Time Value of Money

Chapter 2
Brealey, Myers, Allen, Principles of Corporate Finance, 13th Edition

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Part I

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Learning Objectives of This Unit
• Understand the idea of Time Value of Money
• Understand and apply the concepts of Future and Present Values
• Calculate Future and Present Values for single cash flows and cash flow streams (Part 1)
• Understand and apply the FV and PV formulas for Perpetuities and Annuities (Part 2)
• Understanding the impact that compounding frequency has on actual interest earned (Part 3)
• Apply Time Value of Money concepts to actual problem solving (Part 4)

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Time Value of Money – Introduction
• What is more valuable…
• $10,000 today, or
• $10,000 in one year?

• What do you prefer…

• $10,000 today, or
• $11,000 in one year?

• Money has a time value – cash you receive in the future is worth less than an equivalent amount of cash you
receive today;
• by how much exactly depends on how much you can earn by investing the cash today, the rate of return on
your capital (money).
• By investing cash today, you earn additional money over time. This additional money represents the time
value of money
• In this chapter, we are learning the tools to compare cash flows with each other that occur at different times

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Key Concepts
• Future Value (FV)
• The value of a dollar at a specified point in the future

• Present Value (PV)

• The value today of a dollar I receive at a specified time in the future

• r: “exchange rate” or the “rate of return” between today’s money and money in the future
• Interest Rate
• Discount rate
• Required return
• Opportunity cost of capital
• Cost of capital

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Introductory Example (one period)
• Let’s assume you have $100 today. What is the value of this $100 in one
year if you can invest the money at a 5% p.a. interest rate (p.a. means
per annum or per year)?

$100 $100 + 5% x $100 = $105

today 1 year

• Future Value is $100 + r x $100 = $100 x (1+r)

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Example continued
• Let’s assume you have $100 today. What is the value of this $100 in one year if you can invest the
money at a 5% p.a. interest rate? (p.a. means per annum or per year)

• The amount I receive (Future Value)

is $105 and it is comprised of:
+105
• $100, which is the principal amount
0 I invested today C0
1
• $5, which is the interest I earned on
-100 the $100 invested for 1 year

• As you can tell, the Future Value depends on

a) the interest rate
b) how long I keep the money invested
• The formula to calculate Future Value is therefore: FVt = C0 x (1+r)t
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Multi-Period Example
• What happens if I leave the money invested for another (second year)?

????

0
1 2

-100

• After one year I have $105 (from previous example) but instead of withdrawing that amount, I reinvest it
for another year.
• Therefore, in year two I get back the $105 plus the interest earned on
$105 for one year at 5% = $105 x 1.05 = $110.25
• Alternatively, we can use the general formula FVt = C0 x (1+r)t
• FV2 = $100 x (1+0.05)2 = $110.25
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Future Value Formulas
• General formula FVt = C0 x (1+r)t

• FVt Future Value at time t

• C0 Cash today
• r Interest rate at which you can invest, expressed per year
• t Number of years over which you invest

• The higher the rate of return (r) and the longer the investment period (t)
the higher the FV becomes
interest rate (r)
Investment period (t)

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Future Values with Different r

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Future Value Table
Future Value of $1 at the end of t periods, earning an interest rate r

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Present Value
• So far, we have calculated the Future Value of an amount we have today.
• Now, we do the opposite and calculate the Present Value of an amount to be received in the
future!

• Example: I get $100 in 1 year from now. What is it worth today?

+100

0
1

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Present Value Calculation
• We can use our Future Value formula to calculate Present Values – let’s just replace C0 with PV

• FVt = C0 x (1+r)t FVt = PV x (1+r)t

• And now we rearrange the equation to solve for Present Value…

• PV = FVt / (1+r)t

• Like with the future value, the Present Value depends on

a) the interest rate
b) how long I have to wait until I receive the payment

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Present Value Table
Present Value of $1 to be received after t periods, earning an interest rate r

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General Relationships

𝑡
𝐹𝑉 𝑡
𝐹𝑉 𝑡 = 𝑃𝑉 × ( 1+ 𝑟 ) 𝑃𝑉 =
( 1+𝑟 )𝑡

• Calculating a present value of a future cash flow is called discounting

• That is why the interest rate r is also called the discount rate

• If t increases, then FV goes up, and PV goes down

• If r increases, then FV goes up, and PV goes down

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PRACTICE PROBLEMS
• Suppose you need $10,000 in one year for the down payment of getting a new car. If you can
earn 7% annually, how much do you need to invest today?

• Suppose you need to save for your retirement in 40 years. You want to be a millionaire when you
retire. If you can earn an annual rate of 5%, how much do you have to invest today?

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Solving for Each Variable

𝑡
𝐹𝑉 𝑡 = 𝑃𝑉 × ( 1+ 𝑟 )

𝐹𝑉 𝑡
𝑃𝑉 =
( 1+𝑟 )𝑡

𝑡=
𝑙𝑛 ( 𝐹𝑉 𝑡
𝑃𝑉 ) 𝑟 =𝑒
𝑙𝑛 ( 𝐹𝑉
𝑡
𝑃𝑉 )
𝑡

−1
𝑙𝑛 ( 1+𝑟 )

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PRACTICE PROBLEMS
• Suppose you want to buy a new car which costs $40,000. Currently you have $20,000 and you can
earn a 20% rate of return on this amount. How long do you have to wait before you can afford
this car?

• Suppose you have $10,000 today and you want to be retiring in 40 years with $1,000,000. What
return do you have to achieve on average to get to your goal?

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