Corporate Finance

Gonzalo Maturana
 Topic 2: Time Value of Money 1

• Reading: RWJ Chapter 5

• Outline
– Future value and compounding
– Present value and discounting
– Implied Interest Rate
– Time Periods
 Key Concepts and Skills

• Understand the concept of time value of money

• Compute the future value of an investment
• Compute the present value of future cash flows
• Compute the return on an investment
• Find a time period equating a future value and a present value
given a discount rate
• Use Excel spreadsheets to solve the time value of money
problems
 Three Basic Assumptions
• For now
1. People prefer more money than less money
2. People would rather have money sooner than later (time
impatience)

• Later
3. People prefer certainty to uncertainty (risk aversion)
 Cash flows

• The term cash flows refers to the movement of cash in and

out of one’s account (or pocket)

• The cash flows into an account are called cash inflows and
those out of an account are called cash outflows
 Timing of Cash Flows

0 1 2 3 4 Time
r% Period

CF0 CF1 CF2 CF3 CF4

• Tick marks the end of a period

– Time 0 is today
– Time 1 is the end of Period 1 or the beginning of Period 2

• r (or rt) is the interest rate

– Also known as the discount rate, cost of capital, opportunity cost of
capital, required rate of return, expected return

• CF>0 is a cash inflow and CF<0 is a cash outflow

 A few examples

0 1 2 3 4 Year
8%
A:
80

0 1 2 3 4
1% Month
B:
100 100 100

0 1 2 3 4 Year
r1 r2 r3
C:
-60 80 80 -20
 How to value Cash Flows?

• It would be useful to have a “number” representing the value

of all cash flows

• Then, when making a financial decision, we can rely on this

“number”
– Prefer the project/security with the greater number
– Invest in a project if and only if the number is positive
– …

• Valuation is the struggle to find this “number”

 How to value Cash Flows?

• Discounting vs. Compounding

– What does a 10% annual interest rate mean?
– I will pay you $110 (=$100*(1+0.1)) one year from today if you lend me
$100 today
– This means that $110 one year from today = $100 today

Discounting

Interest
Today’s value Future value
Rate

Compounding
 Basic Definitions of Valuation

• Present Value (or PV)

– Current value of future cash flows discounted at a certain rate
• Future Value (or FV)
– Value of a cash flow in the future (based on certain rate)
• Simple interest (rarely used)
– Interest earned on principal only
• Compounding interest
– Interest earned on principal and previously earned interest
 Future Value with Simple Interest

• Suppose you deposit $100 in a bank account that pays a

simple interest of 10% annually. What is the future value of
your account in three years?
• Investment (PV): $100
• Simple interest rate
(Annually): 10%
• Time period: 3 yrs
• Future value: ???

0 1 2 3 4 Year
10 %

-100 100 (Principal)

10 (Interest) 10 (Interest) 10 (Interest)

130 (Total)
 Future Value with Compounding Interest

• Suppose you deposit $100 in a bank account paying a

compounding interest of 10% annually. What is the future
value of your account in three years?
• Investment (PV): $100
• Compounding interest rate
(Annually): 10%
• Time period: 3 yrs
• Future value: ???
0 1 2 3 4 Year
10 %

-100 100 (Principal)

10 (Interest) 11 (Interest) 12.1 (Interest)

=100*0.1 =(100+10)*0.1 =(100+10+11)*0.1
133.1 (Total)
 General Formula: Future Value
<Note>
• Investment (PV): PV • Interest rate is time-invariant
• Interest rate: r% • The frequency of interest
• Time period: t rate and the unit of time
• Future value: ??? period is comparable
(e.g., Annual: Year, Monthly: Month)

Simple Interest
FVt = PV(1+rt)

Compound Interest
FVt = PV(1+r)t
 Why Compounding?

• Simple Interest is not realistic since

– Interest is reinvested
– The time value of principal = The time value of Interest

• Simple interest is rarely used

• However, for an educational purpose (i.e., for exams), I expect

you to understand simple interest, since it is a basic form of
interest
 Example 1: The Power of Compounding

• Assume your great-grand parents put aside $100 for you 100
years ago, and it earned 10% compound interest rate over the
years. How much is it worth now? What if it earned a 20%
simple interest rate?

• Investment (PV): $100 • Investment (PV): $100

• Compounding interest rate • Simple interest rate
(Annually): 10% (Annually): 20%
• Time period: 100 yrs • Time period: 100 yrs
• Future value: ??? • Future value: ???
 Example 1: The Power of Compounding (Sol’n)

• Compounding Interest

FV = 100(1+0.1)100 = $1,380,000

• Simple Interest

FV = 100(1+0.2*100) = $2,100
 Example 2: FV as a Growth Formula

• Suppose your company expects to increase unit sales of

widgets by 15% per year for the next 5 years. If you
currently sell 3 million widgets each year, how many widgets
do you expect to sell in year 5?

• Present Value: 3 Mil

• Compounding interest rate
(Annually): 15%
• Time period: 5 yrs
• Future value: ???
 Example 2: FV as a Growth Formula (Sol’n)

• Note that we use compounding

• Answer: FV = 3mil(1+0.15)5 = 6.03mil

 What have we covered so far?

• Contrast between discounting and compounding

• Understand the difference between simple interest and

compounding interest

• Future value
 Present Value

• Revisiting the formula of Future values

FVt = PV(1+r)t

• Dividing both sides by (1+r)t,

PV = FVt / (1+r)t Formula of Present value

 Present Value

• PV answers the following question

– How much do I have to invest today to have a certain amount in the
future?
– What is the value today equivalent to a certain amount of money at a
specified date in the future?

• Note that we need 3 components to calculate PV

– Interest rate (r)
– Future value (FV)
– Time period (t)
The PV and FV formulas

PV = FVt / (1+r)t

Divide by (1+r)t =
“Discounting”

FVt = PV (1+r)t

Multiply by (1+r)t =
“Compounding”
 Discount Factor (DF)

• DFt = 1 / (1+r)t Definition of

Discount Factor

• PV = FVt * DFt

• FVt = PV / DFt
 Discount Factor (DF)

• Implication of DF
– Each dollar in year t is worth DFt now
– DFt relates to how time-inpatient an investor is

• DF increases as interest rate decreases

– When investors are time-inpatient (low DF), they require a high
interest rate on investment

• DF decreases as time period increases

– Investors prefer money next year to money 10 years from now
(Basic Assumption 2)
 Example 3: Present Value

• Your parents set up a trust fund for you 10 years ago that is
now worth $19,671.51. If the fund earned 7% per year, how
much did your parents invest?

• Present Value: ???

• Compounding interest rate
(Annually): 7%
• Time period: 10 yrs
• Future value: $19,671.51
 Example 3: Present Value (Sol’n)
0 1 2 … 10 Years
r=7%

PV0 = ? FV10 =19,671.51

PV = FVt / (1 + r)t = 19,671.51/(1.07)10

= 10,000

Alternatively,
DF10 = 1/(1.07)10 = 0.508,
PV=FV*DF=19,671.51*.508=10,000
 Example 4: Comparing Cash Flows

• Assume r = 10%. Security E promises $100 in two years,

while F promises $108 in three years. Which one do you
prefer?

Security E Security F
•Present Value: ??? •Present Value: ???
• Compounding interest rate • Compounding interest rate
(Annually): 10% (Annually): 10%
• Time period: 2 yrs • Time period: 3 yrs
• Future value: $100 • Future value: $108
 Example 4: Comparing Cash Flows (Sol’n)
Method 1: Compare Present Value
0 1 2 3 Years
10 %

E PV0 (E)=? 100

F PV0 (F)=? 108

PV0 (E) = FV2/(1+r)2 = 100/(1.1)2 = 82.64

PV0 (F) = FV3/(1+r)3 = 108/(1.1)3 = 81.14

Hence, E is preferred.
 Example 4: Comparing Cash Flows (Sol’n)

• We have a “number” for valuation

• Is it the only way comparing two cash flows?

• No!

• The only reason we cannot compare two cash flow profiles

directly is the different time periods
– We can match time periods to any year (period) 1, 2, 3, …
– The comparison’s result is robust to the choice of year
 Example 4: Comparing Cash Flows (Sol’n)
Method 2: Compare cash flows at time 2

0 1 2 3 Years
10 %

E 100

F FV2 (F)=? 108

FV2 (F)=FV3/(1+r)=108/(1.1)=98.18<100=PV2 (E)

Hence, E is preferred.
 Example 4: Comparing Cash Flows (Sol’n)
Method 3: Compare cash flows at time 3

0 1 2 3 Years
10 %

E 100 FV3 (E)=?

F 108

FV3 (E)=FV2 (1+r)=100(1.1)=110>108=FV3 (F)

Hence, E is preferred.
 Quick Quiz - PV

• Suppose you need $15,000 in 3 years. If you can earn 6%

annually, how much do you need to invest today?
• If you could invest the money at 8%, would you have to invest
more or less than the previous case? How much?
 Implied Interest Rate (Discount Rate)

• Revisiting the formula of Future values

FVt = PV(1+r)t

• By simple algebra,

r = (FVt/PV)1/t - 1
 Implied Interest Rate (Discount Rate)

• The implied interest rate is obtained to answer the following

questions
– If you can earn a certain amount of money at a specified date in the
future from a certain investment, what is the implied return of the
investment?
– You need a certain amount of money at a specified date in the future.
However, you have only some amount of money now. To make the
money you need, what return on investment is required?
 Example 5: Implied Rate of Interest

• You are looking at an investment that will pay $1,200 in 5

years if you invest $1,000 today. What is the implied rate of
interest?

• Present Value: $1,000

• Compounding interest rate
(Annually): ???
• Time period: 5 yrs
• Future value: $1,200
Example 5: Implied Rate of Interest (Sol’n)

0 1 2 … 5 Years
r =?

PV0 = 1,000 FV5 =1,200

r =(1200/1000)1/5 -1 = .0371 = 3.71%

 Example 6: Discount Rate

• Suppose you have a 1-year-old son and you want to provide

$75,000 in 17 years for his college education. You currently
have $5,000 to invest. What interest rate must you earn to
have the $75,000 when you need it?

• Present Value: $5,000

• Compounding interest rate
(Annually): ???
• Time period: 17 yrs
• Future value: $75,000
 Example 6: Discount Rate (Sol’n)

0 1 2 … 17 Years
r =?

PV0 = 5,000 FV17 =75,000

r =(75000/5000)1/17 -1 = 17.27%
 Quick Quiz – Interest Rate

• You are offered the following investments:

– You can invest $500 today and receive $600 in 5 years. The
investment is considered low risk.
– You can invest the $500 in a bank account paying 4%.

• What is the implied interest rate for the first choice

and which investment should you choose?
 Time Periods

• Revisiting the formula of Future values

FVt = PV(1+r)t

• By (less) simple algebra,

t = ln(FVt/PV) / ln(1+r)
 Time Periods

• This formula answers the following question

– How long will it take to make a certain amount of money by investing
in a project with certain interest rate?
 Example 7: Time to Accumulate Funds

• Assume the interest rate is 10% per year, how long do you
need to invest before you double your money?

• Present Value: $X
• Compounding interest rate
(Annually): 10%
• Time period: ???
• Future value: $2X
Example 7: Time to Accumulate Funds (Sol’n)
0
r =10%
1 … t=? Years

PV0 = X FVt =2X

t =ln(2X/X) / ln(1.1) = ln(2) / ln(1.1) = 7.27 yrs

 Example 8: Number of Periods

• Suppose you want to buy a new house. You currently have

$15,000 and you figure you need to have a 10% down
payment plus an additional 5% of the loan amount for
closing costs. Assume the type of house you want will cost
about $150,000 and you can earn 7.5% per year, how long
will it be before you have enough money for the down
payment and closing costs?
• Present Value: $15,000
• Compounding interest rate
(Annually): 7.5%
• Time period: ???
• Future value: $21,750
(Not obvious)
 Example 8: Number of Periods (Sol’n)

0
r =7.5%
1 … t=? Years

PV0 = 15,000 FVt =downpay+closing

• How much do you need to have in the future?

– Down payment = .1(150,000) = 15,000
– Closing costs = .05(150,000 – 15,000) = 6,750
– Total needed = 15,000 + 6,750 = 21,750

• Since 15,000 = 21,750/(1.075)t, the time need is

t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years
 Quick Quiz – Time Periods

• Suppose you want to buy some new furniture for your family
room. You currently have $500 and the furniture you want
costs $600. If you can earn 6%, how long will you have to wait
if you don’t add any additional money?
 Comprehensive Problem

• You have $10,000 to invest for five years.

• How much additional interest will you earn if the investment
provides a 5% annual return, when compared to a 4.5%
annual return?
• How long will it take your $10,000 to double in value if it
earns 5% annually?
• What annual rate has been earned if $1,000 grows into
$4,000 in 20 years?
 What did we learn?

• FVt = PV(1+r)t

• Discounting Vs. Compounding

• Implications of the Discount Factor

• Valuation Applications
 Next Class

Topic 3: The Time Value of Money 2

Read: RWJ Chapter 6