3- 1

Fundamentals of Corporate Finance

Third Edition Chapter 3

The Time
Value of
Money

Brealey Myers Marcus

slides by Matthew Will

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 2

Topics Covered

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

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 3

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.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 4

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

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 5

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

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 6

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

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 7

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

Today Future Years

1 2 3 4 5
Interest Earned
Value 100

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 8

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

Today Future Years

1 2 3 4 5
Interest Earned 6
Value 100 106

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 9

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

Today Future Years

1 2 3 4 5
Interest Earned 6 6
Value 100 106 112

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 10

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

Today Future Years

1 2 3 4 5
Interest Earned 6 6 6
Value 100 106 112 118

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 11

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

Today Future Years

1 2 3 4 5
Interest Earned 6 6 6 6
Value 100 106 112 118 124

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 12

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

TodayFuture Years
1 2 3 4 5
Interest Earned 6 6 6 6 6
Value 100 106 112 118 124 130

Value at the end of Year 5 = $130

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 13

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

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 14

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

Interest Earned Per Year =Prior Year Balance x .06

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 15

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

Today Future Years

1 2 3 4 5
Interest Earned
Value 100

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 16

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

Today Future Years

1 2 3 4 5
Interest Earned 6.00
Value 100 106.00

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 17

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

Today Future Years

1 2 3 4 5
Interest Earned 6.00 6.36
Value 100 106.00 112.36

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 18

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

Today Future Years

1 2 3 4 5
Interest Earned 6.00 6.36 6.74
Value 100 106.00 112.36 119.10

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 19

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

Today Future Years

1 2 3 4 5
Interest Earned 6.00 6.36 6.74 7.15
Value 100 106.00 112.36 119.10 126.25

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 20

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

Today Future Years

1 2 3 4 5
Interest Earned 6.00 6.36 6.74 7.15 7.57
Value 100 106.00 112.36 119.10 126.25 133.82

Value at the end of Year 5 = $133.82

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 21

Future Values

Future Value of $100 = FV

t
FV  $100  (1  r )

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 22

Future Values
t
FV  $100  (1  r )

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 23

Future Values
t
FV  $100  (1  r )

Example - FV
What is the future value of $100 if interest is
compounded annually at a rate of 6% for five years?

5
FV  $100  (1  .06)  $133.82

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 24

Future Values with Compounding

70 Interest Rates
60 0%
5%
50
10%
15%
FV of $1

40

30

20

10

Number of Years

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 25

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%.
374
FV  $24  (1  .08)
 $75.979 trillion
FYI - The value of Manhattan Island land is
well below this figure.
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
3- 26

Present Values
Present Value
Value today of
a future cash
flow.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 27

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

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 28

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

Discount Rate
Interest rate used
to compute
present values of
future cash flows.
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
3- 29

Present Values

Present Value = PV

Future Value after t periods

PV = (1+r) t

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 30

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  3000
(1.08 ) 2
 $2,572

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 31

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.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 32
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  1
(1 r ) t

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 33
Time Value of Money
(applications)

Value of Free Credit

Implied Interest Rates
Internal Rate of Return
Time necessary to accumulate funds

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 34

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
4 , 000
PV1  (1.08 )1
 3,703.70
4 , 000
PV2  (1.08 ) 2
 3,429.36
Total PV  $15,133.06
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
3- 35

PV of Multiple Cash Flows

PVs can be added together to evaluate

multiple cash flows.

C1 C2
PV  (1 r ) 1  (1 r ) 2 ....

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 36

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.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 37

Perpetuities & Annuities

PV of Perpetuity Formula

PV  C
r

C = cash payment
r = interest rate

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 38

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%?

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 39

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%?

100 , 000
PV  .10  $1,000,000

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 40

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?

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 41

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?

1, 000 , 000
PV  (1 .10 ) 3
 $751,315

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 42

Perpetuities & Annuities

PV of Annuity Formula

PV  C  1
r  1
r (1 r ) t 
C = cash payment
r = interest rate
t = Number of years cash payment is received

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 43

Perpetuities & Annuities

PV Annuity Factor (PVAF) - The present

value of $1 a year for each of t years.

PVAF   1
r  1
r (1 r ) t 
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
3- 44

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
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
3- 45

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  PVAF   (1  r ) t

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 46

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   (1.10) 20

FV  $229,100

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 47

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.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 48

Inflation

1+nominal interest rate

1  real interest rate = 1+inflation rate

approximation formula

Real int. rate  nominal int. rate - inflation rate

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 49

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+.050
1  real interest rate = 1+.022 Savings

1  real interest rate = 1.027 Bond

real interest rate = .027 or 2.7%

Approximation = .050 - .022 = .028 or 2.8%

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
3- 50

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.

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 51

Effective Interest Rates

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

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001

3- 52

Effective Interest Rates

example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual
Percentage Rate (APR)?
12
EAR = (1+.01) - 1 = r
12
EAR = (1+.01) - 1 =.1268 or 12.68%

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

Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
3- 53

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
Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001