CHAPTER 6: TIME VALUE OF MONEY ANALYSIS

The time value of money analysis (TVMA) is also called the discounted
cash flow analysis (DCFA). These two terms are used interchangeably in this
chapter.

The primary goal of financial management is to maximize the value of the

firm‟s share. In order for a financial manager to realize this goal, it is pivotal that
he/she must be an expert in doing TVMA. In the day-to-day functions of a
financial manager, he/she would be doing DCFA. Some of the situations that
financial managers are tasked to do, which use skills in TVMA are:
1. Evaluating new projects proposals that would entail cash inflow as well as
outflow;
2. Assessing whether or not the company would need to acquire or merely
lease an equipment it may need for operation;
3. Managing and valuing cash funds like sinking funds and bond
redemptions funds, pension funds, and employee benefits;
4. Managing and valuing receivables specifically for banks having long-term
loan receivables handle; and
5. Managing and valuing long-term obligations like bond payable where
refunding a bond issued is concerned.
In all these situations, a financial manager may be asked to know the present
or future value of cash inflows and cash outflows. As you go on reading and
learning through this chapter, you may get to understand why DCFA is often
referred to as the “cornerstone of finance”.
MAKING CAPITAL OUTLAY DECISIONS
In the task presented in the prologue, it was mentioned that financial
managers may need to evaluate and assess new project proposals or do “buy-
or-lease” decisions. These decisions entail capital outlays on the part of the
entity. It is pivotal that financial managers use mathematical tools of the TVMA
as the primary step in making decisions involving capital outlay.
An important TVMA concept one must keep in mind is that in making
financial decisions that involves comparing two amounts of different time
periods, both amounts must first be converted into the same time value. This
would mean that if we compare one amount pegged from a current and one
amount pegged from a future value, both amounts must first be valued at the
same time period before they can be correctly compared. There is no sense in
comparing a present valued amount to a future valued amount.
FUTURE VALUE WITH A SINGLE AMOUNT OR FUTURE VALUE OF ₱1

The ₱1 you have today is worth more than ₱1 that you would receive a
year from now. This is so because if you have ₱1 now and invest it, you would
receive more than just ₱1 after a year. When a company is to receive or pay
something once in the future value of ₱1 is computed.
Gapenski said that the “process of going from today‟s values, or present
values (PV), to future values is called compounding.” This is because the interest
is added to the principal to compute the interest of the next period. In other
words, the interest earns interest, thus, the term “compounding”.

Illustrative Example:
Assume that on January 1, 2020 Donjon invested ₱100,000 in a financing
company. Donjon would like to find out what would be the worth of his ₱100,000
after 5 years with an interest rate pegged at 8%. On December 31, 2020, which
is after a year, Donjon‟s ₱100,000 would be ₱108,000 (₱100,000 × 1.08). By
December 31, 2021 his ₱100,000 will be worth ₱116,640 (₱108,000 × 1.08). The
pattern of computation will be followed for three more years to know the worth
of Donjon‟s ₱100,000 after 5 years.
Itemized Method
Table 1

Table of Computation

December 31, 2020 ₱100,000 × 1.08 ₱108,000

December 31, 2021 ₱108,000 × 1.08 116,640
December 31, 2022 ₱116,640 × 1.08 125,971
December 31, 2023 ₱125,971 × 1.08 136,049
December 31, 2024 ₱136,049 × 1.08 146,933

Based on the computation above, Donjon‟s ₱100,000 is worth ₱146,933

after 5 years. This may appear simple but in actual practice, the period covered
can be longer. It is for this reason that a mathematical model method was
designed to simplify the computation above.
Mathematical Model Method

The basic formula to compute the future value is:

𝐹𝑉𝑛 = 𝑃𝑉(1 + 𝑖)𝑛

Where: FV = future value of an amount

n = number of periods

PV = present value of an amount

i = interest rate
If we apply the formula for the Donjon‟s query,

FV = ₱100,000 (1 + .08)5
= ₱100,000 (1.08)5

= ₱146,933
Using Interest Tables (Tabular Method)
The mathematical formula may be modified by using a present value and
future value table. The future value table can be seen at the appendix of the
book. With the table, you can determine the future value interest factor or
simply future value factor.
FV = ₱100,000 × FV factor of ₱1
= ₱100,000 × 1.469 taken from the future value table

= ₱146,900
The difference in the answers using the different methods is due to the
rounding off of the future value factor.
What are future value factors of ₱1 and present value factors of ₱1?
The future value factor is actually the ratio or the relationship of the
future value of an amount to its present value. This factor is essential in
computing the future value of an amount that is received or paid only once in
the future.
FUTURE VALUE WITH SEVERAL AMOUNTS (ORDINARY ANNUITY)
What we have discussed is the future value of a single amount or the
future value of ₱1. This means that the future value we have computed is a
value of an amount we would receive or pay once in the future. However, what
if we are going to receive or pay something for several consecutive periods in
equal amounts? For instance, if we are to receive ₱1 million in 5 years, and we
will receive the whole amount on a staggered basis, that means we will receive
₱200,000 each year for the next 5 years. Thus, we need to compute the future
value of several equal amounts (₱200,000) annually for the next 5 years.
Therefore, the future value of several amounts or future value annuity must
be computed if the company receives or pays a series of equal amounts.
Illustrative example:
Assume that Enzo Company is to make an annual investment of ₱200,000
for four years. The interest for this investment was pegged at 9%. The investment
is made every year-end. What is the future value of this annuity?

Long Method
Table 2
Table of Computation

Period Amount Invested FV Factor of ₱1 Future Value

Dec. 31 - 4th year ₱200,000 1.00 ₱200,000
Dec. 31 - 3rd year ₱200,000 1.09 218,000
Dec. 31 - 2nd year ₱200,000 1.1881 237,620
Dec. 31 - 1st year ₱200,000 1.2950 259,000
FV Annuity Factor
4.5731 ₱914,620
Future Value Annuity

In this solution, we computed the FV of each single amount and added

them to get the future value annuity. The future value factor of ₱1 is taken from
the FV Factor Table.

Note that in computing the FV annuity, the table started from Year End 4.
Why is this so? We can view it this way: if Enzo is going to invest or save ₱200,000
at the end of each year for the next 4 years, how much would Enzo receive
after 4 years if the funds grew with 9% interest? This can be answered by
interpreting Table 2.

Interpretation and Discussion of Table 2

Let us break down the interpretation. You may place a check mark on
Table 2 as you go through each interpretation. Take note that the end of the 4th
year is the end of the investment period.

 Table 2 purports that if Enzo invested ₱200,000 at the end of year 1, he

would receive ₱259,000 at the end of the investment period.
 If Enzo invested another ₱200,000 at the end of year 2, he would receive
₱237,620 at the end of the investment period.
 If Enzo invested another ₱200,000 at the end of year 3, he would receive
₱218,000 at the end of the investment period.
 Lastly, if Enzo invested another ₱200,000 at the end of year 4, he would
receive ₱200,000 at the end of the investment period (which is also the
end of year 4).
 Because Enzo invested ₱200,000 each year for the past 4 years, Enzo will
receive a gross amount of ₱914,620 for his investments. This explains the
figures in Table 2.
Short Method

The solution above is a long method of computing ordinary annuity. A

shorter solution is presented below:

FV Annuity = Amount periodically received or paid × FV annuity factor

= ₱200,000 × 4.5731
= ₱914,620

The FV annuity factor is taken from the FV Annuity Factor Table (see
Appendices). Note that if you look at the table of computation and add the FV
factor of ₱1, you will get the sum of 4.5731. This is the same FV Annuity Factor
found in the FV Annuity Factor Table.
Using Mathematical Formula for Future Value Annuity

So far, both the long and short method used in computing future value
annuity utilized the Table of Future Value Annuity. However, a formula may be
used in computing the FV Annuity.
 ( )
FV Annuity = Amount periodically received or paid [ ]
( )
= ₱200,000 × [ ]
= ₱914,620

FUTURE VALUE WITH SEVERAL AMOUNTS (ANNUITY DUE)

The preceding example assumes that the receipt or payment of the
amount is at the end of the period. But what if the receipt or payment is made
at the beginning of the period?
Illustrative Example:

Let us use the data of Enzo Company. Assume that Enzo is to make
annual investments of ₱200,000 for four years. The interest for this investment was
pegged at 9%. The investment is made at the beginning of each year. What is
the future value of this annuity due?
Long Method

Table 3
Table of Computation

Period Amount Invested FV Factor of ₱1 Future Value

Jan. 1 - 4th year ₱200,000 1.09 ₱218,000
Jan. 1 - 3rd year ₱200,000 1.1881 237,620
Jan. 1 - 2nd year ₱200,000 1.2950 259,000
Jan. 1 - 1st year ₱200,000 1.4116 282,320
FV Annuity Factor
4.9847 ₱996,940
Future Value Annuity

Notice the difference between FV ordinary annuity, FV annuity due, and

the period columns for Table 2 and 3. Under the annuity due, the payment or
receipt of cash is at the beginning of the year, so we compute the FV annuity
table at the beginning (January 1), not the end of Year 4.
Did you notice that the FV of annuity due (Table 3) is much higher than
the FV of ordinary annuity in Table 2? The reason is that the investment is done at
an earlier date (beginning of the year), naturally more interest would be earned.
Therefore, the FV of annuity due is bigger in comparison to the FV of ordinary
annuity.
We can view it this way: if Enzo is going to invest or save ₱200,000 at the
beginning each year for the next 4 years, how much would Enzo receive after 4
years if the funds grew with 9% interest? This can be answered by interpreting
Table 3.

In the solution, we computed the FV of each single amount and added all
the future values of the single amount to get the future value annuity. The future
value factor of ₱1 is taken from the FV Factor Table.

Interpretation and Discussion of Table 3

Let us break down the interpretation. You may place a check mark on
Table 3 as you go through each interpretation. Take note that the end of the 4 th
year is the end of the investment period.
 Table 3 purports that if Enzo invested ₱200,000 at the beginning of the 1st
year, he would receive ₱282,320 at the end of the investment period.
 If Enzo invested another ₱200,000 at the beginning of the 2nd year, he
would receive ₱259,000 at the end of the investment period.
 If Enzo invested another ₱200,000 at the beginning of the 3rd year, he
would receive ₱237,620 at the end of the investment period.
 Lastly, if Enzo invested another ₱200,000 at the beginning of 4th year, he
would receive ₱218,000 at the end of the investment period (which is also
the end of year 4).
 Because Enzo invested ₱200,000 each year for the past 4 years, Enzo will
receive a gross amount of ₱966,940 for his investments. This explains the
figures in Table 3.
Short Method
The solution above is a long method of computing annuity due. A shorter
solution is presented below:
FV Annuity = Amount periodically received or paid × FV annuity factor

= ₱200,000 × 4.9847
= ₱996,940
The FV annuity factor is taken from the FV Annuity Factor Table (see
Appendices). Note that if you look at the table of computation and add the FV
factor of ₱1, you will get the sum of 4.9847. This is the same FV Annuity Factor
found in the FV Annuity Factor Table.

PRESENT VALUE WITH A SINGLE AMOUNT OR PRESENT VALUE OF ₱1

The present value is the opposite of the future value we have discussed.
Reviewing the Donjon‟s example in future value with a single amount topic, we
can see that if the company invests ₱100,000, he would get ₱146,933 given an
interest rate of 8% five years in the future. We may now reverse our perspective
that is if Donjon would like to receive ₱146,933 five years in the future with 8%
interest, he would have to invest ₱100,000 today. Stated differently, ₱146,933‟s
present value with 8% interest rate or discount rate is ₱100,000.
Notice that interest rate is also termed as discount rate. This is related to
the fact that finding the present value of a future value is called discounting.
Relating this to our previous knowledge, finding the future value of a present
value is called compounding. Remember?

It is worth reiterating that the present value factor of ₱1 is actually the ratio
or relationship of the present value of an amount to its future value. The present
value of a single amount pertains to the present value of an amount to be
received only once in the future.
The mathematical formula used to compute the present value of an
amount is taken from the formula for future value. Observe below:

Future Value - = (1 + )

Present Value - = [( )
]

Illustrative example:
Assume that Tria Corporation would like to know the amount of
investment it will make in order to yield an amount of ₱100,000, which it will
receive three years from now. Assume that the discount rate for this type of
investment is 25%.

Solution:
Let‟s try to determine what will be the future value of ₱1 in three years.

Table 4
Table of Computation
 Period Computation Future value of ₱1
After First year ₱1 × 1.25 ₱1.25
After Second year ₱1.25 × 1.25 ₱1.5625
After Third year ₱1.5625 × 1.25 ₱1.9531

Based on the computations, we can see that the future value of ₱1 in

three years with an interest rate of 25% would be ₱1.9531. Now if we are to
apply the concept that PVF is the ratio or relationship of the present value (₱1.0)
to its future value (₱1.9531) then:

PVF = Present Value / Future Value

₱1.0 / ₱1.9531 = 0.512
To compute for the present value of a single amount or ₱1:

PV of an amount = Amount to be received or paid × PVF

PV of ₱100,000 = ₱100,000 × 0.512

= ₱51,200
Or

PV of an amount = [( ]
)

PV of ₱100,000 = 1 [( ]
)

= ₱51,200

Interpretation of ₱51,200:

The computed amount of ₱51,200 is the present value of ₱100,000 (the

amount to be received in the future); or you can say that ₱100,000 is the future
value of ₱51,200.
Implication to Tria Corporation:
This would mean that Tria needs to invest ₱51,200 today in order to yield
₱100,000 return three years from now.
Computing the Present Value of ₱1 Factor
a. Through the formula
 1
= [ ]
(1 + )
Notice that this formula is the one found in computing the PV of an
amount.

b. Through the Present Value Factor Table

The present value factor of ₱1 can be seen in the Present Value
Factor Table found in the appendix of this book. The “n” is the number of
periods and the interest rate in 25%.
PRESENT VALUE WITH SEVERAL AMOUNTS (ORDINARY ANNUITY)

In finding the present value of an ordinary annuity you merely reverse the
treatment for the future value of ordinary annuity. The present value of ordinary
annuity occurs when you would like to determine the present value of a series of
amounts you will receive or pay in the future. Theoretically, the present value of
an ordinary annuity is the sum of all the present values of ₱1 in a series of
amounts that you will receive or pay at the end of each year in the future.

The basic formula to compute the present value of ordinary annuity is:
PV of OA = Series of future values of amounts to be received or paid × PV
of Ordinary Annuity Factor
Illustrative example:
Assume that on January 1 of the current year, Keith Corporation sold its
equipment costing ₱500,000 for ₱800,000 to Arvin Corporation. Arvin paid
₱200,000 as down payment and the balance will be paid with a non-interest
bearing note for ₱600,000. The note shall be paid in equal annual installments
(this is the series of amounts that Keith will receive in the future) every year end
amounting to ₱200,000/year. The prevailing interest rate for this type of note is
10%. You have been tasked by Keith Corporation on the present value of the
note receivable to be recognized by the company.

Long Method
Table 5
Table of Computation

Period Series of future PV Factor of ₱1 PV of ₱1 for

values to be at 10% each amount
received by
 Keith
Yr. End - 1st yr ₱200,000 0.9091 ₱181,820
Yr. End - 2nd yr ₱200,000 0.8264 165,280
Yr. End - 3 yr
rd ₱200,000 0.7513 150,260
PV of Ordinary Annuity Factor
2.4869 ₱497,360
Present Value Ordinary Annuity

Short Method
Applying the formula:

PV of OA = Series of future values of PV of Ordinary

amounts to be received × Annuity Factor
or paid
= ₱200,000 × 2.4869

= ₱497,380

Nota bene: The PV of Ordinary Annuity factor is sum of the PV of ₱1 in the series
of amounts received.

Interpretation of the Table of Computations

You may ask why Keith would require the financial manager to provide
the present value of notes receivable (₱600,000). For recognition purposes, non-
interest bearing notes should be measured by the company at its present value,
as prescribed by both the International Financial Reporting Standards
Committee (IFRSC) and the Philippine Financial Reporting Standards committee
(PFRSC).
The following interpretations can be culled from Table 5;
1. The present value of the ₱200,000 (1st equal annual installment) to be
received by Keith a year from now is ₱181,820. The present value of the
₱200,000 (2nd annual installment) to be received by Keith two years
from now is ₱165,280 and so on.
2. The present value of the entire ₱600,000 note receivable that Keith will
receive on a staggered or I installment basis is ₱497,360
PRESENT VALUE OF SEVERAL AMOUNTS (ANNUITY DUE)
 In finding the present value of an annuity due, you merely reverse the
treatment for the future value of an annuity due. The present value of annuity
due is similar to ordinary annuity. The only difference is that in annuity due, the
period on which amounts are received or paid at the beginning of the year. The
present value of annuity due occurs when you would like to determine the
present value of a series of amounts you will receive or pay in the future.
Theoretically, the present value of an annuity due is the sum of all the present
values of ₱1 in a series of amounts that you will receive or pay at the beginning
of each year in the future.
Illustrative Example:
Let us use the example from ordinary annuity.
Assume that on January 1 of the current year, Keith Corporation sold its
equipment costing ₱500,000 for ₱800,000 to Arvin Corporation. Arvin paid
₱200,000 as down payment and the balance will be paid with a non-interest
bearing note for ₱600,000. The note shall be paid in equal annual installments
(this is the series of amounts that Keith will receive in the future) every year end
amounting to ₱200,000/year. The prevailing interest rate for this type of note is
10%. You have been tasked by Keith Corporation on the present value of the
note receivable to be recognized by the company.
Long Method

Table 6
Table of Computation

Period Series of future PV Factor of ₱1 PV of ₱1 for

values to be at 10% each amount
received by
Keith
Yr. End - 1 yr
st ₱200,000 1.0000 ₱200,000
Yr. End - 2 yr
nd ₱200,000 0.9091 181,820
Yr. End - 3rd yr ₱200,000 0.8264 165,280
PV of Ordinary Annuity Factor
2.7355 ₱547,100
Present Value Ordinary Annuity

Short Method
Applying the formula:
PV of AD = Series of future values of PV of Annuity
×
 amounts to be received due Factor
or paid
= ₱200,000 × 2.7355

= ₱547,100
PERPETUITIES
In computing for annuities, the payments or receipts are to be made over
some predetermined time frame. This can be seen in the examples we have
studied. However, there are annuities that may go on independently or
perpetually. This type of annuity is referred to as perpetuities.
The formula to compute perpetuities is:

Example:
Assume that the Philippine government sold small-denominated bonds in
1980. Assume further that these bonds remain floating up to the present. In 2010,
the government sold huge amount of bonds to pay off the smaller bond issues
they made in the „80s. The purpose of issuing the huge amount of bonds is to
consolidate the government‟s past debts due to the smaller bonds issued.
Assume that each consolidation promised to pay ₱100,000 per year in
perpetuity. How much would each bond be worth if the discount rate is 10%?
15%? 20%?
1
1 = = 1
1
1
1 = =
1
1
= =

It can be observed that the value of the perpetuity significantly varies

when the interest rate is changed. There is an indirect proportional relationship
between the interest rate and the PV perpetuity.
PRESENT VALUE OF COMPLEX STREAMS
If you will notice in the previous examples, the payments or receipts
involved are constant or the same for a given period of time. However, not all
situations involve several equal or even amounts of an annuity. The investment
proposal or payments may involve uneven amounts of cash flows. For instance,
investment in securities would not necessarily yield uniform dividend income per
year, or investments in property, plant and equipment would not normally yield
constant inflows (receipts) of cash per year. Sometimes, the payments/receipts
may involve uneven cash flow in the first three years and from the 4th year to the
succeeding years an annuity or an even cash flow is paid or received.
The question is, “How do we compute the present value or future value of
uneven cash payment or receipts or uneven cash flows?” This can be answered
by the example provided.
Illustrative Example 1:
Assume the following annual payments of notes payable of Blanche
Company with 8% discount rate:
Table 7
Table of Computation
Period Series of future PV Factor of ₱1 PV of ₱1 for
values of at 8% each amount
amounts to be
paid by Blanche
Co.
1 yr
st ₱200,000 0.9259 ₱185,180
2nd yr ₱250,000 0.8573 214,325
3 yr
rd ₱300,000 0.7938 238,140
4 yr
th ₱375,000 0.7350 275,625
Total present value of uneven cash flows: ₱913,270

In this case, you can see that the present value of one is computed for
each cash payment to come up with the PV of uneven cash flows. The present
values of ₱1 are then added to come up with the PV of uneven cash flows. The
present values of ₱1 are then added to come up with the annuity.
Illustrative Example 2:
Assume the following annual payments of notes payable of Blanche
Company with 8% discount rate. What is the present value of the annual
payments? Consider the data below:
Period Series of future values of amounts to be paid by Dorothy Co.
 1st yr ₱200,000
2nd yr ₱250,000
3rd yr ₱300,000
4th yr ₱375,000
5th yr ₱375,000
6th yr ₱375,000
7th yr ₱375,000

Solution:
Method 1
Table 8
Table of Computation
Period Series of future values of amounts to be PV Factor of PV of ₱1 for
paid by Dorothy Co. (Cash Flows) ₱1 at 8% each
amount
1st yr ₱200,000 0.9259 ₱185,180
2 yr
nd ₱250,000 0.8573 214,325
3 yr
rd ₱300,000 0.7938 238,140
4 yr
th ₱375,000 0.7350 275,625
5th yr ₱375,000 0.6805 255,188
6 yr
th ₱375,000 0.6302 236,325
7 yr
th ₱375,000 0.5835 218,813
Present Value of Cash Flows: ₱1,623,596

Alternative Method 2:
Table 9
Table of Computation
Period Series of future values of amounts to be PV Factor of PV of ₱1 for
paid by Dorothy Co. (Cash Flows) ₱1 at 8% each
amount
1st yr ₱200,000 0.9259 ₱185,180
2nd yr ₱250,000 0.8573 214,325
3rd yr ₱300,000 0.7938 238,140
4th yr ₱375,000 2.6292* 985,951
 5th yr ₱375,000
6th yr ₱375,000
7th yr ₱375,000
Present Value of Cash Flows: ₱1,623,596
*2.6292 = 0.7350 + 0.6805 + 0.6302 + 0.5835

Alternative Method 3:
For the first three years, follow the same procedure as method 1 and 2 but
for the 4th year, use the procedure below:

PV(4th year) = FV × PVAF of 8% for the 4 years × PV Factor of ₱1 of 8% for

the 3rd year
= ₱375,000 × 3.312 × 0.7938
= ₱985,900
PV = ₱185,180 + 214,325 + 238,140 + 985,900
= ₱1,623,545
FUTURE VALUE OF UNEVEN CASH PAYMENT OR RECEIPTS (CASH FLOWS)
The future value of an uneven cash payment/receipt is sometimes
referred to as terminal value. This can be computed by compounding each
payment/receipt each year and adding all the future values.
Illustrative example:
Assume that Rose Company is to make an investment of uneven cash
payments for four years. The interest for this investment was pegged at 9% and
the investment is made every year-end. What is the future value of this annuity?
Consider the data below:
Period Amount Invested
Dec. 31 - 4th yr ₱200,000
Dec. 31 - 3rd yr ₱250,000
Dec. 31 - 2nd yr ₱300,000
 Dec. 31 - 1st year ₱325,000

Solution:
Table 10
Table of Computation
Period Amount Invested FV Factor of ₱1 Future Value
Dec. 31 - 4 yr
th ₱200,000 1.00 ₱200,000
Dec. 31 - 3 yr
rd ₱250,000 1.09 272,500
Dec. 31 - 2 yr
nd ₱300,000 1.1881 356,430
Dec. 31 - 1 year
st ₱325,000 1.2950 420,875
Future Value of Cash Flows: ₱1,249,805
The future value of cash flows is computed by multiplying the FV factor of
₱1 for every cash flow made during each year. The results are then added to
compute the future value of cash flows for the entire investment.
VARIED COMPOUNDING PERIODS
The examples presented so far involved compounding or discounting
interest rates annually. However, there are financial contracts like acquisitions on
installment basis or corporate bond contracts that may require for semi-annual,
quarterly, or monthly compounding periods.
Under these situations, we compute:
Period = number of years × 2 (semi-annual)
× 4 (quarterly)
× 12 (monthly)
Interest = interest rate / 2 (semi-annual)
/ 4 (quarterly)
 / 12 (monthly)
Example:
Find the future value of Sophia Corporation with a ₱100,000 investment.
The investment is good for 5 years with 6% annual interest. Assume that the
investment is compounded semi-annually.
Period = 5 × 2 = 10
Interest = 6%/2 = 3%
In computing for the future value factor (FVF), you will be using 3% rate
and the period is not 5 periods but 10 periods. Based on the new period and
interest rate, the FVF is 10.78.
Future value = ₱100,000 × 10.78
= ₱1,078,000
PARTICULAR USAGES OF TVMA
There are basically five uses for TVMA, the first of which was discussed
thoroughly in Chapter 3 for analyzing cash flows. Below, we shall be exploring
the other applications for TVMA:
1. Compounding Interests More Regularly than a Year
There are circumstances where the interests on investments or on
debts made are compounded more frequently than a year. Banks and
other financial institutions may compound their interests on a semi-
annually, quarterly, and even monthly basis.
Under these cases, the annual interests are divided depending on
the compounding periods in order to determine the future value or
present value of an amount. For instance, if investment is pegged with a
12%per annum rate interest and the interest is compounded semi-
annually, then the interest rate used to determine the TVM (future value or
present value) is 6% (12%/2). If the same investment interest rate is
compounded quarterly, then the interest rate derived to determine future
value or present value is 3% (12%/4). Under this scenario, the nominal
interest of 12%, which is paid annually, half of the interest rate (6%) is paid
twice a year.
Under these cases where the interest is compounded semi-annually,
quarterly, and so on, the periods are multiplied depending on the
compounding periods in order to determine future value or present value
 of an amount. For instance, if the investment is semi-annually, then the
periods shall be 2 periods (first six months and second six months). If the
investment is quarterly, then the periods shall be 4 periods, and so on.
Illustrative Example:
Assume that at the beginning of the calendar year 20xx, Nico
Corporation as the opportunity to deposit ₱100,000 in a savings account that
has a nominal interest rate of 12%, which is compounded semi-annually.
Consider the matrix below showing the future value from depositing ₱100,000 at
12% interest compounded semi-annually over 2 years.
Table 11
Future Value at 12% Interest
Compounded semi-annually
Period Principal Future Value Factor Future Value at
(a) (b) end of Period
(c)
(a × b)
Jan. 1 - June 30 ₱100,000 1.06 ₱106,000
July 1 - Dec. 31 ₱106,000 1.06 112,360
Jan. 1 - June 30
₱112,360 1.06 119,101.60
(2nd year)
July 1 - Dec. 31
₱119,101.60 1. 06 126,247.70
(2nd year)
The matrix above shows that the ₱100,000 deposit made by Nico at the
beginning of the calendar year increased by 6% after the first six months making
it ₱106,000. After another six months, Nico‟s investment balance of ₱106,000
again increased by 6% to ₱112,360. The story continues for the next two
succeeding 6 months. You may notice two things: the nominal interest rate of
12% became 6% (12%/2, because it is compounded semi-annually).
2. Computation of Effective Interest Rate
In assessing returns of investments or loan values, it is important for
business entities to have common basis for comparing interest rates. But to
do so, it is critical that we understand the two types of interest rates:
a. Nominal Rate(NR) - the rate stated in the contract of loan or
investment.
b. Effective Rate(ER) - the rate that is actually paid by the borrower
or actually received or earned by the investor.
 For instance, in cases involving Loans receivable (consult financial
accounting books), two essential values are considered:
a. Origination Fees - fees charged by the bank or financial
institutions against the borrower in order to create the loan. The
origination fees are considered as an addition to the unearned
interest income.
b. Direct Organization Costs - transaction costs that are considered
to be straightforwardly attributed to the loan receivable; the
direct origination costs are considered to be a deduction to the
unearned interest income.
The Unearned Interest Income account is annually amortized and is
converted into interest income. This would mean that the interest income
is either increased or decreased by the unearned interest income when
they are amortized usually at year-end.
Since the origination fees and direct origination costs both affect
the interest income being received by the lender, a new effective rate is
computed. Effective rates are usually computed using “trial and error” or
through “interpolation”.
Illustrative Example:
The National Bank of Manila approved a loan to Riel Corporation, a
borrower on January 1, 2020. The contract has a nominal interest rate of
10% which is payable every year-end commencing December 31, 2020.
The maturity date of the loan is December 31, 2022. The loan amounted
to ₱15,000,000. The origination fees and direct origination costs amounted
to ₱995,400 and ₱300,000, respectively.
The initial carrying value of the loan is computed as:

Loan ₱15,000,000

Origination Fees (₱995,400)

Direct origination costs ₱300,000

Carrying value of the loan ₱14,304,600

 Under this example, we can see that the initial carrying value of the loan is
lower than the loan value or the principal amount of the loan. This would purport
that there was a discount; hence, we can say that effective interest rate must
be higher than the nominal rate of 12%.

Trial and Error:

Let us compute the present value of the loan under 12%:

Present Value of the Principal Loan (0.7117 × ₱10,675,500

₱15,000,000)

Present Value of the Interest (2.4018 × (10% × ₱3,602,700

₱15,000,000)

Present Value of the Loan at 12% ₱14,278,200

The present value factor of 0.7117 and present value annuity of 2.4018
was derived using the method discussed in this book or by accessing the present
value table 12% of 3 periods.
Compare the ₱14,278,200 with the carrying value of the loan which is
₱14,304,600, we can conclude that 12% is not effective rate because there is a
difference between these two values. This means that we need to try again.
This time, let us use 11%.

Present Value of the Principal Loan (0.7312 × ₱10,968,000

₱15,000,000)

Present Value of the Interest (2.4437 × (10% × ₱3,665,550

₱15,000,000)

Present Value of the Loan at 12% ₱14,633,550

 The present value factor 0.7312 and the present value annuity of 2.4437
was derived using the method discussed in this book or by accessing the present
value table 11% of 3 periods.
Compare ₱14,633,550 with the carrying value of the loan, which is
₱14,304,600. We can conclude that 11% is not the effective rate because there
is a difference between these two values. We can try again but we may stop
here, because it is conceivable that the effective rate is between 11% to 12%.
The effective rate, however, can be computed much easily and with high
degree of accuracy by using a financial calculator.

3. Determining accumulated annual deposits for funds

There are times when management may want to determine the
amount of annual deposit it needs in order to accumulate a certain
amount of cash in the future. Assume that Tria Corporation would like to
acquire a land and building 5 years from today and they estimated that
the initial boot to pay is ₱4,000,000. The company may opt to deposit
equal amounts every year-end while paying interest per annum of 8%. Tria
must find out the size of annuity that would come out with a consolidated
amount of ₱4,000,000 on the 5th year. Under this case, the amount can be
computed by employing the future value of an ordinary annuity.
This can be seen in the formula below:

= ( )
Where:
Sn = the amount to be accumulated
A = Annual deposit
T2 (1,n) = interest rate, number of years
A formula to compute annual deposit may be derived o compute
from the formula above:
or amount to be accumulated
= ( ) or you can use the method discussed in computing
future value annuity using an ordinary calculator or
using the Table on Future Value Annuity
 = = 1 1

This would mean that the company needs to make an annual

deposit of ₱681,814 for the next five years to have an accumulated amount of
fund worth ₱4,000,000.
4. Loan Amortization
When a loan is made, it could be that such loan can be paid on an
equal staggered basis until said loan is fully paid. A typical example is the
loan borrowed by individuals or companies acquiring land and building or
house and lot where the payment could be done in 25 years.
A garden variety formula for the amortization loan payment would
be:

= ( 1)

Illustrative example:
Enzo Corporation loaned ₱2,500,000 for 4 years with an interest pegged at
11%. What is the amount of amortization to be done by Enzo to fully pay the
loan?

= = 1
1
This would mean that Enzo Corp. would need to annually pay ₱6,446,621
to pay up the loan of ₱20,000,000 after 4 years.
Other uses for TVMA that would be thoroughly discussed in Fundamentals
of Financial Management part II would include:
1. Bond valuation
2. Loan Amortization Matrix
3. Rates of Return Computation