Chapter 5

Introduction to Valuation:
The Time Value of
Money
Le Duc Hoang

McGraw-Hill Ryerson Copyright © 2010 McGraw-Hill Ryerson Limited

 Chapter Outline
• Future Value and Compounding
• Present Value and Discounting
• Growing Cash Flows
• Perpetuities
• Annuities
• Loan Amortization
• Summary and Conclusions

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All
LOs
Basic Definitions
• Present Value – earlier money on a time
line
• Future Value – later money on a time
line
• Interest rate – “exchange rate” between
earlier money and later money
• Discount rate
• Cost of capital
• Opportunity cost of capital
• Required return 5-2
LO1
Future Value – Example 1
• Suppose you invest $1000 for one year at 5%
per year. What is the future value in one
year?
• Interest = 1000(.05) = 50
• Future Value (FV) = 1000(1 + .05) = 1050
• Suppose you leave the money in for another
year. How much will you have two years
from now?
• FV = 1000(1.05)(1.05) = 1000(1.05)2 = 1102.50

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LO1
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

5-4
LO1
Effects of Compounding
• Simple interest –principal
• Compound interest – principal and reinvested
interest
• Consider the previous example
• FV with simple interest = 1000 + 50 + 50 =
1100
• FV with compound interest = 1102.50
• The extra 2.50 comes from the interest of
.05(50) = 2.50 earned on the first interest
payment

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LO1
Example 2- Future Value
• Suppose you invest the $1000 from the
previous example for 5 years. How much
would you have?
• Formula Approach:
• FV = 1000(1.05)5 = 1276.28

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LO2
Present Values – 5.2
• How much do I have to invest today to
have some specified amount in the future?
• FV = PV(1 + r)t
• Rearrange to solve for PV = FV / (1 + r)t

5-7
LO2
Present Value – One Period
Example

• Suppose you need $10,000 in one year. If

you can earn 7% annually, how much do
you need to invest today?
• PV = 10,000 / (1.07)1 = 9345.79

5-8
LO2
Present Value – Example 2

• You want to begin saving for your daughter’s college

education and you estimate that she will need
$150,000 in 17 years.
• You can earn 8% per year, how much do you need
to invest today?
• PV = 150,000 / (1.08)17 = 40,540.34

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LO2
Present Value – Important
Relationship I
• For a given interest rate – the longer the
time period, the lower the present value

• What is the present value of $500 to be

received in 5 years? 10 years? The
discount rate is 10%

5-10
LO2
Important Relationship I
continued

• Formula Approach
• 5 years: PV = 500 / (1.1)5 = 310.46
• 10 years: PV = 500 / (1.1)10 = 192.77
• Notice that the 10-year present value is
lower than the 5-year present value

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LO2
Present Value – Important
Relationship II
• For a given time period – the higher the
interest rate, the smaller the present value

• What is the present value of $500 received

in 5 years if the interest rate is 10%?
15%?

5-12
LO2
Important Relationship II
continued
• Formula Approach
• Rate = 10%: PV = 500 / (1.1)5 = 310.46
• Rate = 15%; PV = 500 / (1.15)5 = 248.59
• Notice that the present value with the 15%
interest rate is lower than the present value
with the 10% interest rate

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LO3
Discount Rate – 5.3

• Rearrange the basic PV equation and

solve for r
• FV = PV(1 + r)t
• r = (FV / PV)1/t – 1

5-14
LO3
Discount Rate – Example 3

• You are looking at an investment that will

pay $1200 in 5 years if you invest $1000
today. What is the implied rate of
interest?
• r = (1200 / 1000)1/5 – 1 = .03714 = 3.714%

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LO4
Finding the Number of Periods
• Start with basic equation and solve for t
(remember your logs)
• FV = PV(1 + r)t
• t = ln(FV / PV) / ln(1 + r)

5-16
LO4
Number of Periods – Example 1
• You want to purchase a new car and you are willing
to pay $20,000. If you can invest at 10% per year
and you currently have $15,000, how long will it be
before you have enough money to pay cash for the
car?
• Formula Approach
• t = ln(20,000 / 15,000) / ln(1.1) = 3.02 years

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 5.4 Perpetuities
• Consider the type of cash flow
streams:

C C C
PV=    ......
(1  r ) (1  r ) (1  r )
2 3

• all the cash flows are the same

• the first cash flow starts at time 1
 5.4 Perpetuities
• you can invest $100 in a bank account
paying 5% interest per year forever
• At the end of the year you’ll have $105 in
the bank – your original $100 plus $5 in
interest
 5.4 Perpetuities
• You withdraw the $5 and reinvest the $100
for another year
 5.4 Perpetuities
• suppose we invest an amount P at an
interest rate r
• Every year we can withdraw the interest
we earned, C=r × P,
 5.4 Perpetuities

Present Value of a Perpetuity

(Eq. 4.4)
 5.4 Perpetuities
Endowing a Perpetuity
Problem:
• You budget $30,000 per year forever for
the party.
• If the university earns 8% per year on its
investments, and if the first party is in one
year’s time, how much will you need to
donate to endow the party?
 5.4 Perpetuities
Endowing a Perpetuity (cont’d)
Solution:
Plan:
• The timeline of the cash flows you want to provide
is:

• This is a standard perpetuity of $30,000 per year. The funding you

would need to give the university in perpetuity is the present value
of this cash flow stream
 5.4 Perpetuities
Endowing a Perpetuity (cont’d)
Execute:
• From the formula for a perpetuity,

P V  C / r  $ 3 0 , 0 0 0 / 0 .0 8  $3
75,000 to d ay
 5.5 Annuities
• Annuities
• An annuity is a stream of N equal cash flows
paid at regular intervals

C C C C
PV=    ......
(1  r ) (1  r ) (1  r ) (1  r )
2 3 N
5.5 Annuities
 5.5
Annuities
Future Value of an Annuity
 Example Future Value of an Annuity
Retirement Savings Plan Annuity
Problem:
• Ellen is 35 years old, and she has decided to plan for her
retirement.
• At the end of each year until she is 65, she will save $10,000
• 10% per year, how much will Ellen have saved at age 65?
 Example Future Value of an Annuity
Retirement Savings Plan Annuity

Execute:

1
FV  $10,000 (1 .1 0
30
 1)
 0.1
0
 $ 1 0 , 0 0 0  1 6 4 .4 9

 $ 1 .6 4 5 m i l l io n at a g e 6
5
 5.6. Growing Cash Flows
• For example, a growing perpetuity with a
first payment of $100 that grows at a
rate of 3% has the following timeline:
 5.6. Growing Cash Flows

Present Value of a Growing Perpetuity

 5.6. Growing Cash Flows
• The following timeline shows a growing
annuity with initial cash flow C, growing at
a rate of g every period until period N:
 5.6. Growing Cash Flows

• Present Value of a Growing Annuity:

N
1  1 g  
PV= C   
1
r - g   1 r  
 5.7 Loan Amortization
• widely used for home mortgages, auto
loans, business loans, retirement plans,
etc.
• Financial calculators and spreadsheets
are great for setting up amortization
tables.
• EXAMPLE: Construct an
amortization schedule for a $1,000,
10% annual rate loan with 3 equal 5-35
payments.
 Step 1:
Find the Required Annual Payment
• All input information is already given
• PV = 1000
• i= 10%
• N= 3
• PMT= 402.11

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 Step 2:
Find the Interest Paid in Year 1

INTt = Beg balt(I)

INT1 = $1,000(0.10) = $100

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 Step 3:
Find the Principal Repaid in Year 1
• If a payment of $402.11 was made at the
end of the first year and $100 was paid
toward interest, the remaining value must
represent the amount of principal repaid.

PRIN = PMT – INT

= $402.11 – $100 = $302.11

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 Step 4:
Find the Ending Balance after Year 1

END BAL = BEG BAL – PRIN

= $1,000 – $302.11
= $697.89

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 Constructing an Amortization Table:
Repeat Steps 1-4 Until End of
Loan

YEAR BEG PMT INT PRIN END

BAL BAL
1 $1,000 $ $10 $ 302 $698
402 0
2 698 402 70 332 366
3 366 402 36 366 0
TOTAL – $1,2 $20 $1,000 –
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All
LOs
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)
• The formula icon is very useful when you can’t
remember the exact formula
• Click on the Excel icon to open a spreadsheet
containing four different examples.

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All
LOs
Table

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All
LOs
Table
1 change in net working capital is measured as the net change in current
assets relative to current liabilities True NWC= current asset - current liabilities
2 the 1st reason make the value of money change over time is that money
received in the future can be invested thus generating more money True
3 in a sole proprietorship, the owner doesn’t need to share earnings with
anyone. True. they can keep all the profits, however, thay also have unlimited liability for business debt
4 The value of cost of equity calculated by Dividend Growth model is
extremely insensitive to estimated growth rate False, capital-> investment ??
5 Maturity is the specified date on which the principal amount of a bond is
paid true
6. Capital Budgeting is the process of planning and managing a firm’s fong-
term capital .
true ?? where to by a particular fixed asset
7. PV is the current value of future cash flows compounded at the appropriate
discount rate true
8. When computing the weighted average cost of capital, we need to use
after-tax cost of
debt and pre-tax cost of equity chịu ?? chắc true
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9. Deprecianice, Provision, Selling and Administrative expenses… are examples of non-
cash items
false?? selling với admini… k phải ?
10. When required return falls, stock values decline.

11. DUPONT identity is used to identify what exactly is generating a firm's net income
true??
12. From the stockholders' point of view, good decisions increase earnings per share.
true because it seem that stock ..
13. A growing annuity is an annuity where the payments grow at a constant rate true
14. The statement of stockholders' equity summarizes a firm's performance over a
period of time
false. income stt ( change in equity)
15. When applying PP and DPP to evaluate projects, we need arbitrary cutoff points
true . .. to decide accept or reject
16. Effective annual rate (EAR) is interest rate that has been adjusted for
inflation false
EAR .. the interest rate expressed as if it were compounded once per year
17. Earnings per share. Price - Earnings ratio. Price-Book value ratio are
examples of
market value measures true
18. Three ways to determine IRR are "trial and error", using calculator of
using NPV function
in Excel true
19. Return on Equity measures the ability of firm to generate profits from its
shareholder’s investments in the company. true
20. The return that the shareholders require on the stock can be interpreted
as the cost of
equity
2.1 A project has an initial investment of $2,010, with $540 annual
inflows for each of the
subsequent four years. If the required return is 5%, what is the NPV?
2.2 Given the following income statement data, calculate revenue if
Expenses (including
depreciation, but excluding interest paid) $31,200; Interest paid $24,800;
Net income is
$4,200; Depreciation $19,000. Tax rate 35%.
2.3 Investment X offers to pay you $340 per year for seven years, what
is the present value of
these cash flow streams if the discount rate is 7 percent?
2.4 Mummy's Shop ha annual sales of $900,
equity of 8 percent. What's total equity?
a profit margin of 12 percent, and a retum
2.5 At 5 percent interest, how long does it take to triple your money?
2.6 Company D just paid a dividend of $11.5 per share on its stock. The
dividends are expected
grow at a constant rate of 0.6 percent per year indefinitely. If the current price
is $120, What the required rate of return?
2.7 An investment project provides cash inflows of $190 per year for five years.
What is the
project payback period if the initial cost is $450?
2.8 MilkTea Corp.'s 2022 balance sheet showed net fixed assets of $8.5
million, and the 2021
balance sheet showed net fixed assets of $6.2 million. The company's 2022
income statement
showed a depreciation expense of $360,000. What was net capital spending
for 2022?
2.9 Kate and Jimmy has net working capital of $7,200, net fixed assets of
$73,100, net income of $3,400 and current liabilities of $51,600. How many
dollar worth of profit are generated from every $1 in total assets?
2.10 The interest on S Motors bond will be $24 in one year, $18.5 in two yeas,
and $15 in three years. You can sell the bond for $96 in three years. If you
require a 10% return on your investment, how much would you be willing to
pay for this bond today?
 Summary
• The basics of time value of money have
been covered. You should be able to:
• Calculate the future value of an amount given
today
• Calculate the present value of an amount to
be received in the future
• Find the interest rate
• Find the number of periods

5-43