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Introduction To Valuation: The Time Value of Money

This document provides an introduction and overview of key concepts related to the time value of money, including future value, present value, compounding, discounting, and interest rates. It outlines the chapter, defines important terms, provides examples of computing future and present value, and explores the relationships between interest rates, time periods, and present versus future value.

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Yannah Hidalgo
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28 views

Introduction To Valuation: The Time Value of Money

This document provides an introduction and overview of key concepts related to the time value of money, including future value, present value, compounding, discounting, and interest rates. It outlines the chapter, defines important terms, provides examples of computing future and present value, and explores the relationships between interest rates, time periods, and present versus future value.

Uploaded by

Yannah Hidalgo
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Chapter 4

Introduction to Valuation:
The Time Value of Money

1
Key Concepts and Skills
• Be able to compute future value (FV)
of investment made today
• Be able to compute present value
(PV) of cash flow to be received at
some future date
• Be able to compute return on
investment

2
Chapter Outline
• Future Value (FV) and Compounding
• Present Value (PV) and Discounting
• More on Present and Future Values

3
Basic Definitions

• Present Value (PV) – sum of money now


discounted by interest rate
• Future Value (FV) – sum of money in the future
compounded by interest rate
• Interest Rate – “exchange rate” between earlier
money and later money with other names as
following:
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required rate of return
4
Future Values – Example 1
• Suppose you invest $1000 for one year at
5% per year. What is the future value in
one year?
– Interest = 1000(0.05) = 50
– Value in one year = principal + interest =
1000 + 50 = 1050
– Future Value (FV) = 1000(1 + 0.05) = 1050
• Suppose you leave the money for another
year. How much will you have two years
from now?
– FV = 1000(1.05)(1.05) = 1000(1.05)2 =
1102.50
5
Future Values: General Formula

• FV = PV(1 + r)t
FV = future value
PV = present value
r = period interest rate, expressed as a
decimal
t = number of periods
• Future value interest factor = (1 + r)t

6
Effects of Compounding
• Simple interest (interest is earned only on the
original principal)
• Compound interest (interest is earned on principal
and on interest received)
• Consider the previous example
– FV with simple interest
= 1000 + 50 + 50
= 1100
– FV with compound interest = 1102.50
– The extra 2.50 comes from the interest of
0.05(50) = 2.50 earned on the first interest
payment
7
Figure 4.1

8
Figure 4.2

9
Future Values – Example 2

• Suppose you invest the $1000 from the


previous example for 5 years. How much
would you have?
– FV = 1000(1.05)5 = 1276.28
• Effect of compounding is small for a small
number of periods, but increases as the
number of periods increases.
• Simple interest would have a future value
of $1250, for a difference of $26.28.

10
Future Values – Example 3
• Suppose you had a deposit $10 at 5.5% interest
200 years ago. How much would that deposit be
worth today?
– FV = 10(1.055)200 = $447,189.84

• What is the effect of compounding?


– Simple interest
= 10 + 10(200)(.055)
= 120
Compounding added $447,069.84 to the value
of the deposit (investment)

11
Quick Quiz: Part 1
• What is the difference between simple interest
and compound interest?

• Suppose you have $500 to invest and you believe


that you can earn 8% per year over the next 15
years.
– How much would you have at the end of 15
years using compound interest?
– How much would you have using simple
interest?

12
Present Values
• How much do I have to invest today to have som
e amount in the future?

FV = PV(1 + r)t
Rearrange to solve for PV = FV / (1 + r)t

• When we talk about discounting, we mean findin


g the present value of some future amount.
• When we talk about the “value” of something, we
are talking about the present value unless we spe
cifically indicate that we want the future value.
13
Present Value – Example 1
One Period Example

• Suppose you need $10,000 in one year


for the down payment on a new car. If you
can earn 7% annually, how much do you
need to invest today?

PV = 10,000 / (1.07)1 = 9345.79

14
Present Values – Example 2

• You want to begin saving for you


daughter’s college education and you
estimate that she will need $150,000 in
17 years. If you feel confident that you
can earn 8% per year, how much do you
need to invest today?

PV = 150,000 / (1.08)17 = 40,540.34

15
Present Values – Example 3

• 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?

PV = 19,671.51 / (1.07)10 = 10,000

16
PV – Important Relationship I

• For a given interest rate – the longer the


time period, the lower the present value

– What is the present value of $500 to be


received in 5 years? 10 years? The discount
rate is 10%

5 years: PV = 500 / (1.1)5 = 310.46


10 years: PV = 500 / (1.1)10 = 192.77

17
PV – Important Relationship II

• For a given time period – the higher the


interest rate, the smaller the present value

– What is the present value of $500 received in


5 years if the interest rate is 10%? 15%?

Rate = 10%: PV = 500 / (1.1)5 = 310.46


Rate = 15%; PV = 500 / (1.15)5 = 248.59

18
Quick Quiz: Part 2
• What is the relationship between present
value and future value?

• 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 at 6%?
How much?

19
Figure 4.3

20
Basic PV Equation - Refresher

• PV = FV / (1 + r)t

• There are four parts in this equatio


n
PV, FV, r, and t
If we know any three, we can solve fo
r the fourth

21
Discount Rate

• Often we will want to know what the


implied interest rate is in an
investment

• Rearrange the basic PV equation and


solve for r
– FV = PV(1 + r)t
– r = (FV / PV)1/t – 1

22
Discount Rate – Example 1

• You are looking at an investment that will


pay $1200 in 5 years if you invest $1000
today. What is the implied rate of interest?

r = (1200 / 1000)1/5 – 1
= 0.03714
= 3.714%

23
Discount Rate – Example 2

• Suppose you are offered an investment


that will allow you to double your money in
6 years.
You have $10,000 to invest.
What is the implied rate of interest?

r = (20,000 / 10,000)1/6 – 1
= 0.122462
= 12.25%
24
Discount Rate – Example 3

• Suppose you have a 1-year old son and


you want to provide $75,000 in 17 years
toward his college education. You
currently have $5000 to invest. What
interest rate must you earn to have the
$75,000 when you need it?

r = (75,000 / 5,000)1/17 – 1
= 0.172686
= 17.27%
25
Quick Quiz: Part 3
• What are some situations where you might want to
compute the implied interest rate?

• Suppose you are offered the following investment


choices:
– 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?

26
Finding Number of Periods (t)

• Start with basic equation and solve fo


r t. Remember the log (ln).

FV = PV(1 + r)t

t = ln(FV / PV) / ln(1 + r)

27
Number of Periods – Example 1

• You want to purchase a new car and you


are willing to pay $20,000. If you can
invest at 10% per year and you currently
have $15,000, how long will it be before
you have enough money to pay cash for
the car?

t = ln(20,000 / 15,000) / ln(1.1)


= 3.02 years

28
Number of Periods – Example 2
• 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% in closing costs.
If the type of house you want costs 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?

29
Example 2 (cont.)

• 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

• Using the formula


t = ln(21,750 / 15,000) / ln(1.075)
= 5.14 years
30
Table 4.4

31
Quick Quiz: Part 4

• When might you want to compute the


number of 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?

32

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