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Fundamentals of Corporate Finance

Sixth Edition

Chapter 5
The Time Value of Money

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

Slides by Matthew Will

McGraw Hill/Irwin McGraw Hill/Irwin

Copyright Copyright 2009 by The McGraw-Hill Companies, Inc. All rights 2009 by The McGraw-Hill Companies, Inc. All rights

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Topics Covered
Future Values and Compound Interest Present Values Multiple Cash Flows Level Cash Flows Perpetuities and Annuities Effective Annual Interest Rates Inflation & Time Value

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

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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

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today Future Years 1 2 3 4 5 Interest Earned 6 6 Value 100 106 112
Value at the end of Year 5 = $130

6 118

6 124

6 130

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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 Interest Earned Value 100

Future Years 1 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 )

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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?
t

FV = $100 (1 + .06) = $133 .82

5

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Future Values with Compounding

1800 1600 1400 FV of $100 1200 1000 800 600 400 200 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Number of Years 0% 5% 10% 15%

Interest Rates

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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 2008, compounded at 8%.

FV = $24 (1 + .08) = $140 .63 trillion

382

FYI - The value of Manhattan Island land is well below this figure.

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Present Values
Present Value Value today of a future cash flow. Discount Rate Interest rate used to compute present values of future cash flows. Discount Factor Present value of a $1 future payment.

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Present Values

Present Va lue = PV PV =
Future Val ue after t periods (1+r)
t

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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.

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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 = FV

1 (1+ r ) t

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Present Values with Compounding

120 100 80 60 40 20 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Number of Years 0% 5% 10% 15%

Interest Rates

PV of $100

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Time Value of Money

(applications)

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

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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?
Immediate payment

8,000.00

PV1 = PV2 =

4 , 000 (1+.08 )1 4 , 000 (1+.08 ) 2

= 3,703 .70 = 3,429 .36

Total PV

= $15,133.06

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Present Values
$8,000 $4,000 Present Value Year 0
0 1 2

$ 4,000

Year

$8,000 4000/1.08 4000/1.082 Total = $3,703.70 = $3,429.36 = $15,133.06

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Perpetuities & Annuities

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 $3,429.36 SUM: Formula in Column C =PV($B$11,A4,0,-B4) =PV($B$11,A5,0,-B5) =PV($B$11,A6,0,-B6)

$15,133.06 =SUM(C4:C6)

Discount rate:

0.08

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PV of Multiple Cash Flows

PVs can be added together to evaluate multiple cash flows.

PV =

C1 (1+ r )
1

+ (1+ r ) 2 +....
C2

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Perpetuities & Annuities

Perpetuity A stream of level cash payments that never ends. Annuity Equally spaced level stream of cash flows for a limited period of time.

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Perpetuities & Annuities

PV of Perpetuity Formula

PV =
C = cash payment r = interest rate

C r

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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 in the rate of interest is 10%?

PV =

100 , 000 .10

= $1,000,000

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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

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Perpetuities & Annuities

PV of Annuity Formula

PV = C

1 r

1 r (1+ r ) t

C = cash payment r = interest rate t = Number of years cash payment is received

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Perpetuities & Annuities

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

PVAF =

1 r

1 r (1+ r ) t

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Perpetuities & Annuities

Example - Annuity You are purchasing a car. You are scheduled to make 3 annual installments of $4,000 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 = 4,000

PV = $9,947 .41

1 .10

1 .10 (1+.10 ) 3

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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 )

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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, what will be the FV of your retirement account?

FV = 4,000

FV = $229 ,100

1 .10

1 .10 (1+.10 ) 20

] (1+.10)

20

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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.

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Effective Interest Rates

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

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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) - 1 = r EAR = (1 + .01)12 - 1 = .1268 or 12.68% APR = .01 x 12 = .12 or 12.00%

12

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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.

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Inflation
Annual U.S. Inflation Rates from 1900 - 2007

Annual Inflation, %

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Inflation
1+nominal in terest rat e 1 + real inter est rate = 1+inflation rate

approximation formula

Real int. rate nominal in t. rate - inflation rate

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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 real interest rate = .039 or 3.9%

Saving s Bond

Approximat ion = .06 - .02 = .04 or 4.0%

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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.

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