Chapter 5.

Introduction to Valuation: The Time Value of Money

Dr. Ali Shehadeh / The University of Jordan

Key Concepts and Skills:

• Be able to compute the future value of an investment made today

• Be able to compute the present value of cash to be received at some future date

• Be able to compute the return on an investment

• Be able to compute the number of periods that equates a present value and a future value
given an interest rate

Chapter Outline:

• Future Value and Compounding

• Present Value and Discounting

• More on Present and Future Values

The very essential topic of this chapter is the Time Value of Money.

Time Value of Money is one of the most important concepts in finance and financial management.

Time value of money indicates that the value of money is associated with and depends on time. The
timing of paying or receiving some amount of money plays significant role in determining the value
of that amount.

Time value of money can be described by the question of:

Which is better for you: to receive $1 today or for example 1$ after one year. (In other words,
which $1 has more value or worth more?)

As long as there is some interest rate that you can earn on the $1 today over a year, then it is better
to get the $1 today. This is because you can invest the $1 today at some interest rate for a year, and
then you will have an amount of more than $1 after one year.

So, time value of money implies that $1 today is worth more than the same 1$ after a period of
time. Again this is because the $1 today can be invested at some interest rate and so over some
period of time the $1 will have a greater value.

Then, time value of money and the idea that the value of money depends on time or timing of
money is relevant because of the existence of interest rate. That is, some rate of return than can be
achieved by investing money for some period of time.

There are two important concepts related to the time value of money:

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 Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

- Future Value (Compounding)

- Present value (Discounting)

So, we are going to learn two essential things from this chapter:

1- how to compute the future value

2- how to compute the present value

Future Value and Compounding:

Future value can be thought of as: what is the value of some amount of money we have today after
some period of time at a given interest rate.

Example: you invest $100 today for one year at an interest rate (IR) of 10%. What is the value of
the $100 after one year?

Solution: the answer is (simply): the value of the $100 after one year is the original amount of $100
(which is called the principal) plus the interest earned over the year

$100 + $100 X 0.10 = $100 + $10 = $110

Principal Interest

It can also be written as:

$100 X (1 + 0.10) = $110

So, the value of the $100 today is $110 after one year at the annual interest rate of 10%.

$110 has two components:

1- The principal which is the $100: the original amount invested at the beginning of the year

2- The interest earned over the year which is the $10 ($100 X 0.10 = $10)

Now: Which is better for you: to have $100 today or $110 after one year if the annual interest rate is
10%?

Because the value of $100 today is $110 after one year, both choices are the same. You are
indifferent whether you get $100 today or $110 after one year. If you get $100 today and invest it at
an annual interest rate of 10% you will end up with $110 after a year.

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

Example: You invest $100 today for two years at an annual interest rate of 10%. What is the value
of the $100 today after two years?

Solution: the value of the $100 today after two years is the $100 (principal) Plus the interest that
will be earned over the two years

- Today or now or present moment (which will be referred to as time zero) you have $100
- After one year (which will be referred to as time 1) you will have $110

$100 + $100 X 0.10 = $100 X (1 + 0.10) = $110 (The principal $100 plus the interest $10 earned in
the first year)

- After two years (which will be referred to as time 2) you will have $121

$110 + $110 X 0.10 = $110 X (1 + 0.10) = $121 (The $110 at the beginning of the second year plus
the interest $11 earned in the second year)

At time zero 0 : $100

At time 1 1 : $100 X (1 + 0.10) = $110

At time 2 2 : $110 X (1 + 0.10) = $121

So, the value of the $100 today after two years at an annual interest rate of 10% is $121

$121 has four components:

- $100: the principal

- $10: the simple interest earned in the first year on the principal ($100 X 0.10 = $10)
- $10: the simple interest earned in the second year on the principal ($100 X 0.10 = $10)
- $1: is the interest on interest earned in the first year ($10 X 0.10 = $1). It is also called
interest from compounding or compound interest.

Compounding: is the process of reinvesting the interest earned in previous periods. Reinvesting
the interest earned will generate interest on interest.

As long as the investment period is longer than one year, there will be interest on interest. And,
the longer the period is, the greater the effect of compounding.

Future value computation implies compounding. So future value computation is also called
compounding process.

Simple interest: is the interest on the principal every period. In the previous example, the simple
interest every year is $10 ($100 X 0.10 = $10). The total simple interest is $20 ($10 every year
for two years: $10 X 2 = $20)

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

FV General Formula: Future value can be calculated directly as

𝑭𝑽 = 𝑷𝑽(𝟏 + 𝒓)𝒕
Where:

FV: is future value

PV: is present value

r: is interest rate (discount rate, expected rate of return, required rate of return)

t: number of period

Note that this formula implies a compounding process

Example: what is the value of $325 today after two years if the annual interest rate is 14%?

𝑭𝑽 = 𝑷𝑽(𝟏 + 𝒓)𝒕
𝐹𝑉 = $325(1 + 0.14)2 = $325(1.14)2 = $422.37

What is the total interest?

Total interest is the difference between future value and present value (the difference between
future value and present value is the interest earned during the time period)

Total interest = FV – PV

Total interest = $422.37 - $325 = $97.37

What is the total simple interest?

Total simple interest is the sum of simple interest every year on the principal

Total simple interest = Principal X Interest rate X number of periods

Total simple interest = $325 X 0.14 X 2 = $91

(Note that every year has a simple interest of $325 X 0.14 = $45.5)

What is the interest from compounding (or interest on interest)?

Interest from compounding is the difference between the total interest and total simple interest

Interest from compounding = Total interest – total simple interest

Interest from compounding = $97.37 - $91 = $6.37

(Note that this interest is the interest on interest earned in the first year: $45.5 X 0.14 = $6.37)

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

Example: What is the value of $100 today after five years if the annual interest rate is 10 percent?

𝑭𝑽 = 𝑷𝑽(𝟏 + 𝒓)𝒕
𝐹𝑉 = $00(1 + 0.10)2 = $100(1.10)5 = $161.05

Future value depends on interest rate (r) and number of periods (t). As interest rate (r) increases,
future value increases. As number of periods (t) increases, future value increases.

Example: You invest $400 today at an annual interest rate of 12 percent.

1.A. what is the future value of the $400 after three years?

𝑭𝑽 = 𝑷𝑽(𝟏 + 𝒓)𝒕
𝐹𝑉 = $400(1 + 0.12)3 = $400(1.12)3 = $561.97

1.B. What is the total interest?

Total interest = FV – PV = $561.97 - $400 = $161.97

1.C. What is the total simple interest?

Total simple interest = Principal X r X t = $400 X 0.12 X 3 = $144

1.D What is the interest from compounding?

Interest from compounding = Total interest – total simple interest = $161.97 - $144 = $17.97

2.A. What is the future value of the $400 after seven years?

𝑭𝑽 = 𝑷𝑽(𝟏 + 𝒓)𝒕
𝐹𝑉 = $400(1 + 0.12)7 = $400(1.12)7 = $884.27

2.B. What is the total interest?

Total interest = FV – PV = $884.27 - $400 = $484.27

2.C. What is the total simple interest?

Total simple interest = Principal X r X t = $400 X 0.12 X 7 = $336

3.D. What is the interest from compounding?

Interest from compounding = Total interest – Total simple interest = $484.27 - $336 = $148.27

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

Future Value Applications:

Future Value is used as a General Growth Formula

Future value formula can be applied in many situations. If we know a present value and that the
present value changes at constant change rate every specific period, then we can use the future
value formula to compute the future value of the present value after any period of time.

Example: A firm currently has 10,000 employees. You expect that the number of employees
will increase 3 percent every year. What is the number of employees after five years?

Solution: we can simply apply the future value formula. We have a present value which is the
current number of employees (10,000), and we expect that this number will increase at a
constant rate (3%) every year.

𝑭𝑽 = 𝑷𝑽(𝟏 + 𝒓)𝒕
𝐹𝑉 = 10,000(1 + 0.03)5 = 10,000(1.03)5 = 11,593 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑒𝑠

Example: ABC Company pays dividends of $5 per share. You expect that dividends will
increase 4 percent per year. What dividends will be paid after eight years?

Solution: again, we can simply apply the future value formula. We know the current dividend
which is the present value, and we expect this present value to increase at a constant rate (4%)
every year.

𝑭𝑽 = 𝑷𝑽(𝟏 + 𝒓)𝒕
𝐹𝑉 = $5(1 + 0.04)8 = $5(1.04)8 = $6.84

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

Present Value and Discounting:

Present value (PV) can be thought of through questions like: what is the value today of some future
amount of money at a given interest rate? Or how much do I need to invest today to have a certain
amount of money after some time period at a given interest rate?

Calculating present value involves a discounting process. Discounting process is just the reverse of
compounding process.

The formula of finding PV is derived from the future value formula.

𝐹𝑉 = 𝑃𝑉(1 + 𝑟)𝑡

𝑭𝑽
𝑷𝑽 =
(𝟏 + 𝒓)𝒕

r in this formula is the interest rate and it is also called the discount rate.

PV has negative relationships with r and t:

- As r increases, PV decreases and vice versa.

- As t increases, PV decreases and vice versa.

Example: suppose you need $1,000 after two years. You can earn 7% per annum. How much do
you need to invest today?

𝐹𝑉 $1,000 $1,000
𝑃𝑉 = = = = $873.44
(1 + 𝑟)𝑡 (1 + 0.07)2 (1.07)2

So, if you today have $873.44 and invest them at interest rate of 7% per year for two years, you will
have $1,000 after 2 years.

Example: Your parents made an investment for you 10 years ago that is now worth $19,671.51. If
the investment earned 7% per year, how much did your parents invest?

𝐹𝑉 $19,671.51 $19,671.51
𝑃𝑉 = = = = $10,000
(1 + 𝑟)𝑡 (1 + 0.07)10 (1.07)10

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

Example: Today you have $50,000. Cost of a car after two years is $68,500. You can earn 9% per
annum. Do you have enough money today so that you can buy the car after two years?

This example can be solved either by finding PV or FV.

- PV: you can find the PV of the cost of car after two years ($68,500) and then compare the
answer to the amount you have today ($50,000).

𝐹𝑉 $68,500 $68,500
𝑃𝑉 = 𝑡
= 2
= = $57,655
(1 + 𝑟) (1 + 0.09) (1.09)2

The PV of $57,655 means that at least you should have $57,655 today to have $68,500 after two
years given the annual interest rate of 9%. Because you only have $50,000 today then you do not
have enough money.

- FV: you can find the value of the $50,000 after two years with 9% annual interest rate and
then compare the answer to the cost of the car after two years ($68,500).

𝐹𝑉 = 𝑃𝑉(1 + 𝑟)𝑡 = $50,000(1.09)2 = $59,405

This means that you don’t have enough money because if you invest the $50,000 today for two
years at 9% annual interest rate you will have $59,405 after two years and the cost of the car is
$68,500.

The Basic PV Equation:

t
•PV = FV / (1 + r)

•There are four parts to this equation:

PV, FV, r and t

If we know any three, we can solve for the fourth

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

Determining the discount rate:

In some cases we may know the PV, FV and number of periods, but what we need to know is the
interest rate or rate of return.

Often, we will want to know what the implied interest rate (rate of return) is on an investment

Example: you invest $1,250 today for one year and get back $1,350. What is the return on your
investment?

You know the PV ($1,250), FV ($1,350), and number of periods (1 year). The unknown is the
interest rate.

So you can use the FV or PV formula.

𝐹𝑉 = 𝑃𝑉(1 + 𝑟)𝑡 = $1,250(1 + 𝑟)1 = $1,350

𝒕 𝑭𝑽
𝒓=√ −𝟏
𝑷𝑽

1 $1,350
𝑟=√ − 1 = 0.08 = 8%
$1,250

Example: you are offered an investment of $100 and that you will double your money in eight
years. What is the annual return on this investment?

Double $100 is 2 X $100 = $200.

So PV is $100, FV is $200, t is 8 years, and the unknown is r

𝑡 𝐹𝑉 8 $200
𝑟=√ −1= √ − 1 = 0.091 = 9.1%
𝑃𝑉 $100

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

Finding the number of periods:

In some cases, we may know the PV, FV and interest rate, but what we need to know is the number
of periods.

Example 6: if you have now $25,000 and your target is to have $50,000. How long will it take to
get your target if you can earn 12% per annum?

𝐹𝑉 = 𝑃𝑉(1 + 𝑟)𝑡

𝑭𝑽
𝒍𝒐𝒈 𝑷𝑽
𝒕=
𝐥𝐨𝐠(𝟏 + 𝒓)

$50,000
𝑙𝑜𝑔 𝑙𝑜𝑔2
$25,000
𝑡= = = 6.116 𝑦𝑒𝑎𝑟𝑠
log (1 + 0.12) 𝑙𝑜𝑔1.12

Look at example 5.11 page 134, and example 5.12 page 135.

I encourage you to look at and solve questions of the chapter.

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Chapter 5. Introduction to Valuation: The Time Value of Money
Dr. Ali Shehadeh / The University of Jordan

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