Time Value of Money

Chapter 8
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

Would it be better for a company

to invest P100,000 in a product
that would return a total of
P200,000 after one year, or one
that would return P220,000 after
two years?
ANSWER

It depends on interest rate!

 Computational Aids

Time Line
Time line depicting an investment’s cash flows
TIME VALUE OF
MONEY
• Time value of money considers three
factors:
(1) principal – refers to the sum borrowed or
invested.
(2) interest rate - is the ratio between the
interest earned in a certain unit of time and
the principal.
(3) time period or term is the period for
which the money is to be used
 Basic Concepts

Future Value Single and Series CF

compounding or growth over time Single cash flows & series of cash
flows can be considered

Present Value Time lines

discounting to today’s value used to illustrate these relationships
 Compounding of
Interest and Future
Values
Compounding Discounting

Process of moving cash Process of moving cash

flows forward in time flows back in time
 • Future value techniques typically measure
cash flows at the end of a project’s life
• Present value techniques measure cash
FUTURE flows at the start of a project‘s life
• Compounding is used in the future value
VALUE technique to find the future value of each
cash flow at the end of the investment’s life
AND and then sums these values to find the
investment’s future value.
PRESENT • While for present value technique, it uses
discounting to find the present value of
VALUE each cash flow at time zero and then sums
these values to find the investment’s value
today.
 Computational Aids

Compounding and Discounting

Time line showing compounding to find future value
and discounting to find present value
 Future Value
The value at a given future date of a present amount placed on
a deposit today and earning interest at a specified rate is called
future value.

Where:
FV = future value of the investment
I = the annual interest rate
PV = present value; or the current value, that is the value today’s peso of
sum of money
n = number of periods that the money is left on deposit
 Simple Interest
With simple interest, you don’t earn interest
on interest.

•Year 1: 5% of $100 = $5 + $100 = $105

•Year 2: 5% of $100 = $5 + $105 = $110
•Year 3: 5% of $100 = $5 + $110 = $115
•Year 4: 5% of $100 = $5 + $115 = $120
•Year 5: 5% of $100 = $5 + $120 = $125
 Compound Interest
•With compound interest, a depositor earns interest
on interest!

•Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00

•Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
•Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
•Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
•Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
 Sample Problem

You receive P10,000 academic award this year for being the best student
in your personal finance course, and you place it in a savings account
paying 5% annual interest compounded annually. How much will your
account be worth in 10 years?

Answer:
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)!
= 𝑃10,000(1 + 5%)"#
= 𝑃10,000 1.62889
𝐹𝑉 = 𝑃16,288.90
Compound Interest with
Non-annual Period
• When an investment is compounded in non-
annual basis, you earn more money faster.

• Money grows faster as the compounding

period becomes shorter.

$
• 𝐹𝑉 = 𝑃𝑉(1 + %)!∗%
 Sample Problem
Compounding Semi-Annual Basis
You receive P10,000 academic award this year for being the best student
in your personal finance course, and you place it in a savings account
paying 5% annual interest compounded annually. How much will your
account be worth in 10 years?

Answer:
 Sample Problem
Compounding Quarterly Basis
You receive P10,000 academic award this year for being the best student
in your personal finance course, and you place it in a savings account
paying 5% annual interest compounded annually. How much will your
account be worth in 10 years?

Answer:
 Sample Problem
Compounding Monthly Basis
You receive P10,000 academic award this year for being the best student
in your personal finance course, and you place it in a savings account
paying 5% annual interest compounded annually. How much will your
account be worth in 10 years?

Answer:
Time Value Terms
 Future Value When Rates
of Interest Change
• You invest P10,000. During the first year the investment earned 20% for
the year. During the second year, you earned only 4% for that year. How
much is your original deposit worth at the end of the two years?

𝐹𝑉 = 𝑃𝑉 1 + 𝑖" 𝑥 1 + 𝑖'
𝐹𝑉 = 𝑃10,000 1.20 𝑥 1.04
𝐹𝑉 = 𝑃12,480
Compounding
of Interest
and
Present Values
Present Value

• The value today of a future cash flow

or series of cash flows.
• Future amount discounted to the
present by some required rate.
• Current peso amount of a future
amount.
 Present Value
𝐹𝑉
𝑃𝑉 =
(1 + 𝑖) !
or
𝑃𝑉 = 𝐹𝑉(1 + 𝑖) (!

Where:
• FV = Future value of the investment
at the end of n years
• n = no. of years until the payment
will be received
• i = the annual discount (or interest)
rate
• PV= present value of the future sum
of money
 Present Value
Assuming Luffy wishes to find the present value of
P 9,000 that will be received 6 years from now.
The discount rate is 5%.
Substituting FV = P 9,000; n=6, and i=0.05:

𝑃9,000
𝑃𝑉 =
(1 + 0.05) )
𝑃9,000
𝑃𝑉 =
1.340
𝑃𝑉 = 𝑃6,716.42
Periodic Even Cash Flow

If you were to choose between P100,000 today

or P105,000 next year with 6% interest, which
would you pick?
𝑃105,000
𝑃𝑉 =
(1 + 0.06)"
𝑃105,000
𝑃𝑉 =
(1 + .06)
𝑃𝑉 = 𝑃99,056
ANNUITY
Annuity

• sequence of equal periodic

payments which are made at
equal intervals of time.

• Pension funds, insurance

obligations, and interest received
from bonds all involve annuities.
Compound
Annuity
• Involves depositing or investing an
equal sum of money at the end of
each year for a certain number of
years and allowing it to grow.

• Saving for children’s education,

new car or new home.
 Annuities

Ordinary Annuity Annuity Due

the cash flow at the end the annuity for which the
of each period cash flow occurs at the
beginning of each period
 Terms of Annuities

Certain Annuity Contingent Annuity

Begin and end on fixed Depend on some event

dates that cannot be fixed
Perpetuity
Annuity
• Special kind of annuity.
• One that carries on indefinitely
• With a perpetuity, the periodic
annuity or cash flow stream
continues forever.
Annuities

• Annuities are equally-spaced cash flows of equal size.

• Annuities can be either inflows or outflows.
• An ordinary (deferred) annuity has cash flows that occur at the
end of each period.
• An annuity due has cash flows that occur 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.
Types of Annuities

• Fran Abrams is choosing which of two annuities to receive. Both

are 5-year $1,000 annuities; annuity A is an ordinary annuity, and
annuity B is an annuity due. Fran has listed the cash flows for
both annuities as shown in Table 4.1 on the following slide.

Note that the amount of both annuities total $5,000.

Future Value of an Ordinary Annuity
 Annuity Future Value Interest
Factor
𝐹𝑉𝐼𝐹𝐴 = 1 + 1 + 𝑖 + 1 + 𝑖 ' + ⋯+ 1 + 𝑖 *("

(1 + 𝐼)!("
𝐹𝑉+,-./0,1 0//3.41 = 𝑃𝑀𝑇
𝑖
Where: FV = future value of the investment at the end of n years
n = number of years until the payment will be received
I = annual discount (interest) rate
PV – present value of the future sum of money
•

Uneven Cash Flow

Mixed Streams - stream of unequal periodic cash flows that reflect no

particular pattern.

Each cash flow must be discounted back to the present (for PV) or
compounded to a future date (for FV); then sum it all to get the total.
Future Value
of an Ordinary Annuity (cont.)
• Fran Abrams wishes to determine how much money she
will have at the end of 5 years if he chooses annuity A,
the ordinary annuity and it earns 7% annually. Annuity a
is depicted graphically below:
Present Value of an Ordinary Annuity

• 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%.

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Present Value of an Ordinary Annuity: The Long
Method

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Present Value of a Perpetuity

• A perpetuity is a special kind of annuity.

• With a perpetuity, the periodic annuity or cash flow stream
continues forever.
PV = Annuity/Interest Rate

• For example, how much would I have to deposit today in order to

withdraw $1,000 each year forever if I can earn 8% on my
deposit?

PV = $1,000/.08 = $12,500
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•

Uneven Cash Flow –

Future Value
•

Uneven Cash Flow –

Future Value
•

Uneven Cash Flow –

Future Value
•

Uneven Cash Flow –

Present Value
•

Uneven Cash Flow –

Present Value
•

Uneven Cash Flow –

Present Value
Future Value of a Mixed Stream

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Future Value of a Mixed Stream (cont.)

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Present Value of a Mixed Stream

• Frey Company, a shoe manufacturer, has been offered an

opportunity to receive the following mixed stream of cash
flows over the next 5 years.

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Present Value of a Mixed Stream

• If the firm must earn at least 9% on its investments, what is the

most it should pay for this opportunity?
• This situation is depicted on the following
time line.

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Present Value of a Mixed Stream

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Compounding Interest
More Frequently Than Annually
• Compounding more frequently than once a year results in a higher
effective interest rate because you are earning on interest on
interest more frequently.
• As a result, the effective interest rate is greater than the nominal
(annual) interest rate.
• Furthermore, the effective rate of interest will increase the more
frequently interest is compounded.

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Compounding Interest
More Frequently Than Annually (cont.)
• Fred Moreno has found an institution that will pay him 8% annual interest,
compounded quarterly. If he leaves the money in the account for 24 months
(2 years), he will be paid 2% interest compounded over eight periods.

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Compounding Interest
More Frequently Than Annually (cont.)

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Compounding Interest
More Frequently Than Annually (cont.)

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Compounding Interest
More Frequently Than Annually (cont.)
• A General Equation for Compounding
More Frequently than Annually

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Compounding Interest
More Frequently Than Annually (cont.)
• A General Equation for Compounding More Frequently than
Annually
– Recalculate the example for the Fred Moreno example assuming (1)
semiannual compounding and (2) quarterly compounding.

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