Chapter 5 Time Value of Money Copyright 2012 Pearson Prentice Hall. All rights reserved. Objectives Discuss the role of time value in finance, the use of computational tools, and the basic patterns of cash flow.

Understand the concepts of future value and present value, their calculation for single amounts, and the relationship between them. Calculate both the future value and the present value of an annuity and a mixed stream of cash flows. Understand the effect that compounding interest more frequently than annually has on future value and the effective annual rate of interest.

2012 Pearson Prentice Hall. All rights reserved. 5-2 The Role of Time Value in Finance Most financial decisions involve costs & benefits that are spread out over time. Time value of money allows comparison of cash flows from different periods. Question: Your father has offered to give you some money and asks that you choose one of the following two alternatives: $1,000 today, or $1,100 one year from now.

What do you do? 2012 Pearson Prentice Hall. All rights reserved. 5-3 The Role of Time Value in Finance (cont.) The answer depends on what rate of interest you could earn on any money you receive today. For example, if you could deposit the $1,000 today at 12% per year, you would prefer to be paid today. Alternatively, if you could only earn 5% on deposited funds, you would be better off if you chose the $1,100 in one year.

2012 Pearson Prentice Hall. All rights reserved. 5-4 Future Value versus Present Value Suppose a firm has an opportunity to spend $15,000 today on some investment that will produce $17,000 spread out over the next five years as follows: Year Cash flow 1

$3,000 2 $5,000 3 $4,000 4 $3,000

5 $2,000 Is this a wise investment? To make the right investment decision, managers need to compare the cash flows at a single point in time. 2012 Pearson Prentice Hall. All rights reserved. 5-5 Compounding and Discounting 2012 Pearson Prentice Hall. All rights reserved.

5-6 Basic Patterns of Cash Flow The cash inflows and outflows of a firm can be described by its general pattern. The three basic patterns include a single amount, an annuity, or a mixed stream: 2012 Pearson Prentice Hall. All rights reserved. 5-7 Future Value of a Single Amount Future value is the value at a given future date of an

amount placed on deposit today and earning interest at a specified rate. Found by applying compound interest over a specified period of time. Compound interest is interest that is earned on a given deposit and has become part of the principal at the end of a specified period. Principal is the amount of money on which interest is paid. 2012 Pearson Prentice Hall. All rights reserved. 5-8 Future Value of a Single Amount: The Equation for Future Value We use the following notation for the various inputs:

FVn = future value at the end of period n PV = initial principal, or present value r = annual rate of interest paid. (Note: On financial calculators, I is typically used to represent this rate.) n = number of periods (typically years) that the money is left on deposit The general equation for the future value at the end of period n is FVn = PV (1 + r)n 2012 Pearson Prentice Hall. All rights reserved. 5-9 Future Value of a Single Amount: The Equation for Future Value

Jane Farber places $800 in a savings account paying 6% interest compounded annually. She wants to know how much money will be in the account at the end of five years. FV5 = $800 (1 + 0.06)5 = $800 (1.33823) = $1,070.58 This analysis can be depicted on a time line as follows: 2012 Pearson Prentice Hall. All rights reserved. 5-10 Present Value of a Single Amount Present value is the current dollar value of a future amountthe amount of money that would have to be invested today at a given interest rate over a specified period to equal the future amount.

It is based on the idea that a dollar today is worth more than a dollar tomorrow. Discounting cash flows is the process of finding present values; the inverse of compounding interest. The discount rate is often also referred to as the opportunity cost, the discount rate, the required return, or the cost of capital. 2012 Pearson Prentice Hall. All rights reserved. 5-11 Present Value of a Single Amount: The Equation for Present Value The present value, PV, of some future amount, FVn, to be received n periods from now, assuming an

interest rate (or opportunity cost) of r, is calculated as follows: 2012 Pearson Prentice Hall. All rights reserved. 5-12 Present Value of a Single Amount: The Equation for Future Value Pam Valenti wishes to find the present value of $1,700 that will be received 8 years from now. Pams opportunity cost is 8%. PV = $1,700/(1 + 0.08)8 = $1,700/1.85093 = $918.46 This analysis can be depicted on a time line as follows: 2012 Pearson Prentice Hall. All rights reserved.

5-13 Annuities An annuity is a stream of equal periodic cash flows, over a specified time period. These cash flows can be inflows of returns earned on investments or outflows of funds invested to earn future returns. An ordinary (deferred) annuity is an annuity for which the cash flow occurs at the end of each period An annuity due is an annuity for which the cash flow occurs at the beginning of each period. An annuity due will always be greater than an otherwise equivalent ordinary annuity because interest will compound for an additional period.

2012 Pearson Prentice Hall. All rights reserved. 5-14 Table 5.1 Comparison of Ordinary Annuity and Annuity Due Cash Flows ($1,000, 5 Years) 2012 Pearson Prentice Hall. All rights reserved. 5-15 Finding the Future Value of an Ordinary Annuity You can calculate the future value of an ordinary annuity that pays an annual cash flow equal to CF by using the

following equation: As before, in this equation r represents the interest rate and n represents the number of payments in the annuity (or equivalently, the number of years over which the annuity is spread). 2012 Pearson Prentice Hall. All rights reserved. 5-16 Finding the Present Value of an Ordinary Annuity You can calculate the present value of an ordinary annuity that pays an annual cash flow equal to CF by using the following equation:

As before, in this equation r represents the interest rate and n represents the number of payments in the annuity (or equivalently, the number of years over which the annuity is spread). 2012 Pearson Prentice Hall. All rights reserved. 5-17 Finding the Present Value of an Ordinary Annuity (cont.) Braden Company, a small producer of plastic toys, wants to determine the most it should pay to purchase a particular annuity. The annuity consists of cash flows of $700 at the end of each year for 5 years. The required return is 8%.

This analysis can be depicted on a time line as follows: 2012 Pearson Prentice Hall. All rights reserved. 5-18 Future Value of a Mixed Stream Shrell Industries, a cabinet manufacturer, expects to receive the following mixed stream of cash flows over the next 5 years from one of its small customers. 2012 Pearson Prentice Hall. All rights reserved. 5-19

Future Value of a Mixed Stream If the firm expects to earn at least 8% on its investments, how much will it accumulate by the end of year 5 if it immediately invests these cash flows when they are received? This situation is depicted on the following time line. 2012 Pearson Prentice Hall. All rights reserved. 5-20 Present Value of a Mixed Stream Frey Company, a shoe manufacturer, has been offered an opportunity to make an investment and then receive the following mixed stream of

cash flows as income over the next 5 years. 2012 Pearson Prentice Hall. All rights reserved. 5-21 Present Value of a Mixed Stream If the firm must earn at least 9% on its investments, what is the most it should pay today for this opportunity? This situation is depicted on the following time line. 2012 Pearson Prentice Hall. All rights reserved. 5-22

Loan Amortization Schedule ($6,000 Principal, 10% Interest, 4-Year Repayment Period) 2012 Pearson Prentice Hall. All rights reserved. 5-23 Chapter Summary Financial managers and investors use time-value-of-money techniques when assessing the value of expected cash flow streams. Alternatives can be assessed by either compounding to find future value or discounting to

find present value. Financial managers rely primarily on present value techniques. The cash flow of a firm can be described by its patternsingle amount, annuity, or mixed stream. Future value (FV) relies on compound interest to measure future amounts: The initial principal or deposit in one period, along with the interest earned on it, becomes the beginning principal of the following period. The present value (PV) of a future amount is the amount of money today that is equivalent to the given future amount, considering the return that can be earned. Present value is the inverse of future value.

Interest can be compounded at intervals ranging from annually to daily, and even continuously. The more often interest is compounded, the larger the future amount that will be accumulated, and the higher the effective rate. 2012 Pearson Prentice Hall. All rights reserved. 5-24