BUSFIN3120 Chapter 3

Fundamentals of Corporate Finance
Chapter 3
Time Value of
Money: An
Introduction
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved.
Cost-Benefit Analysis
Quantifying Costs and Benefits
• Any decision in which the value of the benefits exceeds the costs
will increase the value of the firm
Example: Comparing Costs and Benefits
Problem:
Suppose you work as a customer account manager for a corn silo

cooperative. A food manufacturer is willing to purchase 5,000 bushels of
corn for today for a total price of $30,000, including delivery. You can
buy corn from local farmers for $5.50 per bushel today, and arrange for
delivery at a cost of $250 today. Will taking this opportunity increase the
value of the firm?
Solution:
Plan:
• To determine whether this opportunity will increase the value of the
firm, we need to value the benefits and the costs using market prices.
We have market prices for our costs:
Wholesale price of corn: $5.50/bushel Delivery cost: $250
• We have a customer offering the following market price for 5,000

bushels of corn: $30,000. All that is left is to compare them.
Execute:
• The benefit of the transaction is $30,000 today.

• The costs are (5,000 bushels)  $5.50/bushel = $27,500 today for the
corn, and $250 today for delivery, for a total cost of $27,750 today.
• If you are certain about these costs and benefits, the right decision is
obvious:
• You should seize this opportunity because the firm will gain:
$30,000 - $27,750 = $2,250.
Evaluate:
• Thus taking this opportunity contributes $2,250 to the value of the

firm, in the form of cash that can be paid out immediately to the
firm’s investors.
Cost-Benefit Analysis
Role of Competitive Markets
• 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
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: Applying the Valuation Principle
Problem:
You are the operations manager at your firm. Due to a pre-existing

contract, you have the opportunity to acquire 500 barrels of oil and
4,000 pounds of copper for a total of $50,000. The current market price
of oil is $75 per barrel and for copper is $2.50 per pound. You are not
sure that you need all of the oil and copper, so you are wondering if you
should you 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?
Solution:
Plan:
• We need to quantify the costs and benefits using market prices.
We are comparing $50,000 with:
―500 barrels of oil at $75 per barrel

―4,000 pounds of copper at $2.50 per pound
Execute:
• Using the competitive market prices we have:

• (500 barrels) × ($75/barrel today) = $37,500 today
• (4,000 pounds of copper) × ($2.50/pound today) = $10,000 today
• The value of the opportunity is the value of the oil plus the value of
the copper less the cost of the opportunity, $37,500 + $10,000 -
$50,000 = -$2,500 today.
• Because the value is negative, we should not take it.
Evaluate:
• Since we are transacting today, only the current prices in a competitive

market matter.
• Our own use for or opinion about the prospects of oil or copper do not
alter the value of the decision today.
• This decision is not good for the firm and will decrease its value by
$2,500.
Market Prices and the Valuation Principle
Why There Can Be Only One Competitive Price for a Good
• Law of One Price

• In competitive markets, securities with the same cash flows must
have the same price
• 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
The Time Value of Money and Interest Rates
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 Interest Rate: Converting Cash Across Time
• 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 in One Year of a $100,000 Investment Today
• If the interest is 10%, the future value (FV) of the investment is:
FV = ($100,000 today) × (1.10 $ in one year/$ today)
= $110,000 in one year
The Interest Rate: Converting Cash Across Time
• 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, expressed as:
1
1+r
• Today’s Value of $250,000 in One Year
• If the interest is 10%, the Present Value (PV) of the

investment is:
PV = ($250,000 in one year) / (1.10 $ in one year/$ today)

= $227,272.73 today
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
• Cash inflows are positive, cash outflow are negative
Year 1 Year 2
Date 0 1 2
Cash Flow –$10,000 $6,000 $6,000
Valuing Cash Flows at Different Points in Time
• 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
0 1 2
$10,000 x 1.10
$11,000 x 1.10
$1,210
• $1000 x (1.10)2 = $1210

• Rule 2: Compounding
• Compound Interest
• The effect of earning “interest on interest”
Future Value of a Cash Flow

𝐹𝑉 𝑛=¿𝐶 × (1 +𝑟 ) × (1 +𝑟 ) × ⋯ × ( 1 +𝑟 ) =𝐶 × (1 +𝑟n)❑
(3.1)
n times
Figure 3.2 The Composition of Interest over Time
• Rule 3: Discounting
• To calculate the value of a future cash flow at an earlier point in
time, we must discount it.
0 1 2
$826.45 1.10
$909.09 1.10
$1,000
$ 1000
2
Same as 1.10
Present Value of a Cash Flow
𝑃𝑉 ❑=¿( 1 + 𝑟
𝐶 ÷ n ) =𝐶 ❑
n
( 1+𝑟 ) (3.2)
n times
• If $826.45 is invested today for two years at 10% interest, the future
value will be $1000
0 1 2
$826.45 x 1.10
$909.09 x 1.10
$1,000
• If $1000 were three years away, the present value, if the interest rate
is 10%, will be $751.31
0 1 2 3
$751.31 1.10 1.10 1.10

$1,000
Using a Financial Calculator: Solving for Present and
Future Values
• Financial calculators and spreadsheets have the formulas pre-
programmed to quicken the process.
• There are five variables used most often:

• N (Number of periods)
• I/Y (Rate per period)
• PV (Present Value)
• PMT (Payment per period)
• FV (Future value)
Example 3.4: Present Value of a Single Future Cash Flow
Problem:
• You are considering investing in a savings bond that will pay $15,000
in ten years. If the competitive market interest rate is fixed at 6% per
year, what is the bond worth today?
• For the TI-BAII Plus calculator:

• Enter 10 and press the <N> key.
• Enter 6 and press the <I/Y> key
• Enter 0 and press the <PMT> key.
• Enter 15,000 and press the <FV> key.
• Press <CPT> <PV>
Example 3.4: Present Value of a Single Future Cash Flow
Execute: $8,375.92 today
1 .06 10
N I/Y PV PMT FV
Given: 10 6 0 15,000
Solve for: -8,375.92
Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.06,10,0,15000)
• Notice that we entered PV (the amount we’re putting into the bank) as a
negative number and FV is shown as a positive number (the amount we
take out of the bank). Cash outflows—money out of our account—have a
negative sign. Inflows—money coming into our account—have a positive
sign.
• It is important to enter the signs correctly to indicate the direction the
funds are flowing.
Example: Present Value of a Single Future Cash Flow
Problem:
• You receive $1,000 as a graduation present from your parents. You
invest this money in a mutual fund that earns an annual average
return of 9%. If you invest this money at age 22, what will it be worth
when you are 62?
Example: Present Value of a Single Future Cash Flow
Execute:
40
$31,409.42
N I/Y PV PMT FV
Given: 40 9 -10000 0
Solve for: 31,409.42
Excel Formula: =FV(RATE,NPER, PMT, PV) = FV(0.09,40,0,-10000)

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Fundamentals of Corporate Finance

Suppose you work as a customer account manager for a corn silo

Wholesale price of corn: $5.50/bushel Delivery cost: $250

• We have a customer offering the following market price for 5,000

• The benefit of the transaction is $30,000 today.

• Thus taking this opportunity contributes $2,250 to the value of the

• A competitive market is one in which a good can be bought and sold at

• The value of a commodity or an asset to the firm or its investors is

You are the operations manager at your firm. Due to a pre-existing

―500 barrels of oil at $75 per barrel

• Using the competitive market prices we have:

• Since we are transacting today, only the current prices in a competitive

• Law of One Price

• In general, a dollar today is worth more than a dollar in one year

• Interest Rate (r)

• Discount Factors and Rates

• If the interest is 10%, the Present Value (PV) of the

PV = ($250,000 in one year) / (1.10 $ in one year/$ today)

Cash Flow –$10,000 $6,000 $6,000

• $1000 x (1.10)2 = $1210

Future Value of a Cash Flow

$751.31 1.10 1.10 1.10

• There are five variables used most often:

• For the TI-BAII Plus calculator:

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