Key Concepts and Skills

Introduction to Valuation: The • Be able to compute:

– The future value of an investment made today
Time Value of Money – The present value of cash to be received at some future
date
– The return on an investment
– The number of periods that equates a present value and
a future value given an interest rate
• Be able to solve time value of money problems
using:
– Formulas

4-1 4-2

Chapter Outline Basic Definitions

• Future Value and Compounding • Present Value (PV)
• Present Value and Discounting – The current value of future cash flows
discounted at the appropriate discount rate
• More on Present and Future Values
– Value at t=0 on a time line
Solving for:
• Future Value (FV)
Implied interest rate
– The amount an investment is worth after one
Number of periods or more periods.
– “Later” money on a time line

4-3 4-4

Basic Definitions Time Line of Cash Flows

• Interest rate (r) •Tick marks at ends of periods
– Discount rate • Time 0 is today;
– Cost of capital
• Time 1 is the end of Period 1
– Opportunity cost of capital
– Required return 0 1 2 3
r%
– Terminology depends on usage
CF0 CF1 CF2 CF3
+CF = Cash INFLOW -CF = Cash OUTFLOW PMT = Constant CF

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Time Line for a P100 Lump Sum Future Values: General Formula
due at the End of Year 2.
FV = PV(1 + r)t
FV = future value
PV = present value
0 1 2 Year r = period interest rate, expressed
r%
as a decimal
100 t = number of periods
• Future value interest factor = (1 + r)t

4-7 4-8

Basic Patterns of Cash Flow Future Values (Single Amount)

– Example 1
Suppose you invest P100 for one year at
• Single amount – a lump-sum amount either 10% per year.
currently held or expected at some future date What is the future value in one year?
• Annuity – a level periodic stream of cash flow
• Mixed stream – a stream of cash flow
that is not an annuity; a stream of
unequal periodic cash flows that reflect
no particular pattern.

4-9 4-10

Future Values – Example 1 Effects of Compounding

Suppose you leave the money for another • Simple interest
year. How much will you have two years – Interest earned only on the original
from now? principal
• Compound interest
– Interest earned on principal and on interest
received
Note: Compound interest
– “Interest on interest” – interest earned on
reinvestment of previous interest
payments
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 Effects of Compounding Future Values – Example 2
• Consider the previous example • Suppose you invest the P100 from the previous
example for 5 years. How much would you have?
– FV w/simple interest

– FV w/compound interest

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Table Figure

4-15 4-16

Future Values – Exercise 1 Future Values – Example 3

1. Jane Farber places P800.00 in a • Suppose you had a relative who
savings account paying 6% interest deposited P10.00 at 5.5% interest
compounded annually. She wants 200 years ago. How much would
to know how much money will be the investment be worth today?
in the account at the end of 5
years.

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 Future Value: General Growth Future Value:
Formula
Important Relationship I
Suppose your company expects to
For a given interest rate:
increase unit sales of widgets by 15%
per year for the next 5 years. If you – The longer the time period,
currently sell 3 million widgets in one – The higher the future value
year, how many widgets do you expect
to sell in 5 years? FV = PV(1 + r)t
For a given r, as t increases, FV increases

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Future Value Figure 4.2

Important Relationship II
For a given time period:
– The higher the interest rate,
– The larger the future value

FV = PV(1 + r)t

For a given t, as r increases, FV increases

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Present Values Present Values

• The current value of future cash flows • Present Value = the current value of an
discounted at the appropriate discount rate amount to be received in the future
• Value at t=0 on a time line • Why is it worth less than face value?
• Answers the questions: – Opportunity cost
– How much do I have to invest today to have
some amount in the future? – Risk & Uncertainty
– What is the current value of an amount to be Discount Rate = ƒ (time, risk)
received in the future?

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 Time Line of Cash Flows Present Values
•Tick marks at ends of periods FV = PV(1 + r)t
• Rearrange to solve for PV
• Time 0 is today;
• Time 1 is the end of Period 1
PV = FV / (1+r)t
0 1 2 3 PV = FV(1+r)-t
r%

CF0 CF1 CF2 CF3 • “Discounting” = finding the present value of

+CF = Cash INFLOW -CF = Cash OUTFLOW PMT = Constant CF one or more future amounts.

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What’s the PV of P100 due in 3 Present Value: Example 1

Years if r = 10%? Single Period
Suppose you need P10,000 in one year for the down
Finding PVs is discounting, and it’s payment on a new car. If you can earn 7% annually, how
the reverse of compounding. much do you need to invest today?

0 1 2 3
10%
PV = P10,000/(1.07)
= P9,345.79
PV = ? 100
=========

4-27 4-28

Present Values: Example 2 Present Values: Example 3

Multi-Periods Multi-Periods
You want to begin saving for your daughter’s college Your parents set up a trust fund for you 10 years ago
education and you estimate that she will need P150,000 that is now worth P19,671.51. If the fund earned 7%
in 17 years. If you feel confident that you can earn 8% per year, how much did your parents invest?
per year, how much do you need to invest today?

PV = P150,000/(1.08)17
= P40, 540.34
================

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 Present Value:
Important Relationship I
PV = P19,671.51/(1.07)10
For a given interest rate:
= P10,000.00
– The longer the time period,
============
the lower the present value
FV
PV =
(1 + r )t
For a given r, as t increases, PV decreases

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Present Value: Present Value

Important Relationship I Important Relationship II
What is the present value of P500 to be For a given time period:
received in 5 years? 10 years? The discount – The higher the interest rate,
rate is 10%
0 r=10% 5 10 the smaller the present value
FV
PV? 500 PV =
PV? 500 (1 + r )t
@5 years @10 years
PV = P500/(1.10)5 PV = P500/(1.10)10 For a given t, as r increases, PV decreases
= P310.46 = P192.78
4-33 4-34

Present Value: Figure 4.3

Important Relationship II
What is the present value of P500 received in 5
years if the interest rate is 10%? 15%?
@10% @15%
PV = P500/(1.10)5 PV = P500/(1.15)5
=P805.26 = P248.59
======= =======

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 The Basic PV Equation - Refresher Discount Rate
• To find the implied interest rate,
PV = FV / (1 + r)t rearrange the basic PV equation and
solve for r:
There are four parts to this equation
– PV, FV, r and t
FV = PV(1 + r)t
– Know any three, solve for the fourth r = (FV / PV)1/t – 1
• Be sure and remember the sign convention
+CF = Cash INFLOW -CF = Cash OUTFLOW

4-37 4-38

Discount Rate – Example 1 Discount Rate – Example 2

You are looking at an investment that will pay P1200 Suppose you are offered an investment that will allow
in 5 years if you invest P1000 today. What is the you to double your money in 6 years. You have
implied rate of interest?
P10,000 to invest. What is the implied rate of interest?

r = (P1,200/P1,000)1/5 – 1
r = (P20,000/P10,000)1/6 – 1
= 3.71%
= 12.25%

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Discount Rate – Example 3

Suppose you have a 1-year old son and you want to r = 17%
provide P75,000 in 17 years towards his college
education. You currently have P5,000 to invest. What
interest rate must you earn to have the P75,000 when
you need it?

r= ?

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 Finding the Number of Periods Number of Periods – Example
• Start with basic equation and solve for t: You want to purchase a new car and you are willing
FV = PV(1 + r)t to pay P20,000. If you can invest at 10% per year and
you currently have P15,000, how long will it be
 FV  before you have enough money to pay cash for the
ln  car?
t=  PV 
ln(1 + r ) t = In [(P20,000/P15,000)]/In (1 + 10%)
= 3.02 years
========

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Special Application of Time

Value: Loan Amortization Table 4.4
CF = (PV x r) ÷ [1 - 1/(1+r)n]

Ex. John Doe borrows P6,000.00 at 10% and agree to

make equal annual end-of-year payments over 4
years. Please prepare a schedule of loan amortization
for John Doe.

CF = (P6000*.10) ÷ [1 - 1/(1+.10)4]
= P1,892.82
========
Loan Amortization.xlsx
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END
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