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Time Value of Money: All Rights Reserved

Uploaded by

Anonymous f7wV1lQKR
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© © All Rights Reserved
Available Formats
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Chapter 5

Time Value of
Money

Copyright © 2012 Pearson Prentice Hall.


All rights reserved.
Learning Goals

LG1 Discuss the role of time value in finance, the use of


computational tools, and the basic patterns of cash
flow.

LG2 Understand the concepts of future value and present


value, their calculation for single amounts, and the
relationship between them.

LG3 Find the future value and the present value of both an
ordinary annuity and an annuity due, and find the
present value of a perpetuity.

© 2012 Pearson Prentice Hall. All rights reserved. 5-2


Learning Goals (cont.)

LG4 Calculate both the future value and the present value
of a mixed stream of cash flows.

LG5 Understand the effect that compounding interest more


frequently than annually has on future value and the
effective annual rate of interest.

LG6 Describe the procedures involved in (1) determining


deposits needed to accumulate a future sum, (2) loan
amortization, (3) finding interest or growth rates, and
(4) finding an unknown number of periods.

© 2012 Pearson Prentice Hall. All rights reserved. 5-3


The Role of Time Value in
Finance
• Most financial decisions involve costs & benefits that are
spread out over time.
• Time value of money allows comparison of cash flows
from different periods.
• Question: Your father has offered to give you some
money and asks that you choose one of the following two
alternatives:
– $1,000 today, or
– $1,100 one year from now.
• What do you do?

© 2012 Pearson Prentice Hall. All rights reserved. 5-4


The Role of Time Value in
Finance (cont.)
• The answer depends on what rate of interest you could
earn on any money you receive today.
• For example, if you could deposit the $1,000 today at
12% per year, you would prefer to be paid today.
• Alternatively, if you could only earn 5% on deposited
funds, you would be better off if you chose the $1,100 in
one year.

© 2012 Pearson Prentice Hall. All rights reserved. 5-5


Future Value versus Present
Value
• Suppose a firm has an opportunity to spend $15,000 today on some
investment that will produce $17,000 spread out over the next five
years as follows:
Year Cash flow
1 $3,000
2 $5,000
3 $4,000
4 $3,000
5 $2,000

• Is this a wise investment?


• To make the right investment decision, managers need to compare
the cash flows at a single point in time.
© 2012 Pearson Prentice Hall. All rights reserved. 5-6
Figure 5.1
Time Line

© 2012 Pearson Prentice Hall. All rights reserved. 5-7


Figure 5.2
Compounding and Discounting

© 2012 Pearson Prentice Hall. All rights reserved. 5-8


Figure 5.3
Calculator Keys

© 2012 Pearson Prentice Hall. All rights reserved. 5-9


Computational Tools (cont.)

Electronic spreadsheets:
– Like financial calculators, electronic spreadsheets have built-in
routines that simplify time value calculations.
– The value for each variable is entered in a cell in the
spreadsheet, and the calculation is programmed using an
equation that links the individual cells.
– Changing any of the input variables automatically changes the
solution as a result of the equation linking the cells.

© 2012 Pearson Prentice Hall. All rights reserved. 5-10


Basic Patterns of Cash Flow

• The cash inflows and outflows of a firm can be described by its


general pattern.
• The three basic patterns include a single amount, an annuity, or a
mixed stream:

© 2012 Pearson Prentice Hall. All rights reserved. 5-11


Future Value of a Single
Amount
• Future value is the value at a given future date of an
amount placed on deposit today and earning interest at a
specified rate. Found by applying compound interest over
a specified period of time.
• Compound interest is interest that is earned on a given
deposit and has become part of the principal at the end of
a specified period.
• Principal is the amount of money on which interest is
paid.

© 2012 Pearson Prentice Hall. All rights reserved. 5-12


Personal Finance Example

If Fred Moreno places $100 in a savings account paying 8%


interest compounded annually, how much will he have at the
end of 1 year?
Future value at end of year 1 = $100  (1 + 0.08) = $108
If Fred were to leave this money in the account for another
year, how much would he have at the end of the second
year?
Future value at end of year 2 = $100  (1 + 0.08)  (1 + 0.08)
= $116.64

© 2012 Pearson Prentice Hall. All rights reserved. 5-13


Future Value of a Single Amount:
The Equation for Future Value
• We use the following notation for the various inputs:
– FVn = future value at the end of period n
– PV = initial principal, or present value
– r = annual rate of interest paid. (Note: On financial calculators, I is typically
used to represent this rate.)
– n = number of periods (typically years) that the money is left on deposit
• The general equation for the future value at the end of period n is
FVn = PV  (1 + r)n

© 2012 Pearson Prentice Hall. All rights reserved. 5-14


Future Value of a Single Amount:
The Equation for Future Value
Jane Farber places $800 in a savings account paying 6% interest
compounded annually. She wants to know how much money will be in
the account at the end of five years.

FV5 = $800  (1 + 0.06)5 = $800  (1.33823) = $1,070.58


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

© 2012 Pearson Prentice Hall. All rights reserved. 5-15


Personal Finance Example

© 2012 Pearson Prentice Hall. All rights reserved. 5-16


Figure 5.4
Future Value Relationship

© 2012 Pearson Prentice Hall. All rights reserved. 5-17


Present Value of a Single
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.

© 2012 Pearson Prentice Hall. All rights reserved. 5-18


Personal Finance Example

Paul Shorter has an opportunity to receive $300 one year


from now. If he can earn 6% on his investments, what is the
most he should pay now for this opportunity?

PV  (1 + 0.06) = $300

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

© 2012 Pearson Prentice Hall. All rights reserved. 5-19


Present Value of a Single Amount:
The Equation for Present Value

The present value, PV, of some future amount, FVn,


to be received n periods from now, assuming an
interest rate (or opportunity cost) of r, is calculated
as follows:

© 2012 Pearson Prentice Hall. All rights reserved. 5-20


Present Value of a Single Amount:
The Equation for Future Value
Pam Valenti wishes to find the present value of $1,700 that will be
received 8 years from now. Pam’s opportunity cost is 8%.

PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46

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

© 2012 Pearson Prentice Hall. All rights reserved. 5-21


Personal Finance Example

© 2012 Pearson Prentice Hall. All rights reserved. 5-22


Figure 5.5
Present Value Relationship

© 2012 Pearson Prentice Hall. All rights reserved. 5-23

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