Chapter
Five
Introduction to
Valuation: The Time
Value of Money
© 2003 The McGraw-Hill Companies, Inc. All rights reserved.
5.1
Time Value of Money
 Time value of money: $1 received today is not
the same as $1 received in the future.
 How do we equate cash flows received or paid
at different points in time?
 Time value of money uses compounding of
interest (i.e., interest is reinvested and receives
interest).
5.2
Basic Definitions
 Present Value – earlier money on a time line
 Future Value – later money on a time line
 Interest rate – “exchange rate” between
money received today and money to be
received in the future




Discount rate
Cost of capital
Opportunity cost of capital
Required return
5.3
Future Value – Example 1 – 5.1
 Suppose you invest $1000 for one year at 5%
per year. What is the future value in one year?
The future value is determined by two
components:





Interest =
Principal = $1,000
Future Value (in one year) = principal + interest
Future Value (FV) =
Suppose you leave the money in for another year.
How much will you have two years from now?
 FV =
5.4
Future Value: 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 = FVIF= (1 + r)t
5.5
Effects of Compounding
 Simple interest – earn interest on principal only
 Compound interest – earn interest on principal and
reinvested interest
 Consider the previous example
 FV with simple interest =
 FV with compound interest =
 The extra $2.50 comes from the interest of 5%
earned on the $50 of interest paid in year one.
5.6
Calculator Keys
 Financial calculator function keys
 FV = future value (amount at which a cash flow or series
of cash flows will grow over a given period of time when
compounded at a given interest rate).
 PV = present value (value today of a cash flow or series
of cash flows)
 PMT = the periodic payment for an annuity or perpetuity
 I/Y = period interest rate
 Interest is entered as a percent, not a decimal
 N = number of interest periods in investment horizon,
number of times interest is paid
 Most calculators are similar in format
5.7
Future Value – Example 2
 Suppose you invest $1000 for 5 years at 5% interest. How
much will you have at the end of the five years?
 Formula Approach:
Calculator Approach:
PV
PMT
N
I/Y
FV
5.8
Future Value – Example 2 continued
 The effect of compounding is small for a small
number of periods, but increases as the number of
periods increases.
 For example, if were to invest $1,000 for five years at
5% simple interest, the future value would be $1,250
versus $1,276.28 when the interest is compounded
(see calculation on the previous page).
 The compounding effect makes a difference of
$26.28.
5.9
Future Value
 Note 1: The longer the investment horizon, the
greater the FV of a present amount.
 The reason for that is there is more interest
and interest on interest (compounded interest).
 FV is PV discounted at an appropriate rate
5.10
Future Value – Example 3
 Compounding over long periods of time makes a
huge difference
 Suppose you had a relative who deposited $10 at 5.5%
interest 200 years ago.
 How much would the investment be worth today?
 Formula Approach
Calculator Approach
PV
PMT
N
I/Y
FV
5.11
Future Value – Example 3 continued
 What is the effect of compounding?
 Using simple interest
FV  PV   PV  I  t 
 10  10 .055 200 
 $120
 Using compound interest
FV  PV 1  r 
 10 1.055 
t
200
 $447,189.84
5.12
Future Value as a General Growth Formula
 Suppose your company expects to increase unit sales of
widgets by 15% per year for the next 5 years. If you currently
sell 3 million widgets in one year, how many widgets do you
expect to sell in 5 years?
 Formula Approach
Calculator Approach
PV
PMT
N
I/Y
FV
units
5.13
Present Values – 5.2
 How much do I have to invest today to have some specified
amount in the future? Start with the formula for FV and
rearrange
FV  PV 1  r 
t
 Rearrange to solve for PV:
PV 
FV
1  r 
t
 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.
5.14
Present Value – 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?
 Formula Approach
Calculator Approach
FV
PMT
N
I/Y
PV
5.15
Present Value – Example 2
 You want to begin saving for you 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?
 Formula Approach
Calculator Approach
FV
PMT
N
I
PV
5.16
Present Value – 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?
 Formula Approach
Calculator Approach
FV
PMT
N
I/Y
PV
5.17
Present Value – Important Relationships
 For a given interest rate:
 The longer the time period, the lower the present value
 For a given time period
 The higher the interest rate, the smaller the present value
 What is the present value of $500
 To be received in 5 years? Discount rate 10% and 15%
FV=500, N=5, I/Y=10 » PV=
FV=500, N=5, I/Y=15 » PV=
 To be received in 10 years? Discount rate 10% and 15%
FV=500, N=10, I/Y=10 » PV=
FV=500, N=10, I/Y=15 » PV=
5.18
The Basic PV Equation - Refresher
FV  PV 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
 If you are using a financial calculator, the calculator
views cash inflows as positive numbers and cash
outflows as negative numbers.
 When solving for time (N) or rate (I/Y) using a
financial calculator, you must have both an inflow
(positive number) and an outflow (negative number),
or you will receive an error message
5.19
Discount Rate – 5.3
 We often want to know the implied interest rate for
an investment
 Rearrange the basic PV equation and solve for r
FV= PV  1+ r 
1
t
t
 FV 
r=
 -1
 PV 
5.20
Discount Rate – Example 1
 You are considering at an investment that will pay
$1200 in 5 years if you invest $1000 today. What is
the implied rate of interest?
 Formula Approach
Calculator Approach
PV
FV
PMT
N
I/Y
%
5.21
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?
 Formula Approach
Calculator Approach
FV
PV
PMT
N
I/Y
%
5.22
Discount Rate – Example 3
 Suppose you have a 1-year old son and you want to provide
$75,000 in 17 years towards 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?
 Formula Approach
Calculator Approach
FV
PV
PMT
N
I/Y
%
5.23
Finding the Number of Periods
 Start with basic equation and solve for t
FV = PV  1+ r 
t
FV
t
=  1+ r 
PV
 FV 
ln 
 = t.ln  1+ r 
 PV 
 FV 
ln 

PV

t= 
ln  1+ r 
5.24
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?
 Formula Approach
Calculator Approach
N
FV
PV
PMT
I/Y
years
5.25
Number of Periods – Example 2
 Suppose you want to buy a new house. You currently have
$15,000 and you figure you need to have a 10% down
payment. If the type of house you want costs about $20,000
and you can earn 7.5% per year, how long will it be before
you have enough money for the down payment?
 Formula Approach
Calculator Approach
N
FV
PV
PMT
I/Y
years
5.26
Table 5.4