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Introduction to Valuation:
The Time Value of Money
Prepared by Ernest Biktimirov, Brock University
2008 McGraw-Hill Ryerson
Chapter Outline
4.1 Future Value and Compounding
4.2 Present Value and Discounting
4.3 More on Present and Future Values
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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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FV = future value
PV = present value
r = period interest rate, expressed as a decimal
t = number of periods
Effects of Compounding
Simple interest interest earned on principal
only
Compound interest interest earned on both
principal and reinvested interest
Consider the previous example
FV with simple interest = 1000 + 50 + 50 = $1,100
FV with compound interest = $1,102.50
The extra $2.50 comes from the interest of .05($50)
= $2.50 earned on the first interest payment
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Calculator Keys
Texas Instruments BA-II Plus
FV = future value
PV = present value
I/Y = period interest rate
P/Y must equal 1 for the I/Y to be the period rate
Interest is entered as a percent, not a decimal
N = number of periods
Remember to clear the registers (CLR TVM) after
each problem
Other calculators are similar in format
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Discount Rate
Often we will want to know what the implied
interest rate is in an investment
Rearrange the basic PV equation and solve
for r
FV = PV(1 + r)t
r = (FV / PV)1/t 1
If you are using the formula approach, you
will want to make use of both the yx and the
1/x keys on your calculator
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Calculator Approach:
I/Y = 10
PV = -15,000
FV = 20,000
CPT N = 3.02 years
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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)
Click on the Excel icon to open a spreadsheet
containing four different examples.
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Summary
The relationship between present value and
future value for a given rate r and time t is
given by the basic present value equation:
PV = FV / (1 + r)t
As we have shown, it is possible to find any
one of the four components (PV, FV, r, or t)
given the other three
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