d- 1 time value of money financial accounting, sixth edition d

D- 1

TIME VALUE OF MONEY

Financial Accounting, Sixth Edition

D

D- 2

1. Distinguish between simple and compound interest.

2. Solve for future value of a single amount.

3. Solve for future value of an annuity.

4. Identify the variables fundamental to solving present value problems.

5. Solve for present value of a single amount.

6. Solve for present value of an annuity.

7. Compute the present value of notes and bonds.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

D- 3

Would you rather receive $1,000 today or $1,000 a

year from now?

Basic Time Value ConceptsBasic Time Value ConceptsBasic Time Value ConceptsBasic Time Value Concepts

Time Value of Money

Today! “Interest Factor”

D- 4

Payment for the use of money.

Excess cash received or repaid over the amount

borrowed (principal).

Variables involved in financing transaction:

1. Principal (p) - Amount borrowed or invested.

2. Interest Rate (i) – An annual percentage.

3. Time (n) - The number of years or portion of a year

(periods) that the principal is borrowed or invested.

Nature of InterestNature of InterestNature of InterestNature of Interest

SO 1 Distinguish between simple and compound interest.SO 1 Distinguish between simple and compound interest.

D- 5

Interest computed on the principal only.



Illustration:

Assume you borrow $5,000 for 2 years at a simple interest of 12% annually. Calculate the annual interest cost.

Interest = p x i x n

= $5,000 x .12 x 2

= $1,200

FULL YEARFULL YEAR

Illustration D-1

Simple Interest

D- 6

Computes interest on

► the principal and

► any interest earned that has not been paid or

withdrawn.

Virtually all business situations use compound

interest.



Compound Interest

D- 7

Illustration: Assume that you deposit $1,000 in Bank Two, where it will earn simple interest of 9% per year, and you deposit another $1,000 in Citizens Bank, where it will earn compound interest of 9% per year compounded annually. Also assume that in both cases you will not withdraw any interest until three years from the date of deposit.

Nature of Interest - Compound InterestNature of Interest - Compound InterestNature of Interest - Compound InterestNature of Interest - Compound Interest


Year 1 $1,000.00 x 9% $ 90.00 $ 1,090.00

Year 2 $1,090.00 x 9% $ 98.10 $ 1,188.10

Year 3 $1,188.10 x 9% $106.93 $ 1,295.03

Illustration D-2Simple versus compound interest

D- 8 SO 2 Solve for a future value of a single amount.SO 2 Solve for a future value of a single amount.

Future value of a single amount is the value at a future date of a given amount invested, assuming compound interest.

Future Value of a Single AmountFuture Value of a Single AmountFuture Value of a Single AmountFuture Value of a Single Amount Section One

FV = p x (1 + i )n

FV = future value of a single amount

p = principal (or present value; the value today)

i = interest rate for one period

n = number of periods

Illustration D-3 Formula for future value

D- 9

Illustration: If you want a 9% rate of return, you would compute the future value of a $1,000 investment for three years as follows:

Illustration D-4

SO 2 Solve for a future value of a single amount.SO 2 Solve for a future value of a single amount.

Future Value of a Single AmountFuture Value of a Single AmountFuture Value of a Single AmountFuture Value of a Single Amount

D- 10

Illustration D-4



What table do we use?

Alternate Method

Illustration: If you want a 9% rate of return, you would compute the future value of a $1,000 investment for three years as follows:

D- 11

What factor do we use?



$1,000

Present Value Factor Future Value

x 1.29503 = $1,295.03

D- 12


Illustration:



Illustration D-5

D- 13

$20,000

Present Value Factor Future Value

x 2.85434 = $57,086.80



D- 14 SO 3 Solve for a future value of an annuity.SO 3 Solve for a future value of an annuity.

Future value of an annuity (right to receive a fixed

amount on the last day of each of n periods) is the sum of

all the payments (receipts) plus the accumulated

compound interest on them.

Necessary to know the

1. interest rate,

2. number of compounding periods, and

3. amount of the periodic payments or receipts

(payments).

Future Value of an AnnuityFuture Value of an AnnuityFuture Value of an AnnuityFuture Value of an Annuity

D- 15

Illustration: Assume that you invest $2,000 at the end of each year for three years at 5% interest compounded annually.

Illustration D-6

SO 3 Solve for a future value of an annuity.SO 3 Solve for a future value of an annuity.


D- 16

Illustration:

Invest = $2,000

i = 5%

n = 3 years



Illustration D-7

D- 17

When the periodic payments (receipts) are the same in each period, the future value can be computed by using a future value of an annuity of 1 table (Table 2 pg. D-6).

Illustration:Illustration D-8



D- 18


$2,500

Payment Factor Future Value

x 4.37462 = $10,936.55



D- 19 SO 4 Identify the variables fundamental to solving present value problems.SO 4 Identify the variables fundamental to solving present value problems.

The present value is the value now of a given amount to be paid or received in the future, assuming compound interest.

Present value variables:

1. Dollar amount to be received in the future,

2. Length of time until amount is received, and

3. Interest rate (the discount rate).

Present Value ConceptsPresent Value ConceptsPresent Value ConceptsPresent Value Concepts Section Two

D- 20

Present Value = Future Value / (1 + i )n

Illustration D-9Formula for present value

p = principal (or present value)

i = interest rate for one period

n = number of periods

Present Value of a Single AmountPresent Value of a Single AmountPresent Value of a Single AmountPresent Value of a Single Amount

SO 5 Solve for present value of a single amount.SO 5 Solve for present value of a single amount.

D- 21 SO 5 Solve for present value of a single amount.SO 5 Solve for present value of a single amount.

Illustration: If you want a 10% rate of return, you would compute the present value of $1,000 for one year as follows:


Illustration D-10

D- 22




Illustration D-10

Illustration: If you want a 10% rate of return, you can also compute the present value of $1,000 for one year by using a present value table.

D- 23

$1,000 x .90909 = $909.09




Future Value Factor Present Value

D- 24




Illustration D-11

Illustration: If you receive the single amount of $1,000 in two years, discounted at 10% [PV = $1,000 / 1.102], the present value of your $1,000 is $826.45.

D- 25

$1,000 x .82645 = $826.45





D- 26

$10,000 x .79383 = $7,938.30



Illustration: Suppose you have a winning lottery ticket and the state

gives you the option of taking $10,000 three years from now or taking

the present value of $10,000 now. The state uses an 8% rate in

discounting. How much will you receive if you accept your winnings

now?


D- 27 SO 5 Solve for present value of a single amount.SO 5 Solve for present value of a single amount.


Illustration: Determine the amount you must deposit now in a bond

investment, paying 9% interest, in order to accumulate $5,000 for a

down payment 4 years from now on a new Toyota Prius.


$5,000 x .70843 = $3,542.15

D- 28

The value now of a series of future receipts or payments,

discounted assuming compound interest.

Necessary to know

1. the discount rate,

2. The number of discount periods, and

3. the amount of the periodic receipts or payments.

SO 6 Solve for present value of an annuity.SO 6 Solve for present value of an annuity.

Present Value of an AnnuityPresent Value of an AnnuityPresent Value of an AnnuityPresent Value of an Annuity

D- 29

Illustration: Assume that you will receive $1,000 cash

annually for three years at a time when the discount rate is

10%.




Illustration D-14

D- 30



$1,000 x 2.48685 = $2,484.85



D- 31

Illustration: Kildare Company has just signed a capitalizable lease contract for equipment that requires rental payments of $6,000 each, to be paid at the end of each of the next 5 years. The appropriate discount rate is 12%. What is the amount used to capitalize the leased equipment?

$6,000 x 3.60478 = $21,628.68



D- 32

Illustration: Assume that the investor received $500 semiannually for three years instead of $1,000 annually when the discount rate was 10%. Calculate the present value of this annuity.

$500 x 5.07569 = $2,537.85



D- 33 SO 7 Compute the present value of notes and bonds.SO 7 Compute the present value of notes and bonds.

Two Cash Flows:

Periodic interest payments (annuity).

Principal paid at maturity (single-sum).

Present Value of a Long-term Note or BondPresent Value of a Long-term Note or BondPresent Value of a Long-term Note or BondPresent Value of a Long-term Note or Bond

0 1 2 3 4 9 10

5,000 5,000 5,000$5,000

. . . . .5,000 5,000

100,000

D- 34 SO 7 Compute the present value of notes and bonds.SO 7 Compute the present value of notes and bonds.


0 1 2 3 4 9 10

5,000 5,000 5,000$5,000

. . . . .5,000 5,000

100,000

Illustration: Assume a 10% bond issue, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. Calculate the present value of the principal and interest payments.

D- 35

$100,000 x .61391 = $61,391

Principal Factor Present Value

SO 7 Compute the present value of notes and bonds.SO 7 Compute the present value of notes and bonds.

PV of Principal


D- 36

$5,000 x 7.72173 = $38,609

Principal Factor Present Value



PV of Interest

D- 37

Illustration: Assume a bond issue of 10%, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1.

Present value of Principal $61,391

Present value of Interest 38,609

Bond current market value $100,000

Account Title Debit Credit

Cash 100,000

Bonds Payable 100,000

Date



D- 38

Illustration: Now assume that the investor’s required rate of return is 12%, not 10%. The future amounts are again $100,000 and $5,000, respectively, but now a discount rate of 6% (12% / 2) must be used. Calculate the present value of the principal and interest payments.


Illustration D-20


D- 39

Illustration: Now assume that the investor’s required rate of return is 8%. The future amounts are again $100,000 and $5,000, respectively, but now a discount rate of 4% (8% / 2) must be used. Calculate the present value of the principal and interest payments.


Illustration D-21


d- 1 time value of money financial accounting, sixth edition d

Documents

future value slide

year illustration d

present value problems

present value of notes

edition d slide

future date

principal p

year periods