TIME VALUE OF MONEY

Interest
• Cost of using money over time
• Excess of resources (usually cash) received or
paid over the amount of resources loaned or
borrowed (principal)

Interest expense
• Cost of the excess resources to the borrower for
the use of money

Interest income
• Benefit of the excess resources to the lender of
the money
Major concepts of time value of money
• Future value
Value of an asset at a specific date. It measures
the nominal future sum of money that a given
sum of money is "worth" at a specified time in
the future assuming a certain interest rate
• Present value
The current worth of a future sum of money

Three factors considered in time value of money

• Principal
• Interest rate
• Time period
Simple interest
• Formula
I=Prt
• Example
ABC Corporation deposits P10,000 in a bank at 10%
interest a year.
Principal 10,000
Interest (10,000 x 10% x 1) 1,000
Future value at end of 1 year 11,000
=====
Simple interest vs. Compound Interest
Simple interest
• Interest paid or earned on the initial principal only
• Formula
I=Prt
• Example
ABC Corporation deposits P10,000 in a bank at 10%
interest a year.
Compound interest
• Interest paid on both principal the amount of interest
accumulated in prior periods
• Compounding – process of determining future value
when compound interest is applied
• Example
ABC Corporation deposits P10,000 in a bank for 2
years paying 10% annual interest.
 Beginning Simple Ending Beginning Compound Ending
Year Amount Interest Amount Amount Interest Amount
1 10,000 1,000 11,000 10,000 1,000 11,000
2 10,000 1,000 12,000 11,000 1,100 12,100
3 10,000 1,000 13,000 12,100 1,210 13,310
4 10,000 1,000 14,000 13,310 1,331 14,641
5 10,000 1,000 15,000 14,641 1,464 16,105
5,000 6,105
Future Value and Present Value
• You deposited P10,000 in savings account.
• The bank pays an interest 3% annually
• How much interest will this account in one year?

There are two common ways to determine the amount of interest that
you will earn
1. Simple interest Method
Formula: I=Prt
I – Interest P – Principal r – Rate t- Time
I = 10,000 x 3% (0.03) x 1
I = 300
The account will earn P300 for one year
Future Value and Present Value
• You deposited P10,000 in savings account.
• The bank pays an interest 3% annually
• How much interest will this account in two years?
2. Compound Interest Method
Using the formula
Formula: FVn = P (1 + i)ⁿ FVn = P (1 + i)ⁿ
where: FVn = 10,000 ( 1 + 0.03)²
FV = future value FVn = 10,609
PV = present value
m = number of times in a year the interest will be compounded
t = term/ number of years
n = total number of conversion periods in a given number of
years (t) is computed as t(m)
r = interest rate
i = interest rate per conversion computed as r/m
Other solution
Year 1: 10,000 x 3% (0.03) = 300
Year 2: (10,000 + 300) x 3% (0.03) = 309

Principal 10,000
Year 1 interest 300
Year 1 interest 309
Future Value 10,609
• Future value of money is the amount of your original funds will
be worth in the future, based on earning an interest rate over a
time period. Using same problem earlier.
FVn = P (1 + i)ⁿ
FVn = 10,000 ( 1 + 0.03)^2
FVn = 10,609
Future Value Example:
Illustration 1
Instead of placing P1,000 in Atlanta Bank that pay 10%
interest annually, the financial manager decides to put
the money in National Bank that pays 10% interest
compounded semiannually`
• Example:
Illustration 2
Find the compound amount on P175,250 for 15 years
and 6 months at 6 3/4% compounded quarterly
Nominal Interest Rate vs. Effective Interest Rate
• Nominal interest rate
Stated rate
• Effective rate
Also called annual percentage rate and the true interest
rate
• Formula
i ᵐ
APR = 1 + - 1
m

• Example
Disney Inc. deposits money in a bank that pays a 10%
nominal interest rate and compounds interest
seminannually
`
Investment Compounding Period Future Value Interest Rate
1,000 Annually 1,100.00 10.00%
1,000 Semiannually 1,102.50 10.25%
1,000 Quarterly 1,103.81 10.38%
1,000 Monthly 1,104.71 10.47%
1,000 Daily 1,105.16 10.52%
Future Value Determination with Stream of
Unequal Payments
• Calculating future value of unequal series of
payments involves finding the future value of
each payment at a specified future date and
getting the total of these future values.
• Example:
A firm plans to deposit P2,000 today and P1,500
one year from today at Mount Carmel Rural
Bank. There are no future deposits or
withdrawals and the bank pay 10% compounded
annually. What is the future value of the account
at the end of four years?
Future Value Determination with Stream of Equal
Payments
• Fixed annuities
A stream of equal payments made at regular time
intervals
• Two types of fixed annuity
➢ Ordinary annuity – one in which payments or
receipts occurs at the end of each period.
Also called regular or deferred annuity
➢ Formula
(1 + i)ⁿ - 1
S = R
i
where:
R = periodic payment
i = periodic rate (r/m)
n = total number of conversion periods for
the whole term t(m)
Future Value Determination with Stream of Equal
Payments
➢ Annuity due – one in which payments or
receipts occur at the beginning of each
period
➢ Formula
(1 + i)ⁿ ¹ - 1
S = R -1
i
where:
R = periodic payment
i = periodic rate (r/m)
n = total number of conversion periods for
the whole term t(m)
Examples:
• Ordinary annuity
Crystal Corp. deposits P1,000 at the end of each
three consecutive years in a bank account
paying 10% interest compounded annually.
Annuity Due
Instead of depositing P1,000 at the end of each
year for 3 consecutive years, the firm makes
deposits at the beginning of each year. Interest
is compounded annually at 10% .
Why do we need to compute for Present Value?

Present value will tell you the initial amount of money required to
achieve your target return at a given interest rate at a certain
number of periods. Therefore, you consider the investment with
a lower present value but with a higher possible returns.
Factors that determine the present value of an investment
include:
• The rate that the market gives.
• The cash flows expected.
• Number of periods these cash flows will continue.
Present Value
• Current value of a future amount of money or
series of payments evaluated at an appropriate
discount rate
• Discount rate
Also called required rate of return. It is the rate
of interest that is used to find present values.
• Formula
FV
PV =
(1 + i)ⁿ
Present Value
• Illustration:
Blueberry Company expects to receive P1,100
one year from now. What is the present value of
this amount if the discount rate is 10%