Chapter 2

Time Value of Money

Future value
Present value
Rates of return
Amortization
2 - 1
Time Value of Money
What is the price of an asset?
Estimation of expected future cash flows
Discounting expected future cash flows to present
value
What is the value of a series of cash flows at a
time in the future?
Compounding expected cash flows to future value
What is a discount rate?
Cost of capital
Opportunity cost of capital
Required return

2 - 2
Why does money have time
value?
You can invest your money and earn
interest on it.
$1 today $1 tomorrow
Would you prefer to get $1 today or to get
$1 in a week? In a year? In 10 years?

2 - 3
Time lines show timing of cash flows
CF
0
CF
1
CF
3
CF
2
0 1 2 3
r%
Tick marks at ends of periods, so Time 0
is today; Time 1 is the end of Period 1;
or the beginning of Period 2.
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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 = number of periods


2 - 5
Future Values
Suppose you leave the money in a savings
account with 5% return for two years. How
much will you have two years from now?

FV = 1050(1.05) = 1102.50

FV = 1000(1.05)(1.05) = 1102.50

FV = 1000(1.05)
2
= 1102.50


2 - 6
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
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Future Values Example 2
Suppose you invest the $1000 from the
previous example for 5 years. How much
would you have?
FV = 1000(1.05)
5
= 1276.28
The effect of compounding is small for a
small number of periods, but increases as
the number of periods increases. (Simple
interest would have a future value of
$1250, for a difference of $26.28.)
2 - 8
Future Value as a General
Growth Formula
Suppose your company expects to increase
unit sales of goods by 15% per year for the
next 5 years. If you currently sell 3 million
goods in one year, how many goods do you
expect to sell in 5 years?

FV = 3,000,000(1.15)
5
= 6,034,072

2
nd
[CLR TVM]
3000000 PV, 15 I/Y, 5 N, CPT FV => -6034072
2 - 9
Present Values
You want to begin saving for you daughters
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

2
nd
[CLR TVM]
150000 FV, 8 I/Y, 17 N, CPT PV => -40540.34
2 - 10
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?

r = (1200 / 1000)
1/5
1 = .03714 = 3.71% (Basis
Points?)

Calculator the sign convention matters!!!

2
nd
[CLR TVM]
-1000 PV (you pay $1,000 today)
1200 FV (you receive $1,200 in 5 years)
5 N, CPT I/Y => 3.71%

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PV Important Relationship I

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

0
PV
t
c
<
c
2 - 12
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
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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?

t = ln(20,000 / 15,000) / ln(1.1) = 3.02 years

2
nd
[CLR TVM]
-15000 PV, 20000 FV, 10 I/Y, CPT N => 3.02

2 - 14
PV Important Relationship II

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

0
PV
r
c
<
c
2 - 15
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
= 248.58

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The Basic FV Equation -
Refresher
Financial calculators solve this equation:
FV + PV (1+i)
n
= 0
There are four variables 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 and remember the sign convention or
you will receive an error when solving for r
or t
2 - 17
Multiple CFs FV Example 2
Suppose you invest $500 in a mutual fund
today and $600 in one year, and $700 in
three years. If the fund pays 9% annually,
how much will you have in four years?

FV = 500(1.09)
4
+ 600(1.09)
3
+ 700(1.09)
FV = 705.79 + 777.02 + 763.00
FV = 2,245.81
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Multiple CFs FV Example 2
How much will you have in 40 years (from
today) if you make no further deposits?

FV = 2,245.81(1.09)
36
= 49,972.02
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Multiple CFs PV Example 2

You are offered an investment that costs
$5000. It 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 should you do it?

PV = 1000 / (1.1)
1
= 909.09
PV = 2000 / (1.1)
2
= 1652.89
PV = 3000 / (1.1)
3
= 2253.94
PV = 909.09 + 1652.89 + 2253.94 = 4815.93
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Multiple CFs PV & FV Example
1
Suppose you are looking at the following
possible cash flows: Year 1 CF = $100;
Years 2 and 3 CFs = $200; nothing in Year
4, Year 5 CF = $100. The required
discount rate is 7%.
1. What is the value of the cash flows today?
2. What is the value of the cash flows at
year 6?
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PV Annuity Example 1
Suppose you win $10 million in the Texas
Lotto. The money is paid in equal annual
installments over 25 years. Assume the
first payment occurs in one year. If the
appropriate discount rate is 4%, how much
are your winnings actually worth today?
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Finding the Payment

Suppose you want to borrow $20,000 for a
new car. You can borrow at 9% per year,
compounded monthly. If you take a 4 year
loan, what is your monthly payment?


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Finding the Number of Payments
Suppose you borrow $2000 at 5%
compounded annually and you are going
to make annual payments of $734.42.
How long before you pay off the loan?
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Amortized Loan with Fixed
Payment - Example
Rate Periods Principal Pmnt
0.08 5 20,000 5009.13
Year Start Bal. Interest Payment Principal End Bal.
1 20,000 1600.00 5009.13 3409.13 16,590.87
2 16,590.87 1327.27 5009.13 3681.86 12,909.01
3 12,909.01 1032.72 5009.13 3976.41 8,932.60
4 8,932.60 714.61 5009.13 4294.52 4,638.08
5 4,638.08 371.05 5009.13 4638.08 0.00
25
Present Value of Perpetuity




0 1 2 * * *
|--------|--------|--------|--------|--------|--------|
C C C C C C
PV
1
0
C
PV
r
=

2 - 26
Perpetuity Example 1
Stock Price is $35 and quarterly dividend is
$.80, what is the current required return?
35 = .8 / r
r = .0229 or 2.29% per quarter
Stock Price is $50 and your required return
is 2.3% per quarter, what dividend do you
expect?
50 = C / .023
C = $1.15 per quarter
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Perpetuity Example 2
You are considering a preferred stock that
will start paying a quarterly dividend of
$1.50 three years from today. If your
desired return is 3% per quarter, how
much would you be willing to pay today?

PV = 1.50/.03 = $50

PV = 50/(1.03)
11
= $36.12

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Computing EAR (Equivalent
Annual Rate)
You are looking at two savings accounts.
One pays 5.25%, with daily compounding.
The other pays 5.35% with semiannual
compounding. Which account should you
use?
First account:
EAR = (1 + (.0525/365))
365
1 = .0539 or 5.39%
Second account:
EAR = (1 + (.0535/2))
2
1 = .0542 or 5.42%
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