B2FIN024
Corporate Finance
Session 2
Time Value of Money
1-1
• Readings:
– Chapter 4
Key Concepts and Skills
• Be able to determine the future value of an investment
made today
• Be able to compute the present value of cash to be
received at a future date
• Be able to find the return on an investment
• Be able to compute how long it takes for an investment
to reach a desired value
• Be able to use a spreadsheet to solve time value of
money problems
Lecture Outline
• Future Value and Compounding
• Present Value and Discounting
• More on Present and Future Values
• Summary
Basic Definitions
• Present Value – earlier money on a time line
• Future Value – later money on a time line
• Interest rate – “exchange rate” between money
received today and money to be received in the
future
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return
Future Value – Example 1
• Suppose you invest $1000 for one year at 5% per year. What is
the future value in one year? The future value is determined by
two components:
– Interest = $1,000(.05) = $50
– Principal = $1,000
– Future Value (in one year) = principal + interest
= $1,000 + $50
= $1,050
– Future Value (FV) = $1,000 x (1 + .05)
= $1,050
– Suppose you leave the money in for another year. How much will you
have two years from now?
– FV = $1,000(1+.05) x (1+.05) = $1,000(1+.05)2 = $1,000(1.05)2 = $1,102.50
Future Value: 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
Effects of Compounding
• Simple interest – earn interest on principal only
• Compound interest – earn interest on principal and reinvested interest
Consider the previous example
– FV with simple interest = $1,000 + $50 + $50
= $1,100
– FV with compound interest = $1,000(1.05)(1.05)
= $1,000(1.05)2
= $1,102.50
The extra $2.50 comes from the interest of 5% earned on the $50 of interest
paid in year one.
Effects of Compounding
1-9
Effects of Compounding
1-10
Future value of €1 for different
periods and rates
11
Future Value – Example 2
• Compounding over long periods of time makes a huge
difference
– Suppose today you deposited $10 at 5.5% interest.
– How much will this investment be worth in 200 years?
Future Value – Example 3 continued
– Using simple interest
FV PV PV I t
10 10 .055 200
$120
– Using compound interest
FV PV 1 r
t
10 1.055
200
$447,189.84
Comparing the impact of Simple and Compound
Interest on $1 invested at 10%
Simple Interest Compound Interest
Years Formula Result Formula Result
1 $1 (1+ 10% x 1) $1.10 $1 (1+ 10%)1 $1.1
10 $1 (1+ 10% x 10) 2 $1 (1+ 10%)10 2.59
50 $1 (1+ 10% x 50) 6 $1 (1+ 10%)50 117.4
100 $1 (1+ 10% x 100) 11 $1 (1+ 10%)100 13,781
150 $1 (1+ 10% x 150) 16 $1 (1+ 10%)150 1,617,718
200 $1 (1+ 10% x 200) 21 $1 (1+ 10%)200 189,905,277
250 $1 (1+ 10% x 250) 26 $1 (1+ 10%)250 22,293,142,370
1000 $1 (1+ 10% x 1000) 101 $1 (1+ 10%)1000 Nobody had this fortune ever
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 PV 1 r
t
3, 000, 000 1.15
5
6, 034, 072
Present Value
• How much do I have to invest today to have some specified amount in the
future? Start with the formula for FV and rearrange
FV PV 1 r
t
– Rearrange to solve for PV:
FV
PV
1 r
t
• 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 of €1 for different
periods and rates
Present Value – Example
• You set up a trust fund 10 years ago that is now worth $19,671.51.
• If the fund earned 7% per year, how much did you invest?
FV
PV
1 r
t
19, 671.51
1.07
10
$10, 000
Present Value – Important Relationships
• For a given interest rate:
– The longer the time period, the lower the present value
• For a given time period
– The higher the interest rate, the smaller the present value
The Basic PV Equation - Refresher
FV PV 1 r
t
• There are four key elements in this equation:
– PV, FV, r and t
– If we know any three, we can solve for the fourth
Discount Rate: r
• We often want to know the implied interest rate for
an investment
• Rearrange the basic PV equation and solve for r
FV= PV 1+ r
t
1
FV t
r= -1
PV
Discount Rate – Example
Suppose you have a 1-year old daughter and you want to provide
$75,000 in 17 years towards her college education. You currently
have $5,000 to invest.
What interest rate must you earn to have the $75,000 when you
need it?
1
FV t
r= -1
PV
1
75, 000
17
-1
5, 000
17.27%
Finding the Number of Periods
• Start with basic equation and solve for t
FV = PV 1+ r
t
FV
= 1+ r
t
PV
FV
ln = t.ln 1+ r
PV
FV
ln
PV
t=
ln 1+ r
Number of Periods – Example
Suppose you want to buy a new apartment. You currently have
$15,000 and you figure you need to have a 10% down payment. If
the type of apartment you want costs about $200,000 and you can
earn 7.5% per year, how long will it be before you have enough
money for the down payment?
FV
ln
PV
t=
ln 1+ r
20,000
ln
15,000
=
ln 1.075
3.98 years
Quick Quiz
How quickly will you double your money?
An investment proposal offers you an annual compound
rate of 6%. If you agree to invest $5,000 today, how long
will it take to double this amount?
Spreadsheet Example
• Use the following formulas for TVM calculations
– FV(rate,nper,pmt,pv)
– PV(rate,nper,pmt,fv)
– RATE(nper,pmt,pv,fv)
– NPER(rate,pmt,pv,fv)
…use Excel to solve the following :
– You need $50,000 in 10 years. If you can earn 6% interest,
how much do you need to invest today?
– You should find $27,920
Summary of FV and PV calculations
Summary
The basics of time value of money have been covered.
You should be able to:
– Calculate the future value (FV) of an amount given today
– Calculate the present value (PV) of an amount to be received in the
future
– Find the interest rate (r)
– Find the number of periods (t)
