Time Value of Money

JQY
 Agenda
• Time Lines
• Future Values
• Present Values
• Solving for Interest Rate and Time
• Future Value of an Annuity
• Present Value of an Annuity
• Perpetuities
• Uneven Cash Flow Streams
• Semiannual and Other Compounding Periods
• Comparison of Different types of interest rates
• Fractional Time Periods
• Amortized Loans
• Amortization
 What is Time Value?
• We say that money has a time value because that money can
be invested with the expectation of earning a positive rate of
return
• In other words, “a dollar received today is worth more than a
dollar to be received tomorrow”
• That is because today’s dollar can be invested so that we have
more than one dollar tomorrow
 If you have P10,000 today, and you
deposit it in the bank, how much will
you most likely receive in 10 years?

a. P9,500
b. P14,000
b.P14,000
c. P10,000
c. P10,000
 Timelines
 An important tool used in the time value of money analysis

 A graphical representation used to show the timing of cash flows

 A timeline is a graphical device used to clarify the timing of the

cash flows for an investment

 Each tick represents one time period

PV FV

0 1 2 3 4 5
Today
 Future Value
• The value of an asset or cash at a specified date in the
future that is equivalent in value to a specified sum
today
• Terms:
 PV – present value, or beginning amount in your account
 i – interest rate the bank pays on the account per year
 INT – amount of interest you earn during the year (aka
discount rate, opportunity cost rate)
 FV – future value or ending amount of your account at the
end of n years
 n – number of periods involved in the analysis
 Future Value
• Simple Annual Interest
Q: Today, Peter invested P1,000 for 5 years with
simple annual interest of 10%. How much is its
future value?
A: FV = PV x [1 + (i*n)]
FV = P1,000 x [1 + (10%*5)]
FV = P1,000 x 1.5
FV = P1,500
 Future Value
• Interest compounded
Q: Today, Peter invested P100 for 3 years at 10%,
compounded annually. How much is its future
value?

A: FV = PV (1+i)ⁿ
0 1 2 3

100 FV = ?

After 1 year : FV = PV (1+i)^1 = 100 (1+10%)^1 = 110

After 2 years: FV = PV (1+i)^2 = 100 (1+10%)^2 = 121
After 3 years: FV = PV (1+i)^3 = 100 (1+10%)^3 = 133.10
 The Magic of Compounding
• In 1898, USA bought the Philippines from Spain for $20 million
• This happened about 112 years ago, so 5% per year could be earned,
the value of the Philippines now (in 2010) would be approximately:

20m (1.05)112 = 4,723,147,316

 If they could have earned 10% per year, the Philippines would
have been worth:

20m (1.10)112 = 864,989,300,000

 Agenda
• Future Value
• Present Value
• Annuities
• Rates of Return
• Amortization
 If you need to have P10,000 in 10
years, how much will you likely
have to invest today?

a. P7,000
a.P7,000
b. P10,000
b. P10,000
c. P12,000
c. P12,000
 Present Value
• The value today of a future cash flow or series
of cash flows.
• Represents the amount that needs to be
invested to achieve some desired future value.
FVN
PV 
1  i N
 Present Value: An Example
• Suppose that your five-year old daughter has just announced
her desire to attend college. After some research, you
determine that you will need about $100,000 on her 18th
birthday to pay for four years of college. If you can earn 8%
per year on your investments, how much do you need to
invest today to achieve your goal?
• N = 13; I = 8%; PV = ?; PMT = 0; FV = 100,000

100,000
PV   $36,769.79
108
. 
13
 Solving for Interest and Time
• I = (FV/PV)^1/n – 1
• Sample problem
You can buy a security at a price of $78.35, and it
will pay you $100 after 5 years. How much is the
interest rate you’d earn if you bought the
security?
I = (100/78.35)^(1/5) – 1 = 5%
 Solving for Interest and Time
• N = ln (FV/PV) / ln (1+i)
• Sample problem
Mr. Amos invested P60,000 in stocks at a 10%
interest rate compounded semi-annually. How
many years did it take Mr. Amos for his investment
to reach P100,000?
N = ln (100,000/60,000) / ln (1 + 5%)
N = 10.47 / 2 = 5.24 years
 Annuities
• An annuity is a series of payments of an equal amount at
fixed intervals for a specified number of periods.
• Annuities are very common:
– Rent
– Mortgage payments
– Car payment
– Pension income
• The timeline shows an example of a 5-year, $100 annuity

100 100 100 100 100

0 1 2 3 4 5
 Annuities
• Ordinary (Deferred) Annuity
– An annuity whose payments occur at the end of
each period.
• Annuity Due
– An annuity whose payments occur at the
beginning of each period.

5-period Annuity Due 100 100 100 100 100

5-period Regular Annuity 100 100 100 100 100

0 1 2 3 4 5
Future Value of an Ordinary Annuity
• Mary deposited P100 at the end of each year
for 3 years in a savings account that pays 5%
interest per year. How much will she have at
the end of three years?

• Fva = 100 {[(1+5%)^3 – 1] / 5%}

• Fva = 315.25
 Future Value of an Annuity Due
• Mary deposited P100 at the beginning of each year
for 3 years in a savings account that pays 5% interest
per year. How much will she have at the end of three
years?

• Fvad = 100 {[(1+5%)^3 – 1] / 5%} (1+5%) = 331.01

Present Value of an Ordinary Annuity
• Mary deposited P100 at the end of each year
for 3 years in a savings account that pays 5%
interest per year. How much is the present
value of her payments?

• Pva = 100 [1 – (1/(1+5%)^3) / 5%]

• Pva = 272.32
 Present Value of an Annuity Due
• Mary deposited P100 at the beginning of each year
for 3 years in a savings account that pays 5% interest
per year. How much is the present value of her
payments?

• Pvad = {100 [1 – [1/(1+5%)^(3-1)] / 5%} + 100

• Pvad = 285.94
Ordinary Annuity – Solving for Payment
when FV is known
• Harold wants to accumulate P50,000 at the end of 5
years. How much should he pay every year assuming
that the interest is 5%, and the first payment will be
made at the end of the year?

• PMT = 50,000 / [(1+5%)^5 – 1] / 5% = 9,048.74

Annuity Due – Solving for Payment when
FV is known
• Harold wants to accumulate P50,000 at the end of 5
years. How much should he pay every year assuming
that the interest is 5%, and the first payment will be
made at the beginning of the year?

• PMTad = 50,000 / {[(1+5%)^5 – 1] / 5%} (1+5%)

• PMTad = 8,617.85
Ordinary Annuity – Solving for Payment
when PV is known
• How much should Sharon pay every year for 5 years
assuming that the interest is 5%, and the first payment
will be made at the end of the year, if the present value
is 10,000?

• PMT = 50,000 / [(1 – (1/(1+5%)^5 )/5%] / 5% = 2,309.75

Annuity Due – Solving for Payment when
PV is known
• How much should Sharon pay every year for 5 years
assuming that the interest is 5%, and the first payment
will be made at the beginning of the year, if the present
value is 10,000?

• PMTad = 10,000 / {[(1 – (1/(1+5%)^(5-1) )/5%] / 5%} + 1

• PMTad = 2,199.76
Ordinary Annuity – Solving for N when FV
is known
• Sharon plans to save P100 per year (first payment at
end of the year). Assuming that the interest is 5%, how
many years does it take for Sharon to accumulate
1,000?

• N = ln[1 – (1,000/-100)5%] / ln (1+5%) = 8.31 years

 Annuity Due – Solving for N when FV is
known
• Sharon plans to save P100 per year (first payment at
beginning of the year). Assuming that the interest is
5%, how many years does it take for Sharon to
accumulate 1,000?

• Nad = {ln[(1,000 x 5%) / (100 x 1.05)] + 1} / ln (1+5%)

• Nad = 7.98 years
Ordinary Annuity – Solving for N when PV
is known
• Sharon plans to save P100 per year (first payment at
end of the year), and the present value if P1,000
Assuming that the interest is 5%, solve for N:

• N = - ln[1 – (1000/100) 5%] / ln (1+5%) = 14.207 years

 Annuity Due – Solving for N when PV is
known
• Sharon plans to save P100 per year (first payment at
end of the year), and the present value if P1,000
Assuming that the interest is 5%, solve for N:

• Nad = {- ln[1 + 5% (1 – (1000/100)] / ln (1+5%)} + 1

• Nad = 13.25 years
 Ordinary Annuity – Solving for I when FV
and PV are known
• Can only be calculated through a trial and error process
unless financial calculator is used.
• However, an approximate equation can be solved,
provided that all inputs in the equation below is
known:
i = {{Annual PMT + [(FV – PV)/Annual N]} / [(40% x FV) + (60% x
PV)]}}
 Ordinary Annuity – Solving for I when FV
and PV are known
Belle has 1,000 today. She plans to make an
investment where she pays 50 annually at the end of
the year. She expects to receive 1,500 at the end of 10
years. How much is the interest rate that is required
for this investment so that Belle will receive 1500 after
10 years?

i = {{50 + [(1,500 – 1,000)/10]} / [(40% x 1,500) + (60% x 1,000)]}}

 Summary
• Rules regarding annuity, ceteris paribus:
Ordinary Annuity Annuity Due

Future Value Lower Higher

Present Value Lower Higher

Payment Higher Lower

N Higher Lower

Interest Higher Lower

 Perpetuities
• A stream of equal payments expected to
continue forever
• PV (Perpetuity) = Payment / Interest rate
• Suppose each consol (British government
perpetual bonds) promised to pay $100 in
perpetuity, if the discount rate or opportunity
cost rate is 5% and 10%:
• PV (Perpetuity) = 100/5% = $2,000
• PV (Perpetuity) = 100/10% = $1,000
 Uneven Cash Flow Stream
• A series of cash flows in which the amount
varies from one period to the next
• PMT = equal cash flows coming at regular
intervals
• CF = uneven cash flows
Uneven Cash Flows: An Example (PV)
• Assume that an investment offers the following cash
flows. If your required return is 7%, what is the maximum
price that you would pay for this investment?

100 200 300

0 1 2 3 4 5

100 200 300

PV     513.04
107
. 
1
107
. 
2
107
. 
3
 Uneven Cash Flows: An Example (FV)
• Terminal Value = The future value of an uneven cash flow stream
• Suppose that you were to deposit the following amounts in an
account paying 5% per year. What would the balance of the
account be at the end of the third year?

300 500 700

0 1 2 3 4 5

FV 300105
.   500105
.   700  1,555.75
2 1
 Non-annual Compounding
• We could assume that interest is earned semi-annually,
quarterly, monthly, daily, or any other length of time
• The only change that must be made is to make sure that the
rate of interest is adjusted to the period length
Non-annual Compounding (cont.)

• Suppose that you have $1,000 available for investment.

After investigating the local banks, you have compiled the
following table for comparison. In which bank should you
deposit your funds?

Bank Interest Rate Compounding

First National 10% Annual
Second National 10% Monthly
Third National 10% Daily
Non-annual Compounding (cont.)

• We can find the FV for each bank as follows:

FV  1,000110
.   1100
1
First National Bank: ,
12
 . 
010
Second National Bank: FV  1,000 1    1104
, .71
 12 
365
 . 
010
Third National Bank: FV  1,000 1    110516
, .
 365 
Obviously, you should choose the Third National Bank
 Continuous Compounding

• There is no reason why we need to stop increasing the

compounding frequency at daily
• We could compound every hour, minute, or second
• We can also compound every instant (i.e., continuously):

F  Pe rt

 Here, F is the future value, P is the present value, r is the annual rate of
interest, t is the total number of years, and e is a constant equal to
about 2.718
Continuous Compounding (cont.)

• Suppose that the Fourth National Bank is offering to pay

10% per year compounded continuously. What is the
future value of your $1,000 investment?

0 .10 1
F  1,000e  110517
, .
 This is even better than daily compounding
 The basic rule of compounding is: The more frequently interest is
compounded, the higher the future value
Continuous Compounding (cont.)

• Suppose that the Fourth National Bank is offering to pay

10% per year compounded continuously. If you plan to
leave the money in the account for 5 years, what is the
future value of your $1,000 investment?

0.10 5
F  1,000e  1,648.72
 Different Rates
• Nominal (Quoted, Stated, Annual Percentage) Interest Rate
– The rate charged by banks and other financial institutions
– For example, 6% compounded quarterly, 5% compounded monthly
• Effective (Equivalent Annual) Rate
– The annual rate of interest actually being earned
– EAR = (1+iNOM/m)^m – 1
– If payment is only once a year, EAR = nominal rate
• Periodic Rate
– Rate charged by a lender or paid by a borrower each period
– iPER = iNOM/m
– If Nominal rate is quoted at 18%, payable monthly, periodic rate is 18%/12 or 1.5%
– If payment is only once a year, Nominal rate = periodic rate.

Landbank charges 10% interest rate, compounded quarterly. How much is the
nominal, EAR, and periodic rate?
Nominal = 10%, EAR = 10.38%, Periodic = 2.5%
 Fractional Time Periods
• If you deposit $100 in a bank that uses daily
compounding and pays a nominal rate of 10% with a
365 days, how much is the FV after 9 months?
N = 365 x 9/12 ; I = 10% / 365 ; PV = 100
FV = PV x [(1 + i)^n] = 100 x [(1 + 0.000273973)^274] =
107.79
• You borrow $100 that charges 10% simple interest but
you borrow only for 274 days. How much interest do
you owe?
Interest owed = 100 x 10% x 274/365 = $7.51
 Amortized Loans
• A loan that is repaid in equal payments over its life.
• If a firm borrows $1,000 and the loan is to be repaid in 3 equal
payments at the end of each of the next three years, and the
lender charges 6% on the loan balance, how much is the
periodic payment, and construct the loan amortization
schedule.
• N = 3; I = 6%; PV = 1000; PMT = ?; FV = 0

• PMT = 1,000 / [(1 – (1/(1+6%)^3)/6%] / 6% = 374.11

 Amortization Schedule

Payment Interest Principal Repayment Balance

Beg 1,000.00

Y1 374.11 60.00 314.11 685.89

Y2 374.11 41.15 332.96 352.93

Y3 374.11 21.18 352.93 (0.00)

 Balloon Loan
• A long-term loan, often a mortgage, that has
one large payment due upon maturity.
• Advantage: very low interest payments,
requiring very little capital outlay during the
life of the loan.
• Disadvantage: An undisciplined borrower will
be in trouble because he has to make a large
single payment upon maturity.
Partial Amortization: Balloon Loans
• A house is worth $200,000, and a bank agrees to lend the
potential home buyer $175,000 secured by a mortgage on the
house. However, the buyer only has $5,000 and he is unable
to make the full $25,000 downpayment. The seller may take a
note of 20k, 8% interest rate and payments at the end of the
year based on a 20 year amortization schedule but with loan
maturing at the end of the 10th year.
• N = 20; I = 8%; PV = 20,000; PMT = ?
• Annual PMT of the note = 2,037.04
Amortization Schedule: Balloon Loans
Payment Interest Principal Repayment Balance
Beg 20,000.00
Y1 2,037.04 1,600.00 437.04 19,562.96
Y2 2,037.04 1,565.04 472.00 19,090.96
Y3 2,037.04 1,527.28 509.76 18,581.19
Y4 2,037.04 1,486.50 550.54 18,030.65
Y5 2,037.04 1,442.45 594.59 17,436.06
Y6 2,037.04 1,394.88 642.16 16,793.91
Y7 2,037.04 1,343.51 693.53 16,100.38
Y8 2,037.04 1,288.03 749.01 15,351.37
Y9 2,037.04 1,228.11 808.93 14,542.44
Y10 2,037.04 1,163.40 873.64 13,668.79
15,705.83
Thank you for listening!