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Chapter 06 - Time Value of Money Concepts

Chapter 6
Question 6-1 Question 6-2

Time Value ofQUESTIONS FOR REVIEW OF KEY Money Concepts

Interest is the amount of money paid or received in excess of the amount borrowed or lent. Compound interest includes interest not only on the original invested amount but also on the accumulated interest from previous periods.

Question 6-3
If interest is compounded more frequently than once a year, the effective rate or yield will be higher than the annual stated rate.

Question 6-4
The three items of information necessary to compute the future value of a single amount are the original invested amount, the interest rate (i) and the number of compounding periods (n).

Question 6-5
The present value of a single amount is the amount of money today that is equivalent to a given amount to be received or paid in the future.

Question 6-6
Monetary assets and monetary liabilities represent cash or fixed claims/commitments to receive/pay cash in the future and are valued at the present value of these fixed cash flows. All other assets and liabilities are nonmonetary.

Question 6-7
An annuity is a series of equal-sized cash flows occurring over equal intervals of time.

Question 6-8
An ordinary annuity exists when the cash flows occur at the end of each period. In an annuity due the cash flows occur at the beginning of each period.

Question 6-9
Table 2 lists the present value of $1 factors for various time periods and interest rates. The factors in Table 4 are simply the summation of the individual PV of $1 factors from Table 2.

6-1

Chapter 06 - Time Value of Money Concepts

Answers to Questions (continued) Question 6-10


Present Value ? 0

Year 1

Year 2

Year 3

Year 4

___________________________________________

$200

$200 $200 n = 4, i = 10%

$200

Question 6-11
Present Value ? 0

Year 1

Year 2

Year 3

Year 4

___________________________________________

$200

$200

$200 $200 n = 4, i = 10%

Question 6-12
A deferred annuity exists when the first cash flow occurs more than one period after the date the agreement begins.

Question 6-13
The formula for computing present value of an ordinary annuity incorporating the ordinary annuity factors from Table 4 is: PVA = Annuity amount x Ordinary annuity factor Solving for the annuity amount, Annuity amount = The annuity factor can be obtained from Table 4 at the intersection of the 8% column and 5 period row.

Question 6-14
Annuity amount Annuity amount = = $125.23

6-2

Chapter 06 - Time Value of Money Concepts

Answers to Questions (concluded) Question 6-15


Companies frequently acquire the use of assets by leasing rather than purchasing them. Leases usually require the payment of fixed amounts at regular intervals over the life of the lease. Certain long-term, noncancelable leases are treated in a manner similar to an installment sale by the lessor and an installment purchase by the lessee. In other words, the lessor records a receivable and the lessee records a liability for the several installment payments. For the lessee, this requires that the leased asset and corresponding lease liability be valued at the present value of the lease payments.

6-3

Chapter 06 - Time Value of Money Concepts

BRIEF EXERCISES
Fran should choose the second investment opportunity. Brief Exercise 6-1More rapid compounding has the effect of increasing the actual rate, which is called the effective rate, at which money grows per year. For the second opportunity, there are four, three-month periods paying interest at 2% (one-quarter of the annual rate). $10,000 invested will grow to $10,824 ($10,000 x 1.0824*). The effective annual interest rate, often referred to as the annual yield, is 8.24% ($824 $10,000), compared to just 8% for the first opportunity.
Future value of $1: n=4, i=2% (from Table 1)

Brief Exercise

Bill will not have enough accumulated to take the trip. 6-2The future value of his investment of $23,153 is $347 short of $23,500.
Future value of $1: n=3, i=5% (from Table 1)

FV = $20,000 (1.15763) = $23,153

Brief Exercise 6-3 Brief Exercise

FV factor = $26,600 = 1.33 $20,000


Future value of $1: n=3, i=? (from Table 1, i = approximately 10%)

John would be willing to invest no more than $12,673 in 6-4this opportunity.

PV = $16,000 (.79209) = $12,673


Present value of $1: n=4, i=6% (from Table 2)

Brief Exercise 6-5

PV factor $16,000

= $13,200 = .825

Present value of $1: n=4, i=? (from Table 2, i = approximately 5%)

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Chapter 06 - Time Value of Money Concepts

Brief Exercise 6-6


Interest is paid for 12 periods at 1% (one-quarter of the annual rate). FVA = $500 (12.6825) = $6,341
Future value of an ordinary annuity of $1: n=12, i=1% (from Table 3)

Brief Exercise 6-7


FVAD

Interest is paid for 12 periods at 1% (one-quarter of the annual rate). = $6,405 PVA $41,002 PVAD = $10,000 (4.38721*) $43,872 PVA = $10,000 x 4.10020= $41,002 = = $10,000 (4.10020) =

= $500 (12.8093)

Future value of an annuity due of $1: n=12, i=1% (from Table 5)

Brief Exercise 6-8 Brief Exercise 6-9

Present value of an ordinary annuity of $1: n=5, i=7% (from Table 4)

Present value of an annuity due of $1: n=5, i=7% (from Table 6)

Brief Exercise 6-10


Table 4)

Present value of an ordinary annuity of $1: n=5, i=7% (from

PV

Present value of $1: n=2, i=7% (from Table 2)

= $41,002

.87344 =

$35,813

Or alternatively: From Table 4, PVA factor, n=7, i=7% PVA factor, n=2, i=7% = PV factor for deferred annuity PV

= = =

5.38929 1.80802 3.58127

= $10,000 x 3.58127 = $35,813 (rounded)

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Chapter 06 - Time Value of Money Concepts

Brief Exercise 6-11


Annuity = $100,000 6.71008 = $14,903 = Payment

Present value of an ordinary annuity of $1: n=10, i=8% (from Table 4)

Brief Exercise 6-12

PV = $6,000,0001 (12.40904) + 100,000,000 (.13137)

PV = $74,454,240 + 13,137,000 = $87,591,240 = price of the bonds


$100,000,000 x 6% = $6,000,000 Present value of an ordinary annuity of $1: n=30, i=7% (from Table 4) Present value of $1: n=30, i=7% (from Table 2)
1

Brief Exercise 6-13


6)

PVAD = $55,000 (7.24689) = $398,579 = Liability


Present value of an annuity due of $1: n=10, i=8% (from Table

6-6

Chapter 06 - Time Value of Money Concepts

EXERCISES
Exercise 6-1
Future value of $1: n=12, i=6% (from Table 1)

1. FV = $15,000 (2.01220) = $30,183

2. FV = $20,000 (2.15892) = $43,178


Future value of $1: n=10, i=8% (from Table 1)

3. FV = $30,000 (9.64629) = $289,389


Future value of $1: n=20, i=12% (from Table 1)

4. FV = $50,000 (1.60103) = $80,052


Future value of $1: n=12, i=4% (from Table 1)

Exercise 6-2

1. FV = $10,000 (2.65330) = $26,533


Future value of $1: n=20, i=5% (from Table 1)

2. FV = $10,000 (1.80611) = $18,061


Future value of $1: n=20, i=3% (from Table 1)

3. FV = $10,000 (1.81136) = $18,114


Future value of $1: n=30, i=2% (from Table 1)

Exercise 6-3

1. PV = $20,000 (.50835) = $10,167


Present value of $1: n=10, i=7% (from Table 2)

2. PV = $14,000 (.39711) = $5,560


Present value of $1: n=12, i=8% (from Table 2)

3. PV = $25,000 (.10367) = $2,592


Present value of $1: n=20, i=12% (from Table 2)

4. PV = $40,000 (.46651) = $18,660


Present value of $1: n=8, i=10% (from Table 2)

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Chapter 06 - Time Value of Money Concepts

Exercise 6-4

Payment First payment: 4,630 1 Second payment 6,000 x Third payment 8,000 x Fourth payment 9,000 x Total

PV of $1 i=8% .85734 .73503 .63017 = = =

PV $5,000 5,144 5,880 5,672 $21,326

n .92593 2 4 6

Exercise 6-5
2. $36,289 $65,000 $15,884 $40,000

PV = $85,000 (.82645) = $70,248 = Note/revenue


Present value of $1: n=2, i=10% (from Table 2)

Exercise 6-6
= .55829

1.

PV = $40,000 (.62092) = $24,837

Present value of $1: n=5, i=10% (from Table 2)

Present value of $1: n=10, i=? (from Table 2, i = approximately 6%)

3.

.3971

Present value of $1: n=?, i=8% (from Table 2, n = approximately 12 years)

4.

$46,651 = $100,000

.46651

Present value of $1: n=8, i=? (from Table 2, i = approximately 10%)

5.

FV = $15,376 (3.86968) = $59,500

Future value of $1: n=20, i=7% (from Table 1)

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Chapter 06 - Time Value of Money Concepts

Exercise 6-7
1. 2. 3. FVA

= $2,000 (4.7793)

= $9,559 = $10,706 FV of $1 i=3% 1.60471 1.42576 1.26677 1.12551

Future value of an ordinary annuity of $1: n=4, i=12% (from Table 3)

FVAD = $2,000 (5.3528)

Future value of an annuity due of $1: n=4, i=12% (from Table 5)

First deposit: Second deposit Third deposit Fourth deposit


4.

Deposit $2,000 2,000 2,000 2,000 Total

x x x x

= = = =

FV $ 3,209 2,852 2,534 2,251 $10,846

n 16 12 8 4

$2,000 x 4 = $8,000

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Chapter 06 - Time Value of Money Concepts

Exercise 6-8
1. 2. 3. PVA

= $5,000 (3.60478)

= $18,024 = $20,187

Present value of an ordinary annuity of $1: n=5, i=12% (from Table 4)

PVAD = $5,000 (4.03735)

Present value of an annuity due of $1: n=5, i=12% (from Table 6)

First payment: Second payment Third payment Fourth payment Fifth payment

Payment $5,000 5,000 5,000 5,000 5,000 Total

x x x x x

PV of $1 i = 3% .88849 .78941 .70138 .62317 .55368

= = = = =

PV $ 4,442 3,947 3,507 3,116 2,768 $17,780

n 4 8 12 16 20

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Chapter 06 - Time Value of Money Concepts

Exercise 6-9
1. 2.

PVA = $3,000 (3.99271) $242,980 = $75,000 3.23973

= $11,978

Present value of an ordinary annuity of $1: n=5, i=8% (from Table 4)

Present value of an ordinary annuity of $1: n=4, i=? (from Table 4, i = approximately 9%)

3.

$161,214 = $20,000

8.0607

Present value of an ordinary annuity of $1: n=?, i= 9% (from Table 4, n = approximately 15 years)

4.

$500,000 = $80,518

6.20979

Present value of an ordinary annuity of $1: n=8, i=? (from Table 4, i = approximately 6%)

5.

$250,000 = 3.16987

$78,868

Present value of an ordinary annuity of $1: n=4, i=10% (from Table 4)

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Chapter 06 - Time Value of Money Concepts

Exercise 6-10
Requirement 1

PV = $100,000 (.68058) = $68,058


Present value of $1: n=5, i=8% (from Table 2)

Requirement 2 Annuity amount = $100,000 5.8666


Future value of an ordinary annuity of $1: n=5, i=8% (from Table 3)

Annuity amount

= $17,046

Requirement 3 Annuity amount = $100,000 6.3359


Future value of an annuity due of $1: n=5, i=8% (from Table 5)

Annuity amount = $15,783

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Chapter 06 - Time Value of Money Concepts

Exercise 6-11

1. Choose the option with the highest present value. (1) PV = $64,000 (2) PV = $20,000 + $8,000 (4.91732)
Present value of an ordinary annuity of $1: n=6, i=6% (from Table 4)

PV = $20,000 + $39,339 = $59,339 (3) PV = $13,000 (4.91732) = $63,925 Alex should choose option (1).

2. FVA = $100,000 (13.8164) = $1,381,640


Future value of an ordinary annuity of $1: n=10, i=7% (from Table 3)

Exercise 6-12
PV

PVA = $5,000

4.35526=

$21,776

Present value of an ordinary annuity of $1: n=6, i=10% (from Table 4)

Present value of $1: n=2, i=10% (from Table 2)

= $21,776

.82645=

$17,997

Or alternatively: From Table 4, PVA factor, n=8, i=10% PVA factor, n=2, i=10% = PV factor for deferred annuity PV = $5,000 x 3.59939 = $17,997

= = =

5.33493 1.73554 3.59939

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Chapter 06 - Time Value of Money Concepts

Exercise 6-13

Annuity = $20,000 5,000 = $670 = Payment 22.39646


Present value of an ordinary annuity of $1: n=30, i=2% (from Table 4)

Exercise 6-14

PVA factor = $100,000 = 7.46938 $13,388

Present value of an ordinary annuity of $1: n=20, i=? (from Table 4, i = approximately 12%)

Exercise 6-15

Annuity =

$12,000

= $734 = Payment

16.35143

Present value of an ordinary annuity of $1: n=20, i=2% (from Table 4)


5 years x 4 quarters = 20 periods 8% 4 quarters = 2%

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Chapter 06 - Time Value of Money Concepts

Exercise 6-16
PV PV = =

x =

.90573= $1,325

1,200

Present value of $1: n=5, i=2% (from Table 2)

$1,200 .90573 ?

PVA = PVA =

x =

14.99203= $88 =

$1,325 Payment

annuity amount

$1,325 14.99203

Present value of an ordinary annuity of $1: n=18, i=2% (from Table 4)

To determine the price of the bonds, we calculate the present Exercise 6-17value of the 40-period annuity (40 semiannual interest payments of $12 million) and the lump-sum payment of $300 million paid at maturity using the semiannual market rate of interest of 5%. In equation form, PV = $12,000,0001 (17.15909) + 300,000,000 (.14205) PV = $205,909,080 + 42,615,000 = $248,524,080 = price of the bonds
$300,000,000 x 4 % = $12,000,000 Present value of an ordinary annuity of $1: n=40, i=5% (from Table 4) Present value of $1: n=40, i=5% (from Table 2)
1

6-15

Chapter 06 - Time Value of Money Concepts

Exercise 6-18
Requirement 1 To determine the price of the bonds, we calculate the present value of the 30period annuity (30 semiannual interest payments of $6 million) and the lump-sum payment of $200 million paid at maturity using the semiannual market rate of interest of 2.5%. In equation form, PV = $6,000,0001 (20.93029) + 200,000,000 (.47674) PV = $125,581,740 + 95,348,000 = $220,929,740 = price of the bonds
$200,000,000 x 3 % = $6,000,000 Present value of an ordinary annuity of $1: n=30, i=2.5% (from Table 4) Present value of $1: n=30, i=2.5% (from Table 2)
1

Requirement 2 $220,929,740 x 2.5% = $5,523,244 Because the bonds were outstanding only for six months of the year, Singleton reports only years interest in 2011.

Exercise 6-19Requirement 1
PVA

= $400,000 (10.59401) = $4,237,604 = Liability

Present value of an ordinary annuity of $1: n=20, i=7% (from Table 4)

Requirement 2 PVAD = $400,000 (11.33560) = $4,534,240 = Liability


Present value of an annuity due of $1: n=20, i=7% (from Table 6)

Exercise 6-20

PVA factor = $2,293,984 = 11.46992 $200,000

Present value of an ordinary annuity of $1: n=20, i=? (from Table 4, i = 6%)

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Chapter 06 - Time Value of Money Concepts

Exercise 6-21
List A e 1. Interest List B a. First cash flow occurs one period after agreement begins. Monetary asset b. The rate at which money will actually grow during a year. Compound interest c. First cash flow occurs on the first day of the agreement. Simple interest d. The amount of money that a dollar will grow to. Annuity e. Amount of money paid/received in excess of amount borrowed/lent. Present value of a single f. Obligation to pay a sum of cash, the amount of amount which is fixed. Annuity due g. Money can be invested today and grow to a larger amount. Future value of a single h. No fixed dollar amount attached. amount Ordinary annuity i. Computed by multiplying an invested amount by the interest rate. Effective rate or yield j. Interest calculated on invested amount plus accumulated interest. Nonmonetary asset k. A series of equal-sized cash flows. Time value of money l. Amount of money required today that is equivalent to a given future amount. Monetary liability m. Claim to receive a fixed amount of money.

m 2. j i k l c d a 3. 4. 5. 6. 7. 8. 9.

b 10. h g f 11. 12. 13.

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Chapter 06 - Time Value of Money Concepts

CPA / CMA REVIEW QUESTIONS


CPA Exam Questions
1. b. PV = FV x PV factor, PV=$25,458 x 0.3075 = $7,828 2. d. The sales price is equal to the present value of the note payments: Present value of first payment Present value of last six payments: $60,000 x 4.36 Sales price 3. a. PVA = $100 x 4.96764 = $497 4. b. First solve for present value of a four-year ordinary annuity: PVA = $100 x 3.03735 = $304 Then discount back two years: PV = $304 x 0.79719 = $242
5.

$ 60,000 261,600 $321,600

d. PVAD = $100,000 x 9.24424 = $924,424

6. a. PVA = $100 x 5.65022 = $565 (present value of the interest payments) PV = $1,000 x 0.32197 = $322 (present value of the face amount) Total present value = $887 = current market value of the bond 7. a. PVA = PMT x PVA factor $15,000 = PMT x 44.955 PMT = $334

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Chapter 06 - Time Value of Money Concepts

CMA Exam Questions


1. d. Both future value tables will be used because the $75,000 already in the account will be multiplied times the future value factor of 1.26 to determine the amount 3 years hence, or $94,500. The three payments of $4,000 represent an ordinary annuity. Multiplying the three-period annuity factor (3.25) by the payment amount ($4,000) results in a future value of the annuity of $13,000. Adding the two elements together produces a total account balance of $107,500. 2. a. An annuity is a series of cash flows or other economic benefits occurring at fixed intervals, ordinarily as a result of an investment. Present value is the value at a specified time of an amount or amounts to be paid or received later, discounted at some interest rate. In an annuity due, the payments occur at the beginning, rather than at the end, of the periods. Thus, the present value of an annuity due includes the initial payment at its undiscounted amount. This lease should be evaluated using the present value of an annuity due.

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Chapter 06 - Time Value of Money Concepts

PROBLEMS
Problem 6-1net of the present value of any cash inflows (Cash outflows are shown
as negative amounts; cash inflows as positive amounts). Machine A: PV = $48,000 1,000 (6.71008) + 5,000 (.46319)
Present value of an ordinary annuity of $1: n=10, i=8% (from Table 4) Present value of $1: n=10, i=8% (from Table 2)

Choose the option with the lowest present value of cash outflows,

PV = $48,000 6,710 + 2,316 PV = - $52,394 Machine B: PV = $40,000 4,000 (.79383) 5,000 (.63017) 6,000 (.54027)
PV of $1: i=8% (from Table 2) n=3
n=6

n=8

PV = - $40,000 - 3,175 - 3,151 - 3,242 PV = - $49,568 Esquire should purchase machine B.

1. PV Problem 6-2Equipment = $10,000 + 8,000 (3.79079) 2. $400,000 = Annuity amount x 5.9753


Future value of an annuity due of $1: n=5, i=6% (from Table 5)

= $40,326 =

Present value of an ordinary annuity of $1: n=5, i=10% (from Table 4)

Annuity amount = $400 ,000 5.9753 Annuity amount = $66,942 = Required annual deposit

3. PVAD = $120,000 (9.36492 ) = $1,123,790 = Lease liability


Present value of an annuity due of $1: n=20, i=10% (from Table 6)

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Chapter 06 - Time Value of Money Concepts

Problem 6-3
Choose the option with the lowest present value of cash payments.
1. PV = $1,000,000 2. PV = $420,000 + 80,000 (6.71008) = $956,806
Present value of an ordinary annuity of $1: n=10, i=8% (from Table 4)

3. PV = PVAD = $135,000 (7.24689) = $978,330


Present value of an annuity due of $1: n=10, i=8% (from Table 6)

4. PV = $1,500,000 (.68058) = $1,020,870


Present value of $1: n=5, i=8% (from Table 2)

Harding should choose option 2.

Problem 6-4the future cash flows discounted at 10% rate is greater than
$800,000.
PV = $80,000 (4.35526) + 70,000 (.51316) + 60,000 (.46651**)
n=7 n=9 n=10

The restaurant should be purchased if the present value of

n=8

+ $50,000 (.42410**) + 40,000 (.38554**) + 700,000 (.38554**)


n=10
Present value of an ordinary annuity of $1: n=6, i=10% (from Table 4) Present value of $1:, i=10% (from Table 2)

PV = $718,838 < $800,000

Since the PV is less than $800,000, the restaurant should not be purchased.

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Chapter 06 - Time Value of Money Concepts

Problem 6-5

The maximum amount that should be paid for the store is the present value of the estimated cash flows. Years 1-5: PVA = $70,000 Years 6-10: PVA = $70,000 PV = $265,355
Present value of an ordinary annuity of $1: n=5, i=10% (from Table 4)

3.99271=

$279,490

Present value of an ordinary annuity of $1: n=5, i=8% (from Table 4)

x x

3.79079= .68058

$265,355 $180,595

Present value of $1: n=5, i=8% (from Table 2)

Years 11-20: PVA = $70,000 PV PV = $395,515 = $245,583 x x x 5.65022 .62092 .68058 = = = $395,515 $245,583 $167,139
Present value of an ordinary annuity of $1: n=10, i=12% (from Table 4) Present value of $1: n=5, i=10% (from Table 2) Present value of $1: n=5, i=8% (from Table 2)

End of Year 20: PV = $400,000 x .32197x .62092 x .68058 = $54,424 $681,648


Present value of $1: n=10, i=12% (from Table 2)

Total PV = $279,490 + 180,595 + 167,139 + 54,424 = The maximum purchase price is $681,648.

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Chapter 06 - Time Value of Money Concepts

Problem 6-6

1. PV of $1 factor = $30,000 = .5000 $60,000


Present value of $1: n=? , i=8% (from Table 2, n = approximately 9 years)

2. Annuity factor = Annuity factor = $28,700 = 4.1000 $7,000


Present value of an ordinary annuity of $1: n= 5, i=? (from Table 4, i = approximately 7%)

3. Annuity amount = Annuity amount = $10,000 = 6.41766 $1,558 = Payment

Present value of an ordinary annuity of $1: n=10, i=9% (from Table 4)

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Chapter 06 - Time Value of Money Concepts

Problem 6-7
Requirement 1 Annuity amount = Annuity amount = $250,000 = $78,868 = Payment 3.16987
Present value of an ordinary annuity of $1: n=4, i=10% (from Table 4)

Requirement 2 Annuity amount = Annuity amount = $250,000 = $62,614 = Payment 3.99271


Present value of an ordinary annuity of $1: n=5, i=8% (from Table 4)

Requirement 3 Annuity factor = Annuity factor = $250,000 = 4.86845 $51,351


Present value of an ordinary annuity of $1: n=? , i= 10% (from Table 4, n = approximately 7 payments)

Requirement 4 Annuity factor = Annuity factor = $250,000 = 2.40184 $104,087


Present value of an ordinary annuity of $1: n= 3, i= ? (from Table 4, i = approximately 12%)

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Chapter 06 - Time Value of Money Concepts

Problem 6-8
Requirement 1 Present value of payments 4-6: PVA = $40,000 PV = $99,474
Present value of an ordinary annuity of $1: n= 3, i= 10% (from Table 4)

x x

2.48685 .75131

= =

$99,474 $74,736

Present value $1: n= 3, i= 10% (from Table 2)

Present value of all payments:


$ 62,171 74,736 $136,907 (PV of payments 1-3: $25,000 x 2.48685)

(PV of payments 4-6 calculated above)

The note payable and corresponding building should be recorded at $136,907. Or alternatively:

PV = $25,000 (2.48685) + 40,000 (1.86841) = $136,907


Present value of an ordinary annuity of $1: n=3, i=10% (from Table 4)

From Table 4, PVA factor, n=6, i=10% PVA factor, n=3 i=10% = PV factor for deferred annuity Requirement 2

= 4.35526 = 2.48685 = 1.86841

$136,907 x 10% = $13,691 = Interest in the year 2011

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Chapter 06 - Time Value of Money Concepts

Problem 6-9

Choose the alternative with the highest present value. Alternative 1: PV = $180,000 Alternative 2: PV = PVAD = $16,000 (11.33560) = $181,370
Present value of an annuity due of $1: n=20, i=7% (from Table 6)

Alternative 3: PVA = $50,000 PV = $351,179 x x 7.02358 .54393 = = $351,179 $191,017


Present value of an ordinary annuity of $1: n=10, i=7% (from Table 4) Present value of $1: n=9, i=7% (from Table 2)

John should choose alternative 3. Or, alternatively (for 3): PV = $50,000 (3.82037) =
(difference due to rounding)

$191,019

From Table 4, PVA factor, n=19, i=7% PVA factor, n=9, i=7% = PV factor for deferred annuity or, From Table 6,

= 10.33560 = 6.51523 = 3.82037

PVAD factor, n=20, i=7% = 11.33560 PVAD factor, n=10, i=7% = 7.51523 = PV factor for deferred annuity = 3.82037

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Chapter 06 - Time Value of Money Concepts

Problem 6-10

PV = $20,000 (3.79079) + 100,000 (.62092) = $137,908


Present value of an ordinary annuity of $1: n=5, i=10% (from Table 4) Present value of $1: n=5, i=10% (from Table 2)

The note payable and corresponding merchandise should be recorded at $137,908.

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Chapter 06 - Time Value of Money Concepts

Problem 6-11Requirement 1
Annuity amount = Annuity amount = $800,000 7.24689

PVAD = Annuity amount x Annuity factor

Present value of an annuity due of $1: n=10, i=8% (from Table 6)

Annuity amount = $110,392 = Lease payment Requirement 2 Annuity amount = $800,000 6.71008
Present value of an ordinary annuity of $1: n=10, i=8% (from Table 4)

Annuity amount = $119,224 = Lease payment Requirement 3 PVAD = (Annuity amount x Annuity factor) + PV of residual Annuity amount = PV of residual = $50,000 x .46319= $23,160
Present value of $1: n=10, i=8% (from Table 2)

Annuity amount = $800,000 23,160 7.24689


Present value of an annuity due of $1: n=10, i=8% (from Table 6)

Annuity amount = $107,196 = Lease payment

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Chapter 06 - Time Value of Money Concepts

Problem 6-12Requirement 1
Annuity amount =

PVA = Annuity amount x Annuity factor

Annuity amount = $800,000 7.36009


Present value of an ordinary annuity of $1: n=10, i=6% (from Table 4)

Annuity amount = $108,694 = Lease payment Requirement 2 Annuity amount = $800,000 15.32380
Present value of an annuity due of $1: n=20, i=3% (from Table 6)

Annuity amount = $52,206 = Lease payment Requirement 3 Annuity amount = $800,000 44.9550
Present value of an ordinary annuity of $1: n=60, i=1% (given)

Annuity amount = $17,796 = Lease payment

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Chapter 06 - Time Value of Money Concepts

Choose the option with the lowest present value of cash Problem 6-13outflows, net of the present value of any cash inflows. (Cash outflows are shown as negative amounts; cash inflows as positive amounts) 1. Buy option: PV = - $160,000 - 5,000 (5.65022) + 10,000 (.32197)
Present value of an ordinary annuity of $1: n=10, i=12% (from Table 4) Present value of $1: n=10, i=12% (from Table 2)

PV = - $160,000 - 28,251 + 3,220 PV = - $185,031 2. Lease option: PVAD = - $25,000 (6.32825) = - $158,206
Present value of an annuity due of $1: n=10, i=12% (from Table 6)

Kiddy Toy should lease the machine.

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Chapter 06 - Time Value of Money Concepts

Problem 6-14
Requirement 1 Tinkers: PVA = $20,000 PV = $143,817 x x 7.19087 .81162 = = $143,817 $116,725
Present value of an ordinary annuity of $1: n=15, i=11% (from Table 4) Present value of $1: n=2, i=11% (from Table 2)

Evers: PVA = $25,000 PV = $179,772 x x 7.19087 .73119 = = $179,772 $131,447


Present value of an ordinary annuity of $1: n=15, i=11% (from Table 4) Present value of $1: n=3, i=11% (from Table 2)

Chance: PVA = $30,000 PV = $215,726


Present value of an ordinary annuity of $1: n=15, i=11% (from Table 4)

x x

7.19087 .65873

= =

$215,726 $142,105

Present value of $1: n=4, i=11% (from Table 2)

Or, alternatively: Deferred annuity factors:


Employee Tinkers Evers Chance PVA factor, i=11% 7.54879 (n=17) 7.70162 (n=18) 7.83929 (n=19) PVA factor, i=11% 1.71252 (n=2) 2.44371 (n=3) 3.10245 (n=4)
= = = =

Deferred annuity factor 5.83627 5.25791 4.73684

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Chapter 06 - Time Value of Money Concepts

Problem 6-14 (concluded) Present value of pension obligations at 12/31/11: Tinkers: $20,000 x 5.83627 = $116,725 Evers: $25,000 x 5.25791 = $131,448* Chance: $30,000 x 4.73684 = $142,105 *rounding difference Requirement 2 Present value of pension obligations as of December 31, 2014:
Employee Tinkers Evers Chance PV as of 12/31/11 $116,725 131,448 142,105 x FV of $1 factor, n=3, i=11% x 1.36763 x 1.36763 x 1.36763 Total present value, 12/31/14 = = = = FV as of 12/31/14 $159,637 179,772 194,347 $533,756

Amount of annual contribution:


FVAD = Annuity amount x Annuity factor Annuity amount = Annuity amount = $533,756 3.7097 = $143,881

Future value of an annuity due of $1: n=3, i=11% (from Table 5)

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Chapter 06 - Time Value of Money Concepts

Problem 6-15

Bond liability: PV = $4,000,0001 (18.40158) + 100,000,000 (.17193) PV = $73,606,320 + 17,193,000 = $90,799,320 = initial bond liability
$100,000,000 x 4 % = $4,000,000 Present value of an ordinary annuity of $1: n=40, i=4.5% (from Table 4) Present value of $1: n=40, i=4.5% (from Table 2)
1

Lease liability: Lease A: PVAD = $200,000 (9.36492) = $1,872,984 = Liability


Present value of an annuity due of $1: n=20, i=10% (from Table 6)

Lease B: PVAD = $220,000 x 8.82371 = $1,941,216


Present value of an annuity due of $1: n=17, i=10% (from Table 6)

PV

= $1,941,216 x .75131 = $1,458,455

Present value of $1: n=3, i=10% (from Table 2)

Or, alternatively for Lease B: PVA = $220,000 x 8.02155 = $1,764,741


Present value of an ordinary annuity of $1: n=17, i=10% (from Table 4)

PV

= $1,764,741 x .82645** = $1,458,470 (difference due to rounding)

**Present value of $1: n=2, i=10% (from Table 2)

Or, alternatively for Lease B: PV = $220,000 (6.62938) = $1,458,464 (difference due to rounding) = = = 8.36492 1.73554 6.62938* From Table 4, PVA factor, n=19, i=10% PVA factor, n=2, i=10% = PV factor for deferred annuity

The companys balance sheet would include a liability for bonds of $90,799,320 and a liability for leases of $3,331,439 ($1,872,984 + 1,458,455).

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Chapter 06 - Time Value of Money Concepts

CASES
The ethical issue is that the 21% return implies an annual Ethics Case 6-1return of 21% on an investment and misrepresents the funds performance to all current and future stakeholders. Interest rates are usually assumed to represent an annual rate, unless otherwise stated. Interested investors may assume that the return for $100 would be $21 per year, not $21 over two years. The Damon Investment Company ad should explain that the 21% rate represented appreciation over two years.

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Chapter 06 - Time Value of Money Concepts

Analysis Case 6-2


Alternative 1: PV = $50,000 Alternative 2:

Sally should choose the alternative with the highest present value.

PV = PVAD = $10,000 (5.21236) = $52,124


Present value of an annuity due of $1: n=6, i=6% (from Table 6)

Alternative 3: PVA = $22,000 PV = $58,806

x x

2.67301 .89000

= =

$58,806 $52,337

Present value of an ordinary annuity of $1: n=3, i=6% (from Table 4) Present value of $1: n=2, i=6% (from Table 2)

Sally should choose alternative 3. Or, alternatively (for 3): PV = $22,000 (2.37897) = $52,337 = = = 4.21236 1.83339 2.37897

From Table 4, PVA factor, n=5, i=6% PVA factor, n=2, i=6% = PV factor for deferred annuity
or, From Table 6,

PVAD factor, n=6, i=6% PVAD factor, n=3, i=6% = PV factor for deferred annuity due=

= 5.21236 = 2.83339 2.37897

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Chapter 06 - Time Value of Money Concepts

Communication Case 6-3


Suggested Grading Concepts and Grading Scheme: Content (65%) _______ 25 Explanation of the method used (present value) to compare the two contracts. _______ 30 Presentation of the calculations. 49ers PV = $6,989,065 Cowboys PV = $6,492,710 _______ 10 Correct conclusion. ______ _______ 65 points Writing (35%) _______ 5 Proper letter format. _______ 6 Terminology and tone appropriate to the audience of a player's agent.

_______ 12 Organization permits ease of understanding. ______ Introduction that states purpose. ______ Paragraphs that separate main points. _______ 12 English ______ Sentences grammatically clear and well organized, concise. ______ Word selection. ______ Spelling. ______ Grammar and punctuation. _____ _______ 35 points

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Chapter 06 - Time Value of Money Concepts

Analysis Case 6-4


The settlement was determined by calculating the present value of lost future income ($200,000 per year) discounted at a rate which is expected to approximate the time value of money. In this case, the discount rate, i, apparently is 7% and the number of periods, n, is 25 (the number of years to Johns retirement). Johns settlement was calculated as follows:
1

$200,000 annuity amount

11.65358=

$2,330,716

Present value of an ordinary annuity of $1: n=25, i=7% (from Table 4) Note: In the actual case, Johns present salary was increased by 3% per year to reflect future salary increases.

1 Intheactualcase,Johnspresentsalarywasincreasedby3%peryeartoreflectfuturesalaryincreases.

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Chapter 06 - Time Value of Money Concepts

Judgment Case 6-5

Purchase price of new machine Sales price of old machine Incremental cash outflow required

$150,000 (100,000) $ 50,000

The new machine should be purchased if the present value of the savings in operating costs of $8,000 ($18,000 - 10,000) plus the present value of the salvage value of the new machine exceeds $50,000. PV = ($8,000 x 3.99271) + ($25,000 x .68058) PV = $31,942 + 17,015 PV = $48,957
Present value of an ordinary annuity of $1: n=5, i=8% (from Table 4) Present value of $1: n=5, i=8% (from Table 2)

The new machine should not be purchased.

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Chapter 06 - Time Value of Money Concepts

Real World Case 6-6


Requirement 1 The effective interest rate can be determined by solving for the unknown present value of $1 factor for 22 semiannual periods (2010-2020): PV of $1 factor = $ 189 = .693578 $272.5
Present value of $1: n= 22, i= ? (from Table 2, i = approximately 1.5%)

There is no row 22 in Table 2. The 24-period factor in the 1.5% column is . 69954. So, 1.5% is the approximate effective semiannual interest rate. A financial calculator or Excel will produce the same rate. Requirement 2 Using a 1.5% effective semiannual rate and 40 periods: PV = $1,000 (.55126) = $551.26
Present value of $1: n=40, i=1.5% (from Table 2)

The issue price of one, $1,000 maturity-value bond was $551.26.

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Chapter 06 - Time Value of Money Concepts

Real World Case 6-7


Requirement 1 The effective interest rate can be determined by solving for the unknown present value of an ordinary annuity of $1 factor for 3 periods: PV of an ordinary annuity of $1 factor = $39 = 2.7857* $14
Present value of an ordinary annuity $1: n= 3, i= ? (from Table 4, i = approximately 4%)

In row 3 of Table 4, the value of 2.77509 is in the 4% column. So, 4% is the approximate effective interest rate. A financial calculator or Excel will produce the same result. Requirement 2 The effective interest rate can be determined by solving for the unknown present value of an annuity due $1 factor for 4 periods: PV of an annuity due of $1 factor = $39 = 2.7857 $14

Present value of an annuity due $1: n= 3, i= ? (from Table 6, i = approximately 8%)

In row 3 of Table 6, the value of 2.78326 is in the 8% column. So, 8% is the approximate effective interest rate. A financial calculator or Excel will produce the same result.

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