MODULE 5

The Time Value of Money

Subject Objectives

After studying Module 5, you should be able to:

1. Understand the concept of interest.
2. Understand and calculate the future and present values:
a. Annual compounding
b. Intra-period compounding
c. Stream of unequal payments
d. Stream of equal payments
e. Discounting
f. Perpetuity

“A peso today is worth more than a peso tomorrow”. All individuals and
businesses face the same two basic finance-related problems:
1) Where to put the money?
2) Where to get the money?

The first problem is called the investment decision; the second, the
“financing” decision.

In addressing the investment problem, individuals and companies choose

from a wide range, real and financial assets.

A common characteristic of these investments is that, most of the time, the

expected returns from these assets do not happen overnight or even within
the current year. Cash flows related to these assets occur at multiple time
periods and may happen over an extended period of time.

Addressing the financing problem requires businesses to seek out finding

sources such as equity infusion by investors or borrowing from financial
institutions such as the banks. The cash inflows in acquiring the funds and

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outflows related to the payment of dividends to the owners and the repayment
of principal and interest to creditors are likely to occur in the long term.

Because cash flows occur at extended periods of time, the time value of money
must be considered in making the appropriate investment and financing
decision. Individuals prefer to receive a peso now instead of later because of
the following main reasons: (a) it can invest the peso now and earn a return
from this investment and (b) a peso expected to be received is riskier and less
certain. We consider the time value of money to make these cash flows
comparable. We either determine their future value at a common future date
or compute their present value today as not to compare “apples” against
“oranges”.

The Concept of Interest

Interest is defined as the cost of using money over time. the excess of
resources (usually cash) received or paid over the amount of resources loaned
or borrowed is called the principal. The cost of the excess resources to the
borrower for the use of money is called interest expense. The benefit of the
excess resources to the lender of money is called interest revenue.

Time value of money involves two major concepts: future value and present
value. Both concepts consider three factors (1) principal, (2) interest rate, and
(3) time period.

Business transactions subject to interest state whether simple or compound

interest is to be calculated.

Simple Interest
If the interest earned or incurred is always based on the original principal,
then the simple interest is assumed.

Example 1:
Evan Dave invested P10,000 for 3 years at 9% and the proceeds from the
investment will all be collected at the end of 3 years.

Using a simple interest assumption, interest will be computed as follows:

Year Principal Rate Time Interest Cumulative Interest Total
1 P10,000 9% 1
2 P10,000 9% 1
3 P10,000 9% 1

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Compound Interest
The usual assumption in most business transactions is to use compound
interest. Compound interest is simply earning interest on interest. This
means that the basis for the computation of the applicable interest for a
certain period is not only the original principal but also any interest earned
in the previous period assuming all cash flows would be paid or received in
lump sum upon maturity.

Example 2:
Using the previous example where Evan Dave invested P10,000 for 3 years at
9% and the proceeds from the investment will all be collected at the end of 3
years, illustrate the computation of compound interest.
Year Principal+Cumulative Rate Time Interest Cumulative Total
Interest Interest
1 P10,000 9% 1
2 P10,000 9% 1
3 P10,000 9% 1

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 own more
than a dollar in the future. The process of going to future values (FVs) from
present values (PVs) is called compounding.

Future Value (Annual Compounding)

FVn=PV(1+k)n

Future value (FVn) is equal to the initial principal amount (PV), compounded
at the interest rate (k) for periods (n).

Example:
Compute for the future values of P1,000 compounded at a 10% annual
interest rate at the end of one year, two years, and five years.
Year Calculation FV
1 FV1=(P1,000)(1+.10)^1 P1,100
2 FV2=(P1,000)(1+.10)^2 P1,210
=(P1,000)(1.21)
5 FV5=(P1,000)(1+.10)^5 P1,610.51
=(P1,000)(1.61051)

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Example:
Compute for the future value of P1,000 compounded at a 10% annual interest
rate at the end of five years.

Using a periodic table, find the value in Table D-1 that corresponds to the
intersection of a 10 percent interest rate with compounding for five years, that
is, FVIF .10,5. This value is 1.611 and represents the calculation (1.10)^5.
Now, substitute 1.611 in the above equation to find the future value.

FV5=(P1,000)(1.611)
=P1,611

Future Value (With Intra-Period Compounding)

Compounding that occurs more than once a year is called intra-period
compounding. The calendar period over which compounding occurs is called
compounding period. For example, compounding may occur annually,
semiannually (2), quarterly (4), or monthly (12). When using the intra-period
compounding, the future value formula must be modified to reflect the
number of times per year compounding occurs, denoted by m.

FVn=PV(1+k/m)mn

Example:
Instead of placing P1,000 in Atlanta Bank that pays 10% interest annually,
the financial manager decides to put the money in National Bank that pays
10% interest compounded semi-annually. Which bank will you choose to put
the money into?

Atlanta Bank (Annual) National Bank (Semiannual)

FV1=(P1,000)(1+.10)^1 FV1=(P1,000)(1+.10/2)^(2)(1)
=(P1,000)(1+.10) =(P1,000)(1.1025)
=P1,100 =P1,102.50

Future Value Determination Involving Stream of Unequal Payments

Calculating the future value of an unequal stream of payments involves the

future value of each payment at a specified future date and then summing
these future values.

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The sigma (∑) notation is a mathematical symbol for summing a series of
values. The future value of a time period (FVn) is found by adding up each
payment (Pt) adjusted for the number periods of in which interest is earned.
The exponent (n-t) indicates the number of periods un which interest is
earned.

Example:
A firm plans to deposit P2,000 today and P1,500 one year from now at Mount
Carmel Rural Bank. No future deposits or withdrawals are made and the bank
pays 10% interest compounded annually. The future values of the account at
the end of 4 years is computed as follows:

FV4=(P2,000)(1.10)^4+(P1,500)(1.10)^3
=(P2,000)(1.464)+(P1,500)(1.331)
=2,928.00+P1,996.50
=P4,924.50

Future Value Determination Involving Stream of Equal Payments

A stream of equal payments made at the regular time intervals is an annuity,

sometimes called a fixed annuity. There are two types of fixed annuities:

1) Ordinary annuity is one in which the payments or receipts occurs at the

end of each period. This type of annuity is also called a regular or deferred
annuity.

FVOAn=A(FVIFAi,n)

FVOA= future value of an ordinary annuity

A= the amount of fixed annuity payment
FVIFAi,n= future value interest factor of an annuity for interest rate (i), and
time period (n)

Example:
Crystal Corporation depends P1,000 at the end of each three consecutive
years in a bank account paying 10% interest compounded annually. The
value of the account at the end of the 3rd year is computed as follows:

FVOA3=(P1,000)(FVIFAi,n)
=(P1,000)(3.310)
=P3,310

2) Annuity due is one which payments or receipts occurs at the beginning of

each period.

FVADn=A(FVIFAi,n)(1+i)

FVADn= future value of an annuity due

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Example:
Instead of depositing P1,000 at the end of each year for three consecutive
years, the firm makes deposits at the beginning of each year. Interest is
compounded annually at 10%. How much will the firm have in account after
three years?

FVAD3=(P1,000)(FVIFAi,n)(1+i)
=(P1,000)(3.310)(1.10)
=P3,641

Present Value
Present value is the current value of a future amount of money, or series of
payments, evaluated at an appropriate discount rate. A discount rate,
sometimes called the required rate of return, is the rate of interest that is
used to find present values. The process of determining the present value of
a future amount is called discounting.

Discounting
Future value determination compounds money forward in time to determine
its worth in the future. Present value determination discounts money that will
be received in the future back in time to see what it is worth in the present.

PV=FVn(PVIFi,n)

Example:
John Archel Arroyo expects to receive P1,000 five years from now and wants
to know what this money is worth today. The value today of P1,000 to be
received five years from now discounted at 10 percent.

PV=(P1,000)(0.621)
=P621

Present Value Determination of a Stream of Unequal Payments

To find the present value of an unequal, or mixed, stream of payments, simply
calculate the present value of each future amount separately and then add
these present values together.

PV=t=1nPt (PVIF i,t)

Example:
Evan Dave Tolentino expects to receive payments of P1,000, P1,500, and
P2,000 at the end of one, two, and three years, respectively. The present value
of this stream of payments discounted at 10 percent.

PV=(P1,000)(0.909)+(P1,500)(0.828)+(P2,000)(.751)
=P909+P1,242+P1,502
=P3,653

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Present Value Determination of a Stream of Equal Payments
PVOAn=A(PVIFAi,n)

Example:
Gillian Azurin expects to receive P1,000 at year’s end for the next three years.
The present value of this annuity is discounted at 10 percent.
PVOA3=(P1,000)(2.487)
=P2,487

Determination of the Present Value of a Perpetuity

A perpetuity is an annuity with an infinite life; that is, the payments continue
indefinitely. The present value of a perpetuity is found using the equation
below.

PV of a perpetuity= Annuity/Discount rate

Example:
Honey Dew Corporation wants to deposit an amount of money in a bank
account that will allow it to withdraw P1,000 indefinitely at the end of each
year without reducing the amount of the initial deposit. If a bank guarantees
to pay the firm 10 percent interest on its deposits, the amount of money the
firm has to deposit is:

PV of a perpetuity= P1,000/.10
=P10,000

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 Self-Assessment

Exercise 1
Compute the annual interest, total interest, and amount to be received or
paid at the end of the term for each scenario using a simple interest
assumption.
1) Your mother invested P18,000 in the government securities that yields 6%
annually for two years.
2) Your father obtained a car loan for P8,000 with an annual rate of 15% for
5 years.
3) Your brother borrowed from your neighbor P7,000 to buy a new mobile
phone. The neighbor charged 11% for the borrowed amount payable after
three years.
Compute the annual interest, total interest, and amount to be received or
paid at the end of the term for each scenario using a compound interest
assumption.
4) Your mother invested P18,000 in government securities that yields 6% for
two years.
5) Your father obtained a car load for P800,000 with an annual rate of 15%
for five years.

Exercise 2

1. Compute for the following:

a. At the end of 3 years, how much is an initial deposit of P100 worth,
assuming an annual interest rate of (1) 10%? (2) 20%? (3) 30%?
b. At the end of 3 years, how much is an initial deposit of P100 worth,
assuming a quarterly compounded interest rate of (1) 10%? (2) 20%? (3) 30%?
c. Why does your answer to part B differ from that to part A?
d. At the end of 10 years, how much is an initial deposit of P100 worth,
assuming an interest rate of 12% compounded (1) annually? (2)
semiannually? (3) quarterly?

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Exercise 3:
1) What is the present value of
a. P8,000 in 10 years at 6 percent?
b. P16,000 in 5 years at 12 percent?
c. P25,000 in 15 years at 8 percent?
d. P1,000 in 40 periods at 20 percent?

2) How much would you have to invest today to receive

a. P12,000 in 6 years at 12 percent?
b. P15,000 in 15 years at 8 percent?
c. P5,000 each year for 10 years at 8 percent?
d. P40,000 each year for 40 years at 5 percent?

3) Find the present value of P5,000 to be received in four years discounted

at the following rates: a) 5 percent, b) 10 percent and c) 15 percent.

4) What is the present value of a stream of payments of P500 per year

forever, assuming interest rates of a) 5 percent and b) 10 percent?

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 References

Cayanan, A.S & Borja, D.V. (2017). Business Finance. REX Book Store

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