Time Value of Money

Module 7
 Time Value of Money
• Founded on the principle that money has
earning capacity.

• The peso that you receive today has a

greater value compared to the peso you
will receive in the future.
 Illustration
• Student A receives Php 500.00 today.
Student A invests money in a time deposit with an earning capacity of 5% per
annum. Thus, by the end of 2019, Student A earns Php 25.00 from his
investment.

By the time, Student B receives his Php 500.00, Student A already earned Php
525.00 from his investment.

• Student B receives Php 500.00 in 2019.

 Time line
• A graphical representation of the timing of
cash flows.

Period 0 1 2 3

Cash PV = Php 500.00 FV = ?

Where: PV = Present Value

FV = Future Value
 Time line
• A graphical representation of the timing of
cash flows.
Beginning of
0 Period 1 1 2 3

Cash PV = Php 500.00 FV = ?

Where: PV = Present Value

FV = Future Value
 Time line
• A graphical representation of the timing of
cash flows.
End of Period 1

0 1 2 3

Cash PV = Php 500.00 FV = ?

Where: PV = Present Value

FV = Future Value
 Time line
• A graphical representation of the timing of
cash flows.
Beginning of
Period 2
0 1 2 3

Cash PV = Php 500.00 FV = ?

Where: PV = Present Value

FV = Future Value
 Time line
• A graphical representation of the timing of
cash flows.
End of Period 2

0 1 2 3

Cash PV = Php 500.00 FV = ?

Where: PV = Present Value

FV = Future Value
Simple vs Compound Interest
• Interest – amount earned when money is
loaned to someone else or is invested in a
financial product that promises earnings
after a certain period of time.
• Example
– Interest earned on money saved in a bank.
 Simple Interest
• Occurs when there is no interest earned on
top of interest that was earned in the
previous periods.

A = Principal (1+rt)
 Compound Interest
• Generating earnings (interest) from
previously generated earnings.

5 % or 0.05
Php 25.00 Php 26.25 Php 27.56

Php 500.00 Php 525.00 Php 551.25 Php 578.81

 Future Value
• FVN = PV (1 + I)N
Where FV = future value
N = no. of periods
I = interest rate
PV = Amount of Outflow at time 0
 Future Value
• FVN = PV (1 + I)N

• FV3 = Php 500 (1+0.05)3

= Php 500 (1.157625)
= Php 578.81
 Present Value
• The current worth of a future sum of
money or stream of cash flow given a
specified rate of return.

• PV = FVn/(1+I)N

• FV = Php 578.81/(1.05)3
FV = Php 578.81/1.157625
FV = Php 499.99 ~ Php 500.00
 When is it most appropriate to
compute for the Present Value?
• Suppose that a broker is trying to convince you
to invest in a bond that will pay Php 578.81 in
three years. Currently, banks are offering 5%
interest rate on 3-year time deposits. You now
have two options: buy the bond or buy the time
deposit. The 5% offered by the bank is your
opportunity cost.
• Opportunity Cost is the rate of return an
investor can earn on an alternative investment.
 Solution
• Two Options
Bond offered by the Broker Invest in a time deposit that
that will pay you Php 578.81 earns 5% in three years
in 3 years

In this case, need to know at what price should we pay for the bond?
First, determine the PV of Php 578.81.

If the broker offers the bond at a price lower than the PV of the bond
which is Php 500.00 then the investor may purchase the bond as this
will yield him a gain.

However, if the broker offers the bond at a price higher than the PV of
the bond then the investor may choose to invest his money in a time
deposit instead.
 Solution
• Two Options
Bond offered by the Broker that will pay you Php 578.81 in 3 years

Selling the bond lower than the PV will yield a gain.

Example: Selling the bond at Php 450.00. Determine the FV of the bond.

FV = PV (1 + I)N Compare the FV of Php 500.00 versus the FV

FV = 450 (1+0.05)3 of Php 450.00. It is clear that the investor will
FV = 520.93 ~ Php 521 yield a gain as the Php 450.00 bond will only
give him Php 521 but the broker promised
him a return of Php 578.81 in 3 years.
 Solution
• Two Options
Bond offered by the Broker that will pay you Php 578.81 in 3 years

Selling the bond higher than the PV will yield a loss.

Example: Selling the bond at Php 550.00. Determine the FV of the bond.

FV = PV (1 + I)N Compare the FV of Php 500.00 versus the FV of

FV = 550 (1+0.05)3 Php 550.00. Now, the investor will yield a loss
FV = Php 636.70 as the Php 550.00 bond will supposedly give
him more than what the broker promised him
of a return of Php 578.81 in 3 years.
 Annuities
• An annuity is a series of equal payments
at fixed intervals for a specified number of
periods.
• Two Types of Annuity
– Ordinary Annuity (payment made at the end
of the period
– Annuity Due (payment made at the beginning
of the period)
 Annuities
• Ordinary Annuity
5%

Php 300 Php 300 Php 300

 Annuities
• Annuity Due
5%

Php 300 Php 300 Php 300

 FV of Ordinary Annuity
• FVAN = PMT [(1+I)N-1/I]
• FVA3 = 300 [(1+0.05)3-1/0.05]
• FVA3 = 300 (3.1525)
• FVA3= Php 945.75
 FV of Annuity Due
• FVAdue = FVAordinary (1+I)
• FVAdue = 945.75 (1.05)
• FVAdue = Php 993.04
 Annuities
• Ordinary Annuity
– FVA3= Php 945.75
• Annuity Due
– FVAdue = Php 993.04
 Annuities
• Ordinary Annuity
5%
1 2

Php 300 Php 300 Php 300

 Annuities
• Annuity Due
5%
1 2 3

Php 300 Php 300 Php 300

 Annuities
• Ordinary Annuity
– FVA3= Php 945.75
• Annuity Due
– FVAdue = Php 993.04
 Present Value of Ordinary Annuity

• PVAN = PMT {1-[1/(1+I)N]/I}

• PVA3 = 300 {1-[1/(1+0.05)3/0.05}
• PVA3 = Php 817.20
 Perpetuities
• A perpetuity is a stream of equal
payments at fixed intervals expected to
continue forever.

• PV of a perpetuity = Annual Payment/Rate per annum

Example = Php 450.00/0.03 or 3%
PV of a perpetuity = Php 15,000.00

• The PV of the perpetuity increases when the rate per

annum decreases.
 Perpetuities
• The PV of the perpetuity increases when the rate per
annum decreases.

• PV of a perpetuity = Annual Payment/Rate per annum

Example = Php 450.00/0.02 or 2%

PV of a perpetuity = Php 22,500.00
 Uneven Cash Flows
• Annuity Plus Additional Final Payment
• 0 1 2 3 4 5

Php 0 Php 100 Php 100 Php 100 Php 100 Php 100 + Php 1000

• Irregular Cash Flows

0 1 2 3 4 5

Php 0 Php 100 Php 300 Php 300 Php 300 Php 500
 Uneven Cash Flows
• PV = CF1/(1+I)1 + CF2/(1+I)2…

• FV = CF1x(1+r)N-1 + CF1x(1+r)N-1 …
Compute for the Present Value of the uneven
cash flow stream below:

• 5 Periods, Interest is 12%

• Cash flows are as follow:
– Period 1 Php 100.00
– Period 2 Php 300.00
– Period 3 Php 300.00
– Period 4 Php 300.00
– Period 5 Php 500.00
Formula: PV = CF1/(1+I)1 + CF2/(1+I)2…
Present the PV of each period and what is the total PV
of the uneven cash flows after 5 periods?
 Compute for the FV of the uneven cash flow
stream below:

• 5 Periods, Interest is 12%

• Cash flows are as follow:
– Period 1 Php 100.00
– Period 2 Php 300.00
– Period 3 Php 300.00
– Period 4 Php 300.00
– Period 5 Php 500.00
Formula: FV = CF1x(1+r)N-1 + CF1x(1+r)N-1 …
Present the FV of each period and what is the total FV
of the uneven cash flows after 5 periods?
 Semiannual and Other Compounding Periods

FVN= PV (1+I)N
Given:
PV = Php 1,000.00
Interest = 6%
No. of Periods = 5 Years
a. Divide the interest rate by 2 (semiannual), making it 3%.
b. Multiply the number of periods by 2, making it 10.
FV10= 1000 (1+0.03)10
FV10= Php 1,343.92
• If compounded annually, the amount will be Php
1,338.23 only.
 Effects of Compounding on
Interest Rates
• The value of the interest rate stated in the contract will differ
if the interest rate is compounded several times annually.

– Nominal, Quoted, or Stated Interest Rate (INOM) – the rate stated

in a contract.

– Effective Annual Rate or Equivalent Annual Rate (EFF%) – is the

annual rate of interest actually being earned.
If a loan or an investment is compounded more than once a year, the
Effective Annual Rate will be higher than the Nominal Rate.

– The annual percentage rate (APR) is the amount of interest on

your total loan amount that you'll pay annually. A lower APR
could translate to lower monthly payments.
 Effective Annual Rate (EFF%)
• EFF% = [1 + (INOM/M)]M-1.0
• M is the number of compounding periods
per year.
• Therefore, a 10% nominal interest rate, if
compounded semi-annually, would be:
EFF% = (1+0.05)2 – 1.0
=1.1025 – 1.0
= 0.1025
EFF% =10.25%
• The annual rate of interest actually being
earned is not 10% but 10.25%.
 Amortized Loans
• Loan amortization – the payment of a loan
in installments over a specified period of
time.
• An amortized loan is a loan that is to be
re-paid in equal payments over specified
period of time.
 Illustration
• Daisy is considering applying for a home
improvement loan in the amount of Php
100,000.00 with an interest rate of 6%. The
term of the loan is 5 years. Equal
payments at the end of every year should
be made until the loan (including interest)
is paid off.
 Amortized Loans
• Amortization Schedule – a table showing
payments to be made, the due dates, and
the breakdown of each payment – the
portion that goes to the principal and how
much goes to interest.
 Illustration
• Daisy is considering applying for a home
improvement loan in the amount of Php
100,000.00 with an interest rate of 6%. The
term of the loan is 5 years. Equal payments at
the end of every year should be made until
the loan (including interest) is paid off.
Beginning Amount = Php 100,000.00
Interest Rate = 6%
Term/Period = 5 Years
 Time Line of Payments
0 1 2 3 4 5

P100,000.00 PMT PMT PMT PMT PMT

The sum of the PVs of all PMTs should equal to Php

100,000.00

P100,000.00 = PMT/(1.06)1 + PMT/(1.06)2…

 How to solve for the PMT per
period?
• PMT = P [r(1+r)n / (1+r)n-1]
PMT = annual amount per period
P = Principal or loan amount
r = Interest rate per period
n = total no. of payment or periods
PMT = 100,000 [0.06(1+0.06)5 / (1+0.06)5-1]
PMT = Php 23,739.64
 Amortization Schedule
Year Beginning Payment Interest Repayment of Ending
Amount Principal Balance
1 Php 100,000.00 23,739.64 6,000.00 17,739.64 82,260.36
2 82,260.36 23,739.64 4,935.62 18,804.02 63,456.34
3 63,456.34 23,739.64 3,807.38 19,932.26 43,524.08
4 43,524.08 23,739.64 2,611.44 21,128.20 22,395.89
5 22,395.89 23,739.64 1,343.75 22,395.89 0.00

•Amount of Interest is solve by determining the product between the

Beginning Amount and Interest Rate.
Php 100,000 x 6% = Php 6,000.00
82,260.36 x 6% = Php 4,935.62
•Repayment of Principal = PMT – Interest
•Ending Balance of the Period = Beginning Amount – Repayment of Principal
Next meeting Module 8 Sources and Uses of Funds

END