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Time Value of Money


Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 1
.
Chapter Organisation
5.1 Future value and compounding
5.2 Present value and discounting
5.3 More on present and future values
5.4 Present and future values of multiple cash
flows
5.5 Valuing equal cash flows: annuities and
perpetuities
5.6 Comparing rates: the effect of
compounding periods
5.7 Loan types and loan amortisation
Summary and conclusions


Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 2
.
Chapter Objectives
Understand how to determine the future value of an investment
made today.
Understand how to determine the present value of cash to be
received at a future date.
Understand how to find the return on an investment.
Understand how long it takes for an investment to reach a desired
value.
Understand how to determine the future and present value of
investments with multiple cash flows.
Understand how loan payments are calculated, and how to find
the interest rate on a loan.
Understand how loans are amortised or paid off.
Understand how interest rates are quoted (and misquoted).
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 3
.
The Interest Rate



Obviously, $10,000 today.
You already recognize that there is
TIME VALUE TO MONEY!!


Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
Which would you prefer -- $10,000
today or $10,000 in 5 years?
.
Why TIME?
Why is TIME such an important element in
your decision?

TIME allows you the opportunity to
postpone consumption and earn
INTEREST.

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
.
Types of Interest
Simple Interest
Interest paid (earned) on only the
original amount, or principal, borrowed
(lent).
Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).



Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
.
Time Value Terminology

Future value (FV) is the amount an investment
is worth after one or more periods.
Present value (PV) is the amount that
corresponds to todays value of a promised
future sum.
The number of time periods between the
present value and the future value is
represented by t.
The rate of interest for discounting or
compounding is called r.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 7
.
Time Value Terminology

Compounding is the process of accumulating
interest in an investment over time, to earn more
interest.
Interest on interest is earned on the reinvestment
of previous interest payments.
Discount rate is the interest rate that reduces a
given future value to an equivalent present value.




Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 8
.
Simple Interest Formula
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
Formula SI = P
0
(r)(t)

SI: Simple Interest
P
0
: Deposit today (t=0)
r: Interest Rate per Period
t: Number of Time Periods
.
Simple Interest Example
Assume that you deposit $100 in an
account earning 10% simple interest
for 5 years. What is the accumulated
interest at the end of the 5th year?

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
SI = P
0
(r)(t )
= $100(.10)(5)
= $50
.
Simple Interest Example
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
FV = P
0
+ SI
= $100 + $50
= $150
What is the Future Value (FV) of the
deposit?
.
Future Value with compounding
You invest $100 in a savings account that earns 10
per cent interest per annum (compounded) for five
years.

After one year: $100 (1 + 0.10) = $110
After two years: $110 (1 + 0.10) = $121
After three years: $121 (1 + 0.10) = $133.10
After four years: $133.10 (1 + 0.10) = $146.41
After five years: $146.41 (1 + 0.10) = $161.05

Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 12
.
Simple Vs Compound Interest
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
.
Future Values of $100 at 10%
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 14
.
Future Value with Compounding
The accumulated value of this investment at the
end of five years can be split into two
components:
original principal $100.00
interest earned $61.05

Using simple interest, the total interest earned
would only have been $50. The other $11.05 is
from compounding.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 15
.
Future Value
In general, the future value, FV
t
, of $1 invested
today at r per cent for t periods is:



The expression (1 + r)
t
is the future value
interest factor (FVIF).
You can also refer to Future Value table for
calculating the future values.

( )
t
t
r + = 1 $1 FV
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 16
.
ExampleFuture Value
What will $1000 amount to in five years time if
interest is 6 per cent per annum, compounded
annually?



From the example, now assume interest is 6 per
cent per annum, compounded monthly.
Always remember that t is the number of
compounding periods, not the number of years.
( )
338.22 $1
1.3382 000 $1
0.06 1 000 $1 FV
5
=
=
+ =
( )
348.90 $1
1.3489 000 $1
0.005 1 000 $1 FV
60
=
=
+ =
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 17
.
Future Value of $1 for Different
Periods and Rates
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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.
Present Value
You need $1000 in five years time. If you can
earn10 per cent per annum, how much do you
need to invest now?

Discount one year: $1000 (1 + 0.10)
1
= $909.09
Discount two years: $909.09 (1 + 0.10)
1
= $826.45
Discount three years: $826.45 (1 + 0.10)
1
= $751.32
Discount four years: $751.32 (1 + 0.10)
1
= $683.02
Discount five years: $683.02 (1 + 0.10)
1
= $620.93

Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 19
.
Present Value
In general, the present value of $1 received in t
periods of time, earning r per cent interest is:



The expression (1 + r)
t
is the present value
interest factor (PVIF).
You can also refer to Present Value table for
calculating the present values.
( )
( )
t
t
r
r
+
=
+ =

1
$1
1 $1 PV
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 20
.
ExamplePresent Value
Your rich uncle promises to give you $100,000 in
10 years time. If interest rates are 6 per cent per
annum, how much is that gift worth today?



( )
840 $55
0.5584 000 $100
0.06 1 000 $100 PV
10
=
=
+ =

Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 21
.
Present Value of $1 for Different
Periods and Rates
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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.
Determining the Discount Rate
You currently have $100 available for investment
for a 21-year period. At what interest rate must
you invest this amount in order for it to be worth
$500 at maturity?
r can be solved in one of two ways:
Take the n
th
root of both sides of the equation
Use the future value tables to find a corresponding
value. In this example, you need to find the r for
which the FVIF after 21 years is 5 (500/100).

Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 23
.
Future Value of Multiple Cash Flows
You deposit $1 000 now, $1 500 in one more
year, $2 000 in two years and $2 500 in three
years in an account paying 10 per cent interest
per annum. How much do you have in the
account at the end of the third year?
You can solve by either:
compounding the accumulated balance
forward one year at a time
calculating the future value of each cash
flow first, and then totaling them.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 24
.
Solutions
Solution 1
End of year 1: ($1 000 1.10) + $1 500 = $2 600
End of year 2: ($2 600 1.10) + $2 000 = $4 860
End of year 3: ($4 860 1.10) + $2 500 = $7 846

Solution 2
$1 000 (1.10)
3
= $1 331
$1 500 (1.10)
2
= $1 815
$2 000 (1.10)
1
= $2 200
$2 500 1.00 = $2 500
Total = $7 846
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 25
.
Solutions on Time Lines
Future value calculated by compounding forward one period at a
time
Time
(years)
0 1 2 3
$0
1000
$1000
$1100
1500
$2600
$2860
2000
$4860
$5346
2500
$7846
x 1.1 x 1.1 x 1.1
Time
(years)
0 1 2 3
$1000 $1500 $2000
$2500
2200
1815
1331
$7846
x 1.1
3
x 1.1
2
x 1.1
Total future value
Future value calculated by compounding each cash flow
separately
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 26
.
Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
.
Present Value of Multiple Cash Flows
You will deposit $1 500 in one years time from
now, $2 000 in two years time and $2 500 in
three years time, in an account paying 10 per
cent interest per annum. What is the present
value of these cash flows?
You can solve by either:
discounting back one year at a time
calculating the present value of each cash
flow first, and then totaling them.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 28
.
Solutions
Solution 1
End of year 2: ($2500 1.10
1
) + $2000= $4273
End of year 1: ($4273 1.10
1
) + $1500= $5385
Present value: ($5385 1.10
1
) + $1000= $5895

Solution 2
$2500 (1.10)
3
= $1878
$2000 (1.10)
2
= $1653
$1500 (1.10)
1
= $1364
$1000 (1.0) = $1000
Total = $5895



Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 29
.
Annuities
An ordinary annuity is a series of equal cash
flows that occur at the end of each period for
some fixed number of periods.

Examples include consumer loans and home
mortgages.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 30
.
Future Value of an Annuity
C = equal cash flow
The compounding term is called the future
value interest factor for annuities (FVIFA).
You can also refer to Future Value Annuity
table for calculating the future value of
annuity.

( ) | |
r
r
C
t
1 1
FVA
+
=
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 31
.
What is the future value of $1 000 deposited at
the end of every year for 20 years if the interest
rate is 6 per cent per annum?




| |
785.60 $36
36.7856 000 $1
0.06
1 (1.06)
000 $1 FVA
20
=
=

=
ExampleFuture Value of an
Annuity
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 32
.
Present Value of an Annuity
C = equal cash flow

The discounting term is called the present
value interest factor for annuities (PVIFA).
You can also refer to Present Value Annuity
table for calculating the present value of
annuity



( ) { }
(

+
=
r
r
C PVA
t
1 1/ 1
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 33
.
Example 1
You will receive $1 000 at the end of each of
the next ten years. The current interest rate is
6 per cent per annum. What is the present
value of this series of cash flows?








( ) { }
360.10 $7
7.3601 000 $1
0.06
1.06 1/ 1
000 $1 PVA
10
=
=
(


=
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 34
.
Example 2
You borrow $10 000 to buy a car and agree
to repay the loan by way of equal monthly
repayments over four years. The current
interest rate is 12 per cent per annum,
compounded monthly. What is the amount
of each monthly repayment?



( ) { }
$263.33
37.97 000 $10
0.01
1.01 1/ 1
000 $10
48
=
=
(


=
C
C
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 35
.
Perpetuities
The future value of a perpetuity cannot be
calculated, as the cash flows are infinite.
The present value of a perpetuity is calculated
as follows:



where C is cash flow
and r is rate.


r
C
= PV
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 36
.
Comparing Rates
The quoted or stated interest rate is the
interest rate expressed in terms of the
interest payment made each year.

The effective annual interest rate (EAR) is
the interest rate expressed as if it was
compounded once per year.

When interest is compounded more
frequently than annually, the EAR will be
greater than the quoted interest rate.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 37
.
Calculation of EAR
1
m
Rate Quoted
1 EAR
m

+ =
m = number of times the interest is compounded
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
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.
Comparing EARS
Consider the following interest rates quoted
by three banks:

Bank A: 8.3%, compounded daily

Bank B: 8.4%, compounded quarterly

Bank C: 8.5%, compounded annually
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 39
.
Comparing EARS
8.50% 1
1
0.085
1 EAR
8.67% 1
4
0.084
1 EAR
8.65% 1
365
0.083
1 EAR
1
C Bank
4
B Bank
365
A Bank
=
(

+ =
=
(

+ =
=
(

+ =
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 40
.
Comparing EARS
Which is the best rate? For a saver, Bank B
offers the best (highest) interest rate. For a
borrower, Banks A and C offer the best (lowest)
interest rates.

The highest quoted interest rate is not
necessarily the best.

Compounding during the year can lead to a
significant difference between the quoted
interest rate and the EAR, especially for higher
rates.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 41
.
Annual Percentage Rate (APR)

The interest rate charged per period
multiplied by the number of periods
per year.

Copyright 2011 McGraw-Hill Australia Pty Ltd PPTs to accompany Fundamentals of Corporate
Finance 5e by Ross et al
1
m
APR
1 EAR
m

+ =
m = number of times the interest is compounded
.
Types of Loans
An interest-only loan requires the borrower to
only pay interest each period, and to repay
the entire principal at some point in the
future.

An amortised loan requires the borrower to
repay parts of both the principal and interest
over time.

Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 43
.
Amortisation of a Loan
Year Beginning
Balance
Total
Payment
Interest
Paid
Principal
Paid
Ending
Balance
1 $5000.00 $1285.46 $450.00 $835.46 $4164.54
2 $4164.54 $1285.46 $374.81 $910.65 $3253.89
3 $3253.89 $1285.46 $292.85 $992.61 $2261.28
4 $2261.28 $1285.46 $203.52 $1081.94 $1179.33
5 $1179.33 $1285.46 $106.13 $1179.33 $0.00
Totals $6427.30 $1427.30 $5000.00


Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 44
.
Quick Quiz Part I
What is the difference between simple interest
and compound interest?
Suppose you have $500 to invest and you
believe that you can earn 8% per year over the
next 15 years.
How much would you have at the end of
15 years using compound interest?
How much would you have using simple
interest?

Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 45
.
Quick Quiz Part II
What is the relationship between present
value and future value?
Suppose you need $15 000 in 3 years. If you
can earn 6% annually, how much do you
need to invest today?
If you could invest the money at 8%, would
you have to invest more or less than at 6%?
How much?

Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 46
.
Quick Quiz Part III
What are some situations in which you might
want to know the implied interest rate?
You are offered the following investments:
You can invest $500 today and receive
$600 in 5 years. The investment is low
risk.
You can invest the $500 in a bank
account paying 4%.
What is the implied interest rate for the
first choice, and which investment should
you choose?


Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 47
.
Quick Quiz Part IV
When might you want to compute the
number of periods?
Suppose you want to buy some new
furniture for your family room. You currently
have $500, and the furniture you want costs
$600. If you can earn 6%, how long will you
have to wait if you dont add any additional
money?
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 48
.
Comprehensive Problem
You have $10 000 to invest for five years.
How much additional interest will you earn if
the investment provides a 5% annual return,
when compared to a 4.5% annual return?
How long will it take your $10 000 to double
in value if it earns 5% annually?
What annual rate has been earned if $1 000
grows into $ 4 000 in 20 years?


Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 49
.
Summary and Conclusions
For a given rate of return, the value at some point in the
future of an investment made today can be determined by
calculating the future value of that investment.
The current worth of a future cash flow or series of cash
flows can be determined for a given rate of return by
calculating the present value of the cash flow(s) involved.
It is possible to find any one of the four components
(PV, FV, r, t) given the other three.
A series of constant cash flows that arrive or are paid at the
end of each period is called an ordinary annuity.
For financial decisions, it is important that any rates are
converted to effective rates before being compared.
Copyright 2011 McGraw-Hill Australia Pty Ltd
PPTs to accompany Fundamentals of Corporate Finance 5e, by Ross, et al.
Slides prepared by Tim Whittaker 5 - 50