Principles of

Corporate Finance
Session 10
Unit II: Time Value of Money

Why TIME?
Why is TIME such an important
element in your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
INTEREST

Types of Interest

Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).

Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).

Simple Interest Formula

Formula

SI = P0(i)(n)

SI:
P0:

Simple Interest
Deposit today (t=0)

i:
n:

Interest Rate per Period

Number of Time Periods

Simple Interest Example

Assume that you deposit $1,000 in an
account earning 7% simple interest for 2
years. What is the accumulated interest at
the end of the 2nd year?

SI

= P0(i)(n)
= $1,000(0.07)(2)
= $140

Simple Interest (FV)

What is the Future Value (FV)
FV of the
deposit?
FV

= P0 + SI
= $1,000 + $140
= $1,140
Future Value is the value at some future time
of a present amount of money, or a series of
payments, evaluated at a given interest rate.

Simple Interest (PV)

What is the Present Value (PV)
PV of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.

Future Value (U.S. Dollars)

Why Compound Interest?

Simple Interest
With simple interest, you dont earn interest on
interest.
Year 1: 5% of $100

$5 + $100 = $105

Year 2: 5% of $100

$5 + $105 = $110

Year 3: 5% of $100

$5 + $110 = $115

Year 4: 5% of $100

$5 + $115 = $120

Year 5: 5% of $100

$5 + $120 = $125

Compound Interest
With compound interest, a depositor earns interest
on interest!
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63

Principles of
Corporate Finance
Session 11 & 12
Unit II: Time Value of Money

The Role of Time Value in Finance

Most financial decisions involve costs & benefits that
are spread out over time.
Time value of money allows comparison of cash flows
from different periods.
Question?
Would it be better for a company to invest
$100,000 in a product that would return a total of
$200,000 in one year, or one that would return
$500,000 after two years?

The Role of Time Value in Finance

Most financial decisions involve costs & benefits that
are spread out over time.
Time value of money allows comparison of cash flows
from different periods.

Answer!
It depends on the interest rate!

Basic Concepts
Future Value: compounding or growth over time
Present Value: discounting to todays value
Single cash flows & series of cash flows can be
considered
Time lines are used to illustrate these relationships

Computational Aids
Use the Equations
Use the Financial Tables
Use Financial Calculators
Use Spreadsheets

Computational Aids

Computational Aids

Computational Aids

Computational Aids

Time Value Terms

PV0 =

present value or beginning amount

interest rate

FVn =

future value at end of n periods

number of compounding periods

an annuity (series of equal payments or

receipts)

Four Basic Models

FVn

PV0(1+k)n

PV(FVIFk,n)

PV0

FVn[1/(1+k)n]

FV(PVIFk,n)

A (1+k)n - 1
k

A(FVIFAk,n)

= A 1 - [1/(1+k)n] =

A(PVIFAk,n)

FVAn =
PVA0

Future Value Example

Algebraically and Using FVIF Tables
You deposit $2,000 today at 6%
interest. How much will you have in 5
years?

$2,000 x (1.06)5 = $2,000 x FVIF6%,5

$2,000 x 1.3382 = $2,676.40

Future Value Example

Using Excel
You deposit $2,000 today at 6%
interest. How much will you have in 5
years?

PV
k
n
FV?

2,000
6.00%
5
$2,676

Excel Function
=FV (interest, periods, pmt, PV)
=FV (.06, 5, , 2000)

Future Value Example

A Graphic View of Future Value

Compounding More Frequently

than Annually

Compounding more frequently than once a year

results in a higher effective interest rate because you

are earning on interest on interest more frequently.
As a result, the effective interest rate is greater than
the nominal (annual) interest rate.
Furthermore, the effective rate of interest will increase
the more frequently interest is compounded.

Compounding More Frequently

than Annually

For example, what would be the difference in future

value if I deposit $100 for 5 years and earn 12%
annual interest compounded (a) annually, (b)
semiannually, (c) quarterly, an (d) monthly?
Annually:

100 x (1 + .12)5 =

$176.23

Semiannually:

100 x (1 + .06)10 =

$179.09

Quarterly:

100 x (1 + .03)20 =

$180.61

Monthly:

100 x (1 + .01)60 =

$181.67

Compounding More Frequently

than Annually
On Excel
Annually
PV

Sem iAnnually Quarterly

100.00

12.0%

FV

$176.23

100.00
0.06
10
$179.08

100.00

Monthly
$

100.00

0.03

0.01

20

60

$180.61

$181.67

Continuous Compounding
With continuous compounding the number of
compounding periods per year approaches infinity.
Through the use of calculus, the equation thus
becomes:
FVn (continuous compounding) = PV x (ekxn)
where e has a value of 2.7183.
Continuing with the previous example, find the Future
value of the $100 deposit after 5 years if interest is
compounded continuously.

Continuous Compounding
With continuous compounding the number of
compounding periods per year approaches infinity.
Through the use of calculus, the equation thus
becomes:
FVn (continuous compounding) = PV x (ekxn)
where e has a value of 2.7183.
FVn = 100 x (2.7183).12x5 = $182.22

Principles of
Corporate Finance
Session 12 & 13
Unit II: Time Value of Money

Nominal & Effective Rates

The nominal interest rate is the stated or contractual
rate of interest charged by a lender or promised by a
borrower.
The effective interest rate is the rate actually paid or
earned.
In general, the effective rate > nominal rate whenever
compounding occurs more than once per year
EAR = (1 + k/m) m -1

Nominal & Effective Rates

For example, what is the effective rate of interest on
your credit card if the nominal rate is 18% per year,
compounded monthly?

EAR = (1 + .18/12) 12 -1
EAR = 19.56%

Double Your Money!!!

Quick! How long does it take to double
$5,000 at a compound rate of 12% per
year (approx.)?

We will use the Rule-of-72.

The Rule-of-72
Quick! How long does it take to double
$5,000 at a compound rate of 12% per
year (approx.)?

Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]

Present Value
Present value is the current dollar value of a future
amount of money.
It is based on the idea that a dollar today is worth
more than a dollar tomorrow.
It is the amount today that must be invested at a given
rate to reach a future amount.
It is also known as discounting, the reverse of
compounding.
The discount rate is often also referred to as the
opportunity cost, the discount rate, the required return,
and the cost of capital.

Present Value Example

Algebraically and Using PVIF Tables
How much must you deposit today in order to
have $2,000 in 5 years if you can earn 6%
interest on your deposit?

$2,000 x [1/(1.06)5] = $2,000 x PVIF6%,5

$2,000 x 0.74758 = $1,494.52

Present Value Example

Using Excel
How much must you deposit today in order to
have $2,000 in 5 years if you can earn 6%
interest on your deposit?
FV
k
n
PV?

2,000
6.00%
5
$1,495

Excel Function
=PV (interest, periods, pmt, FV)
=PV (.06, 5, , 2000)

Present Value Example

A Graphic View of Present Value

Annuities

Annuities are equally-spaced cash flows of equal size.

Annuities can be either inflows or outflows.
An ordinary (deferred) annuity has cash flows that
occur at the end of each period.
An annuity due has cash flows that occur at the
beginning of each period.
An annuity due will always be greater than an
otherwise equivalent ordinary annuity because interest
will compound for an additional period.

Annuities

Future Value of an Ordinary Annuity

Using the FVIFA Tables
Annuity = Equal Annual Series of Cash Flows
Example: How much will your deposits grow to if you
deposit $100 at the end of each year at 5% interest for
three years.
FVA = 100(FVIFA,5%,3) = $315.25
Year 1 $100 deposited at end of year

$100.00

Year 2 $100 x .05 = $5.00 + $100 + $100

$205.00

Year 3 $205 x .05 = $10.25 + $205 + $100

$315.25

Future Value of an Ordinary Annuity

Using Excel
Annuity = Equal Annual Series of Cash Flows
Example: How much will your deposits grow to if you
deposit $100 at the end of each year at 5% interest for
three years.
PMT
k
n
FV?

100
5.0%
3
$ 315.25

Excel Function
=FV (interest, periods, pmt, PV)
=FV (.06, 5,100, )

Future Value of an Annuity Due

Using the FVIFA Tables
Annuity = Equal Annual Series of Cash Flows
Example: How much will your deposits grow to if you
deposit $100 at the beginning of each year at 5%
interest for three years.
FVA = 100(FVIFA,5%,3)(1+k) = $330.96
FVA = 100(3.152)(1.05) = $330.96

Future Value of an Annuity Due

Using Excel
Annuity = Equal Annual Series of Cash Flows
Example: How much will your deposits grow to if you
deposit $100 at the beginning of each year at 5%
interest for three years.

PMT $ 100.00
k
5.00%
n
3
FV
$315.25
FVA? $ 331.01

Excel Function
=FV (interest, periods, pmt, PV)
=FV (.06, 5,100, )
=315.25*(1.05)

Present Value of an Ordinary Annuity

Using PVIFA Tables
Annuity = Equal Annual Series of Cash Flows
Example: How much could you borrow if you could
afford annual payments of $2,000 (which includes
both principal and interest) at the end of each year for
three years at 10% interest?
PVA = 2,000(PVIFA,10%,3) = $4,973.70

Present Value of an Ordinary Annuity

Using Excel
Annuity = Equal Annual Series of Cash Flows
Example: How much could you borrow if you could
afford annual payments of $2,000 (which includes
both principal and interest) at the end of each year for
three years at 10% interest?
PMT
I
n
PV?

2,000
10.0%
3
$4,973.70

Excel Function
=PV (interest, periods, pmt, FV)
=PV (.10, 3, 2000, )

Present Value of a Mixed Stream

Using Tables
A mixed stream of cash flows reflects no particular
pattern
Find the present value of the following mixed stream
assuming a required return of 9%.
Year Cash Flow

PVIF9%,N

PV

400

0.917

$ 366.80

800

0.842

$ 673.60

500

0.772

$ 386.00

400

0.708

$ 283.20

300

0.650

$ 195.00

PV

$1,904.60

Present Value of a Mixed Stream

Using EXCEL
A mixed stream of cash flows reflects no particular
pattern
Find the present value of the following mixed stream
assuming a required return of 9%.
Year Cash Flow
1

400

800

500

400

300

NPV

$1,904.76

Excel Function
=NPV (interest, cells containing CFs)
=NPV (.09,B3:B7)

Present Value of a Perpetuity

A perpetuity is a special kind of annuity.
With a perpetuity, the periodic annuity or cash flow
stream continues forever.
PV = Annuity/k
For example, how much would I have to deposit today
in order to withdraw $1,000 each year forever if I can
earn 8% on my deposit?
PV = $1,000/.08 = $12,500