Time Value of Money

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Time Value of Money

I. Concepts in Time Value


A. Opportunity Cost
 People are constantly making choices among various financial decisions. In making those choices,
people must give up something in order to gain something else. For example, if you want to save
up for a new phone, you may need to give up eating out on weekends. The opportunity cost of a
new phone is eating out on weekends. Therefore, the opportunity cost is something that you give
up in order to achieve something.
 The time value of money states that all things being equal, a peso today is worth more than a peso
in the future. The peso you have today is something that you can use now and earn interest, while
you cannot use a future peso.
 Because money is a limited resource, you cannot save and spend at the same time. If an individual
decides to save his/her money, then he/she gives up the opportunity to spend it. Good money
management is needed, in personal life and in business.

II. Simple interest is a method to calculate the amount of interest charged on a sum at a given rate and for a
given period of time. In simple interest, the principal amount is always the same, unlike compound
interest where we add the interest of previous years’ principal to calculate the interest of the next year.

III. In this lesson, you will be introduced to the concept of borrowing money and the simple interest that is
derived from borrowing. You will also be introduced to terms such as principal, amount, rate of interest,
and time period. Through these terms, you can calculate simple interest using the simple interest formula.

What is Simple Interest?

Simple interest is a quick and easy method to calculate interest on the money, in the simple interest
method interest always applies to the original principal amount, with the same rate of interest for every time
cycle. When we invest our money in any bank, the bank provides us interest on our amount. The interest
applied by the banks is of many types one of them is simple interest. Now, before going deeper into the
concept of simple interest, let's first understand what is the meaning of a loan.

A loan is an amount that a person borrows from a bank or a financial authority to fulfill their needs. Loan
examples include home loans, car loans, education loans, and personal loans. A loan amount is required to be
returned by the person to the authorities on time with an extra amount, which is usually the interest you pay
on the loan

Simple Interest Formula

Simple interest is calculated with the following formula: S.I. = P × R × T, where P = Principal, R = Rate of Interest
in % per annum, and T = Time, usually calculated as the number of years. The rate of interest is
in percentage r% and is to be written as r/100.
 Principal: The principal is the amount that initially borrowed from the bank or invested. The principal is
denoted by P.
 Rate: Rate is the rate of interest at which the principal amount is given to someone for a certain time, the
rate of interest can be 5%, 10%, or 13%, etc. The rate of interest is denoted by R.
 Time: Time is the duration for which the principal amount is given to someone. Time is denoted by T.
 Amount: When a person takes a loan from a bank, he/she has to return the principal borrowed plus the
interest amount, and this total returned is called Amount.

Simple Interest Example:

Michael's father had borrowed $1,000 from the bank and the rate of interest was 5%. What would the simple
interest be if the amount is borrowed for 1 year? Similarly, calculate the simple interest if the amount is
borrowed for 2 years, 3 years, and 10 years?

Solution:

Principal Amount = $1,000, Rate of Interest = 5% = 5/100. (Add a sentence here describing the given
information in the question.)
Compound Interest

Compound interest is an interest accumulated on the principal and interest together over a given time
period. The interest accumulated on a principal over a period of time is also accounted under the principal.

A sum of money of 100,000 invested over a period of time for a 10% rate would give a simple interest of
10,000, 10,000, 10,000... over successive time periods of 1 year, but would give a compound interest of 10k,
11k, 12.1k, 13k….Let us understand more about this, and the calculations of compound interest in the below
content.

The simple interest value for each of the years is the same, as the principal on which it is calculated is constant.
But the compound interest is varying and increasing across the years. Because the principal on which the
compound interest is calculated is increasing. The principal for a particular year is equal to the sum of the initial
principal value, and the accumulated interest of the past years.

For example, a sum of $10,000 is deposited at a rate of 10%. The below table explains the difference between
simple interest and compound interest computation on this principal:
II. Future Value

A. Future Value

There are three (3) reasons why a peso today is worth more than a peso in the future:

Preference for present consumption - Individuals prefer present consumption to future consumption. In order
to convince people to give up present consumption for future consumption, there needs to be a strong incentive.
For example, a businessman would be willing to deposit money if he is assured that it will bring a higher interest.

Inflation – When there is inflation, the value of the currency decreases over time. The greater the inflation, the
greater the difference in value between a peso today and a peso tomorrow.

Risk – If there is any uncertainty or risk associated with the cash flow in the future, people will think it is better
to spend their money now.

The formula for the future value is:

FVt = PV ( 1 +i) t
Where:

𝐹𝑉 = Future value in t period

𝑃𝑉 = Present value or the money invested today

i = Interest rate

t = Number of periods
 As an example, let us continue from the previous interest problem. If you deposit P10,000 at 3%
compounded annual interest, how much will it earn in the second year?
 Using the formula, we compute the future value of the deposit:
FVt = P10,000 ( 1 + 3% ) 2
FVt = P10,609

The future value of the original deposit at the end of the second year is P10, 609.
 Complete the table:

Rate 3%
Year Principal Interest Total
1 10,000.00 300.00 10,300.00
2 10,300.00 309.00 10,609.00
3
4
5
6
7
8
9
10

IV. Present Value


A. Present Value
 The present value formula is:

PV = FV
( 1 + i )t

Where:
PV= Present value
FV= Future value
i = Interest rate
t = Time period
Where:

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