Time value of

Money
 Learning Objectives
• Understand how the time value of money works and
why it is important in finance
• Learn how to calculate the present value and future value of
single and lump sums ;
• To know and identify the different types of annuities for both
present value and future value of both an ordinary annuity
and an annuity due;
• Calculate the present value and future value of an uneven
cash flow stream;
• Explain the difference between nominal, periodic and
effective
interest rates
• Discuss the basics loan amortization
 Time Lines
➢ An important tool used in time value analysis;
➢ It is a graphical representation used to show the timing
of cash flows.
• The first step in time value analysis is to set up a time line,
which will help you visualize what’s happening in a
particular problem.
• As an illustration, consider the following diagram, where
PV represents $100 that is on hand today, and FV is the
value that will be in the account on a future date:
 Time Value of Money
• It indicates the relationship between time and
money.
• A peso received today is worth more than a
peso to be received tomorrow."
• This is because the peso amount you received
today can be invested to earn interest.
• The single most important in all
financial concepts.
Future Values
➢ A dollar in hand today is worth more than a dollar to
be received in the future because if you had it now,
you could invest it, earn interest, and own more than
a dollar in the future.
➢ The process of going to future value (FV) from
present value (PV) is called compounding.
➢ For Illustration, refer back to our 3-year time line, and
assume that you plan to deposit $100 in a bank that
pays a guaranteed 5% interest each year. How much
would you have at the end of Year 3?
Definition of Terms
PV = Present value, or beginning amount. In
our example, PV = $100.
FVN = Future value, or ending amount, of
your account after N periods. FVN is the
value N periods into the future, after the
interest earned has been added to the
account.
CFt = Cash flow. Cash flows can be positive or
negative. The cash flow for a particular period is
often given as a subscript, CFt, where t is the period.
Thus, CF0 = PV = the cash flow at Time 0, whereas
CF3 is the cash flow at the end of Period 3.
Definition of Terms
I/r = Interest rate earned per year. Sometimes a lowercase i
is used. Interest earned is based on the balance at the
beginning of each year, and we assume that it is paid at the
end of the year. Here I = 5% or, expressed as a decimal, 0.05.
INT = Dollars of interest earned during the year =
Beginning amount x I.
In our example, INT = $100(0.05) = $5.
N = Number of periods involved in the analysis. In our
example, N = 3. Sometimes the number of periods is
designated with a lowercase n, so both N and n indicate the
number of periods involved.
 STEP-BY-STEP APPROACH
The time line used to find the FV of $100 compounded for 3 years at 5%,
along with some calculations, is shown. Multiply the initial amount and
each succeeding amount by (1 + I) = (1.05):
FORMULA APPROACH
In the step-by-step approach, we multiply the amount at the beginning of
each period by (1 + I) = (1.05). If N = 3, we multiply by (1 + I) three different
times, which is the same as multiplying the beginning amount by (1 + I)3. This
concept can be extended, and the result is this key equation:

FVN = PV(1 + I)N

We can apply Equation 5.1 to find the FV in our example:

FVN = PV(1 + I)N

FV3 = 100(1 + .05)3
= 115.76
 SIMPLE VERSUS
COMPOUND INTEREST
Interest earned on the interest earned in prior periods, as
was true in our example and is always true when we
apply Equation 5.1, is called compound interest.
If interest is not earned on interest, we have simple
interest.
FV = PV + PV(I)(N)
FV = $100 + $100(0.05)(3)
= $100 + $15
= $115
 Compounding, Simple Interest
and Compound Interest
• Compounding is the arithmetic process of
determining the final value of cash flow or
series of cash flows when compounded interest
is applied. – Brigham, 2011
• Simple Interest occurs when interest is not
earned on interest. – Brigham, 2011
• Compound Interest occurs when interest is
earned on prior periods’ interest. –Brigham,
2011
 Simple interest
Mr. Lopez invest $10,000 at 5% annual rate
for 2 years. How much will be the Maturity
value?

0 1 2

Periods
PV = 10,000 FV = ?

F = P(1+rt) or FV = PV + PV(I)(N)
= $10,000(1.1) = 10,000 + 10,000*.05*2
= $11,000 = 11,000
 Future Value (compounded)
Mr. Lopez invest $10,000 compounded
at 5% annual rate for 2 years. How
much will be the Maturity value?
0 1 2

PV = $10,000 FV= ?

FVN= PV(1+r)N
PV = Present Value
r = interest rate
N= number of years / time
 Future Value (compounded)
0 1 2

PV=$10,000 $10,500 $11,025

Given: PV = 10,000
i = .05
N= 2

FV1= PV(1+i)n FV2 = PV(1+i)n

=$10,000(1+.05) = $10,500(1.05)
FV1 = $10,500 = $11,025

FV2 = PV(1+i)n
=$ 10,000 (1+.05)2
= $ 10,000 (1.05)2
= $10,000(1.10250)
=$ 11,025 the maturity value after 2 years
 Present Value
• The value today of a future cash flow
or series of cash flows. – Brigham,
2011
• It is the amount of money today
that is equivalent to a given amount
to be received or paid in the future. –
Cabrera, 2011
• it is just a reverse of the future value,
in a way that instead of compounding
the money forward into the future, we
discount it back to the present.
We illustrate PVs with the following example. A
broker offers to sell you a Treasury bond that will
pay $115.76 three years from now.
Banks are currently offering a guaranteed 5%
interest on 3-year certificates of deposit (CDs), and if
you don’t buy the bond, you will buy a CD.
The 5% rate paid on the CDs is defined as your
opportunity cost, or the rate of return you could
earn on an alternative investment of similar risk.

Given these conditions, what’s the most you should

pay for the bond? We answer this question using the
either formula method or step by step method
 𝑭𝑽𝒏
Present value or PV = 𝟏+𝑰 𝑵
3
= 115.76/(1+.05)
=115.76/1.157625

= 100
 Single-Period Case
• Suppose you need $50,000.00 to buy laptop
next year. You can earn 10% on your money by
putting in on the bank. How much do you have
to put up today?
• 0 1

PV =? FV = $50,000
𝑭𝑽𝒏
PV = 𝟏+𝑰 𝑵
= $50,000/ (1+.10)1
= $45,454.54 the amount needed to invest today
 Multiple Period Case
• Angelo would like to buy a new automobile. He
has $600,000, but the car costs $800,000. If he
can earn 12%, how much does he need to
invest today in order to buy the car in two
years? Does he have enough money, assuming
the price will still the same?
• 0 1 2

PV = ? $800,000

FV = Future Value
i = Interest Rate
N = Number of years / Time
Multiple Period Case
𝑭𝑽𝒏
PV =
𝟏+𝑰 𝑵
= $800,000 / (1+.12) 2
=$637,755.102
The Amount Angelo must
invest today.

= $600,000 - $637,755.102
= $37,755.102
Angelo is still short of $37,755.102
ANNUITIES
• Thus far we have dealt with single
payments, or “lump sums.”
• However, many assets provide a series of
cash inflows over time, and many
obligations, such as auto, student, and
mortgage loans, require a series of
payments.
• When the payments are equal and are
made at fixed intervals, the series is an
annuity.
ANNUITIES
• It is a series of equal sized cash
flows occurring over equal
intervals of time. –Cabrera,
2011
• A series of equal payment at
fixed intervals for a specified
number of periods –
Brigham, 2011
Two types of Annuity
⦿Ordinary Annuity
➢ exists when the cash flows occur at
the end of each period.
• 0 1 2 3
Periods
Payments -100 -100 -100

⦿Annuity Due
➢ exists when the cash flows occur at
the beginning of each period.
⦿ 0 1 2 3
Periods
Payments -100 -100 -100
Future Value of Ordinary Annuity
• The future value of an annuity formula is
used to calculate what the value at a
future date would be for a series of
periodic payments, and payment is at the
end of each period.
The future value of an annuity formula assumes
that
1. The rate does not change
2. The first payment is one period away
3. The periodic payment does not change
Future Value of Ordinary Annuity

Suppose you deposit $2,000 at the end of year 1, another

$2,000 at the end of year 2, how much will you have in 5
years, if you deposit ₱2,000 at the end of each year? Assume a
10% interest rate throughout.
Given : PMT = 2,000
r=.10
n=5

𝟏+𝒓 𝒏−𝟏
FVA = PMT [ ]
𝒓
FVA = $2,000(6.10510)
= $12,210.2
 FUTURE VALUE OF AN ANNUITY
DUE
The future value of annuity due formula is used to calculate
the ending value of a series of payments or cash flows
where the first payment is received immediately (which
means payment is the beginning of each period).

𝟏+𝒓 𝒏−𝟏
FVAD = PMT [ ] x (1+r)
𝒓
PMT= Periodic Payments
r= interest rate
N= number of years / periods
FUTURE VALUE OF AN ANNUITY
DUE
Jose deposits $3,500 every beginning of the
month at his bank that credits 3% monthly for a
year. How much he will have at the end of the
term?
Given: PMT = $3,500
r=3%
n=12

𝟏+𝒓 𝒏−𝟏
FVAD = PMT [ ]x (1+r)
𝒓
FVAD = $3,500 (14.61779)
= $51,162.265
 Future Value of Annuity Due (FVAD)
(uneven cash flows)

Suppose you deposit today $100 in an account paying 8%. In one year,
you will deposit another $200 and
₱300 at the beginning of the third year, how much will you have in
three years?

𝟏+𝒓 𝒏−𝟏
• FVAD = PMT [ ] x (1+r)
𝒓

• FVAD1 = $100 (1.0800)

= $108.00
• FVAD2 = $308 ( 1.0800)
= $332.64
• FVAD3 = $632.64(1.0800)
= $683.25
• FVAD = $683.25
Present Value of Ordinary
Annuity
Used when you want to determine the present value of
the series of future payments, and payment is at the end
of each period. The following are the assumptions for
this formula:
1. The periodic payment does not change
2. The rate does not change
3. The first payment is one period away
−
𝑛
1− 1+𝑟
PVA = PMT[ ]
𝑟
PMT = Periodic Payment
r = Interest Rate
n = time / term
Present Value of Ordinary Annuity
• How much is the cash equivalent of the IPAD
that can be purchased by giving a down
payment of $3,000 and $2,500 payable at the
end of each period for 5 months at 5%?

Given: PMT = $2,500

−
r=.05 n=5
𝑛
1− 1+𝑟
PVA = PMT[ ]
𝑟
PVA = $2,500 (4.32948)
= $10,823.7

Cash equivalent = PVA + down payment

= $10,823.7 + $3,000
= $13,823.7
 Present Value of Ordinary Annuity (uneven cash
flows)
• You are offered an investment that will pay you $200
in one year, $400 the next year, $600 the next year and
$800 at the end of the next year. You can earn 12% on
very similar investments. What is the most you should
pay for this one?
−
𝒏
𝟏− 𝟏+𝒓
• PVA = PMT[ ]
𝒓
• PVA = $200 ( 0.89286)
= $178.572
• PVA = $578.572 (0.89286)
= $559.4398
• PVA = $1,159.44 (0.89286)
= $1,035.217
• PVA = $1,835.217 (0.89286)
= $1,638.592
• PVA = $ 1,638.592
Present Value of Annuity
Due
It is the present value of a series of equal
sized cash flows with the first payment
taking place at the beginning of the annuity
period. – Cabrera,2011
−
𝒏
𝟏− 𝟏+𝒓
PVAD = PMT[ ] x (1+r)
𝒓
PMT = Periodic Payment
i = Interest Rate
n = time / term
Present Value of Annuity Due

A machine can be bought for $4,000 down payment and 8 equal

monthly payments of $1,200 payable every beginning of the
month. If money is worth 6% compounded monthly, what is the
cash equivalent of the machine?
Given:
PMT = $1,200 r = .06
n=8 dp = $4,000
−
𝑛
1− 1+𝑟
PVAD = PMT[ ] x (1+r)
𝑟
PVAD = $1,200 (6.58238)
= 7,898.856

Cash Equivalent = Down payment + PVAD

= $4,000+ $7898.856
= $11,898.856
A perpetuity is simply an annuity with
an extended life.
Because the payments go on forever,
you can’t apply the step-by-step
approach. However, it’s easy to find the
PV of a perpetuity with a formula
found by solving Equation with N set
at infinity

PVP= PMT/I
Let’s say, for example, that you buy
preferred stock in a company that pays you
a fixed dividend of $2.50 each year the
company is in business. If we assume that
the company will go on indefinitely, the
preferred stock can be valued as a
perpetuity. If the discount rate on the
preferred stock is 10%, the present value of
the perpetuity, the preferred stock, is $25:

PVP= PMT/I
PVP=2.50 /.10
PVP= 25
 Types of Interest Rates
• Nominal Interest Rate (Quoted or
stated) – The contracted, or quoted or
stated interest rate. It is also called
annual percentage rate (APR); the
periodic rate times the number of
periods per year.

• Effective Annual Rate – The annual

rate of interest actually being earned, as
opposed to the quoted rate. This is the
rate that would produce the same
future value under annual
compounding as would more frequent
compounding at a given nominal rate.
 Amortization
• A method of repaying an interest bearing debt by a
series of equal payments at expected time interval.
−
𝒏
𝟏− 𝟏+𝒓
• A= PMT[ ]
𝒓
i
• PMT = Periodic Payment
• i = Interest Rate
• n = time / term

• Amortized loan – a loan that is to be repaid in

equal amounts on a monthly, quarterly, or annual
basis.
• Amortization Schedule - a table showing how a
loan will be repaid.
• A homeowner borrows $100,000 on a
mortgage loan. The loan is to be repaid
in five equal payments at the end of
each of the next 5 years. The lender
charges 6% on the balance at the
beginning of each
−
year.
𝒏
𝟏− 𝟏+𝒓
•A = PMT[ ]
𝒓
• 100,000=PMT(4.212363786)
• PMT=100k/ 4.212363786
• PMT = $23,739.64
 Amortization Schedule

Year Beginning Payment Interest Repayment Ending

Amount (1) (2) (3) Of Principal (4) Balance (5)

(1x.06) (2-3) (1-4)

1 $100,000.00 $23,379.64 $6,000.00 $17,739.64 $76,620.36

2 76,620.36 23,379.64 4,597.22 18,872.42 53,240.72

3 53,240.72 23,379.64 3,194.44 20,185.20 29,861.08

4 29,861.08 23,379.64 1,791.665 21,587.98 6,481.44

5 6,481.44 23,379.64 388.886 22,990.75 0.00

 References:
• Brigham, Eugene F., Houston, Joel F.,
Financial Management Fundamentals
(12th Edition), Manila Philippines, 2011.

• Ma. Elenita Balatbat Cabrera,

Management Accounting Concepts and
Applications 2011 Edition

• Arce, Aquino, CoPo, Gabuyo, Laddaran,

Mananquil, Mathematics of Investment
2010 Edition.