Introduction

Which is the best alternative?

Php 1.0 million now
Php 2.0 million next year
Php 2.2 million in two years
Answer: It depends on the interest rate
Role of Time Value of Money
Financial decisions involve costs and benefits
that are spread out over time
Examples:
Investments in financial instruments
Capital expenditures
Working capital decisions
Time value of money allows comparison of
cash flows from different periods
Cash Flow Patterns
Single Amount
Stream of Cash Flow
Annuity
Perpetuity
Ordinary Annuity
Annuity Due
Mixed Stream
Single Amount: Future Value
0 1 2 3 4 5
-10,000 ?
Consider a Php10,000 investment at year 0.
What will be the value of the investment in
year 5 if it can earn 5 percent per year?
Simple Interest
Principal Rate Interest FV
Year 1 10,000.0 5% 500.0 10,500.0
Year 2 10,000.0 5% 500.0 11,000.0
Year 3 10,000.0 5% 500.0 11,500.0
Year 4 10,000.0 5% 500.0 12,000.0
Year 5 10,000.0 5% 500.0 12,500.0
With simple interest, you do not earn interest on interest
Compound Interest
Principal Rate Interest FV
Year 1 10,000.0 5% 500.0 10,500.0
Year 2 10,500.0 5% 525.0 11,025.0
Year 3 11,025.0 5% 551.3 11,576.3
Year 4 11,576.3 5% 578.8 12,155.1
Year 5 12,155.1 5% 607.8 12,762.8
With compound interest, you earn interest on interest.
Compound Interest
Principal Rate Interest FV
Year 1 PV r PV(r) PV(1+r)
Year 2 PV(1+r) r PV(1+r)(r) PV(1+r)
2
Year 3 PV(1+r)
2
r PV(1+r)
2
(r) PV(1+r)
3
Year 4 PV(1+r)
3
i PV(1+r)
3
(r) PV(1+r)
4
Year 5 PV(1+r)
4
r PV(1+r)
4
(r) PV(1+r)
5
General Formula: FV = PV * (1+r)
n
Single Amount: Future Value
0 1 2 3 4 5
-10,000 ?
Consider a Php10,000 investment at year 0.
What will be the value of the investment in
year 5 if it can earn 5 percent per year?
FV = PV * (1 + r)
n
FV = (10,000) * (1+ 0.05)
5

= 12,762.8
Single Amount: Future Value
Future value is cash you will receive at a given
future date.
The future value technique uses compounding to find the
future value of a cash flow.
We speak of compound interest to indicate that the
amount of interest earned on a given deposit has
become part of the principal at the end of the period.

Single Amount: Future Value
Source: Gitman, Lawrence, Introduction to Managerial Finance, 11
th
edition, Prentice Hall, 2006
Single Amount: Future Value Example
An investment instrument worth1,000
promises to pay 6 percent per annum
compounded annually. What is the value of
the investment after 5 years? 10 years?

FV
5%,5
= 1,000 * (1+ 0.06)
5
= 1,338.25
FV
5%,10
= 1,000 * (1+ 0.06)
10
= 1,790.85
Single Amount: Present Value
0 1 2 3 4 5
?
Consider an investment that earns 5 percent
per year. How much should be invested in
year 0 to have 20,000 in year 5?
PV = FV / (1 + r)
n
= (20,000) / (1+ 0.05)
5

= 15,670.5
20,000
Single Amount: Present Value
Present value is the current value of a future amount of
money.
It is based on the idea that a peso today is worth more
than a peso tomorrow.
It is the amount today that must be invested at a given
rate to reach a future amount.
Calculating present value is also known as discounting.
The discount rate is often also referred to as the
opportunity cost, the discount rate, the required return, or
the cost of capital.
Single Amount: Present Value
Source: Gitman, Lawrence, Introduction to Managerial Finance, 11
th
edition, Prentice Hall, 2006
Single Amount: Present Value Example
Pablo has an opportunity to receive
Php250,000 one year from now. If he can
earn 6% on his investments, what is the most
he should pay now for this opportunity?
PV = 250,000 / (1+ 0.06)

= 235,849.1
Time Value Variables & Basic Models
Time Value Variables
FV : Future Value
PV : Present Value
r : Interest Rate
n : Number of Periods
Basic Models
FV = PV (1+r)
n
PV = FV / (1+r)
n
r = (FV/PV)
1/n
- 1
n = ln(FV/PV) /
ln(1+r)
Single Amount: Interest
0 1 2 3 4 5
-10,000
Consider a Php10,000 investment at year 0.
What interest rate will increase the value of
investments to 20,000 in year 5?
i = (FV/PV)
1/n
- 1
= (20,000/10,000)
1/5
- 1

= 14.9%
20,000
Single Amount: Number of Periods
0 1 2 3 4 n
-10,000
Consider a Php10,000 investment at year 0
that earns 5% interest per year. How long will
it take for the investment to grow to 20,000?
n = ln(FV/PV) / ln(1+r)
= ln(20,000/10,000) / ln(1+0.05)

= 14.2
20,000
Aside: Rule of 72
How long will it take to double your money
that earns 5 percent per annum?
Answer:
Formula: ln(2/1)/ln(1+0.05) = 14.2 years
Rule of 72: 72/5 = 14.4 years
Stream of Cash Flows: Annuity
Annuities are equally-spaced cash flows of equal
size which can be either inflows or outflows.
An ordinary (deferred) annuity has cash flows that
occur at the end of each period.
An annuity due has cash flows that occur at the
beginning of each period.
An annuity due will always be greater than an
otherwise equivalent ordinary annuity because
interest will compound for an additional period.
Ordinary Annuity vs Annuity Due
0 1 2 3 4 5
10,000 10,000 10,000 10,000
Ordinary Annuity
0 1 2 3 4 5
10,000 10,000 10,000 10,000
Annuity Due
Ordinary Annuity vs Annuity Due
Ordinary Annuity Annuity Due
Annuity PV
r=5%
Annuity PV
r=5%
Year 0 100 100
Year 1 100 95.2 100 95.2
Year 2 100 90.7 100 90.7
Year 3 100 80.4
Total 272.3 285.9
Stream of Cash Flows: Perpetuity
A perpetuity is a special kind of annuity.
With a perpetuity, the periodic annuity or cash flow
stream continues forever.
0 1 2 3 4 5
10,000 10,000 10,000 10,000
Perpetuity
10,000
Present Value of Perpetuity
How much would I have to deposit today in order to
withdraw 360,000 each year forever if I can earn 8% on
my deposit?
Answer
Let x: Deposit today
Then x * 8% = 360,000
x = 360,000/8%
x = 4,500,000
General Formula:
PV = PMT/RATE
PV and FV of Ordinary Annuity
( )
( )
( )
( )

+
=
+

+
=

+
=
r
1 r 1
A FVA
r 1
r
) r 1 /( 1 1
A FVA
r
) r 1 /( 1 1
A PVA
n
n , r
n
n
n , r
n
n , r
PV Annuity
FV Annuity
PV and FV of Annuity Due
PV Annuity
FV Annuity
( )
( )
( )
1 n
n
n , r
n
n , r
r 1
r
) r 1 /( 1 1
A FVAD
) r 1 (
r
) r 1 /( 1 1
A PVAD
+
+

+
=
+

+
=
Growing Perpetuities
A special kind of perpetuity wherein the annual cash flow
grows at a constant rate of growth.



Consider a common stock that is expected to pay P5 per
share after one year, which is expected to grow at 10%
per year thereafter. Assuming a discount rate of 20%, the
present value of the stocks future cash dividends is

PV = CF
1
/(Interest Rate Growth Rate)
PV = 5/(.20-0.1) = 50
Stream of Cash Flows: Mixed Streams
If the firm must earn at least 9% on its investments,
what is the most it should pay for this opportunity?
This situation is depicted on the following time line.

Compounding Interest More
Frequently Than Annually
Compounding more frequently than once a year
results in a higher effective interest rate because
you are earning interest on interest more frequently.
As a result, the effective interest rate is greater than
the nominal (annual) interest rate.
Furthermore, the effective rate of interest will
increase the more frequently interest is
compounded.
FV
t
= PV * (1+r/m)
mn
Compounding Interest More
Frequently Than Annually
Future Value from Investing Php 100 at 8% Annual Interest
Compounded Semi-annually Over 24 Months
Period
Beginning
Principal
FVIF Future Value
6 Months 100.00 1.04 104.00
12 Months 104.00 1.04 108.16
18 Months 108.16 1.04 112.49
24 Months 112.49 1.04 116.99
Compounding Interest More
Frequently Than Annually
Future Value from Investing Php 100 at 8% Annual Interest
Compounded Quarterly Over 24 Months
Period
Beginning
Principal
FVIF Future Value
3 Months 100.00 1.02 102.00
6 Months 102.00 1.02 104.04
9 Months 104.04 1.02 106.12
12 Months 106.12 1.02 108.24
15 Months 108.24 1.02 110.41
18 Months 110.41 1.02 112.62
21 Months 112.62 1.02 114.87
24 Months 114.87 1.02 117.17
Compounding Interest More
Frequently Than Annually
Future Value from Investing Php 100 at 8% Annual Interest
Given Various Compounding Periods
End of Year Annual Semi-Annual Quarterly
1 108.00 108.16 108.24
2 116.64 116.99 117.17
Continuous Compounding/Discounting

Continuous Compounding
FV
t
= PV * (1+r/m)
mn
, m
= PV e
rn
Continuous Discounting
PV = FV
t
/ (1+r/m)
mn
, m
= FV
t
e
-rn
e = 2.71828

Special Applications
A family borrows P2.0 million to buy a house and lot.
The lender charges interest at 12% compounded
monthly and payments are expected to run for 5
years. What is the monthly the amortization of the
loan?
PV = P2.0 million
r = 12%
m = 12
n = 5
Find PMT

Special Applications
A bond maturing in three years has a coupon rate of
8% per annum. The coupons are paid semi-
annually. The par value is 1000. Investors consider
10% per annum (compounded semi-annually) to be
an appropriate required rate of return considering
the risk level associated with the bond. The current
price of the bond is 900.
What is the bonds theoretical price? Should the
bond be purchased?
What is the yield-to-maturity (YTM) of the bond
given its market price?