Chapter 4: Time Value of Money

● To discuss the role of time value in finance, the use of computational tools, and the basic patterns of
cash flow.
● To understand the concepts of future value and present value, their calculations for single amounts,
and the relationship between them.
● To be able to find the future value and the present value of both annuity and an annuity due, and find
the present value of a perpetuity.
● To be able to calculate both the future value and the present value of a mixed stream of cash flows.
● To understand the effect that compounding interest more frequently than annually has on future value
and on the effective annual rate of interest.
● To describe the procedures involved in (1) determining deposits needed to accumulate a future sum,
(2) loan amortization, (3) finding interest or growth rate, and (4) finding an unknown number of
periods.

A single peso today may not be equivalent to a single peso in the past or in the future, the actual value of
money changes from time to time. Your money could change its value either through investments or
inflation.
Time value of money (TVM) is the idea that money that is available at the present time is worth more than
the same amount in the future, due to its potential earning capacity. This core principle of finance holds
that provided money can earn interest, any amount of money is worth more the sooner it is received. One
of the most fundamental concepts in finance is that money has a time value attached to it. In simpler
terms, it would be safe to say that a dollar was worth more yesterday than today and a dollar today is
worth more than a dollar tomorrow. (https://psu.instructure.com/courses/1806581/pages/introduction-
what-is-time-value-of-money)

Time Value of money involves two major concepts: future value and present value. Both concept consider
three factors (1) principal, (2) interest rate, and (3) time period.

Present value answers, if we want X how much should we invest today.

While future value answers, if we invest X today, how much will we have in the future.
General Note for the Chapter: All factors are rounded off to the 4 th decimal place, All interest is rounder off to the 2 nd decimal place and all
Amounts are rounded to the nearest whole number for uniformity, understandability and simplicity.

Simple Interest vs compounding.

Simple Interest means only the principal earns interest while compounding means that interests also earn
interest.
Using Simple interest, Interest = Principal x interest rate. While compounding interest, Interest = Carrying
Amount x interest rate. While both of them might be the same, the principal never change but the Carrying
Amount changes per interest is paid, Carrying Amount = Principal + Interest – any payment

Example: ABC Corporation deposits P10,000 in a bank at 10 percent interest per annum, how much will the
investment be after 2 years, using a. simple interest and b. compound interest
a. Simple interest b. Compound Interest
 Year 1: Principal 10,000 Year 1: Principal 10,000
Interest (10,000 x 10%) 1,000 Interest (10,000 x 10%) 1,000
Carrying Amount 11,000 Carrying Amount 11,000
Year 2: Interest (10,000 x 10%) 1,000 Year 2: Interest (11,000 x 10%) 1,100
Carrying Amount 12,000 Carrying Amount 12,100

Periods of Compounding:
Interest maybe compounded monthly, quarterly, semi-annually or annually. Interest is not equal for
different compounding interest.
When an interest is compounded to another periods other annually, the n is multiplied by the number of
periods (2 for semi-annual, 4 for quarterly and 12 for monthly) while i is divided by the number of periods:
Using the same example: ABC Corporation deposits P10,000 in a bank at 10 percent interest per annum,
how much will the investment be after 2 years, using compound interest a. compounded yearly and b.
compounded semi-annually

a. Compound Interest b. Compound Interest

Period1: Principal 10,000 Period1: Principal 10,000
Interest (10,000 x 10%) 1,000 Interest (10,000 x 5%*) 500
Carrying Amount 10,500
Period2: Interest (10,500 x 5%) 525
Carrying Amount 11,000 Carrying Amount 11,025
Period2: Interest (11,000 x 10%) 1,100 Period3: Interest (11,025 x 5%) 551
Carrying Amount 11,576
Period4: Interest (11,576 x 5%) 579
Carrying Amount 12,100 Carrying Amount 12,155
Since it is semi-annual, Interest = 10%/2 = 5% and Period = 2 x 2 = 4 Periods.

Computation of Effective Interest:

The interest for the same rate compounded at different periods have different effective interest rate,
effective interest is the actual annual interest rate for a single year.

Formula:
Effective Interest = [(1+i)n]-1

Example: A company invest in a 12% interest rate compounded for 2 years, compute the :
a. Annually
b. Semi-Annually
c. Quarterly
d. Monthly
Annually: (1+.12)1-1 = .12 or 12%
2
Semi-Annually: (1+.06) -1 = .1236 or 12.36%
4
Quarterly: (1+.03) -1 = .1255 or 12.55%
Monthly: (1+.01)12-1 = .1268 or 12.68%
n should only be equivalent to one year for effective interest, regardless of the given period.

Formulas in time value of money is divided into:

 a. Future Value
b. Present Value
Future Value – used when determining the future value of cash.

Formula:

Single Payment:
FVf = (1+i)n
FV = FVf x PMT

Where:
FV = Future Value
FVf= Future Value Factor
i = Interest Rate
n = Number of Periods
PMT = Amount of money invested/borrowed

Using the same example: ABC Corporation deposits P10,000 in a bank at 10 percent interest per annum,
how much will the investment be after 2 years, interest is compounded semi-annually
FVf = (1+0.05)4
= 1.2155
FV = 1.2155 x 10,000
FV = 12,155
Note on the previous example in the previous page, the carrying amount of the investment after 2 years on
semi-annual compounding is also 12,155. In the previous example, it features the long method in solving
for the future value while for this example, it features the formula method.
Annuity: (Annuity means equal payments at fixed interval example 2,000 per year for the next 5 years)
FVfa = [(1+i)n-1]
i
FV = FVfa x PMT
Where:
FV = Future Value
FVfa= Future Value Factor at an annuity
i = Interest Rate
n = Number of Periods
PMT = Amount of money invested/borrowed

Example: ABC Company will invest 2,000 per year for the next 5 years in an investment that earns 10% per
annum. How much would the investment be after 5 years?
FVfa = [(1+0.1)5-1]
0.1
= 6.1051
FV = 6.1051 x 2,000
FV = 12,210.20

Present Value – used when determining the today value of a future amount.
Formula:
Single Payment:

PVf = (1+i)-n
PV = PVf x PMT
Where:
PV = Present Value
PVf= Present Value Factor
i = Interest Rate
n = Number of Periods
PMT = Amount of money invested/borrowed
Example:
Using the same example as Present Value Single Payment:
ABC Corporation want to have 12,155 at the end of 2 years in a bank at 10 percent interest per annum, how
much should he invest today if the interest is compounded semi-annually. (The answer should be 10,000 as
the question in the Present Value Single Payment is only reversed.)
PVf = (1+0.05)-4
= 0.8227
PV = 0.8227 x 12,155
= 9,999.92 or 10,000. (The difference of 0.08 is due to rounding off)
It should be noted that the Present Value and Future Value are interrelated with each other. Hence you can
use the PVf to solve for the Future Value and FVf to solve for the Present Value.

Example:
Solving for the Future Value using the PVf:
FV = PMT
PVf
FV = 10,000
0.8227
FV = 12,155

Solving for the Present Value using the FVf:

PV = PMT
FVf
PV = 12,155
1.2155
= 10,000

Annuity: (Annuity means equal payments at fixed interval)

Present Value of an Annuity

PVfa = [1-(1+i)-n]
i
PVa = PVfa x PMT
Where:
 PVa = Present Value of an Annuity
PVfa= Present Value Factor at an annuity
i = Interest Rate
n = Number of Periods
PMT = Amount of money invested/borrowed

Example: If you wish to receive 5,000 every year for the next 3 years, in an investment which earns 12%
interest compounded annually, how much should you invest today?

PVfa = [1-(1+0.12)-3]
0.12
= 2.4018
PV = 2.4018 x 5,000
=12,009

Checking if the answer is correct:

Using the Previous problem, the answer is you need to invest 12,009 to receive 5,000 in a year for 3 years.
To Check:
Balance of the Investment = 12,009
Interest(12,009 x 12%) 1,441
Receive 5,000 (5,000)
Carrying Amount 8,450
Interest (8,450 x 12%) 1,014
Receive 5,000 (5,000)
Carrying Amount 4,464
Interest (4464 x 12%) 536
Receive (5,000)
Carrying Amount 0

Future Value of an Annuity

FVfa = [(1+i)n-1]
i
FVa = FVfa x PMT
Where:
PVa = Future Value of an Annuity
FVfa= Future Value Factor at an annuity
i = Interest Rate
n = Number of Periods
PMT = Amount of money invested/borrowed

Example: If you wish to invest 5,000 every year for the next 3 years, in an investment which earns 12%
interest compounded annually, how much will you receive in the future?

FVfa = [(1+0.12)3-1]
0.12
 = 3.3744
FVa = 3.3744 x 5,000
=16,872
Computation of the PVfa and FVfa using the PVf and FVf formula:
Using the Previous Problems.
ABC Company will invest 2,000 per year for the next 5 years in an investment that earns 10% per annum.
How much would the investment be after 5 years?
Using the formula FVfa = 6.1051
Another way to solve for FVfa:
1st Period = (1+0.1)4 =1.4641
2nd Period = (1+0.1)3 =1.331
rd
3 Period = (1+0.1)2 =1.21
4th Period = (1+0.1)1 =1.1
5th Period = (1+0.1)0 =1.0 _
6.1051

If you wish to receive 5,000 for the next 3 years, in an investment which earns 12% interest compounded
annually, how much should you invest today?

Using the Formula PVfa =2.4018

Another way to solve for PVfa:
1st Period = (1+0.12)-1 =0.8929
2nd Period = (1+0.12)-2 =0.7972
rd
3 Period = (1+0.12)-3 =0.7118
2.4019 or 2.4018 (due to rounding off)

Solving for a problem with a mix stream payment:

Mix steam = periodic payment but with different amount, example for the 1 st year 3,000 for the 2nd year
5,000 and 3rd year 6,000.

Example: What is the present value of an investment that gives 3,000 in the 1 st year, 5,000 in the 2nd year
and 6,000 in the 3rd year if the investment earns 12% per annum compounded annually:

1st Period = (1+0.12)-1 =0.8929 x 3,000 = 2,679

2nd Period = (1+0.12)-2 =0.7972 x 5,000 = 3,986
3rd Period = (1+0.12)-3 =0.7118 x 6,000 = 4,271
10,936

Solving of the interest rate:

Using trial and error method is used to determine the interest rate of a problem, but what if you are solving
for the exact interest rate, including the decimal.

First, solve for the higher and lower interest rate using the trial and error

(LIRA – EA)
Interest rate = LIR +
(LIRA – HIRA)
Where: LIR = Lower Interest Rate
LIRA = Amount using the lower interest rate
EA = Exact Amount, the Amount Given
HIRA = Amount using the higher interest rate

Example: ABC Company invested 20,000 for 5 years, compounded annually, after 5 years the amount grows
to 29,048. What is the interest rate of the investment?
Using Trial and Error
LIR = 7%
HIR = 8%
Answer = 7-8%

Solve for the Exact,

(28,051– 29,048)
Interest rate = 7% +
(28,051 – 29,387)
(997)
Interest rate = 7% +
(1,336)
Interest Rate = 7% + 0.75% = 7.75%

LIRA = (1.07)5 x 20,000 = 28,051

HIRA = (1.08)5 x 20,000 = 29,387
EA = Given

Computation of period
Computation for period is just the same as the computation of interest rate.

First, solve for the higher and lower period using the trial and error

(LPA – EA)
Period = LP +
(LPA – HPA)

Where: LP = Lower Period

LPA = Amount using the lower period
EA = Exact Amount, the Amount Given
HPA = Amount using the higher period

Example: ABC Company invest 20,000 in a 12% interest rate compounded annually, how many years will it
take for the investment to grow 28,950.

LP = 3 years
HP = 4 years

Period = 3 Years + (28,098 – 28,950)

(28,098 – 31,469)
 (852)
Period = 3 Years +
(3,371)

Period = 3 Years + 0.25

Period = 3.25 Years or 3.2634 (due to adjustments)

Alternative Method:
Log (Future Amount/Present
Period = Amount)
Log (1+i)

Example: ABC Company invest 20,000 in a 12% interest rate compounded annually, how many years will it
take for the investment to grow 28,950.

Log (28,950/20,000)
Period =
Log (1+0.12)
Log (1.4475)
Period =
Log (1.12)
Period = 3.2634