Chap 004

Chapter 4

Introduction to Valuation: The Time Value of Money

1 McGraw-Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter Outline • Future Value and Compounding • Present Value and Discounting • More on Present and Future Values

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Basic Definitions

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• Present Value (PV)– earlier $ on a time line • Future Value (FV)– later $ on a time line • No. of period (t) - times of compounding • Interest rate (r)– “exchange rate” between earlier money and later money – Discount rate – Cost of capital – Opportunity cost of capital – Required return

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Time line T= 0 1 2 3 4 5 _____________________________________________ PV

FV5

PV = Present Value FV = Future Value t / n = Numbers of period r = Interest rate 3 ways: Formulas, tables and financial calculator 4

Future Values

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• FV: the amount of $/ an investment today (PV) will grow to over some period of time (t) at some given interest rate (r). • Suppose you invest $1000 for one year at 5% per year. What is the future value in one year?

• Suppose you leave the money in for another year. How much will you have two years from now?

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Future Values: General Formula • FV = PV(1 + r)t – FV = future value – PV = present value – r = period interest rate, expressed as a decimal – t = numbers of period

• Future value interest factor = (1 + r)t – Appendix A.1 (pg. 580) – FV = PV*FVIF(r%,t) 6

Effects of Compounding

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• Simple interest: interest is not reinvested • Compound interest: earn interest on interest • Consider the previous example

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Future Values – Example 2

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• Suppose you invest the $1000 with 5% interest for 5 years. How much would you have?

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Future Values – Example 3

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

• What is the effect of compounding?

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Figure 4.1

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Figure 4.2

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Future Value as a General Growth Formula

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• 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 year 5?

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Quick Quiz: Part 1 • What is the difference between simple interest and compound interest? • Suppose you have $500 to invest and you believe that you can earn 8% per year over the next 15 years. – How much would you have at the end of 15 years using compound interest? (FV = $1586.08) – How much would you have using simple interest? (FV = $1100) – How much interest on interest? (i on i = $486.08) 13

Present Values

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• How much do I have to invest today to have some amount in the future? – – – – –

FV = PV(1 + r)t Rearrange to solve for PV = FV / (1 + r)t 1/(1+r)t = Present Value Interest Factor (PVIF) Appendix A.2, pg.582 PV = FV*PVIF(r,t)

• When we talk about discounting, we mean finding the present value of some future amount. 14

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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?

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Present Values – 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?

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PV – Important Relationship I • For a given interest rate – the longer the time period, the lower the present value – What is the present value of $500 to be received in 5 years? 10 years? The discount rate is 10%

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PV – Important Relationship II • For a given time period – the higher the interest rate, the smaller the present value – What is the present value of $500 received in 5 years if the interest rate is 10%? 15%?

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Figure 4.3

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Quick Quiz: Part 2 • Suppose you need $15,000 in 3 years. If you can earn 6% annually, how much do you need to invest today? (PV=$12,594.29) • If you could invest the money at 8%, would you have to invest more or less than at 6%? How much?(less, PV=$11907.48) 20

The Basic PV Equation Refresher

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• FV = PV * (1 + r)t • There are four parts to this equation – PV, FV, r and t – If we know any three, we can solve for the fourth

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Discount Rate (r)

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• Often we will want to know what the implied interest rate is in an investment • Rearrange the basic FV equation and solve for r    

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

• If you are using formulas, you will want to make use of both the yx and the 1/x keys 22

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Discount Rate – Example 1 • You are looking at an investment that will pay $1200 in 5 years if you invest $1000 today. What is the implied rate of interest?

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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 towards his college education. You currently have $5000 to invest. What interest rate must you earn to have the $75,000 when you need it?

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Quick Quiz: Part 3 • Suppose you are offered the following investment choices: 1)You can invest $500 today and receive $600 in 5 years. The investment is considered low risk. 2)You can invest the $500 in a bank account paying 4%. • What is the implied interest rate for the first choice (r=3.71%) • Which investment should you choose? (second choice is better) 25

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Finding the Number of Periods (t) • 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)

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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?

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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 plus an additional 5% in closing costs. If the type of house you want costs about $150,000 and you can earn 7.5% per year, how long will it be before you have enough money for the down payment and closing costs? 28

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Example 2 Continued

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Quick Quiz: Part 4 • Suppose you want to buy some new furniture for your family room. You currently have $500 and the furniture you want costs $600. If you can earn 6%, how long will you have to wait if you don’t add any additional money? (t=3.129 years)

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Tutorial • Problem 6, 11,18, 20, 24 and 26 from page 115

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Time Value of Money • You have $1,000 to deposit, and you can earn 12% per year. How much will your investment be worth in 10 years?

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Time Value of Money • You have $1,000 to deposit, and you can earn 12% per year compounded monthly. How much will your investment be worth in 10 years?