MODULE 5

TIME VALUE
OF MONEY
TOPIC OUTLINE
•Importance of Time
•Types of Interest
• Simple Interest
• Compound Interest
•Future Value / Present Value
• Lump Sum
• Annuities
 WHICH DO YOU PREFER?

P20,000
NOW

P20,000 in 5
yrs
allows you to postpose
consumption and earn
INTEREST
SIMPLE INTEREST vs
COMPOUND INTEREST
How it works?
• Simple interest is interest on the principal amount.
• Compound interest is when your principal and any
earned interest both earn interest.
SIMPLE INTEREST
SI = P0(r)(t)
SI: Simple Interest
P0: Deposit today (t=0), Principal
r: Interest Rate per Period
t: Number of Time Periods
 SIMPLE INTEREST
• Assume that you deposit ₱1,000 in an account earning 7%
simple interest for 2 years. What is the accumulated
interest at the end of the 2nd year?

SI= P0(r)(t) = ₱1,000 (.07)(2)

= ₱140
COMPOUND INTEREST
nt
 r 
A  p 1  
 n 

A— Total amount
p — Principal
r — Interest Rate
n — number of compounding periods
t — time in years
Example: P 100 is invested at 10%
interest compounded yearly for 6 years
You begin with P100 invested at 10%
annual interest.
After Simple Interest Compound Interest

1 year 110 110

2 years 120 121
3 years 130 133
4 years 140 146
5 years 150 161
10 years 200 259
20 years 300 672
50 years 600 11,739
 Try these:
1. P750 at 6.5% for 5 years compounded annually
2. P25,000 at 8% for 3 years compounded annually
3. P680 at 5.5% for 1.5 years compounded monthly
4. P1500 at 4.5% for 2 years compounded monthly
 Time Lines
0 1 2 3
i%

CF0 CF1 CF2 CF3

• Show the timing of cash flows.

• Tick marks occur at the end of periods, so Time 0 is today; Time 1
is the end of the first period (year, month, etc.) or the beginning
of the second period.
Time line for a P100 lump sum due
at the end of Year 2.

0 1 2 Year
i%

100
Time line for an ordinary
annuity of P100 for 3 years

0 1 2 3
I%

100 100 100

Time line for uneven CFs

0 1 2 3
I%

-50 100 75 50
 PRESENT VALUE
• is the current value of a future amount of money, or
a series of payments, evaluated at a given interest
rate.

• The VALUE TODAY!!

 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.

• Principal plus Accumulated Interest

 What is the future value (FV) of an initial
P100 after 3 years, if i/yr = 10%?

• Finding the FV of a cash flow or series of cash flows when

compound interest is applied is called compounding.

0 1 2 3
10%

100 FV = ?
Solving for FV:
The arithmetic method
• After 1 year:
• FV1 = PV ( 1 + i ) = P100 (1.10)
= P110.00
• After 2 years:
• FV2 = PV ( 1 + i )2 = P100 (1.10)2
=P121.00
• After 3 years:
• FV3 = PV ( 1 + i )3 = P100 (1.10)3
=P133.10
• After n years (general case):
• FVn = PV ( 1 + i )n
Solving for Future Value

FVn = PV ( 1 + i ) n
 Example

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

0 1 2 3 4 5

10%
P10,000
FV5
 What is the present value (PV) of P100 due
in 3 years, if i/YR = 10%?
• Finding the PV of a cash flow or series of cash flows when
compound interest is applied is called discounting (the reverse of
compounding).
• The PV shows the value of cash flows in terms of today’s
purchasing power.

0 1 2 3
10%

PV = ? 100
PV Formula (derived from FV
formula)

PV = FVn / ( 1 + i ) n
SOLUTION:

• PV = FVn / ( 1 + i )n
• PV = FV3 / ( 1 + i )3
= P100 / ( 1.10 )3
= P75.13

Therefore, you have to deposit P75.13 today to have P100

after 3 years.
ANNUITY
 Ordinary Annuity vs.
Annuity Due

Ordinary Annuity
0 1 2 3
I%

P100=PMT P100 P100

Annuity Due
0 1 2 3
I%

P100=PMT P100 P100

28
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today
Equal Cash Flows
Each 1 Period Apart
Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows
Each 1 Period Apart
 Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 n n+1
i% . . .

R R R
R = Periodic
Cash Flow

FVAn
FVAn = R(1+i) + R(1+i) +
n-1 n-2
... + R(1+i) 1

+ R(1+i)0
 Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period
0 1 2 3 4
7%
P1,000 P1,000 P1,000
P1,070
P1,145
FVA3 = P1,000(1.07)2 + P1,000(1.07)1 +
P1,000(1.07)0 P3,215 = FVA3
= P1,145 + P1,070 + P1,000 = P3,215
What’s the FV of a 3-year ordinary annuity of P100
at 10%?

0 1 2 3
10%

100 100 100

110
121
FV = 331
33
FV Annuity Formula
The future value of an annuity with N periods and an interest rate of I
can be found with the following formula:

(1+i)n-1
= PMT
i
(1+0.10)3-1
= P100 = P331
0.10
34
What’s the PV of this ordinary
annuity?

0 1 2 3
10%

100 100 100

90.91
82.64
75.13
248.69 = PV 35
PV Annuity Formula

The present value of an annuity with N periods and an interest rate of I

can be found with the following formula:

1 1
= PMT −
I I (1+I)N
1 1
= P100 − = P248.69
0.1 0.1(1+0.1)3
36
 Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 n-1 n
. . .
i%
R R R R R

FVADn = R(1+i)n + R(1+i)n-1 + ... + R(1+i)2 FVADn

+ R(1+i)1 = FVAn (1+i)
 Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period
0 1 2 3 4
7%
P1,000 P1,000 P1,000 P1,070
P1,145
P1,225
FVAD3 = P1,000(1.07)3 + P1,000(1.07)2 + P3,440 = FVAD3
P1,000(1.07)1
= P1,225 + P1,145 + P1,070 = P3,440
Find the FV and PV if the
annuity were an annuity due.

0 1 2 3
10%

100 100 100

39
PV and FV of Annuity Due
vs. Ordinary Annuity

PV of annuity due:
= (PV of ordinary annuity) (1+i)
= (P248.69) (1+ 0.10) = P273.56

40
PV and FV of Annuity Due
vs. Ordinary Annuity

FV of annuity due:
= (FV of ordinary annuity) (1+i)
= (P331.00) (1+ 0.10) = P364.10

41
 EXAMPLE:
Scenario Solution
• Want to retire in 35 years
• Deposit (invest) P2,500 year into a
fund (which returns 12.1% annually) Pmt = P2,500
• How much will you have to retire on N= 35
in 35 years? i = 12.1%
• How much cash did you have to FV = ? = P1,104,853
outlay in total to accumulate that
much?
P2500/yr x 35 yrs = P87,500 total
cash outlay
 EXAMPLE
Scenario Solution
• Want to retire with you in 35 years,
but is ski bum & fails to save his 1st Pmt = P2500
15 years
N= 20
• Deposit (invest) $2500 year into an i = 12.1%
S&P 500 Index fund (which returns FV = ? = P182,231
12.1% annually)
• How much will you have to retire on P2500/yr x 20 yrs = P50,000 total cash
in 35 years? outlay
• How much cash did you have to
outlay in total to accumulate that P1,104,853 vs. P182,231
much?
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 44
END OF MODULE 5