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Time Value of
Money Concepts
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?
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?
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
FV = I (1 + i)
Amount invested at the beginning of
I = the period
i = Interest rate
n = Number of compounding periods
LO6-2
FV = I FV
Factor
FV = $1,000
1.331
FV = $1,331
LO6-3
$1,331 $1,331
PV = = = $1,00
(1 + . 1.331 0
10)3
LO6-3
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
$1,000 $1,331
PV FV
n = 2, i
=?
LO6-4
.
.75131
.
751
31
LO6-4
n = ?, i =
10%
LO6-4
.75131
.
751
. 31.
Preview of Accounting Applications LO6-4
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
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
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
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
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
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