Lecture 3: Time Value of Money and DCF Valuation

BUS 718A: Managerial Finance

Prof. Emmanuel N. Gyam…

engyam…@gimpa.edu.gh

GIMPA Business School

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 1 / 72

Learning Objectives

At the end of this session, you should be able to:

Describe the basic mechanics of the time value of money

Future Value and Compounding

Present Value and Discounting

More about Present and Future Values

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 2 / 72

Time and Money
The single most important skill for a student to learn in this course is
the manipulation of money through time.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 3 / 72

Time and Money...con’t
We will use the time line to visually represent items over time. Let’s
start with fruit. . . .. yes, fruit!

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 4 / 72

Time and Money...con’t

If I gave you apples, one per year, then you can easily conclude that I
have given you a total of three apples.
Visually this would look like:

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 5 / 72

Time and Money...con’t
But money doesn’t work this way.
If I gave you $100 each year, how much would you have, in total?
$300, right?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 6 / 72

Time and Money...con’t
But money doesn’t work this way.
If I gave you $100 each year, how much would you have, in total?
$300, right?
NO

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 6 / 72

Time and Money...con’t

The di¤erence between money and fruit is that money can work for you
over time, earning interest.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 7 / 72

Time and Money...con’t

Which would you rather receive: A or B?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 8 / 72

Time and Money...con’t

A is better because you get all of the $300 today instead of having to wait
two years.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 9 / 72

Time and Money...con’t

Receiving money one year from now, or two years from now, is di¤erent
than getting all the money today.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 10 / 72

Time and Money...con’t

So going back to the fruit analogy, receiving money over time is like
receiving di¤erent fruits over time.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 11 / 72

Time and Money...con’t

And you don’t mix fruits in …nance!

Thus every time you see money spread out over time, you must think
of the money as di¤erent; you can’t just add it up!

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 12 / 72

Time and Money...con’t

Money received over time is not equal in value.

So how do we “value” future money?
That’s the $64,000 question!

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 13 / 72

Basic De…nitions

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 or required rate of return

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 14 / 72

Time value of money

Important distinctions to note

Present value vs. Future value

Simple vs. Compound interest

E¤ective vs. Nominal rates

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 15 / 72

Present Value of a Single Sum

Present Value
FV
PV =
(1 + r )n
where PV is the present value, FV is the future value r the discount
rate and n is period in years.

(1 + r )n is the present value discount factor

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 16 / 72

Present Value of a Single Sum...con’t

For a given interest rate – the longer the time period, the lower the
present value.

For a given time period – the higher the interest rate, the smaller the
present value.

When we talk about “discounting”, we mean …nding the present value

of some future amount.

When we talk about the “value” of something, we are talking about

the present value unless we speci…cally indicate that we want the
future value.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 17 / 72

Present Value of a Single Sum...con’t

Example 1

Problem
A business owner wishes to replace her machinery in 5 years time and
would like to invest an amount today that will earn interest at 8% p.a.
compounded annually. How much must she set aside today if the
projected cost in 5 years time is c/450,000?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 18 / 72

Present Value of a Single Sum...con’t

Solution

FV
PV =
(1 + r )n

450, 000
PV =
(1 + 0.08)5
450, 000
PV =
1.4693

PV = 306, 268

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 19 / 72

Present Value of a Single Sum...con’t

Example 2

Problem
Your parents set up a trust fund for you 10 years ago that is now worth
c/19,672. If the fund earned 7% per year, how much did they set aside?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 20 / 72

Present Value of a Single Sum...con’t

Solution

FV
PV =
(1 + r )n

19, 672
PV =
(1 + 0.07)10
19, 672
PV =
1.9672

PV= 10, 000

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 21 / 72

Future Value of a Single Sum

Future Value
FV = (1 + r )n PV
where all the notations are as before

(1 + r )n is called the the future value interest factor

Finance uses “compounding” as the verb for going into the future and
“discounting” as the verb to bring funds into the present.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 22 / 72

Future Value of a Single Sum...con’t

Example 1

Problem
A college student recently received a c/40,000 gift from her grandparents
and has decided to invest the amount in a fund that earns 7.5% interest
compounded yearly. How much can she expect to receive after 10 years?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 23 / 72

Future Value of a Single Sum...con’t

Solution

FV = (1 + r )n PV

FV = (1 + 0.075)10 40, 000

FV = 2.0610 40, 000

FV = 82, 440

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 24 / 72

Future Value of a Single Sum...con’t

Example 2

Problem
Suppose you had a relative deposit c/10 at 5.5% 200 years ago? How
much will you have today?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 25 / 72

Time value of money...con’t
Future Value of a Single Sum...con’t

Solution

FV = (1 + r )n PV

FV = (1 + 0.055)200 10

FV = 44, 719 10

FV = 447, 190

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 26 / 72

Calculating Compound or Discount Growth Rate

Given the Future Value(FV) and Present Value (PV), as well as the
number of periods, the rate of compounding or discounting can be derived
as follows:

1/n
FV
r= 1
PV

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 27 / 72

Calculating Compound or Discount Growth Rate...con’t

Example

Problem
If you invested c/35,000 at one point in time and received c/60,000 after 5
years, what annual rate of interest (or growth rate) would you have
obtained?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 28 / 72

Calculating Compound or Discount Growth Rate...con’t

Solution
1/n
FV
r= 1
PV
1/5
60, 000
r= 1
35, 000

r = (1.7143)1/5 1

r = 1.1138 1

r = 0.1138 = 11.38%

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 29 / 72

Calculating ’n’(number of periods)

Given the Future Value(FV) and Present Value (PV), as well as the
rate of compounding or discounting, the number of periods can be
calculated as follows:

log(FV /PV )
n=
log(1 + r )

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 30 / 72

Calculating ’n’(number of periods)...con’t

Problem
You want to purchase a new car, and you are willing to pay c/20,000. If
you can invest at 10% per year and you currently have c/15,000, how long
will it be before you have enough money to pay cash for the car?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 31 / 72

Calculating ’n’(number of periods)...con’t

Solution
log(FV /PV )
n=
log(1 + r )
log(20, 000/15, 000)
n=
log(1 + 0.1)
log(1.3333)
n=
log(1.1)

0.1249
n =
0.0414

n = 3.02

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 32 / 72

Calculating ’n’(number of periods)...con’t

Problem
How long will take c/30,000 to double in value if it grows at an annual
compound rate of 10%?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 33 / 72

Calculating ’n’(number of periods)...con’t

Solution
log(FV /PV )
n=
log(1 + r )
log(60, 000/30, 000)
n=
log(1 + 0.1)
log(2)
n=
log(1.1)

0.3010
n =
0.0414

n = 7.27

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 34 / 72

The Rule of 72

The rule of 72 relates the amount of time (n ) or the interest rate

(r ) required for a present value to double.

It is expressed as follows:

72
DT =
r
where DT is the time it takes for the initial sum to double its value
and r is rate in percent.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 35 / 72

The Rule of 72...con’t

Problem
Using the rule of 72, how long will take c/30,000 to double in value if it
grows at an annual compound rate of 10%?

Solution
72
DT =
10

DT = 7.2 years

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 36 / 72

Present Value of a Multiple Cash Flows

The concept (and formula) are identical if we simply look at the

problem as a series of single payments.

To compute the present value of future stream of cash, we just take

each year to the present, one at a time, using the same formula below

FV
PV =
(1 + r )n

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 37 / 72

Present Value of a Multiple Cash Flows

Example 1
Problem
You are considering an investment that will pay you c/1,000 in one year,
c/2,000 in two years and c/3,000 in three years. If you want to earn 10% on
your money, how much would you be willing to pay?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 38 / 72

Present Value of a Multiple Cash Flows

Solution
1000 2000 3000
PV = 1
+ 2
+
(1 + 0.1) (1 + 0.1) (1 + 0.1)3

PV = 909.09 + 1, 652.89 + 2, 253.94

PV = 4, 816

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 39 / 72

Present Value of a Multiple Cash Flows

Example 2
Problem
Your broker calls you and tells you that he has this great investment
opportunity. If you invest c/100 today, you will receive c/40 in one year and
c/75 in two years. If you require a 15% return on investments of this risk,
should you take the investment?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 40 / 72

Present Value of a Multiple Cash Flows

Solution
40 75
PV = +
(1 + 0.15)1 (1 + 0.15)2

PV = 34.78 + 56.71

PV = 91.49

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 41 / 72

Present Value of a Multiple Cash Flows

Solution
40 75
PV = +
(1 + 0.15)1 (1 + 0.15)2

PV = 34.78 + 56.71

PV = 91.49

No! – the broker is charging more than you would be willing to pay
(c/100 versus the PV of c/91.49)

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 41 / 72

Break (15 mins)

BREAK TIME

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 42 / 72

Annuities

An annuity is a …nite series of equal payments that occur at regular

intervals over a speci…ed time period.

There are two basic types of annuities.

Ordinary annuit
the cash ‡ow occurs at the end of each period.

Annuity due
the cash ‡ow occurs at the beginning of each period.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 43 / 72

The Present Value of an Ordinary Annuity

The present value of an annuity formula is as follows:

1 !
1 (1 +r )n
PV = PMT
r

where PMT is the periodic amount, r the discount rate and n is time

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 44 / 72

The Present Value of an Ordinary Annuity...con’t

Example
Problem
A tenant o¤ers to sign a lease paying a rent of c/12,000 per annum in
arrears for 5 years. What is the present value of the lease if the discount
rate is 10 p.a%?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 45 / 72

Time value of money...con’t
The Present Value of an Ordinary Annuity...con’t

Solution
1 !
1 (1 +r )n
PV = PMT
r
1 !
1 (1 +0.1 )5
PV = 12, 000
0.1

PV = 12, 000 (3.7908)

PV = 45, 490

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 46 / 72

The Present Value of an Annuity Due

This requires a little modi…cation to the previous formula as follows:

1 !
1 (1 +r )n
PV = PMT (1 + r )
r

where PMT is the periodic amount, r the discount rate and n is time

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 47 / 72

The Present Value of an Annuity Due...con’t

Example
Problem
A tenant o¤ers to sign a lease paying a rent of c/12,000 per annum in
advance for 5 years. What is the present value of the lease if the discount
rate is 10% p.a?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 48 / 72

Time value of money...con’t
The Present Value of an Ordinary Annuity...con’t

Solution
1 !
1 (1 +r )n
PV = PMT (1 + r )
r
1 !
1 (1 +0.1 )5
PV = 12, 000 (1 + 0.1)
0.1

PV = 12, 000 (1.1) (3.7908)

PV = 12, 000 4.1699

PV = 50, 039

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 49 / 72

Calculating an annuity given a Present value amount

This answers the question; what annuity (or periodic payments) will
an amount today give over a speci…ed period of time and at a given
rate of interest?

Formula is simply the inverse of present value of annuity formula

!
1 (1 +1r )n
PV = PMT
r
!
r
PMT = PV
1 (1 +1r )n

where PMT is the periodic amount, r the discount rate and n is time

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 50 / 72

Calculating an annuity given a Present value
amount...con’t

Example
Problem
A couple has recently been awarded c/500,000 as a compensation for an
accident. They have decided to purchase an annuity from an insurance
company that bears interest at 6% p.a. How much can they expect to
receive every year over a 10 year period?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 51 / 72

Calculating an annuity given a Present value
amount...con’t

Solution
!
r
PMT = PV 1
1 (1 +r )n
!
0.06
PMT = 500, 000 1
1 (1 +.06 )10

0.06
PMT = 500, 000
0.4416

PMT = 500, 000 (0.1359)

PMT = 67, 950

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 52 / 72

The future value of an ordinary annuity

This answers the question; how much will a periodic equal payments
amount to over a period of time if it earns interest at a certain rate?

The formula is given as follows:

(1 + r )n 1
FV = PMT
r

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 53 / 72

The future value of an ordinary annuity...con’t

Example
Problem
In anticipation of his retirement in 12 years time, a business executive has
decided to set aside c/50,000 from his pro…ts at the end of every year in a
retirement fund. How much will he have in the account if he earns 9.5%
interest p.a.?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 54 / 72

The future value of an ordinary annuity...con’t

Solution
(1 + r )n 1
FV = PMT
r
!
(1 + 0.095)12 1
FV = 50, 000
0.095

1.9715
FV = 50, 000
0.095

FV = 50, 000 (20.7526)

FV = 1, 037, 630

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 55 / 72

The future value of an annuity due

The formula is given as follows:

(1 + r )n 1
FV = PMT (1 + r )
r

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 56 / 72

The future value of an annuity due...con’t

Example
Problem
In anticipation of his retirement in 12 years time, a business executive has
decided to set aside c/50,000 from his pro…ts at the beginning of every year
in a retirement fund. How much will he have in the account if he earns
9.5% interest p.a.?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 57 / 72

The future value of an annuity due...con’t

Solution
(1 + r )n 1
FV = PMT (1 + r )
r
!
(1 + 0.095)12 1
FV = 50, 000 (1 + 0.095)
0.095

1.9715
FV = 50, 000 (1.095)
0.095

FV = 50, 000 (1.095) (20.7526)

FV = 1, 136, 205

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 58 / 72

Perpetuities

Perpetuity means in…nite series of equal payments

The formula for calculating the Present Value of a perpetuity is

PMT
PV =
r

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Perpetuities...con’t

Example
Problem
Abigail decides to take a life assurance policy with her husband as the
bene…ciary. If she decides to pay c/1,000 every year forever, what is the
present value of that annuity if her required rate of return is 5% p.a.?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 60 / 72

Perpetuities...con’t

Solution
PMT
PV =
r

1, 000
PV =
0.05

PV = 20, 000

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Time value of money...con’t
Compounding at less than Yearly intervals

For monthly, quarterly or semi-annual intervals, modify the formulas

by dividing the interest rate by 12, 4 or 2 respectively and then
multiply n (in years) by these same numbers.

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 62 / 72

Compounding at less than Yearly Intervals...con’t

Example

Problem
A tenant o¤ers to sign a lease paying a rent of c/1,000 per month in
arrears for 5 years. What is the present value of the lease if the discount
rate is 10 p.a%?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 63 / 72

Compounding at less than Yearly Intervals...con’t

Solution
PMT = 1, 000 n=5 12 = 60 r = 0.1/12 = 0.0083
1 !
1 (1 +0.0083 )60
PV = PMT
0.0083

1 !
1 (1 +0.0083 )60
PV = 1, 000
0.0083

0.3910
PV = 1, 000
0.0083
PV = 1, 000 (47.1084)
PV = 47, 108

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 64 / 72

Compounding at less than Yearly Intervals...con’t

Example

Problem
A tenant o¤ers to sign a lease paying a rent of c/3,000 per quarter in
arrears for 5 years. What is the present value of the lease if the discount
rate is 10 p.a%?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 65 / 72

Compounding at less than Yearly Intervals...con’t

Solution
PMT = 3, 000 n=5 4 = 20 r = 0.1/4 = 0.025
1 !
1 (1 +0.025 )20
PV = PMT
0.025

1 !
1 (1 +0.025 )20
PV = 3, 000
0.025

0.3897
PV = 3, 000
0.025
PV = 3, 000 (15.588)
PV = 46, 764

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 66 / 72

Compounding at less than Yearly Intervals...con’t

The higher the frequency of compounding, the higher the present

value, all other things being equal.

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Time value of money...con’t
Other Useful Formulas

Continuous Compounding

FV = PV e rn
E¤ective Annual Rate (EAR)
r m
EAR = 1 + 1
m
Sinking Fund

r
PMT = FV
(1 + r )n 1

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 68 / 72

Sinking Fund

Important distinction to note:

Annuity payment
a payment made to an investment fund each period at a …xed interest
rate.

Sinking fund payment

a payment made to an investment fund each period at a …xed interest
rate to yield a predetermined future value.

Annuity certain
an annuity paid over a guaranteed number of periods

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 69 / 72

Sinking Fund...con’t

Problem
A business owner wishes to replace her machinery in 5 years time. How
much must she set aside every year from now to meet the cost of the
machinery if the projected cost in 5 years time is c/450,000 and her
required rate of return is 8% p.a. compounded annually?

Prof. Gyam… (GIMPA Business School) Lecture 3: Time Value of Money 70 / 72

Sinking Fund...con’t

Solution
r
PMT = FV
(1 + r )n 1
!
0.08
PMT = 450, 000
(1 + 0.08)5 1

PMT = 450, 000 0.1705

PMT = 76, 725

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End...Question time

QUESTION TIME

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