Chapter 5

Introduction to
Valuation: The Time
Value of Money

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin
 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
• Be able to compute the number of periods
that equates a present value and a future
value given an interest rate
• Be able to use a financial calculator and/or a
spreadsheet to solve time value of money
problems
5F-1
 Basic Definitions

• Present Value – earlier money on a time

line
• Future Value – later money on a time line
• Interest rate – “exchange rate” between
earlier money and later money
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return

5F-2
 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

5F-3
 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

5F-4
 Effects of Compounding
• Simple interest
• Compound interest
• 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

5F-5
 Calculator Keys
• Texas Instruments BA-II Plus
– FV = future value
– PV = present value
– I/Y = period interest rate
• P/Y must equal 1 for the I/Y to be the period rate
• Interest is entered as a percent, not a decimal
– N = number of periods
– Remember to clear the registers (CLR TVM) after
each problem
– Other calculators are similar in format

5F-6
 Future Values – Example 2
• Suppose you invest the $1,000 from the
previous example for 5 years. How much
would you have?

– FV = ????

5F-7
 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.)

5F-8
 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 + 200(10)(.055) = 120.00
– Compounding added $447,069.84 to the value
of the investment

5F-9
 Future Value as a General
Growth Formula
• Suppose your company expects to increase
unit sales of cars by 15% per year for the
next 5 years. If you currently sell 3 million
cars in one year, how many cars do you
expect to sell in 5 years?

– FV = 3,000,000(1.15)5 = 6,034,072

5F-10
 Quick Quiz – Part I

• What is the difference between simple

interest and compound interest?
• Suppose you have $500 to invest and you
believe that you can earn 8% per year
over the next 15 years.
– How much would you have at the end of 15
years using compound interest?
– How much would you have using simple
interest?

1586.08 & 1100

5F-11
 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
• 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.

5F-12
 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?
• PV = 10,000 / (1.07)1 = 9,345.79
• Calculator
– 1N
– 7 I/Y
– 10,000 FV
– CPT PV = -9,345.79

5F-13
 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?

5F-14
 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

5F-15
 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 = ?

5F-16
 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

5F-17
 Present Value –
Important Relationship I
• For a given interest rate – the longer the
time period, the lower the present value
– What is the present value of $500 to be
received in 5 years, 10 years, if the
discount rate is 10% ?
– 5 years: PV = 500 / (1.1)5 = 310.46
– 10 years: PV = 500 / (1.1)10 = 192.77

5F-18
 Present Value –
Important Relationship II

• For a given time period – the higher the

interest rate, the smaller the present value
– What is the present value of $500
received in 5 years if the interest rate is
10%? 15%?
• Rate = 10%: PV = 500 / (1.1)5 = 310.46
• Rate = 15%; PV = 500 / (1.15)5 = 248.59

5F-19
 Quick Quiz – Part II
• What is the relationship between present
value and future value?
• Suppose you need $15,000 in 3 years. If
you can earn 6% annually, how much do
you need to invest today?
• If you could invest the money at 8%,
would you have to invest more or less
than at 6%? How much?

5F-20
 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
• If you are using a financial calculator, be
sure to remember the sign convention or
you will receive an error (or a nonsense
answer) when solving for r or t .

5F-21
 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

5F-22
 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 return?

5F-23
 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 return?

– r = (1,200 / 1,000)1/5 – 1 = .03714 = 3.714%

– Calculator – the sign convention matters!
• N=5
• PV = -1,000 (you pay 1,000 today)
• FV = 1,200 (you receive 1,200 in 5 years)
• CPT I/Y = 3.714%

5F-24
 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 return?

5F-25
 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 return?

r = (20,000 / 10,000)1/6 – 1 = .122462

= 12.25%

5F-26
 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 rate
of return must you earn to have the
$75,000 when you need it?

5F-27
 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 rate
of return must you earn to have the
$75,000 when you need it?
– r = (75,000 / 5,000)1/17 – 1 = .172688
= 17.27%

5F-28
 Quick Quiz – Part III

• What are some situations in which you might

want to know the implied interest rate?
• You are offered the following investments:
– You can invest $500 today and receive $600 in 5 years.
The investment is considered low risk.
– You can invest the $500 in a bank account paying 4%.
– What is the implied interest rate for the first choice and
which investment should you choose?

5F-29
 Finding the Number of Periods

• Start with the basic equation and

solve for t (remember your logs)
– FV = PV(1 + r)t
– t = ln(FV / PV) / ln(1 + r)

• You can use the financial keys on the

calculator as well; just remember the sign
convention.

5F-30
 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?

5F-31
 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

5F-32
 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 plus an
additional 5% of the loan amount for closing
costs. Assume the type of house you want will
cost about $150,000 and you can earn 7.5%
per year, how long will it be before you have
enough money for the down payment and
closing costs?

5F-33
 Number of Periods – Example 2
Continued
• How much do you need to have in the future?
– Down payment = .1(150,000) = 15,000
– Closing costs = .05(150,000 – 15,000) = 6,750
– Total needed = 15,000 + 6,750 = 21,750

• Compute the number of periods

• Using the formula

– t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years

• Per a financial calculator:

– PV = -15,000, FV = 21,750, I/Y = 7.5, CPT N =
5.14 years

5F-34
 Quick Quiz – Part IV

• When might you want to compute the

number of periods?
• Suppose you want to buy some new
furniture for your family room. You
currently have $500, and the furniture
you want costs $600. If you can earn
6%, how long will you have to wait if
you don’t add any additional money?

5F-35
 Spreadsheet Example
• Use the following formulas for TVM calculations
– FV(rate,nper,pmt,pv)
– PV(rate,nper,pmt,fv)
– RATE(nper,pmt,pv,fv)
– NPER(rate,pmt,pv,fv)
• The formula icon is very useful when you can’t
remember the exact formula
• Click on the Excel icon to open a spreadsheet
containing four different examples.

5F-36
 Work the Web Example
• Many financial calculators are available
online
• Click on the web surfer to go to
Investopedia’s web site and work the
following example:
– You need $50,000 in 10 years. If you can earn
6% interest, how much do you need to invest
today?
– You should get $27,919.74

5F-37
Table 5.4

5F-38
End of Chapter

5F-39