Lesson 2

CH 5: Time Value of Money (The Basic)

FIN3101/3701 Corporate Finance

Dr. Sarina Preechalert

 Question 1:

• If you keep money in your pocket, will your

money grow?
Answer:
• No

3
 Question 2:
If you are given 2 choices
• (1) $100 received today and
• (2) $100 received one year from now
• which one is better or worth more today?
Answer:
• Choice 1: $100 dollar received today

4
Example:

0 1 year 0 i. = 10% 1 year

i. = 10%

$100 $100 $100 $105

110
0 1 year
0 1 year

$100 $115 $100 $110

 Time Value of Money
What:
• Money has a value as a time goes by
• How: By saving or investing money.

$$$ $ $
$
$$$$$ $ $$$$
$$ $$$$

6
 EX: TVOM

EX: Save $100 at the bank paying 10% yearly

0 1 2 3
10% 100
110 121 133.1
100 * 0.1 = 10 110 * 0.1 = 11 121 * 0.1 = 12.1

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 Factors Affecting TVOM

• Present Value (PV)

• Future Value (FV)
• Interest rate (i)
• Number of periods (n)
• Payment (PMT)

$ $ $
$ $$$$
$$$$$ $$ $$$

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 Time Line

0 i =? 1 2 3 4 5

- $CFs CFs CFs CFs - CFs CFs

• Time 0 = Now, today

• Time 1 = 1 period from today
• Period = Intervals
EX: yearly, semi-annually, quarterly
• Tick mark = End of the current period
• Beginning of the next period
• Cash flows = - CFs (cash outflows), CFs (cash inflows)
• Interest = i.
9
 Checkpoint 1
Creating a Timeline
• Suppose you lend a friend $10,000 today to help him finance a
new franchise and in return he promises to give you $12,155 at
the end of year four.
• How can you represent this information in a timeline?
• Assume interest rate is 5%.
Simple vs Compound Interest
 Simple Interest vs. Compound Interest

• Simple interest:
– Interest is earned only on principal amount.
• Principal = $100
• Int. 10%
• Year 1 = 110
• Year 2 = 120
• Compound interest:
– Interest is earned on both principal & accumulated interest
of prior periods.
• Principal = $100
• Int. 10%
• Year 1 = 110
• Year 2 = 121 = 100(1+10%)2
 Simple Interest
• What: INT is earned on original principal amount only
• 1) 1-year simple int : FV = PV + (PV * i)
• 2) Years simple int : FV = PV * [ 1 + i * n ]
EX: You save $100, int = 10% simple interest

• 1 year  FV = 100 + (100 * 0.10) = $110

• 2 years  FV = 100 * (1 + 0.10 * 2) = $120

• 3 years  FV = 100 * (1 + 0.10 * 3 ) = $130

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 Simple Interest

• EX: You save $100, int = 10% simple interest

• 1 year  FV = 100 * (1 + 0.10 * 1) = $110
• 2 years  FV = 100 * (1 + 0.10 * 2) = $120
• 3 years  FV = 100 * (1 + 0.10 * 3) =$130

Principal = $100 Interest = $100 FV = $200

• 10 years  FV = 100 * (1 + 0.10 * 10) = $200

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 Compound Interest
• What: INT is earned on principal and INT
• INT is earned on both 1) principal and 2) interest
• Formula : FV = PV * (1 + i)n
EX: You save $100, int = 10% compounded for 2 yrs.

0 1 2
2
$100 FV2 = ??? 100
PV * ( 1 + 0.10)
i ) n
FV = 121

15
Simple Interest vs. Compound Interest

Simple Interest Compound Interest

Year PV INT FV PV INT FV
1 100 10 110 100 10 110
2 100 10 120 110 11 121
3 100 10 130 121 12.1 133.1

10 100 10 200 235.79 23.6 259.39

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 EX: TVOM

EX: Save $100 at the bank paying 10% yearly

0 1 2 3
10% 100
110 121 133.1
100 * 0.1 = 10 110 * 0.1 = 11 121 * 0.1 = 12.1

Compound Interest
Simple Interest vs. Compound Interest

Simple Interest Compound Interest

Year PV INT FV PV INT FV
1 100 10 110 100 10 110
2 100 10 120 110 11 121
3 100 10 130 121 12.1 133.1

10 100 10 200 235.79 23.6 259.39

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 EX: Simple Interest vs. Compound Interest
0 1 2 3
100
10% 110 120 130
simple
100 * 0.1 = 10 100 * 0.1 = 10 100 * 0.1 = 10

0 1 2 3
100
10% 110 121 133.1
comp
100 * 0.1 = 10 100 * 0.1 = 10 100 * 0.1 = 10
10 * 0.1 = 1 21 * 0.1 = 2.1
= 11 = 12.1
Future Value
 Future Value (FV)
• FV = Value at specific time in the future
Compounding CFs
• Process of going from today value to FV

FV = PV ( 1 + i.) n FV = PV (FVIF i., n)

0 i. = 10% 1

100 FV = ?
Compounding CFs 110

21
1.5%22
 FV = PV ( 1 + i.) n FV = PV (FVIF i., n)

Time Compounded (Same int) Interest (Same time)

• Longer time  Higher FV • Higher int  Higher FV
• Less time  Lower FV • Lower int  Lower FV

100 (1.10)3 = 133.1 100 (1.10)5 = 161.05

10% 0 1 2 3 4 5

15% 100
100 (1.15)3
152.09
100 (1.15)5
201.14

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 FV = PV ( 1 + i.) n FV = PV (FVIF i., n)

EX1.1: Deposit $500 today @ 6% compounded annually for 5 yrs

FV = 500 (1.06)5 FV = 500 (FVIF 6%,5)

FV = 500 (1.3382) FV = 500 (1.3382)
FV = 669.10 FV = 669.10
0 1 2 3 4 5

6%
500

FV5=?

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 Checkpoint 2

Calculating Future Value of a Cash Flow

• You are put in charge of managing your firm’s working capital.
Your firm has $100,000 in extra cash on hand and decides to put it
in a savings account paying 7% interest compounded annually.
• How much will you have in your account in 10 years?

(1a)
FIGURE 9.1 Future Value, Interest Rate, and Time
Period Relationships
 FV = PV ( 1 + i.) n FV = PV (FVIF i., n)

EX1.2: Deposit $500 today @ 6%compounded quarterly for 5 years

FV = 500 (1.015)20 FV = 500 (FVIF 1.5%,20)
FV = 500 (1.3469) FV = 500 (1.3469)
FV = 673.45 FV = 673.45
0 1 2 3 4 5

6% 500
PV (1 + i.)n FV5 =???

Int = 6% / 4 = 1.5% n = 5 * 4 = 20

30
More Frequent Compounding
or Discounting Interest
 More Frequent Compound or Discount
• Make 2 Adjustments : (1) Int = i. / m
(2) n = n * m
where, m = number of periods per year

EX: Interest = 5%, n = 5 years

Interest: i. / m Periods: n * m
• Yearly m=1 5% / 1 = 5% 5*1 =5
• Semi m=2 5% / 2 = 2.5% 5*2 = 10

• Quarterly m = 4 5% / 4 = 1.25% 5*4 = 20

• Monthly m = 12 5% / 12 = 0.42% 5 * 12 = 60

• Daily m = 365 5% / 365 = 0.01% 5 * 365 = 1,825

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 Checkpoint 3
Calculating Future Values Using Non-Annual Compounding Periods
• You have been put in charge of managing your firm’s cash position
and noticed that Plaza National Bank of Portland, Oregon, has recently
decided to begin paying interest compounded semi-annually instead
of annually.
• If you deposit $1,000 with the bank at an interest rate of 12%, what will
your account balance be in five years?
Present Value
 Present Value (PV)
• PV = Value today of a future payment
Discounting CFs
• How much you need to invest today (PV) in order
to have a certain amount of $$ in the future

PV = FV / ( 1 + i.) n
0 i. = 10% 5

PV = FV * 1 100M
PV = ?
(1 + i.)n Discounting CFs

PV = FV (PVIF i., n)
PV

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 PV = FV * 1
PV = FV / ( 1 + i.) n PV = FV (PVIF i., n)
(1 + i.)n

Time Discounted (Same int) Interest (Same time)

• Longer time  Lower PV • Higher int  Lower PV
• Less time  Higher PV • Lower int  Higher PV

0 1 2 3 4 5

5%
127.63 127.63
127.63 / (1.05)3
110.25
127.63 / (1.05)5
100

63.45 127.63 / (1.15)5 15%

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FIGURE 9.2 Present Value, Interest Rate, and Time
Period Relationships
 PV = FV * 1
PV = FV / ( 1 + i.)n PV = FV (PVIF i., n)
(1 + i.)n

EX2.1: Loan of $500 due in yr 5, int = 6% yearly, value today?

PV = 500 * [ 1/(1.06)5 ] PV = 500 (PVIF 6%,5)

PV = 500 * (0.7473) PV = 500 (0.7473)
PV = $373.65 PV = $373.65
0 1 2 3 4 5

6% 500
FV / (1+ i.)n
PV=?

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PV

44
 PV = FV * 1
PV = FV / ( 1 + i.)n PV = FV (PVIF i., n)
(1 + i.)n

EX2.2: Loan of $500 due in yr 5 @ i = 6% semiannually, value today?

PV = 500 * [ 1/(1.03)10 ] PV = 500 (PVIF 3%,10)

PV = 500 * (0.7441) PV = 500 (0.7441)
PV = $372.05 PV = $372.05
0 1 2 3 4 5

500
FV / (1 + i.)n
PV=?
Int = 6% / 2 = 3% n = 5 * 2 = 10

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 Checkpoint 4
Solving for Present Value of a Future Cash Flow
• Your firm has just sold a piece of property for $500,000, but
under sales agreement, it won’t receive $500,000 until ten years
from today.
• What is the present value of $500,000 to be received ten years
from today if discount rate is 6% annually?

(2)
Solving for Other Variables
 Solving for i and n

FV = PV ( 1 + i.) n PV = FV / ( 1 + i.) n

FV = PV (FVIF i., n) PV = FV (PVIF i., n)

• FV
• PV
• i. = ?
• n =?

50
 FV = PV (FVIF i.,n) PV = FV (PVIF i., n)

EX3:Borrow 50,000 and agree to payback 66,910, 5 yrs from now.

66,910 = 50,000 (FVIF i., 5) 50,000 = 66,910 (PVIF i., 5)
66,910 / 50,000 = (FVIF i., 5) 50,000 / 66,910 = (PVIF i., 5)
1.3382 = (FVIF i., 5) 0.7473 = (PVIF i., 5)
i. = 6% i. = 6%
0 1 2 3 4 5
i%
50,000

66,910

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4 3
53
PV

4 54 3
 FV = PV (FVIF i.,n) PV = FV (PVIF i., n)

EX4:The security will provide a return of 4% yearly that it will

cost $950 and you will receive $1,068.62 at the maturity.

1,068.62 = 950 (FVIF 4%, n) 950 = 1,068.62 (PVIF 4%, n)

1,068.62 / 950 = (FVIF 4%, n) 950 / 1,068.62 = (PVIF 4%, n)
1.1249 = (FVIF 4%, n) 0.8890 = (PVIF 4%, n)
n = 3 years n = 3 years

0 1 2 n =?
4%
950
1,068.62

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 Checkpoint 5

Solving for Number of Periods (n)

• Let’s assume that Toyota Corporation has guaranteed that
price of a new Prius car will always be $20,000, and you’d like to
buy one but currently have only $7,752.
• How many years will it take for your initial investment of $7,752
to grow to $20,000 if it is invested so that it earns 9%
compounded annually?

(1a)
 Checkpoint 6
Solving for Interest Rate (i)
• Let’s go back to Prius example in Checkpoint 5. Recall that Prius
car always costs $20,000.
• In 10 years, you’d really like to have $20,000 to buy a new Prius,
but you only have $11,167 now.
• At what rate must your $11,167 be compounded annually for it
to grow to $20,000 in 10 years?

(1a)
Rule of 72
 Rule of 72
Investors often ask, “How long will it take for my money to
double in value at a particular INT rate?”

• A shortcut method referred to as Rule of 72

What:
• Can be used to approximate the time required for an
investment to double in value

• Formula: 72 / Interest Rate = _______ years

EX: Rule of 72
If interest rate is 8 percent, how long will it take the
investment to be double in value?
• Answer: 72 / 8 = 9 years

At an interest rate of 10 percent:

• Answer: 72 / 10 = 7.2 years
• Earn higher interest
• Take less time to double in value
Making Interest Rate Comparable
 Making Interest Rate Comparable

If INT is compounded differently (e.g. annually, quarterly,…), it is

difficult to determine:
• How much will you earn from investment?

• How much will you pay for the loan?

Need to compare INV/loan with different compounding INT:

• INV: 8% compounded annually vs 8% compounded quarterly

• Loan: 8.084% compounded annually vs 7.85% compounded quarterly

How: Need to find “Annual Percentage Rate (APR)”.

65
 Annual Percentage Rate (APR)

• What: Annual (simple) interest rate without taking

compounding into consideration.
• Called also nominal (stated / quoted) interest rate
• For investors, APR is annual return earned on investment.
• EX: Deposits, investment in debt instruments

• For borrowers, APR is annual cost charged on funds/loans.

• EX: Credit card, car loans, mortgages

Formula:

APR = Interest Rate per period * Compounding Periods per year

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 Annual Percentage Rate (APR)

Formula:

APR = Interest Rate per period * Compounding Periods per year

EX 1.1: If a credit card charges interest 1% per month, APR?

• Compounding period per year = 12
• APR = 1% per month * 12 = 12%

EX 2.1: If a credit card charge interest 0.06273% daily, APR?

• Compounding period per year = 365
• APR = 0.06273% per day * 365 = 22.896%  22.9%

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 Effective Annual Rate (EAR)

• What: Annual interest rate that takes compounding into

consideration
• INV: Investors receive per year (e.g. interest from investment)
• Loan: Borrowers pay per year (e.g. interest on loans/debts)
• It reflects the true cost / return
Formula:
m Benefits:
APR
EAR = 1 + −1 To compare deposit rate / loan rate
m

m = Number of compounding periods per year

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 m
APR
EX 1.2 and 2.2: EAR EAR = 1 +
m
−1

APR = Interest Rate per period * Compounding Periods per year

EX 1.1: APR = 12% EX 2.1: APR = 22.9%

EX 1.2: EAR =? EX 2.2: EAR =?
𝟏𝟐 𝟑𝟔𝟓
0.12 0.𝟐𝟐𝟗
EAR = 1 + −1 EAR = 1 + −1
12 365

EAR = 12.68% EAR = 25.73%

• If you carry your balance for a year, • If you carry your balance for a
effective INT (EAR) = 12.68% as a result year, effective INT (EAR) = 25.73%
of compounding INT monthly. as a result of compounding INT
each day.

69
 m
APR
EX 3: EAR EAR = 1 +
m
−1

A 1-year Loan with 8.084% compounded annually (loan 1) vs

7.85% compounded quarterly (loan 2).
• To compare 2 loans, we need to convert them to the same number of
compounding periods (e.g. annual)

• APR = 7.85% quoted annually but compounded quarterly

• m =4
• EAR = [ 1 + (7.85% / 4) ]4 – 1
• EAR = 0.08084 = 8.084%
Which loan will you choose?
• You are indifferent between 2 choices of loans.
• Reason: Pay the same effective interest (EAR) at 8.084%.

70
 m
APR
EX 4: EAR EAR = 1 +
m
−1

• 1-year INV A pays 10% interest, compounded monthly.

• 1-year INV B pays 10.1% compounded semi-annually.
• Which investment is better?

• INV A: ( 1 + (10% / 12)) 12 – 1 = 10.47%

• INV B: ( 1 + (10.1% / 2)) 2 –1 = 10.36%

• INV A is better
• Reason: Earning more interest (EAR)
• INV B has a higher stated nominal interest rate (10.1%) than B.
• But, EAR of INV B (10.36%) is lower than EAR of INV A (10.47%).
• Reason: INV B compounds fewer times over the year.
 m
APR
EX 5: EAR EAR = 1 +
m
−1

• 1-year loan A pays 10% interest, compounded monthly.

• 1-year loan B pays 10.1% compounded semi-annually.
• Which loan is the better offer?
• Loan A: ( 1 + (10% / 12)) 12 – 1 = 10.47%
• Loan B: ( 1 + (10.1% / 2)) 2 – 1 = 10.36%

• Loan B is cheaper
• Reason: paying lower interest (EAR)
• Loan B has a higher stated nominal interest rate (10.1%) than A.
• But, EAR of loan B (10.36%) is lower than EAR of loan A (10.47%).
• Reason: Loan B compounds fewer times over the year.
 m
APR
EX 6: EAR EAR = 1 +
m
−1

Savings rate (APR) @10% per year with different compounding period  EAR = ?

(B) * (C)
* = =(1 + C4)^B4–1 =(1 + 10%)1 – 1

* =
* =
* = =(1 + C7)^B7–1 =(1 + 0.833%)12 – 1

* =
* =

APR = INT per period * Periods per year

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 EX 7: EAR EAR = 1 +
APR
m
−1
APR = Interest Rate per period * Compounding Periods per year m

A 2-year loan of $100,000 with monthly compounding requires you to

make one payment at the maturity of $126,973.
Find quoted interest on the loan  EAR?

126,933 = 100,000 (FVIF i./12, 2*12)

• INT = 1% per month
• APR = 1% * 12 = 12% per year

1%
? =RATE(nper, pmt, pv, fv) EAR = (1 + 12%/12)12 – 1
?
12% =RATE(24, 0, 100,000, -126,973) EAR = (1 + B7/B5)^B5 - 1
?
12.68%
=RATE(B4 * B5, 0, B3, B2) EAR = 12.68%

74
 m
APR
EX 8: EAR EAR = 1 +
m
−1

A 2-year loan of $100,000 requires you to make one payment at the

maturity of $126,973. Find quoted interest on the loan  EAR?
126,933 = 100,000 (FVIF i., 2)
1.2697 = (FVIF i., 2)

FVIF 12%, 2 = 1.2544

X B A
Y FVIF i., 2 = 1.2697
FVIF 13%, 2 = 1.2769

i.– 12% = 1.2697 – 1.2544

𝟎.𝟏𝟐𝟔𝟖 𝟏
13% - 12% 1.2796 – 1.2544 𝐄𝐀𝐑 = 𝟏 + 𝟏 -1
i. – 12% = 0.0153 = 0.68
0.0225
i. = 0.68 + 12% = 12.68%  EAR
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 Conclusion
• If interest rate is compounded differently
(e.g. annually, quarterly,…),
• Find APR APR = Interest Rate per period * Compounding Periods per year

m
• Find EAR EAR = 1 +
APR
−1
m
 EX: EAR

https://corporatefinanceinstitute.com/resources/knowledge/finance/effective-annual-interest-rate-ear/
 Checkpoint 7
Calculating EAR (Effective Annual Rate)
• Assume that you just received your first credit card statement
and APR (Annual Percentage Rate) listed on the statement is
21.7%.
• When you look closer you notice that interest is compounded
daily. What is EAR (Effective Annual Rate) on your credit card?

(4)
Exercises
 EX 1: Robin invests $5,000 at 12% interest compounded
annually. How much will he have after 5 years?

• FV = PV (1+ i.)n • FV = PV (FVIF i.,n)

• FV = 5,000 (1.12)5 • FV = 5,000 (FVIF 12%, 5)
• FV = 5,000 (1.7623) • FV = 5,000 (1.7623)

• FV = 8,811.5 • FV = 8,811.5

• FV = 5,000 (1.12)5
• FV = 8,811.71
 EX 2: Sara wants to have $300,000, 15 years from now.
How much should she invest now if she supposes to
receive an interest rate of 18% per year?

• PV = FV * [ 1 / (1 + i.)n ] • PV = FV (PVIF i.,n)

• PV = 300,000*[ 1 / (1.18)15 ] • PV = 300,000 (PVIF18%,15)
• PV = 300,000 * (0.0835) • PV = 300,000 (0.0835)
• PV = 25,050 • PV = 25,050

• PV = FV / (1 + i.) n
• PV = 300,000 / (1.18)15
• PV = 25,054.81
The End 