Invested at r Percent for t Periods:
FVt  C  1  r 
t
•

1  r 
t
• The term is called the present value factor.

III. Present Value of C to Be Received in t Periods at r Percent per Period:

PV  C 1  r 
t
•
• The term 1 1  r 
t
is called the present value factor.
© McGraw Hill 3-27 © McGraw Hill 3-28
 SELECTED CONCEPT QUESTIONS
• What do we mean by the future value of an investment?
• What does it mean to compound interest? How does
compound interest differ from simple interest?
• What do we mean by the present value of an investment?
• The process of discounting a future amount back to the
present is the opposite of doing what? END OF CHAPTER
• What is the basic present value equation?
CHAPTER 5

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