Time Value of Money

INTENDED LEARNING OUTCOME

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.
Time Value of Money
INTENDED LEARNING OUTCOME

Identify the different types of

annuities and calculate the
present value and future value
of both an ordinary annuity
and an annuity due.
Calculate relevant annuity
payments.
Time Value of Money
INTENDED LEARNING OUTCOME

Calculate the present value and future

value of an uneven cash flow stream.
Explain the difference between
nominal, periodic, and effective interest
rates.
Discuss the basics of loan amortization.

Reference: Brigham, Fundamentals of Financial Management

Time Value of Money
involves two major concepts:
future value and present value
both concepts consider three
factors:
1) principal
2) interest rate
3) time period
* Cabrera, Elenita, Financial Management vol. 1
Future Value (FV)

amount to which a cash

flow or series of cash flows
will grow over a given
period of time when
compounded at a given
interest rate
Future Value (FV)
(Terminal Value)

value at some future time

of a present amount of
money, or a series of
payments, evaluated at a
given interest rate
* Van Horne, Fundamentals of Financial Management
Present Value (PV)

the value today of a future cash

flow or series of cash flows.
current value of a future
amount of money, or a series of
payments, evaluated at a given
interest rate.
* Van Horne, Fundamentals of Financial Management
Time Line

The first step in time value

analysis is to set up a time line,
which will help one visualize
whats happening in a particular
problem.
As an illustration, consider the
following diagram, where PV
represents P100 that is on hand
today and FV is the value that will
Period
s 0 1 2 3
5%

CASH
PV = FV = ?
P100
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.
Time Line

an important tool used in

time value analysis
a graphical
representation used to
show the timing of cash
flows.
Time Line

Essential when you are first

learning time value concepts, but
even experts use them to analyze
complex finance problems;
We begin each problem by setting
up a time line to show whats
happening, after which we provide
an equation that must be solved
to find the answer.
Interest

money paid (earned) for the use

of money
Simple interest occurs when
interest is not earned on interest.
interest paid (earned) on only the
original amount, or principal,
borrowed (lent) * Van Horne
Simple Interest

the product of the principal

amount multiplied by the
periods interest rate (a one
year rate is standard) * Cabrera
Simple Interest Illustration
(Cabrera)

ABC Corporation deposits P10,000 in a bank

at 10% interest a year. One year later the
P10,000 will have grown to P11,000; that is,
P10,000 principal and P1,000 interest.
The amount of interest is determined by
multiplying the interest rate of 10% (0.10 in
decimal notation) by the principal of
P10,000 (0.10 x P10,000 = P1,000). Thus,
the value of a peso today can increase in
the future because of the interest.
Simple Interest Illustration
(Cabrera)

Principal (beginning balance) P10,000

Interest for year 1 (10%)
(0.10 x P10,000) 1,000
Future value at the end
of year 1 P11,000
=======
P 10,000 P11,000
PV ___________________________________ FV
___________________________________ Time
t t
0 1
Compound Interest

occurs when interest is earned

on prior periods interest.
interest paid (earned) on any
previous interest earned, as
well as on the principal
borrowed (lent)
* Van Horne
Compound Interest

interest paid on both the principal

and the amount of interest
accumulated in prior periods
The process of determining future
value when compound interest is
applied is called compounding.

* Cabrera
Compounding

arithmetic process of determining

the final value of a cash flow or
series of cash flows when
compound interest is applied
process of going to future
values (FVs) from present
values (PVs)
 Compound Interest
Illustration
(Cabrera)
ABC Corp. leaves its P10,000 on deposit for two years in the bank
paying 10% annual interest.
Balance at the beginning of year 2 P 11,000
Interest for year 2 at 10%
(0.10 x P11,000) 1,100
Future value at the end of year 2 P 12,100

P10,000 P11,000 P 12,100

PV FV1 FV2

t 0 t 1t 2
Future Value of a P10,000 invested at 10% compound interest 2
two years.