Introduction to Valuation: The Time Value of Money

Be able to compute the future value of an investment made today Be able to compute the present value of cash to be received at some future date

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

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Congratulations!!! You have won a cash prize! You have two payment options: A. Receive $10,000 now OR B. Receive $10,000 in three years. Okay, the above offer is hypothetical, Which option would you choose?

Money received sooner rather than later allows one to use the funds for investment or consumption purposes. This concept is referred to as the

TIME VALUE OF MONEY!!

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
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Suppose you invest $1000 for one year at 5% per year. What is the future value in one year?

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 Interest = 1000(.05) = 50 Value in one year = principal + interest = 1000 + 50

= 1050 Future Value (FV) = 1000(1 + .05) = 1050

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

Simple interest Compound interest Consider the previous example

FV with simple interest = 1000 + 50 + 50 = 1100 FV with compound interest = 1102.50 The extra 2.50 comes from the interest of .05(50)

= 2.50 earned on the first interest payment

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FV = PV(1 + r)t
FV = future value PV = present value r = period interest rate, expressed as a decimal t = number of periods

Future value interest factor = (1 + r)t

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Future Value Amount to which an investment will grow after earning interest Present Value Value today of a future cash flow.

Future Value of $100 = FV

FV $100 (1 r )

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 /
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t (1 + r)

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 = 9345.79 Calculator

1 N; 7 I/Y; 10,000 FV PV = 9345.79

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Discount Rate Interest rate used to compute present values of future cash flows.

Discount Factor Present value of a $1 future payment.

Present Value = PV PV = discount factor C1

Discount Factor = DF = PV of $1

DF

1 (1 r ) t

Discount Factors can be used to compute the present value of any cash flow.

How do we measure the time value of money. A discount rate or cost of capital or cutoff rate will be given to u in each question. At a particular discount rate suppose 10% Discount factor X one rupee= present value of money

Eg-

value of Re one at the end of one year is .909 Of second year Re one will be .826 Third year it will be .729 and so on

Calculate the present value, discounted at 10 percent, of receiving: (a) $800at the end of year 4; ( b )$200 at the end of year 3 and $300 at the end of year 5, (c) $500 at the end of year 4 and $300 at the end of year 6, and

Present Value. Your favorite uncle has offered you the choice of the following options. He will give you either $2,000 1year from now or $3,000 4 years from now. Which would you choose if the discount rate is (a) 10 percent? ( b )20 percent?

P = F, * PVIFj., (a) Option 1:$2,000 one year from now. In this case i = 10%, n = 1, Fl = $2,000, and PVIFlo,l = 0.9091. Therefore, P = $2,000(0.9091) = $1,818.20 Option 2: $3,000 four years from now. In this case i = 10%,n = 4, F4 = $3,000, and PVIFlo,4 = 0.6830. Therefore, P = $3,000(0.6830) = $2,049 At 10 percent, the best choice is $3,000 four years from now. (b) Option 1:$2,000 one year from now. In this case i = 20%, n = 1,F1= $2,000, and PVIFm,l = 0.8333. Therefore, P = $2,000(0.8333) = $1,666.60 Option 2: $3,000 four years from now. In this case i = 20%, n = 4, F4 = $3,000, and PVIFm,4 = 0.4823. Therefore, P = $3,000(0.4823) = $1,446.9 At 20 percent, the best choice is $2,000 one year from now.

Your father is about to retire. His firm has given him the option of retiring with a lump sum of $20,000or an annuity of $2,500 for 10 years. Which is worth more now, if an interest rate of 6 percent is used for the annuity?

Consider two projects whose after-tax cash inflows are not even. Year A ($) B ($1 1 100 500 2 200 400 3 300 300 4 400 100 5 500 6 600 Calculate the present value at the discount rate of 5%, 10%, 20%, 30%

Youve just joined the investment banking firm of Dewey, Cheatum, and Howe. Theyve offered you two different salary arrangements. You can have $80,000 per year for the next two years, or you can have $60,000 per year for the next two years, along with a $35,000 signing bonus today. The bonus is paid immediately, and the salary is paid at the end of each year. If the discount rate is 10 percent, which do you prefer?