fin 600

FIN 600 – Lecture 3
Discounted Cash Flow Valuation

Chapter Outline
Time Value of Money
Valuation: The One-Period Case
The Multiperiod Case
Compounding Periods
Simplifications
What Is a Firm Worth?

Time Value of Money







A dollar received today is worth more than a dollar received in the future.
Interest - is the return you receive for investing your money. The interest rate is the basis for a test that any proposed investment must pass.
Example:




Putting $100 in the bank
Earn 6% interest
After 1 year $106

$100

$106

Future Values and compound rate
Future Value - Amount to which an investment will grow after earning interest.
Simple Interest - Interest earned only on the original investment. Compound Interest - Interest earned on interest.
- The sooner your money can earn interest, the faster the interest can earn interest.

Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a principal balance of $100.

Interest Earned Per Year = 100 x .06 = $ 6

Future Values
Example - Simple Interest
Interest earned at a rate of 6% for five years on a principal balance of $100.
Today
1
Interest Earned
Value
100

6
106

Future Years
2
3
4

6
112

Value at the end of Year 5 = $130

6
118

6
124

5

6
130

Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on the previous year’s balance.
Interest Earned Per Year =Prior Year Balance x .06

Future Values
Example - Compound Interest
Interest earned at a rate of 6% for five years on the previous year’s balance.
Today
Interest Earned
Value
100

1

Future Years
2
3

4

5

6
6.36
6.74
7.15
7.57
106 112.36 119.10 126.25 133.82

Value at the end of Year 5 = $133.82

Future Value


The general formula for the future value of an investment over many periods can be written as:
FV = C0×(1 + r)T

Where
C0 is cash