Introduction to Valuation: The

Time Value of Money

Chapter
Five
 Chapter Outline
• Future Value and Compounding
• Present Value and Discounting
• More on Present and Future Values
 Basic Definitions
• Present Value – earlier money on a time
line
• Future Value – later money on a time line
• Interest rate – “exchange rate” between
earlier money and later money
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return
 Future Values
• Suppose you invest $1000 for one year at 5%
per year. What is the future value in one year?

Interest = 1000(.05) = 50

Value in one year = principal + interest

Value in one year = 1000 + 50 = 1050

Future Value (FV) = 1000(1 + .05) = 1050

 Future Values
• Suppose you leave the money in for
another year. How much will you have two
years from now?

FV = 1050(1.05) = 1102.50

FV = 1000(1.05)(1.05) = 1102.50

FV = 1000(1.05)2 = 1102.50
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

• FVIF(r,t) = (1 + r)t
 Effects of Compounding
• Simple interest
• Compound interest
• 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
.05(50) = 2.50 earned on the first interest
payment
 Calculator Keys
• Texas Instruments BA-II Plus
FV = future value
PV = present value
I/Y = period interest rate
• P/Y must equal 1 for the I/Y to be the period rate
• Interest is entered as a percent, not a decimal
N = number of periods
!!Remember to clear the registers (2nd
[CLR TVM]) before each problem!!
 Calculator Keys
Set interest rate I/YR to periodic rate:
2nd [P/Y], 1, ENTER  2nd [QUIT]

Set significant digits:

2nd [FORMAT] , 8, ENTER 2nd [QUIT]

If LCD has “BGN”:

2nd [BGN] 2nd [SET] 2nd [QUIT]
 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 = 1276.281563
• The 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.)
 Future Values – Example 2
• Suppose you invest the $1000 from the previous
example for 5 years. How much would you
have?

2nd [CLR TVM]

5N
5 I/Y
-1000 PV
CPT FV => 1276.281563
 Future Values – Example 3
• Suppose you had a relative deposit $10 at 5.5%
interest 200 years ago. How much would the
investment be worth today?
FV = 10(1.055)200 = 447,189.8387
2nd [CLR TVM]
10 PV, 5.5 I/Y, 200 N, CPT FV => -447189.8387
• What is the effect of compounding?
Principal + Simple interest
= 10 + 200(10)(.055) = 120
Compounding added $447,069.8387 to the value of the
investment
 Future Value as a General
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 in one
year, how many widgets do you expect to sell in 5
years?

FV = 3,000,000(1.15)5 = 6,034,071.563

2nd [CLR TVM]

3000000 PV, 15 I/Y, 5 N, CPT FV => -6034071.563
 Present Values
• How much do I have to invest today to
have some amount in the future?
FV = PV(1 + r)t

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

or PV = FV(1 + r)-t

Present Value Interest Factor = 1 / (1 + r)t

PVIF(r,t) = 1 / (1 + r)t
 Present Values
• When we talk about discounting, we mean
finding the present value of some future
amount.
• When we talk about the “value” of
something, we are talking about the
present value unless we specifically
indicate that we want the future value.
 Present Value – Example 1
• 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 = 9345.794393

2nd [CLR TVM]

10000 FV, 7 I/Y, 1 N, CPT PV
=> -9345.794393
 Present Values – Example 2
• You want to begin saving for your 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 = 40,540.34272

2nd [CLR TVM]

150000 FV, 8 I/Y, 17 N, CPT PV => -40540.34272
 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 = 9,999.998184

2nd [CLR TVM]

19671.51 FV, 7 I/Y, 10 N, CPT PV => -9,999.98184
Pure Discount Loans – Example
Treasury bills are pure discount loans. Also known
as zero coupon bonds. The principal amount is
repaid at some future date, without any periodic
interest payments.

If a T-bill promises to repay $10,000 in 6 months

and the market interest rate is 5% per year, how
much will the bill sell for in the market?

PV = 10,000 / (1.05).5 = $9,759.000729

2nd [CLR TVM]

10000 FV, 5 I/Y, .5 N, CPT PV => -9759.000729
 Discount Rate
Start with basic FV equation and solve for r,

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

r = (FV / PV)1/t – 1
 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 = .0371372893

= 3.71% (Basis Points?)

Calculator – the sign convention matters!!!

2nd [CLR TVM]

-1000 PV (you pay $1,000 today)
1200 FV (you receive $1,200 in 5 years)
5 N, CPT I/Y => 3.71372893%
 Discount Rate – Example 2
• Suppose you have a 1-year old son and you
want to provide $75,000 in 17 years towards
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 = .1726862656

= 17.27%

2nd [CLR TVM]

-5000 PV, 75000 FV, 17 N,
CPT I/Y => 17.26862656%
 PV – Important Relationship I
• 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 = 310.4606615

Rate = 15%; PV = 500 / (1.15)5 = 248.5883676
PV – Important Relationship I

 1 
PV  FV  t 
 1  r  

PV
0
r
 Finding the Number of Periods
Start with basic FV equation and solve for t,

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

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

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) = 3.01837719 years

2nd [CLR TVM]

-15000 PV, 20000 FV, 10 I/Y, CPT N => 3.01837719
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?
Number of Periods – Example 2
• 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

t = ln(21,750 / 15,000) / ln(1.075)

= 5.13772342 years

2nd [CLR TVM]

-15000 PV, 21750 FV, 7.5 I/Y, CPT N => 5.13772342
Number of Periods – Example 3
• Your cousin Vinnie is offering you a chance to
invest in his new pizzeria in Brooklyn. He claims
he will guarantee you a 20% return per year on
your money. How long will it take for you to
double your money?

t = ln(2 / 1) / ln(1.2) = 3.80178402 years

2nd [CLR TVM]

-1 PV, 2 FV, 20 I/Y, CPT N => 3.80178402
Number of Periods – Rule of 72
• Your cousin Vinnie is offering you a
chance to invest in his new pizzeria in
Brooklyn. He claims he will guarantee you
a 20% return per year on your money.
How long will it take for you to double your
money? Approximately

72/20 = 3.6 years

 PV – Important Relationship II
• 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 = 310.4606615

10 years: PV = 500 / (1.1)10 = 192.7716447
PV – Important Relationship II

 1 
PV  FV  t 
 1  r  

PV
0
t
 The Basic FV Equation -
Refresher
• FV = PV(1 + r)t
• There are four variables to this equation
– PV, FV, r and t
– If we know any three, we can solve for the
fourth
• If you are using a financial calculator, be
sure and remember the sign convention or
you will receive an error when solving for r
or t