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TIME VALUE OF MONEY

Chapter 5

Time Value of Money

The basic idea behind the concept of time value of money
is:
 A peso actually received today is worth more than a peso in the
future
OR
 A peso received in the future is worth less than a peso today

Why?
– because interest can be earned on the money

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Simple Interest
 Interest – it is a rental fee to borrow money

Simple Interest
Interest is based solely on the amount of money
that was initially invested. The interest earned
each period or year will be the same.
= initial Investment x (1 +(Interest rate X number of period))
=1,480

Time Lines
Periods

0 1 2 3 4
12%

PV= 1,000 FV=?

Cash

 Show the timing of cash flows.

 Tick marks occur at the end of periods, so Time 0 is today; Time 1 is
the end of the first period (year, month, etc.) or the beginning of the
second period.

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Future value
 The process of going to future value from present value is
called Compounding.
 Compounding interest means that the interest not withdrawn
also earns interest.
FV= future value(present + interest)
PV=Principal value
r = rate
i = annual interest rate
n =number of periods

Future value

FV= PV(1+i)n
0 1 2 3 4
12%

PV= 1,000 FV=?

FV= 1000(1.12)4
FV = 1000(1.573)
FV = 1, 573

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Future value
 Example:
Mario placed 1,000 in a savings account earning 7%
interest compounded annually. How much money will
he accumulate after 5 years?

FV= PV(1+i)n
=1000 (1.403)
=1403

Intra-year Compounding

FV= PV(1+i/m)t x m
Annually m=1
Semi-annually m=2
Quarterly m=4
Monthly m=12
 Example:
Assume that PV = 1,000, i = 12% and t = 4 years.
Annual compounding (m=1): FV= PV(1+i/m)t x m
FV = 1000(1+.12/1)4 X 1
FV = 1000(1.574)4
FV = 1, 574

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Intra-year Compounding
 Example:
Assume that PV = 1,000, i = 12%, and n = 4
years.
Semi- annual Compounding (m=2) ? 1594
Quarterly Compounding (m=4) ? 1605
Monthly Compounding (m=12) ?1612

FV= PV(1+i/m)t x m

Annuities
 Annuity is defined as a series of equal payments
(or receipt) made at fixed intervals for a specified
number of periods.
 Ordinary Annuity – when payment occurs at the
end of the period.
 Annuity Due – when the payment occurs at the
beginning of each period

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Future Value of an Ordinary Annuity

 Example:
Aiza wants to determine the sum of money she will have in her
savings account at the end of 5 years by depositing 1, 000 at
the end of each year for the next 5 years. The annual interest
rate is 8%.
Year Saving FV factor Future values
0
1 1000 (1.08)5-1 1360.49
2 1000 (1.08)3 1259.71
3 1000 (1.08)2 1166.4
4 1000 (1.08)1 1080
5 1000 (1.08)0 1000
5866.60

Future Value of an Ordinary Annuity

 Example:
Aiza wants to determine the sum of money she will have in her
savings account at the end of 5 years by depositing 1, 000 at
the end of each year for the next 5 years. The annual interest
rate is 8%.
FVA =amount of an annuity
PVA =present value of annuity
PMT = annuity payment deposited
FVA or received at the end of each
period

= 5866.60

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Future Value of an Annuity Due

 Example:
Aiza wants to determine the sum of money she will have in her
savings account at the end of 5 years by depositing 1, 000 at
the beginning of each year for the next 5 years. The annual
interest rate is 8%.

Future Value of an Annuity Due

 Example:
Aiza wants to determine the sum of money she will have
in her savings account at the end of 5 years by
depositing 1, 000 at the beginning of each year for the
next 5 years. The annual interest rate is 8%.

FVA (1+ i)

= 6, 335.93

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Present Value at Compounded Interest

 Discounting is the process of calculating present value, it is
the reverse of finding a future value.
 Discounting is the reverse of compounding.
 In PV the interest rate is called discount rate.

Recall that:
FV= PV(1+i)n
Therefore, by simple transposition:
PV= FV / (1 + i)n
or
PV = FV(1+i)-n

Present Value at Compounded Interest

 Example:
Roval Toro is given the opportunity to receive 50, 000 10
years from now. If he can earn 15% on his investment
compounded annually, what is the most he should pay to
benefit from this opportunity?
PV = FV(1+i)-n
PV= 50,000(1.15)-10
PV = 50,000(0.247)
PV = 12, 350

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Present Value of Annuity

−n
PVA = PMT [ ]
Example:
Martha offered the opportunity to receive the following equal cash flow
over the next years:
Year Revenue
1 10,000
2 10,000
3 10,000
If she earns a minimum of 8% on her investment, what is the most she
should pay today?
−n
PVA = PMT [ ]
. −3
PVA =10,000[ .
]
PVA = 25, 770.97

Present Value of Unequal Cash Flows

Example:
Martha offered the opportunity to receive the following unequal cash flow
over the next years:
Year Revenue
1 10,000
2 12,500
3 9,500
If she earns a minimum of 8% on her investment, what is the most she
should pay today?
Answer:
Year Revenue 𝟏+𝒊 −n Present Value
1 10,000 .926 9,260
2 12,500 .875 10, 712.5
3 9,500 .794 7,543
27,515.50

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Amortized Loans
Recall that:
−n
PVA = PMT [ ]
By transposition the periodic payment is:
−n
PMT = PVA /[ ]
Example:
Ferlie has a 60 month auto Loan of 650, 000 at 12% annual
interest rate. She wants to find out how much the monthly
payment should be.
−n
PMT = PVA /[ ]
.
PMT = 650,000/[ ]
.
PMT = 650, 000 /44.955
PMT= 14,458.90

Perpetuity
 A perpetuity is a fixed cash flows received over an
indefinite number of periods.
Present Value of perpetuity
PV= Cash flow/ Interest Rate
 Example :
10, 000 per year forever with an available interest rate of
5 %.
PV= 10,000/0.05
PV= 200, 000
2, 000 per month forever with an available interest rate of
5 %.
PV= 2000/(0.05/12)
PV= 480, 000

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