Chapter 4

Introduction to Valuation: The Time Value of Money

Chapter Outline

• Future Value and Compounding

• Present Value and Discounting

• More on Present and Future Values

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

Future Values

• Suppose you invest $1000 for two year at 5% per year. How much will you have
two years from now?

• FV = 1,000(1.05)2 = 1,102.50

• 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

Effects of Compounding

• Simple interest (interest is earned only on the original principal)

• Compound interest (interest is earned on principal and on interest received)

• 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

Example

Assume you just started a new job and your current annual salary is $25,000. Suppose
the rate of inflation is about 4% annually for the next 40 years, and you receive annual
cost-of-living increases tied to the inflation rate. What will your ending salary be?

Final annual salary will be:

25,000(1.04)40 = $120,026.

Joe invested $6,000 twenty years ago with an insurance company that has paid him 4
percent simple interest on his funds. Betty invested $6,000 twenty years ago in a fund
that has paid her 4 percent interest, compounded monthly. How much more interest
has Betty earned than Joe over the 20 years?

a. $889.00

b. $1,761.18

c. $1,837.63

d. $2,535.49

Joe:

FV = $6,000 + ($6,000 × .04 × 20) = $10,800

Betty:
2012
 .04 
FV  $6,000  1    $13,335.49
 12 

Difference = $13,335.49 − $10,800 = $2,535.49

Ten years ago, Fred deposited $2,500 into an account. Five years ago, he added an
additional $2,500 to his account. He earned 8 percent, compounded quarterly, for the
first 5 years and 12 percent, compounded annually, for the last 5 years. How much
money does Fred have in his account today?

a. $9,018.68
54
 .08 
b. $10,952.72 FV  $2,500  1    $3,714.87
 4 
c. $11,192.81

FV  ($3,714.87  $2,500)  1  .12  $10,952.72

5
d. $11,408.17

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 indicate that we want the future value.

Example

• 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 = 10,000

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%

• 5 years: PV = 500 / (1.1)5 = 310.46

• 10 years: PV = 500 / (1.1)10 = 192.77

 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%?

• Rate = 10%: PV = 500 / (1.1)5 = 310.46

• Rate = 15%; PV = 500 / (1.15)5 = 248.59

The Basic PV Equation

• 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

Discount Rate

• Often we will want to know what the implied interest rate is in an investment

• Rearrange the basic PV equation and solve for r

• FV = PV(1 + r)t

• r = (FV / PV)1/t – 1

• FV = PV(1 + r)t

FV/PV = (1 + r)t

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

(FV / PV)1/t – 1 = r

r = (FV / PV)1/t – 1

(remember your logs)

Ln (a^b) = b ln (a)
FV = PV (1 + r)t

FV/PV= (1 + r)t

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

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

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

Number of Periods – Example

• 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(1.1) = 3.02 years

• 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?

• How much do you need to have in the future?

• Down payment = .10 (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 r = 7.5

• Using the formula

• t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years

 Chapter 5

Discounted Cash Flow Valuation

Chapter Outline

• Future and Present Values of Multiple Cash Flows

• Valuing Level Cash Flows: Annuities and Perpetuities

Future Values of Multiple Cash Flows

There are two ways to calculate the future value of multiple cash flows:

Compound the accumulated balance forward one period at a time

Or calculate the future value of each cash flow and add them up.

Future Values of Multiple Cash Flows

• 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?

FV = 500(1.09)2 + 600(1.09) = 1,248.05

• How much will you have in 5 years if you make no further deposits?

• First way:

FV = 500(1.09)5 + 600(1.09)4 = 1,616.26

• Second way – use value at year 2:

FV = 1,248.05(1.09)3 = 1,616.26

Present Values of Multiple Cash Flows

• You are considering an investment that will pay you $1,000 in one year, $2,000 in
two years and $3,000 in three years. If you want to earn 10% on your money,
how much would you be willing to pay?

PV = 1000 / (1.1)1 = 909.09

PV = 2000 / (1.1)2 = 1,652.89

PV = 3000 / (1.1)3 = 2,253.94

PV = 909.09 + 1,652.89 + 2,253.94 = 4,815.92

Decisions

• Your broker calls you and tells you that he has this great investment opportunity.
If you invest $100 today, you will receive $40 in one year and $75 in two years. If
you require a 15% return on investments of this risk, should you take the
investment?

PV = 40/(1.15)1 + 75/(1.15)2 = 91.49

No – the broker is charging more than you would be willing to pay.

Saving For Retirement

• You are offered the opportunity to put some money away for retirement. You will
receive five annual payments of $25,000 each beginning in 40 years. How much
would you be willing to invest today if you desire an interest rate of 12%?

PV = 25,000/(1.12)40 + 25,000/(1.12)41 + 25,000/(1.12)42 + 25,000/(1.12)43 +

25,000/(1.12)44 = 1,084.71

Perpetuities and Annuities Defined

• Perpetuity – infinite series of equal payments

• Annuity – finite series of equal payments that occur at regular intervals

– If the first payment occurs at the end of the period, it is called an ordinary
annuity

– If the first payment occurs at the beginning of the period, it is called an

annuity due

Present Value of Perpetuity

• Perpetuity formula: PV = C / r

• Example: Suppose the Fellini Co. wants to sell preferred stock at $100 per share.
A very similar issue of preferred stock already outstanding has a price of $40 per
 share and offers a dividend of $1 every Quarter. What dividend will Fellini have to
offer if the preferred stock is going to sell?

• The issue that is already out has a present value of $40 and a cash flow of $1
every quarter forever. Since this is a perpetuity, current required return
calculated as:

40 1 / r

r = .025 or 2.5% per quarter

Dividend for new preferred:

100 = C / .025

C = 2.50 per quarter

Present Value for Annuities – Basic Formula

 1 
1  
(1  r ) t
PV  C  
 r 

 


Present Value for Annuity – Example

• Suppose you win $10 million. The money is paid in equal annual installments of
$333,333.33 over 30 years. If the appropriate discount rate is 5%, how much are
you actually worth today?

PV = 333,333.33[1 – 1/1.0530] / .05 = 5,124,150.29

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?

Daily rate = .055 / 365 = .00015068493

Number of days = 3(365) = 1095

PV = 15,000 / (1.00015068493)1095 = 12,718.56

Problem

The meed Co. is debating over which one of two projects they should accept. Project A
will produce annual cash flows of $38,000 a year for six years. Project B will produce
cash flows of $22,000 a year for twelve years. The company requires a 12 percent rate
of return. Which project should the company select and why?
1  [1 /(1  .12) 6 ] 
PVA  $38,000   
 .12 
 $38,000  4.1114073
 $156,233.48
1  [1 /(1  .12)12 ]
PVB  $22,000 
.12
 $22,000  6.1943742
 $136,276.23
Project A; because the project’s net present value exceeds that of project B by
approximately $19,957.

Future Values for Annuities - Basic Formula

 (1  r )t  1
FV  C  
 r 
Future Value: Ordinary and Due Annuities

Suppose you begin saving for your retirement by depositing $2,000 per year in a bank. If
the interest rate is 7.5%, how much will you have in 40 years?

FV(Ordinary) = 2,000(1.07540 – 1)/.075 = 454,513.04

FV(Due) = 454,513.04 x 1.075 = 488,601.52

Future Values with Monthly Compounding

 Suppose you deposit $50 per month into an account that has an APR of 9%,
based on monthly compounding. How much will you have in the account in 35 years?

Monthly rate = .09 / 12 = .0075

Number of months = 35(12) = 420

FV = 50[1.0075420 – 1] / .0075 = 147,089.22

ProblemMagi plans to save $200 a month, starting today, for twenty years. Fred plans
to save $225 a month for twenty years, starting one month from today. Both Magi
and Fred expect to earn an average return of 9.5 percent on their savings. At the end
of the twenty years, Magi will have approximately __________less than Fred.

a. $16,671 b. $17,798

c. $17,939 d. $19,066

  .095  2012 
 1    1
   .095 
FVAD  $200   
12 
  1  
 .095   12 
 12 
 $200  711.9235161  1.007916667
 $143,511.92
  .095  2012 
 1    1
 
FVA  $225   
12 
.095 
 
 12 
 $225  711.9235161
 $160,182.79
Difference $143,511.92 − $160,182.80 = -$16,670.88 = -$16,671