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| This page has an explanation of calculating present value. When you are ready to solve the problem, click the Problem tab at the bottom of the spreadsheet. | |
| In this final week, we have one problem using the effective interest rate method. | |
| In order to use this, we need to calculate time value of money. There are three ways | |
| to go about this: | |
| 1. Use a table that is an appendix in most accounting books and is easily found by | |
| conducting an Internet search for “amortization tables.” | |
| 2. Use a mathematical formula. | |
| 3. Use an Excel present value formula. | |
| Let’s assume we want the present value of $5,000, which we will receive six months from now, | |
| assuming an 8% interest rate. We know that the present value will be less than $5,000. | |
| Using a table: | |
| You can find a “present value of a lump sum” table by going to principlesofaccounting.com | |
| and clicking “supplements” at the bottom-left of the screen. “Time value of money” | |
| will be one of the supplements listed. | |
| You will use the table called “Present Value of $1.” Because we are interested in a payment | |
| six months from now, we will have to divide the interest rate by 2 to represent a half-year. | |
| Looking at 4% for 1 period, we get a factor of .96154. | |
| Multiply the $5,000 by this factor. | $ 4,807.70 |
| Using a mathematical formula: | |
| Here, the formula will be the principal amount × (1 plus the interest rate) to the power of the time period. | |
| In Excel, the math symbol for “to the power of” is ^ | |
| The interest rate is the full 8% and the time period is 0.5 years. When we want present | |
| value, we will enter the power of as negative because we are discounting the principal amount | |
| backwards. If we were calculating future value, the time period would be positive. | |
| Formula is 5000*(1+.08 )^−0.5 | $ 4,811.25 |
| Notice this comes out slightly different. | |
| This is because some calculations use 360 days and some use 365. | |
| We can mostly correct for this by multiplying the period by 365 and dividing by 360. | |
| Formula is 5000*(1+.08 )^−(0.5*365 ¸ 360) | $ 4,808.68 |
| Using the Excel formula: | |
| The present value formula is =PV(rate, periods, amount) | |
| The rate must be divided by 2 because it is a half-year. | |
| You will get a negative answer as a result because the formula is used to ask, “What amount do I | |
| need to invest now (negative cash flow) to get a certain amount in the future?” | |
| =PV(.08 ¸ 2,1,5000) | ($4,807.69) |
| If you are preparing a spreadsheet and you need the number to display as positive, | |
| simply put a negative in front of the amount in the formula | |
| =PV(.08 ¸ 2,1,-5000) | $4,807.69 |
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