Chapter 5

Introduction to
Valuation: The
Time Value of
Money

1
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills

• Be able to compute the future value of
an investment made today
• Be able to compute the present value
of cash to be received at some future
date
• Be able to compute the return on an
investment

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Chapter Outline
• Future Value and Compounding
• Present Value and Discounting
• More on Present and Future Values

3
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Why TIME?

Why is TIME such an important

element in your decision?

TIME allows you the opportunity to

postpone consumption and earn
INTEREST.
INTEREST
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Basic Definitions
• Present Value –
 The current value of future cash flows
discounted at the appropriate discount rate.
 earlier money on a time line
• Future Value –
 The amount an investment is worth after one
or more periods
 later money on a time line

5
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Basic patterns of Cash flows

1. Single Amount: A lump sum amount either
currently held or expected at some future
date.
2. Annuity: A level periodic stream of cash
flow
3. Mixed Streams: A stream of cash flows
that is not an annuity, a stream of unequal
periodic cash flows with no particular
pattern.
© 2012 Pearson 5-6
Prentice Hall. All rights
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• Interest rate – “exchange rate” between

earlier money and later money
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return

7
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• Time lines are used to illustrate these

relationships. A horizontal line on which time
zero appears at the left most end and future
periods are marked from left to right, can be
used to depict investment cash flows.

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Future Values
• Suppose you invest $1,000 for one year at
5% per year. What is the future value in one
year?
– Interest = $1,000(.05) = $50
– Value in one year = principal + interest =
$1,000 + 50 = $1,050
– Future Value (FV) = $1,000(1 + .05) = $1,050
• Suppose you leave the money in for another
year. How much will you have two years from
now?
 FV = $1,000(1.05)(1.05) = $1,000(1.05)2 =
$1,102.50
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Future Values: General Formula

• FV = PV(1 + r)t
– FV = future value
– PV = present value
– r = period interest rate, expressed as a
decimal
– T = number of periods
• Future value interest factor = (1 + r)t
• OR FVIF ( for Table)
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Effects of Compounding
• Simple interest (interest is earned only on
the original principal)
• Compound interest (interest is earned on
principal and on interest received)
• Consider the previous example
– FV with simple interest = $1,000 + 50 + 50 =
$1,100
– FV with compound interest = $1,102.50
– The extra $2.50 comes from the interest of .
05($50) = $2.50 earned on the first interest
payment
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Figure 4.1

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Future Values – Example 2

• Suppose you invest the $1,000 from the
previous example for 5 years. How much
would you have?
 FV = $1,000(1.05)5 = $1,276.28
• The effect of compounding is small for a
small number of periods, but increases as
the number of periods increases. (Simple
interest would have a future value of $1,250,
for a difference of $26.28.)

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Future Values – Example 3

• Suppose you had a relative deposit $10 at
5.5% interest 200 years ago. How much
would the investment be worth today?
– FV = $10(1.055)200 = $447,189.84
• What is the effect of compounding?
– Simple interest = $10 + $10(200)(.055) = $120
– Compounding added $447,069.84 to the value of
the investment

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Present Values
• How much do I have to invest today to have
some amount in the future?
 FV = PV(1 + r)t
 Rearrange to solve for PV = FV / (1 + r)t
 (1 + r)t or PVIF present value interest Factor
(Table)
• When we talk about discounting, we mean finding
the present value of some future amount.
• When we talk about the “value” of something, we
are talking about the present value unless we
specifically indicate that we want the future value.

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PV – One-Period Example
• Suppose you need $10,000 in one year for
the down payment on a new car. If you can
earn 7% annually, how much do you need to
invest today?
• PV = $10,000 / (1.07)1 = $9,345.79

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Present Values – Example 2

• You want to begin saving for your
daughter’s college education and you
estimate that she will need $150,000 in
17 years. If you feel confident that you
can earn 8% per year, how much do
you need to invest today?
 PV = $150,000 / (1.08)17 = $40,540.34

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Present Values – Example 3

 Your parents set up a trust fund for you
10 years ago that is now worth
$19,671.51. If the fund earned 7% per
year, how much did your parents
invest?
 PV = $19,671.51 / (1.07)10 = $10,000

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Present value:
Important relationship I
For a given interest rate:
– The longer the time period,
the lower the present value.
FV
PV 
(1  r ) t

For a given r, as t increases, PV decreases.

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Present value:
Important relationship II
For a given time period:
– The higher the interest rate,
the smaller the present value.
FV
PV 
(1  r ) t

For a given t, as r increases, PV decreases.

Copyright  2011 McGraw-Hill Australia Pty Ltd
PPTs t/a Essentials of Corporate Finance 2e by Ross et al. 4-20
Slides prepared by David E. Allen and Abhay K. Singh
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Single-Period PV

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?
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The Basic PV Equation -

Refresher
• PV = FV / (1 + r)t
• There are four parts to this equation
– PV, FV, r, and t
– If we know any three, we can solve for the
fourth

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Discount Rate
• Often, we will want to know what the
implied interest rate is in an investment
• Rearrange the basic PV equation and
solve for r
 FV = PV(1 + r)t
 r = (FV / PV)1/t – 1
• If you are using formulas, you will want
to make use of both the yx and the 1/x
keys
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Discount Rate – Example 1

• You are looking at an investment that will pay
$1,200 in 5 years if you invest $1,000 today.
What is the implied rate of interest?
 r = ($1,200 / $1,000)1/5 – 1 = .03714 = 3.714%

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Discount Rate – Example 2

• Suppose you are offered an investment
that will allow you to double your
money in 6 years. You have $10,000
to invest. What is the implied rate of
interest?
 r = ($20,000 / $10,000)1/6 – 1 = .122462 =
12.25%

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Discount Rate – Example 3

• Suppose you have a 1-year old son
and you want to provide $75,000 in 17
years toward his college education.
You currently have $5,000 to invest.
What interest rate must you earn to
have the $75,000 when you need it?
 r = ($75,000 / $5,000)1/17 – 1 = .172686 =
17.27%

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Finding the Number of Periods

• Start with basic equation and solve for t
(remember your logs)
 FV = PV(1 + r)t
 t = ln(FV / PV) / ln(1 + r)

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Number of Periods – Example 1

• You want to purchase a new car and
you are willing to pay $20,000. If you
can invest at 10% per year and you
currently have $15,000, how long will it
be before you have enough money to
pay cash for the car?
 t = ln($20,000 / $15,000) / ln(1.1) = 3.02
years

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Saving Up
You would like to buy a new
automobile. You have $50,000 or so,
but the car costs $68,500.
•If you can earn 9%, how much do
you have to invest today to buy the
car in two years?
•Do you have enough?
•Assume the price will stay the same.
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Evaluating Investments
To give you an idea of how we will be
using present and future values,
considering the following simple
investment. Your company proposes to
buy an asset for $335. This investment
is very safe. You would sell off the
asset in three years for $400. You know
you could invest the $335 elsewhere at
10% with very little risk. What do you
think of the proposed investment?
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Saving for College

You estimate that you will need about

$80,000 to send your child to school
college in eight years. You have about
$35,000 now.
•If you can earn 20% per year, will you
make it?
• At what rate will you just reach your goal?
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Only 18,262.5 Days to

Retirement

You would like to retire in 50 years as a

millionaire. If you have $10,000 today,
what rate of return do you need to earn
to achieve your goal?
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Valuing level cash flows

Annuities and perpetuities
• Annuity—finite series of equal payments
that occur at regular intervals
– If the first payment occurs at the end of the
period, it is called an ordinary annuity
– If the first payment occurs at the beginning of
the period, it is called an annuity due
• Perpetuity—infinite series of equal
payments

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Annuities and perpetuities

Basic formulas
• Perpetuity: PV = C/r
• Annuities:
 1 
1  
(1  r ) t
PV  C  
 r 

 

 (1  r ) t  1 
FV  C  
 r 

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Examples of Annuities

• Student Loan Payments

• Car Loan Payments
• Insurance Premiums
• Mortgage Payments
• Retirement Savings
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Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today
Equal Cash Flows
Each 1 Period Apart
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Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
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Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
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Valuation Using Table III

FVAn = R (FVIFAi%,n)
FVA3 = $1,000 (FVIFA7%,3)
= $1,000 (3.215) = $3,215
Period 6% 7% 8%
1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
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Example of an
Ordinary Annuity -- PVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$934.58
$873.44
$816.30
$2,624.32 = PVA3 PVA3 = $1,000/(1.07)1 +
$1,000/(1.07)2 +
$1,000/(1.07)3
= $934.58 + $873.44 + $816.30
= $2,624.32
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Valuation Using Table IV

PVAn = R (PVIFAi%,n)
PVA3 = $1,000 (PVIFA7%,3)
= $1,000 (2.624) = $2,624
Period 6% 7% 8%
1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
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Annuity
Example 5.5
• You can afford $632
per month.
 1 
• Going rate =  1  
(1.01)48
PV  632    23,999.54
1%/month for 48  .01 
months.  
• How much can you
borrow?
• You borrow money
TODAY so you
need to compute
the present value.
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Annuity—Sweepstakes example
• Suppose you win the Publishers
Clearinghouse $10 million. The money is
paid in equal annual instalments of $333
333.33 over 30 years. If the appropriate
discount rate is 5%, how much is the
sweepstakes actually worth today?
– PV = 333 333.33[1 – 1/1.0530] / .05 =
$5 124 150.29

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Quick quiz: Part 1

• You know the payment amount for a loan
and you want to know how much was
borrowed.
– Do you compute a present value or a future
value?

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Finding the number of payments

• $1000 is due on a credit card
• Payment = $20 month minimum
• Rate = 1.5% per month
– How long would it take to pay off the $1000?
– Formula solution:
• 1000 = 20(1 – 1/1.015t) / .015
• .75 = 1 – 1 / 1.015t
• 1 / 1.015t = .25
• 1 / .25 = 1.015t
• t = ln(1/.25) / ln(1.015) = 93.111 months = 7.75 years

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Finding the number of payments—

Another example
• Suppose you borrow $2,000 at 5% and
you are going to make annual payments of
$734.42. How long before you pay off the
loan?
– 2000 = 734.42(1 – 1/1.05t) / .05
– .136161869 = 1 – 1/1.05t
– 1/1.05t = .863838131
– 1.157624287 = 1.05t
– t = ln(1.157624287)/ln(1.05) = 3 years
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Solving for r
• Suppose you borrow $1,000 and loan
arrangement requires you to pay $282 per
year for the next 4 [Link] the payment
made at the end of each year, what
interest rate are you paying on the loan?
• Ans r=5%

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Annuity due
• An annuity for which the cash flows occur at the
beginning of the period.
• You are saving for a new house and you put $10 000 per
year in an account paying 8%. The first payment is made
today. How much will you have at the end of 3 years?

 (1  r )t  1
FVAD  PMT   (1  r )
 r 
 (1.08) 3  1
FVAD  10000  (1.08)  35,061.12
 .08 

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Annuity due formula

49
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Perpetuities—
Example 5.7
• An annuity in which the cash flows continue
forever.
• Perpetuity formula: PV = C / r
• If $100 receives each year forever and
interest rate is 8% pv of perpetuity?
• Ans:$1,250.

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Quick quiz
• You are considering preferred stock that
pays a quarterly dividend of $1.50. If your
desired return is 3% per quarter, how
much would you be willing to pay?
– $1.50/0.03 = $50

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PV OF UNEVEN CASH FLOWS

Mixed Streams
Pattern of Unequal periodic cash flows that reflect no particular pattern.

3-52
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FV OF UNEVEN CASH FLOWS

3-53
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“Piece-At-A-Time”

0 1 2 3 4 5

10%
$600 $600 $400 $400 $100
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV0 of the Mixed Flow
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“Group-At-A-Time” (#1)
0 1 2 3 4 5
10%
$600 $600 $400 $400 $100
$1,041.60
$ 573.57
$ 62.10

$1,677.27 = PV0 of Mixed Flow [Using Tables]

$600(PVIFA10%,2) = $600(1.736) = $1,041.60

$400(PVIFA10%,2)(PVIF10%,2) = $400(1.736)(0.826) = $573.57
$100 (PVIF10%,5) = $100 (0.621) = $62.10
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Steps
Steps to
to Solve
Solve Time
Time Value
Value
of
of Money
Money Problems
Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single
CF, annuity stream(s), or mixed flow
6. Solve the problem
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Frequency
Frequency of
of
Compounding
Compounding
General Formula:
FVn = PV0(1 + [r/m])mn
n: Number of Years
m: Compounding Periods per Year i:
Annual Interest Rate FVn,m:
FV at the end of Year n
PV0: PV of the Cash Flow today
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Impact
Impact of
of Frequency
Frequency
Julie Miller has $1,000 to invest for 2 Years
at an annual interest rate of 12%.
Annual FV2 = 1,000(1
1,000 + [0.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1
1,000 + [0.12/2])(2)(2)
= 1,262.48
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Impact
Impact of
of Frequency
Frequency
Qrtly FV2 = 1,000(1
1,000 + [0.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1
1,000 + [0.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1
1,000 + [0.12/365])(365)(2)
= 1,271.20
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Continuous Compounding
With continuous compounding the number
of compounding periods per year approaches infinity.
Through the use of calculus, the equation thus becomes:

FVn (continuous compounding) = PV x (ekxn)

where “e” has a value of 2.7183

 Continuing with the previous example, find the future value of the
$100 deposit after 5 years if interest is compounded continuously.

FVn = 100 x (2.7183).12x5 = $182.22

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Computing payments with APRs

• Suppose you want to buy a new computer system and
the store is willing to allow you to make monthly
payments. The entire computer system costs $3500. The
loan period is for 2 years and the interest rate is 16.9%,
with monthly compounding. What is your monthly
payment?

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Future values
with monthly compounding
• Suppose you deposit $50 a month into an
account that has an interest rate of 9%,
based on monthly compounding. How
much will you have in the account in 35
years?

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Present value with daily compounding

• You need $15 ,000 in 3 years for a new car. If

you can deposit money into an account that
pays an interest rate of 5.5% based on daily
compounding, how much would you need to
deposit?

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Effective annual rate (EAR)

• This is the actual rate paid (or received)
after accounting for compounding that
occurs during the year.
• If you want to compare two alternative
investments with different compounding
periods, you need to compute the EAR
and use that for comparison.

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Annual percentage rate (APR)

• This is the annual rate that is quoted by
law.
• By definition APR = period rate times the
number of periods per year.
• So, to get the period rate we rearrange the
APR equation:
– Period rate = APR/number of periods per year
• You should NEVER divide the effective
rate by the number of periods per year—it
will NOT give you the period rate.
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Computing APRs
• What is the APR if the monthly rate is .5%?
– .5(12) = 6%
• What is the APR if the semi-annual rate is .5%?
– .5(2) = 1%
• What is the monthly rate if the APR is 12%, with
monthly compounding?
– 12 / 12 = 1%
– Can you divide the above APR by 2 to get the semi-
annual rate? NO!!! You need an APR based on semi-
annual compounding to find the semi-annual rate.

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Things to remember
• You ALWAYS need to make sure that the
interest rate and the time period match:
– If you are looking at annual periods, you need an
annual rate.
– If you are looking at monthly periods, you need a
monthly rate.
• If you have an APR based on monthly
compounding, you have to use monthly
periods for lump sums, or adjust the interest
rate appropriately if you have payments other
than monthly.

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EAR formula
m
 APR 
EAR  1   1
 m 
• APR = the quoted rate
• m = number of compounds per year

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Decisions, decisions… II
• Which savings accounts should you
choose:
– 5.25%, with daily compounding
– 5.30%, with semiannual compounding
• First account:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
• Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%

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Decisions, decisions… II (cont.)

• Let’s verify the choice. Suppose you invest
$100 in each account. How much will you
have in each account in one year?
– First account:
• Daily rate = .0525 / 365 = .00014383562
• FV = 100(1.00014383562)365 = $105.39
– Second account:
• Semiannual rate = .0539 / 2 = .0265
• FV = 100(1.0265)2 = $105.37
• You will have more money in the first account.

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Computing APRs from EARs

• If you have an effective rate, how can
you compute the APR? Rearrange the
EAR equation and you get:


APR  m (1  EAR)
1
m
-1
 
m = number of compounding periods per year

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APR—Example
• Suppose you want to earn an effective rate of
12% and you are looking at an account that
compounds on a monthly basis. What APR
must they pay?
 
APR  12 (1  .12)1/ 12  1  .113 8655 or 11.39%

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Why is it important to consider effective rates

of return?

• See how the effective return varies between

investments with the same nominal rate, but
different compounding intervals.

EARANNUAL 10.00%
EARSEMIANNUALLY 10.25%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%

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• EAR with continuous compounding

• EAR=e^r-1

74
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Steps
Steps to
to Amortizing
Amortizing aa Loan
Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t – 1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step 3)
5. Start again at Step 2 and repeat.
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Amortised loan with fixed payment—

Example
• Each payment covers the interest expense
plus reduces principal.
• Consider a 5-year loan with annual
payments. The interest rate is 9% and the
principal amount is $5000.
– What is the annual payment?
• 5000 = PMT[1 – 1 / 1.095] / .09 PMT = 1285.46

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Amortised loan with fixed payment Example:

Amortisation table

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Usefulness of Amortization
1. Determine Interest Expense – Interest
expenses may reduce taxable income
of the firm.
2. Calculate Debt Outstanding – The
quantity of outstanding debt may be
used in financing the day-to-day
activities of the firm.