Class 2

Introduction to
Valuation: The Time
Value of Money

Michele Vincenti, MBA, CIM, FCSI, STI, CFP, CMC

© 2003 The McGraw-Hill Companies, Inc. All rights reserved.

5.2 Chapter 5 Outline

• Future Value and Compounding

• Present Value and Discounting
• More on Present and Future Values
5.3 Basic Definitions

• Present Value – earlier money on a time line

• Future Value – later money on a time line
• Interest rate – “exchange rate” between earlier
money and later money
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return
5.4 Future Value – Example 1 – 5.1

• Suppose you invest $1000 for one year at 5% per

year. 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
5.5 Calculator Keys

• Texas Instruments BA-II Plus

– FV = future value
– PV = present value
– I/Y = period interest rate
• P/Y must equal 1 for the I/Y to be the period rate
• Interest is entered as a percent, not a decimal
– N = number of periods
– Remember to clear the registers (CLR TVM) after
each problem
– Other calculators are similar in format
5.6 Future Value – Example 2

• Suppose you had a relative deposit $10 at

5.5% interest 200 years ago. How much would
the investment be worth today?
– Formula Approach
• FV = 10(1.055)200 = 447,189.84
– Calculator Approach
• 200 N
• 5.5 I/Y
• 10 PV
• CPT FV = -447,189.84
5.7 Future Value – Example 3 continued

• 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
5.8 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?
5.9 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 your
answer above? How much?
5.10 Quick Quiz – Part III

• Suppose you are offered the following

investment choices:
– You can invest $500 today and receive $600 in 5
years. The investment is considered 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?
5.11 Chapter 6 Outline

• Future and Present Values of Multiple Cash

Flows
• Valuing Level Cash Flows: Annuities and
Perpetuities
• Comparing Rates: The Effect of
Compounding
• Loan Types and Loan Amortization
5.12
Multiple Cash Flows 6.1 – FV Example 1
• You currently have $7,000 in a bank account
earning 8% interest. You think you will be
able to deposit an additional $4,000 at the end
of each of the next three years. How much
will you have in three years?
5.13
Multiple Cash Flows FV Example 1 continued

• Find the value at year 3 of each cash flow

and add them together.
– Formula Approach
• Today (year 0): FV = 7000(1.08)3 = 8,817.98
• Year 1: FV = 4,000(1.08)2 = 4,665.60
• Year 2: FV = 4,000(1.08) = 4,320
• Year 3: value = 4,000
• Total value in 3 years = 8817.98 + 4665.60 + 4320 +
4000 = 21,803.58
5.14 Multiple Cash Flows FV Example 1 continued

– Calculator Approach
• Today (year 0 CF): 3 N; 8 I/Y; -7000 PV; CPT FV =
8817.98
• Year 1 CF: 2 N; 8 I/Y; -4000 PV; CPT FV = 4665.60
• Year 2 CF: 1 N; 8 I/Y; -4000 PV; CPT FV = 4320
• Year 3 CF: value = 4,000
• Total value in 3 years = 8817.98 + 4665.60 + 4320 +
4000 = 21,803.58
5.15 Decisions, Decisions

• Your broker calls you and tells you that he has this
great investment opportunity. If you invest $100
today, you will receive $40 in one year and $75 in two
years. If you require a 15% return on investments of
this risk, should you take the investment?
– Use the CF keys to compute the value of the
investment
• CF; CF0 = 0; C01 = 40; F01 = 1; C02 = 75; F02 = 1
• NPV; I = 15; CPT NPV = 91.49
– No – the broker is charging more than you would be
willing to pay.
5.16 Saving For Retirement

• You are offered the opportunity to put some

money away for retirement. You will receive
five annual payments of $25,000 each
beginning in 40 years. How much would you
be willing to invest today if you desire an
interest rate of 12%?
5.17 Quick Quiz – Part I

• Suppose you are looking at the following

possible cash flows: Year 1 CF = $100; Years
2 and 3 CFs = $200; Years 4 and 5 CFs =
$300. The required discount rate is 7%
• What is the value of the cash flows at year 5?
• What is the value of the cash flows today?
• What is the value of the cash flows at year 3?
5.18 Finding the Number of Payments – Example 2

• Suppose you borrow $2000 at 5% and you are

going to make annual payments of $734.42.
How long before you pay off the loan?
5.19 Finding the Number of Payments – Example 2
continued
– Formula Approach
• 2000 = 734.42(1 – 1/1.05t) / .05
• .136161869 = 1 – 1/1.05t
• 1/1.05t = .863838131
• 1.157624287 = 1.05t
• t = ln(1.157624287) / ln(1.05) = 3 years
– Calculator Approach
• Sign convention matters!!!
• 5 I/Y
• 2000 PV
• -734.42 PMT
• CPT N = 3 years
5.20 Annuity Due – Example 1

• You are saving for a new house and you put

$10,000 per year in an account paying 8%
compounded annually. The first payment is
made today. How much will you have at the
end of 3 years?
5.21 Annuity Due – Example 1 Timeline

0 1 2 3

10000 10000 10000

32,464

35,061.12
5.22 Annuity Due – Example 1 continued
– Formula Approach
• FV = 10,000[(1.083 – 1) / .08](1.08) = 35,061.12
– Calculator Approach
• 2nd BGN 2nd Set (you should see BGN in the
display)
• 3N
• -10,000 PMT
• 8 I/Y
• CPT FV = 35,061.12
• 2nd BGN 2nd Set (be sure to change it back to an
ordinary annuity)
5.23 Mortgages

• In Canada, financial institutions are required

by law to quote mortgage rates with semi-
annual compounding
• Since most people pay their mortgage either
monthly (12 payments per year), semi-
monthly (24 payments) or bi-weekly (26
payments), you need to remember to convert
the interest rate before calculating the
mortgage payment!
5.24 Mortgages – Example 1

• Theodore D. Kat is applying to his friendly,

neighbourhood bank for a mortgage of
$200,000. The bank is quoting 6%. He would
like to have a 25-year amortization period and
wants to make payments monthly. What will
Theodore’s payments be?
5.25 Mortgage – Example 1 continued
• First, calculate the EAR
2
 0.06 
EAR  1    1  6.09%
 2 
• Second, calculate the effective monthly rate

Effective Monthly Rate  1  0.0609

1
12  1  0.4939%

• Then, calculateCthe monthly

 1payment

200,000  1
0.004939  1.004939300 
C  1,279.61

– OR, 300 N, 0.4939 I/Y, 200,000 PV, CPT PMT