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D- 1 TIME VALUE OF MONEY Financial Accounting, Sixth Edition D.

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Presentation on theme: "D- 1 TIME VALUE OF MONEY Financial Accounting, Sixth Edition D."— Presentation transcript:

1 D- 1 TIME VALUE OF MONEY Financial Accounting, Sixth Edition D

2 D Distinguish between simple and compound interest Solve for future value of a single amount Solve for future value of an annuity Identify the variables fundamental to solving present value problems Solve for present value of a single amount Solve for present value of an annuity Compute the present value of notes and bonds. Study Objectives

3 D- 3 Would you rather receive $1,000 today or $1,000 a year from now? Basic Time Value Concepts Time Value of Money Today! “Interest Factor”

4 D- 4  Payment for the use of money.  Excess cash received or repaid over the amount borrowed (principal). Variables involved in financing transaction: 1.Principal (p) - Amount borrowed or invested. 2.Interest Rate (i) – An annual percentage. 3.Time (n) - The number of years or portion of a year (periods) that the principal is borrowed or invested. Nature of Interest SO 1 Distinguish between simple and compound interest.

5 D- 5  Interest computed on the principal only. SO 1 Distinguish between simple and compound interest. Nature of Interest Illustration: Assume you borrow $5,000 for 2 years at a simple interest of 12% annually. Calculate the annual interest cost. Interest = p x i x n = $5,000 x.12 x 2 = $1,200 FULL YEAR Illustration D-1 Simple Interest

6 D- 6  Computes interest on ► the principal and ► any interest earned that has not been paid or withdrawn.  Virtually all business situations use compound interest. Nature of Interest SO 1 Distinguish between simple and compound interest. Compound Interest

7 D- 7 Illustration: Assume that you deposit $1,000 in Bank Two, where it will earn simple interest of 9% per year, and you deposit another $1,000 in Citizens Bank, where it will earn compound interest of 9% per year compounded annually. Also assume that in both cases you will not withdraw any interest until three years from the date of deposit. Nature of Interest - Compound Interest SO 1 Distinguish between simple and compound interest. Year 1 $1, x 9%$ 90.00$ 1, Year 2 $1, x 9%$ 98.10$ 1, Year 3 $1, x 9%$106.93$ 1, Illustration D-2 Simple versus compound interest

8 D- 8 SO 2 Solve for a future value of a single amount. Future value of a single amount is the value at a future date of a given amount invested, assuming compound interest. Future Value of a Single Amount Section One FV = p x (1 + i ) n FV =future value of a single amount p =principal (or present value; the value today) i =interest rate for one period n =number of periods Illustration D-3 Formula for future value

9 D- 9 Illustration: If you want a 9% rate of return, you would compute the future value of a $1,000 investment for three years as follows: Illustration D-4 SO 2 Solve for a future value of a single amount. Future Value of a Single Amount

10 D- 10 Illustration D-4 SO 2 Solve for a future value of a single amount. Future Value of a Single Amount What table do we use? Alternate Method Illustration: If you want a 9% rate of return, you would compute the future value of a $1,000 investment for three years as follows:

11 D- 11 What factor do we use? SO 2 Solve for a future value of a single amount. Future Value of a Single Amount $1,000 Present ValueFactorFuture Value x = $1,295.03

12 D- 12 What table do we use? Illustration : SO 2 Solve for a future value of a single amount. Future Value of a Single Amount Illustration D-5

13 D- 13 $20,000 Present ValueFactorFuture Value x = $57, SO 2 Solve for a future value of a single amount. Future Value of a Single Amount

14 D- 14 SO 3 Solve for a future value of an annuity. Future value of an annuity (right to receive a fixed amount on the last day of each of n periods) is the sum of all the payments (receipts) plus the accumulated compound interest on them. Necessary to know the 1.interest rate, 2.number of compounding periods, and 3.amount of the periodic payments or receipts (payments). Future Value of an Annuity

15 D- 15 Illustration: Assume that you invest $2,000 at the end of each year for three years at 5% interest compounded annually. Illustration D-6 SO 3 Solve for a future value of an annuity. Future Value of an Annuity

16 D- 16 Illustration: Invest = $2,000 i = 5% n = 3 years SO 3 Solve for a future value of an annuity. Future Value of an Annuity Illustration D-7

17 D- 17 When the periodic payments (receipts) are the same in each period, the future value can be computed by using a future value of an annuity of 1 table (Table 2 pg. D-6). Illustration: Illustration D-8 SO 3 Solve for a future value of an annuity. Future Value of an Annuity

18 D- 18 What factor do we use? $2,500 PaymentFactorFuture Value x = $10, SO 3 Solve for a future value of an annuity. Future Value of an Annuity

19 D- 19 SO 4 Identify the variables fundamental to solving present value problems. The present value is the value now of a given amount to be paid or received in the future, assuming compound interest. Present value variables: 1.Dollar amount to be received in the future, 2.Length of time until amount is received, and 3.Interest rate (the discount rate). Present Value Concepts Section Two

20 D- 20 Present Value = Future Value / (1 + i ) n Illustration D-9 Formula for present value p = principal (or present value) i = interest rate for one period n = number of periods Present Value of a Single Amount SO 5 Solve for present value of a single amount.

21 D- 21 SO 5 Solve for present value of a single amount. Illustration: If you want a 10% rate of return, you would compute the present value of $1,000 for one year as follows: Present Value of a Single Amount Illustration D-10

22 D- 22 What table do we use? SO 5 Solve for present value of a single amount. Present Value of a Single Amount Illustration D-10 Illustration: If you want a 10% rate of return, you can also compute the present value of $1,000 for one year by using a present value table.

23 D- 23 $1,000x.90909= $ What factor do we use? SO 5 Solve for present value of a single amount. Present Value of a Single Amount Future ValueFactorPresent Value

24 D- 24 What table do we use? SO 5 Solve for present value of a single amount. Present Value of a Single Amount Illustration D-11 Illustration: If you receive the single amount of $1,000 in two years, discounted at 10% [PV = $1,000 / ], the present value of your $1,000 is $

25 D- 25 $1,000x.82645= $ Future ValueFactorPresent Value What factor do we use? SO 5 Solve for present value of a single amount. Present Value of a Single Amount

26 D- 26 $10,000x.79383= $7, SO 5 Solve for present value of a single amount. Present Value of a Single Amount Illustration: Suppose you have a winning lottery ticket and the state gives you the option of taking $10,000 three years from now or taking the present value of $10,000 now. The state uses an 8% rate in discounting. How much will you receive if you accept your winnings now? Future ValueFactorPresent Value

27 D- 27 SO 5 Solve for present value of a single amount. Present Value of a Single Amount Illustration: Determine the amount you must deposit now in a bond investment, paying 9% interest, in order to accumulate $5,000 for a down payment 4 years from now on a new Toyota Prius. Future ValueFactorPresent Value $5,000x.70843= $3,542.15

28 D- 28 The value now of a series of future receipts or payments, discounted assuming compound interest. Necessary to know 1.the discount rate, 2.The number of discount periods, and 3.the amount of the periodic receipts or payments. SO 6 Solve for present value of an annuity. Present Value of an Annuity

29 D- 29 Illustration: Assume that you will receive $1,000 cash annually for three years at a time when the discount rate is 10%. What table do we use? SO 6 Solve for present value of an annuity. Present Value of an Annuity Illustration D-14

30 D- 30 What factor do we use? Present Value of an Annuity $1,000 x = $2, Future ValueFactorPresent Value SO 6 Solve for present value of an annuity.

31 D- 31 Illustration: Kildare Company has just signed a capitalizable lease contract for equipment that requires rental payments of $6,000 each, to be paid at the end of each of the next 5 years. The appropriate discount rate is 12%. What is the amount used to capitalize the leased equipment? $6,000 x = $21, SO 6 Solve for present value of an annuity. Present Value of an Annuity

32 D- 32 Illustration: Assume that the investor received $500 semiannually for three years instead of $1,000 annually when the discount rate was 10%. Calculate the present value of this annuity. $500 x = $2, SO 6 Solve for present value of an annuity. Present Value of an Annuity

33 D- 33 SO 7 Compute the present value of notes and bonds. Two Cash Flows :  Periodic interest payments (annuity).  Principal paid at maturity (single-sum). Present Value of a Long-term Note or Bond ,000 $5, , ,000

34 D- 34 SO 7 Compute the present value of notes and bonds. Present Value of a Long-term Note or Bond ,000 $5, , ,000 Illustration: Assume a 10% bond issue, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. Calculate the present value of the principal and interest payments.

35 D- 35 $100,000 x = $61,391 Principal FactorPresent Value SO 7 Compute the present value of notes and bonds. PV of Principal Present Value of a Long-term Note or Bond

36 D- 36 $5,000 x = $38,609 Principal FactorPresent Value SO 7 Compute the present value of notes and bonds. Present Value of a Long-term Note or Bond PV of Interest

37 D- 37 Illustration: Assume a bond issue of 10%, five-year bonds with a face value of $100,000 with interest payable semiannually on January 1 and July 1. Present value of Principal $61,391 Present value of Interest 38,609 Bond current market value $100,000 SO 7 Compute the present value of notes and bonds. Present Value of a Long-term Note or Bond

38 D- 38 Illustration: Now assume that the investor’s required rate of return is 12%, not 10%. The future amounts are again $100,000 and $5,000, respectively, but now a discount rate of 6% (12% / 2) must be used. Calculate the present value of the principal and interest payments. SO 7 Compute the present value of notes and bonds. Illustration D-20 Present Value of a Long-term Note or Bond

39 D- 39 Illustration: Now assume that the investor’s required rate of return is 8%. The future amounts are again $100,000 and $5,000, respectively, but now a discount rate of 4% (8% / 2) must be used. Calculate the present value of the principal and interest payments. SO 7 Compute the present value of notes and bonds. Illustration D-21 Present Value of a Long-term Note or Bond


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