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Fundamentals of Corporate Finance

Third Edition

Chapter 3
The Time Value of Money

Brealey

Myers Marcus

slides by Matthew Will

The McGraw-Hill Companies, Inc.,2001

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Topics Covered
Future Values Present Values Multiple Cash Flows Perpetuities and Annuities Inflation & Time Value Effective Annual Interest Rate

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Future Values
Future Value - Amount to which an investment will grow after earning interest. Compound Interest - Interest earned on interest. Simple Interest - Interest earned only on the original investment.
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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100.

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Interest Earned Per Year = 100 x .06 = $ 6

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100.

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today 1 Interest Earned Value 100 Future Years 2 3

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today Interest Earned Value 100 1 6 106 Future Years 2 3

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today Interest Earned Value 100 1 6 106 Future Years 2 3 6 112

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today Interest Earned Value 100 1 6 106 Future Years 2 3 6 6 112 118

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today Interest Earned Value 100 1 6 106 Future Years 2 3 4 6 6 6 112 118 124

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Future Values
Example - Simple Interest Interest earned at a rate of 6% for five years on a principal balance of $100. Today Interest Earned Value 100 1 6 106 Future Years 2 3 4 5 6 6 6 6 112 118 124 130

Value at the end of Year 5 = $130

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Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.

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Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance. Interest Earned Per Year =Prior Year Balance x .06

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Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.
Today 1 Interest Earned Value 100 Future Years 2 3

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Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.
Today Interest Earned Value 100 1 6.00 106.00 Future Years 2 3

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Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.
Today Interest Earned Value 100 Future Years 1 2 3 6.00 6.36 106.00 112.36

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Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.
Today Interest Earned Value 100 Future Years 1 2 3 4 6.00 6.36 6.74 106.00 112.36 119.10

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Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.
Today Interest Earned Value 100 Future Years 1 2 3 4 5 6.00 6.36 6.74 7.15 106.00 112.36 119.10 126.25

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Future Values
Example - Compound Interest Interest earned at a rate of 6% for five years on the previous years balance.
Today Interest Earned Value 100 Future Years 1 2 3 4 5 6.00 6.36 6.74 7.15 7.57 106.00 112.36 119.10 126.25 133.82

Value at the end of Year 5 = $133.82

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Future Values
Future Value of $100 = FV

FV ! $100 v (1  r )

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Future Values
FV ! $100 v (1  r ) t
Example - FV What is the future value of $100 if interest is compounded annually at a rate of 6% for five years?

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Future Values
FV ! $100 v (1  r ) t
Example - FV What is the future value of $100 if interest is compounded annually at a rate of 6% for five years?

FV ! $ 100 v (1  .06 ) ! $ 133 .82

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Future Values with Compounding

70 60 50 FV of $1 40 30 20 10 0

Interest Rates
0% 5% 10% 15%

12

14

18

20

22

24

26

28

Number of Years
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30

10

16

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Manhattan Island Sale

Peter Minuit bought Manhattan Island for $24 in 1626. Was this a good deal? To answer, determine $24 is worth in the year 2000, compounded at 8%.

FV ! $ 24 v (1  .08 )

374

! $ 75 .979 trillion
FYI - The value of Manhattan Island land is well below this figure.
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Present Values
Present Value Value today of a future cash flow.

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Present Values
Present Value Value today of a future cash flow. Discount Factor Present value of a $1 future payment.

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Present Values
Present Value Value today of a future cash flow. Discount Rate Interest rate used to compute present values of future cash flows.
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Discount Factor Present value of a $1 future payment.

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Present Values

Present PV =

alue

PV

Future Value a ter t periods (1+ r)

t

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Present Values
Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

PV !
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3000 2 (1.08 )

! $2,572
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Present Values
Discount Factor = DF = PV of $1

DF !

1 (1 r ) t

Discount Factors can be used to compute the present value of any cash flow.
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Time Value of Money

(applications) The PV formula has many applications. Given any variables in the equation, you can solve for the remaining variable.

PV ! FV v

1 t (1 r )

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Time Value of Money

(applications) Value of Free Credit Implied Interest Rates Internal Rate of Return Time necessary to accumulate funds

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PV of Multiple Cash Flows

Example
Your auto dealer gives you the choice to pay $15,500 cash now, or make three payments: $8,000 now and $4,000 at the end of the following two years. If your cost of money is 8%, which do you prefer?
Immediate payment

8,000.00

PV1 ! PV 2 !

4 , 000 (1 .08 )1 4 , 000 (1 .08 ) 2

! 3,703 .70 ! 3,429 .36

Total PV
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! $15,133.06
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PV of Multiple Cash Flows

PVs can be added together to evaluate multiple cash flows.

PV !

C1 (1 r )
1

 (1 r ) 2 ....

C2

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Perpetuities & Annuities

Perpetuity A stream of level cash payments that never ends. Annuity Equally spaced level stream of cash flows for a limited period of time.

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Perpetuities & Annuities

PV of Perpetuity Formula

PV !
C = cash payment r = interest rate

C r

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Perpetuities & Annuities

Example - Perpetuity In order to create an endowment, which pays $100,000 per year, forever, how much money must be set aside today in the rate of interest is 10%?

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Perpetuities & Annuities

Example - Perpetuity In order to create an endowment, which pays $100,000 per year, forever, how much money must be set aside today in the rate of interest is 10%?

PV !

100 , 000 .10

! $1,000,000

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Perpetuities & Annuities

Example - continued If the first perpetuity payment will not be received until three years from today, how much money needs to be set aside today?

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Perpetuities & Annuities

Example - continued If the first perpetuity payment will not be received until three years from today, how much money needs to be set aside today?

PV !

1, 000 , 000 ( 1 .10 ) 3

! $751,315

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Perpetuities & Annuities

PV of Annuity Formula

PV ! C

1 r

1 t r ( 1 r )

C = cash payment r = interest rate t = Number of years cash payment is received

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Perpetuities & Annuities

PV Annuity Factor (PVAF) - The present value of $1 a year for each of t years.

PVAF !

1 r

1 t r ( 1 r )

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Perpetuities & Annuities

Example - Annuity You are purchasing a car. You are scheduled to make 3 annual installments of $4,000 per year. Given a rate of interest of 10%, what is the price you are paying for the car (i.e. what is the PV)?

PV ! 4 ,000

1 .10

1 .10 ( 1 .10 ) 3

PV ! $9,947.41
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Perpetuities & Annuities

Applications Value of payments Implied interest rate for an annuity Calculation of periodic payments
Mortgage payment Annual income from an investment payout Future Value of annual payments

FV ! ?C v PVAF Av (1  r )
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Perpetuities & Annuities

Example - Future Value of annual payments You plan to save $4,000 every year for 20 years and then retire. Given a 10% rate of interest, what will be the FV of your retirement account?

FV ! 4 ,000

1 .10

1 .10 ( 1  .10 ) 20

Av (1.10)

20

FV ! $229,100
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Inflation
Inflation - Rate at which prices as a whole are increasing. Nominal Interest Rate - Rate at which money invested grows. Real Interest Rate - Rate at which the purchasing power of an investment increases.

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Inflation
1 nominal interest rate 1  real interest rate = 1 inflation rate

approximation formula

Real int. rate } nominal int. rate - inflation rate

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Inflation
Example If the interest rate on one year govt. bonds is 5.0% and the inflation rate is 2.2%, what is the real interest rate?
1 + real interest rate = 1+.050 1+.022 1 + real interest rate = 1.027 eal interest rate = .027 or 2.7 pproximation = .050 - .022 or .028 or 2.8
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Savings Bond

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Effective Interest Rates

Effective Annual Interest Rate - Interest rate that is annualized using compound interest.

Annual Percentage Rate - Interest rate that is annualized using simple interest.

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Effective Interest Rates

example Given a monthly rate of 1%, what is the Effective Annual Rate(EAR)? What is the Annual Percentage Rate (APR)?

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Effective Interest Rates

example Given a monthly rate of 1%, what is the Effective Annual Rate(EAR)? What is the Annual Percentage Rate (APR)?

EAR = (1 .01) EAR = (1 .01)

12 12

- 1 = r - 1 =.1268 or 12.68%

APR =.01 x 12 =.12 or 12.00%

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Web Resources

invest-faq.com/articles/analy-fut-prs-val.html www.bankrate.com/brm/default.asp www.financenter.com www.financialplayerscenter.com/Overview.html

Click to access web sites Internet connection required

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