Week 2 Titman - PPT - CH05

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 5
The Time Value of
Money—The Basics
Copyright © 2018, 2014, 2011 Pearson

CopyrightEducation, Inc. All
© 2018, 2014, 2011 Pearson Rights
Education, Inc. All Reserved
Rights Reserved
Learning Objectives (1 of 2)
1. Construct cash flow timelines to organize your
analysis of problems involving the time value of
money.
2. Understand compounding and calculate the
future value of cash flows using mathematical
formulas, a financial calculator, and an Excel
spreadsheet.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Learning Objectives (2 of 2)
3. Understand discounting and calculate the
present value of cash flows using mathematical
formulas, a financial calculator and an Excel
spreadsheet.
4. Understand how interest rates are quoted and
know how to make them comparable.
Principles Applied in this Chapter
• Principle 1: Money Has a Time Value.
5.1 USING TIMELINES TO VISUALIZE CASHFLOWS
Using Timelines to Visualize Cashflows
• A timeline identifies the timing and amount of a
stream of payments – both cash received and
cash spent - along with the interest rate earned.
Timelines are a critical first step that financial
analysts use to solve financial problems.
• A timeline is typically expressed in years, but it
could also be expressed as months, days or any
other unit of time.
Time Line Example
i = 10%
Years 0 1 2 3 4
Cash flow −$100 $30 $20 −$10 $50
• The 4-year timeline illustrates the following:

– The interest rate is 10%.
– A cash outflow of $100 occurs at the beginning of the
first year (at time 0), followed by cash inflows of $30
and $20 in years 1 and 2, a cash outflow of $10 in year
3 and cash inflow of $50 in year 4.
5.2 COMPOUNDING AND FUTURE VALUE
Compounding and Future Value
Time value of money calculations involve Present
value (what a cash flow would be worth to you
today) and Future value (what a cash flow will be
worth in the future).
Future Value Number of Years (n)

Present  Annual 
in Year n =  1+ 
Value (PV)  Interest Rate (i) 
(FVn )
Compound Interest and Time (1 of 2)
The Future value of an investment grows with the
number of periods we let it compound.
Example: Suppose that you deposited $500 in your
savings account that earns 5% annual interest. How
much will you have in your account after two years?
After five years?
• FV2 = PV(1+i)n = 500(1.05)2 = $551.25
• FV5 = PV(1+i)n = 500(1.05)5 = $638.14
Compound Interest and Time (2 of 2)
YEAR PV or Interest Earned (5%) FV or
Beginning Value Ending Value
1 $500.00 $500*.05 = $25 $525
2 $525.00 $525*.05 = $26.25 $551.25
3 $551.25 $551.25*.05 = $27.5 $578.81
4 $578.81 $578.81*.05 = $28.94 $607.75
5 $607.75 $607.75*.05 = $30.39 $638.14
Using Equation 5-1a: FV = PV(1+i)n

= 500(1.05)5 = $638.14
Figure 5.1 Future Value and Compound Interest Illustrated
(Panel A) Calculating Compound Interest
Interest Earned = Beginning Value  Interest Rate
Year Beginning Value Interest Earned Ending Value
1 $ 100.00 $ 6.00 $ 106.00
2 $ 106.00 $ 6.36 $ 112.36
3 $ 112.36 $ 6.74 $ 119.10
4 $ 119.10 $ 7.15 $ 126.25
(Panel B) The Power of Time
(Panel C) The Power of the Rate of Interest
Applying Compounding to Things Other
Than Money
Example A car rental firm is currently renting 8,000
cars per year. How many cars will the firm be
renting in 10 years if the demand for car rentals
is expected to increase by 7% per year?
• Using Equation 5-1a,
– FV = 8000(1.07)10 = 15,737.21 Cars
CHECKPOINT 5.2: CHECK YOURSELF
Calculating the FV of a Cash Flow
What is the FV of $10,000 compounded at 12% annually for 20 years?
Compound Interest with Shorter
Compounding Periods
Banks frequently offer savings account that
compound interest every day, month, or quarter.
More frequent compounding will generate higher
interest income and lead to higher future values.
m × (Number of Years ( n ))
 Annual 
Future Value  
Present Interest Rate ( i )
in Year n = 1+ 
Value (PV )  Compounding  (5-1b)
(FVn )  Periods per Year ( m) 
 
Table 5-2 The Value of $100 Compounded at Various Non—
Annual Periods and Various Rates (1 of 2)
For 1 Year at i Percent i = 2% 5% 10% 15%
Compounded annually $102.00 $105.00 $110.00 $115.00
Compounded semiannually 102.01 105.06 110.25 115.56
Compounded quarterly 102.02 105.09 110.38 115.87
Compounded monthly 102.02 105.12 110.47 116.08
Compounded weekly (52) 102.02 105.12 110.51 116.16
Compounded daily (365) 102.02 105.13 110.52 116.18
Table 5-2 The Value of $100 Compounded at Various Non—
Annual Periods and Various Rates (2 of 2)
For 10 Years at i Percent i = 2% 5% 10% 15%
Compounded annually $121.90 $162.89 $259.37 $404.56
Compounded semiannually 122.02 163.86 265.33 424.79
Compounded quarterly 122.08 164.36 268.51 436.04
Compounded monthly 122.12 164.70 270.70 444.02
Compounded weekly (52) 122.14 164.83 271.57 447.20
Compounded daily (365) 122.14 164.87 271.79 448.03
Table 5-2 Observations
Table 5-2 shows how shorter compounding periods
lead to higher future values. For example, if you
invested $100 at 15 percent for one year and the
investment was compounded daily rather than
annually, you would end up with $1.18 more
($116.18-$115.00). However, if the period was
extended to 10 years, then the difference would
grow to $43.47 ($448.03-$404.56)
= $135,352.07

Calculating Future Values Using
Non-Annual Compounding Periods
If you deposit $50,000 in an account that pays an annual interest rate of 10%
compounded monthly, what will your account balance be in 10 years?
5.3 DISCOUNTING AND PRESENT VALUE
Present Value: The Key Question
• What is value today of cash flow to be received in
the future?
• The answer to this question requires computing
the present value (PV) - the value today of a
future cash flow - and the process of discounting,
determining the present value of an expected
future cash flow.
The Mechanics of Discounting Future
Cash Flows
 
Future Value  
Present  1 
= in Year n  Numbers of Years ( n ) 
Value (PV )
(FVn )   1+ Annual 
 
  Interest Rate ( i )  
• The term in the bracket is known as the Present

Value Interest Factor (PVIF).
• PV = FVn × PVIF
Figure 5.2 The Present Value of $100 Compounded at
Different Rates and for Different Time Periods
= $29,530

Solving for the PV of a Future Cash Flow
What is the present value of $100,000 to be received at the end of 25 years, given a
5% discount rate?
Two Additional Types of Discounting
Problems
Solving for: (1) Number of Periods; and
(2) Rate of Interest
Solving for the Number of Periods
How long will it take to accumulate a specific
amount in the future?
• It is easier to solve for “n” using the financial
calculator or Excel rather than mathematical
formula. (See checkpoint 5.5)
The Rule of 72
It determine the number of years it will take to
double the value of your investment.
N = 72/interest rate
For example, if you are able to generate an
annual return of 9%, it will take 8 years (=72/9)
to double the value of investment.
Solving for Number of Periods, n
How many years will it take for $10,000 to grow to $200,000, given a 15% compound
growth rate?
Step 1: Picture the Problem
i = 15%
Years 0 1 2… N=?
Cash flow Blank −$10,000 Blank $200,000
We know FV,
PV, and i and
are solving for N
Step 2: Decide on a Solution Strategy
In this problem, we are solving for “n”. We know the
interest rate, the present value and the future value.
We can calculate “n” using a financial calculator or
an Excel spreadsheet.
Step 3: Solve
• Using a Financial Calculator • Using an Excel Spreadsheet
I/Y = 15 N = NPER(rate,pmt,pv,fv)
PMT = 0 = NPER(.15,0, −10000,200000)
PV = −10,000 = 21.4 years
FV = 200,000
N = 21.4 years
Step 4: Analyze
It will take 21.4 years for $10,000 to grow to
$200,000 at an annual interest rate of 15%.
Interpolasi
• Bisa juga dicari dengan menggunakan interpolasi.
• Contoh: berapa tahun kah nilai $300 untuk menjadi $500 pada i = 10%
?
• Rumus FV = PV * (1+i)n
• tabel FVIA 5 tahun: 300*1,6105 = $483,1530
• tabel FVIA 6 tahun: 300*1,7716 = $531,4863
= 6 - ((531,4863 – 500)/(531,4863-483,1530))
= 6 - 0,65131128 = 5,3487 tahun
= $499,47970 (tidak bulat 500 karena interpolasi merupakan garis
lurus sedangkan fungsi FV adalah parabola)
Solving for the Rate of Interest
What rate of interest will allow your investment to
grow to a desired future value?
We can determine the rate of interest using
mathematical equation, the financial calculator or
the Excel spread sheet.
.1050 or 10.50%

Solving for the Interest Rate, i
At what rate will $50,000 have to grow to reach $1,000,000 in 30 years?
5.4 MAKING INTEREST RATES COMPARABLE
Annual Percentage Rate (APR)
The annual percentage rate (APR) indicates the
interest rate paid or earned in one year without
compounding. APR is also known as the nominal
or quoted (stated) interest rate.
Calculating the Interest Rate and
Converting it to an EAR
We cannot compare two loans based on APR if
they do not have the same compounding period.
To make them comparable, we calculate their
equivalent rate using an annual compounding
period. We do this by calculating the effective
annual rate (EAR)
m
 APR or Quoted 
 
Annual Rate
Effective Annual Rate ( EAR ) = 1+  1
 Compounding Periods 
 
 per Year ( m ) 
To the Extreme: Continuous
Compounding
• As m (number of compounding period) increases,
so does the EAR. When the time intervals
between when interest is paid are infinitely small,
we can use the following mathematical formula to
compute the EAR.
• EAR = (e quoted rate ) −1
– Where “e” is the number 2.71828
EAR with Continuous Compounding
• Example What is the EAR on your credit card with
continuous compounding if the APR is 18%?
• EAR = e.18 −1
= 1.1972 −1
= .1972 or 19.72%
Key Terms (1 of 2)
• Annual Percentage Rate (APR)
• Compounding
• Compound Interest
• Discounting
• Discount Rate
• Effective Annual Rate (EAR)
• Future Value
Key Terms (2 of 2)
• Future Value Interest Factor
• Nominal or quoted (stated) Interest Rate
• Present Value
• Present Value Interest Factor
• Rule of 72
• Simple Interest
• Timeline
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Financial Management:

Principles & Applications

Copyright © 2018, 2014, 2011 Pearson

• The 4-year timeline illustrates the following:

Future Value Number of Years (n)

Using Equation 5-1a: FV = PV(1+i)n

Interest Earned = Beginning Value  Interest Rate

Year Beginning Value Interest Earned Ending Value

1 $ 100.00 $ 6.00 $ 106.00

2 $ 106.00 $ 6.36 $ 112.36

3 $ 112.36 $ 6.74 $ 119.10

4 $ 119.10 $ 7.15 $ 126.25

Compounded annually $102.00 $105.00 $110.00 $115.00

Compounded semiannually 102.01 105.06 110.25 115.56

Compounded quarterly 102.02 105.09 110.38 115.87

Compounded monthly 102.02 105.12 110.47 116.08

Compounded weekly (52) 102.02 105.12 110.51 116.16

Compounded daily (365) 102.02 105.13 110.52 116.18

Compounded annually $121.90 $162.89 $259.37 $404.56

Compounded semiannually 122.02 163.86 265.33 424.79

Compounded quarterly 122.08 164.36 268.51 436.04

Compounded monthly 122.12 164.70 270.70 444.02

Compounded weekly (52) 122.14 164.83 271.57 447.20

Compounded daily (365) 122.14 164.87 271.79 448.03

CHECKPOINT 5.3: CHECK YOURSELF

• The term in the bracket is known as the Present

CHECKPOINT 5.4: CHECK YOURSELF

CHECKPOINT 5.6: CHECK YOURSELF

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