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Time Value of Money
Appendix
C
C1
Would you rather receive $1,000 today or a year from now? You should prefer
to receive the $1,000 today because you can invest the $1,000 and earn interest
on it. As a result, you will have more than $1,000 a year from now. What this
example illustrates is the concept of the
time value of money
. Everyone
prefers to receive money today rather than in the future because of the interest
factor.
STUDY OBJECTIVES
After studying this appendix, you should be able to:
1
Distinguish between simple and compound interest.
2
Identify the variables fundamental to solving present value
problems.
3
Solve for present value of a single amount.
4
Solve for present value of an annuity.
5
Compute the present value of notes and bonds.
NATURE OF INTEREST
Interest
is payment for the use of another person’s money. It is the difference be
tween the amount borrowed or invested (called the
principal
) and the amount re
paid or collected.The amount of interest to be paid or collected is usually stated as
a
rate
over a specific period of time. The rate of interest is generally stated as an
annual rate
.
The amount of interest involved in any financing transaction is based on three
elements:
1.
Principal (
p
):
The original amount borrowed or invested.
2.
Interest Rate (
i
):
An annual percentage of the principal.
3.
Time (
n
):
The number of years that the principal is borrowed or invested.
Simple Interest
Simple interest
is computed on the principal amount only. It is the return
on the principal for one period. Simple interest is usually expressed as
shown in Illustration C1 on the next page.
Distinguish between simple and
compound interest.
STUDY OBJECTIVE 1
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Appendix C
Time Value of Money
Interest
Hh
h
For example, if you borrowed $5,000 for 2 years at a simple interest rate of 12%
annually, you would pay $1,200 in total interest computed as follows:
Interest
H
p
h
i
h
n
H
$5,000
h
.12
h
2
H
$1,200
Time
n
Rate
i
Principal
p
Illustration C1
Interest computation
Compound Interest
Compound interest
is computed on principal
and
on any interest earned that has
not been paid or withdrawn. It is the return on the principal for two or more time
periods. Compounding computes interest not only on the principal but also on the
interest earned to date on that principal, assuming the interest is left on deposit.
To illustrate the difference between simple and compound interest, assume
that you deposit $1,000 in Bank Two, where it will earn
simple interest
of 9% per
year, and you deposit another $1,000 in Citizens Bank, where it will earn com
pound interest of 9% per year
compounded annually
. Also assume that in both
cases you will not withdraw any interest until three years from the date of deposit.
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 Summer '08
 Janson
 Accounting

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