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    19 views11 pages

    Time Value of Money (FINANCIAL MANAGEMENT)

    Uploaded by

    Lalaine Beatriz

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    of 11
    Introduction In business, finance managers rely on the concept ‘of time value of money which states that the amount of ‘money today is different from whac it will be in the future. Because of this difference, a finance manager ‘makes computations carefully before arriving at a decision. For instance, an insurance company that ‘pays P500,000 after 20 years toa policyholder receives 4 premium payment of P12,500 a year. For 20 years, the premium payment made by the policyholder will amount to a sum of up to P250,000 only. Why is the insurance company willing to sacrifice the other £P250,0002 The answer to the question is simple, ic., the insurance company believes that it can do much. ‘more using the P12,500 thar i actually receives every yyeat. The firm believes that the expected return ‘exceed whar i is willing to pay the policyholder. ee aaa! At the end of the chapter, students should be able to: ‘understand the concept of time value of money; compute the time value of money in various situations; solve problems using the time vatue of money; explain the importance of the tirne value of money in the decision- making process; and enumerate the other areas in financial management where the time value of money is applied. The time value of money is 2 critical consideration in financial and investment decisions. It helps individuals and firms determine how much money must be placed today to accumulate a future sum given an interest rate for a given period. Thus, the placement may be in either lump-sum or regular intervals, and at the beginning or at the end of the period. Likewise, the time value of money helps determine how much interest money will earn if placed today at a certain rate for a certain period. ‘The compounding of interest determines the ftture amount of money earned if an investment is made at the present. Itis also used to ascertain how much money should be invested to acquire a target amount in the future, e.g.. pension funds for retiring employees. sinking funds for long-term obligations, etc. Discounting, the opposite of compounding, is used to evaluate future cash flows associated with capital budgeting projects and the valuation of bonds and stocks. Future Value A peso actually received today is worth more than a peso to be received tomorrow. This valuation holds ‘true because ofthe interest money can earn after having been invested. Compounding interest means that the interest not withdrawn also earns interes, ie, the interest itselfalso earns interest. Knowinghow much, imtetestis earned on the money placed in the present helps individuals decide whether or not to look for other investment opportunities. For a better understanding of the concept of compounding, the following symbols are defined: FV = fucure value (present + interest) or die amount of money at year end n PY = principal value : i= annual interest rate n= number of periods [foe ets b= If the amount PV at year 0 is placed at a rate i, then FV= PV(1+i)" In this case, if PV = P1,000, i = 12%, and n « 4, the result is: FV P1000 (1.12)! The (1.12)is equal to 1.573 which is obtained by multiplying 1.12 four times by itself. The interest iq table for the Future value of 1 may also be used for convenience. Example: Mario Orio placed P1,000 in a savings account earning 7% interest compounded annually. How ‘much money will he accumulate after 5 years? FV = PV (si 1,000 (1.07)° 1,000 (1.403) = P1,403 Note: The value 1.403 may also be found in the interest table using the future value of 1. Example: Lackie Tyan invested a large sum of money in ZZ, Corporation. The company pays a P3 dividend pershare. The dividends are expected to increase by 15% per year for the next 3 years. Lackie wants to [project the dividends from years 1 t0 3, Answer: FV=?V(+iP Acyear 1 FY = P3 (115)! Ar year2 FV = P53 (115? = 3 (1.322) = 7397 At year 3 FV = P3 (1.15 3 (1521) = P456 -year Compounding Interest is often compounded more than once a year. Banks and other financial institutions accepting its compound interest quarterly, daily, or even continuously. interest is compounded many times the general formula for solving the future value is: FV =PV(1+ilmy*o i : i i a __The number of conversion periods for I year is denoted by m while the total number of conversion periods for the whole investment term is denoted by 1. Conversion periods are usually expressed by any Jength of time and usually taken as an exact division of the year, .g., monthly, quartety,semi- p and annually. When the conversion periods are: m=1 m=2 m=4 m=12 ‘The total number of conversion periods for the whole term n can be found from the relation: n= time x number of conversion periods per year m astxm ‘Thus, the term 5 years compounded: annually, Sxl ne5 semi-annually, 5x2 n= 10 quarterly, 5x4 n=20 monthly, 5x 12_n = 60 ‘The interest rate is usually expressed as an annual or ycatly rate, and must be changed to the interest fate per conversion period or periedi rate i and can be found from the relation: interest rater ‘Conversion peciod per year m 9 | race nations ira ‘Thus, the interest rate at 9% compounded: annually, 9% +1 i = 9.00% semi-annually, 9% +2 i = 450% quarerly, 9% #4 i = 2.25% monthly, 9% + 12. i, = 0.75% The formula reflects a mote frequent compounding (¢ x m) at a smaller interest rate per petiod (é/m). ‘The future value increases as m increases. Thus, continuous compounding results in the maximum possible future value at the end of n periods for agiven rate of interest. Example: ‘Assume that P = P1,000, I = 12% and n = 4 years. Thus: Annual compounding (m= 1: FV = P1,000(1.12)**? = P1,000(1.574)* = PLS ‘Semi-annual compounding (m = 2): FV = ?1,000(1 + 0.12/2)**? = P1,000(1.06)8 = P1,000(1.594) = PLS Quarterly compounding (m = 4): FV = PI,000(1 + 0.12/4)*4 = P1,000(1.03)' = P1,000(1.605) = PLGOS FV = P1,000 (1 + 0.12/12)"*!2 = P1000 (1.0* = P1000 (1.612) = P1612 © Monthly compounding (m = 12): Future Value of an Annuity ‘An annuity s defined as a series of equal payments (or receipts) made at fixed intervals fora specified number of periods. IF the payment occurs at the end of the period, itis called an ordinary annuity. Examples are mortgages on housing, car loans, and bank loans. Ifthe payment occursat the beginning of each period, the annuity is called an annuity duc. Life and car insurance premiums and rental payments are some typical ‘examples of an annuity due. Between the two types of annuities, the ordinary annuity is more common in practice. Example: Aza wants w determine che sum of money she will have in her savings accoune at the end of 5 years by depositing P1,000 at the end ofeach year for the next 5 years. The annual incerest rate is 896, Answer: Savings Furure Value Factor Future Values 1,000 (1.08)* 1,360.49 1,000 (1.08) 1,259.71 1,000 (1.08)? 1,166.40 1,000 (1.08)! 1,080.00, 1,000 (1.08)? 1,000.00 ‘5,866.60 "Each deposit is made at the'tnd of the year and compounded at the end of the period ». The sum of ‘compounded deposits is the future value of an annuity. Another way of solving this problem is by using the future value of an annuity formula. £55 Gaara Assume the following: FV, = amount of an annuity PV, = present value of an annuity A =anmuity due Thus: FY, +(e) Eun However, the formula can only be used ifthe cash payments oF receipts are even; otherwise, each payment “or receipt is computed individually using the present value. Based on the previous example: Fy, a (tert) Example: ‘Aina wants to determine the sum of money she will have in her savings account at the end of 5 years, by depositing P1,000 at the beginning of each year for the next 5 years. The annual interest rate is 8%. ° 1 2 3 4 5 P1000 P1000 P1,000 P1,000 Pi,000.00 LF 1080.00.09" 1,166.40 (1.08)? 1,259.71 (1.08? 1,360.49 (1.08) = 1,469.33 (1.08 P 6,335.93 Since the deposits started at the beginning of each year, more interest is earned as compared t0 deposits made at the end of the year. Another way of solving this problem is by using the future value of an annuity formula. Again, the formula to be given will only be useful ifc has an equal cash flow. The formula is a follows: BSS | rrncias nanacensnr rar FINAN ENT Part ° FY, -a(t=) a0 Because of an earlier deposit or payment, the future value of an ordinary annuity has been £ compounded for one additional period. Thus, applying the formula: FV, = 1,000 ( } (4.08) 0.08 = P6,335.93. Present Value at Compounded Interest ‘The present value of a future sum is the amount that must be invested today at a compound interest to reach a desited sum in the future. The process of calculating present values, or discounting, is usually the opposite of finding the compounded future value. In connection with present value calculations, the interest rate is called the discount rate. Recall that: FV =PV (sit ‘Therefore, by simple transposition: BV PV coy of FV rd Example: Roval Toro is given the opportunity to receive P50,000 10 years from now. Ifhe can earn 15% on his investment compounded annually, what is the mosthe should pay to benefit from this opportunity? FV(+9* = 50,000 (1.15)? = 50,000 (0.247) = P12,350.00 Roval Toro should invest at the maximum amount of P12,350 earning at 15% to accumulate a future amount of P50,000. Present Value of an Annuity Interest received from bonds, pension funds, and insurance obligations all involve annuities. To compare these financial instruments, the present value of each must be known. ‘The present value of an annuity can be found using the following equation: (14a } S Martha Fobre is offered the opportunity to receive the following equal cash flow over the next 3 years: Year Revenue 1 10,000 2 10,000 3 10,000 Tfshe must earn a minimum of 8% on her investment, what is the most she should pay today? The present value of the equal cashflow is a follows: ‘Timeline: P10,000 10,000 P10, 0 @ I ! P 9,259.26 «1 8573.39 25,720.97 2 Martha Fobre has to deposit P25,770.97 to receive a yearly amount of P10,000 for three years. Anothes way of solving this problem is by using the preset value of an annuity formula, The formula +o be given is only useful if it has an equal cash flow. The formula is as follows: maf) BS | noennewne B33 | ner rncaneee i i FINANCIAL MANAGEMENT | arti (1+0.08) =P10,000|—" Toa Present Value of Unequal Cash Flows ‘Time-value-of- money problems may revolve around a series of payments or cash receipts. However, not every situation involves a single amountaf annuity. A problem may involve an unequal cash flow each, petiod for a certain number of years. ‘The present value of unequal cash flows is the suum of the present values of each unequal cash flow. Example: Xenetea Trias was offered the opporcunity to receive the following unequal cash flows over the next 3 years Year Revenue 1 10,000 2 12,500 3 9,500 Ifshe must carn a minimum of 8% on her investment, what amount should she pay today? The present value of unequal cash flows of revenue is as follows: Year Revenue (1 +i)" Present Value 1 P10,000 0.926 P 9,260.00 2 12,500 0.857 10,712.50 3 9500 0.794 2543.00 P 2751550 Applications of Future and Present Values Furure and present values have numerous applications in financial and investment decisions. They are useful in decision-making whether for personal reasons (¢g.. how much deposit must be made to acquire certain amount of money, amortize a loan, or pay offa sinking fund2) or corporate reasons (e.g. capital budgeting, bond and stock valuation, and right financing mia). ‘An individual may wane to know che annual deposit (or payment) necessary to accumulate a fucure sum, To determine this future amount, the formula in computing the furure value of annuity can be used. Example: Ziram Ilamu is interested to know the equal annual, end-of year deposits required ro accumulate P15,000 ar the end of 10 years when her son enters college. The interest rate is 1296. The annual deposits are as follows: P15,000 = A (17.549) A = P15,000 17549 A = PB5475 If Ziram lamu deposits P854.75 at the end of every year for 10 yeats at 12% interest, she will accumulate F15,000 at the end ofthe fifth year. G2 | tmevauccroney Amortized Loans Payments of obligations are made in equal installments which may be monthly, quarterly, semi-annually, ‘or annually. Amortized loans include housing loans and auto loans. Other loans are classified as long-term Toans. The periodic payment can be computed using the present value of an annuity of 1: PV, ‘Thus, by transposition, the periodic payment i: Ferlie Shells has a 60-month auto loan of P650,000 ata 12% annual interest rate. She wants to find ‘out how much the monthly payment should be. : P650,000 (Har) 001 £650,000 44.955 = 14,458.90 ‘To repay the principal and intcrest on a 650,000, 12%, 60-month auto loan, Ferlie Shells has to pay P14,458.90 a month for the next 60 months. $23 | marcas namcrcortac Example: ‘Assume that a firm borrows P120,000 to be repaid annually for the next 5 years. The creditor-bank stipulated a 1296 interest. Compute the amount of each payment. P120,000 a = (t-G.2y 0.12 A = piz0.000 » s 3.605 = 33,287.10 Each Joan payment made.is distributed partly to the interest and partly to the principal. The breakdown is often displayed in a loan amortization schedule. The interest component is largest in the first period and subsequently declines, whereas the principal portion is smallest in the first period and increases thereafter. Example: Using the same data in Example 10, the amortization schedule is as follows: Principal Outstanding Year Payment Ineerest pu - 0 120,000.00 1 P 33,287.10 P 14,400.00 P 18,887.10 101,112.90 2 33,287.10 12,133.55 21,153.55 79,959.35 3 33,287.10 9,595.12 23,691.98 56,267.37 4 33,287.10 6,752.08 26,535.02 29,732.35 5 33,287.10 3,567.88 __ 29,732.35 0.00 P166,435.50_P 46,448.63 _P120, Annual Percentage Rate (APR) ‘The dferenecypes of financial instruments use various compounding periods. Bonds for instance "usually pay incerest semi-annually; banks pay interest on deposits quarterly: and firms offering credic cards pay interest monthly. If an investor wants to compare financial instruments with different compounding periods, a mathematical tool should be used to make the comparison possible. For this purpose, the effective

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