LONG-TERM FINANCIAL

CONCEPTS:
TIME VALUE OF MONEY
By: Mary Ann B. Mariano
TVM (Time Value of Money)

“ A peso today is worth more than a peso tomorrow.”

• Where to put money
• Real assets
• Financial assets
• Where to get money
• Investors
• Financial institutions

The time value of money must be considered in making the

appropriate investment decision.
• determine their future value at a future date
• compute their present value today
Present Value Vs. Future value

• Future value:
What amount of money in the future is equivalent to ₱15,000 today?
In other words, what is the future value of ₱15,000?
• Present Value:
What amount today is equivalent to ₱17,000 paid out over the next 5
years as outlined above? In other words, what is the present value of
the stream of cash flows coming in the next 5 years?

Time line:
Present Value Vs. Future value

• Future value: Uses compounding

• Present Value: Uses discounting

Cash Flow:
• Single Amount
• Annuity
• Mixed Stream
Cash Flow: Future Value of a Single Amount

Future value is the amount to which an amount of money will grow in a defined period of time at a specified
investment rate. A business may face questions such as:
■ Question 1
If we borrow ₱380,000 today to replace outdated equipment and the terms are 8 percent for 5 years compounded
quarterly, what is the total cost of the purchase?
To determine the total cost of the equipment purchase, the calculation is
FV = PV (1 + r)n
FV = future value of the investment or loan
P= principal
r = interest rate per period of compounding
n = number of compounding periods in the length of the loan

Where:
PV = 380,000
r= 8% / 4 (quarterly) = 2% or .02 = quarterly interest If we invest ₱20,000 per month in an
n = 4 (quarterly) x 5 (years) = 20 = compounding periods employee retirement account at an
annual interest rate of 6 percent
FV = ₱380,000 (1 + 0.02)20
FV = ₱380,000 (1.4859) compounded monthly, what will be
FV = ₱564,642 the value of the fund in 10 years?
Cash Flow: Present Value of a Single Amount

Borrowing money: the lender will charge interest for the time the company uses the money.
A typical procedure is for the lender to discount the loan.
A discount is the amount of money subtracted from a loan at the time of lending equal to the
interest charged by the lender.
PV = FV ÷ (1 + r)n
■ Example 1
If a business borrows ₱10,000 for one year from a bank at an interest (discount) rate of 8
percent, how much is the actual amount of money received?
Where:
FV = 10,000
r =8%
n=1 If a company has ₱30,000 of
accounts receivable that are due in
PV = 10,000 ÷ (1 + .08)1 90 days, another company may offer
PV = 10,000 ÷ (1 + .08)1 to discount them at an annual rate of
PV = 9,260.00 20 percent. What is the present
value?
Annuity

A stream of equal periodic cash flows over a specified time period.

These cash flows can be inflows of returns earned on investments or
outflows of funds invested to earn future returns.

Types of Annuities:
• Ordinary Annuity
• Anuity Due
FUTURE VALUE OF AN ORDINARY ANNUITY

FVn = CF [(1 + r)n – 1] ÷r

FV = Future value
CF = Cash Flow / annual payment
r = interest rate per period of compounding
n = number of compounding periods in the length of the loan

Example:
Ms. Dela Cruz wishes to determine how much money she will have at the end of 5 years if she chooses ordinary
annuity. She will deposit ₱1,000 annually, at the end of each of the next 5 years, into a savings account paying 7%
annual interest.
Where:
CF = 1,000
r = 7%
n = 5 years If a company has ₱30,000 of
accounts receivable that are due in
FV5 = ₱1,000 [(1 + .07)5
– 1] ÷.07
90 days, another company may offer
FV5 = ₱1,000 [1.40255 – 1] ÷.07
FV5 = ₱402.5517÷ 0.07 to discount them at an annual rate of
FV5 = ₱5,751.00 20 percent. What is the present
value?
FUTURE VALUE OF AN ANNUITY DUE

FVn = CF [((1 + r)n – 1)÷r] (1+r)

Where:
CF = 1,000
r = 7%
n = 5 year

FV5 = ₱1,000 [((1 + .07)5 – 1) ÷.07] x (1.07)

FV5 = ₱1,000 [1.40255 – 1) ÷.07] (1.07)
FV5 = ₱402.5517÷ 0.07 (1.07)
FV5 = ₱5,750.74 (1.07)
FV5 = ₱6,153.00

**Ordinary annuity ₱5,750.74 versus Annuity due ₱6,153.29

PRESENT VALUE OF AN ORDINARY ANNUITY

Formula: PVn = (CF÷r) [1 – (1÷(1+r)n )]

Example:
Braden Company, a small producer of plastic toys, wants to determine the most it should pay
to purchase a particular ordinary annuity. The annuity consists of cash flows of ₱700 at the
end of each year for 5 years. The firm requires the annuity to provide a minimum return of
8%.
Where:
CF = 700
r = 8%
n = 5 years

PV5 = (700÷.08) [1 – (1÷(1+.08)5 )]

PV5 = (8,750) [1 – (1÷(1+.08)5 )]
PV5 = (8,750) [1 – (1÷(1.4693)]
PV5 = (8,750) [1 – .680596]
PV5 = (8,750) [.31940]
PV5 = 2,795.00
PRESENT VALUE OF AN ANNUITY DUE

Formula: PVn = (CF÷r) [1 – (1÷(1+r)n )] (1+r)

PV5 = (700÷.08) [1 – (1÷(1+.08)5 )] (1+.08)
PV5 = (8,750) [1 – (1÷(1+.08)5 )] (1+.08)
PV5 = (8,750) [1 – (1÷(1.4693)] (1+.08)
PV5 = (8,750) [1 – .680596] (1+.08)
PV5 = (8,750) [.31940] (1.08)
PV5 = 2,795.00 (1.08)
PV5 = 3,018.00
PERPETUITY

A perpetuity is an annuity with an infinite life—in other words, an annuity that

never stops providing its holder with a cash flow at the end of each year (for
example, the right to receive ₱500 at the end of each year forever).
Formula: PV = CF ÷ r
Example:
Ross Clark wishes to endow a chair in finance at his alma mater. The university
indicated that it requires ₱200,000 per year to support the chair, and the
endowment would earn 10% per year. To determine the amount Ross must
give the university to fund the chair, we must determine the present value of a
₱200,000 perpetuity discounted at 10%.
Where:
CF = 200,000
r= .10
Solution:
PV = ₱200,000 ÷ 0.10 = ₱2,000,000
MIXED STREAMS

Two basic types of cash flow streams are possible, the annuity and the
mixed stream. Whereas an annuity is a pattern of equal periodic cash
flows, a mixed stream is a stream of unequal periodic cash flows that
reflect no particular pattern.
FUTURE VALUE OF A MIXED STREAM
Formula: FV = CF1(1+r)N-1 + CF2(1+r)N-2 + ….
N = number of periods
CF = cash flow at period t
r = interest rate per period
Cash Flow
1 ₱ 1,000
2 ₱ 800
3 ₱ 1,100
4 ₱ 700
5 ₱ 1,050

Solution:
FVCF1 = ₱1,000 (1+0.12)(5-1) = ₱1,573.52
FVCF2 = ₱800 (1+0.12)(5-2) = ₱1,123.94FVCF3 = ₱1,100 (1+0.12)(5-3) = ₱1,379.84
FVCF4 = ₱700 (1+0.12)(5-4) = ₱784.00
FVCF5 = ₱1,050 (1+0.12)(5-5) = ₱1,050.00 (remember anything to the power of zero is 1)
Thus, the total future value of the uneven cash flow stream is ₱5,911.30.
PRESENT VALUE OF A MIXED STREAM
Formula: PV = CF1÷ (1+r)1 + CF2÷ (1+r)2 + ….
Example:
Where:
r = 15.75%
N = 5 years
Cash Flow
1 ₱ 1,500
2 ₱ 1,850
3 ₱ 2,100
4 ₱ 2,500
5 ₱ 2,950

Solution:
PV = CFN÷ (1+r)N
PV = 1,500÷ (1+0.1575)1 = 1,295.90
PV = 1,850÷ (1+0.1575)2 = 1,380.80 1.33980625
PV = 2,100÷ (1+0.1575)3 = 1,354.12
PV = 2,500÷ (1+0.1575)4 = 1,392.69
PV = 2,950÷ (1+0.1575)5 = 1,419.77
Thus, the present value of the uneven cash flow stream will be ₱6,843.27.