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Chapter 5

Introduction to Valuation:
The Time Value of Money

Le Duc Hoang

McGraw-Hill Ryerson Copyright 2010 McGraw-Hill Ryerson Limited


Chapter Outline
Future Value and Compounding
Present Value and Discounting
Growing Cash Flows
Perpetuities
Annuities
Loan Amortization
Summary and Conclusions

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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
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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

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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

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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

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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

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LO2
Present Value One Period
Example

Suppose you need $10,000 in one year. If


you can earn 7% annually, how much do
you need to invest today?
PV = 10,000 / (1.07)1 = 9345.79

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LO2
Present Value Example 2

You want to begin saving for your daughters college


education and you estimate that she will need
$150,000 in 17 years.
You can earn 8% per year, how much do you need
to invest today?
PV = 150,000 / (1.08)17 = 40,540.34

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LO2
Present Value 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%

5-10
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

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LO2
Present Value 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%?

5-12
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

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LO3
Discount Rate 5.3

Rearrange the basic PV equation and


solve for r
FV = PV(1 + r)t
r = (FV / PV)1/t 1

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LO3
Discount Rate Example 3

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 = 3.714%

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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)

5-16
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

all the cash flows are the same


the first cash flow starts at time 1
5.4 Perpetuities
you can invest $100 in a bank account
paying 5% interest per year forever
At the end of the year youll have $105 in
the bank your original $100 plus $5 in
interest
5.4 Perpetuities
You withdraw the $5 and reinvest the $100
for another year
5.4 Perpetuities
suppose we invest an amount P at an
interest rate r
Every year we can withdraw the interest
we earned, C=r P,
5.4 Perpetuities

Present Value of a Perpetuity

(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:

This is a standard perpetuity of $30,000 per year. The funding you


would need to give the university in perpetuity is the present value of
this cash flow stream
5.4 Perpetuities
Endowing a Perpetuity (contd)
Execute:
From the formula for a perpetuity,

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

Future Value of an Annuity


Example Future Value of an Annuity
Retirement Savings Plan Annuity
Problem:
Ellen is 35 years old, and she has decided to plan for her retirement.
At the end of each year until she is 65, she will save $10,000
10% per year, how much will Ellen have saved at age 65?
Example Future Value of an Annuity
Retirement Savings Plan Annuity

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

Present Value of a Growing Perpetuity


5.6. Growing Cash Flows
The following timeline shows a growing
annuity with initial cash flow C, growing at
a rate of g every period until period N:
5.6. Growing Cash Flows

Present Value of a Growing Annuity:

1 g
N
1
PV= C 1
r - g 1 r
5.7 Loan Amortization

widely used for home mortgages, auto


loans, business loans, retirement plans,
etc.
Financial calculators and spreadsheets
are great for setting up amortization
tables.
EXAMPLE: Construct an amortization
schedule for a $1,000, 10% annual rate
loan with 3 equal payments. 5-35
Step 1:
Find the Required Annual Payment
All input information is already given
PV = 1000
i= 10%
N= 3
PMT= 402.11

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Step 2:
Find the Interest Paid in Year 1

INTt = Beg balt(I)


INT1 = $1,000(0.10) = $100

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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.

PRIN = PMT INT


= $402.11 $100 = $302.11

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Step 4:
Find the Ending Balance after Year 1

END BAL = BEG BAL PRIN


= $1,000 $302.11
= $697.89

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Constructing an Amortization Table:
Repeat Steps 1-4 Until End of Loan

YEAR BEG BAL PMT INT PRIN END BAL


1 $1,000 $ 402 $100 $ 302 $698
2 698 402 70 332 366
3 366 402 36 366 0
TOTAL $1,206 $206 $1,000

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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.

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All
LOs
Table

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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

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