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Choice #1: $350,000 per year for the next 20 years with the first check received today
Choice #2: a single lump sum amount of $4 million payable to you today
Depending on one’s financial self-discipline, age, or need for immediate cash, one could base the
decision solely on the attraction of having a large amount of cash today versus a steady stream of
cash for many years. A rational decision maker, though, would also want to know whether one of
the options is “worth” more than the other in the long run. Time value of money analysis allows
one to evaluate rigorously which alternative will yield the greatest financial benefit overall.
After presentation and discussion of time value of money concepts, we will return to this
example to determine which alternative would be preferable.
Computing Interest
The time value of money is rooted in the concept of interest. In fact, interest is how the time
value of money is measured. Interest is an amount paid by a borrower — to a lender — for the
privilege of using the lender’s money. It can be said that interest is the price paid to rent money.
The basic formula for computing interest is:
where principal is the amount borrowed, rate is the interest rate per period, and time is the
portion of a period the money will be borrowed. Unless stated otherwise, assume that when a
rate of interest is quoted, it is an annual rate. Unless stated otherwise, the length of the period
will be one year. (Unless, of course, you borrow money on the street corner from people in
sharkskin suits. There, the 20% rate may be a weekly or daily rate!!!) To illustrate the typical
situation, suppose you borrow $100 at 5% interest for six months. Since nothing is said
otherwise, the 5% is an annual rate and the time of the borrowing is one-half of one (annual)
period. The amount of interest you must pay is computed as follows:
b. Rate 5% 5% 5%
The first tool, future value of a single sum (FVss), involves a single sum of money that is
available today and is used to determine what larger amount it will grow to over a specific
period of time when invested at a specific rate of compound interest.(Compound interest means
that interest is being earned on interest. Interest earned during one period is added to the balance
of the account, where it earns more interest.) This tool is used to answer questions such as, “If
today you place $100 into a savings account paying 5% interest compounded annually, what
amount will be in the account at the end of 3 years?”
The second tool, present value of a single sum (PVss), involves a single sum of money that will
be available at a specific point in the future and is used to determine what smaller amount one
would be willing to settle for today instead of having to wait for the cash. This process is called
discounting a future amount to present value. It is used to answer such questions as, “What is
the smallest amount I would be willing to accept in full payment today for the $500 I am due to
be paid three years from now? I could earn 5% interest compounded annually on the money if I
had it available for investment today.”
The third tool, future value of an annuity (FVann), is similar to the first tool (FVss) except that it
deals with a series of equal-size amounts rather than with a single sum. A series of equal-size
amounts is called an annuity, hence the use of the ann subscript. It is used to determine what a
series of equal-size amounts will grow to over a specific period of time at a specific rate of
interest. It is used to answer questions such as, “What amount would be in a 5% compound
interest savings account at the end of four years if I deposited $100 into it at the end of each
year for the next four years?” The annuity just described is referred to as an ordinary annuity;
the cash flows occur at the end of each period. A second type of annuity, called an annuity due,
assumes that cash flows occur at the beginning of each period. When you see the word annuity
used by itself without being labeled as either an ordinary annuity or an annuity due, you may
assume it is an ordinary annuity. Annuities due will always have the word “due” attached to
them. For now, we will focus on ordinary annuities only. Near the end of this chapter we will
discuss annuities due.
The fourth tool, present value of an annuity, (PVann) is similar to the second tool (PVss) except
that it deals with a series of equal-size amounts (an annuity) rather than with a single sum. It is
used to determine the smaller lump sum amount that one would be willing to settle for today
instead of having to wait for the future receipt of a series of equal-size payments. It is used to
answer questions such as, “What is the smallest lump sum amount I would be willing to accept
today instead of receiving a series of $500 amounts in the future starting one year from today? I
could earn 5% compounded annually on the money if I had it available for investment today.”
Interest Factors
The key to applying each tool is the use of interest factors (IF). An interest factor is a
mathematical combination of a specified interest rate and a specified number of periods of time
that reveals what happens to $1 under each of the above tools. Once the effect on $1 is known,
the decision maker simply multiplies the interest factor (IF) times the actual number of dollars
involved in the problem under consideration. For example, the mathematical formula to
compute an interest factor for finding the future value of a single sum is (1 + i)n where i is the
interest rate for a period and n is the number of periods. Each time value of money tool has a
separate mathematical formula that combines the interest rate and number of periods into an
interest factor (IF).
Before the common availability of handheld calculators (1970), or personal computers (1984)
hard-copy tables of interest factors were typically constructed that contain combinations of
commonly used rates and periods. Rather than merely teach you which buttons to push on a
fancy calculator, we will go back to the future. Using the “old-fashioned technique,” we will
probe deeply into the underlying concepts. By the time we complete our coverage of this topic,
you will be better prepared to handle the complexities of this topic than your competitors in the
workplace. Tables 1-4, respectively, show interest factors (IF) for the future value of $1, the
present value of $1, the future value of an annuity of $1, and the present value of an annuity of
$1. (The tables appear at the end of this chapter.) Note that the formula for computing the
interest factors for a given table appears in the top right-hand comer of each table. You can use
this formula to compute interest factors for combinations of interest rate and numbers of periods
not shown on the table. The mathematical formulas for interest factors (IF) are programmed into
many hand-held calculators as well as PC-based spreadsheet programs such as Microsoft Excel.
$100 ?
5% |--------------------------|--------------------------|------------------------►|
0 1 2 3
Once the timeline is accurately drawn, the information can be inserted into a simple formula for
solution. While the formula differs for each of the four tools (FVss, PVss, FVann, PVann), you will
notice a striking similarity among them.
In each case, the right side of the equation might be expressed as “amount x IF.” Also, note that
the interest factor (IF) must always be taken from the table named on the left-hand side of the
equation.
First, draw the timeline. The timeline for this question was illustrated previously and is
reproduced below.
$100 ?
5% |--------------------------|--------------------------|------------------------►|
0 1 2 3
Notice again that in this problem a current amount is known (the $100 that is available today)
and that we are trying to determine the amount that it will grow to in the future (the FVss) if
invested at 5% interest compounded annually.
Next, insert this information into the related formula and solve it. In this case, the unknown
(what we are looking for) is the FVss.
FVss = current amount x IF
= $100 x 1.1576
= $115.76
Notice that the interest factor (IF = 1.1576) is taken from Table 1, Future Value of a $1 Single
Sum, from the intersection of the 3 period row and the 5% column.
This analysis reveals that the amount in the savings account at the end of three years will total
$115.76. Remember that the interest factor represents what happens to $1 at the interest rate and
number of periods stated. Here, each dollar left on deposit at 5% for three years will grow to
$1.1576. Multiplying that amount (1.1576) by the number of dollars involved ($100) yields the
solution of $115.76. Notice that this is the same problem that was used to illustrate compound
interest earlier and that the solution is identical ($115.76). A problem such as this could be
solved manually on a step-by-step, year-by-year basis as the illustration of compound interest
was but the solution gets a little tedious if it’s a 25-year problem instead of only 3 years. In
reality, use of interest factors cuts the solution time dramatically. In this problem, the $100
available today will grow to $115.76 at the end of three years, which means that the “time value
of money” in this case is $15.76 ($115.76 - $100).
The future value of a single sum tool (FVss) can be used anytime a current amount is known and
there is a question as to what amount it will grow to in the future.
? $500
5% |◄-----------------------|--------------------------|---------------------------|
0 1 2 3
Notice that the $500 to be received in the future is placed on the timeline at the end of year 3
when it is scheduled to be received, that the interest rate of 5% is placed in the left margin, and
that the question mark is placed at the left end of the timeline to indicate the end of year zero (the
beginning of the problem ... today). Lastly, the arrow is at the left-end of the timeline to indicate
that we are “going back” in time ... or discounting from the future back to the present. A future
amount (the $500) is being discounted back to the present; hence the term present value.
Second, insert this information into the related formula and solve it. In this case, the unknown
(what we are looking for) is the PVss.
PVss = future amount x IF
= $500 x .8638
= $431.90
Notice that the interest factor (IF = .8638) is taken from Table 2, Present Value of a $1 Single
Sum, from the intersection of the 3 period row and the 5% column.
This analysis reveals that the financial equivalent to receiving $500 three years from now,
discounted at 5%, is $431.90. This means that unless matters such as need for cash, age, or
financial self-discipline are involved, the decision maker should be indifferent between receiving
$431.90 today or waiting to receive $500 three years from today. Any settlement today that
exceeded $431.90 would make that option preferable to waiting for three years to receive the
$500. Notice that the interest factor (IF) of .8638 means that the present value of $1, discounted
for three years at 5%, is just a little more than 86.38 cents. Multiplying the value of $1 (.8638)
times the number of dollars in the problem ($500) yields the solution of $431.90. Since $500
would be received at the end of three years whereas $431.90 could be received now, the “time
value of money” in this problem is $64.10 ($500 - $431.90).
The present value of a single sum tool (PV ss) can be used anytime a future cash flow is known
and the question is “what lesser amount received today would be its financial equivalent?”
First, draw the timeline. This timeline will be a little more complex because, rather than
containing just one cash flow, there will be a series of cash flows identified. Also, the question
mark indicating the future value will be placed on the same date as one of the cash flows.
?
$100 $100 $100
5% |--------------------------|--------------------------|------------------------►|
0 1 2 3
Remember that this problem stated that the deposits were to occur at the end of each period.
Therefore, the deposits are placed on the timeline at the end of year 1, end of year 2, and end of
year 3. Notice this is a diagram of an ordinary annuity; the cash flows occur at the end of the
periods. You may be concerned that the timeline makes it look like the third deposit will not earn
any interest. If so, YOU ARE CORRECT. The last deposit of an ordinary annuity will earn no
interest because the problem ends immediately after the last deposit. Do not be concerned about
this, though, because the interest factors (IF) are determined by taking this into account. Those
factors are computed such that they assume the first deposit will earn interest during period two
and period three while the second deposit will earn interest during period three only. The factor
is computed such that it recognizes that the third deposit will earn no interest before the problem
ends. Notice also that no interest will be earned in this problem (or in any other ordinary annuity
problem) during the first period. This is because there were no funds on deposit during the first
period. Cash was first deposited into the savings account at the end of period 1.
Next, insert the information from the timeline into the related formula and solve it. Here it is
important to note that the size of an annuity is determined by the size of each payment, not by
what the series of payments add up to. In this problem, the “amount of the annuity” is $100
because that is the size of each equal payment.
Notice that the interest factor is taken from Table 3, Future Value of an Annuity, from the
intersection of the 3 period row and the 5% column. The interest factor of 3.1525 reveals that a
three-period ordinary annuity of $1 will grow to just over $3.15 if invested at 5% compound
interest.
According to this analysis, the account will grow to an ending balance of $315.25 at the end of
the three-year period. Since three deposits of $100 will be made to the account (a total of $300),
the “time value of money” in this case is $15.25 ($315.25 - $300).
Next, insert the information into the appropriate formula and solve it. Again, the amount of the
annuity is equal to the size of the payment; in this case, $500.
Notice that the interest factor is taken from Table 4, Present Value of a $1 Annuity, from the
intersection of the 3 period row and the 5% column. The interest factor of 2.7233 reveals that the
present value of a three-period, $1 ordinary annuity is just a little more than $2.72 if discounted
at 5% compound interest. Since the annuity in this problem is 500 times larger than a $1 annuity,
we merely multiply the effect of a $1 annuity by 500 to obtain the solution of $1,361.65.
According to this analysis, the smallest amount one would be willing to accept today in lieu of
waiting for the series of $500 payments is $1,361.65. If we wait to collect all three payments, a
total of $1,500 will be received (three payments of $500 each). This analysis reveals that we
7/10/2008 8 2008 by David A. Hansen
11:57:57 AM All Rights Reserved Worldwide
Used by Permission
ACC 515 Time Value of Money Analysis
would be willing to sacrifice $138.35 ($1,500 - $1,361.65) for the privilege of receiving the
money immediately and not having to wait for it. The $138.35 is the “time value of money” in
this problem.
d. Speedy Lapco has just won this year’s Good-Ole-Boy 500 stock
car race. The prize money will be distributed to him at a rate of
$2.000 per year for the next 25 years. Assuming that 8% is the
appropriate rate, what is the “value” of Speedy’s winnings? _____ __________
To illustrate, assume that you will deposit $1,000 into a savings account paying 8% interest
compounded semiannually. This means that the account will earn 4% during the first six months
of the year and another 4% during the second six months for a total of 8% for the year. The
7/10/2008 9 2008 by David A. Hansen
11:57:57 AM All Rights Reserved Worldwide
Used by Permission
ACC 515 Time Value of Money Analysis
difference between annual compounding and semiannual compounding is that with semiannual
compounding the interest earned during the first six months will be added to the principal during
the second six months and earn additional interest during the second six months. To compound
semiannually means that the length of the period has been changed from one-year to six months.
There are now two periods in a year and each period earns 4% interest. The diagrams below
demonstrate the effect of annual compounding versus semi-annual compounding when $1,000 is
deposited into a 8% account for one year.
Annual Compounding
$1,000 ?
8% | ----------------------------------------------------------------------------► |
0 (interest earned = $1,000 x 8% = $80) 1
Under annual compounding, the $1,000 principal earns $80 of interest during the one-year period
($1,000 x 8% = $80). Under semiannual compounding, the $1,000 earns $40 interest during the
first half of the year ($1,000 x 4% = $40). This $40 is added to the principal for the computation
of interest during the second half of the year ($1,000 principal + $40 interest = $1,040 of
principal during the second half of the year). Interest earned during the second half of the year,
then, is $41.60 ($1,040 x 4%). Total interest earned for the entire year under semiannual
compounding is $81.60 ($40 + $41.60). This is $1.60 more than under annual compounding and
is caused by the first six month’s worth of interest ($40) earning interest during the second six
months ($40 x 4% = $1.60).
Semiannual compounding
Tables 1-4 can be adjusted slightly to incorporate less-than-annual compounding by changing the
interest rate and the number of periods that are used in finding the correct interest factor. The
adjustments are based on the number of compounds per year. Notice, for example, that under
semi-annual compounding there are two compounds per year (i.e., compounding occurs once
every six months). Therefore, the two general adjustments that must be made whenever a
problem calls for less-than-annual compounding are to:
(1) divide the interest rate by the number of compounds per year, and
(2) multiply the number of periods by the number of compounds per year
To find the interest factor (IF) for a semi-annual compounding problem, the interest rate would
be divided by two and the number of periods would be multiplied by two. To find the interest
factor (IF) for a quarterly compounding problem, the interest rate would be divided by four and
the number of periods multiplied by four.
To illustrate using the previous example of depositing $1,000 for one year into an account paying
8% interest compounded semi-annually, the interest factor (from Table 1; Future Value of $1) is
found at the intersection of 4% and two periods; 1.08160.
This is the same result as was obtained earlier when computing the future value manually. All
four tables are adjusted in exactly the same manner.
ANNUITIES DUE
When the word annuity is used without a modifier, it is usually safe to assume that an ordinary
annuity is being considered. Recall that an ordinary annuity is one in which the cash flows occur
at the end of each period. A second type of annuity, referred to as an annuity due, has its cash
flows occurring at the beginning of each period. Note how the timelines below differ for the two
types of annuity.
Ordinary annuity:
? $100 $100 $100
5% |---------------------------|--------------------------|-----------------------►|
0 1 2 3
Annuity Due:
? $100 $100 $100
5% |---------------------------|--------------------------|-----------------------►|
0 1 2 3
One way to think of the difference is that, for the annuity due, each cash flow is on deposit (and
earns interest) for one extra period. For example, the first cash flow of the ordinary annuity is
made at the end of period 1 and earns interest during two periods (i.e., during period 2, and
during period 3). In contrast, the first cash flow of the annuity due is made at the beginning of
period 1 and earns interest during all three periods (i.e., during period 1, during period 2, and
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Used by Permission
ACC 515 Time Value of Money Analysis
during period 3). This same difference exists for all the other cash flows in the annuity too.
Therefore, when computing the future value of an annuity due, as compared to the future value
of an ordinary annuity, every cash flow earns one extra period’s worth of interest. When
computing the present value of an annuity due, as compared to the present value of an ordinary
annuity, every cash flow is discounted one less period because every cash flow is one period
closer to today. Ordinary annuity interest factors can be converted into annuity due interest
factors with a simple adjustment To convert an ordinary annuity factor into an annuity due
factor,
(1) obtain the relevant ordinary annuity interest factor from Table 3 or Table 4,
(2) convert the interest factor to annuity due by multiplying it by (1 + i), where i is the
interest rate of the column from which the interest factor was obtained.1
For example, the 3-year, 5%, $100 annuity due problem shown above would be solved as
follows. (Notice use of the new subscript to differentiate an annuity due from an ordinary
annuity.) The ordinary annuity factor for 3 periods and 5% is taken from Table 3 and multiplied
by (1 + i).
1
When you think about it, this conversion technique makes logical sense. For example, when computing the future
value of an annuity due, each equal amount will be on deposit (and earn interest) during one extra period (as
compared to an ordinary annuity). Multiplying the ordinary annuity factor by (1 + i) adds the interest for one extra
period. Similarly, when computing the present value of an annuity due, each equal amount is one period closer to
receipt than in a corresponding ordinary annuity. This means that each equal amount should be discounted one less
period than if it were an ordinary annuity. This means that the ordinary annuity factor discounts the annuity due by
one too many periods. Multiplying the ordinary annuity factor by (1 + i) adds back an extra period’s interest.
The four data points in this equation are (1) FVss, (2) amount, (3) interest rate, and (4) number of
periods. (Recall that the interest factor in the formula is a combination of (3) interest rate and (4)
number of periods.) This means that the basic formula can be used to solve for any of the four
pieces of information. So far, we have only addressed problems that involve solving for the term
on the left-hand side of the equal sign. Sometimes, for example, the FVss is known and one of the
other three items is the unknown.
For example, suppose you have $1,000 that you can put into a savings account today and want it
to grow to $2,000 at the end of 9 years. You wonder what rate of interest the savings account
would have to pay to accomplish this goal. This type of problem, finding the interest rate, can
also be solved with one of the four basic formulas. First, draw a timeline of the data available.
$1,000 $2,000
? |----------|----------|----------|----------|----------|----------|----------|----------|------ ►|
0 1 2 3 4 5 6 7 8 9
Notice that three of the four data points necessary to solve such a problem are known. The
$2,000 on the right end of the time line is a future value of a single sum, the $1,000 on the left
end of the time line is an amount currently available, and the number of periods is 9. The
unknown data point in this problem is the interest rate (note the question mark in the left margin
where the interest rate is usually found). Since three of the four data points are known, we can
substitute the known amounts into the future value of a single sum equation and solve for the
unknown term (the interest rate) as follows.
Rearranging terms:
To complete the solution, we must inspect the 9-period row of Table 1 (Future Value of a $1
Single Sum) to find the interest factor closest to 2.00000. Notice from Table 1 that at the
intersection of the 9-period row and the 8% column is the interest factor of 1.99900. While this is
not exactly 2.00000, it is very close. This means that it takes an interest rate very close to 8% to
make $1,000 grow to $2,000 over nine years. Further, notice that if Table 1 contained columns
for fractional interest rates (e.g., 8 ¼%, 8 3/8%, etc.), an interest factor of 2.00000 would appear
somewhere between the 8% column and the 9% column in the nine-year row. This means that
the actual rate is between 8% and 9%. Also, notice that since 2.00000 is much closer to the 8%
factor (1.99900) than it is the 9% factor (2.17189), the exact interest rate solution for this
problem is just a “smidge” more than 8%. Mathematical interpolation could be used to obtain a
more precise estimate of the actual rate, but be aware that time value of money analysis is often
based on estimates, assumptions and projected results. Often, obtaining a more mathematically
precise solution falsely implies a greater degree of precision than is warranted by the data. For
most managerial applications of time value analysis, the solution detailed above (e.g., just a
“smidge” more than 8% interest) is appropriate.
For another example, suppose you are shopping for a used car. You determine that cars of the
type, age and condition that interest you sell for about $7,000. Further, you have an
advertisement in-hand from a local bank offering a new type of financing. The bank offers 9%
financing, requires no down payment, but requires three equal year-end payments. You wonder
what the amount of the three equal annual payments might be on a $7,000 car. First, draw a
timeline of the data.
$7,000 ? ? ?
9% |--------------------------|--------------------------|------------------------►|
0 1 2 3
Here again, three of the four necessary components are known. Since there are multiple cash
flows, it must be an annuity problem. Since the payments are due at the end of each period, it is
an ordinary annuity. Notice that we know the present value of the annuity is $7,000 because this
is the amount that would be owed today if we purchased the car today. That is, the three
payments must be large enough to exactly payoff the $7,000 purchase price by the third payment
plus pay interest on the unpaid balance each year. Second, we know the interest rate (9%), and
third, we know the number of periods (3). We can set up the equation, insert the known data, and
solve as follows.
Rearranging terms:
amount (of each payment) = $7,000 / 2.53129
= $2,765.39
The amount of each of the three year-end payments would be $2,765.39. To prove this result
manually, inspect the debt reduction table shown in Exhibit 1.
The amount owed at the end of year zero (beginning of year 1) is $7,000. During year 1, interest
at 9% is incurred totaling $630.00. This causes the balance at the end of year l, just prior to the
scheduled payment, to grow to $7,630 ($7,000 + $630). The year-end payment of $2,765.39
causes the ending balance for year 1 to be reduced to $4,864.61 ($7,630 - $2,765.39). Similar
calculations are made for years 2 and 3. The 3¢ rounding error, which is immaterial, is caused by
using interest factors that have been rounded off.
Choice #1: $350,000 per year for the next 20 years with the first check received today
Choice #2: a single lump sum amount of $4 million payable to you today
Let’s assume that you have superior self-discipline regarding management of cash, expect to live
forever, and have no desperate need for an immediate lump sum of cash. You desire to choose
solely based on which option has the greatest financial worth to you; which is to say, the one
with the higher present value. Note that the present value of Choice #2 is simple. The present
value of $4 million to be received today is equal to the face amount; $4 million. There is no
discounting necessary for cash that is to be received today.
The question is whether the present value of Choice #1 exceeds $4 million. Determining the
present value of Choice #1, however, requires that you make an assumption as to what you could
earn on these funds if paid to you in a lump sum. Let’s assume you are confident you could
reinvest the funds at 8%. Following the usual solution steps, first draw a timeline.
?
$350k $350k $350k $350k $350k $350k $350k $350k
8% |-----------|-----------|-----------|---------| -- ◄ ··· ◄ ----|----------|----------|------◄|
0 1 2 3 4 17 18 19 20
Notice that if there are 20 payments, with the first one paid today, the 20th payment will occur at
the beginning of period 20 (which is also the end of year 19). Notice, also, that this is a diagram
of an annuity due; the cash flows occur at the beginning of each period.
Next, insert the information from the timeline into the relevant formula and solve the equation.
Remember to adjust the ordinary annuity interest factor to obtain the annuity due interest factor.
The present value of Choice #1 (the $350,000 annuity due) is only $3.7 million which is less
than the present value of Choice #2 (the single lump sum payment of $4 million). Therefore, if
8% is the appropriate discount rate, Choice #2 (the single lump sum payment) should be selected
because it has the greater present value.
Recognize, though, that the results of decision models such as time value of money are based on,
and sensitive to, their assumptions. Changes in the assumptions often change the results of the
analysis. For example, suppose the appropriate discount rate (interest rate) in this problem was
assumed to be 6% instead of 8%. This would change the interest factor and the adjustment factor
so that the solution to the problem would be as follows.
With the change in discount rate, the present value changes significantly. In fact, it changes so
much that the present value of Choice #1 is now greater than Choice #2 and should be selected.
It should be intuitively appealing that a lower discount rate results in a higher present value.
After all, the less you discount something the greater is the final amount.
This example demonstrates that it is very important to question the reasonableness of the
assumptions when using a quantitative tool. If the assumptions are not reasonable, the result will
generally not be reasonable either. This example also demonstrates one reason why different
persons may make different financial decisions. If one decision maker believes strongly that 8%
is the best assumption, he/she will select Choice #2. Another decision maker, however, may
believe strongly that 6% is the best assumption and select Choice #1. Do not blindly follow the
decision model. Carefully evaluate the assumptions.
future cash flows. Because bonds are an important financing instrument of both companies and
governments, they are the subject of this section.
A bond is a long-term IOU; generally having a face value of $1,000. Bonds are issued by
companies or government as a way of borrowing large sums of money for long periods of time.
While bond life varies, bonds often have a life of 20 or 30 years. In a few extreme cases, l00-year
bonds have been sold. In return for loaning money to a company or government, a bondholder
typically receives two promises from the issuer. First, the issuer promises to pay interest
regularly during the life of the bond, and second, the issuer promises to repay the face value of
the bond at the end of the bond’s life (i.e., at the maturity date.)
TYPES OF BONDS
The two major categories of corporate bonds are debenture bonds and mortgage bonds.
Debentures are bonds issued with no specific collateral backing. They are backed only by the
general creditworthiness of the issuer. Mortgage bonds, on the other hand, are backed by specific
assets that have been “mortgaged” to secure repayment of the bonds’ principal and interest. If
interest and principal payments are not made as scheduled, the mortgaged assets can be attached
and sold to satisfy the obligation. In recent years, a variation of mortgage bonds has become
common. These are called asset-backed securities. Usually issued by financial institutions, these
bonds are backed by assets such as outstanding credit-card balances or home equity loans. In the
public sector, there is an additional type of bond; revenue bonds. Revenue bonds are usually
issued by a government entity (e.g., state, city, school district) and backed by a reliable stream of
future revenue. For example, revenue bonds might be sold to finance construction of a new city
water system and future revenues from the water system be pledged to pay the interest and
principal. Most government bonds, however, are general-obligation bonds; similar in nature to
corporate debentures.
A special type of corporate bonds, convertible bonds may be exchanged for shares of common
stock according to a prearranged formula. Typically, these bonds pay a “less than normal” rate of
interest because of the convertibility feature. Investors are willing to accept a “less than normal”
rate of interest because of the potential for gain upon conversion of the bonds into common
stock. Most bonds, however, are not convertible. Zero-coupon bonds are a special type of bond
that do not pay periodic interest. The only return on this bond is the repayment of face value at
maturity. Accordingly, zero-coupon bonds sell at a deep discount initially; perhaps at only 25%
to 50% of face value. The investor’s return is the difference between the original selling price
and the face value. Junk bonds — or high-yield bonds if you prefer a less disparaging term —
are bonds having a higher risk of default than normal. Bond rating companies such as Moody’s
or Standard and Poor’s employ multi-step rating systems to estimate the likelihood that interest
and principal payments will be made as promised. Exhibit 2 illustrates some of the bond rating
categories used by two of the best-known bond rating companies. Bonds earning higher ratings
are referred to as investment grade bonds. Junk bonds, also called speculative grade bonds, have
earned one of the lower ratings.
Regardless of the type of bond, its market price is determined by time value of money concepts.
Every bond — except for zero-coupon bonds — contains two cash flow promises. The first is a
promise to repay the bond’s face value at maturity and the second is to pay periodic interest
while the bond is outstanding. The price at which a bond will sell is simply the present value of
the expected cash flows. Usually, the market price of a bond is different from its face value. This
is caused by fluctuating market interest rates. While the interest that a bond pays is fixed, the rate
demanded by the market moves up and down over time in response to general economic
Exhibit 2: Bond Rating Categories Used by Moody’s and Standard and Poor’s
Rating Categories
Quality Moody’s Standard and Poor’s Explanation
conditions and the financial condition of the issuer. Accordingly, over a 20 or 30-year life, a
bond seldom is ever paying exactly the rate that the market demands. Therefore, bonds must be
sold at either a discount (less than face value) or premium (more than face value) to equate the
actual rate of return to the rate demanded by the market. The concepts and processes discussed
below apply equally to both sellers of bonds and buyers of bonds. After all, there is both a buyer
and a seller in each transaction.
How much would investors be willing to pay today to buy this investment? The answer depends
on the investors’ required rate of return. If they require a very high rate of return, the amount
they are willing to pay to acquire these bonds will be low. If they are satisfied with a smaller rate
of return, they will be willing to pay a higher price. Assume investors demand an 8% return. The
time line of this investment would appear as follows. (Note the semiannual compounding; there
are six periods, with 4% compounding.)
7/10/2008 18 2008 by David A. Hansen
11:57:57 AM All Rights Reserved Worldwide
Used by Permission
ACC 515 Time Value of Money Analysis
? 100,000
? 3,500 3,500 3,500 3,500 3,500 3,500
4% |◄------------|---------------|----------------|----------------|----------------|----------------|
0 1 2 3 4 5 6
The present value of the $100,000 single sum and the present value of the $3,500 annuity are
computed as follows:
If 8%, compounded semiannually, were the minimum desired rate of return on this type of
investment, investors would be willing to pay up to $97,379. Notice that this amount is less than
the face value of the bonds. This is reasonable. Investors require an 8% return but the bonds pay
only 7%. By discounting the purchase price by $2,621 ($100,000 - $97,379), the return on this
investment is increased to 8%. In other words, even though the bonds pay only 7% cash interest
(or 3 ½ % interest twice per year), the total interest earned includes an “extra” $2,621 that will be
received on the maturity date of the bonds. Investors will pay only $97,379 for the bonds, but
will receive back the entire $100,000 face value ($100,000 - $97,379 = $2,621)
To prove those investors earn (and that it costs Regency Park) exactly 8% on this issue of bonds,
complete the bond amortization table in Exhibit 3. On the table, end of period zero is the
purchase date; therefore, the calculations begin one period later — at the end of period 1. To
simplify the example and get you started, some of the calculations are already filled in; as are the
column totals.
In filling out the period 1 row of the table, notice that the carrying value of the bonds has been
$97,379 during the first semiannual period. If the bonds earn the investor 4% semiannually, the
interest revenue earned during period 1 will total $3,895 ($97,379 x 4%). Of this amount, only
$3,500 ($100,000 x 3.5%) will be received in cash at the end of the period. The difference
between the two amounts ($3,895 - $3,500 = $395) is part of the $2,621 “extra” that will be
received at the maturity date of the bonds. Since $395 has been earned — but not received during
the first period, it is added to the carrying value of the bonds at the end of period 1. This is
merely accrual-basis accounting at work. A total of $3,895 was earned by investors, but only
$3,500 of it was paid. The $395 difference is accrued — added to the carrying value of the debt
— and will be paid at maturity. The amount of interest revenue for investors and interest expense
for Regency Park is not determined by the $3,500 cash flow, but is determined by applying the
required market rate to the carrying amount of the debt. The end-of-period-l-value becomes the
carrying value during period two. The end-of-period-2-value becomes the carrying value during
period three, and so on. Follow the logic of this process to fill in the data for periods 2, 3, and 4.
When you have completed Exhibit 3, you should observe the following. First, the total interest
revenue earned by investors — and the amount of interest expense incurred by Regency Park —
is comprised of two parts as summarized in Exhibit 3.
Second, the carrying value of the bonds increased from the original selling price ($97,379) to
their face value ($100,000) by the maturity date. Each year, the amount owed to investors
increases by the amount of interest revenue the investors have earned, but not yet received.
This is another good example accrual-basis accounting differing from cash flow. The interest
revenue/expense in column B is accrued each semiannual period and reported on the income
statement. The amount varies each semiannual period. Over the life of the investment, interest
revenue/expense totals to $23,621. The interest cash flow pattern, however, is quite different. For
each of the first five semiannual periods, the interest cash flow is constant at $3,500. At the end
of the sixth semiannual period, however, the interest cash flow is $3,500 + the “extra” interest of
$2,621 received/paid at maturity. These amounts also total to $23,621. Total interest
revenue/expense equals total cash flow — but the patterns are different.
Assume investors are willing to settle for a 6% return on this investment in bonds. This means
that the bonds are paying 7% interest but investors demand only 6%. The expected cash flows,
however, are exactly the same as in the previous example:
The time line of the bond investment’s two expected cash flows would appear as follows. Again,
note the semiannual compounding. Also, notice that the only change from the prior example is
the rate of discounting — from 4% semiannually to 3% semiannually. All the cash flows are
identical.
? 100,000
? 3,500 3,500 3,500 3,500 3,500 3,500
3% |◄------------|---------------|----------------|----------------|----------------|----------------|
0 1 2 3 4 5 6
The present value of the principal repayment and interest payments would now be computed as
follows:
If 6%, compounded semiannually, were the minimum desired rate of return on this type of
investment, investors would be willing to pay up to $102,709 to acquire these bonds. Notice that
this amount is greater than the face value of the bonds. This is reasonable. Investors require a 6%
return but the bonds pay 7%. By raising the purchase price to a premium of $2,709 ($102,709-
$100,000), the return on this investment is decreased to 6%. This occurs because, even though
the bonds pay 7% cash interest (or 3 ½% interest twice per year), the $2,709 premium is
forfeited. At maturity, the face value of the bonds will be received ($100,000) — not the original
purchase price ($102,709).
To prove that a purchase price of $102,709 yields a 6% return, complete the bond amortization
table in Exhibit 4. Notice that the carrying value decreases each period until it equals face value
of the bonds on the maturity date. Once again, part of the table has been completed to minimize
pencil pushing. When you have completed Exhibit 4, you should observe the following. First, the
total interest revenue earned by investors — and the amount of interest expense incurred by
Regency Park — is computed in two steps as summarized below.
Total cash interest received/paid semiannually (column C total) $21,000
Plus: Portion of purchase price forfeited at maturity (column D total) (2,709)
Total interest revenue/expense (column B total) $18,291
Second, the carrying value (also known as book value) of the bonds decreased from the original
selling price ($102,709) to their face value ($100,000) by the maturity date. Each year, the
amount owed to investors decreases by the amount of cash they received that year in excess of
interest revenue they earned that year.
7/10/2008 21 2008 by David A. Hansen
11:57:57 AM All Rights Reserved Worldwide
Used by Permission
ACC 515 Time Value of Money Analysis
EXERCISES
Annual
Cash flow interest
Item amount rate Compound Years
a. PV of a single sum $2,500 7% annual 30
b. FV of an annuity $5,000 6% semiannual 12
c. PV of an annuity $1,800 12% quarterly 10
d. FV of a single sum $10,000 9% tri-annually 8
e. PV of an annuity due $4,000 5% semiannual 20
f. FV of an annuity $2,000 10% annual 50
a. What balance will be in the fund on October 1, 2017, if interest is compounded annually at
5%?
b. If no further deposits are made after October 2017, and the balance is left to earn interest at
the same rate, what will be accumulated by October 1, 2027?
b. Assume the same facts as in A except that starting on her 55th birthday the division manager
wishes to make a series of annual payments through her 64th birthday which will provide the
desired income. How large must each payment be?
c. 12% annual interest on 16 semi-annual deposits if the first deposit is made exactly six
months from today?
REQUIRED: (a) For each transaction above, determine the amount of sales revenue that should
be recognized from the sale.
(b) Prepare the journal entry for each transaction.
a. What is the maximum amount you would be willing to pay today to acquire these financial
assets if you require at least a 10% return on your money?
b. What is the maximum amount you would be willing to pay today to acquire these financial
assets if you require at least an 8% return on your money?
c. What generalization can you make regarding the relationship between an investor’s expected
rate of return and the buying price of an investment?
2. The manufacturer of the Party Time model has offered its boat to Gulf on an 8-year lease.
A particularly appealing aspect of this offer is that at the end of the lease, Gulf may keep
the boat. The lease requires 8 beginning-of-the-year lease payments of $29,804 each. In
addition, there would be a one-time processing fee of $196 payable immediately. Gulf
would be responsible for insurance, maintenance, and repairs during the lease period.
a. What is the size of the equal annual payments necessary to finance the Sun Splasher model?
Round your answer to the nearest dollar.)
b. What is the present value of the costs necessary to finance acquisition of the Party Time
model? (Assume a 9% discount rate and round your answer to the nearest dollar.)
c. How does the pattern of cash flows differ between the alternatives?
d. How does the present value of the two alternatives differ?
e. What material economic differences are there between these two alternatives?
a. $9,372.07
b. $8,519.34
c. $4,372.16
d. $3,974.56
4. Which of the following will always yield the largest dollar total for a given interest rate and
amount?
a. future value of an ordinary annuity b. present value of a single sum
b. future value of an annuity due
c. present value of an ordinary annuity
d. future value of a single sum
5. The primary difference between an ordinary annuity and an annuity due is the:
a. rate of interest that is earned.
b. total number of cash flows that occur.
c. total amount of cash that is deposited or received.
d. pattern of the cash flows.
6. Compared to the number of cash flows in a 5-period ordinary annuity, the number of cash
flows in a 5-period annuity due is:
a. one more.
b. one less.
c. the same.
d. one more or one less depending on whether present value or future value is being
determined.
7. A friend observes that “the higher the discount rate, the less the present value of an annuity.”
This statement:
a. is never true.
b. is always true.
c. is of uncertain truth without knowing the specific interest rate and number of periods.
d. applies differently to an ordinary annuity than to an annuity due.
8. Deepen Dette Company issued some 12%, 2D-year bonds. According to the terms of the
bond issue, the company’s factory equipment will be sold and the proceeds distributed to
bondholders if the company does not make interest and principal payments on time. Which
term best describes the type of bonds that have been sold?
a. debenture
b. zero coupon
c. general obligation
d. revenue
e. mortgage
9. Compared to a bond sold at face value, one sold at a discount results in:
a. more cash being paid out (or received) each period.
b. less cash being paid out (or received) each period.
c. more interest expense (or interest revenue) being recorded each period.
d. less interest expense or (interest revenue) being paid out each period.
10. Devilish Delights, Inc. sold a $100,000, 10% issue of annual bonds on January 1, 2008 to
yield 8%. The present value of a $1 annuity for ten periods at 8% is $6.7101. The present
value of $1 for ten periods at 8% is $0.4632. If these bonds mature in ten years, their initial
selling price was:
a. $113,421
b. $105,651.
c. $99,996.
d. $95,477