Muhammad Nadeem

Financial Management

Time Value of
Money

5-1
Chapter Outline
Future Value and Compounding
Present Value and Discounting
Future and Present Values of Multiple
Cash Flows
Valuing Level Cash Flows: Annuities and
Perpetuities
Comparing Rates: The Effect of
Compounding
Loan Amortization


5-2
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
5-3
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

5-4
Future Values
Suppose you invest $1000 for one year at 5%
per year. What is the future value in one year?
Interest = 1000(.05) = 50
Value in one year = principal + interest = 1000
+ 50 = 1050
Future Value (FV) = 1000(1 + .05) = 1050
Suppose you leave the money in for another
year. How much will you have two years from
now?
FV = 1000(1.05)(1.05) = 1000(1.05)
2
=
1102.50
5-5
Effects of Compounding
Simple interest
Compound interest
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
5-6
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?
200 N; 5.5 I/Y; 10 PV
CPT 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
5-7
Future Value as a General
Growth Formula
Suppose your company expects to
increase unit sales by 15% per year for the
next 5 years. If you currently sell 3 million
widgets in one year, how many units do
you expect to sell in 5 years?
5 N;15 I/Y; 3,000,000 PV
CPT FV = -6,034,072 units (remember the
sign convention)
5-8
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.
5-9
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?
N = 10; I/Y = 7; FV = 19,671.51
CPT PV = -10,000
5-10
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
5-11
Finding the Number of Periods
Start with basic equation and solve for t
(remember you logs)
FV = PV(1 + r)
t

t = ln(FV / PV) / ln(1 + r)
You can use the financial keys on the
calculator as well; just remember the sign
convention.
6-12
Multiple Cash Flows FV
Suppose you invest $500 in a mutual fund
today and $600 in one year. If the fund
pays 9% annually, how much will you have
in two years?
Year 0 CF: 2 N; -500 PV; 9 I/Y; CPT FV =
594.05
Year 1 CF: 1 N; -600 PV; 9 I/Y; CPT FV =
654.00
Total FV = 594.05 + 654.00 = 1248.05
6-13
Multiple Cash Flows FV
Suppose you plan to deposit $100 into an
account in one year and $300 into the
account in three years. How much will be
in the account in five years if the interest
rate is 8%?
Year 1 CF: 4 N; -100 PV; 8 I/Y; CPT FV =
136.05
Year 3 CF: 2 N; -300 PV; 8 I/Y; CPT FV =
349.92
Total FV = 136.05 + 349.92 = 485.97
6-14
Example 6.3 Timeline
0 1 2 3 4
200 400 600 800
178.57
318.88
427.07
508.41
1432.93
6-15
Multiple Cash Flows Using a
Spreadsheet
You can use the PV or FV functions in
Excel to find the present value or future
value of a set of cash flows
6-16
Multiple Cash Flows PV
You are considering an investment that will
pay you $1000 in one year, $2000 in two
years and $3000 in three years. If you
want to earn 10% on your money, how
much would you be willing to pay?
N = 1; I/Y = 10; FV = 1000; CPT PV = -909.09
N = 2; I/Y = 10; FV = 2000; CPT PV = -1652.89
N = 3; I/Y = 10; FV = 3000; CPT PV = -2253.94
PV = 909.09 + 1652.89 + 2253.94 = 4815.92
6-17
Quick Quiz
Suppose you are looking at the following
possible cash flows: Year 1 CF = $100;
Years 2 and 3 CFs = $200; Years 4 and 5
CFs = $300. The required discount rate is
7%
What is the value of the cash flows at year
5?
What is the value of the cash flows today?
6-18
Annuities and Perpetuities
Basic Formulas
Perpetuity: PV = C / r
Annuities:
(

+
=
(
(
(
(

=
r
r
C FV
r
r
C PV
t
t
1 ) 1 (
) 1 (
1
1
6-19
Annuity Example
You borrow money TODAY so you need to
compute the present value.
48 N; 1 I/Y; -632 PMT; CPT PV = 23,999.54
($24,000)
Formula:

54 . 999 , 23
01 .
) 01 . 1 (
1
1
632
48
=
(
(
(
(

= PV
6-20
Annuities and the Calculator
You can use the PMT key on the calculator
for the equal payment
Ordinary annuity versus annuity due




Perpetuity
Perpetuity formula: PV = C / r

) 1 ( *
1 ) 1 (
r
r
r
C FV
t
+
(

+
=
6-21
Effective Annual Rate (EAR)
This is the actual rate paid (or received) after
accounting for compounding that occurs during
the year



Suppose you can earn 1% per month on $1
invested today.
What is the APR? 1(12) = 12%
How much are you effectively earning?
FV = 1(1.01)
12
= 1.1268
Rate = (1.1268 1) / 1 = .1268 = 12.68%

1
m
APR
1 EAR
m

+ =
6-22
Present Value with Daily
Compounding
You need $15,000 in 3 years for a new car.
If you can deposit money into an account
that pays an APR of 5.5% based on daily
compounding, how much would you need
to deposit?
3(365) = 1095 N
5.5 / 365 = .015068493 I/Y
15,000 FV
CPT PV = -12,718.56
6-23
Amortized Loan with Fixed Principal
Payment - Example
Consider a $50,000, 10 year loan at 8%
interest. The loan agreement requires the
firm to pay $5,000 in principal each year
plus interest for that year.
6-24
Amortized Loan with Fixed
Payment - Example
Each payment covers the interest expense plus
reduces principal
Consider a 4 year loan with annual payments.
The interest rate is 8% and the principal amount
is $5000.
What is the annual payment?
4 N
8 I/Y
5000 PV
CPT PMT = -1509.60