Chapter 5
Introduction to
Valuation: The Time
Value of Money
Copyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.
McGraw-Hill/Irwin
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-1
Chapter Outline
• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future Values
5C-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
5C-3
Future Values – Example 1
• Suppose you invest $100 for one year at 5% per
year. What is the future value in one year?
– Interest = 100(.05) = 5
– Value in one year = principal + interest = 100 + 5 = 105
– Future Value (FV) = 100(1 + .05) = 105
• Suppose you leave the money in for another
year. How much will you have two years from
now?
– FV = 100(1.05)(1.05) = 100(1.05)2 = 110.25
5F-4
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
5F-5
Simple Interest versus Compound
Interest
• Simple interest
– FV with simple interest = 100 + 5 + 5 = 110
• Compound interest
– FV with compound interest = 110.25
• What is the effect of compounding?
– The extra 0.25 comes from the interest of .05(5) = 0.25
earned on the first interest payment
5F-6
Calculator Keys
• Texas Instruments BA-II Plus
– FV = future value
– PV = present value
– I/Y = period interest rate
• P/Y must equal 1 for the I/Y to be the period rate
• Interest is entered as a percent, not a decimal
– N = number of periods
– Remember to clear the memory (CLR TVM) after each
problem
– Other calculators are similar in format
5F-7
Future Values – Example 2
• Suppose you invest the $100 from the previous
example for 5 years. How much would you have?
– FV with simple interest = 100 + 5 + 5 + 5 + 5 + 5 = 125
– FV with compound interest = 100(1.05)5 = 127.63
• Using financial calculator: 5 N; 5 I/Y; 100 PV, CPT FV =
-127.63
• The effect of compounding is small for a small
number of periods but increases as the number of
periods increases
5C-8
Future Values – Example 3
• Suppose you had a relative who deposited $100
at 5.5% interest 200 years ago. How much would
the investment be worth today?
– FV with simple interest = 100 + 200(100)(.055) = 1200
– FV with compound interest = 100(1.055)200 = 4,471,898
• Using financial calculator: 200 N; 5.5 I/Y; -100 PV,
CPT FV = 4,471,898
• What is the effect of compounding?
– Compounding resulted in an additional $4,470,698 to
the value of the investment
5C-9
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?
– FV with compounding = 3,000,000(1.15)5 = 6,034,072
– Using financial calculator: 5 N;15 I/Y; 3,000,000 PV;
CPT FV = -6,034,072 units (remember the sign
convention)
5C-10
Quick Quiz – Part I
• 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
simple interest?
– How much would you have at the end of 15 years using
compound interest?
5C-11
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-12
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
– Using financial calculator: 1 N; 7 I/Y; 10,000 FV, CPT PV = -
9,345.79
5C-13
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 = 150,000 / (1.08)17 = 40,540.34
– Using financial calculator: 17 N; 8 I/Y; 150,000 FV, CPT PV =
-40,540.34 (remember the sign convention)
5C-14
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 = 19,671.51 / (1.07)10 = 9,999.998 = 10,000
– Using financial calculator: 10 N; 7 I/Y; 19,671.51 FV, CPT
PV = -10,000 (remember the sign convention)
5C-15
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 = 500 / (1.10)5 = 310.46
Using financial calculator: 5 N; 10 I/Y; 500 FV, CPT
PV = -310.46
• 10 years: PV = 500 / (1.10)10 = 192.77
Using financial calculator: 10 N; 10 I/Y; 500 FV, CPT
PV = -192.77
5C-16
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 = 500 / (1.10)5 = 310.46
Using financial calculator: 5 N; 10 I/Y; 500 FV,
CPT PV = -310.46
• Rate = 15%; PV = 500 / (1.15)5 = 248.59
Using financial calculator: 5 N; 15 I/Y; 500 FV,
CPT PV = -248.59
5C-17
Quick Quiz – Part 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%?
5C-18
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
• If you are using a financial calculator, be sure to
remember the sign convention or you will receive
an error (or a nonsensical answer) when solving
for r or t
5C-19
Discount Rate
• Often we will want to know the implied rate of
interest of an investment
• Rearrange the basic PV equation and solve for r
– FV = PV(1 + r)t
– r = (FV / PV)1/t – 1
5C-20
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%
– Using financial calculator (the sign convention
matters!!!): 5 N; -1,000 PV (you pay 1,000 today); 1,200
FV (you receive 1,200 in 5 years); CPT I/Y = 3.714%
5C-21
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?
– r = (20,000 / 10,000)1/6 – 1 = .1225 = 12.25%
– Using financial calculator: 6 N; -10,000 PV; 20,000 FV;
CPT I/Y = 12.25%
5C-22
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?
– r = (75,000 / 5,000)1/17 – 1 = .1727 = 17.27%
– Using financial calculator: 17 N; -5,000 PV; 75,000 FV;
CPT I/Y = 17.27%
5C-23
Quick Quiz – Part III
• What are some situations in which you might want
to know the implied rate of interest?
• 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 rate of interest for the first choice,
and which investment should you choose?
5C-24
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.
5C-25
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?
– t = ln(20,000 / 15,000) / ln(1 + 0.1) =3.02 years
– Using financial calculator: 10 I/Y; -15,000 PV; 20,000 FV;
CPT N = 3.02 years
5C-26
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?
5C-27
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
– t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years
– Using financial calculator: -15,000 PV; 21,750 FV; 7.5
I/Y; CPT N = 5.14 years
5C-28
Handy Rule of Thumb
• Rule of 72 can estimate how long it takes to
double a sum of money
– Time to double money = 72 / (interest rate per year)
• If interest rate = 9% per year, it will take 8 years
to double the money
– Time to double money = 72 / 9% = 8 years
• If the time taken to double the money is 8
years, the interest rate is 9% per year
– Interest rate per year = 72 / 8 years = 9%
5C-29
Quick Quiz – Part 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?
5C-30
Spreadsheet Example
• Use the following formulas for Time Value of
Money (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 the four formulas.
5C-31
Work the Web Example
• 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
5C-32
Table 5.4
5C-33
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 versus if
it provides a 4.5% annual return?
• How long will it take your $10,000 to double in
value if it earns 5% annually?
• What is the annual implied rate of interest if
$1,000 grows into $4,000 in 20 years?
5C-34
End of Chapter
5C-35
