CHAPTER 7: TIME VALUE OF MONEY

I. LEARNING OUTCOMES
At the end of this chapter, the students should be able to:
1. Differentiate simple interest and compound interest;
2. Compute for simple interest and compound interest;
3. Explain future value, present value, ordinary annuity, and annuity due;
4. Solve problems involving future value, present value, ordinary annuity,
and annuity due; and
5. Evaluate and choose the best investment alternative using the concept of
net present value.
 II. LEARNING CONTENTS / PROPER
Money grows when invested. Of course, holding on to money you lose in
terms of the opportunity cost of the interest you would rather have earned assets
like T-bills, negotiable CD’s, MMDAs, MMMFs, and the like. The value of money
currently will grow to a future value greater than the current value because of the
interest it will earn, more so of the interest is compounded.
The concept of time value of money is based on the notion that a peso
received today is worth more than a peso received in the future. This is because a
peso received today can be invested and its value is increased by an interest rate
or return. This concept is based on the belief that people have a positive time
preference of consumption, that is, people prefer to consume goods today rather
than consume similar goods in the future. Therefore, people would rather have
their peso today than in the future.
1. What is the difference and computation of simple interest and compound
interest?
Before we go to the future value and present value discussion, let us review simple
interest and compound interest. Compound interest is the interest involved in
future value determination. Interest is the earnings or yielding on investments. To
avoid the lost in the value of money, the holder thereof must learn to manage it
well. One way of managing money is through investment where it can earn
interest. Even promissory notes could earn interest that is why there are interest-
bearing promissory notes. Bonds are interest-bearing; hence, the earnings on
bonds are in the form of interest. Investments could be in the form of time deposit
in the bank, MMDAs, MMMFs, T-bills, or T-bonds. These investments are termed
financial assets, financial securities, of financial instruments.
Interest, in financial parlance, is the money paid for the use of money lent.
Interest is measured by a certain percentage commonly known as interest rate.
With interest, the value of money after some period of time grows.
There are two basic types of interest measurement, namely:
1. Simple interest
2. Compound interest
 1.1. Simple Interest
For simple interest, the internet is computed based on principal throughout
time. The formula is:
I=P x i x t
where P= Principal amount lent
i= Interest rate
t= time period money is borrowed/invested
Time is generally computed per year, unless stated otherwise in the
instrument or agreement. It follows in the period in which the interest rate is
started, which could be per day, per month, per quarter, or per year, which means
that if the rate is per year, the time should be expressed in terms of year; if the
rate is per month, the time should be expressed in terms of months.
Examples:
1. Assuming ₱1,000,000 was placed in 90-day time deposit earning 5% interest,
and assuming we are using ordinary interest, which means we will use 360
days for a year. For exact interest, we use 365 days a year. Ordinary interest
is commonly used. The interest earned from the said deposit will amount to
₱12,500 for ordinary interest and ₱12,328.77 for exact interest, computed as
follows:
Ordinary interest = P x i x t
= ₱1,000,000 x 5% x 90/360
= ₱12,500
Exact interest = ₱1,000,000 x 5% x 90/365
= ₱12,328.77
The instrument is a 90-day time deposit. When the interest rate is silent about
the period, that is, if it is per month, per day, or per year, it is understood to
be per year. That is why we divided 90 by 360 days for ordinary interest and
by 365 days for exact interest.
At the end of 90 days, the investor receives the maturity value of the investment,
computed as follows:
MV = P + I
Where MV = Maturity value
P = Principal
I = Interest
In our example, maturity value would be:
 MV = ₱1,000,000 + ₱12,500 = ₱1,012,500 using ordinary interest;
and
MV = ₱1,000,000 + ₱12,328.77 = ₱1,012,328.77 for exact interest.
2. Assuming that instead of 90-day time deposit, the amount was invested in a
1-year time deposit with the same interest rate. The interest earned would
amount to ₱50,000.
Interest = Pxixt
= ₱1,000,000 x 5% x 1 year
= ₱50,000
The time is exactly 1 year; hence, the maturity value at the end of 1 year is
₱1,050,000. Take note that there are four 90 days in year. Therefore, if the
interest for 90 days is ₱12,500, the interest for one year would be ₱12,500 x 4
= ₱50,000.

3. Assuming the amount was invested in a 3-year time deposit with the same
interest rate. The total interest earned from this investment would amount to
₱150,000.
Interest = Pxixt
= ₱1,000,000 x 5% x 3 years
= ₱150,000
The time is more than 1 year; hence, the maturity value at the end of the third
year is ₱1,150,000. Again, interest for a year of ₱50,000 x 3 years = ₱150,000,
which when added at the end of the 3 years.

4. Assuming the amount of ₱100,000 was borrowed from an individual lending

investor who charge 5% interest per month. The borrower is required to pay
the interest per month until the principal amount is paid. If it takes the
borrower 5 months to pay the principal, the total interest which the borrower
had pay would be ₱25,000, computed as follows:
1st month: ₱100,000.00 x 5% = ₱5,000
2nd month: ₱100,000.00 x 5% = ₱5,000
3 month: ₱100,000.00 x 5% =
rd ₱5,000
4 month: ₱100,000.00 x 5% =
th ₱5,000
5 month: ₱100,000.00 x 5% =
th ₱5,000
Total interest = ₱25,000
Or simply computed as: ₱100,000 x 5% per month x 5 months = ₱25,000

At the end of the fifth month, the amount needed to be paid by the borrower
is the principal amount of ₱100,000 plus the interest for the fifth month
(since the monthly interest is paid every month) of ₱5,000 which is equal to
₱105,000.
 1.2. Compound Interest
For compound interest, the interest is computed by adding the interest to
the principal to be used as the new basis or new principal for the succeeding
year or period. Generally, this is on the assumption that the interest is not paid
monthly, but is accumulated until maturity date. Simply stated, interest earns
interest through time. This us idea of compounding, that is, interest added to
the original principal becomes the new principal.
Using example 3, the interest compounded annually is computed as follows:
Year Principal Rate Time Interest Principal Maturity Value
1 ₱1,000,000 5% 1 ₱50,000 ₱1,000,000 ₱1,050,000
2 ₱1,050,000 5% 1 ₱52,500 ₱1,050,000 ₱1,102,500
3 ₱1,102,500 5% 1 ₱55,125 ₱1,102,500 ₱1,157,625

At the end of the first year, interest earned is ₱50,000, which is added to
the principal of ₱1,000,000 for a total of ₱1,050,000, which becomes the new
basis of new principal for the second year. At the end of the second year, the
interest earned is ₱52,500. The ₱52,500 earned on the second year is now added
to the previous higher principal of ₱1,050,000 to give us ₱1,102,500. This figure
becomes the new principal that is multiplied by 5% to get the new interest for
the third year of ₱55,125. Added to the principal at the beginning of the third
year of ₱1,102,500, the maturity value at the end of the third year becomes
₱1,157,625.
Compounding interest yields a higher return because interest earned
becomes part of the principal that will still earn additional interest. The
computation above just shows accumulated interest to earn higher interest every
succeeding period. However, the method above is tedious; hence, it is applicable
only for a short period of time.
For longer period of time, like 10 or 20 years, it is easier to use the following
formula with the aid of a scientific calculator:
MV = P (1 + 𝑖)𝑛
Where MV = Maturity value
P = Principal
i = Interest rate
n = Number of years
Examples:
1. Assuming the amount of ₱1,000,000 is invested in a 10-year time deposit
earning 5% interest compound annually.

MV = P (1 + 𝑖)𝑛

= ₱1,000,000(1 + 5%)10
= ₱1,000,000(1.6289)
= ₱1,628,900
I = MV-P
= ₱1,628,900-₱1,000,000
= ₱628,900
Maturity value in computing compound interest is equal to the future value
(FV). We can make use of the FV table.
The interest in the table above example is earned once a year. For interest
which is earned more than once a year, the formula for MV is:
MV = P (1 + 𝑖/𝑚)𝑚𝑛
Where MV = Maturity value
i = Interest rate
n = Number of years (term)
m = Number of times interest is earned in a year.

2. Assume the amount of ₱1,000,000 is invested in a 10-year time deposit

earning 5% interest compounded semi-annually. The interest is earned
twice a year.
MV = P (1 + 𝑖/𝑚)𝑚𝑛

= ₱1,000,000(1 + .05/2)2(10)
= ₱1,000,000(1.6386)
= ₱1,638,600
I = ₱1,638,600-₱1,000,000
= ₱638,600
 3. Assume instead of semi-annually, the interest is compounded quarterly,
meaning four times in a year.

MV = ₱1,000,000(1 + .05/4)4(10)
= ₱1,000,000(1.6436)
= ₱1,643,600
I = ₱1,643,600-₱1,000,000
= ₱643,600
Take note that interest receive quarterly (₱643,600) for a year is higher than
interest received semi-annually for a year (₱638,600), which is higher than
interest received annually (₱628,900). Remember that the more times that the
interest is compounded, the higher the interest will be. Compounding the
interest monthly will yield a higher return.

2. What are the explanation and computation of future value, present

value, ordinary annuity, and annuity due?

2.1. FUTURE VALUE AND COMPOUNDING

Future value is the sum of money which will be received in the future period
resulting from investments, taking into account the interest it will earn. It is
synonymous with the terms “terminal value” and “maturity value”. Compounding
or accumulation is the process in which future value is determine.
Assuming ₱1,000,000 invested in a 4-year, 10% financial asset. What is the
future value?

Year P i I FV (P+I)
1 ₱1,000,000 10% ₱100,000 ₱1,100,000
2 ₱1,100,000 10% ₱110,000 ₱1,210,000
3 ₱1,210,000 10% ₱121,000 ₱1,331,000
4 ₱1,331,000 10% ₱133,000 ₱1,464,100

At point 0 or the period when the amount is invested, the amount is

₱1,000,000. It earns compound interest from year 1 to year 4. At the end of the
fourth year, the value is ₱1,464,100, its future value. Substituting FV for MV in
the formula of maturity value, we get:

FV = P (1 + 𝑖)𝑛

= ₱1,000,000(1 + .10)4

= ₱1,000,000(1.4641)

= ₱1,464,100
The investment is made once; hence, the factor used to multiply the principal
with is (1 + 𝑖)𝑛 which represent the future value of 1 at the end of a given period,
the FV factor available in the future value table. The factors in the FV table are
the reciprocal of corresponding factors in the PV table. This is because for the
FV, we use (1 + 𝑖)𝑛 , while for the PV factor, we use 1/(1 + 𝑖)𝑛 .

If, instead of using the formula, we use the FV table:

FV = PV x Future value factor for n periods at i %

FV = PV (FVFn, i)

Using the FV table, we look at 10% and year 4 and we get 1.4641, exactly
what we got when we raised 1.1 to the fourth power.

FV = PV (FVFn, i)
= ₱1,000,000 𝑥 1.4641 = ₱1,464,100
The use of the table makes computation easier.

2.2. PRESENT VALUE AND DISCOUNTING

Present value is the value at the current time cash flow expected to be
received after some period of time. It answers the question how much is the
worth today of an amount that will be received in the future. The present value
is always a smaller quantity than the future amount. For example, how much is
the present value of ₱1,000,000 to be received in 5 years at a discount rate of 5%?
The ₱1,000,000 is the future value and the 5% is the discount rate. In the present
value called discounting. The rate applied in discounting is called the discount
rate. The discount rate is expected rate of return.
The net cash flow could be received in two ways:
1. after a number years; or

2. annually.

The formula is determining the present value of net cash flow received after
a number of years is as follows:

PV = 𝐶𝐹 ⟦1/(1 + 𝑖)𝑛 ⟧
Where: CF = Net cash flow
i = Discount rate
So, if one is to received a cash flow of ₱1,000,000 after 5 years with a
discount rate of 5%, its present value is ₱783,500.00 computed as follows:
PV = 𝐶𝐹 ⟦1/(1 + 𝑖)𝑛 ⟧
= ₱1,000,000⟦1/(1 + .05)5 ⟧
= ₱1,000,000(0.784)
= ₱784,000
Using the present value table,
FV = PV x Future value factor for n periods at i %

FV = PV (FVFn, i)

= ₱1,000,000(0.784) = ₱784,000
 2.3. ORDINARY ANNUITY AND ANNUITY DUE
An annuity is defined as a stream or series of payments made or receipts
received over time. Annuity problems involved a series of equal periodic
payments or receipts called rents. In an ordinary annuity, the rents occur at the
end of each period. The first rent will occur one period from now. In an ordinary
annuity, the rents occur at the beginning of each period. The first rent will occur
now. Most annuities are ordinary annuities. Installment loans and coupon-
bearing bonds are examples of ordinary annuities. Rent payments, which are
typically due on the day commencing with the rental period, are an example of
an annuity due.
In a deferred annuity, the rents occur in the future. A deferred annuity
does not begin to produce rents unit two or more periods have expired. A deferred
annuity problem can occur in either an ordinary annuity situation or an annuity
due situation. In an ordinary annuity of n rents deferred for y periods, the first
rent will occur (y + 1) periods from now. In an annuity due of n rents deferred
for y periods, the first rent will occur y periods from now. (Wiley.com)
Let us use scenario 2 under NPV to use the ordinary annuity table, since
the future cash flow during the first 4 years is a series of ₱1.5M. a final cash flow
of ₱23M is received in the fourth year. The problem can be solved in two ways:
PV of ₱1.5M received for = ₱1.5M x PV of annuity 6%,
years ordinary 4 yrs.

= ₱1.5𝑀(3.465) =₱5,197,500
PV of ₱23M received on the =₱ 23M x PV of ₱1.00 6%,
fourth year 4yrs.

= ₱ 23M (0.792) = ₱18,216,000

Total PV = ₱ 23,413,500
Invested required (20,000,000)
NPV = ₱3,413,500

PV of ₱1.5M received for 3 = ₱1.5M x PV of ordinary

years annuity 6%,4 yrs.

= ₱1.5𝑀(2.673) = ₱4,009,500
PV of ₱24.5M received on = ₱ 24.5M x PV of ₱1.00 6%,
the fourth year 4yrs.

= ₱ 24.5M (0.792) = 19,404,000

Total PV = ₱ 23,413,500
Invested required (20,000,000)
NPV = ₱ 3,413,500
 To illustrate annuity due, let us assume that the ₱1.5M in our example is
received at the beginning of the year. We will assume further that we sold the
housing project at the end of the fourth year. Our solution would modified as
follows:
PV of ₱1.5M received for 4 = ₱1.5M x PV of Annuity Due
years 6%, n = 4

= ₱1.5𝑀 𝑥 3.673 = ₱5,509,500

PV of ₱23M received on the = ₱ 24.5M x PV of ₱1.00 6%,
fourth year 4yrs.

= ₱ 23M (0.792) = 18,216,000

Total PV = ₱ 23,725,500
Invested required (20,000,000)
NPV =₱ 3,725,500

Take note that the present value of the annuity (₱5,509,500), being
received at the end of the year, is lower than the present value of annuity due
(₱ 3,725,500), being received at the beginning of the year.
In annuity problems, the rents, interest payments, and number of
periods must all be stated on the same basis. For example, if interest is
compounded semi-annually, then n= the number of semi-annual rents paid or
received, i= the annual interest rate divided by 2, and R= the amount of rent
period or received every 6 months.
The following computation for the PV of an ordinary annuity, the PV of
an annuity due, the FV of an ordinary annuity, and the FV of an annuity due
(Frickpa.com).
The present value of an ordinary annuity of ₱50 per year over 3 years at 7%
would be:
1 − (1 + 𝑖)𝑛 1 − (1 + 0.07)3
FV𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 = 𝑃𝑀𝑇 ( ) = 50.00 ( ) = 131.22
𝑖 0.07

The present value of an annuity due would be:

FV𝑑𝑢𝑒 = PV𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 (1 + 𝑖 ) = 131.22(1.07) = 140.40

The PV of the annuity due is greater than the PV of the ordinary annuity
because it is received ahead. That illustrates exactly what time value of money
means.
The future value of an ordinary annuity of ₱25 per year over 3 years at 9%
would be:
(1 + 𝑖)𝑛 − 1 (1 + 0.09)3 − 1
FV𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 = 𝑃𝑀𝑇 ( ) = 25.00 ( ) = 81.95
𝑖 0.09

The future value of an annuity due under the same terms is calculated as:
FV𝑑𝑢𝑒 = PV𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 (1 + 𝑖 ) = 81.95(1.09) = 89.33

Again, the FV of an annuity due is greater than the FV of the ordinary annuity.
The difference between the ordinary annuity and annuity due of n rents
deferred for y periods are as follows (Wiley.com)
Ordinary Annuity of n Rents Annuity Due of Returns
Deferred for y Periods Deferred for y periods

First rent occurs (y + 1) periods from now y periods from now

Last rent occurs (y + n) periods from now (y + n - 1) periods from now

Future amount is immediately after the last rent one period after last rent
 1. How to evaluate and choose the best investment alternative using the
concept of net present value?

1.1. NET PRESENT VALUE

The concept of net present value is used in financial decision-making,
particularly in evaluating investment alternatives. Drawing on the concept of
present value, the total present value of all future cash flow is obtained.
Deducting the investment or principal needed for the project or investment
from this total present value, the result is the net present value (NPV). If the
NPV is positive, the project of investment alternative is accepted; if negative,
the project of investment alternative is rejected.
Let us take an investment opportunity to build a housing project. Assume
that a land for sale is suitable for the project for ₱4.5M. The construction of a
townhouse will cost ₱15.5M. therefore, the total project will cost ₱20M.
Currently, the opportunity cost of capital is 6%. Assume the following scenarios:
1. in a year’s time, the entire complex can be sold for ₱23M.
2. you can rent the project for 4 years at a total yearly sum of ₱1.5M. At
the end of the fourth year, you can sell the townhouse to the tenants
for cash worth ₱23M.
let us take scenario 1:
PV of the ₱23M to be received in a year’s time = ₱23 x PV factor at 6%, n= 1
= ₱23 x 0.943
= ₱21,689,000
Investment required (20,000,000)
Net present value (NPV) = ₱1,689,000
The NPV is positive, therefore, we can accept the project.
However, let us see what the NPV would be for scenario 2:
Year Cash Flow PV Factor PV
1 ₱1.5M 0.943 ₱1,414,500
2 1.5M 0.890 1,335,000
3 1.5M 0.840 1,260,000
4 24.5M 0.792 19,404,000
Total present value = ₱23,413,500
Investment required (20,000,000)
NPV = ₱ 3,413,500
 The NPV is positive and should be accepted. Comparing the NPV for the
second option with the NPV for the first option, the NPV for the second option is
higher; therefore, it would be better if the townhouse project is rented out and
then sold at the end of the fourth year than selling it after the project is done in
the first year.
III. LEARNING / CHAPTER ACTIVITIES

Problem Solving:
You are contemplating on building a house project. The land cost ₱4.5M
and a construction of a town house will cost ₱15.5M. you can sell the entire
project in a year’s time for ₱23M. Assuming an opportunity cost of capital of 6%,
will you invest in the project? Why?
1. Using the data in the problem, but with an opportunity cost of 16%, will
you accept the project? Why?

2. Using the data in the problem, but instead of selling the entire housing
project in a year’s time, you decide to lease the town house for 4 years at
a total yearly sum of ₱1.5M. At the end of the fourth year, you will sell the
townhouse units for a total sum of ₱24.5M. Assume the same opportunity
cost of capital of 6%. Which is better, outright sales as in number 1 or
leasing it out and selling it in the fourth year? Why?

3. A 5-year housing project costing ₱500,000 is the projected to give the

following annual returns.
Year 1 ₱75,000
Year 2 150,000
Year 3 225,000
Year 4 300,000
Year 5 350,000
Will you accept the project? Why?
4. If the project in number 3 showed a reversed annual return as follows:
Year 1 ₱350,000
Year 2 300,000
Year 3 225,000
Year 4 150,000
Year 5 75,000
Will you accept the project? Why? Which is better, the project I number 3
or the project in umber 4? Why?
5. If you put ₱500,000 in number 3 in the bank, it will give you a compound
interest of 10%
How much money will you have at the end of the 5-year period? How much
would the present value of that amount be? Compute for the NPV. Which
is the best, putting the money in project number 3? 4? or 5? Why?
IV. REFERENCES

Books

a. Brown, et. al. (2015) Capital Markets, Cengage Learning Asia Pte Ltd.
b. Mariano, N. (2017) Capital Markets, Rex Book Store Inc.