Chapter 5 and 6

CONCEPT OF TIME VALUE

 P5,000,000 today or after 5 years? Which has
more value? (i = 5%)
 Will your answer change if the choice is
P5,000,000 today or P5,500,000 after 5
years?
 Is P500,000 worth the 5 years?
 Time value is based on the belief that a peso
today is worth more than a peso to be
received at some future date. It assist
managers in making decisions for cash flows
involving different time periods
TYPES OF TIME VALUE
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
TWO VIEWS OF TIME VALUE
 Future Value – value of an investment today
at a future date
 Known item- current cash flow
 Process of computing the FV- compounding or
projecting

 PresentValue- value today of a cash flow to

be received in the future
 Known item- future cash flow
 Process of computing the PV- discounting
PATTERNS OF CASH FLOW
 Lump Sum–single cash flow either currently held
or expected at a future date

 Annuity- stream of equal periodic cash flows

 Ordinary annuity- occurs at the end of each period
(commonly used)
 Annuity due- occurs at the beginning of each period

 Mixed Stream- series of unequal cash flows

reflecting no particular pattern
 TIMELINE DEPICTING CASH FLOW
Future
Value

PROJECTING/
COMPOUNDING
P1,020,000
-P1,000,000 P1,000 P1,000 P1,000 P1,000 P1,000

0 1 2 3 4 5

DISCOUNTING

Present
Value
COMPUTATIONAL TOOLS
 There are different methods in calculating
Present Value or Future Value
 1st: use of equation or algebraic formula

 2nd: use of financial tables

 3rd: use of financial calculator
 4th: use of financial spreadsheet (Excel)
ELEMENTS IN COMPUTATION
 FV – future value or terminal value
 PV – present value
 r – interest rate or opportunity cost per
period (typically 1 year)
 n – number of periods invested (typically
years)
 CFt – cash flow at the end of year t
 t - year number (1,2,3….n)
 CF – annuity’s annual payment
 g – constant annual growth rate
 m – number of times compounded per year
SIMPLE VS COMPOUND INTEREST

 There are two ways to apply interest over the

principal:
 Simple interest- interest paid only on the initial principal
of an investment
 Compound interest- interest earned on both principal
and on interest earned in previous period (commonly
used)
 Example: P2,000,000 earning 12% per year under
a 3-year time deposit. Compute for the maturity
value applying:
1. Simple
interest
2. Compound interest
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
 FUTURE VALUE OF A LUMP SUM
 Value of a single amount in the future
 Example: The projected amount of
P1,000,000 after 5 years with an effective
interest of 10%
Future
Value

P1,000,000

0 1 2 3 4 5
FUTURE VALUE OF A LUMP SUM (CONT’D)
Details Applying in the example
Equation FV = 1,000,000 x (1+10%)5

Table FV = PV x FVFr%,n FVF10%,5 = 1.61051

Determine the FV factor FV = 1,000,000 x 1.61051
(FVF) Table
Financial Input n, r% and PV PV= 1,000,000
Calculator N = 5; I = 10
Excel Excel function (fx): =- fx =-fv(10%, 5,0,1000000)
fv(rate, nper, pmt, [pv],
[type])
Compounding more frequently than
annually
 For: Semiannual, Quarterly, monthly, weekly or
daily
 Modify FV equation by dividing the interest rate
(r) by the number of times compounded per year
(m) and multiplying the period (n) by m.

 Example: P1,000,000 compounded monthly for 5

years, assuming a 10% interest rate
 FV = 1,000,000 x [1+(10%/12)](12x5)
APR vs. EAR
 Annual Percentage Rate (APR)- aka simple,
nominal, quoted or stated interest rate
 APR-the interest paid or earned in one year
without compounding

 Effective Annual Rate (EAR) – the annual

compounded rate that produces the same return
as the nominal or stated rate
Computing APR vs. EAR
 Example: Where will you invest your P5,000,000
given the following options: (1) At a time deposit
with 12.25% interest rate or (2) At a time deposit
with 12% interest rate compounded monthly

 APR (option 1)= 12.25%

 APR (option 2) = 12%

 EAR (option 1) = [1+(12.25%/1)]1 -1

 EAR (option 2) = [1+(12%/12)]12 -1
Continuous Compounding
 Compounding interest literally all the time.
Equivalent to compounding interest an infinite
number of times per year.
 We use exponential function as follows:

Example: P1,000,000 compounded continuously at

10% interest rate for 2 years

FV = 1,000,000 x e(10%x2)
EAR = e10%-1
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
FUTURE VALUE OF AN ORDINARY ANNUITY

 Value of equal cash flows made each year in

the future
 Example: The compounded amount of P1,000
every end of the year for 5 years with an
effective interest of 10%
Future
Value

P1,000 P1,000 P1,000 P1,000 P1,000

0 1 2 3 4 5
FUTURE VALUE OF AN ORDINARY
ANNUITY (CONT’D)
Details Applying in the example
Equation FV = 1,000 x {[(1+10%)5 -
1]/10%}

Table FV = PMT x FVFAr%,n FVFA10%,5 = 6.10510

Determine the FV factor FV = 1,000 x 6.10510
annuity (FVFA) Table
Financial Input n, r% and PMT in PMT= 1,000;
Calculator calculator N = 5; I = 10
Excel Excel function (fx): =- fx =-fv(10%, 5,1000,0,0)
fv(rate, nper, pmt, [pv],
[type])
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
 FUTURE VALUE OF AN ANNUITY DUE

 Value of equal cash flows made each year in

the future
 Example: The compounded amount of P1,000
every beginning of the year for 5 years with
an effective interest of 10%
Future
Value

P1,000 P1,000 P1,000 P1,000 P1,000

0 1 2 3 4 5
FUTURE VALUE OF ANNUITY DUE
(CONT’D)
Details Applying in the example
Equation FV = 1,000 x {[(1+10%)5 -
1]/10%} x (1+10%)

Table FV = PMT x FVFAr%,n x (1 + FVFA10%,5 = 6.10510

i) FV = 1,000 x 6.10510 x
Determine the FV factor (1+10%)
annuity (FVFA) Table
Financial Input n, r% and PMT in PMT= 1,000;
Calculator calculator N = 5; I = 10; multiply
answer by (1+10%)
Excel Excel function (fx): =- fx =-fv(10%, 5,1000,0,1)
fv(rate, nper, pmt, [pv],
[type])
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
FUTURE VALUE OF A MIXED STREAM
 Value of unequal cash flows in the future
 Example: The terminal value of the following
cash flows: year 1 = P5,500; year 2 = P1,500;
year 4 = P500; with an effective interest of
10%
Future
Value

P5,500 P1,500 P500

0 1 2 3 4 5
FUTURE VALUE OF MIXED STREAM
(CONT’D)
Details Applying in the example

Equation FV=[5,500 x (1+10%)5-1] +

or [1,500 x (1+10%)5-2] + [500 x
(1+10%)5-4]
FV = CF1 x (1+i)n-1 + CF2 x
(1+i)n-2 +…+ CFn x (1+i)n-n

Table FV = (CFt x FVFr%,n-t) + (CFt FVF10%,4 = 1.46410

x FVFr%,n-t) … FVF10%,3 = 1.33100
Determine the FV factor FVF10%,1 = 1.10000
(FVF) Table
FV = (5,500 x 1.46410) +
(1,500 x 1.33100) + (500 x
1.10000)
FUTURE VALUE OF MIXED STREAM
(CONT’D)
Details Applying in the example
Financial Compute for NPV: input Enter the CFs: 5,500; 1,500;
Calculator* interest and cash flows for 0; 500; 0
the period N = 12
Then compute for FV: Enter: N = 5, I = 10, NPV =
Input n, r% and PV
Excel* Excel function (fx)for NPV: NPVfx =NPV(10%,5500,1500,
=NPV(rate,CF1,CF2,CF3, 0,500,0)
CF4,CF5) FVfx =-fv(10%, 5,0,PV)
Excel function (fx)for FV:
=-fv(rate, nper, pmt, [pv],
[type])

* Comprise of two computations: discount all cash flows at

year 0 (NPV) then compute for the FV
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
 PRESENT VALUE OF A LUMP SUM
 Valuetoday of single future cash flow
 Example: The discounted amount of
P1,100,000 to be received after 5 years
assuming an opportunity cost of 10%

P1,100,000

0 1 2 3 4 5

Present
Value
PRESENT VALUE OF A LUMP SUM (CONT’D)
Details Applying in the example
Equation PV = 1,100,000 / (1+10%)5

Table PV = FV x PVFr%,n PVF10%,5 = 0.62092

Determine the PV factor PV = 1,100,000 x 0.62092
(PVF) Table
Financial Input n, r% and FV FV= 1,100,000;
Calculator N = 5; I = 10
Excel Excel function (fx): =- fx =-pv(10%, 5,0,1100000)
pv(rate, nper, pmt, [fv],
[type])
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
 PRESENT VALUE OF AN ORDINARY ANNUITY
 Value today of equal cash flows to be made
in the future
 Example: The discounted amount of P1,000
every end of the year for 5 years with an
opportunity cost of 10%
P1,000 P1,000 P1,000 P1,000 P1,000

0 1 2 3 4 5

Present
Value
PRESENT VALUE OF AN ORDINARY
ANNUITY (CONT’D)
Details Applying in the example
Equation PV = (1,000/10%) x {1-
[1/(1+10%)5]}

Table PV = PMT x PVFAr%,n PVFA10%,5 = 3.79079

Determine the PV factor PV = 1,000 x 3.79079
annuity (PVFA) Table
Financial Input n, r% and PMT in PMT= 1,000;
Calculator calculator N = 5; I = 10
Excel Excel function (fx): =- fx =-pv(10%, 5,1000,0,0)
pv(rate, nper, pmt, [pv],
[type])
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
 PRESENT VALUE OF AN ANNUITY DUE

 Value today of equal cash flows to be made

in the future
 Example: The discounted amount of P1,000
every beginning of the year for 5 years with
an opportunity cost of 10%
P1,000 P1,000 P1,000 P1,000 P1,000

0 1 2 3 4 5

Present
Value
PRESENT VALUE OF ANNUITY DUE
(CONT’D)
Details Applying in the example
Equation PV = (1,000/10%) x {1-
[1/(1+10%)5]} x (1+10%)

Table PV = PMT x PVFAr%,n x (1 + PVFA12%,5 = 3.79079

R) PV = 1,000 x 3.79079 x
Determine the PV factor (1+10%)
annuity (PVFA) Table
Financial Input n, r% and PMT in PMT= 1,000;
Calculator calculator N = 5; I = 10; then multiply
by (1+10%)
Excel Excel function (fx): =- fx =-pv(10%, 5,1000,0,1)
pv(rate, nper, pmt, [pv],
[type])
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
 PRESENT VALUE OF A MIXED STREAM
 Value today of unequal cash flows to be made in
the future
 Example: The discounted amount of the
following cash flows: year 1 = P2,500; year 2 =
P1,500; year 4 = P800; with an opportunity cost
of 10%
P2,500 P1,500 P800

0 1 2 3 4 5

Present
Value
PRESENT VALUE OF MIXED STREAM
(CONT’D)
Details Applying in the example

Equation PV=
{2,500 x [1/(1+10%)1]} +
or {1,500 x[1/(1+10%)2]} + {800
x [1/(1+10%)4]}
PV = CF1 x [1/(1+r)1] + CF2
x [1/(1+r)2] +…+ CFn x
[1/(1+r)n]
Table PV = (CFt x PVFr%,t) + (CFt x PVF10%,1 = 0.90909
PVFr%,t) + … + (CFn x PVF10%,2 = 0.82645
PVFr%,n) +
PVF10%,4 = 0.68301
Determine the PV factor
FV = (2,500 x 0.90909) +
(PVF) Table
(1,500 x 0.82645) + (800 x
0.68301)
PRESENT VALUE OF MIXED STREAM
(CONT’D)
Details Applying in the example
Financial Compute for NPV: input Enter the CFs: 2,500; 1,500;
Calculator interest and cash flows for 0; 800; 0
the period N = 10

Excel Excel function (fx)for NPV: NPVfx =NPV(10%,2500,1500,

=NPV(rate,CF1,CF2,CF3, 0,800)
CF4,CF5)
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
PRESENT VALUE OF A LEVEL PERPETUITY

 Perpetuity- an annuity that continues forever or

has no maturity
 Level perpetuity- an annuity with constant level
of payments with an infinite life
 Annuities with infinite lives, hence period (n) is
expressed as infinity (∞)
 Example: Perpetual bonds or Preferred shares
with an annual interest or dividend of P1,000
assuming a 10% opportunity cost.
 Computed using the formula:
 PV = 1,000/ 10%
TIME VALUE

Future value

Lump Sum Annuity Mixed Stream

Ordinary

Due

Present Value

Lump Sum Annuity Mixed Stream Perpetuity

Ordinary Level

Due Growing
PRESENT VALUE OF A GROWING
PERPETUITY
 Growing Perpetuity- a perpetuity in which the
payments grow at a constant rate from period
to period over time
 Accounts for expected growth in future cash
flows
 Example: Salaries and wages, dividends SSS
payments, rent and utility expense, car price or
tuition starting at P1,000 per year with 2%
growth rate and assuming a 10% opportunity
cost.
 Computed using the: wherein r>g
 PV = 1,000/ (10% - 2%)
PRESENT VALUE OF A GROWING
PERPETUITY (cont’d)
 Cash flow of any specific future year: CFt= CF1 x
(1 + g)t-1

 Example: Determine the cash flow for the 13th

year.
 CF13= 1,000 x (1 + 2%)13-1
INITIAL QUESTION
 P5,000,000today or after 5 years? Which has
more value? (i=5%)
Compare at 5M TODAY 5M AFTER 5 years
PV (year 0) P5,000,000 P3,917,630.83
FV (year 5) P6,381,407.81 P5,000,000

 Will
your answer change if the choice is
P5,000,000 today or P5,500,000 after 5
years? Is P500,000 worth the 5 years?

Compare at TODAY AFTER 5 years

PV (year 0) P5,000,000 P4,309,393.92
FV (year 5) P6,381,407.81 P5,500,000
APPLICATIONS OF TIME VALUE
TECHNIQUES
 Common applications and refinements:
1. Compounding more frequently than annually
2. Stated vs. effective annual interest rates
3. Regular deposits needed to accumulate a future
sum- using FV of an annuity equation

4. Loan amortization- using PV of an annuity

equation
APPLICATIONS OF TIME VALUE
TECHNIQUES
 Common applications and refinements:
5. Determining interest or growth rate- using FV of
a lump sum equation

6. Determining unknown number of periods-using

FV of a lump sum or annuity equation
Rule of 72- is a simplified way to determine how long an
investment will take to double, given a fixed annual rate of
interest. By dividing 72 by the annual rate of return,
investors can get a rough estimate of how many years it will
take for the initial investment to duplicate itself.
Rule of 72
COMPLEX TIME VALUE PROBLEM
Joie is planning to attend 4-year college when she
graduates from high school 7 years from now. She
anticipates that she will need P10,000 at the beginning
of each college year to pay for tuition and fees, and
have some spending money. Joie has made an
arrangement with her father to do the household
chores if her dad deposits P3,500 at the end of each
year for the next 7 years in a bank account paying 10
percent interest. Will there be enough money in the
account for Joie to pay for her college expenses?
Assume the rate of interest stays at 10 percent during
the college years.
 Future
Value

P3,500 P3,500 P3,500 P3,500 P3,500 P3,500 P3,500

0 1 2 3 4 5 6 7 8 9 10
-P10,000 -P10,000 -P10,000 -P10,000

Present
Value
KEY POINTS
 PV or FV enable us to compare cash flow with
different periods
 The higher the interest rates and period, the
higher the FV or the lower its PV.
 The present value and future value of an annuity
due is always greater than that of an identical
ordinary annuity (same CFs, interest rate and
period), hence:
 PV (annuity due) = PV (ordinary annuity) x (1+r)
 FV (annuity due) = FV (ordinary annuity) x (1+r)
 Computing mixed stream cash flows is simply the
summation of the PV or FV of lump sums
KEY POINTS (CONT’D)
 Using present value or future value to compare
options will result in the same choice of answer
 Increasing the frequency of compounding
increases overall rate of return, hence, results
to a higher FV.
 EAR allows us to compare interest rate with
different compounding periods.
 The more frequent the compounding occurs, the
higher the EAR.
Seatwork 1
1. When you retire you expect to live for another 30 years. During
those 30 years you want to be able to withdraw P45,000 at the
beginning of each year for living expenses. How much money do
you have to have in your retirement account to make this happen.
Assume that you can earn 8% on your investments.
2. If you were to invest P120 for two years, while earning 8%
compound interest, what is the total amount of interest that you
will earn?
3. A bank is offering a new savings account that pays 8% per year.
How long it will take a P100 investment to double?
4. Your credit card carries a 9.9% annual percentage rate,
compounded daily. What is the effective annual rate, or annual
percentage yield?