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Introduction to Valuation:
The Time Value of Money
Le Duc Hoang
5-1
All
LOs
Basic Definitions
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
Discount rate
Cost of capital
Opportunity cost of capital
Required return
5-2
LO1
Future Value Example 1
Suppose you invest $1000 for one year at 5%
per year. What is the future value in one year?
Interest = 1000(.05) = 50
Future Value (FV) = 1000(1 + .05) = 1050
Suppose you leave the money in for another
year. How much will you have two years from
now?
FV = 1000(1.05)(1.05) = 1000(1.05)2 = 1102.50
5-3
LO1
Future Value: 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
Future value interest factor = (1 + r)t
5-4
LO1
Effects of Compounding
Simple interest principal
Compound interest principal and reinvested
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
5-5
LO1
Example 2- Future Value
Suppose you invest the $1000 from the
previous example for 5 years. How much
would you have?
Formula Approach:
FV = 1000(1.05)5 = 1276.28
5-6
LO2
Present Values 5.2
How much do I have to invest today to
have some specified amount in the future?
FV = PV(1 + r)t
Rearrange to solve for PV = FV / (1 + r)t
5-7
LO2
Present Value One Period
Example
5-8
LO2
Present Value Example 2
5-9
LO2
Present Value Important
Relationship I
For a given interest rate the longer the
time period, the lower the present value
5-10
LO2
Important Relationship I
continued
Formula Approach
5 years: PV = 500 / (1.1)5 = 310.46
10 years: PV = 500 / (1.1)10 = 192.77
Notice that the 10-year present value is
lower than the 5-year present value
5-11
LO2
Present Value Important
Relationship II
For a given time period the higher the
interest rate, the smaller the present value
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LO2
Important Relationship II
continued
Formula Approach
Rate = 10%: PV = 500 / (1.1)5 = 310.46
Rate = 15%; PV = 500 / (1.15)5 = 248.59
Notice that the present value with the 15%
interest rate is lower than the present value
with the 10% interest rate
5-13
LO3
Discount Rate 5.3
5-14
LO3
Discount Rate Example 3
5-15
LO4
Finding the Number of Periods
Start with basic equation and solve for t
(remember your logs)
FV = PV(1 + r)t
t = ln(FV / PV) / ln(1 + r)
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LO4
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?
Formula Approach
t = ln(20,000 / 15,000) / ln(1.1) = 3.02 years
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5.4 Perpetuities
Consider the type of cash flow streams:
C C C
PV= ......
(1 r ) (1 r ) (1 r )
2 3
(Eq. 4.4)
5.4 Perpetuities
Endowing a Perpetuity
Problem:
You budget $30,000 per year forever for
the party.
If the university earns 8% per year on its
investments, and if the first party is in one
years time, how much will you need to
donate to endow the party?
5.4 Perpetuities
Endowing a Perpetuity (contd)
Solution:
Plan:
The timeline of the cash flows you want to provide is:
P V C / r $ 3 0 , 0 0 0 / 0 .0 8 $ 3 7 5 , 0 0 0 t o d ay
5.5 Annuities
Annuities
An annuity is a stream of N equal cash flows
paid at regular intervals
C C C C
PV= ......
(1 r ) (1 r ) (1 r ) (1 r )
2 3 N
5.5 Annuities
5.5 Annuities
Execute:
1 30
FV $10,000 (1 .1 0 1)
0.10
$ 1 0 , 0 0 0 1 6 4 .4 9
$ 1 .6 4 5 m i l l io n at a g e 6 5
5.6. Growing Cash Flows
For example, a growing perpetuity with a
first payment of $100 that grows at a rate
of 3% has the following timeline:
5.6. Growing Cash Flows
1 g
N
1
PV= C 1
r - g 1 r
5.7 Loan Amortization
5-36
Step 2:
Find the Interest Paid in Year 1
5-37
Step 3:
Find the Principal Repaid in Year 1
If a payment of $402.11 was made at the
end of the first year and $100 was paid
toward interest, the remaining value must
represent the amount of principal repaid.
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Step 4:
Find the Ending Balance after Year 1
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Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan
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All
LOs
Spreadsheet Example
Use the following formulas for TVM calculations
FV(rate,nper,pmt,pv)
PV(rate,nper,pmt,fv)
RATE(nper,pmt,pv,fv)
NPER(rate,pmt,pv,fv)
The formula icon is very useful when you cant
remember the exact formula
Click on the Excel icon to open a spreadsheet
containing four different examples.
5-41
All
LOs
Table
5-42
Summary
The basics of time value of money have
been covered. You should be able to:
Calculate the future value of an amount given
today
Calculate the present value of an amount to
be received in the future
Find the interest rate
Find the number of periods
5-43