Accounting and the Time Value of Money

Chapter

Chapter 6-1

Compound Interest
Variables Fundamental to Compound Interest
Rate of Interest
Number of Time Periods Present Value

Future Value
Illustration 6-6

Chapter 6-2

Single-Sum Problems
Generally Classified into Two Categories
Unknown Present Value

Unknown Future Value

Chapter 6-3

Single-Sum Problems

Future Value formula

FV = PV (1+i) - for one period FV = PV(1+i)(1+i) - for two periods FV = PV(1+i)n - for n periods

Present Value formula (inverse relationship)

PV = FV(1+i)-n

Note: the discount rate, i, must be on the same basis as the compounding periods, n. For example, if the periods are years, the rate must be annual. If the periods are quarters, the rate must be in effective quarterly rate.

Chapter 6-4

Compound Interest Tables

Five Tables in Chapter 6
Table 1 - Future Value of 1 Table 2 - Present Value of 1

Table 3 - Future Value of an Ordinary Annuity of 1

Table 4 - Present Value of an Ordinary Annuity of 1 Table 5 - Present Value of an Annuity Due of 1
Number of Periods = number of years x the number of compounding periods per year. Compounding Period Interest Rate = annual rate divided by the number of compounding periods per year.
Chapter 6-5

Single-Sum Problems (PV)

Present Value of a Single Sum
Multiply the future value by the present value factor [(1+i)-n ]. Illustration: Itzak Perlman needs $20,000 in 4 years. What amount must he invest today if his investment earns 12% compounded quarterly?

Chapter 6-6

Single-Sum Problems (PV)

Present Value?
Future Value $20,000

Itzak Perlman needs $20,000 in 4 years. What amount must he invest today if his investment earns 12% compounded quarterly?

What table do we use?

Chapter 6-7

Single-Sum Problems (PV)

Table 6-2
Number of Periods 4 8 12 16 Discount Rate 4% 6% 9% 0.85480 0.73069 0.62460 0.53391 0.79209 0.62741 0.49697 0.39365 0.70843 0.50187 0.35554 0.25187

3% 0.88849 0.78941 0.70138 0.62317

12% 0.63552 0.40388 0.25668 0.16312

What factor do we use?

Chapter 6-8

Single-Sum Problems (PV)

Table 6-2
Number of Periods 4 8 12 16 Discount Rate 4% 6% 9% 0.85480 0.73069 0.62460 0.53391 0.79209 0.62741 0.49697 0.39365 0.70843 0.50187 0.35554 0.25187

3% 0.88849 0.78941 0.70138 0.62317

12% 0.63552 0.40388 0.25668 0.16312

$20,000
Future Value
Chapter 6-9

.62317
Factor

$12,463
Present Value

Single-Sum Problems (n and i)

Solving for Other Unknowns
ExampleComputation of the Interest Rate
Illustration 6-15

Chapter 6-10

Single-Sum Problems (n and i)

ExampleComputation of the Interest Rate
Illustration 6-16

Using the future value factor of 1.76234, refer to Table 6-1 and read across the 5-period row to find the factor.

Chapter 6-11

Single-Sum Problems (n and i)

ExampleComputation of the Interest Rate
Illustration 6-16

Using the present value factor of .56743, refer to Table 6-2 and read across the 5-period row to find the factor.

Chapter 6-12

Annuities
Annuities are characterized by the following:
(1) (2) (3)

Periodic payments or receipts (called rents) of the same amount, The same-length interval between such rents, and Compounding of interest once each interval.

Two Types of Annuities

(1)

Ordinary annuity - rents occur at the end of each period.

(2)

Annuity Due - rents occur at the beginning of each period.

Chapter 6-13

Present Value of an Ordinary Annuity

Present Value of an Ordinary Annuity
Present value of a series of equal amounts to be withdrawn or received at equal intervals. Periodic rents occur at the end of the period. Ex: Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the end of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%.
Chapter 6-14

Present Value of an Ordinary Annuity

Present Value
$100,000 100,000 100,000 100,000 100,000 100,000

.....
0 1 2 3 4 19 20

Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the end of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%.

What table do we use?

Chapter 6-15

Present Value of an Ordinary Annuity

Table 6-4
Number of Periods 1 5 10 15 20 Discount Rate 8% 0.92593 3.99271 6.71008 8.55948 9.81815

4% 0.96154 4.45183 8.11090 11.11839 13.59033

6%

10% 0.90900 3.79079 6.14457 7.60608 8.51356

12% 0.89286 3.60478 5.65022 6.81086 7.46944

0.94340 4.21236 7.36009 9.71225 11.46992

What factor do we use?

Chapter 6-16

Present Value of an Ordinary Annuity

Table 6-4
Number of Periods 1 5 10 15 20 Discount Rate 8% 0.92593 3.99271 6.71008 8.55948 9.81815

4% 0.96154 4.45183 8.11090 11.11839 13.59033

6%

10% 0.90900 3.79079 6.14457 7.60608 8.51356

12% 0.89286 3.60478 5.65022 6.81086 7.46944

0.94340 4.21236 7.36009 9.71225 11.46992

$100,000
Receipt
Chapter 6-17

9.81815
Factor

$981,815
Present Value

Present Value of an Annuity Due

Present Value of an Annuity Due
Present value of a series of equal amounts to be withdrawn or received at equal intervals. Periodic rents occur at the beginning of the period. EX:Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the beginning of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%.
Chapter 6-18

Present Value of an Annuity Due

Present Value
$100,000 100,000 100,000 100,000 100,000 100,000

.....
0 1 2 3 4 19 20

Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the beginning of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%.

What table do we use?

Chapter 6-19

Present Value of an Annuity Due

Table 6-5
Number of Periods 1 5 10 15 20 Discount Rate 8% 1.00000 4.31213 7.24689 9.24424 10.60360

4% 1.00000 4.62990 8.43533 11.56312 14.13394

6%

10% 1.00000 4.16986 6.75902 8.36669 9.36492

12% 1.00000 4.03735 6.32825 7.62817 8.36578

1.00000 4.46511 7.80169 10.29498 12.15812

What factor do we use?

Chapter 6-20

Present Value of an Annuity Due

Table 6-5
Number of Periods 1 5 10 15 20 Discount Rate 8% 1.00000 4.31213 7.24689 9.24424 10.60360

4% 1.00000 4.62990 8.43533 11.56312 14.13394

6%

10% 1.00000 4.16986 6.75902 8.36669 9.36492

12% 1.00000 4.03735 6.32825 7.62817 8.36578

1.00000 4.46511 7.80169 10.29498 12.15812

$100,000
Receipt
Chapter 6-21

10.60360
Factor

$1,060,360
Present Value

Deferred Annuities
Rents begin after a specified number of periods.

Future Value - Calculation same as the future value of an annuity not deferred.
Present Value - Must recognize the interest that accrues during the deferral period. Present Value
100,000 100,000

Future Value
100,000

.....
0
Chapter 6-22

19

20

Valuation of Long-Term Bonds

Arcadian Inc. issues $1,000,000 of 7% bonds due in 10 years with interest payable at year-end. The current market rate of interest for bonds is 8%. What amount will Arcadian receive when it issues the bonds?

1,000,000 $70,000 70,000 70,000 70,000 70,000 70,000

.....
0
Chapter 6-23

10

Valuation of Long-Term Bonds

Table 6-4
Number of Periods 1 5 10 15 20

PV of Interest
10% 0.90900 3.79079 6.14457 7.60608 8.51356 12% 0.89286 3.60478 5.65022 6.81086 7.46944

4% 0.96154 4.45183 8.11090 11.11839 13.59033

6%

Discount Rate 8% 0.92593 3.99271 6.71008 8.55948 9.81815

0.94340 4.21236 7.36009 9.71225 11.46992

$70,000
Chapter 6-24

6.71008
Factor

$469,706
Present Value

Interest Payment

Valuation of Long-Term Bonds

Table 6-2
Number of Periods 1 5 10 15 20

PV of Principal
10% 0.90909 0.62092 0.38554 0.23939 0.14864 12% 0.89286 0.56743 0.32197 0.18270 0.10367

4% 0.96154 0.82193 0.67556 0.55526 0.45639

6%

Discount Rate 8% 0.92593 0.68058 0.46319 0.31524 0.21455

0.94340 0.74726 0.55839 0.41727 0.31180

$1,000,000
Principal Payment
Chapter 6-25

.46319
Factor

$463,190
Present Value

Valuation of Long-Term Bonds

Arcadian Inc. issues $1,000,000 of 7% bonds due in 10 years with interest payable at year-end. Present value of Interest Present value of Principal Bond current market value $469,706 463,190 $932,896

Date Account Title Cash Discount on Bonds Bonds payable

Chapter 6-26

Debit 932,896 67,104

Credit

1,000,000