1 Chapter 4 Introduction to Valuation: The Time Value of Money

2 Overview Future Value and Compounding Present Value and Discounting More on Present and Future Values

3 The Time Value of Money Concept We know that receiving $1 today is worth more than $1 in the future. This is due to opportunity costs The opportunity cost of receiving $1 in the future is the interest we could have earned if we had received the $1 sooner 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

4 Future Value for a Single Payment Notice that 1. $110.00= $100 X ( ) 2. $121.00= $110 X ( ) = $100 X 1.10 X 1.10 = $100 X (1.10) 2 3. $133.10= $121 X ( ) = $100 X 1.10 X 1.10 X 1.10 = $100 X (1.10) 3 In general, the future value, FV t, of $1 invested today at r% for t periods is FV t = $1 x (1 + r) t or FV t = PV x (1 + r) t The expression (1 + r) t is the future value interest factor. This is the process of compounding – interest earns interest

5 Example 1 Q. Deposit $5,000 today in an account paying 12%. How much will you have in 6 years? How much is simple interest? How much is compound interest? A. Multiply the $5,000 by the future value interest factor: $5,000 X (1 + r) t = $5,000 X (1.12) 6 = $5,000 X = $9, At 12%, the simple interest is 0.12 X $5000 = $600 per year. After 6 years, this is 6 X $600 = $3,600 The difference between compound and simple interest is thus $4, – $3,600 = $1,269.11

6 Future Value of $100 at 10 Percent

7 Future Value, Time, and Interest Rate

8 Using TI BA II PLUS Calculator Keys (TI BA II PLUS) NNumber of periods I/YInterest per Year (Entered in percent form) P/YPayment per Year (2 ND Access) C/YCompounding per Year (2 ND Access) PVPresent Value PMTPayMenT (Periodic and Fixed) FVFuture Value MODEEND for ending and BGN for beginning (2 ND Access)

9 Some Important Notes on TI BA II PLUS We will first use keys located at 3 rd row from top of your calculator To clear previous entries you can use 2 ND CLR TVM I prefer entering “0” for irrelevant variables For most cases, PV should be entered as a negative number Always keep in mind that “N” is number of periods not necessarily years. Compounding per Year (C/Y) can be modified by changing 2 ND P/Y. This determines how frequently interest is earned. Therefore we will use C/Y and P/Y interchangeably. There are situations in which you would have to distinguish between the two that we will see in the next chapter Amount of interest would be based on periodic rate Periodic Rate = Annual Rate / Number of Periods in a Year Always make sure P/Y is consistent with the problem at hand – this means you need to check its setting every time. P/Y also help us determine number of periods N = P/Y X Number of Years

10 Example 2 Interest on Interest Illustration Q. You have just won a $1 million jackpot in the state lottery. You can buy a ten year certificate of deposit which pays 6% compounded annually. Alternatively, you can give the $1 million to your brother-in-law, who promises to pay you 6% simple interest annually over the ten-year period. Which alternative will provide you with more money at the end of ten years? Answer: The future value of the CD is $1 million x (1.06) 10 = $1,790, The future value of the investment with your brother-in-law, on the other hand, is $1 million + [$1 million X (0.06) X (10)] = $1,600,000. Thus, compounding (or the payment of “interest on interest”), results in incremental wealth of nearly $191,000. NI/YP/YPVPMTFVMODE ,000,00001,790,847.70

11 Present Value of a Single Payment How much do I have to invest today to have some amount in the future? FV t = PV x (1 + r) t Rearrange to solve for PV = FV t / (1 + r) t 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.

12 Example 3 Want to be a millionaire? No problem! Suppose you are currently 21 years old, and can earn 10 percent on your money. How much must you invest today in order to accumulate $1 million by the time you reach age 65? First define the variables: FV = $1 million, r = 10 percent and t = = 44 years PV = $1 million/(1.10) 44 = $15,091. NI/YP/YPVPMTFVMODE , ,000,000

13 Example 4 Q. Suppose you need $20,000 in three years to pay your college tuition. If you can earn 8% on your money, how much do you need today? A. Here we know the future value is $20,000, the rate (8%), and the number of periods (3). What is the unknown present amount? PV = $20,000/(1.08) 3 = $15, NI/YP/YPVPMTFVMODE , ,000

14 Present Value, Time, and Interest Rate

15 Example 5 Finding the Rate Suppose you deposit $5,000 today in an account paying r percent per year. If you are promised to get $10,000 in 10 years, what rate of return are you being offered? Set this up as present value equation: FV = $10,000, PV = $ 5,000,t = 10 years, r = ? PV = FV t / (1 + r) t $5,000 = $10,000 / (1 + r) 10 Now solve for r: (1 + r) 10 = $10,000 / $5,000 = 2 (1 + r) 10 = 2 then r = (2) 1/ = = 7.18% NI/YP/YPVPMTFVMODE ,000010,000

16 Example 6 Finding the Number of Periods Suppose you need $2,000 to buy a new stereo for your car. If you have $500 to invest at 14% compounded annually, how long will you have to wait to buy the stereo? Set this up as future value equation: FV = $2,000, PV = $ 500, r = 14%, t = ? FV t = PV x (1 + r) t $2,000 = $500 x ( ) t Now solve for t: ( ) t = $2,000 / $500 = 4 ( ) t = 4 and t = ln (4) / ln (1.14) = years NI/YP/YPVPMTFVMODE ,000

17 A Note on Non-Annual Compounding – Continued Remember that FV t = PV 0 x (1 + r) t When dealing with non annual interest and payment you should make two adjustment Interest rate should be periodic Number of periods should reflect the total number of periods given number of years and frequency of interest earnings in a year Formulations should be adjusted as follows If “m” is the number of compounding in a year then where you see “r” divide it by “m” and multiply “t” by “m.” This assumes that “t” is the number of years FV t = PV 0 x (1 + r / m ) t X m Excel adjustment are same as formulations that can be made in a function dialog box or data cells

18 A Note on Non-Annual Compounding FV t = PV 0 x (1 + r / m ) t X m Entering the above equation into TI BA II PLUS Method 1: Keep P/Y = 1 (so is C/Y = 1) N = t X m (Number of periods) I/Y = r / m (Periodic interest rate) Rest of the information is entered as before Method 2: Change P/Y = m (so is C/Y = m) N = t X m (Number of periods) I/Y = r (Annual interest rate) Rest of the information is entered as before Note that P/Y has to be checked for consistency every time

19 Example: Spreadsheet Strategies Use the following formulas for TVM calculations FV(rate,nper,pmt,pv,type) PV(rate,nper,pmt,fv,type) RATE(nper,pmt,pv,fv,type) NPER(rate,pmt,pv,fv,type) The default setting for “type” is “0” which sugests end-of-period payments (pmt). It should be set to “1” for beginning-of-period payments. See Excel file for the solution of examples.