SH1663

Time Value of Money

I. Concepts in Time Value
A. Opportunity Cost
• People are constantly making choices among various financial decisions. In making those
choices, people must give up something in order to gain something else. For example, if
you want to save up for a new phone, you may need to give up eating out on weekends.
The opportunity cost of a new phone is eating out on weekends. Therefore, the opportunity
cost is something that you give up in order to achieve something.
• The time value of money states that all things being equal, a peso today is worth more than
a peso in the future. The peso you have today is something that you can use now and earn
interest, while you cannot use a future peso.
• Because money is a limited resource, you cannot save and spend at the same time. If an
individual decides to save his/her money, then he/she gives up the opportunity to spend it.
Good money management is needed, in personal life and in business.

B. Interest
• The formula for interest is as follows: 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 × 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 × 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇
• This formula can be summarized as 𝐼𝐼 = 𝑃𝑃𝑃𝑃𝑃𝑃.
• Three (3) other variations of this formula can be used to find P, R, and T:
𝐼𝐼 𝐼𝐼 𝐼𝐼
𝑃𝑃 = 𝑅𝑅𝑅𝑅 ; 𝑅𝑅 = 𝑃𝑃𝑃𝑃 ; 𝑇𝑇 = 𝑃𝑃𝑃𝑃
• To compute for the maturity amount (interest plus principal), this formula will be used:
𝐴𝐴 = 𝑃𝑃 (1 + 𝑅𝑅𝑅𝑅)
• Note that when using formulas, the R and T should be in the same time units. For example,
if the rate is monthly and the time is given yearly, adjustments must be made.

II. Future Value

A. Future Value
• There are three (3) reasons why a peso today is worth more than a peso in the future:
o Preference for present consumption - Individuals prefer present consumption to future
consumption. In order to convince people to give up present consumption for future
consumption, there needs to be a strong incentive. For example, a businessman would
be willing to deposit money if he is assured that it will bring a higher interest.
o Inflation – When there is inflation, the value of the currency decreases over time. The
greater the inflation, the greater the difference in value between a peso today and a peso
tomorrow.
o Risk – If there is any uncertainty or risk associated with the cash flow in the future,
people will think it is better to spend their money now.
• The formula for the future value is:
𝐹𝐹𝑉𝑉𝑡𝑡 = 𝑃𝑃𝑃𝑃 (1 + 𝑖𝑖)𝑡𝑡
Where:
𝐹𝐹𝐹𝐹 = Future value in 𝑡𝑡 period
𝑃𝑃𝑃𝑃 = Present value or the money invested today
𝑖𝑖 = Interest rate
𝑡𝑡 = Number of periods

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• As an example, let us continue from the previous interest problem. If you deposit P10,000
at 3% compounded annual interest, how much will it earn in the second year?
• Using the formula, we compute the future value of the deposit:
𝐹𝐹𝑉𝑉𝑡𝑡 = 𝑃𝑃10,000 (1 + 3%)2
𝐹𝐹𝑉𝑉𝑡𝑡 = 𝑃𝑃10,609

The future value of the original deposit at the end of the second year is P10, 609.
• Complete the table:
Rate 3%
Year Principal Interest Total
1 10,000.00 300.00 10,300.00
2 10,300.00 309.00 10,609.00
3 10,609.00 318.27 10,927.27
4 10,927.27 327.82 11,255.09
5 11,255.09 337.65 11,592.74
6 11,592.74 347.78 11,940.52
7 11,940.52 358.22 12,298.74
8 12,298.74 368.96 12,667.70
9 12,667.70 380.03 13,047.73
10 13,047.73 391.43 13,439.16
III. Present Value
A. Present Value
• The present value formula is:
𝐹𝐹𝐹𝐹
𝑃𝑃𝑃𝑃 =
(1 + 𝑖𝑖)𝑡𝑡
Where:
𝑃𝑃𝑃𝑃 = Present value
𝐹𝐹𝐹𝐹 = Future value
𝑖𝑖 = Interest rate
𝑡𝑡 = Time period

IV. Nominal and Effective Interest Rates

A. Nominal and Effective Rates
• The stated annual rate is usually referred to as the nominal rate. The nominal rate may be
computed using the 𝐼𝐼 = 𝑃𝑃𝑃𝑃𝑃𝑃 formula.
• Lenders may also require borrowers to pay interest compounded monthly, quarterly, or
semi-annually instead of annually. The interest for this type of borrowing is called the
effective rate. This payment scheme will change the computation of interest on loans.
Compounded interest uses the following formula:
𝑖𝑖 𝑛𝑛𝑛𝑛
𝐹𝐹𝐹𝐹 = 𝑃𝑃𝑃𝑃 �1 + �
𝑚𝑚
Where:
𝐹𝐹𝐹𝐹 = Future value in 𝑛𝑛 period
𝑃𝑃𝑃𝑃 = Present value or the money invested today
𝑚𝑚 = Number of compounding periods per year
𝑛𝑛 = Number of years
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References:
Benito, P. P., Chan Pao, T. P., & Yumang, K. (2016). Exploring small business and personal finance
in senior high. Quezon City: Phoenix Publishing House.
Cussen, M. P. (2016). Interest rates explained: Nominal, real, effective. Retrieved from Investopedia
website: http://www.investopedia.com/articles/investing/082113/understanding-interest-rates-
nominal-real-and-effective.asp
Difference between nominal and effective interest rates. (2011). Retrieved from Accounting
Explanation website:
http://www.accountingexplanation.com/difference_between_nominal_and_effective_interest
_rate.htm
Kapoor, J., Dlabay, L., & Hughes, R. J. (2015). Personal finance. Columbus: McGrawHill.
Tracy, J. A. (2006). Nominal and effective interest rates for business loans. Retrieved from Dummies
website: http://www.dummies.com/business/accounting/nominal-and-effective-interest-rates-
for-business-loans/

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