Chapter 5

Introduction to Valuation: The Time

Value
of Money

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Outline

• Time and Money

• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future Values

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 Chapter Outline

• Time and Money

• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future Values

5-3
 Time and Money
The single most important skill for a
student to learn in this course is the
manipulation of money through time.

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 Time value of money
The idea that money available at the present time
is worth more than the same amount in the future
due to its potential earning capacity.

it is better to have money now rather than later ?
You can do much more with the money if you have
it now because over time you can earn more
interest on your money.
 The Timeline
A friend owes you money. He has agreed to repay the
loan by making two payments of $10,000 at the end of
each of the next two years
Example of timeline
1. You’re still feeling generous and have agreed to lend your
brother $10,000 today. Your brother has agreed to repay
this loan in two installments of $6000 at the end of each of
the next two years
2. Suppose you must pay tuition of $10,000 per year for the
next two years. Your tuition payments must be made in
equal installments at the start of each semester. What is the
timeline of your tuition payments? Assuming that each
year, we have two semesters.
INTEREST and INTEREST RATES

Interest in general is the cost of borrowing

money.
An interest rate is the cost stated as a
percent of the amount borrowed (principal)
per period of time, usually one year.

Interes
Simple t Compound
interest interest
 INTEREST RATES:
Simple and Compound interest
Simple Interest
Simple interest is calculated on the original principal only.
Accumulated interest from prior periods is NOT used in
calculations for the following periods.
Simple interest is normally used for a single period of less
than a year, such as 30 or 60 days.

Simple Interest = p * i * n
where:
p = principal (original amount borrowed or loaned)
i = interest rate for one period
n = number of periods
 INTEREST RATES:
Simple and Compound interest

Simple Interest
Example 1: You borrow $10,000 for 3 years at
5% simple annual interest.
Example 2: You borrow $10,000 for 60 days at
5% simple interest per year (assume a 365 day
year).
 INTEREST RATES:
Simple and Compound interest
Compound Interest
Compound interest is calculated each period on
the original principal and all interest accumulated
during past periods.
The compounding periods can be annual, semiannual or
quarterly…

Compound Interest = p * (1+i )n

 Future Values: General
Formula
FV = PV(1 + r) t

(1 + r)t = the future value interest factor

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Year Beginning Interest Ending balance
balance
1 C0 C0*r C0*(1+r)

2 C0*(1+r) C0*(1+r)*r C0*(1+r)2

……. ………… ………. …………….

t C0*(1+r)t-1 C0*(1+r)t-1*r C0*(1+r)t

Initial investment is C0.

The interest rate is r.
FV: The future value.
 INTEREST RATES:
Simple and Compound interest

FV = C0*(1+r)t

Compounding (Tính lãi gộp – Lãi tính chồng lên lãi)

For example: The interest of the second year =C0*(1+r)*r
= C0*r + (C0*r)*r
In which: C0*r is the interest on principal; (C0*r)*r is the
interest on interest.
 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 or “interest on interest”
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 INTEREST RATES:
Simple and Compound interest

Compound Interest
For example, you borrow $10,000 for three
years at 5% annual interest compounded
annually. What is your wealth at the end of
the investment period?
Example
If you have $1 today, calculate your wealth at the end of the
following years using simple and compound interest?
(R=9%)
Year 1
Year 2
Year 3
 INTEREST RATES:
Simple and compound interest rate
 INTEREST RATES:
Quoted and Effective annual interest rate

The government of France and Germany pays interest on its bonds annually.
In the United States and Britain government bonds pay interest
semiannually.
So if the interest rate on a U.S. government bond is quoted as 10%, the
investor receives interest of 5% every six months.
 If you invest $100 in a bond that pays interest of 10% compounded
semiannually, your wealth will grow to 1.05 x $100 = $105 by the end of
six months and to 1.05 x $105 = $110.25 by the end of the year.
 An interest rate of 10% compounded semiannually is equivalent to
10.25% compounded annually.
10% is called the quoted annual interest rate
10.25% is called the effective annual interest rate
 EAR: Effective annual rate

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 INTEREST RATES:
Quoted and Effective annual interest rate

Effective annual interest

Quoted annual interest rate
rate
Interest paid once a year

Interest paid more frequently

(semiannually, quarterly, …)
m
  r 
Effective annual interest rate1=   1
  m 
Where:
r: quoted annual interest rate
m: number of compounding periods
 INTEREST RATES:
Quoted and Effective annual interest rate

Quoted annual interest Effective annual interest

rate rate
Interest paid once a year =
Interest paid more frequently
(semiannually, quarterly, …) <
m
  r 
Effective annual interest rate = 1    1
  m 
Where:
r: quoted annual interest rate
m: number of compounding periods
Benjamin Franklin’s statement, “Money
makes money and the money that makes
money makes more money,”
Effective annual rate
Example:
1) The bank A is lending money at the rate of 12%,
compounded semi-annually. The bank intends to move to a
new plan where the interest is compounded quarterly. Find
the new quoted interest rate (APR: annual percentage rate)
that the bank will announce?.
2) Youbank offers personal loans at 10%, compounded
quarterly. SaveBank, on the other hand, offers similar loans
at 10.5%, compounded annually. Which bank should you
borrow from?
 FUTURE VALUE

Future Value is the value of an asset or cash at a

specified date in the future that is equivalent in
value to a specified sum today.
 FUTURE VALUE (cont)
Suppose you invest $100 in a bank account that pays interest of r
= 7% a year. In the first year you will earn interest of .07 x $100 =
$7 and the value of your investment will grow to $107:

Value of investment after 1 year = $100 x (1 + 7%) = $107

 By investing, you give up the opportunity to spend $100 today

and you gain the chance to spend $107 next year.
 FUTURE VALUE (cont)

• If you leave your money in the bank for a second year,

you earn interest of .07 x $107 = $7.49 and your
investment will grow to:
$107 x (1 + 7%) = $100 x (1 + 7%)2 = $114.49

Initial
investment
 You earn interest on
Compound
both Previous year’s
interest
interest
 FUTURE VALUE: formula

• The general formula for the future value of an investment over

many periods can be written as:
FV = CF0 × (1 + r)T
Where : CF0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.
 FUTURE VALUE

How an investment of $100 grows with compound interest

at different interest rates.

$1,636.6
5

$672.75

$265.33
$100
 Example

CF0 = $10,000
CFt is the future value of CF0
r = 9%
t = 10 years
If interest is compounded annually, the future value is:

If interest is compounded monthly, the future value is:

Impact of frequency?
 Example

CF0 = $10,000
CFt is the future value of CF0
r = 9%
t = 10 years
If interest is compounded annually, the future value is:
CF t = $10,000(1 + .09)10 = $23,674
If interest is compounded monthly, the future value is:
CF t = $10,000(1 + .09/12)120 = $24,514
--> when you increase the frequency of compounding, you also increase the
future value of your investment
 PRESENT VALUE

How much you need to

What is the
invest today to
present value (PV)
produce $114.49 at the OR
of the $114.49
end of the second
payoff?
year?

 Run the future value calculation in reverse:

 PRESENT VALUE

How much you need to

What is the
invest today to
present value (PV)
produce $114.49 at the OR
of the $114.49
end of the second
payoff?
year?

 Run the future value calculation in reverse:

$114 .49
PV   $100
(1  7%) 2
PRESENT VALUE: formula

CFt
PV 
(1  r ) t

CF1 is cash flow at date 1

CFt is cash flow at date t
r is the appropriate interest rate
t is the number of compounding periods
 1 
 (1  r) t  = discount factor
 
Example
 Chapter Outline

• Time and Money

• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future Values

5-38
 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 or required rate of return

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 Future Value as a General
Growth Formula
The formula for growth works for
money, but it also works for
numerous other variables:

Bacteria
Housing
Epidemics
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Production
 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 sell 3 million widgets in the current year, how
many widgets do you expect to sell in the fifth year?

5 N;15 I/Y; 3,000,000 PV

CPT FV = -6,034,072 units
(remember the sign convention)

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 Quick Quiz

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?
How much would you have using simple interest?

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 Chapter Outline

• Time and Money

• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future Values

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 PV and FV
Finance uses “compounding” as the verb for
going into the future and “discounting” as the
verb to bring funds into the present.
Today 1 2 3 4 5

Compounding
PV FV
Today 1 2 3 4 5

Discounting
5-44 PV FV
 Quick Quiz II

What is the relationship between present value and

future value?
Suppose you need $15,000 in 3 years. If you can earn
6% annually, how much do you need to invest today?
If you could invest the money at 8%, would you have
to invest more or less than at 6%? How much?

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 Chapter Outline

• Time and Money

• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future Values

5-46
 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

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 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%

Calculator note – the sign convention matters (for the PV)!
N = 5
 PV = -1,000 (you pay 1,000 today)
 FV = 1,200 (you receive 1,200 in 5 years)
 CPT I/Y = 3.714%

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 Discount Rate – Example 2
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
CPT I/Y = 12.25%

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 Discount Rate – Example 3
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

CPT I/Y = 17.27%

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 Quick Quiz III

What are some situations in which you might want to

know the implied interest rate?
You are offered the following investments:
You can invest $500 today and receive $600 in 5 years.
The investment is low risk.
You can invest the $500 in a bank account paying 4%.
What is the implied interest rate for the first choice, and
which investment should you choose?

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 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)
 You can use the financial keys on the
calculator as well; just remember the
sign convention.
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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?

I/Y = 10; PV = -15,000; FV = 20,000

CPT N = 3.02 years

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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%
of the loan amount for closing costs. Assume the
type of house you want will cost 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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 Number of Periods: Example
2 (Continued)
How much do you need to have in the future?
Down payment = .1(150,000) = 15,000
Closing costs = .05(150,000 – 15,000) = 6,750
Total needed = 15,000 + 6,750 = 21,750

Compute the number of periods

PV = -15,000; FV = 21,750; I/Y = 7.5
CPT N = 5.14 years

Using the formula

t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years
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 Quick Quiz IV

When might you want to compute the number of

periods?

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?

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 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.
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 Finance Formulas

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 Work the Web
Many financial calculators are available
online.
Click on the web surfer to go to
Investopedia’s web site and work the
following example:
You need $50,000 in 10 years. If you can earn
6% interest, how much do you need to invest
today?
You should get $27,919.74
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 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?

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 Terminology
Future Value
Present Value
Compounding
Discounting
Simple Interest
Compound Interest
Discount Rate
Required Rate of Return

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 Formulas

FV = PV(1 + r)t
PV = FV / (1 + r)t

r = (FV / PV)1/t – 1

t = ln(FV / PV) / ln(1 + r)

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 Key Concepts and Skills
• Compute the future value
of an investment made today
• Compute the present value
of an investment made in the future
• Compute the return on an investment
and the number of time periods
associated with an investment

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 What are the most
important topics of this
chapter?
1. Time changes the value of money as
money can be invested.

2. Money in the future is worth more

than money received today.

3. Money received in the future is worth

less today.

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 What are the most
important topics of this
chapter?

4. The interest rate (or discount rate)

and time determine the change in
value of an investment.

5. The longer money is invested, the

more compounding will increase the
future value.

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