FoCFinance CH 3

Fundamentals of Corporate Finance
Fifth Edition, Global Edition
Chapter 3
Time Value of Money: An
Introduction
Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

Chapter Outline
3.1 Cost-Benefit Analysis
3.2 Market Prices and the Valuation Principle
3.3 The Time Value of Money and Interest Rates
3.4 Valuing Cash Flows at Different Points in Time

Learning Objectives
• Identify the role of financial managers and competitive
markets in decision making
• Understand the Valuation Principle, and how it can be
used to identify decisions that increase the value of the
firm
• Assess the effect of interest rates on today’s value of
future cash flows
• Calculate the value of distant cash flows in the present and
of current cash flows in the future

3.1 Cost-Benefit Analysis (1 of 8)
• Role of the Financial Manager
– Make decisions on behalf of the firm’s investors
▪ For good decisions, the benefits exceed the costs

• Role of the Financial Manager
– Real-world opportunities are often difficult to quantify
and involve using skills from other management
disciplines:
▪ Marketing
▪ Economics
▪ Organizational Behavior
▪ Strategy
▪ Operations

• Quantifying Costs and Benefits
– Any decision in which the value of the benefits exceeds
the costs will increase the value of the firm

– Suppose a jewelry manufacturer has the opportunity to
trade 200 ounces of silver and receive 10 ounces of
gold today
– To compare the costs and benefits, we first need to
quantify their values in equivalent terms – cash today


– If the current market price for silver is $20 per ounce,
then the 200 ounces of silver we give up has a cash
value of: ( 200 ounces of silver ) × ( $20/ounce ) = $4,000

– Assume gold can be bought and sold for a current
market price of $1,000 per ounce. Then the 10 ounces
of gold we receive has a cash value of: (10 ounces of
gold)× ( $1,000/ounce ) = $10,000


– Therefore, the jeweler’s opportunity has a benefit of
$10,000 today and a cost of $4,000 today. In this case,
the net value of the project today is: $10,000-
$4,000=$6,000
– Because it is positive, the benefits exceed the costs
and the jeweler should accept the trade

– Role of Competitive Market Prices
▪ A competitive market is one in which a good can be
bought and sold at the same price
▪ In a competitive market, the price determines the
value of the good
– Personal opinion of the “fair” price is irrelevant

Example 3.1 Competitive Market
Prices Determine Value (1 of 4)
Problem
• You have just won a radio contest and are disappointed to
learn that the prize is four tickets to the Def Leppard
reunion tour (face value $40 each). Not being a fan of
1980s power rock, you have no intention of going to the
show. However, the radio station offers you another option:
two tickets to your favorite band’s sold-out show (face
value $45 each). You notice that, on StubHub, tickets to
the Def Leppard show are being bought and sold for $30
apiece and tickets to your favorite band’s show are being
bought and sold at $50 each. What should you do?

Solution
Plan
• Market prices, not your personal preferences (or the face
value of the tickets), are relevant here:
– 4 Def Leppard tickets at $30 apiece
– 2 of your favorite band’s tickets at $50 apiece
• You need to compare the market value of each option and
choose the one with the highest market value.

Execute
• The Def Leppard tickets have a total value of $120 (4×$30)

versus the $100 total value of the other 2 tickets (2×$50).
Instead of taking the tickets to your favorite band, you
should accept the Def Leppard tickets, sell them on
StubHub, and use the proceeds to buy 2 tickets to your
favorite band’s show. You’ll even have $20 left over to buy
a T-shirt.

Evaluate
• Even though you prefer your favorite band, you should still
take the opportunity to get the Def Leppard tickets instead.
As we emphasized earlier, whether this opportunity is
attractive depends on its net value using market prices.
Because the value of Def Leppard tickets is $20 more than
the value of your favorite band’s tickets, the opportunity is
appealing.

Example 3.1a Competitive Market
Problem:
• Your car recently broke down and it needs $2,000 in
repairs. But today is your lucky day because you have just
won a contest where the prize is either a new motorcycle,
with a MSRP of $15,000, or $10,000 in cash. You do not
have a motorcycle license, nor do you plan on getting one.
You estimate you could sell the motorcycle for $12,000.
Which prize should you choose?

Solution:
Plan:
• Market prices, not your personal preferences (nor the face
value of the tickets), are relevant here:
– A motorcycle worth $12.000
– $10,000 cash
• You need to compare the market value of each option and
choose the one with the highest market value

Execute:
• Instead of taking the cash, you should accept the
motorcycle, sell it for $12,000, use $2,000 to pay for your
car repairs, and still have $10,000 left over.

Evaluate:
• As we emphasized earlier, whether this opportunity is
attractive depends on its net value using market prices
• Because the net value of taking the motorcycle and selling
it is $2,000 more than taking the cash, the opportunity is
appealing

3.2 Market Prices and the Valuation
Principle
• The Valuation Principle
– The value of a commodity or an asset to the firm or its
investors is determined by its competitive market price
– The benefits and costs of a decision should be
evaluated using those market prices
– When the value of the benefits exceeds the value of
the costs, the decision will increase the market value of
the firm

Example 3.2 Applying the Valuation
Principle (1 of 4)
Problem
• You are the operations manager at your firm. Due to a pre-
existing contract, you have the opportunity to acquire 200
barrels of oil and 3000 pounds of copper for a total of
$25,000. The current market price of oil is $90 per barrel
and for copper is $3.50 per pound. You are not sure that
you need all the oil and copper, so you are wondering
whether you should take this opportunity. How valuable is
it? Would your decision change if you believed the value of
oil or copper would plummet over the next month?

Principle (2 of 4)
Solution
Plan
• We need to quantify the costs and benefits using market
prices. We are comparing $25,000 with:
– 200 barrels of oil at $90 per barrel
– 3000 pounds of copper at $3.50 per pound

Principle (3 of 4)
Execute
• Using the competitive market prices we have:
– ( 200 barrels of oil ) × ( $90/barrel today ) = $18,000 today

– ( 3000 pounds of copper )× ( $3.50/pound today ) = $10,500 today

Principle (4 of 4)
• The value of the opportunity is the value of the oil plus the
value of the copper less the cost of the opportunity, or
$18,000 + $10,500-$25,000 = $3500 today. Because the
value is positive, we should take it. This value depends
only on the current market prices for oil and copper. If we
do not need all of the oil and copper, we can sell the
excess at current market prices. Even if we thought the
value of oil or copper would drop soon, the value of this
investment would be unchanged. (We can always
exchange them for dollars immediately at the current
market prices.)

Example 3.2a Applying the Valuation
Principle (1 of 4)
Problem:
• You are offered the following investment opportunity: In
exchange for $50,000 today, you will receive 2,500 shares
of stock in the Ford Motor Company and 10,000 euros
today. The current market price for Ford stock is $14 per
share and the current exchange rate is $1.12 per €. Should
you take this opportunity? Would your decision change if
you believed the value of the euro would rise over the next
month?

Principle (2 of 4)
Solution:
Plan:
• The costs and benefits must be converted to their cash
values. Assuming competitive market prices:
– 2,500 shares×$14/share = $35,000
– €10,000×$1.12/ € = $11,200

Principle (3 of 4)
Execute:
• The net value of the opportunity $35,000 + $11,200-
$50,000 =-$3,800, we should not take it.

Principle (4 of 4)
Evaluate:
• This value depends only on the current market prices for
Ford and the euro.
• Our personal opinion about the future prospects of the
euro and Ford does not alter the value the decision today.
• This decision is not good for the firm, and will decrease its
value by $3,800

Principle (1 of 2)
• Why There Can Be Only One Competitive Price for a Good
– Law of One Price
▪ In competitive markets, securities that produce
exactly the same cash flows must have the same
price

Principle (2 of 2)
• Why There Can Be Only One Competitive Price for a Good
– Arbitrage
▪ The practice of buying and selling equivalent goods
to take advantage of a price difference
– Arbitrage Opportunity
▪ Any situation in which it is possible to make a profit
without taking any risk or making any investment

3.3 The Time Value of Money and
Interest Rates (1 of 13)
• The Time Value of Money
– In general, a dollar today is worth more than a dollar in
one year
▪ If you have $1 today and you can deposit it in a
bank at 10%, you will have $1.10 at the end of one
year
– The difference in value between money today and
money in the future the time value of money.

• The Time Value of Money
– Consider a firm's investment opportunity with a cost of
$100,000 today and a benefit of $105,000 at the end of
one year.

Figure 3.1 Converting Between Dollars
Today and Gold or Dollars in the Future
We can convert dollars today to different goods or points in time by using
the competitive market price or interest rate. Once values are in
equivalent terms, we can use the Valuation Principle to make a decision.

• The Interest Rate: Converting Cash Across Time
– By depositing money, we convert money today into
money in the future
– By borrowing money, we exchange money in the future
for money today

– Interest Rate (r)
▪ The rate at which money can be borrowed or lent
over a given period
– Interest Rate Factor (1 + r)
▪ It is the rate of exchange between dollars today and
dollars in the future
▪ It has units of “$ in one year/$ today”

– Value of $100,000 Investment in One Year
▪ If the interest is 10%, the cost of the investment is:
Cost = ( $100,000 today ) ×(1.10 $ in one year/$1
today) = $110,000 in one year

▪ $110,000 is the opportunity cost of spending $100,000
today
– The firm gives up the $110,000 it would have had in
one year if it had left the money in the bank
– Alternatively, by borrowing the $100,000 from the
same bank, the firm would owe $110,000 in one year.

▪ The investment’s net value is difference between
the cost of the investment and the benefit in one
year: $105,000-$110,000 =-$5,000 in one year

– Value of $100,000 Investment Today
▪ How much would we need to have in the bank today so
that we would end up with $105,000 in the bank in one
year?
– This is calculated by dividing by the interest rate
factor:

– Value of $100,000 Investment Today
▪ The investment’s net value today is the difference
between the cost of the investment and the benefit
in one year: $95,454.55-$100,000 =-$4,545.55
today

– Present Versus Future Value
▪ Present Value
– The value of a cost or benefit computed in terms of
cash today
• (-$4,545.45)
▪ Future Value
– The value of a cash flow that is moved forward in time
• ( $5,000 )( -$4,545.45 today )×(1.10 $ in one
year/$ today) =-$5,000 in one year

– Discount Factors and Rates
▪ Money in the future is worth less today so its price
reflects a discount
▪ Discount Rate
– The appropriate rate to discount a cash flow to
determine its value at an earlier time
▪ Discount Factor
– The value today of a dollar received in the future
– The one-year discount factor is expressed as:
1
1+r
Example 3.3 Comparing Revenues at
Different Points in Time (1 of 4)
Problem
• The launch of Sony’s PlayStation 3 was delayed until November
2006, giving Microsoft’s Xbox 360 a full year on the market
without competition. Sony did not repeat this mistake in 2013
when PS4 launched at the same time as Xbox One. Imagine that
it is November 2005 and you are the marketing manager for the
PlayStation. You estimate that if PlayStation 3 were ready to be
launched immediately, you could sell $2 billion worth of the
console in its first year. However, if your launch is delayed a year,
you believe that Microsoft’s head start will reduce your first-year
sales by 20% to $1.6 billion. If the interest rate is 8%, what is the
cost of a delay of the first year’s revenues in terms of dollars in
2005?
Solution
Plan
• Revenues if released today: $2 billion
• Revenue if delayed: $1.6
• billion Interest rate: 8%
• We need to compute the revenues if the launch is delayed and
compare them to the revenues from launching today. However, in
order to make a fair comparison, we need to convert the future
revenues of the PlayStation if they are delayed into an equivalent
present value of those revenues today.

Execute
• If the launch is delayed to 2006, revenues will drop by 20%
of $2 billion, or $400 million, to $1.6 billion. To compare
this amount to revenues of $2 billion if launched in 2005,
we must convert it using the interest rate of 8%:
$1.6 billion
$1.6 billion in 2006÷ ( $1.08 in 2006/$1 in 2005 ) = =$1.481 billion in 2005
(1.08 )
• Therefore, the cost of a delay of one year is

$2 billion-$1.481 billion = $0.519 billion ( $519 million ) .

Evaluate
• Delaying the project for one year was equivalent to giving
up $519 million in cash. In this example, we focused only
on the effect on the first year’s revenues. However,
delaying the launch delays the entire revenue stream by
one year, so the total cost would be calculated in the same
way by summing the cost of delay for each year of
revenues.

Example 3.3a Comparing Costs at
Problem:
• The cost of replacing a fleet of company trucks
with more energy efficient vehicles was $100 million in
2019. The cost is estimated to rise by 8.5% in 2020. If the
interest rate is 4%, what is the cost of a delay in terms of
dollars in 2020?

Example 3.3a Comparing Costs at
Solution:
Plan:
• We need to compute the cost if the replacement is delayed
and compare them to the cost from replacing today
• However, in order to make a fair comparison, we need to
convert the future costs of waiting a year into an equivalent
present value of those costs today

Example 3.3a Comparing Revenues
at Different Points in Time (1 of 2)
Execute:
– If the project were delayed, its cost in 2020 will be:
▪ $100 million× (1.085 ) = $108.5 million
– Compare this amount to the cost of $100 million in
2019 using the interest rate of 4%:
▪ $108.5 million÷1.04 = $104.33 million in 2019
dollars.
– The cost of a delay of one year would be:
▪ $104.33 million-$100 million = $4.33 million in
2019 dollars.
Example 3.3a Comparing Revenues
at Different Points in Time (2 of 2)
Evaluate:
• Delaying the project for one year was equivalent to giving
up $4.33 million in cash

• Timelines
– Constructing a Timeline
– Identifying Dates on a Timeline
▪ Date 0 is today, the beginning of the first year
▪ Date 1 is the end of the first year

• Timelines
– Distinguishing Cash Inflows from Outflows
– Representing Various Time Periods

▪ Just change the label from “Year” to “Month” if
monthly
3.4 Valuing Cash Flows at Different
Points in Time (1 of 6)
• Rule 1: Comparing and Combining Values
– It is only possible to compare or combine values at the
same point in time

• Rule 2: Compounding
– To calculate a cash flow’s future value, you must
compound it

• Rule 2: Compounding
– Compound Interest
▪ The effect of earning “interest on interest”

Figure 3.2 The Composition of
Interest over Time (1 of 2)
This bar graph shows how the account balance and the
composition of the interest changes over time when an
investor starts with an original deposit of $1000, represented
by the red area, in an account earning 10% interest over a
20-year period. The green (middle) bars show the effect of
simple interest, interest earned only on the initial deposit.
The blue (top) bars show the effect of compound interest,
where interest is also earned on prior interest payments.
Over time, the effect of compounding is more pronounced,
and by year 20, simple interest is only $2000, whereas
interest on interest is $3727.50.

Figure 3.2 The Composition of
Interest over Time (2 of 2)
This bar graph shows how the account balance and the composition of the interest
changes over time when an investor starts with an original deposit of $1000, represented
by the red area, in an account earning 10% interest over a 20-year period. The green
(middle) bars show the effect of simple interest, interest earned only on the initial deposit.
The blue (top) bars show the effect of compound interest, where interest is also earned on
prior interest payments. Over time, the effect of compounding is more pronounced and by
year 20, simple interest is only $2000, whereas interest on interest is $3727.50.

• Rule 3: Discounting
– To calculate the value of a future cash flow at an earlier
point in time, we must discount it.

– If $826.45 is invested today for two years at 10%
interest, the future value will be $1000

– If $1000 were three years away, the present value, if
the interest rate is 10%, will be $751.31

Example 3.4 Present Value of a Single
Future Cash Flow (1 of 4)
Problem
• You are considering investing in a savings bond that will
pay $15,000 in 10 years. If the competitive market interest
rate is fixed at 6% per year, what is the bond worth today?

Solution
Plan
• First, set up your timeline. The cash flows for this bond are
represented by the following timeline: Thus, the bond is
worth $15,000 in 10 years. To determine the value today,
we compute the present value using Equation 3.2 and our
interest rate of 6%.
Execute
15,000
PV= 10
=$8375.92 today
1.06
Evaluate
• The bond is worth much less today than its final payoff
because of the time value of money.

Excel Formula: =PV(RATE,NPER,PMT,FV) =PV ( 0.06,10, 0,15000 )

Example 3.4a Present Value of a
Single Future Cash Flow (1 of 4)
Problem:
• XYZ Company expects to receive a cash flow of $2 million
in five years. If the competitive market interest rate is fixed
at 4% per year, how much can they borrow today in order
to be able to repay the loan in its entirety with that cash
flow?

Solution:
Plan:
• First set up your timeline. The cash flows for the loan are
represented by the following timeline:
• Thus, XYZ Company will be able to repay the loan with its
expected $2 million cash flow in five years. To determine
the value today, we compute the present value using Eq.
3.2 and our interest rate of 4%.
Execute:
$2,000,000
PV= =$1,643,854.21
(1.04 )
5
Excel Formula: =PV(RATE,NPER,PMT,FV) =PV ( 0.04, 5, 0, 2000000 )

Evaluate:
• The loan is much less than the $2 million the company will
pay back because of the time value of money

The Three Rules of Valuing Cash
Flows
Table 3.1 The Three Rules of Valuing Cash Flows
Rule Formula
1: Only values at the same point in None
time can be compared or combined.
2: To calculate a cash flow’s future Future value of a cash flow:
value, we must compound it. FVn = C  (1 + r )
F V sub n = C times left parenthesis 1 + r right parenthesis to the n power
3: To calculate the present value of a Present value of a cash flow:

future cash flow, we must discount it. C
PV = C  (1 + r ) =
P V = C divided by left parenthesis 1 + r right parenthesis to the n power = start fraction C over left parenthesis 1 + r right parenthesis to the n power end fraction.
(1 + r )
n

Chapter Quiz
1. If crude oil trades in a competitive market, would an oil
refiner that has a use for the oil value it differently than
another investor would?
2. How do we determine whether a decision increases the
value of the firm?
3. Is the value today of money to be received in one year
higher when interest rates are high or when interest rates
are low?
4. What do you need to know to compute a cash flow’s
present or future value?

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Fundamentals of Corporate Finance

Fifth Edition, Global Edition

Copyright © 2023 Pearson Education, Ltd. All Rights Reserved.

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• Quantifying Costs and Benefits

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• Quantifying Costs and Benefits

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• The Def Leppard tickets have a total value of $120 (4×$30)

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– ( 200 barrels of oil ) × ( $90/barrel today ) = $18,000 today

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– 2,500 shares×$14/share = $35,000

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• Therefore, the cost of a delay of one year is

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– Representing Various Time Periods

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