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Time Value of

Money Concepts

Time Value of Money

earn interest and grow to a larger dollar

amount in the future

Example:

Invested Annual Future

in bank yield value

6 $10

$100

% 6

liabilities

LO6-1

Interest

Amount of money paid or received in

excess of the amount of money borrowed

or lent

Simple Interest Intere

Initial Perio

investm st d of

ent rate time

Compound Interest

Includes interest not only on the initial

investment but also on the

accumulated interest in previous

LO6-1

Simple Interest

Example:

What is the simple interest earned each year

on a $1,000 investment paying 10% interest?

$1,00

nt 10

rate 1

period $10

interest

=

0 % Year 0

LO6-1

Compound Interest

Example:

Cindy Johnson invested $1,000 in a savings account

paying 10% interest compounded annually. How much

interest will she earn in each of the next three years, and

what will be her investment balance after three years?

(Interest rate

Outstanding Balance)

Initial deposit $1,000

End of year 1 10% $1,000 = $100 $1,100

End of year 2 10% $1,100 = $110 $1,210

End of year 3 10% $1,210 = $121 $1,331

LO6-1

Compound Interest

Effective rate

Actual rate at which money grows per

year

Example:

Assuming an annual rate of 12%:

Interest Rate

Per

Compound Compounding

ed Period

Semiannual 12% 6

ly 2= %

12% 3

LO6-1

Compound Interest

Example:

Cindy Johnson invested $1,000 in a savings

account paying 10% interest compounded

twice a year. What will be her investment

balance at the end of the year? What is the

Interest

effective annual interest rate?

10% 2 =

5% (Interest rate

Outstanding

Date balance) Balance

Initial deposit $1,000.00

After six 5% $1,000 =

months $50.00

$1,102.50

$1,050 .00

5% $1,050

$1,000 =

Effective

End of yearannual

1 interest

$52.50rate = $102.50

$1,102.50

$1,000 = 10.25%

LO6-2

The amount of money that a dollar will

grow to at some point in the future

FV = I (1 + i)

Amount invested at the beginning of

I = the period

i = Interest rate

n = Number of compounding periods

LO6-2

Example:

Cindy Johnson invested $1,000 in a savings

account for three years paying 10% interest

compounded annually. Future

value

$1,000 $1,331

End of

End of End of

0 year 3

year 1 year 2

FV = I FV

Factor

FV = $1,000

1.331

FV = $1,331

LO6-3

in the future

F

FV = PV (1 + i) PV =

n (1V +

n

Example: i)

$1,331 $1,331

PV = = = $1,00

(1 + . 1.331 0

10)3

LO6-3

Example:

The present value of $1,331 received at the

end of three years:

PV = FV PV

Factor

PV = $1,331 .

75131

PV = $1,000

LO6-3

Value and the Future Value

End of End of End of

0 year 1 year 2 year 3

$100 $110 $121

$1,000 $1,331

PV FV

Present value entails the removal of interest

Accountants use PV calculations much more

frequently than FV

LO6-4

and PV Are Known

Determining an Unknown Interest

Rate

Suppose a friend asks to borrow $500 today

and promises to repay you $605 two years

from now. What is the annual interest rate you

would be agreeing to?

Present Future

value value

$500 $605

End of End of

0 year 1 year 2

n = 2, i

=?

LO6-4

Rate (continued)

$500 (present value) = $605 (future

value) PVF*

*Present value of $1; n =

2, i = ?

$500 (present value) $605 (future

value)

*Present= value

0.82645*

of $1; ni =

2, =?

i=

10%

.

.75131

.

751

31

LO6-4

and PV Are Known

Periods

You want to invest $10,000 today to accumulate

$16,000 for graduate school. If you can invest at

an interest rate of 10% compounded annually,

Present Future

how many years will it take to accumulate the

value value

required amount?

$10,000 $16,000

End of End of End of End of

0 year 1 year 2 year n-1 year n

n = ?, i =

10%

LO6-4

of Periods (continued)

$10,000 (present value) = $16,000 (future

*Present value

value) of $1;

PVF * i=

10%, n = ?

$10,000 (present value) $16,000 (future

value) = value

*Present 0.625* of $1; i = n =

10%, ?

n=

5

.75131

.

751

. 31.

Preview of Accounting Applications LO6-4

Single Cash Amount

Most monetary assets and monetary liabilities are

valued at the present value of future cash flows

Monetary assets

Include money and claims to receive money in the

future, the amount of which is fixed or

determinable

Examples:

Cash and most receivables

Monetary liabilities

Obligations to pay amounts of cash in the future,

the amount of which is fixed or determinable

Example:

Notes payable

Valuing a Note: One Payment,

LO6-4

Explicit Interest

Example:

The Stridewell Wholesale Shoe Company

manufactures athletic shoes for sale to

retailers. The company recently sold a large

order of shoes to Harmon Sporting Goods for

$50,000. Stridewell agreed to accept a note in

payment for the shoes requiring payment of

$50,000

Preseafter one year plus interest Future

at 10%.

nt value

value $55,0

?

0 00

End of

year 1

n = 1, i =

LO6-4

Explicit Interest

$55,000 (future value) 0.90909* = $50,000

(present value)

*Present value of $1; n = 1, i

= 10%

Valuing a Note: One Payment, No

LO6-4

Interest Stated

Example:

The Stridewell Wholesale Shoe Company

recently sold a large order of shoes to Harmon

Sporting Goods. Terms of the sale require

Harmon to sign a noninterest-bearing note of

$60,500

Present with payment due in two years. Future

value value

? $60,500

End of

year 2

n = 2, i =

To find the PV of the10%

note (price of the shoes), we need

to know either the cash price of the shoes or the

appropriate interest rate for a transaction like this one.

LO6-4

Explicit Interest

$60,500 (future value) .82645* = $50,000

(present

*Presentvalue)

value of $1; n = 2, i =

10%

LO6-4

Concepts No. 7 (SFAC No. 7)

Provides a framework for using future cash

flows in accounting measurement when

uncertainty is present.

The objective in valuing an asset or liability

using present value is to approximate fair

value of that asset or liability

o Key to that objective is determining the

present value of future cash flows, taking

into account any uncertainty concerning

the amounts and timing of the cash flows

LO6-4

Approach

LDD Corporation faces the likelihood of having to pay an uncertain

amount in five years in connection with an environmental cleanup.

Calculate the expected cash flow. Also calculate the present value of

the expected cash flow if the companys credit-adjusted risk-free rate

of interest is 5%. The future cash flow estimate is in the range of

$100 million to $300

Loss million

Amount with the following estimated

Probability

probabilities:

$100 million 10%

$200 million 60%

$300 million 30%

$100 X 10% = $ 10 million

200 X 60% = 120 million

300 X 30% = 90 million

$220 million

Present value of

$1: n = 5, i =

$220,000,000 X .78353 =

5%

LO6-5

Basic Annuities

Annuity

Series of cash flows of same amount

received or paid each period

Example:

A loan on which periodic interest is paid in

equal amounts

Ordinary Annuity

Cash flows occur at the end of each

period

Annuity Due

Cash flows occur at the beginning of

LO6-5

Ordinary Annuity

Example:

An installment note payable dated December

31, 2016, might require the debtor to make

three equal annual payments, with the first

payment due on December 31, 2017, and

the last one on December 31, 2019.

LO6-5

Annuity Due

Example:

A three-year lease of a building that begins on

December 31, 2016, and ends on December

31, 2019, may require the first years lease

payment in advance on December 31,

2016. The third and last payment would take

place on December 31, 2018, the beginning of

the third year of the lease.

Future Value of an Ordinary

LO6-6

Annuity

Sally Rogers wants to accumulate a sum of money to pay for graduate

school. Rather than investing a single amount today that will grow to a

future value, she decides to invest $10,000 a year over the next

three years in a savings account paying 10% interest compounded

annually. She decides to make the first payment to the bank one

year from today.

FV of Future value

Payme $1 (at the end of year 3) n

nt i=

First $10,00 1.21

10% = $12,10 2

payment

Second 010,000 1.10 = 0

11,000 1

payment

Third 10,000 1.00 = 10,000 0

payment

Tota 3.31 $33,1

00

LO6-6

Future Value

FVA = $10,000 (annuity amount) =

3.31*value of an ordinary annuity of $1: n = $33,100

*Future 3, i

=10%

LO6-6

FV of Future value

Payme $1 (at the end of year 3) n

nt i=

First $10,00 1.331 = $13,31 3

10%

payment

Second 010,000 1.210 = 0

12,100 2

payment

Third 10,000 1.100 = 11,000 1

payment

Tota 3.641 $36,4

Easier way: 10

l

FVA = $10,000 (annuity amount) 3.641* =

$36,410

*Future value of an ordinary annuity of $1: n

= 3, i =10%

LO6-7

She wants to invest a single amount today in a savings account

earning 10% interest compounded annually that is equivalent to

investing $10,000 at the end of each of the next three years.

PV of Present value

Payme $1 (at the beginning of n

nt i= the year 1)

First $10,00 .90909 = $9,091 1

10%

payment

Second 010,000 .82645 = 8,264 2

payment

Third 10,000 .75131 = 7,513 3

payment

Tota 2.486 $24,8

l 85 68

LO6-7

Present Value

PVA = $10,000 (annuity amount) 2.48685*

= $24,868

LO6-7

In the previous illustration, suppose that the three equal payments of

$10,000 are to

be made at the beginning of each of the three years. What is the

present value of this annuity?

PV of Present value

Payme $1 (at the beginning of n

nt i=

First $10,00 1.0000 = the year 1)

$10,00 0

payment 10% 0

Second 010,000 0

.90909 = 9,091 1

payment

Third 10,000 .82645 = 8,264 2

payment

Tota 2.735 $27,3

l 54 55

LO6-7

Present Value

$27,355

*Present value of an annuity due of $1: n = 3, i =

10%

From Table 6

LO6-8

Value Situations

Determining the Annuity Amount when Other

Variables are Known

amount

$700 (present value) 3.31213* = $211.34

(annuity amount)

* Present value of an ordinary annuity of $1: n = 4, i

= 8%

LO6-8

Determining the Unknown Number of PeriodsOrdinary Annuity

?* value of an ordinary annuity of $1: n = ?,PVA table

*Present

i = 7% factor

$700 (present value) $100 (annuity amount) =

* Present value of an ordinary annuity of $1: n

7.0000*

= ?, i = 7%

In the PVA table (Table 4), search the 7% column ( i = 7%)

for this value and find 7.02358 in row 10. So it would take

about 10 years to repay the loan.

LO6-8

Determining i When Other Variables Are Known

?* value of an ordinary annuity of $1: n = 4,

*Present

PVA table

i =? factor

$331 (present value) $100 (annuity amount) =

*3.31*

Present value of an ordinary annuity of $1: n = 4, i

=?

In the PVA table (Table 4), search row four (n = 4) for

3.31. We find it in the 8% column. So the effective

LO6-9

On June 30, 2016, Fumatsu Electric issued 10% stated rate

bonds with a face amount of $200 million. The bonds mature

on June 30, 2036 (20 years). The market rate of interest for

similar issues was 12%. Interest is paid semiannually (5%) on

June 30 and December 31, beginning December 31, 2016. The

interest payment is $10 million (5% X $200 million).

What was the price of the bond issue? What amount of interest

expense will Fumatsu record for the bonds in 2016?

Present value of an ordinary annuity of $1: n

= 40, i = 6%

PVA = $10 million (annuity amount) X = $150,463,0

PV = $200 million (lump-sum)15.04630 00

X . = 19,444,000

09722

Price of the bond issue = $169,907,

Present value of $1: n = 40, 000

i = 6%

$169,907,000 6% =

Interest expense =

$10,194,420

LO6-9

On January 1, 2016, the Stridewell Wholesale Shoe Company

signed a 25-year lease agreement for an office building. Terms

of the lease call for Stridewell to make annual lease payments

of $10,000 at the beginning of each year, with the first

payment due on January 1, 2016. Assuming an interest rate of

10% properly reflects the time value of money in this situation,

how should Stridewell value the asset acquired and the

corresponding

PVAD =lease liability? (annuity amount)

$10,000

9.98474 = $99,847

Present value of an annuity due of $1: n = 25,

i =10%

Leased office building 99,847

Lease payable 99,847

Summary of Time Value of Money

Concepts

End of Chapter 6

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