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Corporate Finance
Session 10
Unit II: Time Value of Money
Why TIME?
Why is TIME such an important
element in your decision?
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
INTEREST
Types of Interest
Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the principal
borrowed (lent).
SI = P0(i)(n)
SI:
P0:
Simple Interest
Deposit today (t=0)
i:
n:
SI
= P0(i)(n)
= $1,000(0.07)(2)
= $140
= P0 + SI
= $1,000 + $140
= $1,140
Future Value is the value at some future time
of a present amount of money, or a series of
payments, evaluated at a given interest rate.
Simple Interest
With simple interest, you dont earn interest on
interest.
Year 1: 5% of $100
$5 + $100 = $105
Year 2: 5% of $100
$5 + $105 = $110
Year 3: 5% of $100
$5 + $110 = $115
Year 4: 5% of $100
$5 + $115 = $120
Year 5: 5% of $100
$5 + $120 = $125
Compound Interest
With compound interest, a depositor earns interest
on interest!
Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
Principles of
Corporate Finance
Session 11 & 12
Unit II: Time Value of Money
Answer!
It depends on the interest rate!
Basic Concepts
Future Value: compounding or growth over time
Present Value: discounting to todays value
Single cash flows & series of cash flows can be
considered
Time lines are used to illustrate these relationships
Computational Aids
Use the Equations
Use the Financial Tables
Use Financial Calculators
Use Spreadsheets
Computational Aids
Computational Aids
Computational Aids
Computational Aids
interest rate
FVn =
PV0(1+k)n
PV(FVIFk,n)
PV0
FVn[1/(1+k)n]
FV(PVIFk,n)
A (1+k)n - 1
k
A(FVIFAk,n)
= A 1 - [1/(1+k)n] =
A(PVIFAk,n)
FVAn =
PVA0
PV
k
n
FV?
2,000
6.00%
5
$2,676
Excel Function
=FV (interest, periods, pmt, PV)
=FV (.06, 5, , 2000)
100 x (1 + .12)5 =
$176.23
Semiannually:
100 x (1 + .06)10 =
$179.09
Quarterly:
100 x (1 + .03)20 =
$180.61
Monthly:
100 x (1 + .01)60 =
$181.67
100.00
12.0%
FV
$176.23
100.00
0.06
10
$179.08
100.00
Monthly
$
100.00
0.03
0.01
20
60
$180.61
$181.67
Continuous Compounding
With continuous compounding the number of
compounding periods per year approaches infinity.
Through the use of calculus, the equation thus
becomes:
FVn (continuous compounding) = PV x (ekxn)
where e has a value of 2.7183.
Continuing with the previous example, find the Future
value of the $100 deposit after 5 years if interest is
compounded continuously.
Continuous Compounding
With continuous compounding the number of
compounding periods per year approaches infinity.
Through the use of calculus, the equation thus
becomes:
FVn (continuous compounding) = PV x (ekxn)
where e has a value of 2.7183.
FVn = 100 x (2.7183).12x5 = $182.22
Principles of
Corporate Finance
Session 12 & 13
Unit II: Time Value of Money
EAR = (1 + .18/12) 12 -1
EAR = 19.56%
The Rule-of-72
Quick! How long does it take to double
$5,000 at a compound rate of 12% per
year (approx.)?
Present Value
Present value is the current dollar value of a future
amount of money.
It is based on the idea that a dollar today is worth
more than a dollar tomorrow.
It is the amount today that must be invested at a given
rate to reach a future amount.
It is also known as discounting, the reverse of
compounding.
The discount rate is often also referred to as the
opportunity cost, the discount rate, the required return,
and the cost of capital.
2,000
6.00%
5
$1,495
Excel Function
=PV (interest, periods, pmt, FV)
=PV (.06, 5, , 2000)
Annuities
Annuities
$100.00
$205.00
$315.25
100
5.0%
3
$ 315.25
Excel Function
=FV (interest, periods, pmt, PV)
=FV (.06, 5,100, )
PMT $ 100.00
k
5.00%
n
3
FV
$315.25
FVA? $ 331.01
Excel Function
=FV (interest, periods, pmt, PV)
=FV (.06, 5,100, )
=315.25*(1.05)
2,000
10.0%
3
$4,973.70
Excel Function
=PV (interest, periods, pmt, FV)
=PV (.10, 3, 2000, )
PVIF9%,N
PV
400
0.917
$ 366.80
800
0.842
$ 673.60
500
0.772
$ 386.00
400
0.708
$ 283.20
300
0.650
$ 195.00
PV
$1,904.60
400
800
500
400
300
NPV
$1,904.76
Excel Function
=NPV (interest, cells containing CFs)
=NPV (.09,B3:B7)