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Introduction to
Valuation: The
Time Value of
Money
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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
• 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
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Future Values
• 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?
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Effects of Compounding
• Simple interest: interest is not reinvested
• Compound interest: earn interest on
interest
• Consider the previous example
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Future Values – Example 2
• Suppose you invest the $1000 with 5%
interest for 5 years. How much would you
have?
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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
• 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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Present Values
• 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.
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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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• 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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Example 2 Continued
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Tutorial
• Problem 6, 11,18, 20, 24 and 26 from
page 115
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