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CHAPTER 7 • KEY CONCEPTUAL ISSUES IN FINANCIAL ACCOUNTING 187

The manager of Marianne’s credit department reckons that a two-year extension is too
generous and suggests Bull repay half the 20,000 in one year’s time and the balance at the end of
the second year. Would Marianne be better off under her manager’s proposal or under Bull’s?
The present value of the credit manager’s proposed payment terms is:

 1   1 
10,000 × (1 + 0.1) + 10,000 × (1 + 0.1)2 
   
= (10,000 × 0.9091) + (10,000 × 0.8264)
= 17,355
(We assume a 10% interest rate can be earned each year.)
Not surprisingly, the manager’s suggestion is more advantageous to Marianne. This is because
the 10,000 received at the end of year 1 can be reinvested then, yielding an expected 1,000
(10,000 × 10%) at the end of year 2. When discounted to today, this is equivalent to 826 (1,000
× 0.8264), the difference (after rounding) between the present values of the two proposals
(17,355 − 16,528).
We introduced a new term, ‘discounted’, in the last paragraph. The procedure of finding the
present value of future cash inflows or outflows is referred to as discounting. The interest rate
on investment opportunities forgone, which is used in present value calculations, is often known
as the discount rate. And the multiples applied to future cash sums – in our example, 0.9091 and
0.8264 (or, more generally, (1 + r)–1, (1 + r)–2, . . . (1 + r)–n) – are described as discount factors.
Discounting is the obverse of compounding. Where compound interest rather than simple
interest is in force, interest is earned or incurred on prior interest as well as the principal of the
investment or debt. Similarly, discount factors reflect interest forgone not just on the principal
but also on the prior interest.
Over long time periods, the effect of ‘lost interest on interest’ can be substantial. Suppose a
company issues ten-year bonds which pay no interest. (Such bonds are known as ‘zero coupon
bonds’.) The purchaser of a bond receives on the maturity of the bond (at the end of ten years)
1,000, the par value of the bond. How much would an investor pay for one such bond, assuming
that, at the time of issuance, the market rate of interest for bonds of equivalent risk is 12% a year?
To answer this question, we need to find the present value of a future sum, 1,000, where the
discount factor, 1/(1 + r)n, is based on an interest rate r of 12% and a period n of ten years. The
investor should pay no more than 322 for the bond:
1
1,000 × = 1,000 × 0.322
(1 + 0.12)10
= 322
The 1,000 the investor receives on the bond’s maturity will exactly compensate her for the loss
of interest (compounded annually) on her 322 in the intervening ten years.

l Use of present value tables

How do we obtain discount factors in practice? After all, computing 1/(1 + 0.12)10 by hand is a
time-consuming and error-prone exercise, though many hand calculators and computer spread-
sheet packages contain present value computational routines. Present value tables are presented
in Exhibit 7.11 for the benefit of those who don’t have access to other sources. They’re also of
help to the calculator- and computer-blessed, because they provide a way of checking calculations.
A short explanation of the tables follows. Table 1 presents discount factors. It shows the present
value of one unit of currency (euro, dollar, yen, etc.) received or paid in the future, for a range