CHAPTER 11
The Road Traveled
Key Points
The first ten chapters of this book examined the role of
accounting in planning, performing, and evaluating
business-operating activities. Chapters 1 – 3 laid the
basic foundation as we explored the evolution of
accounting and the role of accounting in today’s business
environment, the basic business processes and the
balanced scorecard. In Chapters 4 – 6, we investigated
the planning process for operating activities and how
accounting information is used in this process. Chapter 7
introduced the accounting cycle and the process of
recording and communicating accounting events.
Chapters 8 - 10 built on these ideas as we examined the
process of recording and evaluating expenditure,
revenue, and conversion process activities. .
Operating, investing, and
financing decisions are
cyclical in nature.
You Are Here
The second half of this text follows the format developed
in the first half—planning, performing, and evaluating.
However, now we explore the capital resources process
(investing and financing activities). Since these types of
activities are long-term in nature (whereas operating
activities studied in the first half of the book tend to be
short-term), we must consider the time value of money.
Chapter 11 discusses the risk-reward relationship, the
concept of compound interest, and uses these ideas to
examine the time value of money. This chapter, then,
lays the foundation for the second half of the book.
The Road Ahead
Chapter 12 uses the time value of money concepts
discussed in Chapter 11 to examine the capital budgeting
process. We explore how companies determine whether
certain long-term projects should be accepted or rejected.
Chapter 13 is the first of two chapters that explore the
process of raising the capital necessary to run the
business and enable it to invest in long-term projects and
human capital. Chapter 13 investigates equity (owner)
financing and Chapter 14 considers debt (creditor)
financing.
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Risk and return are
related.
A dollar today is worth
more than a dollar
tomorrow.
The six time value of
money elements are:
 FV = future value
 PV = present
value
 ANN = annuity
(equal payments
over equal time
periods)
 r = annual interest
rate
 c = number of
compoundings
(payments) per
year
 n = total number
of compoundings
(payments) over
the life
DISCUSSION OUTLINE
Chapter 11’s discussion should focus on the time value of money. You must understand
the components of time value of money problems (r, c, n, FV, PV, ANN) and you must
know when a problem is an annuity.
Investing and Financing Activities
•
•
Investing activities concern
 Purchase
 Use
 Sale of long term assets
Financing activities concern
 Raising cash by borrowing
 By issuing an ownership interest in the business
 Paying cash to repay monies borrowed from creditors
 To provide a return to owners
What is the difference between return of and return on investment and what is the
expected rate of return?

Return of investment

Return on investment—

Expected rate of return—
What is risk, how is it measured, and how is it related to return?
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
Risk—

Inflation risk—

Business risk—

Liquidity risk—

Risk premium—
What is the difference between simple and compound interest and why did we use
simple interest in the operating section of the book?
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
Simple—

Compound—

We used simple interest in the operating section because the decisions were shortterm and, therefore, any compounding would be immaterial
http://www.youtube.com/watch?v=gRYh41zllUk&feature=related
What is the future value of $1?


Answers the question, what amount will $1 grow to in the future
If I invest $3,000 today, what will it be worth in 5 years if I earn 8 percent interest
compounded quarterly?
r = 8, c = 4, n = 20, PV = 3,000, ANN = 0, FV = $4,457.84
FV = ($1 + 0.08/4)20 * $3,000 = $4,457.84
What is the present value of $1?


Answers the question, what is $1 in the future worth today
If I receive $3,000 in 5 years, what is it worth today if I could invest it at 8
percent compounded quarterly?
r = 8, c = 4, n = 20, FV = 3,000, ANN = 0, PV = $2,018.91
PV = 1/($1 +0.08/4)20 * 3,000 = $2,018.91
What is an annuity?

A series of EQUAL cash payments made at EQUAL intervals
What is the future value of an annuity?


Answers the question, what is a series of payments going to be worth in the future
If I invest $200 every month for 10 years and earn 11 percent annual interest, how
much money will I have in 10 years?
r = 11, c = 12, n = 120, PV = 0, ANN = 200, FV = $43,399.63
FV = [($1 + 0.11/12)120 - $1]/0.11/12 * $200 = $43,399.63
What is the present value of an annuity?


Answers the question, how much must be received today to generate a series of
equal payments in the future?
If I want to buy a new car for $25,000 and the dealer will finance me at 8 percent
annual interest for 6 years, what is my monthly car payment?
r = 8, c = 12, n = 72, PV = 25,000, FV = 0, ANN = $438.33
$25,000 = [$1 – $1/($1 + 0.08/12)72]/0.08/12 * ANN; ANN = $438.33
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Lecture Examples
1.
You want to save for a new stereo system for your car. The system costs $3,000.
How much money must you put aside every month for 2 years if you can earn 8
percent interest annually?
r = 8, c = 12, n = 24, FV = 3,000, PV = 0, ANN = $115.68
2.
You want to buy a new car when you graduate with your Ph.D. in accounting.
How much money should you invest today to have $40,000 in 10 years if you can
earn 9 percent annually?
FV= 40,000, c = 1, n = 10, r = 8, ANN = 0, PV = $18,527.74
3.
You want to buy a used car today. The car costs $16,000. You can obtain
financing at 10 percent interest for 4 years. How much is your monthly payment?
PV = 16,000, r = 10, c = 12, n = 48, FV = 0, ANN = $405.80
4.
You have $2,000 to invest. If you earn 15 percent in the stock market, what will
your investments be worth when you graduate in 3.5 years?
PV = 2,000, r = 15, c = 1, n = 3.5, ANN = 0, FV = $2,088.88
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