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CHAPTER

TIME VALUE OF MONEY

LEARNING OBJECTIVES

After studying this chapter, you should be able to…

1. Discuss future value of single amount;

2. Describe future value of annuity;
3. Differentiate present value of single amount and annuity; and
4. State the formula to compute for present and future values.

FUTURE VALUE: SINGLE AMOUNT

The time value of money plays a very significant role in making long-term
investment decisions. The basic tenet in finance relative to time value of money is: The
peso today is worth more than a peso in the future.

Why is this so? The peso you have today can be invested to earn an interest,
giving you a larger future amount in return. The concept of time value of money is
always involved whenever investment decisions are made. Time value money analysis
serves as the prelude to all investment discussions.

Simply imagine this situation: It has been said that in 1624, the Native Americans
sold Manhattan for only $24. If that $24 had been deposited at the time of sale at an
interest rate of 6% compounded annually, the investment in 2018, 394 years after the
sale, will roughly be $224 billion. However, in case the $24 had been deposited at a
higher rate, for example, at 8% compounded annually, the investment will roughly reach
$354 trillion by 2018. With $354 trillion in a bank, the descendants of the seller will be
the richest family in the world in 2018. This process of accumulating the amount of
money as time passes by is governed by the principles of time value of money.

The present applications of time value of money analysis include, among others,
determination of the value of retirement, computations of the value of stocks and bond,
and preparation of amortization schedule of long-term bank borrowings.

In time value of money analysis, compound interest, and not simple interest, is
applied. Simple interest means that the amount of interest is computed only once during
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the term of the investment or borrowing regardless of whatever the term is less than one
year, equal to one year, or more than one year.

The simple interest is computed using the formula

I=P xRxT

Where: I – Interest

P – Principle

R – Rate

T – Time

Compound interest, on the other hand, indicates that the interest of one
compounding period is added to the principal of the prior period to form the new
principal as basis for computing the interest of succeeding periods.

Illustration 1

Nicanor has invested ₱300,000 at 6% simple interest for a period of three years.

Required: compute the simple interest.

Answer: Since the term of the interest is simple, the amount of interest is
computed only once. Applying the formula, the simple interest for three years
appears as follows:

I=PxRxT
= ₱300,000 x .06 x 3
= ₱54,000

It can be observed that, though the term of the investment is three years, the
amount of interest is only computed once. The computation of interest follows the
Banker’s Rule, that is, using 360 days as denominator whenever the term is expressed in
the number of days.

For example, if the term in Illustration 1 is 120 days, the interest will be ₱6,000
computed as follows:

I=PxRxT
= ₱300,000 x .06 x 120/360
= ₱6,000
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In the succeeding discussions, compound interest is used. Simple interest

computation does not apply to investment valuation.

Future Value

Understanding future value is necessary for a proper time money value analysis.
Future value (FV), otherwise known as compound amount, is the accumulated value of
the principal or present value (PV) and all interest amounts of prior periods. In other
words, it is the value in the future of a certain amount invested today at a specific
compounded interest rate.

Illustration 2

Jenny has invested ₱10,000 on January 1, 2018 at 10% interest compounded

annually for five years.

Required: Compute the future value at the end of five years.

Answer: the future value refers to the amount at the end of the fifth year as an
interest of 8% is earned based on the compounded amount at the beginning of
every year.

This illustrates in the timeline as follows:

Periods 0 1 2 3 4 5

PV = 10,000 FV = ?

Future value indicates a compounding of interest. As mentioned, compounding

simply means that the interest at the end of one compounding period is added to the
principal as basis of computing the interest for the next period.

A step-by-step process to determine the future value of ₱10,000 at 10%

compounded annually for five years is as follows:

Principal at the
beginning of the Interest
period (P x R x T) Future amount
Year (a) (b) (a + b)
1 ₱10,000 ₱1,000 ₱11,000
2 11,000 1,100 12,100
3 12,100 1,210 13,310
4 13,310 1,331 14,641
5 14,641 1464 16,105*
*Amounts are rounded off to the nearest peso to highlight the process.
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Column 1 list the period of compounding

Column 2 shows the principal or present value at the beginning to the period. In
year 1, the amount of ₱10,000 represents the initial investment.in the succeeding periods,
the amounts signify the future value of the preceding period.

Column 3 presents the interest for one compounding period. It is computed by

multiplying the principle with the interest and the compounding period. For year 1, the
interest of ₱1,000 is computed as ₱10,000 x 10% x 1 year.

Column 4 refers to the future amount at the end of the compounding period. It is
determined by adding columns 2 and 3.

As computed using the step-by-step approach, the future amount of ₱10,000

invested at 10% compounded annually is ₱16,105. The timeline appears as follows:

Periods 0 1 2 3 4 5

10,000 11,000 12,100 13,310 14,641 FV =

16,105

It can be observed that the value of the investment increases along with the period
because of interest. Investment is only made once at the beginning of the period.

Just imagine how tedious the mathematical computations is if the period is 50

years. The annual interest is computed 50 times. It is much more complex if the period
covers 364 years as in the case of the sale of Manhattan in 1624.

Future Value Using the Formula

To facilitate an easier computation of future value, the following formula has

been developed:

FV = PV (1 + i)n
Where FV = Future value
= Present value
i = Periodic interest rate
n = Total number of compounding periods

Before going further, the following terms are defined.

Nominal rate is the rate of investment or borrowings.it is quoted as an annual

interest rate, unless otherwise specified. In illustration 2, the nominal rate is 10%.
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Compounding period refers to the period of conversion made during the year. It
can be annual, semi-annual, quarterly, or monthly. In illustration 2, the compounding
period is annual.

Frequency of conversion is the number of times the interest is added to the

principal during the year. If the compounding period is annual, the frequency of
conversion is 1; if semi-annual, the frequency is 2; if quarterly, it is 4;, and if monthly, it
is 12. In illustration 2, the frequency of conversion is 1 since the term is annually
compounded.

Total compounding period (n) refers to the number of times an interest is

computed during the term of the investment. It is computed by multiplying the frequency
of conversion and the term of the investment. In illustration 2, the total compounding
period is 5 (1 x 5 years). In case the compounding period is quarterly, the total
compounding period for a term of 5 years will be 20 (4 x 5 years).

Periodic interest rate (i) refers to the interest rate per compounding period. It is
computed by dividing the nominal rate by the compounding period. In illustration 2, the
periodic interest rate is 10% (10% ÷ 4).

Applying the formula to illustration 2, the future value is computed as follows:

FV = PV (1 + i)
= 10,000 (1 + .10)
= 10,000 (1.61051)
= 16,105

*rounded off to the nearest peso.

Future Value Using the Table

The future value can also be determined using the table of future value in Annex
A. The factor value in Annex A uses the future value formula of (1 + 1) n. The first
column represents the different periods (n) followed by several columns for different
interest rates.

Illustration 3

Yvone invested ₱200,000 at 8n = interest compounded quarterly for a period of 5

years.

Required: using the table of future value, compute the amount of the investment
at the end of the fifth year.

Answer: from the given date, the following are determined:

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Present value - ₱200,000

Nominal value - 8%
Frequency value - 4 (quarterly)
Periodic interest rate - 2% (8% / 4)
Terms - 5 years
Total compounding periods - 20 (5 years x 4)

In table 1, locate the column for 2%. Run your finger on the column until you
reach the period 20. The value where n and the interest rate intersect represents the value
of (1 + i)n. In this case, the value in the intersection of n = 20 and I = 2% is 1.4859.

The future value of ₱200,000 after the end of 20 years in then computed as
follows:

FV = ₱2000,000 x 1.4859
= ₱297,180

The table of future value is used in case the computation is made without the help
of scientific or financial calculators. However, the value of n in the table is only good for
100 periods.

How is the future value computed when n exceeds 100 periods?

When the value of n exceeds the periods provided in the table, the future value
factor can be determined using the law of exponents, xm, xn = xm+n.

For example, the term of investment is 25 years at 10% interest compounded

quarterly. In this case, the total compounding periods (n) is 100 (25 years x 4), and the
periodic interest rate is 2.50% (10% ÷ 4).

To compute the future value factor, the period of 100 is split into two values.
Hence, it may be split into 60 and 40 or into 50 and 50.

Assuming it is splitting into 60 and 40, the corresponding future amounts using
the future value factor in the table at 2.5% are 4.3998 and 2.6851, respectively.
Multiplying the two future values, their product is 11.8139 (4.3998 x 2.6851) which is
equal to the future value factor using the formula (1.025)100.

In case 100 is split into 50 and 50, the future value factor in the table at 2.5% is
3.4371. Again, if 3.4371 is multiplied with the same value factor, the result is 11.8137
(3.3471 x 3.4371) which is equal to the future value factor of the 60-40 split.
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FUTURE VALUE: ANNUITY

The preceding section discussed the determination of the future value of an

investment assuming that only a single amount is invested at the beginning of the term.
When several investments are made during the entire term in computing the future value,
the concept of annuity comes into the picture.

Annuity refers to a series of consecutive equal investment or payments made at an

equal interval of time. In simple terms, an investment is considered in annuity if:

1. There is a series of payments made;

2. The investments or payments are of equal amount; and
3. The payments are made at an equal interval of time.

Illustration 4

Angel invested ₱5,000 every end of the year at 10% interest compounded
annually for four years.

Required: present the timeline of the investment.

Answer: the timeline of the ₱5,000 annual investment at 10% compounded

annually for four years appears as follows:

Periods 0 1 2 3 4

1 - 5,000 (1.10)3 ?
2 5,000 (1.10) 2
?
3 5.000 (1.10)1 ?
4 5,000

Generally, periodic investment or payments are made at the end of the periodic
interval. In the diagram, the first investment has been made at the end of Year 1 which is
also the beginning of Year 2. This kind of annuity is called ordinary annuity.

On the other hand, when the periodic investment or payments are made at the
beginning of the periodic interval, the annuity is called annuity due. This material
discusses only ordinary annuity. Other types of annuity are taken in collegiate courses
under mathematics of investment.
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Future Value of Annuity Using the Formula

The future value of an annuity is equal to the sum of the future amounts of several
investments or payments made from the first interval payment to the end of the term. The
future value of the annuity in illustration 4 is computed as follows:

End of period 1 ₱5,000 (1.10)3 ₱6,655

End of period 2 5,000 (1.10)2 6,050
End of period 3 5,000 (1.10)1 5,500
End of period 4 5,000 (x.10)0 5,000
Future value ₱23,205

` The procedural process as illustrated above is a step-by-step approach of a single

amount. It is very tedious process. Simply imagine the computations that will be made in
case the compounding period is 60.

To facilitate a simpler computation, the following formula is used to determine

the future value of an annuity:

(1 + i)n - 1
FV = A
i
Where FV = Future value of annuity
A = Annuity investment
i = Periodic interest rate
n = Total compounding periods

The formula to compute the future value of ₱5,000 invested every end of the year
for four years at 10% compounded interest appears as follows:

(1 + i)n - 1
FV = A
i
(1.10)4 - 1
FV = A
.10
= ₱5,000 (4.641)
= ₱23,205

The future amount delivered using the formula is equal to the amount computed
using the step-by- step approach.

Future Value of Annuity Using a Table

The table of the future value of annuity is provided in Annex C. The table of
annuity is commonly used when the computation is made without the aid of scientific or
financial calculators.
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Using the information in illustration 4, the future value of the annuity 5,000
invested at 10% interest compounded annually for four years can be determined using the
value factor in Annex C.

Locate the column for 10% interest. Run your finger on the column until you
reach the period 4. The value where n and the interest rate intersect represents the future
value factor of the annuity. In this case, the value in the intersection of n = 20 and I =
10% is 4.641. This value is multiplied by the amount of investment of 5,000 to give the
future value of the annuity shown as follows:

Future value of annuity = ₱5,000 x 4.641

= ₱23,205

The result indicates that when ₱5,000 is invested every end of the year for four
years with an interest of 10% compounded annually, the investment will eventually
amount to ₱23,205 at the end of four years.

PRESENT VALUE: SINGLE AMOUNT

The term present value simply refers to the value of the money at present. Hence,
the ₱100 in your pocket today has a present value of ₱100. However, the amount of ₱100
10 years from now is not the same as ₱100 today. Its present value is definitely lower.

This concept is illustrated in the timeline as follows:

Periods 0 1 2 n 10

1 ₱100
2 ? ₱100

In determining the future value of a single amount, compounding is applied.

However, when the present value of a certain amount is computed, discounting is used.

Discounting refers to the process of determining the present value of a single

amount or series of cash flows. It is the reverse process of compounding. Both concepts -
compounding and discounting - are important in the discussion of investment.

Present Value Using the Formula

The procedure to compute the present value of an amount is to reverse the process of
computing future value. The formula to compute the present value appears as follows:

FV = PV (1 + i)-n
Where PV = Present value
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FV = Future value
i = Periodic interest rate
n = Total number of compounding periods

Illustration 5

Princess's goal is ty have an investment of ₱500,000 after four years. The amount
to be invested will earn an interest of 12% compounded quarterly.

Required: determine the amount to be invested by Princess at 12% interest

compounded quarterly.

Answer: the problem is simply asking for the present value or discounted value
of ₱500,000 which has been invested at 12% compounded quarterly for four years.

In this case, the future value is ₱500,000. The nominal interest rate is 12%
compounded quarterly; hence, the periodic interest is 3% (12% ÷ 4). Since the term is
four years and the frequency of conversion is quarterly, then the total compounding
periods is 16.

PV = FV (1 + i)-n
= ₱500,000 x (1.03) -16
= ₱500,000 x .6232
= ₱311,600

Based on the computation, Princess needs to invest ₱311,600 at 12% interest

compounded quarterly in order to have an investment of ₱500,000 at the end of four
years.

The timeline appears as follows:

Periods 0 1 2 3 4

PV ₱311,600 ₱500,000 FV

Present Value Using a Table

The present value of an amount can also be computed using the table of present
value shown in Annex B.

Again, the table of present value serves as the alternative approach whenever the
computation is not aided by scientific or financial calculators.

Illustration 6
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Hyzel plans to accumulate ₱800,000 at the end of eight years in which the money
earns an interest of 9% compounded quarterly.

Required: determine the amount to be invested by Hyzel at an interest of 9%

compounded quarterly using the table of present value.

Answer: since the frequency of conversion is quarterly, the periodic interest rate
is 2.25% (9% ÷ 4), and the total compounding periods is 32 (8 years x 4).

Locate the column of 2.25% interest rate. Run your finger don't he column until
you reach the period 32. The value where n = 32, and the interest rate of 2.25% intersect
represent s the present value factor (0.4907). This present value factor is then multiplied
to the future value of 800,000 to determine the present value of investment computed as
follows:

PV = FV (1 + i)-n
= ₱800,000 x (0.4907)
= ₱392,560

It indicates that Hyzel should invest ₱392,560 today at an interest of 9%

compounded quarterly in order to have an accumulated amount of ₱800,000 at the end of
eight years.

PRESENT VALUE: ANNUITY

The present value of annuity refers to the present value of all individual
investment or deposits made. Each individual investment is discounted and then all the
discounted amounts are added to represent the present value of the annuity.

This concept is illustrated in the timeline using that the annuity is ₱10,000 at 10%
interest compounded annually for four years:

Periods 0 1 2 3 4

1 ? ₱10,000
2 ? ₱10,000
3 ? ₱10,000
4 ? ₱10,000
PV ?

Using the step-by-step approach, the present value of the ₱10,000 annuity for four
years compounded at 10% annually appears as follows:

Period 1 ₱10,000 x (1.10)-1 or ₱10,000 x 0.9091 ₱ 9,091

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2 10,000 x (1.10)-2 or 10,000 x 0.8264 8,264

3 10,000 x (1.10)-3 or 10,000 x 0.7513 7,513
4 10,000 x (1.10)-4 or 10,000 x 0.6830 6,830
Present value of ₱10,000 annuity ₱31,698

This indicates that the ₱10,000 annuity of annual investment made every end of
the year for four years at the interest rate of 10% compounded annually, or a total
investment of ₱40,000 for four years has a value today (present) of ₱31,698. The total
investments of ₱40,000, however, does not represent the future value of ₱31,698.

Since present value is the reverse of future value, the present value of ₱31,698 can
be interpreted from the concept of future value of annuity. In this case, an amount of
₱31,698 invested today at the rate of 10% compounded annually can provide an annuity
of ₱10,000 every end of the year for four years.

Present Value of Annuity Using the Formula

The step-by-step process appears to be tedious which may lead to the possibility
of committing mechanical errors in the computation. Thus, the following formula has
been devised to determine the present value of the annuity:

1 - (1 + i)-n
PV = A
i
Where PV = Present value of annuity
A = Annuity
i = Periodic interest rate
n = Total compounding periods

Illustration 7

Izzy plans to invest ₱3,000 at the end of every quarter for 8 years at the interest
rate of 10% compounded quarterly.

Required: determine the present value of the quarterly annuity of ₱3,000 for
eight years.

Answer: the periodic interest rate of 2.5% (10% ÷ 4), and the total compounding
period is 32 (8 years x 4). Since Izzy will make an investment of ₱3,000 every end of the
quarter, the total investment of Izzy for 32 quarters will be ₱96,000 (₱3,000 x 32).

Applying the formula, the present value of ₱3,000 quarterly annuity for eight
years at the interest rate of 10% compounded quarterly is computed as follows:

1 - (1 + i)-n
PV = A
i
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1 – (1.025)-32
= ₱3,000
0.025
= ₱3,000 (21.848)
= ₱65,544

The present value of ₱3,000 annuity at the end of every quarter for 32 quarters at
the interest rate of 10% compounded quarterly is ₱65,544, though the total investment
amounts to ₱96,000 (₱3,000 x 32 quarters).

The timeline may appear as follows:

Periods 0 Qrt.1 Qrt. 2 Qrt. n Qrt. 32

PV ₱65,544 ₱3,000 ₱3,000 ₱3,000 ₱3,000

The diagram shows that the annuity of ₱3,000 at the end of every quarter is
discounted to determine the present value. The sum of the individual present values
represents the present value of the annuity.

Present Value of Annuity Using a Table

In case, the process can be performed with the aid of present value of annuity
factor shown in Annex D.

Illustration 8

Rolly invests ₱5,000 every end of the six years. The money is compounded semi-
annually at a nominal rate of 8%.

Required: determine the present value of the annuity of using the factor value in
Annex D

Answer: in this case, the frequency of conversion is semi-annual; hence, the total
compounding periods are 12 years (6 years x 2) while the periodic interest rate is 4% (8%
÷2).

Using the value factor in the table, locate the column of 4% interest rate. This
time, run your finger on the column until you reach the period (n) 12. The value in the
intersection of n = 12 and I = 4% is 9.3851. The quarterly annuity of ₱5,000 is then
 | 49

multiplied by the value in order to determine the present value annuity of ₱5,000 for six
years at 8% compounded semiannually.

The computation appears as follows:

PV = ₱5,000 (9.3851)
= ₱46,925.50

The mathematical formulas presented and discussed here to determine the future
and present values of the annuity are applicable only if the frequency of conversion
coincides with the compounding period. For example, the frequency of conversion and
the compounding period are both quarterly. However, in case the frequency of conversion
does not coincide with the compounding period, the formulas given can no longer be
used. This latter type of equity is discussed in a collegiate course under mathematics of
investment.

QUESTIONS FOR REVIEW AND DISCUSSION

1. Differentiate single interest from compound interest

2. Give the formula to compute the future value of a single amount?
3. Discuss how the future value of a single amount is computed using the table of
future value.
4. Discuss the present value and discounting
5. Give the formula to determine the present value of a single amount.
6. Describe the present in determining the present value of a single amount using the
table of present value.