A company rece i ves cash today and promises to make

A company rece
i
ves cash today and promises to make per
i
od
i
c
i
nterest pay·
ments over time and a principal payment at the bond's matur
i
ty.
A company receives the use of a product or property and promises lo make
periodic payments to the party from whom it obtained the use of the product
or property.
A company promises to pay employees a certain amount after they retire.
We begin our discussion of the ti111e value of money by distinguishing between two types of
interest-simple and compo1111d.

EXAMPLE 7 . 1 Simple Interest
PROBLEM: Solin1de Company borrows $60,000 for 3 years wiih a stated annual rate of 5%. What
is the intere .st expense incurred by Solitude, assuming that interest is computed as simple interest?
Accounting and the Time Value of Money
317
Simple Interest
The term simple interest means that interest is computed on only the principal (the initial amount)
but is not computed on any interest ean1ed and left on deposit Thus,
simple interest
is the initial
investment multiplied by the stated interest rate for a single period and the amount of time (in
terms of the nmnber of periods) the investment is held.
Si1nple Interest
=
Principal X Interest Rate X Time
(7.1)
Time
Compound Interest
Interest co1nputed on both the principal and the interest left on deposit is refen-ed to as compound
interest.
Any interest earned is then immediately included in the computation of the next period's
interest. The compounding period can be over any time period such as a quarter or a day.
Exhibit 7 .2 provides a graphical depiction of compound interest. Assume you invest $ I 00
today for IO years at an annual interest rate of 10%. Today (Year 0) you have$ JOO. After the first
year, you have the original $100 plus an additional $IO ($100 X 10%) of interest. So, you now
leave $ IIO on deposit.
During the second year, that $110 also earns I 0% interest or$ I I ($ I IO X
l 0%). At the end
of the second year, your deposit is valued at $ 121 ($100
+
$IO
+
$1 I). This pattern continues
until the tenth year
,
when you have a total of$259, which consists of your original deposit or prin-
cipal of$ I 00 plus$100 of interest earned on the principal ($100 X I 0% X IO years) and$59 of
interest earned on the interest left on deposit. If this investment earned only simple interest, your
total value at the end of the tenth year would be $200. That is, interest would be earned only on
the principal ($100
=
$100 X I 0% X IO years), not on the interest left on deposit. Therefore.
co1npounding increases your retm11 by $59 and increases your effective interest rate.
EXHIBIT 7 . 2 Compound Interest
300 ,;::
======
;-- - - - -7
Interest on Interest
250
Interest on Princ
i
pal
• P r in c
i
pa l
:,
..