Time value of money

• All individuals and businesses face the same two basic finance-related problems:

1. Where to put the money ?

2. Where to get a money ?

• The first problem. Is called the "investment" decision ; the second, the "financing"
decision. In addressing the investment problem. Individuals & companies choose from a
wide range of real & financial assets. They can opt to put their funds in real assets that
represents their various project.

• A common char. Of these investment is that, most of the time, the expected returns from
these assets do not happen overnight or even the current year. Cash flow are related to
these assets occur at multiple time periods and may happen over an extended period of
time. The time value of money must be considered in making the appropriate investment
& financing decisions. Individuals prefer to receive a peso now instead of later because of
the ff. Main reasons:

a. It can invest the peso now and earn a return from this investment and

b. A peso expected to receive in the future is risker and less certain.

The concept of interest

• Interest is earned or incurred for the use of the principal amount over the relevant time
period.

The most basic finance-related formula is the computation of interest. It is computed as follows:

Where:

I= interest

P= principal

R= interest rate

T= time period

• For example, an individual borrowed a P 1 000 from a local bank at an interest rate of 9%
over a one-year period. In this example, the P 1 000 amount borrowed is the principal of
the loan; 9% is the applicable interest rate; and the relevant time period is one year. The
interest on the loan is computed as:

I=PxRxT

I = P 1 000 x 9% x 1

I = P 90

• Thus, the interest on the loan is P 90. This P 90 is the cost of using the P 1 000 borrowed
for one year.

• Interest is earned or incurred for the use of principal amount over the relevant time
period.
 • Ex. An individual borrowed a P1 000 from a local bank at an interest rate of 9% over a one-
year period. In this ex. The P1 000 amount is the principal of the loan ; 9% is the interest
rate, nd the relevant time period is one-year. The interest on the loan is computed as:

I= P x R x T

I= 1 000 x 9% x 1

I= P90

Simple interest

• If the interest earned or incurred is always based on the original principal, then simple
interest is assumed.

• For example, you invested P 10 000 for 3 years at 9% and the proceeds from the
investment will all be collected at the end of 3 years. Using a simple interest assumption,
interest will be computed as follows;

Yea Princip Rat Tim Interes Cumulativ Tot

r al e e t e Interest al

1 P 10 9% 1 P 900 P 900 10
000 900

2 10 000 9% 1 900 1 800 11

800

3 10 000 9% 1 900 2 700 12

700

• Interest, in this example, is always calculated based on the orig. pricipal of P 10 000. Under
this assumption, the interest for every year is the same, in this case. P 900 annually. The
total interest for the three-year period is P 2 700 (P 900 x 3 years).

• Interest in this example, is increasing per period because the principal is also increasing by
the amount of interest earned in the previous year. Under this assumption, the interest for
every year is no longer the same but is higher as it nears maturity. The total interest for the
three-year period is P 2 950.29. this is the sum of the increasing interest for the three-year
period (P 900 + 981 + 1 069.29).

Compound interest
 • It is simply earning interest. This means that the basis for the computation of the applicable
interest for a certain period is not only the original principal but also any interest earned in
the previous period assuming all cash flows would be paid or received in lump sum upon
maturity.

• Using the previous example where you invested P 10 000 for 3 years at 9% and the proceeds
from the investment will all be collected at the end of 3 years, we illustrate the computation
of compound interest. Using a compound interest assumption, interest will be computed as
follows;

Year Principal + Rate Time Interest Cumulative Total

Cumulative Interest
Interest

1 P 10 000 9% 1 P 900 P 900 P 10 900

2 10 900 9% 1 981 1 881 11 881

3 11 881 9% 1 1 069.29 2 950.29 12 950.29

• Interest in this example, is increasing per period because the principal is also increasing by
the amount of interest earned in the previous year. Under this assumption, the interest for
every year is no longer the same but is higher as it nears maturity. The total interest for the
three-year period is P 2 950.29. this is the sum of the increasing interest for the three-year
period (P 900 + 981 + 1 069.29).

Future value of money

• Future value is the value of an asset at a specific date. It measures the nominal future sum

of money that a given sum of money is "worth" at a specified time in the future assuming a
certain interest rate, or more generally, rate of return; it is the present value multiplied by
the accumulation function.

• We use the general formula below to determine the future value:

Where:
R = Interest Rate

T = Time Period

Future Value = Initial Value x (1 + R)  T

• To get the future value, we use the formula above w/c is reffered to as the future value
interest factor (FVIF).

• In the previous example, the value of the investment at the end of the year 1 is to P 10 900
computed as follows;

Value at the End of Year 1 = P 10 000 + (P 10 000 x 9% x 1 year)

= P 10 000 x (1 + 9%)

= P 10 900

• We, therefore, say that given an interest rate of 9%, the future value of P 10 000 after one
year is P 10 900.

• Similarly, the future value of the P 10 000 at the end of year 2 will be equal to the value at
the end of 1 plus the compound interest earned in year 2 shown below:

Value at the End of Year 2 = P 10 900 + ( P 10 900 x 9% x 1 year)

= P 10 900 x (1 + 9%)

= P 10 000 x (1 + 9%) x (1 + 9%)

= P 10 000 x (1 + 9%) 2

= P 11 881

• The future value then at the end of year 3 determined as follows:

Value at the End of Year 3 =P 11 881 x ( P 11 881 x 9% x 1 year)

= P 11 881 x (1 + 9%)

= P 10 900 x (1 + 9%) x (1 + 9%)

= P 10 000 x (1 + 9%) x (1 + 9%) x (1 + 9%)

= P 10 000 x (1 + 9%) 3

= P 12 950.29

• The future value of P 10 000 invested for 3 years at a rate of 9% is equal to P 12 950.29.

• Using the example, the FVIF given 3 years and a rate of 9% is equal to 1.2950. This is the
intersection of time period = 3 and interest rate = 9% in the PVIF table. This is equal to
(1 + 9%) 3 = 1.2950 (rounded off to 4 decimal places). To get the future value of our
example:

= P 10 000 x (1+ R)T

= P 10 000 x (1+9 % )3

= P 10 000 x 1.2950

= P12 950.29

• For example, your father told you that he will entrust you with the funds for your graduate
program education. He gave you 2 options: (1) receive the money nowin the amount of P
200 000 or (2) receive P 500 000 ten years from now. The available investment opportunities
to you provide a 10% rate of return. W/c option would you prefer?

• To address the dilemma, you either determine the future value of the P 200 000 and
compare it with the expected cash flow of P 500 000 ten years from now, or compute the
present value of the P 500 000 and compare it with the P 200 000 w/c you can receive today.
 • Choosing the second method will require you to get the present value of P 500 000 as shown
below:

Future Value
Present Value = T
(1+ R)
500 000
= 10
(1+10 %)
Present Value = P 192 771.64

P 192 771.64 < P 200 000

• Since the P 200 000 is greater than 192 771.64 (the present value of the P 500 000), you will
choose to receive the P 200 000 today instead of waiting for it in ten years’ time. Getting it
now will give you the opportunity to grow the investment at the rate of 10% and the related
future value is expected to be greater than the P 500 000 . To validate this, we compute for
the future value of the P 200 000:

Future Value = Present Value x (1+ R)T

= P 200 000 x (1+10 %)10

Future Value = P 518 748.50

P 518 748.50 > P 500 000

• Using our examole, the PVIF given 10 years and a rate of 10% is equal to 0.3855. This is the
intersection of time period = 10 and interest rate = 10%in the PVIF table.

1
• This is equal to 10 = 0.3855 (rounded off 4 decimal places).
(1+10 %)
• To get the present value of our example:

= P 500 000 x 0.3855

= P 192 750

P 192 750 ~ P 192 771.64

• In this case, you will choose the cheaper option or the one with the lower present value.

Multiple cash flow

• If multiple cash flows occur at diff. Times, the more difficult it becomes to compare these
cash flows streams. Getting their present values becomes more imperative in order to make
an appropriate decision. Simply get the present values of the individual cash flows and add
them together. Since the present value refer to the same date (today), these are value-
addictive.

• For example, you are contemplating on purchasing a laptopcomputer w/c is worth P 70 000
if you pay for the whole amount today. The comp. Store also allows buyers to pay in
installment requiring the buyer to pay P 25 000 annually at the end of each year for the next
three years. You regularly invest your savings in a time deposit account that provides an
 annual return of 5%. You are now deciding whether to avail of the installment plan or pay
for the whole amount today. To aid you in your decision, you need to get the present value
of the multiple cash flows and compare it with the P 70 000 cash price. Since the perspective
taken is that of the individual disbursing money, youneed to choose the cheaper option.

• Compute the individual present values and get the sum:

P 25 000 P 25 000 P 25 000

• Total Present Value = 1 + 2 + 3
(1+5 %) (1+5 %) (1+5 %)
• = P 25 000 x PVIF (5 % ,1) + P 25 000 x PVIF(5 % ,2) P 25 000 x PVIF (5 % ,3)

• = P 25 000 x 0.9524 + P 25 000 x 0.9070 + P 25 000 x 0.8638

• = P 23 810 + 22 675 + 21 595

• Total Present Value = P 68 080

• P 68 080 is cheaper than P 70 000 cash price w/c means you should pay through installment
instead.

Annuities

• Annuity a series of equal cash flows – payments, required for a specific number of periods.

1 1
Present Value of Annuity = C x ( −
R R ( 1+ R )T )
C = Equal Cash Flow Stream

R = Interest Rate

T = Time Period

• Using our example, the PVIFA given 3 years and a rate of 5% is equal to 2.7232. This is the
intersection of time period = 3 and interest rate = 5% in the PVIFA table:

• To get the present value of our example:

= P 25 000 x 2.7232

= P 68 080

• Our example is called ordinary annuity since the cash flow is required at the end of each
year. If the cash flow happens at the start of the year, then it is called an annuity due.

• If the cash flow stream lasts forever or its indefinite, the it is called perpetuity. The present
value of the perpetuity is determined by simply dividing the equal cash flow stream by the
appropriate interest rate. Let us say, you expect to receive P 25 000 annually (5% interest
rate) in perpetuity then the present value is determined by:

Perpetuity
Present Value of a Perpetuity =
R
P 25 000
=
5%
Present Value of a Perpetuity = P 500 000

Loan amortization

• A classic example of a business transaction that pays out an equal cash flow stream regularly
is amortizing loan. It require the borrower to pay that equal amount either annually, semi-
annually, quarterly, or most of the time, monthly.

Equal principal repayments

• Ex. On July 1, 2015, DD company borrowed 3 million from ASC Bank at the rate of 10% a
[Link] loan is paid at the rate of 500,000 every Dec.31 and June 30 until the full amount is
paid. On the other slide is an amortization table for the loan.

Amortization Payments Interest Principal Principal Release

Date- Payment

3 000 000

Dec. 31, 2015 650,000 150,000 500 000 2 500 000

 June 30, 2016 625,000 125,000 500 000 2 000 000

Dec. 31, 2016 600,000 100,000 500 000 1 500 000

June 30, 2017 575,000 75,000 500 000 1 000 000

Dec. 31, 2017 550,000 50,000 500 000 500 000

June 30, 2018 525,000 25,000 500 000

• Note that the interest rate of 10% is for 1 year. Therefore, for 6 months, the interest rate is
only 5%. Let us compute the interest expense from June 30 to Dec. 31 2015.

Interest = 3,000,000 × 10% × (6/12)

Interest = 150,000

• For the next 6 months ending June 30, 2016, the interest expense is only P 125 000 because
the principal balance is already reduced to P 2 500 000 as of Dec. 31, 2015. Thus, the part of
the semi-annual payment is for the repayment of principal and interest payments.

Equal regular payments (principal and interest combined)

• For example, you plan to purchase a house worth P3 000 000. Assuming you incur a 10-year
loan that is repaid in equal annual installments with an interest rate of 10%. What is the
annual mortgage payment?

Present Value of an Annuity P 3 000 000

C= =
PVIFA 6.144
P 3 000 000
= C = P 488 236.57
PVIFA (10 %,10)

Effective annual interest rate

 • Interest rate are normally quoted as annual rates but the compounding frequency may differ
per transaction. To determine the effective annual rate, the following formula is used:

Effective Annual Rate = (1  +  R/M)  M - 1

Where:

R = Annual Rate

M = Frequency of Compounding

• For example, credit card companies usually charge a monthly interest rate of 3.5% (exclusive
for other charges). The annual effective rate is not simply determined by multiplying 3.5% by
12 months since the transaction assumes monthly compounding. To get the annual effective
rate, we compute the ff:

Effective Annual Rate = (1  +  R/M)  M - 1

=  [ 1 + (3.5%  /  12)] 12 - 1

Effective Annual Rate = 3.56%

Basic application of the time value of money on investment problems

• When the present value method is use to determine whether a project should be accepted
or rejected by a company.

• For example, a project requires an initial outlay of P 100 000. the relevant inflows associated
with the project are P 60 000 in year one and P 50 000 in years 2 and 3. The appropriate
discount rate for this project is 11%. To compute the net present value.

Risk-Return Trade-off

• Is the concept that the level of return to be earned from an investment should increase as
the level of risk increase. Conversely, this means that inventors will be less likely to pay a
high price for investment that have a low risk, such a high-grade corporate or government
bonds.

• Is an investment principle that indicates that the higher the risk, the higher the potential
reward