Timelines: Illustration: The Diagram Shows A Present Value (PV) of P1,000, Which Means On Hand Today, and Future Value
Timelines: Illustration: The Diagram Shows A Present Value (PV) of P1,000, Which Means On Hand Today, and Future Value
Timelines: Illustration: The Diagram Shows A Present Value (PV) of P1,000, Which Means On Hand Today, and Future Value
Timelines
The first step in time value analysis is setting up a timeline, which will help in visualizing what is happening in a
problem. Timeline is an important tool used in time value analysis, and this is a graphical representation to
present the timing of cash flows (Brigham & Houston, 2017).
Illustration: The diagram shows a Present Value (PV) of P1,000, which means on hand today, and Future Value
(FV) is the value that will be in the account on the future date:
The intervals from 0 to 1, 1 to 2, and 2 to 3 are time periods such as years or months. Time 0 is the beginning
of Period 1; Time 1 is one period from 0 and both end of period 1 and the beginning of Period 2; and so forth.
Although the periods are often in years, periods can also be in quarters or months or even days. Each tick mark
corresponds to both the end of one period and the beginning of the next one.
Cash flows are shown directly below the tick marks, and the relevant interest rate is shown above the timeline.
Question marks indicate unknown cash flows. On the illustration, the interest rate is 5%, a single cash outflow,
P1,000, is invested at Time 0; and the Time 3 value is an unknown inflow. In the example, cash flows occur only
at Times 0 and 3, with no flows at Times 1 or 2. Note that the interest rate is constant for all three (3) years.
That condition is generally true; if not, the different interest rate must be shown for the different periods.
Timelines are essential when learning time value concept, but even experts use this to analyze complex financial
problems. Each problem must begin with by setting up a timeline to illustrate the situation, after which an
equation can be provided to solve the problem (Brigham & Houston, 2017).
Future Values
A peso on hand today is worth more than a peso amount to be received in the future because the money you
have now, could be invested, could earn interest, and earn more in the future. Compounding is the process of
increasing the value of an asset due to the interest earned on both a principal and accumulated interest (Chen,
2019).
Using the same illustration above, some terms are defined and identified:
• Present Value (PV) – The value today of future cash flow or series of cash flows. PV = P1,000
• Future Value (FV) – The amount to which a cash flow or series of cash flows will grow over a given period
of time when compounded at a given interest rate.
• N – The number of periods involved in the analysis. In the example, N = 3. Sometimes the number of periods
is designated with a lowercase n, so both N and n indicate the number of periods involved.
• Cash Flow (CF) - Cash flows can be positive or negative. The cash flow for a particular period is often given
as a subscript, CFt, where t is the period. Thus, CF0 = PV the cash flow at Time 0, whereas CF3 is the cash
flow at the end of Period 3.
• Interest Rate (I) – Sometimes a lowercase i is used. Interest earned is based on the balance at the beginning
of each year and assumed that it is paid at the end of the year. I = 5% or, expressed as a decimal, 0.05.
Step-by-step Approach
The timeline used to find the FV of P1,000 compounded for three (3) years at 5%, along with some calculations,
is shown. The initial amount and each succeeding amount is multiplied by (1 + I) = 1.05:
Formula Approach
In the step-by-step approach, the amount at the beginning of each period is multiplied by (1+I) = 1.05. If N = 3,
three different times were multiplied by 1.05, which is the same as multiplying the beginning amount by (1 + I)3.
This concept can be extended as a key equation:
Applying the equation, the FV in the previous example can be computed as:
Present Value
𝐹𝑉𝑁
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑉 =
(1 + 𝐼)𝑁
Illustration: A broker offers to sell a Treasury bond that will pay P1,157.63 three (3) years from now. Banks are
currently offering a guaranteed 5% interest on 3-year certificates of deposit (CDs); and if the customer didn’t
buy the bond, he would buy a CD. The 5% rate paid on the CDs is defined as the opportunity cost (the rate of
return the customer could earn on an alternative investment of similar risk). Given these conditions, what is the
most he should pay for the bond?
Using the step-by-step approach, each future value will be divided by (1 + I).
𝐹𝑉𝑁 𝑃1,157.63
𝑃𝑉 = 𝑁
= = 𝑷𝟏, 𝟎𝟎𝟎. 𝟎𝟎
(1 + 𝐼) (1.05)3
This is more efficient than the step-by-step approach, and it gives the same result.
Annuities
An annuity is a series of equal payments at fixed intervals for a specified number of periods.
For example, a 3-year annuity where P1,000 was paid at the end of each year. If the payments occur at the end
of each year, the annuity is an ordinary (or deferred) annuity. If the payments are made at the beginning of
each year, the annuity is an annuity due. Ordinary annuities are more common in finance; so, when the term
annuity is used, it is assumed that the payments occur at the ends of the periods unless otherwise noted.
The following are the timelines for a P1,000, 3-year, 5% ordinary annuity and for an annuity due. For an annuity
due, each payment is shifted to left by one year. A P1,000 deposit will be made each year, so each payment
was shown with minus signs:
The timelines show the annuity’s future and present value, the interest rate built into annuity contracts, and the
length of time it takes to reach a financial goal using an annuity (Brigham & Houston, 2017).
Illustration: Consider the ordinary annuity previously presented, where P1,000 was deposited at the end of each
year for 3 years and earned 5% per year. The amount to be earned at the end of the third year is shown below.
Where: payment amount (PMT) is P1,000; Interest rate (I) is 5%, and the number of periods (N) is 3.
Step-by-step Approach
Each payment is
multiplied by (1 + I)N-t
and computes the
total of all the FVs to
find the FVAN
Each payment out to Time 3 was compounded. The first payment earns interest for two (2) periods, the second
payment earns interest for one (1) period, and the third payment earns no interest at all because it is made at
the end of the annuity’s life. This approach is straightforward; but if the annuity extends out for many years, the
approach is cumbersome and time-consuming.
Formula Approach
Because each payment occurs one (1) period earlier with an annuity due, all the payments earn interest for one
additional period. Therefore, the FV of an annuity due will be greater than that of a similar ordinary annuity.
𝐹𝑉𝐴𝑑𝑢𝑒 = 𝐹𝑉𝐴𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 (1 + 𝐼)
The present value of an annuity, PVAN, can be found using the step-by-step or formula method. The deposits
were compounded to find the FV of the annuity. To find the PV, each deposit was discounted by dividing each
payment by (1+I)t.
The step-by-step procedure is diagrammed as follows: With the formula approach, the equation could
be:
1
1−
(1 + 1)𝑁
𝑃𝑉𝐴𝑁 = 𝑃𝑀𝑇 [ ]
𝐼
1
1−
(1.05)3
𝑃𝑉𝐴𝑁 = 𝑃1,000 [ ] = 𝑷𝟐, 𝟕𝟐𝟑. 𝟐𝟓
0.05
Perpetuities
Perpetuity is simply an annuity with an extended life. Because the payments go on forever, the step-by-step
approach can’t be applied. However, it’s easy to find the PV of perpetuity with a formula.
𝑃𝑀𝑇
𝑃𝑉 𝑜𝑓 𝑎 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝐼
Illustration: A preferred stock was bought in a company that pays a fixed dividend of P2,500 each year the
company is in business. If the company goes on indefinitely, the preferred stock can be valued as a perpetuity.
If the discount rate on the preferred stock is 10%, the present value of the perpetuity, the preferred stock, is
P25,000:
𝑃2,500
𝑃𝑉 𝑜𝑓 𝑎 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = = 𝑷𝟐𝟓, 𝟎𝟎𝟎
0.10
The definition of an annuity includes the words “constant payment.” In other words, annuities involve payments
that are equal in every period. Although many financial decisions involve constant payments, many others
involve uneven or nonconstant cash flows (CFt).
A. Annuity plus additional final payment: a stream that consists of a series of annuity payments plus an
additional final lump sum. Bonds represent the best example of this type; and
B. Irregular cash flows: all other uneven streams which are best illustrated by stocks and capital investments.
The PV of any of the streams can be solved using a formula method and following the step-by-step procedure.
Where each cash flow was discounted and added to find the PV of the stream:
𝑁
𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑁 𝐶𝐹𝑡
𝑃𝑉 = + + ⋯+ =∑
(1 + 𝐼)1 (1 + 𝐼)2 (1 + 𝐼)𝑁 (1 + 𝐼)𝑡
𝑡=1
Applying the equation would result in the following PV for Stream 1, P9,279.04 and Stream 2, P10,163.47. The
step-by-step procedure is straightforward; but if there are many cash flows, it is time-consuming.
The values of all financial assets like stocks, bonds, and business capital investments are same as the present
values of their expected future cash flows. Therefore, present values need to be calculated very often, far more
often than future values. On the relatively few occasions, FV of uneven cash flow stream is presented using the
step-by-step procedure. This approach works for all cash flow streams, even those for which some cash flows
are zero or negative.
Compounding Periods
Annual Compounding
This is the arithmetic process of determining the final value of cash flow or series of cash flows when interest is
added once a year.
Illustration: Assume that P1,000 is deposited in an account that pays 5% for 10 years.
Semiannual Compounding
This is the arithmetic process of determining the final value of cash flow or series of cash flows when interest is
added twice a year.
If the interest was paid semiannually, two (2) conversions must be made:
1. Convert the stated interest rate into a “periodic rate.”
2. Convert the number of years into “number of periods.”
The conversions are done as follows, where 𝐼 is the stated annual rate, 𝑀 is the number of compounding periods
per year, and 𝑁 is the number of years:
Illustration: Assume that P1,000 is deposited in an account that pays 5% compounded semiannually for 10
years.
Analysis:
5%
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑟𝑎𝑡𝑒 = = 2.5% 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 = (10 𝑦𝑒𝑎𝑟𝑠)(2) = 20 𝑝𝑒𝑟𝑖𝑜𝑑𝑠
2
Under semiannual compounding, the P1,000 investment will earn 2.5% every six (6) months for 20 semiannual
periods, not 5% per year for 10 years. The periodic rate and number of periods, not the annual rate and number
of years, must be shown on timelines.
The future value under semiannual compounding, P1,638.62, exceeds the FV under annual compounding,
P1,628.89, because interest starts accruing sooner; thus, the deposit earns more interest on interest.
Different compounding periods are used for different types of investments. For example, bank accounts
generally pay interest daily; most bonds pay interest semiannually; stocks pay dividends quarterly; and
mortgages, auto loans, and other instruments require monthly payments. The following are some terms used
to compare investments or loans with different compounding periods:
• Nominal Interest Rate (𝐼𝑁𝑂𝑀 ) also known as annual percentage rate (APR), (or quoted or stated rate) is
the rate that is charged by credit card companies, student loan officers, auto dealers, and other lenders.
Remember that if two (2) banks were offering loans with a stated rate of 8%, one might require monthly
payments and the other quarterly payments, because either of the two is not charging a ‘true’ rate. The one
that requires monthly payments is charging more than the one with quarterly payments because it will
receive the payment sooner. So, to compare loans across lenders or interest rates earned on different
securities, effective annual rates should be calculated.
Illustration: A nominal rate of 10% with semiannual compounding is equivalent to a rate of 10.25% with annual
compounding because both rates will cause P1,000 to grow to the same amount after one (1) year.
• Effective Annual Rate is also called the equivalent annual rate (EAR). This is the rate that would produce
the future value under the annual compounding as would more frequent compounding at a given nominal
rate.
Where:
𝐼𝑁𝑂𝑀 𝑀 𝐼𝑁𝑂𝑀 = the nominal rate expressed as a decimal
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑎𝑡𝑒 (𝐸𝐴𝑅) = [1 + ] −1
𝑀
M = the number of compounding periods per year
0.10 2
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑎𝑡𝑒 (𝐸𝐴𝑅) = [1 + ] − 1 = 0.1025 × 100 = 𝟏𝟎. 𝟐𝟓%
2
If a loan or an investment use annual compounding, its nominal rate is also its effective rate. However, if
compounding occurs more than once a year, the 𝐸𝐴𝑅 is higher than 𝐼𝑁𝑂𝑀 .
It is assumed on the previous topics that payments occur at the beginning or at the end of the period but not
within periods. Situations may be encountered that requires compounding or discounting over fractional periods.
Illustration: Suppose P1,000 was deposited in a bank that pays a nominal rate of 10% but adds interest daily,
based on a 365-day year. How much would the P1,000 be after nine (9) months?
0.10
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑟𝑎𝑡𝑒 (𝐼𝑃𝐸𝑅 ) = = 𝟎. 𝟎𝟎𝟎𝟐𝟕𝟑𝟗 𝒑𝒆𝒓 𝒅𝒂𝒚
365
9
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 = ( ) (365) = (0.75)(365) = 273.75 𝑜𝑟 𝟐𝟕𝟒 𝒅𝒂𝒚𝒔
12
Amortized Loans
This is a loan that is to be repaid in equal amounts on a monthly, quarterly, or annual basis. This an important
application of compound interest, which involves loans that are paid off in installments over time. Included are
automobile loans, home mortgage loans, student loans, and many business loans.
Illustration: A homeowner borrows P1,000,000 on a mortgage loan, and the loan is to be repaid in five (5) equal
payments at the end of each of the next five (5) years. The lender charges 6% on balance at the beginning of
each year.
Analysis:
1. Determine the payment the homeowner must make each year.
5
𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇
𝑃1,000,000 = 1
+ 2
+ 3
+ 4
+ 5
=∑
(1.06) (1.06) (1.06) (1.06) (1.06) (1.06)𝑡
𝑡=1
2. Prepare a Loan Amortization Schedule for P1,000,000 at 6% for five (5) years.
• Interest in each period is calculated by multiplying the loan balance at the beginning of the year by the
interest rate. Therefore, interest in Year 1 is P1,000,000 x 6% = P60,000; in Year 2, it is P49,356.34; and
so forth.
• Repayment of principal is equal to the payment of P237,394.35 minus the interest charge for the year.
• Ending balance is the beginning amount minus repayment of principal.
n 1% 2% 3% 4% 5% 6% 8% 10% 12%
1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9259 0.9091 0.8929
2 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.7833 1.7355 1.6906
3 2.941 2.8839 2.8286 2.7751 2.7233 2.673 2.5771 2.4869 2.4018
4 3.902 3.8077 3.7171 3.6299 3.546 3.4651 3.3121 3.1699 3.0374
5 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 3.9927 3.7908 3.6048
6 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.6229 4.3553 4.1114
7 6.7282 6.472 6.2303 6.0021 5.7864 5.5824 5.2064 4.8684 4.5638
8 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.7466 5.3349 4.9676
9 8.566 8.1622 7.7861 7.4353 7.1078 6.8017 6.2469 5.759 5.3283
10 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 6.7101 6.1446 5.6502
11 10.3676 9.7869 9.2526 8.7605 8.3064 7.8869 7.139 6.4951 5.9377
12 11.2551 10.5753 9.954 9.3851 8.8633 8.3838 7.5361 6.8137 6.1944
13 12.1337 11.3484 10.635 9.9857 9.3936 8.8527 7.9038 7.1034 6.4236
14 13.0037 12.1063 11.2961 10.5631 9.8986 9.295 8.2442 7.3667 6.6282
15 13.8651 12.8493 11.938 11.1184 10.3797 9.7123 8.5595 7.6061 6.8109
16 14.7179 13.5777 12.5611 11.6523 10.8378 10.1059 8.8514 7.8237 6.974
17 15.5623 14.2919 13.1661 12.1657 11.2741 10.4773 9.1216 8.0216 7.1196
18 16.3983 14.992 13.7535 12.6593 11.6896 10.8276 9.3719 8.2014 7.2497
19 17.226 15.6785 14.3238 13.1339 12.0853 11.1581 9.6036 8.3649 7.3658
20 18.0456 16.3514 14.8775 13.5903 12.4622 11.4699 9.8182 8.5136 7.4694
21 18.857 17.0112 15.415 14.0292 12.8212 11.7641 10.0168 8.6487 7.562
22 19.6604 17.6581 15.9369 14.4511 13.163 12.0416 10.2007 8.7715 7.6447
23 20.4558 18.2922 16.4436 14.8568 13.4886 12.3034 10.3711 8.8832 7.7184
24 21.2434 18.9139 16.9355 15.247 13.7986 12.5504 10.5288 8.9847 7.7843
25 22.0232 19.5235 17.4132 15.6221 14.0939 12.7834 10.6748 9.077 7.8431
26 22.7952 20.121 17.8768 15.9828 14.3752 13.0032 10.81 9.161 7.8957
27 23.5596 20.7069 18.327 16.3296 14.643 13.2105 10.9352 9.2372 7.9426
28 24.3164 21.2813 18.7641 16.6631 14.8981 13.4062 11.0511 9.3066 7.9844
29 25.0658 21.8444 19.1885 16.9837 15.1411 13.5907 11.1584 9.3696 8.0218
30 25.8077 22.3965 19.6004 17.292 15.3725 13.7648 11.2578 9.4269 8.0552
Source: AccountingTools, 2019
References
AccountingTools. (2019, January 10). Present value of an ordinary annuity table. Retrieved from Accounting Tools:
https://www.accountingtools.com/articles/2017/5/16/present-value-of-an-ordinary-annuity-table
Brigham, E. F., & Houston, J. F. (2017). Fundamentals of Financial Management (Concise) (9e). New Jersey, Boston, United States of
America: Cengage Learning.
Chen, J. (2019). What Is Compounding? Retrieved from Investopedia: https://www.investopedia.com/terms/c/compounding.asp