TIME VALUE OF

MONEY
Part 2
The time value of money is one of the most
fundamental concepts in finance; it is based
on the notion that receiving a sum of money
in the future is less valuable than receiving
that sum today.

This is because a sum received today can be

invested and earn interest.
The four basic time value of
money concepts are:

ꢀfuture value of a sum

ꢀpresent value of a sum
ꢀfuture value of an annuity
ꢀpresent value of an annuity
If a sum is invested today, it will earn interest
and increase in value over time. The value that
the sum grows to is known as its future value.

Computing the future value of a sum is known

as compounding.
The future value of a sum depends on
the interest rate earned and the time
horizon over which the sum is invested.

This is shown with the following formula:

FVN = PV(1+I)N
where:

FVN = future value of a sum

invested for N periods
I = periodic rate of interest
PV = the present or current
value of the sum invested
N = number of periods
Suppose that a sum of Php. 1,000 is invested for
four years at an annual rate of interest of 3%.
What is the future value of this sum?
In this case,

N=4
I = 3%
PV = Php. 1,000
Using the future value formula,

FVN = PV(1+I)N
FV4 = 1,000(1+.03)4
FV4 = 1,000(1.125509)
FV4 = Php. 1,125.51
The present value of a sum is the amount
that would need to be invested today in
order to be worth that sum in the future.

Computing the present value of a sum is

known as discounting.
The formula for computing the
present value of a sum is:

FVN
PV = N
(1+ I )
How much must be deposited in a bank
account that pays 5% interest per year in
order to be worth Php. 1,000 in three years?
In this case,

N=3
I=5
FV3 = Php. 1,000
 FVN 1,000
PV = N
= 3
(1+ I ) (1.05)

1,000
= = Php. 863.84
1.1576
An annuity is a periodic stream of
equally-sized payments.

The two basic types of annuities are:

ꢀ rdinary annuity
o
ꢀ nnuity due
a
With an ordinary annuity, the first
payment takes place one period in
the future.

With an annuity due, the first

payment takes place immediately.
The formulas used to compute the
future value and present value of a
sum can be easily extended to the
case of an annuity.
The formula for computing the future
value of an ordinary annuity is:

(1+ I ) − 1 N
FVAN = PMT
I
where:

FVAN = future value of an

N-period ordinary annuity

PMT = the value of the

periodic payment
Suppose that a sum of Php. 1,000 is invested at
the end of each of the next four years at an
annual rate of interest of 3%. What is the
future value of this ordinary annuity?
In this case,

N=4
I=3
PMT = Php. 1,000
Using the formula,

(1+ I ) − 1
N
FVAN = PMT
I
 (1+ .03) −1
4

FVA4 = 1,000 = P 4,183.63

.03
The future value of the annuity can
also be obtained by computing the
future value of each term and then
combining the results:
1,000(1.03)3 + 1,000(1.03)2 +
1,000(1.03)1 + 1,000(1.03)0

= 1,092.73 + 1,060.90 +
1,030.00 + 1,000.00

= Php. 4,183.63
The future value of an annuity due
is computed as follows:

FVAdue = FVAordinary(1+I)
Referring to the previous example, the
future value of an annuity due would be:

4,183.63(1+.03) = Php. 4,309.14

The formula for computing the present
value of an ordinary annuity is:

⎡ 1 ⎤
1 −
⎢ (1+ I )N ⎥
PVAN = PMT ⎢ ⎥
⎢ I ⎥
⎢⎣ ⎥⎦
where:

PVAN = future value of an

N-period ordinary annuity

PMT = the value of the

periodic payment
How much must be invested today in a bank
account that pays 5% interest per year in order
to generate a stream of payments of Php. 1,000 at
the end of each of the next three years?
In this case,

N=3
I=5
PMT = Php. 1,000
Using the formula,

⎡ 1 ⎤
1 −
⎢ (1+ I )N ⎥
PVAN = PMT ⎢ ⎥
⎢ I ⎥
⎢⎣ ⎥⎦
 ⎡ 1 ⎤
⎢ 1 − 3 ⎥
(1+ .05)
PVA3 = 1,000 ⎢ ⎥ = Php. 2, 723.25
⎢ .05 ⎥
⎢⎣ ⎥⎦
The present value of the annuity can
also be obtained by computing the
present value of each term and then
combining the results:
1,000(1.05)-3 + 1,000(1.05)-2 + 1,000(1.05)-1
= 863.84 + 907.03 + 952.38
= Php. 2,723.25
The present value of an annuity
due is computed as follows:

PVAdue = PVAordinary(1+I)
Referring to the previous example, the
present value of an annuity due would be:

2,723.25(1+.05) = Php. 2,859.41

Thank you!