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Time value of money is a critical consideration in financial and investment decisions. For example,
compound interest calculations are needed to determine future sums of money resulting from an
investment. Discounting, or the calculation of present value, which is inversely related to compounding, is
used to evaluate future cash flow associated with capital budgeting projects. There are plenty of
applications of time value of money in finance.

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A peso today is worth more than a peso to be received tomorrow because of the interest it could
earn from putting it in an investment activity. Compounding interest means that interest not withdrawn also
earns interest. For better understanding of the concepts of compounding and time value, let us define:

FV = future value (present + interest) the amount of money at the end year n
PV = principal value
r = rate
i = annual interest rate
n = number of periods

Then,
If the amount P at year 0 is placed at a rate i, then

FV = PV (1 + i) n

In this case, if PV = P1,000, i = 12%, and n = 4, we will have:

FV = P1,000 (1.12) 4

The (1.12)4is equal to 1.762 which is obtained by multiplying the 1.12 four times by itself. The interest
table for the future value of 1 may also be used for convenience.



Mario Oirma placed P1,000 in a savings account earning 7 percent interest compounded annually. How
much money will he have in the account at the end of 5 years?

FV = PV (1 + i) n
= P1,000 (1.07)5
= P1,000 (1.403)
= P1,403

Note: The value 1.403 may also be found at the interest table using the future value of 1.



Jackie Tyan invested a large sum of money in the stock of ZZZ Corporation. The company paid a P3
divided per share. The dividend is expected to increase by 15 percent per year for the next 3 years. She
wishes to project the dividends for years 1 through 3.

FV = PV (1 + i) n

At year 1
FV = P3 (1.15)1
= P3 (1.15)
= P3.45
At year 2
FV = P3 (1.15)2
= P3 (1.322)
= P3.97

At year 3
FV = P3 (1.15)3
= P3 (1.521)
= P4.56

h
 
Interest more often are compounded more than once a year. Bank and other financial institutions accepting
placements compound interest quarterly, daily, and even continuously. If interest is compounded m times a
year, then the general formula for solving for the future values becomes
nxm
FV = PV (1 + i/m) 

The number of conversion periods for one year is denoted by , while the total number of conversion
periods for the whole investment term is denoted by . Conversion periods are usually expressed by any
convenient length of time, and usually taken as an exact division of the year, such as monthly, quarterly,
semiannually and annually. When the conversion periods are:

annually m= 1
semiannually m= 2
quarterly m= 4
monthly m = 12

The total number of conversion periods for the whole term can be found from the relation:

n = time x number of conversion periods per year 

n=txm

Thus, the term 5 years compounded:

annually 5x1 n= 5
semiannually 5x2 n = 10
quarterly 5x4 n = 20
monthly 5 x 12 n = 60

The interest rate is usually expressed as an annual or yearly rate, and must be changed to the
interest rate per conversion period or

 and can be found from the relation:

i = Interest rate r
conversion period per year m

i = r
m

Thus, the interest rate at 6% compounded:

annually 6% ÷ 1 i = 6%
semiannually 6% ÷ 2 i = 3%
quarterly 6% ÷ 4 i = 1 ½%
monthly 6% ÷ 12 i = ½%
The formula reflects more frequent compounding (n.m) at a smaller interest rate per period (i/m). The
future value increases as m increases. Thus, continues compounding results in the maximum possible
future value at the end of n periods for a given rate of interest.



Assume that P = P1,000, I = 12% and n = 4 years. Then for

Annual compounding (m = 1): FV = P1,000(1.12)4 x 1

= P1,000(1.574) 4
= P1,574

Semiannual compounding (m = 2): FV = P1,000(1+0.12/2)4 x 2

= P1,000(1.06)8
= P1,000(1.594)
= P1,594

Quarterly compounding (m = 4): FV = P1,000(1+0.12/4)3 x 4

= P1,000(1.03)12
= P1,000(1.426)
= P1,426

Monthly compounding (m-12): FV = P1,000 ( 1 + 0.12/12)3 x 12

= P100(1.01)36
= P100(1.431)
= P1,431

  
An annuity is defined as a series of equal payments (or receipts) made at fixed intervals for a
specified number of periods. If the payment occurs at the end of the period, then it is called an ordinary
annuity. Examples of these are mortgages on housing, car loans and bank loans. If the payment occurs at
the beginning of each period, the annuity is called an annuity due. Life insurance premiums, car insurance,
and rental payments are some of the typical examples of an annuity due. Between the two types of
annuities, the ordinary annuity is more common in practice.



Mario Sinungkaan would like to determine the sum of money he will have in his savings account at the end
of 5 years by depositing P1,000 at the end of each year for the next 5 years. The annual interest rate is 8
percent.
Time line:

0 1 2 3 4 5

P1,000 P1,000 P1,000 P1,000 P1,000.00

1,080.00 (1.08)1
1,166.40 (1.08)2
1,259.71 (1.08)3
1,360.49 (1.08)4
P 5,867.00

Each deposit is made at the end of the year and is compounded out to the end of the period n.
The sum of the compounded deposits is the future value of an annuity.
Another way of solving problem 4 is through the use of the future value of an annuity formula.
Let us assume the following:

FVA= amount of an annuity

PVA= present value of an annuity
A = annuity due

Then we can write

FVA= A (1 + i) n - 1
i

However, the formula can only be used if the cash payments or receipts are even; otherwise, each payment
or receipt will be computed individually using the present value. To solve for problem 4 using the formula
for the future value of an annuity, we have;

FVA= A (1 + i) n - 1
i

= P1,000 (1 + 0.08) 5 - 1
0.08

= P1,000 (5.867)

= P5,867



Assume the same problem as problem 4 except that the deposits are made at the beginning of the period.

Time line:

0 1 2 3 4 5

P1,000 P1,000 P1,000 P1,000 P1,000.00

P 1,080.00 (1.08)1
1,166.40 (1.08)2
1,259.71 (1.08)3
1,360.49 (1.08)4
1,469.33 (1.08)5
P6,335.93

The deposits started at the beginning of each year, so more interest is earned as compared to deposits made
at the end of the year. Another way of solving this is through the use of a future value of an annuity
formula. Again, the formula to be given will only be useful if it has an equal cash flow. The formula shall
be;

FVA= A (1 + i)n ± 1 (1 + i)
i
Because of an earlier deposit or payment, the future value of an ordinary annuity has been compounded for
one additional period. Thus applying the formula, we have

FVA= 1,000 (1.08) 5 ± 1 (1.08)

0.08

= P6,335.93


 
h 
The present value of a future sum is the amount that must be invested today at compound interest to
reach a desired sum in the future. The process of calculating present values, or discounting, is usually the
opposite of finding the compounded future value. In connection with present value calculations, the interest
rate is called the discount rate.

Recall that

FV = PV (1+i) n

Therefore by simple transposition,

PV = FV or FV (1 + i)-n
(1+ i)n


!
Roval Toro has been given an opportunity to receive P50,000 10 years from now. If he can earn 15 percent
on his investments compounded annually, what is the most he should pay for this opportunity?

PV = FV (1 + i) -n
= P50,000 (1.15) -10
= P50,000 (0.247)
= P12,350.00

Roval Toro should invest at the maximum amount of P12,350 earning at 15% to accumulate a future
amount of P50,000.

   
Interest received from bonds, pension funds, and insurance obligations all involve annuities. To
compare these financial instruments, we need to know the present value of each. The present value of an
annuity can be found by using the following equation:

PVA= A 1- (1 + i)-n
i




"
MarizLatim has been offered an opportunity to receive the following equal cash flow over the next 3 years:

Year Revenue
1 P10,000
 2 10,000
3 10,000

If she the must earn a minimum of 8 percent on her investment, what is the most she should pay today? The
present value of this equal cash flow shall be as follows:

Time line:
   0 1 2 3


    P10,000 P10,000 P10,000

P9,259.26
 8,573.39
  7,938.32
 P25,770.97

MarizLatim has to deposit the amount of P25,770.97 in order to receive a yearly amount of P10,000 for
three years. Another way of solving this is through the use of a present value of an annuity formula. The
formula to be given will only be useful if it has an equal cash flow. The formula shall be;

PVA = A 1 - (1 + i)-n
i

= P10,000 1 ± (1 + 0.08)-3

0.08
= P25,770.97

  # $ % 

Time value of money problems may evolve around a series of payments or cash receipts. However,
not every situation involved a single amount of annuity. A problem may call for an unequal cash flow each
period for a certain number of years. The present value of an unequal cash flow is the sum of the present
values of each unequal cash flow.


&
XeneteaTrias has been offered an opportunity to receive the unequal cash flow over the next 3 years:
Year Revenue
1 P10,000
2 P12,500
3 P 9,500

If she the must earn a minimum of 8 percent on her investment, what amount should she pay today? The
present value of these unequal cash flows of revenue is as follows:

Year Revenue (1 + i) -n = Present Value

1 10,000 0.926 P 9,260.00
2 12,500 0.857 10,712.50
3 9,500 0.794 7,543.00
P27,515.50
 '      
Future and present values have numerous applications in financial and investment decisions. It is
useful in decision making ranging from personal decisions ± how much deposit must be made to acquire
certain amount of money, amortization of loan and sinking fund, to more complex corporate financial
decisions ± capital budgeting, bond and stock valuation and right financing mix.

An individual might wish to find the annual deposit (or payment) that is necessary to accumulate a
future sum. To find this future amount we can use the formula for finding the future value of annuity.


&
ZiramIlamu wishes to determine the equal annual end-of-year deposits required to accumulate P15,000 at
the end of 10 years when her son enters college. The interest rate is 12 percent. The annual deposits are:

FVA= A (1 + i) n - 1
i

P15,000 = A (1 + 0.12) 10 - 1
0.12

P15,000 = A (17.549)

A = P15,000
17.549

A = P854.75

If ZiramIlamu deposits P854.75 at the every end of the year for 10 years at 12 percent interest, she will
have accumulated P15,000 at the end of the fifth year.



 ( 
Payments of obligations are made in equal installment. It may be monthly, quarterly, semi-annually
or annually. Loans that are amortized include housing loans, auto loans, and other loans classified as long-
term loan. The periodic payment can easily be computed by using the present value of an annuity of 1:


PVA = A 1 - (1 + i)-n
i

Thus, by transposition, we can derive the periodic payment as:

PVA
A= 1 - (1 + i)-n
i








)
FerlieUmali has a 60 months auto loan of P650,000 at a 12 percent annual interest rate. He wants to find
out the how much will be the monthly payment.

P650,000 
A= 1 - (1.01)-60
0.01

A = P650,000
44.955

= P14,458.90

So, to repay the principal and interest on a P650,000, 12 percent, 60 month loan, FerlieUmali has to pay
P14,458.90 a month for the next 60 months.


*
Assume that a firm borrows P120,000 to be repaid in annually for the next five years. The bank wants 12
percent interest. Compute the amount of each payment.

P120,000

A= 1 - (1.12)-5
0.12

A = P120,000
3.605

= P33,287.10

Each loan payment consists partly of interest and partly of principal. The breakdown is often
display in a loan amortization schedule. The interest component is largest in the first period and
subsequently declines, whereas the principal portion is smallest in the first period and increases thereafter,
as shown in the ff example.



Using the same data as in example 10 we set up the following amortization schedule:

Principal Outstanding
Year Payment Interest Payment Balance
120,000.00
1 33,287.10 14,400.00 18,887.10 101,112.90
2 33,287.10 12,133.55 21,153.55 79,959.35
3 33,287.10 9,595.12 23,691.98 56,267.37
4 33,287.10 6,752.08 26,535.02 29,732.35
5 33,287.10 3,567.88 29,732.35 0.00
166,435.50 46,448.64 120,000.00