Prepared by
Coby Harmon
University of California, Santa Barbara
Westmont College
G- 1
Appendix
G Time Value of Money
Learning Objectives
After studying this chapter, you should be able to:
[1] Indicate the benefits of budgeting.
[2] Distinguish between simple and compound interest.
[2] Identify the variables fundamental to solving present value problems.
[3] Solve for present value of a single amount.
[4] Solve for present value of an annuity.
[5] Compute the present value of notes and bonds.
G- 2
Nature of Interest
Interest
Payment for the use of money.
Excess cash received or repaid over the amount borrowed
(principal).
Elements involved in financing transaction:
1. Principal (p) Original amount borrowed or invested.
2. Interest Rate (i) An annual percentage.
3. Time (n) - The number of years or portion of a year that the
principal is borrowed or invested.
G- 3 LO 1 Distinguish between simple and compound interest.
Nature of Interest
Simple Interest
Interest computed on the principal amount only.
Illustration: Assume you borrow $5,000 for 2 years at a simple
interest of 6% annually. Calculate the annual interest cost.
Illustration G-1
Interest = p x i x n
FULL YEAR = $5,000 x .06 x 2
= $600
Advance slide in
presentation mode
G- 4 to reveal answer. LO 1 Distinguish between simple and compound interest.
Nature of Interest
Compound Interest
Computes interest on
the principal and
any interest earned that has not been paid or
withdrawn.
Most business situations use compound interest.
G- 5 LO 1 Distinguish between simple and compound interest.
Compound Interest
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.
Illustration G-2
Simple versus compound interest
Year 1 $1,000.00 x 9% $ 90.00 $ 1,090.00
Year 2 $1,090.00 x 9% $ 98.10 $ 1,188.10
Year 3 $1,188.10 x 9% $106.93 $ 1,295.03
G- 6 LO 1
Present Value Concepts
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 (future amount),
2. Length of time until amount is received (number of periods),
and
3. Interest rate (the discount rate). The
The process
process of
of determining
determining
the
the present
present value
value is
is referred
referred
to
to as
as discounting
discounting thethe
future
future amount.
amount.
G- 7 LO 2 Identify the variables fundamental to solving present value problems.
Present Value of a Single Amount
Illustration G-3
Formula for present value
Present Value = Future Value (1 + i )n
p = principal (or present value)
i = interest rate for one period
n = number of periods
G- 8 LO 3 Solve for present value of a single amount.
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:
Illustration G-4
G- 9 LO 3 Solve for present value of a single amount.
Present Value of a Single Amount
Illustration G-4
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.
What table do we use?
G- 10 LO 3 Solve for present value of a single amount.
Present Value of a Single Amount
TABLE 1
Present Value of 1
What factor do we use?
$1,000 x .90909 = $909.09
Future Value Factor Present Value
G- 11 LO 3 Solve for present value of a single amount.
Present Value of a Single Amount
Illustration G-5
Illustration: If you receive the single amount of $1,000 in two
years, discounted at 10% [PV = $1,000 1.102], the present
value of your $1,000 is $826.45.
What table do we use?
G- 12 LO 3 Solve for present value of a single amount.
Present Value of a Single Amount
TABLE 1
Present Value of 1
What factor do we use?
$1,000 x .82645 = $826.45
Future Value Factor Present Value
G- 13 LO 3 Solve for present value of a single amount.
Present Value of a Single Amount
TABLE 1
Present Value of 1
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?
$10,000 x .79383 = $7,938.30
Future Value Factor Present Value
G- 14 LO 3 Solve for present value of a single amount.
Present Value of a Single Amount
TABLE 1
Present Value of 1
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.
$5,000 x .70843 = $3,542.15
Future Value Factor Present Value
G- 15 LO 3 Solve for present value of a single amount.
Present Value of an Annuity
The present value of an annuity is the value now of a
series of future receipts or payments, discounted assuming
compound interest.
Present Value
$100,000 100,000 100,000 100,000 100,000 100,000
.....
0 1 2 3 4 19 20
G- 16 LO 4 Solve for present value of an annuity.
Present Value of an Annuity
Illustration G-8
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?
G- 17 LO 4 Solve for present value of an annuity.
Present Value of an Annuity
TABLE 1
Present Value of an Annuity of 1
What factor do we use?
$1,000 x 2.48685 = $2,484.85
Future Value Factor Present Value
G- 18 LO 4 Solve for present value of an annuity.
Present Value of an Annuity
TABLE 1
Present Value of an Annuity of 1
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 3.60478 = $21,628.68
G- 19 LO 4 Solve for present value of an annuity.
Time Periods and Discounting
Illustration: When the time frame is less than one year, you need to
convert the annual interest rate to the applicable time frame. Assume
that the investor received $500 semiannually for three years instead of
$1,000 annually when the discount rate was 10%.
TABLE 1
Present Value of an Annuity of 1
$500 x 5.07569 = $2,537.85
G- 20 LO 4
Present Value of a Long-term Note or Bond
Two Cash Flows:
Periodic interest payments (annuity).
Principal paid at maturity (single-sum).
100,000
$5,000 5,000 5,000 5,000 5,000 5,000
.....
0 1 2 3 4 9 10
G- 21 LO 5 Compute the present value of notes and bonds.
Present Value of a Long-term Note or Bond
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. Calculate the present value of the
principal and interest payments.
100,000
$5,000 5,000 5,000 5,000 5,000 5,000
.....
0 1 2 3 4 9 10
Year 1
G- 22 LO 5 Compute the present value of notes and bonds.
Present Value of a Long-term Note or Bond
TABLE 1
Present Value of 1 PV of Principal
$100,000 x .61391 = $61,391
Principal Factor Present Value
G- 23 LO 5 Compute the present value of notes and bonds.
Present Value of a Long-term Note or Bond
TABLE 1
Present Value of an Annuity of 1 PV of Interest
$5,000 x 7.72173 = $38,609
Principal Factor Present Value
G- 24 LO 5 Compute the present value of notes and bonds.
Present Value of a Long-term Note or Bond
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
G- 25 LO 5
Present Value of a Long-term Note or Bond
Illustration: Now assume that the investors 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.
Illustration G-14
G- 26 LO 5 Compute the present value of notes and bonds.
Present Value of a Long-term Note or Bond
Illustration: Now assume that the investors 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.
Illustration G-15
G- 27 LO 5 Compute the present value of notes and bonds.
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G- 28
