time value of money

Have you studied the text for this topic?

Question?
Would a business expect to pay the same for a machine purchased and paid for today, as the same machine acquired today but not paid for for two years?

Definition of Interest

Simple Interest

Compound Interest
Interest

earned (simple interest formula) is left in bank and added to the original principal next simple interest calculation thus uses a larger P keeps growing each period

The

Result

is that money grows exponentially instead of linearly with compound interest

Graphical View of Simple vs Compound

$$$ Compound Interest

Simple Interest

Time

Application of compound interest

Power of Compounding
Example given in your text. Put $2000/yr in RRSP starting at age 25 instead of 35 ( an extra $20,000 of deposits) You will have an extra $300,000* of accumulated wealth at age 65

* Exact amount depends on the interest rate and

frequency of compounding

Interest on Interest Illustrated Assume $1 invested at 10% for a year Applying Simple interest formula
I = Prt I = ($1) (.10) (1) I = 10 cents
Applying

at end of year 2

I = ($1.10) (.10) (1) I = 11 cents

This extra cent is HUGE! It represents interest on interest and is the secret of compound interest

c
$1.10 $1.21 $1.33 $1.46 Extend the calculations for 5 more years: Look how interest increases each year $1.61 $1.77 $1.94

c c c c c c

Results Compared

Money doubles in approximately

Rule of 72

(72)
( interest %)

years

Question:
If $18,000 is invested to earn 8% compounded quarterly How much will the investment be worth at the end of 6 years? Question type = FV of a single amount

The Time Line

FV of $18,000 single amount in 6 years, money worth 8%, quarterly compounding)

PV = $18,000 t=0

FV = $28,951.20 t = 24

If we use the simple interest formula Lots of figuring.

$18,000 x 2% = $360 $18,360 x 2% = $367.20 $18,727.20 x 2% Etc Etc Etc 24 separate calculations required using I=Prt ......... Bah humbug!!!! Eventually get a result of $28,951.20 Most of you would not.high risk or clerical error

The Compound Interest Formula

The Compound Interest Formula

Pretty neat...........but requires scientific/business calculator to do exponents
Note

that 8% interest rate given = always by definition an annual (or effective) interest rate We needed to express it in same time frame as compounding period (a quarter) = 8/4 = 2 Note also n = number of compounding periods & not number of years

(1+r)n..bah humbug

Table for (1+r)n on Page 18

Zero in on 2nd column and 24th row

n r

1%

2%

3%

1 2 23 24

1.6084

Next StepMove from one amount to multiple cash flows..an annuity

DEFINTIONAn identical stream of cash flows (payment or receipt) made each compounding period
Often

called the periodic rent

Future value of an annuity

Question: If we invest $1,000 at the end of each of the next 4 years at 10% can we afford to retire to a beach?

Time Line
Question: If we invest $1,000 at the end of each of the next 4 years at 10% can we afford to retire to a beach?

$1000

$1000

$1000

$1000

t=0

t=1

t=2

t=3

t=4

$1 invested at the end of each of the next four years at 10% will be $4.64 at the end of the four years.

End Period 1 Period 2 Period 3 Period 4

c c
$2.10 $3.31

c
$4.64*

How do we get the $3.31? There is $2.10 sitting all through period 3 earning interest at 10% =21 cents + an additional deposit of $1. So $2.10 + 0.21 + $1 = $3.31

Choices

FV of Annuity Tablepage 20 of Module 8

Using the table

Question: If we invest $1,000 at the end of each of the next 4 years at 10% can we afford to retire to a beach? Rent = $1000 r = .10 n=4 Factor from intersection of 10% column and n = 4 row = 4.6410

FV = rent x factor = $1000 x 4.6410 = $4,641

Future value of an annuitythe power of compounding kicks in as number of compounding periods increases

Present Value
We

have now looked at FV of a single amount and FV of an annuity Next we look at PV of a single amount and PV of an annuity PV is the amount at time zero

Present Value of a single amount

New Question: How much must be invested now so as to have $30,000 five years from now, if the interest rate is 8% compounded semiannually?

Time Line
Question: How much must be invested now so as to have $30,000 five years from now, if the interest rate is 8% compounded semi-annually? Required deposit at t0 = PV = ??? $30,000 accumulation at t10 = FV
t = 10

t=0

t=1

t=9

Present Value of single amount formula

PV = FV (1 + r )n
PV = $30,000 / (1.04)10 PV = $20,267 Notice this is the same formula as before but with PV isolated instead of FV

Present Value TablePage 19

Present Value using factors

Question: How much must be invested now so as to have $30,000 five years from now, if the interest rate is 8% compounded semi-annually?

FV = 30,000 PV = ? R = .04 T = 10

Solution: $30,000 x .67556 (present value of $1 for 10 periods @ 4%) = $20,267

Accounting application
What would we capitalize an asset at (the debit in the G/L) for if.. we agree to pay $30,000 in five years for an it when interest rates are 8% compounded semiannually

Accounting application
Solution: $20,267 its present value (not the future value of $30,000)

Asset and Liability Valuation

When

time periods are short (less than one year), the time value of money is often ignored. time periods are longer, assets and liabilities are valued at the present value of the future payments

When

Discount
When the present value is LESS than the amount which will ultimately be paid/received the difference is a discount Dr Asset $20,267 Dr Discount on Note Payable $9,733 Cr Note Payable $30,000 Discount is a contra account the Note Payable would be valued as a $20,267 liability initially

Discount is reduced as time passes .

Interest expense for the first six month period Dr Interest Expense $811 Cr Discount $811 ($20,267 x 4% = 811)

Discount amortization using the effective interest method

Another Accounting Question:

What is the journal entry to record the acquisition of a machine when the vendor agrees to wait 4 years for $150,000 payment ? interest rates are 10% and money compounded annually.

Question:
What is the journal entry to record the acquisition of a machine when the vendor agrees to wait 4 years for $150,000 payment interest rates are 10%

Solution: Dr Machine $102,452 Dr Discount $ 47,548 Cr Note Payable $150,000

Discount amortization

What if the payment terms are different..

Business often negotiates installment payments or leases instead of agreeing to a single large payment at the end of a long period of time How much would four annual payments need to be.. to make the deal equivalent to a cash payment now of $102,452 (or $150,000 in 4 years)?

Time Line
How much would four annual payments need to be.. to make the deal equivalent to a cash payment now of $102,452 (or $150,000 in 4 years)?

Pmt = ?

Pmt = ?

Pmt = ?

Pmt = ?

t=0

t=1

t=2

t=3

t=4

PV = $102, 452

FV = $150,000

End Period 1

Recall this slide from earlier.the FV of an annuity is the rent x 4.6410

Period 2

Period 3

Period 4

c c
$2.10 $3.31

c
$4.64*

$1 invested at the end of each of the next four years at 10% will be $4.64 at the end of the four years.

$4.64 is the future value of an ordinary annuity

Relationship between FV and PV

if the FV = (periodic rent) x (annuity factor) Then rearranging the equation gives:

Rent = FV / annuity factor Rent = $150,000 / 4.6410 Rent = $32,321

Present value of an annuity

End Period 1 Period 2 Present Value of an annuity is single amount to invest today which has same future value * as an annuity $2.10 $3.31 Period 3 Period 4

c c c
$4.64*

c c
$3.49 Invest $1 at end of four years at 10% $3.84 $4.22

$4.64*

Formula for PV of Annuity

PV = (rent) x 1 - (1+r)-n r

Question: If assets and liabilities are valued at their present value what is the present value of an annuity of $32,321 for 4 years when rates are 10%?

PV = ($32,321) x 3.16986 PV = $102,453

PV of Annuity TablePage 21

PV of an annuityusing factor

Amortization table for an annuity of payments separating payments into repayments of principal and interest component

($102,453 - $22,076 = $80,377)

The Ordinary Annuity (in arrears) vs the Annuity Due

Look at our Time Line

If payments start one period earlier then there is effectively one more full period for compounding to occur
Pmt Pmt Pmt Pmt

t=0

t=1

t=2

t=3

t=4

Annuities Due
We will leave this topic until intermediate accounting

You should note that PV or NPV (net present value) as it is often called Is taught in Finance, Math and numerous other courses because it is a universally useful concept Study it well as business studentsyou will encounter it time and time again

Solving Time Value Problems

1. Asking for FV or PV? 2. Single amount or annuity? 3. Identify r and n in equivalent time frames 4. Find right table and right factor

Complex Problem
Fred

Flintstone is 62 years old and wishes to deposit equal amounts at the end of his 63rd, 64th and 65th years so that starting at age 65 he can withdraw $5,000 per year for ten years. Money is worth 8%

Complex Problem solved

The

trick is to realize there are two different calculations involved First translate the ten year annuity of $5,000 pmts into the PV at age 65 Second find what annuity payments have a FV equivalent to that amount (the PV)

Complex Problem solved

Factor for PV of Annuity (n = 10, r = 8) = 6.71008 PV = ($5,000) x 6.71008 = $33,550

FV = rent x (FV factor for annuity) $33,550 = rent x (3.2464) Rent = $33,550/3.2464 = $10,335

If Fred deposits $10,335 for next 3 years at 8%, he can withdraw $5,000 a year for 10 years.

Another Problem

Your mother put $1,000 a year in the bank starting ten years ago to fund your college education. Money is worth 12%. How much can she give you today?

FV = rent x factor for FV of annuity FV = 1,000 x (17.54874) FV = $17,549 Better get a part time job

Key Topics Module 8

Basic concept of the time value of money Simple Interest Compound Interest Future Value vs Present Value Time Lines to analyze problems Single amounts vs Annuities Formulas vs Tables Ordinary Annuities ($1 in Arrears) vs Annuities Due Accounting Applications of PV

Still awake??? Time to go home!!!