Time Value of Money
Future Value and
Present Value
Outline
Meaning of Time Value
Concept of Future Value and Compounding (FV)
Concept of Present Value and Discounting (PV)
Frequency of Compounding
Present Value versus Future Value
Determining the Interest rate (r)
Determining the Time Period (n)
Future Value and Present Value of Multiple Cash Flows
Annuities and Perpetuities
Time Value of Money
Basic Problem:
– How to determine value today of cash flows that are expected in the
future?
Time value of money refers to the fact that a dollar in hand today
is worth more than a dollar promised at some time in the future
Which would you rather have -- $1,000 today or $1,000 in 5
years?
Obviously, $1,000 today.
Money received sooner rather than later allows one to use the
funds for investment or consumption purposes. This concept is
referred to as the TIME VALUE OF MONEY!!
TIME allows one the opportunity to postpone consumption and
earn INTEREST.
Definition of Terms
Future Value (FV) – The amount of money which a
cash flow or series of cash flows will grow over a given
period of time when compounded at a given interest
rate.
Present Value (PV) – The value of money today of a
future cash flow or series of cash flows.
Compounding – The arithmetic process of determining
the final value of cash flows when compound interest is
applied.
Future Value and Compounding
Future value refers to the amount of money an investment will grow to over some
length of time at some given interest rate
To determine the future value of a single cash flows, we need:
present value of the cash flow (PV)
interest rate (I), and
time period (n)
FVn = PV0 × (1 + I)n
Future Value Interest Factor at ‘I’ rate of interest for ‘n’ time
periods
Examples on computation of future value of a single cash flow
Future Value Graphic
If you invested Php2,000 today in an account that
pays 6% interest, with interest compounded
annually, how much will be in the account at the
end of two years if there are no withdrawals?
0 1 2
6%
Php2,000
FV
Future Value Formula
FV1 = PV (1+I)n
= Php2,000 (1.06)2
= Php2,247.20
FV = future value, a value at some future point in time
PV = present value, a value today which is usually designated as time 0
I = rate of interest per compounding period
n = number of compounding periods
Future Value Graphic
Juan wants to know how large his Php100,000
deposit will become at an annual compound
interest rate of 8% at the end of 5 years.
0 1 2 3 4 5
8%
Php100,000
FV5
Future Value Solution
Calculation based on general formula:
FVn = PV (1+I)n
FV5 = Php100,000 (1+ 0.08)5
= Php146,933.00 or 146,900.00 (round off)
Future Value Solution
Calculation based on FV Table
FVn = Php100,000 x 1.469
FV5 = Php146,900.00
Future Value with Several Amounts
(Ordinary Annuity)
You deposited Php100 per year at the end of
each year and earn 5% per year. How much
will you have at the end of the third year?
The answer, Php315.25, is the future value of
annuity (FVAn).
Future Value with Several Amounts
(Ordinary Annuity)
You deposited Php100 per year at the end of
each year and earn 5% per year. How much
will you have at the end of the third year?
The answer, Php315.25, is the future value of
annuity (FVAn).
Future Value with Several Amounts
(Ordinary Annuity)
Step-by-Step Approach/Long Method:
FVAn = PMT(1+I)n-1 + PMT(1+I)n-2 + PMT(1+I)n-3
FVA3 = 100(1+.05)3-1 + 100 (1+.05)3-2 + 100(1+.05)3-3
FVA3 = 100(1.05)2 + 100 (1.05)1 + 100(1.05)0
FVA3 = 100(1.1025) + 100(1.05) + 100
FVA3 = 110.25 + 105 + 100
FVA3 = 315.25
Future Value with Several Amounts
(Ordinary Annuity)
Formula Approach/Short Method:
FVAn = PMT x [ (1+I)n-1]
I
FVA3 = 100 x [ (1+.05)3-1]
.05
FVAn = 100 x 1.1576 - 1
.05
FVAn = 100 x 3.1525
FVAn = 315.25
Future Value with Several Amounts
(Annuity Due)
Using the same example: a Php100 investment
per year for 3 years with 5% interest will have a
FV of Php331.01 as opposed to the Php315.25
of an ordinary annuity.
Future Value with Several Amounts
(Annuity Due)
Step-by-Step Approach/Long Method:
FVAn = PMT(1+I)n + PMT(1+I)n-1 + PMT(1+I)n-2
FVA3 = 100(1+.05)3 + 100 (1+05)2 + 100(1+.05)1
FVA3 = 100(1.05)3 + 100 (1.05)2 + 100(1.05)1
FVA3 = 100(1.11576) + 100(1.1025) + 100
FVA3 = 115.76 + 110.25 + 105
FVA3 = 331.01
Future Value with Several Amounts
(Annuity Due)
Formula Approach/Short Method:
FVAdue = FVAordinary(1+I)
FVAdue = 315.25 (1.05)
FVAdue = 331.01
Present Value and Discounting
The current value of future cash flows discounted at the appropriate
discount rate over some length of time period
Discounting is the process of translating a future value or a set of future
cash flows into a present value.
To compute present value of a single cash flow, we need:
Future value of the cash flow (FV)
Interest rate (I) and
Time Period (n)
PV0 = FVn / (1 + I) n
PVIF (I,n)
Present Value (Graphic)
Assume that you need to have exactly Php4,000 saved
10 years from now. How much must you deposit today
in an account that pays 6% interest, compounded
annually, so that you reach your goal of Php4,000?
0 5 10
6%
Php4,000
PV0
Present Value – Single Amount
(Formula)
PV0 = FV / (1+I)10
= Php4,000 / (1.06)10
= Php2,233.58
0 5 10
6%
Php4,000
PV0
Present Value Example
(Single Amount)
Joann needs to know how large of a deposit to make
today so that the money will grow to Php2,500 in 5
years. Assume today’s deposit will grow at a
compound rate of 4% annually.
0 1 2 3 4 5
4%
Php2,500
PV0
Present Value Solution
(Single Amount)
Calculation based on general formula:
PV0 = FVn / (1+I)n
PV0 = Php2,500/(1.04)5
= Php2,054.81
Present Value Solution
(Use PV Factor)
Assume that Bead Corporation would like to
know how much investment is needed to
yield Php100,000 three years from now.
The discount rate is 25%. To determine the
present value, multiply the value of money
today by the PV factor. To determine the PV
Factor use this formula:
PV Factor = present value/future value
Present Value Solution
(Use PV Factor)
Thus, the future value of Php1 must be determined
at 25%.
PV Factor = present value/future value
PV Factor = Php1/Php1.9531 = 0.512
Present Value Solution
(Use PV Factor)
Once the PV Factor is computed, use the formula
to compute for the PV.
PV = PMT x PV Factor
PV = Php100,000 x 0.512
PV = Php51,200.00 (The amount Bead Corporation
will invest to receive Php100,000 after three years.)
PMT refers to the payment
Present Value with Several
Amounts (Ordinary Annuity)
In finding the present value of the ordinary
annuity, you simply reverse the treatment
of the future value of an ordinary annuity.
The present value of an ordinary annuity
is the sum of all the present values of
Php1 in a series of amounts that you will
receive or pay at the end of each year in
the future.
Present Value with Several
Amounts (Ordinary Annuity)
Step-by-step Process
PVAn = PMT/(1+I)1 + PMT/(1+I)2 + PMT/(1+I)3
PVA3 = 100/(1+.05)1 + 100/(1+.05)2 + 100/(1+.05)3
PVA3 = 100/(1.05) + 100/(1.1025) + 100/(1.1576)
PVA3 = 95.24 + 90.70 + 86.38
PVA3 = 272.32
Present Value with Several
Amounts (Ordinary Annuity)
Amount of Investment monthly – Php100
PV of Ordinary Annuity = Series of future values of amounts to be received or paid
x PV of Ordinary Annuity Factor
Php100 x 2.72325 = 272.32
Present Value with Several
Amounts (Annuity Due)
In finding the present value of an annuity due, you simply
reverse the treatment for the future value of an annuity due.
The present value of annuity due is similar to ordinary
annuity. The only difference is that in annuity due, the
period on which amounts are received or paid is at the
beginning of the year. The present value of annuity due
occurs when you would like to determine the present value of
a series of amounts you will receive or pay in the future.
PVAD = PMT x PV Annuity Due Factor
Present Value with Several
Amounts (Annuity Due)
Example:
PVAD = PMT x PV Annuity Due Factor
PVAD = Php100 x 2.85941 = Php285.94
Present Value with Several
Amounts (Annuity Due)
Perpetuities
A series of level/even/equal sized cash flows
that occur at the end of each period for an
infinite time period
Examples of Perpetuities:
Consoles issued by British Government
Preferred Stock
Present Value of a Perpetuity
Perpetuities
Perpetuities are annuities that may go indefinitely. It is
an annuity with an extended life because the payments
go on forever. The step-by-step approach cannot be
applied but the present value of a perpetuity can be
easily computed with this formula:
PV of a perpetuity = PMT/I
Perpetuities
ABC Company acquired a preferred stock from Shine
Corporation that pays a fixed dividend of Php100 each year the
corporation is in business. Assuming that the corporation will
go on indefinitely, the preferred stock can be valued as a
perpetuity. If the discount rate on the preferred stock is 5%,
the present value of the perpetuity, preferred stock is:
PV of a perpetuity = Php100/0.05
= Php2,000
Perpetuities
If the discount rate is 10%, the present value of the perpetuity,
preferred stock is:
PV of a perpetuity = Php100/0.10
= Php1,000
If the discount rate is 15%, the present value of the perpetuity,
preferred stock is:
PV of a perpetuity = Php100/0.15
= Php666.67
Based on the computations, it can be noted that there is an indirect
proportional relationship between interest rate and the PV perpetuity.
Present Value versus Future Value
Present value factors are reciprocals of future value
factors
Interest rates and future value are positively related
Interest rates and present value are negatively related
Time period and future value are positively related
Time period and present value are negatively related
