Session 4

Introduction to Valuation: Time Value of Money

Key Concepts and Skills
 Be able to compute the future value and/or present
value of a single cash flow or series of cash flows
 Be able to compute the return on an investment
 Be able to use the spreadsheet to solve time value

problems
 Understand perpetuities and annuities

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Chapter Outline

Valuation: The One-Period Case

The Multiperiod Case
Compounding Periods
Simplifications

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What is Inflation?

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India’s Inflation- Last 5 years

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4.1 Valuation: The One-Period Case
 If you were to invest $10,000 at 12-percent interest for one
year, your investment would grow to?

$1,200 would be interest ($10,000 × .12)

$10,000 is the principal repayment ($10,000 × 1)
$11,200 is the total due. It can be calculated as:

$11,200 = $10,000 × (1.12)

 The total amount due at the end of the investment is called the
Future Value (FV).

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One-Period Case Future Value
 In the one-period case, the formula for FV can be
written as:
FV = PV × (1 + r)

Where PV is present value (i.e., the value today), and

r is the appropriate interest rate.

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Present Value - I
 If you were to be promised $11,424 due in one year
when interest rates are 12 percent, your investment
would be worth _____ in today’s dollars.

The amount that a borrower would need to set aside

today to be able to meet the promised payment of
$11,424 in one year is the Present Value (PV).
Note that $11,424 = $10,200 × (1.12).

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Present Value – II
 In the one-period case, the formula for PV can be
written as:

C1
PV 
1 r
Where C1 is cash flow at date 1, and r is the
appropriate interest rate.


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4.2 The Multiperiod Case
The general formula for the future value of an
investment over many periods can be written as:
FV = PV × (1 + r)t
Where
PV is present value,
r is the appropriate interest rate, and
t is the number of periods over which the cash is
invested.

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Multi period Case Future Value
 Suppose a stock currently pays a dividend of $1.10,
which is expected to grow at 40 percent per year for
the next five years.
 What will the dividend be in five years?

FV = PV × (1 + r)t

$5.92 = $1.10 × (1.40)5

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Future Value and Compounding - I
 Notice that the dividend in year five, $5.92, is
considerably higher than the sum of the original
dividend plus five increases of 40 percent on the
original $1.10 dividend:

$5.92 > $1.10 + 5 × [$1.10 × .40] = $3.30

This is due to compounding.

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Future Value and Compounding – II
5
$ 1 . 1 0  (1 . 4 0 )
$ 1 . 1 0  (1 . 4 0 ) 4
$ 1 . 10  (1 . 40 ) 3
$ 1 . 1 0  (1 . 4 0 ) 2
$ 1 . 1 0  (1 . 4 0 )

$ 1 . 10 $ 1 . 54 $ 2 . 1 6 $ 3 .0 2 $ 4 .2 3 $ 5 .9 2

0 1 2 3 4 5

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Present Value and Discounting
 How much would an investor have to set aside today
in order to have $20,000 five years from now if the
current rate is 15 percent?
PV $20,000

0 1 2 3 4 5
$ 20,000
$ 9,943 .53  5
(1 .15 )

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Finding the Number of Periods
If we deposit $5,000 today in an account paying 10 percent,
how long does it take to grow to $10,000?
T
$ 1 0 , 0 0 0  $ 5 , 0 0 0  (1 . 1 0 )
T$ 10 ,000
(1 .10 )  2
$ 5,000
T
ln( 1 . 1 0 )  ln( 2 )

ln( 2 ) 0 .6931
T    7 .27 years
ln( 1 .10 ) 0 .0953

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What Rate Is Enough?
Assume the total cost of a college education will be
$50,000 when your child enters college in 12 years.
You have $5,000 to invest today. What rate of interest
must you earn on your investment to cover the cost of
your child’s education?
About 21.15%.
12
$ 5 0 , 0 0 0  $ 5 , 0 0 0  (1  r )

12 $ 50 ,000 1 12
(1  r )   10 (1  r )  1 0
$ 5,000

r  1 0 1 1 2  1  1 .2 1 1 5  1  .2 1 1 5
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Multiple Cash Flows
 Consider an investment that pays $200, 400, 600, 800
from year one through year four. If the interest rate is
12 percent, what is the present value of this stream of
cash flows?
 If the issuer offers this investment for $1,500, should

you purchase it?

 Calculate the FV for the same cash flows

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Multiple Cash Flows – II
0 1 2 3 4

200 400 600 800

178.57

318.88

427.07

508.41
1,432.93
Present Value < Cost → Do Not Purchase

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4.3 Compounding Periods

Compounding an investment m times a year for T years

provides for future value of wealth:

( )
𝑚𝑇
𝑟
𝐹𝑉 =𝐶 0 × 1+
𝑚

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Compounding Periods

For example, if you invest $50 for three year at 12

percent interest compounded semiannually, your
investment will grow to:

2 3
 . 12 
F V  $ 50   1    $ 50  (1 . 06 ) 6  $ 70 . 93
 2 

Annual percentage rate

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Effective Annual Rates of Interest – I
A reasonable question to ask in the above example is
“what is the effective annual rate of interest on that
investment?”
. 12 2  3
F V  $ 50  (1  )  $ 50  (1 . 06 ) 6  $ 70 . 93
2
The Effective Annual Rate (EAR) of interest is the
annual rate that would give us the same end-of-
investment wealth after 3 years:

$ 5 0  (1  E A R ) 3  $ 7 0 . 9 3
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Effective Annual Rates of Interest – II
F V  $ 5 0  (1  E A R ) 3  $ 7 0 . 9 3
3$ 70 .93
(1  EAR ) 
$ 50
13
 $ 70 . 93 
EAR     1  .1236
 $ 50 
EAR= (1+APR/m)^m- 1
So, investing at 12.36 percent compounded annually is
the same as investing at 12 percent compounded
semiannually.
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