40 Chapter 2 Time Value of Money

We can use four different procedures to solve time value problems. 2 These methods are described in the following sections.

Step-by-Step Approach
The time line used to find the FV of $100 compounded for 3 years at 5%, along with some calculations, is shown below:
2A

fifth procedure is called the tabular approach. It used tables showing interest factors and was used before financial calculators and computers became available. Now, though, calculators and spreadsheets such as Excel are programmed to calculate the specific factor needed for a given problem and then to use it to find the FV. This is much more efficient than using the tables. Moreover, calculators and spreadsheets can handle fractional periods and fractional interest rates. For these reasons, tables are not used in business today; hence we do not discuss them in the text. For an explanation of the tabular approach, see Web Extension 2C at the textbooks Web site.

Time Amount at beginning of period $100.00 0 5% 1 2 3 $105.00 $110.25 $115.76 You start with $100 in the accountthis is shown at t _ 0. Then multiply the initial amount, and each succeeding amount, by (1 _ I) _ (1.05). You earn $100(0.05) _ $5 of interest during the first year, so the amount at the end of Year 1 (or t _ 1) is FV1 _ PV _ INT _ PV _ PV(I) _ PV(1 _ I) _ $100(1 _ 0.05) _ $100(1.05) _ $105. You begin the second year with $105, earn 0.05($105) _ $5.25 on the now larger beginning-of-period amount, and end the year with $110.25. Interest during Year 2 is $5.25, and it is higher than the first years interest, $5, because you earned $5(0.05) _ $0.25 interest on the first years interest. This is called compounding, and interest earned on interest is called compound interest. This process continues, and because the beginning balance is higher in each successive year, the interest earned each year increases. The total interest earned, $15.76, is reflected in the final balance, $115.76.

Corporate Valuation and the Time Value of Money

In Chapter 1, we told you that managers should strive to make their firms more valuable and that the value of a firm is determined by the size, timing, and risk of its free cash flows (FCF). Recall that free cash flows are the cash flows available for distribution to all of a firms investors (stockholders and creditors) and that the weighted average cost of capital is the average rate of return required by all of the firms investors. We showed you a formula, the same as the one below, for calculating value. That formula takes future cash flows and adjusts them to show how much those future risky cash flows are worth today. That formula is based on time value of money concepts, which we explain in this chapter. Value _ FCF1 11 _ WACC21 _ FCF2 11 _ WACC22 _ FCF3 11 _ WACC23 _ p _ FCFq 11 _ WACC2q