5

Calculators

Introduction to Valuation:
The Time Value of
Money

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline
• Future Value and Compounding

• Present Value and Discounting

• More on Present and Future Values

5-1
 Time is valuable
Which option do you prefer?
• (1) $1,000 today or
• (2) $1,000 in 5 years later?
• Obviously, (1) $1,000 TODAY
 TIME VALUE of MONEY
• How valuable is the time when
• You are late for the airport
• You are behind in a car racing
• Rescue the 911 victims
5-2
 The Cash Flow Time Line

One of the most important tools to solve

complicated problems!

Cf0 Cf1 Cf2 Cf3 Cf4

r1 r2 r3 r4

t=0 t=1 t=2 t=3 t=4

5-3
 The Cash Flow Time Line
2nd Step: CF 2nd Step: CF
Outflow Cash Inflow Cash
(negative CF): (Positive CFs):
Downward Arrow Upward Arrows

Cf0 Cf1 Cf2 Cf3 Cf4

r1 r2 r3 r4

0 1 2 3 4
Time 0
(can be 1st step: Time line
current/ 3rd Step: Number of periods
(year/month/week)
Past/ Interest rate
future) per period
5-4
 The Time Line

Today End of the Beginning of the

third period fourth period
Cf0 Cf1 Cf2 Cf3 Cf4
r1 r2 r3 r4

t=0 t=1 t=2 t=3 t=4

• A period can be a year, a month, a day or even shorter

• We assume that the cash collected during a period has
the same value as that collected at the end of the period

5-5
 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 = …
5-6
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 FV = (1 + r)t

5-7
 Effects of Compounding
• Simple interest:
• FV= P+ P*r*n
• Compound interest:
• FV=P*(1+r) n
• Consider the previous example:
• FV with simple interest = 1000 + 50 + 50 = 1100
• FV with compound interest = 1102.50
• The extra 2.50 comes from the interest of .05(50) =
2.50 earned on the first interest payment

5-8
Figure 5.1

Compound
interest results
in a higher FV
EXCEPT the
first period!

5-9
 Common Question
PV Payment FV
PMT
Cf0 I/Y Cf1 Cf2 Cf3 Cf4
r2 r3 r4
N
t=0 t=1 t=2 t=3
#Period
• 5 variables:
• Number of Periods (N)
• Interest Rate (I/Y)
• Present Value (PV)
• Periodic Payment (PMT): chapter 6
• Future Value (FV)

• Question: given 4 variables, calculate the fifth?

5-10
 Future Values – Example 2
• Suppose you invest the $1,000 from the
previous example for 5 years. How much would
you have?
-1000 FV?
5%

t=0 1 2 … 5

• FV = 1000(1.05)5 = 1,276.28
5-11
5-12
 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?
-10 5.5% 0 0 0 FV?

t=0 t=1 … … 200

• FV = .........
• 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
$447,189.84 - $120= $447,069.84!
5-13
The value of Manhattan island - Example 4

• Peter Minuit bought the island for $24 in goods

and trinkets in 1626. Was it cheap?
• Assume that he can earn 10%/year, how much
would it be worth today?
• N=2008-1626=382
• FV=24*1.1382 = 1.557*1017
=1.557*105 trillions
US GDP= 14.29 trillions (2008)

5-14
 Quick Quiz – Part I
• 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?

• FV = …

5-15
 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?
• FV = …………….?
• FV = ……………..?
5-16
 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.
5-17
 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? 7% 10,000

t=0 t=1 … …

• PV = 10,000 / (1.07)1 = $9,345.79

5-18
 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? 8% 0 0 0 150000

t=0 t=1 … … 17

• N = 17; r = 8%; FV = 150,000

• PV = ………………

5-19
 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?
19,671.51
PV? 7% 0 0 0

t=0 t=1 … … 10

• N = 10; r = 7%; FV = 19,671.51

• PV = …………..

5-20
 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? The discount rate is 10%
• 5 years : N = 5; r = 10%; FV = 500
--> PV = 310.45
• 10 years: N = 10; r = 10%; FV = 500
--> PV = 192.77

5-21
 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%: N = 5; r = 10%; FV = 500
--> PV = 310.46
• Rate = 15%; N = 5; r = 15%; FV = 500
--> PV = 248.59

5-22
 Discounted Value
 Graphically: Present Value of $100 to be received in
the future.
$100 i = 0%
90
80
70
60 i = 5%
50
40
30 i = 10%
20
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Year
5-23
 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?
• PV = ….
• PV = ….
• More or Less? …

5-24
 The Basic PV Equation -
Refresher
• PV = FV / (1 + r)t
• There are four parts to this equation
• PV, FV, r, t
• If we know any three, we can solve for the fourth

5-25
 Discount Rate
• Often we will want to know what the
implied interest rate is on an investment
• Rearrange the basic PV equation and
solve for r:
• FV = PV(1 + r)t
• r = (FV / PV)1/t – 1

5-26
 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 = (1200 / 1000)1/5 – 1 = .03714 = 3.714%

5-27
 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?

• N = 6, PV = 10,000, FV = 20,000
• r = (20,000 / 10,000)1/6 – 1 = .122462 = 12.25%

5-28
 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?

• N = 17; PV = 5000; FV = 75,000

• r = (75,000 / 5,000)1/17 – 1 = .172686 = 17.27%

5-29
 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 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?
r = ……………………………………….

5-30
 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)

5-31
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?
• r = 10%; PV = 15,000; FV = 20,000
• t = ln(20,000 / 15,000) / ln(1.1) = 3.02
 N = 3.02 years

5-32
 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?
t = …………………………………….

5-33
 Practice
• You need $50,000 in 10 years. If you can earn
6% interest, how much do you need to invest
today?
PV = …………………………

• Practice Exercise (end-of-chapter exercises)

5-34
Table 5.4

5-35
 5
Calculators

End of Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.