TIME VALUE OF MONEY

Learning Objectives
You will be able to:
• Understand the concept of time value of money;
• Compute the time value of money in various
situations;
• Solve problems using the time value of money
• Explain the importance of the time value of
money in the decision-making process, and
• Enumerate the other areas in financial
management where the time value of money is
applied
In summary:
Future value
Present value
Rates of return
Amortization
 Time lines show timing of cash flows (CF).

0 1 2 3

i%
CF0 CF1 CF2 CF3

Tick marks at ends of periods, so Time 0 is today; Time 1 is the end of Period
1; or the beginning of Period 2.
Time line for a ₱100 lump sum due
at the end of Year 2.

0 1 2 Year

i%

100
Time line for an ordinary annuity of
₱100 for 3 years.

0 1 2 3

i%

100 100 100

Time line for uneven CFs -₱50 at t =
0 and ₱100, ₱75, and ₱50 at the end
of Years 1 through 3.

0 1 2 3

i%

-50 100 75 50
What’s the FV of an initial ₱100
after 3 years if i = 10%?

0 1 2 3

10%
100 FV = ?

Finding FVs is COMPOUNDING.

After 1 year:

FV1 = PV + INT1 = PV + PV(i)

= PV(1 + i)
= ₱100(1.10)
= ₱110.00.

After 2 years:

FV2 = PV(1 + i)2

= ₱100(1.10)2
= ₱121.00.
After 3 years:

FV3 = PV(1 + i)3

= ₱100(1.10)3
= ₱133.10.

In general,

FVn = PV(1 + i)n.

 Four Ways to Find FVs

• Solve the equation with a regular calculator.

• Use tables.
• Use a financial calculator.
• Use a spreadsheet.
 Financial Calculator Solution

Financial calculators solve this equation:

FVn = PV(1 + i)n.

There are 4 variables. If 3 are known, the

calculator will solve for the 4th.
Here’s the setup to find FV:

INPUTS 3 10 -100 0
N I/YR PV PMT FV
OUTPUT 133.10

Clearing automatically sets everything to 0, but

for safety enter PMT = 0.
Set: P/YR = 1, END
 What’s the PV of ₱100 due in 3 years
if i = 10%?

Finding PVs is discounting, and it’s the reverse

of compounding.

0 1 2 3

10%

PV = ? 100
Solve FVn = PV(1 + i )n for PV:

( )
n
FVn 1
PV = = FVn
(1 + i)n 1+i

( ) = ₱100(PVIF
3
1
PV = ₱100 1.10 i,n)

= ₱100(0.7513) = ₱75.13.
 Financial Calculator Solution

INPUTS 3 10 0 100
N I/YR PV PMT FV
OUTPUT -75.13

Either PV or FV must be negative. Here

PV = -75.13. Put in ₱75.13 today, take
out ₱100 after 3 years.
If sales grow at 20% per year, how
long before sales double?

Solve for n:

FVn = ₱1(1 + i)n;

n
₱2 = ₱1(1.20)
Use calculator to solve, see next slide.
INPUTS 20 -1 0 2
N I/YR PV PMT FV
OUTPUT 3.8

Graphical Illustration:

FV
2

3.8
1

0 Year
1 2 3 4
What’s the difference between an ordinary annuity and
an annuity due?

Ordinary Annuity
0 1 2 3
i%

PMT PMT PMT

Annuity Due
0 1 2 3
i%

PMT PMT PMT

What’s the FV of a 3-year ordinary
annuity of ₱100 at 10%?

0 1 2 3

10%
100 100 100

110
121
FV = 331
 Financial Calculator Solution

INPUTS 3 10 0 -100
N I/YR PV PMT FV
OUTPUT 331.00

Have payments but no lump sum PV, so enter

0 for present value.
What’s the PV of this ordinary annuity?

0 1 2 3

10%

100 100 100

90.91

82.64

75.13

248.68 = PV
INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -248.69

Have payments but no lump sum FV, so

enter 0 for future value.
Find the FV and PV if the
annuity were an annuity due.

0 1 2 3

10%

100 100 100

Switch from “End” to “Begin.”
Then enter variables to find
PVA3 = ₱273.55.

INPUTS 3 10 100 0
N I/YR PV PMT FV
OUTPUT -273.55

Then enter PV = 0 and press FV to find

FV = ₱364.10.
What is the PV of this uneven cash
flow stream?
0 1 2 3 4
10%
100 300 300 -50

90.91

247.93

225.39

-34.15

530.08 = PV
• Input in “CFLO” register:
CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300
CF4 = -50
• Enter I = 10, then press NPV button to get NPV
= ₱530.09. (Here NPV = PV.)
What interest rate would cause
₱100 to grow to ₱125.97 in 3 years?

₱100 (1 + i )3 = ₱125.97.

INPUTS 3 -100 0 125.97

N I/YR PV PMT FV
OUTPUT 8%
The Power of Compound Interest

A 20-year old student wants to start saving

for retirement. She plans to save ₱3 a day.
Every day, she puts ₱3 in her drawer. At
the end of the year, she invests the
accumulated savings (₱1,095) in an online
stock account. The stock account has an
expected annual return of 12%.
How much money by the age of 65?

INPUTS 45 12 0 -1095
N I/YR PV PMT FV
OUTPUT 1,487,261.89

If she begins saving today, and sticks to

her plan, she will have ₱1,487,261.89 by
the age of 65.
How much would a 45-year old
investor accumulate by this method?

INPUTS 25 12 0 -1095
N I/YR PV PMT FV
OUTPUT 146,000.59

Waiting until 45, the investor will only have ₱146,000.59, which is over
₱1.3 million less than if saving began at 20. So it pays to get started
early.
How much would the 45-year old
investor need to save to accumulate
as much as the 20-year old?
INPUTS 25 12 0 1487261.89
N I/YR PV PMT FV
OUTPUT -11,154.42

The 45-year old investor would have to save

₱11,154.42 every year, or ₱30.56 per day to have
as much as the investor beginning at the age of
20.
Will the FV of a lump sum be larger or
smaller if we compound more often,
holding the stated i% constant? Why?

LARGER! If compounding is more

frequent than once a year--for example,
semiannually, quarterly,
or daily--interest is earned on interest
more often.
 0 1 2 3
10%

100 133.10
Annually: FV3 = ₱100(1.10)3 = ₱133.10.

0 1 2 3
0 1 2 3 4 5 6
5%

100 134.01
Semiannually: FV6 = ₱100(1.05)6 = ₱134.01.
We will deal with 3 different
rates:

iNom = nominal, or stated, or

quoted, rate per year.
iPer = periodic rate.

EAR= EFF% =
effective annual
.
rate
• iNom is stated in contracts. Periods per year
(m) must also be given.
• Examples:
 8%; Quarterly
 8%, Daily interest (365 days)
• Periodic rate = iPer = iNom/m, where m is
number of compounding periods per year. m
= 4 for quarterly, 12 for monthly, and 360 or
365 for daily compounding.
• Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 =
0.021918%.
• Effective Annual Rate (EAR = EFF%):
The annual rate that causes PV to grow to the
same FV as under multi-period compounding.
Example: EFF% for 10%, semiannual:
FV = (1 + iNom/m)m
= (1.05)2 = 1.1025.
EFF% = 10.25% because
(1.1025)1 = 1.1025.
Any PV would grow to same FV at 10.25%
annually or 10% semiannually.
• An investment with monthly payments is
different from one with quarterly payments.
Must put on EFF% basis to compare rates of
return. Use EFF% only for comparisons.
• Banks say “interest paid daily.” Same as
compounded daily.
How do we find EFF% for a nominal rate
of 10%, compounded
semiannually?

( ) –1
m
EFF = 1 + iNom
m

=(1 + )2
0.10 – 1.0
2
= (1.05)2 – 1.0
= 0.1025 = 10.25%.
Or use a financial calculator.
EAR = EFF% of 10%

EARAnnual = 10%.

EARQ = (1 + 0.10/4)4 – 1 = 10.38%.

EARM = (1 + 0.10/12)12 – 1 = 10.47%.

EARD(365) = (1 + 0.10/365)365 – 1 = 10.52%.

Can the effective rate ever be equal
to the nominal rate?

• Yes, but only if annual compounding is used,

i.e., if m = 1.
• If m > 1, EFF% will always be greater than the
nominal rate.
When is each rate used?

iNom: Written into contracts, quoted by

banks and brokers. Not used in
calculations or shown on time lines.
iPer: Used in calculations, shown on time
lines.

If iNom has annual compounding,

then iPer = iNom/1 = iNom.
EAR = EFF%: Used to compare returns on
investments with different
payments per year.

(Used for calculations if and only if dealing

with annuities where payments don’t match
interest compounding periods.)
FV of ₱100 after 3 years under 10%
semiannual compounding? Quarterly?

1 iNom  mn
FV = PV  + 
n  
m

 0.10  2x3
FV = ₱100  1 + 
3S  2 

= ₱100(1.05)6 = ₱134.01.
FV3Q = ₱100(1.025)12 = ₱134.49.
 What’s the value at the end of Year 3
of the following CF stream if the quoted
interest rate is 10%, compounded
semiannually?

0 1 2 3 4 5 6
6-mos.
5% periods

100 100 100

• Payments occur annually, but
compounding occurs each 6 months.
• So we can’t use normal annuity valuation
techniques.
1st Method: Compound Each CF
0 1 2 3 4 5 6

5%
100 100 100.00

110.25
121.55
331.80

FVA3 = ₱100(1.05)4 + ₱100(1.05)2 + ₱100

= ₱331.80.
 2nd Method: Treat as an Annuity

Could you find FV with a

financial calculator?

Yes, by following these steps:

a. Find the EAR for the quoted rate:

2
EAR = (1 + 0.10 ) – 1 = 10.25%.
2
Or, to find EAR with a calculator:

NOM% = 10.
P/YR = 2.
EFF% = 10.25.
b. The cash flow stream is an annual
annuity. Find kNom (annual) whose
EFF% = 10.25%. In calculator,

EFF% = 10.25
P/YR = 1
NOM% = 10.25
c.

INPUTS 3 10.25 0 -100

N I/YR PV PMT FV
OUTPUT 331.80
What’s the PV of this stream?
0 1 2 3

5%
100 100 100

90.70
82.27
74.62
247.59
Amortization

Construct an amortization schedule for a

₱1,000, 10% annual rate loan with 3 equal
payments.
 Step 1: Find the required annual
payments.
0 1 2 3

10%
-1,000 PMT PMT PMT

INPUTS 3 10 -1000 0
N I/YR PV PMT FV
OUTPUT 402.11
Step 2: Find the interest paid in
Year 1.
INTt = Beg balt (i)
INT1 = ₱1,000(0.10) = ₱100.

Step 3: Find repayment of principal in

Year 1.
Repmt = PMT – INT
= ₱402.11 – ₱100
= ₱302.11.
Step 4: Find ending balance after
Year 1.

End bal = Beg bal – Repmt

= ₱1,000 – ₱302.11 = ₱697.89.

Repeat steps 2-4 for Years 2 and 3

to complete the amortization table.
 BEG PRIN END
YR BAL PMT INT PMT BAL

1 ₱1,000 ₱402 ₱100 ₱302 ₱698

2 698 402 70 332 366
3 366 402 37 366 0
TOT 1,206.34 206.34 1,000

Interest declines. Tax implications.

 ₱
402.11
Interest

302.11

Principal Payments

0 1 2 3
Level payments. Interest declines because
outstanding balance declines. Lender earns
10% on loan outstanding, which is falling.
• Amortization tables are widely used--for home
mortgages, auto loans, business loans,
retirement plans, etc. They are very
important!

• Financial calculators (and spreadsheets) are

great for setting up amortization tables.