Slide

Interest: Concepts of
Future and Present Value

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Time Value of Money

Interest is the
cost of using
money over time.

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Time Value of Money

That’s right! A dollar
today is more valuable
than a dollar to be
received in one year.

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Time Value of Money

The time value of
money concept is
important to our
business success.

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Basic Interest Concepts
Simple Interest
Interest amount = P × i × n

Assume you invest $1,000 at 6%

simple interest for 3 years.

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Basic Interest Concepts
Simple Interest
Interest amount = P × i × n

Assume you invest $1,000 at 6%

simple interest for 3 years.

You would earn $180 interest

($1,000 × .06 × 3 = $180).
(or $60 each year for 3 years)

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Basic Interest Concepts
Compound Interest
When we compound interest we
assume you earn interest on both
principal and interest

Principal Interest

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Overview of Future and
Present Value
 Single principal amount
 Based on a one-time-only investment
amount that earns compound interest from
the start to the end of the investment time
frame.
 Annuity amount
 A series of uniform payments occurring at
uniform intervals over a specified
investment time frame.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,

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Single Principal Amount

Assume we will save $1,000 for three

years and earn 8% interest
compounded annually.

What is the balance in

our account at the
end of three years?
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Single Principal Amount

Original balance $ 1,000.00
First year interest 60.00
Balance, end of year $ 1,060.00

Balance, beginning of year two $ 1,060.00

Second year interest 63.60
Balance, end of year two $ 1,123.60

Balance, beginning of year three $ 1,123.60

Third year interest 67.42
Balance, end of year three $ 1,191.02

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Single Principal Amount

Original balance $ 1,000.00
First year interest 60.00
Balance, end of year $ 1,060.00

Balance, beginning of year two $ 1,060.00

Second year interest 63.60
Balance, end of year two $ 1,123.60

Balance, beginning of year three $ 1,123.60

Third year interest 67.42
Balance, end of year three $ 1,191.02

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Single Principal Amount

Original balance $ 1,000.00
First year interest 60.00
Balance, end of year $ 1,060.00

Balance, beginning of year two $ 1,060.00

Second year interest 63.60
Balance, end of year two $ 1,123.60

Balance, beginning of year three $ 1,123.60

Third year interest 67.42
Balance, end of year three $ 1,191.02

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Single Principal Amount

We multiplied a year’s beginning principal

by the interest rate and added that year’s
interest to the account balance.

Another way to solve the problem is . . .

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Compound Interest
$1,000.00 × 1.06 = $1,060.00
and
$1,060.00 × 1.06 = $1,123.60
and
$1,123.60 × 1.06 = $1,191.02

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Compound Interest

Writing in a more efficient way, we can

say . . . .

$1,000 × 1.06 × 1.06 × 1.06 = $1,191.02

or
$1,000 × [1.06]3 = $1,191.02

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Compound Interest
3
$1,000 × [1.06] = $1,191.02

We can generalize this as . . .

FV = PV × (1 + i) n
Number
of Periods
Future Present Interest
Value Value Rate

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Consistent Interest
Periods and Rates
 Interest rates are usually expressed
as a rate per year.

 Sometimes interest is compounded

more frequently than once a year. To
adjust interest calculations, do the
following . . .

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Consistent Interest
Periods and Rates
 Divide the stated interest rate by the
number of compounding periods per
year.

 Multiply the number of years by the

number of compounding periods per
year.

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Consistent Interest
Periods and Rates
How would we calculate the amount to
be invested today in order to
accumulate to $20,000 in 5 years, if
you can earn 8% interest
compounded quarterly?

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Consistent Interest
Periods and Rates
Because there are 4 compounding
periods per year (quarterly) . . .

8% ÷ 4 = 2% rate
5 × 4 = 20 periods

In any present value computation, we

will use 2% as the interest rate and
20 as the number of periods.
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Overview of Future and
Present Value
 Ordinary annuity
 Payments or receipts occur at the
end of each interest compounding
period.
 Annuity due
 Payments or receipts occur at the
beginning of each interest
compounding period.

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Future Value of 1

Remember our equation?

n
FV = PV × [1 + i]
Where:
FV = Future Value
PV = Present Value
i = Interest Rate
n = Number of Periods

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Future Value of 1

Find the future

amount of $1
table in your
textbook.
Look at the
equation at the
top of the
table.
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Future Value of 1

Find the factor for 6% and 3 periods.

Solve our problem like this. . .

FV = $1,000.00 × 1.19102
FV = $1,191.02

The same answer we got using the

year-by-year approach

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Question
You invest $10,000 today and earn 8%
interest for 8 years. What will the
balance in your account be at the end
of 8 years if . . . .

A. Interest is simple?
B. Interest is compounded annually?
C. Interest is compounded quarterly?

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,

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Question
A - Simple Interest
$10,000 × .08 × 8 = $6,400
$10,000 + $6,400 = $16,400

B - Compound Annually

$10,000 × 1.85093 = $18,509.30

C - Compound Quarterly
i = 2% n = 32
$10,000 × 1.88454= $18,845.40
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Present Value of 1

Instead of asking what is the future

value of a current amount, we might
want to know what amount we must
invest today to accumulate a known
future amount.

This is a present value question.

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,

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Present Value of 1

Remember our equation?

n
FV = PV × [1 + i]

We can solve for PV and get . . . .

FV
PV = n
[1 + i]

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Present Value of 1

We can rearrange the equation . . .

1
PV = FV × n
[1 + i]

or

PV = FV × [1 + i]-n

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,

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Present Value of 1

Find the present

value of $1 table
in your textbook.
Look at the
equation at the
top of the table.
It looks familiar
doesn’t it?

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Question

Assume you plan to buy a new car in 5

years and you think it will cost
$20,000 at that time.
What amount must you invest today in
order to accumulate $20,000 in 5 years,
if you can earn 8% interest
compounded annually?

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Question

i = .08, n = 5
Present Value Factor = .68058

$20,000 × .68058 = $13,611.60

If you deposit $13,611.60 now at 8%

annual interest, you will have $20,000
at the end of 5 years.

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Question

If you deposit $5,000 in a bank at 8%

interest compounded annually, how
much will you have in 5 years? . . . in
10 years?
5 Years 10 Years
a. $7,387 $8,144
b. $7,347 $10,795
c. $7,347 $9,471
d. $6,984 $9,186
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Question

If you deposit $5,000 in a bank at 8%

interest compounded annually, how
much will you have in 5 years? . . . in
10 years?
5 Years 10 Years
a. $7,387 $8,144
b. $7,347 $10,795
c. Future
$7,347Value of $1$9,471
Table
$5,000 × 1.46933 = $ 7,346.65
d. $6,984 $9,186
$5,000 × 2.15892 = $10,794.60
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Question

What amount must you deposit today at

6% interest compounded annually, to
have $10,000 for your first year of
college 5 years from now?
a. $7,462
b. $7,921
c. $7,473
d. $7,581

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Question

What amount must you deposit today at

6% interest compounded annually, to
have $10,000 for your first year of
college 5 years from now?
a. $7,462
b. $7,921 Present Value of $1 Table
c. $7,473 $10,000 x .74726 = $7,472.60
d. $7,581

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Question
On June 1, 19X9, your company
purchases equipment by paying
$5,000 down and issuing a $27,000
noninterest-bearing note payable
that is due in three years.
Similar transactions carry a stated
interest rate of 6%.

What is the purchase price of the

equipment?

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Question
Present value factor
i = 6%, n = 3 0.83962
Face of note $ 27,000
Present value of note $ 22,670
Cash paid 5,000
Cost of equipment $ 27,670

Journal entry to record

the note and equipment

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Question
GENERAL JOURNAL Page: 1
Date Description PR Debit Credit
6/1

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Question
GENERAL JOURNAL Page: 1
Date Description PR Debit Credit
6/1 Equipment 27,670
Discount on Notes Payable 4,330
Notes Payable 27,000
Cash 5,000

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Unknown Rate or
Number of Periods
 Unknown Interest Rate
 Searching the Tables
 Interpolation

 Unknown Number of Interest Periods

 Searching the Tables
 Interpolation

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Annuities

An annuity is a series of equal

periodic payments

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Future Value of Annuity

The equation to find the future value of

an annuity is . . .

(1 + i) n - 1
FVA =
i

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Future Value of Annuity

The equation to find the future value of

an annuity is . . .

(1 + i) n - 1
FVA =
i

This is the equation for the FV of $1,

so it’s not all that difficult
to remember!

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Future Value of Annuity

To find the future value of an ordinary

annuity, multiply the amount of a
single payment or receipt by the
future value factor.

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Future Value of Annuity
Example
We plan to invest $2,500 at the end of
each of the next 10 years. We can
earn 8%, compounded annually, on
all invested funds.

What will be the fund balance at the

end of 10 years?

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Future Value of Annuity
Example
Amount of annuity $ 2,500.00
Future value factor
i = 8%, n = 10 14.48656
Balance $ 36,216.40

Find the future value factor in your

textbook.

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Future Value of Annuity
Example
You could use your calculator . . .
10
(1 + .08) - 1
FVA =
.08
FVA = 14.48656

FV = $2,500 x 14.48656

FV = $36,216.40
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Present Value of Annuity

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Present Value of Annuity

The equation to find the present value

of a series of $1 payments is . . . .
1
1 -
[ 1 + i ]n
PV =
i

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Present Value of Annuity

The equation to find the present value

of a series of $1 payments is . . . .
1
1 -
[ 1 + i ]n
PV =
i

This is the equation

for the PV of $1

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Present Value of Annuity
Example
You wish to withdraw $10,000 at the end of
each of the next 4 years from a bank
account that pays 10% interest
compounded annually.

How much do you need to invest today to

meet this goal?

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Present Value of Annuity
Example
Today 1 2 3 4

$10,000 $10,000 $10,000 $10,000

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Present Value of Annuity
Example
Today 1 2 3 4

$10,000 $10,000 $10,000 $10,000

PV1

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Present Value of Annuity
Example
Today 1 2 3 4

$10,000 $10,000 $10,000 $10,000

PV1
PV2

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Present Value of Annuity
Example
Today 1 2 3 4

$10,000 $10,000 $10,000 $10,000

PV1
PV2
PV3

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Present Value of Annuity
Example
Today 1 2 3 4

$10,000 $10,000 $10,000 $10,000

PV1
PV2
PV3
PV4

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Present Value of Annuity
Example
PV Present
Annuity Factor Value
PV1 $ 10,000 0.90909 $ 9,090.90
PV2 10,000 0.82645 8,264.50
PV3 10,000 0.75131 7,513.10
PV4 10,000 0.68301 6,830.10
Total 3.16986 $ 31,698.60

If you invest $31,698.70 today you will be able to

withdraw $10,000 at the end of each of the next
four years
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Present Value of Annuity
Example
PV Present
Annuity Factor Value
PV1 $ 10,000 0.90909 $ 9,090.90
PV2 10,000 0.82645 8,264.50
PV3 10,000 0.75131 7,513.10
PV4 10,000 0.68301 6,830.10
Total 3.16986 $ 31,698.60

Now, find this value in your text. Look up

the factor for 10% and 4 periods.
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Question
How much must a person 65 years old
invest today at 8% interest
compounded annually to provide for
an annuity of $20,000 at the end of
each of the next 15 years?
a. $153,981
b. $171,190
c. $167,324
d. $174,680

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,

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Question
How much must a person 65 years old
invest today at 8% interest
compounded annually to provide for
an annuity of $20,000 at the end of
each of the next 15 years?
a. $153,981
b. $171,190
c. $167,324 PV of Ordinary Annuity Table
Payment $ 20,000.00
d. $174,680 PV Factor × 8.55948
Amount $171,189.60
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,
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Question
Assume the person only has $140,000.
What annuity will this amount provide at
the end of each of the next 15 years if it
is invested today at 8% interest
compounded annually?
a. $15,891
b. $16,356
c. $17,742
d. $18,123

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc.,

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Question
Assume the person only has $140,000.
What annuity will this amount provide at
the end of each of the next 15 years if it
is invested today at 8% interest
compounded annually?
a. $15,891
b. $16,356
Present Value of Ordinary Annuity
c. $17,742 Amount $ 140,000
d. $18,123 Divided by ÷ 8.55948
Annuity $16,356.13
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Ordinary Annuity

We have discussed annuities that call

for payments to be made at the end
of the period.

These types of annuities are called

ordinary annuities.

End End
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Annuity Due

An annuity with payments at the

beginning of the period is known as
an annuity due.
The present value factor for an annuity
due, is the factor for an ordinary
annuity multiplied by [1 + i]

Beginning Beginning Beginning

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Annuity Due
Example
Compute the present value of $10,000
received at the beginning of each of
the next four years with interest at
6% compounded annually.

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Annuity Due
Example
PV factor for ordinary
annuity, n = 4, i = 6% 3.46511
Adjustment (1 + i) 1.06
PV factor for annuity due 3.67302
Amount of annuity $ 10,000
Present value of annuity $ 36,730

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Question

Western Gas, Inc. lost a lawsuit

requiring the company to pay
$2,250,000 immediately or $260,000 at
the end of each of the next 15 years.
Assume Western Gas can earn 9% on
all funds available.

Which settlement option would you

recommend to Western Gas’s
management?
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Question
Annual payment $ 260,000
PV factor for ordinary
annuity, n = 15, i = 9% 8.06069
PV of annuity payments $ 2,095,779

Because the present value of the payments

is less than the lump sum payment, you
would recommend that Western Gas make
the annual payments.

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Question
On 1/1/X8, Gill, Inc. purchased equipment
by paying $5,000 cash and issuing a
note payable requiring six annual
beginning of period payments of
$5,000 each. The first payment is to be
made on 1/1/X8, and the note bears
interest at 12%.

Prepare the journal entries required on

1/1/X8 and 12/31/X8.

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Question
PV factor for ordinary
annuity, n = 6, i = 12% 4.11141
Adjustment (1 + i) 1.12
PV factor for annuity due 4.60478
Annual note payment $ 5,000
PV of note payable $ 23,024
Cash down payment 5,000
Cost of equipment $ 28,024

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Question
GENERAL JOURNAL Page: 1
Date Description PR Debit Credit

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Question
GENERAL JOURNAL Page: 1
Date Description PR Debit Credit

1/1/X8 Equipment 28,024

Discount on Notes Payable 6,976
Notes Payable 30,000
Cash 5,000

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Question
Note Amortization Schedule
Carry
Date Payment Interest Principal Value
Initial carrying value of note $ 23,024
1/1/X8 $ 5,000 $ - $ 5,000 18,024
1/1/X9 5,000 2,163 2,837 15,187
1/1/00 5,000 1,822 3,178 12,009
1/1/X1 5,000 1,441 3,559 8,450
1/1/X2 5,000 1,014 3,986 4,464
1/1/X3 5,000 536 4,464 0
$ 30,000 $ 6,976

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Question
GENERAL JOURNAL Page: 1
Date Description PR Debit Credit

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Question
GENERAL JOURNAL Page: 1
Date Description PR Debit Credit
12/31/X8 Interest Expense 2,163
Interest Payable 2,163

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We’ve Conquered Time

77

Value of Money!

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