1 Time Value of Money

August 16, 2014

2 The Concept of Time Value of Money and Interest
3 Introduction
4 The Concept of Interest
Time Value of Money (TVM) is described as the idea that money available at the present time is worth more than the same
amount in the future due to its potential earning capacity. This core principle of nance holds that, provided money can earn
interest, any amount of money is worth more the sooner it is received.
Principal is dened as
The money borrowed or land
Interest is dened as
The cost of using money over time or as economist refers to the time value of money
Interest Expense is cost of the excess resources to the borrower for the use of the money.
Interest Revenue benet of the excess resources to the lender of the money.
5 Simple Interest
Simple interest is determined by multiplying the interest rate by the principal by the number of periods.
Example 1: ABC Corporation deposits !10,000 in a bank at 10 percent interest a year. Using simple interest, how much is
the interest and the future value of the deposit after 1 year?
Answer:
Principal (beginning balance)!10,000.00
Interest for 1 year at10 percent
(10% xP10,000) 1,000.00
Future value at the end of year 1 !11,000.00
6 Simple Interest
Example 2: ABC Corporation deposits !10,000 in a bank at 7 percent interest a year. Using simple interest, how much is the
total interest and the future value of the deposit after 2 years?
Answer:
Principal (beginning balance)!10,000.00
Interest for 2 years at 7 percent
(7% x 2 years x P10,000) 1,400.00
Future value at the end of year 1 !11,400.00
7 Compound Interest
7 Compound Interest
Compound interest is the interest paid on both the principal ,and the amount of interest accumulated in prior periods. The
process of determining future value when compound interest is applied is called compounding.
Formula
Annual Compounding : FVn = PV (1 + i) n
Intraperiod Compounding :
8 Compound Interest
Example 3: ABC Corporation deposits !10,000 in a bank at 10 percent interest a year. How much is the total interest and the
future value of the deposit after 2 years if interest is compounded annually?
Answer:
Principal (beginning balance)!10,000.00
Interest for year 1 at 10 percent
(10% x P10,000) 1,000.00
Future value at the end of year 1 !11,000.00
Interest for year 2 at 10 percent
(10% x P11,000, Principal plus interest) 1,100.00
Future value at the end of year 2 !12,100.00
9 Compound Interest
Answer: (Formula Approach)
Substitute:
FVn = PV (1 + i) n
FV2 = !10,000 (1 + 0.10) 2
FV2 = !10,000 (1.2100)
FV2 = !12,100
10 Compound Interest
Example 4: Using the same data in Example 3 only that interest is compounded semi-annually. Calculate the Future value
and total interest for Year 2.
Given:
Principal = !10,000.00
Annual Interest = 10 percent
Principal = !10,000.00
Annual Interest = 10 percent
Compounding = Semi-annual
Years Calculated = 2 years
11 Compound Interest
Answer:
Principal (beginning balance)!10,000.00
Interest for 1st half of year 1 at 10 percent
(5% x P10,000) 500.00
Future value at the 1st half of year 1 !10,500.00
Interest for 1st half of year 1 at 10 percent
(10% x P10,500, Principal plus interest) 525.00
Future value at the end of year 1 !11,025.00
Interest for 1st half of year 1 at 10 percent
(5% x P11,025) 551.25
Future value at the 1st half of year 2 !11,576.25
Interest for 1st half of year 2 at 10 percent
(5% x P11,576.2, Principal plus interest) 578.81
Future value at the end of year 2 !12,155.06
12 Compound Interest
Answer: (Formula Approach)
Substitute:
FV2 = !10,000(1.05)4
FV2 = !10,000(1.215506)4
FV2 = !12,155.06
13 Simple Interest vs Compound Interest
Simple interest is determined by multiplying the interest rate by the principal by the number of periods.
13 Simple Interest vs Compound Interest
Simple interest is determined by multiplying the interest rate by the principal by the number of periods.
Example 1: ABC Corporation deposits !10,000 in a bank at 10 percent interest a year. Using simple interest, how much is
the interest and the future value of the deposit after 1 year?
Answer:
Principal (beginning balance)!10,000.00
Interest for 1 year at10 percent
(10% xP10,000) 1,000.00
Future value at the end of year 1 !11,000.00
14 Future Value
(By Using A Table)
Formula:
FVn = PV (FVIFi,n)
15 Future Value
(By Using A Table)
Answer:
Principal (beginning balance)!10,000.00
Interest for 1st half of year 1 at 10 percent
(5% x P10,000) 500.00
Future value at the 1st half of year 1 !10,500.00
Interest for 1st half of year 1 at 10 percent
(10% x P10,500, Principal plus interest) 525.00
Future value at the end of year 1 !11,025.00
Interest for 1st half of year 1 at 10 percent
(5% x P11,025) 551.25
Future value at the 1st half of year 2 !11,576.25
Interest for 1st half of year 2 at 10 percent
(10% x P11,576.2, Principal plus interest) 578.81
Future value at the end of year 2 !12,155.06
16 Future Value
Annual Compounding
16 Future Value
Annual Compounding
Example 5: Calculate Example 3 using FVIF table. Calculate the Future value 2 Years. (Note: answer in Example 3 is FV =
!12,100)
Given:
Principal = !10,000.00
Annual Interest = 10 percent
Compounding = Annual
Years Calculated = 2 years
17 Future Value
(By Using A Table)
Subtitute:
FVn = PV (FVIFi,n)
FV2 = !10,000 (1.2100)
FV2 = !12,100
18 Compound Interest
Example 7: Calculate using FVIF table the Future value 2 Years. (Note: answer in Example 3 is FV = !12,155)
Given:
Principal = !10,000.00
Annual Interest = 10 percent
Compounding = Semi-annual
Years Calculated = 2 years
19 Future Value
(By Using A Table)
Subtitute:
FV4 = PV (FVIFi,n)
FV4 = !10,000 (1.2155)
FV4 = !12,155
20 Future Value
(By Using A Table)
20 Future Value
(By Using A Table)
Example 8: Calculate using the below data and the FVIF table. Calculate the future value in 2 Years.
Given:
Principal = !10,000.00
Annual Interest = 12 percent
Compounding = Quarterly
Years Calculated = 2 years
21 Future Value
(By Using A Table)
Subtitute:
FV8 = PV (FVIFi,n)
FV8 = !10,000 (1.2668)
FV8 = !12,668
22 Nominal and E!ective Rate
Nominal interest rate is the stated rate or face value rate.
E"ective interest rate is the true interest rate which defers from nominal rate depending on the frequency of compounding.
Also called the annual percentage rate (APR).
Formula
where: i = interest and m = number of compounding
Note: If compounding is annual then APR = Nominal Rate
23 Nominal and E!ective Rate
Example 8: Using the information in Example 8 calculate the E"ective Rate being used.
Given:
Principal = !10,000.00
Annual Interest = 12 percent
Compounding = Quarterly
Years Calculated = 2 years
24 Nominal and E!ective Rate
Years Calculated = 2 years
24 Nominal and E!ective Rate
Answer:
25 Future Values and
Present Values
26 DETERMINATION OF THE FUTURE VALUE OF A STREAM OF PAYMENTS
Future Value Determination Involving Stream of Unequal Payments
27 Future Value Determination Involving Stream of Unequal Payments
Example 9 : ABC Corporation deposits today !10,000; !15,000 in the beginning of Year 2; !15,000 in the beginning of Year
3 and !20,000 in the end of Year 3 in a bank at 10 percent interest a year. How much is the value of ABCs deposit after
three years?
Given
Beg. Year 1 = !10,000 ; Beg. Year 2 = !15,000
Beg. Year 3 = !15,000 ; End. Year 3 = !20,000
Nominal Rate = 10%
28 Future Value Determination Involving Stream of Unequal Payments
Solution:
Beg. Year 1 = !10,000 x (1+0.10)3-0 = !10,000 x 1.1331 =
!13,331
Beg. Year 2 = !15,000 x (1+0.10)3-1 = !15,000 x 1.210 =
!18,150
Beg. Year 3 = !15,000 x (1+0.10)3-2 = !15,000 x 1.10 =
!16,500
End. Year 3 = !20,000 x (1+0.10)3-3 = !20,000 x 1 = !20,000
Future Value of the Deposits !67,981
29 Future Value Determination Involving Stream of Equal Payments
A stream of equal payments made at regular time intervals is an annuity, sometimes called a xed annuity.
Two Types of Annuity
Ordinary annuity - payments or receipts occur at the end of each period. Also called a regular or deferred annuity
Annuity due - payments or receipts occur at the beginning of each period
30 Ordinary Annuity (Formula)
Ordinary annuity
30 Ordinary Annuity (Formula)
Ordinary annuity
FVOAn = A (FVIFAi,n)
FVOAn = future value of an ordinary annuity
A = the amount of the xed annuity payment
FVIFAi,n = future value interest factor of an annuity for interest rate (i), and time period (n)
31 Ordinary Annuity
Example 10 : Crystal Corporation deposits !1,000 at the end of each of three consecutive years in a bank account paying
10 percent interest compounded annually.
Given
A = !1,000
i = 10%
n = 3
32 Ordinary Annuity
(Long Method)
Solution:
End Year 1 = !1,000 x (1+0.10)2-0 = !1,000 x 1.210 = !1,210
End Year 2 = !1,000 x (1+0.10)2-1 = !1,000 x 1.100 = !1,100
End Year 3 = !1,000 x (1+0.10)2-2 = !1,000 x 1.000 = !1,000
Future Value of the Deposits !3,310
33 Ordinary Annuity
(Formula Method)
Solution:
FVOAn = A (FVIFAi,n)
FVOAn = !1,000 (FVIFA0.10,3)
FVOAn = !1,000 (3.3100)
FVOAn = !3,310
34 Annuity Due (Formula)
Annuity Due
FVADn = A (FVIFAi,n) (1 + i)
FVADn = future value of an annuity due
A = the amount of the xed annuity payment
FVADn = future value of an annuity due
A = the amount of the xed annuity payment
FVIFAi,n = future value interest factor of an annuity for interest rate (i), and time period (n)
35 Annuity Due
Example 11 : Instead of depositing !1,000 at the end of each year for three consecutive years, the rm makes deposits at
the beginning of each year. Interest is compounded annually at 10 percent. How much will the rm have in account after
three years?
Given
A = !1,000
i = 10%
n = 3
36 Annuity Due
(Long Method)
Solution:
Beg. Year 1 = !1,000 x (1+0.10)3-0 = !1,000 x 1.331= !1,331
Beg. Year 2 = !1,000 x (1+0.10)3-1 = !1,000 x 1.210= !1,210
Beg. Year 3 = !1,000 x (1+0.10)3-2 = !1,000 x 1.100= !1,100
Future Value of the Deposits !3,641
37 Annuity Due
(Formula Method)
Solution:
FVADn = A (FVIFAi,n)(1 + i)
FVADn = !1,000 (FVIFA0.10,3)(1 + 0.10)
FVADn = !1,000 (3.3100)(1.10)
FVADn = !3,641
38 Annuity Due
(Shortcut Method)
Solution:
FVADn = A (FVIFADi,n)
FVADn = !1,000 (FVIFAD0.10,3)
FVADn = !1,000 (3.6410)
FVADn = !3,641
FVADn = !1,000 (3.6410)
FVADn = !3,641
39 Present Value
Present value is the current value of a future amount of money, or series of payments, evaluated at an appropriate discount
rate.
A discount rate, sometimes called the required rate of return or hurdle rate, is the rate of interest that is used to nd present
values
Discounting is the process of determining the present value of a future amount.
40 Discounting
Formula Method
PVIF Table
41 Present Value
Example 12 : JGC Company expects to receive !1,000 ve years from now and wants to know what this money is worth
today. The value today of !1,000 to be received ve years from now discounted at 10 percent is?
Given
FV5 = !1,000
i = 10%
n = 5
42 Present Value
Solution:
PV = FVn (PVIFi,n)
PV = (!1,000) (0.6209)
PV = !620.90
43 Present Value Determination Involving Stream of Unequal Payments
Example 13 : MNM Company, expects to receive payments of !1,000, !1,500, and !2,000 at the end of one, two and three
years, respectively. The present value of this stream of payments discounted at 10 percent is computed as follows.
Given
FV1 = !1,000 ; FV2 = !1,500 ; FV3 = !2,000
i = 10% n = 5
44 Present Value Determination Involving Stream of Unequal Payments
Solution:
44 Present Value Determination Involving Stream of Unequal Payments
Solution:
End Year 1 = !1,000 x [1/(1+0.10)1] = !1,000 x 0.9091 =
! 909.10
End Year 2 = !1,000 x [1/(1+0.10)2] = !1,500 x 0.8264 =
!1,239.60
End Year 3 = !1,000 x [1/(1+0.10)3] = !2,000 x 0.7513 =
!1,502.60
Present Value of Future Deposits !3,651.30
45 Present Value Determination Involving Stream of Equal Payments
Present Value of an Annuity
PVOAn = A(PVIFAi,n)
where:
Present Value Interest Factor of an Annuity
PVIFAi,n = # PVIFi,n
46 Present Value Interest Factor of an Annuity
Example 14 : Find the Present Value Interest Factor of an Annuity for the following:
a.) i = 10% n= 3 years
b.) i = 3% n= 5 years
47 Present Value Determination Involving Stream of Equal Payments
Example 15 : Summer Corporation expects to receive !1,000 at year's end for the next three years. The present value of this
annuity discounted at 10 percent is computed as follows.
Given
FV5 = !1,000
i = 10%
n = 3
48 Present Value Determination Involving Stream of Equal Payments Value
Solution:
PV = A (PVIFi,n)
PV = (!1,000) (2.4868)
PV = !2,486.80
49 PRESENT VALUE OF A PERPETUITY
PV = !2,486.80
49 PRESENT VALUE OF A PERPETUITY
Perpetuity is an annuity with an innite life; that is, the payments continue indenitely.
50 PRESENT VALUE OF A PERPETUITY
Example 16 : Honey Dew Corporation wants to deposit an amount of money in a bank account that will allow it to withdraw
P1,000 indenitely at the end of each year without reducing the amount of the initial deposit. If a bank guarantees to pay the
rm 10 percent interest on its deposits, the amount of money the rm has to deposit is?
Given
A = !1,000
i = 10%
51 PRESENT VALUE OF A PERPETUITY
Solution:
52 Growth Rate
Another application of the time value of money concept is calculating the compound annual growth or interest rate (i), of a
stream of payments or receipts. The equation below shows how to compute this rate when the growth rate is constant.
Formula:
53 Growth Ratw
Example 17 : Sugar Company has steadily increased its dividends per share from !1.00 in 2007 to !1.36 in 2011. The
annual compound growth rate of these dividend payments over the four years is Given
FVn = !1.36
PV = !1.00
54 Growth Rate
Solution:
FVIF = 1.36
Answer: 8%
55 Net Present Value
56 The Concept of Net Present Value in Business
55 Net Present Value
56 The Concept of Net Present Value in Business
The net present value (NPV) or net present worth (NPW) of a time series of cash ows, both incoming and outgoing, is
dened as the sum of the present values (PVs) of the individual cash ows of the same entity.
Formula:
NPV = # PVinow - # PVoutow
Usage:
Capital Budgeting; Feasibility Study; Project Analysis
57 The Concept of Net Present Value in Business
If the Net Present Value of any project analysed is positive. Then the project is considered a protable project.
The greater the Net Present Value the better
58 Net Present Value
Example 18 : ABC Corporation invests today !1,000,000 for an equipment that is forecasted to earn !400,000 in Year 1;
!450,000 in Year 2 and !500,000 in Year 3. It is expected that the equipment will not be able to be used after 3 years. What
is the:
Net present Value if the hurdle rate is 20% and should they continue the purchase.
Net present Value if the bank interest rate is 10% and should they continue the purchase.
59 Net Present Value
Solution: Scenario A
Investment =-1,000,000 x [1/(1+0.15)0] = -!1,000,000 x 1.0 =
(!1,000,000)
Inow Yr1 = !400,000 x [1/(1+0.15)1] = !400,000 x 0.8333=
!333,320
Inow Yr2 = !450,000 x [1/(1+0.15)2] = !450,00 x 0.6944
= !312,480
Inow Yr3 = !500,000 x [1/(1+0.15)3] = !500,000 x 0.5787=
!289,350
Present Value of Future Deposits (!64,850)
Decision is to not purchase the equipment
Decision is to not purchase the equipment
60 Net Presnt Value
Solution: Scenario B
Investment =-1,000,000 x [1/(1+0.20)0] = -!1,000,000 x 1.0 =
(!1,000,000)
Inow Yr1 = !400,000 x [1/(1+0.20)1] = !400,000 x 0.9091=
!363,640
Inow Yr2 = !450,000 x [1/(1+0.20)2] = !450,00 x 0.8264
= !371,880
Inow Yr3 = !500,000 x [1/(1+0.20)3] = !500,000 x 0.7513
= !375,650
Present Value of Future Deposits !111,170
Decision is to purchase the equipment
61