Slides Chapter 4

Part 3: Valuation of Future Cash
Flows
Chapter 4: Introduction to Valuation.
The Time Value of Money
Chapter outline
• Future Value and Compounding
• Present Value and Discounting
• Determining the Discount Rate
• Finding the Number of Periods
Future Value and Compounding
• The cash value of an investment at some time
in the future.
• Two cases should be considered:
• Case 1: Investing in a single period
• Case 2: Investing for more than one period
Future value and Compounding
• Case 1: Suppose you will invest $100 in a
saving account paying 10% interest/ year how
much money you will receive at the end of this
year?
• In this case the present value (PV) is the $100
that you will invest today and the 10% we call
is Interest rate/ discount rate (r) an the year is
called the number of periods (t) and we need
to find out the future value (FV).
Future value and compounding
• In this case lets apply the following rule:
• FV = PV (1 + r)
• FV= $100(1+0.1)= $110
• Case 2: Investing for more than one period.
• In this case we need to analyze the effect of
compounding.
• FV = PV (1+r)t
• Example: You will invest today $325 at 14%
interest rate for 2 years.
• FV= $422.37.
Future Value and compounding
• Lets analyze this number:
• $325 initial investment
• Year one interest earned =$45.50
• Year two interest earned= 97.37
• Ending amount= $422.37
• Simple interest= 45.50$
• Compounded interest= $97.47
• 97.47-91(45.50*2)= $6.37 due to compounding
• Compounding: The process of accumulating
interest in an investment over time to earn
more interest.
• Compound interest: Interest earned on both
the initial amount invested and the reinvested
interest and gets bigger every year.
• Simple Interest: Interest earned on the original
amount invested only and is constant every
year.
• Example: Investing $400 at 12% for 7 years.
• FV= FV = PV (1+r)t $884.27
• How much interest you have earned?
• *884.27-400=$ 484.27.
• How much is the amount of simple interest?
• $400*0.12= $48 received every year (48*7)= $336 simple
interest
• How much is the amount of compounded interest?
• $484.27-$336= $148.27 received due to the accumulation
of interest.
• Note: The effect of compunding gets bigger
with larger time periods.
• There is a positive relationship between the
FV and both (t & r)
• Problem 1: Ben invested $5,000 twenty years ago with an insurance company that
has paid him 5 percent simple interest on his funds. Charles invested $5,000
twenty years ago in a fund that has paid him 5 percent interest, compounded
annually. How much more interest has Charles earned than Ben over the past 20
years?
• Answer: $5000*0.05= $250 *20 years= $5000 (simple interest)
• Total FV (Ben)= $5000 ( initial investment )+ $5000 (simple interest).
• FV (Charles) = FV = PV (1+r)t= $13,266.
• The amount of simple interest $5000

• $13,266-$5000= $8,266 (received by Charles due to the accumulation of interest)
• ($13,266-$10,000$) = $$3,266
• (8,266-$5000)= $3.266.
• Problem 2:Elaine has just received an
insurance settlement of $25,000. She wants to
save this money until her daughter goes to
college. If she can earn an average of 6.5
percent, compounded annually, how much
will she have saved when her daughter enters
college 8 years from now?
Present Value and Discounting
• How much should I invest today to have some
amount in the future?
• Rearrange the FV formula:
• FV = PV (1+r)t 
• PV = FV / (1+r)t
• Discounting: Calculating the PV of some future
amount.
• There is an inverse relationship between PV and
the interest rate and the number of periods.
Present value and Discounting
Problem 3: You want to have $25,000 for a down payment
on a house 6 years from now. If you can earn 6.5 percent,
compounded annually, on your savings, how much do you
need to deposit today to reach your goal?
• The question in this problem is to calculate how much you
need to deposit today in order to have $ 25,000 six years
from now. Accordingly we can consider the following;

• FV= $25,000, T= 6 years, Interest rate= 6.5%
• Present value = $25,000/(1 + 0.065)6 = $17,133.35
Present value and discounting
Problem 4: You want to have $35,000 in cash to
buy a car 4 years from today. You expect to
earn 8 percent, compounded annually, on
your savings. How much do you need to
deposit today if this is the only money you
save for this purpose?
More on Present value and Future Values
• In order to find the discount rate and the

number of periods we can use the following:
• Financial calculator
• Solve the equation
• Use a future value table where we have to
use the following:
Future value factor= (1+r)t
Present Vale Factor= = 1/ (1+r)t
Determining the Discount Rate
• Some time we want to know what is the

implied interest rate in an investment
• So, we are going to rearrange the basic FV
equation in order to solve for the r.
• FV = PV (1+r)t
• R= (FV / PV) 1/t – 1
Finding the Discount Rate
• Problem 5:Your friend claims that he invested
$5,000 seven years ago and that this
investment is worth $38,700 today. For this to
be true, what annual rate of return did he
have to earn? Assume the interest compounds
annually.
Finding the discount Rate
Solution:
PV= $5,000
FV= $ 38,700
T= 7 years
R= ??
FV/PV= 38,700/5000= 7.74
r = (FV / PV) 1/t – 1
• r = (38700 / 5000)1/7 – 1 = .03714 = 33.96%.

Finding the number of Periods
• There are four variables in the basic time
value equation. If we know three of the four,
we can always solve for the fourth. So, in this
case the missing variable is “t” or the number
of periods.
• we are going to rearrange our basic equation
in order to solve for t:
• t = ln (FV/PV) / ln(1+r)
Finding the Number of Periods
Problem 6:
• Isaac only has $690 today but needs $800 to
buy a new laptop. How long will he have to
wait to buy the laptop if he earns 5.4 percent
compounded annually on his savings?
Finding the Number of Periods
• In this case we will consider the following,
• FV= $800
• PV= $690
• R=5.4% compounded annually
• T= ?
ln (800/690)/ln (1+0.054)
• ln 1.1595/ ln 1.054= 0.1482/0.05259=2.81 years.
• $800 = $690  (1 + 0.054)t; t = 2.81 years
Using Future value tables and future value
factors
• Problem 7:
You estimate that you need about $80,000 to
send your child to college in eight years. You
have about $35,000 now. If you can earn 20%
will you make it? At what rate will you just
reach your goal?
Using Future value tables and Future value
factors
• FV= PV (1+r)t
=$150,493.
By using the FV factor:
$35,000* (1+r)t=$80,000
(1+r)t= 80,000/35000= 2.2857
By looking at table A1 at 8 years we will find this FV
factor is between 10-12% showing that the appropriate
interest rate in this case is approximately =11%.
So you will just reach your goal if you can earn 11%.

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Part 3: Valuation of Future Cash

• FV (Charles) = FV = PV (1+r)t= $13,266.

• The amount of simple interest $5000

• In order to find the discount rate and the

• Some time we want to know what is the

• r = (38700 / 5000)1/7 – 1 = .03714 = 33.96%.

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