CHAPTER 5

TIME VALUE OF MONEY

The time value of money (TVM) is the concept that money you have now is worth more than the
identical sum in the future due to its potential earning capacity. This core principle of finance holds that
provided money can earn interest, any amount of money is worth more the sooner it is received. TVM
is also sometimes referred to as present discounted value.

COMPOUNDING VS. DISCOUNTING

Time Value of Money says that the worth of a unit of money is going to be changed in future. Put
simply, the value of one rupee today will be decreased in future. The whole concept is about the present
value and future value of money. There are two methods used for ascertaining the worth of money at
different points of time, namely, compounding and discounting. Compounding method is used to
know the future value of present money. Conversely, discounting is a way to compute the present
value of future money. Compounding is helpful to know the future values, of the cash flow, at the end
of the particular period, at a definite rate. Contrary to this, Discounting is used to determine the present
value of the future cash flow, at a certain interest rate. Here, in this article, we’ve described the
differences between compounding and discounting.
Present Value of an Annuity

The present value of an annuity is the current value of all the income that will be generated by that
investment in the future. In more practical terms, it is the amount of money that would need to be
invested today to generate a specific income down the road. 
Using the interest rate, desired payment amount, and the number of payments, the present value
calculation discounts the value of future payments to determine the contribution necessary to achieve
and maintain fixed payments for a set time period.
Present value of a future single sum of money is the value that is obtained when the future value is
discounted at a specific given rate of interest. In the other words present value of a single sum of
money is the amount that, if invested on a given date at a specific rate of interest, will equate the sum
of the amount invested and the compound interest earned on its investment with the face value of the
future single sum of money.

Formula
The formula to calculate present value of a future single sum of money is:

Future Value (FV)

Present Value (PV) =
(1 + i)n

Where, i is the interest rate per compounding period which equals the annual percentage rate divided
by the number compounding periods in one year; and n is the number of compounding periods.
1/(1+i)n is called the present value factor.

Examples
Example 1: Calculate the present value on Jan 1, 2011 of $1,500 to be received on Dec 31, 2011. The
market interest rate is 9%. Compounding is done on monthly basis.
Solution
We have,
Future Value FV = $1,500
Compounding Periods n = 12
Interest Rate i = 9%/12 = 0.75%
Present Value PV = $1,500 / ( 1 + 0.75% )^12
= $1,500 / 1.0075^12
≈ $1,500 / 1.093807
≈ $1,371.36
Future Value of an Annuity
The future value of an annuity represents the total amount of money that will be accrued by making
consistent investments over a set period, with compound interest.
Rather than planning for a guaranteed amount of income in the future by calculating how much must be
invested now, this formula estimates the growth of savings, given a fixed rate of investment for a given
amount of time.

Formula
Compound interest rate is the most common method of interest accumulation in which case the future
value can be calculated using the following formula:
Future Value (Compound Interest)
= Present Value (PV) × (1 + i)n
Where,
i is the periodic interest rate (= annual percentage rate divided by compounding periods per year; and
n are the total number of compounding periods.
(1 + i × n) and (1 + i)n are the future value factors in case of simple interest and compound interest
respectively.

Examples
Example 1: An amount of $10,000 was invested on Jan 1, 2019 at annual interest rate of 8%. Calculate
the value of the investment on Dec 31, 2021. Compounding is done on quarterly basis.
Solution
We have,
Present Value PV = $10,000
Compounding Periods n = 3 × 4 = 12
Interest Rate i = 8%/4 = 2%
Future Value FV = $10,000 × ( 1 + 2% )^12
= $10,000 × 1.02^12
≈ $10,000 × 1.268242
≈ $12,682.42

Visit this link for more examples of finding Future and Present Value:
https://youtu.be/BXm5mZqMp6Y
How to Calculate Interest Rate Using Present & Future Value

You can use this formula:

r= (FV/PV)^1/t -1
r-rate
FV-future value
PV- present value
t-time

Example: You want to know the annual interest rate you need to earn to grow $1,000 today to $1,750
in 10 years.
Solution:
r=(1,750/1,000)^1/10 -1
= .0576 or 5.76%

You can also follow these simple steps:

Step 1
Divide the future value by the present value. Say you want to know the annual interest rate you need to
earn to grow $1,000 today to $1,750 in 10 years. Divide $1,750 by $1,000 to get 1.75.

Step 2
Divide 1 by the number of periods you will leave the money invested. Each period can be a month,
year or some other interval. In this example, you’ll invest your money for 10 years, so divide 1 by 10 to
get 0.1.

Step 3
Raise your Step 1 result to the power of your Step 2 result. In this example, raise 1.75 to the 0.1 power
to get 1.0576.

Step 4
Subtract 1 from your result. In this example, subtract 1 from 1.0576 to get 0.0576.
Step 5
Multiply your result by 100 to calculate the interest rate as a percentage. This percentage represents the
rate your investment must earn each period to get to your future value. Concluding the example,
multiply 0.0576 by 100 for a 5.76 percent interest rate. You need to earn 5.76 percent annually to get to
$1,750 in 10 years.
You can visit this link for another way of solving interest rate: https://youtu.be/SDPh2UVLuVY?t=231

Finding Number of Periods

You can use this formula:
n = ln (FV / PV )
In (1+r)

Example:
We want to know how many periods it takes to turn $1,000 into $2,000 at 10% interest.

Solution: n = ln( $2,000 / $1,000 ) / ln( 1 + 0.10 )

= ln(2)/ln(1.10)
= 0.69315/0.09531
= 7.27

Another Example: How many years to turn $1,000 into $10,000 at 5% interest?

Solution:
n = ln (FV / PV )
In (1+r)
n = ln ($10,000 / $1,000 )
In (1 + 0.05)
n = ln (10 )
In (1.05)
n = 2.3026
0.04879
= 47.19

For more ways of solving for time, you can visit this link: https://youtu.be/a2kxBYYpCfM
Amortized Loan
An amortized loan is a type of loan with scheduled, periodic payments that are applied to both the
loan's principal amount and the interest accrued. An amortized loan payment first pays off the relevant
interest expense for the period, after which the remainder of the payment is put toward reducing the
principal amount. Common amortized loans include auto loans, home loans, and personal loans from a
bank for small projects or debt consolidation.

How an Amortized Loan Works

The interest on an amortized loan is calculated based on the most recent ending balance of the loan; the
interest amount owed decreases as payments are made. This is because any payment in excess of the
interest amount reduces the principal, which in turn, reduces the balance on which the interest is
calculated. As the interest portion of an amortized loan decreases, the principal portion of the payment
increases. Therefore, interest and principal have an inverse relationship within the payments over the
life of the amortized loan.
An amortized loan is the result of a series of calculations. First, the current balance of the loan is
multiplied by the interest rate attributable to the current period to find the interest due for the period.
(Annual interest rates may be divided by 12 to find a monthly rate.) Subtracting the interest due for the
period from the total monthly payment results in the dollar amount
The amount of principal paid in the period is applied to the outstanding balance of the loan. Therefore,
the current balance of the loan, minus the amount of principal paid in the period, results in the new
outstanding balance of the loan. This new outstanding balance is used to calculate the interest for the
next perio

Amortized Loans vs. Balloon Loans vs. Revolving Debt (Credit

Cards)
While amortized loans, balloon loans, and revolving debt–specifically credit cards–are similar, they
have important distinctions that consumers should be aware of before signing up for one.

Amortized Loans
Amortized loans are generally paid off over an extended period of time, with equal amounts paid for
each payment period. However, there is always the option to pay more, and thus, further reduce the
principal owed.

Balloon Loans
Balloon loans typically have a relatively short term, and only a portion of the loan's principal balance is
amortized over that term. At the end of the term, the remaining balance is due as a final repayment,
which is generally large (at least double the amount of previous payments).
Revolving Debt (Credit Cards)
Credit cards are the most well-known type of revolving debt. With revolving debt, you borrow against
an established credit limit. As long as you haven't reached your credit limit, you can keep borrowing.
Credit cards are different than amortized loans because they don't have set payment amounts or a fixed
loan amount.

Example of an Amortization Loan Table

EXAMPLE: Construct an amortization schedule for a $1,000, 10% annual rate loan with 3 equal
payments.
1st Step: Calculate the Payment using this formula:

Pmt =1,000 x .10/(1-1/(1+.10)^3)

=402.11

2nd Step :Find the interest paid

INTEREST = Beginning balance x interest rate

INTEREST = $1,000 (0.10) = $100

3rd Step: Find the principal repaid

PRINCIPAL = PAYMENT – INTEREST

= $402.11 - $100 = $302.11
4th Step: Find the ending balance

ENDING BALANCE= =BEG BAL - PRIN

=$1000-$302.11
=$697.89

AMORTIZATION SHEDULE

END BAL
PERIOD BEG BAL PAYMENT INTEREST PRINCIPAL

1 $1,000 $402 $100 $302 $698

2 698 402 70 332 366
3 366 402 37 366 0
TOTAL   1,206.34 206.34 1,000 -

Watch this video for another example: https://youtu.be/9Vm_X6023Yk

Activities:

Items 1-5. Solve for the Future Value. Show your solution. 5 points each.

1 2 3 4 5
PV $5,500 $5,500 $5,500 $5,500 $5,500
rate 5% 6% 7% 8% 9%
5 years 5 years 5 years 5 years 5 years
time compounded compounded compounded compounded compounded
anually semi-monthly monthly quarterly daily

6-10. Solve for the PresentValue. Show your solution. 5 points each.

6 7 8 9 10
FV $5,500 $5,500 $5,500 $5,500 $5,500
rate 5% 6% 7% 8% 9%
5 years 5 years 5 years 5 years 5 years
time compounded compounded compounded compounded compounded
anually semi-monthly monthly quarterly daily
11-15. Solve for the rate. Show your solution. 5 points each.

11 12 13 14 15
FV $5,500 $5,500 $5,500 $5,500 $5,500
PV $3,500 $4,000 $2,500 $4,700 $2,000

time 3 years 2 years 1 year 4 years 5 years

16-20. Calculate the time/period. Show your solution. 5 points each.

16 17 18 19 20
FV $5,500 $5,500 $5,500 $5,500 $5,500
PV $3,500 $4,000 $2,500 $4,700 $2,000

rate 9% 12% 15% 7% 3%

21-30. Construct an amortization schedule for a $25,000 loan with 5% quarterly interest rate
payable for 1 year (4 equal payments). 40 ponits.

___________________________________________________________________________________
Question1: Sir how are we going to submit our answers?

Answer: Through (ONE ON ONE) oral recitation via messenger video call. Just tell me when you are
ready. I will ask you several questions, including your techniques in solving the time value of money.

Question2: Sir can we have our oral anytime?

Answer: NO. I’m only available at 7pm-10pm MWF, 9pm-10pm TTH and 1pm-10pm Saturdays and
Sundays. Be guided with the schedule.

Oral recitation will range from 10-15 minutes per student. First 5 students to recite will be given
additional points.

DEADLINE IS OCTOBER 16, 2020.

Good Luck! Stay safe!