1.

7 A Pension Problem—Complicating the Future Value Problem A typical exercise is the following:
You are currently 55 years old and intend to retire at age 60. To make your retirement easier, you
intend to start a retirement account: • At the beginning of each of years 1, 2, 3, 4 (that is, starting
today and at the beginning of each of the next four years), you intend to make a deposit into the
retirement account. You think that the account will earn 8% per year. 34 Chapter 1 • After retirement
at age 60, you anticipate living 8 more years. 5 At the beginning of each of these years you want to
withdraw $30,000 from your retirement account. Your account balances will continue to earn 8%.
How much should you deposit annually in the account? The following spreadsheet fragment below
shows how easily you can go wrong in this kind of problem—in this case, you ’ ve calculated that in
order to provide $30,000 per year for 8 years, you need to contribute $240,000/5 = $48,000 in each
of the fi rst 5 years. As the spreadsheet shows, you ’ ll end up with a lot of money at the end of 8
years! (The reason—you ’ ve ignored the powerful effects of compound interest. If you set the
interest rate in the spreadsheet equal to 0%, you ’ ll see that you ’ re right.) 1 2 3 4 5 6 7 8 9 10 11 12
13 14 15 16 17 18 19 20 21 A BC D E F tseretnI %8 Annual deposit 48,000.00 Annual retirement
withdrawal 30,000.00 =$B$2*(C7+B7) Year Account balance, beginning of year Deposit at beginning
of year Interest earned during year Total in account, end year 1 7B+7C+7D= --

This chapter aims to give you some fi nance basics and their Excel implementation. If you have had a
good introductory course in fi nance, this chapter is likely to be at best a refresher. 1 This chapter
covers: • Net present value (NPV) • Internal rate of return (IRR) • Payment schedules and loan tables
• Future value • Pension and accumulation problems • Continuously compounded interest • Time-
dated cash fl ows (Excel functions XNPV and XIRR ) Almost all fi nancial problems are centered on fi
nding the value today of a series of cash receipts over time . The cash receipts (or cash fl ows, as we
will call them) may be certain or uncertain. The present value of a cash fl ow CF t anticipated to be
received at time t is CF r t t ( ) 1+ . The numerator of this expression is usually understood to be the
expected time t cash flow , and the discount rate r in the denominator is adjusted for the riskiness of
this expected cash flow—the higher the risk, the higher the discount rate.

The basic concept in present value calculations is the concept of opportunity cost . Opportunity cost
is the return which would be required of an investment to make it a viable alternative to other,
similar investments. In the financial literature there are many synonyms for opportunity cost, among
them: discount rate, cost of capital, and interest rate. When applied to risky cash flows, we will
sometimes call the opportunity cost the risk-adjusted discount rate (RADR) or the weighted average
cost of capital (WACC). It goes without saying that this discount rate should be risk-adjusted, and
much of the standard fi nance literature discusses how to do this. As illustrated below, when we
calculate the net present value, we use the investment ’ s opportunity cost as a discount rate. When
we calculate the internal rate of return, we compare the calculated return to the investment ’ s
opportunity cost to judge its value. 1. In my book Principles of Finance with Excel (Oxford University
Press, 2nd edition, 2008) I have discussed many basic Excel/fi nance topics at greater length. 14
Chapter 1 1.2 Present Value and Net Present Value Both of these concepts are related to the value
today of a set of future anticipated cash fl ows. As an example, suppose we are valuing an investment
which promises $100 per year at the end of this and the next 4 years. We suppose that these cash fl
ows are risk free: There is no doubt that this series of 5 payments of $100 each will actually be paid.
If a bank pays an annual interest rate of 10% on a 5-year deposit, then this 10% is the investment ’ s
opportunity cost, the alternative benchmark return to which we want to compare the investment.
We can calculate the value of the investment by discounting its cash fl ows using this opportunity
cost as a discount rate: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 A BC D etar tnuocsiD %01 Year Cash flow
Present value 1 5A^)2$B$+1(/5B= --<-- =SUM(C5:C9) Using Excel's NPV function 379.08 <--
=NPV(B2,B5:B9) Using Excel's PV function 379.08 <-- =PV(B2,5,-100) COMPUTING THE PRESENT
VALUE The present value , 379.08, is the value today of the investment. In a competitive market, the
present value should correspond to the market price of the cash fl ows. The spreadsheet illustrates
three ways of obtaining this value: • Summing the individual present values in cells C5:C9. To simplify
the copying, note the use of “ ∧ ” to represent the power and the use of both the relative and
absolute references; for example: = B5/(1 + $B$2) ∧ A5 in cell C5. • Using the Excel NPV function. As
we show on the next page, Excel ’ s NPV function is unfortunately misnamed—it actually computes
the present value and not the net present value.