Unit 5: Basic Long-term Financial Concepts

Lesson 5.1
Time Value of Money
Contents
Introduction 1

Learning Objectives 2

Quick Look 3

Learn the Basics 4

Understanding the Time Value of Money 5
Recalling Simple and Compound Interest 6
Simple Interest 6
Compound Interest 8
Future Value 9
Future Value of an Annuity 11
Present Value 13
Present Value of an Annuity 15

Keep in Mind 17

Try This 18

Practice Your Skills 19

Challenge Yourself 21

Photo Credit 22

Bibliography 22

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Unit 5: Basic Long-term Financial Concepts

Lesson 5.1

Time Value of Money

Introduction

If you were given an option, would you rather receive ₱10,000 today or two years from now?
Chances are you prefer to have it today. But you must have also heard of the saying that a
peso today can be worth more tomorrow. How do you reconcile these two concepts? Is it
better to have the money now or in the future?

Spending the money you have today is more certain than waiting in the future. These funds
can have actual, immediate, and practical use for you. You can buy the daily necessities or a
gadget you urgently need. However, you could also consider depositing or investing the
money to earn interest and dividends over the years.

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Unit 5: Basic Long-term Financial Concepts

This situation illustrates the idea of time value of money. As a student, you may be handling
a small amount of money from your allowance, but understanding the growing value of
money through time can be beneficial for you. This concept is important in personal finance
as well as in business finance. In this unit, you will learn the concept of simple and
compound interest and annuity; also, how the future value of money and the present value
of money is calculated.

Learning Objectives DepEd Competency

Calculate future value and present value of

In this lesson, you should be able to do the
money (ABM_BF12-IIIg-h-18).
following:
● Define the time value of money.

● Calculate the future value and present

value of money.
● Analyze business situations concerning
the time value of money.

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Unit 5: Basic Long-term Financial Concepts

Quick Look

Interesting Interest
Interest has two faces. It represents the income of lenders for letting other people or
business entities borrow their money. On the other hand, it is also the amount of money
that borrowers pay in exchange for using the money. There are two basic ways of
calculating the interest: simple and compound methods.

Consider the following situation. A business owner wants to deposit ₱750,000 in a bank at
5% interest annually for two years. Two banks offered a good deal: Bank A offered simple
interest and Bank B compound interest. Calculate the annual interest, total interest, and
amount to be received at the end of the term using simple and compound interest
assumptions.

Complete the table and answer the questions that follow.

Table 1. Simple Interest

Cumulative
Year Principal Rate Time Interest Total
Interest

Table 2. Compound Interest

Cumulative
Year Principal Rate Time Interest Total
Interest

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Unit 5: Basic Long-term Financial Concepts

Questions to Ponder
1. How much will the business owner earn at the end of term for depositing his money?
__________________________________________________________________________________________
__________________________________________________________________________________________
__________________________________________________________________________________________

2. Which bank has a better deal? Justify your answer.

__________________________________________________________________________________________
__________________________________________________________________________________________
__________________________________________________________________________________________

3. What is the difference between simple interest and compound interest?

__________________________________________________________________________________________
__________________________________________________________________________________________
__________________________________________________________________________________________

Learn the Basics

In the previous lesson, you learned the different sources and uses of funds. You now know
that businesses have varied financing options. Borrowed money entails specific obligations,
but when used appropriately can be beneficial for growing a business.

One of the obligations of borrowers towards creditors is paying interest. They pay an
additional amount on top of the principal amount for the opportunity to spend the money
upfront. On the other hand, investors and creditors pass up the opportunity to spend their
funds today in exchange for earning interest.

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Unit 5: Basic Long-term Financial Concepts

Essential Question

How can present and future value of money affect financing and investing
decisions?

Understanding the Time Value of Money

The time value of money is a financial concept that says it is better to receive money sooner
rather than later (Gitman and Zutter 2015). The money you have today can be used to
produce more money through profits and other investments. Therefore, the inflow of funds
today is worth more than those that will come in the future. Thus, businesses need a tool to
determine the value of money that comes at different times.

In understanding the time value of money, the timeline concept is very important. A time
line is used by financial managers to identify the cash flow at every given period. It is a
graphical illustration that presents the outflow associated with an investment and the inflow
of cash over time. An example of a 5-year time line is shown in Figure 1.

Figure 1. A timeline showing the outflow and inflow of cash from investments.

The time periods are in years. The zero mark represents the present period when a ₱10,000
investment was made. The next mark represents a year from today, and so on. It shows that
every year, an amount of ₱2,200 will flow into the company. A timeline can be used in
making payments or investments. It gives rise to the concept of interest.

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Unit 5: Basic Long-term Financial Concepts

Recalling Simple and Compound Interest

Recall, interest is a payment fee or rent for the use of money. The price varies depending on
the one who lends you the money, called the interest rate. When money is invested in a bank
or other institutions, it accumulates interest; the same thing happens when money is
borrowed.

Simple Interest
Simple interest is the basic finance-related computation of interest. It is computed on the
principal amount of the loan. The formula for simple interest is:

Where:
I = Interest
P = Principal amount loaned
r = interest rate
t = period (in years)

Closer Look

Calculating Simple Interest

Company ABC invests ₱25,000 in a bank at 7% for three years. How much
interest had it earned?

Solution:
Step 1: Identify what is required in the problem.
Interest earned after three years.

Step 2: Identify the given in the problem.

P = ₱25,000
r = 7% = 0.07
t = 3 years

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Unit 5: Basic Long-term Financial Concepts

Step 3: Write the working equation.

𝐼 = 𝑃 × 𝑟 × 𝑡

Step 4: Substitute the given values.

𝐼 = 𝑃 × 𝑟 × 𝑡
𝐼 = ₱25, 000 × 0. 07 × 3
𝐼 = ₱5, 250

Step 5: Find the answer.

The investment earned ₱5, 250 after three years at 7% interest rate.

Table 3 shows the interest based on the given example. The interest is calculated based on
the original principal ₱25,000. The interest for every year is the same, ₱1,750 annually. The
total interest for the three years is ₱5,250.

Table 3. Simple Interest

Cumulative
Year Principal Rate Time Interest Total
Interest

1 ₱25,000 7% 1 ₱1,750 ₱1,750 ₱26,750

2 ₱25,000 7% 1 ₱1,750 ₱3,500 ₱28,500

3 ₱25,000 7% 1 ₱1,750 ₱5,250 ₱30,250

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Unit 5: Basic Long-term Financial Concepts

Check Your Progress

The company decided to borrow ₱2,000,000 from the bank that yields 3%
annually for five years. Compute the annual interest, total interest, and
amount to be paid at the end of the term.

Compound Interest
Most banks and other financial institutions use compound interest on loans. Compound
interest is computed on the principal amount and the accumulated interest. The formula for
compound interest is:

where

Where:
F = future or final value at the end of N periods.
P = principal
J = nominal interest rate per year
M = number of compounding periods per year
I = rate per compounding period
N = total number of compounding periods
T = number of years

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Unit 5: Basic Long-term Financial Concepts

Considering the same example: Company ABC invests ₱25,000 in a bank at 7% for three
years. How much interest had it earned? Table 4 shows the interest schedule.

Table 4. Compound Interest

Cumulative
Year Principal Rate Time Interest Total
Interest

1 ₱25,000 7% 1 ₱1,750 ₱1,750 ₱26,750

2 ₱26,750 7% 1 ₱1,873 ₱3,623 ₱28,623

3 ₱28,623 7% 1 ₱2,004 ₱5,626 ₱30,626

The interest is increasing per period. The principal every year is based on the principal plus
the interest accumulated in the previous year. The principal is not the same but is higher as
it matures. The total interest for three years is ₱5,626.

Future Value
Future value (FV) is the equivalent amount of money in the future of a specific present
amount. It can also be understood as the amount of money after the interest compounds.
Practically, it is the amount after the invested money has grown over time at some given
interest rate. The formula for future value is:

where:
FV = Future Value
IV = Initial Value
r = interest rate
t = period (in years)

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Unit 5: Basic Long-term Financial Concepts

Closer Look

The Future Value of an Investment

Company ABC invests ₱25,000 in a bank at 7% for three years. Compute
the future value.

Solution:
Step 1: Identify what is required in the problem.
Future value of the investment.

Step 2: Identify the given in the problem.

IV = ₱25,000
r = 7% = 0.07
t = 3 years

Step 3: Write the working equation.

𝑡
𝐹𝑉 = 𝐼𝑉 × (1 + 𝑟)

Step 4: Substitute the given values.

𝑡
𝐹𝑉 = 𝐼𝑉 × (1 + 𝑟)
3
𝐹𝑉 = ₱25, 000 × (1 + 0. 07)
𝐹𝑉 = ₱25, 000 × 1. 225043
𝐹𝑉 = ₱30, 626. 07

Step 5: Find the answer.

The future value is ₱30, 626. 07.

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Unit 5: Basic Long-term Financial Concepts

Check Your Progress

A company decided to invest ₱2,000,000 from the bank that yields 3%

annually for five years. Compute for the future value at the end of the term.

Future Value of an Annuity

An annuity is a series of equal, fixed, and periodic cash flows over a period of time. In the
case of a regular or regular annuity, the payment or receipt occurs at the end of each period.
If the payment or receipt occurs at the beginning of each period, it is called annuity due
(Gitman and Zutter, 2015). The formula for computing the future value of an annuity is:

where:
FVA = Future Value of an Annuity
A = Period cash flow (annuity payment)
r = interest rate
t = period (in years)

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Unit 5: Basic Long-term Financial Concepts

Closer Look

The Future Value of a Retirement Fund

A businessman plans to contribute ₱12,000 every year to a retirement
account which is paying 6% interest. If the businessman retires in 25
years, what is the future value of this amount?

Solution:
Step 1: Identify what is required in the problem.
Future value of an annuity.

Step 2: Identify the given in the problem.

A = ₱12,000
r = 6% = 0.06
t = 25 years

Step 3: Write the working equation.

𝑡
(1+𝑟) −1
𝐹𝑉𝐴 = 𝐴 × 𝑟

Step 4: Substitute the given values.

𝑡
(1+𝑟) −1
𝐹𝑉𝐴 = 𝐴 × 𝑟
25
(1+0.06) −1
𝐹𝑉𝐴 = ₱12, 000 × 0.06

𝐹𝑉𝐴 = ₱25, 000 × 54. 86

𝐹𝑉𝐴 = ₱658, 374. 14

Step 5: Find the answer.

The future value of an annuity is ₱658, 374. 14.

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Unit 5: Basic Long-term Financial Concepts

Check Your Progress

A company plans to contribute ₱2,000,000 every year to an investment

account which is paying 3% interest. If the company recovers its investment
in 5 years, what is the future value of this amount?

Present Value
The present value (PV) is the present amount today that is equivalent to a specific amount
paid out over a period of time. The formula for calculating present value is:

Where:
PV = Present Value of Money
FV = Future Value
r = interest rate
t = period (in years)

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Unit 5: Basic Long-term Financial Concepts

Closer Look

Planning an Investment
Company ABC is expecting ₱225,000 in three years’ time after investing in
a bank at 4% annually. Calculate the present value.

Solution:
Step 1: Identify what is required in the problem.
Present value of the investment.

Step 2: Identify the given in the problem.

FV = ₱225,000
r = 4% = 0.04
t = 3 years

Step 3: Write the working equation.

1
𝑃𝑉 = 𝐹𝑉 × 𝑡
(1+𝑟)

Step 4: Substitute the given values.

1
𝑃𝑉 = 𝐹𝑉 × 𝑡
(1+𝑟)
1
𝑃𝑉 = ₱225, 000 × 3
(1+0.04)

𝑃𝑉 = ₱225, 000 × 1. 225043

𝑃𝑉 = ₱200, 024. 18

Step 5: Find the answer.

The present value is ₱200, 024. 18.

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Unit 5: Basic Long-term Financial Concepts

Check Your Progress

The company is expecting to receive ₱5,000,000 in two years’ time after

investing in government securities that yield 3% annually. Calculate the
present value.

Present Value of an Annuity

The present value of an annuity is the present value of future payments from an annuity.
The higher the discount rate, the lower the present value of the annuity. It is calculated using
the following formula.

where:
PVA = Present Value of an Annuity
A = Period cash flow (annuity payment)
r = interest rate
t = period (in years)

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Unit 5: Basic Long-term Financial Concepts

Closer Look

Planning for a Yearly Yield

Company ABC is expecting to get ₱225,000 every year at the end of the
next three years after investing in securities that yield 4% annually.
Calculate the present value interest factor for an ordinary annuity.

Solution:
Step 1: Identify what is required in the problem.
Present value of an annuity.

Step 2: Identify the given in the problem.

A = ₱225,000
r = 4% = 0.04
t = 3 years

Step 3: Write the working equation.

𝑃𝑉𝐴 = 𝐴 ×
(
1−
1
(1+𝑟)
𝑡 )
𝑟

Step 4: Substitute the given values.

𝑃𝑉𝐴 = 𝐴 ×
(
1−
1
(1+𝑟)
𝑡 )
𝑟

𝑃𝑉𝐴 = ₱225, 000 ×

(
1−
1
3
(1+0.04) )
0.04

𝑃𝑉𝐴 = ₱225, 000 × 2. 775091033

𝑃𝑉𝐴 = ₱624, 395. 48

Step 5: Find the answer.

The present value is ₱624, 395. 48.

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Unit 5: Basic Long-term Financial Concepts

Check Your Progress

The company is expecting to get ₱500,000 every year at the end of the next
three years after investing in a security that yields 3% annually. Calculate the
present value interest factor for an ordinary annuity.

Keep in Mind

● It is better to receive money sooner, rather than later: this is the concept of time value
of money. Investing money today provides opportunities for the amount of money to
grow over time at a certain interest rate.
● Recall that there are two types of interests: simple and compound. Simple interest is
the interest computed on a principal amount. Compound interest is computed on the
principal amount and the accumulated interest.
● Businesses use various tools to calculate how much an investment is worth in the
future based on a given compounded interest. These tools and the formula for
calculating them are summarized below.

Tools Description Formula

the equivalent amount of money

Future Value of
in the future of a specific present 𝐹𝑉 = 𝐼𝑉 × (1 + 𝑟)
𝑡
Money
amount of money

a series of equal, fixed, and

Future Value of 𝑡
periodic cash flows over a period 𝐹𝑉𝐴 = 𝐴 ×
(1+𝑟) −1
an Annuity 𝑟
of time

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Unit 5: Basic Long-term Financial Concepts

the present amount today that is

Present Value of 1
equivalent to a specific amount 𝑃𝑉 = 𝐹𝑉 ×
Money
𝑡
(1+𝑟)
paid out over a period of time

Present Value of the present value of future 1− ( 1

𝑡 )
(1+𝑟)
an Annuity payments from an annuity 𝑃𝑉𝐴 = 𝐴 × 𝑟

Try This

A. Identification. Write the correct answer on the provided space before each number.

________________ 1. It is the amount of money paid in exchange for using the

money at present.

________________ 2. It is the concept which states that the amount of money today
is worth more than money in the future.

________________ 3. It is the equivalent amount of money in the future for a specific

present amount of money.

________________ 4. It is the current value of a future sum of money or stream of

cash flows given a specified rate of return.

________________ 5. It is a series of equal, fixed, and periodic cash flows over a

period of time.

B. True or False. Write true if the statement is correct. Otherwise, write false.

________________ 1. The present value would increase as the discount rate

decreases.

________________ 2. Finding the present value refers to calculating the simple

interest.

________________ 3. The present value for ₱1 at present is zero.

5.1. Time Value of Money 18

Unit 5: Basic Long-term Financial Concepts

________________ 4. It would be best if you calculate the future value of money to

know how much a ₱100,000 investment today can grow based
on a specific interest rate.

________________ 5. If you are targeting to earn a specific amount of money in the

future and want to know how much you should invest today, it
would be best to calculate the future value of money
considering the interest rate.

Practice Your Skills

Exploring Investment Options

Company XYZ is exploring all possible investment options. Read each problem carefully and
calculate what is being asked.

1. Company XYZ plans to borrow ₱3,000,000 from a bank for office expansion. The
bank offered to lend them money in exchange for an 8% interest payable after five
years. Calculate the annual interest, total interest, and amount to be paid at the end
of the term using a simple interest assumption.

5.1. Time Value of Money 19

Unit 5: Basic Long-term Financial Concepts

2. Company XYZ borrowed ₱3,000,000 from the bank for office expansion. The bank
charged the company 8% for the borrowed amount payable after five years.
Calculate the future value at the end of the term.

3. Company XYZ borrowed money from a bank for office expansion. The bank charged
the company 8% for the borrowed amount payable after five years at a total amount
of ₱5,700,000. Calculate the present value at the end of the term.

4. Company XYZ borrowed money from a bank for office expansion. The bank charged
the company 8% for the borrowed amount payable in five annual payments of
₱672,000. Calculate the present value of an annuity.

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Unit 5: Basic Long-term Financial Concepts

5. Company XYZ is expecting ₱251,000 annually for six years after investing in a bank at
8% annually. Calculate how much money they should invest today.

Challenge Yourself

Answer the following questions:

1. What is the significance of understanding the time value of money on cash

budgeting? Explain your answer.
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________

2. Suppose you are pitching a new product or program. Which tool in calculating the
time value of money would you use to support your proposal? Justify your answer.
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________

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Unit 5: Basic Long-term Financial Concepts

3. Provide a scenario in handling your personal finance wherein calculating the

present value of the annuity would be useful. Explain your answer.
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________
_________________________________________________________________________________________

Photo Credit
Coins Currency Investment by Steve Buissinne is licensed under Pixabay License via
Pixabay.

Bibliography
“2. Time Value of Money - Scanton.edu.” Accessed January 21, 2022.
https://www.scranton.edu/faculty/hussain/teaching/mba503c/MBA503C02.pdf.

Christian, Rachel. “Present Value of an Annuity: How to Calculate & Examples.”

Annuity.org. Accessed January 21, 2022.
https://www.annuity.org/selling-payments/present-value/#:~:text=The%20formula%
20for%20determining%20the,Dollar%20amount%20of%20each%20payment

“Compound Interest: Formulas, Derivation & Solved Examples.” Cuemath. Accessed

January 21, 2022. https://www.cuemath.com/commercial-math/compound-interest/.

Fernando, Jason. “Time Value of Money (TVM).” Investopedia. Investopedia, September 3,

2021. https://www.investopedia.com/terms/t/timevalueofmoney.asp

Gitman, Lawrence and Chad Zutter. Principles of Managerial Finance, 14th Edition. Harlow:
Pearson Education Limited, 2015.

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Unit 5: Basic Long-term Financial Concepts

Irena, Munteanu, and Bacula Mariana. “The Time Value of Money in Financial
Management.” Accessed January 21, 2022.
https://www.stec.univ-ovidius.ro/html/anale/ENG/2017-2/Section%20IV/1.pdf

Kagan, Julia. “Future Value of an Annuity.” Investopedia. Investopedia, February 20, 2021.
https://www.investopedia.com/terms/f/future-value-annuity.asp

“Strand: Finance Simple and Compound Interest.” Accessed January 21, 2022.
http://accioneduca.org/admin/archivos/clases/material/interest-rates_1564084248.p
df

“Structure - Shivaji College.” Accessed January 21, 2022.

https://www.shivajicollege.ac.in/sPanel/uploads/econtent/bda1bf7448be516600459
74356345384.pdf

“Understanding the Time Value of Money - Iowa State University.” Accessed January 21,
2022. https://www.extension.iastate.edu/agdm/wholefarm/pdf/c5-96.pdf

5.1. Time Value of Money 23