Chapter 1

Time
Time Value
Value of
of
Money
Money

1
 After studying Chapter 1,
you should be able to:
1. Understand what is meant by "the time value of money."
2. Understand the relationship between present and future value.
3. Describe how the interest rate can be used to adjust the value of
cash flows – both forward and backward – to a single point in
time.
4. Calculate both the future and present value of: (a) an amount
invested today; (b) a stream of equal cash flows (an annuity);
and (c) a stream of mixed cash flows.
5. Distinguish between an “ordinary annuity” and an “annuity due.”
6. Build an “amortization schedule” for an installment-style loan.

2
 The
The Time
Time Value
Value of
of Money
Money
 The Interest Rate
 Simple Interest
 Compound Interest
 Amortizing a Loan
 Compounding More Than
Once per Year
3
 The
The Interest
Interest Rate
Rate
Which would you prefer -- P10,000
today or P10,000 in 5 years?
years

Obviously, P10,000 today.

today

You already recognize that there is

TIME VALUE TO MONEY!!
MONEY

4
 Why
Why TIME?
TIME?

Why is TIME such an important

element in your decision?

TIME allows you the opportunity to

postpone consumption and earn
INTEREST.
INTEREST

5
 Types
Types of
of Interest
Interest
 Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
 Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).

6
 Simple
Simple Interest
Interest Formula
Formula

Formula SI = P(i)(n)
SI: Simple Interest
P: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
7
 Simple
Simple Interest
Interest Example
Example
 Assume that you deposit P1,000 in an
account earning 7% simple interest for
2 years. What is the accumulated
interest at the end of the 2nd year?
 SI = P (i)(n)
= P1,000(.07)(2)
= P140
8
 Simple
Simple Interest
Interest (FV)
(FV)
 What is the Future Value (FV)
FV of the
deposit?
FV = P + SI
= P1,000 + P140
= P1,140
 Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
9
 Simple
Simple Interest
Interest (PV)
(PV)
 What is the Present Value (PV)
PV of the
previous problem?
The Present Value is simply the
P1,000 you originally deposited.
That is the value today!
 Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
10
rate.
 Why
Why Compound
Compound Interest?
Interest?

11
 Future
Future Value
Value -- Single
Single Deposit
Deposit

Assume that you deposit P1,000 at

a compound interest rate of 7% for
2 years.
years
0 1 2
7%
P1,000
FV2
12
 Future
Future Value
Value
Single
Single Deposit
Deposit (Formula)
(Formula)
FV1 = P (1+i)1 = P1,000 (1.07)
= P1,070
Compound Interest
You earned P70 interest on your P1,000
deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
13
 Future
Future Value
Value
Single
Single Deposit
Deposit (Formula)
(Formula)
FV1 = P0 (1+i)1 = P1,000 (1.07) =
P1,070
FV2 = FV1 (1+i)1 = P0 (1+i)(1+i) =
P1,000(1.07)(1.07)
P1,000 = P0 (1+i)2 =
P1,000(1.07)
P1,000 2 = P1,144.90

You earned an EXTRA P4.90 in Year 2 with

compound over simple interest.
14
 General
General Future
Future
Value
Value Formula
Formula
FV1 = P(1+i)1
FV2 = P(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n

15
 Story
Story Problem
Problem Example
Example
Julie Miller wants to know how large her deposit
of P10,000 today will become at a compound
annual interest rate of 10% for 5 years.
years

0 1 2 3 4 5
10%
P10,000
FV5
16
 Story
Story Problem
Problem Solution
Solution
 Calculation based on general formula:
FVn = P(1+i)n
FV5 = P10,000 (1+ 0.10)5
= P16,105.10

17
 Double
Double Your
Your Money!!!
Money!!!

Quick! How long does it take to double

P5,000 at a compound rate of 12% per
year (approx.)?

18
 Quick!
Quick! How
How long
long does
does itit take
take to
to double
double P5,000
P5,000
at
at aa compound
compound rate
rate of
of 12%
12% per per year
year (approx.)?
(approx.)?

19
 Present
Present Value
Value
Single
Single Deposit
Deposit (Graphic)
(Graphic)
Assume that you need P1,000 in 2 years.
Let’s examine the process to determine
how much you need to deposit today at a
discount rate of 7% compounded annually.
0 1 2
7%
P1,000
PV0 PV1
20
 Present
Present Value
Value
Single
Single Deposit
Deposit (Formula)
(Formula)
PV = FV2 / (1+i)2 = P1,000 / (1.07)2
= FV2 / (1+i)2 = P873.44

0 1 2
7%
P1,000
PV
21
 General
General Present
Present
Value
Value Formula
Formula

etc.

22
 Story
Story Problem
Problem Example
Example
Julie Miller wants to know how large of a
deposit to make so that the money will grow
to P10,000 in 5 years at a discount rate of
10%.
0 1 2 3 4 5
10%
P10,000
PV
23
 Story
Story Problem
Problem Solution
Solution
 Calculation based on general formula:
PV = FVn / (1+i)n
PV = P10,000 / (1+ 0.10)5
= P6,209.21


24
 Types
Types of
of Annuities
Annuities
 An Annuity represents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
 Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
 Annuity Due:
Due Payments or receipts
occur at the beginning of each period.

25
 Examples of Annuities

 Student Loan Payments

 Car Loan Payments
 Insurance Premiums
 Mortgage Payments
 Retirement Savings
26
 Steps
Steps to
to Solve
Solve Time
Time Value
Value
of
of Money
Money Problems
Problems
1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line
4. Determine if it is a PV or FV problem
5. Determine if solution involves a single
CF, annuity stream(s), or mixed flow
6. Solve the problem

27
 Steps
Steps to
to Amortizing
Amortizing aa Loan
Loan
1. Calculate the payment per period.
2. Determine the interest in Period t.
(Loan Balance at t-1) x (i% / m)
3. Compute principal payment in Period t.
(Payment - Interest from Step 2)
4. Determine ending balance in Period t.
(Balance - principal payment from Step 3)
5. Start again at Step 2 and repeat.
28
 Usefulness of Amortization

1. Determine Interest Expense --

Interest expenses may reduce
taxable income of the firm.
2. Calculate Debt Outstanding --
The quantity of outstanding
debt may be used in financing
the day-to-day activities of the
firm.
29