POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

GRADUATE SCHOOL

Master in Business Administration

MBA 656 Advanced Financial Management

LONG TERM INVESTMENT

DECISIONS:
TIME VALUE OF MONEY (TVM)

Submitted to:

DR. RELLITA D. PAEZ, CPA, DBA

Submitted by:

GROUP 2 - MARY ANN B. MARIANO

 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

LONG TERM INVESTMENT

DECISIONS:
TIME VALUE OF MONEY (TVM)
The time value of money refers to the observation that it is better to receive money
sooner than later. Money that you have in hand today can be invested to earn a positive
rate of return, producing more money tomorrow. For that reason, “A peso today is worth
more than a peso tomorrow.” All individuals and businesses face the same two basic
finance-related problems:
 Where to put money: Investment
 Where to get money: Financing decisions
In addressing the investment problem, individuals and companies choose from a
wide variety of real and financial assets.
They can opt to put their funds in REAL ASSETS that represent their projects such
as purchasing equipment and machinery with the purpose of generating revenues across
the useful lives of these assets. This could also take the form of adding a new factory or
office building, and acquisition of licensed brands.
FINANCIAL ASSETS include investing in the shares of another company, lending
money to others and purchasing fixed income instruments such as government issued
Treasury securities and corporate bonds.
Time value of money is used to determine the value of investments. Investments
are affected by both inflation and interest rates. Investment decisions are based on what
can be purchased now versus what can be purchased with the same amount of money in
the future considering the effects of inflation and interest rates. To make an investment
worthwhile, the amount earned by the end of the investment period should be greater than
the rate of inflation over the same time period. Obtaining a loan to have money to use today
makes financial sense if the present value of the money is higher than the value of the
money including interest when the loan is repaid.
The time value of money compares the future value with the present value of an
amount of money.
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 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

FUTURE VALUE VS. PRESENT VALUE

 Future value: FV, is the amount to which an amount of money will grow in a
defined period of time at a specified investment rate.
Q: What amount of money in the future is equivalent to ₱15,000 today? In other
words, what is the future value of ₱15,000?
 Present Value: Present value is the current value of an amount of money to
be received at a future date based on a specified investment rate. Time value of money
is used to determine the value of investments.
Q: What amount today is equivalent to ₱17,000 paid out over the next 5 years as
outlined above? In other words, what is the present value of the stream of cash flows coming
in the next 5 years?
A time line depicts the cash flows associated with a given investment. It is a
horizontal line on which time zero appears at the leftmost end and future periods are marked
from left to right.

The cash flows occurring at time zero (today) and at the end of each subsequent
year are above the line; the negative values represent cash outflows (₱15,000 invested
today at time zero), and the positive values represent cash inflows (₱3,000 inflow in 1 year,
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₱5,000 inflow in 2 years, and so on).

 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

The future value technique uses compounding to find the future value of each cash
flow at the end of the investment’s life and then sums these values to find the investment’s
future value. Alternatively, the present value technique uses discounting to find the present
value of each cash flow at time zero and then sums these values to find the investment’s
value today. In practice, when making investment decisions, managers usually adopt the
present value approach.
BASIC PATTERNS OF CASH FLOW
The cash flow—both inflows and outflows—of a firm can be described by its general
pattern. It can be defined as a single amount, an annuity, or a mixed stream.
 Single amount: A lump-sum amount either currently held or expected at some fu-
ture date. Examples include ₱1,000 today and ₱650 to be received at the end of 10 years.
 Annuity: A level periodic stream of cash flow. For our purposes, we’ll work primarily
with annual cash flows. Examples include either paying out or receiving ₱800 at the end of
each of the next 7 years.
 Mixed stream: A stream of cash flow that is not an annuity; a stream of unequal
periodic cash flows that reflect no particular pattern. Examples include the following two
cash flow streams A and B.
a) SINGLE AMOUNT
i. Future Value of a Single Amount
Future value is the amount to which an amount of money will grow in a defined
period of time at a specified investment rate. A business may face questions such as:
■ Example: If we borrow ₱380,000 today to replace outdated equipment and the
terms are 8 percent for 5 years compounded quarterly, what is the total cost of the
purchase?
To determine the total cost of the equipment purchase, the calculation is
Formula: FV = PV (1 + r)n
FV = future value of the investment or loan
P= principal
r = interest rate per period of compounding
n = number of compounding periods in the length of the loan
Where:
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PV = 380,000
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

r= 8% / 4 (quarterly) = 2% or .02 = quarterly interest

n = 4 (quarterly) x 5 (years) = 20 = compounding periods
Solution:
FV = ₱380,000 (1 + 0.02)20
FV = ₱380,000 (1.4859)
FV = ₱564,642
ii. Present Value of a Single Amount
Businesses encounter several situations where they need to determine the present
value of money. If a company wants to borrow money, the lender will charge interest for the
time the company uses the money. A typical procedure is for the lender to discount the loan.
A discount is the amount of money subtracted from a loan at the time of lending
equal to the interest charged by the lender.
Formula: PV = FV ÷ (1 + r)n
■ Example: If a business borrows ₱10,000 for one year from a bank at an interest
(discount) rate of 8 percent, how much is the actual amount of money received?
Where:
FV = 10,000
r =8%
n=1
Solution:
PV = 10,000 ÷ (1 + .08)1
PV = 10,000 ÷ (1 + .08)1
PV = 9,260.00
b) ANNUITY
A stream of equal periodic cash flows over a specified time period. These cash flows
can be inflows of returns earned on investments or outflows of funds invested to earn future
returns.
TYPES OF ANNUITIES
A. ordinary annuity - An annuity for which the cash flow occurs at the end of each
period.
B. annuity due - An annuity for which the cash flow occurs at the beginning of each
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period.
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

i. FINDING THE FUTURE VALUE OF AN ORDINARY ANNUITY

Formula: FVn = CF [(1 + r)n – 1] ÷r
FV = Future value
CF = Cash Flow / annual payment
r = interest rate per period of compounding
n = number of compounding periods in the length of the loan
■ Example: Ms. Dela Cruz wishes to determine how much money she will have at
the end of 5 years if she chooses ordinary annuity. She will deposit ₱1,000 annually, at the
end of each of the next 5 years, into a savings account paying 7% annual interest.
Where:
CF = 1,000
r = 7%
n = 5 years
Solution:
FV5 = ₱1,000 [(1 + .07)5 – 1] ÷.07
FV5 = ₱1,000 [1.40255 – 1] ÷.07
FV5 = ₱402.5517÷ 0.07
FV5 = ₱5,751.00
ii. FINDING THE FUTURE VALUE OF AN ANNUITY DUE
Formula: FVn = CF [((1 + r)n – 1)÷r] (1+r)
FV5 = ₱1,000 [((1 + .07)5 – 1) ÷.07] x (1.07)
FV5 = ₱1,000 [1.40255 – 1) ÷.07] (1.07)
FV5 = ₱402.5517÷ 0.07 (1.07)
FV5 = ₱5,750.74 (1.07)
FV5 = ₱6,153.00
**Ordinary annuity ₱5,750.74 versus Annuity due ₱6,153.29
iii. FINDING THE PRESENT VALUE OF AN ORDINARY ANNUITY
Formula: PVn = (CF÷r) [1 – (1÷(1+r)n )]
■ Example: Braden Company, a small producer of plastic toys, wants to determine
the most it should pay to purchase a particular ordinary annuity. The annuity consists of
cash flows of ₱700 at the end of each year for 5 years. The firm requires the annuity to
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provide a minimum return of 8%.

 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

Where:
CF = 700
r = 8%
n = 5 years
Solution:
PV5 = (700÷.08) [1 – (1÷(1+.08)5 )]
PV5 = (8,750) [1 – (1÷(1+.08)5 )]
PV5 = (8,750) [1 – (1÷(1.4693)]
PV5 = (8,750) [1 – .680596]
PV5 = (8,750) [.31940]
PV5 = 2,795.00
iv. FINDING THE PRESENT VALUE OF AN ANNUITY DUE
Formula: PVn = (CF÷r) [1 – (1÷(1+r)n )] (1+r)
PV5 = (700÷.08) [1 – (1÷(1+.08)5 )] (1+.08)
PV5 = (8,750) [1 – (1÷(1+.08)5 )] (1+.08)
PV5 = (8,750) [1 – (1÷(1.4693)] (1+.08)
PV5 = (8,750) [1 – .680596] (1+.08)
PV5 = (8,750) [.31940] (1.08)
PV5 = 2,795.00 (1.08)
PV5 = 3,018.00
c) PERPETUITY
A perpetuity is an annuity with an infinite life—in other words, an annuity that never
stops providing its holder with a cash flow at the end of each year (for example, the right to
receive ₱500 at the end of each year forever).
Formula: PV = CF ÷ r
■ Example: Ross Clark wishes to endow a chair in finance at his alma mater. The
university indicated that it requires ₱200,000 per year to support the chair, and the
endowment would earn 10% per year. To determine the amount Ross must give the
university to fund the chair, we must determine the present value of a ₱200,000 perpetuity
discounted at 10%.
Where:
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CF = 200,000
 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

r= .10
Solution:
PV = ₱200,000 ÷ 0.10 = ₱2,000,000
In other words, to generate ₱200,000 every year for an indefinite period requires
₱2,000,000 today if Ross Clark’s alma mater can earn 10% on its investments. If the
university earns 10% interest annually on the ₱2,000,000, it can withdraw ₱200,000 per
year indefinitely.
d) MIXED STREAMS
Two basic types of cash flow streams are possible, the annuity and the mixed
stream. Whereas an annuity is a pattern of equal periodic cash flows, a mixed stream is a
stream of unequal periodic cash flows that reflect no particular pattern. Financial managers
frequently need to evaluate opportunities that are expected to provide mixed streams of
cash flows.
i. FUTURE VALUE OF A MIXED STREAM
The future value of uneven cash flows is the sum of future values of each cash flow.
It can also be called “terminal value.” Unlike annuities where the amount of payment is
constant, many financial instruments and assets generate cash flows that can vary from
period to period. For example, dividends on common stock and coupon payments of a
floating rate bond can vary. Cash flow generated by business activity is another common
example of uneven or irregular cash flows.
Formula: FV = CF1(1+r)N-1 + CF2(1+r)N-2 + ….
N = number of periods
CF = cash flow at period t
r = interest rate per period

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 POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

■ Example

Cash Flow

1 ₱ 1,000

2 ₱ 800

3 ₱ 1,100

4 ₱ 700

5 ₱ 1,050

Where:
r = 12%
N = 5 years
Solution:
FVCF1 = ₱1,000 (1+0.12)(5-1) = ₱1,573.52
FVCF2 = ₱800 (1+0.12)(5-2) = ₱1,123.94
FVCF3 = ₱1,100 (1+0.12)(5-3) = ₱1,379.84
FVCF4 = ₱700 (1+0.12)(5-4) = ₱784.00
FVCF5 = ₱1,050 (1+0.12)(5-5) = ₱1,050.00
(remember anything to the power of zero is 1)
Thus, the total future value of the uneven cash flow stream is ₱5,911.30.

ii. PRESENT VALUE OF A MIXED STREAM

Common examples of an uneven cash flow stream are dividends on common stock,
coupon payments on a floating-rate bond, or the free cash flow of a business. Since the
value of each cash flow in the stream can vary and occur at irregular intervals, the present
value of uneven cash flows is calculated as the sum of the present values of each cash flow
in the stream.
Formula: PV = CF1÷ (1+r)1 + CF2÷ (1+r)2 + ….
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POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

■ Example

Cash Flow

1 ₱ 1,500

2 ₱ 1,850

3 ₱ 2,100

4 ₱ 2,500

5 ₱ 2,950

Where:
r = 15.75%
N = 5 years
Solution:
PV = CFN÷ (1+r)N
PV = 1,500÷ (1+0.1575)1 = 1,295.90
PV = 1,850÷ (1+0.1575)2 = 1,380.80 1.33980625
PV = 2,100÷ (1+0.1575)3 = 1,354.12
PV = 2,500÷ (1+0.1575)4 = 1,392.69
PV = 2,950÷ (1+0.1575)5 = 1,419.77
Thus, the present value of the uneven cash flow stream will be ₱6,843.27.
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