BM 232

TIME VALUE OF
MONEY
 TIME VALUE OF MONEY
 The 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.

 Time Value of Money (TVM) is an important concept in

financial management. It can be used to compare investment
alternatives and to solve problems involving loans, leases and
savings.
TOPICS
 Simple Interest
 Compounded interest
 Annuity
 Short term
 Long term
 Perpetual Annuity
 Inflation
 Monetary value in todays buying power of the money
Simple interest
 Simple Interest is an interest which is based only on the original
capital or principal

 Let I = total interest earned after n interest periods

I = Pin
F=P+I
F= P(1+in)
 Ordinary
Simple Interest – period is based on one banker year.
(30 months,12 months/year, 360 days/year)

 Exactsimple interest –period based on actual days in the

calendar
example

 Sarah deposits $4,000 at a bank at an interest rate of

4.5% per year. How much interest will she earn at the
end of 3 years?

Solution:
I=Pin
Simple Interest = 4,000 × 4.5% × 3 = 540

She earns $540 at the end of 3 years.

example
 Raymund bought a car for $40, 000. He took a $20,000 loan from a bank at
an interest rate of 13% per year for a 3-year period. What is the total amount
(interest and loan) that he would have to pay the bank at the end of 3 years?
Solution :
I = Pin
Simple Interest = 20,000 × 13% × 3 = 7,800
At the end of 3 years, he would have to pay
F = P+I
F = $20,000 + $7,800 = $27,800
example
 Determine the ordinary simple interest on $10,000 for 9
months and 12 days if the rate of interest is 18%.

Solution :
n= 282 /360 = 0.78

So, the ordinary simple interest,

I = Pin

I = $10,000 x 18% x 0.78 = $1,404

example
 Find the total amount on $10,500 invested at 5% for 75 days
using exact simple interest.
Solution :
n= 75 /365 = 0.21

So, the total amount / future amount,

F = P(1+in)
F = $10,500 ( 1 + (5% x 0.21)) = $10,610.25
Compounding Interest
 An interest which is based on the current account
or on the original capital plus the accumulated
interest.

F= P (1+i)^n
Nominal Rate
 The basic annual rate of interest or interest earned

FV = PVo (1+ (i/m))^mn

Example:
If you deposited Php 5000 at the bank with a nominal interest rate of 8% , what is
the FUTURE VALUE of the at the end of six months? at the end of the year?

Answer:
at the end of six months FV0.5 = 5000 x (1 + (0.08/ 2))
= 5,200
at the end of a year FV1 = 5000 X (1 + (0.08/2))^ (2)(1)
= 5, 400
 PVo = FVn /(1 + (i/m))^mn

where;
FVn is the future cash flow to be received at the end of year n

Example:
What is the Present Value of 5000 to be received at the end
of year 3 of a nominal rate of 8% compounded quarterly?
compounded annually?
Answer:

Compounded quarterly: Php 3, 942. 4658

Compounded annually: Php 3, 969. 1612
Effective Rate of Interest
-the actual rate of interest earned on the principal
during a period of one year

ER= (1+ (NR/m)^ m) – 1 for compound interest

Annuity -a fixed sum of money paid to someone
each year, typically for the rest of their life.
  FV = Future Value
 PV = Present Value
 i = Interest rate
 n = Number of compounded periods
 Annuity
 Sample:

• Apple wants to take a nice vacation trip, so she

begins setting aside $250 per month. If she deposits
this money on the first of each month in a savings
account that pays 6% interest compounded monthly,
how much will she have at the end of 10 months?

• Apple’s first payment will earn 10 months interest. So

F = 250(1 + .06/12)12(10/12). Note that the time t is
10/12. Therefore F = 250(1.005)10 = $262.79.
Table of future values
Payment Future Value
Totaling up the future value
1st 250(1.005)10 = $262.79 column, we see that Claire has
2nd 250(1.005)9 = $261.48 $2569.80 to use for her
vacation. She earned $69.80 in
3rd 250(1.005)8 = $260.18
interest.
4th 250(1.005)7 = $258.88
5th 250(1.005)6 = $257.59
6th 250(1.005)5 = $256.31
7th 250(1.005)4 = $255.04
8th 250(1.005)3 = $253.77
9th 250(1.005)2 = $252.51
10th 250(1.005)1 = $251.25
 $2569.80

251.25
252.51
253.77
𝑛
𝑓𝑣
  = 𝐴 (1+𝑖) 255.04
256.31
𝑓𝑣=250(1+
  .06/ 12)𝑛
257.59
258.88
260.18
261.48
262.79

FV
 

FV Other Formula
FV = $2569.80
Long Term Annuity
 ORDINARY ANNUITY
 ANNUITY DUE – receives one more period of
compounding than the ordinary annuity so the
formula is

Fv  A
 1 i
n
1
i

 FV
• Bing wants to by new car. so she begins setting aside
$1000 per month. If she deposits this money on the
first of each month in a savings account that pays 2%
interest compounded monthly, how much will she
have at the end of 2 years?

Fv  A
 1 i 1
n

Fv  1000
 1  .02 / 12   1
24
 24,465
.02 / 12

FV
 

FV
FV = $24,465
• A woman deposits $ 300 at the end of each six
months in a bank paying 2% compounded semi
annually. How much will she save to her credit at the
end of 10 years?

Fv  A
 1 i 1
n

Fv  300
 1  .02 / 2   1
20
 $ 6605.7
.02 / 2

FV
 

FV
FV = $ 6605.7
 Perpetual Annuity - Perpetuity refers to an infinite amount of
time. In finance, perpetuity is a constant stream of identical cash flows
with no end.
  PV = Present Value
 i = Interest rate
n=C

 
𝑷𝑽
• What is the present value of a perpetual annuity of
5000 each payable at the end of each year, Assume
money is worth 10% per annum.
 
∞
5000
 
5000
5000
5000
5000
FV
 

FV
FV = $ 50,000
• If money is worth 8%, determine the present value
of a perpetual annuity of 1000 payable with the first
payment due at the end of 5 years
 
∞
1000
 𝑃𝑣= 𝐴 /𝑖
1000
1000
1000
1000
FV
 

FV
FV = $ 9,187.87
Inflation - is a sustained increase in the general
price level of goods and services in an economy over a
period of time.
  FV = Future Value
 PV = Present Value
 f = Inflation rate annually
 n = Number of years

FV
• One economist has predicted that there will be a 7%
per year inflation of prices during the next 10 years.
If this proves to be correct, an item that sells 100
would sell for what price 10 years after?

PV   FV
FV
FV = 196.71
FV
 Monetary value in todays buying power
of the money

i
P 1  i 
n
P' 
1  f  n i f

FV

 P’ =
Value of money in terms of the present (Year 0) buying
power of money.
• An Economy is experiencing inflation at an annual
rate of 8%. If this continues, what will be $1000 be
worth 2 years from now, in terms of todays dollar?

i
P 1  i 
n
P' 
1  f  n f

P 1  i  FV
n
P' 
1  f  n
1000
P' 
1  0.08 2
P '  857.338