TIME VALUE OF MONEY

Overview on Time Value of Money (TVM)

Time value of money is the concept that the value of peso on hand today. One
reason is the money future is less that value of a peso on hand today. One reason is
that money received today can be invested thus generation more money. Another
reason is that when a person opts to receive a sum of money in future rather than
today, he is effectively lending the money and there are risks involved in lending such
as default risk and inflation.

Time value of money principle also applies when comparing the worth of money
to be received in future and the worth of money to be received in further future. In other
words, ATM principle says that the value of given sum of money to be received on a
particular date is more than same of money to be received on a later date.

Few of the basic terms used in time value of money calculations are:

1. Present Value – the resulting value when a future payment or series of payments are
discounted at the given rate of interest up to the present date to reflect the time value of
money.

2. Future Value – is the amount that is obtained by enhancing the value of a present
payment or a series of payments at the given rate of interest to reflect the time value of
money.

3. Interest – is the charge against use of money paid by the borrower to the lender in
addition to the actual money lent. The interest is typically express as a percentage and
can be either simple or compounded. Simple interest is only based on the principle
amount of a loan, while compound interest is based on the principal amount had
accumulated interest.

Compound interest, is calculated by multiplying the principal amount by one plus the
annual interest rate raised to the numbers of compound periods minus one. As opposed
to simple interest, compound interest accrues on the principal amount and the
accumulated interest of previous periods.

For example, P4000 is deposited into a bank account and the annual interest rate is
8%. How much the interest after 4 years?

Use the following simple interest formula:

Interest = Principal × rate of interest × time or I=p× r × t

I=4000× 8% × 4
I=4000× 0.08 × 4
I=P 1280
However, compound interest is the interest earned not only on the original principal, but
also on all interest earned previously. In other words, at the end of each year, the
interest earned is added to the original amount and the money is reinvested.

If we use compound interest for the situation above, the interest will be computed
as follows:

o Interest at the end of the first year:

I = 4,000 x 8% x 1
I = P320
New principal P4,000 + 320 = 4320
o Interest at the end of the second year:

I = 4320× 0.08 × 1
I = P345.6
Your new principal is now 4320 + 345.6 = 4665.6
o Interest at the end of the third year:

I = 4665.6 × 0.08 × 1
I = P373.25
Your new principal is now 4665.60 + 373.25 = 5038.85
2
 o Interest at the end of the fourth year:

I = 5038.85 × 0.08 × 1
I = P403.10
Your new principal is now 5038.85 + 403.10= 5441.95
Total interest earned = 5441.95 -4000 = 1441.95
(Compound Interest) 1,441.96 – (Simple Interest) 1,280 = 161.96.
As you can see, compound interest yields better result, so you make more money.
Therefore, before investing your money, you should double check with your local bank if
compound interest will be used.

Application of Time Value of Money Principle

There are many applications of time value of money principle.

 We can use it compare the worth of cash flows occurring at different times in
future
 To find the present worth of a series of payments to be received periodically in
future
 To find the required amount of current investment that must be made at a given
interest rate to generate a required future cash flow.
Money loses its value over period of time and there are several reasons why money
losses value overtime. Most obviously, there is inflation which reduce the buying power
of money.

The present or future value of cash flows is calculated using a discount rate that is
determined on the basis of several factors such as:

1. Rate of inflation - higher the rate of inflation, higher the return that investors would
require on their investment.

3
2. Interest rate- Higher the interest rate on deposits and debt securities, greater the
loss of interest income on future cash inflows causing investors to demand a higher
return on investment.

3. Risk Premium - Greater the risk associated with future cash flows of an investment,
higher the rate of return required by an investors to compensate for the additional risk.

Example: supposed that you have earned a cash bonus for an outstanding
performance at your job during last year. You pleased boss gives you two options to
choose from:

1. Option A: Receive P10,000 bonus now

2. Option B: Receive P10,800 bonus after 1 Year
Further information which you may consider in your decision?
1. Inflation rate is 5% per annum
2. Interest rate on bank deposits is 12% per annum.

WHICH OPTION WOULD YOU CHOOSE?

Solution:

Although in absolute terms, Option B offers the highest amount of bonus, Option A
gives you the choice of receiving bonus one year earlier than option B, this can be
beneficial for the following reasons:

1. To start with, you can buy more with P10,800 in one year's time due to the 5%
inflation.

2. Secondly, if you receive the bonus now, you could invest the cash in a bank deposit
and earn a safe annual return of 12%. In Contrast, you stand to lose this interest income
if you choose Option B.

4
3. Thirdly, future is uncertain. In worst case scenario, the company you work for could
become bankrupt during the next year which would significantly reduce your chances of
receiving any bonus. The probability of this happening might be remote, but there would
be a slim chance nonetheless.

Discount Rates

As the interest rate on bank deposits is higher than the rate of inflation, we should set
the discount rate at 12% for our analysis because it represents the highest opportunity
cost for receiving the bonus in one year's time rather than today.

Future Values

The future value of Option A will be the amount of bonus plus the interest income of
12% which could be earned for one year.

Option A Option B

Bonus P10, 000 P10,800

Interest
(P10,000x12%) P 1,200
Income

P11,200 after 1
(P10,000+P 1,200)
Future value Year
P10,800 after 1 Year

* No interest income shall accrue on P10,800 as it shall be received after one year.
Based on the future Values, option A is preferable as it has the highest future value.

Present values

The present value of Option B will be the amount required today that shall equal
to P10,800 in one year's time after having accrued an interest income of 12%.

5
 Option A Option B

Bonus P10,800 P10,800

Interest 1.0 0.8928 (1÷ [1 + 0.12 ])

Income

Present Value P10,000 ($10,000 × 1.0) P9,642* (P10,800 × 0.8928)

*No need to discount as P10, 000 is already stated in its present value terms.

*The present value of P9, 642 represent the amount of cash that, if invested in the bank
deposit at 12% p.a., shall equal to P10, 800 in one year. This can be confirmed as
follows; P9, 642 × 1.12 = P10, 800

Based on the present values, option A is preferable as it has the highest present value.

Present Value is simply the reciprocal of compound interest. Another way to think of
present value is to adopt a stance out on the time line in the future and look back toward
time 0 to see what the beginning amount was.

Present Value = P / (1+I)ᶰ

Contents of a Net Present Value Analysis

1. Asset Purchases. All of the expenditures associated with the purchase, delivery,
installation and testing of the asset being purchased.

2. Asset-linked expenses. Any ongoing expenses, such as warranty agreements,

property taxes, and maintenance that are associated with the asset .

3. Contribution margin. Any incremental cash flows resulting from sales that can be
attributed to the project.

4. Depreciation effect. The asset will be depreciated and this depreciation shelters a
portion of any net income from income taxes.
6
5. Expense reductions. Any incremental expense reductions caused by the project,
such as automation that eliminates direct labor hour.

6. Tax Credits. If an asset purchase triggers a tax credit (such as for a purchase of
energy - reduction equipment) then note the credit.

7. Taxes. Any income tax payments associated with net income expected to be derived
from the asset.

8. Working Capital Changes. Any net changes in inventory, accounts receivable, or

accounts payable associated with the asset.

Cautions when using Net Present Value

Net Present Value does not consider the presence of a constraint in the system of
generating cash flow, which could restrict the total amount of cash actually generated.
The result can be an estimated net present value that cannot be realized.

A positive net present value means a better return, and a negative net present value
means a worse return, than the return from zero net present value. It is one of the two
discounted cash flow techniques used in comparative appraisal of investment proposals
where the flow of income varies over time.

DEFINITION OF "RISK RETURN TRADE OFF"

Investment decisions consider this trade off which an investor faces between risk and
return. Higher risk is associated with greater probability of higher return and lower risk
with a greater probability of smaller return.

For example. Rohan faces a risk return trade off while making his decision to invest.
If he deposits all his money in a savings bank account, he will earn a low return. i.e, the
interest rate paid by the bank, but all his money will be insured up to an amount of P 1
MILLION PESOS.

7
However, if he invests in equities, he faces the risk of losing a major part of his capital
along with a chance to get a much higher return than compared to a saving deposit in a
bank. The word of investing can be a cold, chaotic, and confusing place.

In the investing world, the dictionary definition of risk is the chance than an investment’s
actual return will be different than expected. Technically, this is measured in statistics by
standard deviation. Practically, risk means you have the possibility of losing some or
even all of your original investment.

A higher standard deviation means a higher risk and therefore, a higher possible return.

A common misconception is that higher risk equals greater return. The risk return trade-
off tells us that the higher risk gives us the possibility of higher returns. There are no
guarantees just a risk means higher potential returns it also means higher potential
losses.

On the lower end of the risk scale is measured called the risk-free rate of return. It is
represented by the return on 10 year Government Securities because their chance of
default is next to nothing. The risk free rate is used as a reference for equity markets
whereas the overnight repo rate is used as a reference for debt markets. If the risk-free
rate is currently 6% this means with virtually no risk we can earn 6% per year on our
money.