Muhammad Nadeem

Financial Management
Time Value of
Money
5-1
apter Outline
Future Value and 4mp4unding
Present Value and Disc4unting
Future and Present Values 41 Multiple
as Fl4s
Valuing Level as Fl4s: Annuities and
Perpetuities
4mparing Rates: Te E11ect 41
4mp4unding
L4an Am4rtizati4n
5-2
asic De1initi4ns
Present Value earlier m4ney 4n a time
line
Future Value later m4ney 4n a time line
nterest rate "excange rate beteen
earlier m4ney and later m4ney
Disc4unt rate
4st 41 capital
Opp4rtunity c4st 41 capital
Required return
5-3
Future Values: General F4rmula
FV = PV(1 + r)
t
FV = 1uture value
PV = present value
r = peri4d interest rate, expressed as a
decimal
t = number 41 peri4ds
Future value interest 1act4r = (1 + r)
t
5-4
Future Values
Supp4se y4u invest $1000 14r 4ne year at 5%
per year. Wat is te 1uture value in 4ne year?
nterest = 1000(.05) = 50
Value in 4ne year = principal + interest = 1000
+ 50 = 1050
Future Value (FV) = 1000(1 + .05) = 1050
Supp4se y4u leave te m4ney in 14r an4ter
year. H4 muc ill y4u ave t4 years 1r4m
n4?
FV = 1000(1.05)(1.05) = 1000(1.05)
2
=
1102.50
5-5
E11ects 41 4mp4unding
Simple interest
4mp4und interest
4nsider te previ4us example
FV it simple interest = 1000 + 50 + 50 =
1100
FV it c4mp4und interest = 1102.50
Te extra 2.50 c4mes 1r4m te interest 41
.05(50) = 2.50 earned 4n te 1irst interest
payment
5-6
Future Values Example 3
Supp4se y4u ad a relative dep4sit $10 at 5.5%
interest 200 years ag4. H4 muc 4uld te
investment be 4rt t4day?
200 N; 5.5 /Y; 10 PV
PT FV = -447,189.84
Wat is te e11ect 41 c4mp4unding?
Simple interest = 10 + 200(10)(.055) = 120.00
4mp4unding added $447,069.84 t4 te value 41
te investment
5-7
Future Value as a General
Gr4t F4rmula
Supp4se y4ur c4mpany expects t4
increase unit sales by 15% per year 14r te
next 5 years. 1 y4u currently sell 3 milli4n
idgets in 4ne year, 4 many units d4
y4u expect t4 sell in 5 years?
5 N;15 /Y; 3,000,000 PV
PT FV = -6,034,072 units (remember te
sign c4nventi4n)
5-8
Present Values
H4 muc d4 ave t4 invest t4day t4 ave
s4me am4unt in te 1uture?
FV = PV(1 + r)
t
Rearrange t4 s4lve 14r PV = FV / (1 + r)
t
Wen e talk ab4ut disc4unting, e mean
1inding te present value 41 s4me 1uture am4unt.
Wen e talk ab4ut te "value 41 s4meting, e
are talking ab4ut te present value unless e
speci1ically indicate tat e ant te 1uture
value.
5-9
Present Values Example 3
Y4ur parents set up a trust 1und 14r y4u 10
years ag4 tat is n4 4rt $19,671.51. 1
te 1und earned 7% per year, 4 muc
did y4ur parents invest?
N = 10; /Y = 7; FV = 19,671.51
PT PV = -10,000
5-10
Disc4unt Rate
O1ten e ill ant t4 kn4 at te
implied interest rate is 4n an investment
Rearrange te basic PV equati4n and
s4lve 14r r
FV = PV(1 + r)
t
r = (FV / PV)
1/t
1
5-11
Finding te Number 41 Peri4ds
Start it basic equati4n and s4lve 14r t
(remember y4u l4gs)
FV = PV(1 + r)
t
t = ln(FV / PV) / ln(1 + r)
Y4u can use te 1inancial keys 4n te
calculat4r as ell; just remember te sign
c4nventi4n.
6-12
Multiple as Fl4s FV
Supp4se y4u invest $500 in a mutual 1und
t4day and $600 in 4ne year. 1 te 1und
pays 9% annually, 4 muc ill y4u ave
in t4 years?
Year 0 F: 2 N; -500 PV; 9 /Y; PT FV =
594.05
Year 1 F: 1 N; -600 PV; 9 /Y; PT FV =
654.00
T4tal FV = 594.05 + 654.00 = 1248.05
6-13
Multiple as Fl4s FV
Supp4se y4u plan t4 dep4sit $100 int4 an
acc4unt in 4ne year and $300 int4 te
acc4unt in tree years. H4 muc ill be
in te acc4unt in 1ive years i1 te interest
rate is 8%?
Year 1 F: 4 N; -100 PV; 8 /Y; PT FV =
136.05
Year 3 F: 2 N; -300 PV; 8 /Y; PT FV =
349.92
T4tal FV = 136.05 + 349.92 = 485.97
6-14
Example 6.3 Timeline
0 1 2 3 4
200 400 600 800
178.57
318.88
427.07
508.41
1432.93
6-15
Multiple as Fl4s Using a
Spreadseet
Y4u can use te PV 4r FV 1uncti4ns in
Excel t4 1ind te present value 4r 1uture
value 41 a set 41 cas 1l4s
6-16
Multiple as Fl4s PV
Y4u are c4nsidering an investment tat ill
pay y4u $1000 in 4ne year, $2000 in t4
years and $3000 in tree years. 1 y4u
ant t4 earn 10% 4n y4ur m4ney, 4
muc 4uld y4u be illing t4 pay?
N = 1; /Y = 10; FV = 1000; PT PV = -909.09
N = 2; /Y = 10; FV = 2000; PT PV = -1652.89
N = 3; /Y = 10; FV = 3000; PT PV = -2253.94
PV = 909.09 + 1652.89 + 2253.94 = 4815.92
6-17
"uick "uiz
Supp4se y4u are l44king at te 14ll4ing
p4ssible cas 1l4s: Year 1 F = $100;
Years 2 and 3 Fs = $200; Years 4 and 5
Fs = $300. Te required disc4unt rate is
7%
Wat is te value 41 te cas 1l4s at year
5?
Wat is te value 41 te cas 1l4s t4day?
6-18
Annuities and Perpetuities
asic F4rmulas
Perpetuity: PV = / r
Annuities:

+
=

=
7
7
'
7
7
!'
9
9
1 ) 1 (
) 1 (
1
1
6-19
Annuity Example
Y4u b4rr4 m4ney TODAY s4 y4u need t4
c4mpute te present value.
48 N; 1 /Y; -632 PMT; PT PV = 23,999.54
($24,000)
F4rmula:
54 . 999 , 23
01 .
) 01 . 1 (
1
1
632
48
=

= !'
6-20
Annuities and te alculat4r
Y4u can use te PMT key 4n te calculat4r
14r te equal payment
Ordinary annuity versus annuity due
Perpetuity
Perpetuity 14rmula: PV = / r
) 1 ( *
1 ) 1 (
7
7
7
'
9
+

+
=
6-21
E11ective Annual Rate (EAR)
Tis is te actual rate paid (4r received) a1ter
acc4unting 14r c4mp4unding tat 4ccurs during
te year
Supp4se y4u can earn 1% per m4nt 4n $1
invested t4day.
Wat is te APR? 1(12) = 12%
H4 muc are y4u e11ectively earning?
FV = 1(1.01)
12
= 1.1268
Rate = (1.1268 1) / 1 = .1268 = 12.68%
1
m
APR
1 EAR
m

+ =
6-22
Present Value it Daily
4mp4unding
Y4u need $15,000 in 3 years 14r a ne car.
1 y4u can dep4sit m4ney int4 an acc4unt
tat pays an APR 41 5.5% based 4n daily
c4mp4unding, 4 muc 4uld y4u need
t4 dep4sit?
3(365) = 1095 N
5.5 / 365 = .015068493 /Y
15,000 FV
PT PV = -12,718.56
6-23
Am4rtized L4an it Fixed Principal
Payment - Example
4nsider a $50,000, 10 year l4an at 8%
interest. Te l4an agreement requires te
1irm t4 pay $5,000 in principal eac year
plus interest 14r tat year.
6-24
Am4rtized L4an it Fixed
Payment - Example
Eac payment c4vers te interest expense plus
reduces principal
4nsider a 4 year l4an it annual payments.
Te interest rate is 8% and te principal am4unt
is $5000.
Wat is te annual payment?
4 N
8 /Y
5000 PV
PT PMT = -1509.60