Chapter 11: Borrowing and Investing Formulas 295

Matching time periods

A common problem when working with Excel’s financial functions is the matching of time peri-
ods. Simply put, the time period that your payment covers must match the time period of your
interest rate. If you put a monthly payment into a financial function, along with an annual interest
rate, the result will be wrong. In this case, you need to convert the interest rate to a monthly rate
so it matches the payment frequency.
The examples in this chapter deal with the issue of matching time periods explicitly. When you
see an interest rate divided by 12, it probably means that an annual interest rate is being con-
verted into a monthly interest rate.

Timing of the first payment

The final concept to keep in mind when constructing financial formulas is the timing of the first
payment. Sometimes the first payment is made right away. Usually, the first payment is made
after the first month (or whatever period payments are normally made). For example, if you get a
car loan on May 15, you probably don’t have to make the first payment until June 15.
In Excel formulas, first payment timing is handled in the type argument of various functions:

h If the first payment is made in arrears (after the first period), you use a type of 0 (zero),
which is generally the default.
h If the first payment is made in advance, use a type of 1.

Down payments are not considered regular payments, so they don’t affect which type
argument you specify.

The Basic Excel Financial Functions

Excel has five basic financial functions: PV, FV, PMT, RATE, and NPER. I discuss each of these
functions in this section, and also provide examples.

All these functions are related, because they deal with different sides of the same situa-
tion. Many of the arguments are the same from function to function.

Calculating present value

The PV function returns the present value of future cash flows. We know that money in the future
has a different value than money today. This function tells us how much that future money is
worth right now. Its syntax, with required arguments in bold, is

PV(rate, nper, pmt, fv, type)

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 296 Part III: Financial Formulas

Financial function arguments

The five basic Excel financial functions have many common arguments. The arguments and their
meanings are listed here:
● rate: The interest rate, expressed as a percentage, that is paid on a loan or used to dis-
count future cash flows.
The period that the interest rate covers must be the same period used for nper and pmt.
● nper: The number of periods. This could be the number of payments on a loan or the num-
ber of periods that money is kept in a savings account.
The number of periods must be expressed in the same terms as rate and pmt. A 30-year
mortgage with monthly payments, for instance, would have an nper of 360.
● pmt: The amount of each payment. For these financial functions, the payments must be
the same amount and made at regular intervals. The payment amount is normally made up
of both principal and interest.
● fv: The future value. This is the last cash flow that settles the transaction. In many cases,
the payments settle the transaction (for example, pay off the loan), so there is no future
value.
● pv: The present value. This is the first cash flow that starts the transaction, such as borrow-
ing money on a loan or putting money into a savings account.
If the transaction is made up of just payments, there may not be a present value.
● type: Whether the payments are made in arrears (0 or default) or in advance (1).
● guess: An approximation of the result. When computing an interest rate, Excel must per-
form many iterations to get the answer. You can help Excel by specifying a guess argu-
ment that you expect to be close to the actual result.

The example in this section computes the present value of a series of future receipts, sometimes
called an annuity. You get one payment of $1,200 each year for ten years. The value of those
payments right now is $6,780.27.

=PV(12%,10,1200,0,0)

In other words, if the payer offered you more than $6,800 right now (so he wouldn’t have to
make the payments to you in the future), you would take it. If he offered you less, you would
pass and wait for the regular payments.

The file basic financial formulas.xlsx on the companion CD-ROM contains all
the examples in this section.

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You may have noticed that in the preceding formula, the interest rate (12%) appeared out of thin
air. The PV function is usually used to determine how much a specific future amount is worth
today. A specific interest rate is not available in those situations.

There are a lot of opinions on what discount rate you should use, and which one you
choose depends a lot on your personality. Some say that you should use the interest
rate you would get from a bank if you borrowed the money with no collateral. Others
say that you should use the interest rate you would receive if you made a risk-free
investment, like in a U.S. Treasury bill. In this example, I use the rate of return you
would make if you invested the money in the stock market.

By choosing 12% in this example, I’m saying that you can take the $6,780, invest it so that you
make a 12% return, and you’ll be in the same financial position as if you had just waited for the
$1,200 payments. If the payer offers you $7,000, you can invest that and be in a better position.
Now let’s turn the tables and say that you have an obligation to pay someone $1,200 per year for
ten years. That formula looks like this:

=PV(12%,10,–1200,0,0)

Instead of a positive cash flow, this formula shows a negative cash flow. The result, $6,780.27, is
also oppositely signed from the previous result. In both examples, the sum total of the payments
constitutes the entire transaction, so there is no future value. Also, the default value of zero for
the type argument is included. Both the fv argument and the type argument are optional, but
they are included here for clarity. Figure 11-1 shows these examples in a workbook.

For simplicity, the formulas presented in this chapter use literal values for function
arguments. In most cases, you’ll use cell references for the arguments.

Figure 11-1: Some present value calculations.

Present value of a lump sum

The previous examples dealt with a series of future cash flows, but sometimes there’s just one
large future cash flow — a lump sum.

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 298 Part III: Financial Formulas

For the next example, assume a wealthy relative wants to give you $100,000, but that you can’t
collect it until your 40th birthday. If you are 25 years old now, the value of that future gift would
be $31,524.17 and is computed as follows:

=PV(8%,15,0,100000)

The payment is an inflow (a positive $100,000) that will occur 15 years from now. If you had
some money now, you think you could make 8% investing it. Because there are no payments, the
type argument is irrelevant.
The result of this formula means that if you had $31,524 now and you invested it at 8%, it would
be worth $100,000 in 15 years. See Figure 11-2.

Figure 11-2: Calculating the present value of a lump sum.

Present value of an annuity with a lump sum

In some cases, future cash flows are followed by a single, large future cash flow.
Assume that your brother-in-law wants you to invest in his carpet-cleaning business. If you’ll
invest $50,000 now, he will pay you $200 per month for five years and then also pay you
$60,000 at the end of the five years. To determine whether this is a good deal, find the present
value of all your future cash inflows:

=PV(10%/12,60,200,60000,1)

Let’s look at each of these arguments (see Figure 11-3):

h You determined that you could make 10% on your money elsewhere, so 10% is the dis-
count rate.
h All the arguments must cover the same time period. Because the $200 payment is made
monthly, all the arguments must be converted to months:
● The rate argument is divided by 12 (for 12 months).
● The nper argument is expressed as 60 (for 60 months; not 5 for 5 years).

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 Chapter 11: Borrowing and Investing Formulas 299

h The payment amount and the lump sum amount were laid out in the deal.
h The type argument is 1 because the brother-in-law wants the first payment now (in
advance).

Figure 11-3: Calculating a present value of an annuity with a lump sum.

The formula tells us that the value of all those future cash flows is $45,958.83. According to the
terms of this deal and your assumptions, you could make more money investing your $50,000
elsewhere.

You can plug in different values for the arguments until you find a solution that is favor-
able — and then make a counter proposal to your brother-in-law. You can even use
Excel’s Goal Seek feature (Data➜Data Tools➜What-If Analysis➜Goal Seek) to find the
value of an argument that results in your desired present value.

Calculating future value

The future value is the other side of the time value of money coin. It calculates how much a
known quantity of money (or a known series of payments) will be worth at some point in the
future. The syntax for the FV function follows. Arguments in bold are required arguments.

FV(rate, nper, pmt, pv, type)

Future value of payments

For this example, assume you start a savings account for your new baby’s college education.
Starting next month, you’ll put $50 per month in the account, and you’ll earn 3% interest. The for-
mula that follows shows that, in 18 years, the account will have $14,297.02 (see Figure 11-4):

=FV(3%/12,18*12,–50,0,0)

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