TIME VALUE OF MONEY

Module Overview

Time Value analysis has many applications, including planning for retirement, valuing stocks and
bonds, setting up loan payment schedules and making corporate decision regarding investing in
new plant and equipment. In fact, all financial concepts, time value of money is the single most important
concept.

Module Objectives/Outcomes:

At the end of this module, students are expected to:

• Explain how the time value of money works and discuss why it is such an important concept
in finance.
• Calculate the present value and future value of lump sums.
• Identify the different types of annuities and calculate the present value and future
value of both an ordinary annuity and an annuity due.
• Calculate the present value and future value of an uneven cash flow stream.

Lessons in the Module:

This module contains the following topics:

Lesson 1: Time Lines

Lesson 2: Future Values
Lesson 3: Present Values
Lesson 4: Ordinary Annuity
Lesson 5: Annuity Due
Lesson 6: Uneven cash flow
Lesson 7: Comparing Interest Rates

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 Time Lines

Introduction

Since you have successfuly accomplished Module 3, you are now ready to take your course to
another level. This time you will have Time Value of Money . Lesson of Module 4 will discuss about Time
Value, Present Value, Future Value and other important lessons necessary in understanding the module.

Activity

1. What comes to your mind when you hear the term Time Value of Money?

Your answer:
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
______________________________________________________

Analysis

2. Do you think time value of money is important in financial management decision making?
Explain.

Your answer:
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
______________________________________________________

The first step in time value analysis is to set up a time line, which will help you imagine what’s happening
in a particular issue. Consider the following diagram below, where Present Value (PV) represents P 100
that is on your hand today and Future Value (FV) is the value that will be in the account on a future date:

Period 0_____1_____2_____3 (Years/months)

Cash Present Value = P 100 Future Value= ?

The intervals from 0 to 1, 1 to 2, and 2 to 3 are time periods such as years or months. Time 0 is today,
and it is the beginning of Period 1; Time 1 is one period from today, and it is both the end of Period 1 and
the beginning of Period 2; and so forth.

Although the periods are often years, periods can also be quarters or months or even days.
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Time lines are essential when you are first learning time value concepts. We begin each problem by
setting up a time line to show what’s happening, after which we provide an equation that must be solved
to find the answer.

Assessment 1:

a. Do time lines deal only with years, or can other periods be used?
b. Set up a time line to illustrate the following situation: You currently have P10,000 in a 3-year time
deposit (CD) that pays a guaranteed 4 annually.

Excellent! You have just finished Lesson 1.

Take some rest and get ready for Lesson 2.

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 Future Values

A peso in hand today is worth more than a peso to be received in the future because if you had it now,
you could invest it, earn interest, and end up with more than a peso in the future. The process of going
to future values (FVs) from present values (PVs) is called compounding.

For an illustration, refer back to our 3-year time line and assume that you plan to deposit P100 in a bank
that pays a guaranteed 5% interest each year.

How much would you have at the end of Year 3? We first define some terms, after which we set up a
time line and show how the future value is calculated.

PV= Present value, or beginning amount, or the value now. In our example, PV= P 100.

FVN= Future value, or ending amount, of your account after N periods. FVN is the value N periods into
the future, after the interest earned has been added to the account.

CFt=Cash flow. It can be positive or negative. The cash flow for a particular period is often given as a
subscript, CFt , where t is the period. Thus, CF0 = PV = the cash flow at Time 0, whereas CF3 is the cash
flow at the end of Period 3.

I = Interest rate earned per year. Interest earned is based on the balance at the beginning of each year,
and we assume that it is paid at the end of the year. Here I = 5% or, expressed as a decimal .05.

INT = Amount of interest earned during the year = Beginning amount x I. In our example, INT =
P100(0.05) =P5.

N = Number of periods involved in the analysis. In our example, N=3. Sometimes the number of periods
is designated with a lowercase n, so both N and n indicate a number of periods.

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Step by Step Approach

The time line used to find the FV of P 100 compounded for 3 years at 5%, along with some calculations,
is shown.

Multiply the initial amount and each succeeding amount by (1 + I) = (1.05):

Year 0 1 2 3
Amount at beg. of
period (Php) 100 105 110.25 115.76

You start with P100 in the account—this is shown at Year 0 (t=0):

• You earn P 100(0.05) = P5 of interest during the first year, so the amount at the end of Year 1 (or t = 1)
is P100 + P5 = P105.

• You begin the second year with P105, earn 0.05(P105) = P5.25 on the now larger beginning-of-period
amount, and end the year with P110.25. Interest during Year 2 is P5.25; and it is higher than the first
year’s interest, P5.00, because you earned P 5(0.05) = P0.25 interest on the first year’s interest. This is
called compounding, and interest earned on interest is called compound interest.

• The total interest earned, P15.76, is reflected in the final balance, P115.76.

The step-by-step approach is useful because it shows exactly what is happening. However, this approach
is time-consuming, especially when a number of years are involved; so streamlined procedures have
been developed.

Formula Approach

In the step-by-step approach, we multiply the amount at the beginning of each period by (1 + I) = (1.05).
If N = 3, we multiply by (1 + I) three different times, which is the same as multiplying the beginning
amount by (1 + I)3. This concept can be extended, and the result is this key equation:

Equation 5-1: FVN = PV(1 + I)N

We can apply equation to find the FV in our example:

FV3 = P100(1.05)3 = P115.76

Equation 5-1 can be used with any calculator that has an exponential function, making it easy to find FVs
no matter how many years are involved.

Another example. Suppose you have P 200, and you’ll be investing it for 3 years with 5% compound
interest. How much is the future value?
FVN = PV(1 + I)N
FV3= 200(1+.05)3
FV3 = P200(1.05)3
FV3= P 200(1.16)
FV3= P 232

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Assessment 2:
1. Explain why this statement is true: A peso in hand today is worth more than a peso to be
received next year.
2. What is compounding? What’s the difference between simple interest and compound interest?
3. Compute the Future Value of P 500 that you invested in Rigene at the end of 1 month with a
monthly interest rate of 5%.
4. Compute the Future Value of your EverHand investment P 500 at the end of 2 months with
monthly interest rate of P 10%.
5. Compute the Future Value of P 1,000 at the end of 3 years with an interest of P 3%.
6. Compute the Future Value of P 1,000 at the end of 4 years with an interest of 3%
7. Compute the Future Value of P 1,000 at the end of 5 years with an interest rate of 2%?

Wooooooooaaah! Guess you’ve

drained your energy, haven’t you? But you
did well and congratulations for that. For
now, take some rest and prepare for the
Lesson 3.

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 Present Values

Finding a present value is the reverse of finding a future value. Indeed, we simply solve Equation 5-1,
the formula for the future value, for the PV to produce the basic present value equation, 5-2:

Future Value= FVN = PV(1+I)N 5-1

Present Value= PV= FVN 5-2
(1+I)N

Example
A broker offers to sell you a Treasury bond that will pay P115.76, 3 years from now. Banks are offering
a guaranteed 5% interest on 3-year certificates of time deposit (TDs); and if you don’t buy the bond,
you will buy a TD.

Given these conditions, what’s the most you should pay for the bond? We answer this question using the
two methods discussed in the last section—step-by-step and formula.

First, recall from the future value example in the last section that if you invested P100 at 5%, it would
grow to P115.76 in 3 years. You would also have P115.76 after 3 years if you bought the T-bond.

Therefore, the most you should pay for the bond is P100—this is its “fair price.” If you could buy the bond
for less than P100, you should buy it rather than invest in the TD. Conversely, if its price was more than
P100, you should buy the CD. If the bond’s price was exactly P100, you should be indifferent between
the T-bond and the CD.

The P100 is defined as the present value, or PV, of P115.76 due in 3 years when the interest rate is
5%. In general, the present value of a cash flow due N years in the future is the amount would grow to
equal the given future amount. Because P100 would grow to P115.76 in 3 years at a 5% interest rate,
P100 is the present value of P115.76 due in 3 years at a 5% rate.

Finding present values is called discounting; and as noted above, it is the reverse of compounding—
if you know the PV, you can compound to find the FV, while if you know the FV, you can discount to find
the PV.

Period 3 2 1 0
Step by Step Approach (Php) 115.76 110.25 105 100
Formular Approach (Php) PV= 115.76/(1/05)3 = 100

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Another example: An agent of a Jaggel Investment company invites you to put up money that will pay P
350,000 for 3 months at 10% monthly. Compute the present value.

Present Value (PV) = FVN

(1+I)N
= P 350,000/(1+10%)3
= P 350,000/(1.1%)3
= P 350,000/1.331
= P 262,960.18

Therefore, you have to invest P 262,960.18 in order to receive P 350,000, with monthly interest of 10%,
after 3 months.

Assessment 3:
1. Find the present value of a time deposit that will pay at P 15,000 for 3 years, 5% annually.
2. Find the present value of a time deposit that will pay at P 10,000 for 4 years, 2% annually.
3. Find the present value of a time deposit that will pay at P 20,000 for 3 years, 5% annually.

Finally, you are done with Lesson 3. It was

tough, right? Congratulations for
sustaining thus far. Please make sure to
review your lessons to insure thorough
understanding.

8
4-4. Ordinary Annuity and Annuity Due

When the payments are equal and are made at fixed intervals, the series is an annuity. For example,
P100 paid at the end of each of the next 3 years is a 3-year annuity.

If the payments occur at the end of each year, the annuity is an ordinary (or deferred) annuity. If the
payments are made at the beginning of each year, the annuity is an annuity due.

Ordinary annuities are more common in finance; so when we use the term annuity in this book, assume
that the payments occur at the ends of the periods unless otherwise noted.

Here are the time lines for a P100, 3-year, 5% ordinary annuity and for the same annuity on an annuity
due basis. With the annuity due, each payment is shifted to the left by one year. A P100 deposit will be
made each year, so we show the payments with minus signs:

Ordinary Annuity (5%)

Period 0 1 2 3
Payments P 100 P 100 P 100

Annuity Due (5%)

Period 0 1 2 3
Payments P 100 P 100 P 100

As we demonstrate in the following sections, we can find an annuity’s future and present values, the
interest rate built into annuity contracts, and the length of time it takes to reach a financial goal using an
annuity. Keep in mind that annuities must have constant payments and a fixed number of periods. If
these conditions don’t hold, we don’t have an annuity.

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Assessment 4&5.1
1. What’s the difference between an ordinary annuity and an annuity due? Explain. Cite an
example.

Future Value of Ordinary Annuity

The future value of an annuity can be found using the step-by-step approach or using a formula, a
financial calculator, or a spreadsheet.

As an illustration, consider the ordinary annuity diagrammed earlier, where you deposit P100 at the end
of each year for 3 years and earn 5% per year.

How much will you have at the end of the third year? The answer, P315.25, is defined as the future value
of the annuity, FVAN ; it is shown in Table 5-3. Computation below.
PMT (Payment Amount)= 100, N=3, I= 5%

FVAN = PMT(1 + I)N=1 + PMT(1 + I)N=2 + PMT(1 + I)N=3

= P100(1.05)2 + P100(1.05)1 + P100(1.05)0
=P 315.25

Explanation:
As shown in the step-by-step section of the table, we compound each payment out to Time 3, then sum
those compounded values to find the annuity’s FV, FVA3 =P315.25. The first payment earns interest for
two periods, the second payment earns interest for one period, and the third payment earns no interest
at all because it is made at the end of the annuity’s life.

We can generalize and streamline the equation as follows: (Equation 5-3)

FVAN = PMT(1 + I)N=1 + PMT(1 + I)N=2 +PMT(1 + I)N=3 + . . . + PMT(1 + I)0

= PMT (1 + I)N - 1
I

= 100 (1+5%)3-1
5%

=100 (1.05)3-1
5%

=100 1.157625-1
5%

=100 .157625
5%

=100(3.1525)
= 315.25

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Assessment 4&5.2
1. For an ordinary annuity with five annual payments of P100 and a 10% interest rate, how many
years will the first payment earn interest? What will this payment’s value be at the end? Answer
this same question for the fifth payment.

2. Assume that you plan to buy a condo 5 years from now, and you estimate that you can save
P2,500 per year. You plan to deposit the money in a bank that pays 4% interest, and you will
make the first deposit at the end of the year. How much will you have after 5 years? How will
your answer change if the interest rate is increased to 6% or lowered to 3%?

Future Value of Annuity Due

Because each payment occurs one period earlier with an annuity due, all of the payments earn interest
for one additional period. Therefore, the FV of an annuity due will be greater than that of a similar ordinary
annuity. If you went through the step-by-step procedure, you would see that our illustrative annuity due
has an FV of P331.01 versus P315.25 for the ordinary annuity.

With the formula approach, we first use Equation 5-3; but since each payment occurs one period earlier,
we multiply the Equation 5-3 result by (1 + I):

FVAdue = FVAordinary (1 + I)

Thus, for the annuity due, FVAdue = P315.25(1.05) = P331.01, which is the same result when the period-
by-period approach is used. With a calculator, we input the variables just as we did with the ordinary
annuity; but now we set the calculator to Begin Mode to get the answer, $331.01.

Assessment 4&5.3
1. Why does an annuity due always have a higher future value than an ordinary annuity?
2. If you calculated the value of an ordinary annuity, how could you find the value of the
corresponding annuity due?

PRESENT VALUE OF AN ORDINARY ANNUITY

The present value of an annuity, PVAN, can be found using the step-by-step, formula, calculator, or
spreadsheet method. Look back at Table 5-3. To Fnd the FV of the annuity, we compounded the deposits.
To find the PV, we discount them, dividing each payment by (1 + I). The step-by-step procedure is
diagrammed as follows:

Periods 0 1 2 3 TOTAL
Payments P 100 P100 P100
Present Value P 95.24 P 90.70 P 86.38 P 272.32

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Equation 5-5 expresses the step-by-step procedure in a formula. The bracketed
form of the equation can be used with a scienti!c calculator, and it is helpful if the
annuity extends out for a number of years:

PVAN = PMT/(1 + I)1 + PMT/(1 + I)2 + . . . + PMT/(1 + I)N

1- 1
= PMT (1+I)N
I

= P100 X [1 - 1/(1.05)3 ]/0.05 = $272.32

Assessment 4&5.3
1. Compared to an ordinary annuity, why does an annuity due have a higher present value?
2. If you know the present value of an ordinary annuity, how can you find the PV of the
corresponding annuity due?

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 Uneven Cash Flow

The definition of an annuity includes the words constant payment—in other words, annuities involve
payments that are equal in every period. Although many financial decisions involve constant payments,
many others involve uneven, or nonconstant, cash flows. For example, the dividends on common stocks
typically increase over time, and investments in capital equipment almost always generate uneven cash
flows. Throughout the book, we reserve the term payment (PMT) for annuities with their equal payments
in each period and use the term cash flow
(CFt) to denote uneven cash flows, where t designates the period in which the cash
flow occurs.

There are two important classes of uneven cash flows: (1) a stream that consists of a series of annuity
payments plus an additional final lump sum and (2) all other uneven streams. Bonds represent the best
example of the first type, while stocks and capital investments illustrate the second type. Here are
numerical examples of the two types of flows:

1. Annuity plus additional final payment

Periods 0 1 2 3 4 5
Cash Flows P0 P100 P100 P100 P100 P 100
I= 12% P1,000
P 1,100

2. Irregular cash flows:

Periods 0 1 2 3 4 5
Cash Flows 0 100 300 300 300 500
I=12%

We can find the PV of either stream by using Equation 5-7 and following the step-by-step procedure,
where we discount each cash flow and then sum them to find the PV of the stream:
PV= ∑N CFt
t-1 (1 + I)t

If we did this, this, we would find the PV of Stream 1 to be P927.90 and the PV of Stream
2 to be P1,016.35.

The step-by-step procedure is straightforward; but if we have a large number of cash flows, it is time-
consuming. However, financial calculators speed up the process considerably. First, consider Stream 1;
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notice that we have a 5-year, 12% ordinary annuity plus a final payment of $1,000. We could find the PV
of the annuity, then find the PV of the final payment and sum them to obtain the PV of the stream.

Periods 0 1 2 3 4 5
Cash Flows (Php) 0 100 300 300 300 500
PV of Cash Flows (Php) 89.29 239.16 213.53 190.66 283.71
Total PV of CF= P 1,016.35

Assessment 6.1:

1. What’s the present value of a 5-year ordinary annuity of P 100 plus an additional P500 at the end
of Year 5 if the interest rate is 6%? What is the PV if the P100 payments occur in Years 1 through
10 and the P500 comes at the end of Year 10?

2. What’s the present value of the following uneven cash flow stream: P0 at Time 0, P100 in Year
1 (or at Time 1), P200 in Year 2, P0 in Year 3, and P400 in Year 4 if the interest rate is 8%?

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 Comparing Interest Rates

Which would you prefer – P1,000 today or P1,000 ten years from today? Common sense tells us to take
the P1,000 today because we recognize that there is a time value to money. The immediate receipt of
P1,000 provides us with the opportunity to put our money to work and earn interest.

Simple interest is interest that is paid (earned) on only the original amount, or principal, borrowed (lent).
The amount of simple interest is a function of three variables: the original amount borrowed (lent), or
principal; the interest rate per time period; and the number of time periods for which the principal is
borrowed (lent). The formula for calculating simple interest is

SI = P0(i)(n)

where SI = simple interest

P0 = principal, or original amount borrowed (lent) at time period 0
i = interest rate per time period
n = number of time periods

For example, assume that you deposit P100 in a savings account paying 8 percent simple
interest and keep it there for 10 years. At the end of 10 years, the amount of interest accumulated is
determined as follows:

P80 = P100(0.08)(10)

To solve for the future value (also known as the terminal value) of the account at the end of 10 years
(FV10), we add the interest earned on the principal only to the original amount invested. Therefore

FV10 = P100 + [ P100(0.08)(10)] = P180

For any simple interest rate, the future value of an account at the end of n periods is

FVn = P0 + SI = P0 + P0(i)(n)

or, equivalently,

FVn = P0[1 + (i)(n)]

Sometimes we need to proceed in the opposite direction. That is, we know the future value of a deposit
at i percent for n years, but we don’t know the principal originally invested – the account’s present value
(PV0 = P0). A rearrangement of Eq. (3.2), however, is all that
is needed.

PV0 = P0 = FVn /[1 + (i)(n)]

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Compound Interest
The distinction between simple and compound interest can best be seen by example. Table 3.1 illustrates
the rather dramatic effect that compound interest has on an investment’s value over time when compared
with the effect of simple interest. From the table it is clear to see why some people have called compound
interest the greatest of human inventions.

The notion of compound interest is crucial to understanding the mathematics of finance. The term itself
merely implies that interest paid (earned) on a loan (an investment) is periodically added to the principal.
As a result, interest is earned on interest as well as the initial principal. It is this interest-on-interest, or
compounding, effect that accounts for the dramatic difference between simple and compound interest.
As we will see, the concept of compound interest can be used to solve a wide variety of problems in
finance.

Years At Simple Interest At Compound Interest

2 P 1.16 P 1.17
20 2.60 4.66
200 17.00 4,838,949.59

Table 3.1. Future value of P1invested for various time periods at an 8% annual interest rate.

Assessment 7
1. You deposit P1,000 in a savings account paying 5 percent simple interest and keep it
there for 5 years. At the end of 5 years, compute the amount of interest accumulated.
2. You deposit P1,000 in a savings account paying 5 percent compound interest and keep
it there for 5 years. At the end of 5 years, compute the amount of interest accumulated.

Finally, you are done with Module 4. It was

tough, right? Congratulations for
sustaining thus far. Please make sure to
review your lessons to insure thorough
understanding.

16
Key Learning Points:
1. Most financial decisions, personal as well as business, involve the time value of money.We use
the rate of interest to express the time value of money.2.
2. Simple interest is interest paid (earned) on only the original amount, or principal, borrowed (lent).
3. Compound interest is interest paid (earned) on any previous interest earned, as well as on the
principal borrowed (lent). The concept of compound interest can be used to solve a wide variety
of problems in finance.
4. Two key concepts – future value and present value – underlie all compound interest problems.
Future value is the value at some future time of a present amount of money, or a series of
payments, evaluated at a given interest rate. Present value is the current value of a future amount
of money, or a series of payments, evaluated at a given interest rate.

5. It is very helpful to begin solving time value of money problems by first drawing a time line on
which you position the relevant cash flows.
6. An annuity is a series of equal payments or receipts occurring over a specified number of
periods.
7. There are some characteristics that should help you to identify and solve the various types of
annuity problems:
a. Present value of an ordinary annuity – cash flows occur at the end of each period, and present value
is calculated as of one period before the first cash flow.
b. Present value of an annuity due – cash flows occur at the beginning of each period, and present
value is calculated as of the first cash flow.
c. Future value of an ordinary annuity – cash flows occur at the end of each period, and future value is
calculated as of the last cash flow.
d. Future value of an annuity due – cash flows occur at the beginning of each period, and future value
is calculated as of one period after the last cash flow.
8. Various formulas were presented for solving for future values and present values of single amounts
and of annuities. Mixed (uneven) cash-flow problems can always be solved by adjusting each flow
individually and then summing the results. The ability to recognize certain patterns within mixed cash
flows will allow you to take calculation shortcuts.

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