TIME VALUE OF MONEY

Let i = the effective rate/prevailing rate, otherwise known as the discount rate
Let n = the number of periods

A. Types of cash flows from a financial instrument (e.g. notes or bonds)

 Principal – refers to the original amount of money borrowed in a loan or put into
an investment. It can be referred to as the face value of the note or the bond.
 Interest – refers to the charge for the privilege of borrowing money. Simply put,
this is the compensation or return received by the lender or the investor for the lost
ability to spend the money that was lent or invested.

B. Term notes (principal is payable at maturity date; interest is payable annually)

Example: On January 1, 2019, Company A received a 5-year, 12% note from a

customer amounting to P200,000. Interest is payable annually, while the principal is
payable on December 31, 2023. The prevailing market rate for similar obligations at
the date of the transaction is 10%.

Let i = 10% (effective rate, or the prevailing market rate for similar obligations)
Let n = 5 periods (the term of the loan)

Compute for the present value of the cash flows arising from the note on January 1,
2019.

Principal = P200,000 x 0.6209* = P 124,180

Interest = P24,000 x 3.7907** = 90,977
Total PV of cash flows P 215,157

* Since the principal is payable at maturity date, we use the present value of single
payment of 1 at 10% (i) for 5 periods (n).

 On your calculator, clear all memory first, then input 1/1+10%, then press equal
sign based on the number of periods (5); or

 On your calculator, clear all memory first, then input 1/1+10%, then press equal
sign, then divide it again by 1+10%, then press equal sign four more times –
which makes it five periods.

** Since the interest is payable annually and the cash flows is the even (or same) each
period, we use the present value of ordinary annuity of 1 at 10% (i) for 5 periods (n).

 On your calculator, clear all memory first, then input 1/1+10%, then press equal
sign based on the number of periods (5). After that, press GT (grand total
function); or

 On your calculator, clear all memory first, then input 1/1+10%, then press equal
sign, then press M+, then repeat the process for four more periods. After doing
the process for the 5th period, press equal sign.

DE CASTRO, K.M. 1|Page

C. Serial notes (equal amount of principal is payable at the end of each period,
interest based on outstanding balance is also payable annually)

Example: On January 1, 2019, Company A received a 5-year, 12% note from a

customer amounting to P200,000. Principal is payable in five equal annual
installments every December 31 and the interest based on the outstanding principal
balance is also payable annually. The prevailing market rate for similar obligations at
the date of the transaction is 10%.

Let i = 10% (effective rate, or the prevailing market rate for similar obligations)
Let n = 5 periods (the term of the loan)

Compute for the present value of the cash flows arising from the note on January 1,
2019.

There are two ways to approach this problem.

(a) First, by identifying the nature of the cash flows.

Since the principal amount is payable annually every December 31, and the cash
flows is even (or the same) for each period, we use the present value of ordinary
annuity of 1 at 10% (i) for 5 periods (n).

Present value of principal = P40,000 x 3.7907 = P151,628

Since the interest is based on the outstanding principal balance, we can expect that
the amount of interest is declining because of the payment of the principal. Hence, for
uneven installment cash flows, we use the present value of single payment of 1 at
10% (i) for each period

Date Outstanding A B AxB

principal Nominal interest Present value Present value
@ 12% factor @ 10%
Dec. 31, 2019 P 200,000 P 24,000 0.9091 P 21,818
Dec. 31, 2020 160,000 19,200 0.8264 15,867
Dec. 31, 2021 120,000 14,400 0.7513 10,819
Dec. 31, 2022 80,000 9,600 0.6830 6,557
Dec. 31, 2023 40,000 4,800 0.6209 2,980
Total PV of interest payments P 58,041

The computation of present value factors was discussed in detail in the first page.

Putting it all together:

Present value of principal P 151,628

Present value of interest 58,041
Total present value of the note P 209,669

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 (b) Second, by combining the cash flows from principal and interest for each
period.

This is how it looks like:

Interest based on
outstanding
Date Principal principal Total cash flows
Dec. 31, 2019 40,000 24,000 64,000
Dec. 31, 2020 40,000 19,200 59,200
Dec. 31, 2021 40,000 14,400 54,400
Dec. 31, 2022 40,000 9,600 49,600
Dec. 31, 2023 40,000 4,800 44,800

For uneven installment cash flows, we use the present value of single payment of 1
at 10% (i) for each period. The computation is presented below:

Interest based on B AxB

outstanding A Present value Present value of
Date Principal principal Total cash flows factor at 10% cash flows
Dec. 31, 2019 40,000 24,000 64,000 0.9091 58,182
Dec. 31, 2020 40,000 19,200 59,200 0.8264 48,923
Dec. 31, 2021 40,000 14,400 54,400 0.7513 40,871
Dec. 31, 2022 40,000 9,600 49,600 0.6830 33,877
Dec. 31, 2023 40,000 4,800 44,800 0.6209 27,816
Total present value of cash flows from the note 209,669

It can be noted that whether you use the first or the second approach, the total present
value of cash flows from the note that you will get will be the same.

D. Serial notes (unequal amount of principal is payable at the end of each period,
interest based on outstanding balance is also payable annually)

Example: On January 1, 2019, Company A received a 5-year, 12% note from a

customer amounting to P200,000. Principal is payable in five annual installments
every December 31 as follows:

December 31, 2019 P 60,000

December 31, 2020 50,000
December 31, 2021 40,000
December 31, 2022 30,000
December 31, 2023 20,000
P 200,000

Interest based on the outstanding principal balance is also payable annually. The
prevailing market rate for similar obligations at the date of the transaction is 10%.

The schedule of uneven cash flows from principal and interest are presented below:

Interest based on
outstanding A
Date Principal principal Total cash flows
Dec. 31, 2019 60,000 24,000 84,000
Dec. 31, 2020 50,000 16,800 66,800
Dec. 31, 2021 40,000 10,800 50,800
Dec. 31, 2022 30,000 6,000 36,000
Dec. 31, 2023 20,000 2,400 22,400

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 For uneven installment cash flows, we use the present value of single payment of 1
at 10% (i) for each period. The computation is presented below:

Interest based on B AxB

outstanding A Present value Present value of
Date Principal principal Total cash flows factor at 10% cash flows
Dec. 31, 2019 60,000 24,000 84,000 0.9091 76,364
Dec. 31, 2020 50,000 16,800 66,800 0.8264 55,204
Dec. 31, 2021 40,000 10,800 50,800 0.7513 38,166
Dec. 31, 2022 30,000 6,000 36,000 0.6830 24,588
Dec. 31, 2023 20,000 2,400 22,400 0.6209 13,908
Total present value of cash flows from the note 208,230

E. Serial notes (equal amount of principal is payable at the beginning of each

period, interest based on outstanding balance is also payable annually)

Example: On January 1, 2019, Company A received a 5-year, 12% note from a

customer amounting to P200,000. Principal is payable in five equal annual
installments every January 1 and the interest based on the outstanding principal
balance is also payable annually. The first principal payment was made on
January 1, 2019. The prevailing market rate for similar obligations at the date of the
transaction is 10%.

Again, there are two ways to approach this problem.

(a) First, by identifying the nature of the cash flows.

Since the principal payment is made at the beginning of each year, and the first
installment payment of P40,000 was made on January 1, 2019, what do you think is
the present value of the first payment? If your answer is P40,000, then you are right.
The present value of the first payment is equal to the face value since the time value
of money has no impact.

How about the remaining four (4) principal payments? We now use present value of
ordinary annuity of 1 at 10% (i) for 4 periods (n). Why 4 periods? Simply because that
is the remaining future periods from the note.

Principal = P40,000 x 3.1698 = P126,792

So the total present value of cash flows arising from the principal amount are as
follows:

Principal paid at January 1, 2019 P 40,000

Principal to be paid on January 1 of future periods 126,792
Total present value of principal P 166,792

Since the interest is based on the outstanding principal balance, we can expect that
the amount of interest is declining because of the payment of the principal. Hence, for
uneven installment cash flows, we use the present value of single payment of 1 at
10% (i) for each period.

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 Date Outstanding A B AxB
principal Nominal interest Present value Present value
@ 12% factor @ 10%
Jan. 1, 2019 P 160,000 P 19,200 0.9091 P 17,455
Jan. 1, 2020 120,000 14,400 0.8264 11,900
Jan. 1, 2021 80,000 9,600 0.7513 7,212
Jan. 1, 2022 40,000 4,800 0.6830 3,278
Total PV of interest payments P 39,846

Putting it all together:

Present value of principal P 166,792

Present value of interest 39,846
Total present value of the note P 206,638

(b) Second, by combining the cash flows from principal and interest for each
period.

This is how it looks like:

Interest based on
outstanding A
Date Principal principal Total cash flows
Jan. 1, 2019 40,000 - 40,000
Jan. 1, 2020 40,000 19,200 59,200
Jan. 1, 2021 40,000 14,400 54,400
Jan. 1, 2022 40,000 9,600 49,600
Jan. 1, 2023 40,000 4,800 44,800

Take note that since the first principal installment was made at Jan. 1, 2019, there is
no accrued interest yet.

For uneven installment cash flows, we use the present value of single payment of 1
at 10% (i) for each period. The computation is presented below:

Interest based on B AxB

outstanding A Present value Present value of
Date Principal principal Total cash flows factor at 10% cash flows
Jan. 1, 2019 40,000 - 40,000 1.0000 40,000
Jan. 1, 2020 40,000 19,200 59,200 0.9091 53,819
Jan. 1, 2021 40,000 14,400 54,400 0.8264 44,956
Jan. 1, 2022 40,000 9,600 49,600 0.7513 37,264
Jan. 1, 2023 40,000 4,800 44,800 0.6830 30,598
Total present value of cash flows from the note 206,638

It can be noted that whether you use the first or the second approach, the total present
value of cash flows from the note that you will get will be the same.

-END OF HANDOUT-

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