FIN 2203 - Financial Management

TIME
VALUE OF
MONEY
Group #2
TO BE
DISCUSSED:
Today we will start our discussion on the time
value of money by discussing the following topics:
Time Value of Money
Future Value of Lump Sums
Future Value of Cash Flow Streams
Special Application of Time Value
TIME VALUE
OF MONEY
Also referred to as Net Present Value (NPV)

This states that the value of money in the present

is worth more than the sum of money to be
received in the future
HOW DOES IT
WORK?
The money on the present has the opportunity to
grow and earn interest through investment.
This eventually result to the money having
greater sum after a period of time compared to
receiving the same sum of money in the future.
 WHICH ONE IS BETTER?

Receive PHP 5,000.00 now Receive PHP 5,000.00 one year later
 WHICH ONE IS BETTER?

Receive PHP 12,000.00 now Receive PHP 1,000.00 monthly

WHY IS IT
SIGNIFICANT?
01 02 03 04
Financial Retirement/ Investment Purchasing
decisions Savings Funds invested in power
Helps investors and The earlier time the present can Your money can buy
people who uses value of money is grow after a period you more today
financial information applied in financial of time compared to what it
to have better planning, the better can
financial decisions the retirement plans buy you in the future
will be
METHODS IN FINDING TVM
Step-by-step Approach
Formula Approach
Financial Calculators
Spreadsheets
 PRESENT
VALUE
AND
FUTURE
VALUE OF
LUMP
SUM

LUMP SUM
A lump sum is a one-time payment or
repayment of funds at a particular point in
time. A lump sum can be either a present
value or future value.
PRESENT VALUE
OF LUMP SUM
Present value (PV) is the current value of a
future sum of money or stream of cash flows
given a specified rate of return.
Future cash flows are discounted at the
discount rate, and the higher the discount
rate, the lower the present value of the
future cash flows.
 where:

FV = Future Value
r = Rate of return
n = Number of periods

EXAMPLE
Mike needs as much money as Anna is willing to invest in his new business. He promises to pay Anna PhP75,000
in 5 years. Anna wants to earn 12% interest. What is the most Anna will give to Mike?
SOLUTION
Mike needs as much money as Anna is willing to invest in his new business. He promises to pay
Anna PhP75,000 in 5 years. Anna wants to earn 12% interest. What is the most Anna will give to
Mike?

? Php 75,000

12% interest

1 2 3 4 5
FUTURE VALUE
OF LUMP SUM
The value of the given investment at some point in the
future. The future value is important to investors and
financial planners.

FUTURE VALUE
OF SINGLE SUM
The equation below calculates how large a single sum will
become at the end of a specified period of time. This value
is referred to as the future value (FV) of a single sum.
FUTURE VALUE (FV) OF A
SINGLE SUM ILLUSTRATED
The following simplified example illustrates the basic operation of
the FV of a single sum formula.

How much will I receive at the end of 3 years if I invest a single sum of $50
today at 8% interest compounded annually? In other words, at 8%, how large
will my $50 grow in 3 years.
FUTURE VALUE (FV) OF A
SINGLE SUM ILLUSTRATED
So now that we have identified our initial deposit, the term of the investment,
and the interest rate, we can summarize our inputs to the FV of a single sum
equation as...

FV = 50.00
i = 0.08
n=3

...and plugging these values into the equation...

COMPOUNDING
FREQUENCY
In this case we must "synchronize" the values for i and n in
order to accommodate the non-annual compounding
frequency.
We start by defining n, the number of compounding periods in
the term, as being equal to the product of two numbers: the
number of compounding periods in the year (m) and the
number of years in the term (Y).
Now that we have modified n, we must adjust i.
i is almost always given as a annual nominal rate. If the
compounding frequency is something other than
annual, then i must be made proportional to the the
period in which it is being applied. Typically this is
accomplished by dividing i by m.
And if in our original example above we had used quarterly rather than
annual compounding, the FV is calculated as
Under monthly compounding, the FV is even larger...

...and larger still under daily compounding...

...and largest under continuous compounding...

CASH FLOW
STREAMS
Cash flow streams are known as finite sets of payments that an
investor will receive or invest over time.
TYPES OF CASH FLOW STREAMS
1. Annuities
2. Perpetuities
3. Uneven Cash Flow Streams
ANNUITIES
A series of equal payments made at regular intervals.

Annuities can be a fixed amount, an amount that grows at a constant rate

over time, or an amount that grows at various rates of growth over time. We
will focus on fixed amounts.

For example, $100 paid at the end of each of the next 3 years is a 3-year
annuity.

- CLASSIFICATIONS OF ANNUITIES
BASED ON TERM
BASED ON PAYMENT SCHEDULE
BASED ON INTEREST PERIOD AND PAYMENT INTERVAL
BASED ON TERM
Contingent Annuities - no fixed number of payments
Annuities Certain - have a specified number of time periods
Perpetuities - can last forever, indefinite

BASED ON PAYMENT SCHEDULE

Ordinary Annuity - paid or received at the end of the time period
Deferred Annuity - the first payment is delayed or deferred for a period
Annuity Due - payments made at the beginning

BASED ON TIME PERIODS

Simple Annuity - compounding frequency and number of payments match
General Annuity - compounding frequency and number of payments do not match
DEFINITION
OF TERMS
1.Payment Interval (payment period) – the length of time between two
successive payments in an annuity.
2.Term of Annuity – the total time from the beginning of the first payment
interval to the end of the last payment interval.
3.Periodic Rent (periodic payment) – the size of each payment.
4.Future Value of an annuity – the sum of the compound amount of all payments
compounded to the end of the term.
5.Present value of an annuity – the lump sum required at the beginning
6.Compounding frequency (conversion frequency) – the number of
compounding that take place in a year.
 t Time period (term) of the loan or investment

n Number of payments in an annuity

If there’s no number of payments given, we can compute it as follows: N = mt
Interest rate per compounding rate (which for simple annuities equals the interest rate per
i payment interval)
If there’s no interest rate given, we can compute it as follows: I = j / m

R Size of each annuity payment

Sn/Sdue Future value of an n-payment annuity

An/Adue Present value of an n-payment annuity

COMPUTATIONS
FOR SIMPLE
ORDINARY
ANNUITY
COMPUTATIONS
FOR sIMPLE
ANNUITY DUE
PERPETUITIES
If the cash flow stream is in the same payment amounts and are
equally spaced and lasts forever, it is a perpetuity.

Although perpetuity is somewhat theoretical (can anything really last

forever?), classic examples include businesses, real estate, and certain types
of bonds.

GENERAL FORMULA FOR PERPETUITIES

PV = C / R
where: C - amount of continuous cash payment and R - interest rate
EXAMPLE FOR PERPETUITIES
Bebe Co. pays PHP 25.00 in dividends annually and estimates
that they will pay the dividends indefinitely. How much are
investors willing to pay for the dividend with a required rate of
return of 5%?

SOLVE BY SUBSTITUTING VALUES TO THE GIVEN FORMULA:

PV = C / R = P25 / 0.05 = P500

ANSWER:
An investor will consider investing in the company if the stock price is P500 or
less.
UNEVEN CASH FLOW STREAM
A series of cash flows where the amount varies from one period
to the next. Although many financial decisions involve constant
payments, many others involve uneven, or nonconstant, cash
flows.

WHAT IS THE IMPORTANT TOOL THAT WE NEED TO

DEVELOP TO BE ABLE TO REPRESENT THE STREAM OF
CASH FLOWS OF AN ECONOMIC OPPORTUNITY?

THE TIMELINE!
 PRESENT VALUE OF AN
UNEVEN CASH FLOW STREAM
The PV of the cash flow stream is equal to the
sum of the present value of each of the
individual cash flows in the stream
pROJECT B IS
BETTER!
 FUTURE VALUE OF AN
UNEVEN CASH FLOW STREAM
Ø The future value of a cash flow stream is
equal to the sum of the future values of the
individual cash flows.
OBSERVATIONS
1. The size of the future cash flows
2. When the future cash flows occur
3. The required rate of return
SPECIAL APPLICATION OF
TIME VALUE OF MONEY
Semi-annual and Other Compounding Periods
Comparing Interest Rates
Fraction-time Period
SEMIANNUAL AND To see the difference of it let's try to compute a sample in annual
compounding so we will be able to see later the difference of annual
OTHER and nonannual compounding.
COMPOUNDING To Illustrate, assume that we deposit a P10,000 inside an account
that pays 9% and let it grow for 8-year period.
PERIODS
So this is just compounded per annum.
In all of the example given so far, the accounts are all
compounded its interest per annum, and that is what we called
Annual Compounding.
But if the bank for example offers a loan stating that they are
putting an annual interest of 9% but credits the interest for
every 6 months that is Semiannual Compounding.
So, what if we try to change the annual compounding to semiannual
It is important to understand the process of a nonannual compounding in the illustration?
compounding.
So, to solve for that we should seek for the stated interest
and the compounding in the given sample.
After that apply the given to get the periodic rate using the Total Deposit = P10,000
given formula below: Number of Periods = 16 periods
Periodic Rate = 4.5%

Now calculate the PV of P10,000 using the given formula:

After computing for the periodic rate, now get the number
of periods using the formula below:
Comparing Interest Rates
Different types of investment comes with a different types of compounding timeline. For instance, bank “X” may offer an account with
an interest payment at a daily basis or bank “Y” an account with an interest payment on a weekly basis which is applicable in a monthly,
quarterly, semi-annual, and in annual basis as well.
The Nominal Interest Rate (I ), also called the annual percentage rate (APR) or (quoted or stated rate) is a rate that does not take
compounding into account. It is stated as a simple interest rate.
The Effective Annual Rate, or EEF% also called the equivalent annual rate (EAR). This is the rate that would produce the same future
value under annual compounding.
An investment or loan that uses annual compounding has the same nominal rate and and effective interest rate but if not, the EEF% will
become higher than I
Let's put 15% as a sample, let say that the nominal rate offered in a loan is 15%, but it has a semi-annual compounding rate which
means that the rate 15% will be sliced into 2 compounding periods resulting in a much higher interest payment. To compare, try to
remove the compounding and put 15% in a year, the payment would be P1,150.00 different from the P1,155.63 payment with the
15% chopped into 2 periods considering that the compounding is taken into account.

In the illustration, we could see that payment at the end of the

annum of the nominal rate 15% w/ semi-annual compounding is
equivalent to the payment of 15.563%, Thus the nominal rate
15% with semi-annual compounding has an effective annual rate
of 15.563%

Given with the nominal rate and no. of compounding periods per annum, we can solve and get the Effective Annual Rate using the formula
below
Nominal Rate(I ) = 15%
Compounding Periods(M) = 2
 Fractional
Time Periods After that we will put that into the equation to get the ending amount.
So far what we all know is how to get the present value and the
future value of payment in a loan or investment.
Is there a way to get the value within the load periods?
For example, you put P10,000 in a bank that offered a nominal rate
of 15% but it adds interest on a daily basis, so that mean its is
compounded 365 times annually. If that is the case how much would But if you loan and want to see how much interest you would pay, this
it be after 7 months? is the formula.
To get the ending amount, identify first the periodic rate and
number of days.
THANK YOU
FOR
LISTENING!