A B C D E F

1
2 Chapter 4. The Time Value of Money
3
4
The worksheet shown below performs most of the calculations required for Chapter 4, and it was used to
5 create many of the chapter's tables and figures. We pasted in a few dialog boxes for specific Excel
6 functions and features; they are shown off to the right of where they were used. However, in general we
7 encourage students to become familiar with our Excel Tutorial and to refer to it if they encounter something
8 they don't understand. It is also useful to learn how Excel models can be used to create tables and graphs
9 that can then be copied into Word documents, which is the way we prepared the text manuscript for
10 submission to the publisher. That procedure is used often in business (and in business courses) to prepare
reports.
11
12
13
14 Although answers to the Self-Test questions within the chapter are generally quite easy and can be worked
15 with a calculator, we also solved them with Excel as a check and also to provide some information on the
solutions for students who might have questions. The tabs at the lower part of this screen take you to the
16 solutions for self-tests in the various sections of the chapter. Even students who are not familiar with Excel
17 should still be able to see the solution setup and then work the problem with a calculator.
18
19
20
21 While we did not create the model specifically for use in lectures, we like to use it in our lectures if we are in
a classroom where a projector is attached to a computer. We scroll through the model and lecture on points
22
and questions as they come up. This is most useful if students have some familiarity with Excel, but that is
23 not really necessary because everything the model does can also be done with a financial calculator.
24
25
26 FUTURE VALUES (Section 4.2)
27
28 A dollar in hand today is worth more than a dollar to be received in the future because, if you had it now, you
29 could invest it, earn interest, and end up with more than one dollar in the future. The process of going to
30 future values (FVs) from present values (PVs) is called compounding.
31
32 To illustrate, refer to our 3-year time line and assume that you plan to deposit $100 in a bank that pays a
33 guaranteed 5% interest each year. How much would you have at the end of Year 3?
34
35 See Columns o the right for a picture of the filled in dialog box for the FV function.
36

1 of 63
 A B C D E F
37 Figure 4-1. Alternative Procedures for Calculating Future Values

38 INPUTS:
39 Investment = CF0 = PV = -$100.00
40 Interest rate = I = 5.00%
41 No. of periods = N = 3
42
43 Setup of the problem as a Periods: 0 5% 1 2
44 Time Line | | |
45 Cash Flow: -$100 0 0
46
47 1. Step-by-Step: Multiply$100 by (1 + I) $100 $105.00 $110.25
48
49 2. Formula: FVN = PV(1+I)N FV3 = $100(1.05)3 =
50
51 3 5 -$100.00 $0
52 3. Financial Calculator: N I/YR PV PMT
53
54
55 4. Excel Spreadsheet: FV Function: FVN = =FV(I,N,0,PV)
56 Fixed inputs: FVN = =FV(0.05,3,0,-100) =
57 Cell references: FVN = =FV(C40,C41,0,C39) =

58 In the Excel formula, the terms are entered in this sequence: interest, periods, 0 to indicate no periodic cash flows, and
then the PV. The data can be entered as fixed numbers or, better yet, as cell references.
59

2 of 63
 A B C D E F
60 The Compounding Process: A Graphic View
61 Figure 4-2 (just below) shows how a $1 investment grows over time at different interest rates. The curves
62 were created by solving for FV at different values for N and I. The graph shows, simultaneously, the effects
63 of time and interest rates.
64
65 The data table used to create this figure is shown to the right. For instruction on data tables and graphing,
66 refer to our Excel Tutorial, Tab 4.
67
68
69
FV of $100
70
After N Years
71
72 $600
73
74
75 $500 I = 20%
76
77
78
$400
79
80
81
82 $300 I = -20%
83 I = 10%
84
85
$200
86
I = 5%
87
88
89 $100 I = 0%
90
91
92
$0
93
0 1 2 3 4 5 6 7 8 9 10
94 Years
95
96
97 PRESENT VALUES (Section 4.3)
98
99 Mathematically, the present value is the opposite of the future value. Instead of compounding a present
100 value forward to find the FV, you discount the FV back to find the PV. Thus, if you know the PV, you can
101 compound to find the FV, while if you know the FV, you can discount to find the PV.
102
103 To illustrate, refer to the time line on Row 70 below and assume that $115.76 is due in 3 years. If a bank
104 pays a guaranteed 5% interest rate each year, how much must you deposit now to have $115.76 in 3 years?
105 The amount of the required deposit is the PV of $115.76 due in 3 years when the discount rate is 5%, and it
106 can be found by any one of four methods.
107

3 of 63
 A B C D E F
108 Figure 4-3. Alternative Procedures for Calculating Present Values

109 INPUTS:
110 Future payment = CFN = FV = $115.76
111 Interest rate = I = 5.00%
112 No. of periods = N = 3
113
114 Problem as a Time Line Periods: 0 1 2
115 | | |
116 Cash Flow Time Line: PV = ?
117
118 1. Step-by-Step: $100.00 $105.00 $110.25
119
120 2. Formula: PVN = FV/(1+I)N PV = $115.76/(1.05)3 =
121
122 3 5 $0
123 3. Financial Calculator: N I/YR PV PMT
124 -$100.00
125
126 4. Excel Spreadsheet: PV Function: PV = =PV(I,N,0,FV)
127 Fixed inputs: PV = =PV(0.05,3,0,115.76) =
128 Cell references: PV = =PV(C111,C112,0,C110) =

129 In the Excel formula, the terms are entered in this sequence: interest, periods, 0 to indicate no periodic cash flows, and
then the FV. The data can be entered as fixed numbers or, better yet, as cell references.
130

4 of 63
 A B C D E F
131 The Discounting Process: A Graphic View
132
133 Figure 4-4 shows how the present value of $1 due in the future declines as either the interest rate or the time
134 until receipt increases. The Data Table to the right provides the data used to draw the figure. At 0%, the PV
135 of $1 always remains at $1, but at higher rates the value at the end of N years is lower the higher the rate,
136 and at a given rate, the value declines the larger the value of N.
137
138
139 Present Value
of $1
140
141
142 I = 0%
1.00
143
144
145 0.80
146
147 I = 5%
148 0.60
149
150 I = 10%
151 0.40
152
153 I = 20%
154 0.20
155
156
0.00
157
0 10 20 30 40 50
158
159 Years
160
161
162 FINDING THE INTEREST RATE (Section 4.4)
163
164 Previously, we solved the basic equation to find FV and PV. However, we could just as easily solve for I or
165 N. For example, suppose we know that a given bond has a cost of $100 and that it will return $150 after 10
166 years. Thus, we know PV, FV, and N, and we want to find the rate of return we would earn if we bought the
167 bond.
168
169 INPUTS:
170
171 Present value (PV) -$100.00
172 Future value (FV) $150.00
173 No. of years (N) 10
174
175 OUTPUT:
176
177 Interest rate (I) = RATE(N,0,PV,FV)
178 Interest rate (I) 4.14%
179

5 of 63
 A B C D E F
180
181
182
183
184
185 FINDING THE NUMBER OF YEARS (Section 4.5)
186
187 Sometimes we need to know how long it will take to accumulate a given sum of money, given our beginning
188 funds and the rate we will earn on those funds. For example, suppose we believe that we could retire
189 comfortably if we had $1 million, and we want to find how long it will take us to reach that goal, assuming
190 that we now have $500,000 invested at 4.5%.
191
192 INPUTS:
193
194 Present value (PV) -$500,000
195 Future value (FV) $1,000,000
196 Interest rate (I) 4.50%
197
198 OUTPUT:
199
200 No. of years (N) =NPER(I,0,PV,FV)
201 No. of years (N) 15.7473
202
203
204
205
206
207
208

6 of 63
 A B C D E F
209 FUTURE VALUE OF AN ORDINARY ANNUITY (Section 4.7)
210 An ordinary annuity has regular, periodic payments that occur at the end of each period. Methods for
211 solving the future value of an ordinary annuity are shown below.
212
213 Figure 4-5. Summary: Future Value of an Ordinary Annuity

214
INPUTS:
215 Payment amount = PMT = -$100.00
216 Interest rate = I = 5.00%
217 No. of periods = N = 3
218
219 1. Step-by-Step: 0 1 2 3
220 | | | |
221 -$100 -$100 -$100
222
223 $100.00
224 Multiply each payment by $105.00
225 (1+I)N-t and sum these FVs to $110.25
226 find FVAN: $315.25
227
228 2. Formula:
229  (1  I) N 1 
230 FVAN = PMT     = $315.25
 I I 
231 
232
233 3. Financial Calculator: 3 5 $0 -$100.00
234 N I/YR PV PMT
235
236
237 4. Excel Spreadsheet: FV Function: FVAN = =FV(I,N,PMT,PV)
238 Fixed inputs: FVAN = =FV(0.05,3,-100,0) =
239 Cell references: FVAN = =FV(C216,C217,C215,0) =
240

7 of 63
 A B C D E F
241 FUTURE VALUE OF AN ANNUITY DUE (Section 4.8)
242
243 An annuity due also has regular, periodic payments, but unlike an ordinary annuity, the payments occur at
244 the beginning of each period.
245
246 Summary: Future Value of an Annuity Due (This table is not in text)
247 INPUTS:
248 Payment amount = PMT = -$100.00
249 Interest rate = I = 5.00%
250 Number of periods = N = 3
251
252 Periods: 0 1 2 3
253 | | | |
254 Cash Flow Time Line: -$100 -$100 -$100
255
256 1. Step-By-Step: $105.00
257 Multiply each payment by $110.25
258 (1+I)N-t and sum these FVs to $115.76
259 find FVAN: $331.01
260
261 2. Formula:
262
(1 + I) N 1
263 FVAN(due) = PMT × - (1 + I) = $331.01
264 I I
265
266 BEG MODE 3 5 0 -100
267 3. Financial Calculator: N I PV PMT
268
269
270 4. Excel Spreadsheet: FV Function: FVAN = =FV(I,N,PMT,PV,Type)
271 Fixed inputs: FVAN = =FV(0.05,3,-100,0,1) =
272 Cell references: FVAN = =FV(C249,C250,C248,0,1) =
273
In the Excel formula, the 1 at the end of the formula indicates that cash flows occur at the beginning of each period. A 0
274 or nothing would indicate end-of-period payments.

275
276

8 of 63
 A B C D E F
277 PRESENT VALUE OF AN ORDINARY ANNUITY (Section 4.9)
278
279 The present value of an ordinary annuity is the sum of the PVs of the individual cash flows. Methods for
280 solving the present value of an ordinary annuity are shown below.
281
282 Figure 4-6. Summary: Present Value of an Ordinary Annuity

283 INPUTS:
284 Payment amount = PMT = -$100.00
285 Interest rate = I = 5.00%
286 Number of periods = N = 3
287
288 Periods: 0 1 2 3
289 | | | |
290 Cash Flow Time Line: -$100 -$100 -$100
291
292 1. Step-By-Step: $95.24
293 Divide each payment by $90.70
294 (1+I) and sum these PVs to
t
$86.38
295 find PVAN: $272.32
296
297 2. Formula:
298 1 1 
299 PVAN = PMT   -  = $272.32
N
300
301 I I (1  I) 
302
303 3 5 -100
304 3. Financial Calculator: N I PV PMT
305 272.32
306
307 4. Excel Spreadsheet: PV Function: PVAN = =PV(I,N,PMT,FV)
308 Fixed inputs: PVAN = =PV(0.05,3,-100,0) =
309 Cell references: PVAN = =PV(C285,C286,C284,0) =
310
311 PRESENT VALUE OF AN ANNUITY DUE (this table is not in text)
312
313 The difference between the present value of an ordinary annuity and an annuity due is that payments are
314 received earlier in an annuity due.
315

9 of 63
 A B C D E F
316 Summary: Present Value of an Annuity Due (Not in text)
317
318 Payment amount = PMT = -$100.00
319 Interest rate = I = 5.00%
320 Number of periods = N = 3
321
322 Periods: 0 1 2 3
323 | | | |
324 Cash Flow Time Line: -$100 -$100 -$100
325
326 Step-By-Step Approach. $100.00
327 Divide each payment by $95.24
328 (1+I)t and sum these PVs to $90.70
329 find PVAN: $285.94
330
331 Formula Approach:
332 1 1 
333 PVAN = PMT   -  (1  I) = $285.94
334  I I (1  I) N 
335  
336 BEG MODE 3 5 -100
337 Calculator Approach: N I PV PMT
338 285.94
339
340 Excel Function Approach: PV Function: PVAN = =PV(I,N,PMT,FV,Type)
341 Fixed inputs: PVAN = =PV(0.05,3,-100,0,1) =
342 Cell references: PVAN = =PV(C319,C320,C318,0,1) =
343
344
345 FINDING ANNUITY PAYMENTS, PERIODS, AND INTEREST RATES (Section 4.10)
346 Fundamentally, this section is no different than previous TVM exercises. When solving for PMT, N, or I, you
347 must be given values for the other variables, and then you solve the problem.
348
349 FINDING PMT
350 Suppose we need to accumulate $10,000 and have it available 5 years from now. Suppose further that we
351 can earn a return of 6% on our savings, which are currently zero. How much must we save in each of the 5
352 years, assuming (a) end-of-year payments and (b) beginning-of-year payments?
353
354 No. of years (N) 5
355 Interest rate (I) 6%
356 Present value (PV) $0
357 Future value (FV) $10,000
358
359 a. END MODE b. BEGIN MODE
360 Payment (PMT) -$1,773.96 Payment (PMT) -$1,673.55
361 =PMT(I,N,PV,FV) =PMT(I,N,PV,FV,Type=1)
362

10 of 63
 A B C D E F
363 FINDING N
364 Suppose you decide to make end-of-year deposits, but you can only save $1,200 per year. Again assume
365 that you would earn 6%. How long would it take you to reach your $10,000 goal?
366
367 BEGIN MODE
368 Interest rate (I) 6% 6%
369 Present value (PV) $0 $0
370 Payment (PMT) -$1,200 -$1,200
371 Future value (FV) $10,000 $10,000
372
373 No. of years (N) 6.96 6.63
374 =NPER(I,PMT,PV,FV,0) =NPER(I,PMT,PV,FV,1)
375 FINDING
Now I
suppose you can only save $1,200 annually, but you still want to have the $10,000 in 5 years. What rate
376 of return would enable you to achieve your goal?
377
378 BEGIN MODE
379 No. of years (N) 5 5
380 Present value (PV) $0 $0
381 Payment (PMT) -$1,200 -$1,200
382 Future value (FV) $10,000 $10,000
383
384 Interest rate (I) 25.78% 17.54%
385 =RATE(N,PMT,PV,FV,0) =RATE(N,PMT,PV,FV,1)
386
387 PERPETUITIES (Section 4.11)
388
389
390 Perpetuities are securities that promise to make payments forever. The present value of a perpetuity can be
found with a simple formula: Value = PMT / I . Note that we cannot calculate the future value of a perpetuity
391 because, since payments go on forever, this value would be infinitely large and thus meaningless.
392
393
394 Consider a British consol that pays a $25 annual payment. If interest rates are currently 5.2%, what is the
395 value of the consol?
396
397 Payment (PMT) $25
398 Interest rate (I) 5.2%
399
400 Value (PV): $25 / 0.052 = $480.77
401
402
403 The value of an annuity is the sum of the PVs of each of its payments, PV t = PMTt/(1+I)t. Note that the value of
404 each additional payment (or year) adds less value than the previous payment because it is discounted more
405 heavily. This helps explain why perpetuities' values are finite, even though the number of payments is
infinite. As N and thus t increases without limit, the PV of the distant payments approaches zero. To see
406
this better, consider the figure below (which is not in the text). The data used to construct the graph are
407 shown to the right. We look at 100 payments, showing the PV of each payment and the total value of the
408 annuity at each value of N. The value of the payments as a 100-year annuity is $999.93. The value of a
409 perpetuity would be 100/0.1 = $1,000. Thus, the value of the payments from year 101 to infinity is only $0.07.
410
411

11 of 63
 A B C D E F
412 PV of Additional
Payments in an
413 Annuity
414
$100
415
416 Value of 25-Year Annuity: $907.70
417 Value of 50-Year Annuity: $991.48
418 Value of 100-Year Annuity: $999.93
Value of Perpetuity: $1,000.00
419
Amt. Added: Years 1-25: $907.70
420 26-50: $83.78
421 51-100: $8.45
422 From 101 to infinity: $0.07
423 $50
424
425
426
427
428
429
430
431 $0
432 012345678910
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
6465
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
433 Years (N)
434
435
436 UNEVEN, OR IRREGULAR, CASH FLOWS (Section 4.12)
437
438
First, consider a security that pays $100 for 5 years plus a lump sum of $1,000 at the end of the 5th year. We
439 can find the PV in several ways: (1) With a financial calculator using the step-by-step approach, or by finding
440 the PV of the annuity plus the PV of the final $1,000 and then summing these two values, or by using the
441 calculator's cash flow register, or (2) with Excel, using either the PV or the NPV function. We illustrate the
442 step-by-step and the two Excel approaches below.
443

12 of 63
 A B C D E F
444 PV of an Annuity Plus a Lump Sum (this figure is not in the text)
445 Step-by-step:
446 Interest rate = I = 12%
447
448 Periods: 0 1 2 3 4
449 | | | | |
450 Constant PMTS $0 $100 $100 $100 $100
451 Final CF
452 CF time line: $0 $100 $100 $100 $100
453 PV of CFs
454 $89.29
455 79.72
456 71.18
457 63.55
458 624.17
459 $927.90
Enter N = 5, I/YR == 12,
PV of cash
PMT flow stream
= 100, and FV==value of the
$1,000. assetPV to get the
Press
460 Calculator: answer, $927.90 (with a minus sign). You could also find the PV of the
461 Excel Functions:annuity
You canand
usethe PV of
either the
the PVfinal $1,000
or the NPVand then sum
function them.
applied to the net CFs on Row 452.
462 Using the PV function: Fixed inputs: PV = =PV(0.12,5,-100,-1000)

463 Cell references PV = =PV(C446,G448,-C450,-G451)

464 Using the NPV function: Fixed inputs: NPV = =NPV(0.12,100,100,100,100,1100)

465 Cell references: NPV = =NPV(C446,C452:G452)

466
467 Now consider an irregular cash flow stream, where the CFs can take on any value.
468
469 Figure 4-7. PV of an Irregular Cash Flow Stream
470 Step-by-step:
471
Interest rate = I = 12%
472 Periods: 0 1 2 3 4
473 | | | | |
474 CF Time Line: $0.00 $100.00 $300.00 $300.00 $300.00
475 PVs of the CFs: $89.29 $239.16 $213.53 $190.66
476
477 Σ C475:G475 = $1,016.35 = Sum of the individual PVs = PV of the irregular CF stream.
478
479 Here we put the PVs of each individual CF under the CF itself and then summed them to find the PV of
480 the entire stream, rather than show them all in Column C as was done in Figure 4-6. This setup takes
481 up less space and also makes the calculations quite transparent, which is useful, especially when the
482 table must be explained to people who did not develop it. People appreciate transparency and clarity.
483

You could enter the cash flows into the cash flow register of a financial
484 Calculator:
calculator, enter I/YR, and then press the NPV key to find the answer.

13 of 63
 A B C D E F
485 Excel Function: Fixed inputs: NPV = =NPV(0.12,100,300,300,300,500)
486 Cell references: NPV = =NPV(C471,C474:G474)
487
488
489 Our Excel formula ignores the initial cash flow (in Year 0). When entering a cash flow range, Excel assumes
that the first value occurs at the end of the first year. As we will see later, if there is an initial cash flow, it
490
must be added separately to complete the NPV formula result. Notice too that you can enter cash flows one-
491 by-one, but if the cash flows appear in consecutive cells, you can enter the cell range, as we did here.
492
493
494 FUTURE VALUE OF AN UNEVEN, OR IRREGULAR, CASH FLOW STREAM (Section 4.13)
495
496 We find the future value of uneven cash flow streams by compounding rather than discounting. The step-
497 by-step approach works the same, but unfortunately, Excel does not have a net future value (NFV) function,
498 although financial calculators do have this function. One way around this is to solve for the NPV and then
499 find the FV of this amount at the end of the cash flow stream.
500
501 Figure 4-8. FV of an Irregular Cash Flow Stream
502
503 Step-by-Step
504 Periods: 0 1 2 3 4
505 Interest rate = I = 12%
506 | | | | |
507 CF Time Line: $0 $100 $300 $300 $300
508 FV of each CF: $0.00 $157.35 $421.48 $376.32 $336.00
509 Sum of the Cash Flows' FVs = FV of the stream =
510
You could enter the cash flows into the cash flow register of a financial
511 Calculator:
calculator, enter I/YR, and then press the NFV key to find the answer.
512
513 Excel: Step 1. Find NPV: =NPV(C505,C507:G507)
514 Step 2. Compound NPV to find NFV: =FV(C507,G504,0,-G513)
515
516 SOLVING FOR I WITH UNEVEN CASH FLOWS (Section 4.14)
517
518
Assume that a bond will pay $100 at the end of each of the next 5 years, plus an additional $1,000 at the end
519
of the 5th year. The cost of the bond is $927.90. What rate of return would you earn if you bought the bond?
520
521
522 You could find the rate of return using Excel's IRR (for "internal rate of return") function or its RATE
523 function, as shown below. The RATE function deals with situations where we have an annuity plus a final
524 lump sum. The IRR function deals with any cash flow pattern, and it is easier to use. You could enter a
525 guess as to the IRR, but this is not necessary.
526
527 Finding the Interest Rate, Annuity Plus Lump Sum
528
529 Annuity pmts $100
530 Future lump sum $1,000

14 of 63
 A B C D E F
531
532 Periods: 0 1 2 3 4
533 | | | | |
534 CF Time Line: -$927.90 $100 $100 $100 $100
535
536 Excel Function Approach: Cell references: IRR = =IRR(B534:G534)
537 Excel Function Approach: Cell references: RATE = =RATE(G532,B529,B534,B530)
538
539
The IRR function is used to find the rate of return on capital budgeting projects, where the firm makes a
540 capital expenditure and then expects to receive a series of cash inflows. Figure 4-9 illustrates this
541 calculation. Note that the IRR function can be used even if one of the post-investment cash flows is
542 negative. Change the 4th year CF from $300 to -$100 and see the IRR drop to 2.90%. Then change it back to
543 $300.
544
545 Figure 4-9. IRR of an Uneven Cash Flow Stream
546
547 Periods: 0 1 2 3 4
548 | | | | |
549 CF Time Line: -$1,000 $100 $300 $300 $300
You could enter the cash flows into the cash flow register of a financial
550 Calculator:
calculator and then press the IRR key to find the answer.
551 Excel IRR Function: Cell references: IRR = =IRR(B549:G549)
552
553 SEMIANNUAL AND OTHER COMPOUNDING PERIODS (Section 4.15)
554
555 If $100 is invested in an account at an annual nominal interest rate of 12% for 1 year, what are the effective
556 interest rates and the future values based on annual, semiannual, quarterly, monthly and daily
557 compounding?
558 than with annual compounding, so you will earn more "interest on interest." Therefore, you will end up with
559 more money, and the effective interest rate will be higher, than with annual compounding.
560
561 Nominal annual rate = 12%
562 Amount invested = $100
563 Number of years = 1
564

15 of 63
 A B C D E F
565 Figure 4-10. Effect on $100 of Compounding More Frequently than Once a Year
Number of
566 Frequency of Nominal periods Periodic Effective
Compounding Annual Rate per year (M)a Interest Rate Annual Rateb Future Valuec
567 Annual 12% 1 12.0000% 12.0000% $112.00
568 Semiannual 12% 2 6.0000% 12.3600% $112.36
569 Quarterly 12% 4 3.0000% 12.5509% $112.55
570 Monthly 12% 12 1.0000% 12.6825% $112.68
571 Daily 12% 365 0.0329% 12.7475% $112.75
572
573 a We used 365 days per year in the calculations.
574 bThe EFF% is calculated using text Equation 4-14.
575 cThe Future Value is calculated using text Equation 4-1.
576
577
578 Cost of Credit based on "Add-On" Interest. This table is not in the text, but the
579 procedure is discussed in the "Truth in Lending Box". This procedure is commonly
580 used by retailers, auto dealers, and many other lenders. The calculator solution is
581 explained in the text and also below. The Excel solution is explained just below.
582
583 Amount borrowed = Cost of TV. Disregards the advanced payment, handled separately.
584 Nominal rate
585 Amount of interest = interest rate x Amt borrowed
586 Stated loan size = Amt borrowed + Interest
587 Number of payments
588 Payment/month
589
590 0 1 2 3 4
591 Amt borrowed $3,000.00
592 Monthly Pmts -$270.00 -$270.00 -$270.00 -$270.00 -$270.00
593 CF time line $2,730.00 -$270.00 -$270.00 -$270.00 -$270.00
594
595 IRR = periodic rate: =IRR(B593:M593) = 1.4313%
596 APR rate: =E595*G587 = 17.1758%
597 EFF%: =(1+E595)^G587-1 = 18.5945%
598
599 Before the ruth in Lending Act, auto dealers, TV dealers, and even student loan officers would
600 make add-on loans and just tell customers about the 8% stated rate. After 1968, such lenders were
601 required to also report the much higher APR rate. But lenders are still not required to report the even
602 higher EFF%, which is the "true" rate that borrowers should base decisions on.
603
604 We showed the cash flows above as a"horizontal" time line, but it's easier to fit the analysis on the
605 screen using a vertical time line, as shown below. The calculations are identical, but the vertical setup
606 is better from a presentation standpoint if we have more cash flows than can be shown on the screen.
607

16 of 63
 A B C D E F
608 Periods Borrowed Payments Monthly CFs
609 0 $3,000.00 -$270.00 $2,730.00
610 1 -$270.00 -$270.00
611 2 -$270.00 -$270.00
612 3 -$270.00 -$270.00
613 4 -$270.00 -$270.00
614 5 -$270.00 -$270.00
615 6 -$270.00 -$270.00
616 7 -$270.00 -$270.00
617 8 -$270.00 -$270.00
618 9 -$270.00 -$270.00
619 10 -$270.00 -$270.00
620 11 -$270.00 -$270.00
621 12 $0.00 $0.00
622 IRR = periodic rate: 1.431313%
623 APR rate: 17.175758%
624 EFF%: 18.594507%
625
626 To solve the problem with a calculator, first set the machine to BEGIN mode, then enter N = 12, PV =
627 3000, and PMT = -270. When you press the I/YR key to get the periodic rate, 1.431313, which you can
628 use to find the APR and EFF% as we did above.
629
630 AMORTIZED LOANS (Section 4.17)
631
632 If a loan is to be repaid in equal amounts on a monthly, quarterly, or annual basis it is said to be an
633 amortized loan.
634
635 Figure 4-11 below illustrates the amortization process. A company borrows $100,000, with the loan to be
636 repaid in 5 equal payments at the end of each of the next 5 years. The lender charges 6% on the balance at
637 the beginning of each year.
638
639
With a calculator, we solve for the required payment, then we construct an amortization table as shown in
640
Figure 4-11. It is far easier, and less prone to errors, to make Figure 4-11 with Excel, as we do here.
641
642
643 Figure 4-11. Loan Amortization Schedule, $100,000 at 6% for 5 Years
644 Amount borrowed: $100,000
645 Years: 5
646 Rate: 6%
647 PMT: $23,739.64 =PMT(C646,C645,-C644)
Beginning Repayment of Ending
648 Amount Payment Interesta Principalb Balance
Year (1) (2) (3) (2) - (3) = (4) (1) - (4) = (5)
649 1 $100,000.00 $23,739.64 $6,000.00 $17,739.64 $82,260.36
650 2 $82,260.36 $23,739.64 $4,935.62 $18,804.02 $63,456.34
651 3 $63,456.34 $23,739.64 $3,807.38 $19,932.26 $43,524.08
652 4 $43,524.08 $23,739.64 $2,611.44 $21,128.20 $22,395.89
653 5 $22,395.89 $23,739.64 $1,343.75 $22,395.89 $0.00

17 of 63
 A B C D E F
654
a
Interest in each period is calculated by multiplying the loan balance at the beginning of the
655
year by the interest rate. Therefore, interest in Year 1 is $100,000(0.06) = $6,000; in Year 2 it
656 is $82,260.36(0.06) = $4,935.62; and so on.
657 b
Repayment of principal is the $23,739.64 annual payment minus the interest charge for the
658 year, $17,739.64 for Year 1.
659
660 Growing Annuities (Section 4.18)
661
662
663 Example 1. A 65-year-old retiree expects to live for 20 more years, currently has $1,000,000 of savings,
expects to earn a 6% rate on his or her money, and expects inflation to average 3%. How much can he or
664
she withdraw at the beginning of each year and keep the withdrawals constant in real terms, i.e., growing at
665 the same rate as inflation and thus enabling him or her to maintain a constant standard of living?
666
667
668 Inputs
669 Number of years = 20
670 Nominal interest rate, rNOM = 6%
671 Available to invest = Portfolio = $1,000,000
672 Inflation rate = 3%
673 Initial withdrawal (guess) = $50,000
674 Withdrawal at beginning or end? Beginning
675
676
Step 1: Set up an "Amortization Table" to show exactly what's happening. We begin with $1 million. But we
677
immediately make the first withdrawal, hence have less than $1 million to invest. We don't know how much
678 we can withdraw initially, so we make a "guess" of $50,000. We subtract the $50,000 from the initial portfolio
679 and get $950,000, which is invested at 6% and thus earns $57,000. The earnings are added to the beginning
680 balance, less the withdrawal, to produce the ending balance, which is carried forward to create the next
681 beginning balance. This process is continued for 20 years.
682
683
We want to end up with a $0.00 ending balance. With the $50,000 initial withdrawal, we see that the ending
684 balance is greater than zero. Therefore, we should make a larger initial withdrawal. We could just go
685 through a series of trials and errors until we found an initial withdrawal that produced the zero ending
686 balance. The amount that does the trick is $64,786.87708. Replace the $50,000 with 64786.87708 to prove
687 that this value "works."
688
689 As you might guess, there are two much easier ways to find the initial withdrawal amount: (1) Use Excel's
690 Goal Seek function, or (2) use an equation. We explain those procedures below, and we also graph the
691 results. We see that the withdrawals rise every year with inflation, earnings decline, and the balance
692 declines faster and faster, as the withdrawals increase and the earnings decline.
693
694 Beginning BOY: Amount Investable
Withdrawal Balance Withdrawn Funds Earnings Ending Balance
695 1 $1,000,000.00 $64,786.88 $935,213.12 $56,112.79 $991,325.91
696 2 $991,325.91 $66,730.48 $924,595.43 $55,475.73 $980,071.15
697 3 $980,071.15 $68,732.40 $911,338.75 $54,680.33 $966,019.08
698 4 $966,019.08 $70,794.37 $895,224.71 $53,713.48 $948,938.19
699 5 $948,938.19 $72,918.20 $876,019.99 $52,561.20 $928,581.19

18 of 63
 A B C D E F
700 6 $928,581.19 $75,105.75 $853,475.44 $51,208.53 $904,683.97
701 7 $904,683.97 $77,358.92 $827,325.05 $49,639.50 $876,964.55
702 8 $876,964.55 $79,679.69 $797,284.87 $47,837.09 $845,121.96
703 9 $845,121.96 $82,070.08 $763,051.88 $45,783.11 $808,835.00
704 10 $808,835.00 $84,532.18 $724,302.82 $43,458.17 $767,760.98
705 11 $767,760.98 $87,068.15 $680,692.84 $40,841.57 $721,534.41
706 12 $721,534.41 $89,680.19 $631,854.22 $37,911.25 $669,765.47
707 13 $669,765.47 $92,370.60 $577,394.88 $34,643.69 $612,038.57
708 14 $612,038.57 $95,141.71 $516,896.86 $31,013.81 $547,910.67
709 15 $547,910.67 $97,995.96 $449,914.70 $26,994.88 $476,909.59
710 16 $476,909.59 $100,935.84 $375,973.74 $22,558.42 $398,532.17
711 17 $398,532.17 $103,963.92 $294,568.25 $17,674.09 $312,242.34
712 18 $312,242.34 $107,082.84 $205,159.51 $12,309.57 $217,469.08
713 19 $217,469.08 $110,295.32 $107,173.76 $6,430.43 $113,604.18
714 20 $113,604.18 $113,604.18 $0.00 $0.00 $0.00
715
716 Using Goal Seek: 1. Put the pointer on the cell for the Ending Balance after the 20th withdrawal, F714.
717 2. Click Data, What-If-Analysis, Goal Seek to get a dialog box, which you then fill out as shown to the right.
718 3. You will be at the "Set cell" because you put the pointer there initially.
719 4. Go down to the "To value to" cell. You want to get 0 as the ending balance, so enter 0 here.
720 5. Now move down to the "By changing cell" box, then click on the cell with the Year 1 withdrawal,
721 C695, to select it.
722 6. Now click OK, and the initial withdrawal will change to $64,786.88, and the final balance will go to
723 $0.00. You could increase the decimals shown to see the extra digits Excel calculated.
724
725 Calculator: Step 1: Find the real rate of return, rr.
726 rr = (1+rNOM)/(1 + inflation) - 1
727 = (1.06)/(1.03) - 1 = 0.029126213592
728 rr = 2.9126214%
729
730 Step 2: Use the PMT function in Excel or a calculator to find the initial amount to be withdrawn. Be
731 sure to set the calculator to BEGIN mode, and make a similar adjustment to the Excel function.
732 N= 20
733 I= rr = 2.9126214%
734 PV = -1,000,000
735 PMT = $64,786.88 This is consistent with the value found using Goal Seek.
736
737
738
If the first withdrawal occurs at the end rather than the beginning of the first year, then the amount of investable funds
739 during each year will be somewhat larger, and the initial withdrawal to leave a zero final balance will also be somewhat
740 larger. We can modify the table by making the first withdrawal at the end of the year and then using Goal Seek to find
741 the initial withdrawal, which is slightly higher than the case of the annuity due because the original funds earned interest
742 for a year prior to the first withdrawal.
743
744 Inputs
745 Number of years = 20
746 Nominal interest rate, rNOM = 6%
747 Available to invest = Portfolio = $1,000,000

19 of 63
 A B C D E F
748 Inflation rate = 3%
749 Initial withdrawal (guess) = $50,000
750 Withdrawal at beginning or end? End
751
752 Beginning EOY: Amount Investable
Balance Withdrawn Funds Earnings Ending Balance
753 1 $1,000,000.00 $68,674.09 $1,000,000.00 $60,000.00 $991,325.91
754 2 $991,325.91 $70,734.31 $991,325.91 $59,479.55 $980,071.15
755 3 $980,071.15 $72,856.34 $980,071.15 $58,804.27 $966,019.08
756 4 $966,019.08 $75,042.03 $966,019.08 $57,961.14 $948,938.19
757 5 $948,938.19 $77,293.29 $948,938.19 $56,936.29 $928,581.19
758 6 $928,581.19 $79,612.09 $928,581.19 $55,714.87 $904,683.97
759 7 $904,683.97 $82,000.45 $904,683.97 $54,281.04 $876,964.55
760 8 $876,964.55 $84,460.47 $876,964.55 $52,617.87 $845,121.96
761 9 $845,121.96 $86,994.28 $845,121.96 $50,707.32 $808,835.00
762 10 $808,835.00 $89,604.11 $808,835.00 $48,530.10 $767,760.98
763 11 $767,760.98 $92,292.23 $767,760.98 $46,065.66 $721,534.41
764 12 $721,534.41 $95,061.00 $721,534.41 $43,292.06 $669,765.47
765 13 $669,765.47 $97,912.83 $669,765.47 $40,185.93 $612,038.57
766 14 $612,038.57 $100,850.22 $612,038.57 $36,722.31 $547,910.67
767 15 $547,910.67 $103,875.72 $547,910.67 $32,874.64 $476,909.59
768 16 $476,909.59 $106,991.99 $476,909.59 $28,614.58 $398,532.17
769 17 $398,532.17 $110,201.75 $398,532.17 $23,911.93 $312,242.34
770 18 $312,242.34 $113,507.81 $312,242.34 $18,734.54 $217,469.08
771 19 $217,469.08 $116,913.04 $217,469.08 $13,048.14 $113,604.18
772 20 $113,604.18 $120,420.43 $113,604.18 $6,816.25 $0.00
773
774 A modified version of the formula could also be used to determine the initial withdrawal:
775 rr = (1+rNOM)/(1 + inflation) - 1
776 rr = 2.9126214%
777
778 Now use the PMT function in Excel or a calculator to find the initial amount to be withdrawn,
779 assuming payments at the end of the year.
780 N= 20
781 I= rr = 2.9126214%
782 PV = 1,000,000
783 PMT = $66,673.87
784 Adjusted PMT = $68,674.09 = PMT(1+ Inflation). The adjustment accounts for Year 1 inflation.
785
786
Example 2, Growing Annuities: Initial deposit to accumulate a given sum. You need to accumulate $100,000
787 in 10 years. You plan to make an initial deposit today, then make 9 more deposits at the beginning of the
788 next 9 years, but with the deposits increasing at the inflation rate. You expect to earn 6% on your funds, and
789 you expect a 2% inflation rate. How large must your initial deposit be to enable you to reach your $100,000
790 target?
791
792 We can set up a table with an arbitrary initial deposit that grows at the inflation rate and is then compounded
793 at the nominal rate for (N - t) years. The sum of the compounded amounts should total to $100,000. With an
794 arbitrary initial amount the ending amount is not likely to be $100,000, so we use goal seek as shown in the
completed dialog box to find the correct initial deposit.

20 of 63
 We can set up a table with an arbitrary initial deposit that grows at the inflation rate and is then compounded
at the nominal rate for (N - t) years. The sum of the compounded amounts should total to $100,000. With an
arbitrary
A initial amount B the ending amount C is not likelyDto be $100,000,Eso we use goalFseek as shown in the
795 completed dialog box to find the correct initial deposit.
796
797 Inputs:
798 Years 10
799 Amount Needed (FV) $100,000
800 Nominal rate earned on account 6.00%
801 Inflation 2.00%
802 Beginning or End? Beginning
803
804
805 Use Goal Seek in the following table to determine the initial deposit. Start with any value for BOY payment
806 at time zero, then use Goal Seek to set the final balance to the target by changing the BOY t=0 payment.
807
808 BOY Payment
Compounded
809 Period (t) Initial(1+I)^t
value
810 0 $6,598.87 $11,817.57
811 1 $6,730.85 $11,371.62
812 2 $6,865.46 $10,942.51
813 3 $7,002.77 $10,529.58
814 4 $7,142.83 $10,132.24
815 5 $7,285.68 $9,749.89
816 6 $7,431.40 $9,381.97
817 7 $7,580.03 $9,027.93
818 8 $7,731.63 $8,687.26
819 9 $7,886.26 $8,359.43
820 N= 10 $0.00 $100,000.00
821
822 Calculator approach:
823 Find the real rate: rr = (1+rNOM)/(1 + inflation) - 1 = 3.921569%
824
Find the real required future amount, discounted at the
825 inflation rate. This is our constant dollar future target: Target
real FV = (Nominal FV)/(1 + Inflation)N = $82,034.83
826

Use a calculator or the Excel PMT function to find the initial

827 payment. The PV=0, FV=82034.83, rate=3.921569, and set to
Beginning mode. $6,598.87
828
829 This is consistent with the Goal Seek solution.
830

21 of 63
 G
1 4/11/2010
2
3
4
pter 4, and it was used to
5 Excel
s for specific
However,6in general we
7
f they encounter something
o create tables
8 and graphs
text manuscript
9 for
usiness courses)
10 to prepare
11
12
13
ite easy and14 can be worked
some information
15 on the
his screen take you to the
16
o are not familiar with Excel
alculator. 17
18
19
20
it in our lectures
21 if we are in
model and lecture on points
22
liarity with Excel, but that is
a financial23calculator.
24
25
26
27
28 had it now, you
cause, if you
29 of going to
The process
30
31
32 that pays a
100 in a bank
r 3? 33
34
on. 35
36

22 of 63
 G
37

38
39
40
41
42
43 3
44 |
45 FV = ?
46
47 $115.76
48
49 $115.76
50
51
52 FV
53 $115.76
54
55
56 $115.76
57 $115.76

te no periodic
58 cash flows, and

59

23 of 63
 G
60
61 The curves
nterest rates.
62
simultaneously, the effects
63
64
65 and graphing,
n data tables
66
67
68
69
70
71
72
73
74
I75
= 20%
76
77
78
79
80
81
I=82-20%
I =8310%
84
85
86
I = 5%
87
88
I =890%
90
91
92
93
8 9 10
94
Years
95
96
97
98
compounding99 a present
ou know the100PV, you can
PV. 101
102
103 If a bank
due in 3 years.
104
to have $115.76 in 3 years?
discount105
rate is 5%, and it
106
107

24 of 63
 G
108

109
110
111
112
113
114 3
115 |
116 $115.76
117
118 $115.76
119
120 $100.00
121
122 $115.76
123 FV
124
125
126
127 -$100.00
128 -$100.00

te no periodic
129 cash flows, and

130

25 of 63
 G
131
132
133 rate or the time
r the interest
134 At 0%, the PV
aw the figure.
lower the135
higher the rate,
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
154
155
156
157
50
158
159
Years
160
161
162
163
164 solve for I or
just as easily
165 $150 after 10
t it will return
would earn166 if we bought the
167
168
169
170
171
172
173
174
175
176
177
178
179

26 of 63
 G
180
181
182
183
184
185
186
187 our beginning
money, given
ve that we188
could retire
each that189
goal, assuming
190
191
192
193
194
195
196
197
198
199
200
201
202
203
204
205
206
207
208

27 of 63
 G
209
h period. 210
Methods for
211
212
213

214

215
216
217
218
219
220
221
222
223
224
225
226
227
228
229
230
231
232
233
234 FV
235 $315.25
236
237
238 $315.25
239 $315.25
240

28 of 63
 G
241
242
243
uity, the payments occur at
244
245
246
247
248
249
250
251
252
253
254
255
256
257
258
259
260
261
262
263
264
265
266
267 FV
268 331.01
269
270
271 331.01
272 331.01
273
beginning of each period. A 0
274

275
276

29 of 63
 G
277
278
279Methods for
cash flows.
280
281
282

283
284
285
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303 0
304 FV
305
306
307
308 $272.32
309 $272.32
310
311
312
313
due is that payments are
314
315

30 of 63
 G
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330
331
332
333
334
335
336 0
337 FV
338
339
340
341 285.94
342 285.94
343
344
345
346
solving for PMT, N, or I, you
347
348
349
. Suppose350further that we
351
st we save in each of the 5
352
353
354
355
356
357
358
359
360
361
362

31 of 63
 G
363
0 per year.364
Again assume
? 365
366
367
368
369
370
371
372
373
374
$10,000 in375
5 years. What rate
376
377
378
379
380
381
382
383
384
385
386
387
388
389
value of a perpetuity can be
390
future value of a perpetuity
391
thus meaningless.
392
393
394 what is the
urrently 5.2%,
395
396
397
398
399
400
401
402
Tt/(1+I)t. Note
403 that the value of
cause it is discounted more
404
number of405 payments is
approaches zero. To see
406
construct the graph are
407 value of the
and the total
999.93. The 408value of a
409 is only $0.07.
r 101 to infinity
410
411

32 of 63
 G
412
413
414
415
$907.70 416
$991.48 417
$999.93 418
,000.00
419
$907.70
$83.78 420
$8.45 421
$0.07 422
423
424
425
426
427
428
429
430
431
81
082
8384
85
86
87
88
89
90432
91
92
93
94
95
96
97
98
99
100
433
Years (N)
434
435
436
437
438
t the end of the 5th year. We
439
-step approach, or by finding
o values, 440or by using the
function. 441We illustrate the
442
443

33 of 63
 G
444
445
446
447
448 5
449 |
450 $100
451 $1,000
452 $1,100
453
454
455
456
457
458
459
460 $927.90
et CFs on461
Row 452.
462 $927.90

463 $927.90

464 $927.90

465 $927.90
466
ue. 467
468
469
470
471

472 5
473 |
474 $500.00
475 $283.71
476
477
478
them to find
479 the PV of
4-6. This 480
setup takes
l, especially
481when the
nsparency and clarity.
482
483

484 $1,016.35

34 of 63
 G
485 $1,016.35
486 $1,016.35
487
488
h flow range,
489 Excel assumes
e is an initial cash flow, it
490
ou can enter cash flows one-
range, as 491
we did here.
492
493
TREAM (Section
494 4.13)
495
496
an discounting. The step-
497(NFV) function,
future value
solve for the
498NPV and then
499
500
501
502
503
504 5
505
506 |
507 $500
508 $500.00
509 $1,791.15
510
511 $1,791.15
512
513 $1,016.35
514 $1,791.15
515
516
517
518
additional $1,000 at the end
519
arn if you bought the bond?
520
521
unction or522
its RATE
523 plus a final
ve an annuity
use. You524could enter a
525
526
527
528
529
530

35 of 63
 G
531
532 5
533 |
534 $1,100
535
536 12.00%
537 12.00%
538
539
where the firm makes a
540 this
4-9 illustrates
tment cash 541flows is
90%. Then542 change it back to
543
544
545
546
547 5
548 |
549 $500

550 12.55%

551 12.55%
552
553
554
year, what555
are the effective
nthly and 556
daily
557
558will end up with
erefore, you
pounding.559
560
561
562
563
564

36 of 63
 G
Once a 565
Year

566 Percentage
increase in FV
567
568 0.32%
569 0.17%
570 0.12%
571 0.06%
572
573
574
575
576
577
text, but578
the
ure is commonly
579
lator solution
580 is
ed just below.
581
582
583 $3,000.00
584 8.00%
585 $240.00
586 $3,240.00
587 12
588 -$270.00
589
590 5
591
592 -$270.00
593 -$270.00
594
595
596
597
598
officers would
599
such lenders
600 were
red to report
601 the even
602
603
the analysis
604on the
l, but the 605
vertical setup
shown on 606
the screen.
607

37 of 63
 G
608
609
610
611
612
613
614
615
616
617
618
619
620
621
622
623
624
625
en enter N626
= 12, PV =
1313, which
627you can
628
629
630
631
632
is it is said to be an
633
634
0,000, with 635the loan to be
harges 6%636 on the balance at
637
638
639
tization table as shown in
640
xcel, as we do here.
641
642
643
644
645
646
647

648

649
650
651
652
653

38 of 63
 G
654
655
656
657
658
659
660
661
662
$1,000,000
663of savings,
3%. How much can he or
664
in real terms, i.e., growing at
andard of665
living?
666
667
668
669
670
671
672
673
674
675
676
egin with $1 million. But we
677
. We don't know how much
0,000 from678
the initial portfolio
s are added679to the beginning
680 the next
rward to create
681
682
683
wal, we see that the ending
684 just go
al. We could
duced the685zero ending
686
with 64786.87708 to prove
687
688
al amount: 689
(1) Use Excel's
690 graph the
and we also
691balance
ine, and the
. 692
693
694
695
696
697
698
699

39 of 63
 G
700
701
702
703
704
705
706
707
708
709
710
711
712
713
714
715
716
ou then fill717
out as shown to the right.
718
alance, so 719
enter 0 here.
with the Year
720 1 withdrawal,
721
and the final
722balance will go to
Excel calculated.
723
724
725
726
727
728
729
amount to730be withdrawn. Be
ent to the Excel
731 function.
732
733
734
und using 735
Goal Seek.
736
737
738
he amount of investable funds
739
balance will also be somewhat
d then using740
Goal Seek to find
e original 741
funds earned interest
742
743
744
745
746
747

40 of 63
 G
748
749
750
751
752
753
754
755
756
757
758
759
760
761
762
763
764
765
766
767
768
769
770
771
772
773
774
775
776
777
778
779
780
781
782
783
784
785
786
need to accumulate $100,000
787
ts at the beginning of the
earn 6% 788
on your funds, and
you to reach789your $100,000
790
791
ate and is792
then compounded
ld total to793
$100,000. With an
e goal seek 794as shown in the

41 of 63
 ate and is then compounded
ld total to $100,000. With an
e goal seek as shownGin the
795
796
797
798
799
800
801
802
803
804
any value 805
for BOY payment
g the BOY t=0 payment.
806
807
808
809
810
811
812
813
814
815
816
817
818
819
820
821
822
823
824

825

826

827

828
829
830

42 of 63
SECTION 4.2
SOLUTIONS TO SELF-TEST

What would the future value of $100 be after 5 years at 10% compound interest?

N 5
I 10%
PV $100
PMT $0 FV $161.05

Suppose you currently have $2,000 and plan to purchase a 3-year certificate of deposit
(CD) that pays 4% interest compounded annually. How much will you have when the CD
matures?

N 3
I 4%
PV $2,000
PMT $0 FV $2,249.73

How would your answer change if the interest rate were 5%, or 6%, or 20%?

Interest rate $2,249.73

5% $2,315.25
6% $2,382.03
20% $3,456.00

A company’s sales in 2009 were $100 million. If sales grow at 8%, what will they be 10
years later?

N 10
I 8%
PV ($M) $100
PMT $0 FV ($M) $215.89

What would they be if they decline by 8% per year for 10 years?

N 10
I -8%
PV ($M) $100
PMT $0 FV ($M) $43.44

How much would $1, growing at 5% per year, be worth after 100 years?

N 100
I 5%
PV $1
PMT $0 FV $131.50
What would FV be if the growth rate were 10%?

N 100
I 10%
PV $1
PMT $0 FV $13,780.61
SECTION 4.3
SOLUTIONS TO SELF-TEST

Suppose a risk-free bond promises to pay $2,249.73 in 3 years. If the going risk-free interest rate is
4%, how much is the bond worth today?

N 3
I 4%
PMT $0
FV $2,249.73 PV $2,000.00

How would your answer change if the bond matured in 5 rather than 3 years?

N 5
I 4%
PMT $0
FV $2,249.73 PV $1,849.11

If the risk-free interest rate is 6% rather than 4%, how much is the 5-year bond worth today?

N 5
I 6%
PMT $0
FV $2,249.73 PV $1,681.13

How much would $1,000,000 due in 100 years be worth today if the discount rate were 5%?

N 100
I 5%
PMT $0
FV $1,000,000 PV $7,604.49

What if the discount rate were 20%?

N 100
I 20%
PMT $0
FV $1,000,000 PV $0.0121
SECTION 4.4
SOLUTIONS TO SELF-TEST

Suppose you can buy a U.S. Treasury bond which makes no payments until the bond matures 10
years from now, at which time it will pay you $1,000. What interest rate would you earn if you
bought this bond for $585.43?

N 10
PMT $0
PV $585.43
FV $1,000 I 5.50%

What rate would you earn if you could buy the bond for $550?

N 10
PMT $0
PV $550.00
FV $1,000 I 6.16%

For $600?

N 10
PMT $0
PV $600.00
FV $1,000 I 5.24%

Microsoft earned $0.33 per share in 1997. Ten years later, in 2007, it earned $1.42. What was the
growth rate in Microsoft’s earnings per share (EPS) over the 10-year period?

N 10
PMT $0
PV $0.33
FV $1.42 I 15.71%

If EPS in 2007 had been $1.00 rather than $1.42, what would the growth rate have been?

N 10
PMT $0
PV $0.33
FV $1.00 I 11.72%
SECTION 4.5
SOLUTIONS TO SELF-TEST

How long would it take $1,000 to double if it were invested in a bank that pays 6% per year?

I 6%
PMT $0
PV $1,000
FV $2,000 N 11.90

How long would it take if the rate were 10%?

I 10%
PMT $0
PV $1,000
FV $2,000 N 7.27

Microsoft’s 2007 earnings per share were $1.42, and its growth rate during the prior 10 years was
15.71% per year. If that growth rate were maintained, how long would it take for Microsoft’s EPS to
double?

I 15.71%
PMT $0
PV $1.42
FV $2.84 N 4.75
SECTION 4.7
SOLUTIONS TO SELF-TEST

For an ordinary annuity with 5 annual payments of $100 and a 10% interest rate, for how many years
will the 1st payment earn interest, and what is the compounded value of this payment at the end?
1st
Annuity Payment
Data Data
N 5 4
I 10% 10% Years of int 4
PMT -$100 $0
PV $0 -$100 Payment FV $146.41

Answer this same question for the 5th payment.

5th
Annuity Payment
Data Data
N 5 0
I 10% 10% Years of int 0
PMT -$100 0
PV $0 -$100 Payment FV $100.00

Assume that you plan to buy a condo 5 years from now, and you estimate that you can save $2,500 per
year to get a down payment. You plan to deposit the money in a bank that pays 4% interest, and you
will make the first deposit at the end of this year. How much will you have after 5 years?

N 5
I 4%
PMT -$2,500
PV $0 FV $13,540.81

How would your answer change if the bank's interest rate were increased to 6%, or decreased to 3%?

N 5
I 6%
PMT -$2,500
PV $0 FV $14,092.73

N 5
I 3%
PMT -$2,500
PV $0 FV $13,272.84
SECTION 4.8
SOLUTIONS TO SELF-TEST

Assume that you plan to buy a condo 5 years from now, and you need to save for a down
payment. You plan to save $2,500 per year, with the first payment being made immediately
and deposited in a bank that pays 4%. How much will you have after 5 years?
BEGIN MODE
N 5
I 4%
PV $0
PMT -$2,500 FV $14,082.44

How much would you have if you made the deposits at the end of each year?

N 5
I 4%
PV $0
PMT -$2,500 FV $13,540.81
SECTION 4.9
SOLUTIONS TO SELF-TEST

What is the PVA of an ordinary annuity with 10 payments of $100 if the appropriate interest rate is
10%?

N 10
I 10%
PMT -$100
FV $0 PV $614.46

What would the PVA be if the interest rate were 4%?

N 10
I 4%
PMT -$100
FV $0 PV $811.09

What if the interest rate were 0%?

N 10
I 0%
PMT -$100
FV $0 PV $1,000.00

What would the PVAs be if we were dealing with annuities due?

Part a Part b Part c

BEGIN MODE BEGIN MODE BEGIN MODE
N 10 N 10 N 10
I 10% I 4% I 0%
PMT -$100 PMT -$100 PMT -$100
FV $0 FV $0 FV $0
PV $675.90 PV $843.53 PV $1,000.00

Assume that you are offered an annuity that pays $100 at the end of each year for 10 years. You
could earn 8% on your money in other equally risky investments. What is the most you should pay
for the annuity?

N 10
I 8%
PMT -$100
FV $0 PV $671.01

If the payments began immediately, then how much would the annuity be worth?
BEGIN MODE
N 10
I 8%
PMT -$100
FV $0 PV $724.69
SECTION 4.10
SOLUTIONS TO SELF-TEST

Suppose you inherited $100,000 and invested it at 7% per year. How large of a withdrawal could
you make at the end of each of the next 10 years and end up with zero?

N 10
I 7%
PV $100,000
FV $0 PMT -$14,237.75

How would your answer change if you made withdrawals at the beginning of each year?
BEGIN MODE
N 10
I 7%
PV $100,000
FV $0 PMT -$13,306.31

If you had $100,000 that was invested at 7% and you wanted to withdraw $10,000 at the end of each
year, how long would your funds last?

I 7.0%
PV $100,000
PMT -$10,000
FV $0 N 17.8

How long would they last if you earned 0%?

I 0.0%
PV $100,000
PMT -$10,000
FV $0 N 10.0

How long would they last if you earned the 7% but limited your withdrawals to $7,000 per year?

I 7.0%
PV $100,000 * This result means that with $7,000
PMT -$7,000 withdrawals, you would never
FV $0 N #NUM! exhaust the funds.

Your rich uncle named you as the beneficiary of his life insurance policy. The insurance company
gives you a choice of $100,000 today or a 12-year annuity of $12,000 at the end of each year. What
rate of return is the insurance company offering?

N 12
PMT -$12,000
PV $100,000
 FV $0 I 6.11%

Assume that you just inherited an annuity that will pay you $10,000 per year for 10 years, with the
first payment being made today. A friend of your mother offers to give you $60,000 for the annuity.
If you sell it to him, what rate of return will your mother’s friend earn on the investment?
BEGIN MODE
N 10
PMT -$10,000
PV $60,000
FV $0 I 13.70%

If you think a “fair” rate of return would be 6%, how much should you ask for the annuity?
BEGIN MODE
N 10
I 6%
PMT -$10,000
FV $0 PV $78,016.92
SECTION 4.11
SOLUTIONS TO SELF-TEST

What is the present value of a perpetuity that pays $1,000 per year, beginning one year from now, if
the appropriate interest rate is 5%?

PMT $1,000
I 5% PV $20,000

What would the value be if the annuity began its payments immediately?

PMT $1,000
**The perpetuity formula values
I 5% PV $21,000 payments 1 through infinity. If a
payment is to be received
immediately, it must be added to the
formula result.
SECTION 4.12
SOLUTIONS TO SELF-TEST

What is the present value of a 5-year ordinary annuity of $100 plus an additional $500 at the end of
Year 5 if the interest rate is 6%?

Interest rate 6%

Year 0 1 2 3 4 5
Ann Pmt $0 $100 $100 $100 $100 $100
Lump Sum $500
Total CFs $0 $100 $100 $100 $100 $600

NPV $794.87

How would the PV change if the $100 payments occurred in Years 1 through 10 and the $500 came
at the end of Year 10?

Interest rate 6%

Year 0 1 2 3 4 5 6 7 8 9 10
Ann Pmt $0 $100 $100 $100 $100 $100 $100 $100 $100 $100 $100
Lump Sum $500
Total CFs $0 $100 $100 $100 $100 $100 $100 $100 $100 $100 $600

NPV $1,015.21

What is the present value of the following uneven cash flow stream: $0 at Time 0, $100 at the end of
Year 1 (or at Time 1), $200 at the end of Year 2, $0 at the end of Year 3, and $400 at the end of Year
4, assuming the interest rate is 8%?

Interest rate 8%
Year 0 1 2 3 4
CFs $0 $100 $200 $0 $400
NPV $558.07
SECTION 4.13
SOLUTIONS TO SELF-TEST

What is the future value of this cash flow stream: $100 at the end of 1 year, $150 after 2 years, and
$300 after 3 years, assuming the appropriate interest rate is 15%?

Interest rate 15%

Year 0 1 2 3
CFs $0 $100 $150 $300

FV of CFs $0.00 $132.25 $172.50 $300.00

NFV $604.75
SECTION 4.14
SOLUTIONS TO SELF-TEST

An investment costs $465 now and is expected to produce cash flows of $100 at the end of each of
the next 4 years, plus an extra lump sum payment of $200 at the end of the 4th year. What is the
expected rate of return on this investment?

Year 0 1 2 3 4
Ann Pmt -$465 $100 $100 $100 $100
Lump Sum $200
Total CFs -$465 $100 $100 $100 $300

IRR 9.05%

An investment costs $465 and is expected to produce cash flows of $100 at the end Year 1, $200 at
the end of Year 2, and $300 at the end of Year 3. What is the expected rate of return on this
investment?

Year 0 1 2 3
CFs -$465 $100 $200 $300

IRR 11.71%
SECTION 4.15
SOLUTIONS TO SELF-TEST

What is the future value of $100 after 3 years if the appropriate interest rate is 8%,
compounded annually?

N 3
I 8%
PV -$100
PMT $0 FV $125.97

Compounded monthly?

N 36
I 0.67%
PV -$100
PMT $0 FV $127.02

What is the present value of $100 due in 3 years if the appropriate interest rate is 8%,
compounded annually?

N 3
I 8%
PMT $0
FV $100 PV $79.38

Compounded monthly?

N 36
I 0.67%
PMT $0
FV $100 PV $78.73

Credit card issuers must by law print their annual percentage rate (APR) on their
monthly statements. A common APR is 18%, with interest paid monthly. What is the
EFF% on such a loan?

Nominal rate 18%

Comp/year 12

Effective rate 19.56% =(1+B35/B36)^B36-1

19.56% =EFFECT(B35,B36)
SECTION 4.16
SOLUTIONS TO SELF-TEST

Suppose a company borrowed $1 million at a rate of 9%, simple interest, with interest paid at the end
of each month. The bank uses a 360-day year. How much interest would the firm have to pay in a 30-
day month?

Loan $1,000,000
Interest rate 9%
Days/year 360
Interest pd (days) 30

Interest paid $7,500

What would the interest be if the bank used a 365-day year?

Loan $1,000,000
Interest rate 9%
Days/year 365
Interest pd (days) 30

Interest paid $7,397.26

Suppose you deposited $1,000 in a credit union that pays 7% with daily compounding and a 365-day
year. What is the EFF%, and how much could you withdraw after 7/12 of a year?

Loan $1,000
Interest rate 7%
Comp/year 365 Time period (months) 7

Effective rate 7.250098% Account value $1,041.67

SECTION 4.17
SOLUTIONS TO SELF-TEST

Consider again the example in Figure 4-11. If the loan were amortized over 5 years with 60
monthly payments, how much would each payment be, and how would the first payment be
divided between interest and principal?

Years 5
Months = N 60
Nom. I 6%
Periodic I 0.5000%
PV $100,000
FV $0
PMT $1,933.28

First payment interest: $500.00 =B10*B11

First payment principal: $1,433.28 =B13-C15

Suppose you borrowed $30,000 on a student loan at a rate of 8% and now must repay it in 3
equal installments at the end of each of the next 3 years. How large would your payments be,
how much of the first payment would represent interest and how much would be principal,
and what would your ending balance be after the first year?

N 3
I 8%
PV $30,000
FV $0

PMT -$11,641.01

Loan Amortization Schedule, $30,000 at 8% for 3 Years

Amount borrowed: $30,000
Years: 3
Rate: 8%
PMT: -$11,641.01

Beginning Payment Repayment of Ending

Year Amount (1) (2) Interest (3) Principal (4) Balance (5)
1 $30,000.00 $11,641.01 $2,400.00 $9,241.01 $20,758.99
2 $20,758.99 $11,641.01 $1,660.72 $9,980.29 $10,778.71
3 $10,778.71 $11,641.01 $862.30 $10,778.71 $0.00

Rather than focus on Year 1 data, we just constructed the full amortization schedule.
SECTION 4.18
SOLUTIONS TO SELF-TEST

If the nominal interest rate is 10% and the expected inflation rate is 5%, what is the expected real rate of
return?

rNOM 10%
Inflation 5%

rr =((1+B6)/(1+B7))-1 = 4.7619%
pected real rate of