Chapter IV Time Value of Money

Overview Time Value of Money

-

Future Value of Money Concepts

Present Value of Money
Risk and Return Concept
Learning Outcomes
At the end of the chapter, the learners must be able to:
a) describe the corncept of the time value of
money;
b) compute and calculate the future and present value of money; and
c)discuss the concept of risk and return.

Overview on Time Value of Money (TVM)

Time value of money is the concept that the value of a peso to be received in
future is less than the value of a peso on hand today. One reason is that money
received today carn be invested thus generating more money. Another reason is
that when a person opts to receive a sum of money in future rather than today, he
is effectively lending the money and there are risks involved in lending such as
default risk and inflation.
Time value of money principle also applies when comparing the worth of
money to be received in future and the worth of money to be received in further
future. In other words, TVM principle says that the value of given sum of money
to be received on a particular date is more than same sum of money to be received
on a later date.
Few of the basic terms used in time value of money calculations are:

1. Present Value
When a future payment or series of payments are discounted at the given rate
of interest up to the present date to reflect the time value of money, the resulting

value is called present value.

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2. Future Value the value of a present
that is obtained by enhancing reflect the time
Future value is amount rate of interest to
at the given
or a series of payments
payment
value of money.

3. Interest
the borrower to the lernder in
Interest is charge against use of money paid by
addition to the actual money lent.
where the borrower pays a fee to
Interest is the cost of borrowing money,
the owner's money. The interest is typically expressed
as
the owner for using
interest is only
a percentage and can be either simple or compounded. Simple
interest is based on the
based on the principal amount of a loan, while compound
principal amount and the accumulated interest.
For example, a student obtains a simple interest loan to pay one year of her
collegetuition, which costs P18,000, and the annual interest rate on her loan is
6%. She repaid her loan over three years and the amount of simple interest she
paid was P3,240, or P18,00*0.063.The total amount she repaid was P21,240, or
P18,000+ P3,240.
Conversely, compound interest, is calculated by multiplying the principal
amount by one plus the annual interest rate raised to the number of compound
periods minus one. As opposed to simple interest, compound interest accrues on
the principal amount and the accumulated interest of previous periods.
For
example,
suppose another studernt
obtains a compound interest loan to pay
one year of his college tuition, which costs P20,000, and the annual interest rate on
his loan is 8%. Unlike the simple interest, the compound interest accrues on both
the principal and the accumulated interest. He
the amount of compound interest he
repaid his loan over four years and
paid was P7,209.77, or P20,000"((1+0.08)4-
1) and the total amount he repaid was P27,209.77, or P20,000+ P7,209.77.
For example, P4000 is
deposited into a bank account and the annual interest
rate is 8%.

How much is the interest after 4years?

Use the following simple interest formula:
I= px r xt
where p is the principal or money deposited
ris the rate of interest
tis time

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 We get:
I=px r xt
I=4000x 8% x 4
I=4000x 0.08 x 4
I=P 1280
iowever, coumpound interest is the interest earned not only on the original
principal, but also on all interests earned previously. In other words, at the end or
the money 1s
each year, the interest earned is added to the original amount and
reinvested
If we use compound interest for the situation above, the interest will be

computed as follows:
Interest at the end of the first year:
I= 4000x 0.08 x 1

I=P320
Your new principal per day is now 4000 +320 = 4320

Interest at the end of the secornd year:

I=4320x 0.08 x 1
I= P345.6
Your new principal is now 4320 + 345.6= 4665.6

Interest at the end of the third year:

I=4665.6x 0.08 x 1

I= P373.25
373.25 5038.85
Your new principal is now 4665.6 +
Interest at the end of the fourth year:

I=5038.848 x 0.08 x1

I= P403.10

Your new principal is now 5038.85 + 403.10 5441.95

Total interestearned 5441.95-4000 1441.95
=

The difference in mony between compound interest and simple interest is

1441.96-1280 = 161.96

compound interest yields better result, so you make more

As you can see,

money.
should double check with vour
Therefore, before investing your money, you
will be used.
local bank if compound interest

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Application of Time Value of Money Principle
There are many applications of time value of money principle. For example.
we can use it to compare the worth of cash flows occurring at different times in
to be received periodically
future, to find the present worth of a series of payments
in future, to find the required amount of current investment that must be madeat
a given interest rate to generate a required future cash flow, etc. Money loses its
value over a period of time and there are several reasons why money loses value
over time. Most obviously, there is inflation which reduces the buying power of

money.
But quite often, the cost of receiving money in the future rather than now will be
of inflation. The opportunity
greater than just the loss in its real value on account
cost of not having the money right now also includes the loss of additional income
that you could have earned simply by having received the cash earlier.

Moreover, receiving money in the future rather than now may involve some
risk and uncertainty regarding its recovery. For these reasons, future cash flows
are worth less than the present cash flows.
Time value of money concept attempts to incorporate the above considerations
into financial decisions by facilitating an objective evaluation of cash flows from
different time periods by convertinig them into present value or future value
equivalents. This ensures the comparison of like with like'.
The present or future value of cash flows is calculated using a discount rate
(also knouwn as cost of capital, WACC and required rate of return) that is determined on
the basis of several factors such as:
1. Rate of inflation Higher the rate of inflation, higher the return that
investors would require on their investment.
2. Interest Rates Higher the interest rates on deposits and debt securities,
the of
greater loss interest income on future cash
inflows causing investors to demand a higher return on
investment.
3. Risk Premium Greater the risk associated with future cash flows of
an investment, higher the rate of return required by an
investors to compensate for the additional risk.
Consider a simple example of a financial decision below that illustrates the
use of time value of money.

Example:
Suppose that you have earned a cash bonus for an
outstanding performance
at your job during the last year. Your pleased bossgives you two options to choose
from:
1. Option A: Receive P10,000 bonus now
2. Option B: Receive P10,800 bonus after one
year

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Further information which vou may consider in your decision:
1. Inflation rate is 5%
per annum.
2. Interest rate on bank
deposits is 12% per annum.

Which option would you choose?

Solution
Although in absolute terms, Option B offers the higher amount of bornus,
Option Agives you the choice of receiving
bonus one earlier than Option B.
year
This can be beneficial for the following reasons:
. T o start with, you can buy more with P10,000 now than with P10,800 in one
year's time due to the 5% inflation.
2. Secondly, if you receive the bonus now, you could invest the cash in a bank
deposit and earn a safe annual return of 12%. In contrast, you stand to lose this
interest income if you choose OptionB.
3. Thirdly, future is uncertain. In worst case scenario, the company you work
for could become bankrupt during the next year which would significantly
reduce your chance_ of receiving any bonus. The probability of this happening
might be remote, but there would be a slim chance nonetheless.
The above considerations must be incorporated into the decision analysis by
factoring them into a discount rate which will then be used to calculate the future
values and present values as illustrated below.

Discount Rates
As the interest rate on bank deposits is higher than the rate of inflation, we
should set the discount rate at 12% for our analysis because it representsthe highest
opportunity cost for receiving the bornus in one year's time rather than today.
For this example, we may assume that the risk of not getting the bonus after
one year (e.g. due to the company becoming bankrupt) is minimal and is therefore
ignored. If such' a risk is considered significant, we would have to increase the
discount rate to reflect that risk.

Using the 12% discount rate, we

could either calculate future value or present
value of the two options to assess which option is better in financial terms. Both
sake although they shall lead to the same
are included here for completeness

conclusion.

Future Values
The future value of Option
A will be the amount of bonus plus the interest
be earned for one year.
income of 12% which could

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Option A
Bonus P10,000
Interest (P10,000 x 12%)
P 1,200
Income
Future Value P11,200 after 1 year (P10,000 + P1,200)

Option B
Bonus P10,800
Interest
Income
Future Value P10,800 after 1 year
shall be received after one year.
*No interest income shall accrue on P10,800 as it
as it has the highest future
Based on the future values, Option A is preferable
value.

Present Values
that shall
The present value of Option B will be the amount required today
accrued an interest income of 12o.
equal to P10,800 in one year's time after having
Option A
Bonus P10,000
Interest Income 1.0
Present Value P10,000 ($10,000 x 1.0)
No need to discount as P10,000 is already stated in its present value terms.

Option B
Bonus P10,800
Interest Income 0.8928 (1+[1+0.12])
Present Value . P9,642* (P10,800 x 0.8928)
*The present value of P9,642 represents the amount of cash that, if invested in a bank
deposit 12% p.a., shall equal to P10,800 in one year. This can be confirmed as follows:

P9,642 x 1.12 P10,800

Based on the present values, Option A is preferable as it has the highest present
value.

Note
Both present and future value analysis lead to the same conclusion (i.e. Option
A is preferable over Option B). This is because both methods are a mirror image
of the other.

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 Pa00)
TOu may wonder why the difference between the two future values (1.e.
and the two present values (P358) is not the same. The difference is just a timing
difference similar to that of other cash flows (i.e. future value is caleulated one year
ahead or present value). The difference can be reconciled by calculating either the
future value of P358 (i.e. P358 x 1.12 = P400) or the present value of P400 (1.e. Pab
x0.8928 P358).

Using Tables to Solve Future Value Problemns

Compound interest tables have been calculated by figuring out the (l+
values for various time periods and interest rates (see appendix). You will notice
that this table summarizes the factors for various interest rates for various years.
To table, simply go down the column to locate
use the left-hand the appropae
number of years. Then goout along the top row until the appropriate interest rate
is located. Note there are three pages containing interest rates 1%o through I97o.

For instance, to find the future value of P100 at 5% compound interest, look up
five years on the table, then go out to 5% interest. At the intersection of these two
values, a factor of 1.2763 appears. Multiplying this factor times the beginning value
of P100.00 results in Pl27.63, exacthly what was calculated using the Compound
Interest Formula previously. Note, however, that there may be slight differences
between using the formula and tables due to rounding errors.
An exanple shows how simple it is to use the tables to calculate future
amounts. You deposit P2,000 today at 6% interest. How much will you have in
five years?

Using Tables to Solve Future Value of Annuity Problems

An annuity is an equal, annual series of cash flows. Annuities may be equal
annual deposits, equal annual withdrawals, equal annual payments, or equal1
annual The key is equal, annual cash flows.
receipts.
When cash flows occur at the end of the year, this makes them an ordinary
annuity. If the cash flows were at the beginning of the year, they would be an
annuity due. Annuities due will be covered later.
Annuities work as follows:

1. Annuity Equal Annual Series of Cash

=
Flowvs
2. Assume annual deposits of P100 deposited at end of year earning 5% interest

forthree years.
Year 1: P100 deposited at end of year P100
.05 P5.00+ P100 + P100 P205
Year 2: P100 x =

.05 P10.25 + P205+ P100 = P315.25

Year 3: P205 x =

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 Again, there are tables for working with annuities (see apPpendix). Basically
this table works the same way as the previous table. Look up the appropriate
number of periods, locate the appropriate interest, take the factor found and
multiply it by the amount of the annuity.
For instance, on the three-year, 5% interest annuity of P100 per year. Going
down three years, out to 5%, the factor of 3.152 is found. Multiply that by the
annuity of P100 yields a future value of P315.20.
Another example of calculating the future value of an annuity is illustrated.
You deposit P300 each year for 15 years at 6%. How much will you have at the end
of that time?

Using Tables to Solve Present Value Problems

Present value is simply the reciprocal of compound interest. Another way to
think of present value is to adopt a stance out on the time line in the future and
look backk toward time 0 to see what was the beginning amount.

Present Value
Present Value = P, = P/ (1+*

TVM Table 3 shows Present Value Factors. Notice that they are all less than
a future value by these factors, the future value
one. Therefore, when multiplying
is discounted down to present value.

The table is used in much the same way as the previously discussed time
value of money tables. To find the present value of a future amount, locate the
appropriate number of years and the appropriate interest rate, take the resulting
factor and multiply it times the future value.
An example illustrates the process.
How much would you have to deposit now to have P15,000 in 8 years if
interest is 7%?

Using Tables to Solve Present Value of an Annuity Problems

To find the present value of an annuity, use TVM Table 4: Present Value of
Annuity Factors. Find the appropriate factor and multiply it times the amount of
theannuity to find the present value of the annuity.
An example illustrates the process.
, Find the present value of a 4-year, P3,000 per year annuity at 6%.

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Net Present Value Analysis
Any capital investment involves an initial cash outflow to pay for it, folowea
by cash intlows in the form of revenue, or a decline in existing cash flows that are
caused by expense reductions. We can lay out this information in a spreadsheet to
show all expected cash flows over the useful life of an investment, and then appy
a discount rate that reduces the cash flows to what they would be worth at the
present date. This caleulation is known as net present value analysis.

Net present value is the traditional approach to evaluating capital proposals,

since it is based on a single factor cash flows that can be used to judge any
proposal arriving from anywhere in a company.

Net Present Value Example

ABC International is planning to acquire an asset that it expects will yield
positive cash flows for the next five years. Its cost of capital is 10%,whichit uses
as the discount rate to construct the net present value of the project. The tollowing
table shows the calculation:

Year Cash Flow 10% Discount Factor Present Value

500,000 1.0000 -P500,000

+130,000 0.9091 +118,1833

+130,000 0.8265 +107,445

3 +130,000 0.7513 +97,669
+130,000. 0.6830 +88,790
+130,000 0.6209 +80,717
Net Present Value $7.196
The net present value of the proposed project is negative at the 10% discount
"

rate, so ABC should not invest in the project.

The Discount Rate

In the "10% Discount Factor" column, the factor becomes smaller for periods
further in the future, because the discounted value of cash flows is reduced as they
the present day. The discount factor is widely available in
progress further from
the tollowing formula:
textbooks, or can be derived from
Future cash flow
Present value of a
(1 Discount rate) squared by the number of periods of
future cash flow discounting
To use the formula for an example,
if we forecast the receipt of $100,000 in one
discount rate of 10 percent, then the calculation is:
year, and are using a

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Present P100,000
value (1+.10)1
Present value = $90,909

Contents of a Net Present Value Analysis

A net present value calculation that truly reflects the reality of cash flows will
likely be more complex than the one shown in the preceding example. It is best
to break down the analysis into a number of sub-categories, so that you can see
exactly when cash flovws are occurring and with what activities they are associated.
Here are the more common contents of a net present value analysis:
1. Asset purchases. All of the expenditures associated with the purchase, delivery,
installation, and testing of the asset being purchased.
2. Asset-linked expenses. Any ongoing expenses, such as warranty agreements,
property taxes, and maintenance, that are associated with the asset.
3. Contribution margin. Any incremental cash flows resulting from sales that can
be attributed to the project.
4. Depreciation effect. The asset will be deprèciated, and this depreciation shelters a
portion of any net income from income taxes, so note the income tax reduction
caused by depreciation.
5. Expense reductions. Any incremental expense reductions caused by the project,
such as automation that eliminates direct labor hours.
6. Tax credits. If an asset purchase triggers a tax credit (such as for a purchase of
energy-reduction equipment), then note the credit.
7. Taxes. Any income tax payments associated with net income expected to be
derived from the asset.
8. Working capital changes. Any net changes in inventory, accounts receivable, or
counts payable associated with the asset. Also, when the asset is eventually
sold off, this may trigger a reversal of the initial
working capital changes.
By itemizing the preceding factors in a net present value analysis, you can
more easily review and revise individual line items."

Cautions when using Net Present Value

Net present value does not consider the
presence of a constraint in the system
of generating cash flow, which could restrict the total amount of cash
actually
generated. The result can be an estimated net present value that cannot be realized.
A positive net present value means a better return, and a
negative net present
value means a worse return, than the return from zero net present value. t is one
of the two discounted cash flow techniques (the other is internal rate of return)
used in comparative appraisal of investment proposals where the flow of income
varies over time.

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 Definition of "Risk Return Trade Off
Higher risk is associated with greater probability of higher return and 1ower
risk with a greater probability of smaller return. This trade off which an investOr

faces between risk and return while considering investment decisions is called tne
risk return trade off.

orexample, Rohan faces a risk return trade off while making his decisio to
invest, If he deposits all his money in a saving barnk account, he will earn a low
return, 1.e, the interest rate paid by the bank, but all his morney will be insured P
to an amount of P 1 MILLION PESO.

However, ifhe invests in equities, he faces the risk of losing a majorpart ot his
capital along with a chance to get a much higher return than compared to a savin8
deposit in a bank. The world of investing can be a cold, chaotic, and confusing
place.

The Risk Return Trade-off

Deciding what amount of risk you can take while remaining comfortable with
your investments is very important.
In the investing world, the dictionary definition of risk is the chance that an
investment's actual return will be different than expected. Technically, this is
measured in statistics by standard deviation. Practically, risk means you have the
possibility of losing some or even all óf your original investment.
Low risks are associated with low potential returns. High isks are associated
with high potential returns. The risk return trade-off is an effort to achieve a
balance between the desire for the lowest possible risk and the highest possible
return. The risk return trade-off theory is aptly demonstrated graphically in the
chart below. A higher standard deviation means a higher risk and, therefore, a
higher possible return.

Risk/Return Trade-off

E
High Risk
High Potential Returm
Low Risk
Low Retum

ww

Standard Deviation for Risk)

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 A common misconception is that higher risk equals greater return. The risk
return trade-off tells us that the higher risk gives us the possibility of higher
returns. There are no guarantees. Just as risk means higher potential returns, it
also means higher potential losses.
On the lower end of the risk scale is a measure called the risk-free rate of
return. It is represented by the return on 10 year Government Securities because
their chance of default (i.e. not being able to repay principal and interest) is next
to nothing. This risk free rate is used as a reference for equity markets whereas the
Overnight repo rate is used as a reference for debt markets. If the risk-free rate is
currently 6 per cent, this means, with virtually no risk, we can earn 6 per cent per
year on our money.

The common question arises: who wants 6 per cent when index funds average
13 per cent per year over the long run (last five years)? The answer to this is that
even the erntire market (represented by the index fund) carries risk. The return on
index funds is not 13 per cent every year, but rather -5 per cent one year, 25 per
cent the next year, and so on. An investor still faces substantially greater risk and
volatility to get an overall return that is higher than a predictable government
security. We call this additional return, the risk premium, which in this case is 7
per cent (13 per cent - 6 per cent).

How do you know what risk level is most appropriate for you? This isn't an
easy question to answer. Risk tolerance differs from person to person. It depends
on goals, income, personal situation, etc. Hence, an individual investor needs
to arrive at his own individual risk return trade-off based on his investment
objectives, his life-stage and his risk appetite.

98
 Chapter Review
Guide Questions:
1. Discuss the concept related to time value of
money.
2. What are the factors that affect time value of
money?
3. What are the
terminologies associated with time value of money
4 What does present value mean?
5. What does future value mean?
6. Discuss the concept of risk.
7. What risk is associated with time value of money?

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Name: Rating
Course: Date:

Exercise 4.3- Comprehensive Problems

1) Calculate the future value of P4,600 received today if it is deposited at 9
percent for three years.

2) Calculate the present value of P89,000 to be received in 15 years, assuming an

opportunity cost of 14 percent.

3) Tandang Sora has deposited P33,000 today in an account which will earn 10
percent annually. She plans to leave the funds in this account for seven years
earning interest. If the goal of this deposit is to cover a future obligation of
P65,000, what recommendation would you make to Tandang Sora?

105
 +) Pia Manufacturing Agents, Inc. is preparing a five-year plan. Today, sales are
P1,000,000. If the growth rate in sales is projected to be 10 percent over the
next five years, what will the amount of sales be in year five?

5) Pacquiao has inherited P6,000 from the death of his Grandma. He would
like to use this money to buy his mom Dionisia a new bicycle costing P7,000
2 years from now. Will Pacquiao have enough money to buy the gift if he
deposits his money in an account paying 8 percent compounded semi-
annually?

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