Learning Goals Learning Goals (cont.

)
Chapter 5
LG1 Discuss the role of time value in finance, the use of LG4 Calculate both the future value and the present value
computational tools, and the basic patterns of cash of a mixed stream of cash flows.
Time Value of flow.
Money LG5 Understand the effect that compounding interest more
LG2 Understand the concepts of future value and present frequently than annually has on future value and the
value, their calculation for single amounts, and the effective annual rate of interest.
relationship between them.
LG6 Describe the procedures involved in (1) determining
LG3 Find the future value and the present value of both an deposits needed to accumulate a future sum, (2) loan
ordinary annuity and an annuity due, and find the amortization, (3) finding interest or growth rates, and
present value of a perpetuity. (4) finding an unknown number of periods.

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The Role of Time Value in The Role of Time Value in Future Value versus Present
Finance Finance (cont.) Value
• Most financial decisions involve costs & benefits that are • The answer depends on what rate of interest you could • Suppose a firm has an opportunity to spend $15,000 today on some
spread out over time. investment that will produce $17,000 spread out over the next five
earn on any money you receive today. years as follows:
• Time value of money allows comparison of cash flows • For example, if you could deposit the $1,000 today at Year Cash flow
from different periods. 12% per year, you would prefer to be paid today. 1 $3,000
• Question: Your father has offered to give you some 2 $5,000
money and asks that you choose one of the following two • Alternatively, if you could only earn 5% on deposited 3 $4,000
alternatives: funds, you would be better off if you chose the $1,100 in 4 $3,000
one year. 5 $2,000
– $1,000 today, or
– $1,100 one year from now. • Is this a wise investment?
• What do you do? • To make the right investment decision, managers need to compare
the cash flows at a single point in time.
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Figure 5.1 Figure 5.2 Figure 5.3

Time Line Compounding and Discounting Calculator Keys

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 Future Value of a Single
Computational Tools (cont.) Basic Patterns of Cash Flow
Amount
Electronic spreadsheets: • The cash inflows and outflows of a firm can be described by its • Future value is the value at a given future date of an
general pattern. amount placed on deposit today and earning interest at a
– Like financial calculators, electronic spreadsheets have built-in
routines that simplify time value calculations. • The three basic patterns include a single amount, an annuity, or a specified rate. Found by applying compound interest over
mixed stream: a specified period of time.
– The value for each variable is entered in a cell in the
spreadsheet, and the calculation is programmed using an • Compound interest is interest that is earned on a given
equation that links the individual cells. deposit and has become part of the principal at the end of
– Changing any of the input variables automatically changes the a specified period.
solution as a result of the equation linking the cells.
• Principal is the amount of money on which interest is
paid.

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Future Value of a Single Amount: Future Value of a Single Amount:

Personal Finance Example The Equation for Future Value The Equation for Future Value
If Fred Moreno places $100 in a savings account paying 8% • We use the following notation for the various inputs: Jane Farber places $800 in a savings account paying 6% interest
interest compounded annually, how much will he have at the – FVn = future value at the end of period n compounded annually. She wants to know how much money will be in
end of 1 year? the account at the end of five years.
– PV = initial principal, or present value
Future value at end of year 1 = $100  (1 + 0.08) = $108 – r = annual rate of interest paid. (Note: On financial calculators, I is typically FV5 = $800  (1 + 0.06)5 = $800  (1.33823) = $1,070.58
used to represent this rate.)
If Fred were to leave this money in the account for another This analysis can be depicted on a time line as follows:
– n = number of periods (typically years) that the money is left on deposit
year, how much would he have at the end of the second
year? • The general equation for the future value at the end of period n is
Future value at end of year 2 = $100  (1 + 0.08)  (1 + 0.08) FVn = PV  (1 + r)n
= $116.64

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Figure 5.4 Present Value of a Single

Personal Finance Example
Future Value Relationship Amount
• Present value is the current dollar value of a future amount—the
amount of money that would have to be invested today at a given
interest rate over a specified period to equal the future amount.
• It is based on the idea that a dollar today is worth more than a dollar
tomorrow.
• Discounting cash flows is the process of finding present values;
the inverse of compounding interest.
• The discount rate is often also referred to as the opportunity cost,
the discount rate, the required return, or the cost of capital.

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 Present Value of a Single Amount: Present Value of a Single Amount:
Personal Finance Example The Equation for Present Value The Equation for Future Value
Paul Shorter has an opportunity to receive $300 one year The present value, PV, of some future amount, FVn, Pam Valenti wishes to find the present value of $1,700 that will be
from now. If he can earn 6% on his investments, what is the received 8 years from now. Pam’s opportunity cost is 8%.
to be received n periods from now, assuming an
most he should pay now for this opportunity? interest rate (or opportunity cost) of r, is calculated PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46
as follows:
This analysis can be depicted on a time line as follows:
PV  (1 + 0.06) = $300

PV = $300/(1 + 0.06) = $283.02

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Figure 5.5
Personal Finance Example Annuities
Present Value Relationship
An annuity is a stream of equal periodic cash flows, over a
specified time period. These cash flows can be inflows of
returns earned on investments or outflows of funds invested
to earn future returns.
– An ordinary (deferred) annuity is an annuity for which the
cash flow occurs at the end of each period
– An annuity due is an annuity for which the cash flow occurs at
the beginning of each period.
– An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound for
an additional period.

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Table 5.1 Comparison of Ordinary Annuity and Finding the Future Value of an
Personal Finance Example Annuity Due Cash Flows ($1,000, 5 Years) Ordinary Annuity
Fran Abrams is choosing which of two annuities to receive. • You can calculate the future value of an ordinary annuity
Both are 5-year $1,000 annuities; annuity A is an ordinary that pays an annual cash flow equal to CF by using the
annuity, and annuity B is an annuity due. Fran has listed the following equation:
cash flows for both annuities as shown in Table 5.1 on the
following slide.

Note that the amount of both annuities total $5,000.

• As before, in this equation r represents the interest rate
and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).

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 Personal Finance Example Finding the Present Value of an
Personal Finance Example
(cont.) Ordinary Annuity
Fran Abrams wishes to determine how much money she will have at the end • You can calculate the present value of an ordinary annuity
of 5 years if he chooses annuity A, the ordinary annuity and it earns 7% that pays an annual cash flow equal to CF by using the
annually. Annuity A is depicted graphically below: following equation:

This analysis can be depicted on a time line as follows:

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).

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Finding the Present Value of an Table 5.2 Long Method for Finding the Finding the Present Value of an
Ordinary Annuity (cont.) Present Value of an Ordinary Annuity Ordinary Annuity (cont.)
Braden Company, a small producer of plastic toys, wants to determine the
most it should pay to purchase a particular annuity. The annuity consists of
cash flows of $700 at the end of each year for 5 years. The required return is
8%.

This analysis can be depicted on a time line as follows:

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Finding the Future Value of an Personal Finance Example

Personal Finance Example
Annuity Due (cont.)
• You can calculate the present value of an annuity due that Fran Abrams now wishes to
pays an annual cash flow equal to CF by using the calculate the future value of an
annuity due for annuity B in
following equation: Table 5.1. Recall that annuity B
was a 5 period annuity with the
first annuity beginning
immediately.
Note: Before using your calculator
to find the future value of an
• As before, in this equation r represents the interest rate annuity due, depending on the
and n represents the number of payments in the annuity specific calculator, you must either
(or equivalently, the number of years over which the switch it to BEGIN mode or use the
annuity is spread). DUE key.

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 Finding the Present Value of an Finding the Present Value of an
Matter of Fact
Annuity Due Annuity Due (cont.)
• You can calculate the present value of an ordinary annuity Kansas truck driver, Donald Damon, got the surprise of his life when
that pays an annual cash flow equal to CF by using the he learned he held the winning ticket for the Powerball lottery drawing
following equation: held November 11, 2009. The advertised lottery jackpot was $96.6
million. Damon could have chosen to collect his prize in 30 annual
payments of $3,220,000 (30  $3.22 million = $96.6 million), but
instead he elected to accept a lump sum payment of $48,367,329.08,
roughly half the stated jackpot total.

• As before, in this equation r represents the interest rate

and n represents the number of payments in the annuity
(or equivalently, the number of years over which the
annuity is spread).

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Finding the Present Value of a

Personal Finance Example Future Value of a Mixed Stream
Perpetuity
• A perpetuity is an annuity with an infinite life, providing Ross Clark wishes to endow a chair in finance at his alma Shrell Industries, a cabinet manufacturer, expects to receive
continual annual cash flow. mater. The university indicated that it requires $200,000 per the following mixed stream of cash flows over the next 5
• If a perpetuity pays an annual cash flow of CF, starting year to support the chair, and the endowment would earn years from one of its small customers.
one year from now, the present value of the cash flow 10% per year. To determine the amount Ross must give the
stream is university to fund the chair, we must determine the present
value of a $200,000 perpetuity discounted at 10%.
PV = CF ÷ r
PV = $200,000 ÷ 0.10 = $2,000,000

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Future Value of a Mixed Stream Present Value of a Mixed

Future Value of a Mixed Stream
(cont.) Stream
If the firm expects to earn at least 8% on its investments, how much Frey Company, a shoe manufacturer, has been offered an opportunity
will it accumulate by the end of year 5 if it immediately invests these to receive the following mixed stream of cash flows over the next 5
cash flows when they are received? years.
This situation is depicted on the following time line.

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 Present Value of a Mixed Present Value of a Mixed Compounding Interest More
Stream Stream (cont.) Frequently Than Annually
If the firm must earn at least 9% on its investments, what is • Compounding more frequently than once a year results in
the most it should pay for this opportunity? a higher effective interest rate because you are earning on
This situation is depicted on the following time line. interest on interest more frequently.
• As a result, the effective interest rate is greater than the
nominal (annual) interest rate.
• Furthermore, the effective rate of interest will increase the
more frequently interest is compounded.

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Table 5.3 Future Value from Investing $100 at Table 5.4 Future Value from Investing $100 at Table 5.5 Future Value from Investing $100 at
8% Interest Compounded Semiannually over 24 8% Interest Compounded Quarterly over 24 8% Interest Compounded Quarterly over 24
Months (2 Years) Months (2 Years) Months (2 Years)

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Compounding Interest More Compounding Interest More Compounding Interest More

Frequently Than Annually (cont.) Frequently Than Annually (cont.) Frequently Than Annually (cont.)
A general equation for compounding more frequently than annually

Recalculate the example for the Fred Moreno example assuming (1)
semiannual compounding and (2) quarterly compounding.

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 Personal Finance Example
Continuous Compounding Personal Finance Example
(cont.)
• Continuous compounding involves the compounding of Find the value at the end of 2 years (n = 2) of Fred Moreno’s
interest an infinite number of times per year at intervals of $100 deposit (PV = $100) in an account paying 8% annual
microseconds. interest (r = 0.08) compounded continuously.
• A general equation for continuous compounding
FV2 (continuous compounding) = $100  e0.08  2
= $100  2.71830.16
where e is the exponential function. = $100  1.1735 = $117.35

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Nominal and Effective Annual

Personal Finance Example Focus on Ethics
Rates of Interest
• The nominal (stated) annual rate is the contractual annual rate of Fred Moreno wishes to find the effective annual rate How Fair Is “Check Into Cash”?
interest charged by a lender or promised by a borrower. associated with an 8% nominal annual rate (r = 0.08) when – There are more than 1,100 Check Into Cash centers among an estimated
• The effective (true) annual rate (EAR) is the annual rate of 22,000 payday-advance lenders in the United States.
interest is compounded (1) annually (m = 1); (2)
interest actually paid or earned. semiannually (m = 2); and (3) quarterly (m = 4). – A payday loan is a small, unsecured, short-term loan ranging from $100 to
$1,000 (depending upon the state) offered by a payday lender.
• In general, the effective rate > nominal rate whenever compounding
– A borrower who rolled over an initial $100 loan for the maximum of four
occurs more than once per year
times would accumulate a total of $75 in fees all within a 10-week period.
On an annualized basis, the fees would amount to a whopping 391%.
– The 391% mentioned above is an annual nominal rate [15%  (365/14)].
Should the 2-week rate (15%) be compounded to calculate the effective
annual interest rate?

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Special Applications of Time Value: Deposits Special Applications of Time

Needed to Accumulate a Future Sum Personal Finance Example
Value: Loan Amortization
The following equation calculates the annual cash payment (CF) that • Loan amortization is the determination of the equal
we’d have to save to achieve a future value (FVn): periodic loan payments necessary to provide a lender with
a specified interest return and to repay the loan principal
over a specified period.
• The loan amortization process involves finding the future
Suppose you want to buy a house 5 years from now, and you estimate
payments, over the term of the loan, whose present value
that an initial down payment of $30,000 will be required at that time.
at the loan interest rate equals the amount of initial
To accumulate the $30,000, you will wish to make equal annual end-
of-year deposits into an account paying annual interest of 6 percent.
principal borrowed.
• A loan amortization schedule is a schedule of equal
payments to repay a loan. It shows the allocation of each
loan payment to interest and principal.
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 Table 5.6 Loan Amortization Schedule
Special Applications of Time Value:
Loan Amortization (cont.)
Personal Finance Example ($6,000 Principal, 10% Interest, 4-Year
Repayment Period)

• The following equation calculates the equal periodic loan payments

(CF) necessary to provide a lender with a specified interest return
and to repay the loan principal (PV) over a specified period:

• Say you borrow $6,000 at 10 percent and agree to make equal

annual end-of-year payments over 4 years. To find the size of the
payments, the lender determines the amount of a 4-year annuity
discounted at 10 percent that has a present value of $6,000.

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Personal Finance Example Special Applications of Time Value:

Focus on Practice Finding Interest or Growth Rates
(cont.)
New Century Brings Trouble for Subprime Mortgages • It is often necessary to calculate the compound annual
• In 2006, some $300 billion worth of adjustable ARMs were reset to interest or growth rate (that is, the annual rate of change
higher rates. in values) of a series of cash flows.
• In a market with rising home values, a borrower has the option to
refinance their mortgage, using some of the equity created by the • The following equation is used to find the interest rate (or
home’s increasing value to reduce the mortgage payment. growth rate) representing the increase in value of some
• But after 2006, home prices started a three-year slide, so investment between two time periods.
refinancing was not an option for many subprime borrowers.
• As a reaction to problems in the subprime area, lenders tightened
lending standards. What effect do you think this had on the housing
market?

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Personal Finance Example

Personal Finance Example Personal Finance Example
(cont.)
Ray Noble purchased an investment four years ago for Jan Jacobs can borrow $2,000
$1,250. Now it is worth $1,520. What compound annual rate to be repaid in equal annual
of return has Ray earned on this investment? Plugging the end-of-year amounts of $514.14
appropriate values into Equation 5.20, we have: for the next 5 years. She wants
to find the interest rate on this
loan.
r = ($1,520 ÷ $1,250)(1/4) – 1 = 0.0501 = 5.01% per year

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 Personal Finance Example Special Applications of Time Value:
Finding an Unknown Number of Periods Personal Finance Example
(cont.)
• Sometimes it is necessary to calculate the number of time Ann Bates wishes to
periods needed to generate a given amount of cash flow determine the number of years
it will take for her initial
from an initial amount.
$1,000 deposit, earning 8%
• This simplest case is when a person wishes to determine annual interest, to grow to
the number of periods, n, it will take for an initial deposit, equal $2,500. Simply stated, at
PV, to grow to a specified future amount, FVn, given a an 8% annual rate of interest,
how many years, n, will it take
stated interest rate, r. for Ann’s $1,000, PV, to grow
to $2,500, FVn?

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Personal Finance Example Personal Finance Example

Personal Finance Example
(cont.) (cont.)
Bill Smart can borrow $25,000 at
an 11% annual interest rate; equal,
annual, end-of-year payments of
$4,800 are required. He wishes to
determine how long it will take to
fully repay the loan. In other
words, he wishes to determine
how many years, n, it will take to
repay the $25,000, 11% loan, PVn,
if the payments of $4,800 are
made at the end of each year.

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Review of Learning Goals Review of Learning Goals

Review of Learning Goals
(cont.) (cont.)
LG1 Discuss the role of time value in finance, the use of LG2 Understand the concepts of future value and present LG3 Find the future value and the present value of both an
computational tools, and the basic patterns of cash value, their calculation for single amounts, and the ordinary annuity and an annuity due, and find the
flow. relationship between them. present value of a perpetuity.
– Future value (FV) relies on compound interest to measure
– Financial managers and investors use time-value-of-money – The future or present value of an ordinary annuity can be
future amounts: The initial principal or deposit in one
techniques when assessing the value of expected cash flow period, along with the interest earned on it, becomes the found by using algebraic equations, a financial calculator,
streams. Alternatives can be assessed by either beginning principal of the following period. or a spreadsheet program. The value of an annuity due is
compounding to find future value or discounting to find always r% greater than the value of an identical annuity.
– The present value (PV) of a future amount is the amount of
present value. Financial managers rely primarily on present The present value of a perpetuity—an infinite-lived
money today that is equivalent to the given future amount,
value techniques. The cash flow of a firm can be described considering the return that can be earned. Present value is annuity—is found using 1 divided by the discount rate to
by its pattern—single amount, annuity, or mixed stream. the inverse of future value. represent the present value interest factor.

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 Review of Learning Goals Review of Learning Goals Review of Learning Goals
(cont.) (cont.) (cont.)
LG4 Calculate both the future value and the present value LG5 Understand the effect that compounding interest more LG6 Describe the procedures involved in (1) determining deposits
of a mixed stream of cash flows. frequently than annually has on future value and the needed to accumulate a future sum, (2) loan amortization, (3)
finding interest or growth rates, and (4) finding an unknown
– A mixed stream of cash flows is a stream of unequal effective annual rate of interest.
number of periods.
periodic cash flows that reflect no particular pattern. The – Interest can be compounded at intervals ranging from – (1) The periodic deposit to accumulate a given future sum can be
future value of a mixed stream of cash flows is the sum of annually to daily, and even continuously. The more often found by solving the equation for the future value of an annuity for
the future values of each individual cash flow. Similarly, interest is compounded, the larger the future amount that the annual payment. (2) A loan can be amortized into equal periodic
the present value of a mixed stream of cash flows is the sum will be accumulated, and the higher the effective, or true, payments by solving the equation for the present value of an annuity
of the present values of the individual cash flows. annual rate (EAR). for the periodic payment. (3) Interest or growth rates can be estimated
by finding the unknown interest rate in the equation for the present
value of a single amount or an annuity. (4) An unknown number of
periods can be estimated by finding the unknown number of periods
in the equation for the present value of a single amount or an annuity.

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Chapter Resources on Integrative Case: Track Integrative Case: Track

MyFinanceLab Software, Inc. Software, Inc.
• Chapter Cases Table 1: Track Software, Inc. Profit, Dividends, and Table 2: Track
Retained Earnings, 2006–2012 Software, Inc.
• Group Exercises Income Statement
• Critical Thinking Problems ($000)for the Year
Ended December
31, 2012

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Integrative Case: Track Integrative Case: Track Integrative Case: Track

Software, Inc. Software, Inc. Software, Inc.
Table 3a: Track Software, Inc. Balance Sheet ($000) Table 3b: Track Software, Inc. Balance Sheet ($000) Table 4: Track Software, Inc. Statement of Retained
Earnings ($000) for the Year Ended December 31, 2012

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 Integrative Case: Track Integrative Case: Track Integrative Case: Track
Software, Inc. Software, Inc. Software, Inc.
Table 5: Track a. Upon what financial goal does Stanley seem to be focusing? Is it d. Analyze the firm’s financial condition in 2012 as it relates to (1)
Software, Inc. the correct goal? Why or why not? liquidity, (2) activity, (3) debt, (4) profitability, and (5) market,
Could a potential agency problem exist in this firm? Explain. using the financial statements provided in Tables 2 and 3 and the
Profit, Dividends,
b. Calculate the firm’s earnings per share (EPS) for each year, ratio data included in Table 5. Be sure to evaluate the firm on
and Retained both a cross-sectional and a time-series basis.
Earnings, 2006– recognizing that the number of shares of common stock
outstanding has remained unchanged since the firm’s inception. e. What recommendation would you make to Stanley regarding
2012 Comment on the EPS performance in view of your response in hiring a new software developer? Relate your recommendation
part a. here to your responses in part a.
c. Use the financial data presented to determine Track’s operating
cash flow (OCF) and free cash flow (FCF) in 2012. Evaluate your
findings in light of Track’s current cash flow difficulties.

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Integrative Case: Track

Software, Inc.
f. Track Software paid $5,000 in dividends in 2012. Suppose an
investor approached Stanley about buying 100% of his firm. If
this investor believed that by owning the company he could
extract $5,000 per year in cash from the company in perpetuity,
what do you think the investor would be willing to pay for the
firm if the required return on this investment is 10%?
g. Suppose that you believed that the FCF generated by Track
Software in 2012 could continue forever. You are willing to buy
the company in order to receive this perpetual stream of free cash
flow. What are you willing to pay if you require a 10% return on
your investment?

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