Topic 2 ： Valuation

Outline – Time Value of Money

• Time and Money
• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future Values
Time and Money
• What are time and money related?
Time and Money
• We will use the time line to visually represent items over time
• Let’s start with fruit!
• If I gave you apples, one per year, then you can easily
conclude that I have given you a total of three apples
Today 1 Year 2 Years
Time and Money
• But money doesn’t work this way.
• If I gave you $100 each year, how much would you have, in total?

Today 1 Year 2 Years

$300, right?
Time and Money
• The difference between money and fruit is that money can work for
you over time, earning interest.
• Consider a savings account that pays 5% interest rate
• You deposit $100 today

Today 1 Year 2 Years

6
Time and Money
• Which would you rather receive: A or B?
Today 1 Year 2 Years

Today 1 Year 2 Years

7
Time and Money
• A is better because you get all of the $300 today instead of having to
wait two years.
• In short, "$1 today is worth more than $1 tomorrow." because of
earned interest

Today 1 Year 2 Years

>
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Time and Money
• Thus every time you see money spread out over time, you must think
of the money as different; you can’t just add it up!
• Money received over time is NOT equal in value.
Today 1 Year 2 Years

$300 9
Definitions
Today 1 Year 2 Years

PV FV 1 FV 2

• Present Value (PV) – today’s money on a time line

• Future Value (FV) – later money on a time line
• Interest Rate (r) – “exchange rate” between earlier money and later money
• Discount rate
• Cost of capital
• Opportunity cost of capital
• Required return or required rate of return
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Future Value (FV)
• Suppose you invest $1,000 for one year at 5% per year.
Today 1 Year 2 Years

$1,000 ?

• What is the future value in one year?

• Interest rate earned: $1,000 * 5% = $50
• Value in one year: principal + interest = $1,000 + $50 = $1050
• FV = $1,000 * ( 1 + r ) = $1,000 * ( 1 + 0.05 ) = $1,050
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Future Value (FV)
• Suppose you leave the money in for another year.
Today 1 Year 2 Years

$1,000 $1,050 ?

• How much will you have two years from now?

• FV = $1,000 * 1.05 * 1.05 = $1,102.5
• The extra $2.5 is “interest on interest”
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Future Value (FV): General Formula

FV = future value
PV = present value
r = interest rate over one period (in decimal, i.e. 0.05)
n = number of periods

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Future Value (FV): General Formula

: the future value interest factor

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Effects of Compounding
• Simple interest versus compound 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 = $1,102.5
• The extra $2.50 comes from the interest of .05 * $50 = $2.50 earned on the
first interest payment or “interest on interest”

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Effects of compounding over 20 years
• Interest rate = 10%
• Interest earned on
$1,000 = $2,000
• Interest on interest =
$3,727.5

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Present Value (PV)
• If we can go forward in time to the future (FV), then why can’t we go
backward in time to the present (PV)?
• Yes, we can!
Today 1 Year 2 Years

? $1,000

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Present Value (PV)
• Remember the general formula

• Rearranging the formula, we get

• This formula tells us how much we have to invest today to get some fixed
amount in the future
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Present Value (PV)
• Suppose you want to have $1,000 in two years from now. How much
should you invest at 5% interest rate?
• PV = FV / (1+r)2 = $1,000 / 1.052 = $907.03

Today 1 Year 2 Years

? $1,000
$907.03

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Present Value (PV)
• When we talk about “discounting”, we mean finding the present value
of some future amount.
• As a matter of fact, finance uses the process of moving future funds
back into the present when we value financial instruments like bonds,
preferred stock, and common stock. We also use it to evaluate
investing in projects.

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PV vs. FV
• Finance uses “compounding” as the verb for going into the future and
“discounting” as the verb to bring funds into the present
Today 1 2 3 4 5

Compounding
PV FV
Today 1 2 3 4 5

Discounting
PV FV
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More formulas

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Time Value of Money (TVM) calculation using a calculator

• An alternative and more powerful way to calculate PV/FV

• TI BA II Plus
Interest Rate
Number of per period in Present Recurring Future
Concept Compute
periods % value payments value
TVM Key

• To clear the TVM sheet, press [2nd] [CLR TVM]

• To recall a TVM value, press [RCL] and a value key

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Example 3: Future value
• Suppose you invest the $1,000 at 5% interest rate for 5 years. What is the future
value?
• Formula: FV = $1,000 * (1+0.05)5 = $1,276.28
• Clear TVM sheet [2nd][CLR TVM]
• Press a value and then a TVM key for all values
• Press [CPT] [FV]
• FV = -1,276.28

TVM Key

Value 5 5 1000 0
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Example 4: Present value
• You would like to have $100,000 in a savings account to fund your kid’s
education in 10 years from now. If the account promises to pay a fixed interest
rate of 5% per year. How much do you need to put in the account today?
• Formula: PV = $100,000 / (1+0.05)10 = $61,391.33
• Clear TVM sheet [2nd][CLR TVM]
• Press a value and then a TVM key for all values
• Press [CPT] [PV]
• PV = -61,391.33
TVM Key

Value 10 5 0 100000
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Example 5: Interest rate
• Suppose you invest $1,000 in a savings account for 5 years and at the end of 5
years, the account value is $1,200. What is the interest rate?
• Formula:
• Clear TVM sheet [2nd][CLR TVM]
• Press a value and then a TVM key for all values
• Press [CPT] [I/Y]
• r = 3.71%

TVM Key

-1000 1,200
Value 5 0
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Example 6: The number of periods
• Suppose you invest $1,000 in a savings account at 5% interest rate for N years and
at the end of N years, the account value is $1,276.28. What is the number of
years?
• Formula:
• Clear TVM sheet [2nd][CLR TVM]
• Press a value and then a TVM key for all values
• Press [CPT] [N]
• n=5
TVM Key

-1000 1,276.28
Value 5 0
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Time Value of Money (TVM) calculation using MS Excel

• Excel has a number of advantages over calculator

• More user friendly in terms of visualizing input, output and calculation.
• More powerful computing capability
• Can run complex programs
• Excel functions for TVM calculation
• PV(rate, nper, pmt, fv, type)
• FV(rate, nper, pmt, pv, type)
• NPER(rate, pmt, pv, fv, type)
• RATE(nper, pmt, pv, fv, type, guess)
• Again, pv and fv have different signs.
rate: interest rate in decimal
nper: the number of periods
pmt: recurring payments
fv: future value
pv: present value
type: 0, end of period; 1, beginning of
period
guess: initial guess for rate
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Example 7: TVM calculation using Excel
• Prior example 3: rate=0.05; pv=1,000; nper=5; pmt=0
Excel: =FV(0.05,5,0,1000,0)=-1,276.28

• Prior example 4: rate=0.05; fv=100,000; nper=10; pmt=0

Excel: =PV(0.05,10,0,100000,0)=-61,391.33

• Prior example 5: pv=-1,000; fv=1,200; nper=5; pmt=0

Excel: =RATE(5,0,-1000,1200,0,0.01)=3.71%

• Prior example 6: rate=0.05; pv=-1,000; fv=1,276.28; pmt=0

Excel: =NPER(0.05,0,-1000,1276.28,0)=5

• Click on the Excel icon for examples

Microsoft Excel
Worksheet
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Single cash flows
• So far the problems we have seen involve only single cash flows on
the time line.
Today 1 Year 2 Year 3 Year 4 Year 5 Years

$1,000 $?

Today 1 Year 2 Year 3 Year 4 Year 5 Years

$? $1,000

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Multiple cash flows
• What if we have more than one cash flow?

• The concept and formula are identical if we simply look at the problem as a
series of single payments.
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Multiple cash flows: Future value
• Suppose you have $1,000 now in a savings account that is earning 6%. You
want to add $500 one year from now and $700 two years from now.
Today 1 Year 2 Years

$1,000 $500 $700

• How much will you have two years from now in your savings account (after
you make your $700 deposit)?
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Multiple cash flows: Future value
• Simply look at each payment separately and move them through time as we did
before.
Today 1 Year 2 Years

$1,000 $500 $700

500*(1+0.06)
$530
1,000*(1+0.06)2
$1,124
+

$2,354

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Multiple cash flows: Future value
• Could we do this problem another way?
• Yes, bring each of the cash flows forward one year at a time and add them up each
year. 1 Year 2 Years
Today

$1,000 $500 $700

1,000*(1+0.06)
$1,060
+
1,560*(1+0.06)
$1,560 $1,654
+

$2,354

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Multiple cash flows: Future value
• Let’s add one more twist to the problem: What would be the value at
year 5 if we made no further deposits into our savings account?

Today 1 2 3 4 5

$1,000 500 700 ?

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Multiple cash flows: Future value
• We could do this two different ways: 1) Bring the “year two” figure
we previously produced to year five

Today 1 2 3 4 5

$1,000 500 700

2,354*(1+0.06)3
$2,354 $2,803

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Multiple cash flows: Future value
• 2) Bring each of the three original dollars to year 5 and add them
all up.
Today 1 2 3 4 5

700*(1+0.06)3
$1,000 $500 $700 $833
500*(1+0.06)4
$631
1,000*(1+0.06)5
$1,338
$2,803
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Multiple cash flows: Present value
• To compute the present value of multiple cash flows, we again just
bring the payments into the present value – one year at a time

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Multiple cash flows: Present value
• Consider receiving the following cash flows:
• Year 1 CF = $200
• Year 2 CF = $400
• Year 3 CF = $600
• Year 4 CF = $800
• If the discount rate is 12%, what would this cash flow be worth today?
Today 1 2 3 4

? 200 400 600 800

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Multiple cash flows: Present value
• To compute the present value of this future stream of cash, we just
take each year to the present, one at a time:
Today 1 2 3 4
200/(1+0.12)
178.57 200 400 600 800
400/(1+0.12)2
318.88
600/(1+0.12)3
427.07
800/(1+0.12)4
508.41

1,432.93

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Multiple cash flows: Present value
• Now use your financial calculator to find the PV of each cash flow:
• Year 1 CF: N = 1; I/Y = 12; FV = 200; CPT PV = -178.57
• Year 2 CF: N = 2; I/Y = 12; FV = 400; CPT PV = -318.88
• Year 3 CF: N = 3; I/Y = 12; FV = 600; CPT PV = -427.07
• Year 4 CF: N = 4; I/Y = 12; FV = 800; CPT PV = -508.41
• Add them all up: total PV = 178.57 + 318.88 + 427.07 + 508.41 =
$1,432.93

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Multiple cash flows using calculator
• Another way to use the financial calculator for uneven cash flows is to use the cash flow keys
1. To clear cash flow worksheet, press [CF], then [2nd][CLR Work]
2. Enter cash flows one at a time starting from year 0. Press [CF], then type cash flow value, and press [Enter]
3. Use the “down arrow” key (denote it by [down] here) to move to the next cash flow and repeat step 2. Note that the
“F” is the number of times a given cash flow occurs in consecutive periods
4. For step 2 & 3, the inputs are: [CF];CF0=0;C01=200;F01=1;C02=400;
F02=1;C03=600;F03=1;C04=800;F04=1
5. After you finish inputting all cash flows, press the [NPV] key and you will see the screen showing “I = ”. Input 12
and press [Enter] to set interest rate. Then press [down], and you will see “NPV=”. Press [CPT] to computing PV
and the answer is -1432.93

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Multiple cash flows using Excel
• You can use the PV or FV functions in Excel to find the present value
or future value of a set of cash flows

• Click on the Excel icon for examples

Microsoft Excel
Worksheet

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Multiple cash flows: general formula
• Present value of a stream of cash flows
Today 1 2 n

C0 C1 C2 Cn
𝐂𝟏 1/(1+r)
𝟏+ 𝐫
𝐂𝟐 1/(1+r)2
( 𝟏+ 𝐫 )𝟐
𝐂𝐧 1/(1+r)n

( 𝟏+ 𝐫 )𝒏

PV = c0+ +…+

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Annuities and Perpetuities: definition
• Annuity: finite series of equal payments that occur at regular intervals
• Two types: ordinary annuity: occurs at the end of the period; annuity due: occurs at the
beginning of the period
• Example: rent, car loans, mortgages and bonds

Today 1 2 n

…
C/0 C C 0/C
• Perpetuity: infinite series of equal payments
Today 1 2

…
C/0 C C
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Annuities and Perpetuities: formulas
• Annuity (ordinary type) – geometric progression
PV =

𝐂
𝐅𝐕 = 𝐂 ( 𝟏+ 𝐫 )
𝐧 −𝟏
+ 𝐂 ( 𝟏+ 𝐫 )
𝐧− 𝟐
+ …+ 𝐂 =
𝐫
( ( 𝟏+ 𝐫 )𝒏 −𝟏 )

• Perpetuity – geometric sequence

PV = +…

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Annuities and Perpetuities: simple examples
• Suppose the cash flows of an annuity and a perpetuity are $100 per
year and interest rate is 10% per year. What is the PV of the annuity
which lasts for 50 years? What is the PV of the perpetuity?
• Annuity:
• Perpetuity:

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Example 8: calculating annuities using calculator

• Suppose you can afford to pay $499 per month for a new car for 48 months. You
local bank can give an interest rate at 4% per year. What is the price of the new
car as of today?
• This is an annuity calculation.
• In this problem, the period is ONE MONTH. The interest rate for one period is
then 4% / 12 = 0.33%
• Use [PMT] on the calculator
TVM Key

Value 48 0.33 499 0

• The price is $22,100.13

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Calculating annuities using Excel

• You can use the PV or FV functions in Excel to find the present value
or future value of an annuity.

• Click on the Excel icon for examples

Microsoft Excel
Worksheet

49
Example 9: : buying a house
• You are ready to buy a house, and you have $20,000 for a down
payment and closing costs. Closing costs are estimated to be 4% of the
loan value. You have an annual salary of $36,000, and the bank is
willing to allow your monthly mortgage payment to be equal to 28%
of your monthly income.
• The interest rate on the loan is 6% per year with monthly
compounding (.5% per month) for a 30-year fixed rate loan.
• How much money will the bank loan you?
• How much can you offer for the house?

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Example 9: : buying a house (continued)
• Bank loan
• Monthly income = 36,000 / 12 = 3,000
• Maximum payment = .28*(3,000) = 840
• Number of periods: 30*12 = 360
• Interest rate per period: 0.5
• [CPT] [PV] = $140,105
TVM Key

Value 360 0.5 -840 0

• Total Price
• Closing costs = .04 * (140,105) = 5,604
• Down payment = 20,000 – 5,604 = 14,396
• Total Price = 140,105 + 14,396 = $154,501
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Example 10: future values for annuities
• Suppose you begin saving for your retirement by depositing $2,000
per year in an IRA. If the interest rate is 7.5%, how much will you
have in 40 years?
• Number of periods: 40
• Interest rate per period: 7.5
• Payment per period: -2000 (the sign convention)
• [CPT][FV] = $454,513.04

TVM Key

Value 40 7.5 0 -2000

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Example 11: perpetuity
• Suppose the Fellini Company wants to sell preferred stock at $100 per
share. A similar issue of preferred stock already outstanding has a
price of $40 per share and offers a dividend of $1 every quarter.
• What dividend will Fellini have to offer if the preferred stock is going
to sell?
• Solution:
• A preferred stock can be viewed as a perpetuity with C = dividend
• We need to find interest rate first. From the $40 stock, we know $40 = $1 / r.
So r = 1/40 = 0.025
• The dividend of the $100 stock should be $100*0.025 = $2.5

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Annuities and Perpetuities: growing cash
flows
• So far, we have considered only cash flow streams that have the same
cash flow every period.
• One interesting and helpful extension is that cash flows are expected
to grow at a constant rate g (>0) in each period.
Today 1 2 n

…
0 C C(1+g)1 C(1+g)n-1

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Growing annuities and perpetuities: formulas
• Growing Annuity:
• Assume growth rate g < r
PV =

• Growing Perpetuity:
• Assume growth rate g < r

PV =

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Example 12: Growing annuity
• A defined-benefit retirement plan offers to pay $20,000 per year for 40
years and increase the annual payment by 3% each year.
• What is the present value at retirement if the discount rate is 10%?
• Solution:
• Growth rate: 3%
• Interest rate: 10%
• Number of periods: 40

• If the annual payment does not increase,

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Example 13: Growing perpetuity
• The expected dividend next year is $1.30, and dividends are expected
to grow at 5% forever.
• If the discount rate is 10%, what is the value of this promised dividend
stream?
𝐂 $𝟏.𝟑
𝐏𝐕 = = =$ 𝟐𝟔
𝐫 − 𝐠 𝟎 . 𝟏 −𝟎 . 𝟎𝟓

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Terms and formulas
• Symbols
• PV = present value, what future cash flows are worth today.
• FV(n) = future value, what cash flows are worth at a future time point n.
• r = interest rate, rate of return discount rate per period – typically, but not always, one year
• g = growth rate of cash flow per period – typically, but not always, one year
• n = number of periods - typically, but not always, the number of years
• C = cash amount
• Annuity

• Growth version:

• Perpetuity

• Growth version:

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Take aways
• Time and Money
• Future Value and Compounding
• Present Value and Discounting
• More about Present and Future Values