You are on page 1of 40

Chapter 6

Time Value of
Money Concepts

Copyright 2015 McGraw-Hill Education. All rights reserved.


Time Value of Money

Means money can be invested today to


earn interest and grow to a larger dollar
amount in the future
Example:
Invested Annual Future
in bank yield value
6 $10
$100
% 6

Useful in valuing a variety of assets and


liabilities
LO6-1

Simple versus Compound Interest

Interest
Amount of money paid or received in
excess of the amount of money borrowed
or lent
Simple Interest Intere
Initial Perio

investm st d of
ent rate time
Compound Interest
Includes interest not only on the initial
investment but also on the
accumulated interest in previous
LO6-1

Simple Interest

Example:
What is the simple interest earned each year
on a $1,000 investment paying 10% interest?

Investme Interest Time = Simple


$1,00
nt 10
rate 1
period $10
interest
=
0 % Year 0
LO6-1

Compound Interest

Example:
Cindy Johnson invested $1,000 in a savings account
paying 10% interest compounded annually. How much
interest will she earn in each of the next three years, and
what will be her investment balance after three years?

Date Interest Balance


(Interest rate
Outstanding Balance)
Initial deposit $1,000
End of year 1 10% $1,000 = $100 $1,100
End of year 2 10% $1,100 = $110 $1,210
End of year 3 10% $1,210 = $121 $1,331
LO6-1

Compound Interest

Effective rate
Actual rate at which money grows per
year
Example:
Assuming an annual rate of 12%:
Interest Rate
Per
Compound Compounding
ed Period
Semiannual 12% 6
ly 2= %
12% 3
LO6-1

Compound Interest
Example:
Cindy Johnson invested $1,000 in a savings
account paying 10% interest compounded
twice a year. What will be her investment
balance at the end of the year? What is the
Interest
effective annual interest rate?
10% 2 =
5% (Interest rate
Outstanding
Date balance) Balance
Initial deposit $1,000.00
After six 5% $1,000 =
months $50.00
$1,102.50
$1,050 .00
5% $1,050
$1,000 =
Effective
End of yearannual
1 interest
$52.50rate = $102.50
$1,102.50
$1,000 = 10.25%
LO6-2

Valuing a Single Cash Flow Amount

Future Value of a Single Amount


The amount of money that a dollar will
grow to at some point in the future

FV = I (1 + i)
Amount invested at the beginning of
I = the period
i = Interest rate
n = Number of compounding periods
LO6-2

Future Value of a Single Amount


Example:
Cindy Johnson invested $1,000 in a savings
account for three years paying 10% interest
compounded annually. Future
value
$1,000 $1,331
End of
End of End of
0 year 3
year 1 year 2

FV = I FV
Factor
FV = $1,000
1.331
FV = $1,331
LO6-3

Present Value of a Single Amount

Todays equivalent to a particular amount


in the future
F
FV = PV (1 + i) PV =
n (1V +
n
Example: i)

$1,331 $1,331
PV = = = $1,00
(1 + . 1.331 0
10)3
LO6-3

Present Value of a Single Amount

Example:
The present value of $1,331 received at the
end of three years:

PV = FV PV
Factor
PV = $1,331 .
75131
PV = $1,000
LO6-3

Relation between the Present


Value and the Future Value
End of End of End of
0 year 1 year 2 year 3
$100 $110 $121

$1,000 $1,331
PV FV

Future value entails the addition of interest


Present value entails the removal of interest
Accountants use PV calculations much more
frequently than FV
LO6-4

Solving for Other Values When FV


and PV Are Known
Determining an Unknown Interest
Rate
Suppose a friend asks to borrow $500 today
and promises to repay you $605 two years
from now. What is the annual interest rate you
would be agreeing to?
Present Future
value value
$500 $605
End of End of
0 year 1 year 2

n = 2, i
=?
LO6-4

Determining an Unknown Interest


Rate (continued)
$500 (present value) = $605 (future
value) PVF*
*Present value of $1; n =
2, i = ?
$500 (present value) $605 (future
value)
*Present= value
0.82645*
of $1; ni =
2, =?
i=
10%

.
.75131
.
751
31
LO6-4

Solving for Other Values When FV


and PV Are Known

Determining an Unknown Number of


Periods
You want to invest $10,000 today to accumulate
$16,000 for graduate school. If you can invest at
an interest rate of 10% compounded annually,
Present Future
how many years will it take to accumulate the
value value
required amount?
$10,000 $16,000
End of End of End of End of
0 year 1 year 2 year n-1 year n

n = ?, i =
10%
LO6-4

Determining an Unknown Number


of Periods (continued)
$10,000 (present value) = $16,000 (future
*Present value
value) of $1;
PVF * i=
10%, n = ?
$10,000 (present value) $16,000 (future
value) = value
*Present 0.625* of $1; i = n =
10%, ?
n=
5

.75131
.
751
. 31.
Preview of Accounting Applications LO6-4

of Present Value Techniques


Single Cash Amount
Most monetary assets and monetary liabilities are
valued at the present value of future cash flows
Monetary assets
Include money and claims to receive money in the
future, the amount of which is fixed or
determinable
Examples:
Cash and most receivables

Monetary liabilities
Obligations to pay amounts of cash in the future,
the amount of which is fixed or determinable
Example:
Notes payable
Valuing a Note: One Payment,
LO6-4

Explicit Interest
Example:
The Stridewell Wholesale Shoe Company
manufactures athletic shoes for sale to
retailers. The company recently sold a large
order of shoes to Harmon Sporting Goods for
$50,000. Stridewell agreed to accept a note in
payment for the shoes requiring payment of
$50,000
Preseafter one year plus interest Future
at 10%.
nt value
value $55,0
?
0 00
End of
year 1

n = 1, i =
LO6-4

Valuing a Note: One Payment,


Explicit Interest
$55,000 (future value) 0.90909* = $50,000
(present value)
*Present value of $1; n = 1, i
= 10%
Valuing a Note: One Payment, No
LO6-4

Interest Stated
Example:
The Stridewell Wholesale Shoe Company
recently sold a large order of shoes to Harmon
Sporting Goods. Terms of the sale require
Harmon to sign a noninterest-bearing note of
$60,500
Present with payment due in two years. Future
value value
? $60,500

End of
year 2
n = 2, i =
To find the PV of the10%
note (price of the shoes), we need
to know either the cash price of the shoes or the
appropriate interest rate for a transaction like this one.
LO6-4

Valuing a Note: One Payment, No


Explicit Interest
$60,500 (future value) .82645* = $50,000
(present
*Presentvalue)
value of $1; n = 2, i =
10%
LO6-4

Expected Cash Flow Approach

Statement of Financial Accounting


Concepts No. 7 (SFAC No. 7)
Provides a framework for using future cash
flows in accounting measurement when
uncertainty is present.
The objective in valuing an asset or liability
using present value is to approximate fair
value of that asset or liability
o Key to that objective is determining the
present value of future cash flows, taking
into account any uncertainty concerning
the amounts and timing of the cash flows
LO6-4

Illustration: Expected Cash Flow


Approach
LDD Corporation faces the likelihood of having to pay an uncertain
amount in five years in connection with an environmental cleanup.
Calculate the expected cash flow. Also calculate the present value of
the expected cash flow if the companys credit-adjusted risk-free rate
of interest is 5%. The future cash flow estimate is in the range of
$100 million to $300
Loss million
Amount with the following estimated
Probability
probabilities:
$100 million 10%
$200 million 60%
$300 million 30%

The expected cash flow:


$100 X 10% = $ 10 million
200 X 60% = 120 million
300 X 30% = 90 million
$220 million

Present value of expected cash flows:


Present value of
$1: n = 5, i =
$220,000,000 X .78353 =
5%
LO6-5

Basic Annuities
Annuity
Series of cash flows of same amount
received or paid each period
Example:
A loan on which periodic interest is paid in
equal amounts

Ordinary Annuity
Cash flows occur at the end of each
period
Annuity Due
Cash flows occur at the beginning of
LO6-5

Ordinary Annuity

Example:
An installment note payable dated December
31, 2016, might require the debtor to make
three equal annual payments, with the first
payment due on December 31, 2017, and
the last one on December 31, 2019.
LO6-5

Annuity Due

Example:
A three-year lease of a building that begins on
December 31, 2016, and ends on December
31, 2019, may require the first years lease
payment in advance on December 31,
2016. The third and last payment would take
place on December 31, 2018, the beginning of
the third year of the lease.
Future Value of an Ordinary
LO6-6

Annuity
Sally Rogers wants to accumulate a sum of money to pay for graduate
school. Rather than investing a single amount today that will grow to a
future value, she decides to invest $10,000 a year over the next
three years in a savings account paying 10% interest compounded
annually. She decides to make the first payment to the bank one
year from today.

FV of Future value
Payme $1 (at the end of year 3) n
nt i=
First $10,00 1.21
10% = $12,10 2
payment
Second 010,000 1.10 = 0
11,000 1
payment
Third 10,000 1.00 = 10,000 0
payment
Tota 3.31 $33,1
00
LO6-6

Using the FVA Table to Calculate the


Future Value
FVA = $10,000 (annuity amount) =
3.31*value of an ordinary annuity of $1: n = $33,100
*Future 3, i
=10%
LO6-6

Future Value of an Annuity Due

FV of Future value
Payme $1 (at the end of year 3) n
nt i=
First $10,00 1.331 = $13,31 3
10%
payment
Second 010,000 1.210 = 0
12,100 2
payment
Third 10,000 1.100 = 11,000 1
payment
Tota 3.641 $36,4
Easier way: 10
l
FVA = $10,000 (annuity amount) 3.641* =
$36,410
*Future value of an ordinary annuity of $1: n
= 3, i =10%
LO6-7

Present Value of an Ordinary Annuity

Sally wants to accumulate a sum of money to pay for graduate school.


She wants to invest a single amount today in a savings account
earning 10% interest compounded annually that is equivalent to
investing $10,000 at the end of each of the next three years.

PV of Present value
Payme $1 (at the beginning of n
nt i= the year 1)
First $10,00 .90909 = $9,091 1
10%
payment
Second 010,000 .82645 = 8,264 2
payment
Third 10,000 .75131 = 7,513 3
payment
Tota 2.486 $24,8
l 85 68
LO6-7

Using the PVA Table to Calculate the


Present Value
PVA = $10,000 (annuity amount) 2.48685*
= $24,868
LO6-7

Present Value of an Annuity Due


In the previous illustration, suppose that the three equal payments of
$10,000 are to
be made at the beginning of each of the three years. What is the
present value of this annuity?

PV of Present value
Payme $1 (at the beginning of n
nt i=
First $10,00 1.0000 = the year 1)
$10,00 0
payment 10% 0
Second 010,000 0
.90909 = 9,091 1
payment
Third 10,000 .82645 = 8,264 2
payment
Tota 2.735 $27,3
l 54 55
LO6-7

Using the PVAD Table to Calculate the


Present Value

PVA= $10,000 (annuity amount) 2.73554* =


$27,355
*Present value of an annuity due of $1: n = 3, i =
10%
From Table 6
LO6-8

Solving for Unknown Values in Present


Value Situations
Determining the Annuity Amount when Other
Variables are Known

$700 (present value) = 3.31213* annuity


amount
$700 (present value) 3.31213* = $211.34
(annuity amount)
* Present value of an ordinary annuity of $1: n = 4, i
= 8%
LO6-8

Solving for Unknown Values in Present Value Situations


Determining the Unknown Number of PeriodsOrdinary Annuity

$700 (present value) = $100 (annuity amount)


?* value of an ordinary annuity of $1: n = ?,PVA table
*Present
i = 7% factor
$700 (present value) $100 (annuity amount) =
* Present value of an ordinary annuity of $1: n
7.0000*
= ?, i = 7%
In the PVA table (Table 4), search the 7% column ( i = 7%)
for this value and find 7.02358 in row 10. So it would take
about 10 years to repay the loan.
LO6-8

Solving for Unknown Values in Present Value Situations


Determining i When Other Variables Are Known

$331(present value) = $100 (annuity amount)


?* value of an ordinary annuity of $1: n = 4,
*Present
PVA table
i =? factor
$331 (present value) $100 (annuity amount) =
*3.31*
Present value of an ordinary annuity of $1: n = 4, i
=?
In the PVA table (Table 4), search row four (n = 4) for
3.31. We find it in the 8% column. So the effective
LO6-9

Valuing a Long-Term Bond Liability


On June 30, 2016, Fumatsu Electric issued 10% stated rate
bonds with a face amount of $200 million. The bonds mature
on June 30, 2036 (20 years). The market rate of interest for
similar issues was 12%. Interest is paid semiannually (5%) on
June 30 and December 31, beginning December 31, 2016. The
interest payment is $10 million (5% X $200 million).
What was the price of the bond issue? What amount of interest
expense will Fumatsu record for the bonds in 2016?
Present value of an ordinary annuity of $1: n
= 40, i = 6%
PVA = $10 million (annuity amount) X = $150,463,0
PV = $200 million (lump-sum)15.04630 00
X . = 19,444,000
09722
Price of the bond issue = $169,907,
Present value of $1: n = 40, 000
i = 6%
$169,907,000 6% =
Interest expense =
$10,194,420
LO6-9

Valuing a Long-Term Lease Liability


On January 1, 2016, the Stridewell Wholesale Shoe Company
signed a 25-year lease agreement for an office building. Terms
of the lease call for Stridewell to make annual lease payments
of $10,000 at the beginning of each year, with the first
payment due on January 1, 2016. Assuming an interest rate of
10% properly reflects the time value of money in this situation,
how should Stridewell value the asset acquired and the
corresponding
PVAD =lease liability? (annuity amount)
$10,000
9.98474 = $99,847
Present value of an annuity due of $1: n = 25,
i =10%

Journal Entry Debit Credit


Leased office building 99,847
Lease payable 99,847
Summary of Time Value of Money
Concepts
End of Chapter 6