Chapter 6

TIME VALUE OF MONEY

CONCEPTS

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.

 Slide 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)

6-2
 Slide 3

Compound Interest

Original balance $ 1,000.00

Assume we deposit
First year interest
$1,000 in a bank that earns
60.00
6% interest compounded annually.
Balance, end of year 1 $ 1,060.00

Balance, beginning of year 2 $ 1,060.00

Second year interest 63.60
Balance, end of year 2 $ 1,123.60

What is the balance

Balance, beginning of yearin3 $ 1,123.60
our account at the
Third year interest 67.42
end of three years?
Balance, end of year 3 $ 1,191.02
6-3
 Slide 4

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
6-4
 Slide 5

Future Value of a Single Amount

Using
Writingthe
in aFuture Value way,
more efficient of $1we
Table,
can saywe. find
...
the factor for 6% and 3 periods is 1.19102.
So, we can solve=our
$1,191.02 × [1.06]
problem
$1,000 3
like this. ..

FV = $1,000 × 1.19102 Number

n
FV = FVPV= $1,191.02
(1 + i) Compounding
of

Periods

Future Amount Interest

Value Invested at Rate
the
Beginning of
the Period
6-5
 Slide 6

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 today’s

equivalent to a particular amount in the future.

6-6
 Slide 7

Present Value of a Single Amount

Remember our equation?

n
FV = PV (1 + i)

We can solve for PV and get . . . .

FV
PV = n
(1 + i)

6-7
 Slide 8

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?

6-8
 Slide 9

Present Value of a Single Amount

i = .08, n = 5
Present Value Factor = .68058

$20,000 × .68058 = $13,611.60

If you deposit $13,611.60 now, at 8% annual

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

6-9
 Slide 10

Solving for Other Values

FV = PV (1 + i)n
Number
of Compounding
Future Present Interest Periods
Value Value 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.
6-10
 Slide 11

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.

6-11
 Slide 12

Accounting Applications of Present Value

Techniques—Single Cash Amount
Monetary assets and monetary
liabilities are valued at the present
value of future cash flows.

Monetary Monetary
Assets Liabilities

Money and claims to Obligations to pay

receive money, the amounts of cash, the
amount which is fixed amount of which is
or determinable fixed or determinable

6-12
 Slide 13

No Explicit Interest
Some notes do not include a stated
interest rate. We call these notes
noninterest-bearing notes.

Even though the agreement states it

is a noninterest-bearing note, the
note does, in fact, include interest.

We impute an appropriate interest

rate for a loan of this type to use
as the interest rate.
6-13
 Slide 14

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 Expected Cash Flow
present value is to Credit-Adjusted Risk-Free
approximate the fair × Rate of Interest
value of that asset Present Value
or liability.
6-14
 Slide 15

Basic Annuities

An annuity is a series of
equal periodic payments.

6-15
 Slide 16

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

Today 1 2 3 4

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

End of year 1

End of year 2

End of year 3
End of year 4

6-16
 Slide 17

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

Today 1 2 3 4

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

Beginning
of year 1
Beginning
of year 2
Beginning
of year 3 Beginning
of year 4

6-17
 Slide 18

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.

6-18
 Slide 19

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?

Am ount of annuity $ 2,500.00

Future value of ordinary annuity of $1
(i = 8%, n = 10) × 14.4866
Future value $ 36,216.50

6-19
 Slide 20

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.

6-20
 Slide 21

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.

Amount of annuity $ 10,000

FV of annuity due of $1
(i=6%, n=4) × 4.63710
Future value $ 46,371

6-21
 Slide 22

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?

6-22
 Slide 23

Present Value of an Ordinary Annuity

Today 1 2 3 4

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

PV1
PV2
PV3
PV4

6-23
 Slide 24

Present Value of an Ordinary Annuity

PV of $1 Present
Annuity Factor Value
PV1 $ 10,000 0.90909 $ 9,090.90
PV2 10,000 0.82645 8,264.50
PV3 10,000 0.75131 7,513.10
PV4 10,000 0.68301 6,830.10
Total 3.16986 $ 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.
6-24
 Slide 25

Present Value of an Ordinary Annuity

PV of $1 Present
Annuity Factor Value
PV1 $ 10,000 0.90909 $ 9,090.90
PV2 10,000 0.82645 8,264.50
PV3 10,000 0.75131 7,513.10
PV4 10,000 0.68301 6,830.10
Total 3.16986 $ 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
6-25
 Slide 26

Present Value of an Ordinary Annuity

How much must a person 65 years old invest

today at 8% interest compounded annually to
provide for an annuity of $20,000 at the end
of each of the next 15 years?
a. $153,981
b. $171,190
c. $167,324 PV of Ordinary Annuity $1
d. $174,680 Payment $ 20,000.00
PV Factor × 8.55948
Amount $171,189.60

6-26
 Slide 27

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.

Amount of annuity $ 10,000

PV of annuity due of $1
(i=6%, n=4) × 3.67301
Present value of annuity $ 36,730

6-27
 Slide 28

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.

6-28
 Slide 29

Present Value of a Deferred Annuity

On January 1, 2009, you are considering an investment
that will pay $12,500 a year for 2 years beginning on
December 31, 2011. If you require a 12% return on
your investments, how much are you willing to pay for
this investment?
Present
Value? $12,500 $12,500

1/1/09 12/31/09 12/31/10 12/31/11 12/31/12 12/31/13

1 2 3 4
PV of $1
Payment i = 12% PV n
1 $ 12,500 0.71178 $ 8,897 3
2 12,500 0.63552 7,944 4
$ 16,841
6-29
 Slide 30

Present Value of a Deferred Annuity

On January 1, 2009, you are considering an investment
that will pay $12,500 a year for 2 years beginning on
December 31, 2011. If you require a 12% return on
your investments, how much are you willing to pay for
this investment?
Present
Value? $12,500 $12,500

1/1/09 12/31/09 12/31/10 12/31/11 12/31/12 12/31/13

1 2 3 4
More Efficient Computation
1. Calculate the PV 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.
6-30
 Slide 31

Present Value of a Deferred Annuity

On January 1, 2009, you are considering an investment
that will pay $12,500 a year for 2 years beginning on
December 31, 2011. If you require a 12% return on
your investments, how much are you willing to pay for
this investment?
Present
Value? $12,500 $12,500

1/1/09 12/31/09 12/31/10 12/31/11 12/31/12 12/31/13

1 2 3 4

PV of
Ordinary
Annuity of $1 PV of $1
Payment n=2, i = 12% PV Future Value n=2, i = 12% PV
$ 12,500 1.69005 $ 21,126 $ 21,126 0.79719 $ 16,841
6-31
 Slide 32

Solving for Unknown Values in Present Value

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

The number of
The interest rate
periods

If you know any three of these, the fourth

can be determined. 6-32
 Slide 33

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?
Present
Value
$700

Today End of End of End of End of

Year 1 Year 2 Year 3 Year 4
6-33
 Slide 34

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?
Present value $ 700.00
PV of ordinary annuity of $1
(i=8%, n=4) ÷ 3.31213
Annuity amount $ 211.34
6-34
 Slide 35

Accounting Applications of Present Value

Techniques—Annuities
Because financial instruments
typically specify equal periodic
payments, these applications quite
often involve annuity situations.

Long-term Long-term
Bonds Leases

Pension
Obligations

6-35
 Slide 36

Valuation of Long-term Bonds

Calculate the Present Value of
the Lump-sum Maturity Payment
(Face Value)
Calculate the Present Value of
the Annuity Payments (Interest)
On January 1, 2009, Fumatsu Electric
issues 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 June 30, 2009.
What is the price of the bonds?

Table Present
Cash Flow Table Value Amount Value
PV of $1
Face value of the bond n=10; i=6% 0.5584 $ 1,000,000 $ 558,400
PV of
Ordinary
Interest (annuity)
Annuity of $1
n=10; i=6% 7.3601 50,000 368,005
Price of bonds $ 926,405

6-36
 Slide 37

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.

6-37
 Slide 38

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. 6-38
 End of Chapter 6

McGraw-Hill /Irwin © 2009 The McGraw-Hill Companies, Inc.