Ch04 Show

Chapter 4
Time Value of Money
© 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Time Value Topics

 Future value
 Present value
 Rates of return
 Amortization
2
Determinants of Intrinsic Value:

The Present Value Equation
Net operating Required investments

−
profit after taxes in operating capital
Free cash flow

=
(FCF)
FCF1 FCF2 FCF∞

Value = + + ... +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞
Weighted average
cost of capital
(WACC)
Market interest rates Cost of debt Firm’s debt/equity mix
Market risk aversion Cost of equity Firm’s business risk

Ehrhardt Chapter 4 Page 1

Time lines show timing of cash
flows.
0 1 2 3
I%
CF0 CF1 CF2 CF3

Tick marks at ends of periods, so Time 0
is today; Time 1 is the end of Period 1; or
the beginning of Period 2.
4
Time line for a $100 lump sum

due at the end of Year 2.
0 1 2 Year
I%
100
5
Time line for an ordinary

annuity of $100 for 3 years
0 1 2 3
I%
100 100 100
6

Time line for uneven CFs
0 1 2 3
I%
-50 100 75 50
7
FV of an initial $100 after

3 years (I = 10%)
0 1 2 3
10%
100 FV = ?
Finding FVs (moving to the right

on a time line) is called compounding.
8
After 1 year
FV1 = PV + INT1 = PV + PV (I)

= PV(1 + I)
= $100(1.10)
= $110.00
9

After 2 years
FV2 = FV1(1+I)
= $110(1.10)
= $121.00
Or
FV2 = PV(1 + I)(1+I)
= PV(1+I)2
= $100(1.10)2
= $121.00
10
After 3 years
FV3 = FV2(1+I)
= $121.00(1.10)
= $133.10
Or
FV3 = FV2(1+I)=PV(1 + I)2(1+I)
= PV(1+I)3
= $100(1.10)3
= $133.10
11
Using the General Formula:

FVN = PV(1 + I)N
Generalizing the approach from

previous slides:
FVN = PV(1 + I)N

FV3 = $100(1.10)3
= $133.10
12

Four Ways to Find FVs
 Step-by-step approach using time line
(as shown in previous slides).
 Solve the equation with a regular
calculator (formula approach).
 Use a financial calculator.
 Use a spreadsheet.
13
Financial calculator: HP 10bII+

 Adjust display brightness: hold down
ON and push + or –.
 Set number of decimal places to
display: Orange Shift key, then DISP
key (in orange), then desired decimal
places (e.g., 3).
 To temporarily show all digits, hit
Orange Shift key, then DISP, then =.
14
HP 10bII+ (Continued)
 To permanently show all digits, hit
ORANGE shift, then DISP, then . (period
key).
 Set decimal mode: Hit ORANGE shift,
then ./, key. Note: many non-US
countries reverse the US use of
decimals and commas when writing a
number.
15

HP 10bII+: Set Time Value
Parameters
 To set END (for cash flows occurring at
the end of the year), hit ORANGE shift
key, then BEG/END.
 To set 1 payment per period, hit 1, then
ORANGE shift key, then P/YR.
16
Financial calculator: BAII+

 Set number of decimal places to
display: 2nd Format; use the up and
down arrows to display DEC=; press 9;
press ENTER
 Set AOS calculation; 2nd Format; down
arrow 4 times until you see Chn (if you
see AOS then just stop and hit CE/C,
you are done); 2nd SET (AOS should
display); CE/C you are done.
17
BAII +: Set Time Value

Parameters
 To set END (for cash flows occurring at
the end of the year), hit 2nd BGN; 2nd
SET will toggle between cash flows at
the beginning of the year (BGN) and
end of the year (END). Leave it as END.
 To set 1 payment per period, hit 2nd P/Y
1 ENTER.
18

BAII+
 To reset TVM calculations; 2nd CLR
TVM.
 To reset cash flow register; CF; 2nd CLR
Work.
Financial Calculator Solution
Financial calculators solve this

equation:
FVN + PV (1+I)N = 0.
There are 4 variables. If 3 are

known, the calculator will solve for
the 4th.
20
Here’s the setup to find FV
INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10
Clearing automatically sets everything to 0,

but for safety enter PMT = 0.
Set: P/YR = 1, END.
21

Spreadsheet Solution
 Use the FV function: see spreadsheet in
Ch28 Mini Case.xls
 = FV(I, N, PMT, PV)

 = FV(0.10, 3, 0, -100) = 133.10
22
What’s the PV of $100 due in

3 years if I/YR = 10%?
Finding PVs is discounting, and it’s the

reverse of compounding.
0 1 2 3
10%
PV = ? 100
23
Solve FVN = PV(1 + I )N for PV
FVN N
1
PV = = FVN
(1+I)N 1+I
1
3
PV = $100
1.10
= $100(0.7513) = $75.13
24

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13
Either PV or FV must be negative. Here

PV = -75.13. Put in $75.13 today, take
out $100 after 3 years.
25
 Use the PV function: see spreadsheet in
Ch04 Mini Case.xls
 = PV(I, N, PMT, FV)
 = PV(0.10, 3, 0, 100) = -75.13
26
Finding the Time to Double
0 1 2 ?
20%
-1 2
FV = PV(1 + I)N
Continued on next slide

27

Time to Double (Continued)
$2 = $1(1 + 0.20)N
(1.2)N = $2/$1 = 2
N LN(1.2) = LN(2)
N = LN(2)/LN(1.2)
N = 0.693/0.182 = 3.8
28
INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8
29
 Use the NPER function: see spreadsheet
in Ch04 Mini Case.xls
 = NPER(I, PMT, PV, FV)
 = NPER(0.10, 0, -1, 2) = 3.8
30

Finding the Interest Rate
0 1 2 3
?%
-1 2
FV = PV(1 + I)N
$2 = $1(1 + I)3
(2)(1/3) = (1 + I)
1.2599 = (1 + I)
I= 0.2599 = 25.99%
31
Financial Calculator
INPUTS 3 -1 0 2
N I/YR PV PMT FV
OUTPUT 25.99
32
 Use the RATE function:
 = RATE(N, PMT, PV, FV)
 = RATE(3, 0, -1, 2) = 0.2599
33

Ordinary Annuity vs. Annuity
Due
Ordinary Annuity
0 1 2 3
I%
PMT PMT PMT

Annuity Due
0 1 2 3
I%
PMT PMT PMT

34
What’s the FV of a 3-year

ordinary annuity of $100 at 10%?
0 1 2 3
10%
100 100 100

110
121
FV = 331
35
FV Annuity Formula
 The future value of an annuity with N

periods and an interest rate of I can be
found with the following formula:
(1+I)N-1
= PMT
I
(1+0.10)3-1
= $100 = $331
0.10
36

Financial Calculator Formula
for Annuities
 Financial calculators solve this equation:

(𝟏+𝐈)𝐍 −𝟏
 𝐏𝐕(𝟏 + 𝐈)𝐍 +𝐏𝐌𝐓 𝐈
+ 𝐅𝐕𝐍 = 𝟎
 There are 5 variables. If 4 are known,

the calculator will solve for the 5th.
37
INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331.00
Have payments but no lump sum PV, so

enter 0 for present value.
38
 Use the FV function: see spreadsheet.
 = FV(I, N, PMT, PV)

 = FV(0.10, 3, -100, 0) = 331.00
39

What’s the PV of this ordinary
annuity?
0 1 2 3
10%
100 100 100

90.91
82.64
75.13
248.69 = PV
40
PV Annuity Formula
 The present value of an annuity with N
periods and an interest rate of I can be
found with the following formula:
1 1
= PMT −
I I (1+I)N
1
= $100 1 − = $248.69
0.1 0.1(1+0.1)3
41
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69
Have payments but no lump sum FV, so

enter 0 for future value.
42

 Use the PV function: see spreadsheet.
 = PV(I, N, PMT, FV)

 = PV(0.10, 3, 100, 0) = -248.69
43
Find the FV and PV if the

annuity were an annuity due.
0 1 2 3
10%
100 100 100
44
PV and FV of Annuity Due

vs. Ordinary Annuity
 PV of annuity due:
 = (PV of ordinary annuity) (1+I)
 = ($248.69) (1+ 0.10) = $273.56
 FV of annuity due:
 = (FV of ordinary annuity) (1+I)
 = ($331.00) (1+ 0.10) = $364.10
45

PV of Annuity Due: Switch
from “End” to “Begin”
BEGIN Mode
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55
46
FV of Annuity Due: Switch

from “End” to “Begin”
BEGIN Mode
INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -364.10
47
Excel Function for Annuities

Due
 Change the formula to:
 =PV(0.10,3,-100,0,1)
 The fourth term, 0, tells the function there

are no other cash flows. The fifth term tells
the function that it is an annuity due. A
similar function gives the future value of an
annuity due:
 =FV(0.10,3,-100,0,1)
48

What is the PV of this
uneven cash flow stream?
0 1 2 3 4
10%
100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
49

 Clear all: Orange Shift key, then C All
key (in orange).
 Enter number, then hit the CFj key.
 Repeat for all cash flows, in order.
 To find NPV: Enter interest rate (I/YR).
Then Orange Shift key, then NPV key
(in orange).
50

(more)
 To see current cash flow in list, hit RCL
CFj CFj
 To see previous CF, hit RCL CFj –
 To see subsequent CF, hit RCL CFj +
 To see CF 0-9, hit RCL CFj 1 (to see CF 1).
To see CF 10-14, hit RCL CFj . (period) 1
(to see CF 11).
51

Financial calculator: BAII +
 Clear all cash flows: CF; 2nd CLR Work.
 CF0 displayed. Enter number, then hit the
ENTER key.
 Hit the down arrow to display C01. Enter
number, hit ENTER.
 F01 displayed. Usually just hit 1 ENTER. If
you have several cash flows that are all the
same, then use F01 to say how many you
have.
52

 Repeat for all cash flows, in order.
 To find NPV: Hit NPV; I = will display.
Enter interest rate (as a percentage, so
enter 10 for 10%) ENTER; Down Arrow;
Displays NPV =; hit CPT and the NPV
will display.
53

(more)
 To see current cash flow in list, hit CF
 Scroll up or down using the up and down
arrows.
54

 Input in “CFLO” register:
 CF0 = 0
 CF1 = 100
 CF2 = 300
 CF3 = 300
 CF4 = -50
 Enter I/YR = 10, then press NPV button
to get NPV = 530.09. (Here NPV = PV.)
55
Excel Formula in cell A3:

=NPV(10%,B2:E2)
56
Nominal rate (INOM)

 Stated in contracts, and quoted by
banks and brokers.
 Not used in calculations or shown on
time lines
 Periods per year (M) must be given.
 Examples:
 8%; Quarterly
 8%, Daily interest (365 days)
57

Periodic rate (IPER )
 IPER = INOM/M, where M is number of
compounding periods per year. M = 4 for
quarterly, 12 for monthly, and 360 or 365 for
daily compounding.
 Used in calculations, shown on time lines.
 Examples:
 8% quarterly: IPER = 8%/4 = 2%.
 8% daily (365): IPER = 8%/365 = 0.021918%.
58
The Impact of Compounding

 Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated I% constant?
 Why?
59
The Impact of Compounding

(Answer)
 LARGER!
 If compounding is more frequent than

once a year--for example, semiannually,
quarterly, or daily--interest is earned on
interest more often.
60

FV Formula with Different
Compounding Periods
MN
INOM
FVN = PV 1 +
M
61
$100 at a 12% nominal rate with

semiannual compounding for 5 years
MN
INOM
FVN = PV 1 +
M
2x5
0.12
FV5S = $100 1 +
2
= $100(1.06)10 = $179.08
62
FV of $100 at a 12% nominal rate for

5 years with different compounding
FV(Ann.) = $100(1.12)5 = $176.23

FV(Semi.) = $100(1.06)10 = $179.08
FV(Quar.) = $100(1.03)20 = $180.61
FV(Mon.) = $100(1.01)60 = $181.67
FV(Daily) = $100(1+(0.12/365))(5x365) = $182.19
63

Effective Annual Rate (EAR =
EFF%)
 The EAR is the annual rate that causes
PV to grow to the same FV as under
multi-period compounding.
64
Effective Annual Rate Example

 Example: Invest $1 for one year at 12%,
semiannual:
FV = PV(1 + INOM/M)M
FV = $1 (1.06)2 = $1.1236.
 EFF% = 12.36%, because $1 invested for
one year at 12% semiannual compounding
would grow to the same value as $1 invested
for one year at 12.36% annual compounding.
65
Comparing Rates
 An investment with monthly payments
is different from one with quarterly
payments. Must put on EFF% basis to
compare rates of return. Use EFF%
only for comparisons.
 Banks say “interest paid daily.” Same
as compounded daily.
66

EFF% for a nominal rate of 12%,
compounded semiannually
M
INOM
EFF% = 1 + −1
M
2
0.12
= 1 + −1
2
= (1.06)2 - 1.0
= 0.1236 = 12.36%.
67
Finding EFF with HP10BII

 Type in nominal rate, then Orange Shift
key, then NOM% key (in orange).
 Type in number of periods, then Orange
Shift key, then P/YR key (in orange).
 To find effective rate, hit Orange Shift
key, then EFF% key (in orange).
68
EAR (or EFF%) for a Nominal

Rate of of 12%
EARAnnual = 12%.
EARQ = (1 + 0.12/4)4 - 1 = 12.55%.
EARM = (1 + 0.12/12)12 - 1 = 12.68%.
EARD(365) = (1 + 0.12/365)365 - 1= 12.75%.
69

Can the effective rate ever be
equal to the nominal rate?
 Yes, but only if annual compounding is
used, i.e., if M = 1.
 If M > 1, EFF% will always be greater
than the nominal rate.
70
When is each rate used?
INOM: Written into contracts, quoted

by banks and brokers. Not used
in calculations or shown
on time lines.
71

(Continued)
IPER: Used in calculations, shown on

time lines.
If INOM has annual compounding,

then IPER = INOM/1 = INOM.
72

(Continued)
 EAR (or EFF%): Used to compare
returns on investments with different
payments per year.
 Used for calculations if and only if
dealing with annuities where payments
don’t match interest compounding
periods.
73
Amortization
 Construct an amortization schedule for
a $1,000, 10% annual rate loan with 3
equal payments.
74
Step 1: Find the required

payments.
0 1 2 3
10%
-1,000 PMT PMT PMT
INPUTS 3 10 -1000 0
N I/Y PV PMT FV
OUTPUT R
402.11
75

Step 2: Find interest charge
for Year 1.
INTt = Beg balt (I)
INT1 = $1,000(0.10) = $100
76
Step 3: Find repayment of

principal in Year 1.
Repmt = PMT - INT

= $402.11 - $100
= $302.11
77
Step 4: Find ending balance

after Year 1.
End bal = Beg bal - Repmt

= $1,000 - $302.11 = $697.89
Repeat these steps for Years 2 and 3

to complete the amortization table.
78

Amortization Table
BEG PRIN END
YEAR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000
79
Interest declines because

outstanding balance declines.
$450
$400
$350
$300
$250 Interest
$200 Principal
$150
$100
$50
$0
PMT 1 PMT 2 PMT 3
80
Amortization
 Amortization tables are widely
used--for home mortgages, auto
loans, business loans, retirement
plans, and more. They are very
important!
 Financial calculators (and
spreadsheets) are great for setting
up amortization tables.
81

Fractional Time Periods
 On January 1 you deposit $100 in an
account that pays a nominal interest
rate of 11.33463%, with daily
compounding (365 days).
 How much will you have on October 1,
or after 9 months (273 days)? (Days
given.)
82
Convert interest to daily rate
IPER = 11.33463%/365
= 0.031054% per day
0 1 2 273
0.031054%
-100 FV=?
83
Find FV
FV273= $100 (1.00031054)273
= $100 (1.08846) = $108.85
84

Calculator Solution
IPER = INOM/M
= 11.33463/365
= 0.031054 per day.
INPUTS 273 -100 0
N I/YR PV PMT FV
OUTPUT 108.85
85
Non-matching rates and periods

 What’s the value at the end of Year 3 of
the following CF stream if the quoted
interest rate is 10%, compounded
semiannually?
86
Time line for non-matching

rates and periods
0 1 2 3 4 5 6 6-mos.
5% periods
100 100 100
87

Non-matching rates and periods
 Payments occur annually, but
compounding occurs each 6 months.
 So we can’t use normal annuity
valuation techniques.
88
1st Method: Compound Each

CF
0 1 2 3 4 5 6
5%
100 100 100.00

110.25
121.55
331.80
FVA3 = $100(1.05)4 + $100(1.05)2 + $100
= $331.80
89
2nd Method: Treat as an

annuity, use financial calculator
Find the EFF% (EAR) for the quoted rate:
2
0.10
EFF% = 1 + − 1 = 10.25%
2
90

Use EAR = 10.25% as the
annual rate in calculator.
INPUTS 3 10.25 0 -100

N I/YR PV PMT FV
OUTPUT
331.80
91
What’s the PV of this stream?
0 1 2 3
5%
100 100 100
90.70
82.27
74.62
247.59
92
Comparing Investments
 You are offered a note that pays
$1,000 in 15 months (or 456 days) for
$850. You have $850 in a bank that
pays a 6.76649% nominal rate, with
365 daily compounding, which is a daily
rate of 0.018538% and an EAR of
7.0%. You plan to leave the money in
the bank if you don’t buy the note.
The note is riskless.
 Should you buy it?
93

Daily time line
IPER = 0.018538% per day.
0 365 456 days

… …
-850 1,000
94
Three solution methods

 1. Greatest future wealth: FV
 2. Greatest wealth today: PV
 3. Highest rate of return: EFF%
95
1. Greatest Future Wealth
Find FV of $850 left in bank for

15 months and compare with
note’s FV = $1,000.
FVBank = $850(1.00018538)456
= $924.97 in bank.
Buy the note: $1,000 > $924.97.

96

Calculator Solution to FV
IPER = INOM/M
= 6.76649/365
= 0.018538 per day.
INPUTS 456 -850 0

N I/YR PV PMT FV
OUTPUT 924.97
97
2. Greatest Present Wealth
Find PV of note, and compare

with its $850 cost:
PV = $1,000/(1.00018538)456
= $918.95
Buy the note: $918.95 > $850

98
6.76649/365 =
INPUTS 456 .018538 0 1000
N I/YR PV PMT FV
OUTPUT -918.95
PV of note is greater than its $850

cost, so buy the note. Raises your
wealth.
99

3. Rate of Return
Find the EFF% on note and compare

with 7.0% bank pays, which is your
opportunity cost of capital:
FVN = PV(1 + I)N
$1,000 = $850(1 + I)456
Now we must solve for I.
100
Calculator Solution
INPUTS 456 -850 0 1000

N I/YR PV PMT FV
OUTPUT 0.035646%
per day
Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR = EFF% = (1.00035646)365 - 1
= 13.89%.
101
Using interest conversion
P/YR = 365
NOM% = 0.035646(365) = 13.01
EFF% = 13.89
Since 13.89% > 7.0% opportunity cost,

buy the note.
102

Ch04 Show

Uploaded by

Copyright:

Available Formats

Ch04 Show

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Ch04 Show

Uploaded by

Copyright:

Available Formats

Chapter 4

Time Value of Money

Time Value Topics

Determinants of Intrinsic Value:

Net operating Required investments

Free cash flow

FCF1 FCF2 FCF∞

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

Ehrhardt Chapter 4 Page 1

CF0 CF1 CF2 CF3

Time line for a $100 lump sum

Time line for an ordinary

100 100 100

Ehrhardt Chapter 4 Page 2

FV of an initial $100 after

Finding FVs (moving to the right

FV1 = PV + INT1 = PV + PV (I)

Ehrhardt Chapter 4 Page 3

Using the General Formula:

Generalizing the approach from

FVN = PV(1 + I)N

Ehrhardt Chapter 4 Page 4

Financial calculator: HP 10bII+

Ehrhardt Chapter 4 Page 5

Financial calculator: BAII+

BAII +: Set Time Value

Ehrhardt Chapter 4 Page 6

Financial Calculator Solution

Financial calculators solve this

There are 4 variables. If 3 are

Here’s the setup to find FV

Clearing automatically sets everything to 0,

Ehrhardt Chapter 4 Page 7

 = FV(I, N, PMT, PV)

What’s the PV of $100 due in

Finding PVs is discounting, and it’s the

Solve FVN = PV(1 + I )N for PV

Ehrhardt Chapter 4 Page 8

Either PV or FV must be negative. Here

 = PV(I, N, PMT, FV)

 = PV(0.10, 3, 0, 100) = -75.13

Finding the Time to Double

Continued on next slide

Ehrhardt Chapter 4 Page 9

Financial Calculator Solution

 = NPER(I, PMT, PV, FV)

 = NPER(0.10, 0, -1, 2) = 3.8

Ehrhardt Chapter 4 Page 10

 = RATE(N, PMT, PV, FV)

 = RATE(3, 0, -1, 2) = 0.2599

Ehrhardt Chapter 4 Page 11

PMT PMT PMT

PMT PMT PMT

What’s the FV of a 3-year

100 100 100

 The future value of an annuity with N

Ehrhardt Chapter 4 Page 12

 Financial calculators solve this equation:

 There are 5 variables. If 4 are known,