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Introductory Financial Accounting

Time Value of Money: Accounting & Business Applications


If someone were to ask you if you would rather have $100 today or $100 next year, your answer would be
Id like the $100 today. Your answer is based on the time value of money. The difference between the
worth of the two amounts is interest.
Many accounting and business applications use the time value of money. These applications include
accounting for bonds, leases, notes and pensions. Examples of business applications include what rate
of return is acceptable for investment and what interest rate to charge credit customers. There are
numerous personal applications as well such as the purchase of a home vs. renting, whether to borrow
for or lease a new car, and retirement planning.
Lets say that you would like to do a little retirement planning and have decided you want to be a
millionaire by age 60. If you are 20 years old right now, and the after-tax rate of return is 1% per month,
how much would you have to save per month to achieve your goal? Only $85 per month! Thats all! The
power of interest and time is on your side.

Simple & Compound Interest


Payment for the use of someone elses money is called interest. There are two types of interest, simple
and compound. Generally, interest is specified in terms of a percentage rate for a period of time, usually a
year. For example, interest at 10% means the annual cost of borrowing an amount of money, called the
principal, is equal to 10% of that amount. If $10,000 is borrowed for a period of one year at 10% annual
interest, the total to be repaid is $11,000, $10,000 principal and $1,000 interest.
Most transactions, however, involve compound interest. Compound interest is the interest that accrues
on both the principal and the past unpaid accrued interest.
There are four basic types of compound interest computations:
1.
2.
3.
4.

Present value of a single sum due in the future.


Present value of an annuity, a series of receipts or payments.
Future value of a single sum at compound interest.
Future value of an annuity.

The easiest way to handle time value problems is to use a timeline to visualize the time periods and the
movement back and forth of money amounts. A timeline should be used for all but the very simplest
problems.
A timeline looks like this:

0
Period

All receipts or payments should be placed on the time line and then the number of periods for movement
forward or back can be counted. Usually the present time is placed at period 0 but this can be adjusted
depending on the question.

Future Value

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications

Future value is the amount to which a present given amount of money will grow, should interest be
charged or earned. The calculation of this amount will require the following information:
1. amount of the investment, which is the principal, p
2. rate of interest (rate of return), i
3. number of time periods, n
For example, we might want to determine the amount of money that we will have in our bank savings
account in 3 years should we deposit $1,000 today, at an annual interest rate of 6%, if compounding is
annual.
The timeline looks like this:
0

$1,000
$1,000 x 1.06= $1,060

$1,060 x 1.06 = $1,123.60

$1,123.60 x 1.06=$1191

The arithmetic determination would be as follows:


-end of year 1 we will have $1000 + ($1000 x 1.06) = $1,060
-end of year 2 we will have $1060 + ($1060 x 1.06) = $1,123.60
-end of year 3 we will have $1123.60 +($1123.60 x 1.06) = $1,191.00
The amount of $1,191 is the future value of $1,000 at 6% per year, compounded annually for 3 years.
This process can be shortened through the use of a formula as follows:
FV = P(1+i)n
For this example, using the formula:
FV = $1,000 (1 + .06)3
= $1,000 (1.191)
= $1,191, which agrees to the arithmetic solution.

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications
Present Value
The present value is the principal that must be invested at time period zero to produce the known future
amount.
Using the previous example, if a firm desires a return of 6% per year and is promised a future receipt of
$1,191 in 3 years, then we can assume they will invest no more than $1,000 today. The determination of
present value is a process of discounting, the reverse of the compounding calculations we performed to
find future value. We can then use the following timeline and formula:
The timeline is as follows:
0

$1,191

Present value (PV) =

FV
(1 + i)n

= $ 1,191
(1+.06)3
= $ 1,191
1.191
= $ 1,000
As you can see from the above, present value and future value are reciprocals of one another.
Compound Interest Tables
The present value formula noted need not be used, since tables are available that provide present value
factors.
Table 1 provides the amounts that must be deposited now at a stated rate of interest to equal $1.00 at the
end of a stated number of periods.
Using Table 1 to solve for the present value for the example we have been using, we would refer to the
6% column, using the factor for 3 periods hence, which is (.84). The present value then would be
determined by multiplying the future value by the factor:
PV = $1,191 x .84
= $1,000 (rounded to the nearest dollar)
In our arithmetic solution of future value, we saw that at the end of year 2 we would have $1,123.60.
Using Table 1 to find the present value of this amount, again we would refer to the 6% column, using the
factor for 2 years hence, (.89),

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications
PV = $1,123.60 x .89
= $1,000
Future value tables are available, but are not really necessary. In this handout we do not have such a
table. Table 1, although it is primarily used for present value calculations, can be used for future value
calculations as well. Remembering that discounting and compounding, present value and future value
are reciprocals of each other, we can use Table 1 factors for future value calculations by using the
factors reciprocal.
For example, the future value of our $1,000 at 6% in 3 years, will be determined by using the n=3 years
factor under the i=6% column in Table 1, (.84), as follows:
FV = $1,000 x ( 1 )
( .84)
= $1,190.48 (the discrepancy is a minor one of less than $1)
Some things to remember:
- tables have i, interest, across the top, n, number of periods down the side, therefore,
- n = the number of compounding periods, not necessarily years
i.e. - 3 years compounded annually,
n=3
- 3 years compounded semi-annually, n = 6
- 3 years compounded monthly,
n = 36
-

i = interest rate for each period, not year, even though in common
given as an annual rate
i.e. - 12% per year compounded annually for 3 years,
i = 12,
- 12% per year compounded semi-annually for 3 years, i = 6,
- 12% per year compounded monthly for 3 years,
i = 1,

usage the interest rate is usually


n=3
n=6
n = 36

When doing time value problems, you must be very careful about which n
and i to use.

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications
Business Applications
The following examples will illustrate applications of the time value of money, including each of the four
situations previously described.
Example 1:

Future Value of a Lump Sum

Bailey Co. loaned its president, Susan Day, $15,000 to purchase a car. Bailey accepted a note due in 4
years with interest at 10% compounded semiannually. How much cash does Bailey expect to receive
from Day when the note is paid at maturity?
Solution:
This problem involves a lump-sum payment to be accumulated 4 years into the future.
The timeline is as follows:
0

PV= $15,000

8
FV= ?

$22,059
FV= 15,000 x 1 / 0.68 (n=8, i=5)

The $15,000 must be accumulated for 4 years at 10% compounded semiannually.


Since the
compounding is semi annually, the periods on the timeline must match the interest rate, hence 8 periods,
interest at 5% per period.
FV = ($15,000 (1/Table 1 factor, n=8, i=5)
= $15,000 x (1/.68)
= $22,059 (rounded as all subsequent examples will be)

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications

Example 2:

Present Value of a Lump Sum

East Enterprises holds a note receivable from a steady customer. The note is for $22,000, which
includes principal and interest, and is due to be paid in exactly 2 years. The customer wants to pay the
note now, and both parties agree that 10% is a reasonable annual interest rate to use in discounting the
note. How much will the customer pay East Enterprises today to settle the obligation?
Solution:
The timeline is as follows:

PV= ?

2
FV= $22,000

PV= $22,000 x 0.83 (n=2, i=10)


PV= $18,260

The lump-sum future payment must be discounted to the present at the agreed upon annual rate of
interest of 10%. Since this involves a present value computation of a lump-sum amount, Table 1 factors
will be used.
PV = FV (Table 1 factor, n=2, i=10)
= $22,000 (.83)
= $18,260
The customer will pay approximately $18,260 today to settle the obligation.

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications

Example 3:

Present Value of a Series of Unequal Payments

Good Life Sporting Goods Co. is considering a $1 million capital investment that will provide the following
expected net receipts at the end of each of the next 6 years:
Year

Expected Net Receipts

$195,000

457,000

593,000

421,000

95,000

5,000

Good Life will make the investment only if the rate of return is greater than 12%. Should Good Life make
the investment?
Solution:
The timeline is as follows:
0

$195,000 x 0.89= $173,550

$457,000 x 0.80= $365,600

$593,000 x 0.71= $421,030

$421,000 x 0.64= $269,440

$95,000 x 0.57= $54,150

$5,000 x x 0.51= $2,550

Sum of PV= $1,286,320

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications
A series of unequal future receipts must be compared with a present lump-sum investment. For such a
comparison to be made, all future cash flows must be discounted to the present.
If the rate of return on the investment is greater than 12%, then the total of all yearly net receipts
discounted to the present at 12% will be greater than the amount invested. Since the future receipts are
not equal, this situation does not involve an annuity. Each receipt must be discounted individually. Table
1 is used.
Year

Receipts

Factor

$195,000

.89

$173,550

457,000

.80

365,600

593,000

.71

421,030

421,000

.64

269,440

95,000

.57

54,150

5,000

.51

2,550

Total

Present Value

$1,286,320

The present value of the 6 future receipts discounted at 12% is $1,286,320. The total discounted receipts
are greater than the $1 million investment; thus, the rate of return is more than 12%. Therefore, other
things being equal, Good Life should invest.

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications

Example 4: Present Value of an Annuity


Mary Sawyer, proprietor of Sawyer Appliance, received two offers for her last, used, deluxe-model
refrigerator. Jerry Samson will pay $650 in cash. Elise Johnson will pay $700 consisting of a down
payment of $100 and 12 monthly payments of $50. If the installment interest rate is 24% compounded
monthly, which offer should Mary accept?
Solution:
In order to compare the two alternative methods of payment, all cash flows must be discounted to one
point in time. As illustrated by the timeline, the present is selected as the point of comparison.
The timeline is follows:
0

$100

$50

$50

$50

$50

$50

10

11

12

$50 $50 $50 $50 $50 $50 $50

= $50.00 x 10.58 (table 2, n=12, I=2)


$529
Johnson
Samson $

$629
650

Using i=2 factors, the present value of this choice will be: 100
Total
+50 x .98 (for n=1, i=2%)
+50 x .96 (for n=2, i=2%)
+50 x .94 (for n=3, i=2%)
+50 x .92 (for n=4, i=2%)
+50 x .91 (for n=5, i=2%)
+50 x .89 (for n=6, i=2%)
+50 x .87 (for n=7, i=2%)
+50 x .85 (for n=8, i=2%)
+50 x .84 (for n=9, i=2%)
+50 x .82 (for n=10, i=2%)
+50 x .80 (for n=11, i=2%)
+50 x .79 (for n=12, i=2%)
(50 x 10.57 (sum of factors))
+ the original 100 above

$49.00
48.00
47.00
46.00
45.50
44.50
43.50
42.50
42.00
41.00
40.00
39.50
528.50
100.00
628.50

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications
As you can see above, instead of multiplying 50 times 12 different factors and then adding the sums up,
we could multiply 50 times the sum of the factors, 50( factors for n=1 to n=12, i=2%)=10.58, adjusted for
rounding.
Table 2 does this summing for us. If you look at Table 2, n=12, i=2, you will get the same factors as
adding the 12 individual ones from Table 1. Therefore, for annuities, we can use Table 2. Table 2
provides the amounts that must be deposited now at a stated rate of interest to permit withdrawals of
$1.00 at the end of regular periodic intervals for the stated number of periods.
Remember annuities involve equal payments at even intervals, at a constant interest rate. If amounts
change (like in example 3) or intervals are not equal, you will need to use Table 1 for individual amounts.
Samsons offer is $650 today. The present value of $650 today is $650. Johnsons offer consists of an
annuity of 12 payments, plus $100 paid today, which is not part of the annuity. The annuity may be
discounted to the present using Table 2.
PV = $50 (10.57) + $100
$629
Therefore, Samsons offer of $650 cash is more desirable than Johnsons offer.
Example 5:

Future Value of an Annuity

Maxwell Co. owes an installment debt of $1,000 per quarter for 5 years. The creditor has indicated a
willingness to accept an equivalent lump-sum payment at the end of the contract period instead of a
series of equal payments made at the end of each quarter. If the money is worth 16% compounded
quarterly, what is the equivalent lump-sum payment at the end of the contract period?
Solution:
The timeline is as follows:

10

15

20

1000.1000...1000...1000...1000

$13,590

= $1,000 x 13.59 (table 2, n=20, i=4)


$29,544
FV= $13,590 x 1 / 0.46 (table 1, n=20, i=4)

We dont have the future value of an annuity table (present value and future value of an annuity are not
reciprocals). We can move the amounts into the future one by one using Table 1, or can do the present
value of annuity using Table 2, then once the amount is determined, move it into the future.
The equivalent lump-sum payment can be found by accumulating the quarterly $1,000 payments to the
end of the contract period. Since the payments are equal, this is an annuity.

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications
FV = ($1,000 x Table 2 factor) x (1/ Table 1 factor)
FV = ($1,000 x 13.59) x (1/ .46)
= $29,544
The $29,544 paid at the end of 5 years is approximately equal to the 20 quarterly payments of $1,000
each plus interest.
Things to remember:
1. The table for the present value of an annuity always gives you the present value one period before
the first payment.
2. The first day and the last day of a period are one period apart. The last day of a period and the first
day of the next period are on the same spot on the time line.
Determining the Number of Periods, the Interest Rate, or the Amount of Payment
So far, the examples have required solutions for the future or present values, with the other three
variables (n, i, either amount of periodic payment, PV or FV) in the formula given. Sometimes business
problems require solving for the number of periods, the interest rate, or the amount of payment instead of
the future or present value amounts. In each of the formulas, there are four variables. If information is
known about any three of the variables, the fourth (unknown) value can be determined.
Example 6:

Determining the Number of Periods

Rocky Mountain Survey Co. wants to purchase new equipment at a cost of $100,000. The company has
$88,850 available in cash but does not want to borrow the other $11,150 for the purchase. If the
company can invest the $88,850 today at an interest rate of 12% compounded quarterly, how many years
will it be before Rocky Mountain will have the $100,000 it needs to buy the equipment?
Solution:
The timeline is as follows:
i = 3, n= ?
0

n
PV= $88,850

FV= $100,000

PV = FV(factor)
PV/FV = factor
$88,850 / $100,000 = .89
Reading down the 3% column in Table 1, the factor of 0.89 corresponds with n = 4 quarters or 1 year.
Example 7:

Determining the Interest Rate

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications
The Howard family wishes to purchase a baby grand piano. The cost of the piano one year from now will
be $5,800. If the family can invest $5,000 now, what annual interest rate must they earn on their
investment to have $5,800 at the end of one year?
Solution:
The timeline is as follows:

PV= $5,000

FV= $5,800

n= 1, I = ?

PV = FV ( Table 1 factor)
$5,000/$5,800 = factor
= .86
Reading across the n = 1 row, the factor value corresponds to an annual effective interest rate of 16%.
Therefore, the Howard family would have to earn 16% annual interest to accomplish their goal.
Example 8:

Determining the Amount of Payment

Canada 1st National Bank is willing to lend a customer $75,000 to buy a warehouse. The note will be
secured by a 5-year mortgage and carry an annual interest rate of 12%. Equal payments are to be made
at the end of each year over the 5-year period. How much will the yearly payment be?
Solution:
The timeline is as follows:
0

PV= $75,000
Table 2, n = 5, i = 12

PV = A (factor from Table 2)


$75,000 = A (factor for n =5, i = 12%)
$75,000 = A(3.60)
$75,000/3.60 = A
$20,833 = A
The payment on this 5-year mortgage would be approximately $20,833 each year.

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications

Timing of Annuity Payments


In the above example, payments (annuities) take place at the end of each period. Table 2 is designed to
give the PV of an annuity one period before the 1st payment. What if National Bank had wanted its
payments at the beginning of each year?
The timeline would be as follows:
0

PV= $75,000
Table 2, n = 4, i = 12

One way of solving the problem is to use Table 2 for all but the 1st payment and then add the 1st payment
to the total (PV of 1st payment is A).
PV = A + A(factor from Table 2, n=4, i=12)
$75,000 = A(1 + 3.04)
A = $75,000/(1 + 3.04)
= $18,564
Another way to solve the problem, if you like to have choices, would be to do the comparison in period 1.
The timeline would be as follows:

-1

$66,750

$75,000 x 0.89, n = 1, i = 12

You 1st must calculate the PV of $75,000 at n = -1 (PV using Table 1, n = 1, i = 12), which is
.89($75,000), $66,750. Then we know that $66,750 =A(Factor from Table 2, n=5,i=12). We can now use
Table 2 to solve this problem since we are bringing the annuity to 1 period before the 1st payment. The
solution would be $66,750 = A(3.60), A=$18,562, with a discrepancy of $2 which is immaterial and due
to rounding of the factors.

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications
In Summary
From the above examples, it can clearly be seen the usefulness of having a sound understanding of time
value concepts. To learn time value of money, you must practice working on problems using the
techniques described above.

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications

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Introductory Financial Accounting


Time Value of Money: Accounting & Business Applications

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