Chapter 1: The Time Value of Money

Chapter 1: The time value of money*
minor bug fix: September 9, 2003 Chapter contents Overview......................................................................................................................................... 2 1.1. Future value ............................................................................................................................ 3 1.2. Present value ......................................................................................................................... 18 1.3. Net present value................................................................................................................... 26 1.4. The internal rate of return (IRR)........................................................................................... 32 1.5. What does IRR mean? Loan tables and investment amortization ....................................... 37 1.7. Saving for the futurebuying a car for Mario ..................................................................... 40 1.8. Saving for the futuremore realistic problems.................................................................... 42 1.9. Computing annual flat payments on a loanExcels PMT function ............................... 49 1.10. How long will it take to pay off a loan?.............................................................................. 51 1.11. An Excel notebuilding good financial models................................................................ 53 Summing up .................................................................................................................................. 55 Exercises ....................................................................................................................................... 57 Appendix: Algebraic Present Value Formulas ............................................................................ 69
Notice: This is a preliminary draft of a chapter of Principles of Finance with Excel by Simon
Benninga (benninga@wharton.upenn.edu). Check with the author before distributing this draft (though you will probably get permission). Make sure the material is updated before distributing it. All the material is copyright and the rights belong to the author.
PFE Chapter 1, Time value of money page 1
Overview
This chapter deals with the most basic concepts in finance: future value, present value, and internal rate of return. These concepts tell you how much your money will grow if deposited in a bank (future value), how much promised future payments are worth today (present value), and what percentage rate of return youre getting on your investments (internal rate of return). Financial assets and financial planning always have a time dimension. Here are some simple examples: You put $100 in the bank today in a savings account. How much will you have in 3 years? You put $100 in the bank today in a savings account and plan to add $100 every year for the next 10 years. How much will you have in the account in 20 years? XYZ Corporation just sold a bond to your mother for $860. The bond will pay her $20 per year for the next 5 years. In 6 years she gets a payment of $1020. Has she paid a fair price for the bond? Your Aunt Sara is considering making an investment. The investment costs $1,000 and will pay back $50 per month in each of the next 36 months. Should she do this or should she leave her money in the bank, where it earns 5%? This chapter discusses these and similar issues, all of which fall under the general topic of time value of money. You will learn how compound interest causes invested income to grow (future value), and how money to be received at future dates can be related to money in hand today (present value). You will also learn how to calculate the compound rate of return earned by an investment (internal rate of return). The concepts of future value, present value, and
PFE Chapter 1, Time value of money
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internal rate of return underlie much of the financial analysis which will appear in the following chapters.
Finance concepts discussed Future value Present value Net present value Internal rate of return Pension and savings plans and other accumulation problems
Excel functions used Excel functions: PV, NPV, IRR, PMT, NPer Goal seek
1.1. Future value

Future value (FV) tells you the value in the future of money deposited in a bank account today and left in the account to draw interest. The future value $X deposited today in an account paying r% interest annually and left in the account for n years is X*(1+r)n. Future value is our first illustration of compound interestit incorporates the principle that you earn interest on interest. If this sounds confusing, read on.
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Suppose you put $100 in a savings account in your bank today and that the bank pays you 6% interest at the end of every year. If you leave the money in the bank for one year, you will have $106 after one year: $100 of the original savings balance + $6 in interest. Now suppose you leave the money in the account for a second year: At the end of this year, you will have: $106 + 6%*$106 = $6.36 = $112.36 The interest in on this balance for the second year Total in account after two years The savings account balance at the end of the first year
A little manipulation will show you that the future value of the $100 after 2 years is $100*(1+6%)2. $100 *
Initial deposit
1.06
Year 1's future value factor at 6%
1.06
Year 2's future value factor
= $100* (1 + 6% ) = $112.36
2
Future value of $100 after one year = $100*1.06 Future value of $100 after two years
Notice that the future value uses the concept of compound interest: The interest earned in the first year ($6) itself earns interest in the second year. To sum up: The value of $X deposited today in an account paying r% interest annually and left in the account for n years is its future value FV = X * (1 + r ) .
n
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Notation
In this book we will often match our mathematical notation to that used by Excel. Since in Excel multiplication is indicated by a star *, we will generally write 6%*$106 = $6.36, even though this is not necessary. Similarly we will sometimes write (1.10 ) as 1.10 ^ 3 .
3
In order to confuse you, we make no promises about consistency!
Future value calculations are easily done in Excel:

A 1 2 3 4 5 6 Initial deposit Interest rate Number of years, n Account balance after n years B 100 6% 2 112.36 <-- =B2*(1+B3)^B4 C
CALCULATING FUTURE VALUES WITH EXCEL
Notice the use of the carat (^) to denote the exponent:
In Excel (1 + 6% ) is written as
2
(1+B3)^B4, where cell B3 contains the interest rate and cell B4 the number of years.
We can use Excel to make a table of how the future value grows with the years and then use Excels graphing abilities to graph this growth:
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A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 Initial deposit Interest rate Number of years, n Account balance after n years Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
B 100 6% 2
THE FUTURE VALUE OF A SINGLE $100 DEPOSIT
112.36 <-- =B2*(1+B3)^B4 Future value 100.00 <-- =$B$2*(1+$B$3)Â9 106.00 <-- =$B$2*(1+$B$3)Â10 112.36 <-- =$B$2*(1+$B$3)Â11 119.10 <-- =$B$2*(1+$B$3)Â12 126.25 <-- =$B$2*(1+$B$3)Â13 133.82 Future Value of $100 at 6% Annual Interest 141.85 150.36 159.38 168.95 350 179.08 300 189.83 250 201.22 200 213.29 150 226.09 100 239.66 50 254.04 0 269.28 0 5 10 15 285.43 Years 302.56 320.71
Future value
20
Excel note
Notice that the formula in cells B9:B29 in the table has $ signs on the cell references (for example: =$B$2*(1+$B$3)Â9 ). This use of the absolute copying feature of Excel is explained in Chapter 000.
In the spreadsheet below, we present a table and graph that shows the future value of $100 for 3 different interest rates: 0%, 6%, and 12%. As the spreadsheet shows, future value is very sensitive to the interest rate! Note that when the interest rate is 0%, the future value doesnt grow.
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A 1 2 Initial deposit 3 Interest rate 4 Year 5 6 0 7 1 8 2 9 3 10 4 11 5 12 6 13 7 14 8 15 9 16 10 17 11 18 12 19 13 20 14 21 15 22 16 23 17 24 18 25 19 26 20 27 28 1000 29 900 30 31 800 32 700 33 600 34 500 35 36 400 37 300 38 200 39 100 40 41 0 42 0 43 44
FUTURE VALUE OF A SINGLE PAYMENT AT DIFFERENT INTEREST RATES How $100 at time 0 grows at 0%, 6%, 12%
100 0% FV at 0% 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 6% FV at 6% 100.00 106.00 112.36 119.10 126.25 133.82 141.85 150.36 159.38 168.95 179.08 189.83 201.22 213.29 226.09 239.66 254.04 269.28 285.43 302.56 320.71 12% FV at 12% 100.00 <-- =$B$2*(1+D$3)^$A6 112.00 <-- =$B$2*(1+D$3)^$A7 125.44 140.49 157.35 176.23 197.38 221.07 247.60 277.31 310.58 347.85 389.60 436.35 488.71 547.36 613.04 686.60 769.00 861.28 964.63
FV at 0% FV at 6% FV at 12%
10
15
20
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Nomenclature: Whats a year? When does it begin?
This is a boring but necessary discussion. following synonyms:

Year 0 Year 1 End of year 1 Beginning of year 2 1 Year 2 End of year 2 Beginning of year 3 2
Throughout this book we will use the
Today Beginning of year 1 0
We use the words Year 0, Today, and Beginning of year 1 as synonyms. This often causes confusion in finance. For example, $100 at the beginning of year 2 is the same as $100 at the end of year 1. Note that we often use in year 1 to mean end of year 1: For example: An investment costs $300 today and pays off $600 in year 1. Theres a lot of confusion on this subject in finance courses and texts. If youre at loss to understand what someone means, ask for a drawing; better yet, ask for an Excel spreadsheet.
Accumulationsavings plans and future value
In the previous example you deposited $100 and left it in your bank. Suppose that you intend to make 10 annual deposits of $100, with the first deposit made in year 0 (today) and each succeeding deposit made at the end of years 1, 2, ..., 9. The future value of all these deposits at the end of year 10 tells you how much you will have accumulated in the account. If you are saving for the future (whether to buy a car at the end of your college years or to finance a pension at the end of your working life), this is obviously an important and interesting calculation.
So how much will you have accumulated at the end of year 10? Theres an Excel function for calculating this answer which we will discuss later; for the moment we will set this problem up in Excel and do our calculation the long way, by showing how much we will have at the end of each year:
A B C D E F
1 2 Interest 3 =E5 4 5 6 7 8 9 10 11 12 13 14 15 Year 1 2 3 4 5 6 7 8 9 10
FUTURE VALUE WITH ANNUAL DEPOSITS at beginning of year

6% =$B$2*(C6+B6) Deposit at Interest Total in Account balance, beginning earned account at beg. year of year during year end of year 0.00 100.00 6.00 106.00 <-- =B5+C5+D5 106.00 100.00 12.36 218.36 <-- =B6+C6+D6 218.36 100.00 19.10 337.46 337.46 100.00 26.25 463.71 463.71 100.00 33.82 597.53 597.53 100.00 41.85 739.38 739.38 100.00 50.36 889.75 889.75 100.00 59.38 1,049.13 1,049.13 100.00 68.95 1,218.08 1,218.08 100.00 79.08 1,397.16 Future value using Excel's FV function
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$1,397.16 <-- =FV(B2,A14,-100,,1)
For clarity, lets analyze a specific year: At the end of year 1 (cell E5) youve got $106 in the account. This is also the amount in the account at the beginning of year 2 (cell B6). If you now deposit another $100 and let the whole amount of $206 draw interest during the year, it will earn $12.36 interest. You will have $218.36 = (106+100)*1.06 at the end of year 2.
6 A 2 B 106.00 C 100.00 D 12.36 E 218.36
Finally, look at rows 13 and 14: At the end of year 9 (cell E13) you have $1,218.08 in the account; this is also the amount in the account at the beginning of year 10 (cell B14). You
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then deposited $100 and the resulting $1,318.08 earns $79.08 interest during the year, accumulating to $1,397.16 by the end of year 10.
13 14 A 9 10 B 1,049.13 1,218.08 C 100.00 100.00 D 68.95 79.08 E 1,218.08 1,397.16
The Excel FV (future value) formula
The spreadsheet of the previous subsection illustrates in a step-by-step manner how money accumulates in a typical savings plan. To simplify this series of calculations, Excel has a
FV formula which computes the future value of any series of constant payments. This formula
is illustrated in cell C16:

B Future value using Excel's 16 FV function C D E
$1,397.16 <-- =FV(B2,A14,-100,,1)
The FV function requires as inputs the Rate of interest, the number of periods Nper, and the annual payment Pmt. You can also indicate the Type, which tells Excel whether payments are made at the beginning of the period (type 1 as in our example) or at the end of the period (type 0).1
Exercises 2 and 3 at the end of the chapter illustrate both cases.
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Dialog box for FV function
Excels function dialog boxes have room for two types of arguments.
Bold faced parameters must be filled inin the FV dialog box these are the interest Rate, the number of periods Nper, and the payment Pmt. (Read on to see why we wrote
a negative payment.) Arguments which are not bold faced are optional. In the example above weve indicated a 1 for the Type; this indicates (as shown in the dialog box itself) that the future value is calculated for payments made at the beginning of the period. Had we omitted this argument or put in 0, Excel would compute the future value for a series of payments made at the end of the period; see the next example for an illustration. Notice that the dialog box already tells us (even before we click on OK) that the future value of $100 per year for 10 years compounded at 6% is $1397.16.
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Excel notea peculiarity of the FV function
In the FV dialog box weve entered in the payment Pmt in as a negative number, as -100. The FV function has the peculiarity (shared by some other Excel financial functions) that a positive deposit generates a negative answer. We wont go into the (strange?) logic that
produced this thinking; whenever we encounter it we just put in a negative deposit.
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Sidebar: Functions and Dialog Boxes

The dialog box which comes with an Excel function is a handy way to utilize the function. There are several ways to get to a dialog box. Well illustrate with the example of the
FV function in Section 1.1.
Going through the function wizard
Suppose youre in cell B16 and you want to put the Excel function for future value in the cell. With the cursor in B16, you move your mouse to the icon on the tool bar:
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Clicking on the
icon brings up the dialog box below. Weve already chosen the
category to be the Financial functions, and weve scrolled down in the next section of the dialog
box to put the cursor on the FV function.
Clicking OK brings up the dialog box for the FV function.
A short way to get to the dialog box
If you know the name of the function you want, you can just write it in the cell and then click the icon on the tool bar. As illustrated below, you have to write
=FV(
and then click on the
iconnote that weve written an equal sign, the name of the function,
and the opening parenthesis. Heres how the spreadsheet looks in this case:
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Look in the text displayed by Excel below cell C16: Some versions of Excel show the format of the function when you type it in a cell.
One further option
You dont have to use a dialog box! If you know the format of the function then just type in its arguments and youre all set. In the example of Section 1.1 you could just type
=FV(B2,A14,-100,,1) in the cell. Hitting [Enter] would give the answer.
[END OF SIDEBAR]
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Beginning versus end of period
In the example above you make deposits of $100 at the beginning of each year. In terms of timing, your deposits are made at dates 0, 1, 2, 3, ..., 9. Heres a schematic way of looking at this, showing the future value of each deposit at the end of year 10:
DEPOSITS AT BEGINNING OF YEAR
Beginning of year 1 0 $100 Beginning of year 2 1 $100 Beginning of year 3 2 $100 Beginning of year 4 3 $100 Beginning of year 5 4 $100 Beginning of year 6 5 $100 Beginning of year 7 6 $100 Beginning of year 8 7 $100 Beginning of year 9 8 $100 Beginning of year 10 9 $100 179.08 168.95 159.38 150.36 141.85 133.82 126.25 119.10 112.36 106.00 Total <-- =100*(1.06)^10 <-- =100*(1.06)^9 <-- =100*(1.06)^8 <-- =100*(1.06)^7 <-- =100*(1.06)^6 <-- =100*(1.06)^5 <-- =100*(1.06)^4 <-- =100*(1.06)^3 <-- =100*(1.06)^2 <-- =100*(1.06)^1 End of year 10 10
1397.16 <-- Sum of the above
In the above example and in the previous spreadsheet you made deposits of $100 at the beginning of each year. Suppose you made 10 deposits of $100 at the end of each year. How would this affect the accumulation in the account at the end of 10 years?
DEPOSITS AT END OF YEAR
Beginning of year 1 0 Beginning of year 2 1 $100 Beginning of year 3 2 $100 Beginning of year 4 3 $100 Beginning of year 5 4 $100 Beginning of year 6 5 $100 Beginning of year 7 6 $100 Beginning of year 8 7 $100 Beginning of year 9 8 $100 Beginning of year 10 9 $100 End of year 10 10 $100 168.95 159.38 150.36 141.85 133.82 126.25 119.10 112.36 106.00 100.00 Total <-- =100*(1.06)^9 <-- =100*(1.06)^8 <-- =100*(1.06)^7 <-- =100*(1.06)^6 <-- =100*(1.06)^5 <-- =100*(1.06)^4 <-- =100*(1.06)^3 <-- =100*(1.06)^2 <-- =100*(1.06)^1 <-- =100*(1.06)^0
1318.08 <-- Sum of the above
The account accumulation is less in this case (where you deposit at the end of each year) than in the previous case, where you deposit at the beginning of the year. In the second example,
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each deposit is in the account one year less and consequently earns one years less interest. In a spreadsheet, this looks like:
A B C D E F
1 2 Interest 3 =E5 4 5 6 7 8 9 10 11 12 13 14 15 16 Year 1 2 3 4 5 6 7 8 9 10
FUTURE VALUE WITH ANNUAL DEPOSITS at end of year

6% =$B$2*B6 Account Deposit at Interest Total in balance, end earned account at beg. year of year during year end of year 0.00 100.00 0.00 100.00 <-- =B5+C5+D5 100.00 100.00 6.00 206.00 <-- =B6+C6+D6 206.00 100.00 12.36 318.36 318.36 100.00 19.10 437.46 437.46 100.00 26.25 563.71 563.71 100.00 33.82 697.53 697.53 100.00 41.85 839.38 839.38 100.00 50.36 989.75 989.75 100.00 59.38 1,149.13 1,149.13 100.00 68.95 1,318.08 Future value $1,318.08 <-- =FV(B2,A14,-100)
Cell C16 illustrates the use of the Excel FV formula for this case. In the dialog box for this formula, we have put in a zero under Type, which indicates that the payments are made at the end of each year:
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Dialog box for FV with end-period payments
In the example above weve omitted any entry in the Type box. As indicated on the dialog box itself, we could have also put a 0 in the Type box. Meaning: Excels default for the
FV function is a deposit at the end of the year.
Some finance jargon and the Excel FV function
An annuity with payments at the end of each period is often called a regular annuity. As youve seen in this section, the value of a regular annuity is calculated with =FV(B2,A14,-100). An annuity with payments at the beginning of each period is often called an annuity due and its value is calculated with the Excel function =FV(B2,A14,-100,,1).
1.2. Present value

In this section we discuss present value.
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The present value is the value today of a payment (or payments) that will be made in the future. Heres a simple example: Suppose that you anticipate getting $100 in 3 years from your Uncle Simon, whose word is as good as a banks. Suppose that the bank pays 6% interest on savings accounts. How much is the anticipated future payment worth today? The answer is
$83.96= 100
(1.06 )
; if you put $83.96 in the bank today at 6 percent annual interest, then in 3 years
you would have $100 (see the proof in rows 9 and 10). 2 $83.96 is also called the discounted
or present value of $100 in 3 years at 6 percent interest.

A 1 2 3 4 5 6 7 8 9 X, future payment n, time of future payment r, interest rate n Present value, X/(1+r) Proof Payment today Future value in n years B C 100 3 6% 83.96 <-- =B2/(1+B4)^B3
SIMPLE PRESENT VALUE CALCULATION
83.96 100 <-- =B8*(1+B4)^B3
To summarize:
The present value of $X to be received in n years when the appropriate interest rate is r% is
(1 + r )
The interest rate r is also called the discount rate. We can use Excel to make a table of how the present value decreases with the discount rate. As you can seehigher discount rates make for lower present values:
Actually,
100
(1.06 )
= 83.96193 , but weve used Format|Cells|Number to show only 2 decimals.
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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
THE PRESENT VALUE OF $100 IN 3 YEARS in this example we vary the discount rate r
X, future payment n, time of future payment r, interest rate n Present value, X/(1+r) 100 3 6% 83.96 <-- =B2/(1+B4)^B3 Present value 100.00 97.06 94.23 91.51 88.90 86.38 83.96 81.63 79.38 77.22 71.18 65.75 60.86 57.87 55.07 51.20 45.52 40.64 36.44 32.80 29.63
Discount rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 12% 15% 18% 20% 22% 25% 30% 35% 40% 45% 50%
<-- =100/(1+A8)^3 <-- =100/(1+A9)^3 <-- =100/(1+A10)^3 <-- =100/(1+A11)^3 <-- =100/(1+A12)^3
120 100 Present value 80 60 40 20 0 0%
Present Value of $100 to be Paid in 3 Years when Discount Rate Varies
10%
20%
30%
40%
50%
Discount rate
Why does PV decrease as the discount rate increases?
The Excel table above shows that the $100 Uncle Simon promises you in 3 years is worth $83.96 today if the discount rate is 6% but worth only $40.64 if the discount rate is 35%. The mechanical reason for this is that taking the present value at 6% means dividing by a smaller denominator than taking the present value at 35%: 83.96 = 100
(1.06 )
>
100
(1.35)
= 40.64
The economic reason relates to future values: If the bank is paying you 6% interest on your savings account, you would have to deposit $83.96 today in order to have $100 in 3 years. If the bank pays 35% interest, then $40.64* (1.35 ) = $100 .
3
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What this short discussion shows is that the present value is the inverse of the future
value:
Time 0 1 2 3 $100.00
PV = 3 $100.00/(1+6%) = $83.96 FV= 3 $83.96*(1+6%) = $100.00
Present value of an annuity
In the jargon of finance, an annuity is a series of equal periodic payments. Examples of annuities are widespread: The allowance your parents give you ($1000 per month, for your next 4 years of college) is a monthly annuity with 48 payments. Pension plans often give the retiree a fixed annual payment for as long as he lives. This is a bit more complicated annuity, since the number of payments is uncertain. Certain kinds of loans are paid off in fixed periodic (usually monthly, sometimes annual) installments. Mortgages and student loans are two examples. The present value of an annuity tells you the value today of all the future payments on the annuity. Heres an example that relates to your generous Uncle Simon. Suppose he has promised you $100 at the end of each of the next 5 years. Assuming that you can get 6% at the bank, this promise is worth $421.24 today:
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A 1 CALCULATING 2 Annual payment 3 r, interest rate 4
B 100 6%
PRESENT VALUES WITH EXCEL
Year 5 6 1 7 2 8 3 9 4 10 5 11 12 Present value of all payments 13 Summing the present values 14 Using Excel's PV function 15 Using Excel's NPV function
Payment Present at end of value of year payment 100 94.34 <-- =B6/(1+$B$3)Â6 100 89.00 <-- =B7/(1+$B$3)Â7 100 83.96 100 79.21 100 74.73
421.24 <-- =SUM(C6:C10) 421.24 <-- =PV(B3,5,-100) 421.24 <-- =NPV(B3,B6:B10)
The example above shows three ways of getting the present value of $421.24: You can sum the individual discounted values. This is done in cell C13. You can use Excels PV function, which calculates the present value of an annuity (cell C14). You can use Excels NPV function (cell C16). This function calculates the present value of any series of periodic payments (whether theyre flat payments, as in an annuity, or non-equal payments). We devote separate subsections to the PV function and to the NPV function.
The Excel PV function
The PV function calculates the present value of an annuity (a series of equal payments). It looks a lot like the FV discussed above, and like FV, it also suffers from the peculiarity that positive payments give negative results (which is why we set Pmt equal to 100). As in the case of the FV function, Type denotes whether the payments are made at the beginning or the end of the year. Because end-year is the default, can either enter 0 or leave the Type entry blank:
Dialog box for the PV function
The Formula result in the dialogue box shows that the answer is $421.24.
The Excel NPV function
The NPV function computes the present value of a series of payments. The payments need not be equal, though in the present example they are. The ability of the NPV function to handle non-equal payments makes it one of the most useful of all Excels financial functions. We will make extensive use of this function throughout this book.
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Dialog box for the NPV function
Important note: Finance professionals use NPV to mean net present value, a
concept we explain in the next section. Excels NPV function actually calculates the present
value of a series of payments. Almost all finance professionals and textbooks would call the
number computed by the Excel NPV function PV. Thus the Excel use of NPV differs from the standard usage in finance.
Choosing a discount rate
Weve defined the present value of $X to be received in n years as
(1 + r )
. The interest
rate r in the denominator of this expression is also known as the discount rate. Why is 6% an appropriate discount rate for the money promised you by Uncle Simon? The basic principle is to choose a discount rate that is appropriate to the riskiness and the duration of the cash flows being discounted. Uncle Simons promise of $100 per year for 5 years is assumed as good as the
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promise of your local bank, which pays 6% on its savings accounts. Therefore 6% is an appropriate discount rate.3
The present value of non-annuity (meaning: non-constant) cash flows
The present value concept can also be applied to non-annuity cash flow streams, meaning cash flows that are not the same every period. Suppose, for example, that your Aunt Terry has promised to pay you $100 at the end of year 1, $200 at the end of year 2, $300 at the end of year 3, $400 at the end of year 4 and $500 at the end of year 5. This is not an annuity, and so it cannot be accommodated by the PV function. But we can find the present value of this promise by using the NPV function:
A 1 CALCULATING 2 r, interest rate 3 B 6% Payment at end of Present year value 100 94.34 <-- =B5/(1+$B$2)Â5 200 178.00 <-- =B6/(1+$B$2)Â6 300 251.89 400 316.84 500 373.63 C D
PRESENT VALUES WITH EXCEL
Year 4 1 5 2 6 3 7 4 8 5 9 10 11 Present value of all payments Summing the present values 12 Using Excel's NPV function 13
1,214.69 <-- =SUM(C5:C9) 1,214.69 <-- =NPV($B$2,B5:B9)
Theres more to be said on the choice of a discount rate, but we postpone the discussion until Chapters 5 and 6.
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Excel note
Excels NPV function allows you to input up to 29 payments directly in the function dialogue box. Heres an illustration for the example above:
1.3. Net present value

In this section we discuss net present value.
The net present value (NPV) of a series of future cash flows is their present value minus the initial investment required to obtain the future cash flows. The NPV = PV(future cash flows) initial investment. The NPV of an investment represents the increase in wealth which you get if you make the investment.
Heres an example based on the spreadsheet on page000. Would you pay $1500 today to get the series of future cash flows in cells B6:B10? Certainly nottheyre worth only $1214.69, so why pay $1500? If asked to pay $1500, the NPV of the investment would be
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NPV = $1,500 + $1, 214.69 = $285.31 .

Cost of the investment Present value of investment's future cash flows at discount rate of 6% Net present value
If you paid $1,500 for this investment, you would be overpaying $285.31 for the investment, and you would be poorer by the same amount. Thats a bad deal! On the other hand, if you were offered the same future cash flows for $1,000, youd snap up the offer, you would be paying $214.69 less for the investment than its worth:
NPV = $1, 000 + $1, 214.69 = $214.69
Cost of the investment Present value of investment's future cash flows at discount rate of 6% Net present value
In this case the investment would make you $214.69 richer. As we said before, the NPV of an investment represents the increase in your wealth if you make the investment. To summarize:
The net present value (NPV) of a series of cash flows is used to make investment decisions: An investment with a positive NPV is a good investment and an investment with a negative NPV is a bad investment. You should be indifferent to making in a zeroNPV investment. An investment with a zero NPV is a fair gamethe future cash flows of the investment exactly compensate you for the investments initial cost.
Net present value (NPV) is a basic tool of financial analysis. It is used to determine whether a particular investment ought to be undertaken; in cases where we can make only one of several investments, it is the tool-of-choice to determine which investment to undertake. Heres another example: Youve found an interesting investmentIf you pay $800 today to your local pawnshop, the owner promises to pay you $100 at the end of year 1, $150 at the end of year 2, $200 at the end of year 3, ... , $300 at the end of year 5. In your eyes, the
page 27
pawnshop owner is as reliable as your local bank, which is currently paying 5% interest. The following spreadsheet shows the NPV of this $800 investment:
A 1 CALCULATING 2 r, interest rate 3 B 5% Present value -800.00 95.24 <-- =B6/(1+$B$2)Â6 136.05 <-- =B7/(1+$B$2)Â7 172.77 205.68 235.06 C D
NET PRESENT VALUE (NPV) WITH EXCEL
Payment Year 4 -800 0 5 1 100 6 2 150 7 3 200 8 4 250 9 5 300 10 11 12 NPV Summing the present values 13 Using Excel's NPV function 14
44.79 <-- =SUM(C5:C10) 44.79 <-- =NPV($B$2,B6:B10)+C5
The spreadsheet shows that the value of the investmentthe net present value(NPV) of its payments, including the initial payment of -$800is $44.79:
NPV = 800 + 100 150 200 250 300 + + + + = 44.97 2 3 4 (1.05) (1.05 ) (1.05) (1.05) (1.05 )5
The present value of the future payments: Calculated with Excel NPV function = 844.79
At a 5% discount rate, you should make the investment, since its NPV is $44.79, which is positive.
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An Excel Note
As mentioned earlier, the Excel NPV functions name does not correspond to the standard finance use of the term net present value.4 In finance, present value usually refers to the value today of future payments (in the example, this is
100 150 200 250 300 + + + + = 844.79 ). Finance professionals use net present 2 3 4 (1.05) (1.05) (1.05) (1.05) (1.05)5 value (NPV) to mean the present value of future payments minus the cost of the initial payment; in the previous example this is $844.79 - $800 = $44.79. In this book we use the term net present value (NPV) to mean its true finance sense. The Excel function NPV will always appear in boldface. We trust that you will rarely be confused
NPV depends on the discount rate
Lets revisit the pawnshop example on page000, and use Excel to create a table which shows the relation between the discount rate and the NPV. As the graph below shows, the higher the discount rate, the lower the net present value of the investment:
Theres a long history to this confusion, and it doesnt start with Microsoft. The original spreadsheetVisicalc
(mistakenly) used NPV in the sense which Excel still uses today; this misnomer has been copied every since by all other spreadsheets: Lotus, Quattro, and Excel.
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A 1 2 r, interest rate 3
B 5%
CALCULATING NET PRESENT VALUE (NPV) WITH EXCEL
Present Payment value Year 4 -800 0 -800.00 5 1 100 95.24 <-- =B6/(1+$B$2)Â6 6 2 150 136.05 <-- =B7/(1+$B$2)Â7 7 3 200 172.77 8 4 250 205.68 9 5 300 235.06 10 11 12 NPV Summing the present values 44.79 <-- =SUM(C5:C10) 13 Using Excel's NPV function 44.79 <-- =NPV($B$2,B6:B10)+C5 14 15 Discount rate NPV 16 0% 200.00 <-- =NPV(A17,$B$6:$B$10)+$B$5 17 1% 165.86 <-- =NPV(A18,$B$6:$B$10)+$B$5 18 2% 133.36 <-- =NPV(A19,$B$6:$B$10)+$B$5 19 3% 102.41 20 4% 72.92 21 NPV and the Discount Rate 250 5% 44.79 22 6% 17.96 23 200 6.6965% 0.00 24 8% -32.11 25 150 9% -55.48 26 100 10% -77.83 27 11% -99.21 28 50 12% -119.67 29 0 13% -139.26 30 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 14% -158.04 31 -50 15% -176.03 32 -100 16% -193.28 33 Discount rate 34 -150 35 36 -200 37 -250 38 39 40
Note that weve indicated a special discount rate: When the discount rate is 6.6965%, the net present value of the investment is zero. This rate is referred to as the internal rate of return (IRR), and well return to it in Section 000. For discount rates less than the IRR, the net present value is positive, and for discount rates greater than the IRR the net present value is negative.
Using NPV to choose between investments
In the examples discussed thus far, weve used NPV only to choose whether to undertake a particular investment or not. But NPV can also be used to choose between investments. Look at the following spreadsheet: You have $800 to invest, and youve been offered the choice
NPV
between Investment A and Investment B. The spreadsheet below shows that at an interest rate of 15%, you should choose Investment B because it has a higher net present value. Investment A will increase your wealth by $219.06, whereas Investment B increases your wealth by $373.75.
A 1 USING NPV 2 Discount rate 3 Year 4 0 5 1 6 2 7 3 8 4 9 5 10 11 12 NPV B 15% Investment A Investment B -800 -800 250 600 500 200 200 100 250 500 300 300 219.06 373.75 <-- =NPV(B2,C6:C10)+C5 C D
TO CHOOSE BETWEEN INVESTMENTS
To summarize: In using the NPV to choose between two positive-NPV investments, we choose the investment with the higher NPV.5
Theres a possible exception to this rule: If we neither have the cash nor can borrow the money to make the
investment (the jargon is cash constrained), we may want to use the profitability index to choose between investments. The profitability index is defined as the ratio of the PV(future cash flows) to the investments cost. See Chapter 3 for a discussion of this topic.
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NomenclatureIs it a discount rate or an interest rate?
In some of the examples above weve used discount rate instead of interest rate to describe the rate used in the net present value calculation. As you will see in further chapters of this book, the rate used in the NPV has several synonyms: Discount rate, interest rate, cost of capital, opportunity costthese are but a few of the names for the rate that appears in the denominator of the NPV:
Cash flowin year t
(1 + r )
Discount rate Interest rate Cost of capital Opportunity cost
1.4. The internal rate of return (IRR)

In this section we discuss the internal rate of return (IRR): The IRR of a series of cash flows is the discount rate that sets the net present value of the cash flows equal to zero. Before we explain in depth (in the next section) why you want to know the IRR, we explain how to compute it. Lets go back to the example on page000: If you pay $800 today to your local pawnshop, the owner promises to pay you $100 at the end of year 1, $150 at the end of year 2, $200 at the end of year 3, $250 at the end of year 4 , and $300 at the end of year 5. Discounting these cash flows at rate r, the NPV can be written:
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NPV = 800 +
100 150 200 250 300 + + + + 2 3 4 (1 + r ) (1 + r ) (1 + r ) (1 + r ) (1 + r )5
In cells B16:B32 of the spreadsheet below, we calculate the NPV for various discount rates. As you can see, somewhere between r = 6% and r = 7%, the NPV becomes negative.
A B C D E F
CALCULATING THE IRR WITH EXCEL 1 2 r, interest rate 6.6965% 3 Payment Year 4 -800 5 0 6 1 100 7 2 150 8 3 200 9 4 250 10 5 300 11 12 NPV 0.00 <-- =NPV(B2,B6:B10)+B5 13 IRR 6.6965% <-- =IRR(B5:B10) 14 Discount rate NPV 15 16 0% 200.00 <-- =NPV(A16,$B$6:$B$10)+$B$5 17 1% 165.86 <-- =NPV(A17,$B$6:$B$10)+$B$5 18 2% 133.36 <-- =NPV(A18,$B$6:$B$10)+$B$5 19 3% 102.41 20 4% 72.92 NPV and the Discount Rate 21 5% 44.79 250 22 6% 17.96 200 23 7% -7.65 150 24 8% -32.11 100 25 9% -55.48 50 26 10% -77.83 0 27 11% -99.21 -50 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 28 12% -119.67 29 13% -139.26 -100 Discount rate 30 14% -158.04 -150 31 15% -176.03 -200 32 16% -193.28 -250 33 34 35
NPV
In cell B13, we use Excels IRR function to calculate the exact discount rate at which the NPV becomes 0. The answer is 6.6965%; at this interest rate, the NPV of the cash flows equals zero (look at cell B12). Using the dialog box for the Excel IRR function:
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Dialog box for IRR function
Notice that we havent used the second option (Guess) to calculate our IRR. We discuss this option in Chapter 4.
What does the IRR mean?
Suppose you could get 6.6965% interest at the bank and suppose you wanted to save today to provide yourself with the future cash flows of the example on page000: To get $100 at the end of year 1, you would have to put the present value
100 = 93.72 in the bank today. 1.06965 To get $150 at the end of year 2, you would have to put its present value 150
(1.06965)
= 131.76 in the bank today.
And so on (see the picture below) The total amount you would have to save is $800, exactly the cost of this investment
opportunity. This is what we mean when we say that:

The internal rate of return is the compound interest rate you earn on an investment.
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Time
Save for time 1's $100 $100/(1+6.6965%) Save for time 1's $150 2 $150/(1+6.6965%) Save for time 3's $200 3 $200/(1+6.6965%) Save for time 4's $250 4 $250/(1+6.6965%) Save for time 5's $300 5 $300/(1+6.6965%)
0
93.72 131.76 164.66 192.90 216.95
1
FV=93.72*(1+6.6965%) =$100.00
FV=131.76*(1+6.6965%) = $150.00
FV=164.66*(1+6.6965%) = $200.00
FV=192.90*(1+6.6965%) =$250.00
FV=216.95*(1+6.6965%) = $300.00
Total saving at time 0
800.00
Using IRR to make investment decisions
The IRR is often used to make investment decisions. Suppose your Aunt Sara has been offered the following investment by her broker: For a payment of $1,000, a reputable finance company will pay her $300 at the end of each of the next four years. Aunt Sara is currently getting 5% on her bank savings account. Should she withdraw her money from the bank to make the investment? To answer the question, we compute the IRR of the investment and compare it to the bank interest rate:
A B C
1 Year 2 3 0 4 1 5 2 6 3 7 4 8 9 IRR
USING IRR TO MAKE INVESTMENT DECISIONS

Cash flow -1,000 300 300 300 300 7.71% <-- =IRR(B3:B7)
The IRR of the investment, 7.71%, is greater than 5% Sara can earn on her alternative investment (the bank account). Thus she should make the investment. Summarizing:
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In using the IRR to make investment decisions, an investment with an IRR greater than the alternative rate of return is a good investment and an investment with an IRR less than the alternative rate of return is a bad investment.
Using IRR to choose between two investments
We can also use the internal rate of return to choose between two investments. Suppose youve been offered two investments. Both Investment A and Investment B cost $1,000, but they have different cash flows. If youre using the IRR to make the investment decision, then you would choose the investment with the higher IRR. Heres an example:
A B C D
USING IRR TO CHOOSE BETWEEN INVESTMENTS

Investment A cash flows -1,000.00 450.00 425.00 350.00 450.00 24.74% Investment B cash flows -1,000.00 550.00 300.00 475.00 200.00 22.26% <-- =IRR(C3:C7)
Year 2 0 3 1 4 2 5 3 6 4 7 8 9 IRR
We would choose Investment A, which has the higher IRR. To summarize:

In using the IRR to choose between two comparable investments, we choose the investment which has the higher IRR. [This assumes that: 1) Both investments have IRR
greater than the alternative rate. 2) The investments are of comparable risk.]
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Using NPV and IRR to make investment decisions
In this chapter we have now developed two tools, NPV and IRR, for making investment decisions. Weve also discussed two kinds of investment decisions. Heres a summary:
Yes or No: Choosing whether to undertake a single investment NPV criterion Investment ranking: Comparing two investments which are mutually exclusive
IRR criterion
The investment should be Investment A is preferred to undertaken if its NPV > 0: investment B if NPV(A) > NPV(B) The investment should be Investment A is preferred to undertaken if its IRR > r, investment B if where r is the appropriate IRR(A) > IRR(B). discount rate.
In Chapter 3 we discuss further implementation of these two rules and two decision problems.
1.5. What does IRR mean? Loan tables and investment amortization
In the previous section we gave a simple illustration of what we meant when we said that
the internal rate of return (IRR) is the compound interest rate that you earn on an asset. This
simple sentencewhich is not easy to understandunderlies a slew of finance applications: When finance professionals discuss the rate of return on an investment or the effective interest rate on a loan, they are almost always refering to the IRR. In this section we explore some meanings of the IRR. Almost the whole of Chapter 2 is devoted to this topic.
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A simple example
Suppose you buy an asset for $200 today and that the asset has a promised payment of $300 in one year. The IRR is 50%; to see this recall that the IRR is the interest rate which makes the NPV zero. Since the investment NPV = 200 + 300 , this means that the NPV is zero when 1+ r
1+ r =
300 = 1.5 . Solving this simple equation gives r = 50%. 200 Heres another way to think about this investment and its 50% IRR:
At time zero you pay $200 for the investment. At time one, the $300 investment cash flow repays the initial $200. The remaining $100 represents a 50% return on the initial $200 investment. This is the IRR. The IRR is the rate of return on an investment; it is the rate that repays, over the life of the asset, the initial investment in the asset and that pays interest on the outstanding investment balances.
A more complicated example
We now give a more complicated example, which illustrates the same point. This time, you buy an asset costing $200. The assets cash flow are $130.91 at the end of year 1 and $130.91 at the end of year 2. Heres our IRR analysis of this investment:
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A 1 2 IRR
THE IRR AS A RATE OF RETURN ON AN INVESTMENT

20.00% <-- =IRR({-200,130.91,130.91}) Investment at beginning of year 200.00 109.09 0.00 Part of payment which is repayment of principal 90.91 109.09 =C4-D4 =$B$2*B5
3 4 5 6 7 8 9 10 11
Year 1 2 3 =B4-E4
Payment at Part of payment end of year which is interest 130.91 40.00 130.91 21.82 =$B$2*B4
=B5-E5
=C5-D5
The IRR for the investment is 20.00%. Note how we calculated thiswe simply typed into cell B2 the formula =IRR({-200,130.91,130.91}) (if youre going to use this method of calculating the IRR in Excel, you have to put the cash flows in the curly brackets).
Using the 20% IRR, $40.00 (=20%*$200) of the first years payment is interest, and the remainder$90.91is repayment of principal. Another way to think of the $40.00 is to consider that to buy the asset, you gave the seller the $200 cost of the asset. When he pays you $130.91 at the end of the year, $40 (=20%*$200) is interestyour payment for allowing someone else to use your money. The remainder, $90.91, is a partial repayment of the money lent out.
This leaves the outstanding principal at the beginning of year 2 as $109.09. Of the $130.91 paid out by the investment at the end of year 2, $21.82 (=20%*109.09) is interest, and the rest (exactly $109.09) is repayment of principal.
The outstanding principal at the beginning of year 3 (the year after the investment finishes paying out) is zero.
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As in the first example of this section, the IRR is the rate of return on the investment defined as the rate that repays, over the life of the asset, the initial investment in the asset and that pays interest on the outstanding investment balances.
Using future value, net present value, and internal rate of returnseveral problems In the remaining sections we apply the concepts learned in the chapter to solve several common problems: 1.7 and 1.8. Saving for the future 1.9. Paying off a loan with flat payments of interest and principal 1.10. How long does it take to pay off a loan?
1.7. Saving for the futurebuying a car for Mario

Mario wants to buy a car in 2 years. He wants to open a bank account and to deposit $X today and $X in one year. Balances in the account will earn 8%. How much should Mario deposit so that he has $20,000 in 2 years? In this section well show you that: In order to finance future consumption with a savings plan, the net present value of all the cash flows has to be zero. In the jargon of financethe future consumption plan is fully funded if the net present value of all the cash flows is zero. In order to see this, start with a graphical representation of what happens:
0 X 1 X 2 -20,000 X*(1.08) X*(1.08)
2
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In year 2 Mario will have accumulated X * (1.08 ) + X * (1.08 ) . This should finance the $20,000
2
car, so that: X * (1.08 ) + X * (1.08 ) =

2
Future value of deposits in 2 years
20, 000
Desired accumulation
Now subtract the $20,000 from both sides of the equation and divide through by (1.08 ) :
2
X+
X 20, 000 =0 (1.08) (1.08)2

Net present value of all cash flows
Weve proved itin order to fully fund Marios future purchase of the car, the net present value of all the payments has to be zero.
Excel solution
Of course, we wont leave it at thiswell show you Marios problem in Excel:

A 1 2 Deposit, X 3 Interest rate B 8,903.13 8.00% C D E
HELPING MARIO SAVE FOR A CAR

Total at In bank, before Deposit or beginning of deposit withdrawal year 0.00 8,903.13 8,903.13 9,615.38 8,903.13 18,518.52 20,000.00 (20,000.00) 0.00
NPV of all deposits and payments
4 5 6 7 8
Year 0 1 2
End of year with interest 9,615.38 20,000.00 0.00
$0.00 <-- =C5+NPV(B3,C6:C7)
If he deposits $8,903.13 in years 0 and 1, then the accumulation in the account at the beginning of year 2 will be exactly $20,000 (cell B7). The NPV of all the payments (cell C9) is zero.
How did we actually arrive at $8,903.13? Well postpone this to the next section, where we discuss a somewhat more complicated and realistic version of the same problem.
1.8. Saving for the futuremore realistic problems

In this section we present more complicated versions of Marios problem from section 1.7. We start by trying to determine whether a young girls parents are putting enough money aside to save for her college education. Heres the problem: On her tenth birthday Linda Joness parents decide to deposit $4,000 in a savings account for their daughter. They intend to put an additional $4,000 in the account each year on her 11th, 12th, ..., 17th birthdays. All account balances will earn 8% per year. On Lindas 18th, 19th, 20th, and 21st birthdays, her parents will withdraw $20,000 to pay for Lindas college education. Is the $4,000 per year sufficient to cover the anticipated college expenses? We can easily solve this problem in a spreadsheet:
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A 1 2 Interest rate 3 Annual deposit 4 Annual cost of college 5
B 8% 4,000.00 20,000 In bank on birthday, before deposit/withdrawal 0.00 4,320.00 8,985.60 14,024.45 19,466.40 25,343.72 31,691.21 38,546.51 45,950.23 28,026.25 8,668.35 -12,238.18 NPV of all payments
SAVING FOR COLLEGE
6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Birthday 10 11 12 13 14 15 16 17 18 19 20 21
Deposit or withdrawal at begin. of year 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 -20,000.00 -20,000.00 -20,000.00 -20,000.00
End of year with interest Total 4,000.00 4,320.00 8,320.00 8,985.60 12,985.60 14,024.45 18,024.45 19,466.40 23,466.40 25,343.72 29,343.72 31,691.21 35,691.21 38,546.51 42,546.51 45,950.23 25,950.23 28,026.25 8,026.25 8,668.35 -11,331.65 -12,238.18 -32,238.18 -34,817.24
-13,826.4037 <-- =NPV(B2,C8:C18)+C7
By looking at the end-year balances in column E, the $4,000 is not enoughLinda and her parents will run out of money somewhere between her 19th and 20th birthdays.6 By the end of her college career, they will be $34,817 in the hole. Another way to see this is to look at the net present value calculation in cell C20: As we saw in the previous section, a combination savings/withdrawal plan is fully funded when the NPV of all the payments/withdrawals is zero. In cell C20 we see that the NPV is negativeLindas plan is underfunded. How much should Lindas parents put aside each year? There are several ways to answer this question, which we explore below.
At the end of Lindas 19 year (row 16), there is $8,668.35 remaining in the account. At the end of the following
year, there is a negative amount in the account.
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Method 1: Trial and error
Assuming that you have written the spreadsheet correctly, you can play with cell B3 until cell E18 or cell C20 equals zero. Doing this shows that Lindas parents should have planned to deposit $6,227.78 annually:
A 1 2 Interest rate 3 Annual deposit 4 Annual cost of college 5 B 8% 6,227.78 20,000 In bank on birthday, before deposit/withdrawal 0.00 6,726.00 13,990.08 21,835.28 30,308.10 39,458.75 49,341.45 60,014.76 71,541.94 55,665.29 38,518.52 20,000.00 NPV of all payments Deposit or withdrawal at begin. of year 6,227.78 6,227.78 6,227.78 6,227.78 6,227.78 6,227.78 6,227.78 6,227.78 -20,000.00 -20,000.00 -20,000.00 -20,000.00 C D E
SAVING FOR COLLEGE
6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Birthday 10 11 12 13 14 15 16 17 18 19 20 21
End of year with interest Total 6,227.78 6,726.00 12,953.77 13,990.08 20,217.85 21,835.28 28,063.06 30,308.10 36,535.88 39,458.75 45,686.52 49,341.45 55,569.22 60,014.76 66,242.54 71,541.94 51,541.94 55,665.29 35,665.29 38,518.52 18,518.52 20,000.00 0.00 0.00
0.0000 <-- =NPV(B2,C8:C18)+C7
Notice that the net present value of all the payments (cell C20) is zero when the solution is reached. The future payouts are fully funded when the NPV of all the cash flows is zero.
Method 2: Using Excels Goal Seek Goal Seek is an Excel function that looks for a specific number in one cell by adjusting
the value of a different cell (for a discussion of how to use Goal Seek, see Chapter 000). To solve our problem of how much to save, we can use Goal Seek to set E18 equal to zero. After hitting Tools|Goal Seek, we fill in the dialog box:
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When we hit OK, Goal Seek looks for the solution. The result is the same as before: $6,227.78.
Method 3: Using the Excel NPV formula
The method in this subsection involves the most preparation. Its advantage is that it leads to a very compact solution to the problema solution that doesnt require a long Excel table for its implementation. On the other hand, the formulas required are somewhat intricate (if you really hate formulas, skip this method!). Lindas parents are going to make 8 deposits of $X each, starting today. The present value of these deposits is
X+ X X X 1 1 1 + + + = X 1 + + ++ 2 7 2 7 (1.08 ) (1.08 ) (1.08) (1.08) (1.08) (1.08) .
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The account created will then have 4 withdrawals of $20,000, starting in year 8. The present value of these withdrawals is:
20, 000 + 20, 000 + 20, 000 + 20, 000 = 20, 000 1 1 1 1 * + + + 1.087 (1.08 ) (1.08 )2 (1.08 )3 (1.08 )4
(1.08)
(1.08 )
(1.08 )
10
(1.08)
11
Setting these two equations equal allows us to solve for X: 20, 000 1 1 1 1 + + + * 1.087 (1.08 ) (1.08 )2 (1.08 )3 (1.08 )4 X= 1 1 1 + + + 1+ 7 (1.08) (1.08)2 (1.08) In Excel both the numerator and the denominator are computed by filling in the dialog box for the PV function:
The numerator:
1 + 1
2
The denominator:
1 +
3
(1.08 ) (1.08 )
(1.08 )
(1.08 )
= 3.1212684
4
1+
(1.08 ) (1.08 )
1
2
++
(1.08 )
= 6.206370059
7
to complete the numerator, we have to multiply Note that Type is 1 (payments at beginning of by 20, 000 / (1.08 ) .
7
period).
Note that for both of these dialog boxes weve put in a negative payment Pmt. For the reason, refer to our discussion on page000.
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Rows 2-9 of the following spreadsheet show how we use these two PV functions to solve for the annual deposit required:
A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 Linda's age when plan started Linda's age at last deposit Number of deposits Number of withdrawals Annual cost of college Interest rate Annual deposit Linda's age today 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 B 10 17 8 <-- =B3-B2+1 4 20,000 8% 6,227.78 <-- =(B6/(1+B7)^(B4-1))*PV(B7,4,-1)/PV(B7,B4,-1,,1) Annual amount deposited 1,768.81 <-- =($B$6/(1+$B$7)^($B$3-A12))*PV($B$7,4,-1)/PV($B$7,$B$3-A12+1,-1,,1) 1,962.73 <-- =($B$6/(1+$B$7)^($B$3-A13))*PV($B$7,4,-1)/PV($B$7,$B$3-A13+1,-1,,1) 2,184.47 <-- =($B$6/(1+$B$7)^($B$3-A14))*PV($B$7,4,-1)/PV($B$7,$B$3-A14+1,-1,,1) 2,439.68 2,735.61 Annual Deposit Required to Fund 4 years of $20,000 25,000 3,081.72 when Linda is 17 3,490.65 20,000 3,979.61 4,572.69 15,000 5,304.68 6,227.78 7,423.96 10,000 9,029.88 11,291.47 5,000 14,700.60 20,404.92 C D
SAVING FOR COLLEGE--USING EXCEL FORMULAS ONLY
6 8 10 Linda's age at start of plan
12
14
The formula in cell B9 is the solution: = (B6/(1+B7)^ ( B4-1) )* PV(B7,B5,-1) / PV(B7,B4,-1,,1)

20,000
(1.08)7
1 1 1 + +...+ 1.08 (1.08 )2 (1.08)4
1+
1 1 1 + +...+ 1.08 (1.08 )2 (1.08)7
The problem as initially set out assumed that Linda was 10 years old today. The table in rows 12 27 shows the problem solution for other starting ages.7
The table in rows 12-27 would be simpler to compute if we used Data Table. This advanced feature of Excel is
explained in Chapter 30. The file Chapter01.xls on the disk accompanying Principles of Finance with Excel shows how to use Data Table to do the calculations in rows 12-27.
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Pension plans
The savings problem of Lindas parents is exactly the same as that faced by an individual who wishes to save for his retirement. Suppose that Joe is 20 today and wishes to start saving so that when hes 65 he can have 20 years of $100,000 annual withdrawals. Adapting the previous spreadsheet, we get:
A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 Joe's age today Joe's age at last deposit Number of deposits Number of withdrawals Annual withdrawal from age 65 Interest rate Annual deposit Joe's age today 20 22 24 26 28 30 32 34 35 38 40 42 44 46 48 50 B C
SAVING FOR RETIREMENT

20 64 45 <-- =B3-B2+1 20 100,000 8% 2,540.23 <-- =(B6/(1+B7)^(B4-1))*PV(B7,B5,-1)/PV(B7,B4,-1,,1) Annual amount deposited 2,540.23 <-- =($B$6/(1+$B$7)^($B$3-A12))*PV($B$7,$B$5,-1)/PV($B$7,$B$3-A12+1,-1,,1) 2,978.96 <-- =($B$6/(1+$B$7)^($B$3-A13))*PV($B$7,$B$5,-1)/PV($B$7,$B$3-A13+1,-1,,1) 3,496.73 <-- =($B$6/(1+$B$7)^($B$3-A14))*PV($B$7,$B$5,-1)/PV($B$7,$B$3-A14+1,-1,,1) 4,109.02 Annual Deposit Required to Fund 20 years of $100,000 4,834.85 when Joe is 65 5,697.73 40,000 6,727.03 35,000 7,959.85 30,000 8,666.90 25,000 11,239.91 20,000 13,430.03 16,123.53 15,000 19,471.60 10,000 5,000 23,688.86 0 29,090.61 20 25 30 35 40 45 50 36,159.79
Joe's age at start of plan
In the table in rows 12 27 you see the power of compound interest: If Joe starts saving at age 20 for his retirement, an annual deposit of $2,540.23 will grow to provide him with his retirement needs of $100,000 per year for 20 years at age 65. On the other hand, if he starts saving at age 35, it will require $8,666.90 per year.
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1.9. Computing annual flat payments on a loanExcels PMT function

Youve just graduated from college and the balance on your student loan is $100,000. You now have to pay the loan off over 10 years at an annual interest rate of 10%. The payment is in even paymentsmeaning that you pay the same amount each year (althoughas youll soon seethe breakdown of each payment between interest and principal is different). How much will you have to pay off? Suppose we denote the annual payment by X. The correct X has the property that the present value of all the payments equals the loan principal: 100, 000 = X X X X + + + ... + 2 3 10 1.10 (1.10 ) (1.10 ) (1.10 )
Rewriting the right-hand side slightly, you can see that X= 100, 000 1 1 + + ... + 3 10 (1.10 ) (1.10 )
1 1 + 1.10 (1.10 )2
This expression can be calculated using Excel's PV function
Heres all this in an Excel spreadsheet:
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A 1 2 3 4 5 6 7 Loan principal Loan interest Years to pay off loan Annual payment
LOAN PAYMENT
100,000 10% 10 16,274.54 <-- =B2/PV(B3,B4,-1) 16,274.54 <-- =PMT(B3,B4,-B2) Part of payment which is interest 10,000.00 9,372.55 8,682.35 7,923.13 7,087.99 6,169.33 5,158.81 4,047.24 2,824.51 1,479.50 Part of payment which is principal 6,274.54 6,901.99 7,592.19 8,351.41 9,186.55 10,105.21 11,115.73 12,227.30 13,450.03 14,795.04
8 9 10 11 12 13 14 15 16 17 18
Year 1 2 3 4 5 6 7 8 9 10
Principal at beginning of year Payment at end year 100,000.00 16,274.54 93,725.46 16,274.54 86,823.47 16,274.54 79,231.27 16,274.54 70,879.86 16,274.54 61,693.31 16,274.54 51,588.10 16,274.54 40,472.37 16,274.54 28,245.07 16,274.54 14,795.04 16,274.54
Nomenclature
The table in rows 9-18 above is often called a loan amortization table (amortize: to pay something off over time).
Here are two things to notice about the computation of this table: Excel has a function, PMT, which does this calculation directly (cell B6).
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Dialog box for PMT function
Like some other Excel financial functions, PMT generates positive answers for negative entries in the Pv box.
When we put all the payments in a loan table (rows 9-18 of the above spreadsheet) you can see the split of each end-year payment between interest on the outstanding principal at the beginning of the year and repayment of principal. If you were reporting to the Internal Revenue Service, the interest column (column D) is deductible for tax purposes; the repayment of principal column (column E) is not.
1.10. How long will it take to pay off a loan?

Youre getting a $1,000 loan from the bank at 10% interest. The maximum payment you can make is $250 per year. How long will it take you to pay off the loan? Theres an Excel
function that answers this question, which well show you in a bit. But first lets do this the long way so we can understand the question. In the spreadsheet below we look at a loan table like the ones considered in section 1.5:
A 1 HOW LONG 2 Loan amount 3 Interest rate 4 Annual payment 5 B 1,000 10% 250 Principal Payment beginning at end of Return of of year year Interest principal 1,000.00 250.00 100.00 150.00 850.00 250.00 85.00 165.00 685.00 250.00 68.50 181.50 503.50 250.00 50.35 199.65 303.85 250.00 30.39 219.62 84.24 250.00 8.42 241.58 C D E
TO PAY OFF THIS LOAN?
Year 6 1 7 2 8 3 9 4 10 5 11 6 12 13 14 15 16 17 18 19 20 21 22 Excel's NPER function
Year 6 is the first year in which the return of principal at the end of the year is > principal at the beginning of the year. Meaning--sometime during year 6 you will have paid off the loan.
5.3596 <-- =NPER(B3,B4,-B2)
As you can see from row 12, year 6 is the first year in which the return of principal at the end of the year is bigger than the principal at the beginning of the year. Thus, sometime between 5 and 6 years you pay off the loan. Excels NPER function, illustrated in cell B24, provides an exact answer to this question:
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Dialog box for NPER function
Like the functions PMT, PV, and FV discussed elsewhere in this chapter, the NPER function requires you to make the amount owed negative in order to get a positive answer.
1.11. An Excel notebuilding good financial models

If youve gotten this far in Chapter 1, youve probably put together a few basic Excel spreadsheets. Youll be doing lots more in the rest of this book, and youll be amazed at the insights Excel gives you over even complicated financial problems. Weve chosen this place in the chapter to tell you a bit about financial modeling (thats what youve been doing ). Here are three important rules for good Excel modeling:
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Put all the variables which are important (the fashionable jargon is value drivers) at the top of your spreadsheet. In the Saving for College spreadsheet of page000, the three value driversthe interest rate, the annual deposit, and the annual cost of collegeare in the top left-hand corner of the spreadsheet:
A B 8% 6,227.78 20,000 In bank on birthday, before deposit/withdrawal 0.00 6,726.00 13,990.08 21,835.28 30,308.10 39,458.75 49,341.45 60,014.76 71,541.94 55,665.29 38,518.52 20,000.00 NPV of all payments Deposit or withdrawal at begin. of year 6,227.78 6,227.78 6,227.78 6,227.78 6,227.78 6,227.78 6,227.78 6,227.78 -20,000.00 -20,000.00 -20,000.00 -20,000.00 C D E
1 2 Interest rate 3 Annual deposit 4 Annual cost of college 5
SAVING FOR COLLEGE
6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Birthday 10 11 12 13 14 15 16 17 18 19 20 21
End of year with interest Total 6,227.78 6,726.00 12,953.77 13,990.08 20,217.85 21,835.28 28,063.06 30,308.10 36,535.88 39,458.75 45,686.52 49,341.45 55,569.22 60,014.76 66,242.54 71,541.94 51,541.94 55,665.29 35,665.29 38,518.52 18,518.52 20,000.00 0.00 0.00
0.0000 <-- =NPV(B2,C8:C18)+C7
Never use a number where a formula will also work. Using formulas instead of hardwiring numbers means that when you change a parameter value, the rest of the spreadsheet changes appropriately. As an examplecell C20 in the above spreadsheet contains the formula =NPV(B2,C8:C18)+C7. We could have written this as
=NPV(8%,C8:C18)+C7. But this means that changing the entry in cell B2 wont go
through the whole model. Avoid the use of blank columns to accommodate cell spillovers. Heres an example of a potentially bad model:
A 1 Interest rate B C 6%
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Because Interest rate has spilled over to column B, the author of this spreadsheet has decided to put the 6% in column C. Hes going to end up getting confused (dont ask why ... ); he should have made column A wider and put the 6% in column B:
A 1 Interest rate B 6%
An Excel Note: Making a Column Wider
Widening the column is simple: Put the cursor on the break between columns A and B:
Clicking the left mouse button will expand the column to accommodate the widest cell. You can also stretch the column by holding the left mouse button down and moving the column width to the right.
Summing up
In this chapter we have covered the basic concepts of the time value of money: Future value (FV): The amount you will accumulate at some future date from deposits made in the present. Present value (PV): The value today of future anticipated cash flows. Net present value (NPV): The value today of a series of future cash flows, including the cost of acquiring these cash flows.
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Weve gone to great pains to point out the difference between the finance concept of net present value (NPV) and the Excel NPV function. The Excel NPV function calculates the present value of the future cash flows, whereas the finance concept of NPV computes the present value of the future cash flows minus the initial cash flow.
Internal rate of return (IRR): The compound interest rate paid by a series of cash flows, including the cost of their acquisition. We have also showed you the Excel functions (FV, PV, NPV, IRR) which do these
calculations and discussed some of their peculiarities. Finally, we have showed you how to do these calculations using formulas.
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Exercises
1. You just put $600 in the bank and you intend to leave it there for 10 years. If the bank pays you 15% interest per year, how much will you have at the end of 10 years?
2. Your generous grandmother has just announced that shes opened a savings account for you with a deposit of $10,000. Moreover, she intends to make you 9 more similar gifts, at the end of this year, next year, etc. If the savings account pays 8% interest, how much will you have accumulated at the end of 10 years (one year after the last gift)?
Suggestion: Do this problem 2 ways, as shown below: a) take each amount and
calculate its future value in year 10 (as illustrated in cells C7:C16) and then sum them; b) use Excels FV function, noting that here the amounts come at the beginning of the year (youll need to enter 1 in the Type option as described in Section 1).
A 3 Interest rate 4 5 Year 6 7 0 1 8 2 9 10 3 11 4 12 5 6 13 14 7 15 8 16 9 17 18 Total (summing C7:C16) 19 Using FV function B 8.00% C D
Gift 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Future value in year 10 21,589.25 <-- =B7*(1+$B$3)^(10-A7)
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3. Your uncle has just announced that hes going to give you $10,000 per year at the end of each of the next 4 years (hes less generous than your grandmother ... ). If the relevant interest rate is 7%, whats the value today of this promise? (If youre going to use PV to do this problem note that the Type option is 0 or omitted.)
4. What is the present value of a series of 4 payments, each $1,000, to be made at the end of years 1, 2, 3, 4? Assume that the interest rate is 14%.
Suggestion: Do this problem 2 ways, as shown in rows 11 and 12 below.
3 4 5 6 7 8 9 10 11 12 A Interest rate Year 1 2 3 4 Total of C6:C9 Using NPV function B 14% C D E
Payment PV 1,000 877.19 <-- =B6/(1+$B$3)Â6 1,000 1,000 1,000
5. Screw-Em-Good Corp. has just announced a revolutionary security: If you pay SEG $1,000 now, you will get back $150 at the end of each of the next 15 years. What is the IRR of this investment? Suggestion: Do this problem two waysonce using Excels IRR function and once using Excels RATE function (illustrated below).
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6. Make-Em-Happy Corp. (MEH) has a different security for sale: You pay MEH $1,000 today and the company will give you back $100 at the end of the first year, $200 at the end of year 2, ... , $1000 at the end of year 10. a. Calculate the IRR of this investment. b. Show an amortization table for the investment.
7. You are thinking about buying a $1,000 bond issued by the Appalachian Development Authority (ADA). The bond will pay $120 interest at the end of each of the next 5 years. At the end of year 6, the bond will pay $1,120 (this is its face value of $1,000 plus the interest). If the relevant discount rate is 7%, how much is the present value of the bonds future payments?
8. Look at the pension problem in Section 1.8, page000. Answer the following questions: 8.a. What if the desired annual pension is $100,000? How much does a 55 year-old have to save annually? The CD-ROM which accompanies the book contains the following template:
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A 1 2 3 4 5 6 7 8 9 10
SAVING FOR THE FUTURE

Your age today Retirement age Planned age of demise Annual desired pension payout Annual payment Interest rate 35 65 85 100,000 ??? 8% Deposit or withdrawal beginning of year
11 12 13 14 15 16 17 18 19 20 21 22
Your age 55 56 57 58 59 60 61 62 63 64 65
Account balance, beg. year
Interest earned during year
Total in account end of year
8.b. Suppose you are 35 years old and you wish to save until you are 65. You wish to withdraw $50,000 per year at the beginning of your 65th, 66th, ..., 89th year. How much would you have to save if the interest rate is 10%?
9. Return to the pension problem discussed in Section 1.8, page000. Use Excel to make a graph showing the relation between the amount saved and the interest rate. Your graph should look like:
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20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42
B Interest rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
C Saving 100,000.00 86,241.57 74,665.98 64,888.48 56,597.56 49,540.14 43,509.98 38,338.41 33,887.08 30,042.08 26,709.35 23,810.92 21,282.00 19,068.53 17,125.28 15,414.25 13,903.45 12,565.85 11,378.50 10,321.93 9,379.48
<-- Data table header (hidden)
Annual Savings Required to Fund 20 years of $50,000 Pension Starting at Age 65

120,000 100,000 80,000 60,000 40,000 20,000 0 0% 5% 10% 15% 20%
Note: If youre going to use the formula approach used in the book, you have to modify the
formula a bit to make it work for interest = 0%. The existing formula in section 3 is:
annual 20 1 pension * 1 1 + r payout X= , 10 10 1 (1 + r ) 1 1+ r but when r = 0, the denominator in this expression becomes 0. On the other hand, when r = 0 it annual number pension * of payout payout years . Use Excels If function to modify the is clear that the payout is X = number of payment years formula in the Section 1.8 spreadsheet.
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10. If you deposit $25,000 today, Union Bank offers to pay you $50,000 at the end of 10 years. What is the interest rate?
11. Assuming that the interest rate is 5%, which of the following is more valuable? 11.a. $5,000 today 11.b. $10,000 at the end of 5 years 11.c. $9,000 at the end of 4 years 11.d. $300 a year in perpetuity (meaning: forever), with the first payment at the end of this year
12. You receive a $15,000 signing bonus from your new employer and decide to invest it for two years. Your banker suggests two alternatives, which both require a commitment for the full two years. The first alternative will earn 8% per year for both years. The second alternative earns 6% for the first year, and 10% for the second year. Interest compounds annually. Which should you choose?
13. Your annual salary is $100,000. You are offered two options for a severance package. Option 1 pays you 6 months salary now. Option 2 pays you and your heirs $6,000 per year forever (first payment at the end of this year). If your required return is 11 percent, which option should you choose?
14. Today is your 40th birthday. You expect to retire at age 65 and actuarial tables suggest that you will live to be 100. You want to move to Hawaii when you retire. You estimate that it will
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cost you $200,000 to make the move (on your 65th birthday), and that your annual living expenses will be $25,000 a year after that. You expect to earn an annual return of 7% on your savings. 14.a. How much will you need to have saved by your retirement date? 14.b. You already have $50,000 in savings. How much would you need to save at the end of each of the next 25 years to be able to afford this retirement plan? 14.c. If you did not have any current savings and did not expect to be able to start saving money for the next 5 years (that is, your first savings payment will be made on your 45th birthday), how much would you have to set aside each year after that to be able to afford this retirement plan?
15. You have just invested $10,000 in a new fund that pays $1,500 at the end of the next 10 years. What is the compound rate of interest being offered in the fund? (Suggestion: Do this problem two ways: Using Excels IRR function and using Excels Rate function.)
16. John is turning 13 today. His birthday resolution is to start saving towards the purchase of a car that he wants to buy on his 18th birthday. The car costs $15,000 today, and he expects the price to grow at 2% per year. John has heard that a local bank offers a savings account which pays an interest rate of 5% per year. He plans to make 6 contributions of $1,000 each to the savings account (the first contribution to be made today); he will use the funds in the account on his 18th birthday as a down payment for the car, financing the balance through the car dealer.
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He expects the dealer to offer the following terms for financing: 7 equal yearly payments (with the first payment due one year after he takes possession of the car); an annual interest rate of 7%. 16.a. How much will John need to finance through the dealer? 16.b. What will be the amount of his yearly payment to the dealer? (Hint: This is like the college savings problem discussed in Section 1.8.)
17. Mary has just completed her undergraduate degree from Northwestern University and is already planning on entering an MBA program four years from today. The tuition will be $20,000 per year for two years, paid at the beginning of each year. In addition, Mary would like to retire 15 years from today and receive a pension of $60,000 every year for 20 years and receive the first payment 15 years from today. Mary can borrow and lend as much as she likes at a rate of 7%, compounded annually. In order to fund her expenditures, Mary will save money at the end of years 1-3 and at the end of years 6-14. Calculate the constant annual dollar amount that Mary must save at the end of each of these years to cover all of her expenditures (tuition and retirement)?
Note: Just to remove all doubts, here are the cash flows:
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A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34
MARY
Future expenses Future savings $X $X $X 20,000 20,000 $X $X $X $X $X $X $X $X $X 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000
18. You are the CFO of Termination, Inc. Your company has 40 employees, each earning $40,000 per year. Employee salaries grow at 4% per year. Starting from next year, and every second year thereafter, 8 employees retire and no new employees are recruited. Your company has in place a retirement plan that entitles retired workers to an annual pension which is equal to their annual salary at the moment of retirement. Life expectancy is 20 years after retirement, and the annual pension is paid at year-end. The return on investment is 10% per year. What is the total value of your pension liabilities?
19. You are 30 today and are considering studying for an MBA. You just received your annual salary of $50,000 and expect it to grow by 3% per year. MBAs typically earn $60,000 upon graduation, with salaries growing by 4% per year. The MBA program youre considering is a full-time, 2-year program that costs $20,000 per year, payable at the end of each study year. You want to retire on your 65th birthday. The relevant discount rate is 8%.8 Is it worthwhile for you to quit your job in order to do an MBA (ignore income taxes)? What is the internal rate of return of the MBA?
20. Youre 55 years old today, and you wish to start saving for your pension. Here are the parameters: You intend to make a deposit today and at the beginning of each of the next 9 years (that is, on your 55th, 56th, ... , 64th birthdays). Starting from your 65th birthday until your 84th, you would like to withdraw $50,000 per year (no plans for after that). The interest rate is 12% 20.a. How much should you deposit in each of the initial years in order to fully fund the withdrawals? 20.b. If you start saving at age 45, what is the answer?
Meaning: Your MBA is an investment like any other investment. On other investments you can earn 8% per year;
the MBA has to be judged against this standard.
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20.c. (More difficult) Set up the formula for the savings amount so that you can solve for various starting ages. Do a sensitivity analysis which shows the amount you need to save as a function of the age at which you start saving.
21. Section 1.8 of this chapter discusses the problem of Linda Joness parents, who wish to save for Lindas college education. The setup of the problem implicitly assumes that the bank will let the Joness borrow from their savings account and will charge them the same 8% it was paying on positive balances. This is unlikely! In this problem you are asked to program the following spreadsheet: In it you will assume that the bank pays Lindas parents 8% on positive account balances but charges them 10% on negative balances. If Lindas parents can only deposit $4,000 per year in the years preceding college, how much will they owe the bank at the beginning of year 22 (the year after Linda finishes college)?
A 1 2 Interest rates 3 On positive balances 4 On negative balances 5 Annual deposit 6 Annual cost of college 7 B C D E
SAVING FOR COLLEGE

8% 10% 4,000.00 20,000 In bank on birthday, before deposit/withdrawal Deposit or withdrawal at begin. of year 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 4,000.00 -20,000.00 -20,000.00 -20,000.00 -20,000.00
8 9 10 11 12 13 14 15 16 17 18 19 20 21
Birthday 10 11 12 13 14 15 16 17 18 19 20 21 22
Total
End of year with interest
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Excel note: In order to set up this spreadsheet you will need to use the Excel If function
(if you are not familiar with this function, see Chapter 28).
22. A fund of $10,000 is set up to pay $250 at the end of each year indefinitely. What is the funds IRR? (Theres no Excel function that answers this questionuse some logic!)
23. In the spreadsheet below we calculate the future value of 5 deposits of $100, with the first deposit made at time 0. As shown in Section 1.????, this calculation can also be made using the Excel function =FV(interest,periods,-amount,,1). 23.a. Show that you can also compute this by
=FV(interest,periods,-amount)*(1+interest).
23.b. Can you explain why FV(r,5,-100,,1)=FV(r,5,-100)*(1+r)?

A 1 2 Interest 3 B 6% Account Deposit at Interest Total in balance, beginning earned account at beg. year of year during year end of year 0.00 100.00 6.00 106.00 <-- =B5+C5+D5 106.00 100.00 12.36 218.36 <-- =B6+C6+D6 218.36 100.00 19.10 337.46 337.46 100.00 26.25 463.71 463.71 100.00 33.82 597.53 C D E F
FUTURE VALUE
4 5 6 7 8 9
Year 1 2 3 4 5
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Appendix: Algebraic Present Value Formulas

Most of the computations in the chapter can also be done with one basic bit of highschool algebra relating to the sum of a geometric series. Suppose you want to find the sum of a geometric series of n numbers a + aq + aq 2 + aq 3 + ... + aq n 1 . In the jargon of geometric series: a q is the first term is the ratio between terms (the number by which the previous term is multiplied to get the next term) n is the number of terms
Denote the sum of the series by S: S = a + aq + aq 2 + aq 3 + ... + aq n 1 . In high school you learned a trick to find the value of S: 1. Multiply S by q: qS = 2. aq + aq 2 + aq 3 + + aq n 1 + aq n
Subtract qS from S: S= a + aq + aq 2 aq + aq 2 + aq 3 + aq 3 + + aq n 1 + aq n ) qS = (
+ + aq n 1
(1 q ) S = a aq
S=
a (1 q n ) 1 q
In the remainder of this appendix we apply this formula to a variety of situations covered in the chapter.
Future value a constant payment
This topic is covered in section 1.1. The problem there is to find the value of $100 deposited annually over 10 years, with the first payment today:
S = 100*(1.06)10 + 100*(1.06)9 + ... + 100*(1.06) = ??? For this geometric series: a = first term = 100*1.0610 q = ratio = 1 1.06
n = number of terms = 10
The formula gives S =
a (1 q n ) 1 q
1 10 100*1.0610 1 1.06 = 1397.16 , where we have done the = 1 1 1.06
calculation in Excel:
A 1 2 3 4 5 6 7 First term, a Ratio, q Number of terms, n Sum Excel PV function B C
FUTURE VALUE FORMULA

179.0848 <-- =100*1.06^10 0.943396 <-- =1/1.06 10 1,397.16 <-- =B2*(1-B3^B4)/(1-B3) 1,397.16 <-- =FV(6%,B4,-100,,1)
Substituting symbols for the numerical values we get:

1 n Future value of n payments Payment * (1 + r ) 1 1+ r = FV(r,n,-1,,1) at end of year n, at interest r = 1 1 first payment today The Excel function 1+ r
n
Present value of an annuity
We can also apply the formula to find the present value of an annuity. Suppose, for example, that we want to calculate the present value of an annuity of $150 per year for 5 years:
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150 150 150 150 150 + + + + . 2 3 4 (1.06 ) (1.06 ) (1.06 ) (1.06 ) (1.06 )5 For this annuity: a = first term = q = ratio = 1 1.06 150 9 . 1.06
n= number of terms = 5. Thus the present value of the annuity becomes: a (1 q 1 q
S=
150 1 1 1.06 1.06 = 1 1 1.06
= 631.85 = PV(6%,5,-150) .
The Excel function
We can work this out in a spreadsheet:

A 1 2 3 4 5 6 7 First term, a Ratio, q Number of terms, n Sum Excel PV function B C
ANNUITY FORMULAS
141.509434 <-- =150/1.06 0.943396226 <-- =1/1.06 5 631.85 <-- =B2*(1-B3^B4)/(1-B3) 631.85 <-- =PV(6%,5,-150)
Cleaning up the formula (a bit)
Standard textbooks often manipulate the annuity formula to make it look better. Heres an example of something you might see in a textbook:
If youre like most of the rest of humanity, you (mistakenly) thought that the first term was a = 150. But look at
the seriesthe first term actually is
150 . So there you are. 1.06

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n annual payment 1 1 1+ r a (1 q n ) (1 + r ) S= = 1 1 q 1 1+ r n annual payment 1 = 1 1+ r r
This is not a different annuity formulaits just an algebraic simplification of the formula weve been using. If you put it in Excel youll get the same answer (and in our opinion, theres no point in the simplification).
The present value of series of growing payments
Suppose were trying to apply the formula to the following series: 150 150* (1.10 ) 150* (1.10 ) 150* (1.10 ) 150* (1.10 ) + + + + 3 4 5 (1.06 ) (1.06 )2 (1.06 ) (1.06 ) (1.06 )
2 3 4
Here there are five payments, the first of which is $150; this payment grows at an annual rate of 10%. We can apply the formula: a = first term = 1.10 1.06 150 . 1.06
q = ratio =
n= number of terms = 5. In the following spreadsheet, you can see that the formula and the Excel NPV function give the same answer for the present value:
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A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 First term, a Ratio, q Number of terms, n Sum
A CONSTANT-GROWTH CASHFLOW
141.5094 <-- =150/1.06 1.037736 <-- =1.1/1.06 5 763.00 <-- =B2*(1-B3^B4)/(1-B3)
Year 1 2 3 4 5
Present value
Payment 150.00 165.00 <-- =B9*1.1 181.50 <-- =B10*1.1 199.65 219.62
763.00 <-- =NPV(6%,B9:B13)
Notice that the formula in cell B6 is more compact than Excels NPV function. NPV requires you to list all the payments, whereas the formula in cell B6 requires only several lines (think about finding the present value of a very long series of growing paymentsclearly the formula is more efficient).
The present value of a constant growth annuity
An annuity is a series of annual payments; a constant growth annuity is an annuity whose payments grow at a constant rate. Heres an example of such a series: 20* (1.05 ) 20* (1.05 ) 20* (1.05 ) 20* (1.05 ) 20 + + + + + ... 3 4 5 (1.10 ) (1.10 )2 (1.10 ) (1.10 ) (1.10 )
2 3 4
We can fit this into our formula: a = first term = 1.05 1.10 20 1.10
q = ratio =
n=number of terms=.
page 73
The formula gives: a (1 q 1 q
S=
20 1.05 1 1.10 1.10 = 1.05 1 1.10

n
1.05 When n , 0 , so that: 1.10 20 1.05 1 1.10 1.10 = 1.05 1 1.10

n
S=
a (1 q 1 q
20 20 = 1.10 = = 400 . 1.05 0.10 0.05 1 1.10
Warning: You have to be careful! This version of the formula only works because the
growth rate of 5% is smaller than the discount rate of 10%. The discounted sum of an infinite series of constantly-growing payments only exists when the growth rate g is less than the discount rate r. Heres a general formula:
CF 1 + g 1 (1 + r ) 1 + r + ... = 1+ g 1 1+ r
sum of 2 CF * (1 + g ) CF * (1 + g ) CF constant-growth = + + 3 (1 + r ) (1 + r )2 (1 + r ) annuity CF = rg undefined To summarize: when g < r otherwise
The present value of a constant-growth annuitya series of cash flows with first term CF which grows at rate gthat is discounted at rate r is CF , provided g < r. rg
page 74
We use this formula in Chapter 6, when we discuss the valuation of stocks using discounted dividends (the Gordon dividend model).
page 75

Chapter 1: The Time Value of Money

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Chapter 1: The time value of money*

PFE Chapter 1, Time value of money

1.1. Future value

PFE Chapter 1, Time value of money

PFE Chapter 1, Time value of money

In order to confuse you, we make no promises about consistency!

Future value calculations are easily done in Excel:

CALCULATING FUTURE VALUES WITH EXCEL

Notice the use of the carat (^) to denote the exponent:

PFE Chapter 1, Time value of money

THE FUTURE VALUE OF A SINGLE $100 DEPOSIT

PFE Chapter 1, Time value of money

PFE Chapter 1, Time value of money

Nomenclature: Whats a year? When does it begin?

This is a boring but necessary discussion. following synonyms:

Throughout this book we will use the

Today Beginning of year 1 0

Accumulationsavings plans and future value

1 2 Interest 3 =E5 4 5 6 7 8 9 10 11 12 13 14 15 Year 1 2 3 4 5 6 7 8 9 10

FUTURE VALUE WITH ANNUAL DEPOSITS at beginning of year

$1,397.16 <-- =FV(B2,A14,-100,,1)

PFE Chapter 1, Time value of money

The Excel FV (future value) formula

is illustrated in cell C16:

$1,397.16 <-- =FV(B2,A14,-100,,1)

Exercises 2 and 3 at the end of the chapter illustrate both cases.

PFE Chapter 1, Time value of money

Dialog box for FV function

PFE Chapter 1, Time value of money

Excel notea peculiarity of the FV function

produced this thinking; whenever we encounter it we just put in a negative deposit.

PFE Chapter 1, Time value of money

Sidebar: Functions and Dialog Boxes

Going through the function wizard

PFE Chapter 1, Time value of money

box to put the cursor on the FV function.

Clicking OK brings up the dialog box for the FV function.

A short way to get to the dialog box

and then click on the

PFE Chapter 1, Time value of money

One further option

=FV(B2,A14,-100,,1) in the cell. Hitting [Enter] would give the answer.

PFE Chapter 1, Time value of money

Beginning versus end of period

1397.16 <-- Sum of the above

1318.08 <-- Sum of the above

PFE Chapter 1, Time value of money

1 2 Interest 3 =E5 4 5 6 7 8 9 10 11 12 13 14 15 16 Year 1 2 3 4 5 6 7 8 9 10

FUTURE VALUE WITH ANNUAL DEPOSITS at end of year

PFE Chapter 1, Time value of money

Dialog box for FV with end-period payments

Some finance jargon and the Excel FV function

1.2. Present value

PFE Chapter 1, Time value of money

or present value of $100 in 3 years at 6 percent interest.

SIMPLE PRESENT VALUE CALCULATION

83.96 100 <-- =B8*(1+B4)^B3

= 83.96193 , but weve used Format|Cells|Number to show only 2 decimals.

PFE Chapter 1, Time value of money