Chapter 5

Fundamentals
of Corporate
Finance
Eighth Edition

Richard A. Brealey
Stewart C. Myers
Alan J. Marcus

Irwin/McGraw Hill

The Time Value

of Money

5- 1
Copyright 2015 by The McGraw-Hill Companies, Inc. All rights

Topics Covered
5.1Future Values and Compound Interest
5.2Present Values
5.3Multiple Cash Flows
5.4Reducing the Chore of the Calculations (1)
5.5 Level Cash Flows: Perpetuities and Annuities
5.6Reducing the Chore of the Calculations (2)
5.7Effective Annual Interest Rates
5.8Inflation & The Time Value of Money

5- 2

Future Values
Future Value - Amount to which an
investment will grow after earning interest.
Simple Interest - Interest earned only on the
original investment .
Compound Interest - Interest earned on
interest.

5- 3

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

5- 4

Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a
principal balance of $100.
Today
1
Interest Earned
Value 100

Future Years
2
3
6
106

6
112

6
118

6
124

6
130

Value at the end of Year 5 = $130

5- 5

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
1
Interest Earned
Value
100

Future Years
2
3
4
5
6
6.36
6.74
7.15
7.57
106 112.36 119.10 126.25 133.82

Value at the end of Year 5 = $133.82

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Future Values
Future Value of $100 = FV

FV $100 (1 r )

5- 8

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

5- 9

Financial Calculators
n

PV

PMT

FV

n is the number of periods

i is the interest rate, expressed as a percentage (not a
decimal)
PV is the present value
PMT is the amount of any recurring payment
FV is the future value.
5- 10

Future Values with Compounding

Interest Rates

5- 11

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 2014,
compounded at 8%.

For
Sale

FV $24 (1 .08)
$223 trillion

388

FYI - The value of Manhattan Island land is

well below this figure.
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Financial Calculators
Example: What is the future value of Peter Minuits $24
investment if invested at 8% for 388 years.

PV

PMT

FV

388

24

FV

Enter the number listed below the key and then push the
financial function key. To get the final answer, then push FV and
you will get -$223.17 trillion. Ignore the minus sign and that is
the answer.
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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.
5- 14

Present Values

Present Value = PV
PV =

Future Value after t periods

(1+r) t

5- 15

Present Values
Discounted Cash Flow (DCF)
Method of calculating present value by
discounting future cash flows.
Future cash flow

Present value

5- 16

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

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.

5- 18

Financial Calculators
Example (same as before)
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

PMT

FV

PV

3000

To get the final answer, then push PV and you will get -$2,572.02.
Ignore the minus sign and that is the answer.

5- 19

Present Values with Compounding

Interest Rates

5- 20

Present Values
Drawing a time line can help us to calculate the present
value of the payments to Kangaroo Autos

5- 21

Time Value of Money

(applications)

The PV formula has many applications.

Given any variables in the equation, you
can solve for the remaining variable.

PV future payment (11r )t

5- 22

Time Value of Money

(applications)

Italy borrowed money for 2 years, but it did not announce

an interest rate. It simply offered to sell each IOU for
963.06. What is the interest rate?

963.06 1,000 (11r ) 2

r .019 or 1.9%

5- 23

Time Value of Money

(applications)

Value of Free Credit

Implied Interest Rates
Internal Rate of Return
Time necessary to accumulate funds

5- 24

FV of Multiple Cash Flows

Example
You are able to put $1,200 in the bank now, and another
$1,400 in 1 year. If you earn an 8% rate of interest, how
much will you be able to spend on a computer in 2 years?

FV1 1,400 (1.08) 1,512.00

FV2 1,200 (1.08) 1,399.68
2

Total FV

$2,911.68
5- 25

PV of Multiple Cash Flows

PVs can be added together to evaluate
multiple cash flows.

PV

C1
(1 r )

(1 r ) 2 ....
C2

5- 26

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?
Immediat epayment 8,000.00

PV1

4 , 000
(1.08)1

3,703.70

PV2

4 , 000
(1.08) 2

3,429.36

Total PV

$15,133.06
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Present Values
$8,000
$4,000
Present Value
Year 0

4000/1.08

$8,000
= $3,703.70

4000/1.082

= $3,429.36

Total

= $15,133.06

$ 4,000

Year

5- 28

Spreadsheets
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?
Finding the present value of multiple cash flows by using a spreadsheet
Time until CF Cash flow Present value
0
8000
$8,000.00
1
4000
$3,703.70
2
4000
$3,429.36
SUM:

Discount rate:

Formula in Column C
=PV($B$11,A4,0,-B4)
=PV($B$11,A5,0,-B5)
=PV($B$11,A6,0,-B6)

$15,133.06 =SUM(C4:C6)

0.08

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Perpetuities & Annuities

Perpetuity
A stream of level cash payments
that never ends.
Annuity
Level stream of cash flows at
regular intervals with a finite
maturity.
5- 30

Perpetuities & Annuities

PV of Perpetuity Formula

PV

C
r

C = cash payment
r = interest rate

5- 31

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 of the rate of interest is 10%?

PV

100 , 000
.10

$1,000,000

5- 32

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

1, 000 , 000
(1 .10 ) 3

$751,315

5- 33

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

5- 34

Perpetuities & Annuities

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

PVAF

1
r

1
t
r (1 r )

5- 35

Perpetuities & Annuities

Example - Annuity
You are purchasing a car. You are scheduled to
make 3 annual installments of $8,000 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 8,000

1
.10

.10(11.10 )3

PV $19,894.82
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Perpetuities & Annuities

Example - Annuity
You are purchasing a car. You are scheduled to make 3 annual installments of
$8,000 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)?

5- 37

Financial Calculators
Example (same as before)
You are purchasing a car. You are scheduled to make 3 annual
installments of $8,000 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

PMT

FV

10

PV

-8000

To get the final answer, then push PV and you will get -$19,894.82.
Ignore the minus sign and that is the answer.
5- 38

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 )

5- 39

Perpetuities & Annuities

Example - Future Value of annual payments
You plan to save $3,000 every year for 4 years.
Given a 8% rate of interest, what will be the FV of
your account?

PV 3,000

1
.08

.08(11.08) 4

PV $9,936
FV $9,936 (1.08) 4 $13,518
5- 40

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, how much will you have saved
by the time you retire?

FV $4, 000

1
.10

FV $229,100

.10(11.10)20 (1 .10) 20

5- 41

Perpetuities & Annuities

Example:
You are purchasing a home and are scheduled to make 30
annual installments of $10,000 per year. Given an interest
rate of 5%, what is the price you are paying for the house
(i.e. what is the present value)?

PV $10, 000

.05(11.05)30

PV $153, 724.51
1
.05

5- 42

Financial Calculators
Example (same as before)
You are taking out a mortgage for $100,000. You will pay it back
over 30 years paying 1% per month. What is your monthly payment?

PV

PMT

FV

360

100,000

PMT

To get the final answer, then push PMT and you will get $1,028.61.
5- 43

Annuity Due
Annuity Due - Level stream of cash flows starting
immediately.
How does it differ from an ordinary annuity?

PVAnnuity Due PVAnnuity (1 r )

How does the future value differ from an ordinary annuity?

FVAnnuity Due FVAnnuity (1 r )

5- 44

Annuities Due: Example

FVAD FVAnnuity (1 r )
Example: Suppose you invest $429.59 annually at the
beginning of each year at 10% interest. After 50 years,
how much would your investment be worth?

5- 45

Spreadsheets

5- 46

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.

5- 47

EAR & APR Calculations

Annual Percentage Rate (APR):
Effective Annual Interest Rate (EAR):

EAR (1 MR )12 1

APR MR 12

MR = monthly interest rate

5- 48

Effective Interest Rates

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

5- 49

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
12

EAR = (1 + .01) - 1 = .1268 or 12.68%

APR = .01 x 12 = .12 or 12.00%
5- 50

EAR & Financial Calculators

Example (same as before)
Given a 12% APR, what is the Effective Annual Rate, given monthly
compounding?

PV

PMT

FV

12

-1

FV

To get the final answer, then push FV and you will get 1.1268.
Subtract 1 and your answer is 12.68%.
5- 51

APR & Financial Calculators

Example (same as before)
Given a 6.50 % EAR what is the APR, given monthly compounding?

n
12

i
i

PV
-1

PMT

FV

1.06
5

To get the final answer, then push i and you will get .5262. Multiply
by 12 and your answer is 6.314%.
5- 52

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.

5- 53

Inflation
Annual U.S. Inflation Rates from 1900 - 2013
Annual Inflation, %

25
20
15
10
5
0
-5
-10
-15

5- 54

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

approximation formula

Real int. rate nominal int. rate - inflation rate

5- 55

Inflation
Example
If the interest rate on one year govt.
bonds is 6.0% and the inflation rate is
2.0%, what is the real interest rate?
1+.06
1 real interest rate = 1+.02

1 real interest rate = 1.039

Saving
s
Bond

real interest rate = .039 or 3.9%

Approximation = .06 - .02 = .04 or 4.0%
5- 56

Inflation

Remember: Current dollar cash

flows must be discounted by the
nominal interest rate; real cash
flows must be discounted by the
real interest rate.

5- 57