Chapter Three

The Time Value of Money and

Capital Budgeting

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Content
• The concepts of Time Value of Money

• Future Value and Compounding

• Present Value and Discounting

• Determining the discount rate

• Annuities and Perpetuities

• Capital Budgeting

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3.1 Time Value of Money - Defined
• Time value of money refers to the fact that a dollar in hand
today is worth more than a dollar promised at some time in the
future.
• On a practical level, one reason for this is that you could earn
interest while you waited; so a dollar today would grow to
more than a dollar later.
• The trade-off between money now and money later thus
depends on, among other things, the rate you can earn by
investing.
• The process of going forward, from present values (PVs) to future
values (FVs), is called compounding.
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 Future Value and Compounding
• Future value (FV) – is the amount an investment is worth after one or
more periods.

• Compounding – is the process of accumulating interest on an investment

over time to earn more interest.

• Interest on Interest - Interest earned on the reinvestment of previous

interest payments.

• Compound interest - Interest earned on both the initial principal and

the interest reinvested from prior periods.

• Simple interest - Interest earned only on the original principal amount

invested.
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 Future Value and Compounding…
• Suppose you invest $100 in a savings account that pays
10 percent interest per year. How much will you have in
one year?
a. When invested for a single period
Future Value = PV + (PV*r*t)
b. When invested for more than one period

FV = PV (1+i) n

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 a) Investing for a Single Period
• You will have $110. This $110 is equal to your
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%.
• 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%, so your investment grows
to 1+.10 = 1.1 dollars per dollar invested.
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 b)Investing for More Than One Period
• What will you have after two years, assuming
the interest rate doesn’t change?
• If you leave the entire $110 in the bank, you will
earn $110 x .10 = $11 in interest during the
second year, so you will have a total of $110
+ 11 = $121.

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• How much would our $100 grow to after three
years?

• The future value of $1 invested for t periods at

a rate of r per period is:

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• 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 and can be abbreviated as FVIF(r, t).
• What would your $100 be worth after five
years? $100 x 1.6105 = $161.05

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• 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.
• Compounding the interest means earning interest
on interest, so we call the result compound
interest.
• With simple interest, the interest is not
reinvested, so interest is earned each period only
on the original principal.

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 Future Value with Multiple Cash Flows
• Consider the future value of $2,000 invested at the end of
each of the next five years. The current balance is zero, and
the rate is 10 percent.

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 Present Value and Discounting
• Present value (PV) – is the current value of future cash flows
discounted at the appropriate discount rate.
• Discounting – the process to calculate the present value of some
future amount.
a. Present Value for a single period

𝑭𝑽
PV =
(𝑷𝑽∗𝒓∗𝒕)

b. Present Value for a multiple period

𝑭𝑽
PV =
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 Present Value and Discounting
• Discount rate - The rate used to calculate the present value of future
cash flows.
• Discounted cash flow (DCF) valuation - Calculating the present
value of a future cash flow to determine its value today.

• Example: Suppose you need $1,000 in three years. You can earn
15 percent on your money. How much do you have to invest
today? To find out, we have to determine the present value of
$1,000 in three years at 15 percent. We do this by discounting $1,000
back three periods at 15 percent. With these numbers, the discount
factor is:

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 Present Value with Multiple Cash Flows

• As with future values, there are two ways we can

do it. We can either discount back one period at a
time, or we can just calculate the present values
individually and add them up.
• Suppose you need $1,000 in one year and $2,000
more in two years. If you can earn 9% on your
money, how much do you have to put up today to
exactly cover these amounts in the future?

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• An alternative way of calculating present values for
multiple future cash flows is to discount back to the
present, one period at a time.
• To illustrate, suppose we had an investment that
was going to pay $1,000 at the end of every year
for the next five years for a 6 percent discount rate.
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 Determining the discount rate
• For example, suppose we know that a given security has a cost of
$100 and that it will return $150 after 10 years.

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 Annuities
 Equal periodic payment at fixed intervals.

1. Ordinary Annuity (Deferred Annuity) – payments are made at the

end of the period.

2. Annuity Due – payments are made at the beginning of the period.

Example: The time lines for a $100, 3-year, 5%,

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 Annuities…
 In Annuity there is always constant payments and a fixed number of

periods. Future Value of an Ordinary Annuity

Example: - What is the future value depositing $100 at the end of each
year for 3 years that earns 5% per year?

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 Annuities…
Future Value of an Annuity Due

Thus, for the annuity due, FVAdue = $315.25(1.05) = $331.01

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 Annuities…
Present Value of an Ordinary Annuity

The present value of an ordinary annuity for the previous example

where $100 is deposited at the end of each year for 3 years that
earns 5% per year.

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 Annuities…
Present Value of an Annuity Due

The present value of an annuity due for the previous example

where $100 is deposited at the end of each year for 3 years that
earns 5% per year.

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 Uneven or Irregular Cash Flows

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 3.2. Capital Budgeting

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 Capital Budgeting – An Overview
 Capital refers to long-term assets used in production

 Budget is a plan that outlines projected expenditures during a

future period.

 Capital budget is a summary of planned investments of assets

that will last for more than a year.

 Capital budgeting is the whole process of analyzing projects and

deciding which ones to accept and thus include in the capital
budget.

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 Recall the Flows of funds and decisions important
to the financial manager

Investment Financing
Decision Decision

Reinvestment Refinancing

Real Assets Financial Financial

Manager Markets

Returns from Investment Returns to Security Holders

Capital
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make the
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 Capital Budgeting – An Overview
Type of projects:
1. Replacement needed to continue profitable operations.

2. Replacement to reduce costs.

3. Expansion of existing products or markets.

4. Expansion into new products or markets.

5. Contraction decisions.

6. Safety and/or environmental projects.

7. Mergers.

8. Other like office building, parking lots and executive aircraft

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 Capital Budgeting – An Overview
Project Screening Criterion:
1. Payback period

2. Net Present Value (NPV)

3. Internal Rate of Return (IRR)

4. Modified Internal Rate of Return (MIRR)

5. Profitability Index (PI)

6. Regular Payback

7. Discounted Payback

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 Payback Period
• Payback period is the number of years required to recover the funds
invested in a project from its operating cash flows.

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 Payback Period
• The length of time required for an investment’s net
revenues to cover its cost.
E.g. Net cash flows for project S and L is given as:

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 Payback Period…

• Applying the same procedure to Project L, we find

Payback L = 3.33 years.

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 Payback Period…

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 Discounted Payback Period
• To counter the first criticism, financial analysts developed the
discounted payback, where cash flows are discounted at the
WACC and then those discounted cash flows are used to find
the payback.

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 Discounted Payback Period…

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 Discounted Payback: Uses discounted
rather than raw CFs.
0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

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 Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
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 Net Present Value
• The net present value (NPV), defined as the present value of a project’s
cash inflows minus the present value of its costs, tells us how much the
project contributes to shareholder wealth.

• The larger the NPV, the more value the project adds and thus the higher
the stock’s price.

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 Net Present Value…
 Example:

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 Net Present Value…
• By similar process we find NPVL = $491.8.

NPV Decision Rules

 Independent projects: - Projects whose cash flows are not affected by
the acceptance or non-acceptance of other projects.
 If NPV exceeds zero, accept the project.

 Mutually exclusive projects: - A set of projects where only one can be

accepted.
 Accept the project with the highest positive NPV. If no project has a
positive NPV, then reject them all.

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 Internal Rate of Return (IRR)
 A project’s IRR is the discount rate that forces the PV of the inflows
to equal the initial cost (or to equal the PVs of all the costs if costs
are incurred over several years).

 This is equivalent to forcing the NPV to equal zero.

 The IRR is an estimate of the project’s rate of return, and it is

comparable to the YTM on a bond.

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Internal Rate of Return (IRR)…

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 Internal Rate of Return (IRR)…
 Three procedures can be used to find the IRR:
1. Trial-and-error.

2. Calculator solution.

3. Excel solution.

 If the IRR criterion is used to rank projects, then the decision rules
are as follows.
– Independent projects: If IRR exceeds the project’s WACC, then the
project should be accepted. If IRR is less than the project’s WACC,
reject it.
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 Internal Rate of Return (IRR)…
• Mutually exclusive projects - Accept the mutually exclusive project with
the highest IRR, provided that the project’s IRR is greater than its WACC.
Reject any project whose best IRR does not exceed the firm’s WACC.

• Multiple internal rate of return – happens when cash out flow occurs again
after cash inflow has started which indicates non-normal cash outflow.

• In this case, the project might have two IRRs—that is, multiple IRRs.

• Reinvestment assumptions – In NPV calculation it is assumed that the cash

inflow is reinvested at a WACC where as In IRR it is assumed that the cash
inflow is reinvested at the rate of IRR itself.

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 Profitability Index (PI)

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 Profitability Index (PI)…
• A project is acceptable if its PI is greater than
1.0; and the higher the PI, the higher the
project’s ranking.

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 In conclusion…
 Mathematically, the NPV, IRR, MIRR, and PI methods will always
lead to the same accept/reject decisions for normal, independent
projects.
– If a project’s NPV is positive, its IRR and MIRR will always exceed r and
its PI will always be greater than 1.0.

– However, these methods can give conflicting rankings for mutually

exclusive projects if the projects differ in size or in the timing of cash
flows.

– If the PI ranking conflicts with the NPV, then the NPV ranking should be
used.

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 The End

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