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Introduction to Valuation: The Time Value of Money

Chapter Five. Introduction to Valuation: The Time Value of Money. Time Value of Money. Time value of money: $1 received today is not the same as $1 received in the future. How do we equate cash flows received or paid at different points in time?

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Introduction to Valuation: The Time Value of Money

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  1. Chapter Five Introduction to Valuation: The Time Value of Money

  2. Time Value of Money • Time value of money: $1 received today is not the same as $1 received in the future. • How do we equate cash flows received or paid at different points in time? • Time value of money uses compounding of interest (i.e., interest is reinvested and receives interest).

  3. Basic Definitions • Present Value – earlier money on a time line • Future Value – later money on a time line • Interest rate – “exchange rate” between money received today and money to be received in the future • Discount rate • Cost of capital • Opportunity cost of capital • Required return

  4. Future Value – Example 1 – 5.1 • Suppose you invest $1000 for one year at 5% per year. What is the future value in one year? The future value is determined by two components: • Interest = • Principal = $1,000 • Future Value (in one year) = principal + interest • Future Value (FV) = • Suppose you leave the money in for another year. How much will you have two years from now? • FV =

  5. Future Value: General Formula • FV = future value • PV = present value • r = period interest rate, expressed as a decimal • T = number of periods • Future value interest factor = FVIF= (1 + r)t

  6. Effects of Compounding • Simple interest – earn interest on principal only • Compound interest – earn interest on principal and reinvested interest • Consider the previous example • FV with simple interest = • FV with compound interest = • The extra $2.50 comes from the interest of 5% earned on the $50 of interest paid in year one.

  7. Calculator Keys • Financial calculator function keys • FV = future value (amount at which a cash flow or series of cash flows will grow over a given period of time when compounded at a given interest rate). • PV = present value (value today of a cash flow or series of cash flows) • PMT = the periodic payment for an annuity or perpetuity • I/Y = period interest rate • Interest is entered as a percent, not a decimal • N = number of interest periods in investment horizon, number of times interest is paid • Most calculators are similar in format

  8. Future Value – Example 2 • Suppose you invest $1000 for 5 years at 5% interest. How much will you have at the end of the five years? • Formula Approach: • Calculator Approach: • PV • PMT • N • I/Y • FV

  9. Future Value – Example 2 continued • The effect of compounding is small for a small number of periods, but increases as the number of periods increases. • For example, if were to invest $1,000 for five years at 5% simple interest, the future value would be $1,250 versus $1,276.28 when the interest is compounded (see calculation on the previous page). • The compounding effect makes a difference of $26.28.

  10. Future Value • Note 1: The longer the investment horizon, the greater the FV of a present amount. • The reason for that is there is more interest and interest on interest (compounded interest). • FV is PV discounted at an appropriate rate

  11. Future Value – Example 3 • Compounding over long periods of time makes a huge difference • Suppose you had a relative who deposited $10 at 5.5% interest 200 years ago. • How much would the investment be worth today? • Formula Approach • Calculator Approach • PV • PMT • N • I/Y • FV

  12. Future Value – Example 3 continued • What is the effect of compounding? • Using simple interest • Using compound interest

  13. Future Value as a General Growth Formula • Suppose your company expects to increase unit sales of widgets by 15% per year for the next 5 years. If you currently sell 3 million widgets in one year, how many widgets do you expect to sell in 5 years? • Formula Approach • Calculator Approach • PV • PMT • N • I/Y • FV units

  14. Present Values – 5.2 • How much do I have to invest today to have some specified amount in the future? Start with the formula for FV and rearrange • Rearrange to solve for PV: • When we talk about discounting, we mean finding the present value of some future amount. • When we talk about the “value” of something, we are talking about the present value unless we specifically indicate that we want the future value.

  15. Present Value – 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? • Formula Approach • Calculator Approach • FV • PMT • N • I/Y • PV

  16. Present Value – Example 2 • You want to begin saving for you 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? • Formula Approach • Calculator Approach • FV • PMT • N • I • PV

  17. Present Value – Example 3 • Your parents set up a trust fund for you 10 years ago that is now worth $19,671.51. If the fund earned 7% per year, how much did your parents invest? • Formula Approach • Calculator Approach • FV • PMT • N • I/Y • PV

  18. Present Value – Important Relationships • 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 • What is the present value of $500 • To be received in 5 years? Discount rate 10% and 15% FV=500, N=5, I/Y=10 » PV= FV=500, N=5, I/Y=15 » PV= • To be received in 10 years? Discount rate 10% and 15% FV=500, N=10, I/Y=10 » PV= FV=500, N=10, I/Y=15 » PV=

  19. The Basic PV Equation - Refresher • There are four parts to this equation • PV, FV, r and t • If we know any three, we can solve for the fourth • If you are using a financial calculator, the calculator views cash inflows as positive numbers and cash outflows as negative numbers. • When solving for time (N) or rate (I/Y) using a financial calculator, you must have both an inflow (positive number) and an outflow (negative number), or you will receive an error message

  20. Discount Rate – 5.3 • We often want to know the implied interest rate for an investment • Rearrange the basic PV equation and solve for r

  21. Discount Rate – Example 1 • You are considering at an investment that will pay $1200 in 5 years if you invest $1000 today. What is the implied rate of interest? • Formula Approach • Calculator Approach • PV • FV • PMT • N • I/Y %

  22. Discount Rate – Example 2 • Suppose you are offered an investment that will allow you to double your money in 6 years. You have $10,000 to invest. What is the implied rate of interest? • Formula Approach • Calculator Approach • FV • PV • PMT • N • I/Y %

  23. Discount Rate – Example 3 • Suppose you have a 1-year old son and you want to provide $75,000 in 17 years towards 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? • Formula Approach • Calculator Approach • FV • PV • PMT • N • I/Y %

  24. Finding the Number of Periods • Start with basic equation and solve for t

  25. 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? • Formula Approach • Calculator Approach • FV • PV • PMT • I/Y • N years

  26. Number of Periods – Example 2 • Suppose you want to buy a new house. You currently have $15,000 and you figure you need to have a 10% down payment. If the type of house you want costs about $20,000 and you can earn 7.5% per year, how long will it be before you have enough money for the down payment? • Formula Approach • Calculator Approach • FV • PV PMT • I/Y • N years

  27. Table 5.4

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