M03Berk148315 - 02 - CorpFin - C03 - GE

Chapter 3
Time Value of
Money: An
Introduction
Copyright © 2012 Pearson Education.

Chapter Outline
3.1 Cost-Benefit Analysis

3.2 Market Prices and the Valuation Principle
3.3 The Time Value of Money and Interest
Rates
3.4 Valuing Cash Flows at Different Points in
Time

3-2
Learning Objectives
• Identify the role of financial managers and

competitive markets in decision making
• Understand the Valuation Principle, and
how it can be used to identify decisions
that increase the value of the firm
• Assess the effect of interest rates on
today’s value of future cash flows
• Calculate the value of distant cash flows in
the present and of current cash flows in
the future

3-3
• Role of the Financial Manager

– Make decisions on behalf of the firm’s investors
• For good decisions, the benefits exceeds the costs

3-4
• Role of the Financial Manager

– Real-world opportunities are often difficult to
quantify and involve using skills from other
management disciplines:
• Marketing
• Economics
• Organizational Behavior
• Strategy
• Operations
3-5
Copyright
Copyright ©©
2012 Pearson
2009 Education.
Pearson Prentice Hall. All rights reserved. 3-5
• Quantifying Costs and Benefits

– Any decision in which the value of the benefits
exceeds the costs will increase the value of the
firm

3-6

– Suppose a jewelry manufacturer has the
opportunity to trade 200 ounces of silver and
receive 10 ounces of gold today.
– To compare the costs and benefits, we first
need to convert them to a common unit.

3-7

– If the current market price for silver is $10 per
ounce, then the 200 ounces of silver we give
up has a cash value of:
(200 ounces of silver) × ($10/ounce) = $2,000

3-8

– Assume gold can be bought and sold for a
current market price of $500 per ounce. Then
the 10 ounces of gold we receive has a cash
value of:
(10 ounces of gold) × ($500/ounce) = $5,000

3-9

– Therefore, the jeweler’s opportunity has a
benefit of $5,000 today and a cost of $2,000
today. In this case, the net value of the project
today is:
$5,000 - $2,000=$3,000
– Because it is positive, the benefits exceed the

costs and the jeweler should accept the trade.

3-10
Example 3.1
Comparing Costs and Benefits
Problem:
• Suppose you work as a customer account manager for an
importer of frozen seafood. A customer is willing to
purchase 300 pounds of frozen shrimp today for a total
price of $1,500, including delivery. You can buy frozen
shrimp on the wholesale market for $3 per pound today,
and arrange for delivery at a cost of $100 today. Will taking
this opportunity increase the value of the firm?

3-11
Example 3.1
Solution:
Plan:
• To determine whether this opportunity will
increase the value of the firm, we need to value
the benefits and the costs using market prices.
We have market prices for our costs:
Wholesale price of shrimp: $3/pound Delivery
cost: $100
• We have a customer offering the following market
price for 300 pounds of shrimp delivered: $1,500.
All that is left is to compare them.

3-12
Example 3.1
Execute:
• The benefit of the transaction is $1,500 today.
• The costs are (300 lbs.)  $3/lbs. = $900 today
for the shrimp, and $100 today for delivery, for a
total cost of $1,000 today.
• If you are certain about these costs and benefits,
the right decision is obvious:
• You should seize this opportunity because the
firm will gain: $1,500 - $1,000 = $500

3-13
Example 3.1
Evaluate:
• Thus taking this opportunity contributes $500 to the value
of the firm, in the form of cash that can be paid out
immediately to the firm’s investors.

3-14
Example 3.1a
Problem:
• Suppose you work as a customer account manager for an
importer of frozen seafood. A customer is willing to
purchase 500 pounds of frozen shrimp today for a total
price of $1,800, including delivery. You can buy frozen
shrimp on the wholesale market for $4 per pound today,
and arrange for delivery at a cost of $150 today. Will taking
this opportunity increase the value of the firm?

3-15
Example 3.1a
Solution:
Plan:
• To determine whether this opportunity will
increase the value of the firm, we need to value
the benefits and the costs using market prices.
We have market prices for our costs:
Wholesale price of shrimp: $4/pound Delivery
cost: $150
• We have a customer offering the following market
price for 500 pounds of shrimp delivered: $1,800.
All that is left is to compare them.

3-16
Example 3.1a
Execute:
• The benefit of the transaction is $1,800 today.
• The costs are (500 lbs.)  $4/lbs. = $2,000 today
for the shrimp, and $150 today for delivery, for a
total cost of $2,150 today.
• If you are certain about these costs and benefits,
the right decision is obvious:
• You should pass up this opportunity because the
firm will lose: $1,800 - $2,150 = -$350

3-17
Example 3.1a
Evaluate:
• Thus taking this opportunity would subtract $350 from the
value of the firm.

3-18
• Role of Competitive Markets

– A competitive market is one in which a good
can be bought and sold at the same price
– In a competitive market, the price determines
the value of the good
• Personal opinion of the “fair” price is irrelevant

3-19
Example 3.2
Competitive Market Prices Determine
Value
Problem:
• You have just won a radio contest and are
disappointed to find out that the prize is 4 tickets
to the Def Leppard reunion tour (face value $40
each). Not being a fan of 1980s power rock, you
have no intention of going to the show. However,
it turns out that there is a second choice: two
tickets to your favorite band’s sold-out show (face
value $45 each). You notice that on Ebay, tickets
to the Def Leppard show are being bought and
sold for $30 apiece and tickets to your favorite
band’s show are being bought and sold at $50
each. What should you do?
3-20
Example 3.2
Value
Solution:
Plan:
• Market prices, not your personal preferences (nor the face
value of the tickets), are relevant here:
– 4 Def Leppard tickets at $30 apiece
– 2 of your favorite band’s tickets at $50 apiece
• You need to compare the market value of each option and
choose the one with the highest market value.

3-21
Example 3.2
Value
Execute:
• The Def Leppard tickets have a total value of $120 (4 
$30) versus the $100 total value of the other 2 tickets (2 
$50).
• Instead of taking the tickets to your favorite band, you
should accept the Def Leppard tickets, sell them on Ebay,
and use the proceeds to buy 2 tickets to your favorite
band’s show.
• You’ll even have $20 left over to buy a t-shirt.

3-22
Example 3.2
Value
Evaluate:
• Even though you prefer your favorite band, you should still
take the opportunity to get the Def Leppard tickets instead.
• As we emphasized earlier, whether this opportunity is
attractive depends on its net value using market prices.
• Because the net value of taking the Def Leppard tickets,
selling them, and buying your favorite band’s tickets is
positive $20, the opportunity is appealing.

3-23
Example 3.2a
Value
Problem:
• You have just won a radio contest and are
disappointed to find out that the prize is 6 tickets
to the Lady Antebellum tour (face value $50
each). Not being a fan of country music, you have
no intention of going to the show. However, it
turns out that there is a second choice: four
tickets to your favorite band’s sold-out show (face
value $40 each). You notice that on Ebay, tickets
to the Lady Antebellum show are being bought
and sold for $45 apiece and tickets to your
favorite band’s show are being bought and sold at
$60 each. What should you do?
3-24
Example 3.2a
Value
Solution:
Plan:
• Market prices, not your personal preferences (nor the face
value of the tickets), are relevant here:
– 6 Lady Antebellum tickets at $45 apiece
– 4 of your favorite band’s tickets at $60 apiece
• You need to compare the market value of each option and
choose the one with the highest market value.

3-25
Example 3.2a
Value
Execute:
• The Lady Antebellum tickets have a total value of $270 (6 
$45) versus the $240 total value of the other 4 tickets (4 
$60).
• Instead of taking the tickets to your favorite band, you
should accept the Lady Antebellum tickets, sell them on
Ebay, and use the proceeds to buy 4 tickets to your favorite
band’s show.
• You’ll even have $30 left over to buy a t-shirt.

3-26
Example 3.2a
Value
Evaluate:
• Even though you prefer your favorite band, you should still
take the opportunity to get the Lady Antebellum tickets
instead. a
• As we emphasized earlier, whether this opportunity is
attractive depends on its net value using market prices.
• Because the net value of taking the Lady Antebellum
tickets, selling them, and buying your favorite band’s tickets
is positive $30, the opportunity is appealing.

3-27
3.2 Market Prices and the Valuation
Principle
• The Valuation Principle
– The value of a commodity or an asset to the
firm or its investors is determined by its
competitive market price
– The benefits and costs of a decision should be
evaluated using those market prices
– When the value of the benefits exceeds the
value of the costs, the decision will increase the
market value of the firm

3-28
Example 3.3
Applying the Valuation Principle
Problem:
• You are the operations manager at your firm. Due
to a pre-existing contract, you have the
opportunity to acquire 200 barrels of oil and
3,000 pounds of copper for a total of $25,000.
The current market price of oil is $90 per barrel
and for copper is $3.50 per pound. You are not
sure that you need all of the oil and copper, so
you are wondering if you should you take this
opportunity. How valuable is it? Would your
decision change if you believed the value of oil or
copper would plummet over the next month?

3-29
Example 3.3
Solution:
Plan:
• We need to quantify the costs and benefits using market
prices. We are comparing $25,000 with:
– 200 barrels of oil at $90 per barrel
– 3,000 pounds of copper at $3.50 per pound

3-30
Example 3.3
Execute:
• Using the competitive market prices we have:
– (200 barrels) × ($90/barrel today) = $18,000
today
– (3,000 pounds of copper) × ($3.50/pound
today) = $10,500 today
• The value of the opportunity is the value of the oil
plus the value of the copper less the cost of the
opportunity, $18,000 + $10,500 - $25,000 =
$3,500 today. Because the value is positive, we
should take it.
3-31
Example 3.3
Evaluate:
• Since we are transacting today, only the current prices in a
competitive market matter.
• Our own use for or opinion about the future prospects of oil
or copper do not alter the value of the decision today.
• This decision is good for the firm, and will increase its value
by $3,500.

3-32
Example 3.3a
Problem:
• You are the operations manager at your firm. Due
to a pre-existing contract, you have the
opportunity to acquire 500 barrels of oil and
4,000 pounds of copper for a total of $50,000.
The current market price of oil is $75 per barrel
and for copper is $2.50 per pound. You are not
sure that you need all of the oil and copper, so
you are wondering if you should you take this
opportunity. How valuable is it? Would your
decision change if you believed the value of oil or
copper would plummet over the next month?

3-33
Example 3.3a
Solution:
Plan:
• We need to quantify the costs and benefits using market
prices. We are comparing $50,000 with:
– 500 barrels of oil at $75 per barrel
– 4,000 pounds of copper at $2.50 per pound

3-34
Example 3.3a
Execute:
• Using the competitive market prices we have:
– (500 barrels) × ($75/barrel today) = $37,500
today
– (4,000 pounds of copper) × ($2.50/pound
today) = $10,000 today
• The value of the opportunity is the value of the oil
plus the value of the copper less the cost of the
opportunity, $37,500 + $10,000 - $50,000 = -
$2,500 today.
• Because the value is negative, we should not take
it.
3-35
Example 3.3a
Evaluate:
• Since we are transacting today, only the current prices in a
competitive market matter.
• Our own use for or opinion about the future prospects of oil
or copper do not alter the value of the decision today.
• This decision is not good for the firm, and will decrease its
value by $2,500.

3-36
Principle
• Why There Can Be Only One Competitive
Price for a Good
– Law of One Price
• In competitive markets, securities with the same cash
flows must have the same price

3-37
Principle
• Why There Can Be Only One Competitive
Price for a Good
– Arbitrage
• The practice of buying and selling equivalent goods to
take advantage of a price difference
– Arbitrage Opportunity
• Any situation in which it is possible to make a profit
without taking any risk or making any investment

3-38
3.3 The Time Value of Money and
Interest Rates
• The Time Value of Money
– In general, a dollar today is worth more than a
dollar in one year
• If you have $1 today and you can deposit it in a bank
at 10%, you will have $1.10 at the end of one year
– The difference in value between money today
and money in the future the time value of
money.

3-39
Interest Rates
• The Time Value of Money
– Consider a firm's investment opportunity with a
cost of $100,000 today and a benefit of
$105,000 at the end of one year.

3-40
Figure 3.1 Converting Between Dollars
Today and Gold or Dollars in the Future

3-41
Interest Rates
• The Interest Rate: Converting Cash Across
Time
– By depositing money, we convert money today
into money in the future
– By borrowing money, we exchange money
today for money in the future

3-42
Interest Rates
Time
– Interest Rate (r)
• The rate at which money can be borrowed or lent
over a given period
– Interest Rate Factor (1 + r)
• It is the rate of exchange between dollars today and
dollars in the future
• It has units of “$ in one year/$ today”

3-43
Interest Rates
• Value of $100,000 Investment in One Year
– If the interest is 10%, the cost of the
investment is:
Cost = ($100,000 today) × (1.10 $ in one year/$
today)
= $110,000 in one year

3-44
Interest Rates
Time
– $110,000 is the opportunity cost of spending
$100,000 today
• The firm gives up the $110,000 it would have had in
one year if it had left the money in the bank
• Alternatively, by borrowing the $100,000 from the
same bank, the firm would owe $110,000 in one year.

3-45
Interest Rates
Time
– The investment’s net value is difference
between the cost of the investment and the
benefit in one year:
$105,000 - $110,000 = -$5,000 in one year

3-46
Interest Rates
Time
– Value of $100,000 Investment Today
• How much would we need to have in the bank today
so that we would end up with $105,000 in the bank in
one year?
– This is calculated by dividing by the interest rate factor:

3-47
Interest Rates
Time
– Value of $100,000 Investment Today
• The investment’s net value is difference between the
cost of the investment and the benefit in one year:
$95,454.55 - $100,000 = -$4,545.55 today

3-48
Interest Rates
Time
– Present Versus Future Value
• Present Value
– The value of a cost or benefit computed in terms of
cash today
» (-$4,545.45)
• Future Value
– The value of a cash flow that is moved forward in time
» ($5,000)
(-$4,545.45 today) × (1.10 $ in one year/$ today) = -$5,000
in one year

3-49
Interest Rates
Time
– Discount Factors and Rates
• Money in the future is worth less today so its price
reflects a discount
• Discount Rate
– The appropriate rate to discount a cash flow to
determine its value at an earlier time
• Discount Factor
– The value today of a dollar received in the future,
expressed as:
1
1 r
3-50
Example 3.4 Comparing Revenues at
Different Points in Time
Problem:
• The launch of Sony’s PlayStation 3 was delayed
until November 2006, giving Microsoft’s Xbox 360
a full year on the market without competition.
Imagine that it is November 2005 and you are the
marketing manager for the PlayStation. You
estimate that if the PlayStation 3 were ready to
be launched immediately, you could sell $2 billion
worth of the console in its first year. However, if
your launch is delayed a year, you believe that
Microsoft’s head start will reduce your first-year
sales by 20%. If the interest rate is 8%, what is
the cost of a delay in terms of dollars in 2005?
3-51
Solution:
Plan:
• Revenues if released today: $2 billion
• Revenue decrease if delayed: 20%
• Interest rate: 8%
• We need to compute the revenues if the launch is
delayed and compare them to the revenues from
launching today. However, in order to make a fair
comparison, we need to convert the future
revenues of the PlayStation if delayed into an
equivalent present value of those revenues today.

3-52
Execute:
• If the launch is delayed to 2006, revenues will
drop by 20% of $2 billion, or $400 million, to
$1.6 billion.
• To compare this amount to revenues of $2 billion
if launched in 2005, we must convert it using the
interest rate of 8%:
$1.6 billion in 2006 ÷ ($1.08 in 2006/$1 in 2005) = $1.481
billion in 2005
• Therefore, the cost of a delay of one year is
$2 billion - $1.481 billion = $0.519 billion ($519
million).

3-53
Evaluate:
• Delaying the project for one year was equivalent to giving
up $519 million in cash.
• In this example, we focused only on the effect on the first
year’s revenues. However, delaying the launch delays the
entire revenue stream by one year, so the total cost would
be calculated in the same way by summing the cost of delay
for each year of revenues.

3-54
Example 3.4a Comparing Revenues
at Different Points in Time
Problem:
• The launch of Sony’s PlayStation 3 was delayed
until November 2006, giving Microsoft’s Xbox 360
a full year on the market without competition.
Imagine that it is November 2005 and you are the
marketing manager for the PlayStation. You
estimate that if the PlayStation 3 were ready to
be launched immediately, you could sell $3 billion
worth of the console in its first year. However, if
your launch is delayed a year, you believe that
Microsoft’s head start will reduce your first-year
sales by 35%. If the interest rate is 6%, what is
the cost of a delay in terms of dollars in 2005?
3-55
Solution:
Plan:
• Revenues if released today: $3 billion, Revenue
decrease if delayed: 35% , Interest rate: 6%
• We need to compute the revenues if the launch is
delayed and compare them to the revenues from
launching today.
• However, in order to make a fair comparison, we
need to convert the future revenues of the
PlayStation if delayed into an equivalent present
value of those revenues today.

3-56
Execute:
• If the launch is delayed to 2006, revenues will
drop by 35% of $3 billion, or $1.05 billion, to
$1.95 billion.
• To compare this amount to revenues of $3 billion
if launched in 2005, we must convert it using the
interest rate of 6%:
$1.95 billion in 2006 ÷ ($1.06 in 2006/$1 in 2005) =
$1.840 billion in 2005
• Therefore, the cost of a delay of one year is
$3 billion - $1.840 billion = $1.160 billion

3-57
Evaluate:
• Delaying the project for one year was equivalent to giving
up $1.16 billion in cash.
• In this example, we focused only on the effect on the first
year’s revenues.
• However, delaying the launch delays the entire revenue
stream by one year, so the total cost would be calculated in
the same way by summing the cost of delay for each year of
revenues.

3-58
Interest Rates
• Timelines
– Constructing a Timeline
– Identifying Dates on a Timeline
• Date 0 is today, the beginning of the first year
• Date 1 is the end of the first year

3-59
Interest Rates
• Timelines
– Distinguishing Cash Inflows from Outflows
– Representing Various Time Periods

• Just change the label from “Year” to “Month” if
monthly

3-60
3.4 Valuing Cash Flows at Different
Points in Time
• Rule 1: Comparing and Combining Values
– It is only possible to compare or combine
values at the same point in time

3-61
Points in Time
• Rule 2: Compounding
– To calculate a cash flow’s future value, you
must compound it

3-62
Points in Time
• Rule 2: Compounding
– Compound Interest
• The effect of earning “interest on interest”

3-63
Figure 3.2 The Composition of Interest
over Time

3-64
Points in Time
• Rule 3: Discounting
– To calculate the value of a future cash flow at
an earlier point in time, we must discount it.

3-65
Points in Time
• If $826.45 is invested today for two years
at 10% interest, the future value will be
$1000

3-66
Points in Time
• If $1000 were three years away, the
present value, if the interest rate is 10%,
will be $751.31

3-67
Example 3.5 Present Value of a
Single Future Cash Flow
Problem:
• You are considering investing in a savings bond that will pay
$15,000 in ten years. If the competitive market interest
rate is fixed at 6% per year, what is the bond worth today?

3-68
Solution:
Plan:
• First set up your timeline. The cash flows for this
bond are represented by the following timeline:
• Thus, the bond is worth $15,000 in ten years. To

determine the value today, we compute the
present value using Eq. 3.2 and our interest rate
of 6%.

3-69
Execute:
15, 000
PV  10
 $8,375.92 today
1.06
Given: 10 6 0 15,000
-
Solve for:
8,375.92
Excel Formula: =PV(RATE,NPER, PMT, FV) = PV(0.06,10,0,15000)

3-70
Evaluate:
• The bond is worth much less today than its final payoff
because of the time value of money.

3-71
Example 3.5a Present Value of a
Problem:
• XYZ Company expects to receive a cash flow of $2 million in
five years. If the competitive market interest rate is fixed at
4% per year, how much can they borrow today in order to
be able to repay the loan in its entirety with that cash flow?

3-72
Solution:
Plan:
• First set up your timeline. The cash flows for the loan are
represented by the following timeline:
• Thus, XYZ Company will be able to repay the loan with its
expected $2 million cash flow in five years. To determine the
value today, we compute the present value using Eq. 3.2 and
our interest rate of 4%.

3-73
Execute:
Given: 5 4 0 2,000,000
Solve for: -1,643,854.21

3-74
Evaluate:
• The loan is much less than the $2 million the company will
pay back because of the time value of money.

3-75
Example 3.5b Present Value of a
Problem:
• You are considering investing in a savings bond that will pay
$20,000 in twenty years. If the competitive market interest
rate is fixed at 5% per year, what is the bond worth today?

3-76
Solution
Plan:
• First set up your timeline. The cash flows for this
bond are represented by the following timeline:
• Thus, the bond is worth $20,000 in twenty years.

To determine the value today, we compute the
present value using Eq. 3.2 and our interest rate
of 5%.

3-77
Execute:
20, 000
PV  20
 $7,537.79 today
1.05
Given: 20 5 0 20,000
Solve for: -7,357.79

3-78
Evaluate:
• The bond is worth much less today than its final payoff
because of the time value of money.

3-79
Chapter Quiz
1. If crude oil trades in a competitive market, would

an oil refiner that has a use for the oil value it
differently than another investor would?
2. How do we determine whether a decision
increases the value of the firm?
3. Is the value today of money to be received in one
year higher when interest rates are high or when
interest rates are low?
4. What do you need to know to compute a cash
flow’s present or future value?

3-80

M03Berk148315 - 02 - CorpFin - C03 - GE

Enviado por

Dados do documento

Título original

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

M03Berk148315 - 02 - CorpFin - C03 - GE

Enviado por

Direitos autorais:

Formatos disponíveis

Chapter 3

Copyright © 2012 Pearson Education.

3.1 Cost-Benefit Analysis

Copyright © 2012 Pearson Education.

• Identify the role of financial managers and

Copyright © 2012 Pearson Education.

• Role of the Financial Manager

Copyright © 2012 Pearson Education.

• Role of the Financial Manager

• Quantifying Costs and Benefits

Copyright © 2012 Pearson Education.

• Quantifying Costs and Benefits

Copyright © 2012 Pearson Education.

• Quantifying Costs and Benefits

Copyright © 2012 Pearson Education.

• Quantifying Costs and Benefits

Copyright © 2012 Pearson Education.

• Quantifying Costs and Benefits

– Because it is positive, the benefits exceed the

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

• Role of Competitive Markets

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.

Copyright © 2012 Pearson Education.