A B C D E F G H

1 1/1/2012
2
3 Chapter 4. Mini Case - Time Value of Money
4 Situation
5 Assume that you are nearing graduation and have applied for a job with a local bank. As part of the
6 bank's evaluation process, you have been asked to take an examination that covers several financial
7 analysis techniques. The first section of the test addresses discounted cash flow analysis. See how
8 you would do by answering the following questions.
9
10 a. Draw time lines for (1) a $100 lump sum cash flow at the end of Year 2, (2) an ordinary annuity of
11 $100 per year for 3 years, and (3) an uneven cash flow stream of -$50, $100, $75, and $50 at the end of
12 Years 0 through 3.
13
14
15 FUTURE VALUE
16 $100 lump sum at the end of year 2.
17 I%
18 Time period 0 1 2
19 FV at year end 100
20
21
22 Ordinary annuity of $100 per year for three years.
23 I%
24 Time period 0 1 2
25 FV at year end 100 100 100
26
27
28 Uneven cash flow stream.
29 I%
30 Time period 0 1 2 3
31 FV at year end -50 100 75 50
32
33 b. (1.) What's the future value of an initial $100 after 3 years if it is invested in an account paying 10%
34 annual interest?
35
36 Interest rate 0.1 These are the basic inputs, in blue.
37 Cash flow 100
38
39 Time period 0 1 2 3
40 FV at year end 100 110.00 121 133.10
41
42 Note: This problem was solved using the formula, FVn = PV (1+I) N. However, there are a number of
43 ways the problem could have used Excel's "Wizard Function".
44
45 First, you must select the Function wizard icon found in the toolbar at the top of the screen, which
46 looks like this: fx. When you get the "Insert Function " dialog box, select the category for Financial
47 Functions, as shown below.
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71 After selecting the category for Financial functions, scroll down until you can selet the FV function, as
72 show below. Alternatively, select the menu Formulas, then then select Financial, then pick FV.
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After selecting the "FV" function from the "Financial" category, we will be using the following dialog
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box to input our data.
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118 Notice that we entered a value instead of a cell reference as the input for the problem for instructional
119 purposes. It's really better to enter cell values so that your spreadsheet can automatically reflect any
120 changes to the input data. This is one of the features that makes the spreadsheet such a valuable
121 tool.
122
123 Using the function wizard yields the following result:
124 FV = $133.10 ($133.10)
125
126 Future Value Interest Factors
127
128 With a spreadsheet, calculating FVIF's is a simple operation, and we can use it to graph the
129 relationship between future value, growth, interest rates, and time. A similar table can be found in the
130 textbook, along with a corresponding graph.
131
132 Period (N) 0% 5% 10% 15%
133 0 1.0000 1.0000 1.0000 1.0000
134 2 1.0000 1.1025 1.2100 1.3225
135 4 1.0000 1.2155 1.4641 1.7490
136 6 1.0000 1.3401 1.7716 2.3131
137 8 1.0000 1.4775 2.1436 3.0590
138 10 1.0000 1.6289 2.5937 4.0456
139

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140
141 Relationships among Future Value, Growth, Interest Rates, and Time
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143

Future Value of $1
144 Relationships among Future Value, Growth, Interest Rate, and Time
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146 $5.00
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148 $4.00
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150 $3.00
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152 $2.00
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$1.00
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$0.00
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0 2 4 6 8 10 12
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159 Periods

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162 b. (2) What is the present value of $100 to be received in 3 years if the appropriate interest rate is
163 10%?
164
165 PRESENT VALUE (PV)
166 Simply put, the present value (PV) is the value today of some future cash flow (or series of cash
167 flows). The interest rate used to "discount" a given cash flow is the opportunity cost rate, and is
168 equivalent to the next best investment alternative of the same risk.
169 PROBLEM
170
171 Interest rate 10%
172 Cash flow 100
173 Number of Years Discounted Back
174 Time period 0 1 2 3
175 PV $75.13 82.64 90.91 100.00
176
177 This problem can also be solved using the function wizard using a procedure similar to that for the FV
178 function. Begin by putting the pointer on the cell in which you want to display the result. Then, after
179 selecting the "PV" function from the "Paste Function" box, the input data for the problem must be
180 entered. Then click OK to get the result, $75.13.
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204 PV = $75.13

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205
206 c. We sometimes need to find how long it will take a sum of money (or anything else) to grow to some
207 specified amount. For example, if a company's sales are growing at a rate of 20% per year, how long
208 will it take sales to double?
209
210 Finding Time to Double
211
212 I= 0.2
213
214 Time period 0 1 2 ?
215 Present Value $1.00 2.00
216
217 Finding N, the number of 3.8 Use the function NPER, as shown below.
218 periods
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242 SOLVING FOR I
243 PROBLEM
244 d. If you want an investment to double in three years, what interest rate must it earn?
245
246 N 3
247 PV -1
248 FV 2
249
250 Once again, Excel has a special function for this calculation. We suggest using either a financial
251 calculator or the function wizard to solve this type of problem, because of its complexity. The
252 procedure can be carried out using the function wizard, by selecting the "Rate" function from the list
253 of financial functions in the "Paste Function" dialog box. Upon entering the time, present value, and
254 future value, the interest rate can be found. Note that you can either type the data in or else activate
255 the menu slot and then click on the appropriate cell.
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280 I = 25.99%
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282 We noted above the difficulty of solving this problem mathematically. This is because it involves
283 taking the Nth root of a value (an operation which generally requires either a calculator or a computer).
284 However, if you would like to know how to solve the problem mathematically, the formula is (FVn/PV)
285
(1/N)
- 1, which is derived from the FV formula.
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287 N 3
288 PV 1 I = 25.99%
289 FV 2
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291
e. What is the difference between an ordinary annuity and an annuity due? What type of annuity is
292
shown below? How would you change it to the other type of annuity? See Ch 04 Mini Case Show.ppt
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295 f. (1.) What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate is
296 10%?
297
298 FUTURE
payments.VALUE OFthis
However, AN is
ANNUITY
tedious, especially if a lot of years are involved. In the following example,
299 we use the input data of the interest rate and time to calculate the future value in time period 3 of each
300 individual cash flow. Lastly, we take the sum of all the future values, which gives us the future value
301 N 3
302 I 0.1
303 PMT 100
304
305 Time period 0 1 2 3
306 CFt 0 100 100 100 Annuity's FV:
307 FV3 0 121 110 100 Σ= $331.00
308
309 An easier procedure is to solving for the future value of an annuity with the function wizard. This
310 procedure is similar to that of a lump sum future value. Whereas before we left the "Pmt" field blank,
311 now we insert the annuity payment ($100 in this case). First, we access the "FV" function box from the
312 list of financial functions. Then, we input our new data. A key thing to watch is the "Type" input box.
313 Previously, we left this box alone. An "0" or no entry in the box indicates an ordinary annuity, and a
314 "1" indicates an annuity due. Though we can leave the box blank, it is a good habit to enter a "0" in
315 the field.
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339 FV = $331.00
340
341 PRESENT VALUE OF AN ANNUITY
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343 f. (2.) What is the present value of the annuity?
344
345 N 3
346 I 0.1
347 PMT 100
348
349 Time period 0 1 2 3
350 CFt 0 100 100 100 Annuity PV
351 PV3 0 90.91 82.64 75.13 = $248.69
352

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353 Or, you could use the function wizard for this ordinary annuity.
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376 PV = $248.69
377
378
379 f. (3.) What would the future and present values be if the annuity were an annuity due?
380
381 The procedure for solving this problems follows the previous example with one notable exception. Since, the
382 payments occur at the beginning of each year, the first annuity payment occurs in time period 0, and the last
383 occurs in time period 2.
384
385 N 3
386 I 0.1
387 PMT 100
388
389 Time period 0 1 2 3
390 CFt 100 100 100 0 Annuity FV
391 FV3 133.1 121 110 0 = $364.10
392
393 Additionally, using the function wizard for this problem is exactly like above, but we enter a "1" instead of a "0"
394 into the "Type" field.
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418 FV = $364.10
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420 To find the present value of the annuity due, this problem is solved just like the previous problem,
421 except that the payments occur in periods 0 through 2.
422
423 N 3
424 I 0.1
425 PMT 100
426
427 Time period 0 1 2 3
428 CFt 100 100 100 0 Annuity PV
429 PV3 100.00 90.91 82.64 0.00 = $273.55
430
431 Using the function wizard, we follow the same procedure as above, except remember to enter a "1" to
432 tell Excel that in this problem the payments occur at the beginning of the periods.
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456 PV = $273.55
457 g. What is the present value of the following uneven cash flow stream? The appropriate interest rate is 10%,
458 compounded annually.
459
460 1 I = 2 10%3 4 5
$100 $200 $200 $200 $200
461 Time period
462 0 1 2 3 4
463
6
464 0 100 300 300 -50 $0
465 Cash Flows
466 PV of Cash Flows

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467 0 90.91 247.93 225.39 -34.15
468
469 NPV = = Σ of PVs = $530.09
470
471 As we show above, the first way to solve for the present value of this uneven cash flow stream is to
472 use the time line to find the present value of each of the cash flows in the periods in which they occur,
473 then sum all the present values. This procedure will yield the correct present value.
474
format is easier to interpret and use. Once we have converted our data into a data table, we can solve
475
for the present value of each of the cash flows (like we did previously) and add all of the present
476
477 I 0.1
478
479 N CFN PV0
480 0 0 0.00
481 1 100 90.91
482 2 300 247.93
483 3 300 225.39
484 4 -50 -34.15
485
486 PV of CF stream = $530.09
487

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488 With, the financial calculator, we could enter each of these cash flows and the discount rate, and
489 simply press NPV for the present value of the cash flow stream. In Excel, we can perform a similar
490 calculation by using the "NPV" function. While this function is very similar, there is a key distinction.
491 In the cash flow register of your calculator, the first entry you make would be the cash flow to occur in
492 time period zero. However, the "NPV" function interprets the first data entry as being the cash flow in
493 time period one. Therefore, the initial cash flow must be added seperately. In this particular example,
494 the initial cash flow is zero.
495
496 Or
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517 PV = $530.09
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519
520 h. (1.) Identify (a) the stated, or quoted, or nominal rate (i Nom) and (b) the periodic rate (iPER).
521
522 Inputs
523 INOM (quarterly) 0.1 This is the rate stated in contracts.
524 m=periods/yr 2 This is the number of periods per year, m.
525
526 The periodic is associated with the number of compounding periods per year. M = 4 quarterly, 12 for monthly, an
527 360 or 365 for annual compounding.
528
529 IPER = inom/m
530
531 IPER = 10% / 2
532 IPER = 5%
533
534
h. (2.) Will the future value be larger or smaller if we compound an initial amount more often than annually, for
535 example, every 6 months (semiannually), holding the stated interest rate constant? Why?
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538 Larger, because interest is earned on interest.
539 The effective annual rate is the annual rate that causes the PV to grow to the same FV as under multiple
540 compounding periods.
541
542 EFF% = (1+ INOM/M)M
543
544 EFF% = (1 + (10%/2))^2 - 1
545
546 EFF% = 10.25%
547
548
549 SEMIANNUAL AND OTHER COMPOUNDING PERIODS
550
551 h. (3.) What is the future value of $100 after 5 years under 12% annual compounding?
552
553 N 3
554 I 0.12 FV = $140.49
555 PV 100
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557

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558 What is the FV with semiannual compounding?
559
560 N (years x 2) 6
561 I (I per year/2) 0.06 FV = $141.85
562 PV 100
563
564
565 What is the FV with quarterly compounding?
566
567 N (years x 4) 12
568 I (I per year/4) 0.03 FV = $142.58
569 PV 100
570
571
572 What is the FV with monthly compounding?
573
574 N (years x 12) 36
575 I (I per year/12) 0.01 FV = $143.08
576 PV 100
577
578
579
580 What is the FV with daily compounding?
581
582 N (years x 365) 1095
583 I (I per year/12) 0.000328767 FV = $143.32
584 PV 100
585
586 I. Will the effective annual rate ever be equal to the nominal (quoted) rate? Only if the compounding period is
587 equal to 1 year.
588
589 j. (1.) What would the required payment be on a $1,000 loan that is to be repaid in three equal installments at the
590 end of each of the next three years if the interest rate is 10%?
591
592
593 N 3 PMT = $402.11 Total pmts Tot. int. paid
594 I 0.1 $1,206 $206
595 PV 1000
596 Now, construct an amortization table for the loan described above.
597
598 j. (2.) What is the annual interest expense for the borrower, and the annual interest income for the lender, duri
599 Year 2?
600
601 N Beg. Amt. Payment Interest Principal End. Amt.
602 1 $1,000.00 $402.11 $100.00 $302.11 $697.89
603 2 $697.89 $402.11 $69.79 $332.33 $365.56
604 3 $365.56 $402.11 $36.56 $365.56 $0.00
605
Payment Distribution
Payment

$450.00
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$400.00
$350.00
$300.00
 A B C D E F G H
606 Payment Distribution
607 Payment
608 $450.00 Note: See Columns M
609 through R for a 30 ye
$400.00
610 mortgage example.
$350.00
611
612 $300.00
613 $250.00 Principal
614 $200.00 Interest
615 $150.00
616 $100.00
617
$50.00
618
619 $0.00
1 2 3
620
621 Year
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626 k. On January 1, you deposit $100 in an account that pays a nominal (or quoted) interest rate of 11.33463%, with
interest added (compounded) daily. How much will you have in your account on October 1, or 9 months later?
627
(273 days)
628
629
630 0 1 2 3 4 5 273
631
632 100
633
634
635 I 0.00031054
636 N 273
637
638 FV $108.85
639
640 l. (1.) What is the value at the end of Year 3 of the following cash flow stream if the quoted interest rate is 10
641 compounded semiannually?
642
643 Annual rate = 10%
644 Periods per year = 2
645 Periodic rate = 5%
646
647
648 Years 0 0.5 1 1.5 2 2.5 3
649 Periods 0 1.0 2 3.0 4 5.0 6
650 Cash Flow 0 100 0 100 0 100
651
652 There are two approaches. First, you could simply find the future value of each cash flow using the
653 period rate and compounded for the appropriate number of periods, as shown below.
654
655 Periods 0 1.0 2 3.0 4 5.0 6
656 FV of CF $121.55 $110.25 $100.00
657
658 Total FV = Σ = $331.80
659
660 Alternatively, you could calculate the annual effective rate and use this to find the future value of a 3-year annuity
661
662 Annual effective rate = 10.25%
663
664 FV = $331.80
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666 l. (2.) What is the PV of the same stream?
667
668 Using the first approach, we find the present value of each individual cash flow using the periodic rate
669 and the number of periods.
670
671 Periods 0 1 2 3.0 4 5.0 6
672 PV of CF $90.70 $82.27 $74.62
673
674 Total FV = $247.59
675
676 In the second approach, we use the annual effective rate to find the present value of a 3-year annuity.
677
678 PV = $247.59
679
680 l. (3.) Is the stream an annuity? No, because we don't have a payment for each compounding period.
681
682
683
l. (4.) An important rule is that you should never show a nominal rate on a time line or use it in calculations unle
684 what condition holds? (Hint: Think of annual compounding, when i NOM = EAR = iPER.) What would be wrong w
685
your answer to questions l(1) and l(2) if you used the nominal rate (10%) rather than the periodic rate (i NOM/2
686 10%/2 = 5%)? Use the nominal rate only for annual compounding.
687
688
689 m. Suppose someone offered to sell you a note calling for the payment of $1,000 in 15 months (or 456 days). Th
offer to sell it to you for $850. You have $850 in a bank time deposit that pays a 6.76649% nominal rate with daily
690
compounding, which is a 7% effective annual interest rate, and you plan to leave the money in the bank unless y
691 buy the note. The note is not risky--you are sure it will be paid on schedule. Should you buy the note? Check th
692 decision in three ways: (1) by comparing your future value if you buy the note versus leaving your money in the
693 bank, (2) by comparing the PV of the note with your current bank account, and (3) by comparing the EFF% on the
694 note versus that of the bank account.
695
696 See which provides the greater future wealth
697
698 0 1 2 3 4 5 456
699
700 850
701
702 I 0.00018538
703 N 456
704
705 Bank account: FV $924.97 < $1,000, so buy the note.
706
707
708 See which has the greater present value
709
710 0 1 2 3 4 5 456
711
712 1000

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713
714 I 0.00018538
715 N 456
716
717 PV of the note: PV $918.95 > $859 cost, so buy the note.
718
719 See which has the higher effective rate of return, EFF%
720
721 0 1 2 3 4 5 456
722
723 850 1000
724
725 N 456
726
727 I 0.035646% per day
728
729 EAR 13.89% > 7% so buy the note.

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e exception.381Since, the
382the last
period 0, and
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ter a "1" instead
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457is 10%,
te interest rate
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iPER). 520
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526monthly, and
uarterly, 12 for
527
528
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530
531
532
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534
e often than annually, for
hy? 535
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539
as under multiple
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compounding 586
period is
587
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589
e equal installments at the
590
591
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593 Tot. prin. pd
594 $1,000
595
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597
ncome for the598lender, during
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606
607
Note: See
608Columns M
through609
R for a 30 year
mortgage
610example.
611
612
613
614
615
616
617
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619
620
621
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est rate of 11.33463%, with
ber 1, or 9 months later?
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628
629
630
631
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635
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639
640 rate is 10%,
quoted interest
641
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659
re value of a 660
3-year annuity.
661
662
663
664
665

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666
667
668
669
670
671
672
673
674
675
676
677
678
679
unding period.
680
681
682
683
use it in calculations unless
What would 684
be wrong with
685
an the periodic rate (i NOM/2 =
686
687
688
months (or 689
456 days). They
9% nominal rate with daily
690
oney in the bank unless you
691 Check the
ou buy the note?
leaving your692
money in the
omparing the 693
EFF% on the
694
695
696
697
698
699
700
701
702
703
704
705
706
707
708
709
710
711
712

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 I
713
714
715
716
717
718
719
720
721
722
723
724
725
726
727
728
729

36 of 36