CH 05

Fundamentals of Corporate
Finance
by
Robert Parrino, Ph.D. & David S. Kidwell, Ph.D.
Chapter 5 – The Time Value of Money 1 Copyright 2008 John Wiley & Sons
CHAPTER 5
The Time Value of Money
Time Value of Money
Time Value of Money

Future Value and Compounding
Present Value and Discounting
Finding the Interest Rate
Rule of 72
Compound Growth Rates
How does a manager determine the value of a
series of future cash flows, whether paying for
an asset or evaluating a project?
What is the value of a stream of future cash

flows today?
We refer to this value as the time value of

money (TVM).
Consuming Today or Tomorrow
TVM is based on the belief that people prefer to

consume goods today rather than wait to
consume similar goods tomorrow.
People have a positive time preference.
Money has a time value because a dollar today

is worth more than a dollar tomorrow.
Consuming Today or Tomorrow
Today’s dollar can be invested to earn interest
or spent.
Value of a dollar invested (positive interest
rate) grows over time.
Rate of interest determines trade-off between
spending today versus saving.
Timelines as Aids to Problem Solving
Timelines are an easy way to visualize cash
flows.
Cash outflows as negative values.
Cash inflows as positive values.
Exhibit 5.1: Five-year Timeline for
$10,000 Investment
Future Value versus Present Value
Financial decisions are evaluated either on a
future value basis or present value basis.
Future value measures what one or more cash
flows are worth at the end of a specified period.
Present value measures what one or more
cash flows that are to be received in the future
will be worth today (at t=0).
Future Value versus Present Value
Compounding is the process of earning

interest over time.
Discounting is the process of converting future

cash flows to their present values.
Exhibit 5.2: Future Value & Present
Value Compared
Single Period Investment
We can determine the value of an investment
at the end of one period if we know the interest
rate to be earned by the investment.
If you invest for one period at an interest rate
of i, your investment, or principle, will grow by
(1 + i) per dollar invested.
The term (1+ i) is the future value interest factor,

often called simply the future value factor.
Two-Period Investing
A two-period investment is simply two
single-period investments back-to-back.
After the first period, interest accrues on
original investment (principle) and interest
earned in preceding periods.
Two-Period Investing
The principal is the amount of money on
which interest is paid.
Simple interest is the amount of interest paid
on the original principal amount only.
Compounding interest consists of both simple
interest and interest-on-interest.
Exhibit 5.3: Future Value of $100
The Future Value Equation
General equation to find the future value after
any number of periods.
The term (1 + i)n is the future value factor.
We can use financial calculators or future

value tables to find the future value factor at
different interest rates and maturity periods.
The general equation to find the future value is:
where:
FVn = future value of investment at the end of period n
PV = original principle (P0) or present value
i = the rate of interest per period, which is often a year
n = the number of periods
Future value example
You leave your $100 invested in the bank savings

account at 10 percent interest for five years. How
much would you have in the bank at the end of five
years?
Exhibit 5.4: How Compound
Interest Grows
Exhibit 5.5: Future Value of $1
Exhibit 5.6: Future Value Factors
Compounding More Frequently Than Once a Year
The more frequently the interest payments are

compounded, the larger the future value of $1 for a
given time period.
where: m = number of compounding periods in a year
Non-annual compounding example
You invest $100 in a bank account that pays a 5
percent interest rate semiannually for two years.
How much would you have in the bank at the end of
two years?
When interest is compounded on a continuous basis,

we can use the equation below.
where: e = exponential function which is about 2.71828
Continuous compounding example
Your grandmother wants to put $10,000 in a savings
account at a bank. How much money would she
have at the end of five years if the bank paid 5
percent annual interest compounded continuously?
Calculator Tips for Future Value Problems
PM
N i PV FV
T
N is the number of periods.

i is the interest rate per period.
PV is the present value of the original principal.
PMT is the amount of any recurring payment.
FV is the future value.
Calculator Tips for Future Value Problems
Financial calculator example:
Suppose we invest %5,000 at 15 percent for 10

years. How much money will we have in 10 years?
-5,00
10 15 0
Enter 0
PM
N i PV FV
T
20,227.
Answer
79
Using Excel: Time Value of Money
Using Excel: Time Value of Money
Excel also has the following functions for time

value of money problems.
PV: PV(RATE, NPER, PMT, FV)

FV: FV(RATE, NPER, PMT, PV)
Discount Rate: RATE(NPER, PMT, PV, FV)
Payment: PMT(RATE, NPER, PV, FV)
Number of Periods: NPER(RATE, PMT, PV, FV)
Present value calculations state the current value of a
dollar in the future.
This process is called discounting, and the
interest rate i is known as the discount rate.
The present value (PV) is often called the
discounted value of future cash payments.
The present value factor is more commonly
called the discount factor.
The equation below gives us the general equation to

find the present value after any number of periods.
Present value example
Suppose you are interested in buying a new BMW

330 Sports Coupe a year from now. You estimate
that the car will cost $40,000. If your local bank pays
5 percent interest on savings deposits, how much
will you need to save to buy the car?
Exhibit 5.8: Comparing Future
Value & Present Value Calculations
The further in the future a dollar will be received,

the less it is worth today.
The higher the discount rate, the lower the
present value of a dollar.
Exhibit 5.9: Present Value Factors
Exhibit 5.10: Present Value of $1
Calculator Tips for Present Value Problems
Financial calculator example:
What is the present value of $1,000 received 10

years from now at 9 percent discount rate?
10 9 0 1,000
Enter
PM
N i PV FV
T
Answer -422.
41
Finding the Interest Rate
A number of situations will require you to determine the

interest rate (or discount rate) for a given stream of
future cash flows.
For an individual investor or a firm, it may be
necessary.
to determine the return on an investment.
to determine the interest rate on a loan.
to determine a growth rate.
The Rule of 72
Rule of 72 is used to determine the amount of

time it takes to double an investment.
It says that the time to double your money (TDM)

approximately equals 72/i, where i is expressed
as a percentage.
Rule of 72 is fairly accurate for interest rates

between 5% and 20%.
Compound growth occurs when the initial value of a

number increases or decreases each period by the
factor (1 + growth rate).
Examples include population growth, earnings
growth.
Compound growth rate example
Because of an advertising campaign, a firm’s

sales increased from $20 million in 2007 to more
than $35 million three years later. What has been
the average annual growth rate in sales?
Compound growth rate example – Calculator solution
3 -20 0 35
Enter
PM
N i PV FV
T
Answer 20.5
1

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Fundamentals of Corporate

The Time Value of Money

Time Value of Money

What is the value of a stream of future cash

We refer to this value as the time value of

TVM is based on the belief that people prefer to

Money has a time value because a dollar today

Compounding is the process of earning

Discounting is the process of converting future

The term (1+ i) is the future value interest factor,

The term (1 + i)n is the future value factor.

We can use financial calculators or future

You leave your $100 invested in the bank savings

The more frequently the interest payments are

where: m = number of compounding periods in a year

When interest is compounded on a continuous basis,

where: e = exponential function which is about 2.71828

N is the number of periods.

Suppose we invest %5,000 at 15 percent for 10

Excel also has the following functions for time

PV: PV(RATE, NPER, PMT, FV)

The equation below gives us the general equation to

Suppose you are interested in buying a new BMW

The further in the future a dollar will be received,

What is the present value of $1,000 received 10

A number of situations will require you to determine the

Rule of 72 is used to determine the amount of

It says that the time to double your money (TDM)

Rule of 72 is fairly accurate for interest rates

Compound growth occurs when the initial value of a

Compound growth rate example

Because of an advertising campaign, a firm’s

Compound growth rate example – Calculator solution

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