Financial Management

Time Value of
MONEY
Ericka Joyce Galvan
BSA - 2
 CONTENTS
01 02 03
Future Value Intrayear Future Value of an
Compounding Annuity

04 05 06
Present Value of Present Value of Present Value of Unequal
Compounded Interest an Annuity Cash Flows

07 08 09
Application of Future Amortized Loans Annual Percentage Rate
and Present Values (APR)
INTRODUCTION
In business, finance managers rely on the
concept of time value of money. It simply
describes that the amount of money today is
different in the future. Because of the
discrepancy between the present and the future
values, calculations are carefully made by
finance managers before arriving at a decision.
For instance, an insurance company who
pays P500,000 after 20 years to the policy
holder is receiving a premium payment of
P12,500 a year. For 20 years, the premium
payment made by the policy holder would
have summed up to P250,000 only.
Time value of money is a critical consideration in
financial and investment decisions. It helps
individuals and firms alike to determine how much
money must be placed in the present to accumulate
a future sum of money given an interest rate for a
given period of time. Thus, the placement may
either be in lump-sum or in regular intervals at the
beginning or end of a period.
The compounding of interest determines the future sum of
money if an investment is made at the present.
Compounding of interest is used to know how much money
is to be invested in order to acquire a target amount in the
future (e.g., pension fund for retiring employees and
sinking fund to pay-off long term obligations. On the other
hand, discounting, the opposite of compounding, is used to
evaluate future cash flows associated with capital
budgeting projects and valuation of bonds and stocks.
Future Value
A peso today is worth more than a peso to be received tomorrow.
This is especially true because of the interest it could earn from
placing money in an investment activity. Compounding interest
means that the interest not withdrawn also earns interest, or simply,
interest earns interest. Knowing how much interest will be earned
on the money placed at the present helps individuals decide whether
or not to look for other investment opportunities.
For better understanding of the concepts of compounding, the following terms are
defined:

FV = future value (present + interest) the amount of money at year end n

PV = principal value
r = rate
i = annual interest rate
n = number of periods

FV = PV (1 + i) n
Example 1:

Mario Orio placed P1,000 in a savings account earning 7% interest compounded annually.
How much money will accumulate at the end of 5 years?

FV = PV (1 + i) n
= P1,000 (1 + 7%) 5
= P1,000 (1.07) 5
= P1,000 (1.403)
= P1,403
Example 2:

Lackie Tyan invested a large sum of money in the stock of ZZZ Corporation. The company paid P3
dividend per share. The dividend is expected to increase by 15% per year for the next 3 years. She
wishes to project the dividends for years 1 to 3.

At year 1, At year 2, At year 3,

FV = PV (1 + i) n FV = PV (1 + i) n FV = PV (1 + i) n
= P3 (1 + 15%) 1 = P3 (1 + 15%) 2 = P3 (1 + 15%) 3
= P3 (1.15) 1 = P3 (1.15) 2 = P3 (1.15) 3
= P3 (1.15) = P3 (1.322) = P3 (1.521)
= P3.45 = P3.97 = P4.56
 Intrayear
Compounding
More often, interests are compounded more than once a
year. Bank and other financial institutions accepting
placements compound interest quarterly, daily, and even
continuously. If interest is compounded many times a
year, the general formula for solving for the future value
becomes

FV = PV (1 + i/m)
txm
The number of conversion periods for one year is
denoted by m, while the total number of conversion
periods for the whole investment term is denoted by n.
Conversion periods are usually expressed by any
convenient length of time and are usually taken as an
exact division of the year, such as monthly, quarterly,
semi-annually and annually.
When the conversion periods are:
Future Value
of an Annuity
An annuity is defined as a series of equal payments (or receipts)
made at fixed intervals for a specified number of periods. If the
payment occurs at the end of the period, then it is called an ordinary
annuity. Examples of these are mortgages on housing, car loans, and
bank loans. If the payment occurs at the beginning of each period,
the annuity is called an annuity due. Life insurance premiums, car
insurance, and rental payments are some of the typical examples of
an annuity due. Between the two types of annuities, the ordinary
annuity is more common in practice.
Example:

Aiza Plaza would like to determine the sum of money he

will have in his savings account at the end of 5 years by
depositing 1,000 at the end of each year for the next 5 years.
The annual interest rate is 8%.
Example:

Aiza Plaza would like to determine the sum of money he

will have in his savings account at the end of 5 years by
depositing 1,000 at the beginning of each year for the next 5
years. The annual interest rate is 8%.
 Present Value at
Compounded Interest
The present value of a future sum is the amount that must
be invested today at compound interest to reach a desired
sum in the future. The process of calculating present
values, or discounting, is usually the opposite of finding
the compounded future value. In connection with present
value calculations, the interest rate is called the discount
rate.
Present Value
of an Annuity
 Present Value
of
Unequal Cash Flows
Time value of money problems may evolve
around a series of payments or cash receipts.
However, not every situation involves a
single amount of annuity. A problem may call
for an unequal cash flow each period for a
certain number of years. The present value of
an unequal cash flow is the sum of the present
values of each unequal cash flow.
Applications of
Future and
Present Values
Future and present values have numerous applications in financial and
investment decisions. They are useful in decision-making ranging from
personal decisions (e.g., how much deposit must be made to acquire a
certain amount of money or amortization of a loan and sinking fund) to more
complex corporate financial decisions (e.g., capital budgeting, bond and
stock valuation, and right financing mix.)

An individual might wish to find the annual deposit (or payment) that is
necessary to accumulate a future sum. To find this future amount, the
formula for finding the future value of annuity can be used.
Amortized Loans
 Annual
Percentage Rate
(APR)
Different types of financial instruments use different compounding
periods. For instance, bonds normally pay interest semiannually,
banks pay interest on deposits on a quarterly basis, and firms
offering credit cards pay interest on a monthly basis. If an investor
would like to make a comparison on financial instruments with
different compounding periods, a mathematical tool should be used
to make the comparison possible. For this purpose, the effective
annual rate should be used, which is also known as the annual
percentage rate (APR).
END OF THE
REPORT