PA RT T H REE Valuation of Future Cash Flows

4 Introduction to Valuation:
The Time Value of Money

A s you are probably aware, the U.S. government has a signifi-

cant amount of debt. That debt, which is widely owned by in-
vestors, comes in different varieties, including Series EE U.S.
LEARNING OBJECTIVES
After studying this chapter, you should
be able to:
Treasury savings bonds. With a Series EE bond, you pay a particular
amount today of, say, $25, and the bond accrues interest over the Determine the future value of an
LO 1
investment made today.
time you hold it. In early 2015, the U.S. Treasury promised to pay
Determine the present value of
.10 percent per year on EE savings bonds. In an interesting (and im- LO 2
cash to be received at a future
portant) wrinkle, if you hold the bond for 20 years, the Treasury date.

promises to “step up” the value to double your cost. That is, if the Calculate the return on an
LO 3
investment.
$25 bond you purchased and all the accumulated interest earned is
Predict how long it takes for an
worth less than $50, the Treasury will automatically increase the LO 4
investment to reach a desired
value of the bond to $50. value.
Is giving up $25 in exchange for $50 in 20 years a good
deal? On the plus side, you get back $2 for every $1 you put up.
That probably sounds good, but, on the downside, you have to wait 20 years to get it.
What you need to know is how to analyze this trade-off. This chapter gives you the tools
you need.
Specifically, our goal here is to introduce you to one of the most important principles
in finance, the time value of money. What you will learn is how to determine the value
today of some cash flow to be received later. This is a very basic business skill, and it
underlies the analysis of many different types of investments and financing arrange-
ments. In fact, almost all business activities, whether they originate in marketing, man-
agement, operations, or strategy, involve comparing outlays made today to benefits
projected for the future. How to do this comparison is something everyone needs to un-
derstand; this chapter gets you started.

Please visit us at essentialsofcorporatefinance.blogspot.com for the latest developments in the world of corporate finance.

97
98 part 3 Valuation of Future Cash Flows

O ne of the basic problems faced by the financial manager is how to determine the value
today of cash flows expected in the future. For example, the jackpot in a PowerBallTM
lottery drawing was $110 million. Does this mean the winning ticket was worth $110 mil-
lion? The answer is no because the jackpot was actually going to pay out over a 20-year
period at a rate of $5.5 million per year. How much was the ticket worth then? The answer
depends on the time value of money, the subject of this chapter.
To find out more about In the most general sense, the phrase time value of money refers to the fact that a dollar
U.S. savings bonds and in hand today is worth more than a dollar promised at some time in the future. On a practi-
other government cal level, one reason for this is that you could earn interest while you waited; so, a dollar
securities, go to today would grow to more than a dollar later. The trade-off between money now and money
www.treasurydirect.gov. later thus depends on, among other things, the rate you can earn by investing. Our goal in
this chapter is to explicitly evaluate this trade-off between dollars today and dollars at some
future time.
A thorough understanding of the material in this chapter is critical to understanding
material in subsequent chapters, so you should study it with particular care. We present a
number of examples in this chapter. In many problems, your answer may differ from ours
slightly. This can happen because of rounding and is not a cause for concern.

4.1 FUTURE VALUE AND COMPOUNDING

future value (FV) The first thing we will study is future value. Future value (FV) refers to the amount of
The amount an investment money an investment will grow to over some period of time at some given interest rate. Put
is worth after one or more another way, future value is the cash value of an investment at some time in the future. We
periods. Also compound
start out by considering the simplest case, a single-period investment.
value.

Investing for a Single Period

Excel Suppose you were to invest $100 in a savings account that pays 10 percent interest per year.
Master How much would you have in one year? You would have $110. This $110 is equal to your
coverage online
original principal of $100 plus $10 in interest that you earn. We say that $110 is the future
value of $100 invested for one year at 10 percent, and we simply mean that $100 today is
worth $110 in one year, given that 10 percent is the interest rate.
In general, if you invest for one period at an interest rate of r, your investment will
grow to (1 + r) per dollar invested. In our example, r is 10 percent, so your investment
grows to 1 + .10 = 1.1 dollars per dollar invested. You invested $100 in this case, so you
ended up with $100 × 1.10 = $110.

Investing for More than One Period

Going back to our $100 investment, what will you have after two years, assuming the inter-
est rate doesn’t change? If you leave the entire $110 in the bank, you will earn $110 × .10 =
$11 in interest during the second year, so you will have a total of $110 + 11 = $121. This
$121 is the future value of $100 in two years at 10 percent. Another way of looking at it is
that one year from now you are effectively investing $110 at 10 percent for a year. This is a
single-period problem, so you’ll end up with $1.1 for every dollar invested, or $110 × 1.1 =
$121 total.
This $121 has four parts. The first part is the $100 original principal. The second part
is the $10 in interest you earn in the first year, and the third part is another $10 you earn in
the second year, for a total of $120. The last $1 you end up with (the fourth part) is interest
you earn in the second year on the interest paid in the first year: $10 × .10 = $1.
 chapter 4 Introduction to Valuation: The Time Value of Money 99

This process of leaving your money and any accumulated interest in an investment for
more than one period, thereby reinvesting the interest, is called compounding. Compound- compounding
ing the interest means earning interest on interest, so we call the result compound interest. The process of
With simple interest, the interest is not reinvested, so interest is earned each period only on accumulating interest in
an investment over time to
the original principal.
earn more interest.
interest on interest
EXAMPLE 4.1 Interest on Interest Interest earned on the
reinvestment of previous
Suppose you locate a two-year investment that pays 14 percent per year. If you invest $325, how interest payments.
much will you have at the end of the two years? How much of this is simple interest? How much is
compound interest
compound interest?
At the end of the first year, you will have $325 × (1 + .14) = $370.50. If you reinvest this entire
Interest earned on both
amount, and thereby compound the interest, you will have $370.50 × 1.14 = $422.37 at the end of
the initial principal and the
the second year. The total interest you earn is thus $422.37 − 325 = $97.37. Your $325 original
interest reinvested from
principal earns $325 × .14 = $45.50 in interest each year, for a two-year total of $91 in simple inter-
prior periods.
est. The remaining $97.37 − 91 = $6.37 results from compounding. You can check this by noting that simple interest
the interest earned in the first year is $45.50. The interest on interest earned in the second year thus Interest earned only on
amounts to $45.50 × .14 = $6.37, as we calculated. the original principal
amount invested.

We now take a closer look at how we calculated the $121 future value. We multiplied
$110 by 1.1 to get $121. The $110, however, was $100 also multiplied by 1.1. In other
words:
$121 = $110 × 1.1
= ($100 × 1.1) × 1.1
= $100 × (1.1 × 1.1)
= $100 × 1.12
= $100 × 1.21

At the risk of belaboring the obvious, let’s ask: How much would our $100 grow to
after three years? Once again, in two years, we’ll be investing $121 for one period at 10 percent.
We’ll end up with $1.1 for every dollar we invest, or $121 × 1.1 = $133.1 total. This
$133.1 is thus:
$133.1 = $121 × 1.1
= ($110 × 1.1) × 1.1
= ($100 × 1.1) × 1.1 × 1.1
= $100 × (1.1 × 1.1 × 1.1)
= $100 × 1.13
= $100 × 1.331

You’re probably noticing a pattern to these calculations, so we can now go ahead and
state the general result. As our examples suggest, the future value of $1 invested for t peri-
ods at a rate of r per period is:
Future value = $1 × (1 + r)t [4.1]

The expression (1 + r)t is sometimes called the future value interest factor (or just future
value factor) for $1 invested at r percent for t periods. It can be abbreviated as FVIF(r, t).
In our example, what would your $100 be worth after five years? We can first compute
the relevant future value factor as:
(1 + r)t = (1 + .10)5 = 1.15 = 1.6105
100 part 3 Valuation of Future Cash Flows

t a b l e 4.1 Year Beginning Amount Interest Earned Ending Amount

Future value of $100 1 $100.00 $10.00 $110.00

at 10 percent 2 110.00 11.00 121.00
3 121.00 12.10 133.10
4 133.10 13.31 146.41
5 146.41 14.64 161.05
Total interest $61.05

Your $100 will thus grow to:

$100 × 1.6105 = $161.05

The growth of your $100 each year is illustrated in Table 4.1. As shown, the interest earned
in each year is equal to the beginning amount multiplied by the interest rate of 10 percent.
In Table 4.1, notice that the total interest you earn is $61.05. Over the five-year span
of this investment, the simple interest is $100 × .10 = $10 per year, so you accumulate $50
this way. The other $11.05 is from compounding.
A brief introduction to Figure 4.1 illustrates the growth of the compound interest in Table 4.1. Notice how the
key financial concepts is simple interest is constant each year, but the compound interest you earn gets bigger every
available at www. year. The size of the compound interest keeps increasing because more and more interest
teachmefinance.com. builds up and there is thus more to compound.
Future values depend critically on the assumed interest rate, particularly for long-lived
investments. Figure 4.2 illustrates this relationship by plotting the growth of $1 for differ-
ent rates and lengths of time. Notice that the future value of $1 after 10 years is about $6.20
at a 20 percent rate, but it is only about $2.60 at 10 percent. In this case, doubling the inter-
est rate more than doubles the future value.

Future
f i g u r e 4.1 value ($)
Future value, simple $161.05
interest, and 160
compound interest
150 $146.41

140
$133.10
130
$121
120

110 $110

100

Time
$0
1 2 3 4 5 (years)

Growth of $100 original amount at 10% per year. Blue

shaded area represents the portion of the total that results
from compounding of interest.
 chapter 4 Introduction to Valuation: The Time Value of Money 101

Future
value
f i g u r e 4 .2
of $1 ($)
Future value of $1 for
different periods and
7 rates
20%
6

4 15%

3
10%
2 5%
1 0%
Time
1 2 3 4 5 6 7 8 9 10 (years)

To solve future value problems, we need to come up with the relevant future value fac-
tors. There are several different ways of doing this. In our example, we could have multi-
plied 1.1 by itself five times. This would work just fine, but it would get to be very tedious
for, say, a 30-year investment.
Fortunately, there are several easier ways to get future value factors. Most calculators
have a key labeled “yx”. You can usually just enter 1.1, press this key, enter 5, and press the
“=” key to get the answer. This is an easy way to calculate future value factors because it’s
quick and accurate.
Alternatively, you can use a table that contains future value factors for some common
interest rates and time periods. Table 4.2 contains some of these factors. Table A.1 in
Appendix A at the end of the book contains a much larger set. To use the table, find the
column that corresponds to 10 percent. Then look down the rows until you come to five
periods. You should find the factor that we calculated, 1.6105.
Tables such as Table 4.2 are not as common as they once were because they predate
inexpensive calculators and are only available for a relatively small number of rates. Inter-
est rates are often quoted to three or four decimal places, so the tables needed to deal with
these accurately would be quite large. As a result, the “real world” has moved away from
using them. We will emphasize the use of a calculator in this chapter.
These tables still serve a useful purpose. To make sure you are doing the calculations
correctly, pick a factor from the table and then calculate it yourself to see that you get the
same answer. There are plenty of numbers to choose from.

Number of Interest Rates t a b l e 4.2

Periods   5% 10% 15% 20%
Future value interest
1 1.0500 1.1000 1.1500 1.2000 factors
2 1.1025 1.2100 1.3225 1.4400
3 1.1576 1.3310 1.5209 1.7280
4 1.2155 1.4641 1.7490 2.0736
5 1.2763 1.6105 2.0114 2.4883
102 part 3 Valuation of Future Cash Flows

EXAMPLE 4.2 Compound Interest

You’ve located an investment that pays 12 percent. That rate sounds good to you, so you invest
$400. How much will you have in three years? How much will you have in seven years? At the end
of seven years, how much interest have you earned? How much of that interest results from
compounding?
Based on our discussion, we can calculate the future value factor for 12 percent and three
years as:

(1 + r)t = 1.123 = 1.4049

Your $400 thus grows to:

$400 × 1.4049 = $561.97

After seven years, you will have:

$400 × 1.127 = $400 × 2.2107 = $884.27

Thus, you will more than double your money over seven years.
Because you invested $400, the interest in the $884.27 future value is $884.27 − 400 =
$484.27. At 12 percent, your $400 investment earns $400 × .12 = $48 in simple interest every year.
Over seven years, the simple interest thus totals 7 × $48 = $336. The other $484.27 − 336 =
$148.27 is from compounding.

How much do you need The effect of compounding is not great over short time periods, but it really starts
at retirement? Locate the to add up as the time horizon grows. To take an extreme case, suppose one of your more
“Retirement Planning” frugal ancestors had invested $5 for you at a 6 percent interest rate 200 years ago. How
link at www.about.com. much would you have today? The future value factor is a substantial 1.06 200 =
115,125.90 (you won’t find this one in a table), so you would have $5 × 115,125.90 =
$575,629.50 today. Notice that the simple interest is just $5 × .06 = $.30 per year. After
200 years, this amounts to $60. The rest is from reinvesting. Such is the power of com-
pound interest!

EXAMPLE 4.3 How Much for That Island?

To further illustrate the effect of compounding for long horizons, consider the case of Peter Minuit
and the Indians. In 1626, Minuit bought all of Manhattan Island for about $24 in goods and trinkets.
This sounds cheap, but the Indians may have gotten the better end of the deal. To see why, suppose
the Indians had sold the goods and invested the $24 at 10 percent. How much would it be worth
today?
Roughly 390 years have passed since the transaction. At 10 percent, $24 will grow by quite a
bit over that time. How much? The future value factor is approximately:

(1 + r)t = 1.1390 ≃ 14,000,000,000,000,000

That is, 14 followed by 15 zeroes. The future value is thus on the order of $24 × 14 quadrillion, or about
$334 quadrillion (give or take a few hundreds of trillions).
Well, $334 quadrillion is a lot of money. How much? If you had it, you could buy the United
States. All of it. Cash. With money left over to buy Canada, Mexico, and the rest of the world, for that
matter.
This example is something of an exaggeration, of course. In 1626, it would not have been
easy to locate an investment that would pay 10 percent every year without fail for the next
390 years.
 chapter 4 Introduction to Valuation: The Time Value of Money 103

USING A FINANCIAL CALCULATOR CALCULATOR

HINTS
Although there are the various ways of calculating future values we have described so far, many of you
will decide that a financial calculator is the way to go. If you are planning on using one, you should read
this extended hint; otherwise, skip it.
A financial calculator is simply an ordinary calculator with a few extra features. In particular, it knows
some of the most commonly used financial formulas, so it can directly compute things like future
values.
Financial calculators have the advantage that they handle a lot of the computation, but that is really
all. In other words, you still have to understand the problem; the calculator just does some of the arith-
metic. In fact, there is an old joke (somewhat modified) that goes like this: Anyone can make a mistake
on a time value of money problem, but to really screw one up takes a financial calculator! We therefore
have two goals for this section. First, we’ll discuss how to compute future values. After that, we’ll show
you how to avoid the most common mistakes people make when they start using financial calculators.

How to Calculate Future Values with a Financial Calculator Examining a typical financial cal-
culator, you will find five keys of particular interest. They usually look like this:

For now, we need to focus on four of these. The keys labeled PV and FV are just what you
would guess: present value and future value. The key labeled N refers to the number of periods,
which is what we have been calling t. Finally, I/Y stands for the interest rate, which we have called r.1
If we have the financial calculator set up right (see our next section), then calculating a future value
is very simple. Take a look back at our question involving the future value of $100 at 10 percent for five
years. We have seen that the answer is $161.05. The exact keystrokes will differ depending on what type
of calculator you use, but here is basically all you do:

1. Enter −100. Press the PV key. (The negative sign is explained below.)
2. Enter 10. Press the I/Y key. (Notice that we entered 10, not .10; see below.)
3. Enter 5. Press the N key.

Now we have entered all of the relevant information. To solve for the future value, we need to ask the
calculator what the FV is. Depending on your calculator, you either press the button labeled “CPT”
(for compute) and then press FV , or else you just press FV . Either way, you should get 161.05. If
you don’t (and you probably won’t if this is the first time you have used a financial calculator!), we offer
some help in our next section.
Before we explain the kinds of problems that you are likely to run into, we want to establish a stan-
dard format for showing you how to use a financial calculator. Using the example we just looked at, in
the future, we will illustrate such problems like this:

Enter 5 10 −100
FV

Solve for 161.05

1
The reason financial calculators use N and I/Y is that the most common use for these calculators is determining
loan payments. In this context, N is the number of payments and I/Y is the interest rate on the loan. But, as we will
see, there are many other uses of financial calculators that don’t involve loan payments and interest rates.

(continued)
104 part 3 Valuation of Future Cash Flows

Here is an important tip: Appendix D in the back of the book contains some more detailed instruc-
tions for the most common types of financial calculators. See if yours is included, and, if it is, follow the
instructions there if you need help. Of course, if all else fails, you can read the manual that came with the
calculator.

How to Get the Wrong Answer Using a Financial Calculator There are a couple of common
(and frustrating) problems that cause a lot of trouble with financial calculators. In this section, we provide
some important dos and don’ts. If you just can’t seem to get a problem to work out, you should refer
back to this section.
There are two categories we examine: three things you need to do only once and three things you
need to do every time you work a problem. The things you need to do just once deal with the following
calculator settings:

1. Make sure your calculator is set to display a large number of decimal places. Most financial
calculators only display two decimal places; this causes problems because we frequently work
with numbers—like interest rates—that are very small.
2. Make sure your calculator is set to assume only one payment per period or per year. Some
financial calculators assume monthly payments (12 per year) unless you say otherwise.
3. Make sure your calculator is in “end” mode. This is usually the default, but you can accidentally
change to “begin” mode.

If you don’t know how to set these three things, see Appendix D or your calculator’s operating manual.
There are also three things you need to do every time you work a problem:

1.Before you start, completely clear out the calculator. This is very important. Failure to do this
is the number one reason for wrong answers; you simply must get in the habit of clearing
the calculator every time you start a problem. How you do this depends on the calculator
(see Appendix D), but you must do more than just clear the display. For example, on a Texas
Instruments BA II Plus, you must press 2nd then CLR TVM for clear time value of money.
There is a similar command on your calculator. Learn it!
Note that turning the calculator off and back on won’t do it. Most financial calculators
remember everything you enter, even after you turn them off. In other words, they remember all
your mistakes unless you explicitly clear them out. Also, if you are in the middle of a problem and
make a mistake, clear it out and start over. Better to be safe than sorry.
2. Put a negative sign on cash outflows. Most financial calculators require you to put a negative
sign on cash outflows and a positive sign on cash inflows. As a practical matter, this usually just
means that you should enter the present value amount with a negative sign (because normally
the present value represents the amount you give up today in exchange for cash inflows later).
You enter a negative value on the BA II Plus by first entering a number and then pressing the
+/– key. By the same token, when you solve for a present value, you shouldn’t be surprised to
see a negative sign.
3. Enter the rate correctly. Financial calculators assume that rates are quoted in percent, so if the
rate is .08 (or 8 percent), you should enter 8, not .08.

If you follow these guidelines (especially the one about clearing out the calculator), you should
have no problem using a financial calculator to work almost all of the problems in this and the next few
chapters. We’ll provide some additional examples and guidance where appropriate.
 chapter 4 Introduction to Valuation: The Time Value of Money 105

conce p t q u es t i o n s
4.1a What do we mean by the future value of an investment?
4.1b What does it mean to compound interest? How does compound interest differ from
simple interest?
4.1c In general, what is the future value of $1 invested at r per period for t periods?

4.2 PRESENT VALUE AND DISCOUNTING

When we discuss future value, we are thinking of questions such as the following: What Excel
will my $2,000 investment grow to if it earns a 6.5 percent return every year for the next Master
coverage online
six years? The answer to this question is what we call the future value of $2,000 invested
at 6.5 percent for six years (verify that the answer is about $2,918).
There is another type of question that comes up even more often in financial manage-
ment that is obviously related to future value. Suppose you need to have $10,000 in
10 years, and you can earn 6.5 percent on your money. How much do you have to invest
today to reach your goal? You can verify that the answer is $5,327.26. How do we know
this? Read on.

The Single-Period Case

We’ve seen that the future value of $1 invested for one year at 10 percent is $1.10. We
now ask a slightly different question: How much do we have to invest today at 10 percent
to get $1 in one year? In other words, we know the future value here is $1, but what is the
present value (PV)? The answer isn’t too hard to figure out. Whatever we invest today present value (PV)
will be 1.1 times bigger at the end of the year. Because we need $1 at the end of the year: The current value of future
cash flows discounted at
Present value × 1.1 = $1 the appropriate discount
rate.
Or, solving for the present value:
Present value = $1/1.1 = $.909

In this case, the present value is the answer to the following question: What amount,
invested today, will grow to $1 in one year if the interest rate is 10 percent? Present value
is thus just the reverse of future value. Instead of compounding the money forward into the
future, we discount it back to the present. discount
Calculation of the present
value of some future
EXAMPLE 4.4 Single-Period PV amount.

Suppose you need $800 to buy textbooks next year. You can earn 7 percent on your money. How
much do you have to put up today?
We need to know the PV of $800 in one year at 7 percent. Proceeding as earlier:

Present value × 1.07 = $800

We can now solve for the present value:

Present value = $800 × (1/1.07) = $747.66

Thus, $747.66 is the present value. Again, this just means that investing this amount for one year at
7 percent will result in a future value of $800.
106 part 3 Valuation of Future Cash Flows

From our examples, the present value of $1 to be received in one period is generally
given as:
PV = $1 × [1/(1 + r)] = $1/(1 + r)

We next examine how to get the present value of an amount to be paid in two or more pe-
riods into the future.

Present Values for Multiple Periods

Suppose you need to have $1,000 in two years. If you can earn 7 percent, how much do you
have to invest to make sure that you have the $1,000 when you need it? In other words,
what is the present value of $1,000 in two years if the relevant rate is 7 percent?
Based on your knowledge of future values, you know that the amount invested must
grow to $1,000 over the two years. In other words, it must be the case that:
$1,000 = PV × 1.07 × 1.07
= PV × 1.072
= PV × 1.1449

Given this, we can solve for the present value:

Present value = $1,000/1.1449 = $873.44

Therefore, $873.44 is the amount you must invest in order to achieve your goal.

EXAMPLE 4.5 Saving Up

You would like to buy a new automobile. You have $50,000, but the car costs $68,500. If you can
earn 9 percent, how much do you have to invest today to buy the car in two years? Do you have
enough? Assume the price will stay the same.
What we need to know is the present value of $68,500 to be paid in two years, assuming a
9 percent rate. Based on our discussion, this is:

PV = $68,500/1.092 = $68,500/1.1881 = $57,655.08

You’re still about $7,655 short, even if you’re willing to wait two years.

As you have probably recognized by now, calculating present values is quite similar to
calculating future values, and the general result looks much the same. The present value of
$1 to be received t periods into the future at a discount rate of r is:
PV = $1 × [1/(1 + r)t] = $1/(1 + r)t [4.2]

The quantity in brackets, 1/(1 + r)t, goes by several different names. Because it’s used to
discount rate discount a future cash flow, it is often called a discount factor. With this name, it is not sur-
The rate used to calculate prising that the rate used in the calculation is often called the discount rate. We tend to call it
the present value of future
cash flows.
this in talking about present values. The quantity in brackets is also called the present value
interest factor (or just present value factor) for $1 at r percent for t periods and is sometimes
discounted cash
flow (DCF) valuation abbreviated as PVIF(r, t). Finally, calculating the present value of a future cash flow to deter-
(a) Calculating the present mine its worth today is commonly called discounted cash flow (DCF) valuation.
value of a future cash flow To illustrate, suppose you need $1,000 in three years. You can earn 15 percent on your
to determine its value money. How much do you have to invest today? To find out, we have to determine the pres-
today. (b) The process of ent value of $1,000 in three years at 15 percent. We do this by discounting $1,000 back
valuing an investment by
three periods at 15 percent. With these numbers, the discount factor is:
discounting its future cash
flows. 1/(1 + .15)3 = 1/1.5209 = .6575
 chapter 4 Introduction to Valuation: The Time Value of Money 107

Number of Interest Rates t a b l e 4.3

Periods 5% 10% 15% 20% Present value
1 .9524 .9091 .8696 .8333 interest factors
2 .9070 .8264 .7561 .6944
3 .8638 .7513 .6575 .5787
4 .8227 .6830 .5718 .4823
5 .7835 .6209 .4972 .4019

The amount you must invest is thus:

$1,000 × .6575 = $657.50

We say that $657.50 is the present, or discounted, value of $1,000 to be received in three
years at 15 percent.
There are tables for present value factors just as there are tables for future value fac-
tors, and you use them in the same way (if you use them at all). Table 4.3 contains a small
set of these factors. A much larger set can be found in Table A.2 in Appendix A.
In Table 4.3, the discount factor we just calculated, .6575, can be found by looking
down the column labeled “15%” until you come to the third row. Of course, you could use
a financial calculator, as we illustrate nearby.
As the length of time until payment grows, present values decline. As Example 4.6 il-
lustrates, present values tend to become small as the time horizon grows. If you look out far
enough, they will always get close to zero. Also, for a given length of time, the higher the
discount rate is, the lower is the present value. Put another way, present values and discount
rates are inversely related. Increasing the discount rate decreases the PV and vice versa.

You solve present value problems on a financial calculator just like you do future value problems. For the CALCULATOR
example we just examined (the present value of $1,000 to be received in three years at 15 percent), you HINTS
would do the following:

Enter 3 15 1,000
FV

Solve for −657.52

Notice that the answer has a negative sign; as we discussed earlier, that’s because it represents an out-
flow today in exchange for the $1,000 inflow later.

EXAMPLE 4.6 Deceptive Advertising

Recently, some businesses have been saying things like “Come try our product. If you do, we’ll give
you $100 just for coming by!” If you read the fine print, what you find out is that they will give you a
savings certificate that will pay you $100 in 25 years or so. If the going interest rate on such certifi-
cates is 10 percent per year, how much are they really giving you today?
What you’re actually getting is the present value of $100 to be paid in 25 years. If the discount
rate is 10 percent per year, then the discount factor is:

1/1.125 = 1/10.8347 = .0923

This tells you that a dollar in 25 years is worth a little more than nine cents today, assuming a 10 percent
discount rate. Given this, the promotion is actually paying you about .0923 × $100 = $9.23. Maybe this
is enough to draw customers, but it’s not $100.
108 part 3 Valuation of Future Cash Flows

f i g u r e 4. 3 Present
value
of $1 ($)
Present value of $1
for different periods
and rates 1.00 r = 0%
.90
.80
.70
.60 r = 5%
.50
.40 r = 10%
.30
r = 15%
.20
r = 20%
.10
Time
1 2 3 4 5 6 7 8 9 10 (years)

The relationship between time, discount rates, and present values is illustrated in
Figure 4.3. Notice that by the time we get to 10 years, the present values are all substan-
tially smaller than the future amounts.

c o n c e p t q ue stio n s
4.2a What do we mean by the present value of an investment?
4.2b The process of discounting a future amount back to the present is the opposite of
doing what?
4.2c What do we mean by discounted cash flow, or DCF, valuation?
4.2d In general, what is the present value of $1 to be received in t periods, assuming a
discount rate of r per period?

4.3 MORE ON PRESENT AND FUTURE VALUES

Excel If you look back at the expressions we came up with for present and future values, you will
Master see there is a very simple relationship between the two. We explore this relationship and
coverage online
some related issues in this section.

Present versus Future Value

For a downloadable, What we called the present value factor is just the reciprocal of (that is, 1 divided by) the
Windows-based financial future value factor:
calculator, go to
www.calculator.org. Future value factor = (1 + r)t
Present value factor = 1/(1 + r)t

In fact, the easy way to calculate a present value factor on many calculators is to first cal-
culate the future value factor and then press the 1/X key to flip it over.
 chapter 4 Introduction to Valuation: The Time Value of Money 109

If we let FVt stand for the future value after t periods, then the relationship between
future value and present value can be written very simply as one of the following:
PV × (1 + r)t = FVt
[4.3]
PV = FVt/(1 + r)t = FVt × [1/(1 + r)t ]

We will call this last result the basic present value equation, and we use it throughout
the text. There are a number of variations that come up, but this simple equation underlies
many of the most important ideas in finance.

EXAMPLE 4.7 Evaluating Investments

To give you an idea of how we will be using present and future values, consider the following simple
investment. Your company proposes to buy an asset for $335. This investment is very safe. You will
sell off the asset in three years for $400. You know you could invest the $335 elsewhere at 10 per-
cent with very little risk. What do you think of the proposed investment?
This is not a good investment. Why not? Because you can invest the $335 elsewhere at
10 percent. If you do, after three years it will grow to:
$335 × (1 + r)t = $335 × 1.13
= $335 × 1.331
= $445.89
Because the proposed investment only pays out $400, it is not as good as other alternatives we
have. Another way of saying the same thing is to notice that the present value of $400 in three years
at 10 percent is:
$400 × [1/(1 + r)t] = $400/1.13 = $400/1.331 = $300.53
This tells us that we only have to invest about $300 to get $400 in three years, not $335. We will
return to this type of analysis later on.

Determining the Discount Rate

It will turn out that we frequently need to determine what discount rate is implicit in an
investment. We can do this by looking at the basic present value equation:
PV = FVt /(1 + r)t

There are only four parts to this equation: the present value (PV), the future value (FVt  ),
the discount rate (r), and the life of the investment (t). Given any three of these, we can
always find the fourth.

EXAMPLE 4.8 Finding r for a Single-Period Investment

You are considering a one-year investment. If you put up $1,250, you will get back $1,350. What rate
is this investment paying?
First, in this single-period case, the answer is fairly obvious. You are getting a total of $100 in
addition to your $1,250. The implicit rate on this investment is thus $100/1,250 = 8 percent.
More formally, from the basic present value equation, the present value (the amount you must
put up today) is $1,250. The future value (what the present value grows to) is $1,350. The time in-
volved is one period, so we have:

$1,250 = $1,350/(1 + r)t

1 + r = $1,350/1,250 = 1.08
r = 8%
In this simple case, of course, there was no need to go through this calculation, but, as we describe
later, it gets a little harder when there is more than one period.
110 part 3 Valuation of Future Cash Flows

To illustrate what happens with multiple periods, let’s say that we are offered an in-
vestment that costs us $100 and will double our money in eight years. To compare this to
other investments, we would like to know what discount rate is implicit in these num-
bers. This discount rate is called the rate of return, or sometimes just return, on the in-
vestment. In this case, we have a present value of $100, a future value of $200 (double
our money), and an eight-year life. To calculate the return, we can write the basic present
value equation as:
  PV = FVt/(1 + r)t
$100 = $200/(1 + r)8

It could also be written as:

(1 + r)8 = $200/100 = 2

We now need to solve for r. There are three ways we could do it:
1. Use a financial calculator. (See below.)
2. Solve the equation for 1 + r by taking the eighth root of both sides. Because this is
the same thing as raising both sides to the power of 1∕8, or .125, this is actually easy
to do with the yx key on a calculator. Just enter 2, then press yx , enter .125,
and press the = key. The eighth root should be about 1.09, which implies that r is
9 percent.
3. Use a future value table. The future value factor for eight years is equal to 2. If you
look across the row corresponding to eight periods in Table A.1, you will see that a
future value factor of 2 corresponds to the 9 percent column, again implying that the
return here is 9 percent.
Why does the Rule Actually, in this particular example, there is a useful “back of the envelope” means of
of 72 work? See solving for r—the Rule of 72. For reasonable rates of return, the time it takes to double your
www.moneychimp.com. money is given approximately by 72/r%. In our example, this means that 72/r% = 8 years,
implying that r is 9 percent as we calculated. This rule is fairly accurate for discount rates in
the 5 percent to 20 percent range.
The nearby Finance Matters box provides some examples of rates of return on col-
lectibles. See if you can verify the numbers reported there.

EXAMPLE 4.9 Double Your Fun

You have been offered an investment that promises to double your money every 10 years. What is
the approximate rate of return on the investment?
From the Rule of 72, the rate of return is given approximately by 72/r % = 10, so the rate is ap-
proximately 72/10 = 7.2%. Verify that the exact answer is 7.177 percent.

A slightly more extreme example involves money bequeathed by Benjamin Franklin,

who died on April 17, 1790. In his will, he gave 1,000 pounds sterling to Massachusetts
and the city of Boston. He gave a like amount to Pennsylvania and the city of Philadelphia.
The money was paid to Franklin when he held political office, but he believed that politi-
cians should not be paid for their service (it appears that this view is not widely shared by
modern-day politicians).
Franklin originally specified that the money should be paid out 100 years after his
death and used to train young people. Later, however, after some legal wrangling, it was
agreed that the money would be paid out in 1990, 200 years after Franklin’s death. By that
FINANCE M AT T ERS

Collectibles as Investments?
I t used to be that trading in collectibles such as baseball
cards, art, and old toys occurred mostly at auctions, swap
meets, and collectible shops, all of which were limited to re-
yourself that the actual return on the investment was only
about 9.07 percent per year. Not too bad, but nowhere
near the return most people expect from looking at the
gional traffic. However, with the growing popularity of online sales price.
auctions such as eBay, trading in collectibles has expanded Comic books have recently grown in popularity among
to an international arena. The most visible form of collectible collectors. Batman, who first appeared in Detective Comics No.
is probably the baseball card, but Furbies, Beanie Babies, 27, is a popular superhero. The comic book sold in May 1939 at
and Pokémon cards have been extremely hot collectibles in a cover price of 10 cents. In 2015, the value of this comic book
the recent past. However, it’s not just fad items that spark had grown to $1,380,000. This gain seems like a very high re-
interest from collectors; virtually anything of sentimental turn to the untrained eye, and indeed it is! See if you don’t
value from days gone by is considered collectible, and, more agree that the return was about 24.15 percent per year.
and more, collectibles are being viewed as investments. Stamp collecting (or philately) is another popular activity.
Collectibles typically provide no cash flows until they Possibly the most famous stamp in the world is the British Gui-
are sold, and condition and buyer sentiment are the major ana One-Cent Black on Magenta stamp, issued in 1856. There
determinants of value. The rates of return have been amaz- is only one known example of this stamp left in existence and
ing at times, but care is needed in interpreting them. For it has been out of public view since 1986. In June 2014, the
example, in 2015, a 1793 “chain cent,” America’s first large stamp sold at auction for $9,480,000. Although this is almost
cent, sold for a record $2,350,000. While that looks like a 1 billion times the original price of the stamp, verify for yourself
whopping price increase to the untrained eye, check for that the annual return is about 13.98 percent.

time, the Pennsylvania bequest had grown to about $2 million; the Massachusetts bequest
had grown to $4.5 million. The money was used to fund the Franklin Institutes in Boston
and Philadelphia. Assuming that 1,000 pounds sterling was equivalent to 1,000 dollars,
what rate of return did the two states earn (the dollar did not become the official U.S. cur-
rency until 1792)?
For Pennsylvania, the future value is $2 million and the present value is $1,000. There
are 200 years involved, so we need to solve for r in the following:
$1,000 = $2 million/(1 + r)200
(1 + r)200 = 2,000

Solving for r, we see that the Pennsylvania money grew at about 3.87 percent per year. The
Massachusetts money did better; verify that the rate of return in this case was 4.3 percent.
Small differences can add up!

We can illustrate how to calculate unknown rates using a financial calculator with these numbers. For CALCULATOR
Pennsylvania, you would do the following: HINTS

Enter 200 −1,000 2,000,000

I/ Y

Solve for 3.87

As in our previous examples, notice the minus sign on the present value, representing Franklin’s outlay
made many years ago. What do you change to work the problem for Massachusetts?

111
112 part 3 Valuation of Future Cash Flows

EXAMPLE 4.10 Saving for College

You estimate that you will need about $80,000 to send your child to college in eight years. You have
about $35,000 now. If you can earn 20 percent per year, will you make it? At what rate will you just
reach your goal?
If you can earn 20 percent, the future value of your $35,000 in eight years will be:

FV = $35,000 × 1.208 = $35,000 × 4.2998 = $150,493.59

So, you will make it easily. The minimum rate is the unknown r in the following:

FV = $35,000 × (1 + r)8 = $80,000

(1 + r)8 = $80,000/35,000 = 2.2857

Therefore, the future value factor is 2.2857. Looking at the row in Table A.1 that corresponds to
eight periods, we see that our future value factor is roughly halfway between the ones shown
for 10 percent (2.1436) and 12 percent (2.4760), so you will just reach your goal if you earn ap-
proximately 11 percent. To get the exact answer, we could use a financial calculator or we could
solve for r:
(1 + r)8 = $80,000/35,000 = 2.2857
1 + r = 2.2857(1/8) = 2.2857.125 = 1.1089
r = 10.89%

EXAMPLE 4.11 Only 18,262.5 Days to Retirement

You would like to retire in 50 years as a millionaire. If you have $10,000 today, what rate of return do
you need to earn to achieve your goal?
The future value is $1,000,000. The present value is $10,000, and there are 50 years until re-
tirement. We need to calculate the unknown discount rate in the following:
$10,000 = $1,000,000/(1 + r)50
(1 + r)50 = 100
The future value factor is thus 100. You can verify that the implicit rate is about 9.65 percent.

Finding the Number of Periods

Suppose we were interested in purchasing an asset that costs $50,000. We currently have
$25,000. If we can earn 12 percent on this $25,000, how long until we have the $50,000?
Finding the answer involves solving for the last variable in the basic present value equa-
tion, the number of periods. You already know how to get an approximate answer to this
particular problem. Notice that we need to double our money. From the Rule of 72, this
will take about 72/12 = 6 years at 12 percent.
To come up with the exact answer, we can again manipulate the basic present value
equation. The present value is $25,000, and the future value is $50,000. With a 12 percent
discount rate, the basic equation takes one of the following forms:
$25,000 = $50,000/1.12t
$50,000/25,000 = 1.12t = 2

We thus have a future value factor of 2 for a 12 percent rate. We now need to solve for t. If
you look down the column in Table A.1 that corresponds to 12 percent, you will see that a
future value factor of 1.9738 occurs at six periods. It will thus take about six years, as we
 chapter 4 Introduction to Valuation: The Time Value of Money 113

I. Symbols t a b l e 4.4
PV = Present value, what future cash flows are worth today
FVt = Future value, what cash flows are worth in the future Summary of time
r = Interest rate, rate of return, or discount rate per period—typically, but not always, value of money
one year calculations
t = Number of periods—typically, but not always, the number of years
C = Cash amount
II. Future value of C invested at r percent per period for t periods
FVt = C × (1 + r)t
The term (1 + r)t is called the future value factor.
III. Present value of C to be received in t periods at r percent per period
PV = C/(1 + r)t
The term 1/(1 + r)t is called the present value factor.
IV. The basic present value equation giving the relationship between present and future
value is
PV = FVt/(1 + r)t

calculated. To get the exact answer, we have to explicitly solve for t (or use a financial cal-
culator). If you do this, you will find that the answer is 6.1163 years, so our approximation
was quite close in this case.

If you do use a financial calculator, here are the relevant entries: CALCULATOR
HINTS
Enter 12 −25,000 50,000
N

Solve for 6.1163

EXAMPLE 4.12 Waiting for Godot

You’ve been saving up to buy the Godot Company. The total cost will be $10 million. You currently
have about $2.3 million. If you can earn 5 percent on your money, how long will you have to wait? At
16 percent, how long must you wait?
At 5 percent, you’ll have to wait a long time. From the basic present value equation:
$2.3 = $10/1.05t
1.05t = 4.35
t = 30.12 years

At 16 percent, things are a little better. Verify for yourself that it will take about 10 years.

This example finishes our introduction to basic time value of money concepts. Table 4.4
summarizes present value and future value calculations for future reference. As the Work the
Web box in this section shows, online calculators are widely available to handle these calcula-
tions, but it is still important to know what is going on.
114 part 3 Valuation of Future Cash Flows

W RK THE WEB
H ow important is the time value of money? A recent search on one web engine returned more
than 791 million hits! It is important to understand the calculations behind the time value of
money, but the advent of financial calculators and spreadsheets has eliminated the need for te-
dious calculations. In fact, many websites offer time value of money calculators. The following is an
example from Moneychimp’s website, www.moneychimp.com. You need $150,000 in 25 years and
will invest your money at 9.2 percent. How much do you need to deposit today? To use the calcu-
lator, you simply enter the values and hit “Calculate.” The results look like this:

Who said time value of money calculations are hard?

QUESTIONS
1. Use the present value calculator on this website to answer the following: Suppose you
want to have $140,000 in 25 years. If you can earn a 10 percent return, how much do
you have to invest today?
2. Use the future value calculator on this website to answer the following question: Sup-
pose you have $8,000 today that you plan to save for your retirement in 40 years. If you
earn a return of 10.8 percent per year, how much will this account be worth when you
are ready to retire?

SPREADSHEET USING A SPREADSHEET FOR TIME VALUE OF MONEY CALCULATIONS

STRATEGIES
More and more, businesspeople from many different areas (and not just finance and accounting) rely
on spreadsheets to do all the different types of calculations that come up in the real world. As a result,
in this section, we show you how to use a spreadsheet to handle the various time value of money
Learn more about using problems we presented in this chapter. We will use Microsoft ExcelTM, but the commands are similar
Excel for time value of for other types of software. We assume you are already familiar with basic spreadsheet operations.
money and other As we have seen, you can solve for any one of the following four potential unknowns: future value,
calculations at www. present value, the discount rate, or the number of periods. With a spreadsheet, there is a separate for-
studyfinance.com. mula for each. In Excel, these are as follows:

To Find Enter This Formula

Future value = FV(rate,nper,pmt,pv)

Present value = PV(rate,nper,pmt,fv)
Discount rate = RATE(nper,pmt,pv,fv)
Number of periods = NPER(rate,pmt,pv,fv)

In these formulas, pv and fv are present and future value; nper is the number of periods; and rate is the
discount, or interest, rate.
 chapter 4 Introduction to Valuation: The Time Value of Money 115

There are two things that are a little tricky here. First, unlike a financial calculator, the spread-
sheet requires that the rate be entered as a decimal. Second, as with most financial calculators, you
have to put a negative sign on either the present value or the future value to solve for the rate or the
number of periods. For the same reason, if you solve for a present value, the answer will have a nega-
tive sign unless you input a negative future value. The same is true when you compute a future value.
To illustrate how you might use these formulas, we will go back to an example in the chapter. If you
invest $25,000 at 12 percent per year, how long until you have $50,000? You might set up a spread-
sheet like this:

A B C D E F G H
1
2 Using a spreadsheet for time value of money calculations
3
4 If we invest $25,000 at 12 percent, how long until we have $50,000? We need to solve for the
5 unknown number of periods, so we use the formula NPER (rate, pmt, pv, fv).
6
7 Present value (pv): $25,000
8 Future value (fv): $50,000
9 Rate: .12
10
11 Periods: 6.116255
12
13 The formula entered in cell B11 is =NPER(B9,0,-B7,B8); notice that pmt is zero and that pv has a
14 negative sign on it. Also notice that the rate is entered as a decimal, not a percentage.

conce p t q u es t i o n s
4.3a What is the basic present value equation?
4.3b What is the Rule of 72?

SUMMARY AND CONCLUSIONS

This chapter has introduced you to the basic principles of present value and discounted
cash flow valuation. In it, we explained a number of things about the time value of money,
including:
1. For a given rate of return, the value at some point in the future of an investment made
today can be determined by calculating the future value of that investment.
2. The current worth of a future cash flow can be determined for a given rate of return
by calculating the present value of the cash flow involved.
3. The relationship between present value and future value for a given rate, r, and time,
t, is given by the basic present value equation:
PV = FVt /(1 + r)t
As we have shown, it is possible to find any one of the four components (PV, FVt, r,
or t) given the other three.
The principles developed in this chapter will figure prominently in the chapters to
come. The reason for this is that most investments, whether they involve real assets or