Time Value of Money Concepts

Chapter 6

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

Copyright2013byTheMcGrawHillCompanies,Inc.Allrightsreserved.

6-2

Simple Interest

Interest amount = P i n
Assume you invest $1,000 at 6%
simple interest for 3 years.
You would earn $180 interest.
($1,000 .06 3 = $180)
(or $60 each year for 3 years)

6-3

Compound Interest
Assume we deposit $1,000 in a bank that
earns 6% interest compounded annually.

What is the balance in

our account at the
end of three years?

6-4

Compound Interest

6-5

Future Value of a Single Amount

The future value of a single amount is the
amount of money that a dollar will grow to at
some point in the future.
Assume we deposit $1,000 for three years that
earns 6% interest compounded annually.
$1,000.00 1.06 = $1,060.00
and
$1,060.00 1.06 = $1,123.60
and
$1,123.60 1.06 = $1,191.02

6-6

Future Value of a Single Amount

Writing in a more efficient way, we can say . . . .

$1,191.02 = $1,000 [1.06]3

FV = PV (1 + i)n
Future
Future
Value
Value

Amount
Amount
Invested
Invested at
at
the
the
Beginning
Beginning
of
of the
the
Period
Period

Interest
Interest
Rate
Rate

Number
Number
of
of
Compounding
Compounding
Periods
Periods

6-7

Future Value of a Single Amount

Using the Future Value of $1 Table, we
find the factor for 6% and 3 periods is
1.19102.
So, we can solve our problem like this. .
.
FV = $1,000 1.19102
FV = $1,191.02

6-8

Present Value of a Single Amount

Instead of asking what is the future value of a
current amount, we might want to know
what amount we must invest today to
accumulate a known future amount.
This is a present value question.
Present value of a single amount is todays
equivalent to a particular amount in the
future.

6-9

Present Value of a Single Amount

Remember our equation?
FV = PV (1 + i)

We can solve for PV and get . . . .

PV =

FV
(1 + i)

610

Present Value of a Single Amount

Assume you plan to buy a new car in 5
years and you think it will cost
$20,000 at that time.
What amount must you invest today in
order to accumulate $20,000 in 5 years,
if you can earn 8% interest compounded
annually?

611

Present Value of a Single Amount

i = .08, n = 5
Present Value Factor = .68058
$20,000 .68058 = $13,611.60
Present Value
of $1 Table

If you deposit $13,611.60 now, at

8% annual interest, you will have
$20,000 at the end of 5 years.

612

Solving for Other Values

FV = PV (1 + i)

Future
Future
Value
Value

Present
Present
Value
Value

Number
Number
of
of Compounding
Compounding
Interest
Periods
Interest
Periods
Rate
Rate

There are four variables needed

when determining the time value
of money.
If you know any three of these, the
fourth can be determined.

Determining the Unknown

Interest Rate
Suppose a friend wants to borrow $1,000
today and promises to repay you $1,092
two years from now. What is the annual
interest rate you would be agreeing to?
a. 3.5%
b. 4.0%
Present Value of $1 Table
c. 4.5%
$1,000 = $1,092 ?
d. 5.0%
$1,000 $1,092 = .91575

Search the PV of $1 table

in row 2 (n=2) for this value.

613

Accounting Applications of Present

Value TechniquesSingle Cash Amount
Some notes do not include a stated
interest rate. We call these notes
noninterest-bearing notes.

Even though the agreement

states it is a noninterestbearing note, the note does,
in fact, include interest.
We impute an appropriate
interest rate for noninterestbearing notes.

614

615

Expected Cash Flow Approach

Statement of Financial Accounting Concepts
No. 7
Using Cash Flow Information and Present
Value in Accounting Measurements
The objective of
valuing an asset
or liability using
present value is
to approximate
the fair value of
that asset or
liability.

The present value factor is

obtained using the companys
credit-adjusted risk-free rate of
interest.

616

Basic Annuities
An annuity is a
series
of equal periodic
payments.

Period 1 Period 2 Period 3 Period 4

$10,000

$10,000

$10,000

$10,000

617

Ordinary Annuity
An annuity with payments at the end of the
period is known as an ordinary annuity.
Today

$10,000

$10,000

$10,000

$10,000

End of year 1
End of year 2
End of year 3
End of year 4

618

Annuity Due
An annuity with payments at the beginning of
the period is known as an annuity due.
Today

$10,000

$10,000

$10,000

$10,000

Beginning
of year 1

Beginning
of year 2
Beginning
of year 3

Beginning
of year 4

619

Future Value of an Ordinary Annuity

To find the future
value of an
ordinary annuity,
multiply the
amount of the
annuity by the
future value of
an ordinary
annuity factor.

620

Future Value of an Ordinary Annuity

We plan to invest $2,500 at the end of each of
the next 10 years. We can earn 8%,
compounded interest annually, on all
invested funds.
What will be the fund balance at the end of 10
years?

621

Future Value of an Annuity Due

To find the future

value of an annuity
due, multiply the
amount of the
annuity by the
future value of an
annuity due factor.

622

Future Value of an Annuity Due

Compute the future value of $10,000
invested at the beginning of each of
the next four years with interest at
6% compounded annually.

623

Present Value of an Ordinary Annuity

You wish to withdraw $10,000 at the
end
of each of the next 4 years from a
bank account that pays 10% interest
compounded annually.
How much do you need to invest today
to meet this goal?

624

Present Value of an Ordinary Annuity

Today

PV1
PV2
PV3
PV4

$10,000

$10,000

$10,000

$10,000

625

Present Value of an Ordinary Annuity

PV1
PV2
PV3
PV4
Total

Annuity
$ 10,000
10,000
10,000
10,000

PV of $1
Factor
0.90909
0.82645
0.75131
0.68301
3.16986

Present
Value
$ 9,090.90
8,264.50
7,513.10
6,830.10
$ 31,698.60

If you invest $31,698.60 today you will

be able to withdraw $10,000 at the
end of each of the next four years.

626

Present Value of an Ordinary Annuity

PV1
PV2
PV3
PV4
Total

Annuity
$ 10,000
10,000
10,000
10,000

PV of $1
Factor
0.90909
0.82645
0.75131
0.68301
3.16986

Present
Value
$ 9,090.90
8,264.50
7,513.10
6,830.10
$ 31,698.60

Can you find this value in the Present Value

of Ordinary Annuity of $1 table?
More Efficient Computation
$10,000 3.16986 = $31,698.60

627

Present Value of an Annuity Due

Compute the present value of $10,000
received at the beginning of each of
the next four years with interest at
6% compounded annually.

628

Present Value of a Deferred Annuity

In a deferred annuity, the first

cash flow is expected to occur
more than one period after the
date of the agreement.

629

Present Value of a Deferred Annuity

On January 1, 2013, you are considering an
investment that will pay $12,500 a year for 2
years beginning on December 31, 2015. If
you require a 12% return on your
investments, how much are you willing to pay
for this investment?
Present
Value?
1/1/13

12/31/13
1

12/31/14
2

$12,500

$12,500

12/31/15
3

12/31/16
4

12/31/17

630

Present Value of a Deferred Annuity

On January 1, 2013, you are considering an
investment that will pay $12,500 a year for 2
years beginning on December 31, 2015. If
you require a 12% return on your
investments, how much are you willing to pay
for this investment?
Present
Value?
1/1/13

12/31/13
1

12/31/14
2

$12,500

$12,500

12/31/15
3

12/31/16
4

12/31/17

More Efficient Computation

1. Calculate the present value of the annuity as of the
beginning of the annuity period.
2. Discount the single value amount calculated in (1) to its
present value as of today.

631

Present Value of a Deferred Annuity

On January 1, 2013, you are considering an
investment that will pay $12,500 a year for 2
years beginning on December 31, 2015. If
you require a 12% return on your
investments, how much are you willing to pay
for this investment?
Present
Value?
1/1/13

12/31/13
1

12/31/14
2

$12,500

$12,500

12/31/15
3

12/31/16
4

12/31/17

Solving for Unknown Values in

Present Value of Annuity Situations
In present value problems involving
annuities, there are four variables:
Present value of
an ordinary
The amount of
annuity or
the annuity
present value of
payment
an annuity due

The number of
periods

The interest rate

If you know any three of these,

the fourth can be determined.

632

633

Solving for Unknown Values

in Present Value Situations
Assume that you borrow $700 from a
friend and intend to repay the amount in
four equal annual installments beginning
one year from today. Your friend wishes
to be reimbursed for the time value of
money at an 8% annual rate.
What is the required annual payment that
must be made (the annuity amount) to
Presentrepay the loan in four years?
Value
$700

Today

End of
Year 1

End of
Year 2

End of
Year 3

End of
Year 4

Solving for Unknown Values

in Present Value Situations
Assume that you borrow $700 from a
friend and intend to repay the amount in
four equal annual installments beginning
one year from today. Your friend wishes
to be reimbursed for the time value of
money at an 8% annual rate.
What is the required annual payment that
must be made (the annuity amount) to
repay the loan in four years?

634

Accounting Applications of Present

Value TechniquesAnnuities
Because financial instruments
typically specify equal periodic
payments, these applications quite
often involve annuity situations.
Long-term
Bonds

Long-term
Leases
Pension
Obligations

635

636

Valuation of Long-term
On Bonds
June 30, 2013, Ebsen
Calculate the Present
Value of the Lump-sum
Maturity Payment (Face
Value)
Calculate the Present
Value of the Annuity
Payments (Interest)

Electric issued 10% stated rate

bonds with a face value of $1
million. The bonds mature in 5
years. The market rate of
interest for similar issues was
12%. Interest is paid
semiannually beginning on
December 31, 2013. What
was the price of the bond
issue?

637

Valuation of Long-term Leases

Certain long-term
leases require the
recording of an
asset and
corresponding
liability at the
present value of
future lease
payments.

638

Valuation of Long-term Leases

On January 1, 2013, Todd Furniture Company signed a
20-year lease for a new retail showroom. The lease
agreement calls for annual payments of $25,000 for
20 years beginning on January 1, 2013. The
appropriate rate of interest for this long-term lease is
8%. Calculate the value of the asset acquired and the
liability assumed by Todd (the present value of an
annuity due at 8% for 20 years).

639

Valuation of Pension Obligations

Some pension plans
create obligations during
employees service
periods that must be paid
during their retirement
periods. The amounts
contributed during the
employment period are
determined using present
value computations of
the estimate of the future
amount to be paid during
retirement.

640

Valuation of Pension Obligations

On January 1, 2013, Todd Furniture Company hired a
new sales manager for the new showroom. The sales
manager is expected to work 30 years before retirement
on December 31, 2042. Annual retirement benefits will
be paid at the end of each year of retirement, a period
that is expected to be 25 years. The sales manager will
earn $2,500 in annual retirement benefits for the first
year worked, 2013. How much must Todd Furniture
contribute to the company pension fund in 2013 to
provide for $2,500 in annual pension benefits for 25
years that are expected to begin in 30 years? Todd
Furnitures pension fund is expected to earn 5% interest.

641

Valuation of Pension Obligations

This is a two-part calculation. The first part requires the
computation of the present value of a 25-year ordinary
annuity of $2,500 as of December 31, 2042. Next we
calculate the present value of the December 31, 2042
amount. This second present value is the amount Todd
Furniture will contribute in 2013 to fund the retirement
benefit earned by the sales manager in 2013.

642

End of Chapter 6