APPENDIX B

TIME VALUE OF MONEY: FUTURE VALUE

AND PRESENT VALUE
The following discussion of future value lays the foundation for our explanation of present value in
Chapter 9 but is not essential. For the valuation of long-term liabilities, some instructors may wish to begin
on page 781 of this appendix.
The term time value of money refers to the fact that money earns interest over time. Interest is the cost
of using money. To borrowers, interest is the expense of renting money. To lenders, interest is the revenue
earned from lending. We must always recognize the interest we receive or pay. Otherwise, we overlook
an important part of the transaction. Suppose you invest $4,545 in corporate bonds that pay 10% inter-
est each year. After one year, the value of your investment has grown to $5,000. The difference between
your original investment ($4,545) and the future value of the investment ($5,000) is the amount of interest
revenue you will earn during the year ($455). If you ignored the interest, you would fail to account for the
interest revenue you have earned. Interest becomes more important as the time period lengthens because
the amount of interest depends on the span of time the money is invested.
Let’s consider a second example, this time from the borrower’s perspective. Suppose you purchase a ma-
chine for your business. The cash price of the machine is $8,000, but you cannot pay cash now. To finance the
purchase, you sign an $8,000 note payable. The note requires you to pay the $8,000 plus 10% interest one year
from the date of purchase, i.e. a total of $8,800. The $800 interest is what you pay for the time value of money
you borrowed. Is your cost of the machine $8,000, or is it $8,800 [$8,000 plus interest of $800 ($8,000 3 0.10)]?
The cost is $8,000. The additional $800 is interest expense and not part of the cost of the machine.

Future Value
The main application of future value is the accumulated balance of an investment at a future date. In our first
example, the investment earned 10% per year. After one year, $4,545 grew to $5,000, as shown in Exhibit B-1.

Exhibit B-1 | Future Value: An Example

Present Value Future Value

Time 0 1 year
Roll forward (compounding)
$4,545 $5,000
Present value * (1 + Interest rate) = Future Value
$4,545 * 1.10 = $5,000

If the money were invested for five years, you would have to perform five such calculations. You
would also have to consider the compound interest that your investment is earning. Compound interest is
not only the interest you earn on your principal amount, but also the interest you receive on the inter-
est you have already earned. Most business applications include compound interest. The following table
shows the interest revenue earned on the original $4,545 investment each year for five years at 10%:

End of Year Interest Future Value

0 — $4,545
1 $4,545 * 0.10 = $455 5,000
2 5,000 * 0.10 = 500 5,500
3 5,500 * 0.10 = 550 6,050
4 6,050 * 0.10 = 605 6,655
5 6,655 * 0.10 = 666 7,321
 Appendix B

Earning 10%, a $4,545 investment grows to $5,000 at the end of one year, to $5,500 at the end of two
years, and $7,321 at the end of five years. Throughout this appendix we round off to the nearest dollar.

Future-Value Tables
The process of computing a future value is called compounding because the future value is more than
the present value. Mathematical tables ease the computational burden. Exhibit B-2, Future Value of $1,
gives the future value for a single sum (a present value), $1, invested to earn a particular interest rate for
a specific number of periods. If you are using a spreadsheet, you can enter the formula =FV(interest
%,periods,,-1) to obtain the time value factors. For example, =FV(5%, 10,,-1) will give you 1.629. Future
value depends on three factors: (1) the amount of the investment, (2) the length of time between
investment and future accumulation, and (3) the interest rate. Future-value and present-value tables are
based on $1 because unity (the value 1) is so easy to work with.

Exhibit B-2 | Future Value of $1

Future Value of $1

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15%

1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100 1.120 1.150
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210 1.254 1.323
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331 1.405 1.521
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464 1.574 1.749
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611 1.762 2.011
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772 1.974 2.313
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949 2.211 2.660
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144 2.476 3.059
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358 2.773 3.518
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594 3.106 4.046
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853 3.479 4.652
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138 3.896 5.350
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452 4.363 6.153
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797 4.887 7.076
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177 5.474 8.137
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595 6.130 9.358
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054 6.866 10.761
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560 7.690 12.375
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116 8.613 14.232
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727 9.646 16.367
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.835 17.000 32.919
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449 29.960 66.212

In business applications, interest rates are usually stated for the annual period of one year unless
specified otherwise. In fact, an interest rate can be stated for any period, such as 3% per quarter or 5% for
a six-month period. The length of the period is arbitrary. For example, an investment may promise a return
(income) of 3% per quarter for six months (two quarters). In that case, you would be working with 3%
interest for two periods. It would be incorrect to use 6% for one period because the interest is 3% com-
pounded quarterly, and that amount differs from 6% compounded semi-annually. Take care in studying
future-value and present-value problems to align the interest rate with the appropriate number of periods.
Let’s see how a future-value table like the one in Exhibit B-2 is used. The future value of $1.00
invested at 8% for one year is $1.08 ($1.00 × 1.080, which appears at the junction of the 8% column and
row 1 in the Periods column). The figure 1.080 includes both the principal (1.000) and the compound
interest for one period (0.080).
Appendix B

Suppose you deposit $5,000 in a savings account that pays annual interest of 8%. The account balance
at the end of one year will be $5,400. To compute the future value of $5,000 at 8% for one year, multiply
$5,000 by 1.080 to get $5,400. Now suppose you invest in a 10-year, 8% certificate of deposit (CD). What
will be the future value of the CD at maturity? To compute the future value of $5,000 at 8% for 10 periods,
multiply $5,000 by 2.159 (from Exhibit B-2) to get $10,795. This future value of $10,795 indicates that
$5,000, earning 8% interest compounded annually, grows to $10,795 at the end of 10 years. Using Exhibit
B-2, you can find any present amount’s future value at a particular future date. Future value is especially
helpful for computing the amount of cash you will have on hand for some purpose in the future.

Future Value of an Annuity

In the preceding example, we made an investment of a single amount. Other investments, called
annuities, include multiple investments of an equal periodic amount at fixed intervals over the duration
of the investment. Consider a family investing for a child’s education. The Dietrichs can invest $4,000
annually to accumulate a college fund for 15-year-old Helen. The investment can earn 7% annually until
Helen turns 18—a three-year investment. How much will be available for Helen on the date of the last
investment? Exhibit B-3 shows the compounding—a total future value of $12,860.

Exhibit B-3 | Future Value of an Annuity

Time 0 1 year 2 years 3 years
$4,000 $ 4,580
$4,000 4,280
4,000
$12,860

The first $4,000 invested by the Dietrichs grows to $4,580 over the invest-ment period. The second
amount grows to $4,280, and the third amount stays at $4,000 because it has no time to earn interest. The
sum of the three future values ($4,580 + $4,280 + $4,000) is the future value of the annuity ($12,860),
which can also be computed as follows:

Annual Increase Future Value

End of Year Investment Interest for the Year of Annuity
0 — — — 0
1 $4,000 — $4,000 $ 4,000
2 4,000 + ($4,000 * 0.07 = $280) = 4,280 8,280
3 4,000 + ($8,280 * 0.07 = $580) = 4,580 12,860

These computations are laborious. As with the Future Value of $1 (a lump sum), mathematical tables
ease the strain of calculating annuities. Exhibit B-4, Future Value of Annuity of $1, gives the future value
of a series of investments, each of equal amount, at regular intervals.If you are using a spreadsheet, you can
enter the formula =FV(interest%,periods,-1,0) to obtain the time value factors. For example, =FV(5%,
10,-1,0) will give you 12.578.
What is the future value of an annuity of three investments of $1 each that earn 7%? The answer,
3.215, can be found at the junction of the 7% column and row 3 in Exhibit B-4. This amount can be used to
compute the future value of the investment for Helen’s education, as follows:

Amount of each Future value of annuity of $1 Future value of

* *
periodic investment (Exhibit B-4) investment
$4,000 * 3.215 * $12,860
 Appendix B

Exhibit B-4 | Future Value of Annuity of $1

Future Value of Annuity of $1

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15%

1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100 2.120 2.150
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310 3.374 3.473
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641 4.779 4.993
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6.353 6.742
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716 8.115 8.754
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487 10.089 11.067
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436 12.300 13.727
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579 14.776 16.786
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 17.549 20.304
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531 20.655 24.349
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384 24.133 29.002
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523 28.029 34.352
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975 32.393 40.505
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 37.280 47.580
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950 42.753 55.717
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545 48.884 65.075
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599 55.750 75.836
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159 63.440 88.212
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275 72.052 102.444
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347 133.334 212.793
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.283 136.308 164.494 241.333 434.745

This one-step calculation is much easier than computing the future value of each annual investment
and then summing the individual future values. In this way, you can compute the future value of
any investment consisting of equal periodic amounts at regular intervals. Businesses make periodic
investments to accumulate funds for equipment replacement and other uses—an application of the future
value of an annuity.

Present Value
Often a person knows a future amount and needs to know the related present value. Recall Exhibit B-1, in
which present value and future value are on opposite ends of the same time line. Suppose an investment
promises to pay you $5,000 at the end of one year. How much would you pay now to acquire this
investment? You would be willing to pay the present value of the $5,000 future amount.
Like future value, present value depends on three factors: (1) the amount of payment (or receipt),
(2) the length of time between investment and future receipt (or payment), and (3) the interest rate.
The process of computing a present value is called discounting because the present value is less than
the future value.
In our investment example, the future receipt is $5,000. The investment period is one year. Assume
that you demand an annual interest rate of 10% on your investment. With all three factors specified, you
can compute the present value of $5,000 at 10% for one year:

Future value $5,000

Present value = = = $4,545
1 + Interest rate 1.10
Appendix B

By turning the data around into a future-value problem, we can verify the present-value computation:

Amount invested (present value) .................................................... $4,545

Expected earnings ($4,545 * 0.10)................................................. 455
Amount to be received one year from now (future value)............... $5,000

This example illustrates that present value and future value are based on the same equation:

Future value = Present value * (1 + Interest rate)

Future value
Present value =
1 + Interest rate

If the $5,000 is to be received two years from now, you will pay only $4,132 for the investment, as
shown in Exhibit B-5. By turning the data around, we verify that $4,132 accumulates to $5,000 at 10% for
two years:

Amount invested (present value) .................................................. $4,132

Expected earnings for first year ($4,132 * 0.10)........................... 413
Value of investment after one year ............................................... 4,545
Expected earnings for second year ($4,545 * 0.10) ...................... 455
Amount to be received two years from now (future value) ........... $5,000

Exhibit B-5 | Present Value: An Example

Present Value Future Value

Time 0 1 year 2 years

Retreat in time (discounting)
? $5,000
$4,132 $4,545 $5,000
$4,545 $5,000
= $4,132 = $4,545
1.10 1.10

You would pay $4,132—the present value of $5,000—to receive the $5,000 future amount at the
end of two years at 10% per year. The $868 difference between the amount invested ($4,132) and the
amount to be received ($5,000) is the return on the investment, the sum of the two interest receipts:
$413 1 $455 5 $868.

Present-Value Tables
We have shown the simple formula for computing present value. However, figuring present value “by
hand” for investments spanning many years is time-consuming and presents too many opportunities for
arithmetic errors. Present-value tables ease our work. Let’s re-examine our examples of present value by
using Exhibit B-6, Present Value of $1, given below. If you are using a spreadsheet, you can enter the
formula =PV(interest%,periods,,-1) to obtain the time value factors. For example, =PV(5%, 10,,-1) will
give you 0.614.
For the 10% investment for one year, we find the junction of the 10% column and row 1 in
Exhibit B-6. The figure 0.909 is computed as follows: 1/1.10 5 0.909. This work has been done for us,
and only the present values are given in the table. To figure the present value for $5,000, we multiply
0.909 by $5,000. The result is $4,545, which matches the result we obtained by hand.
For the two-year investment, we read down the 10% column and across row 2. We multiply 0.826
(computed as 0.909/1.10 5 0.826) by $5,000 and get $4,130, which confirms our earlier computation of
$4,132 (the difference is due to rounding in the present-value table). Using the table, we can compute
the present value of any single future amount.
 Appendix B

Exhibit B-6 | Present Value of $1

Present Value of $1

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.893 0.870
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.797 0.756
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.712 0.658
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.636 0.572
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.567 0.497
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.507 0.432
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.452 0.376
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.404 0.327
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.361 0.284
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.322 0.247
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.287 0.215
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.257 0.187
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.229 0.163
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.205 0.141
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.183 0.123
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.163 0.107
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.146 0.093
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.130 0.081
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 0.116 0.070
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.104 0.061
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.059 0.030
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.033 0.015

Present Value of an Annuity

Return to the investment example near the bottom of page 828 of this appendix. That investment provided
the investor with only a single future receipt ($5,000 at the end of two years). Annuity investments provide
multiple receipts of an equal amount at fixed intervals over the investment’s duration.
Consider an investment that promises annual cash receipts of $10,000 to be received at the end of
three years. Assume that you demand a 12% return on your investment. What is the investment’s present
value? That is, what would you pay today to acquire the investment? The investment spans three periods,
and you would pay the sum of three present values. The computation follows.

Present Value Present Value

Annual of $1 at 12% of Annual
Year Cash Receipt (Exhibit B-6) Cash Receipt
1 $10,000 0.893 $ 8,930
2 10,000 0.797 7,970
3 10,000 0.712 7,120
Total present value of investment............... $24,020

The present value of this annuity is $24,020. By paying this amount today, you will receive $10,000 at the
end of each of the three years while earning 12% on your investment.
This example illustrates repetitive computations of the three future amounts, a time-consuming pro-
cess. One way to ease the computational burden is to add the three present values of $1 (0.893 1 0.797 1
0.712) and multiply their sum (2.402) by the annual cash receipt ($10,000) to obtain the present value of
the annuity ($10,000 3 2.402 5 $24,020).
An easier approach is to use a present-value-of-an-annuity table. Exhibit B-7 on the following page
shows the present value of $1 to be received periodically for a given number of periods. The present value
of a three-period annuity at 12% is 2.402 (the junction of row 3 and the 12% column). Thus, $10,000
received annually at the end of each of three years, discounted at 12%, is $24,020 ($10,000 3 2.402),
which is the present value.
Appendix B

Exhibit B-7 | Present Value Annuity of $1

Present Value of Annuity of $1

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 12% 15%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.893 0.870
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 1.690 1.626
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.402 2.283
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 3.037 2.855
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.605 3.352
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.111 3.784
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 4.564 4.160
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 4.968 4.487
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.328 4.772
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.650 5.019
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 5.938 5.234
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.194 5.421
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 6.424 5.583
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 6.628 5.724
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 6.811 5.847
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 6.974 5.954
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 7.120 6.047
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 7.250 6.128
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 7.366 6.198
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514 7.469 6.259
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077 7.843 6.464
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427 8.055 6.566

Using Spreadsheets to Calculate Time Value of Money

Whilst financial tables are useful in performing time value of money calculations, they are limited to the
predetermined columns and rows in the table. If you have a scientific calculator, you could also use the
mathematical formulas to calculate the desired time value factors. However, a more popular (and easier)
method is to use a spreadsheet such as Microsoft Excel to perform your time value of money calculations.
The easiest way to do this is to try it out yourself and compare the results with the factor tables in
earlier exhibits. The two primary functions you will need are the PV (present value) and FV (future value)
functions. Both functions take similar arguments as shown below:

PV function = PV(rate, nper, pmt, fv, type)

FV function = FV(rate, nper, pmt, pv, type)

where: rate is the interest rate per period

nper is the total number of periods
pmt is the known payment/receipt amount (only if calculating annuities)
fv is the known future value amount (only if calculating present value)
pv is the known present value amount (only if calculating future value)
type is 0 for ordinary annuity (default) or 1 for annuity due

Note that the pmt, pv, or fv amounts are usually entered as negative numbers. If you are
calculating PV or FV, remember to “skip” the pmt amount.

For example, the following formulas (functions and arguments) will result in:
Formula examples Meaning Results
= PV (3%, 10,, -1000) PV of a $1,000 future value at 3% in 10 periods 744.09
= FV (3%, 10,, -1000) FV of a $1,000 present value at 3% in 10 periods 1,343.92
= PV (3%, 10, -1000) PVA of a $1,000 annuity at 3% in 10 periods 8,530.20
= FV (3%, 10, -1000) FVA of a $1,000 annuity at 3% in 10 periods 11,463.88
 Appendix B

Present Value of Bonds Payable

The present value of a bond—its market price—is the present value of the future principal amount at
maturity plus the present value of the future stated interest payments. The principal is a single amount to
be paid at maturity. The interest is an annuity because it occurs periodically.
Let’s compute the present value of 9% five-year bonds of Unilever. The face value of the bonds
is $100,000, and they pay 41/2%—stated (cash) interest semi-annually (that is, twice a year).1 At
issuance, the market interest rate is expressed as 10% annually, but it is computed at 5% semiannually.
Therefore, the effective interest rate for each of the 10 semi-annual periods is 5%. We thus use 5% in
computing the present value (PV) of the maturity and of the interest. The market price of these bonds is
$96,149, as follows:

Annual Market Number of Semi-annual

Interest Rate , 2 Interest Payments
PV of principal:
$100,000 * PV of single amount at 5% for 10 periods
$100,000 * 0.614 (Exhibit B-6) ................................................... $61,400
PV of stated (cash) interest:
$100,000 * 0.045 * PV of annuity at 5% for 10 periods
$4,500 * 7.722 (Exhibit B-7) ......................................... 34,749
PV (market price) of bonds .................................................................. $96,149

The market price of the Unilever bonds shows a discount because the contract (stated) interest rate on
the bonds (9%) is less than the market interest rate (10%).
Let’s consider a premium price for the 9% Unilever bonds. Assume that the market interest rate is
8% (rather than 10%) at issuance. The effective interest rate is thus 4% for each of the 10 semi-annual
periods:

Annual Market Number of Semi-annual

Interest Rate , 2 Interest Payments
PV of principal:
$100,000 * PV of single amount at 4% for 10 periods
$100,000 * 0.676 (Exhibit B-6) ................................................... $ 67,600
PV of stated (cash) interest:
$100,000 * 0.045 * PV of annuity at 4% for 10 periods
$4,500 * 8.111 (Exhibit B-7) ......................................... 36,500
PV (market price) of bonds .................................................................. $104,100

We discuss accounting for these bonds on pages 522–534. It may be helpful for you to reread this section
(“Present Value of Bonds Payable”) after you’ve studied those pages.

1
For a definition of stated interest rate, see page 518.
Appendix B

A Closer Look
Can you use a spreadsheet formula to calculate a bond’s issuance price? Yes, but
you will need to utilize both the pmt and fv arguments. You will need to work out the
interest payments (based on the bond’s stated rate) and enter it as pmt, and the bond
face value is entered as fv. Again, remember to use negative signs to ensure the calcu-
lations are correct. There will be slight differences between the results using spread-
sheets and the amounts calculated using present value tables, due to rounding.
Formula examples Meaning Results
= PV (5%, 10, − 4500, PV of a bond payable with interest 96,139.13
−100000) payments of $4,500 and face value of
$100,000 discounted at market rate
of 5% over 10 periods (at a discount)
= PV (4%, 10, − 4500, PV of a bond payable with interest 104,055.45
−100000) payments of $4,500 and face value of
$100,000 discounted at market rate
of 4% over 10 periods (at a premium)

Capital Leases
How does a lessee compute the cost of an asset acquired through a capital lease?2 Consider that the lessee
gets the use of the asset but does not pay for the leased asset in full at the beginning of the lease. A capital
lease is therefore similar to an installment purchase of the leased asset. The lessee must record the leased
asset at the present value of the lease liability. The time value of money must be weighed.
The cost of the asset to the lessee is the sum of any payment made at the beginning of the lease period
plus the present value of the future lease payments. The lease payments are equal amounts occurring at
regular intervals—that is, they are annuity payments.
Consider a 20-year equipment lease that requires 20 annual payments of $10,000 each, with the first
payment due immediately.3 The interest rate in the lease is 10%, and the present value of the 19 future
payments is $83,650 ($10,000 × PV of annuity at 10% for 19 periods, or 8.365 from Exhibit B-7). The
lessee’s cost of the equipment is $93,650 (the sum of the initial payment, $10,000, plus the present value
of the future payments, $83,650). The lessee would base its accounting for the leased asset (and the related
depreciation) and for the lease liability (and the related interest expense) on the cost of the equipment that
we have just computed.

Appendix Problems
PC-1.  For each situation, compute the required amount.
a. Kellogg Corporation is budgeting for the acquisition of land over the next several years. Kellogg
can invest $100,000 today at 9%. How much cash will Kellogg have for land acquisitions at the
end of five years? At the end of six years?
b. Davidson, Inc., is planning to invest $50,000 each year for five years. The company’s investment
adviser believes that Davidson can earn 6% interest without taking on too much risk. What will be
the value of Davidson’s investment on the date of the last deposit if Davidson can earn 6%? If Da-
vidson can earn 8%?

See page 532 for the definition of capital leases.

2

3
This lease is calculated as annuity due where the first payment is made immediately on the signing of the lease. If you
are calculating leases based on ordinary annuity, the first payment will be made at the end of year 1. This will affect PV
calculations.
 Appendix B

PC-2. For each situation, compute the required amount.

a. Intel Corporation operations are generating excess cash that will be invested in a special fund.
During 20X3, Intel invests $5,643,341 in the fund for a planned advertising campaign on a new
product to be released six years later, in 20X9 (i.e. 6 years later). If Intel’s investments can earn
10% each year, how much cash will the company have for the advertising campaign in 20X9?
b. Intel will need $10 million to advertise a new type of chip in 20X9. How much must Intel invest
in 20X3 to have the cash available for the advertising campaign? Intel’s investments can earn 10%
annually.
c. Explain the relationship between your answers to a and b.
PC-3.  Determine the present value of the following notes and bonds:
1. Ten-year bonds payable with maturity value of $500,000 and stated interest rate of 12%, paid
semi-annually. The market rate of interest is 12% at issuance.
2. Same bonds payable as in number 1, but the market interest rate is 14%.
3. Same bonds payable as in number 1, but the market interest rate is 10%.
PC-4.  On December 31, 20X6, when the market interest rate is 8% Libby, Libby, & Short, a partnership,
issues $400,000 of 10-year, 7.25% bonds payable. The bonds pay interest semi-annually.

Requirements
1. Determine the present value of the bonds at issuance.
2. Assume that the bonds are issued at the price computed in Requirement 1. Prepare an effective-inter-
est-method amortization table for the first two semi-annual interest periods.
3. Using the amortization table prepared in Requirement 2, journalize issuance of the bonds and the first
two interest payments and amortization of the bonds.
PC-5.  St. Mere Eglise Children’s Home needs a fleet of vans to transport the children to singing engage-
ments throughout Normandy. Renault offers the vehicles for a single payment of €630,000 due at the end
of four years. Peugeot prices a similar fleet of vans for four annual payments of €150,000 at the end of
each year. The children’s home could borrow the funds at 6%, so this is the appropriate interest rate.
Which company should get the business, Renault or Peugeot? Base your decision on present value, and
give your reason.
PC-6.  American Family Association acquired equipment under a capital lease that requires six annual
lease payments of $40,000. The first payment is due when the lease begins, on January 1, 20X6. Future
payments are due on January 1 of each year of the lease term. The interest rate in the lease is 16%.

Requirement
1. Compute the association’s cost of the equipment.

Answers
PC-1 a.  5 yrs. $153,900 b. 6% $281,850
  6 yrs. $167,700 8% $293,350
PC-2 a. $10,000,000 b. $5,640,000
PC-3 1. $500,100 2. $446,820 3. $562,360
PC-4 1. $379,455 2. Bond
carry. amt. at 12-31-11 $380,838
PC-5 Renault PV €498,960
Peugeot PV €519,750
PC-6 Cost $170,960