Basic Time LEARNING OBJECTIVE 1

Accounting and the Value Concepts

Describe the fundamental
concepts related to the time
value of money.
Time Value of Money
Time Value of Money
LEARNING OBJECTIVES ◆ A relationship between time and money.
After studying this chapter, you should be able to:
◆ A dollar received today is worth more than a dollar
1. Describe the fundamental 4. Solve present value of
concepts related to the time ordinary and annuity due promised at some time in the future.
value of money. problems.
2. Solve future and present value 5. Solve present value When deciding among investment or borrowing
of 1 problems. problems related to deferred
alternatives, it is essential to be able to compare
annuities, bonds, and
3. Solve future value of ordinary today’s dollar and tomorrow’s dollar on the same
expected cash flows.
and annuity due problems. footing—to “compare apples to apples.”

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Basic Time Value Concepts

PREVIEW
Applications of Time Value Concepts:
1. Notes 5. Shared-Based
Compensation
2. Leases
6. Business Combinations
3. Pensions and Other
Postretirement 7. Disclosures
Benefits
8. Environmental Liabilities
4. Non-Current Assets

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 Basic Time Value Concepts Basic Time Value Concepts

The Nature of Interest Simple Interest

◆ Payment for the use of money. ◆ Interest computed on the principal only.

◆ Excess cash received or repaid over the amount lent Illustration: Barstow Electric Inc. borrows $10,000 for 3 years
or borrowed (principal). at a simple interest rate of 8% per year. Compute the total
interest to be paid for 3 years.
Variables in Interest Computation
Interest = p x i x n
1. Principal. The amount borrowed or invested. Total
2. Interest Rate. A percentage of the outstanding principal. Interest = $10,000 x .08 x 3
3. Time. The number of years or fractional portion of a year that the = $2,400
principal is outstanding.

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Basic Time Value Concepts Basic Time Value Concepts

Simple Interest Simple Interest

◆ Interest computed on the principal only. ◆ Interest computed on the principal only.

Illustration: Barstow Electric Inc. borrows $10,000 for 3 years Illustration: If Barstow borrows $10,000 for 3 months at a 8%
at a simple interest rate of 8% per year. Compute the total per year, the interest is computed as follows.
interest to be paid for 1 year.
Interest = p x i x n
Interest = p x i x n
Partial
Annual = $10,000 x .08 x 3/12
= $10,000 x .08 x 1 Year
Interest
= $200
= $800

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 Basic Time Value Concepts Basic Time Value Concepts

Compound Interest Compound Interest Tables

◆ Computes interest on Table 6.1 - Future Value of 1

► principal and Table 6.2 - Present Value of 1

Table 6.3 - Future Value of an Ordinary Annuity of 1
► interest earned that has not been paid or
withdrawn. Table 6.4 - Present Value of an Ordinary Annuity of 1
Table 6.5 - Present Value of an Annuity Due of 1
◆ Typical interest computation applied in business
situations. Number of Periods = number of years x the number of compounding
periods per year.
Compounding Period Interest Rate = annual rate divided by the
number of compounding periods per year.

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Compound Interest Basic Time Value Concepts

Illustration: Tomalczyk Company deposits $10,000 in the Last National
Bank, where it will earn simple interest of 9% per year. It deposits another
Compound Interest Tables ILLUSTRATION 6.2
Excerpt from Table 6.1
$10,000 in the First State Bank, where it will earn compound interest of
9% per year compounded annually. In both cases, Tomalczyk will not
withdraw any interest until 3 years from the date of deposit.

Year 1 $10,000.00 x 9% $ 900.00 $ 10,900.00

Year 2 $10,900.00 x 9% $ 981.00 $ 11,881.00

Year 3 $11,881.00 x 9% $1,069.29 $ 12,950.29

How much principal plus interest a dollar accumulates to at the end of

each of five periods, at three different rates of compound interest.
ILLUSTRATION 6.1
Simple vs. Compound Interest
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 Basic Time Value Concepts Basic Time Value Concepts

Compound Interest Tables Compound Interest Tables

Formula to determine the future value factor (FVF) for 1: Number of years X number of compounding periods per year =
Number of periods

Where:

FVFn,i = future value factor for n periods at i interest

n = number of periods
i = rate of interest for a single period

ILLUSTRATION 6.4
Frequency of Compounding

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Basic Time Value Concepts Basic Time Value Concepts

Compound Interest Tables Compound Interest Tables

To illustrate the use of interest tables to calculate compound A 9% annual interest compounded daily provides a 9.42% yield.
amounts, Illustration 6.3 shows the future value to which 1
Effective Yield for a $10,000 investment.
accumulates assuming an interest rate of 9%.

*Note that these amounts appear in Table 6.1 in the 5% column.

ILLUSTRATION 6.3 ILLUSTRATION 6.5
Accumulation of Compound Amounts Comparison of Different Compounding Periods

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 Basic Time Value Concepts Single-Sum Problems

Fundamental Variables Future Value of a Single Sum

◆ Rate of Interest ◆ Future Value Value at a future date of a given amount invested, assuming
◆ Number of Time Periods ◆ Present Value compound interest.

Where:
FV = future value
PV = present value (principal or single sum)
FVF n,i = future value factor for n periods at i interest

ILLUSTRATION 6.6
Basic Time Diagram

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LEARNING OBJECTIVE 2
Single-Sum Problems Solve future and present value
of 1 problems.
Future Value of a Single Sum

Two Categories Illustration: Bruegger AG wants to determine the future

value of €50,000 invested for 5 years compounded annually at
Unknown Present Value Unknown Future Value an interest rate of 6%.

ILLUSTRATION 6.7
Future Value Time
Diagram (n = 5, i = 6%)

ILLUSTRATION 6.6 = €66,912

Basic Time Diagram

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 Future Value of a Single Sum Alternate
Calculation
Future Value of a Single Sum

Illustration: Bruegger AG wants to determine the future Illustration: Shanghai Electric Power (CHN) deposited
value of €50,000 invested for 5 years compounded annually at ¥250 million in an escrow account with Industrial and Commercial
Bank of China (CHN) at the beginning of 2019 as a commitment
an interest rate of 6%.
toward a power plant to be completed December 31, 2022. How
much will the company have on deposit at the end of 4 years if
interest is 10%, compounded semiannually?

ILLUSTRATION 6.7
Future Value Time
Diagram (n = 5, i = 11%)

What table
do we use? ILLUSTRATION 6.8
Future Value Time
Diagram (n = 8, i = 5%)
What table do we use?
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Future Value of a Single Sum Alternate Future Value of a Single Sum

Calculation

TABLE 6.1 FUTURE VALUE OF 1 (FUTURE VALUE OF A SINGLE SUM) i=6% TABLE 6.1 FUTURE VALUE OF 1 (FUTURE VALUE OF A SINGLE SUM) i=5%
n=5 n=8

What factor do we use?

€50,000 x 1.33823 = €66,912 ¥250,000,000 x 1.47746 = ¥369,365,000

Present Value Factor Future Value
Present Value Factor Future Value

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 Single-Sum Problems Present Value of a Single Sum

Present Value of a Single Sum Illustration 6.9 shows the “present value of 1 table” for five
different periods at three different rates of interest.
Amount needed to invest now, to produce a known future value.
Formula to determine the present value factor for 1:

Where:

PVFn,i = present value factor for n periods at i interest

n = number of periods
i = rate of interest for a single period
ILLUSTRATION 6.9
Excerpt from Table 6.2

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Present Value of a Single Sum Present Value of a Single Sum

Assuming an interest rate of 9%, the present value of 1 Amount needed to invest now, to produce a known future value.
discounted for three different periods is as shown in
Illustration 6.10.

Where:

FV = future value
PV = present value
*Note that these amounts appear in Table 6.2 in the 5% column. PVF n,i = present value factor for n periods at i interest
ILLUSTRATION 6.10
Present Value of 1 Discounted at 5% for Three Periods

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 Present Value of a Single Sum Present Value of a Single Sum
i=8% TABLE 6.2 PRESENT VALUE OF 1
Illustration: What is the present value of €73,466 to be n=5
received or paid in 5 years discounted at 8% compounded
annually?

What factor?
ILLUSTRATION 6.11
Present Value Time
Diagram (n = 5, i = 8%)
€73,466 x .68058 = €50,000
Future Value Factor Present Value
= €50,000
(rounded by €.51)

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Present Value of a Single Sum Present Value of a Single Sum

Illustration: What is the present value of €73,466 to be Illustration: Assume that your rich uncle decides to give you
received or paid in 5 years discounted at 8% compounded $2,000 for a vacation when you graduate from college 3 years from
annually? now. He proposes to finance the trip by investing a sum of money
now at 8% compound interest that will provide you with $2,000
upon your graduation. The only conditions are that you graduate
and that you tell him how much to invest now.

ILLUSTRATION 6.11
Present Value Time
Diagram (n = 5, i = 8%)

What table do we use? ILLUSTRATION 6.12

Present Value Time
Diagram (n = 3, i = 8%)
What table do we use?
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 Present Value of a Single Sum Solving for Other Unknowns
i=8% TABLE 6.2 PRESENT VALUE OF 1
n=3
Example—Computation of the Number of Periods
ILLUSTRATION 6.14

Using the future value factor of

1.46410, refer to Table 6.1 and read
down the 10% column to find that
factor in the 4-period row.

TABLE 6.1 FUTURE VALUE OF 1

What factor?

$2,000 x .79383 = $1,587.66

Future Value Factor Present Value

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Single-Sum Problems Solving for Other Unknowns

Solving for Other Unknowns Example—Computation of the Number of Periods

ILLUSTRATION 6.14
Example—Computation of the Number of Periods
Using the present value factor of
The Village of Somonauk wants to accumulate $70,000 for the .68301, refer to Table 6.2 and read
down the 10% column to find that
construction of a veterans monument in the town square. At the factor in the 4-period row.
beginning of the current year, the Village deposited $47,811 in a
memorial fund that earns 10% interest compounded annually. How TABLE 6.2 PRESENT VALUE OF 1
many years will it take to accumulate $70,000 in the memorial
fund?
ILLUSTRATION 6.13

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 Solving for Other Unknowns Solving for Other Unknowns

Example—Computation of the Interest Rate Example—Computation of the Interest Rate

ILLUSTRATION 6.16
Advanced Design, SA needs €1,070,584 for basic research five
Using the present value factor of
years from now. The company currently has €800,000 to invest .74726, refer to Table 6.2 and
for that purpose. At what rate of interest must it invest the read across the 5-period row to
find the factor.
€800,000 to fund basic research projects of €1,070,584, five
years from now?
TABLE 6.2 PRESENT VALUE OF 1

ILLUSTRATION 6.15

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LEARNING OBJECTIVE 3
Solving for Other Unknowns Annuities Solve future value of ordinary
and annuity due problems.

Example—Computation of the Interest Rate Annuity requires:

ILLUSTRATION 6.16
(1) Periodic payments or receipts (called rents) of the
Using the future value factor of
1.33823, refer to Table 6.1 and same amount,
read across the 5-period row to
find the factor. (2) Same-length interval between such rents, and

(3) Compounding of interest once each interval.

TABLE 6.1 FUTURE VALUE OF 1 (FUTURE VALUE OF A SINGLE SUM)

Two Ordinary Annuity - rents occur at the end of each period.

Types Annuity Due - rents occur at the beginning of each period.

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 Annuities (Future Value) Future Value of an Ordinary Annuity

Future Value of an Ordinary Annuity Illustration 6.18 provides an excerpt from the “future value of an
ordinary annuity of 1” table.
◆ Rents occur at the end of each period. ILLUSTRATION 6.18

◆ No interest during 1st period.

Present Value Future Value

$20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

0 1 2 3 4 5 6 7 8

*Note that this annuity table factor is the same as the sum
of the future values of 1 factors shown in Illustration 6.17.
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Future Value of an Ordinary Annuity Future Value of an Ordinary Annuity

Illustration: Assume that $1 is deposited at the end of each A formula provides a more efficient way of expressing the
of five years (an ordinary annuity) and earns 12% interest future value of an ordinary annuity of 1.
compounded annually. Illustration 6.17 shows the
computation of the future value, using the “future value of 1”
table (Table 6.1) for each of the five $1 rents.

Where:
R = periodic rent
FVF-OA n,i = future value factor of an ordinary annuity
factor for n periods at i interest

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 Future Value of an Ordinary Annuity Future Value of an Ordinary Annuity

Illustration: What is the future value of five $5,000 deposits TABLE 6.3 FUTURE VALUE OF AN ORDINARY ANNUITY OF 1 i=6%
n=5
made at the end of each of the next five years, earning
interest of 6%?

What factor?
= $28,185.45
$5,000 x 5.63709 = $28,185.45
ILLUSTRATION 6.19
Time Diagram for Future Value of Ordinary Annuity (n = 5, i = 6%) Deposits Factor Future Value

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Future Value of an Ordinary Annuity Future Value of an Ordinary Annuity

Alternate
Calculation

Illustration: What is the future value of five $5,000 deposits Illustration: Hightown Electronics deposits $75,000 at the end
made at the end of each of the next five years, earning of each six-month period for the next three years, to accumulate
interest of 6%? enough money to meet debts that mature in three years. What
ILLUSTRATION 6.19
is the future value that the company will have on deposit at the
end of three years if the annual interest rate is 10%?

What table do we use?

What table do we use?
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 Future Value of an Ordinary Annuity Future Value of an Annuity Due
TABLE 6.3 FUTURE VALUE OF AN ORDINARY ANNUITY OF 1 i=5%
n=6
Comparison of Ordinary Annuity with an Annuity Due
ILLUSTRATION 6.21

$75,000 x 6.80191 = $510,143.25

Deposit Factor Future Value

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Annuities Future Value of Annuity Problems

Future Value of an Annuity Due Computation of Rent

◆ Rents occur at the beginning of each period. Illustration: Assume that you plan to accumulate CHF14,000 for a
◆ Interest will accumulate during 1st period. down payment on a condominium apartment 5 years from now. For
the next 5 years, you earn an annual return of 8% compounded
◆ Annuity due has one more interest period than ordinary semiannually. How much should you deposit at the end of each 6-
annuity. month period?
◆ Factor = multiply future value of an ordinary annuity factor by
1 plus the interest rate.
Future Value

$20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000 ILLUSTRATION 6.24

0 1 2 3 4 5 6 7 8
R = CHF1,166.07
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 Future Value of Annuity Problems Alternate Future Value of Annuity Problems
Calculation
ILLUSTRATION 6.24

Computation of Rent Computation of Future Value

CHF14,000
= CHF1,166.07 Illustration: Walter Goodwrench deposits $2,500 today in a savings
12.00611 account that earns 9% interest. He plans to deposit $2,500 every
TABLE 6.3 FUTURE VALUE OF AN ORDINARY ANNUITY OF 1
year for a total of 30 years. How much cash will Mr. Goodwrench
accumulate in his retirement savings account, when he retires in 30
years?
ILLUSTRATION 6.27

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LEARNING OBJECTIVE 4
Future Value of Annuity Problems Annuities (Present Value) Solve present value of ordinary
and annuity due problems.

Computation of Number of Periodic Rents Present Value of an Ordinary Annuity

Illustration: Suppose that a company’s goal is to accumulate ◆ Present value of a series of equal amounts to be
$117,332 by making periodic deposits of $20,000 at the end of each
withdrawn or received at equal intervals.
year, which will earn 8% compounded annually while accumulating.
How many deposits must it make? ◆ Periodic rents occur at the end of the period.

Present Value
ILLUSTRATION 6.25
5.86660
$100,000 100,000 100,000 100,000 100,000 100,000
.....
0 1 2 3 4 19 20

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 Present Value of an Ordinary Annuity Present Value of an Ordinary Annuity

Illustration: Assume that $1 is to be received at the end of Illustration: What is the present value of rental receipts of
each of five periods, as separate amounts, and earns 5% $6,000 each, to be received at the end of each of the next 5
interest compounded annually. years when discounted at 6%?
ILLUSTRATION 6.30

ILLUSTRATION 6.28
Solving for the Present Value of an Ordinary Annuity
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Present Value of an Ordinary Annuity Present Value of an Ordinary Annuity

A formula provides a more efficient way of expressing the Present Value

present value of an ordinary annuity of 1.
$100,000 100,000 100,000 100,000 100,000 100,000
.....
0 1 2 3 4 19 20

Illustration: Jaime Yuen wins $2,000,000 in the state lottery.

She will be paid $100,000 at the end of each year for the next
Where: 20 years. How much has she actually won? Assume an
appropriate interest rate of 8%.

What table do we use?

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 Present Value of an Ordinary Annuity Present Value of an Annuity Due
i=8%
n=20 TABLE 6.4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1 Comparison of Ordinary Annuity with an Annuity Due
ILLUSTRATION 6.31

$100,000 x 9.81815 = $981,815

Receipts Factor Present Value

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Annuities (Present Value) Present Value of an Annuity Due

Present Value of an Annuity Due Illustration: Space Odyssey, Inc., rents a communications
satellite for 4 years with annual rental payments of $4.8 million
◆ Present value of a series of equal amounts to be
to be made at the beginning of each year. If the relevant
withdrawn or received at equal intervals.
annual interest rate is 5%, what is the present value of the
◆ Periodic rents occur at the beginning of the period. rental obligations?

Present Value

$100,000 100,000 100,000 100,000 100,000 100,000

.....
ILLUSTRATION 6.33
Computation of Present Value of an Annuity Due
0 1 2 3 4 19 20

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 Present Value of Annuity Problems Present Value of Annuity Problems

Illustration: Jaime Yuen wins $2,000,000 in the state lottery. Computation of the Interest Rate
She will be paid $100,000 at the beginning of each year for the Illustration: Assume you receive a statement from MasterCard with
next 20 years. How much has she actually won? Assume an a balance due of €528.77. You may pay it off in 12 equal monthly
appropriate interest rate of 8%. payments of €50 each, with the first payment due one month from
now. What rate of interest would you be paying?
Present Value

$100,000 100,000 100,000 100,000 100,000 100,000

.....
0 1 2 3 4 19 20
Referring to Table 6.4 and reading across the 12-period row, you find 10.57534 in
the 2% column. Since 2% is a monthly rate, the nominal annual rate of interest is
What table do we use? 12
24% (12 x 2%). The effective annual rate is 26.82413% [(1 + .02) - 1].

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Present Value of Annuity Problems Present Value of Annuity Problems

i=8%
n=20 TABLE 6.5 PRESENT VALUE OF AN ANNUITY DUE OF 1 Computation of a Periodic Rent
Illustration: Juan and Marcia Perez have saved $36,000 to finance
their daughter Maria’s college education. They deposited the money
in the Santos Bank, where it earns 4% interest compounded
semiannually. What equal amounts can their daughter withdraw at
the end of every 6 months during her 4 college years, without
exhausting the fund?

$100,000 x 10.60360 = $1,060,360

12
Receipts Factor Present Value

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 Other Time Value LEARNING OBJECTIVE 5
Solve present value problems Deferred Annuities
of Money Issues related to deferred annuities,
bonds, and expected cash
flows.

Deferred Annuities Present Value of Deferred Annuity

Illustration: Bob Boyd has developed and copyrighted tutorial
◆ Rents begin after a specified number of periods. software for students in advanced accounting. He agrees to sell the
◆ Future Value of a Deferred Annuity - Calculation same copyright to Campus Micro Systems for six annual payments of $5,000
as the future value of an annuity not deferred. each. The payments will begin five years from today. Given an annual
interest rate of 8%, what is the present value of the six payments?
◆ Present Value of a Deferred Annuity - Must recognize
the interest that accrues during the deferral period. Two options are available to solve this problem.

Future Value
Present Value
100,000 100,000 100,000
.....
0 1 2 3 4 19 20

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Deferred Annuities Present Value of Deferred Annuity

ILLUSTRATION 6.38

Future Value of Deferred Annuity

Illustration: Sutton Corporation plans to purchase a land site in six
years for the construction of its new corporate headquarters. Sutton
budgets deposits of $80,000 on which it expects to earn 5% annually,
only at the end of the fourth, fifth, and sixth periods. What future value
will Sutton have accumulated at the end of the sixth year?

Use Table 6.4 ILLUSTRATION 6.39

ILLUSTRATION 6.37

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 Present Value of Deferred Annuity Valuation of Long-Term Bonds

Use Table 6.2 and 6.4 Present Value

HK$140,000 140,000 140,000 140,000 140,000 2,140,000

.....
0 1 2 3 4 9 10

BE6-15: Wong Inc. issues HK$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
Wong receive when it issues the bonds?

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Other Time Value of Money Issues Valuation of Long-Term Bonds i=8%

n=10

TABLE 6.4 PRESENT VALUE OF AN ORDINARY ANNUITY OF 1

Valuation of Long-Term Bonds PV of Interest

Two Cash Flows:

◆ Periodic interest payments (annuity).
◆ Principal paid at maturity (single-sum).

2,000,000

$140,000 140,000 140,000 140,000 140,000 140,000

..... HK$140,000 x 6.71008 = HK$939,411

0 1 2 3 4 9 10 Interest Payment Factor Present Value

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 Valuation of Long-Term Bonds i=8%
Effective-Interest Method of Amortization
n=10

TABLE 6.2 PRESENT VALUE OF 1

PV of Principal BE6-15: Schedule of Bond Discount Amortization
10-Year, 7% Bonds Sold to Yield 8%

Cash Bond Carrying

Interest Interest Discount Value
Year
Date Paid Expense Amortization of Bonds
1/1/12 1,865,791
1
12/31/12 140,000 149,263 9,263 1,875,054
2
12/31/13 140,000 150,004 10,004 1,885,059
3
12/31/14 140,000 150,805 10,805 1,895,863
4
12/31/15 140,000 151,669 11,669 1,907,532
5
12/31/16 140,000 152,603 12,603 1,920,135
6
12/31/17 140,000 153,611 13,611 1,933,746
7
12/31/18 140,000 154,700 14,700 1,948,445
8
12/31/19 140,000 155,876 15,876 1,964,321
HK$2,000,000 x .46319 = HK$926,380 9
12/31/20 140,000 157,146 17,146 1,981,467
10
12/31/21 140,000 158,533 * 18,533 2,000,000
Principal Factor Present Value * rounding

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Valuation of Long-Term Bonds Present Value Measurement

BE6-15: Wong Inc. issues HK$2,000,000 of 7% bonds due in IFRS 13 explains the expected cash flow approach that
10 years with interest payable at year-end. uses a range of cash flows and incorporates the probabilities
of those cash flows.
Present value of Interest HK$ 939,411
Present value of Principal 926,380 Choosing an Appropriate Interest Rate
Bond current market value HK$1,865,791
Three Components of Interest:
Risk-free rate of
◆ Pure Rate return. IASB states a
company should
Date Account Title Debit Credit ◆ Expected Inflation Rate discount expected
Cash 1,865,791 cash flows by the risk-
Bonds payable 1,865,791 ◆ Credit Risk Rate free rate of return.

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 Present Value Measurement COPYRIGHT
E6-21: Angela Contreras is trying to determine the amount
Copyright © 2018 John Wiley & Sons, Inc. All rights reserved.
to set aside so that she will have enough money on hand in 2 years to
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overhaul the engine on her vintage used car. While there is some
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Instructions: How much should Angela Contreras deposit today in an
account earning 6%, compounded annually, so that she will have enough
money on hand in 2 years to pay for the overhaul?

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Present Value Measurement

Instructions: How much should Angela Contreras deposit today in an
account earning 6%, compounded annually, so that she will have enough
money on hand in 2 years to pay for the overhaul?

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