TIME VALUE OF MONEY

A Research Paper Presented in Partial Fulfillment

Of the Requirements for the Course

Financial Management

Submitted by:

Date Submitted:
 TABLE OF CONTENTS

CHAPTER Page

1. Introduction ……………………………………………………………… 1
2. What Is the Time Value of Money ……………………………………… 1
3. The Source of the Time Value of Money ……………………………….. 2
4. How to Calculate the Time Value of Money ……………………………. 2
5. Factors Affecting the Time Value of Money ……………………………. 10
6. The Meaning of the Time Value of Money …………………………….... 11
7. Insights what you have learned about the topics ………………………… 11

Reference ………………………………………………………………………… 12
I. Introduction
If you are given the option, would you prefer to receive ₱1,000,000.00 today or
₱85,000.00 for the next 12 months. If you answered ₱85,000.00 for the next 12 months,
you might have considered the difference of ₱20,000.00 (₱85,000.00 x 12 months =
₱1,020,000.00). But if you chose to receive the ₱1,000,000.00 today, then you realize
that money has a time value. By understanding the time value of money, you can weigh
the opportunity for growth against the consistency of recurring payments.

You may have heard the expression “A bird in the hand is worth two in the bush.” In a
way, this refers to the time value of birds; that is, it is better to have a single bird in
hand now than the possibility of catching two birds in the future.

Time value of money is an important concept in financial management. It can help you
make decisions on how to best use your money, whether you should spend it, save it or
invest it. To understand the concept of time value of money, we need to understand
what is the time value of money, its sources and the factors affecting it. And to better
illustrate the concept of time value of money, some examples are incorporated in this
research paper and how to compute for the future value and present value of money.

II. What Is the Time Value of Money?

Time Value of Money is a concept that the money at the present time has a greater value
than the same amount of money in the future. It is a theory on the advantage of having
money today than later. The time value of money involves two major concepts: the
future value and present value. The future value sometimes called compound value, is
the amount to which a present amount of money or a series of payments will grow over
time when compounded at a given interest rate. While, present value is the current
value of a future amount of money, or series of payments, evaluated at an appropriate
discount rate. To further differentiate the two, the future value is the cash that will be
receive at a future given date, whereas, the present value is just like a cash in hand at
the present time.

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III. The Source of the Time Value of Money
There are four main reasons why it is better to receive the money today than receive it
in the future. The first reason is due to inflation, it is expected that the price of
commodities in the future will increase due to inflation, which will result to the decline
in the value of today’s money in the future. The next reason is interest earning, because
the money that you can deposit today can already earn some interest. Another reason
is investment; the money you can invest now has an opportunity to gain some profit or
generate more money. And lastly is the risk in the usage of the money. For example,
lending money to someone creates potential risk of not being paid back in full that will
reduce the worth of your money in the future.

IV. How to Calculate the Time Value of Money?

The process of determining the future value of each cash flow at the end of the time
period is called compounding, while the process of determining present value of a
future amount is called discounting. There are mathematical formulas or equations for
compounding and discounting, and this formulas or equations will use the following
notation:
FV = Future Value
PV = Present Value
i = Interest Rate
n = Number of periods
m = Number of times per year

To determine the worth of the money in the future, the compounding equations or
formulas are use:

a. Future Value of Annual Compounding:

n
FV n = PV ( 1+i )

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 b. Future Value of Intraperiod Compounding - compounding that occurs more
than once a year

mn
FV n = PV { 1+ ( i
m ) }
The following examples will illustrate how to apply the compounding equations.

Example 1. The financial manager has choice of leaving ₱1,000,000.00 with ABC
bank paying 10 percent simple interest or 10 percent compound interest for five years.

Option 1: Simple Interest of 10 percent for five years

Beginning Amount Simple Interest Ending Amount

Year
(1) (2) = [0.10 x (1)] (3) = [(1) + (2)]
1 ₱1,000,000.00 ₱100,000.00 ₱1,100,000.00
2 1,000,000.00 100,000.00 1,200,000.00
3 1,000,000.00 100,000.00 1,300,000.00
4 1,000,000.00 100,000.00 1,400,000.00
5 1,000,000.00 100,000.00 1,500,000.00
Total Interest ₱500,000.00

With simple interest, the financial manager earns 10 percent interest each year on the
principal of ₱1,000,000.00 amounting to ₱100,000.00 (0.10 x ₱1,000,000 x 5) each
year or a total of ₱500,000.00 for five years.

Option 2: Compound Interest of 10 percent for five years

Beginning Amount Compound Interest Ending Amount

Year
(1) (2) = [0.10 x (1)] (3) = [(1) + (2)]
1 ₱1,000,000.00 ₱100,000.00 ₱1,100,000.00
2 1,100,000.00 110,000.00 1,210,000.00
3 1,210,000.00 121,000.00 1,331,000.00
4 1,331,000.00 133,100.00 1,464,100.00
5 1,464,100.00 146,410.00 1,610,510.00
Total Interest ₱610,510.00

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In compound interest, the amount of interest earned increases each year because the
beginning amount upon which the interest is calculated increases each year. The
compound interest total ₱610,510.00 after five years. The ₱110,510.00 difference in
interest favors compound interest.

To determine the future value on the specific year without preparing the table, the
formula on future value of annual compounding can be use. The computation using the
formula will produce the same result but without the need to prepare the table or to
compute the future value per year. To compute for the future value of ₱1,000,000.00
in five years with compound interest of 10 percent, the computation will be as follows:

FV n = PV ( 1+i )
Let the:
FV = Future Value
PV = 1,000,000.00
i = 10 percent
n = 5 years

5*
FV 5 = 1,000,000.00 ( 1 + 0.10 )
FV 2 = 1,000,000.00 ( 1 .61051 )
= 1,610,510.00

The future value of the other years can be computed as follows:

Year Calculation Future Value

n
FV n = PV ( 1+i )
1
1 FV 1 = 1,000,000.00 ( 1 + 0.10 ) = ₱1,100,000.00

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 Year Calculation Future Value
n
FV n = PV ( 1+i )
2
2 FV 2 = 1,000,000.00 ( 1 + 0.10 )
2*
FV 2 = 1,000,000.00 ( 1 .10 )
FV 2 = 1,000,000.00 ( 1 .21 ) = ₱1,210,000.00
3*
3 FV 3 = 1,000,000.00 ( 1 + 0.10 )
FV 2 = 1,000,000.00 ( 1 .331 ) = ₱1,331,000.00
4*
4 FV 4 = 1,000,000.00 ( 1 + 0.10 )
FV 2 = 1,000,000.00 ( 1 .4641 ) = ₱1,464,100.00
5*
5 FV 5 = 1,000,000.00 ( 1 + 0.10 )
FV = 1,000,000.00 ( 1 .61051 ) = ₱1,610,510.00
2

* Computation of future value interest factor

2
(1.10) = (1.1)(1.1) = 1.21
3
(1.10) = (1.1)(1.1) (1.1) = 1.331
4
(1.10) = (1.1)(1.1)(1.1) (1.1) = 1.4641
5
(1.10) = (1.1)(1.1)(1.1)(1.1)(1.1) = 1.61051

The future value interest factor may be viewed as the result of investing or lending
₱1.00 at interest rate (i) for (n) periods. It can be found using the table of Future Value
of ₱1.00 for ease of reference. However, the accuracy level of the future value interest
factor listed in the table is lower because of rounding. This means that the most optimal
way to calculate the future value interest factor would be to use the actual formula.

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This illustration depicted the future value of the ₱1,000,000.00 in five years with
compound interest of 10 percent.

₱1,000,000.00 ₱1,210,000.00 ₱1,464,100.00

₱1,100,000.00 ₱1,331,000.00 ₱1,610,510.00
PV FV1 FV2 FV3 FV4 FV5
Time
t0 t1 t2 t3 t4 t5

The compounding that occurs for more than once in a year is called intraperiod
compounding. The calendar period over which compounding occurs is called the
compounding period. The compounding period could be annually, semiannually,
quarterly or even monthly.

Example 2. Instead of placing ₱1,000,000.00 in ABC bank that pays 10 percent interest
compounded annually, the financial manager decides to put the money in DEF bank
that pays 10 percent interest compounded semi-annually. The computation for the two
options are shown below:

Annual Compounding
n
FV n = PV ( 1+i )
Let the:
FV = Future Value
PV = 1,000,000.00
i = 10 percent
n = 5 years

1
FV 1 = 1,000,000.00 ( 1 + 0.10 )
= 1,000,000.00 ( 1 + 0.10 )
FV 1 = 1,100,000.00

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 Intraperiod Compounding
mn
FV n = PV { 1+ ( i
m ) }
Let the:
FV = Future Value
PV = 1,000,000.00
i = 10 percent
n = 5 years
m = 2 times per year

(2)(1)
FV 1 = 1,000,000.00 { 1+ ( 0.10
2 ) }
2
= 1,000,000.00 { 1+ ( 0.05 ) }
2

= 1,000,000.00 { 1 .05 }
= 1,000,000.00 { 1 .1025 }
FV 1 = 1,102,500.00

Between the two banks, there would be a difference in the future value of investment
after one year. The future value of investment after one year is ₱2,500.00 more with
intraperiod compounding than with annual compounding. Increasing the frequency of
the compounding period makes the future value grow rapidly because more interest is
earned on the changing balance. The table below will show the difference of future
value using annual compounding and intraperiod compounding:

Year Annual Compounding Intraperiod Compounding Difference

1 ₱1,100,000.00 ₱1,102,500.00 ₱2,500.00
2 1,210,000.00 1,215,510.00 5,510.00

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 Year Annual Compounding Intraperiod Compounding Difference
3 1,331,000.00 1,340,100.00 9,100.00
4 1,464,100.00 1,477,460.00 13,360.00
5 1,610,510.00 1,628,890.00 18,380.00

The future value in intraperiod compounding were computed as follows:

Year Calculation Future Value

mn
FV n = PV { 1+ ( m
i
) }
(2)(2)
2 FV 2 = 1,000,000.00 { 1+ ( 0.10
2 ) }
4

= 1,000,000.00 { 1 .05 }
= 1,000,000.00 { 1 .21551 } = ₱1,215,100.00
(2)(3)
3 FV 3 = 1,000,000.00 { 1+ ( 0.10
2 ) }
6

= 1,000,000.00 { 1 .05 }
= 1,000,000.00 { 1 .34010 } = ₱1,340,100.00
(2)(4)
4 FV 4 = 1,000,000.00 { 1+ ( 0.10
2 ) }
8

= 1,000,000.00 { 1 .05 }
= 1,000,000.00 { 1 .47746 } = ₱1,477,460.00
(2)(5)
5 FV 5 = 1,000,000.00 { 1+ ( 0.10
2 ) }
10

= 1,000,000.00 { 1 .05 }
= 1,000,000.00 { 1 .62889 } = ₱1,628,890.00

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On the other hand, the following discounting equation or formula are used to discounts
money that will be received in the future back in time to see what it is worth in the
present:
FV n
PV =
(1+i)n

or
1
PV = FV n { (1+i)n }
The example below will illustrate how to apply the discounting equation.

Example 3. XYZ Company expects to receive ₱1,100,000.00 one year from now. What
is the present value of this amount if the discount rate is 10 percent?

Let the:
PV = Present Value
FV = 1,100,000.00
i = 10 percent
n = 1 year

FV n
PV =
(1+i)n

1,100,000.00 1
PV =
( 1 + 0.10 ) 1
1,100,000.00
=
1.10

PV = 1,000,000.00

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 Present Value can also be computed as follow:
1
PV = FV n { (1+i)n }
1
PV = 1,100,000.00 { ( 1 + 0.10 ) 1 }
1
= 1,100,000.00 { ( 1.10 ) }
= 1,100,000.00 { 0.9091 }
PV = 1,000,010.00

This example shows that discounting ₱1,100,000.00 at 10 percent yields a present value
of ₱1,000,000.00. The difference of ₱10.00 is caused by rounding the term in the
bracket.

To summarize the determination of future value and present value, the future value
determination compounds money forward in time to determine its worth in the future.
While, present value determination discounts money that will be received in the future
back in time to see what it is worth in the present.

Future Value (Compounding)

Time
t0 t1 t2 t3 t4 t5
Present Value (Discounting)

V. Factors Affecting the Time Value of Money

The factors affecting time value of money are principal, interest and time period. The
principal is the amount of money borrowed or invested today, the interest is the amount
paid for the borrowed money or amount earned for invested money, while the time
period is the length of time or number of periods during which interest is paid or earned.

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VI. The Meaning of the Time Value of Money
Time Value of Money means that a peso today is worth more than a peso tomorrow. By
owning a sum money today, you could spend and get your satisfaction now rather than
waiting for the chance to spend it in the future or even if you decided to save or invest
your money, you would rather choose to deposit or invest it today and already start
earning interest or profit than doing in a later date/time.

VII. Insights what you have learned about the topics

The most significant lesson in the time value of money is how time affects the worth
of money and the principle that the money you have currently at hand is worth more
than it will be in the future. Therefore, we should always prefer to receive the money
now rather than receiving it in the future, for the reason that the future is uncertain and
the money you have at hand has the potential to increase. A good example to apply
principle of time value of money is the retirement and pension benefit plan that allow
retirees to choose between the option to receive a lump sum amount worth of five years’
pension upon retirement and receive the monthly pension after five years against the
option to receive the monthly pension immediately after retirement. Since taking the
lump sum amount worth of five years’ pension does not cost anything, it would be
logical to possess it right away. Besides by taking the money now will enable you to
spend it and get your satisfaction now rather than waiting for the chance to spend it in
the future, which is uncertain or you can deposit it or invest it that can potentially
generate more money. Also, time value of money enables someone to compute the
future value and present value of money, that are useful and very helpful on how to
manage the funds wisely.

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References

 Cabrera, E.B., Cabrera, G.B., Cabrera, B.B. (2021) A Time Value of Money
Concepts. Financial Management Principles and Applications, p.714-728
 Hofstrand, D. (June 2013) Understanding the Time Value of Money. Ag Decision
Maker, Iowa State University
https://www.extension.iastate.edu/agdm/wholefarm/pdf/c5-96.pdf
 Politeknik NSC Surabaya E-Books Collection. Chapter 4 Time Value of Money
https://nscpolteksby.ac.id/ebook/files/Ebook/Accounting/Principles%20of%20Ma
nagerial%20Finance%2010th%20edition%20%20Lawrence%20J%20Gitman%20
(2010)/Chapter%204%20%20Time%20Value%20of%20Money.pdf
 Rahman, M. (2018) Time value of money: A case study on its concept and its
application in real life problems. Institute of Business Administration,
Jahangirnagar University, Bangladesh
https://www.allfinancejournal.com/article/view/5/1-1-5

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