3- 1

Fundamentals of Corporate Finance

Third Edition

Chapter 3
The Time
Value of
Money

Brealey

Myers Marcus

slides by Matthew Will

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Topics Covered
Future Values
Present Values
Multiple Cash Flows
Perpetuities and Annuities
Inflation & Time Value
Effective Annual Interest Rate

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3- 3

Future Values
Future Value - Amount to which an
investment will grow after earning interest.
Compound Interest - Interest earned on
interest.
Simple Interest - Interest earned only on the
original investment.
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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.

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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Interest Earned Per Year = 100 x .06 = $ 6

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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.

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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today

Future Years
2
3

Interest Earned
Value
100

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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today
Interest Earned
Value
100

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1
6
106

Future Years
2
3

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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today
Interest Earned
Value
100

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1
6
106

Future Years
2
3
6
112

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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today
Interest Earned
Value
100

Irwin/McGraw-Hill

1
6
106

Future Years
2
3
6
6
112 118

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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today
Interest Earned
Value
100

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1
6
106

Future Years
2
3
4
6
6
6
112 118 124

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Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today
Interest Earned
Value
100

1
6
106

Future Years
2
3
4
5
6
6
6
6
112 118 124 130

Value at the end of Year 5 = $130

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Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on the
previous years balance.

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Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on the
previous years balance.
Interest Earned Per Year =Prior Year Balance x .06

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Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous years balance.
Today

Future Years
2
3

Interest Earned
Value
100

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Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous years balance.
Today
Interest Earned
Value
100

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1
6.00
106.00

Future Years
2
3

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Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous years balance.
Today
Interest Earned
Value
100

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Future Years
1
2
3
6.00 6.36
106.00 112.36

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Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous years balance.
Today
Interest Earned
Value
100

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Future Years
1
2
3
6.00 6.36 6.74
106.00 112.36 119.10

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Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous years balance.
Today
Interest Earned
Value
100

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Future Years
1
2
3
4
6.00 6.36 6.74 7.15
106.00 112.36 119.10 126.25

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Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on
the previous years balance.
Today
Interest Earned
Value
100

Future Years
1
2
3
4
5
6.00 6.36 6.74 7.15 7.57
106.00 112.36 119.10 126.25 133.82

Value at the end of Year 5 = $133.82

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Future Values
Future Value of $100 = FV

FV $100 (1 r )

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Future Values
FV $100 (1 r )

Example - FV

What is the future value of $100 if interest is

compounded annually at a rate of 6% for five years?

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Future Values
FV $100 (1 r )

Example - FV

What is the future value of $100 if interest is

compounded annually at a rate of 6% for five years?

FV $ 100 (1 .06 ) $ 133 .82

5

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Future Values with Compounding

Interest Rates

70

0%

60

5%

FV of $1

50

10%
15%

40
30
20
10

30

28

26

24

22

20

18

16

14

12

10

Number of Years
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Manhattan Island Sale

Peter Minuit bought Manhattan Island for $24 in 1626.
Was this a good deal?
To answer, determine $24 is worth in the year 2000,
compounded at 8%.

FV $24 (1 .08 )
$75 .979 trillion
374

FYI - The value of Manhattan Island land is

well below this figure.
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Present Values
Present Value
Value today of a
future cash
flow.

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Present Values
Present Value

Discount Factor

Value today of a
future cash
flow.

Present value of
a $1 future
payment.

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Present Values
Present Value

Discount Factor

Value today of a
future cash
flow.

Present value of
a $1 future
payment.
Discount Rate

Interest rate used

to compute
present values of
future cash flows.
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Present Values

Present Value = PV
PV =

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Future Value after t periods

(1+r) t

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Present Values
Example
You just bought a new computer for $3,000. The payment
terms are 2 years same as cash. If you can earn 8% on
your money, how much money should you set aside today
in order to make the payment when due in two years?

PV
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3000
(1.08)2

$2,572

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Present Values
Discount Factor = DF = PV of $1

DF

1
t
(1 r )

Discount Factors can be used to compute

the present value of any cash flow.
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Time Value of Money

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(applications)
The PV formula has many applications.
Given any variables in the equation, you
can solve for the remaining variable.

PV FV

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1
( 1 r ) t

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Time Value of Money

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(applications)
Value of Free Credit
Implied Interest Rates
Internal Rate of Return
Time necessary to accumulate funds

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PV of Multiple Cash Flows

Example
Your auto dealer gives you the choice to pay $15,500 cash
now, or make three payments: $8,000 now and $4,000 at
the end of the following two years. If your cost of money is
8%, which do you prefer?
Immediate payment

PV1

4 , 000
(1.08 )1

3,703.70

PV2

4 , 000
(1.08 ) 2

3,429.36

Total PV
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8,000.00

$15,133.06
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PV of Multiple Cash Flows

PVs can be added together to evaluate
multiple cash flows.

PV

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C1
(1 r )

(1 r ) 2 ....
C2

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Perpetuities & Annuities

Perpetuity
A stream of level cash payments
that never ends.
Annuity
Equally spaced level stream of cash
flows for a limited period of time.

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Perpetuities & Annuities

PV of Perpetuity Formula

PV

C
r

C = cash payment
r = interest rate

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Perpetuities & Annuities

Example - Perpetuity
In order to create an endowment, which pays
$100,000 per year, forever, how much money must
be set aside today in the rate of interest is 10%?

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Perpetuities & Annuities

Example - Perpetuity
In order to create an endowment, which pays
$100,000 per year, forever, how much money must
be set aside today in the rate of interest is 10%?

PV

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100 , 000
.10

$1,000,000

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Perpetuities & Annuities

Example - continued
If the first perpetuity payment will not be received
until three years from today, how much money
needs to be set aside today?

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Perpetuities & Annuities

Example - continued
If the first perpetuity payment will not be received
until three years from today, how much money
needs to be set aside today?

PV

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1, 000 , 000
(1 .10 ) 3

$751,315

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Perpetuities & Annuities

PV of Annuity Formula

PV C

1
r

1
t
r ( 1 r )

C = cash payment
r = interest rate
t = Number of years cash payment is received
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Perpetuities & Annuities

PV Annuity Factor (PVAF) - The present
value of $1 a year for each of t years.

PVAF

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1
r

1
t
r ( 1 r )

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Perpetuities & Annuities

Example - Annuity
You are purchasing a car. You are scheduled to
make 3 annual installments of $4,000 per year.
Given a rate of interest of 10%, what is the price
you are paying for the car (i.e. what is the PV)?

PV 4 ,000

1
.10

1
.10 ( 1 .10 ) 3

PV $9,947.41
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Perpetuities & Annuities

Applications
Value of payments
Implied interest rate for an annuity
Calculation of periodic payments
Mortgage

payment
Annual income from an investment payout
Future Value of annual payments

FV C PVAF (1 r )

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Perpetuities & Annuities

Example - Future Value of annual payments
You plan to save $4,000 every year for 20 years
and then retire. Given a 10% rate of interest, what
will be the FV of your retirement account?

FV 4 ,000

1
.10

1
.10 ( 1 .10 ) 20

(1.10)

20

FV $229,100

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Inflation
Inflation - Rate at which prices as a whole are
increasing.
Nominal Interest Rate - Rate at which money
invested grows.
Real Interest Rate - Rate at which the
purchasing power of an investment increases.

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Inflation
1+ nominal interest rate
1 real interest rate =
1+inflation rate

approximation formula

Real int. rate nominal int. rate - inflation rate

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Inflation
Example
If the interest rate on one year govt. bonds is 5.0%
and the inflation rate is 2.2%, what is the real
interest rate?
1 + real interest rate = 1+.050
1+.022

Savings
Bond

1 + real interest rate = 1.027

Real interest rate = .027 or 2.7%

Approximation = .050 - .022 or .028 or 2.8%

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Effective Interest Rates

Effective Annual Interest Rate - Interest rate
that is annualized using compound interest.

Annual Percentage Rate - Interest rate that is

annualized using simple interest.

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Effective Interest Rates

example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)?

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Effective Interest Rates

example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)?

EAR = (1+.01)

12

- 1 = r

EAR = (1+.01)

12

- 1 =.1268 or 12.68%

APR =.01 x 12 =.12 or 12.00%

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Web Resources

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www.financialplayerscenter.com/Overview.html

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