Chapter 4
Introduction to
Valuation: The
Time Value of
Money
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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• Future Value and Compounding
• Present Value and Discounting
• More on Present and Future Values
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Basic Definitions
• Present Value (PV)– earlier $ on a time
line
• Future Value (FV)– later $ on a time line
• No. of period (t) - times of compounding
• Interest rate (r)– “exchange rate” between
earlier money and later money
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return
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Time line
T= 0 1 2 3 4 5
_____________________________________________
PV FV5
PV = Present Value
FV = Future Value
t / n = Numbers of period
r = Interest rate
3 ways: Formulas, tables and financial calculator
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Future Values
• FV: the amount of $/ an investment today (PV) will
grow to over some period of time (t) at some given
interest rate (r).
• Suppose you invest $1000 for one year at 5% per
year. What is the future value in one year?
• Suppose you leave the money in for another year.
How much will you have two years from now?
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Future Values: General Formula
• FV = PV(1 + r)t
– FV = future value
– PV = present value
– r = period interest rate, expressed as a
decimal
– t = numbers of period
• Future value interest factor = (1 + r)t
– Appendix A.1 (pg. 580)
– FV = PV*FVIF(r%,t)
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Effects of Compounding
• Simple interest: interest is not reinvested
• Compound interest: earn interest on
interest
• Consider the previous example
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Future Values – Example 2
• Suppose you invest the $1000 with 5%
interest for 5 years. How much would you
have?
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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?
• What is the effect of compounding?
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Figure 4.1
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Figure 4.2
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Future Value as a General
Growth Formula
• 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 year
5?
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Quick Quiz: Part 1
• 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? (FV = $1586.08)
– How much would you have using simple interest?
(FV = $1100)
– How much interest on interest? (i on i = $486.08)
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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
– 1/(1+r)t = Present Value Interest Factor (PVIF)
– Appendix A.2, pg.582
– PV = FV*PVIF(r,t)
• When we talk about discounting, we mean
finding the present value of some future amount.
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PV – 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?
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Present Values – Example 2
• You want to begin saving for you
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?
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PV – 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%
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PV – 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%?
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Figure 4.3
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Quick Quiz: Part 2
• Suppose you need $15,000 in 3 years. If
you can earn 6% annually, how much do
you need to invest today?
(PV=$12,594.29)
• If you could invest the money at 8%,
would you have to invest more or less
than at 6%? How much?(less,
PV=$11907.48)
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The Basic PV Equation -
Refresher
• FV = PV * (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
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Discount Rate (r)
• Often we will want to know what the
implied interest rate is in an investment
• Rearrange the basic FV equation and
solve for r
FV = PV(1 + r)t
FV/PV = (1+ r)t
(FV/PV)1/t = 1+ r
r = (FV / PV)1/t – 1
• If you are using formulas, you will want to
make use of both the yx and the 1/x keys
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Discount Rate – Example 1
• You are looking at an investment that will
pay $1200 in 5 years if you invest $1000
today. What is the implied rate of interest?
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Discount Rate – Example 2
• 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 $5000 to invest. What
interest rate must you earn to have the
$75,000 when you need it?
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Quick Quiz: Part 3
• Suppose you are offered the following
investment choices:
1)You can invest $500 today and receive $600 in 5
years. The investment is considered low risk.
2)You can invest the $500 in a bank account
paying 4%.
• What is the implied interest rate for the first
choice (r=3.71%)
• Which investment should you choose? (second
choice is better)
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Finding the Number of Periods (t)
• Start with basic equation and solve for t
(remember your logs)
– FV = PV(1 + r)t
– FV/PV = (1+r)t
– ln (FV/PV) = t ln(1+r)
– t = ln (FV / PV) / ln(1 + r)
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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?
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Number of Periods – Example 2
• Suppose you want to buy a new house.
You currently have $15,000 and you figure
you need to have a 10% down payment
plus an additional 5% in closing costs. If
the type of house you want costs about
$150,000 and you can earn 7.5% per
year, how long will it be before you have
enough money for the down payment and
closing costs?
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Example 2 Continued
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Quick Quiz: Part 4
• 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=3.129 years)
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Tutorial
• Problem 6, 11,18, 20, 24 and 26 from
page 115
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Time Value of Money
• You have $1,000 to deposit, and you can
earn 12% per year. How much will your
investment be worth in 10 years?
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Time Value of Money
• You have $1,000 to deposit, and you can
earn 12% per year compounded monthly.
How much will your investment be worth in
10 years?
