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Accounting 490

Professor Jeff Harkins


9/13/2016

The Time Value of Money


Interest, the time value of money, implicitly derives from an individuals preference for
current consumption over future consumption. People prefer current consumption
because people have present wants and needs and because there is a risk that they might
not be around in the future if they forego consumption today. However, people will
forego consumption today, if they are rewarded for doing so. The reward, which we will
call interest, must reimburse the individual who sacrifices todays consumption for the
uncertainty associated with the deferral of present consumption. The model for evaluating
the present and future values of monetary transactions is built from this basic need for a
reward to sacrifice todays consumption.
In accounting and finance, the time value of money is used to measure and evaluate many
business and economic transactions, including:

accounts and notes receivable


accounts and notes payable
long-term capital assets
stocks, bonds and other securities
long-term leases
pensions and retirement plans
investment analysis
depreciation
business combinations
capital budgeting decisions
mergers and acquisitions

It is important that students of business, especially accounting and finance students, be


comfortable with techniques for evaluating financial transactions using time value of
money techniques.

Future Values and Present Values


For an introduction to the basic structure and technique of determining the time value of
money, consider that you have deposited $1,000 in a savings account at the bank today
and that you will leave the money with the bank for one year. You might ask yourself if
you would be willing to leave the money with the bank for the year, then at the end of the
year, withdraw the funds ($1,000), with no additional compensation. If not, why not?
Reflecting on your response may help you to understand the introductory paragraph.
No, you probably expect to receive more than $1,000 from the bank at the end of the year.
There are many ways to view the subtleties of this event. One perspective directs you to
recognize that the bank is borrowing your money for one year - and because they are
using your money, you expect to receive rent for the use of the funds for the year.
Another way of thinking about this transaction is to consider that you are investing your
funds in a relatively low-risk investment (the savings account) and that you expect to
329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

receive a return on your investment. In either case, you expect a reward for placing
your funds at the disposal of the bank, thus the bank pays you a fee, called interest. The
interest fee or rent is usually quoted as a rate or interest rate and refers to the
percentage payment that will be paid on the principal for a period of time. Unless stated
otherwise, the conventional means of quoting interest rates is to state the interest rate for
an annual period or one year. Thus, if our $1,000 deposited at the bank earned interest at
9%, it would be assumed that the bank is paying us $90 for use of the money deposited for
one year.
To place the above scenario into a more structured argument and contemporary syntax, if
we deposit $1,000 today (the present value) which will earn 9% per year (the
compounding rate of interest per period); the funds on deposit in one year (the future
value) total $1,090. This future value is calculated as follows:
Future value (FV) = Present value (PV) + [Present value (PV) * Interest rate ( r )]
or
FV = PV + [PV * r]
or
FV = $1,000 + [$1,000 * .09]
= $1,090
Suppose we decided to leave the funds on deposit for two years instead of one year. This
could be calculated as follows:
FV =
=
=
=
=

PV + [PV * r] + {[PV + (PV * r)] * r}


$1,000 + [$1,000*.09] + {[$1,000 + ($1,000 * .09)] * .09}
$1,000 + [$90] + [$1,090 * .09]
$1,000 + $90 + $98.10
$1,188.10

If you are comfortable with algebra, you might notice that the right hand side of the
preceding equation can be simplified by factoring.
Begin with:
FV = PV + [PV * r] + {[PV + (PV * r)] * r}
Clear the brackets, which produces:
FV = PV + PVr + PVr + PVr2
Then factor the term PV from the restated equation and collect terms:
FV = PV (1+ r + r + r2)
329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

FV = PV (1+ 2r + r2)
Then reduce the result to its simplest form:
FV = PV (1+ r )2
If we substitute the information from our earlier example for $1,000 earning 9% interest
compounded annually for two periods, we get the result:
FV =
FV =
FV =
FV =
FV =

PV (1+ r )2
$1,000 (1+ .09 )2
$1,000 (1.09 )2
$1,000 (1.1881)
$1,188.81

This is equivalent to the extended calculations rendered above.


As you might have suspected, the calculation of the future value of a present amount is a
geometric series and the formula can be generalized as follows:
FV = PV (1 + r)n
where:
FV = Future value of a present amount
PV = Present value of amount
r = Interest rate per period
n = Number of compounding periods
This generalized form serves as the basis of all calculations involving the time value of
money. For instance, suppose that we were interested in determining the present value of
an amount we wanted or expected to receive in the future. By solving the future value
equation for the unknown PV, we can determine the present value.
Consider that you want to buy a car in 4 years and you want to pay cash for the vehicle.
You expect the car to cost $10,000. If you could earn 8% per year on a Certificate of
Deposit at the local bank, how much would you have to deposit today in order to
accumulate the $10,000?
We can solve this problem by manipulating the equation for future value.
We know that:
FV = PV (1 + r)n
$10,000 = PV (1 + .08)4
$10,000 = PV (1.08)4
PV = $10,000/(1.08)4
PV = $10,000/(1.08)4
329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

PV = $10,000/1.3604889
PV = $7,350.30
The result is that if you deposit $7,350.30 today in an interest-bearing investment that
earns 8% annually for four years, you would accumulate $10,000 by the end of four years.
If you wish to evaluate this, you might consider reviewing the table that reflects the
extended form of calculation.
Date
1/1/Year1 Deposit
12/31/Year1
12/31/Year2
12/31/Year3
12/31/Year4

Interest Rate
8%
8%
8%
8%

Interest Earned
588.02
635.07
685.87
740.74

Balance
7,350.30
7,938.32
8,573.39
9,259.26
10,000.00

As may be obvious, we could simply restate the future value equation to solve for the
present value, which would produce:
FV = PV (1 + r)n
PV = FV /(1 + r)n
The term, (1 + r)n , is usually referred to as a time value of money factor and is the
variable that relates the future value to the present value. You are probably familiar with
tables of present value factors and future value factors. The equations above reflect the
information contained in the tables; that is, the tables represent the calculation of the
factor for various combinations of interest rates and time periods. Further, our formulas
tell us that the present value factors are directly related to the future value factors. The
relationship is evident - the factor for the future value table, (1 + r)n , is the inverse of the
factor found in present value tables 1/(1 + r)n
To affirm that this is the case, consider the factors used to solve the previous problem. If
we wanted to know the future value of $7,350.30 deposited in an interest bearing
investment, earning 8% per year for four years, we would use the future value equation, as
follows:
FV = PV (1 + r)n
FV = $7,350.30 (1 + .08)4
FV = $7,350.30 (1 + .08)4
FV = $7,350.30 (1.3604889)
FV = $10,000.00
The factor for this future value calculation is (1.3604889). From the present value
calculation, the factor was (1/1.3604889), the inverse of the future value factor. From this
simple example, you could prepare a full set of present and future value tables, for as many
combinations of interest rates and time periods as you would like. Of course, since you
can calculate any factor (with a calculator), the tables may not be a necessity, but a

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

convenience. To permit you to practice with present and future value factors, you should
sit down with a calculator and the attached Tables 1 and 2 and verify the construction of
few numbers on the tables. The tables are included in the appendix.

Two Concepts of Interest: Simple and Compound


Generally, there are two concepts of interest: simple interest and compound interest. The
distinction is simple, really. Simple interest refers to situations when interest is earned on a
principal amount only. This usually occurs when the interest is remitted to (or withdrawn
by) the person entitled to receive the interest. Compound interest describes situations
where interest is earned on the original principal amount as well as any interest earned and
accumulated with the original principal. Our example of the $1,000 on deposit for two
years is an example of compound interest. Had the $90 interest earned in the first year
been withdrawn from the bank (and all interest for all subsequent years), then the example
would have converted to a simple interest example. The focus of our study from this point
on will be on compound interest situations - which as you will discover, is the heart of the
time value of money calculation and the key to resolving many complex accounting,
finance and investment problems.
Before we leap into the nuances of present and future value problems, consider the matter
of compounding. Recall that unless stated otherwise, you should assume that interest is
compounded and paid annually. However, most banks and savings and loans company
transactions, mortgage company transactions, corporation bond and other monetary
transactions are based upon compound interest and/or dividends for periods other than
one year (quarterly, monthly, weekly, even daily). When this situation arises, it is easy to
convert an annual interest rate to the appropriate interest rate per compounding period.
When the stated annual interest rate is compounded on any basis other than annually,
simply divide the stated annual interest rate by the number of times the interest is
compounded during the year to determine the interest rate per compounding period. For
example, if the annual interest rate is 12% and the interest is compounded quarterly (every
three months), the compounding rate is 3% or 12%/4.
It may be obvious to you, but when interest is compounded more than once a year, the
actual or effective interest rate will always be greater than the stated annual interest rate
(sometimes called the nominal or face rate). This concept is of some significance to
business people, investors and consumers. For example, suppose a bank offers to lend you
$ 10,000 for one year at an annual rate of 10%. If the interest is compounded annually,
the interest accrued is $1,000. However, if the interest is compounded and paid quarterly
(every three months), the interest amount paid each quarter equals $250, but because of
the fact that the debtor must pay the amounts every three months, rather than at the end of
the year, the cost of the sacrifice (loss of the use of the money) increases the effective cost
of the debt to the borrower. Because the creditor enjoys the use of the money in four
installments during the year, instead of having to wait until the end of the year (and the
funds can be reinvested), the creditor (bank) enjoys a higher rate of return. Note that you
can use your knowledge of future value to determine the difference between the rates of
return for the two options.

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

For the annual payment, the effective interest rate is the same as the annual or stated
rate, i.e., 10%. But, for the quarterly compounding of interest, the effective interest rate
or yield is 10.38%, calculated by determining the future value at the end of the year of
four quarterly payments of $250 and comparing that to the amount of the loan. The
calculations are presented in the schedule below:

Totals

Interest Paid
10%/4 = 2.5%
$ 250
$ 250
$ 250
$ 250
$ 1,000

Compounding
Periods
3
2
1
0

Factor at 2.5%
1.07689
1.05063
1.02500
1.00000

Future Value
269.22
262.66
256.25
250.00
1,038.13

Dividing the Yield calculation ($1,038.13) by the loan principal ($10,000) produces an
effective interest rate of 10.38%.
Coincidentally, the formula for calculating the effective rate when interest is calculated
more frequently than annually is:
Yield or Effective Rate = (1 + r ) n -1
where:
r = compounding rate per period
n = number of compounding periods for the year

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

Annuities
Often, business transactions involve equal periodic payments; e.g., mortgages, bonds,
consumer loans, life insurance contracts, leases, the Christmas savings club. For example,
suppose that you are interested in purchasing a new stereo for your apartment. You want
to be able to pay cash and you are willing to save $50 per month for one year to save for
the stereo. If you put your money in a savings account earning 6% per year, compounded
monthly, how much would you be able to spend for the stereo at the end of the year?
Future Value of an Annuity
One way we could solve this problem would be to think of the savings amounts of $50 per
month as twelve (12) future value problems. It would take a few minutes, but this
technique would certainly provide an answer. Lets assume that we started saving at the
end of January and we plan to purchase the new stereo during the after Christmas and
inventory clearance sales that occur right after the first of the year. The calculations are
presented in the schedule below:
Date of
Deposit

Deposit or
Present Value

Interest Rate
6% Per Year

Interest Factor
(1+r)n

1/31/XX
2/28/XX
3/31/XX
4/30/XX
5/31/XX
6/30/XX
7/31/XX
8/31/XX
9/30/XX
10/31/XX
11/30/XX
12/31/XX

$50.00
$50.00
$50.00
$50.00
$50.00
$50.00
$50.00
$50.00
$50.00
$50.00
$50.00
$50.00

.5% per month


.5% per month
.5% per month
.5% per month
.5% per month
.5% per month
.5% per month
.5% per month
.5% per month
.5% per month
.5% per month
.5% per month

1.0563958
1.0511401
1.0459106
1.0407070
1.0355294
1.0303775
1.0252513
1.0201505
1.0150751
1.0100250
1.0050000
1.0000000

$ 52.81
52.56
52.30
52.04
51.78
51.52
51.26
51.01
50.75
50.50
50.25
50.00

12.3355623

$616.78

Future Value

There are a couple of points to note: first, by saving $50 per month, you will accumulate
$616.78 in twelve months; second, by examining the table carefully, we could take
advantage of a shortcut. If we factored the $50.00 monthly saving from the calculations
(it is the same amount each month, we could simply add up the interest factors for each
month and multiply that total by the uniform savings amount (an annuity) to find the total
amount saved; e.g., $50.00 * 12.3355623 = $616.78. Further, by constructing a table for
several combinations of interest rates and compounding periods, we could reduce the
calculations for the future value of an annuity to a formula approach. From out example
above, we can state that:

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

Future value of ordinary annuity (FVoa) = Annuity amount (A) * Factor (F)
or
FVoa = A * Fr,n
where:
A
Fr,n

is the amount of uniform payment each period


is the compounded interest factor for the interest rate per period [r] and
number of time periods [n]

Setting up the previous example, we get:


FVoa = A * Fr,n
FVoa = $50 * F .05, 12
FVoa = $50 * 12.3355623
FVoa = $616.78
And, in fact, that is precisely what a future value of an annuity table provides - an array of
various combinations of compounding periods and interest rates. It would be useful to
examine Table 3 in the appendix and use the table to solve the following problem:
In order to accumulate funds for the construction of a new building, a company
invests $50,000 a year for 5 years. The funds will earn 9% annually. How much
money will the company have at the end of the five years?
Using the factors from Table 3, the solution is straightforward. We know the
annuity amount, A, is $50,000. And we know the annual interest rate is 9% and
that there are five (5) compounding periods. Using the Future Value of an
Annuity Table, we determine that the interest compounding factor is 5.98471. If
we substitute these items into our formula for the future value of an annuity, we
obtain the result that the company will have $299,235.50 at the end of the fifth
year, as follows:
FVoa = A * Fr,n
FVoa = $50,000 * 5.98471
FVoa = $299,235.50
You might want to affirm the calculation and your understanding of the
relationships between the future value of a principal amount and the future value of
an annuity by turning to Table 1 and summing the factors under the 9% interest
column for 5 periods (this is looking at the problem as five individual future value
problems, rather than an annuity!) Be careful now - we have assumed that the first
payment is being deposited by the company at the end of the first year, thus, when
we obtain the data from Table 1, we must be sure to recognize that the last deposit
is made at the end of the five year period and earns no interest. This particular
transaction is usually not reflected in a future value of a principal amount table.

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

It is usually a good idea to draw a picture of the problem before you begin to
consult tables and perform calculations. It doesnt take long and it can provide a
schematic or framework for the problem-solving tasks. One example of such a
schematic is:

Time

$50,000

$50,000

$50,000

$50,000

$50,000

Notice that the number of deposits is five(5), but that the number of compounding
periods is four(4), because the first deposit is made at the end of the first period.
This kind of annuity example is usually referred to as an ordinary annuity or an
annuity in arrears. It is possible to prepare a table for annuity payments which
occur at the beginning of the first period. This type of annuity table is usually
called an annuity in advance or an annuity due. We will return to this issue
shortly.
Back to the problem, your results should be:
Deposit Number
1
2
3
4
5
Total

Compounding Periods
4
3
2
1
0

Interest Factor
1.41158
1.29503
1.18810
1.09000
1.00000
5.98471

If your results were the same as mine, you will note that the factor calculated from
Table 1 is equal to the factor extracted from Table 3. A nice result to know! If you
were hard-pressed, you wouldnt really need a future value of an annuity table, you
could simply extract what you needed from a future value table.
Just to satisfy your curiosity, the future value of an ordinary annuity table factors can be
calculated by formula. The formula is derived from the sum of a uniform set of geometric
series and is stated as follows:
FVoa = [( 1 + r ) n -1] / r
where:
FVoa = Future value of an ordinary annuity
r = interest rate per compounding period
n = number of annuity payments
If you are faced with a future value of an annuity due (annuity in advance); that is, the
terms of the annuity require or provide for a payment at the beginning a period, the
formula for this interest factor is:

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

FVad = {[( 1 + r ) n -1] / r } * (1 + r)


where:
FVad = Future value of an annuity due
r = interest rate per compounding period
n = number of annuity payments
If you examine this formula carefully, you will notice that the only difference is to add the
term ( 1 + r ) to the calculation. This term adjusts the ordinary annuity formula for the one
additional compounding period that results from moving the annuity payments from the
end of the compounding period to the beginning of the compounding period.
One final point about future value annuities. If you are using a future value of an
ordinary annuity table (annuity in arrears), but you are confronted with a future value
of an annuity due (annuity in advance) problem, you can adjust the factors in the
ordinary annuity table for use in annuity due (in advance) problems. All you must do is
increase the number of compounding periods by one and subtract the number one (1) from
the factor. Think about it - the ordinary annuity table provides an interest factor for the
final compounding period of one (1); there is no interest earned on the final deposit or
payment. If we advance all the payments by one period, we add one compounding period
of earned interest, replacing the period for which no interest was earned.
And, if you have an annuity due table, but are trying to solve an annuity in advance
(ordinary annuity) problem, simply subtract one compounding period and add the integer
1 to the factor that you extract from the table.
Present Value of an Annuity
As you might expect, just as the present value of principal amounts are related to future
value of principal amounts are related and that future value of annuities and future value of
single principal amounts are related, it follows that the present value of an annuity and the
present value of a principal amount are related. The primary formula involving the present
value of an annuity is:
Present value of ordinary annuity (PVoa) = Annuity amount (A) * Factor (F)
or
PVoa = A * Fr,n
where:
A
Fr,n

is the amount of uniform payment each period


is the compounded interest factor for the interest rate per period [r] and
number of time periods [n]

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

The interest factor (F) is derived by the formula, which can be computed by calculators
with exponent functions, or found in tables:
PVoa = [ 1 - { 1 / ( 1 + r ) n } ] / r
As an example of solving for the present value of an annuity, suppose you were given the
choice of receiving $8,000 a year for five years or receiving $25,000 today. What would
you do? Well, for the sake of analysis, lets suppose that your time preference rate for
money is 10% (reflecting your feelings about present versus future consumption, risk,
inflation and other uncertainties about the future) and that you can earn this in a money
market fund. What you want to be able to do is to compare the two cash flows to see if
you have a preference for one or the other. If we examine just the total aggregate cash
flows, it is evident that the choice is difficult.
We can take $25,000 today, but if we take the $8,000 per year for five years, we receive a
total of $40,000. The problem is that the two cash flows are not comparable, are they?
The $25,000 is a present value. The five $8,000 payments are an annuity and the
aggregate of $40,000 is not comparable to the $25,000. But, if our concerns about risk
are reflected properly in our time preference rate of 10% and the money market fund that
we could invest in reflects an appropriate return/risk relationship (10%), we could
evaluate the present value of those future cash flows and compare them with the value of
the option of having the $25,000 today. Of course, one way of evaluating the two cash
flows would be to convert the two cash payoffs to future values and compare them (given
the material presented earlier, we already know how to do that). But that would involve
two calculations: first evaluating the future value of the $25,000, then evaluating the
future value of the annuity of five $8,000 payments. As you will see, by simply
determining the present value of annuity, the calculation and analysis can be completed in
one step. Go to Table 4, Present Value of an Ordinary Annuity and extract the interest
factor for an interest rate of 10% over five compounding periods and insert it into the
formula above. Then complete the calculation and compare the result with the $25,000
option. Your calculation should be as follows:
PVoa = A * Fr,n
PVoa = $8,000 * 3.79079
PVoa = $30,326.32
When we compare the present value of the annuity with the present value of the $25,000
cash payment, it should be evident that the annuity is worth more to us. But maybe you
are still somewhat skeptical. We can confirm this finding by restating the problem just a
bit. Suppose that you have just won a lottery and you get your choice of two prize
options - one, you win a $25,000 deposit, which will earn 10% annually. You may not
withdraw any funds from this account for 5 years, at which time the total fund is yours.
The alternate prize is a five-year annuity of $8,000. The annuity is also deposited in a fund
which will earn 10% per year. At the end of five years, the total fund is yours to keep.
Which plan would you prefer? Lets compute the future values of both options.
Plan 1

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

FV = PV (1 + r)n
FV = $25,000 (1 + .10)5
FV = $25,000 (1.10)4
FV = $25,000 (1.4641)
FV = $36,602.50
The results report that the future value of $25,000 deposited in an interest-bearing
investment earning 10% per year is $36,602.50.
Plan 2
FVoa = A * [( 1 + r ) n -1] / r
FVoa = $8,000 [(1 + .10)5 - 1] / .10
FVoa = $8,000 [(1.10)5 - 1] / .10
FVoa = $8,000 [1.61051 - 1] / .10
FVoa = $8,000 [.61051] / .10
FVoa = $8,000 * 6.1051
FVoa = $48,840.80
It seems apparent that, when assessed as a future value comparison, the 5-payment annuity
is the preferred plan. First, just to confirm the validity of the future value tables, go to
Table 3 and identify the factor for a 5-period annuity earning 10% per period. The factor
is 6.1051, consistent with the formula based calculation.
Finally to affirm the relationship between present value and future value concepts, consider
the present value of $48,840.80 to be received in five years. Utilizing the present value of
a future amount formula, the present value is:
PV = FV * 1 / (1 + r)n
PV = $48,840.80 * 1 / ( 1 + .10 ) 5
PV = $48,840.80 * 1 / ( 1.61051 )
PV = $48,840.80 * .62092132
PV = $30,326.29

Notice that, except for the effects of rounding, this result is the equivalent of the
calculation used to determine the present value of the 5-period, 10% annuity at the
beginning of this exercise. Please consider the factors that make this the case. In any
event, it is evident that the best option, under the circumstances, would be to select the
five year annuity of $8,000 rather than the $25,000 today.
As you review the above material, please pay attention to the fact that the problems were
solved in a variety of ways - using the basic formulas, using factors from tables, converting
a present value problem to future value, converting an annuity to a principal-type problem.
Quite often, it is the ingenuity of the problem solver that sees the most efficient and
effective way of resolving the choices, comparisons and calculations involving the time
value of money. While learning to use time value of money techniques, it may be prudent
to use the formulas, tables and various approaches to the problem.

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

Following are some examples to review before you launch into the assigned problem set.
Example 1: Financing the purchase of a new car
Suppose that you are interested in purchasing a new car. You and the dealer have agreed
upon a price of $18,000 (four-wheel drive, short-bed, extended cab pickup!). Now all you
need is the money. The dealer suggests that you contact the local bank. The local banker
offers you the following terms:
Down payment
Annual interest rate
Financing period

$3,000
12%
4 years

The terms seemed reasonable to you and you left the bank to try to figure out where to
get the down payment. The banker knew that you were a recent business student and he
assumed that you were familiar with the techniques for calculating loan payments. When
you arrived home, you realized that you didnt know how much the loan payments would
be.
Required:
a. Calculate the monthly payment that would be required to service the loan used to
finance the purchase of the car.
b. Determine the total amount of interest that would be paid on this loan.
c. Determine the effective cost of the loan.
Solution:
a. While we could use tables to assist us with this part of the problem, the table set
included with this material does not include interest factors equivalent to forty-eight
periods and 1% per period. Consequently, the formula approach will be used to deal
with the issues.
The problem is defined as a loan amortization type and is common in consumer
lending, mortgages, bonds and other types of installment debt. The problem of
determining the monthly payment or the annuity payment is easily resolved using
the present value of an ordinary annuity format, as follows:
PVoa = A * Fr,n
First, recognize that the equation can be restated to solve for the annuity payment (A).
A = PVoa / Fr,n
A = $15,000 / Fr,n
The interest factor (F) is derived by the formula for the present value annuity
F=[ 1- { 1 /( 1 +r) n} ] /r
329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

F = [ 1 - { 1 / ( 1 + .01 ) 48 } ] / .01
F = [ 1 - { 1 / ( 1.01 ) 48 } ] / .01
F = [ 1 - { 1 / 1.6122261 } ] / .01
F = [ 1 - { .62026041 } ] / .01
F = [ .37973959 ] / .01
F = 37.973959
By substituting the factor into the primary annuity equation, the loan payment
(annuity) is determined to be $395.01 per month.
A = $15,000 / 37.973959
A = $395.01
b. This four year (48 month loan) will incur a total interest expense of $3,960.48 ,
determined as follows:
Total cash payments (395.01 * 48)
Less: Total amount financed
Total interest expense

$18,960.48
15,000.00
$3,960.48

c. The effective interest rate is 12.6825 % determined as follows:


Yield or Effective Rate = (1 + r ) n -1
Yield or Effective Rate = (1 + .01 ) 12 -1
Yield or Effective Rate = (1.01 ) 12 -1
Yield or Effective Rate = (1.126825) -1
Yield or Effective Rate = .126825
Yield or Effective Rate = 12.6825 %
Example 2: Accumulating a Retirement Fund
Jason, age 20, wants to retire at age 45. He wants to accumulate a retirement fund of
$600,000. If he plans to deposit equal monthly amounts, starting one month from
today, in an Individual Retirement Account (IRA) which will earn 6% per year, how
much should he plan to deposit each month? How much will Jason have earned on his
savings?
Solution:
This is an adaptation of the future value of an ordinary annuity and the solution
requires a calculator, unless you have an extensive table set.
FVoa = A * [( 1 + r ) n -1] / r
A = FVoa / [( 1 + r ) n -1] / r
A = $600,000 / [( 1 + .005 ) 300 -1] / .005
A = $600,000 / [( 1.005 ) 300 -1] / .005

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

A = $600,000 / [4.4649695 -1] / .005


A = $600,000 / [3.4649695] / .005
A = $600,000 / 692.99
A = $865.81
If Jason saves $865.81 a month for 25 years (300 months) and the funds earn 6%per
year (.5% per month), Jason will have a fund of $600,000.
Total fund accumulation
Total deposits ($865.81 * 300)
Total interest

$600,000
$259,743
$340,743

Jason will earn $340,743 over the 25 year period, if the fund earns interest at 6% per
year.

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

Appendix: Time Value of Money Formulas and Interest Factor Tables

Time Value of Money and Interest Factors


Time Value Concept

Symbol

General Formula

Factor or Table Formula

Simple Interest

SI

PV * r* n

n/a

Effective Interest

EI

(1 + r ) n -1

n/a

Present value of single amount

PV

FV * F

1 / [(1 + r ) n ]

Future value of single amount

FV

PV * F

(1 + r ) n

Present value of ordinary annuity

PVoa

A * F r,n

[1-{1/(1+r)n}]/r

Present value of annuity due

PVad

A * F r,n

[[ 1 - { 1 / ( 1 + r ) n } ] / r ] * (1 +
r)

Future value of ordinary annuity

FVoa

A * F r,n

[( 1 + r ) n -1] / r

Future value of annuity due

FVad

A * F r,n

{[( 1 + r ) n -1] / r} * (1 + r)

329485633.doc; The Time Value of Money

Accounting 490

Professor Jeff Harkins


9/13/2016

Table 1: Future Value of $1


[FV = PV (1+r) n]
(n)
Periods
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

8%
1.08000
1.16640
1.25971
1.36049
1.46933
1.58687
1.71382
1.85093
1.99900
2.15892
2.33164
2.51817
2.71962
2.93719
3.17217
3.42594
3.70002
3.99602
4.31570
4.66096
5.03383
5.43654
5.87146
6.34118
6.84848
7.39635
7.98806
8.62711
9.31727
10.06266
10.86767
11.73708
12.67605
13.69013
14.78534
15.96817
17.24563
18.62528
20.11530
21.72452

9%
1.09000
1.18810
1.29503
1.41158
1.53862
1.67710
1.82804
1.99256
2.17189
2.36736
2.58043
2.81267
3.06581
3.34173
3.64248
3.97031
4.32763
4.71712
5.14166
5.60441
6.10881
6.65860
7.25787
7.91108
8.62308
9.39916
10.24508
11.16714
12.17218
13.26768
14.46177
15.76333
17.18203
18.72841
20.41397
22.25123
24.25384
26.43668
28.81598
31.40942

329485633.doc; The Time Value of Money

Interest Rates
10%
11%
1.10000
1.11000
1.21000
1.23210
1.33100
1.36763
1.46410
1.51807
1.61051
1.68506
1.77156
1.87041
1.94872
2.07616
2.14359
2.30454
2.35795
2.55803
2.59374
2.83942
2.85312
3.15176
3.13843
3.49845
3.45227
3.88328
3.79750
4.31044
4.17725
4.78459
4.59497
5.31089
5.05447
5.89509
5.55992
6.54355
6.11591
7.26334
6.72750
8.06231
7.40025
8.94917
8.14028
9.93357
8.95430
11.02627
9.84973
12.23916
10.83471
13.58546
11.91818
15.07986
13.10999
16.73865
14.42099
18.57990
15.86309
20.62369
17.44940
22.89230
19.19434
25.41045
21.11378
28.20560
23.22515
31.30821
25.54767
34.75212
28.10244
38.57485
30.91268
42.81808
34.00395
47.52807
37.40434
52.75616
41.14479
58.55934
45.25926
65.00087

12%
1.12000
1.25440
1.40493
1.57352
1.76234
1.97382
2.21068
2.47596
2.77308
3.10585
3.47855
3.89598
4.36349
4.88711
5.47357
6.13039
6.86604
7.68997
8.61276
9.64629
10.80385
12.10031
13.55235
15.17863
17.00000
19.04007
21.32488
23.88387
26.74993
29.95992
33.55511
37.58173
42.09153
47.14252
52.79962
59.13557
66.23184
74.17966
83.08122
93.05097

15%
1.15000
1.32250
1.52088
1.74901
2.01136
2.31306
2.66002
3.05902
3.51788
4.04556
4.65239
5.35025
6.15279
7.07571
8.13706
9.35762
10.76126
12.37545
14.23177
16.36654
18.82152
21.64475
24.89146
28.62518
32.91895
37.85680
43.53532
50.06561
57.57545
66.21177
76.14354
87.56507
100.69983
115.80480
133.17552
153.15185
176.12463
202.54332
232.92482
267.86355

Accounting 490

Professor Jeff Harkins


9/13/2016

Table 2: Present Value of 1


[PV = FV / (1 + r )n ]
(n)
Period
s
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

8%
.92593
.85734
.79383
.73503
.68058
.63017
.58349
.54027
.50025
.46319
.42888
.39711
.36770
.34046
.31524
.29189
.27027
.25025
.23171
.21455
.19866
.18394
.17032
.15770
.14602
.13520
.12519
.11591
.10733
.09938
.09202
.08520
.07889
.07305
.06763
.06262
.05799
.05369
.04971
.04603

9%
.91743
.84168
.77218
.70843
.64993
.59627
.54703
.50187
.46043
.42241
.38753
.35554
.32618
.29925
.27454
.25187
.23107
.21199
.19449
.17843
.16370
.15018
.13778
.12641
.11597
.10639
.09761
.08955
.08216
.07537
.06915
.06344
.05820
.05340
.04899
.04494
.04123
.03783
.03470
.03184

329485633.doc; The Time Value of Money

Interest Rates
10%
11%
.90909
.82645
.75132
.68301
.62092
.56447
.51316
.46651
.42410
.38554
.35049
.31863
.28966
.26333
.23939
.21763
.19785
.17986
.16351
.14864
.13513
.12285
.11168
.10153
.09230
.08391
.07628
.06934
.06304
.05731
.05210
.04736
.04306
.03914
.03558
.03235
.02941
.02674
.02430
.02210

.90090
.81162
.73119
.65873
.59345
.53464
.48166
.43393
.39092
.35218
.31728
.28584
.25751
.23199
.20900
.18829
.16963
.15282
.13768
.12403
.11174
.10067
.09069
.08170
.07361
.06631
.05974
.05382
.04849
.04368
.03935
.03545
.03194
.02878
.02592
.02335
.02104
.01896
.01708
.01538

12%

15%

.89286
.79719
.71178
.63552
.56743
.50663
.45235
.40388
.36061
.32197
.28748
.25668
.22917
.20462
.18270
.16312
.14564
.13004
.11611
.10367
.09256
.08264
.07379
.06588
.05882
.05252
.04689
.04187
.03738
.03338
.02980
.02661
.02376
.02121
.01894
.01691
.01510
.01348
.01204
.01075

.86957
.75614
.65752
.57175
.49718
.43233
.37594
.32690
.28426
.24719
.21494
.18691
.16253
.14133
.12289
.10687
.09293
.08081
.07027
.06110
.05313
.04620
.04017
.03493
.03038
.02642
.02297
.01997
.01737
.01510
.01313
.01142
.00993
.00864
.00751
.00653
.00568
.00494
.00429
.00373

Accounting 490

Professor Jeff Harkins


9/13/2016

Table 3: Future Amount of an Ordinary Annuity of 1


[FVa = (1 + r )n -1 / r]

(n)
Periods
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

8%
1.00000
2.08000
3.24640
4.50611
5.86660
7.33592
8.92280
10.63663
12.48756
14.48656
16.64549
18.97713
21.49530
24.21492
27.15211
30.32428
33.75023
37.45024
41.44626
45.76196
50.42292
55.45676
60.89330
66.76476
73.10594
79.95442
87.35077
95.33883
103.96594
113.28321
123.34587
134.21354
145.95062
158.62667
172.31680
187.10215
203.07032
220.31595
238.94122
259.05652

9%
1.00000
2.09000
3.27810
4.57313
5.98471
7.52334
9.20044
11.02847
13.02104
15.19293
17.56029
20.14072
22.95339
26.01919
29.36092
33.00340
36.97371
41.30134
46.01846
51.16012
56.76453
62.87334
69.53194
76.78981
84.70090
93.32398
102.72314
112.96822
124.13536
136.30754
149.57522
164.03699
179.80032
196.98234
215.71076
236.12472
258.37595
282.62978
309.06646
337.88245

329485633.doc; The Time Value of Money

Interest
10%
1.00000
2.10000
3.31000
4.64100
6.10510
7.71561
9.48717
11.43589
13.57948
15.93743
18.53117
21.38428
24.52271
27.97498
31.77248
35.94973
40.54470
45.59917
51.15909
57.27500
64.00250
71.40275
79.54302
88.49733
98.34706
109.18177
121.09994
134.20994
148.63093
164.49402
181.94343
201.13777
222.25154
245.47670
271.02437
299.12681
330.03949
364.04343
401.44778
442.59256

Rates
11%
1.00000
2.11000
3.34210
4.70973
6.22780
7.91286
9.78327
11.85943
14.16397
16.72201
19.56143
22.71319
26.21164
30.09492
34.40536
39.18995
44.50084
50.39593
56.93949
64.20283
72.26514
81.21431
91.14788
102.17415
114.41331
127.99877
143.07864
159.81729
178.39719
199.02088
221.91317
247.32362
275.52922
306.83744
341.58955
380.16441
422.98249
470.51056
523.26673
581.82607

12%
1.00000
2.12000
3.37440
4.77933
6.35285
8.11519
10.08901
12.29969
14.77566
17.54874
20.65458
24.13313
28.02911
32.39260
37.27972
42.75328
48.88367
55.74972
63.43968
72.05244
81.69874
92.50258
104.60289
118.15524
133.33387
150.33393
169.37401
190.69889
214.58275
241.33268
271.29261
304.84772
342.42945
384.52098
431.66350
484.46312
543.59869
609.83053
684.01020
767.09142

15%
1.00000
2.15000
3.47250
4.99338
6.74238
8.75374
11.06680
13.72682
16.78584
20.30372
24.34928
29.00167
34.35192
40.50471
47.58041
55.71747
65.07509
75.83636
88.21181
102.44358
118.81012
137.63164
159.27638
184.16784
212.79302
245.71197
283.56877
327.10408
377.16969
434.74515
500.95692
577.10046
644.66553
765.36535
881.17016
1014.34568
1167.49753
1343.62216
1546.16549
1779.09031

Accounting 490

Professor Jeff Harkins


9/13/2016

Table 4: Present Value of an Ordinary Annuity of 1


PVa = [ 1 - { 1/( 1+ i ) n }/ i ]

(n)
Periods
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

8%
.92593
1.78326
2.57710
3.31213
3.99271
4.62288
5.20637
5.74664
6.24689
6.71008
7.13896
7.53608
7.90378
8.24424
8.55948
8.85137
9.12164
9.37189
9.60360
9.81815
10.01680
10.20074
10.37106
10.52876
10.67478
10.80998
10.93516
11.05108
11.15841
11.25778
11.34980
11.43500
11.51389
11.58693
11.65457
11.71719
11.77518
11.82887
11.87858
11.92461

9%
.91743
1.75911
2.53130
3.23972
3.88965
4.48592
5.03295
5.53482
5.99525
6.41766
6.80519
7.16073
7.48690
7.78615
8.06069
8.31256
8.54363
8.75563
8.95012
9.12855
9.29224
9.44243
9.58021
9.70661
9.82258
9.92897
10.02658
10.11613
10.19828
10.27365
10.34280
10.40624
10.46444
10.51784
10.56682
10.61176
10.65299
10.69082
10.72552
10.75736

329485633.doc; The Time Value of Money

Interest Rates
10%
11%
.90909
.90090
1.73554
1.71252
2.48685
2.44371
3.16986
3.10245
3.79079
3.69590
4.35526
4.23054
4.86842
4.71220
5.33493
5.14612
5.75902
5.53705
6.14457
5.88923
6.49506
6.20652
6.81369
6.49236
7.10336
6.74987
7.36669
6.98187
7.60608
7.19087
7.82371
7.37916
8.02155
7.54879
8.20141
7.70162
8.36492
7.83929
8.51356
7.96333
8.64869
8.07507
8.77154
8.17574
8.88322
8.26643
8.98474
8.34814
9.07704
8.42174
9.16095
8.48806
9.23722
8.54780
9.30657
8.60162
9.36961
8.65011
9.42691
8.69379
9.47901
8.73315
9.52638
8.76860
9.56943
8.80054
9.60858
8.82932
9.64416
8.85524
9.67651
8.87859
9.70592
8.89963
9.73265
8.91859
9.75697
8.93567
9.77905
8.95105

12%
.89286
1.69005
2.40183
3.03735
3.60478
4.11141
4.56376
4.96764
5.32825
5.65022
5.93770
6.19437
6.42355
6.62817
6.81086
6.97399
7.11963
7.24967
7.36578
7.46944
7.56200
7.64465
7.71843
7.78432
7.84314
7.89566
7.94255
7.98442
8.02181
8.05518
8.08499
8.11159
8.13535
8.15656
8.17550
8.19241
8.20751
8.22099
8.23303
8.24378

15%
.86957
1.62571
2.28323
2.85498
3.35216
3.78448
4.16042
4.48732
4.77158
5.01877
5.23371
5.42062
5.58315
5.72448
5.84737
5.95424
6.04716
6.12797
6.19823
6.25933
6.31246
6.35866
6.39884
6.43377
6.46415
6.49056
6.51353
6.53351
6.55088
6.56598
6.57911
6.59053
6.60046
6.60910
6.61661
6.62314
6.62882
6.63375
6.63805
6.64178