LONG TERM INVESTMENT DECISIONS:

TIME VALUE OF MONEY (TVM)

REPORTED BY:
GROUP 2 - MARY ANN B. MARIANO
MBA 656 ADVANCED FINANCIAL MANAGEMENT
PROFESSOR: RELLITA D. PAEZ, CPA, DBA

The time value of money refers to the observation that it is better to receive money sooner than later. Money
that you have in hand today can be invested to earn a positive rate of return, producing more money tomorrow. For
that reason, “A peso today is worth more than a peso tomorrow.” All individuals and businesses face the same two
basic finance-related problems:
 Where to put money: Investment
 Where to get money: Financing decisions
In addressing the investment problem, individuals and companies choose from a wide variety of real and
financial assets.
They can opt to put their funds in REAL ASSETS that represent their projects such as purchasing equipment
and machinery with the purpose of generating revenues across the useful lives of these assets. This could also take
the form of adding a new factory or office building, and acquisition of licensed brands.
FINANCIAL ASSETS include investing in the shares of another company, lending money to others and
purchasing fixed income instruments such as government issued Treasury securities and corporate bonds.

Time value of money is used to determine the value of investments. Investments are affected by both
inflation and interest rates. Investment decisions are based on what can be purchased now versus what can be
purchased with the same amount of money in the future considering the effects of inflation and interest rates. To
make an investment worthwhile, the amount earned by the end of the investment period should be greater than the
rate of inflation over the same time period. Obtaining a loan to have money to use today makes financial sense if the
present value of the money is higher than the value of the money including interest when the loan is repaid.
The time value of money compares the future value with the present value of an amount of money.

A. FUTURE VALUE VS. PRESENT VALUE

 Future value: FV, is the amount to which an amount of money will grow in a defined period of time at a specified
investment rate.
Q: What amount of money in the future is equivalent to ₱15,000 today? In other words, what is the future value of
₱15,000?
 Present Value: Present value is the current value of an amount of money to be received at a future date based on
a specified investment rate. Time value of money is used to determine the value of investments.
Q: What amount today is equivalent to ₱17,000 paid out over the next 5 years as outlined above? In other words,
what is the present value of the stream of cash flows coming in the next 5 years?

A time line depicts the cash flows associated with a given investment. It is a horizontal line on which time
zero appears at the leftmost end and future periods are marked from left to right.
 The cash flows occurring at
time zero (today) and at the end of
each subsequent year are above the
line; the negative values represent
cash outflows (₱15,000 invested
today at time zero), and the positive
values represent cash inflows
(₱3,000 inflow in 1 year, ₱5,000
inflow in 2 years, and so on).
The future value technique
uses compounding to find the
future value of each cash flow at the
end of the investment’s life and
then sums these values to find the investment’s future value. Alternatively, the present value technique uses
discounting to find the present value of each cash flow at time zero and then sums these values to find the
investment’s value today. In practice, when making investment decisions, managers usually adopt the present value
approach.

B. BASIC PATTERNS OF CASH FLOW

The cash flow—both inflows and outflows—of a firm can be described by its general pattern. It can be defined as a
single amount, an annuity, or a mixed stream.
 Single amount: A lump-sum amount either currently held or expected at some future date. Examples include
₱1,000 today and ₱650 to be received at the end of 10 years.
 Annuity: A level periodic stream of cash flow. For our purposes, we’ll work primarily with annual cash flows.
Examples include either paying out or receiving ₱800 at the end of each of the next 7 years.
 Mixed stream: A stream of cash flow that is not an annuity; a stream of unequal periodic cash flows that
reflect no particular pattern. Examples include the following two cash flow streams A and B.

1. SINGLE AMOUNT

Future Value of a Single Amount

Future value is the amount to which an amount of money will grow in a defined period of time at a specified
investment rate. A business may face questions such as:
■ Question 1
If we borrow ₱380,000 today to replace outdated equipment and the terms are 8 percent for 5 years
compounded quarterly, what is the total cost of the purchase?
To determine the total cost of the equipment purchase, the calculation is
Formula: FV = PV (1 + r)n
FV = future value of the investment or loan
P= principal
r = interest rate per period of compounding
n = number of compounding periods in the length of the loan
Where:
PV = 380,000
 r= 8% / 4 (quarterly) = 2% or .02 = quarterly interest
n = 4 (quarterly) x 5 (years) = 20 = compounding periods
Solution:
FV = ₱380,000 (1 + 0.02)20
FV = ₱380,000 (1.4859)
FV = ₱564,642

■ Question 2
If we invest ₱20,000 per month in an employee retirement account at an annual interest rate of 6 percent
compounded monthly, what will be the value of the fund in 10 years?
Note: Not only is interest being compounded each month, the principal is being increased every month as
well.
The formula to determine the future value of the retirement fund is
Formula: FV =PV [((1 + r)n -1) ÷ r]
PV= present value of the investment or loan
r = interest rate per period of compounding
n = number of compounding periods in the length of the loan
Where:
PV = 20,000
n = 10 (years) x 12 (months) = 120 = compounding periods
r =6% /12 (months) = 0.5% or 0.005 = monthly interest rate
Solution:
FV = ₱20,000 [((1 + 0.005)120 - 1) ÷ 0.005]
FV = ₱20,000 (1.8194 -1) ÷ 0.005
FV = ₱20,000 (163.88)
FV = ₱3,277,600

Present Value of a Single Amount

Businesses encounter several situations where they need to determine the present value of money. If a
company wants to borrow money, the lender will charge interest for the time the company uses the money. A typical
procedure is for the lender to discount the loan.
A discount is the amount of money subtracted from a loan at the time of lending equal to the interest
charged by the lender.
Formula: PV = FV ÷ (1 + r)n
■ Example 1
If a business borrows ₱10,000 for one year from a bank at an interest (discount) rate of 8 percent, how much
is the actual amount of money received?
Where:
FV = 10,000
r =8%
n=1
Solution:
PV = 10,000 ÷ (1 + .08)1
PV = 10,000 ÷ (1 + .08)1
PV = 9,260.00

■ Example 2
Another example of the use of present value is when a company has a large amount of accounts receivable
from customers but needs cash immediately. It can sell those accounts to another business for a discounted value.
That business will then attempt to collect the full value of the accounts from customers in the future when payments
are scheduled.
If a company has ₱30,000 of accounts receivable that are due in 90 days, another company may offer to
discount them at an annual rate of 20 percent. What is the present value?
Where:
FV = 30,000
r =20% ÷ 4 = 5% or .05 (90 days is ¼ of a year)
n = 1 x .25 = .25
Solution:
PV =30,000 [1 ÷ (1 + .05).25]
PV =30,000 [1 ÷ 1.01227]
PV =30,000 [.9878787]
PV = 29,636.00

■ Example 3
What is the present value of receiving a single amount of ₱10,000 at the end of five years, if the time value of
money is 6% per year, compounded semi-annually?
Where:
FV = 10,000
r = 6% ÷ 2 (semi-annual) = 3%
n = 5 x 2 (semi-annual) = 10
Solution:
PV = FV [1 ÷ (1+r)n ]
PV = 10,000 [1 ÷ (1+.03)10 ]
PV = 10,000 [1 ÷ 1.3439]
PV = 10,000 [.7441]
PV = 7,441.00

2. ANNUITY

A stream of equal periodic cash flows 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.
TYPES OF ANNUITIES
 ordinary annuity
An annuity for which the cash flow occurs at the end of each period.
 annuity due
An annuity for which the cash flow occurs at the beginning of each period.

FINDING THE FUTURE VALUE OF AN ORDINARY ANNUITY

Formula: FVn = CF [(1 + r)n – 1] ÷r

FV = Future value
CF = Cash Flow / annual payment
r = interest rate per period of compounding
n = number of compounding periods in the length of the loan

Example:
 Ms. Dela Cruz wishes to determine how much money she will have at the end of 5 years if she chooses
ordinary annuity. She will deposit ₱1,000 annually, at the end of each of the next 5 years, into a savings
account paying 7% annual interest.
Where:
CF = 1,000
r = 7%
n = 5 years
Solution:
FV5 = ₱1,000 [(1 + .07)5 – 1] ÷.07
FV5 = ₱1,000 [1.40255 – 1] ÷.07
FV5 = ₱402.5517÷ 0.07
FV5 = ₱5,751.00

FINDING THE FUTURE VALUE OF AN ANNUITY DUE

Formula: FVn = CF [((1 + r)n – 1)÷r] (1+r)
FV5 = ₱1,000 [((1 + .07)5 – 1) ÷.07] x (1.07)
FV5 = ₱1,000 [1.40255 – 1) ÷.07] (1.07)
FV5 = ₱402.5517÷ 0.07 (1.07)
FV5 = ₱5,750.74 (1.07)
FV5 = ₱6,153.00

**Ordinary annuity ₱5,750.74 versus Annuity due ₱6,153.29

FINDING THE PRESENT VALUE OF AN ORDINARY ANNUITY

Formula: PVn = (CF÷r) [1 – (1÷(1+r)n )]
Example:
Braden Company, a small producer of plastic toys, wants to determine the most it should pay to purchase a
particular ordinary annuity. The annuity consists of cash flows of ₱700 at the end of each year for 5 years. The
firm requires the annuity to provide a minimum return of 8%.
Where:
CF = 700
r = 8%
n = 5 years
Solution:
PV5 = (700÷.08) [1 – (1÷(1+.08)5 )]
PV5 = (8,750) [1 – (1÷(1+.08)5 )]
PV5 = (8,750) [1 – (1÷(1.4693)]
PV5 = (8,750) [1 – .680596]
PV5 = (8,750) [.31940]
PV5 = 2,795.00

FINDING THE PRESENT VALUE OF AN ANNUITY DUE

Formula: PVn = (CF÷r) [1 – (1÷(1+r)n )] (1+r)

PV5 = (700÷.08) [1 – (1÷(1+.08)5 )] (1+.08)
PV5 = (8,750) [1 – (1÷(1+.08)5 )] (1+.08)
PV5 = (8,750) [1 – (1÷(1.4693)] (1+.08)
PV5 = (8,750) [1 – .680596] (1+.08)
PV5 = (8,750) [.31940] (1.08)
 PV5 = 2,795.00 (1.08)
PV5 = 3,018.00

3. PERPETUITY

A perpetuity is an annuity with an infinite life—in other words, an annuity that never stops providing its holder with a
cash flow at the end of each year (for example, the right to receive ₱500 at the end of each year forever).
Formula: PV = CF ÷ r
Example:
Ross Clark wishes to endow a chair in finance at his alma mater. The university indicated that it requires
₱200,000 per year to support the chair, and the endowment would earn 10% per year. To determine the
amount Ross must give the university to fund the chair, we must determine the present value of a ₱200,000
perpetuity discounted at 10%.
Where:
CF = 200,000
r= .10
Solution:
PV = ₱200,000 ÷ 0.10 = ₱2,000,000

In other words, to generate ₱200,000 every year for an indefinite period requires ₱2,000,000 today if Ross Clark’s
alma mater can earn 10% on its investments. If the university earns 10% interest annually on the ₱2,000,000, it can
withdraw ₱200,000 per year indefinitely.

4. MIXED STREAMS

Two basic types of cash flow streams are possible, the annuity and the mixed stream. Whereas an annuity is a pattern
of equal periodic cash flows, a mixed stream is a stream of unequal periodic cash flows that reflect no particular
pattern. Financial managers frequently need to evaluate opportunities that are expected to provide mixed streams of
cash flows.

FUTURE VALUE OF A MIXED STREAM

The future value of uneven cash flows is the sum of future values of each cash flow. It can also be called “terminal
value.” Unlike annuities where the amount of payment is constant, many financial instruments and assets generate
cash flows that can vary from period to period. For example, dividends on common stock and coupon payments of a
floating rate bond can vary. Cash flow generated by business activity is another common example of uneven or
irregular cash flows.
Formula: FV = CF1(1+r)N-1 + CF2(1+r)N-2 + ….
N = number of periods
CF = cash flow at period t
r = interest rate per period

Cash Flow

1 ₱ 1,000
2 ₱ 800
3 ₱ 1,100
4 ₱ 700
5 ₱ 1,050
Where:
r = 12%
N = 5 years

Solution:
FVCF1 = ₱1,000 (1+0.12)(5-1) = ₱1,573.52
FVCF2 = ₱800 (1+0.12)(5-2) = ₱1,123.94
FVCF3 = ₱1,100 (1+0.12)(5-3) = ₱1,379.84
FVCF4 = ₱700 (1+0.12)(5-4) = ₱784.00
FVCF5 = ₱1,050 (1+0.12)(5-5) = ₱1,050.00 (remember
anything to the power of zero is 1)
Thus, the total future value of the uneven cash flow stream is ₱5,911.30.

PRESENT VALUE OF A MIXED STREAM

Common examples of an uneven cash flow stream are dividends on common stock, coupon payments on a floating-
rate bond, or the free cash flow of a business. Since the value of each cash flow in the stream can vary and occur at
irregular intervals, the present value of uneven cash flows is calculated as the sum of the present values of each cash
flow in the stream.
Formula: PV = CF1÷ (1+r)1 + CF2÷ (1+r)2 + ….
Example:

Cash Flow

1 ₱ 1,500
2 ₱ 1,850
3 ₱ 2,100
4 ₱ 2,500
5 ₱ 2,950

Where:
r = 15.75%
N = 5 years
Solution:
PV = CFN÷ (1+r)N
PV = 1,500÷ (1+0.1575)1 = 1,295.90
PV = 1,850÷ (1+0.1575)2 = 1,380.80 1.33980625
PV = 2,100÷ (1+0.1575)3 = 1,354.12
PV = 2,500÷ (1+0.1575)4 = 1,392.69
PV = 2,950÷ (1+0.1575)5 = 1,419.77
Thus, the present value of the uneven cash flow stream will be ₱6,843.27.