Module Two

Valuation, capital budgeting and risk

Chapter 5 –
First Principles of Valuation:
The Time Value of Money

. 5-9
Learning Objectives
By the end of this module, you should be able to:
A. Distinguish between simple and compound interest.
B. Calculate the present value and future value of a single
amount for both one period and multiple periods.
C. Calculate the present value and future value of multiple
cash flows.
D. Calculate the present value and future value of annuities.
E. Compare nominal interest rates (NIR) and effective
annual interest rates (EAR).
F. Distinguish between the different types of loans and
calculate the present value of each type of loan.

5-10
Time Value of Money

a dollar today is
worth more than a
dollar tomorrow
Warren Buffett

5-11
Simple interest
• refers to interest earned only on the original capital
investment amount.

r = 5% / year

Source: navicoresolutions 5-12

Compound interest
• refers to interest earned on both the initial capital
investment and on the interest reinvested from prior periods.

r = 5% / year

5-13
Future Value of a Lump
Sum

You invest $100 in a savings account that earns 10% interest per
annum (compounded) for three years. How much your saving
account will be worth in 3 years?

After one year: $100  (1 + 0.10) = $110

After two years: $110  (1 + 0.10) = $121
After three years: $121  (1 + 0.10) = $133.10

5-14
Future Value of a Lump
Sum
• The accumulated value of this investment at the end of
three years can be split into two components:
• original principal $100
• interest earned $33.10

• Using simple interest, the total interest earned would only

have been $30.

• The other $3.10 is from compounding.

5-15
Future Value of a
Lump Sum

• In general, the future value, FVt, of $1 invested today at

r% for t periods is:

t
FVt = $1  (1 + r )
• The expression (1 + r)t is also known as the future
value interest factor (FVIF).

5-16
Example: Future Value
of a Lump Sum
• What will $1,000 be worth in five years time, if interest is 12% per
annum, compounded annually?
FV5 = $1,000 1 + 0.12
= $1,000 × 1.7623

• From the example above, now assume interest is 12% per annum,
= $1,762.30

compounded monthly. How much the FV will be?

FV60 = $1,000 1 + 0.01
= $1,000 × 1.8167
= $1,816.70

Always remember that t is the number of compounding periods,

not the number of years.

5-17
Present Value of a
Lump Sum
You need $1,000 in three years time.
If you can earn 10% per annum, how much do you need to
invest now?

0 1 2 3
10% 10% 10%

PV $1,000

Discount 1 year: $1000 (1 + 0.10) –1 = $909.09

Discount 2 years: $909.09 (1 + 0.10) –1 = $826.45
Discount 3 years: $826.45 (1 + 0.10) –1 = $751.32

5-20
Interpretation

• In general, the present value of $1 received in t periods of

time, earning r (%) interest is:
−t
PV = $1  (1 + r )
$1
= t
(1 + r )
• The expression is the present value interest factor
(PVIF).

5-21
Example: Present Value
of a Lump Sum
Your grandmother promises to give you $10,000 after 10 years
from now. If interest rates are 12% per annum, how much is
that gift worth today?

PV = $10,000 × 1 + 0.12
= $10,000 × 0.3220
= $3,219.73

5-22
Solving for the
Discount Rate
• You currently have $100 available, and you are considering an
investment for a 21-year period. At what interest rate must you
invest this $100 in order get $500 at maturity?

→ r = 7.97%
• $100*(1+r)21 = $500
•1 + = 5

• Given any three factors in the PV or FV equation, the 4th factor

(r%) can be solved in either ways:
i. Use a financial calculator
ii. Take the nth root of both sides of the equation

5-25
FINDING THE NUMBER OF
PERIODS
For a lump sum investment of $250,000 invested at a stated
annual rate of 3%, compounded daily, the number of months
needed to grow the sum to $1,000,000 is closest to:
A. 555
B. 563
C. 576

(1+r)N = FVN / PV = 1,000,000/250,000 = 4

(1+ 3%/365) N =4
Taking natural log (ln) of both sides, we have: ln[((1+ 3%/365) N] = ln(4)
Or N*ln(1+3%/365) = ln(4)  N = 16,867.3 (days) or approx. 562.2
(months)

Note: ln(yx) = x*ln(y)

Questions
• Today, if you deposit VND1bn to Vietcombank to earn 7.4% p.a;
assume that this interest rate is fixed, how long it may take to double
your deposit amount?

• How long does it take you to get the answer?

The Rule of 72

• The ‘Rule of 72’ is a handy rule of thumb that states:

If you earn r (%) per year, your money will double in

about years.

• For example, if you invest at 6% per year, your money will

double in about 12 years.

• This rule is only an approximate rule.

5-28
Future Value of
Multiple Cash Flows

• You deposit $1,000 now, $1,500 in one year, $2,000 in two years and
$2,500 in three years in an account paying 10% interest per annum.
• How much do you have in the account at the end of the third year?

• You can solve by either:

i. compounding the accumulated balance forward one year at a
time
ii. calculating the future value of each cash flow first and then
totaling/aggregating them.

5-29
Solutions
• Solution 1
End of year 1: ($1,000  1.10) + $1,500 = $2,600
End of year 2: ($2,600  1.10) + $2,000 = $4,860
End of year 3: ($4,860  1.10) + $2,500 = $ 846

• Solution 2
$1,000  (1.10)3 = $1,331
$1,500  (1.10)2 = $1,815
$2,000  (1.10)1 = $2,200
$2,500  1.00 = $2,500
Total = $7,846

5-30
Present Value of
Multiple Cash Flows
You will deposit in an account paying 10% interest per annum,
with the following amounts of money:
$1,500 in one year’s time,
$2,000 in two years time and
$2,500 in three years time.

What is the Present Value of these cash flows?

• You can solve by either:

i. discounting back one year at a time
ii. calculating the present value of each cash flow and then
totaling them.

5-31
Solutions
• Solution 1
End of year 2: ($2,500  1.10–1) + $2,000 = $4,273
End of year 1: ($4,273  1.10–1) + $1,500 = $5,385
Present value: ($5,385  1.10–1) = $4,895

• Solution 2
$2,500  (1.10) –3 = $1,878
$2,000  (1.10) –2 = $1,653
$1,500  (1.10) –1 = $1,364
Total = $4,895

5-32
Annuities
An annuity is a series of regular payments made at equal intervals.

❖ Examples:
• Regular deposits to a savings account
• Monthly home mortgage/loans payments
• Monthly insurance payments

❖ Common types of annuities

• An ordinary annuity is a series of equal cash flows, that occur at
the end of each period for some fixed number of periods.
• A perpetuity is an annuity in which the cash flows continue forever.

5-33
Present Value of
an Annuity

1 − 1/ (1 + r )t 
 
PV = C   
 r 

in which: C = equal cash flow

• The discounting term is called the present value interest

factor for annuities (PVIFA).

5-34
• Example 1

From now on, you will receive $500 at the end of each
year of the next 5 years.
The current interest rate is 9% per annum.
What is the PV of this series of cash flows?

5
1 − 1/ (1.09) 
 
PV = $500   
 0.09 
= $500  3.8897
= $1 944.85

5-35
• Example 2

You borrow $7,500 to buy a car and agree to repay the

loan by way of equal monthly repayments over five years.
The current interest rate is 12% per annum, compounded
monthly.
What is the amount of each monthly repayment?

1
1 −( )
$7,500 = × 1.01^60
0.01

=> = $7,500 ÷ 44.955

=> = $166.83

5-36
Future Value of
an Annuity

t
FV = C 
(1 + r ) − 1
r
• The compounding term is called the future value interest
factor for annuities (FVIFA).

5-37
Example: Future Value
of an Annuity

What is the FV of $200 deposited at the end of every year

for 10 years from now, if the interest rate is 6% per annum?

(1.06 )10 − 1
 
FV = $200 
0.06
= $200  13.181
= $2636.20

5-38
Perpetuities

• Perpetuity is a series of regular payments that continue

forever.

• The present value of a perpetual cash flow of C and rate

of return of r(%) is calculated as follows:

C
PV =
r

5-39
Comparing Rates
(Nominal vs Effective)
• The nominal interest rate (NIR) is the interest rate
working according to the simple interest method and
does NOT take into account the compounding periods.

• The effective annual interest rate (EAR) is the interest

rate expressed as if it was compounded once per year.

• When interest is compounded more frequently than

annually, the effective interest rate (EAR) will be greater
than the NIR.

5-40
Calculation of EAR

m
 NIR 
EAR = 1 +  − 1
 m 
m = number of times the interest is compounded

5-41
Comparing EARS
These are Nominal Interest Rates

Consider the following interest lending rates quoted by three

banks:

Bank A: 15%, compounded daily

Bank B: 15.5%, compounded quarterly

Bank C: 16%, compounded annually

Which is the best rate for the bank?

5-42
Comparing EARS

365
 0.15 
EAR Bank A = 1 +  − 1 = 16.18%
 365 
4
 0.155 
EAR Bank B = 1 +  − 1 = 16.42%
 4 
1
 0.16 
EAR Bank C = 1 +  − 1 = 16%
 1 

5-43
Comparing EARs

• For a saver, Bank B offers the best (highest) interest

rate. For a borrower, Bank C offers the best (lowest)
interest rate.

• Compounding during the year can lead to a significant

difference between the NIR and the EAR.

5-44
Types of Loans
A loan might be repaid in equal instalments, or in a single lump
sum. There are 02 basic forms of repayments:

• An interest-only loan: requires the borrower to only pay

interest each period and to repay the entire principal at
some point in the future.

• An amortised loan: requires the borrower to repay parts of

both the principal and interest over time.

5-45
Amortisation of a Loan
• Amortization is the process of spreading out a loan into a series
of fixed payments. The loan is paid off at the end of the payment
schedule.
• Example: loan principal $5,000, r = 9%, loan term of 5 years
Year Beginning Total Interest Principal Ending
Balance Payment Paid Paid Balance

1 $5000.00 $1285.46 $450.00 $835.46 $4164.54

2 $4164.54 $1285.46 $374.81 $910.65 $3253.89

3 $3253.89 $1285.46 $292.85 $992.61 $2261.28

4 $2261.28 $1285.46 $203.52 $1081.94 $1179.33

5 $1179.33 $1285.46 $106.13 $1179.33 $0.00

Totals $6427.30 $1427.30 $5000.00

5-46
Amortisation of a Loan
• Amortization is the process of spreading out a loan into a series
of fixed payments. The loan is paid off at the end of the payment
schedule.
• Example: loan principal $5,000, r = 9%, loan term of 5 years

-5,000 +1,285 +1,285 +1,285 +1,285 +1,285

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

=> PV of the series of future payments (including interest and

principal) should be equal to the original loan principal.

5-47
Example of amortised loan
Suppose you borrow $10,000. You are going to repay the loan by
making equal annual payments for five years. The interest rate on
the loan is 14%/year.
Prepare an amortization schedule for the loan.
How much interest will you pay over the life of the loan?

( )
. ^

= $2,912.84
.

• Annual payment =
• $10,000 = Equal annual payment ×
$ ,

• In year 1:
.

o Interest payment = $10,000 x 14% = $1,400

o Principal repayment = $2,912.84 - $1,400 = $1,512.84
o Principal balance = $10,000 - $1,512.84 = $8,487.16
• So on for year 2, 3, 4, 5.

5-48
Example
Suppose you borrow $10,000. You are going to repay the loan by
making equal annual payments for five years. The interest rate on
the loan is 14%/year.
Prepare an amortization schedule for the loan.
How much interest will you pay over the life of the loan?

5-49
QUESTION PRACTICE 1

A person deposits the following amounts in an account paying a

stated annual rate of 4%, compounded semiannually

Year End of Year Deposits ($)

1 4,000
2 8,000
3 7,000
4 10,000

At the end of Year 4, the value of the account is closest to:

A. $30,432
B. $30,447
C. $31,677

5-50
QUESTION PRACTICE 1 (answer)

We need to compute the future value of each payment as of Year 4

at the semiannual rate of 2%, and then sum the individual future
values, as follows:

Year End of Year Compounding Future Value ($)

Deposits ($) Factor
1 4,000 1.026 4,504.65
2 8,000 1.024 8,659.46
3 7,000 1.022 7,282.80
4 10,000 1.020 = 1 10,000.00

Sum of 4 future values as of Year 4 is 30,447

So the correct answer is B
QUESTION PRACTICE 2

Given the stated annual interest rate (or Nominal Interest Rate), an
increase in the frequency of compounding most likely:

A. Increases the FV but decreases the PV of an amount.

B. Increases both the FV and PV of an amount.
C. Decreases both the FV and PV of an amount.

An increase in compounding frequency increases the

effective annual rate (EAR). Therefore:
• The FV of an amount increases.
• The PV of an amount falls.
QUESTION PRACTICE 3

Given a stated annual interest rate of 6%, compounded quarterly,

How much should you deposit quarterly, will grow to £25,000 at the end
of 10 years from now:

A. $461
B. $474
C. $836
QUESTION PRACTICE 4

Tuan wants to borrow $100,000 to finance his business.

He is offered a nominal interest rate of 6%/year from XYZ bank,
but is told that he would be paying an effective interest rate of 6.09%/year
The frequency of compounding on his loan is closest to:

A. Monthy
B. Semi-annually
C. Quarterly

Effective annual interest rate with semi‐annual compounding

= (1 + 0.06/2)2 − 1 = 6.09%
QUESTION PRACTICE 5

Mr. Nam purchases a car using a loan.

The borrowing amount is $44,000 and the terms for the
loan to be repaid over 7 years, using equal monthly
payments, with an annual nominal interest rate of 12%
and monthly compounding.
The monthly payment is closest to:
A. $776.72
B. $803.43
C. $923.13