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A Ch 02 Mini Case

G 4/6/2003

Chapter 2. Mini Case

Situation Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the bank's evaluation process, you have been asked to take an examination which covers several financial analysis techniques. The first section of the test addresses discounted cash flow analysis. See how you would do by answering the following questions.

a. Draw time lines for (1) a $100 lump sum cash flow at the end of year 2, (2) an ordinary annuity of $100 per year for 3 years, and (3) an uneven cash flow stream of -$50, $100, $75, and $50 at the end of Years 0 through 3.

FUTURE VALUE
$100 lump sum at the end of year 2. I% Time period 0 FV at year end

2 100

Ordinary annuity of $100 per year for three years. I% Time period 0 1 2 FV at year end 100 100 100 Uneven cash flow stream. I% Time period FV at year end 0 -50 1 100 2 75 3 50

b. (1.) What is the future value of an initial $100 after 3 years if it is invested in an account paying 10 percent annual interest? Interest rate Cash flow Time period FV at year end 0.1 100 0 100 These are the basic inputs, in blue.

1 110.00

2 121

3 133.10

Note: This problem was solved using the formula, FVn = PV (1+I)n. However, there are a number of ways this problem could have Wizard". First, you must select the Function wizard icon found in the toolbar at the top of the screen, which looks like this . This button been solved. One of the most valuable features in Excel is the "Function" Wizard. Here is how to access and use the "Function. On the left side of the dialog box is a menu entitled, "Function category", and on the right is a menu called "Function name".

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We will be selecting the "FV" function from the "Financial" category, and will be using the following dialog box to input our data.

Notice that we entered a value instead of a cell reference as the input for the problem for instructional purposes instead of the actual value. You should enter the cell value so that your spreadsheet can automatically reflect any changes to the input data. This is one of the features that makes the spreadsheet such a valuable tool. Using the function wizard will yield the following result: FV = $133.10 TABLE Future Value Interest Factors

With a spreadsheet, calculating FVIF's is a simple operation, and we can use it to graph the relationship between future value, growth, interest rates, and time. A similar table can be found in the textbook, along with a corresponding graph. Period (n) 0 2 4 6 8 10 0% 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 5% 1.0000 1.1025 1.2155 1.3401 1.4775 1.6289 10% 1.0000 1.2100 1.4641 1.7716 2.1436 2.5937 15% 1.0000 1.3225 1.7490 2.3131 3.0590 4.0456

GRAPH Relationships among Future Value, Growth, Interest Rates, and Time

A 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166

Relationships among Future Value, Growth, Interest Rate, and Time

$5.00 $4.00 Future Value of $1 $3.00

$2.00
$1.00 $0.00

6
Periods

10

12

(2.) What is the present value of $100 to be received in 3 years if the appropriate interest rate is 10 percent?

PRESENT VALUE
Simply put, the present value is the value today of some future cash flow (or series of cash flows). The interest rate used to "discount" a given cash flow is the opportunity cost rate, and is equivalent to the next best investment alternative of the same risk. PROBLEM Interest rate Cash flow Time period Present Value 0.1 100 0 $75.13 Number of Years Discounted Back 1 2 3 82.64 90.91 100.00

This problem can also be solved using the function wizard using a procedure similar to that for the FV function. Begin by putting the pointer on the cell in which you want to display the result, in this case Cell C167. Then, after selecting the "PV" function from the "Paste Function" box, the input data for the problem must be entered. Then click OK to get the result, $75.13.

PV =

$75.13

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c. We sometimes need to find how long it will take a sum of money (or anything else) to grow to some specified amount. For example, if a company's sales are growing at a rate of 20 percent per year, how long will it take sales to double? Finding Time to Double I= Time period Present Value 0.2 0 $1.00 1 2 ? 2.00 3.8 Use the function NPER, as shown below.

Finding N, the number of periods

SOLVING FOR I
PROBLEM d. If you want an investment to double in three years, what interest rate must it earn? N PV FV 3 -1 2

Once again, Excel has a special function for this calculation. We suggest using either a financial calculator or the function wizard to solve this type of problem, because of its complexity. The procedure can be carried out using the function wizard, by selecting the "Rate" function from the list of financial functions in the "Paste Function" dialog box. Upon entering the time, present value, and future value, the interest rate can be found. Note that you can either type the data in or else activate the menu slot and then click on the appropriate cell.

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A B C D E F G H Once again, Excel has a special function for this calculation. We suggest using either a financial calculator or the function wizard to solve this type of problem, because of its complexity. The procedure can be carried out using the function wizard, by selecting the "Rate" function from the list of financial functions in the "Paste Function" dialog box. Upon entering the time, present value, and future value, the interest rate can be found. Note that you can either type the data in or else activate the menu slot and then click on the appropriate cell.

I =

25.99%

We noted above the difficulty of solving this problem mathematically. This is because it involves taking the nth root of a value (an operation which generally requires either a calculator or a computer). However, if you would like to know how to solve the problem mathematically, the formula is: (FVn/PV)1/ n - 1, which is derived from the FV formula N PV FV 3 1 2

I =

25.99%

e. What is the difference between an ordinary annuity and an annuity due? What type of annuity is shown below? How would you change it to the other type of annuity? See Ch 02 Mini Case Show.ppt

f. (1.) What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate is 10 percent?

FUTURE VALUE OF AN ANNUITY

As explained below, one way to solve this problem is to find the future value of each of the annuity payments. However, this is somewhat tedious, especially if a lot of years are involved. In the following example, we use the input data of the interest rate and time to calculate the future value in time period 3 of each individual cash flow. Lastly, we take the sum of all the future values, which gives us the future value of the entire annuity. N I PMT Time period CFn FV3 3 0.1 100 0 0 0 1 100 121 2 100 110 3 100 100

Annuity's FV: $331.00

An easier procedure is to solving for the future value of an annuity with the function wizard. This procedure is similar to that of a lump sum future value. Whereas before we left the "Pmt" field blank, now we insert the annuity payment ($100 in this case). First, we access the "FV" function box from the list of financial functions. Then, we input our new data. A key thing to watch is the "Type" input box. Previously, we left this box alone. A "0" or no entry in the box indicates an ordinary annuity, and a "1" indicates an annuity due. Though we can leave the box blank, it is a good habit to enter a "0" in the field.

An easier procedure is to solving for the future value of an annuity with the function wizard. This procedure is similar to that of a lump sum future value. Whereas before we left the "Pmt" field blank, now we insert the annuity payment ($100 in this case). A First, we access B the "FV" C function box Dfrom the listE of financial functions. F Then, G we input our H new data. A key 285 thing to watch is the "Type" input box. Previously, we left this box alone. A "0" or no entry in the box indicates an 286 ordinary annuity, and a "1" indicates an annuity due. Though we can leave the box blank, it is a good habit to enter a "0" 287 in the field. 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 FV = $331.00 305 306 PRESENT VALUE OF AN ANNUITY 307 308 (2.) What is the present value of the annuity? 309 310 N 3 311 I 0.1 312 PMT 100 313 314 Time period 0 1 2 3 315 CFn 0 100 100 100 Annuity PV 316 PV3 0 90.91 82.64 75.13 = $248.69 317 318 Or, you could use the function wizard for this ordinary annuity. 319 320 321 322 323 324 325 326 327 328 329 330 331 332 333 334 335 336 PV = $248.69 337 338 339 PROBLEM 340 (3.) What would the future and present values be if the annuity were an annuity due? 341 342 343 The procedure for solving this problems follows the previous example with one notable exception. Since, the payments occur at the beginning of each year, the first annuity payment occurs in time period 0, and the last occurs in time period 2.

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A B C D previous example E F notable exception. G Hthe payments The procedure for solving this problems follows the with one Since, occur at the beginning of each year, the first annuity payment occurs in time period 0, and the last occurs in time period 2. N I PMT Time period CFn FV3 3 0.1 100 0 100 133.1 1 100 121 2 100 110 3 0 0

Annuity FV $364.10

Additionally, using the function wizard for this problem is exactly like above, but we enter a "1" instead of a "0" into the "Type" field.

FV =

$364.10

To find the present value of the annuity due, this problem is solved just like the previous problem, except that the payments occur in periods 0 through 2. N I PMT Time period CFn PV3 3 0.1 100 0 100 100.00 1 100 90.91 2 100 82.64 3 0 0.00

Annuity PV $273.55

Using the function wizard, we follow the same procedure as above, except remember to enter a "1" to tell Excel that this problem has payments occurring at the beginning of the periods.

A B C D E F 403 404 405 406 407 408 PV = $273.55 409 410 411 412 UNEVEN CASH FLOWS 413 414 g. Calculate the present value of the following cash flow stream, discounted at 10%. 415 1 2 3 4 5

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Time period

C I =

D 10%

0 0
Cash Flows PV of Cash Flows

1 100
90.91 $530.09

2 300
247.93

3 300
225.39

4
6

-50
-34.15

0 NPV =

As we show above, the first way to solve for the present value of this uneven cash flow stream is to use the time line to find the present value of each of the cash flows in the periods in which they occur, then sum all the present values. This procedure will yield the correct present value.

This problem could also be set up in a column format; it is a matter of personal preference as to which format is easier to interpret and use. Once we have converted our data into a data table, we can solve for the present value of each of the cash flows (like we did previously) and add all of the present values together. I N 0 1 2 3 4 CFn 0 100 300 300 -50 0.1 PV0 0.00 90.91 247.93 225.39 -34.15

PV of CF stream

$530.09

With, the financial calculator, we could enter each of these cash flows and the discount rate, and simply press NPV for the present value of the cash flow stream. In Excel, we can perform a similar calculation by using the "NPV" function. While this function is very similar, there is a key distinction. In the cash flow register of your calculator, the first entry you make would be the cash flow to occur in time period zero. However, the "NPV" function interprets the first data entry as being the cash flow in time period one. Therefore, the initial cash flow must be added seperately. In this particular example, the initial cash flow is zero.

Ranges from either the time line or the columns could be entered for Value1, such as B440:B443.

PV =

$530.09