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TABLE OF CONTENTS

INTRODUCTION 1 1 1

TIMEVALUEOFMONEYREVIEW SimplePresent&FutureValue

Present&FutureValuewithNonAnnualCompoundingPeriods 2 EffectiveandNominalRates 2 3 3 4 4 5 6 6 9 11 11

Present&FutureValuewithContinuousCompounding Present&FutureValueofanAnnuity

NPV,IRR&FVSCHEDULE

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INTRODUCTION

We begin with a review of simple Time Value of Money formulas, and then discuss how these formulas may be applied in Microsoft Excel. Please note that this document assumes basic familiarity with Time Value of Money concepts, and with the basics of Excel itself. If you are already familiar with Time Value of Money concepts and simply wish to apply them in Excel, click here. If you need a refresher in Excel basics, click here. The Time Value of Money review below is based on material from Quantitative Methods for Investment Analysis, Second Edition by R.A. DeFusco, D.W. McLeavey, J.E. Pinto, and D.E.Runkle,drawnfromVolumeIoftheCFALevelI2006ProgramCurriculum.

The following time value of money concepts will be reviewed: simple Present & Future Value, Present & Future Value with NonAnnual Compounding Periods, Effective/Nominal rates, Continuous Compounding, Annuity and Perpetuity formulas, Net Present Value (NPV) & Internal Rate of Return calculations, and Compound GrowthRates. Simple Present & Future Value The following formulas are used to determine the simple Present and Future value of aninvestment:

PV = FVN (1 + r )

n

FVN = PV (1 + r )

Inbothofthese formulas,rrepresents the interest rate (or discount rate) to beused and nrepresentsthenumberofperiods. Example 1: You will receive $15,000 in 5 years time. You are able to borrow and lend at a rate of 4% per year. What is the Present Value of the Investment? Answer: PV = $15,000(1.04)-5 = $12,328.91

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Present & Future Value with Non-Annual Compounding Periods In many Time Value of Money applications, the act of compounding occurs more frequently than on an annual basis. The following formulas modify the simple Present &Futurevalueformulastocorrectformorefrequentcompoundingperiods:

PV = FVN 1 + FVN = PV 1 +

rs mn m

rs mn m

where m is equal to the number of compounding periods per year, rs is the stated annual rate, or nominal rate in Excel terminology (as will be discussed in the next section), and n now stands for the number of years. As such, mn represents the total numberofcompoundingperiods. Example 2: You will receive $15,000 in 5 years time. You are able to borrow and lend at an annual rate of 4%, compounded monthly. What is the Present Value of the Investment? Answer: PV = $15,000(1+(0.04/12))-60 = $12,285.05 Note that the simple Present & Future Value formulas in the previous section are a specialcaseoftheseformulaswheremisequalto1. Effective and Nominal Rates As an extension of the previous formula, when a stated or nominal annual rate is quoted with nonannual compounding periods, the following formula can be used to determinetheeffectiveannualrate:

Effective Rate = (1 + rs m ) 1 m

where, again, m is equal to the number of compounding periods per year, and rs is the nominalrate. Example 3: You are charged an annual interest rate of 8.75% on your personal line of credit with your bank, compounded daily. What is the effective annual interest rate? Answer: (1+(0.0875/365))365-1 = 0.0914, or 9.14%.

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Present & Future Value with Continuous Compounding While the above formulas deal with discrete compounding intervals, a number of applications in Finance deal with continuous compounding, when an infinite number ofcompoundingperiodsarepresent.ThisconventionisespeciallyprominentinOption pricingmodels.

PV = FVN ( e rs n )

FVN = PV ( ers n )

where e is a mathematical constant equal to the base of the natural logarithm (2.718281828).Theformulaiscalculatedonayearlybasis. Example 4: You have $12,280.96 in your bank account. You are able to invest the full amount for 5 years, continuously compounded at a rate of 4%. What is the Future Value of the investment? Answer: FV = $12,280.96(e0.2) = $15,000 Present & Future Value of an Annuity Whiletheaboveformulasareusedtocalculatethefairvalueofalumpsuminvestment, separateformulasexisttocalculatethePresent&FutureValueofanequalseriesofcash flows,referredtoasAnnuities.Theseformulasareshownbelow:

1 1 (1+ n r) PV = A r

(1 + r )n 1 FVN = A r where A is the cash flow per period, r is the interest rate per period, and n is the numberofperiods. Example 5: You are offered the option of choosing between an immediate, one-time, lump sum payment of $12,000, and $1,500 per year for 10 years. You are able to borrow and lend at an annual rate of 4%. Which option should you choose?

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Answer: PV = $1,500[(0.3244)/0.04] = $1,500(8.1108) = $12,166.34. Therefore, you should choose the annuity because it is worth about $166 more in todays dollars than the lump sum payment. Keep in mind that these formulas assume the same cash flow per period. If the amount of the cash flow changes over time but is stable within intervals (i.e., $1,500 for years 1 5, $2,000 for years 610, etc.), an annuity calculation can be performed for each interval at the beginning of the interval, and then discounted back to present value. Otherwise, ifthecashflowsvaryfromperiodtoperiod,usingtheNetPresentValue(NPV)method willbenecessary,asdiscussedbelow. An Annuity with Infinite Periods A Perpetuity When the number of periods in the Present Value version of the annuity formula approachesinfinity,theannuityformulareducestoamuchsimplerversion:

PV = A r

In effect, a perpetual stream of cash flows, a perpetuity, can be valued simply by dividing the periodic cash flow by the periodic interest rate. A variant of this formula, the growing perpetuity (the denominator becomes rg, where g is the growth rate), is often an essential element in estimating the terminal value of an investment when conductingDiscountedCashFlowAnalysis. Net Present Value and the Internal Rate of Return Asmentionedabove,theNetPresentValue(NPV)methodisusedtoproperlydiscount aseriesofunequalcashflowsbacktopresentvalue.TheNPVformulaisasfollows:

NPV =

t =0

(1 + r )

CFt

whereCFtequalstherelevantcashflowattimet,andrisequaltothediscountrate.The rate obtained by setting NPV to 0 and solving for r is referred to as the Internal Rate of Return.

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Compound Annual Growth Rate The last formula to be reviewed deals with calculating a compound annual growth rate foraninvestmentoraccountingvalue. RearrangingthesimpleFutureValueformulatosolveforr,weobtainthefollowing:

FV N r = N 1 PV

In many cases, you may see the interest rate above labelled as g (for growth rate) or CAGR (for Compound Annual Growth Rate). This is because the formula is often applied to situations where the variable cannot be correctly viewed as an interest rate. For example, change in accounting values (such as Total Assets, Sales, etc.) are often measuredwiththisformula. Example 6: Company ABC Inc. had $150 and $175 million in Total Assets as at December 31st, 2001 and 2006 respectively. Calculate the Compound Annual Growth Rate in total assets over the 5 year period. Answer: CAGR = (175/150)0.2 -1 = 0.0313 or 3.13%.

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Please note that this section will make references to the solved examples on pages 15 above. PV, FV, RATE, NPER, PMT When calculating Present and Future value using a computing aide (spreadsheet program or a financial calculator), there are always five variables involved in the calculation: the present value, future value, interest rate, number of periods, and the periodicpayment(or annuity).Onecansolveforanyofthesevariablesiftheotherfour are provided, and in Excel, a function exists for calculating each. The five functions are: PV,FV,RATE,NPERandPMT. With the exception of the continuous compounding formula, these functions will work forany of the Presentand Future value formulasthat weve discussed above, including annuities. Asanexample,Figure1illustratesthesyntaxforthePVfunction:

FIGURE 1

Typing in the beginning of the function prompts the entry of the four remaining variables plus the [type] option which can be specified to indicate whether payments aremadeatthebeginning(1)ortheendoftheperiod(0).Ifyouomitavaluefor[type], Excel assumes that payments are made at the end of the period. When calculating simple Present and Future values, no value for payment exists. To indicate this, enter a valueofzeroforPMT. RecallingExample1above,RATE=0.04,NPER=5,PMT=0,andFV=15000.Applying thisexamplewithExcelsPVfunctionisillustratedinFigure2below:

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FIGURE 2

You will notice that the result matches the answer given in Example 1, however, it is displayed as a negative. This is a worth noting when performing Time Value of Money calculationsusingExcel,andisimportanttounderstand. When calculating Present and Future values in Excel (or financial calculators for that matter), investments are treated as negative cash flows, whereas the return of capital (plusanygains)istreatedasapositivecashflow.Inthiscase,sincethe$15,000isagain, it is treated as a positive cash flow, and the present value of that gain is viewed as an investment (negative cash flow). If the $15,000 was owed at the end of 5 years, i.e., a loanat4%interestcompoundedannually,thentheFutureValuewouldbenegativeand thePresentValuewouldbepositive,asshowninFigure3:

FIGURE 3

Nonannual compounding periods are handled in the same fashion, except the RATE and NPER values must be represented on a periodic basis. Figure 4 illustrates the calculationofExample2aboveinExcel:

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FIGURE 4

As you can see, you do not need to actually perform the periodic rate calculation in advance, it can simply be entered into Excel as a mathematical operation, (0.04/12) and (5*12)inthiscase,andtheprogramwillcalculateitforyou. Asforcalculatingannuities,theonlydifferenceinthefunctionsyntaxisthatapayment is present (PMT is the same as A in the annuity formulas discussed in the review). Figure5belowillustratesthecalculationinExcelofExample5above:

FIGURE 5

Using the same example, one could solve for the other variables used when calculating PresentValue,asshownbelow: Inputting: =RATE(10,1500,-12166.34,0) will return 4% =NPER(0.04,1500,-12166.34,0) will return 10 =PMT(0.04,10,-12166.34,0) will return $1,500 =FV(0.04,10,1500,-12166.34) will return 0 Lastly,RATEcanalsobeusedtocalculateaCompoundAnnualGrowthRate.Recalling Example6,NPER=5,PMT=0,PV=150,FV=175.ApplyingthisexamplewithExcels RATEfunctionisillustratedinFigure6below:

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FIGURE 6

EFFECT & NOMINAL Excel functions also exist to calculate the Effective or Nominal rate. In order to use them, you must first make sure that the Excel Analysis ToolPak addin is installed and enabled. To doso,clickon Toolsin the Menu bar and then select AddIns, as shown in Figure7:

FIGURE 7

This will bring up the window displayed in Figure 8. If it isnt already checked, check theboxtotheleftoftheAnalysisToolPakoptionandthenclickonOk.

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FIGURE 8

Once the ToolPak has been enabled, you will be able to use the EFFECT & NOMINAL functionsinExcel.Thesyntaxforbothfunctionsisasfollows: =EFFECT(nominal_rate,npery) =NOMINAL(effect_rate,npery) wherenperyrepresentsthenumberofcompoundingperiodsperyear. Recalling Example 3 above, NOMINAL_RATE = 0.0875 and NPERY = 365. Applying thisexamplewithExcelsEFFECTfunctionisillustratedinFigure9below:

FIGURE 9

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EXP No direct function exists in Excel to calculate continuous compounding. However, the EXPfunctioncanbeusedtogeneratethediscountfactor,asitcalculatesex. RecallingExample4above,PV=$12,281ande0.04(5)=1.2214.Applyingthisexamplewith ExcelsEXPfunctionisillustratedinFigure10below:

FIGURE 10

NPV, IRR & FVSCHEDULE As an example of how to use the NPV, IRR and FVSCHEDULE functions in Excel, assume the following: a project has construction, machinery and maintenance costs of $45,000 in the first year and $2,000 per year afterwards (to year 5). Labour costs are $60,000 per year for all five years, and revenues are $100,000 per year starting in year 2. Alsoassumethatinflationisnotanissue. Figure 11 gives an example of how the cash flows from this project can be structured in Excel:

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FIGURE 11

In Figure 11, rows 2 through 4 represent the cash flows as described above. Notice that costs,orcashoutflows,arelistedasnegative numbers. This is a crucial element of NPV analysis, and is in line with the discussion about the PV function. Row 5 represents the sum of each of the yearly cash flows. In row 7, a series of possible discount rates has been listed, and Net Present Values have been calculated in row 8 for each of these rates.AnexampleofthisisincellB8,wheretheNPViscalculatedbasedonanassumed 6%discountrate.ThesyntaxfortheNPVfunctionisasfollows: =NPV(rate,value1,[value2],) For cell B8, the rate is 6% (cell B7), and the range of cash flows is displayed in cells B5:F5. The same calculation is performed based on the assumption of an 8%, 10%, 12% and14%discountrateincellsC8throughF8,andwecanseethattheNPVispositivein each case. The NPV would continue to be positive up to and including a discount rate of16.63%,aswecanseeusingtheIRRfunction(seeFigure12below).

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FIGURE 12

The IRR syntax is simpler as it only requires the range of cash flows that the NPV calculation is based on. As mentioned previously, the IRR is the discount rate that sets theNPVequaltozero.AscanbeseeninFigures11&12,theNPVvaluesdeclineasthe discount rate increases, and would be equal to zero at the rate calculated by the IRR function. Please note that there are several wellknown problems with using the IRR methodologyasaselectioncriteriaformultipleprojects 1 . AnotherwaytocalculatetheNPVofaseriesofcashflowsistodiscountthemmanually using the FVSCHEDULE function (which, like the EFFECT and NOMINAL functions, requiretheAnalysisToolPaktobeenabled).Whiletherewouldbenoneedtodothisin the case of the above example, this function can prove useful when correcting for reinvestmentrateassumptionsandwhenconductingdiscountedcashflowanalysis. ThesyntaxfortheFVSCHEDULEfunctionisasfollows: =FVSCHEDULE(principal,schedule) Theschedulevariableinthiscasecanbeasingleinterestrate,orcanbeaseriesofrates. If you are entering values into the formula manually, they must be entered in as arrays (with curly brackets). If you use cell references for the schedule, you can do so without anarray.Considerthefollowingexample:

Seehttp://www.investopedia.com/ask/answers/05/irrvsnpvcapitalbudgeting.asp 13of15

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Entering =FVSCHEDULE(5000,{0.05,0.06,0.07}) returns $5,954.55, which is the same as $5,000*(1.05)*(1.06)*(1.07) Now assume that 0.05, 0.06 and 0.07 are entered as values in cells A1, B1 and C1 respectively. Entering =FVSCHEDULE(5000,A1:C1) also returns $5,954.55. In terms of calculating NPV, we will use just one interest rate and employ the FVSCHEDULE function to calculate discount factors. An illustration of this is shown in Figure13below:

FIGURE 13

Here,thefunctionhasbeenusedsimplytocalculatethefirstyeardiscountfactor,based onanassumeddiscountrateof14%.Sinceacellreferenceisusedfortheschedule,curly brackets are not required. Figure 14 shows how this can be extended for the remaining discountfactors:

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FIGURE 14

Note that the principal value for the function as entered in cell C8 is different than that in cell B8. Here, cell B8 is set as the principal, and while the rate is still found in cell B7, it is an absolute reference as opposed to a relative cell reference. As a result, the function in cell C8 can be dragged all the way to cell F8, because the principal value is always taken from the cell to the left of the function. Had we not included the absolute reference for cell B7, the function would have referenced cells C7, D7, etc. for the discountrate. Once the discount factors are calculated, row 9 simply divides the cash flows in row 5 by the relevant discount factor, and cell B10 sums up these discounted cash flows. As wecansee,thevalueisexactlythesameastheNPVcalculatedasshowninFigure11.

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Lastmodified:11May2007

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