4

Time Value of
Money 1: Analyzing
Single Cash Flows
Finance 5th Edition
Cornett, Adair, and Nofsinger
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill

Education .
Introduction
• Time value of money (TVM)
• Refers to the difference in buying power for a
dollar over time
• Used by financial and nonfinancial business
managers
• Key to making sound personal financial
decisions

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-2
Introduction (continued)
• TVM basic concept

• Factors to consider when making TVM

decisions
• Size of the cash flows
• Time between the cash flows
• Rate of return we can earn

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-3
Organizing Cash Flows
• Managing cash flow timing is one of the
most important tasks in successfully
operating a business
• A time line shows the magnitude of cash flows
at different points in time
• Monthly
• Quarterly
• Semiannually
• Annually

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-4
Organizing Cash Flows (continued)
• Cash we receive is called an inflow
• Cash that leaves us, such as a payment or
contribution to a deposit, is an outflow

Inflow Outflow
Organization
(Positive #) (Negative #)

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-5
Time Line Example

Outflow Inflow

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-6
Future Value
• Future value is the value of an investment
after one or more periods
• For example, the $105 payment your bank
credits to your account one year from the
original $100 investment at 5% annual interest

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-7
Single-Period Future Value
• To compute the future value of a sum of
money one year from today, you simply add
the interest earned to today’s cash flow

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-8
Single-Period Future Value Example
• Assumptions
• You invest $100 today
• You will earn 5% interest annually (for one
period)

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-9
Compounding and Future Value Example
• Assumptions
• You invest $100 today
• You will earn 5% interest for two periods

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-10
Compounding and Future Value
• Compounding is the process of adding
interest earned every period on both the
original investment and the reinvested
earnings

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-11
INPUT 2 5 -100 0
N I/YR PV PMT FV
OUTPUT 110.25

INPUT 20 5 -100 0
N I/YR PV PMT FV
OUTPUT 265.30

INPUT 40 5 -100 0
N I/YR PV PMT FV
OUTPUT 704.00
4-12
Interest Earned on Prior Interest at 5%

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-13
Present Value
• Finding the present value is essentially the
opposite process as finding the future value
• Future value = compounding
• Example: What happens when you deposit $100 cash
in the bank to earn 5 percent interest for one year?
• Present value = discounting
• Example: If the bank will pay you $105 in one year
and interest rates are 5 percent, how much would you
be willing to deposit now, to receive that payment in a
year?

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-14
Present Value (continued)
• Discounting is the process of finding
present value by reducing future values
using the discount, or interest, rate
• Significantly decreases the value of a future
amount to the present

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-15
Present Value Example
• Assumptions
• The bank will pay you $105 in 1 year
• Interest rates are 5 percent

• What is the present value?

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-16
Discounting Over Multiple Periods
• Discounting over multiple periods is simply
the reverse of compounding over multiple
periods

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-17
Discounting Over Multiple Periods Example
• Assumptions
• $100 payment will be received in five years
• Discount rate is 5 percent
• Note that the interest rate used to calculate present
value is often referred to as the discount rate

INPUT 2 5 0 100
N I/YR PV PMT FV
OUTPUT -78.35
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-18
Discounting with Multiple Rates
• A future cash flow can be discounted at
different interest rates per period

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-19
Discounting with Multiple Rates Example
• Assumptions
• Bank will pay you $2,500 at the end of 3rd year
• Interest rate in year 1 = 7%
• Interest rate in year 2 = 8%
• Interest rate in year 3 = 8.5%

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-20
Using Present Values and Future Values
• Managers may find it useful to move cash
flows to different points in time as they
analyze investment projects, debt
management, and cash flows
• Use PV equation to move cash flows to an
earlier point in time
• Use FV calculation to move cash flows to a later
point in time

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-21
Present Values and Future Values Example
• Example
• What’s the value in year 2 of a $200 cash flow
to be received in three years, when interest
rates are 6 percent?
• Problem requires moving $200 payment in the third
year to a value in the second year, which means we
need to use the PV equation

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-22
Present and Future Value Example (continued)

• Example
• What about moving the $200 cash flow to year
5?
• Requires moving the cash flow later in time by two
years, so we use the future value equation

INPUT 2 6 -200 0
N I/YR PV PMT FV
OUTPUT 224.72
Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-23
Rule of 72
• Albert Einstein introduced a simple
mathematical approximation for the number
of years required to double an investment,
called the Rule of 72

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-24
Rule of 72 Example
• Example
• How many years will it take to double money
deposited at 6 percent per year?

• Rule of 72 calculation
• = 12 years

• Thus, it will take 12 years for the money to double at a 6

percent interest rate

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-25
Computing Interest Rates
• Solving for the interest rate, or rate of
return, can answer questions like the
following:
• If you bought a gold coin for $350 three years
ago and sell it now for $475, what rate of return
have you earned?

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-26
INPUT 3 -350 0 475
N I/YR PV PMT FV
OUTPUT 10.72

4-27
Solving for Time
• It may be useful to determine the time
period needed to accumulate a specific
amount of money
• Information needed to solve for the number of
years that you will need to accumulate that
money
• Starting cash flow
• Interest rate
• Future cash flow (or, the amount you will need)

• Complex calculation – use financial calculator

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-28
Solving for Time Example
• Question: When interest rates are 9%, how
long will it take $5,000 to double?
• Inputs
• Interest = 9%
• PV = -5,000
• PMT = 0
• FV = 10,000

• Solution: 8.04 years

Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education 4-29