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Chapter 4 - Time Value of Money
Chapter 4 - Time Value of Money
PREVIEW OF CHAPTER 6
Intermediate Accounting
IFRS 2nd Edition
Kieso, Weygandt, and Warfield
6-2
6 Accounting and the
Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the 6. Solve future value of ordinary and annuity due
time value of money is relevant. problems.
2. Distinguish between simple and compound 7. Solve present value of ordinary and annuity
interest. due problems.
3. Use appropriate compound interest tables. 8. Solve present value problems related to
deferred annuities and bonds.
4. Identify variables fundamental to solving
interest problems. 9. Apply expected cash flows to present value
measurement.
5. Solve future and present value of 1 problems.
6-3
BASIC TIME VALUE CONCEPTS
6-4 LO 1
BASIC TIME VALUE CONCEPTS
6-5 LO 1
BASIC TIME VALUE CONCEPTS
6-6 LO 1
6 Accounting and the
Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the time 6. Solve future value of ordinary and annuity due
value of money is relevant. problems.
2. Distinguish between simple and 7. Solve present value of ordinary and annuity
compound interest. due problems.
3. Use appropriate compound interest tables. 8. Solve present value problems related to
deferred annuities and bonds.
4. Identify variables fundamental to solving
interest problems. 9. Apply expected cash flows to present value
measurement.
5. Solve future and present value of 1 problems.
6-7
BASIC TIME VALUE CONCEPTS
Simple Interest
◆ Interest computed on the principal only.
Interest = p x i x n
Annual
Interest = $10,000 x .08 x 1
= $800
6-8 LO 2
BASIC TIME VALUE CONCEPTS
Simple Interest
◆ Interest computed on the principal only.
Interest = p x i x n
Total
Interest = $10,000 x .08 x 3
= $2,400
6-9 LO 2
BASIC TIME VALUE CONCEPTS
Simple Interest
◆ Interest computed on the principal only.
Interest = p x i x n
Partial
Year = $10,000 x .08 x 3/12
= $200
6-10 LO 2
6 Accounting and the
Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the time 6. Solve future value of ordinary and annuity due
value of money is relevant. problems.
2. Distinguish between simple and compound 7. Solve present value of ordinary and annuity
interest. due problems.
4. Identify variables fundamental to solving 9. Apply expected cash flows to present value
interest problems. measurement.
6-11
BASIC TIME VALUE CONCEPTS
Compound Interest
◆ Computes interest on
► principal and
► interest earned that has not been paid or withdrawn.
6-12 LO 3
Compound Interest
Illustration: Tomalczyk Company deposits $10,000 in the Last National
Bank, where it will earn simple interest of 9% per year. It deposits another
$10,000 in the First State Bank, where it will earn compound interest of
9% per year compounded annually. In both cases, Tomalczyk will not
withdraw any interest until 3 years from the date of deposit.
ILLUSTRATION 6-1
Simple vs. Compound Interest
6-13 LO 3
WHAT’S
A PRETTYYOUR PRINCIPLE
GOOD START
6-14 LO 3
BASIC TIME VALUE CONCEPTS
6-15 LO 3
BASIC TIME VALUE CONCEPTS
6-16 LO 3
BASIC TIME VALUE CONCEPTS
Where:
6-17 LO 3
BASIC TIME VALUE CONCEPTS
6-18 LO 3
BASIC TIME VALUE CONCEPTS
6-19 LO 3
BASIC TIME VALUE CONCEPTS
6-20 LO 3
6 Accounting and the
Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the time 6. Solve future value of ordinary and annuity due
value of money is relevant. problems.
2. Distinguish between simple and compound 7. Solve present value of ordinary and annuity
interest. due problems.
3. Use appropriate compound interest tables. 8. Solve present value problems related to
deferred annuities and bonds.
4. Identify variables fundamental to
solving interest problems. 9. Apply expected cash flows to present value
measurement.
5. Solve future and present value of 1 problems.
6-21
BASIC TIME VALUE CONCEPTS
Fundamental Variables
◆ Rate of Interest ◆ Future Value
◆ Number of Time Periods ◆ Present Value
ILLUSTRATION 6-6
Basic Time Diagram
6-22 LO 4
6 Accounting and the
Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the time 6. Solve future value of ordinary and annuity due
value of money is relevant. problems.
2. Distinguish between simple and compound 7. Solve present value of ordinary and annuity
interest. due problems.
3. Use appropriate compound interest tables. 8. Solve present value problems related to
deferred annuities and bonds.
4. Identify variables fundamental to solving
interest problems. 9. Apply expected cash flows to present value
measurement.
5. Solve future and present value of 1
problems.
6-23
SINGLE-SUM PROBLEMS
Two Categories
ILLUSTRATION 6-6
Basic Time Diagram
6-24 LO 5
SINGLE-SUM PROBLEMS
Where:
FV = future value
PV = present value (principal or single sum)
FVF n,i = future value factor for n periods at i interest
6-25 LO 5
Future Value of a Single Sum
ILLUSTRATION 6-7
Future Value Time
Diagram (n = 5, i = 11%)
= €84,253
6-26 LO 5
Future Value of a Single Sum Alternate
Calculation
ILLUSTRATION 6-7
Future Value Time
Diagram (n = 5, i = 11%)
What table
do we use?
6-27 LO 5
Future Value of a Single Sum Alternate
Calculation
i=11%
n=5
6-28 LO 5
Future Value of a Single Sum
ILLUSTRATION 6-8
Future Value Time
Diagram (n = 8, i = 5%)
What table do we use?
6-29 LO 5
Future Value of a Single Sum
i=5%
n=8
6-30 LO 5
SINGLE-SUM PROBLEMS
Where:
PVFn,i = present value factor for n periods at i interest
n = number of periods
i = rate of interest for a single period
6-31 LO 5
Present Value of a Single Sum
6-32 LO 5
Present Value of a Single Sum
ILLUSTRATION 6-9
Excerpt from Table 6-2
6-33 LO 5
Present Value of a Single Sum
Where:
FV = future value
PV = present value
PVF n,i = present value factor for n periods at i interest
6-34 LO 5
Present Value of a Single Sum
ILLUSTRATION 6-11
Present Value Time
Diagram (n = 5, i = 11%)
= €50,000
6-35 LO 5
Present Value of a Single Sum Alternate
Calculation
ILLUSTRATION 6-11
Present Value Time
Diagram (n = 5, i = 11%)
6-36 LO 5
Present Value of a Single Sum
i=11%
n=5
What factor?
6-37 LO 5
Present Value of a Single Sum
ILLUSTRATION 6-12
Present Value Time
Diagram (n = 3, i = 8%) What table do we use?
6-38 LO 5
Present Value of a Single Sum
i=8%
n=3
What factor?
6-39 LO 5
SINGLE-SUM PROBLEMS
6-40 LO 5
Solving for Other Unknowns
6-41 LO 5
Solving for Other Unknowns
6-42 LO 5
Solving for Other Unknowns
6-43 LO 5
Solving for Other Unknowns
6-44 LO 5
Solving for Other Unknowns
6-45 LO 5
6 Accounting and the
Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the time 6. Solve future value of ordinary and
value of money is relevant. annuity due problems.
2. Distinguish between simple and compound 7. Solve present value of ordinary and annuity
interest. due problems.
3. Use appropriate compound interest tables. 8. Solve present value problems related to
4. Identify variables fundamental to solving deferred annuities and bonds.
interest problems. 9. Apply expected cash flows to present value
5. Solve future and present value of 1 problems. measurement.
6-46
ANNUITIES
Annuity requires:
(1) Periodic payments or receipts (called rents) of the
same amount,
6-47 LO 6
ANNUITIES
0 1 2 3 4 5 6 7 8
6-48 LO 6
Future Value of an Ordinary Annuity
6-49 LO 6
Future Value of an Ordinary Annuity
*Note that this annuity table factor is the same as the sum of
the future values of 1 factors shown in Illustration 6-17.
6-50 LO 6
Future Value of an Ordinary Annuity
Where:
R = periodic rent
FVF-OA n,i = future value factor of an ordinary annuity
i = rate of interest per period
n = number of compounding periods
6-51 LO 6
Future Value of an Ordinary Annuity
= $31,764.25
ILLUSTRATION 6-19
Time Diagram for Future
Value of Ordinary
Annuity (n = 5, i = 12%)
6-52 LO 6
Future Value of an Ordinary Annuity
Alternate
Calculation
i=12%
n=5
What factor?
6-54 LO 6
Future Value of an Ordinary Annuity
0 1 2 3 4 5 6 7 8
6-55 LO 6
Future Value of an Ordinary Annuity
i=12%
n=8
6-56 LO 6
ANNUITIES
0 1 2 3 4 5 6 7 8
6-57 LO 6
Future Value of an Annuity Due
6-58 LO 6
Future Value of an Annuity Due
Computation of Rent
Illustration: Assume that you plan to accumulate CHF14,000 for a
down payment on a condominium apartment 5 years from now. For
the next 5 years, you earn an annual return of 8% compounded
semiannually. How much should you deposit at the end of each 6-
month period?
ILLUSTRATION 6-24
R = CHF1,166.07
6-59 LO 6
Future Value of an Annuity Due Alternate
Calculation
ILLUSTRATION 6-24
Computation of Rent
CHF14,000
= CHF1,166.07
12.00611
6-60 LO 6
Future Value of an Annuity Due
ILLUSTRATION 6-25
5.86660
6-61 LO 6
Future Value of an Annuity Due
6-62 LO 6
Future Value of an Annuity Due
Present Value
Future Value
0 1 2 3 4 5 6 7 8
6-63 LO 6
Future Value of an Annuity Due
i=12%
n=8
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the time 6. Solve future value of ordinary and annuity due
value of money is relevant. problems.
2. Distinguish between simple and compound 7. Solve present value of ordinary and
interest. annuity due problems.
3. Use appropriate compound interest tables. 8. Solve present value problems related to
4. Identify variables fundamental to solving deferred annuities and bonds.
interest problems. 9. Apply expected cash flows to present value
5. Solve future and present value of 1 problems. measurement.
6-65
ANNUITIES
Present Value
6-66 LO 7
Present Value of an Ordinary Annuity
6-67 LO 7
Present Value of an Ordinary Annuity
Where:
6-68 LO 7
Present Value of an Ordinary Annuity
6-69 LO 7
Present Value of an Ordinary Annuity
Present Value
6-70 LO 7
Present Value of an Ordinary Annuity
i=8%
n=20
6-71 LO 7
WHAT’S
UP YOUR
IN SMOKE PRINCIPLE
Time value of money concepts also can be equal amounts (e.g., an annuity), the present
relevant to public policy debates. For example, value of the tobacco payment is:
many governments must evaluate the financial $5.6 billion ÷ 25 = $224 million
cost-benefit of selling to a private operator the
future cash flows associated with government-run $224 million X 10.67478* = $2.39 billion
services, such as toll roads and bridges. In these *PV-OA (i = 8%, n = 25)
cases, the policymaker must estimate the present Why would the government be willing to take just
value of the future cash flows in determining the $1.26 billion today for an annuity whose present
price for selling the rights. In another example, value is almost twice that amount? One reason is
some governmental entities had to determine how that the governmental entity was facing a hole in
to receive the payments from tobacco companies its budget that could be plugged in part by the
as settlement for a national lawsuit against the lump-sum payment. Also, some believed that the
companies for the healthcare costs of smoking. In risk of not getting paid by the tobacco companies
one situation, a governmental entity was due to in the future makes it prudent to get the money
collect 25 years of payments totaling $5.6 billion. earlier. If this latter reason has merit, then the
The government could wait to collect the present value computation above should have
payments, or it could sell the payments to an been based on a higher interest rate. Assuming a
investment bank (a process called securitization). discount rate of 15%, the present value of the
If it were to sell the payments, it would receive a annuity is $1.448 billion ($5.6 billion ÷ 25 = $224
lump-sum payment today of $1.26 billion. Is this a million; $224 million x 6.46415), which is much
good deal for this governmental entity? Assuming closer to the lump-sum payment offered to the
a discount rate of 8% and that the payments will governmental entity.
be received in
6-72 LO 7
ANNUITIES
Present Value
6-73 LO 7
Present Value of an Annuity Due
6-74 LO 7
Present Value of an Annuity Due
6-75 LO 7
Present Value of Annuity Problems
Present Value
6-76 LO 7
Present Value of Annuity Problems
i=8%
n=20
6-77 LO 7
Present Value of Annuity Problems
Referring to Table 6-4 and reading across the 12-period row, you find 10.57534 in
the 2% column. Since 2% is a monthly rate, the nominal annual rate of interest is
12
24% (12 x 2%). The effective annual rate is 26.82413% [(1 + .02) - 1].
6-78 LO 7
Present Value of Annuity Problems
12
6-79 LO 7
6 Accounting and the
Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the time 6. Solve future value of ordinary and annuity due
value of money is relevant. problems.
2. Distinguish between simple and compound 7. Solve present value of ordinary and annuity
interest. due problems.
3. Use appropriate compound interest tables. 8. Solve present value problems related
4. Identify variables fundamental to solving to deferred annuities and bonds.
interest problems. 9. Apply expected cash flows to present value
5. Solve future and present value of 1 problems. measurement.
6-80
MORE COMPLEX SITUATIONS
Deferred Annuities
◆ Rents begin after a specified number of periods.
◆ Future Value of a Deferred Annuity - Calculation same
as the future value of an annuity not deferred.
◆ Present Value of a Deferred Annuity - Must recognize
the interest that accrues during the deferral period.
Future Value
Present Value
100,000 100,000 100,000
.....
0 1 2 3 4 19 20
6-81 LO 8
MORE COMPLEX SITUATIONS
ILLUSTRATION 6-37
6-82 LO 8
MORE COMPLEX SITUATIONS
6-83 LO 8
Present Value of Deferred Annuity
ILLUSTRATION 6-38
6-84 LO 8
Present Value of Deferred Annuity
6-85 LO 8
MORE COMPLEX SITUATIONS
2,000,000
6-86 LO 8
Valuation of Long-Term Bonds
Present Value
6-87 LO 8
Valuation of Long-Term Bonds i=8%
n=10
PV of Interest
6-88 LO 8
Valuation of Long-Term Bonds i=8%
n=10
PV of Principal
6-89 LO 8
Valuation of Long-Term Bonds
6-90 LO 8
Valuation of Long-Term Bonds
* rounding
6-91 LO 8
6 Accounting and the
Time Value of Money
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. Identify accounting topics where the time 6. Solve future value of ordinary and annuity due
value of money is relevant. problems.
2. Distinguish between simple and compound 7. Solve present value of ordinary and annuity
interest. due problems.
3. Use appropriate compound interest tables. 8. Solve present value problems related to
deferred annuities and bonds.
4. Identify variables fundamental to solving
interest problems. 9. Apply expected cash flows to present
5. Solve future and present value of 1 problems. value measurement.
6-92
PRESENT VALUE MEASUREMENT
6-93 LO 9
PRESENT VALUE MEASUREMENT
E6-21: Angela Contreras is trying to determine the amount
to set aside so that she will have enough money on hand in 2 years to
overhaul the engine on her vintage used car. While there is some
uncertainty about the cost of engine overhauls in 2 years, by conducting
some research online, Angela has developed the following estimates.
6-94 LO 9
PRESENT VALUE MEASUREMENT
Instructions: How much should Angela Contreras deposit today in an
account earning 6%, compounded annually, so that she will have enough
money on hand in 2 years to pay for the overhaul?
6-95 LO 9
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6-96