Taylor’s University

Dual Degree Program

Introduction
to Finance
Topic 4
Valuation of Future
Cash Flows – Time
Value of Money
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Acknowledgement Ross et al, 2011, Essentials of Corporate Finance, 7 th Ed, McGraw-Hill Companies, Inc..
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Learning Outcomes
At the end of the lesson, students should:
Be able to compute:
The future value of an investment made today
The present value of cash to be received at some
future date
The return on an investment
The number of periods that equates a present value
and a future value given an interest rate
Be able to solve time value of money problems
using:
Formulas
A financial calculator

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Topic Outline
• Future Value and Compounding
• Present Value and Discounting
• Future and Present Values of
Multiple Cash Flows
• Valuing Level Cash Flows:
Annuities and Perpetuities

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Basic Definitions
• Present Value – earlier money
• Future Value – later money
• Interest rate – “exchange rate” between
earlier money and later money
– Discount rate
– Cost of capital
– Opportunity cost of capital
– Required return
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Effects of Compounding
• Simple interest
– Interest earned only on the original
principal
• Compound interest
– Interest earned on principal and on
interest received
– “Interest on interest” – interest earned
on reinvestment of previous interest
payments
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Future Values:General Formula

• FV = PV + PVrt – simple interest
• FV = PV(1 + r)t – compound interest
– FV = future value
– PV = present value
– r = period interest rate, expressed
as a decimal
– t = number of periods
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Simple Interest – Example 1

• Suppose you invest $1,000 for one year at 5%
per year. What is the future value in one year?
– Future Value (FV) = $1,000 + 50 = $1,050
• Suppose you leave the money in for another
year. How much will you have two years from
now?
– $1,000 + 50 + 50 = $1,100
– Or FV = PV + PVrt
= 1000 + 1000(.05*2) = $1,100
= 1000 + 100 = $1,100
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Compound Interest–Example 2
• Compound interest (interest is earned on
principal and on interest received)
• Consider the previous example
– FV with compound interest = $1,102.50
– The extra $2.50 comes from the interest
of .05($50) = $2.50 earned on the first interest
payment
– OR FV = PV(1 + r)t
= 1000 ( 1 + 0.05)2
= 1000 ( 1.05) ( 1.05)
= 1000 ( 1.1025) = 1,102.50
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Time Line

0 1 2 Year
r = 5%

-1000 1102.50
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Texas Instruments BA-II Plus

• FV = future value One of these MUST
• PV = present value be negative
• I/Y = period interest rate (r)
• N = number of periods (t)
• Remember to clear the
Registers (2ND, Reset,
Enter/CLR TVM) before
(and after) each problem
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Future Values – Example 2

• Suppose you invest $1,000 for one year at 5% per year.
What is the future value in two years?
• Using formula
 FV = $1,000(1.05)2 = $1,050(1.05)
 = $1,102.50
• Using financial calculator:
 N = 2; I/Y = 5; PV = –1000;
CPT FV = 1,102.50
**Sign Convention in Calculator:
FV – $1,000(1.05)2 = 0
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Future Values – Example 3

Suppose you had a relative deposit $10 at 5.5%
interest 200 years ago. How much would the
investment be worth today?

Formula Solution: Calculator Solution:

200 N
FV = PV(1+r)t
5.5 I/Y
= 10(1.055)200 -10 PV
0 PMT
=10(44718.984)
CPT FV =
=447,189.84 447,189.84
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Present Values

• Present Value = the current value of

an amount to be received in the future
• Why is it worth less than face value?
– Opportunity cost
– Risk & Uncertainty
Discount Rate = (time, risk)
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Present Values
FV = PV(1 + r)t
• Rearrange to solve for PV

PV = FV / (1+r)t
PV = FV(1+r)-t

• “Discounting” = finding the present value of

one or more future amounts.
Return
to Quiz
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PV – One-Period Example
• Suppose you need $10,000 in one year for
the down payment on a new car. If you can
earn 7% annually, how much do you need to
invest today?
• PV = $10,000 / (1.07)1 = $9,345.79
• Using Financial Calculator
 N = 1 I/Y = 7 FV = 10,000 PMT = 0
 CPT PV = – 9,345.79
** 0 = – PV + $10,000 / (1.07)1
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Present Values – Example 2

• You want to begin saving for your
daughter’s college education and you
estimate that she will need $150,000 in
17 years. If you feel confident that you
can earn 8% per year, how much do you
need to invest today?
 PV = $150,000 / (1.08)17 = $40,540.34
 N = 17; I/Y = 8; FV = 150000;
CPT PV = – 40,540.34
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PV – Important Relationship I
• For a given interest rate – the longer the
time period, the lower the present value
(ceteris paribus: all else equal)
– What is the present value of $500 to be
received in 5 years? 10 years? The discount
rate is 10%
– 5 years: PV = $500 / (1.1)5 = $310.46
– 10 years: PV = $500 / (1.1)10 = $192.77

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PV – Important Relationship II
• For a given time period – the higher the
interest rate, the smaller the present value
(ceteris paribus)
– What is the present value of $500 received in
5 years if the interest rate is 10%? 15%?
• Rate = 10%: PV
= $500 / (1.10)5 = $310.46
• Rate = 15%; PV
= $500 / (1.15)5 = $248.59
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Discount Rate
• Often, we will want to know what the
implied interest rate is in an investment
• Rearrange the basic PV equation and
solve for r
 FV = PV(1 + r)t
 r = (FV / PV)1/t – 1

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Discount Rate – Example 1

• You are looking at an investment that will pay
$1,200 in 5 years if you invest $1,000 today.
What is the implied rate of interest?
 r = ($1,200 / $1,000)1/5 – 1
= .03714 = 3.714%
 Calculator – the sign convention matters!!!
•N = 5
• PV = -1,000
• FV = 1,200
• CPT I/Y = 3.71%
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Discount Rate – Example 2

• Suppose you have a 1-year old son and you
want to provide $75,000 in 17 years toward
his college education. You currently have
$5,000 to invest. What interest rate must you
earn to have the $75,000 when you need it?
 r = ($75,000 / $5,000)1/17 – 1

= .172686 = 17.27%
 N = 17; FV = 75,000; PV = - 5,000;
CPT I/Y = 17.27%
Practice
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Finding the Number of Periods

• Start with basic equation and solve for t
(remember your logs)
 FV = PV(1 + r)t
 FV/PV =(1 + r)t
 ln(FV/PV) = t ln(1 + r)
 t = ln(FV / PV) / ln(1 + r)
• You can use the financial keys on the
calculator as well. Just remember the sign
convention.
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Number of Periods–Example 1
• You want to purchase a new car and you
are willing to pay $20,000. If you can invest
at 10% per year and you currently have
$15,000, how long will it be before you have
enough money to pay cash for the car?
 t = ln($20,000 / $15,000) / ln(1.1) =
3.02 years
 I/Y = 10; FV = 20,000; PV = - 15,000;
CPT N = 3.02 years

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Table 4.4

Revision
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Comprehensive Problem
• You have $10,000 to invest for five years.
• How much additional interest will you earn
if the investment provides a 5% annual
return, when compared to a 4.5% annual
return?
• How long will it take your $10,000 to
double in value if it earns 5% annually?
• What annual rate has been earned if
$1,000 grows into $4,000 in 20 years?
Practice
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Comprehensive Problem (Solutions)

• You have $10,000 to invest for five years.
• How much additional interest will you earn
if the investment provides a 5% annual
return, when compared to a 4.5% annual
return?
N=5
PV = -10,000
I/Y = 5%, CPT FV = 12762.82
I/Y = 4.5%, CPT FV =12461.82
Difference (Additional Interest) =301 Practice
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Comprehensive Problem (Solution)

• How long will it take your $10,000 to

double in value if it earns 5% annually?
Solution:
I/Y = 5
PV = –10,000
FV = 10,000 x 2 = 20,000
CPT N = 14.21 years
Practice
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Comprehensive Problem (Solution)

• What annual rate has been earned if

$1,000 grows into $4,000 in 20 years?
N = 20
PV = -1,000
FV = 4,000
CPT I/Y = 7.18%
1,000 r = ?% 4,000

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Practice
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Multiple Cash Flows – FV Example
• So far you have dealt with present value
of single future value or future value of
single present value
• We next explore FVs and PVs for multiple
c/flows
• Example :
– You can deposit $4k at the end of each
of the next 3 years at 8%
– You currently have $7k
– How much will you have in 3 years? 4
years?
FV ? FV ?
Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 29
$7k $4k $4k $4k
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Multiple Cash Flows – FV Example

• Find the value at year 3 of each cash flow
and add them together.
– Today (year 0): FV = $7,000(1.08)3
= $8,817.98
– Year 1: FV = $4,000(1.08)2 = $4,665.60
– Year 2: FV = $4,000(1.08) = $4,320
– Year 3: Value = $4,000
– Total value in 3 years = $8,817.98 +
4,665.60 + 4,320 + 4,000 = $21,803.58
• Value at year 4 = $21,803.58(1.08)
= $23,547.87
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Calculator: 1-31
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Today (year 0):
N = 3; I/Y = 8; PV = -7,000; CPT FV = 8,817.98
Year 1:
N = 2; I/Y = 8; PV = -4,000; CPT FV = 4,665.60
Year 2
N = 1; I/Y = 8; PV = -4,000; CPT FV = 4,320
Year 3
CF = 4,000
Total value in 3 years = 8,817.98 + 4,665.60 +
4,320 + 4,000 = 21,803.58
Total value at year 4:
N = 1; I/Y = 8; PV = 21,803.58;
CPT FV = -23,547.87
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Multiple Cash Flows –
FV Example 2
• Suppose you invest $500 in a mutual
fund today and $600 in one year. If the
fund pays 9% annually, how much will
you have in two years?

FV ?
Yr 0 Yr 1 Yr 2

500 600
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Example 2 Continued
• Suppose you invest $500 in a mutual fund
today and $600 in one year. If the fund pays
9% annually, how much will you have in two
years?
• Using formula:
FV = $500(1.09)2 + $600(1.09) = $1,248.05
• Calculator:
Year 0: N = 2; I/Y = 9; PV = 500; CPT FV = 594.05
Year 1: N = 1; I/Y = 9; PV = 600; CPT FV = 654.00
Total FV = 594.05 + 654.00 = 1,248.05
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Multiple Cash Flows –
PV Example
• You are considering an investment that will
pay you $1,000 in one year, $2,000 in two
years and $3,000 in three years. If you want
to earn 10% on your money, how much would
you be willing to pay?
 PV = $1,000 / (1.1)1 = $909.09
 PV = $2,000 / (1.1)2 = $1,652.89
 PV = $3,000 / (1.1)3 = $2,253.94
 PV = $909.09 + 1,652.89 + 2,253.94
= $4,815.93
Practice
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Time Line

PV=? 1000 2000 3000

|_______|________|_______| I/Y=10%
0 1 2 3

Practice
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You are attempting to find the annuity value where PV is $3500
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Calculator:
N = 1; I/Y = 10; FV = 1,000; CPT PV = -909.09
N = 2; I/Y = 10; FV = 2,000; CPT PV = -1,652.89
N = 3; I/Y = 10; FV = 3,000; CPT PV = -2,253.94
 PV = $909.09 + 1,652.89 + 2,253.94
= $4,815.93
NPV Function:
• CF [2ND CLR WORK] CF0= 0 C01=1000
F01=1 C02=2000 F02=1 C03=3000 F03=1
NPV I=10 CPT NPV= 4815.93
Practice
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Quick Quiz: Part 1

• Suppose you are looking at the following
possible cash flows: Year 1 CF = $100;
Years 2 and 3 CFs = $200; Years 4 and 5
CFs = $300. The required discount rate is 7%
• What is the value of the cash flows today?
874.17
• What is the value of the cash flows at year 5?
1226.07
• What is the value of the cash flows at year 3?
1070.90
Practice
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Quick Quiz: Part 1

• Suppose you are looking at the following
possible cash flows: Year 1 CF = $100;
Years 2 and 3 CFs = $200; Years 4 and 5
CFs = $300. The required discount rate is 7%
• What is the value of the cash flows today?
874.17
• What is the value of the cash flows at year 5?
1226.07
• What is the value of the cash flows at year 3?
1070.90
Practice
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Reading
• Ross Chapter 5

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