Tutorial 6

Accounting and the Time Value of Money

E6-4 (Computation of Future Values and Present Values) Using
the appropriate interest table, answer the following questions (each
case is independent of the others).

(a) What is the future value of 20 periodic payments of $4,000 each
made at the beginning of each period and compounded at 8%?
Answer
Future value of an ordinary
annuity of $4,000 a period
for 20 periods at 8%


$183,047.8


($4,000 X 45.76196)
Factor (1 + .08) X 1.09
Future value of an annuity
due of $4,000 a period at 8%

$197,691.66


(b) What is the present value of $2,500 to be received at the
beginning of each of 30 periods, discounted at 10% compound interest?
Answer
Present value of an ordinary
annuity of $2,500 for 30
periods at 10%


$23,567.28


($2,500 X 9.42691)
Factor (1 + .10) X
1.10

Present value of annuity
due of $2,500 for 30 periods
at 10%


$25,924.00


(Or see Table 6-5 which
gives $25,924.03)

(c) What is the future value of 15 deposits of $2,000 each made at
the beginning of each period and compounded at 10%? (Future value
as of the end of the fifteenth period.)
Answer
Future value of an ordinary
annuity of $2,000 a period
for 15 periods at 10%


$63,544.96


($2,000 X 31.77248)
Factor (1 + 10) X
1.10

Future value of an annuity
due of $2,000 a period
for 15 periods at 10%


$69,899.46


(d) What is the present value of six receipts of $1,000 each received
at the beginning of each period, discounted at 9% compounded interest?
Answer
Present value of an ordinary
annuity of $1,000 for 6
periods at 9%


$4,485.92


($1,000 X 4.48592)
Factor (1 + .09) X
1.09

Present value of an annuity
date of $1,000 for 6 periods
at 9%


$4,889.65


(Or see Table 6-5)

E6-7 (Computation of Bond Prices) What would you pay for a $50,000
debenture bond that matures in 15 years and pays $5,000 a year in
interest if you wanted to earn a yield of:
(a) 8%?
Answer
(a)

$50,000 X .31524

=

$15,762.00



+ $5,000 X 8.55948

=

42,797.40







$58,559.40

(b) 10%?
Answer





(c) 12%?
Answer
(b)

$50,000 X .23939

=

$11,969.5
0



+ $5,000 X 7.60608

=


38,030.40







$49,999.9
0

(c)

$50,000 X .18270

=

$
9,135.00



+ $5,000 X 6.81086

=


34,054,30







$43,189.3
0

E6-12 (Analysis of Alternatives) The Black Knights Inc., a
manufacturer of high-sugar, low-sodium, low-cholesterol TV dinners,
would like to increase its market share in the Sunbelt. In order to do so,
Black Knights has decided to locate a new factory in the Panama City
area. Black Knights will either buy or lease a site depending upon
which is more advantageous. The site location committee has
narrowed down the available sites to the following three buildings.
Building A: Purchase for a cash price of $600,000, useful life 25 years.
Building B: Lease for 25 years with annual lease payments of $69,000
being made at the beginning of the year.
Building C: Purchase for $650,000 cash. This building is larger than
needed; however, the excess space can be sublet for 25 years at a net
annual rental of $7,000. Rental payments will be received at the end of
each year. The Black Knights Inc. has no aversion to being a landlord.

Instructions
In which building would you recommend that The Black Knights Inc.
locate, assuming a 12% cost of funds?
Answer
Building APV = $600,000.
Building B
Rent X (PV of annuity due of 25 periods at 12%) = PV
$69,000 X 8.78432 = PV
$606,118.08 = PV
Building C
Rent X (PV of ordinary annuity of 25 periods at 12%) = PV
$7,000 X 7.84314 = PV
$54,901.98 = PV






Answer: Lease Building C since its present value of its net cost is
the
smallest.


Cash purchase price
of

$650,000.00



PV of rental income

54,901.98



Net present value

$595,098.02

E6-19 (Computation of Bond Liability) Your client, Faith Hill Inc., has
acquired Tracy Lawrence Manufacturing Company in a business
combination that is to be accounted for as a purchase transaction (at
fair market value). Along with the assets and business of Tracy
Lawrence, Faith Hill assumed an outstanding debenture bond issue
having a principal amount of $8,000,000 with interest payable
semiannually at a stated rate of 8%. Tracy Lawrence received
$7,300,000 in proceeds from the issuance 5 years ago. The bonds are
currently 20 years from maturity. Equivalent securities command a
12% rate of interest, interest paid semiannually.

Instructions
Your client requests your advice regarding the amount to record for the
acquired bond issue.
Answer
Time diagram:
i = 6% per six months
Principal
$8,000,000
Interest
P = ? $320,000 $320,000 $320,000 $320,000 $320,000


0 1 2 38
39 40
n = 40 six-month periods


Present value of the principal FV (PVF
40, 6%
)
= $8,000,000 (.09722) $ 777,760

Present value of the interest payments R (PVFOA
40, 6%
)
= $320,000 (15.04630) 4,814,816

Total present value of bond liability $5,592,576

E6-24 (Determine Interest Rate) On July 17, 2000, Tim McGraw
borrowed $42,000 from his grandfather to open a clothing store.
Starting July 17, 2001, Tim has to make ten equal annual payments of
$6,500 each to repay the loan.
Instructions
What interest rate is Tim paying?

Answer
10



?



42,000



6,500



0







































8.85%













N

I/YR.

PV

PMT

FV

P6-1 (Various Time Value Situations) Answer each of
these unrelated questions.
(a) On January 1, 2001, Rather Corporation sold a building
that cost $250,000 and that had accumulated depreciation
of $100,000 on the date of sale. Rather received as
consideration a $275,000 non-interest-bearing note due on
January 1, 2004. There was no established exchange price
for the building, and the note had no ready market. The
prevailing rate of interest for a note of this type on January
1, 2001, was 9%. At what amount should the gain from the
sale of the building be reported?
Answer

(a) Given no established value for the building, the fair market
value of the note would be estimated to value the building.

Time diagram:

i = 9%
PV = ?
FV = $275,000


1/1/01 1/1/02 1/1/03 1/1/04
n = 3


Formula: PV = FV (PVF
n, i
)
PV = $275,000 (PVF
3, 9%
)
PV = $275,000 (.77218)
PV = $212,349.50


Cash equivalent price of building $212,349.50
Less book value ($250,000 $100,000) 150,000.00
Gain on disposal of the building $ 62,349.50

(b) On January 1, 2001, Rather Corporation purchased 200 of the
$1,000 face value, 9%,10-year bond of Walters Inc. The bonds mature
on January 1, 2011, and pay interest annually beginning January 1,
2002. Rather Corporation purchased the bonds to yield 11%. How
much did Rather pay for the bonds?
Answer
(b) Time diagram:
i = 11%
Principal
$200,000
Interest
PVOA = ? $18,000 $18,000 $18,000
$18,000


1/1/01 1/1/02 1/1/03
1/1/2010 1/1/2011
n = 10

PROBLEM 6-1 (Continued)

Present value of the principal

FV (PVF
10, 11%
) = $200,000 (.35218) = $ 70,436.00

Present value of the interest payments

R (PVFOA
10, 11%
) = $18,000 (5.88923) = 106,006.14

Combined present value (purchase price) $176,442.14

(c) Rather Corporation bought a new machine and agreed to pay for it
in equal annual installments of $4,000 at the end of each of the next 10
years. Assuming that a prevailing interest rate of 8% applies to this
contract, how much should Rather record as the cost of the machine?
Answer
(a) Time diagram:

i = 8%
PVOA = ? $4,000 $4,000 $4,000
$4,000 $4,000


0 1 2
8 9 10
n = 10


Formula: PVOA = R (PVFOA
n,i
)
PVOA = $4,000 (PVFOA
10, 8%
)
PVOA = $4,000 (6.71008)
PVOA = $26,840.32 (cost of machine)

(d) Rather Corporation purchased a special tractor on December 31,
2001. The purchase agreement stipulated that Rather should pay
$20,000 at the time of purchase and $5,000 at the end of each of
the next 8 years. The tractor should be recorded on December 31, 2001,
at what amount, assuming an appropriate interest rate of 12%?
Answer
(d) Time diagram:

i = 12%
PVOA = ?
$20,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
$5,000 $5,000


0 1 2 3 4
5 6 7 8
n = 8

Formula: PVOA = R (PVFOA
n,i
)
PVOA = $5,000 (PVFOA
8, 12%
)
PVOA = $5,000 (4.96764)
PVOA = $24,838.20

Cost of machine = $20,000 + $24,838.20 = $44,838.20
(e) Rather Corporation wants to withdraw $100,000 (including
principal) from an investment fund at the end of each year for 9 years.
What should be the required initial investment at the beginning of the
first year if the fund earns 11%?
Answer
(e) Time diagram:

i = 11%
PVOA = ? $100,000 $100,000 $100,000
$100,000


0 1 2
8 9
n = 9

Formula: PVOA = R (PVFOA
n, i
)
PVOA = $100,000 (PVFOA
9, 11%
)
PVOA = $100,000 (5.53705)
PVOA = $553,705
P6-3 (Investment Problem) Mack Aroni, a bank robber, is worried
about his retirement. He decides to start a savings account. Mack
deposits annually his net share of the "loot," which consists of $75,000
per year, for 3 years beginning January 1, 2001. Mack is arrested on
January 4, 2003 (after making the third deposit), and spends the rest of
2003 and most of 2004 in jail. He escapes in September of 2004. He
resumes his savings plan with semiannual deposits of $30,000 each
beginning January 1, 2005. Assume that the bank's interest rate was
9% compounded annually from January 1, 2001, through January 1,
2004, and 12% annual rate compounded semiannually thereafter.

(Instructions)
When Mack retires on January 1, 2008 (6 months after his last deposit),
what is the balance in his savings account?
Answer
Time diagram:
FVOA = ?
i = 9% per year i = 6% per six months


$75,000 $75,000 $75,000 $30,000 $30,000 $30,000 $30,000
$30,000 $30,000


1/1/01 1/1/02 1/1/03 1/1/04 1/1/05 1/1/06
1/1/07 1/1/08

This problem can be solved more easily by first computing the future
value of the $75,000 payments and adding to it the future value of the
$30,000 payments.

Future value of $75,000 annuity due on 1/1/04
$75,000 X (Future value of an ordinary annuity for 3 periods at 9% X
1.09)
$75,000 X (3.27810 X 1.09)
$75,000 X 3.57313
$267,984.75

Future value of $267,984.75 on 1/1/08
FV = $267,984.75 (FVF
8, 6%
)
FV = $267,984.75 (1.59385)
FV = $427,127.49

Future value of $30,000 annuity due on 1/1/01
$30,000 X (Future value of an ordinary annuity for 6 periods at 6% X
1.06)
$30,000 X (6.97532 X 1.06)
$30,000 X 7.39384
FV = $221,815.20

Future value of $267,984.75 on 1/1/08 $427,127.49
Future value of $30,000 annuity due on 1/1/08 221,815.20
$648,942.69
P6-7 (Analysis of Alternatives) Sally Brown died, leaving to her
husband Linus an insurance policy contract that provides that the
beneficiary (Linus) can choose any one of the following four options.

(a) $55,000 immediate cash.
(b) $3,700 every 3 months payable at the end of each quarter for 5
years.
(c) $18,000 immediate cash and $1,600 every 3 months for 10 years,
payable at the beginning of each 3-month period.
(d) $4,000 every 3 months for 3 years and $1,200 each quarter for the
following 25 quarters, all payments payable at the end of each quarter.

Instructions
If money is worth 2'/z% per quarter, compounded quarterly, which
option would you recommend that Linus exercise?
Answer
(a) The present value of $55,000 cash paid today is $55,000.

(b) Time diagram:

i = 2% per quarter
PVOA = R =
? $3,700 $3,700
$3,700 $3,700 $3,700


0 1 2 18 19 20
n = 20 quarters

Formula: PVOA = R (PVFOA
n, i
)
PVOA = $3,700 (PVFOA
20, 2%
)
PVOA = $3,700 (15.58916)
PVOA = $57,679.89



(b) Time diagram:

i = 2% per quarter
$18,000
PVAD =
R = $1,600 $1,600 $1,600 $1,600
$1,600


0 1 2 38 39 40
n = 40 quarters

Formula: PVAD = R (PVFAD
n, i
)
PVAD = $1,600 (PVFAD
40, 2%
)
PVAD = $1,600 (25.73034)
PVAD = $41,168.54

The present value of option (c) is $18,000 + $41,168.54, or
$59,168.54.



(b) Time diagram:

i = 2% per quarter

PVOA = R =
? $1,200 $1,200 $1,200
$1,200
PVOA = R =
? $4,000 $4,000 $4,000


0 1 11 12
13 14 36 37
n = 12 quarters n = 25 quarters


Formulas:
PVOA = R (PVFOA
n,i
) PVOA = R (PVFOA
n,i
)
PVOA = $4,000 (PVFOA
12, 2%
) PVOA = $1,200 (PVFOA
3712, 2%
)
PVOA = $4,000 (10.25776) PVOA = $1,200 (23.95732 10.25776)
PVOA = $41,031.04 PVOA = $16,439.47

The present value of option (d) is $41,031.04 + $16,439.47, or
$57,470.51.

Present values:
(a) $55,000.
(b) $57.679.89.
(c) $59,168.54.
(d) $57,470.51.

Option (c) is the best option, based upon present values alone.
P6-9 (Purchase Price of a Business) During the past year, Nicole
Bobek planted a new vineyard on 150 acres of land that she leases for
$27,000 a year. She has asked you as her accountant to assist her in
determining the value of her vineyard operation.

The vineyard will bear no grapes for the first 5 years (1-5). In the next
5 years (6-10), Nicole estimates that the vines will bear grapes that can
be sold for $60,000 each year. For the next 20 years (11-30) she
expects the harvest will provide annual revenues of $100,000. But
during the last 10 years (31-40) of the vineyard's life she estimates that
revenues will decline to $80,000 per year.

During the first 5 years the annual cost of pruning, fertilizing, and
caring for the vineyard is estimated at $9,000; during the years of
production, 6-40; these costs will rise to $10,000 per year. The relevant
market rate of interest for the entire period is 12%. Assume that all
receipts and payments are made at the end of each year.

Instructions
Dick Button has offered to buy Nicoles vineyard business by
assuming the 40-year lease. On the basis of the current value of the
business what is the minimum price Nicole should accept?

Answer
Time diagram:
i = 12%
PVOA = ? R =
($36,000) ($36,000) $23,000
23,000 $63,000 $63,000 $63,000 $63,000 $43,000 $43,000 $43,000


0 1 5 6
10 11 12 29 30 31 39 40

n = 5 n = 5 n = 20 n = 10
(0 $27,000
$9,000)
($60,000 $27,000
$10,000)
($100,000 $27,000
$10,000)
($80,000 $27,000
$10,000)

Formulas:
PVOA = R (PVFOA
n, i
) PVOA = R (PVFOA
n, i
) PVOA = R
(PVFOA
n, i
) PVOA =R (PVFOA
n, i
)
PVOA = ($36,000)(PVFOA
5, 12%
) PVOA = $23,000 (PVFOA
10-5, 12%
) PVOA =
$63,000 (PVFOA
3010, 12%
) PVOA = $43,000 (PVFOA
4030, 12%
)
PVOA = ($36,000)(3.60478) PVOA = $23,000 (5.650223.60478) PVOA =
$63,000 (8.055185.65022) PVOA = $43,000 (8.243788.05518)
PVOA =($129,772.08) PVOA = $23,000 (2.04544) PVOA =
$63,000 (2.40496) PVOA = $43,000 (.18860)
PVOA = $47,045.12 PVOA = $151,512.48
PVOA = $8,109.80

Present value of future net cash inflows:
$(129,772.08)
47,045.12
151,512.48

8,109.80
$ 76,895.32

Nicole Bobek should accept no less than $76,895.32 for her vineyard business.
ETHICS CASE

James Qualls, newly appointed controller of KBS, is considering ways
to reduce his company's expenditures on annual pension costs. One
way to do this is to switch KBS's pension fund assets from First
Security to NET Life. KBS is a very well-respected computer
manufacturer that recently has experienced a sharp decline in its
financial performance for the first time in its 25-year history. Despite
financial problems, KBS still is committed to providing its employees
with good pension and postretirement health benefits.

Under its present plan with First Security, KBS is obligated to pay $43
million to meet the expected value of future pension benefits that are
payable to employees as an annuity upon their retirement from the
company. . On the other hand NET Life requires KBS to pay only $35
million for identical future pension benefits. First Security is one of the
oldest and most reputable insurance companies in North America.
NET Life has a much weaker reputation in the insurance industry. In
pondering the significant difference in annual pension costs, Qualls
asks himself, "Is this too good to be true?"
(c) Who are the stakeholders that could be affected by Qualls's
decision?
Instructions
Answer the following questions:
(a) Why might NET Life's pension cost requirement be $8 million less than
First Security's requirement for the same future value?
Answer
The time value of money would suggest that NET Lifes discount
rate was substantially lower than First Securitys. The actuaries
at NET Life are making different assumptions about inflation,
employee turnover, life expectancy of the work force, future
salary and wage levels, return on pension fund assets, etc. NET
Life may operate at lower gross and net margins and it may
provide fewer services.

(b) What ethical issues should James Qualls consider
before switching KBS's pension fund assets?


(B) As the controller of KBS, Qualls assumes a fiduciary
responsibility to the present and future retirees of the
corporation. As a result, he is responsible for ensuring that
the pension assets are adequately funded and are
adequately protected from most controllable risks. At the
same time, Qualls is responsible for the financial condition
of KBS. In other words, he is obligated to find ethical ways
of increasing the profits of KBS, even if it means switching
pension funds to a less costly plan. At times, Qualls role to
retirees and his role to the corporation can be in conflict,
especially if Qualls is a member of a professional group
such as CPAs or CMAs.


(c) Who are the stakeholders that could be affected by Qualls's decision?

Answer
(a) If KBS switched to NET Life

The primary beneficiaries of Qualls decision would be the
corporation and its many stockholders by virtue of reducing 8
million dollars of annual pension costs.

The present and future retirees of KBS may be negatively affected
by Qualls decision because the change of losing a future benefit
may be increased by virtue of higher risks (as reflected in the
discount rate and NET Lifes weaker reputation).

If KBS stayed with First Security

In the short run, the primary beneficiaries of Qualls decision
would be the employees and retirees of KBS given the lower risk
pension asset plan.

KBS and its many stakeholders could be negatively affected by
Qualls decision to stay with First Security because of the com-
panys inability to trim 8 million dollars from its operating
expenses.