GOLIS UNIVERSITY

Faculty Of Business And Economics

Chapter three (part one)

Accounting and time value of money

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BASIC TIME VALUE CONCEPTS
In accounting (and finance), the phrase time value of
money indicates a relationship between time and money—
that a dollar received today is worth more than a dollar
promised at some time in the future. Why?
Because of the opportunity to invest today’s dollar and
receive interest on the investment.

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The Nature of Interest
Interest is payment for the use of money. It is the excess cash
received or repaid over and above the amount lent or borrowed
(principal).
For example, Corner Bank lends Hillfarm Company $10,000 with
the understanding that it will repay $11,500. The excess over
$10,000, or $1,500, represents interest expense for Hillfarm and
interest revenue for Corner Bank. The lender generally states the
amount of interest as a rate over a specific period of time.
For example, if Hillfarm borrowed $10,000 for one year before
repaying $11,500, the rate of interest is 15 percent per year ($1,500 /
$10,000).
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How is the interest rate determined?
One important factor is the level of credit risk (risk of non
payment) involved. Other factors being equal, the higher
the credit risk, the higher the interest rate.
 Low-risk borrowers like Microsoft or Intel can probably
obtain a loan at or slightly below the going market rate of
interest. However, a bank would probably charge the
neighborhood delicatessen several percentage points above
the market rate, if granting the loan at all.

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VARIABLES IN INTEREST
COMPUTATION
The amount of interest involved in any financing
transaction is a function of three variables:
PRINCIPAL. The amount borrowed or invested.
INTEREST RATE. A percentage of the outstanding
principal.
TIME. The number of years or fractional portion of a year
that the principal is outstanding.

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Thus, the following three relationships apply:

The larger the principal amount, the larger the dollar

amount of interest.
The higher the interest rate, the larger the dollar amount of
interest.
 The longer the time period, the larger the dollar amount of
interest.

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Simple Interest
Companies compute simple interest on the amount of the
principal only. It is the return on (or growth of) the
principal for one time period.
The following equation expresses simple interest.
Interest = p * I * n
p = principal
i = rate of interest for a single period
n = number of periods

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EXAMPLE
To illustrate, Barstow Electric Inc. borrows $10,000 for 3
years with a simple interest rate of 8% per year. It computes
the total interest it will pay as follows.

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Compound Interest
We compute compound interest on principal and on any
interest earned that has not been paid or withdrawn. It is
the return on (or growth of) the principal for two or more
time periods.
Compounding computes interest not only on the principal
but also on the interest earned to date on that principal,
assuming the interest is left on deposit.

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Example
To illustrate the difference between simple and compound
interest, assume that:
Vasquez Company deposits $10,000 in the Last National Bank,
where it will earn simple interest of 9% per year. It deposits
another $10,000 in the First State Bank, where it will earn
compound interest of 9% per year compounded annually. In
both cases, Vasquez will not withdraw any interest until 3 years
from the date of deposit. Determine the computation of
interest Vasquez will receive, as well as its accumulated year-
end balance.
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Answer

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Fundamental Variables
 RATE OF INTEREST. This rate, unless otherwise stated, is an
annual rate that must be adjusted to reflect the length of the
compounding period if less than a year.
NUMBER OF TIME PERIODS. This is the number of
compounding periods. (A period may be equal to or less than a
year.)
FUTURE VALUE. The value at a future date of a given sum or
sums invested assuming compound interest.
PRESENT VALUE. The value now (present time) of a future sum
or sums discounted assuming compound interest.
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Continue …
Illustration below depicts the relationship of these four
fundamental variables in a time diagram.

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SINGLE-SUM PROBLEMS
Many business and investment decisions involve a single amount
of money that either exists now or will in the future. Single-sum
problems are generally classified into one of the following two
categories
1. Computing the unknown future value of a known single sum
of money that is invested now for a certain number of periods
at a certain interest rate.
2. Computing the unknown present value of a known single sum
of money in the future that is discounted for a certain number
of periods at a certain interest rate.
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Continue…
When analyzing the information provided, determine first whether
the problem involves a future value or a present value. Then apply
the following general rules, depending on the situation:
If solving for a future value, accumulate all cash flows to a future
point. In this instance, interest increases the amounts or values
over time so that the future value exceeds the present value.
If solving for a present value, discount all cash flows from the
future to the present.
In this case, discounting reduces the amounts or values, so that the
present value is less than the future amount.
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Future Value of a Single Sum
To determine the future value of a single sum, multiply the
future value factor by its present value (principal), as
follows.
FV = PV (FVFn,i)
where
FV =future value
PV = present value (principal or single sum)
FVFn,i =future value factor for n periods at i interest

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Example
Bruegger Co. wants to determine the future value of
$50,000 invested for 5 years compounded annually at an
interest rate of 11%. Illustration below shows this
investment situation in time-diagram form.

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Solution
Using the future value formula, Bruegger solves this
investment problem as follows.

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Example
assume that Commonwealth Edison Company deposited
$250 million in an escrow account with Northern Trust
Company at the beginning of 2014 as a commitment
toward a power plant to be completed December 31, 2017.
How much will the company have on deposit at the end of
4 years if interest is 10%, compounded semiannually?

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Continue …

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Solution

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Present Value of a Single Sum
The Bruegger example on page 295 showed that $50,000
invested at an annually compounded
interest rate of 11% will equal $84,253 at the end of 5
years. It follows, then, that $84,253, 5 years in the future, is
worth $50,000 now. That is, $50,000 is the present value of
$84,253. The present value is the amount needed to invest
now, to produce a known future value.

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Continue …
The present value is always a smaller amount than the
known future value, due to earned and accumulated
interest.
The following formula is used to determine the present
value of 1 (present value factor):

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Continue …
The present value of any single sum (future value), then, is
as follows.

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Example
To illustrate, what is the present value of $84,253 to be
received or paid in 5 years discounted at 11% compounded
annually? Illustration below shows this problem as a time
diagram.

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Solution

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