Basic Financial Calculations

2.1 Basic Financial Calculations using excel

Overview
This chapter aims to give you some finance basics and their Excel implementation. If you have had a good
introductory course in finance, this chapter is likely to be at best a refresher.
This chapter covers:
 Net present value (NPV)
 Internal rate of return (IRR)
 Payment schedules and loan tables
 Future value
Almost all financial problems are centered on finding the value today of a series of cash receipts over time.
The cash receipts (or cash flows, as we will call them) may be certain or uncertain. The present value of a cash
𝐶𝐹𝑡
flow CF t anticipated to be received at time t is . The numerator of this expression is usually understood
(1+𝑟)𝑡
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 finance 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.
2.2 Present value and Net Present Value
Both of these concepts are related to the value today of a set of future anticipated cash flows. 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 flows 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 flows using this opportunity cost as a
discount rate:

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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 flows. 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.
 Using the Excel PV function. This function computes the present value of a series of constant payments.
PV(B2,5,-100) is the present value of 5 payments of 100 each at the discount rate in cell B2. The PV
function returns a negative value for positive cash flows; to prevent this unfortunate occurrence, we have
made the cash flows negative.
The Difference between Excel’s PV and NPV Functions
The above spreadsheet may leave the misimpression that PV and NPV perform exactly the same computation.
But this is not true—whereas NPV can handle any series of cash flows, PV can handle only constant cash
flows:

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Excel’s NPV Function Is Misnamed!
In standard finance terminology, the present value of a series of cash flows is the value today of the future cash
𝑡
𝐶𝐹𝑡
flows: ∑ 𝑡
𝑡=1 (1+𝑟)

The net present value is the present value minus the cost of acquiring the asset (the cash flow at time zero):
𝑡
𝐶𝐹𝑡
Net Present Value = ∑ − 𝐶𝐹0 𝑡ℎ𝑖𝑠 𝑖𝑠 𝑡ℎ𝑒 𝑎𝑐𝑡𝑢𝑎𝑙 𝑓𝑜𝑟𝑚𝑢𝑙𝑎 𝑓𝑜𝑟 𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑖𝑛𝑔 𝑁𝑃𝑉
(1 + 𝑟)𝑡
𝑡=0
𝑡
𝐶𝐹𝑡
But in financial Excel we may use: NPV = 𝐶𝐹0 + ∑ (1+𝑟)𝑡 because CF0 is put in the Excel with negative
𝑡=0
sign which show cash out flow for investment or acquisition of asset.
The Net Present Value, NPV
Suppose that the above investment is sold for $400. Clearly it would not be worth its purchase price, since—
given the alternative return (discount rate) of 10%—the investment is worth only $379.08. The net present
value (NPV) is the applicable concept here. Denoting by r the discount rate applicable to the investment, the
NPV is calculated as follows:
𝑡
𝐶𝐹𝑡
NPV = 𝐶𝐹0 + ∑ (1
+ 𝑟)𝑡
𝑡=0

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Where CFt is the investment’s cash flow at time t and C F0 is today’s cash flow.
Suppose, for example, that the series of 5 cash flows of $100 is sold for $250.
Then, as shown below, the NPV = 129.08.

The NPV represents the wealth increment of the purchaser of the cash flows. If you buy the series of 5 cash
flows of 100 for 250, then you have gained 129.08 in wealth today. In a competitive market the NPV of a
series of cash flows ought to be zero: Since the present value should correspond to the market price of the cash
flows, the NPV should be zero. In other words, the market price of our 5 cash flows of 100 ought in a
competitive market, assuming that 10% is the correct risk-adjusted discount rate be 379.08.
The Present Value of an Annuity—Some Useful Formulas
An annuity is a security which pays a constant sum in each period in the future. Annuities may have a finite or
infinite series of payments. If the annuity is finite, and the appropriate discount rate is r, then the value today of
the annuity is its present value:
𝐶 𝐶 𝐶 𝐶
𝑃𝑉 𝑜𝑓 𝑓𝑖𝑛𝑖𝑡𝑒 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = + + +⋯
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑛
1
1− 1 − (1 + 𝑟)−𝑛 1 (1 + 𝑟)−𝑛
( 1 + 𝑟) 𝑛
𝑃𝑉 𝑜𝑓 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = 𝐶 [ ]=𝐶 [ ]=𝐶[ − ]
r 𝑟 𝑟 𝑟

If the annuity promises an infinite series of constant future payments, then this formula reduces to:
𝐶 𝐶 𝐶
𝑃𝑉 𝑜𝑓 𝑓𝑖𝑛𝑖𝑡𝑒 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 = + +⋯
(1 + 𝑟)1 (1 + 𝑟)2 r
Both of these formulas can be computed with Excel. Below we compute the value of a finite annuity in three
ways: using the formula (cell B6), using Excel’s PV function (cell B7), and using Excel’s NPV function:

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Computing the value of an infinite annuity is even simpler: based on the above example.

Present value of infinite Annuity 8,333.33 <-- =B2/B4

2.3 The IRR and Loan Tables
The internal rate of return (IRR) is defined as the compound rate of return r which makes the NPV equal to
zero:
𝑡
𝐶𝐹𝑡
𝑁𝑃𝑉 = 𝐶𝐹0 + ∑ (1 = 0 𝑜𝑟 𝑁𝑃𝑉 = 0
+ 𝑟)𝑡
𝑡=0
To illustrate, consider the example given in rows 2–10 below: A project costing 800 in year zero returns a
variable series of cash flows at the end of years 1–5. The IRR of the project (cell B10) is 22.16%:

Note that the Excel IRR function includes as arguments all of the cash flows of the investment, including the
first in this case negative cash flow of –800.

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Loan Tables and the Internal Rate of Return
The IRR is the compound rate of return paid by the investment. To understand this fully, it helps to make a
loan table, which shows the division of the investment’s cash flows between investment income and the return
of the investment principal:

Division of cash flow

between investment
income and return of
=$B$10*B15 principal
=C15-D15

=-B3

=B15-E15

The remaining investment principal in

the year after the last cash flow is zero,
indicating that all the principal has been
repaid.
The loan table divides each of the cash flows of the asset into an income component and a return-of-principal
component. The income component at the end of each year is IRR times the principal balance at the beginning
of that year. Notice that the principal at the beginning of the last year (327.44 in the example) exactly equals
the return of principal at the end of that year.
2.4 Future values and Applications
We start with a triviality. Suppose you deposit 1,000 in an account today, leaving it there for 10 years. Suppose
the account draws annual interest of 10%. How much will you have at the end of 10 years? The answer, as
shown in the following spreadsheet, is 2,593.74:

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As cell C17 shows, you don’t need all these complicated calculations: The future value of 1,000 in 10 years at
10% per year is given by:
FV = 1,000*(1+ 10%)10 = 2,593.74
Now consider the following, slightly more complicated, problem: Again, you intend to open a savings account.
Your initial deposit of 1,000 today will be followed by a similar deposit at the beginning of years 1, 2… 9. If
the account earns 10% per year, how much will you have in the account at the start of year 10?

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Thus the answer is that we will have 17,531.17 in the account at the end of year 10. This same answer can be
represented as a formula that sums the future values of each deposit:
Total at beginning of year 10 = 1,000 (1+ 10%)10 + 1 000 (1+ 10% )9 + … + 1,000(1+10%)1
10
Or = Total at beginning of year 10 = ∑𝑡=1 1,000(1 + 10%)𝑡 .
Or we can use future value of
annuity due; when periodic rents (R) or cash flow (C) started at the beginning of
the period.
(1 + 𝑖)𝑛 − 1 (1 + 𝑖)𝑛 1
𝐹𝑉𝐴𝐷 =𝑅 [ ] (1 + 𝑖)𝑜𝑟 𝐹𝑉𝐴𝐷 = 𝑅[ − ] (1 + 𝑖)
i 𝑖 𝑖

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