Saturday, February 9, 2013

What are Present Value Concepts in Accounting

The basic present value concept is that cash paid (or received) in the future has less value now than the same amount of cash paid (or received) today. To illustrate, if we must pay $1 one year from now, its present value is less than $1. To see this, assume that we borrow $0.9259 today that must be paid back in one year with 8% interest. Our interest expense for this loan is computed as $0.9259 × 8%, or $0.0741. When the $0.0741 interest is added to the $0.9259 borrowed, we get the $1 payment necessary to repay our loan with interest. This is formally computed in Exhibit 14A.1. The $0.9259 borrowed is the present value of the $1 future payment. More generally, an amount borrowed equals the present value of the future payment. (This same interpretation applies to an investment. If $0.9259 is invested at 8%, it yields $0.0741 in revenue after one year. This amounts to $1, made up of principal and interest.)

EXHIBIT 14A.1Components of a One-Year Loan

Point: Benjamin Franklin is said to have described compounding as “the money, money makes, makes more money.”

To extend this example, assume that we owe $1 two years from now instead of one year, and the 8% interest is compounded annually. Compounded means that interest during the second period is based on the total of the amount borrowed plus the interest accrued from the first period. The second period’s interest is then computed as 8% multiplied by the sum of the amount borrowed plus interest earned in the first period. Exhibit 14A.2 shows how we compute the present value of $1 to be paid in two years. This amount is $0.8573. The first year’s interest of $0.0686 is added to the principal so that the second year’s interest is based on $0.9259. Total interest for this two-year period is $0.1427, computed as $0.0686 plus $0.0741.

EXHIBIT 14A.2Components of a Two-Year Loan

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