Chapter 5 Time Value of Money

Chapter 5
Calculators
Introduction to
Valuation: The Time
Value of Money
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
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 a
spreadsheet to solve time value of money problems
5C-2
Chapter Outline
• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future
Values
5C-3
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
5C-4
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
5C-5
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
5C-6
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
5C-7
Future Values – Example 2
• Suppose you invest the $1,000 from the previous
example for 5 years. How much would you have?
– FV = 1,276.28
• 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.)
5C-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 = 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
5C-9
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.
5C-10
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
5C-11
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 = 40,540.34
5C-12
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 = 10,000
5C-13
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: PV = 310.46
– 10 years: PV = 192.77
5C-14
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 = 310.46
• Rate = 15%; PV = 248.59
5C-15
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
5C-16
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
5C-17
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 = (1,200 / 1,000)1/5 – 1 = .03714 = 3.714%
5C-18
• 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 = 12.25%
5C-19
• 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 = 5,000; FV = 75,000
– R = 17.27%
5C-20
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)
5C-21
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

– N = 3.02 years
5C-22
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.
5C-23
Table 5.4
5C-24
Comprehensive Problem
• You have $10,000 to invest for five years.
• How much additional interest will you earn
if the investment provides a 5% annual
return, when compared to a 4.5% annual
return?
• How long will it take your $10,000 to
double in value if it earns 5% annually?
• What annual rate has been earned if
$1,000 grows into $4,000 in 20 years?
5C-25

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Chapter 5

• The effect of compounding is small for a small

– R = 10; PV = -15,000; FV = 20,000

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