UNDERSTANDIN

G THE TIME
VALUE OF
MONEY
WALTER M. REYES - FINANCIAL MANAGEMENT
Time Value of Money
Definition
The time value of money (TVM)
is the concept that a sum of
money is worth more now than
the same sum will be at a future
date due to its earnings potential
in the interim. The time value of
money is a core principle of
finance. A sum of money in the
hand has greater value than the
same sum to be paid in the
future.
Example:
 Importance of TVM
The importance of the time value of money (TVM) in finance and decision-making cannot be
overstated. Here are some key reasons why TVM is crucial:

● Investment and Decision Making

● Budgeting and Financial Planning
● Risk Assessment
● Borrowing and Lending
● Pricing of Financial Instruments
● Capital Budgeting
● Retirement Planning
● Evaluating Economic Decisions
● Loan Amortization
● Inflation Management
 KEY CONCEPTS
Interest Rates and Compounding
Interest Rate
An interest rate is the cost of borrowing money or the return on investment for lending or investing
money. It’s typically expressed as a percentage and can be fixed or variable.

Simple Interest
In simple interest, interest is calculated only on the initial principal amount. It doesn’t take into account
any interest that has already been earned or paid.

Compound Interest
Compound interest, on the other hand, takes into account not only the initial principal but also the
interest that accumulates over time. This means that the interest is earned on both the principal amount
and any previously earned interest. Compound interest can significantly increase the total amount over
time.

Frequency of Compounding
How often interest is added to the principal has a big impact on the total amount earned or paid.
Common compounding frequencies include annually, semi-annually, quarterly, monthly, and daily.
 KEY CONCEPTS
Present Value
The Present Value (PV) is an
estimation of how much a
future cash flow (or stream of
cash flows) is worth right
now. All future cash flows
must be discounted to the
present using an appropriate
rate that reflects the expected
rate of return (and risk profile)
because of the “time value of
money.”
 KEY CONCEPTS
Future Value
The Future Value (FV) refers to the
implied value of an asset as of a
specific date in the future based upon
a growth rate assumption. It is a
fundamental concept to corporate
finance, whether it be for determining
the valuation of a potential investment
or projecting cash flows to support
capital budgeting decisions.
 Simple Interest
The simple interest formula is:

Simple Interest = P x r x t

where:
- P is the principal amount (initial amount of
money),
- r is the interest rate per period, and
- t is the time the money is borrowed or
invested for in years.
Example - Simple Interest

Let’s say you borrow $1,200 at a simple interest rate of 6% per

year. The simple interest formula is:

Simple Interest = Prt

= 1,200 x 0.06 x 2
= $144.00

After 2 years, the simple interest would be $144.

Formula of Compound Interest

A = the future value of the investment/loan, including

interest
P = the principal amount (initial investment or loan
amount)
r = the annual interest rate (in decimal form)
n = the number of times that interest is compounded per
year
t = the number of years the money is invested or
borrowed for
 Example of Compound Interests

Let’s consider a scenario where you invest $500 at an annual

interest rate of 8%, compounded annually for 3 years.

A = $500 x (1+[0.08/3])^(1x3)
A= $612.25

After 3 years, the future value would be approximately

$612.25 with compounding interest.
The Effect of Compounding
Effect of Compounding

The more frequently interest is compounded,

the higher the effective interest rate will be,
which leads to faster growth of your investment
or a larger cost for a loan.
Compounding and Discounting
Compounding and
Discounting are simply
opposite to each other.
Compounding converts the
present value into future
value and discounting
converts the future value into
present value. So, we can
say that if we reverse
compounding it will become
discounting.
Importance of Compounding

• Investment Growth
• Saving for the Future
• Interests on Savings and Investments
• Investment Decision-making
• Loan and Debt Managment
• Present Value of Future Cash Flow
• Inflation Consideration
• Real-estate valuation
• Risk Assessment
NET PRESENT VALUE
The Net Present Value (NPV) is the difference between the present value (PV) of a
future stream of cash inflows and outflows.
- Cash outflow refers to the money leaving a business or an individual's
possession, typically to pay for expenses, investments, or other financial
obligations. Examples include purchasing goods or services, paying bills, or
making loan repayments. It represents a reduction in available cash or liquid
assets.

In practice, NPV is widely used to determine the perceived profitability of a potential

investment or project to help guide critical capital budgeting and allocation decisions.

The net present value (NPV) represents the discounted values of future cash inflows and outflows
related to a specific investment or project.

The present value (PV) of a stream of cash flows refers to the value of the future cash flows as of
the current date.
THANK YOU