TIME

VALUE
OF
MONEY
QUESTION
Your father has offered to give you some money
and asks that you choose one of the following two
alternatives:
• ₱1,000 today, or
•₱ 1,100 one year from now.

What do you do?

THE ROLE OF TIME VALUE IN FINANCE

• The answer depends on what rate of interest you could earn on any
money you receive today.
• For example, if you could deposit the ₱1,000 today at 12% per year,
you would prefer to be paid today.
• Alternatively, if you could only earn 5% on deposited funds, you
would be better off if you chose the ₱1,100 in one year.
THE ROLE OF TIME VALUE IN FINANCE

• Most financial decisions involve costs & benefits that

are spread out over time.
• Time value of money allows comparison of cash flows
from different periods.
TIME VALUE OF MONEY refers to the
observation that it is better to receive money
sooner than later.
 A peso in hand today is worth
more than a peso to be received
in the future because if you had
it now, you could invest it, earn
interest, and end up with more
than a peso in the future.
BASIC CONCEPTS/DEFINITION OF TERMS

• Present Value: discounting to today’s value

- The value today of a future cash flow or series of cash
flow.
BASIC CONCEPTS/DEFINITION OF TERMS

• Future Value: compounding or growth over time.

- The amount to which a cash flows or series of cash flows
will grow over a given period of time when compounded at a
given interest rate.
- The amount to which a current investment will grow over
time when placed in an account that pays compound interest.
BASIC CONCEPTS/DEFINITION OF TERMS

• Compounding: The arithmetic process of determining the final

value of a cash flow or series of cash flows when compound
interest is applied.
• Compound Interest: Occurs when interest is earned on prior
period interest.
• Simple Interest: Occurs when interests is not earned on
interest.
BASIC CONCEPTS/DEFINITION OF TERMS

• Principal: The amount of money on which

interest is paid.
• Discounting: The process of finding the present
value of a cash flow or a series of cash flows.
- It is the reverse of compounding.
Time Line Depicts the cash flows associated with a given investment. It can
be used to depict investment cash flows.

A firm has an opportunity to spend P15,000 today on some investment

that will produce P17,000 spread out over the next five years as
follows:
Year 1 3,000
Year 2 5,000
Year 3 4,000
Year 4 3,000
Year 5 2,000
Time Line Depicts the cash flows associated with a given investment. It can
be used to depict investment cash flows.

A firm has an opportunity to spend P15,000 today on some investment

that will produce P17,000 spread out over the next five years as
follows:
Year 1 3,000
Year 2 5,000
Year 3 4,000
Year 4 3,000
Year 5 2,000
Compounding and Discounting

5
Financial Tables
BASIC PATTERNS OF CASH FLOW

• The cash inflows and outflows of a firm can be described by its general
pattern.

• The three basic patterns include a single amount, an annuity, or a

mixed stream.
SIMPLE INTEREST OCCURS WHEN INTERESTS IS NOT
EARNED ON INTEREST
With simple interest, you don’t earn interest on interest.
• Year 1: 5% of $100 = $5 + $100 = $105
• Year 2: 5% of $100 = $5 + $105 = $110
• Year 3: 5% of $100 = $5 + $110 = $115
• Year 4: 5% of $100 = $5 + $115 = $120
• Year 5: 5% of $100 = $5 + $120 = $125
COMPOUND INTEREST Occurs when interest is
earned
on prior period interest.
With compound interest, a depositor earns interest on interest!
• Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00
• Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
• Year 3: 5% of $110.25 = $5 .51+ $110.25 = $115.76
• Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
• Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63
TIME VALUE TERMS

• PV0 = present value or beginning amount

•i = interest rate
• FVn = future value at end of “n” periods

•n = number of compounding periods

•A = an annuity (series of equal payments or receipts)
FOUR BASIC MODELS

• FVn = PV0(1+i)n = PV x (FVIFi,n)

• PV0 = FVn[1/(1+i)n] = FV x (PVIFi,n)

• FVAn = A (1+i)n - 1 = A x (FVIFAi,n)

i

• PVA0 = A 1 - [1/(1+i)n] = A x (PVIFAi,n)

i
 FUTURE VALUE OF A SINGLE AMOUNT

• Future Value techniques typically measure cash flows at the end of a project’s
life.
• Future value is cash you will receive at a given future date.
• The future value technique uses compounding to find the future value of each
cash flow at the end of an investment’s life and then sums these values to find
the investment’s future value.
• We speak of compound interest to indicate that the amount of interest earned on
a given deposit has become part of the principal at the end of the period.
FUTURE VALUE OF A SINGLE AMOUNT: USING FVIF
TABLES
If Fred Moreno places $100 in a savings account
paying 8% interest compounded annually, how much
will he have in the account at the end of one year?

FVn = PV0(1+i)n = PV x
(FVIFi,n)
FUTURE VALUE OF A SINGLE AMOUNT: USING FVIF
TABLES
If Fred Moreno places $100 in a savings account
paying 8% interest compounded annually, how much
will he have in the account at the end of one year?

FVn = PV (1+i)
0
n
= PV x
(FVIFi,n)
$100 x (1.08)1 = $100 x FVIF8%,1
$100 x 1.08 = $108
FUTURE VALUE OF A SINGLE AMOUNT: THE
EQUATION FOR FUTURE VALUE
Jane Farber places $800 in a savings account paying 6%
interest compounded annually. She wants to know how
much money will be in the account at the end of five
years.
FUTURE VALUE OF A SINGLE AMOUNT: THE
EQUATION FOR FUTURE VALUE
Jane Farber places $800 in a savings account paying 6%
interest compounded annually. She wants to know how
much money will be in the account at the end of five
years.
FVn = PV0(1+i)n = PV x
(FVIFi,n)

FV5 = $800 X (1 + 0.06)5 = $800 X (1.338) = $1,070.40

FUTURE VALUE OF A SINGLE AMOUNT:
A GRAPHICAL VIEW OF FUTURE VALUE

Figure 4.5
Future Value
Relationship
 PRESENT VALUE OF A SINGLE AMOUNT
• Present value is the current dollar value of a future amount of money.
• It is based on the idea that a dollar today is worth more than a dollar
tomorrow.
• It is the amount today that must be invested at a given rate to reach a
future amount.
• Calculating present value is also known as discounting.
• The discount rate is often also referred to as the opportunity cost, the
discount rate, the required return, or the cost of capital.
PRESENT VALUE OF A SINGLE AMOUNT: USING PVIF
TABLES

Paul Shorter has an opportunity to receive $300 one

year from now. If he can earn 6% on his investments,
what is the most he should pay now for this
opportunity?

PV0 = FV [1/(1+i) ] = FV x (PVIFi,n)

n
n
PRESENT VALUE OF A SINGLE AMOUNT: USING PVIF
TABLES

Paul Shorter has an opportunity to receive $300 one

year from now. If he can earn 6% on his investments,
what is the most he should pay now for this
opportunity?

PV0 = FV [1/(1+i) ] = FV x (PVIFi,n)

n
n

$300 x [1/(1.06)1] = $300 x PVIF6%,1

$300 x 0.9434 = $283.02
PRESENT VALUE OF A SINGLE AMOUNT: THE
EQUATION FOR FUTURE VALUE
Pam Valenti wishes to find the present value of $1,700
that will be received 8 years from now. Pam’s
opportunity cost is 8%.

PV0 = FVn[1/(1+i)n] = FV x (PVIF i,n )

PRESENT VALUE OF A SINGLE AMOUNT: THE
EQUATION FOR FUTURE VALUE
Pam Valenti wishes to find the present value of $1,700
that will be received 8 years from now. Pam’s
opportunity cost is 8%.

PV0 = FVn[1/(1+i)n] = FV x (PVIF i,n )

PV = $1,700/(1 + 0.08)8 = $1,700/1.851 = $918.42

PRESENT VALUE OF A SINGLE AMOUNT: A GRAPHICAL
VIEW OF PRESENT VALUE

Figure 4.6
Present
Value
Relationship
ANNUITIES
ANNUITIES
• A stream of equally-spaced cash flows of equal size, over a specified
time period. These cash flows can be inflows of returns earned on
investments or outflows of funds invested to earn future returns.

• An annuity is a financial product that pays out a fixed stream of

payments to an individual, primarily used as an income stream for
retirees.
 BREAKING DOWN 'ANNUITY'
• Annuities were designed to be a reliable means of securing a steady cash flow
for an individual during their retirement years and to alleviate fears of
longevity risk, or outliving one's assets.
• Annuities can also be created to turn a substantial lump sum into a steady cash
flow, such as for winners of large cash settlements from a lawsuit or from
winning the lottery.
• Defined benefit pensions and Social Security are two examples of lifetime
guaranteed annuities that pay retirees a steady cash flow until they pass.
TWO TYPES OF ANNUITIES
BASIS FOR COMPARISON ORDINARY ANNUITY ANNUITY DUE

Meaning Ordinary annuity is one in Annuity due is described

which the inflow or as the series of cash flows
outflow of cash fall due for occurring at the beginning
payment at the end of each of each period.
period.
TYPES OF ANNUITIES
Example
Fran Abrams is choosing which of two annuities to receive. Both are 5-
year $1,000 annuities; annuity A is an ordinary annuity, and annuity B
is an annuity due. Fran has listed the cash flows for both annuities as
shown in Table on the following slide.

Note that the amount of both annuities total

$5,000.
COMPARISON OF ORDINARY ANNUITY AND ANNUITY
DUE CASH FLOWS ($1,000, 5 YEARS)
ORDINARY ANNUITY

• An ordinary (deferred) annuity has cash flows that occur at the end of
each period.
• An ordinary annuity is a series of equal payments made at the end of
consecutive periods over a fixed length of time. While the payments in an
annuity can be made as frequently as every week, in practice, ordinary
annuity payments are made monthly, quarterly, semi-annually or annually.
 FINDING THE FUTURE VALUE OF AN
ORDINARY ANNUITY
Fran Abrams wishes to determine how much money she will have at the
end of 5 years if he chooses annuity A, the ordinary annuity and it earns
7% annually.
 FINDING THE FUTURE VALUE OF AN
ORDINARY ANNUITY
Fran Abrams wishes to determine how much money she will have at the
end of 5 years if he chooses annuity A, the ordinary annuity and it earns
7% annually. Annuity a is depicted graphically below:
 FINDING THE FUTURE VALUE OF AN
ORDINARY ANNUITY
One way to find the future value of an ordinary annuity is to calculate the
future value of each of the individual cash flows and then add up those figures.
 USING COMPUTATIONAL TOOLS TO FIND
THE FUTURE VALUE OF AN ORDINARY ANNUITY

Future value interest factor for an ordinary annuity

The multiplier used to calculate the future value of an ordinary annuity at a
specified interest rate over a given period of time.
FUTURE VALUE OF AN ORDINARY ANNUITY: USING
THE FVIFA TABLES
FUTURE VALUE OF AN ORDINARY ANNUITY: USING
THE FVIFA TABLES

FVA = $1,000 (FVIFA,7%,5)

= $1,000 (5.751)
= $5,751
PRESENT VALUE OF AN ORDINARY ANNUITY
Braden Company, a small producer of plastic toys, wants to determine the
most it should pay to purchase a particular annuity. The annuity consists of
cash flows of $700 at the end of each year for 5 years. The required return is
8%.
PRESENT VALUE OF AN ORDINARY ANNUITY
Braden Company, a small producer of plastic toys, wants to determine the
most it should pay to purchase a particular annuity. The annuity consists of
cash flows of $700 at the end of each year for 5 years. The required return is
8%.
FINDING THE PRESENT VALUE OF AN ORDINARY
ANNUITY
One way to find the present value of an ordinary annuity is to calculate
the present value of each of the individual cash flows and then add up those
figures.
 USING COMPUTATIONAL TOOLS TO FIND
THE PRESENT VALUE OF AN ORDINARY ANNUITY
Present value interest factor for an ordinary annuity
The multiplier used to calculate the present value of an ordinary
annuity at a specified discount rate over a given period of time.
 PRESENT VALUE OF AN ORDINARY ANNUITY: USING
PVIFA TABLES
By letting PVA equal to the present value of an n-year
ordinary annuity, letting PMT equal the amount received
annually at the end of each year, and letting PVIFA represent
the appropriate present value interest factor for a one dollar
ordinary annuity discounted at i percent of n years, we can
express the relationship among these variable as
PVA = $700 (PVIFA,8%,5)
= $700 (3.993)
= $2,795.10
A mathematical expression that can be applied to calculate the present value interest
factor for an ordinary annuity is more efficiently is

The use of this expression is especially attractive in the absence of any financial
calculators, electronic spreedsheet, or the appropriate financial tables.
PRESENT VALUE OF AN ORDINARY ANNUITY: THE LONG
METHOD
Long Method for Finding the Present Value of an Ordinary Annuity
 ANNUITY DUE
• An annuity due has cash flows that occur at the beginning of
each period.
• Annuity due is an annuity whose payment is due immediately at
the beginning of each period. A common example of an annuity
due payment is rent, as landlords often require payment upon
the start of a new month as opposed to collecting it after the
renter has enjoyed the benefits of the apartment for an entire
month.
 FINDING THE FUTURE VALUE
OF AN ANNUITY DUE
As the cash flow of an annuity due occur at the start of the of the period, we
are dealing with annual payments which means that each payment can earn an extra
year's worth of interest.
 FUTURE VALUE OF AN ANNUITY DUE:
USING THE FVIFA TABLES
Fran Abrams now wishes to calculate the future value of an annuity due for
annuity B. Recall that annuity B was a 5 period annuity with the first annuity
beginning immediately.
 FUTURE VALUE OF AN ANNUITY DUE:
USING THE FVIFA TABLES
Fran Abrams now wishes to calculate the future value of an annuity due for
annuity B. Recall that annuity B was a 5 period annuity with the first annuity
beginning immediately.

FVA = $1,000(FVIFA,7%,5)(1+.07)
= $1,000 (5.751) (1.07)
= $6,154
 FINDING THE PRESENT VALUE
OF AN ANNUITY DUE
Calculating the present value of an annuity can be easily performed by
adjusting the ordinary calculation. Each annuity due cash flow is discounted back
one less year than for an ordinary annuity.
 PRESENT VALUE OF AN ANNUITY DUE:
USING PVIFA TABLES
In the earlier example, we found that the value of Braden Company’s $700, 5
year ordinary annuity discounted at 8% to be about $2,795. If we now
assume that the cash flows occur at the beginning of the year, we can find the
PV of the annuity due.
 PRESENT VALUE OF AN ANNUITY DUE:
USING PVIFA TABLES
In the earlier example, we found that the value of Braden Company’s $700, 5
year ordinary annuity discounted at 8% to be about $2,795. If we now
assume that the cash flows occur at the beginning of the year, we can find the
PV of the annuity due.

PVA = $700 (PVIFA,8%,5) (1.08)

= $700 (3.993) (1.08)
= $3,018.40
FINDING THE PRESENT VALUE OF PERPETUITY

A perpetuity is an annuity with an infinite life-in other words, an

annuity that never stops providing its holders with a cash flow at the
end of each year. For example, the right to receive Php 5,000 at the end
of each year forever.