LN05Titman 449327 12 LN05

Chapter 5
The Time Value

of Money
The Basics
Slide Contents
Learning Objectives
Principles Applied in this Chapter
5.1
5.2
5.3
5.4
Using Timelines to Visualize Cash Flows

Compounding and Future Value
Discounting and Present Value
Making Interest Rates Comparable
Key Terms
Copyright 2014 Pearson Education, Inc. All rights reserved.
5-2
Learning Objectives
1. Construct cash flow timelines to organize
your analysis of problems involving the
time value of money.
2. Understand compounding and calculate the
future value of cash flows using
mathematical formulas, a financial
calculator, and an Excel spreadsheet.
5-3
Learning Objectives (cont.)

3. Understand discounting and calculate the
present value of cash flows using
mathematical formulas, a financial
calculator and an Excel spreadsheet.
4. Understand how interest rates are quoted
and know how to make them comparable.
5-4
Principles Applied in this Chapter

Principle 1: Money Has a Time Value.
5-5
5.1 USING TIMELINES TO

VISUALIZE CASHFLOWS
5-6
Using Timelines to Visualize

Cashflows
A timeline identifies the timing and amount
of a stream of payments both cash
received and cash spent - along with the
interest rate earned.
A timeline is typically expressed in years,
but it could also be expressed as months,
days or any other unit of time.
5-7
Time Line Example

i=10%
Years
Cash flow
-$100
$30
$20
-$10
$50
The 4-year timeline illustrates the following:

The interest rate is 10%.
A cash outflow of $100 occurs at the beginning of the first
year (at time 0), followed by cash inflows of $30 and $20
in years 1 and 2, a cash outflow of $10 in year 3 and cash
inflow of $50 in year 4.
5-8
5.2 COMPOUNDING AND

FUTURE VALUE
5-9
Compounding and Future Value

Time value of money calculations involve
Present value (what a cash flow would be
worth to you today) and Future value (what
a cash flow will be worth in the future).
5-10
Compound Interest and Time

Example: Suppose that you deposited $500
in your savings account that earns 5%
annual interest. How much will you have in
your account after two years? After five
years?
FV2 = PV(1+i)n = 500(1.05)2 = $551.25
5-11
Compound Interest and Time

YEAR
PV or
Interest Earned (5%)
Beginning Value
FV or
Ending
Value
$500.00
$500*.05 = $25
$525
$525.00
$525*.05 = $26.25
$551.25
$551.25
$551.25*.05 =$27.56
$578.81
$578.81
$578.81*.05=$28.94
$607.75
$607.75
$607.75*.05=$30.39
$638.14
Using Equation 5-1a: FV = PV(1+i)n

= 500(1.05)5
= $638.14
5-12
Figure 5.1 Future Value and Compound Interest

Illustrated
(Panel A) Calculating Compound Interest
5-13

Illustrated (cont.)
(Panel B) The Power of Time
5-14

Illustrated (cont.)
(Panel C) The Power of the Rate of Interest
5-15
Applying Compounding to Things

Other Than Money
Example A DVD rental firm is currently renting
8,000 DVDs per year. How many DVDs will
the firm be renting in 10 years if the demand
for DVD rentals is expected to increase by 7%
per year?
Using Equation 5-1a,
FV = 8000(1.07)10
= 15,737.21 DVDs
5-16
CHECKPOINT 5.2:
CHECK YOURSELF
Calculating the FV of a Cash Flow
What is the FV of $10,000 compounded at
12% annually for 20 years?
5-17
Step 1: Picture the Problem

i=12%
Years
Cash flow
20
-$10,000
Future
Value=?
5-18
Step 2: Decide on a Solution

Strategy
This is a simple future value problem. We can
find the future value using Equation 5-1a.
5-19
Step 3: Solve
Solve Using a Mathematical Formula
FV
= $10,000(1.12)20
= $10,000(9.6463)
= $96,462.93
5-20
Step 3: Solve (cont.)

Solve Using a
Financial Calculator
N = 20
I/Y = 12%
PV = -10,000
PMT = 0
Solve Using an Excel

Spreadsheet
=FV(rate,nper,pmt, pv)
=FV(0.12,20, 0,-10000)
= $96,462.93
FV = $96,462.93
5-21
Step 4: Analyze
If you invest $10,000 at 12%, it will grow
to$96,462.93 in 20 years.
5-22
Compound Interest with Shorter

Compounding Periods
Banks frequently offer savings account that
compound interest every day, month, or
quarter.
More frequent compounding will generate
higher interest income and lead to higher
future values.
5-23
Table 5-2 The Value of $100 Compounded at

Various Non-Annual Periods and Various Rates
5-24
CHECKPOINT 5.3:
CHECK YOURSELF
Calculating Future Values Using
Non-Annual Compounding Periods
If you deposit $50,000 in an account that pays
an annual interest rate of 10% compounded
monthly, what will your account balance be
in 10 years?
5-25
i=10%
Months
Cash flow
120
-$50,000
FV of $50,000
Compounded for
120 months
@ 10%/12
5-26

Strategy
This involves solving for future value of
$50,000. Since the interest is compounded
monthly, we will use equation 5-1b.
5-27
Step 3: Solve
Using a Mathematical Formula
FV = PV (1+i/12)m*12
= $50,000
(1+0.10/12)10*12
= $50,000
(2.7070)
= $135,352.07
Using a Financial
Calculator
N = 120
I/Y = .833%
PV = -50,000
PMT = 0
FV = $135,352
5-28
Step 3: Solve (cont.)

Using an Excel Spreadsheet
=FV(rate,nper,pmt, pv)
=FV(0.00833,120, 0,-50000)
= $135,346.71
5-29
Step 4: Analyze
More frequent compounding leads to a
higher FV as you are earning interest more
often on interest you have previously
earned.
If the interest was compounded annually,
the FV would have been equal to only
$129,687.12
$50,000 (1.10)10 = $129,687.12
5-30
5.3 DISCOUNTING AND

PRESENT VALUE
5-31
The Key Question

What is value today of cash flow to be
received in the future?
The answer to this question requires
computing the present value (PV) i.e. the
value today of a future cash flow, and the
process of discounting, determining the
present value of an expected future cash
flow.
5-32
The Mechanics of Discounting Future

Cash Flows
The term in the bracket is known as the

Present Value Interest Factor (PVIF).
PV = FVn PVIF
5-33
Figure 5.2 The Present Value of $100

Compounded at Different Rates and for Different
Time Periods
5-34
CHECKPOINT 5.4:
CHECK YOURSELF
Solving for the PV of a Future Cash Flow
What is the present value of $100,000 to be
received at the end of 25 years given a 5%
discount rate?
5-35

i=5%
Years
Cash flow
25
$100,000
Present
Value =?
5-36

Strategy
Here we are solving for the present value (PV)
of $100,000 to be received at the end of 25
years using a 5% interest rate. We can solve
using equation 5-2.
5-37
Step 3: Solve
Using a Mathematical
Formula
PV
= $100,000
[1/(1.05)25)
= $100,000 [0.2953]
= $29,530
Using a Financial
Calculator
N = 25
I/Y = 5
PMT = 0
FV = 100,000
PV = -$29,530
5-38
Step 4: Analyze
Once youve found the present value, it can
be compared to other present values. Present
value computation makes cash flows that
occur in different time periods comparable so
that we can make good decisions.
5-39
Two Additional Types of Discounting

Problems
Solving for: (1) Number of Periods; and
(2) Rate of Interest
(1): How long will it take to accumulate a
specific amount in the future?
It is easier to solve for n using the financial calculator
or Excel rather than mathematical formula. (See
checkpoint 5.5)
5-40
The Rule of 72
It determine the number of years it will take
to double the value of your investment.
N = 72/interest rate
For example, if you are able to generate an annual
return of 9%, it will take 8 years (=72/9) to double
the value of investment.
5-41
CHECKPOINT 5.5:
CHECK YOURSELF
Solving for Number of Periods, n
How many years will it take for $10,000 to
grow to $200,000 given a 15% compound
growth rate?
5-42

i=15%
Years
Cash flow
-$10,000
N =?
$200,000
We know FV,
PV, and i and
are solving for
N
5-43

Strategy
In this problem, we are solving for n. We
know the interest rate, the present value and
the future value. We can calculate n using a
financial calculator or an Excel spreadsheet.
5-44
Step 3: Solve
Using a Financial Using an Excel
Calculator
Spreadsheet
I/Y = 15
PMT = 0
PV = -10,000
FV = 200,000
N = NPER(rate,pmt,pv,fv)
= NPER(.15,0,-10000,200000)
= 21.4 years
N = 21.4 years
5-45
Step 4: Analyze
It will take 21.4 years for $10,000 to grow to
$200,000 at an annual interest rate of 15%.
5-46
Solving for the Rate of Interest

(2): What rate of interest will allow your
investment to grow to a desired future value?
We can determine the rate of interest using
mathematical equation, the financial
calculator or the Excel spread sheet.
5-47
CHECKPOINT 5.6:
CHECK YOURSELF
Solving for the Interest Rate, i
At what rate will $50,000 have to
grow to reach $1,000,000 in 30
years?
5-48

i=?%
Years
Cash flow
1
-$50,000
30
$1,000,000
We know FV, PV
and N and are Solving
for interest rate
5-49

Strategy
Here we are solving for the interest rate. The
number of years, the present value, the future
value are known. We can compute the
interest rate using mathematical formula, a
financial calculator or an Excel spreadsheet.
5-50
Step 3: Solve
Using a Mathematical
Formula
Using an Excel
Spreadsheet
I = (FV/PV)1/n - 1
= (1000000/50000)1/30 - 1
= (20)0.0333 - 1
= 1.1050 - 1
= .1050 or 10.50%
=Rate (nper, pmt, pv, fv)

=Rate(30,0,-50000,1000000)
=10.50%
5-51
Step 4: Analyze
You will have to earn an annual interest rate
of 10.50 percent for 30 years to increase the
value of investment from $50,000 to
$1,000,000.
5-52
5.4 MAKING INTEREST RATES

COMPARABLE
5-53
Annual Percentage Rate (APR)

The annual percentage rate (APR) indicates
the interest rate paid or earned in one year
without compounding. APR is also known as
the nominal or quoted (stated) interest
rate.
5-54
Calculating the Interest Rate and

Converting it to an EAR
We cannot compare two loans based on APR if
they do not have the same compounding
period.
To make them comparable, we calculate their
equivalent rate using an annual compounding
period. We do this by calculating the
effective annual rate (EAR)
5-55
CHECKPOINT 5.7:
CHECK YOURSELF
Calculating an EAR
What is the EAR on a quoted or
stated rate of 13 percent that is
compounded monthly?
5-56
i= an annual rate of 13% that is compounded monthly

Months
0
12
Compounding periods
are expressed in months
(i.e. m=12) and we are
Solving for EAR
5-57

Strategy
Here we need to solve for Effective Annual
Rate (EAR). We can compute the EAR by
using equation 5-4
5-58
Step 3: Solve
EAR
= [1+.13/12]12 - 1
= 1.1380 1
= .1380 or 13.80%
5-59
Step 4: Analyze
There is a significant difference between
APR and EAR (13.00% versus 13.80%).
If the interest rate is not compounded
annually, we should compute the EAR to
determine the actual interest earned on an
investment or the actual interest paid on a
loan.
5-60
To the Extreme:
Continuous Compounding
As m (number of compounding period)
increases, so does the EAR. When the time
intervals between when interest is paid are
infinitely small, we can use the following
mathematical formula to compute the EAR.
EAR = (e quoted rate ) 1
Where e is the number 2.71828
5-61
Continuous Compounding (cont.)

Example What is the EAR on your credit
card with continuous compounding if the
APR is 18%?
EAR = e.18 - 1
= 1.1972 1
= .1972 or 19.72%
5-62
Key Terms
Annual Percentage Rate (APR)

Compounding
Compound Interest
Discounting
Discount Rate
Effective Annual Rate (EAR)
Future Value
5-63
Key Terms (cont.)
Future Value Interest Factor

Nominal or Stated Interest Rate
Present Value
Present Value Interest Factor
Simple Interest
Timeline
5-64

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Chapter 5

The Time Value

Using Timelines to Visualize Cash Flows

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Learning Objectives (cont.)

Copyright 2014 Pearson Education, Inc. All rights reserved.

Principles Applied in this Chapter

Copyright 2014 Pearson Education, Inc. All rights reserved.

5.1 USING TIMELINES TO

Copyright 2014 Pearson Education, Inc. All rights reserved.

Using Timelines to Visualize

Copyright 2014 Pearson Education, Inc. All rights reserved.

Time Line Example

The 4-year timeline illustrates the following:

Copyright 2014 Pearson Education, Inc. All rights reserved.

5.2 COMPOUNDING AND

Copyright 2014 Pearson Education, Inc. All rights reserved.

Compounding and Future Value

Copyright 2014 Pearson Education, Inc. All rights reserved.

Compound Interest and Time

Copyright 2014 Pearson Education, Inc. All rights reserved.

Compound Interest and Time

Using Equation 5-1a: FV = PV(1+i)n

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 5.1 Future Value and Compound Interest

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 5.1 Future Value and Compound Interest

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 5.1 Future Value and Compound Interest

Copyright 2014 Pearson Education, Inc. All rights reserved.

Applying Compounding to Things

Copyright 2014 Pearson Education, Inc. All rights reserved.

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 1: Picture the Problem

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Step 2: Decide on a Solution

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 3: Solve (cont.)

Solve Using an Excel

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Compound Interest with Shorter

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Table 5-2 The Value of $100 Compounded at

Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 1: Picture the Problem

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Step 2: Decide on a Solution

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Copyright 2014 Pearson Education, Inc. All rights reserved.

Step 3: Solve (cont.)

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Copyright 2014 Pearson Education, Inc. All rights reserved.

5.3 DISCOUNTING AND

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The Key Question

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The Mechanics of Discounting Future

The term in the bracket is known as the

Copyright 2014 Pearson Education, Inc. All rights reserved.

Figure 5.2 The Present Value of $100