Personal Finance and
Investment
Chapter 4
TIME VALUE OF MONEY
Which is better: money today
or money tomorrow?
✓the value of money is
different at different points
of time.
There are various reasons why
money loses value over time.
Most obvious reason is inflation –
this reduces buying power of
money.
Simple interest
It is the interest on the amount invested
or borrowed at a given rate and for a
given time. It is usually associated with
loans or investments which are short term
in nature.
Formula: I=Prt
I = simple interest
P= principal amount borrowed or lent
r= interest rate per period
t= time factor
When you deposit money in a
bank, the bank usually pays you
for the use of your money. When
you take out a loan from a bank,
you have to pay the bank for the
use of their money. In both
cases, the money paid is called
the interest.
The Principal (P) is the amount
of money deposited or borrowed.
The Interest Rate (r) is a percent
of the principal earned or paid.
The Time (t) is the length of
time the money is deposited or
borrowed.
Example; How much is the interest
expense of a 3 months loan payable
worth P20,000 with a stated interest rate
of 10% per annum?
How much is its maturity value?
P = 20,000
R= 10% per annum
T= 3 months
1. I = P x r x t
2. Maturity value= P+I
A1 = 20,000 x.10 x 3/12 =
500 is the interest
A2= 20,000 + 500= P20, 500
is the maturity value
Compute for the interest
and maturity value of
P80,000 borrowed from a
bank with an interest of
12% per annum after 6
months.
I=P x r x t
I=80,000 x.12=9,600
9,600 x 6/12
I= 4,800
MV=84, 800
Raymond bought a motor bike
for 40, 000. He took a 20,000
loan from a bank at an interest
rate of 13% per year for a 3-
year period. What is the total
amount (interest and loan)
that he would have to pay the
bank at the end of 3 years?
Answer:
Simple Interest = 20,000 × 13% × 3 =
7,800
At the end of 3 years, he would have
to pay
20,000 + 7,800 = 27,800
With single period investments,
the concept of time value is
relatively straightforward. The
future value is simply the present
value applied to the interest rate
compounded one time.
To get the future value of a single
payment use this formula:
FV=PV x (1+r)t
FV=Future Value
PV=present Value
r=Rate of period
t= number of period
Q 1: AMV co. invested its excess
cash worth 20,000 in a savings
account earning interest at 5%
every year. What is its future
value four years (4) from now?
A: 20,000 X (1+.05)^4 = 23, 152.50
1.05x1.05x1.05x1.05=1.21550625
✓20,000x=1.21550625= 24, 310.13
Q2: Suppose that a sum of
P10, 000 is invested for four years
at an annual rate of 3%. What is
the future value of this sum?
Answer:
FV=PV x (1+r)t
= 10,000 x (1+.03)4
=11, 255.09
Exercise 1: An amount of
30,000 was invested on Jan 1,
2015 at annual interest rate of
8%. Calculate the value of the
investment on Jan 1, 2018.
FV = PV x (1+r)t
=30,000 x (1+.08)3
= 37,791.36
Exercise 2:
Let us assume that Aunt Bee, a big-
time saver, has decided to open a
savings account with a 7% interest
rate annually. She wants to know
how much her account will be worth
in 7 years after she makes this one-
time deposit of 100,000.
PV= 100,000
r= 7%
t=7
FV = 100,000 x (1+.07)7
FV = 100,000 x (1.605781476)
FV= 160,578.15
Present Value of a single
payment
The present value is defined as the
principal which you would have to
invest now at a given interest rate, so
that it will amount to some
predetermined future some of money.
PV = FV / (1+r)t
FV = Future Value r=rate per period
PV=present value t=number of periods
AMV co intends to buy a small lot
worth P24, 310.13. According to the
owner of the land, they would only
sell the lot to prospective buyers four
years (4) from today.
How much does AMV co. needs to
place in a bank today, in order to
have enough cash to buy the said
property? Assume that the bank can
give 5% interest?
Stated differently, what is the
present value of P24, 310.13 at
5% interest.
PV= FV/(1+r)t
PV = P24, 310.13 / (1+.05)^4
= 24, 310.13 / 1.211550625
= 20,000.00
Use the formula to calculate
Present Value of 9,000 in 3
years with a 10%
interest:
PV = FV / (1+r)t
PV = 9000 / (1 + 0.10)3
= 9000 / 1.103
= 9000/1.331
= 6,761.83
Example: You are promised
80,000 in 4 years time. What
is its Present Value at an
interest rate of 6% ?
PV = 80,000 / (1+0.06)4
= 80,000 / 1.2624……
= 63, 367.49
CONCEPT OF COMPOUNDING
Albert Einstein called
compounding interest “the
greatest mathematical
discovery of all time “.
Unlike trigonometry and
calculus, compounding can be
applied to everyday life.
The Concept Of Compounding
Compound Interest
Compound interest happens when interest is added to
the principal, and the interest itself also earns interest.
This addition of the interest to the principal is what is
known as compounding. This is the wonder of
compounding; it makes your money earn bigger and
faster than simple interest normally would.
In finance compounding is the process of generating
earnings on an asset’s reinvested earnings. It requires
only two things to work: the re-investment of earnings
and time. When more time is given to an investment,
the more it is able to accelerate the income potential
of the original investment. Over time, compound
interest allows for exponential growth.
Interest can be classified as either simple or
compounded.
If interest is “simple” it means that only the original
principal would earn or incur interest.
If interest is “compounded”, it means that the
interest earned in prior periods would also earn in
subsequent periods.
Interest could either be compounded annually,
semi annually, quarterly or monthly.
Let us assume this information:
JC would like to invest p70,000 in a bank for 1
year. It has an annual interest rate of 24%. JC
would have the option to choose between 4
compounding methods.
a. Compounded annually
b. Compounded semi annually
c. Compounded quarterly
d. Compounded monthly
If the bank deposit would be
compounded annually, there
would only be one period
and rate per period is 24%
If the bank deposit would be
compounded semi annually,
there would be 2 periods and
the rate per period is 12%.
If the bank deposit would be
compounded quarterly, there
would be 4 periods and the rate
period is 6%. If the bank deposit
would be compounded monthly,
there would be 12 periods and
the rate per period is 2%.
Which would be the best option form him if
he is willing to leave his money in this bank
for 1 year?
a. 70,000x24% = 16, 800
b. 70,000 x 12% = 8,400 + 70,000 = 78,400
78, 400 x12% = 9,408+78,400 =87,808
c. 70,000x6% =4,200+70,000 =74,200
74, 200 x6% =4452+74,200 =78,652
78,652x6% =4,719.12+78652 =83, 371.12
83,371.12X6%=5,002.27+83,371.27=88,373.54
If you invest 100,000 today at 6% interest rate,
you will have 106,000 (100,000 x 1.06) in a year’s
time.
Now let’s say that you don’t withdraw the 6000
gained from interest and reinvest it for another
year. If you continue to earn the same rate of 6%,
your investment will grow to 112,360 (106,000 x
1.06) by the end of the second year. Because
you reinvested the 6000 you earned from the
principal, it now works together with the initial
investment, and earning you 6,360 on the
second year.
While 360 may not be a large sum, don’t forget
that you didn’t have to do anything to earn this
amount. In addition to this, the 360 will also have
the capacity to earn interest. If you continue to
reinvest the earnings from interest, your investment
will now be worth 119, 101.60 (112, 360 x 1.106)
On the third year you earned 6,741.16, which is
741.16 more than the first year. This increase in the
amount made each year is compounding in
action: interest earning interest on interest and so
on. It will carry on as long as you keep reinvesting
and earning interest.
