Compound Interest, Future

Value, and Present Value

When money is borrowed, the amount
borrowed is known as the loan principal.
For the borrower, interest is the cost of using the
principal.

Investing money is the same as

making a loan.
The interest received is the return
on the investment.

Compound Interest, Future

Value, and Present Value
Calculating the amount of interest depends on the
interest rate and the interest period.
Types of interest:
Simple interest - the interest rate multiplied by an
unchanging principal amount
Compound interest - the interest rate multiplied by a
changing principal amount
The unpaid interest is added to the principal balance and becomes
part of the new principal balance for the next interest period.

Future Value
Future value - the amount accumulated over
time, including principal and interest
For example, if a person lets $10,000 sit in a
bank account that pays 10% interest per year for
3 years, the future value of the $10,000 is
$13,310 and is determined as follows:
Year 1:
Year 2:
Year 3:

$10,000 x 1.10 = $11,000

$11,000 x 1.10 = $12,100
$12,100 x 1.10 = $13,310

Future Value
The general formula for computing the
future value (FV) of S dollars in n years at
interest rate i is:

FV S (1 i )

n refers to the number of periods the funds are invested. The

interest rate must be stated consistently with the time period.

Future Value
The calculations for future values can be
very tedious. Most people use future value
tables to determine future values.
In the table, each number is the solution to the
expression (1 + i)n.
The value of i is given in the column heading.
The value of n is given in the row label for the
number of periods.

Future Value
To how much will $25,000 grow if left in the
bank for 20 years at 6% interest?
The answer is determined as follows:
$25,000 x 3.2071* = $80,177.50
*3.2071 is the future value factor for 20 periods at 6%
interest.

Present Value
Present value - the value today of a future cash
inflow or outflow
Present value calculations are the reverse of
future value calculations.
In future value calculations, you determine how much
money you will have at a date in the future given a
certain interest rate.
In present value calculations, you determine how
much must be invested today given a certain interest
rate to get to how much money you want in the future.

Present Value
For example, if $1.00 is to be received in
one year and the interest rate is 6%, you
will have to invest $0.9434 ($1.00 / 1.06).
Thus, $0.9434 is the present value of $1.00 to
be received in one year at 6% interest.

Present Value
The general formula for the present value
(PV) of a future value (FV) to be received
or paid in n periods at an interest rate of i
per period is:

FV
PV
n
(1 i )

Present Value
Just as with future values, tables can be
helpful in determining the present value of
amounts.
In the table, each number is the solution to the
expression 1/(1 + i)n.
The value of i is given in the column heading.
The value of n is given in the row label for the
number of periods.

Present Value
Interest rates are sometimes called discount
rates in calculations involving present values.
Present values are also called discounted
values, and the process of finding the present
value is discounting.
Present values can be thought of as decreasing
the value of a future cash inflow or outflow
because
the cash is to be received or paid
in the future, not today.

Present Value
A city wants to issue $100,000 of noninterest-bearing bonds to be repaid in a lump
sum in 5 years. How much should investors
be willing to pay for the bonds if they require
a 10% return on their investment?
$100,000 x .6209* = $62,090
*.6209 is the present value of $1 factor for 5 years at 10%
interest.

Present Value
Remember to pay attention to the number
of periods. Interest is often compounded
semiannually instead of annually.
If interest is compounded semiannually, the
number of periods is twice the number of years,
and the interest rate is one-half of the annual
interest rate.
In the previous example, if interest were
compounded semiannually, the number of periods
is 10 instead of 5, and the interest rate is 5%
instead of 10%.

Present Value of an Ordinary Annuity

Annuity - a series of equal cash flows to
take place during successive periods of
equal length
The present value of an annuity is the sum
of the present values of each cash receipt or
payment.
If a note has a series of payments, its present
value can be determined by finding the present
value of each payment and adding those present
values together.

Present Value of an Ordinary Annuity

Again, tables can be helpful in determining
the present value of an ordinary annuity.
The factors in a present value of an annuity
table are merely the cumulative sum of the
present value of $1 factors in the present value
of $1 table for the number of annuity periods.
The present value of an ordinary annuity tables
are especially helpful if the cash payments or
receipts extend into the future over many periods.

Present Value of an Ordinary Annuity

A city wants to issue $1,000,000 of noninterest-bearing bonds to be repaid
$100,000 per year for 10 years. How much
should investors be willing to pay for the
bonds if they require a 10% return on their
investment?
$100,000 x 6.1446* = $614,460
*6.1446 is the present value of an annuity of $1 for 10
periods at 10% interest.

Present Value of an
Ordinary Annuity
Notice that the higher the interest rate, the
lower the present value factor.
This occurs because at higher
interest rates, less must be invested
to obtain the same stream of future
annuity payments or a certain
amount in the future.

Valuing Bonds
Because bonds create cash flows in future periods,
they are recorded at the present value of those future
payments, discounted at the market interest rate in
effect when the liability is created.
Bond - formal certificate of indebtedness that is
typically accompanied by:
A promise to pay interest in cash at a specified annual
rate plus
A promise to pay the principal at a specific maturity date

Valuing Bonds

When valuing bonds, the present value tables are

used to determine the amount of proceeds that
will be received.
The present value of $1 table is used to determine the
present value of the face amount of the bonds.
The present value of an annuity of $1 is used to
determine the present value of the series of interest
payments.
The amounts are added together to determine the
amount of proceeds and any premium or discount.

Valuing Bonds

Discount on bonds - occurs when the market

interest rate is greater than the coupon rate.
Premium on bonds - occurs when the market
interest rate is less than the coupon rate.

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Valuing Bonds
A company issues $20,000,000 of 5-year
bonds with a coupon rate of 7%. Interest is
to be paid semiannually on June 30 and
December 31 of each year. At the time of
the issuance, the market rate is 10%. What
is the amount of the proceeds and any
premium or discount on the bonds?

Valuing Bonds
To determine the proceeds:
$20,000,000 x .6139* = $12,278,000
$700,000 x 7.7217* = 5,405,190
$17,683,190
===============================

($700,000 = ($20,000,000 x 7%) / 2)

*PV factors are for 10 periods at 5%

The company will receive $17,683,190 upon

issuance.
The bonds are issued at a discount of $2,316,810.

Bonds Issued at a Discount

When bonds are issued at at discount, the
amount of proceeds received from the
issuance is less than the actual liability.
The difference must be recorded in a separate
account on the books.
Cash

17,683,190

Discount on bonds payable

Bonds payable

2,316,810
20,000,000

Bonds Issued at a Discount

The discount on bonds payable is a contra
account; it is deducted from bonds payable.
Balance sheet presentation:
Bonds payable, 7%
Deduct: Discount on bonds payable
Net liability

$ 20,000,000
2,316,810
$ 17,683,190
============================

Bonds Issued at a Discount

For bonds issued at a discount, the discount can be
thought of as a second interest amount payable to the
investors at the maturity date.
Rather than recognizing the extra interest expense
all at once upon maturity, the issuer should spread
the extra interest over the life of the bonds.
This is accomplished by discount amortization.
The amortization of a discount increases the interest
expense of the issuer at each cash interest payment
date, but it has no effect on cash paid.

Bonds Issued at a Discount

Discount amortization can be calculated using
two methods.
Straight-line amortization
The amortization of the discount is an equal amount each
period, but the effective interest rate is different each period.

Effective-interest amortization
The effective interest rate is the same each period, but the
amortization of the discount is a different amount each
period.

Bonds Issued at a Discount

Amortization using the effective-interest
method:
For each period, interest expense is equal to the
carrying value of the debt multiplied by the
market rate of interest in effect when the bond
was issued.
The cash interest payment is the coupon rate
times the face amount of the bonds.
The difference between the interest expense and
the cash interest payment is the amount of
discount amortization for the period.

Bonds Issued at a Discount

Journal entries:
To record the issuance of the bonds:
Cash
xxxxxx
Discount on bonds payable
Bonds payable
xxxxxx

xxxx

To record the payment of interest and discount amortization:

Interest expense (Carrying value x Market rate)
Discount on bonds payable
Cash (Face value x Coupon rate)
xxx

xxx
xx

Bonds Issued at a Premium

Accounting for bonds issued at a premium
is just the opposite of accounting for bonds
issued at a discount.
The cash proceeds exceed the face amount.
The amount of the contra account Premium on
Bonds Payable is added to the face amount to
determine the net liability reported in the
balance sheet.
The amortization of bond premium decreases
the interest expense to the issuer.

Bonds Issued at a Premium

A company issues $20,000,000 of 5-year
bonds with a coupon rate of 7%. Interest is
to be paid semiannually on June 30 and
December 31 of each year. At the time of
the issuance, the market rate is 6%. What is
the amount of the proceeds and any
premium or discount on the bonds?

Bonds Issued at a Premium

To determine the proceeds:
$20,000,000 x .7441* = $14,882,000
$700,000 x 8.5302* =
$20,853,140

5,971,140

===========================

($700,000 = ($20,000,000 x 7%) / 2)

*PV factors are for 10 periods at 3%

The company will receive $20,853,140 upon

issuance.
The bonds are issued at a premium of $853,140.

Early Extinguishment
When a company redeems its own bonds
before the maturity date, the transaction is
called an early extinguishment.
Early extinguishment usually results in a gain or
loss to the company redeeming the bonds.
The gain or loss is the difference between the cash
paid and the net carrying amount (face amount
less unamortized discount or plus unamortized
premium) of the bonds.

Early Extinguishment
Allen Company purchased all of its bonds
on the open market at 98. The bonds have a
face amount of $100,000 and a $12,000
unamortized discount. Determine any gain
or loss on the early extinguishment, and
prepare the journal entries to record the
transaction.

Early Extinguishment
Carrying amount:
Face value
$100,000
Deduct: Unamortized discount
12,000
$88,000
Cash required ($100,000 x 98%)
98,000
Loss on early extinguishment
$10,000
==================

Bonds payable
Loss on early extinguishment
Cash
Discount on bonds payable

100,000
10,000
98,000
12,000

Accounting for Leases

Lease - a contract whereby an owner
(lessor) grants the use of property to a
second party (lessee) for rental payments
Some leases are recorded simply as if one party
is renting property from another.
Other leases are recorded as liabilities
and assets when the lease contract is
signed.

Operating and Capital Leases

Capital lease - a lease that transfers
substantially all the risks and benefits of
ownership to the lessee
They are the same as installment sales which
provide for payments over time along with
interest.
The leased item must be
recorded as if it were sold by the lessor and
purchased
by the lessee.

Operating and Capital Leases

Operating lease - a lease that should be
accounted for by the lessee as ordinary
rental expenses; any lease other than a
capital lease
Examples include rental of an apartment or
rental of a car on a daily basis.

Operating and Capital Leases

Differences in accounting for operating and
capital leases:
Operating - treat as rental expense
Rent expense
Cash xxx

xxx

Capital - treat as if the lessee borrowed the money

and purchased the leased asset
Leased property xxxx
Capital lease liability xxxx

Differences in Income Statements

The major difference in the income statements for
a capital lease and an operating lease is the timing
of the expenses.
A capital lease tends to bunch heavier charges
in the early years. These charges are the
amortization of the lease plus the interest factor.
An operating lease records the payments
directly as expenses, generally in a straight-line
manner.
For comparable leases, the total expenses are
the same.

Criteria for Capital Leases

Before GAAP established criteria for leases
to be classified as capital leases, many
companies were keeping off balance sheet
financing by treating noncancellable leases
as monthly rentals.
These leases created assets and
liabilities that the companies
were not recognizing.

Criteria for Capital Leases

Under GAAP, a capital lease exists if one or more
of the following conditions are met:
Title to the leased property is transferred to the lessee
by the end of the lease term.
An inexpensive purchase option is available to the
lessee at the end of the lease.
The lease term equals or exceeds 75% of the estimated
economic life of the property.
At the start of the lease, the present value of minimum
lease payments is at least 90% of the propertys fair
value.