Chapter Six: Accounting and Time Value of Money

I.

Basic Concepts:

Principal: the amount borrowed or invested.

Interest: payment for the use of money; in other words, the excess cash received or repaid over
the amount borrowed or invested (the principal).
Interest Rate: a percentage of the outstanding principal. PLEASE NOTE that Federal law
requires the disclosure of interest rates on ANNUAL BASIS.
-

Compounding period interest rate: annual rate divided by the number of compounding
periods per year

Time: the number of periods that the principal is outstanding.

-

II.

Number of compounding periods: number of years times the number of compounding

periods per year.

Simple Interest and Compound Interest

Simple Interest

Main Idea

Compound Interest

Interest computed on the

Interest computed on the principal

principal only

AND the interest earned that has not

been paid or withdrawn

Example: Kim deposits

$10,000 in the bank for 3
years. The interest rate is
12%. Compute the total
interest Kim can receive
from this investment
activity.

III.

1st: 10,000*12%=1,200

1st:

2nd: 10,000*12%=1,200

2nd: (10,000+1,200)*12%=1,344

3rd: 10,000*12%=1,200

3rd:

Single Sum Problems

Elements in Single Sum Problems:

-

Compounding rate of interest

Number of compounding periods

Future value, and

Present value

3,600

10,000*12%=1,200

(10,000+1,200+1,344)*12%=1,505.28
4049.28

Notes: knowing any three of them can get the fourth one.
Example 1: Kim deposits $10,000 in the bank for 3 years. The interest rate is 10% and interests
are compounded quarterly. Assuming Kim will not withdraw any interest during the 3 years, how
much will Kim receive in 3 years?
PV=10,000
# of periods=3*4=12
Compounding interest rate=10%/4=2.5%
FV=?
FV = PV*FVF-SS (12, 2.5%) = 10,000*1.34489 = 13,448.9
Example 2: Kim wants to receive $10,000 in 3 months. The interest rate is 24%. Assuming Kim
will not withdraw any interest during the 3 months, how much should Kim invest today?
PV=?
# of periods=3
Compounding interest rate=24%/12=2%
FV=10,000
PV = FV*PVF-SS (3, 2%) = 10,000*0.94232 = 9,423.2
Example 3: Kim invests $10,000 today. The interest rate is 12%. At the end of her investment,
Kim will receive a total amount of $17,623. Assuming Kim will not withdraw any interest during
this investment activity, what is the number of periods Kim invests her money for?
PV=10,000
# of periods=?
Compounding interest rate=12%
FV=17,623

FV = PV*FVF-SS (N, 12%), 17,623 = 10,000*FVF-SS (N, 12%), FVF-SS (N, 12%) =
17,623/10,000 = 1.7623
Or,
PV = P=FV*PVF-SS (N, 12%), 10,000 = 17,623 *PVF-SS (N, 12%), FVF-SS (N, 12%) =
10,000/17,623 = 0.5674
N=5
Example 4: Kim invests $10,000 today and will receive $15,939 in 8 years. Assuming Kim will
not withdraw any interest during this investment activity, what is the interest rate?
PV=10,000
# of periods=8
Compounding interest rate=?
FV=15,939
FV = PV*FVF-SS (8, I), 15,939 = 10,000*FVF-SS (8, I), FVF-SS (8, I) = 15,939/10,000 =
1.5939
Or,
PV = P=FV*PVF-SS (8, I), 10,000 = 15,939*PVF-SS (8, I), PVF-SS (8, I) = 10,000/15,939 =
0.6274
I=6%

IV.

Annuities

Elements in annuities:
-

Periodic payments or receipts (called rents) of the same amount

Same-length interval between such rents

Compounding of interest once each interval

Compounding interest rate

Number of compounding periods (the number of intervals)

Future value

Present value

Note: among future value/present value, rents, number of compounding periods, and
compounding interest rate, knowing any three of them can get the fourth one.
Types in annuities:
-

Ordinary Annuity: rents occur at the end of each period

Annuity Due - rents occur at the beginning of each period; interest starts to accumulate
during 1st period; multiply future value of an ordinary annuity factor by 1 plus the
interest rate
Ordinary Annuity

Annuity Due

Kim makes five $5,000

Assuming the deposits are

made at the end of each year
Rent=5,000

Assuming the deposits are made at the

beginning of each year
Rent=5,000

deposits in each of the

Interest rate=12%

Interest rate=12%

next 5 years, earning

# of periods=5

# of periods=5

interest of 12%. What

FV=?

FV=?

will Kim receive at the

FV=5,000*FVF-OA (5,

FVF-AD (5, 12%)=(1+12%)*FVF-OA

end of the fifth year?

12%)=5,000*6.35285=31,746.25. (5, 12%)=(1+12%)*6.35285=7.115192.

FV=5,000*FVF-AD (5,
12%)=5,000*7.115192=35,575.96

Kim makes five $5,000

Rent=5,000

Rent=5,000

deposits in each of the

Interest rate=12%

Interest rate=12%

next 5 years, earning

# of periods=5

# of periods=5

interest of 12%. What

PV=?

PV=?

is the present value of

PV=5,000*PVF-OA (5,

PV=5,000*PVF-AD (5,

these five deposits?

12%)=5,000*3.60478=18,023.9

12%)=5,000*4.03735=20,186.75

Kim plans to

Rent=?

Rent=?

accumulate $14,000

Compounding interest rate=8%

Compounding interest rate=8%

for a down payment of

# of periods=5

# of periods=5

her house five years

FV=14,000

from now. For the next FV=14,000=Rent*FVF-OA (5,

FV=14,000
FV=14,000=Rent*FVF-AD (5, 8%),

5 years, the annual

8%)=Rent*5.867.

where FVF-AD (5, 8%)=(1+8%)*FVF-

return of 8%. How

Rent=14,000/5.867=2,386.23

OA (5, 8%)=(1+8%)*5.867=6.33636.

much should Kim

Rent=14,000/6.33636=2,209.47

deposit each year?

V.

Deferred Annuities: rents begin after a specified number of periods.

Example: Kim plans to make five $5,000 deposits in the next several years. The deposits wont
start until the end of the third year. The annual interest rate is 12%. What is the present value of
these five deposits? What is the future value of these five deposits?
The calculation of FV:
Treat it like ordinary annuities.
FV=Rent*FVF-OA (5, 12%) = 5,000*6.35285=31,746.25.
The calculation of PV:
It is a combination of single sum and annuities (either ordinary annuities or annuities due).
Step 1, ordinary annuities: PV at the end of year 2=5,000* PVF-OA (5, 12%) =
5,000*3.60478=18,023.9
Step 2, single sum: PV at the beginning of year 1 = PV at the end of year 2*PVF-SS (2, 12%) =
18,023.9*0.79719=14,368.47.

VI.

Valuations of Bonds

Two Cash Flows:

-

Periodic interest payments (annuity)

Principal paid at maturity (single-sum)

Example: Clancey Inc. issues $2,000,000 of 7% bonds due in 10 years with interest payable at
year-end. The current market rate of interest for bonds of similar risk is 8%. What amount will
Clancey receive when it issues the bonds?
The effective rate is the market rate, which is 8% here. The 7% is face rate of the bond.
The principal: 2,000,000
The present value of the principal: 2,000,000*PVF-SS (10, 8%) = 2,000,000* .46319=926,380
The rent (interest payment): 2,000,000*7%=140,000
The present value of the interest payments: 140,000*PVF-OA (10, 8%) = 14,000*
6.71008=939,411
The total present value of the bond (current market value of the bond):
926,380+939,411=1,865,791<2,000,000 (it is a discount)
Cash

1,865,791

Bond discount

134,209

Bond payable

VII.

2,000,000

Practice section

1. On July 1, 2012, Pitts Company sold some equipment to Gannon Company. The two
companies entered into an installment sales contract at a rate of 8%. The contract
required 8 equal annual payments ($10,000) with the first payment due on July 1, 2012.
What is the present value in this situation?
Annuity Due Case, looking for present value
PV=Rent*PVF-AD (8, 8%) = 10,000*6.20637=62,063.7

2. On July 1, 2012, Pitts Company sold some equipment to Gannon Company. The two
companies entered into an installment sales contract at a rate of 8%. The contract
required 8 equal annual payments ($10,000) with the first payment due on July 1, 2012.
What is the future value in this situation?
Annuity Due Case, looking for future value
FVF-AD (8, 8%) = (1+8%)*FVF-OA (8, 8%) = 1.08*10.63663=11.4875604
FV=Rent*FVF-AD (8, 8%) = 10,000*11.4875604=114,875.604

3. On July 1, 2012, Pitts Company sold some equipment to Gannon Company. The two
companies entered into an installment sales contract at a rate of 12%. The contract
required 8 equal semi-annual payments ($5,000) with the first payment due on July 1,
2013. What is the future value in this situation?
Deferred Annuity Case, looking for future value
Treat it like an ordinary annuity.
FV=Rent*FVF-OA (8, 6%) = 5,000*9.89747=49,487.35

4. On July 1, 2012, Pitts Company sold some equipment to Gannon Company. The two
companies entered into an installment sales contract at a rate of 12%. The contract
required 8 equal semi-annual payments ($5,000) with the first payment due on January 1,
2013. What is the present value in this situation?
Ordinary Annuity Case, looking for present value
PV=Rent*PVF-OA (8, 6%) = 5,000*6.20979=31,048.95

5. On January 1, 2012, Pitts Company sold some equipment to Gannon Company. Because
of the cash problem of Gannon Company, Pitts Company agreed to make a long term
payment arrangement. According to the arrangement, Gannon Company is to pay
$100,000 on December 31, 2015. The interest rate is 12%. The interests are compounded
semi-annually. What is the present value in this situation?
Single Sum Case, looking for present value

PV=FV*PVF-SS (8, 6%) = 10,000*0.62741=6,274.1

6. On January 1, 2012, Pitts Company sold some equipment to Gannon Company. The total
value of the equipments is $50,000. Because of the cash problem of Gannon Company,
Pitts Company agreed to make a long term payment arrangement. According to the
arrangement, Gannon Company is to pay $50,000 plus all interests on December 31,
2015. The interest rate is 8% and interests are compounded quarterly. What is the amount
Gannon Company going to pay on December 31, 2015?
Single Sum Case, looking for future value
FV=PV*FVF-SS (16, 2%) = 50,000*1.37279=68,639.5

7. On July 1, 2012, Pitts Company sold some equipment to Gannon Company. The two
companies entered into an installment sales contract at a rate of 12%. The contract
required 8 equal semi-annual payments ($5,000) with the first payment due on January 1,
2013. What is the future value in this situation?
Ordinary Annuity Case, looking for future value
FV=Rent*FVF-OA (8, 6%) = 5,000* 9.897= 49,485

8. On July 1, 2012, Pitts Company sold some equipment to Gannon Company. The two
companies entered into an installment sales contract at a rate of 12%. The contract
required 8 equal semi-annual payments ($5,000) with the first payment due on July 1,
2013. What is the present value in this situation?
Deferred Annuity Case, looking for present value
Step 1, ordinary annuities: PV on Jan 1, 2013 = 5,000* PVF-OA (8, 6%) = 5,000* 6.210= 31,050
Step 2, single sum: PV on July 1, 2012 = PV on Jan 1, 2013 *PVF-SS (1, 6%) =
31,050*0.943=29,280.15.