5.

1 Chapter Outline

Chapter 5 – Part 1
Introduction to Valuation: The Time Value of Money

Chapter Organization
 5.1.1 Computing Interest Rates: Simple and Compound
Interests

 5.1.2 Computing Future Value and Compounding

 5.1.3 Computing Present Value and Discounting

 5.1.4 Computing Number of Periods

Time Value Terminology
 Consider the timeline below:
PV FV
...
0 1 2 3 t
 PV is the Present Value, that is, the value today.

 FV is the Future Value, or the value at a future date.

 The number of time periods between the Present Value and

the Future Value is represented by “t”.
 The rate of interest is typically called “r”.

 All time value questions involve the four values above: PV,
FV, r, and t. Given three of them, it is always possible to
calculate the fourth.

Slide 2
How to use a Financial Calculator
 By using a financial calculator, in general, you need to enter
four known values and calculate the unknown fifth value:

N I PV PMT FV

x x x 0 ?

 Where:

N= The number of periods

I= The interest rate during each period
PV = The present value (here: the initial investment)
PMT = The value of cash flows that reoccur each period (e.g.
additional investments, withdrawals or
disbursements, see chapter 5, part 2)
FV = The future value
Slide 3
Some Notes on how to use a Financial Calculator
 When to use Positive/Negative Cash Flows:
 On most calculators, the PV has to be entered as a negative cash flow
 Why? Because the investment that you make today is a cash outflow for you.
 Unfortunately, not all calculators use this rationale.
  The best solution is to familiarize yourself with your calculator and understand how values
have to be entered.

 If you get Incorrect Results:

 Particularly in the calculations we perform in chapter 5, where we look at reoccurring cash flows
(the PMT button), you may initially get incorrect results
 Why? Because the factory settings for compounding periods per year (PMT/Y) and beginning- vs.
end-of-period cash flows (BGN/END) may be set differently to what we will use in class
  Solution: Set your compounding periods per year (P/Y) to 1 and change the settings to
beginning- vs. end-of-period cash flows carefully.

 Operations Order:
 There is another “peculiarity” of financial calculators that often leads to errors: Calculate the
following simple equation on a financial calculator and compare it to the result you get when
using a scientific calculator: 2+2*3=?
 Why are the results different? Because financial calculators don’t adhere to the same order of
operations that is normally used by scientific calculators.
  Solution: Make sure that you enclose calculations you want the calculator to perform
separately in brackets: Typing 2+(2*3) will give you the right result.
Slide 4
5.1.1 Interest Rates: Simple Interest and Compound Interest

 Simple interest:
 Is only applied to the principal (P).
 Total interest earned = P*r*t
 Ending balance or FV = P + (P*r*t)

 Compound interest:
 Is earned on both the principal (P) and accrued interest.
 Total interest earned = P(1 + r)t – P
 Ending balance or FV = P(1 + r)t

Slide 5
5.1.1 Interest Rates: Simple Interest and Compound Interest (cont’d)

 Example I: suppose you invest $100 in a security earning a

10% annual rate of return for a period of 3 years. How much
is simple interest? How much is compound interest?
 Calculate simple interest:
 Total interest earned = P*r*t = $100*0.1*3 = $30
 Ending balance = P + (P*r*t) = $100 + ($100*0.1*3) = $130
 Calculate compound interest:
 Total interest earned = P(1 + r)t – P = $100(1+0.1)3 – $100 = $33.10
 Ending balance = P(1 + r)t = $100(1+0.1)3 = $133.10
Notice that:
1. $110 = $100  (1 + .10)
2. $121 = $110  (1 + .10) = $100  1.10  1.10 = $100  1.102
3. $133.10 = $121  (1 + .10) = $100  1.10  1.10  1.10 = $100  1.103

Slide 6
5.1.1 Interest Rates: Simple Interest and Compound Interest (cont’d)

 We can also use a financial calculator to compute the ending

balance or the FV of a compound interest account:

N I PV PMT FV
?

Slide 7
5.1.1 Computing Simple and Compound Interests of $100 at 10 Percent:
Beginning Simple Interest on Compound Ending
Year Amount Interest Interest Interest Amount

1 $100.00 $10.00 $ 0.00 $10.00 $110.00

2 110.00 10.00 1.00 11.00 121.00
3 121.00 10.00 2.10 12.10 133.10
4 133.10 10.00 3.31 13.31 146.41
5 146.41 10.00 4.64 14.64 161.05
Totals $50.00 $ 11.05 $ 61.05

Slide 8
5.1.1 Interest Rates: Simple Interest and Compound Interest (cont’d)
 Example II: you deposit $5,000 today in an account paying
12%. How much will you have in 6 years? How much is
simple interest? How much is compound interest?

 The simple interest is:

0.12  $5,000 = $600 per year.

After 6 years, this is 6  $600 = $3,600

 The compound interest is:

$5,000  (1 + r )t - $,5000 = ($5,000  (1.12)6) - $5,000
= ($5,000  1.9738227) - $5,000
= $4,869.11

The difference between compound and simple interest is

thus $4869.11 - $3600 = $1269.11

Slide 9
5.1.1 Interest Rates: Simple Interest and Compound Interest (cont’d)
 Example III: you opened a savings account with an initial
investment of $500 three years ago. Today the account balance
is $600. If the account paid interest compounded annually, how
much interest on interest was earned?

 Step 1: calculate the annual compound interest (r):

Ending balance = P  (1 + r )t
$600 = $500  (1 + r)3
$600/$500 = (1 + r)3
1.2 1/3 = 1+r
1.2 1/3 -1 = r
0.0627 = r
6.27% = r

Slide 10
5.1.1 Interest Rates: Simple Interest and Compound Interest (cont’d)

 Alternative for step 1: We can also use a financial

calculator to compute the compound interest rate (r):

N I PV PMT FV

Slide 11
5.1.1 Interest Rates: Simple Interest and Compound Interest (cont’d)

 Step 2: calculate the sum of all simple interest payments

earned on the principal of $500:
= P*r*t = $500* 6.27%*3 = $94.05

 Step 3: find the total interest earned in the account:

= $600 - $500 = $100

 Step 4: calculate the interest on interest by subtracting the

total simple interest from the total compound interest:
= $100 - $94.05 = $5.95

Slide 12
5.1.2 Future Value of a Lump Sum

 Basis formula: FVt = PV(1 + r)t

 The expression (1 + r)t is the compound factor.

 Timeline:

PV FV
...
0 1 2 3 t

Slide 13
5.1.2 Future Value of a Lump Sum (cont’d)

 Suppose you invest $100 in a security earning a 10% annual

rate. How much will you have after 3 years?

 First define the variables:

PV = $100 r = 10 percent
t = 3 years FV = ?

 Solve for the future value:

FV3= $100(1 + 0.1)3 = $133.10

Slide 14
5.1.2 Future Value of a Lump Sum (cont’d)

 We can also use a financial calculator to solve this

problem.

N I PV PMT FV
?

FV = $133.10

Slide 15
5.1.3 Present Value of a Lump Sum

 Basis formula: PVt = FV*1/(1 + r)t

 The expression 1/(1 + r)t is called the discount factor.

 The discount factor is the reciprocal of the compound factor.

 Timeline:

PV FV
...
0 1 2 3 t
Slide 16
5.1.3 Present Value of a Lump Sum (cont’d)
 Want to be a millionaire? No problem! Suppose you just turned 21
years old, and can earn 10 percent on your money. How much
must you invest today in order to accumulate $1 million by the
time you reach age 65?

 First define the variables:

FV = $1 million r = 10 percent
t = 65 - 21 = 44 years PV = ?

 Set this up as a future value equation and solve for the

present value:
$1 million = PV  (1.10)44
PV = $1 million/(1.10) 44 = $15,091.

Slide 17
5.1.3 Present Value of a Lump Sum (cont’d)

 We can also use a financial calculator to solve this

problem.

N I PV PMT FV

PV = $15,091

Slide 18
5.1.4 Number of Periods

 Number of Periods (t) :

 Is the life of the investment.
 Can be easily computed using your financial calculator:

N I PV PMT FV

? x x 0 x

Slide 19
5.1.4 Number of Periods (cont’d)
 You need $15,000 to buy a new car. If you have $8,000 to invest at a 5%
interest rate compounded annually, how long do you have to wait to
buy the car?

 First, define the variables:

FV = $15,000 r = 5 percent
PV = $8,000 t= ?

 Set this up as a future value equation and solve for the number of periods (t):
FVt = PV(1 + r)t
$15,000 = $8,000(1 + 0.05) t
(1 + 0.05) t = $15,000/$8,000
t = 12.88

Slide 20
5.1.4 Number of Periods (cont’d)

 Using the financial calculator to solve for t:

N I PV PMT FV

N = 12.88
Slide 21
Self-study problem

 Suppose you deposit $5000 today in an account paying r

percent per year. If you will get $10,000 in 10 years, what rate
of return are you being offered?
 Set this up as present value calculation:

FV = $10,000 PV = $ 5,000 t = 10 years

PV = FVt/(1 + r )t
$5000 = $10,000/(1 + r)10

 Now solve for r:

(1 + r)10 = $10,000/$5,000 = 2.00

r = (2.00)1/10 - 1 = .0718 = 7.18%

Slide 22
Self-study problem

 We can also use a financial calculator to solve for r:

N I PV PMT FV

r = 7.18
Slide 23