Chapter 5: The time value of money*

This version: June 27, 2004

Chapter contents
Overview......................................................................................................................................... 2

5.1. Future value ............................................................................................................................ 3

5.2. Present value ......................................................................................................................... 19

5.3. Net present value................................................................................................................... 27

5.4. The internal rate of return (IRR)........................................................................................... 33

5.5. What does IRR mean? Loan tables and investment amortization ....................................... 38

5.6. Saving for the future—buying a car for Mario ..................................................................... 41

5.7. Solving Mario’s savings problem—3 solutions.................................................................... 43

5.8. Saving for the future—more complicated problems............................................................. 46

5.9. Computing annual “flat” payments on a loan—Excel’s PMT function ............................... 53

5.10. How long will it take to pay off a loan?.............................................................................. 56

5.11. An Excel note—building good financial models................................................................ 59

Summing up .................................................................................................................................. 61

Exercises ....................................................................................................................................... 63

Appendix: Algebraic Present Value Formulas ............................................................................ 75

*
Notice: This is a preliminary draft of a chapter of Principles of Finance with Excel by Simon Benninga

(benninga@wharton.upenn.edu). All the material is copyright and the rights belong to MIT Press and the author.

PFE Chapter 5, Time value of money page 1

Overview

This chapter deals with the most basic concepts in finance: future value, present value,

net present value, and internal rate of return. These concepts tell you how much your money will

grow if deposited in a bank (future value), how much promised future payments are worth today

(present value), what an investment is worth (net present value), and what percentage rate of

return you’re getting on your investments (internal rate of return).

Financial assets and financial planning always have a time dimension. Here are some

simple examples:

• You put $100 in the bank today in a savings account. How much will you have in 3

years?

• You put $100 in the bank today in a savings account and plan to add $100 every year

for the next 10 years. How much will you have in the account in 20 years?

• XYZ Corporation just sold a bond to your mother for $860. The bond will pay her

$20 per year for the next 5 years. In 6 years she gets a payment of $1020. Has she

paid a fair price for the bond?

• Your Aunt Sara is considering making an investment. The investment costs $1,000

and will pay back $50 per month in each of the next 36 months. Should she do this or

should she leave her money in the bank, where it earns 5%?

This chapter discusses these and similar issues, all of which fall under the general topic of

time value of money. You will learn how compound interest causes invested income to grow

(future value), and how money to be received at future dates can be related to money in hand

today (present value and net present value). You will also learn how to calculate the compound

rate of return earned by an investment (internal rate of return). The concepts of future value,

PFE Chapter 5, Time value of money page 2

present value, net present value, and internal rate of return underlie much of the financial

analysis which will appear in the following chapters.

As always, we use Excel, which provides us with the best financial tool available today.

Finance concepts discussed

• Future value

• Present value

• Net present value

• Internal rate of return

• Pension and savings plans and other accumulation problems

Excel functions used

• Excel functions: PV, NPV, IRR, PMT, NPer

• Goal seek

5.1. Future value

Future value is the value at some future date of a payment (or payments) made before

this future date. The future value includes the interest earned on the payments.

Future value (FV) is a concept that relates the value in the future of money deposited in a

bank account today and over time and left in the account to draw interest. Suppose, for example,

that you put $100 in a savings account in your bank today and that the bank pays you 6% interest

at the end of every year. If you leave the money in the bank for one year, you will have $106

PFE Chapter 5, Time value of money page 3

after one year: $100 of the original savings balance + $6 in interest. The $106 is the future

value after one year of the initial deposit of $100 at 6% annual interest.

Now suppose you leave the money in the account for a second year: At the end of this

year, you will have:

$106 The savings account balance at the end of the first year

6%*$106 = $6.36 The interest in on this balance for the second year

= $112.36 Total in account after two years

The $112.36 is the future value after 2 years of the initial deposit of $100 at 6% annual interest.

Another way to express this is $112.36 = $100*(1+6%)2 :

= $100* (1 + 6% ) = $112.36
2
$100 * 1.06 * 1.06
↑ ↑ ↑
Initial deposit Year 1's future Year 2's
value factor at 6% future value factor

↑
Future value of $100 after
one year = $100*1.06

↑
Future value of $100 after two years

Notice that the future value uses the concept of compound interest: The interest earned in

the first year ($6) itself earns interest in the second year. To sum up:

The future value of $X deposited today in an account paying r% interest annually and left

in the account for n years is FV = X * (1 + r ) .

n

PFE Chapter 5, Time value of money page 4

 Notation

In this book we will often match our mathematical notation to that used by Excel. Since

in Excel multiplication is indicated by a star “*”, we will sometimes write 6%*$106 = $6.36,

even though this is not necessary. Similarly we will sometimes write (1.10 ) as 1.10 ^ 3 .
3

Future value calculations are easily done in Excel:

A B C
1 CALCULATING FUTURE VALUES WITH EXCEL
2 Initial deposit 100
3 Interest rate 6%
4 Number of years, n 2
5
6 Account balance after n years 112.36 <-- =B2*(1+B3)^B4

In Excel (1 + 6% ) is written as
2
Notice the use of the carat (^) to denote the exponent:

(1+B3)^B4, where cell B3 contains the interest rate and cell B4 the number of years.

We can use Excel to make a table of how the future value grows with the years and then

use Excel’s graphing abilities to graph this growth:

PFE Chapter 5, Time value of money page 5

 A B C D E F G
1 THE FUTURE VALUE OF A SINGLE $100 DEPOSIT
2 Initial deposit 100
3 Interest rate 6%
4 Number of years, n 2
5
6 Account balance after n years 112.36 <-- =B2*(1+B3)^B4
7
8 Year Future value
9 0 100.00 <-- =$B$2*(1+$B$3)^A9
10 1 106.00 <-- =$B$2*(1+$B$3)^A10
11 2 112.36 <-- =$B$2*(1+$B$3)^A11
12 3 119.10 <-- =$B$2*(1+$B$3)^A12
13 4 126.25 <-- =$B$2*(1+$B$3)^A13
14 5 133.82
15 6 141.85 Future Value of $100 at 6% Annual Interest
16 7 150.36
17 8 159.38
18 9 168.95 350
19 10 179.08 300
20 11 189.83
Future value

250
21 12 201.22 200
22 13 213.29 150
23 14 226.09 100
24 15 239.66 50
25 16 254.04 0
26 17 269.28 0 5 10 15 20
27 18 285.43 Years
28 19 302.56
29 20 320.71

Excel note

Notice that the formula in cells B9:B29 in the table has $ signs on the cell references (for

example: =$B$2*(1+$B$3)^A9 ). This use of the absolute copying feature of Excel is

explained in Chapter 000.

In the spreadsheet below, we present a table and graph that shows the future value of

$100 for 3 different interest rates: 0%, 6%, and 12%. As the spreadsheet shows, future value is

very sensitive to the interest rate! Note that when the interest rate is 0%, the future value doesn’t

grow.

PFE Chapter 5, Time value of money page 6

 A B C D E
FUTURE VALUE OF A SINGLE PAYMENT AT DIFFERENT INTEREST RATES
1 How $100 at time 0 grows at 0%, 6%, 12%
2 Initial deposit 100
3 Interest rate 0% 6% 12%
4
5 Year FV at 0% FV at 6% FV at 12%
6 0 100.00 100.00 100.00 <-- =$B$2*(1+D$3)^$A6
7 1 100.00 106.00 112.00 <-- =$B$2*(1+D$3)^$A7
8 2 100.00 112.36 125.44
9 3 100.00 119.10 140.49
10 4 100.00 126.25 157.35
11 5 100.00 133.82 176.23
12 6 100.00 141.85 197.38
13 7 100.00 150.36 221.07
14 8 100.00 159.38 247.60
15 9 100.00 168.95 277.31
16 10 100.00 179.08 310.58
17 11 100.00 189.83 347.85
18 12 100.00 201.22 389.60
19 13 100.00 213.29 436.35
20 14 100.00 226.09 488.71
21 15 100.00 239.66 547.36
22 16 100.00 254.04 613.04
23 17 100.00 269.28 686.60
24 18 100.00 285.43 769.00
25 19 100.00 302.56 861.28
26 20 100.00 320.71 964.63
27
28
29 1000
30 900
31 800
32 FV at 0%
700
33 FV at 6%
34 600
FV at 12%
35 500
36 400
37 300
38
39 200
40 100
41 0
42 0 5 10 15 20
43
44

PFE Chapter 5, Time value of money page 7

 Terminology: What’s a year? When does it begin?

While these questions may seem obvious, this is not the case. There’s a lot of semantic

confusion on this subject in finance courses and texts.

Throughout this book we will use the following as synonyms:

Year 0 Year 1 Year 2

End of End of
Today year 1 year 2

Beginning Beginning Beginning

of year 1 of year 2 of year 3

0 1 2 3

To reiterate, the words “Year 0,” “Today,” and “Beginning of year 1” are synonyms. For

example, “$100 at the beginning of year 2” is the same as “$100 at the end of year 1.” If you’re

at loss to understand what someone means, ask for a drawing; better yet, ask for an Excel

spreadsheet.

Accumulation—savings plans and future value

In the previous example you deposited $100 and left it in your bank. Suppose that you

intend to make 10 annual deposits of $100, with the first deposit made in year 0 (today) and each

succeeding deposit made at the end of years 1, 2, ..., 9. The future value of all these deposits at

the end of year 10 tells you how much you will have accumulated in the account. If you are

saving for the future (whether to buy a car at the end of your college years or to finance a

pension at the end of your working life), this is obviously an important and interesting

calculation.

PFE Chapter 5, Time value of money page 8

 So how much will you have accumulated at the end of year 10? There’s an Excel

function for calculating this answer which we will discuss later; for the moment we will set this

problem up in Excel and do our calculation the long way, by showing how much we will have at

the end of each year:

A B C D E F
FUTURE VALUE WITH ANNUAL DEPOSITS
1 at beginning of year
2 Interest 6%
3 =$B$2*(C6+B6)
Account Deposit at Interest Total in
=E5
balance, beginning earned account at
4 Year beg. year of year during year end of year
5 1 0.00 100.00 6.00 106.00 <-- =B5+C5+D5
6 2 106.00 100.00 12.36 218.36 <-- =B6+C6+D6
7 3 218.36 100.00 19.10 337.46
8 4 337.46 100.00 26.25 463.71
9 5 463.71 100.00 33.82 597.53
10 6 597.53 100.00 41.85 739.38
11 7 739.38 100.00 50.36 889.75
12 8 889.75 100.00 59.38 1,049.13
13 9 1,049.13 100.00 68.95 1,218.08
14 10 1,218.08 100.00 79.08 1,397.16
15
Future value
using Excel's
16 FV function $1,397.16 <-- =FV(B2,A14,-100,,1)

For clarity, let’s analyze a specific year: At the end of year 1 (cell E5) you’ve got $106

in the account. This is also the amount in the account at the beginning of year 2 (cell B6). If you

now deposit another $100 and let the whole amount of $206 draw interest during the year, it will

earn $12.36 interest. You will have $218.36 = (106+100)*1.06 at the end of year 2.

A B C D E
6 2 106.00 100.00 12.36 218.36

Finally, look at rows 13 and 14: At the end of year 9 (cell E13) you have $1,218.08 in

the account; this is also the amount in the account at the beginning of year 10 (cell B14). You

PFE Chapter 5, Time value of money page 9

then deposited $100 and the resulting $1,318.08 earns $79.08 interest during the year,

accumulating to $1,397.16 by the end of year 10.

A B C D E
13 9 1,049.13 100.00 68.95 1,218.08
14 10 1,218.08 100.00 79.08 1,397.16

The Excel FV (future value) function

The spreadsheet of the previous subsection illustrates in a step-by-step manner how

money accumulates in a typical savings plan. To simplify this series of calculations, Excel has a

FV function which computes the future value of any series of constant payments. This function

is illustrated in cell C16:

B C D E
Future value
using Excel's
16 FV function $1,397.16 <-- =FV(B2,A14,-100,,1)

The FV function and the inputs required can be computed using a dialog box—an

important feature that comes with each Excel function. The Excel note which follows illustrates

how to generate the dialog box for the computation in cell C16. If you already know how to use

dialog boxes, here it is for this example:

PFE Chapter 5, Time value of money page 10

 The FV function requires as inputs the Rate of interest, the number of periods Nper, and

the annual payment Pmt. You can also indicate the Type, which tells Excel whether payments

are made at the beginning of the period (type 1 as in our example) or at the end of the period

(type 0).1

1
Exercises 2 and 3 at the end of the chapter illustrate both cases.

PFE Chapter 5, Time value of money page 11

 Excel Note: Functions and Dialog Boxes

Cell C16 of the previous example contains the function FV(B2,A14,-100,,1). In this note

we illustrate the use of the dialog box for FV to generate this function.

The last part of this Excel note discusses why the payment of $100 is entered into this

function as a negative number. This is a peculiarity of the FV function shared by many other

Excel financial functions.

Going through the function wizard

Suppose you’re in cell C16 and you want to put the Excel function for future value in the

cell. With the cursor in C16, you move your mouse to the icon on the tool bar:

PFE Chapter 5, Time value of money page 12

 Clicking on the icon brings up the dialog box below. We’ve chosen the category to

be the Financial functions, and we’ve scrolled down in the next section of the dialog box to put

the cursor on the FV function.

Clicking OK brings up the dialog box for the FV function, which can now be filled in as

illustrated below:

Excel’s function dialog boxes have room for two types of variables.

PFE Chapter 5, Time value of money page 13

 • Bold faced variables must be filled in—in the FV dialog box these are the interest Rate,

the number of periods Nper, and the payment Pmt. (Read on to see why we wrote a

negative payment.)

• Variables which are not bold faced are optional. For example Type refers to when the

payments are made and so has only two options—1 when the payments are made at the

beginning of the period and 0 when they made at the end of the period. In the example

above we’ve indicated a 1 for the Type; this indicates (as shown in the dialog box itself)

that the future value is calculated for payments made at the beginning of the period. Had

we omitted this variable or put in 0, Excel would compute the future value for a series of

payments made at the end of the period; see the subsection of Section 5.1 entitled

“Beginning versus end of period” for an illustration.

Notice that the dialog box already tells us (even before we click on OK) that the future

value of $100 per year for 10 years compounded at 6% is $1397.16.

A short way to get to the dialog box

If you know the name of the function you want, you can just write it in the cell and then

click the icon on the tool bar. As illustrated below, you have to write

=FV(

and then click on the icon—note that we’ve written an equal sign, the name of the function,

and the opening parenthesis.

Here’s how the spreadsheet looks in this case:

PFE Chapter 5, Time value of money page 14

 Look in the text displayed by Excel below cell C16: As illustrate here, some versions of

Excel show the format of the function when you type it in a cell.

One further option

You don’t have to use a dialog box! If you know the format of the function then just type

in its variables and you’re all set. In the example of Section 5.1 you could just type

=FV(B2,A14,-100,,1) in the cell. Hitting [Enter] would give the answer.

Why is the Pmt variable a negative number?

In the FV dialog box we’ve entered in the payment Pmt in as a negative number, as -100.

The FV function has the peculiarity (shared by some other Excel financial functions) that a

PFE Chapter 5, Time value of money page 15

positive deposit generates a negative answer. We won’t go into the (strange?) logic that

produced this thinking; whenever we encounter it we just put in a negative deposit.

[End of Excel note]

[Continuation of Section 5.1]

Beginning versus end of period

In the example above you make deposits of $100 at the beginning of each year. In terms

of timing, your deposits are made at dates 0, 1, 2, 3, ..., 9. Here’s a schematic way of looking at

this, showing the future value of each deposit at the end of year 10:

DEPOSITS AT BEGINNING OF YEAR

Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning End of
of year 1 of year 2 of year 3 of year 4 of year 5 of year 6 of year 7 of year 8 of year 9 of year 10 year 10

0 1 2 3 4 5 6 7 8 9 10

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100

179.08 <-- =100*(1.06)^10

168.95 <-- =100*(1.06)^9
159.38 <-- =100*(1.06)^8
150.36 <-- =100*(1.06)^7
141.85 <-- =100*(1.06)^6
133.82 <-- =100*(1.06)^5
126.25 <-- =100*(1.06)^4
119.10 <-- =100*(1.06)^3
112.36 <-- =100*(1.06)^2
106.00 <-- =100*(1.06)^1

Total 1397.16 <-- Sum of the above

Suppose you made 10 deposits of $100 at the end of each year. How would this affect

the accumulation in the account at the end of 10 years? The schematic diagram below illustrates

the timing and accumulation of the payments:

PFE Chapter 5, Time value of money page 16

DEPOSITS AT END OF YEAR

Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning Beginning End of
of year 1 of year 2 of year 3 of year 4 of year 5 of year 6 of year 7 of year 8 of year 9 of year 10 year 10

0 1 2 3 4 5 6 7 8 9 10

$100 $100 $100 $100 $100 $100 $100 $100 $100 $100

168.95 <-- =100*(1.06)^9

159.38 <-- =100*(1.06)^8
150.36 <-- =100*(1.06)^7
141.85 <-- =100*(1.06)^6
133.82 <-- =100*(1.06)^5
126.25 <-- =100*(1.06)^4
119.10 <-- =100*(1.06)^3
112.36 <-- =100*(1.06)^2
106.00 <-- =100*(1.06)^1
100.00 <-- =100*(1.06)^0

Total 1318.08 <-- Sum of the above

The account accumulation is less when you deposit at the end of each year than in the

previous case, where you deposit at the beginning of the year. When you deposit at the end of

each year, each deposit is in the account one year less and consequently earns one year’s less

interest. In a spreadsheet, this looks like:

A B C D E F

FUTURE VALUE WITH ANNUAL DEPOSITS

1 at end of year
2 Interest 6%
3 =$B$2*B6
Account Deposit at Interest Total in
=E5
balance, end earned account at
4 Year beg. year of year during year end of year
5 1 0.00 100.00 0.00 100.00 <-- =B5+C5+D5
6 2 100.00 100.00 6.00 206.00 <-- =B6+C6+D6
7 3 206.00 100.00 12.36 318.36
8 4 318.36 100.00 19.10 437.46
9 5 437.46 100.00 26.25 563.71
10 6 563.71 100.00 33.82 697.53
11 7 697.53 100.00 41.85 839.38
12 8 839.38 100.00 50.36 989.75
13 9 989.75 100.00 59.38 1,149.13
14 10 1,149.13 100.00 68.95 1,318.08
15
16 Future value $1,318.08 <-- =FV(B2,A14,-100)

Cell C16 illustrates the use of the Excel FV formula for this case. Here’s the dialog box

for FV for this case:

PFE Chapter 5, Time value of money page 17

 Dialog box for FV with end-period payments

In the example above we’ve omitted any entry in the Type box. We could have also put

a 0 in the Type box and gotten the same result.

Some finance jargon and the Excel FV function

An annuity is a series of equal periodic payments made over a specified amount of time.

Examples of annuities are widespread:

• The allowance your parents give you ($1000 per month, for your next 4 years of

college) is a monthly annuity with 48 payments.

• Pension plans often give the retiree a fixed annual payment for as long as he lives.

This is a bit more complicated annuity, since the number of payments is uncertain.

• Certain kinds of loans are paid off in fixed periodic (usually monthly, sometimes

annual) installments. Mortgages and student loans are two examples.

PFE Chapter 5, Time value of money page 18

 An annuity with payments at the end of each period is often called a regular annuity. As

you’ve seen in this section, the value of a regular annuity is calculated with =FV(B2,A14,-100).

An annuity with payments at the beginning of each period is often called an annuity due and its

value is calculated with the Excel function =FV(B2,A14,-100,,1).

5.2. Present value

The present value is the value today of a payment (or payments) that will be made in the

future.

Here’s a simple example: Suppose that you anticipate getting $100 in 3 years from your

Uncle Simon, whose word is as good as a bank’s. Suppose that the bank pays 6% interest on

savings accounts. How much is the anticipated future payment worth today? The answer is

100
$83.96= ; if you put $83.96 in the bank today at 6% annual interest, then in 3 years you
(1.06 )
3

would have $100 (see the “proof” in rows 9 and 10). 2 $83.96 is also called the discounted or

present value of $100 in 3 years at 6% interest.

A B C
1 SIMPLE PRESENT VALUE CALCULATION
2 X, future payment 100
3 n, time of future payment 3
4 r, interest rate 6%
n
5 Present value, X/(1+r) 83.96 <-- =B2/(1+B4)^B3
6
7 Proof
8 Payment today 83.96
9 Future value in n years 100 <-- =B8*(1+B4)^B3

PFE Chapter 5, Time value of money page 19

 To summarize:

The present value of $X to be received in n years when the appropriate interest rate is r%

X
is .
(1 + r )
n

The interest rate r is also called the discount rate. We can use Excel to make a table of

how the present value decreases with the discount rate. As you can see—higher discount rates

make for lower present values:

A B C D E F G H

THE PRESENT VALUE OF $100 IN 3 YEARS

1 in this example we vary the discount rate r
2 X, future payment 100
3 n, time of future payment 3
4 r, interest rate 6%
n
5 Present value, X/(1+r) 83.96 <-- =B2/(1+B4)^B3
6
Present
7 Discount rate value
8 0% 100.00 <-- =100/(1+A8)^3
9 1% 97.06 <-- =100/(1+A9)^3
10 2% 94.23 <-- =100/(1+A10)^3
11 3% 91.51 <-- =100/(1+A11)^3
12 4% 88.90 <-- =100/(1+A12)^3
13 5% 86.38
14 6% 83.96 Present Value of $100 to be Paid in 3 Years when
15 7% 81.63 120 Discount Rate Varies
16 8% 79.38
17 9% 77.22 100
Present value

18 12% 71.18 80
19 15% 65.75
20 18% 60.86 60
21 20% 57.87 40
22 22% 55.07
23 25% 51.20 20
24 30% 45.52 0
25 35% 40.64 0% 10% 20% 30% 40% 50%
26 40% 36.44
27 45% 32.80 Discount rate
28 50% 29.63

100
2
Actually, = 83.96193 , but we’ve used Format|Cells|Number to show only 2 decimals.
(1.06 )
3

PFE Chapter 5, Time value of money page 20

 Why does PV decrease as the discount rate increases?

The Excel table above shows that the $100 Uncle Simon promises you in 3 years is worth

$83.96 today if the discount rate is 6% but worth only $40.64 if the discount rate is 35%. The

mechanical reason for this is that taking the present value at 6% means dividing by a smaller

denominator than taking the present value at 35%:

100 100
83.96 = > = 40.64
(1.06 ) (1.35)
3 3

The economic reason relates to future values: If the bank is paying you 6% interest on

your savings account, you would have to deposit $83.96 today in order to have $100 in 3 years.

If the bank pays 35% interest, then of $40.64 today will grow to $100 in 3 years, since

$40.64* (1.35 ) = $100 .

3

What this short discussion shows is that the present value is the inverse of the future

value:

Time 0 1 2 3
$100.00

PV =
3
$100.00/(1+6%)
=
$83.96

FV=
3
$83.96*(1+6%)
= $100.00

Present value of an annuity

Recall that an annuity is a series of equal periodic payments. The present value of an

annuity tells you the value today of all the future payments on the annuity. Suppose you’ve been

PFE Chapter 5, Time value of money page 21

promised $100 at the end of each of the next 5 years. Assuming that you can get 6% at the bank,

this promise is worth $421.24 today:

A B C D
1 CALCULATING PRESENT VALUES WITH EXCEL
2 Annual payment 100
3 r, interest rate 6%
4
Payment Present
at end of value of
5 Year year payment
6 1 100 94.34 <-- =B6/(1+$B$3)^A6
7 2 100 89.00 <-- =B7/(1+$B$3)^A7
8 3 100 83.96
9 4 100 79.21
10 5 100 74.73
11
12 Present value of all payments
13 Summing the present values 421.24 <-- =SUM(C6:C10)
14 Using Excel's PV function 421.24 <-- =PV(B3,5,-100)
15 Using Excel's NPV function 421.24 <-- =NPV(B3,B6:B10)

The example above shows three ways of getting the present value of $421.24:

• You can sum the individual discounted values. This is done in cell C13.

• You can use Excel’s PV function, which calculates the present value of an annuity (cell

C14).

• You can use Excel’s NPV function (cell C16). This function calculates the present value

of any series of periodic payments (whether they’re flat payments, as in an annuity, or

non-equal payments).

We devote separate subsections to the PV function and to the NPV function.

The Excel PV function

The PV function calculates the present value of an annuity (a series of equal payments).

It looks a lot like the FV discussed above, and like FV, it also has the peculiarity that positive

payments give negative results (which is why we set Pmt equal to –100). As in the case of the

PFE Chapter 5, Time value of money page 22

FV function, Type denotes whether the payments are made at the beginning or the end of the

year. Because end-year is the default, you can either enter 0 or leave the Type entry blank (if the

payment is at the beginning of the period you have to enter 1 in the Type box):

Dialog box for the PV function

The “Formula result” in the dialogue box shows that the answer is $421.24.

The Excel NPV function

The NPV function computes the present value of a series of payments. The payments

need not be equal, though in the current example they are. The ability of the NPV function to

handle non-equal payments makes it one of the most useful of all Excel’s financial functions.

We will make extensive use of this function throughout this book. In the current example, since

the annual payments are equal, the result is the same ($421.24) whether we use the PV function

or the NPV function.

PFE Chapter 5, Time value of money page 23

 Dialog box for the NPV function

Excel’s NPV function computes the present value of a series of payments. You can

either enter the payments separately (as Value1, Value2, … ), or—as illustrated above—you can

enter a range of payments into the Value1 box.

Important Notation Note

Finance professionals use “NPV” to mean “net present value,” a concept we explain in

the next section. Excel’s NPV function actually calculates the present value of a series of

payments. Almost all finance professionals and textbooks would call the number computed by

the Excel NPV function “PV.” Thus the Excel use of “NPV” differs from the standard usage in

finance which is explained in Section 5.3.

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 Exercises

1. You just put $600 in the bank and you intend to leave it there for 10 years. If the bank pays

you 15% interest per year, how much will you have at the end of 10 years?

2. Your generous grandmother has just announced that she’s opened a savings account for you

with a deposit of $10,000. Moreover, she intends to make 9 more similar gifts, at the end of this

year, next year, etc. If the savings account pays 8% interest, how much will you have

accumulated at the end of 10 years (one year after the last gift)?

Suggestion: Do this problem 2 ways, as shown below: a) take each amount and

calculate its future value in year 10 (as illustrated in cells C7:C16) and then sum them; b) use

Excel’s FV function, noting that here the amounts come at the beginning of the year (you’ll need

to enter “1” in the Type option as described in Section 1).

A B C D
3 Interest rate 8.00%
4
5
Future value
6 Year Gift in year 10
7 0 10,000 21,589.25 <-- =B7*(1+$B$3)^(10-A7)
8 1 10,000
9 2 10,000
10 3 10,000
11 4 10,000
12 5 10,000
13 6 10,000
14 7 10,000
15 8 10,000
16 9 10,000
17
18 Total (summing C7:C16)
19 Using FV function

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3. Your uncle has just announced that he’s going to give you $10,000 per year at the end of each

of the next 4 years (he’s less generous than your grandmother ... ). If the relevant interest rate is

7%, what’s the value today of this promise? (If you’re going to use PV to do this problem note

that the Type option is 0 or omitted.)

4. What is the present value of a series of 4 payments, each $1,000, to be made at the end of

years 1, 2, 3, 4? Assume that the interest rate is 14%.

Suggestion: Do this problem 2 ways, as shown in rows 11 and 12 below.

A B C D E
3 Interest rate 14%
4
5 Year Payment PV
6 1 1,000 877.19 <-- =B6/(1+$B$3)^A6
7 2 1,000
8 3 1,000
9 4 1,000
10
11 Total of C6:C9
12 Using NPV function

5. Screw-‘Em-Good Corp. has just announced a revolutionary security: If you pay SEG $1,000

now, you will get back $150 at the end of each of the next 15 years. What is the IRR of this

investment?

Suggestion: Do this problem two ways—once using Excel’s IRR function and once

using Excel’s RATE function (illustrated below).

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6. Make-‘Em-Happy Corp. (MEH) has a different security for sale: You pay MEH $1,000 today

and the company will give you back $100 at the end of the first year, $200 at the end of year 2, ...

, $1000 at the end of year 10.

a. Calculate the IRR of this investment.

b. Show an amortization table for the investment.

7. You are thinking about buying a $1,000 bond issued by the Appalachian Development

Authority (ADA). The bond will pay $120 interest at the end of each of the next 5 years. At the

end of year 6, the bond will pay $1,120 (this is its face value of $1,000 plus the interest). If the

relevant discount rate is 7%, how much is the present value of the bond’s future payments?

8. Look at the pension problem in Section 5.8, page000. Answer the following questions:

8.a. What if the desired annual pension is $100,000? How much does a 55 year-old have

to save annually? The CD-ROM which accompanies the book contains the following

template:

PFE Chapter 5, Time value of money page 65

10. If you deposit $25,000 today, Union Bank offers to pay you $50,000 at the end of 10 years.

What is the interest rate?

11. Assuming that the interest rate is 5%, which of the following is more valuable?

11.a. $5,000 today

11.b. $10,000 at the end of 5 years

11.c. $9,000 at the end of 4 years

11.d. $300 a year in perpetuity (meaning: forever), with the first payment at the end of

this year

12. You receive a $15,000 signing bonus from your new employer and decide to invest it for

two years. Your banker suggests two alternatives, which both require a commitment for the full

two years. The first alternative will earn 8% per year for both years. The second alternative earns

6% for the first year, and 10% for the second year. Interest compounds annually.

Which should you choose?

13. Your annual salary is $100,000. You are offered two options for a severance package.

Option 1 pays you 6 months salary now. Option 2 pays you and your heirs $6,000 per year

forever (first payment at the end of this year). If your required return is 11%, which option

should you choose?

14. Today is your 40th birthday. You expect to retire at age 65 and actuarial tables suggest that

you will live to be 100. You want to move to Hawaii when you retire. You estimate that it will

PFE Chapter 5, Time value of money page 68

cost you $200,000 to make the move (on your 65th birthday), and that your annual living

expenses will be $25,000 a year after that. You expect to earn an annual return of 7% on your

savings.

14.a. How much will you need to have saved by your retirement date?

14.b. You already have $50,000 in savings. How much would you need to save at the

end of each of the next 25 years to be able to afford this retirement plan?

14.c. If you did not have any current savings and did not expect to be able to start saving

money for the next 5 years (that is, your first savings payment will be made on your 45th

birthday), how much would you have to set aside each year after that to be able to afford

this retirement plan?

15. You have just invested $10,000 in a new fund that pays $1,500 at the end of the next 10

years. What is the compound rate of interest being offered in the fund? (Suggestion: Do this

problem two ways: Using Excel’s IRR function and using Excel’s Rate function.)

16. John is turning 13 today. His birthday resolution is to start saving towards the purchase of a

car that he wants to buy on his 18th birthday. The car costs $15,000 today, and he expects the

price to grow at 2% per year.

John has heard that a local bank offers a savings account which pays an interest rate of

5% per year. He plans to make 6 contributions of $1,000 each to the savings account (the first

contribution to be made today); he will use the funds in the account on his 18th birthday as a

down payment for the car, financing the balance through the car dealer.

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 He expects the dealer to offer the following terms for financing: 7 equal yearly payments

(with the first payment due one year after he takes possession of the car); an annual interest rate

of 7%.

16.a. How much will John need to finance through the dealer?

16.b. What will be the amount of his yearly payment to the dealer?

(Hint: This is like the college savings problem discussed in Section 5.8.)

17. Mary has just completed her undergraduate degree from Northwestern University and is

already planning on entering an MBA program four years from today. The tuition will be

$20,000 per year for two years, paid at the beginning of each year. In addition, Mary would like

to retire 15 years from today and receive a pension of $60,000 every year for 20 years and

receive the first payment 15 years from today. Mary can borrow and lend as much as she likes at

a rate of 7%, compounded annually. In order to fund her expenditures, Mary will save money at

the end of years 1-3 and at the end of years 6-14.

• Calculate the constant annual dollar amount that Mary must save at the end of each of

these years to cover all of her expenditures (tuition and retirement)?

Note: Just to remove all doubts, here are the cash flows:

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