Introduction To Valuation:

The Time Value Of Money

Chapter 4
Topics
1. How To Determine The Future
Value Of An Investment
2. How To Determine The Present
Value Of Cash To Be Received At A
Future Date
3. How To Find The Return On An
Investment

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 Fundamental Truth in Finance:
 A dollar earned now is worth more than a dollar earned later.
 This is true because of the ability of individuals to earn interest.

Today 1 year from today

$1 received today $1 received 1 year from today

The $1 received today is worth more than a

dollar received 1 year from now because
you can invest the dollar and earn interest.

Today (at 10% simple rate) 1 year from today

$1.00 grows to $1.10

Present Value Future Value

(Interest going backwards) (Interest going forward)
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Fundamental Financial Concept
 A dollar received today is worth
more than a dollar received later
 This is because of interest 
 This is because of the discount rate 

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Definitions:
 Simple interest
 Interest earned only on the original principal
amount invested
 Compound interest
 Interest earned on both the initial principal
and the interest reinvested from prior periods
 Interest on interest
 Interest earned on the reinvestment of
pervious interest payments
 Compounding
 The process of accumulating interest in an
investment over time to earn more interest
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Variables for the Financial Functions Defined:
An = Annuity = Regular Payments (PMT) Made at Regular Time Intervals
Made at End of Period
LS = Lump Sum Payment = Payment Made Once
FV=Future Value (Lump Sum Value in the Future)
PV=Present Value (Lump Sum Value in the Present)
PMT = Regular Payment Made at Regular Time Intervals
i = Annual Interest Rate
n = Number of Compounding Periods per Year
x = Years

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Future value:
 The amount an investment is worth after
one or more periods

n*x
 i
FVLS = PVLS * 1+ 
 n

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Future Values: (Textbook formula)
 Textbook 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

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100 bucks invested @ 10%
compounded yearly for 2 years
100*(1+.10)=110
110*(1+.10)=121

100*(1+.10)*(1+.10)=121
100*(1+.10) 2 =121
1*2
 .10 
100* 1+   121
 1 
n* x
 i
FVLS  PVLS * 1  
 n 9
10
11
How To Determine The Future Value Of
An Investment
 Suppose you invest $1000 for one year at 5% per
year, compounded yearly. What is the future value
in one year?
 Interest = 1000(.05) = 50
 Value in one year = principal + interest = 1000 +
50 = 1050
 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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Effects of Compounding
 Simple interest
 Compound 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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Future Values – Example 2
 Suppose you invest the $1000 from the
previous example for 5 years, compounded
yearly. How much would you have?
 FV = 1000(1.05)5 = 1276.28
 Theeffect of compounding is small for a small
number of periods, but increases as the number
of periods increases. (Simple interest would
have a future value of $1250, for a difference of
$26.28.)
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Future Values – Example 3
 Suppose you had a relative deposit $10 at 5.5%
interest 200 years ago , compounded yearly.
How much would the investment be worth
today?
 FV = 10(1.055)200 = 447,189.84
 What is the effect of compounding?
 Simple interest = 10 + 200(10)(.055) = 210.55
 Compounding added $446,979.29 to the value of
the investment

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Present Value
 How much should you put in the bank
today in order to receive a future value
amount after one or more periods
 The current value of future cash flows
discounted at the appropriate rate

If you know the

FVLS future amount you
PVLS = n*x
would like, assume

 i an interest rate, and

1+ 
take all the interest
that you will need to
 n earn out of the
future value amount
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Present Values (Textbook formula)
 How much do I have to invest today to have some
amount in the future?
 Textbook FV = PV(1 + r)t
 Rearrange to solve for PV = FV / (1 + r)t

 When we talk about discounting, we mean finding the

present value of some future amount.
 When we talk about the “value” of something, we are

talking about the present value unless we specifically

indicate that we want the future value.

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Definitions:
 Discount Rate
 The rate used to calculate the present
value of future cash flows
 Discount
 Calculate the present value of some
future amounts
 Discounted Cash Flow (DCF) valuation
 Calculating the present value of future
cash flows to determine its value today

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How To Determine The Present Value Of
Cash To Be Received At A Future Date
 You want to begin saving for you daughter’s
college education and you estimate that she will
need $150,000 in 17 years. If you feel
confident that you can earn 8% per year,
compounded yearly, how much do you need to
invest today?
 PV = 150,000 / (1.08)17 = 40,540.34

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Present Values – Example 2
 Yourparents set up a trust fund for you 10
years ago that is now worth $19,671.51. If the
fund earned 7% per year, compounded yearly,
how much did your parents invest?
 PV = 19,671.51 / (1.07)10 = 10,000

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PV – Important Relationship I
 Fora 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%,
compounded yearly.
 5 years: PV = 500 / (1.1)5 = 310.46

 10 years: PV = 500 / (1.1)10 = 192.77

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PV – 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%? (both
compounded yearly).
 Rate = 10%: PV = 500 / (1.1)5 = 310.46
 Rate = 15%; PV = 500 / (1.15)5 = 248.58

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Figure 4.3

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How To Find The Return On An
Investment
 If you invest $100 today in an account
that compounds interest yearly and in 8
years you have $200, what is the interest
rate?

 Rule of 72 = A reasonable estimate for

the required rate to have an investment
double = 72/(i/n) = Number of periods

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How To Find The Number Of Periods
Required For An Investment
 If you want to buy an asset that
cost $100,000 and you have
$50,000 to invest now, at a rate of
12%, compounded annually, how
many years must you wait?

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Example: Spreadsheet Strategies
 Usethe 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)

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Real assets/ Financial assets
 Present value and future value are
fundamental to finance
 Most instruments:
 Real assets
 Buildings, trucks
 Financial assets
 Debt, Equity, Preferred stock,
derivatives
Can be analyzed using DCF valuation
techniques
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