Chapter 2

Concepts in
Valuation
The Time Value of Money
The Interest Rate
Simple Interest
Compound Interest
Amortizing a Loan
Compounding More Than
Once per Year
Obviously, $10,000 today.
You already recognize that there is
TIME VALUE TO MONEY!!
The Interest Rate
Which would you prefer -- $10,000
today or $10,000 in 5 years?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.

Why TIME?
Why is TIME such an important
element in your decision?
Types of Interest
Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).
Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
Simple Interest Formula
Formula SI = P
0
(i)(n)
SI: Simple Interest
P
0
: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
SI = P
0
(i)(n)
= $1,000(.07)(2)
= $140
Simple Interest Example
Assume that you deposit $1,000 in an
account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?
FV = P
0
+ SI
= $1,000 + $140
= $1,140
Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
Simple Interest (FV)
What is the Future Value (FV) of the
deposit?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.
Simple Interest (PV)
What is the Present Value (PV) of the
previous problem?
0
5000
10000
15000
20000
1st Year 10th
Year
20th
Year
30th
Year
Future Value of a Single $1,000 Deposit
10% Simple
Interest
7% Compound
Interest
10% Compound
Interest
Why Compound Interest?
F
u
t
u
r
e

V
a
l
u
e

(
U
.
S
.

D
o
l
l
a
r
s
)

Assume that you deposit $1,000 at
a compound interest rate of 7% for
2 years.
Future Value
Single Deposit (Graphic)
0 1 2
$1,000
FV
2
7%
FV
1
= P
0
(1+i)
1
= $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your $1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
Future Value
Single Deposit (Formula)
FV
1
= P
0
(1+i)
1
= $1,000 (1.07)
= $1,070
FV
2
= FV
1
(1+i)
1

= P
0
(1+i)(1+i) = $1,000(1.07)(1.07)
= P
0
(1+i)
2
= $1,000(1.07)
2

= $1,144.90
You earned an EXTRA $4.90 in Year 2 with
compound over simple interest.
Future Value
Single Deposit (Formula)
FV
1
= P
0
(1+i)
1

FV
2
= P
0
(1+i)
2


General Future Value Formula:
FV
n
= P
0
(1+i)
n

or FV
n
= P
0
(FVIF
i,n
) -- See Table I
General Future
Value Formula
etc.
FVIF
i,n
is found on Table I
at the end of the book.
Valuation Using Table I
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
FV
2
= $1,000 (FVIF
7%,2
)
= $1,000 (1.145)
= $1,145 [Due to Rounding]
Using Future Value Tables
Period 6% 7% 8%
1 1.060 1.070 1.080
2 1.124 1.145 1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
Julie Miller wants to know how large her deposit
of $10,000 today will become at a compound
annual interest rate of 10% for 5 years.
Story Problem Example
0 1 2 3 4 5
$10,000
FV
5
10%
Calculation based on Table I:
FV
5
= $10,000 (FVIF
10%, 5
)
= $10,000 (1.611)
= $16,110 [Due to Rounding]
Story Problem Solution
Calculation based on general formula:
FV
n
= P
0
(1+i)
n

FV
5
= $10,000 (1+ 0.10)
5

= $16,105.10
We will use the Rule-of-72.
Double Your Money!!!
Quick! How long does it take to
double $5,000 at a compound rate
of 12% per year (approx.)?
Approx. Years to Double = 72 / i%
72 / 12% = 6 Years
[Actual Time is 6.12 Years]
The Rule-of-72
Quick! How long does it take to
double $5,000 at a compound rate
of 12% per year (approx.)?
Assume that you need $1,000 in 2 years.
Lets examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
0 1 2
$1,000
7%
PV
1
PV
0
Present Value
Single Deposit (Graphic)
PV
0
= FV
2
/ (1+i)
2
= $1,000 / (1.07)
2

= FV
2
/ (1+i)
2
= $873.44
Present Value
Single Deposit (Formula)
0 1 2
$1,000
7%
PV
0
PV
0
= FV
1
/ (1+i)
1

PV
0
= FV
2
/ (1+i)
2


General Present Value Formula:
PV
0
= FV
n
/ (1+i)
n

or PV
0
= FV
n
(PVIF
i,n
) -- See Table II
General Present
Value Formula
etc.
PVIF
i,n
is found on Table II
at the end of the book.
Valuation Using Table II
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681

PV
2
= $1,000 (PVIF
7%,2
)
= $1,000 (.873)
= $873 [Due to Rounding]
Using Present Value Tables
Period 6% 7% 8%
1 .943 .935 .926
2 .890 .873 .857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
Julie Miller wants to know how large of a
deposit to make so that the money will
grow to $10,000 in 5 years at a discount
rate of 10%.
Story Problem Example
0 1 2 3 4 5
$10,000
PV
0
10%
Calculation based on general formula:
PV
0
= FV
n
/ (1+i)
n

PV
0
= $10,000 / (1+ 0.10)
5

= $6,209.21
Calculation based on Table I:
PV
0
= $10,000 (PVIF
10%, 5
)
= $10,000 (.621)
= $6,210.00 [Due to Rounding]
Story Problem Solution
Types of Annuities
Ordinary Annuity: Payments or receipts
occur at the end of each period.
Annuity Due: Payments or receipts
occur at the beginning of each period.
An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
Examples of Annuities
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
Parts of an Annuity
0 1 2 3
$100 $100 $100
(Ordinary Annuity)
End of
Period 1

End of
Period 2
Today
Equal Cash Flows
Each 1 Period Apart

End of
Period 3
Parts of an Annuity
0 1 2 3
$100 $100 $100
(Annuity Due)
Beginning of
Period 1

Beginning of
Period 2
Today
Equal Cash Flows
Each 1 Period Apart

Beginning of
Period 3
FVA
n
= R(1+i)
n-1
+ R(1+i)
n-2
+
... + R(1+i)
1
+ R(1+i)
0
Overview of an
Ordinary Annuity -- FVA
R R R
0 1 2 n n+1
FVA
n
R = Periodic
Cash Flow
Cash flows occur at the end of the period
i%
. . .
FVA
3
= $1,000(1.07)
2
+
$1,000(1.07)
1
+ $1,000(1.07)
0

= $1,145 + $1,070 + $1,000
= $3,215
Example of an
Ordinary Annuity -- FVA
$1,000 $1,000 $1,000
0 1 2 3 4
$3,215 = FVA
3
7%
$1,070
$1,145
Cash flows occur at the end of the period
Hint on Annuity Valuation
The future value of an ordinary
annuity can be viewed as
occurring at the end of the last
cash flow period, whereas the
future value of an annuity due
can be viewed as occurring at
the beginning of the last cash
flow period.
FVA
n
= R (FVIFA
i%,n
)
FVA
3
= $1,000 (FVIFA
7%,3
)
= $1,000 (3.215) = $3,215
Valuation Using Table III
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
FVAD
n
= R(1+i)
n
+ R(1+i)
n-1
+
... + R(1+i)
2
+ R(1+i)
1

= FVA
n
(1+i)
Overview View of an
Annuity Due -- FVAD
R R R R R
0 1 2 3 n-1 n
FVAD
n
i%
. . .
Cash flows occur at the beginning of the period
FVAD
3
= $1,000(1.07)
3
+
$1,000(1.07)
2
+ $1,000(1.07)
1

= $1,225 + $1,145 + $1,070
= $3,440
Example of an
Annuity Due -- FVAD
$1,000 $1,000 $1,000 $1,070
0 1 2 3 4
$3,440 = FVAD
3

7%
$1,225
$1,145
Cash flows occur at the beginning of the period
FVAD
n
= R (FVIFA
i%,n
)(1+i)
FVAD
3
= $1,000 (FVIFA
7%,3
)(1.07)
= $1,000 (3.215)(1.07) = $3,440
Valuation Using Table III
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
PVA
n
= R/(1+i)
1
+ R/(1+i)
2
+ ... + R/(1+i)
n
Overview of an
Ordinary Annuity -- PVA
R R R
0 1 2 n n+1
PVA
n
R = Periodic
Cash Flow
i%
. . .
Cash flows occur at the end of the period
PVA
3
= $1,000/(1.07)
1
+
$1,000/(1.07)
2
+
$1,000/(1.07)
3

= $934.58 + $873.44 + $816.30
= $2,624.32
Example of an
Ordinary Annuity -- PVA
$1,000 $1,000 $1,000
0 1 2 3 4
$2,624.32 = PVA
3
7%
$934.58
$873.44
$816.30
Cash flows occur at the end of the period
Hint on Annuity Valuation
The present value of an ordinary
annuity can be viewed as
occurring at the beginning of the
first cash flow period, whereas
the future value of an annuity
due can be viewed as occurring
at the end of the first cash flow
period.
PVA
n
= R (PVIFA
i%,n
)
PVA
3
= $1,000 (PVIFA
7%,3
)
= $1,000 (2.624) = $2,624
Valuation Using Table IV
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
PVAD
n
= R/(1+i)
0
+ R/(1+i)
1
+ ... + R/(1+i)
n-1

= PVA
n
(1+i)
Overview of an
Annuity Due -- PVAD
R R R R
0 1 2 n-1 n
PVAD
n
R: Periodic
Cash Flow
i%
. . .
Cash flows occur at the beginning of the period
PVAD
n
= $1,000/(1.07)
0
+ $1,000/(1.07)
1
+
$1,000/(1.07)
2
= $2,808.02
Example of an
Annuity Due -- PVAD
$1,000.00 $1,000 $1,000
0 1 2 3 4
$2,808.02 = PVAD
n
7%
$ 934.58
$ 873.44
Cash flows occur at the beginning of the period
PVAD
n
= R (PVIFA
i%,n
)(1+i)
PVAD
3
= $1,000 (PVIFA
7%,3
)(1.07)
= $1,000 (2.624)(1.07) = $2,808
Valuation Using Table IV
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
Solving the PVAD Problem
N I/Y PV PMT FV
Inputs
Compute
3 7 -1,000 0
2,808.02
Complete the problem the same as an ordinary annuity
problem, except you must change the calculator setting
to BGN first. Dont forget to change back!
Step 1: Press 2
nd
BGN keys
Step 2: Press 2
nd
SET keys
Step 3: Press 2
nd
QUIT keys
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
7. Check with financial calculator (optional)
Steps to Solve Time Value
of Money Problems
Julie Miller will receive the set of cash
flows below. What is the Present Value
at a discount rate of 10%.
Mixed Flows Example
0 1 2 3 4 5
$600 $600 $400 $400 $100
PV
0
10%
1. Solve a piece-at-a-time by
discounting each piece back to t=0.
2. Solve a group-at-a-time by first
breaking problem into groups of
annuity streams and any single
cash flow groups. Then discount
each group back to t=0.
How to Solve?
Piece-At-A-Time
0 1 2 3 4 5
$600 $600 $400 $400 $100
10%
$545.45
$495.87
$300.53
$273.21
$ 62.09
$1677.15 = PV
0
of the Mixed Flow
Group-At-A-Time (#1)
0 1 2 3 4 5
$600 $600 $400 $400 $100
10%
$1,041.60
$ 573.57
$ 62.10
$1,677.27 = PV
0
of Mixed Flow [Using Tables]
$600(PVIFA
10%,2
) = $600(1.736) = $1,041.60
$400(PVIFA
10%,2
)(PVIF
10%,2
) = $400(1.736)(0.826) = $573.57
$100 (PVIF
10%,5
) = $100 (0.621) = $62.10
Group-At-A-Time (#2)
0 1 2 3 4
$400 $400 $400 $400
PV
0
equals
$1677.30.
0 1 2
$200 $200
0 1 2 3 4 5
$100
$1,268.00
$347.20
$62.10
Plus
Plus
Use the highlighted
key for starting the
process of solving a
mixed cash flow
problem
Press the CF key
and down arrow key
through a few of the
keys as you look at
the definitions on
the next slide
Solving the Mixed Flows
Problem using CF Registry
Defining the calculator variables:
For CF0: This is ALWAYS the cash flow occurring
at time t=0 (usually 0 for these problems)
For Cnn:* This is the cash flow SIZE of the nth
group of cash flows. Note that a group may only
contain a single cash flow (e.g., $351.76).
For Fnn:* This is the cash flow FREQUENCY of the
nth group of cash flows. Note that this is always a
positive whole number (e.g., 1, 2, 20, etc.).
Solving the Mixed Flows
Problem using CF Registry
* nn represents the nth cash flow or frequency. Thus, the
first cash flow is C01, while the tenth cash flow is C10.
Solving the Mixed Flows
Problem using CF Registry
Steps in the Process
Step 1: Press CF key
Step 2: Press 2
nd
CLR Work keys
Step 3: For CF0 Press 0 Enter keys
Step 4: For C01 Press 600 Enter keys
Step 5: For F01 Press 2 Enter keys
Step 6: For C02 Press 400 Enter keys
Step 7: For F02 Press 2 Enter keys
Solving the Mixed Flows
Problem using CF Registry
Steps in the Process
Step 8: For C03 Press 100 Enter keys
Step 9: For F03 Press 1 Enter keys
Step 10: Press keys
Step 11: Press NPV key
Step 12: For I=, Enter 10 Enter keys
Step 13: Press CPT key

Result: Present Value = $1,677.15
General Formula:
FV
n
= PV
0
(1 + [i/m])
mn
n: Number of Years
m: Compounding Periods per Year
i: Annual Interest Rate
FV
n,m
: FV at the end of Year n
PV
0
: PV of the Cash Flow today
Frequency of
Compounding
Julie Miller has $1,000 to invest for 2
Years at an annual interest rate of
12%.
Annual FV
2
= 1,000(1+ [.12/1])
(1)(2)

= 1,254.40
Semi FV
2
= 1,000(1+ [.12/2])
(2)(2)

= 1,262.48
Impact of Frequency
Qrtly FV
2
= 1,000(1+ [.12/4])
(4)(2)

= 1,266.77
Monthly FV
2
= 1,000(1+ [.12/12])
(12)(2)

= 1,269.73
Daily FV
2
= 1,000(1+[.12/365])
(365)(2)

= 1,271.20
Impact of Frequency
The result indicates that a $1,000
investment that earns a 12% annual
rate compounded quarterly for 2 years
will earn a future value of $1,266.77.
Solving the Frequency
Problem (Quarterly)
N I/Y PV PMT FV
Inputs
Compute
2(4) 12/4 -1,000 0
1266.77
Solving the Frequency
Problem (Quarterly Altern.)
Press:
2
nd
P/Y 4 ENTER
2
nd
QUIT
12 I/Y
-1000 PV
0 PMT
2 2
nd
xP/Y N
CPT FV
The result indicates that a $1,000
investment that earns a 12% annual
rate compounded daily for 2 years will
earn a future value of $1,271.20.
Solving the Frequency
Problem (Daily)
N I/Y PV PMT FV
Inputs
Compute
2(365) 12/365 -1,000 0
1271.20
Solving the Frequency
Problem (Daily Alternative)
Press:
2
nd
P/Y 365 ENTER
2
nd
QUIT
12 I/Y
-1000 PV
0 PMT
2 2
nd
xP/Y N
CPT FV
Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nominal
rate for factors such as the number
of compounding periods per year.

(1 + [ i / m ] )
m
- 1
Effective Annual
Interest Rate
Basket Wonders (BW) has a $1,000
CD at the bank. The interest rate
is 6% compounded quarterly for 1
year. What is the Effective Annual
Interest Rate (EAR)?
EAR = ( 1 + 6% / 4 )
4
- 1
= 1.0614 - 1 = .0614 or 6.14%!
BWs Effective
Annual Interest Rate
Converting to an EAR
Press:
2
nd
I Conv
6 ENTER

4 ENTER
CPT
2
nd
QUIT
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.
Steps to Amortizing a Loan
Julie Miller is borrowing $10,000 at a
compound annual interest rate of 12%.
Amortize the loan if annual payments are
made for 5 years.
Step 1: Payment
PV
0
= R (PVIFA
i%,n
)
$10,000 = R (PVIFA
12%,5
)
$10,000 = R (3.605)
R = $10,000 / 3.605 = $2,774
Amortizing a Loan Example
Amortizing a Loan Example
End of
Year
Payment Interest Principal Ending
Balance
0 --- --- --- $10,000
1 $2,774 $1,200 $1,574 8,426
2 2,774 1,011 1,763 6,663
3 2,774 800 1,974 4,689
4 2,774 563 2,211 2,478
5 2,775 297 2,478 0
$13,871 $3,871 $10,000
[Last Payment Slightly Higher Due to Rounding]
The result indicates that a $10,000 loan
that costs 12% annually for 5 years and
will be completely paid off at that time
will require $2,774.10 annual payments.
Solving for the Payment
N I/Y PV PMT FV
Inputs
Compute
5 12 10,000 0
-2774.10
Using the Amortization
Functions of the Calculator
Press:
2
nd
Amort
1 ENTER
1 ENTER
Results:
BAL = 8,425.90*
PRN = -1,574.10*
INT = -1,200.00*
Year 1 information only
*Note: Compare to 3-82
Using the Amortization
Functions of the Calculator
Press:
2
nd
Amort
2 ENTER
2 ENTER
Results:
BAL = 6,662.91*
PRN = -1,763.99*
INT = -1,011.11*
Year 2 information only
*Note: Compare to 3-82
Using the Amortization
Functions of the Calculator
Press:
2
nd
Amort
1 ENTER
5 ENTER
Results:
BAL = 0.00
PRN =-10,000.00
INT = -3,870.49
Entire 5 Years of loan information
(see the total line of 3-82)
Usefulness of Amortization
2. Calculate Debt Outstanding --
The quantity of outstanding
debt may be used in financing
the day-to-day activities of the
firm.
1. Determine Interest Expense --
Interest expenses may reduce
taxable income of the firm.