1 Basic Financial Calculations

1.1 Overview

This chapter aims to give you some finance basics and their Excel implementa-
tion. If you have had a good introductory course in finance, this chapter is
likely to be at best a refresher.1
This chapter covers:

• Net present value (NPV)

• Internal rate of return (IRR)
• Payment schedules and loan tables
• Future value
• Pension and accumulation problems
• Continuously compounded interest
• Time-dated cash flows (Excel functions XNPV and XIRR)

Almost all financial problems are centered on finding the value today of a
series of cash receipts over time. The cash receipts (or cash flows, as we will
call them) may be certain or uncertain. The present value of a cash flow CFt
CFt
anticipated to be received at time t is . The numerator of this
(1 + r )t
expression is usually understood to be the expected time t cash flow, and the
discount rate r in the denominator is adjusted for the riskiness of this expected
cash flow—the higher the risk, the higher the discount rate.
The basic concept in present value calculations is the concept of opportunity
cost. Opportunity cost is the return which would be required of an investment
to make it a viable alternative to other, similar investments. In the financial
literature there are many synonyms for opportunity cost, among them: discount
rate, cost of capital, and interest rate. When applied to risky cash flows, we
will sometimes call the opportunity cost the risk-adjusted discount rate (RADR)
or the weighted average cost of capital (WACC). It goes without saying that
this discount rate should be risk-adjusted, and much of the standard finance
literature discusses how to do this. As illustrated below, when we calculate the
net present value, we use the investment’s opportunity cost as a discount rate.
When we calculate the internal rate of return, we compare the calculated return
to the investment’s opportunity cost to judge its value.

1. In my book Principles of Finance with Excel (Oxford University Press, 2nd edition, 2008) I
have discussed many basic Excel/finance topics at greater length.
14 Chapter 1

1.2 Present Value and Net Present Value

Both of these concepts are related to the value today of a set of future antici-
pated cash flows. As an example, suppose we are valuing an investment which
promises $100 per year at the end of this and the next 4 years. We suppose
that these cash flows are risk free: There is no doubt that this series of 5 pay-
ments of $100 each will actually be paid. If a bank pays an annual interest
rate of 10% on a 5-year deposit, then this 10% is the investment’s opportunity
cost, the alternative benchmark return to which we want to compare the invest-
ment. We can calculate the value of the investment by discounting its cash
flows using this opportunity cost as a discount rate:

A B C D
1 COMPUTING THE PRESENT VALUE
2 Discount rate 10%
3
Present
4 Year Cash flow value
5 1 100 90.9091 <-- =B5/(1+$B$2)^A5
6 2 100 82.6446 <-- =B6/(1+$B$2)^A6
7 3 100 75.1315 <-- =B7/(1+$B$2)^A7
8 4 100 68.3013 <-- =B8/(1+$B$2)^A8
9 5 100 62.0921 <-- =B9/(1+$B$2)^A9
10
11 Net present value
12 Summing cells C5:C9 379.08 <-- =SUM(C5:C9)
13 Using Excel's NPV function 379.08 <-- =NPV(B2,B5:B9)
14 Using Excel's PV function 379.08 <-- =PV(B2,5,-100)

The present value, 379.08, is the value today of the investment. In a competi-
tive market, the present value should correspond to the market price of the
cash flows. The spreadsheet illustrates three ways of obtaining this value:

• Summing the individual present values in cells C5:C9. To simplify the

copying, note the use of “∧” to represent the power and the use of both the
relative and absolute references; for example: =B5/(1+$B$2)∧A5 in cell C5.
• Using the Excel NPV function. As we show on the next page, Excel’s NPV
function is unfortunately misnamed—it actually computes the present value
and not the net present value.
15 Basic Financial Calculations

• Using the Excel PV function. This function computes the present value of
a series of constant payments. PV(B2,5,-100) is the present value of 5 pay-
ments of 100 each at the discount rate in cell B2. The PV function returns a
negative value for positive cash flows; to prevent this unfortunate occurrence,
we have made the cash flows negative.2

The Difference Between Excel’s PV and NPV Functions

The above spreadsheet may leave the misimpression that PV and NPV perform
exactly the same computation. But this is not true—whereas NPV can handle
any series of cash flows, PV can handle only constant cash flows:

A B C D
COMPUTING THE PRESENT VALUE
In this example the cash flows are not equal
Either discount each cash flow separately or use Excel's NPV
function
1 Excel's PV doesn't work for this case
2 Discount rate 10%
3
Cash Present Present value
4 Year flow value of each cash flow
5 1 100 90.9091 <-- =B5/(1+$B$2)^A5
6 2 200 165.2893 <-- =B6/(1+$B$2)^A6
7 3 300 225.3944 <-- =B7/(1+$B$2)^A7
8 4 400 273.2054 <-- =B8/(1+$B$2)^A8
9 5 500 310.4607 <-- =B9/(1+$B$2)^A9
10
11 Net present value
12 Summing cells C5:C9 1065.26 <-- =SUM(C5:C9)
13 Using Excel's NPV function 1065.26 <-- =NPV(B2,B5:B9)

Excel’s NPV Function Is Misnamed!

In standard finance terminology, the present value of a series of cash flows is

the value today of the future cash flows:
N
CFt
Present value = ∑
t = 1 (1 + r )
t

2. This strange property—returning negative values for positive cash flows—is shared by a
number of otherwise impeccable Excel functions such as PMT and PV. The somewhat convoluted
logic which led Microsoft to write these functions this way is not worth explaining.
16 Chapter 1

The net present value is the present value minus the cost of acquiring the asset
(the cash flow at time zero):
N N
CFt CFt
Net present value = ∑ = CF
0 + ∑ (1 + r )
t = 0 (1 + r )
t t
t =1
↑
In many cases
 
CF0 < 0 , meaning ↑
that it represents the This is the present
price paid for the asset. value , given by Excel ′s
NPV function.

Excel’s language about discounted cash flows differs somewhat from the
standard finance nomenclature. To calculate the finance net present value of a
series of cash flows using Excel, we have to calculate the present value of the
future cash flows (using the Excel NPV function), taking into account the
time-zero cash flow (this is often the cost of the asset in question).

The Net Present Value, NPV

Suppose that the above investment is sold for $400. Clearly it would not be
worth its purchase price, since—given the alternative return (discount rate) of
10%—the investment is worth only $379.08. The net present value (NPV) is
the applicable concept here. Denoting by r the discount rate applicable to the
investment, the NPV is calculated as follows:
N
CFt
NPV = CF0 + ∑
t = 1 (1 + r )
t

where CFt is the investment’s cash flow at time t and CF0 is today’s cash flow.
Suppose, for example, that the series of 5 cash flows of $100 is sold for
$250. Then, as shown below, the NPV = 129.08.

A B C D
1 COMPUTING THE NET PRESENT VALUE
2 Discount rate 10%
3
Present
4 Year Cash flow value
5 0 -250 -250.00 <-- =B5/(1+$B$2)^A5
6 1 100 90.91 <-- =B6/(1+$B$2)^A6
7 2 100 82.64 <-- =B7/(1+$B$2)^A7
8 3 100 75.13 <-- =B8/(1+$B$2)^A8
9 4 100 68.30 <-- =B9/(1+$B$2)^A9
10 5 100 62.09 <-- =B10/(1+$B$2)^A10
11
12 Net present value
13 Summing cells C5:C10 129.08 <-- =SUM(C5:C10)
14 Using Excel's NPV function 129.08 <-- =B5+NPV(B2,B6:B10)
17 Basic Financial Calculations

The NPV represents the wealth increment of the purchaser of the cash flows.
If you buy the series of 5 cash flows of 100 for 250, then you have gained
129.08 in wealth today. In a competitive market the NPV of a series of cash
flows ought to be zero: Since the present value should correspond to the market
price of the cash flows, the NPV should be zero. In other words, the market
price of our 5 cash flows of 100 ought—in a competitive market, assuming
that 10% is the correct risk-adjusted discount rate—be 379.08.

The Present Value of an Annuity—Some Useful Formulas3

An annuity is a security which pays a constant sum in each period in the future.
Annuities may have a finite or infinite series of payments. If the annuity is
finite, and the appropriate discount rate is r, then the value today of the annuity
is its present value:

C C C
PV of finite annuity = + +…+
1 + r (1 + r ) 2
(1 + r ) n
⎛ 1− 1 ⎞
⎜ (1 + r ) n ⎟
=C⎜ ⎟
⎜ r ⎟
⎝ ⎠

If the annuity promises an infinite series of constant future payments, then

this formula reduces to:
C C C
PV of infinite annuity = + +…=
1 + r (1 + r ) 2 r

Both of these formulas can be computed with Excel. Below we compute

the value of a finite annuity in three ways: using the formula (cell B6), using
Excel’s PV function (cell B7), and using Excel’s NPV function:

3. All the formulas in this subsection depend on some well-known but oft-forgotten high school
algebra.
18 Chapter 1

A B C
1 COMPUTING THE VALUE OF A FINITE ANNUITY
2 Periodic payment, C 1,000
3 Number of future periods paid, n 5
4 Discount rate, r 12%
5 Present value of annuity
6 Using formula 3,604.78 <-- =B2*(1-1/(1+B4)^B3)/B4
7 Using Excel's PV function 3,604.78 <-- =PV(B4,B3,-B2)
8
Annuity
9 Period payment
10 1 1,000.00 <-- =B2
11 2 1,000.00
12 3 1,000.00
13 4 1,000.00
14 5 1,000.00
15
16 Present value using Excel's NPV function 3,604.78 <-- =NPV(B4,B10:B14)

Computing the value of an infinite annuity is even simpler:

A B C
1 COMPUTING THE VALUE OF AN INFINITE ANNUITY
2 Periodic payment, C 1,000
3 Discount rate, r 12%
4 Present value of annuity 8,333.33 <-- =B2/B3

The Value of a Growing Annuity

A growing annuity pays out a sum C , which grows at a periodic growth rate
g. If the annuity is finite, its value today is given by:

C (1 + g ) C (1 + g )
2
C
PV of finite growing annuity = + +
1 + r (1 + r ) 2 ( 1 + r )3
C (1 + g )
n−1
+…+
(1 + r )n
⎛ 1+ g⎞ ⎞
n
C ⎜1− ⎛
⎝ ⎝ 1 + r ⎠ ⎟⎠
=
r−g
19 Basic Financial Calculations

Taking this formula and letting n → ∞, we can compute the value of infinite
growing annuity:

C (1 + g ) C (1 + g )
2
C
PV of infinite growing annuity = + + +…
1 + r (1 + r )2 (1 + r ) 3
C 1+ g
= , provided <1
r−g 1+ r

These formulas can easily be implemented in Excel. Below we compute the

value of a finite growing annuity using the formula above and using Excel’s
NPV function:

A B C
1 COMPUTING THE VALUE OF A FINITE GROWING ANNUITY
2 First payment, C 1,000
3 Growth rate of payments, g 6%
4 Number of future periods paid, n 5
5 Discount rate, r 12%
6 Present value of annuity
7 Using formula 4,010.91 <-- =B2*(1-((1+B3)/(1+B5))^B4)/(B5-B3)
8
Annuity
9 Period payment
10 1 1,000.00 <-- =B2
11 2 1,060.00 <-- =$B$2*(1+$B$3)^(A11-1)
12 3 1,123.60 <-- =$B$2*(1+$B$3)^(A12-1)
13 4 1,191.02 <-- =$B$2*(1+$B$3)^(A13-1)
14 5 1,262.48 <-- =$B$2*(1+$B$3)^(A14-1)
15
16 Present value using Excel's NPV function 4,010.91 <-- =NPV(B5,B10:B14)

When the growing annuity has an infinite life:

A B C
1 COMPUTING THE VALUE OF AN INFINITE GROWING ANNUITY
2 Periodic payment, C 1,000 <-- Starting at date 1
3 Growth rate of payments, g 6%
4 Discount rate, r 12%
5 Present value of annuity 16,666.67 <-- =B2/(B4-B3)
20 Chapter 1

The Gordon Formula

The Gordon formula values a stock by discounting its future anticipated

dividends at the cost of equity rE. Letting P0 be the current stock
price, Div0 the current dividend, and g the growth rate of future dividends,
then
∞
Div0 (1 + g ) Div0 (1 + g )
t
P0 = ∑ =
t =1 (1 + rE )t rE − g

Using the formula for an infinite growing annuity, we can write this as

Div0 (1 + g )
P0 = provided g < rE
rE − g

Inverting this formula shows that

Div0 (1 + g )
rE = +g
P0

The Gordon formula is used in Financial Modeling’s Chapters 2, 4, 5, and

6 to model the firm’s terminal value and in Chapter 3 to model the firm’s cost
of equity rE .

1.3 The Internal Rate of Return (IRR) and Loan Tables

The internal rate of return (IRR) is defined as the compound rate of return r
which makes the NPV equal to zero:
N
CFt
CF0 + ∑ =0
t = 1 (1 + r )
t

To illustrate, consider the example given in rows 2–10 below: A project

costing 800 in year zero returns a variable series of cash flows at the end of
years 1–5. The IRR of the project (cell B10) is 22.16%:
21 Basic Financial Calculations

A B C
1 INTERNAL RATE OF RETURN
Cash
2 Year flow
3 0 -800
4 1 200
5 2 250
6 3 300
7 4 350
8 5 400
9
10 Internal rate of return 22.16% <-- =IRR(B3:B8)

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

Determining the IRR by Trial and Error

There is no simple formula to compute the IRR. Excel’s IRR function uses
trial and error, which can be simulated by using trial and error in a spreadsheet
as illustrated below:

A B C
1 INTERNAL RATE OF RETURN
2 Discount rate 12%
3
4 Year Cash flow
5 0 -800
6 1 200
7 2 250
8 3 300
9 4 350
10 5 400
11
12 Net present value (NPV) 240.81 <-- =B5+NPV(B2,B6:B10)

By playing with the discount rate or by using Excel’s Goal Seek (found under
Data|What-if analysis, see Chapter 31), we can determine that at 22.16% the
NPV in cell B12 is zero:
22 Chapter 1

A B C
1 INTERNAL RATE OF RETURN
2 Discount rate 22.16%
3
4 Year Cash flow
5 0 -800
6 1 200
7 2 250
8 3 300
9 4 350
10 5 400
11
12 Net present value (NPV) 0.00 <-- =B5+NPV(B2,B6:B10)

Here’s the way the Goal Seek screen looked before we got the correct
answer:
23 Basic Financial Calculations

Loan Tables and the Internal Rate of Return

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

A B C D E F
1 INTERNAL RATE OF RETURN
2 Year Cash flow
3 0 -800
4 1 200
5 2 250
6 3 300
7 4 350
8 5 400
9
10 Internal rate of return 22.16% <-- =IRR(B3:B8)
11
12 USING THE IRR IN A LOAN TABLE
Division of cash flow
between investment
income and return of
=-B3 =$B$10*B15
principal
13
Investment at
beginning of Cash flow Return of
14 Year year at end of year Income principal
15 1 800.00 200.00 177.28 22.72 <-- =C15-D15
16 2 777.28 250.00 172.25 77.75
17 3 699.53 300.00 155.02 144.98
18 4 554.55 350.00 122.89 227.11
19 5 327.44 400.00 72.56 327.44
20 6 0.00
21 =B15-E15
22 The remaining investment principal
23 in the year after the last cash flow is
24 zero, indicating that all the principal
25 has been repaid.
26
24 Chapter 1

The loan table divides each of the cash flows of the asset into an income
component and a return-of-principal component. The income component at
the end of each year is IRR times the principal balance at the beginning of
that year. Notice that the principal at the beginning of the last year (327.44 in
the example) exactly equals the return of principal at the end of that year.
We can use the loan table to find the internal rate of return. Consider an
investment costing 1,000 today that pays off the cash flows indicated below
at the end of years 1, 2, … 5. At a rate of 15% (cell B2), the principal at the
beginning of year 6 is negative, indicating that too little has been paid out in
income. Thus the IRR must be larger than 15%:

A B C D E F
1 USING A LOAN TABLE TO FIND THE IRR
2 IRR? 15.00%
3
Division of cash flow
between investment
income and return of
4 principal
Principal Cash flow
at beginning at end of
5 Year of year year Income Principal
6 1 1,000.00 300 150.00 150.00 <-- =C6-D6
7 2 850.00 200 127.50 72.50
8 3 777.50 150 116.63 33.38
9 4 744.13 600 111.62 488.38
10 5 255.74 900 38.36 861.64
11 6 -605.89
12 =$B$2*B6
13 =B6-E6

If the interest rate in cell B3 is indeed the IRR, then cell B11 should be 0. We
can use Excel’s Goal Seek (found under Data|What-if analysis) to calculate
the IRR:
25 Basic Financial Calculations

As shown below, the IRR is 24.44%:

A B C D E F
1 USING A LOAN TABLE TO FIND THE IRR
2 IRR? 24.44%
3
Division of cash flow
between investment
income and return of
4 principal
Principal Cash flow
at beginning at end of
5 Year of year year Income Principal
6 1 1,000.00 300 244.36 55.64 <-- =C6-D6
7 2 944.36 200 230.76 -30.76
8 3 975.13 150 238.28 -88.28
9 4 1,063.41 600 259.86 340.14
10 5 723.26 900 176.74 723.26
11 6 0.00
12 =$B$2*B6
13 =B6-E6
26 Chapter 1

The loan table is an effective illustration that the IRR is the interest rate that
pays off an investment over its term. Of course, we could have simplified life
by just using the IRR function:

A B C D
15 Direct calculation of IRR
16 Year Cash flow
17 0 -1,000
18 1 300
19 2 200
20 3 150
21 4 600
22 5 900
23
24 IRR 24.44% <-- =IRR(B17:B22)

Excel’s Rate Function

Excel’s Rate function computes the IRR of a series of constant future pay-
ments. In the example below, we pay $1,000 today for an annual payment of
$100 for the next 30 years. Rate shows that the IRR is 9.307%:

A B C
USING EXCEL'S RATE FUNCTION TO
1 COMPUTE THE IRR
2 Initial investment 1,000
3 Periodic cash flow 100
4 Number of payments 30
5 IRR 9.307% <-- =RATE(B4,B3,-B2)

Note: Rate works much like PMT and PV discussed elsewhere in this
chapter; it requires a sign change between the initial investment and the peri-
odic cash flow (note that we have used –B2 in cell B5). It also has switches
to allow for payments which start today and payments which start one period
from now (not shown in the above example).
 27 Basic Financial Calculations

1.4 Multiple Internal Rates of Return

Sometimes a series of cash flows has more than one IRR. In the next example
we can tell that the cash flows in cells B6:B11 have two IRRs, since the NPV
graph crosses the x-axis twice:

A B C D E F G H I
1 MULTIPLE INTERNAL RATES OF RETURN
2 Discount rate 6%
3 NPV -3.99 <-- =NPV(B2,B7:B11)+B6 DATA TABLE
Discount
4 rate NPV
5 Year Cash flow -3.99 Table header, <-- =B3
6 0 -145 0% -20.00
7 1 100 3% -10.51
8 2 100 6% -3.99
9 3 100 9% 0.24
10 4 100 12% 2.69
11 5 -275 15% 3.77
12 18% 3.80
13 21% 3.02
14
Two IRRs 24% 1.62
15 5.00 27% -0.24
16 30% -2.44
0.00
17 0% 10% 20% 30% 40% 33% -4.90
Net present value

18 -5.00
36% -7.53
19 39% -10.27
20 -10.00
21 Discount rate Note: For a discussion of how to create data
22 -15.00
tables in Excel, see Chapter 31.
23
24 -20.00
25
-25.00
26
27
28
29 Identifying the two IRRs
30 First IRR 8.78% <-- =IRR(B6:B11,0)
31 Second IRR 26.65% <-- =IRR(B6:B11,0.3)

Excel’s IRR function allows us to add an extra argument which will help
us find both IRRs. Instead of writing =IRR(B6:B11), we write
=IRR(B6:B11,guess). The argument guess is a starting point for the algorithm
which Excel uses to find the IRR; by adjusting the guess, we can identify both
the IRRs. Cells B30 and B31 give an illustration.
28 Chapter 1

There are two things to note about this procedure:

• The argument guess merely has to be close to the IRR; it is not unique.
For example, by setting the guesses equal to 0.1 and 0.5, we will still get the
same IRRs:

A B C D
29 Identifying the two IRRs
30 First IRR 8.78% <-- =IRR(B6:B11,0.1)
31 Second IRR 26.65% <-- =IRR(B6:B11,0.5)

• In order to identify the number and the approximate value of the IRRs, it
helps greatly to graph (as we did above) the NPV of the investment as a func-
tion of various discount rates. The internal rates of return are then the points
where the graph crosses the x-axis, and the approximate location of these
points should be used as the guesses in the IRR function.4

From a purely technical point of view, a set of cash flows can have multiple
IRRs only if it has at least two changes of sign. Many typical cash flows have
only one change of sign. Consider, for example, the cash flows from purchas-
ing a bond having a 10% coupon, a face value of $1,000, and 8 more years to
maturity. If the current market price of the bond is $800, then the stream of
cash flows changes signs only once (from negative in year 0 to positive in
years 1–8). Thus there is only one IRR:

A B C D E F G H I J K
1 BOND CASH FLOWS: NPV CROSSES X-AXIS ONLY ONCE, SO THERE IS ONLY ONE IRR
2 Year Cash flow Data table: Effect of
3 0 -800 discount rate on NPV
4 1 100 1,000.00 <-- =NPV(E4,B4:B11)+B3, table header
5 2 100 0% 1,000.00
6 3 100 2% 786.04 1200
NPV of Bond Cash Flows
7 4 100 4% 603.96
1000
8 5 100 6% 448.39
800
9 6 100 8% 314.93
10 7 100 10% 200.00 600
NPV

11 8 1,100 12% 100.65 400

12 14% 14.45 200
13 IRR 14.36% <-- =IRR(B3:B11) 16% -60.62 0
14 18% -126.21 -200 0% 5% 10% 15% 20%
15 20% -183.72 -400
16 Discount rate
17

4. If you don’t put in a guess (as we did in the previous section), Excel defaults to a guess of 0.1.
Thus, in the current example, IRR(B34:B39) will return 8.78%.
29 Basic Financial Calculations

1.5 Flat Payment Schedules

Another common problem is to compute a “flat” repayment for a loan. For

example: You take a loan for $10,000 at an interest rate of 7% per year. The
bank wants you to make a series of payments which will pay off the loan and
the interest over 10 years. We can use Excel’s PMT function to determine how
much each annual payment should be:

Notice that we have put “PV”—Excel’s nomenclature for the initial loan
principal—with a minus sign. As discussed above, if we do not do this Excel
returns a negative payment (a minor irritant). You can confirm that the answer
of 2,097.96 is correct by creating a loan table:
30 Chapter 1

A B C D E F G
1 FLAT PAYMENT SCHEDULES
2 Loan principal 10,000
3 Interest rate 7%
4 Loan term 6 <-- Number of years over which loan is repaid
5 Annual payment 2,097.96 <-- =PMT(B3,B4,-B2)
6
7 Split payment into: =$B$3*C9
Principal
at beginning Payment at Return of
8 Year of year end of year Interest principal
9 1 10,000.00 2,097.96 700.00 1,397.96
10 2 8,602.04 2,097.96 602.14 1,495.82 =D9-E9
11 3 7,106.23 2,097.96 497.44 1,600.52
12 =C9-F9 4 5,505.70 2,097.96 385.40 1,712.56
13 5 3,793.15 2,097.96 265.52 1,832.44
14 6 1,960.71 2,097.96 137.25 1,960.71
15 7 0.00

The zero in cell C15 indicates that the loan is fully repaid over its term of
6 years. You can easily confirm that the present value of the payments over
the 6 years is the initial principal of 10,000.

1.6 Future Values and Applications

We start with a triviality. Suppose you deposit 1,000 in an account today,

leaving it there for 10 years. Suppose the account draws annual interest of
10%. How much will you have at the end of 10 years? The answer, as shown
in the following spreadsheet, is 2,593.74:
31 Basic Financial Calculations

A B C D E
1 SIMPLE FUTURE VALUE
2 Interest 10%
3
Account
Interest Total in
balance,
Year earned account,
beginning of
during year end year
4 year
5 1 1,000.00 100.00 1,100.00 <-- =C5+B5
6 2 1,100.00 110.00 1,210.00 <-- =C6+B6
7 3 1,210.00 121.00 1,331.00
8 4 1,331.00 133.10 1,464.10
=$B$2*B5
9 5 1,464.10 146.41 1,610.51
10 6 1,610.51 161.05 1,771.56
11 7 1,771.56 177.16 1,948.72
12 8 1,948.72 194.87 2,143.59
13 9 2,143.59 214.36 2,357.95
14 10 2,357.95 235.79 2,593.74
15 11 2,593.74 =D5
16
17 A simpler way 2,593.74 <-- =B5*(1+B2)^10

As cell C17 shows, you don’t need all these complicated calculations: The
future value of 1,000 in 10 years at 10% per year is given by:
FV = 1, 000* (1 + 10%) = 2, 593.74
10

Now consider the following, slightly more complicated, problem: Again,

you intend to open a savings account. Your initial deposit of 1,000 today will
be followed by a similar deposit at the beginning of years 1, 2, … , 9. If the
account earns 10% per year, how much will you have in the account at the
start of year 10?
 32 Chapter 1

This problem is easily modeled in Excel:

A B C D E F
1 FUTURE VALUE WITH ANNUAL DEPOSITS
2 Interest 10%
3 Annual deposit 1,000 <-- Made today and at beginning of each of next 9 years
4 Number of deposits 10
5
Account
Deposit at Interest Total in
balance,
Year beginning earned account,
beginning of
of year during year end year
6 year
7 1 0.00 1,000 100.00 1,100.00 <-- =D7+C7+B7
8 2 1,100.00 1,000 210.00 2,310.00 <-- =D8+C8+B8
9 3 2,310.00 1,000 331.00 3,641.00
10 4 3,641.00 1,000 464.10 5,105.10 =$B$2*(B7+C7)
11 5 5,105.10 1,000 610.51 6,715.61
12 6 6,715.61 1,000 771.56 8,487.17
13 7 8,487.17 1,000 948.72 10,435.89
14 8 10,435.89 1,000 1,143.59 12,579.48
15 9 12,579.48 1,000 1,357.95 14,937.42
16 10 14,937.42 1,000 1,593.74 17,531.17
17
18 Future value 17,531.17 <-- =FV(B2,B4,-B3,,1) =E7

Thus the answer is that we will have 17,531.17 in the account at the end of
year 10. This same answer can be represented as a formula that sums the future
values of each deposit:

Total at beginning of year 10 = 1, 000* (1 + 10%) + 1, 000* (1 + 10%)

10 9

+ … + 1, 000 * (1 + 10%)
1

10
= ∑ 1, 000* (1 + 10%)
t

t =1

An Excel function: Note from cell B18 that Excel has a function FV which
gives this sum. The dialog box brought up by FV is the following:
33 Basic Financial Calculations

We note three things about this function:

• For positive deposits FV returns a negative number. This is an irritating

property of this function, which it shares with PV and PMT. To avoid negative
numbers, we have put the Pmt in as −1,000.
• The line Pv in the dialog box refers to a situation wherein the account has
some initial value other than 0 when the series of deposits is made. In the
above example, this has been left blank, which indicates that the initial account
value is zero.
• As noted in the picture, “Type” (either 1 or 0) refers to whether the deposit
is made at the beginning or the end of each period (in our example the former
is the case).

1.7 A Pension Problem—Complicating the Future Value Problem

A typical exercise is the following: You are currently 55 years old and intend
to retire at age 60. To make your retirement easier, you intend to start a retire-
ment account:

• At the beginning of each of years 1, 2, 3, 4 (that is, starting today and at the
beginning of each of the next four years), you intend to make a deposit into
the retirement account. You think that the account will earn 8% per year.
34 Chapter 1

• After retirement at age 60, you anticipate living 8 more years.5 At the begin-
ning of each of these years you want to withdraw $30,000 from your retirement
account. Your account balances will continue to earn 8%.

How much should you deposit annually in the account? The following
spreadsheet fragment below shows how easily you can go wrong in this kind
of problem—in this case, you’ve calculated that in order to provide $30,000
per year for 8 years, you need to contribute $240,000/5 = $48,000 in each of
the first 5 years. As the spreadsheet shows, you’ll end up with a lot of money
at the end of 8 years! (The reason—you’ve ignored the powerful effects of
compound interest. If you set the interest rate in the spreadsheet equal to 0%,
you’ll see that you’re right.)

A B C D E F
1 A RETIREMENT PROBLEM
2 Interest 8%
3 Annual deposit 48,000.00
4 Annual retirement withdrawal 30,000.00
5 =$B$2*(C7+B7)
Account
Deposit at Interest Total in
balance,
Year beginning earned account,
beginning
of year during year end year
6 of year
7 1 0.00 48,000.00 3,840.00 51,840.00 <-- =D7+C7+B7
8 2 51,840.00 48,000.00 7,987.20 107,827.20
9 3 107,827.20 48,000.00 12,466.18 168,293.38
10 4 168,293.38 48,000.00 17,303.47 233,596.85
11 5 233,596.85 48,000.00 22,527.75 304,124.59
12 6 304,124.59 -30,000.00 21,929.97 296,054.56
13 7 296,054.56 -30,000.00 21,284.36 287,338.93
14 8 287,338.93 -30,000.00 20,587.11 277,926.04
15 9 277,926.04 -30,000.00 19,834.08 267,760.12
16 10 267,760.12 -30,000.00 19,020.81 256,780.93
17 11 256,780.93 -30,000.00 18,142.47 244,923.41
18 12 244,923.41 -30,000.00 17,193.87 232,117.28
19 13 232,117.28 -30,000.00 16,169.38 218,286.66
20
Note: This problem has 5 deposits and 8 annual withdrawals, all made at the beginning of the year. The
beginning of year 13 is the last year of the retirement plan; if the annual deposit is correctly computed, the
21 balance at the beginning of year 13 after the withdrawal should be zero.

5. Of course you’re going to live much longer! And I wish you good health! The dimensions of
this problem have been chosen to make it fit nicely on a page.
35 Basic Financial Calculations

There are several ways to solve this problem. The first involves Excel’s
Solver. This can be found on the Data menu.6

6. If the Solver does not appear on the Tools menu, then you have to load it. Go to File|Options|Add-
ins and click Solver Add-In on the list of programs. Note that you could also use the Goal Seek
tool to solve this problem. For simple problems such as this one, there is not much difference
between the Solver and Goal Seek; the one (not inconsiderable) advantage of the Solver is that
it remembers its previous arguments, so that if you bring it up again on the same spreadsheet, you
can see what you did in the previous iteration. In later chapters we will illustrate problems that
cannot be solved by Goal Seek and in which the use of the Solver is a necessity.
36 Chapter 1

Clicking on Solver opens a dialog box. Below we’ve filled it in:

37 Basic Financial Calculations

If we now click on the Solve box, we get the answer:

A B C D E F
1 A RETIREMENT PROBLEM
2 Interest 8%
3 Annual deposit 29,386.55
4 Annual retirement withdrawal 30,000.00
5 =$B$2*(C7+B7)
Account
Deposit at Interest Total in
balance,
Year beginning earned account,
beginning
of year during year end year
6 of year
7 1 0.00 29,386.55 2,350.92 31,737.48 <-- =D7+C7+B7
8 2 31,737.48 29,386.55 4,889.92 66,013.95
9 3 66,013.95 29,386.55 7,632.04 103,032.54
10 4 103,032.54 29,386.55 10,593.53 143,012.62
11 5 143,012.62 29,386.55 13,791.93 186,191.10
12 6 186,191.10 -30,000.00 12,495.29 168,686.39
13 7 168,686.39 -30,000.00 11,094.91 149,781.30
14 8 149,781.30 -30,000.00 9,582.50 129,363.81
15 9 129,363.81 -30,000.00 7,949.10 107,312.91
16 10 107,312.91 -30,000.00 6,185.03 83,497.94
17 11 83,497.94 -30,000.00 4,279.84 57,777.78
18 12 57,777.78 -30,000.00 2,222.22 30,000.00
19 13 30,000.00 -30,000.00 0.00 0.00

Solving the Retirement Problem Using Financial Formulas

We can solve this problem in a more intelligent fashion if we understand the

discounting process. The present value of the whole series of payments, dis-
counted at 8%, must be zero:
4 12
Initial deposit 30, 000
∑ (1.08 ) t
−∑
(1.08 )t
=0
t =0 t=5
12 4
30, 000 1
⇒ Initial deposit = ∑ ∑ (1.08)
t = 5 (1.08 )
t t
t =0

12 8
30, 000 1 30, 000
Rewrite∑ (1.08)t (1.08)4 ∑ (1.08)t . We can now use Excel’s PV and
=
t =5 t =1

PMT functions to solve the problem:

38 Chapter 1

A B C
1 A RETIREMENT PROBLEM
2 Interest 8%
3 Annual retirement withdrawal 30,000.00
4 Years of withdrawal 8
5 Years of deposit 5
6 Present value of withdrawals 117,331.98 <-- =-PV(B2,B4,B3)/(1+B2)^B5
7 Annual deposit 29,386.55 <-- =PMT(B2,B5,-B6)

1.8 Continuous Compounding

Suppose you deposit $1,000 in a bank account which pays 5% per year. This
means that at the end of the year you will have $1,000*(1.05) = $1,050. Now
suppose that the bank interprets “5% per year” to mean that it pays you
2.5% interest twice a year. Thus after 6 months you’ll have $1,025, and
2
after 1 year you will have $1, 000 * ⎛ 1 +
0.05 ⎞
= $1, 050.625 . By this logic,
⎝ 2 ⎠
if you get paid interest n times per year, your accretion at the end of the
n
year will be $1, 000 * ⎛ 1 +
0.05 ⎞
. As n increases this amount gets larger,
⎝ n ⎠
converging (rather quickly, as you will soon see) to e0.05, which in Excel is
written as the function Exp. When n is infinite, we refer to this as continuous
compounding. (By typing Exp(1) in a spreadsheet cell, you can see that e =
2.7182818285. …)
As you can see in the next display, $1,000 continuously compounded for 1
year at 5% grows to $1,000*e0.05 = $1,051.271 at the end of the year. Continu-
ously compounded for t years, it will grow to $1,000*e0.05*t, where t need not
be a whole number (for example, when t = 4.25 then the accumulation factor
e0.05*4.25 measures the growth of the initial investment at 5% annually, continu-
ously compounded for 4 years and 3 months).
39 Basic Financial Calculations

A B C
1 MULTIPLE COMPOUNDING PERIODS
2 Initial deposit 1,000
3 Interest rate 5%
4 Number of compounding periods per year 2
5 Interest per compounding period 2.500% <-- =B3/B4
6 Accretion in one year 1,050.625 <-- =B2*(1+B5)^B4
7 Continuous compounding with Exp 1,051.271 <-- =B2*EXP(B3)
8
9 Effect of Multiple Compounding Periods
10 1,051.40
11
1,051.20
12
End-year accretion

13 1,051.00
14 1,050.80
15
1,050.60
16
17 1,050.40
18 1,050.20
19
1,050.00
20 Number of compounding intervals
21 1,049.80
22 1 10 100 1000
23
End-year
Compounding periods per year
24 accretion
25 1 1,050.000 <-- =$B$2*(1+$B$3/A25)^A25
26 2 1,050.625 <-- =$B$2*(1+$B$3/A26)^A26
27 10 1,051.140
28 20 1,051.206
29 50 1,051.245
30 100 1,051.258
31 150 1,051.262
32 300 1,051.267
33 800 1,051.269

The conclusion: More compounding periods increase the future value,

though there is a clear asymptotic value; as we will see below, for accretion
over t years, this value is ert.

Back to Finance—Continuous Discounting

If the accretion factor for continuous compounding at interest r over t years

is ert, then the discount factor for the same period is e−rt. Thus a cash flow Ct
occurring in year t and discounted at continuously compounded rate r will be
worth Cte–rt today. This is illustrated below:
40 Chapter 1

A B C D
1 CONTINUOUS DISCOUNTING
2 Interest 8%
3
Continously
discounted
4 Year Cash flow PV
5 1 100 92.312 <-- =B5*EXP(-$B$2*A5)
6 2 200 170.429 <-- =B6*EXP(-$B$2*A6)
7 3 300 235.988
8 4 400 290.460
9 5 500 335.160
10
11 Present value 1,124.348 <-- =SUM(C5:C9)

Calculating the Continuously Compounded Return from Price Data

Suppose at time 0 you had $1,000 in the bank and suppose that 1 year later
you had $1,200. What was your percentage return? Although the answer may
appear obvious, it actually depends on the compounding method. If the bank
paid interest only once a year, then the return would be 20%:
1, 200
− 1 = 20%
1, 000

However, if the bank paid interest twice a year, you would need to solve
the following equation to calculate the return:
2 1/ 2
r ⎛ 1, 200 ⎞
1, 000 * ⎛ 1 + ⎞ = 1, 200 ⇒ = ⎜
r
⎟ − 1 = 9.5445%
⎝ 2⎠ 2 ⎝ 1, 000 ⎠
The annual percentage return when interest is paid twice a year is therefore
2*9.5445% = 19.089%.
In general, if there are n compounding periods per year, you have to solve
1/ n
r ⎛ 1, 200 ⎞
=⎜ ⎟ − 1 and then multiply the result appropriately. If n is very large,
n ⎝ 1, 000 ⎠
⎛ 1, 200 ⎞
this converges to r = ln ⎜ = 18.2322%:
⎝ 1, 000 ⎟⎠
41 Basic Financial Calculations

A B C
1 CALCULATING RETURNS FROM PRICES
2 Initial deposit 1,000
3 End-of-year value 1,200
4 Number of compounding periods 2
5 Implied annual interest rate 19.09% <-- =((B3/B2)^(1/B4)-1)*B4
6
7 Continuous return 18.23% <-- =LN(B3/B2)
8

9 Implied annual interest rate with n compounding periods

10 Number of compounding periods Rate
11 19.09% <-- =B5, data table header
12 1 20.00%
13 2 19.09%
14 4 18.65%
15 8 18.44%
16 20 18.32%
17 1,000 18.23%

Why Use Continuous Compounding?

All of this may seem somewhat esoteric. However, continuous compounding/

discounting is often used in financial calculations. In this book, it is used to
calculate portfolio returns (Chapters 8–13) and in practically all of the options
calculations (Chapters 15–19).
There’s another reason to use continuous compounding—its ease of calcula-
tion. Suppose, for example, that your $1,000 grew to $1,500 in 1 year and 9
months. What’s the annualized rate of return? The easiest—and most
consistent—way to do this is to calculate the continuously compounded annual
return. Since 1 year and 9 months equals 1.75 years, this return is:
1 ⎡ 1, 500 ⎤
1, 000 * exp [ r * 1.75] = 1, 500 ⇒ r = ln ⎢ = 23.1694%
1.75 ⎣ 1, 000 ⎥⎦
42 Chapter 1

1.9 Discounting Using Dated Cash Flows

Most of the computations in this chapter consider cash flows which occur at
fixed periodic intervals. Typically we look at cash flows which occur on dates
0, 1, … , n, where the period indicates an annual, semi-annual, or other fixed
interval. Two Excel functions, XIRR and XNPV, allow us to do computations
on cash flows which occur on specific dates that need not be at even
intervals.7
In the following example we compute the IRR of an investment of $1,000
made on 1 January 2014 with payments on specific dates:

A B C
USING XIRR TO COMPUTE THE
ANNUALIZED INTERNAL RATE OF
1 RETURN
2 Date Cash flow
3 01-Jan-14 -1,000
4 03-Mar-14 150
5 04-Jul-14 100
6 12-Oct-14 50
7 25-Dec-14 1,000
8
9 IRR 37.19% <-- =XIRR(B3:B7,A3:A7)

The function XIRR outputs an annualized return. It works by computing

the daily IRR and annualizing it, XIRR = (1 + daily IRR ) − 1.
365

XNPV computes the net present value of a series of cash flows occurring
on specific dates:

7. If you do not see these functions, add them in by going to Tools|Add-ins on the toolbar and
checking Analysis ToolPak.
43 Basic Financial Calculations

A B C
USING XNPV TO COMPUTE THE NET
1 PRESENT VALUE
2 Annual discount rate 12%
3
4 Date Cash flow
5 01-Jan-14 -1,000
6 03-Mar-15 100
7 04-Jul-15 195
8 12-Oct-16 350
9 25-Dec-17 800
10
11 Net present value 16.80 <-- =XNPV(B2,B5:B9,A5:A9)
12
Note that XNPV has a different syntax from NPV!
XNPV requires all the cash flows, including the initial cash flow,
whereas NPV assumes that the first cash flow occurs one period
13 hence.

Fixing Bugs in XNPV and XIRR

Both XNPV and XIRR have bugs, which Microsoft has not fixed in several
versions of Excel. The file with this chapter includes functions that fix these
bugs, called NXNPV and NXIRR.8

• XNPV doesn’t work with zero or negative interest rates.

• XIRR does not identify multiple internal rates of return.

The XNPV relates to the failure of this function to correctly deal with zero
or negative discount rates.

8. These bug fixes were developed by my colleague Benjamin Czaczkes.

 44 Chapter 1

A B C
PROBLEM WITH XNPV
1 XNPV does not work with zero or negative discount rates
2 Discount rate -3.00%
3 Net present value #NUM! <-- =XNPV(B2,B7:B13,A7:A13)
4 -194.87 <-- =nXNPV(B2,B7:B13,A7:A13)
5
6 Date Cash flow
7 30-Jun-14 -500
8 14-Feb-15 100
9 14-Feb-16 300
10 14-Feb-17 400
11 14-Feb-18 600
12 14-Feb-19 800
13 14-Feb-20 -1,800

The NXNPV function fixes this problem.

The bug in XIRR is that the Guess switch on XIRR doesn’t work. Consider
the following problem:

A B C D E F
1 PROBLEMS WITH XIRR
2 Discount rate 22.00%
3 Net present value 64.96186 <-- =XNPV(B2,B9:B15,A9:A15)
4 IRR #NUM! <-- =XIRR(B9:B15,A9:A15) , no Guess
5 #NUM! <-- =XIRR(B9:B15,A9:A15,35%), Guess = 35%
6 #NUM! <-- =XIRR(B9:B15,A9:A15,5%) , Guess = 5%
7
8 Date Cash flow Data table: XNPV as function of discount rate
9 30-Jun-14 -500
10 14-Feb-15 100 Rate 64.962 <-- =B3, data table header
11 14-Feb-16 300 0.1% -97.366
12 14-Feb-17 400 2.5% -42.753
13 14-Feb-18 600 4.9% -2.310
14 14-Feb-19 800 7.3% 26.837
15 14-Feb-20 -1,800 9.7% 46.983
16 12.1% 59.961
17 80 XNPV as Function of Discount Rate 14.5% 67.240
18 16.9% 70.000
19 60 19.3% 69.191
20 40
21.7% 65.578
21 24.1% 59.780
22 20 26.5% 52.296
23 28.9% 43.528
0
24 31.3% 33.803
0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30% 33% 36% 39% 42%
25 -20 33.7% 23.384
26 36.1% 12.484
27 -40 38.5% 1.272
28 -60 40.9% -10.113
29
30 -80
31
-100
32
33 -120
34
45 Basic Financial Calculations

From the data table, it is evident that there are two internal rates of return
(around 5% and around 39%). But the XIRR function does not identify either
(see cells B4:B6).
The function NXIRR fixes this bug:

A B C

1 NXIRR FIXES THE XIRR BUG

2 Discount rate -3.00%
3 IRR 5.06% <-- =nXIRR(B8:B14,A8:A14) , no Guess
4 38.77% <-- =nXIRR(B8:B14,A8:A14,35%), Guess = 35%
5 5.06% <-- =nXIRR(B8:B14,A8:A14,5%) , Guess = 5%
6
7 Date Cash flow
8 30-Jun-14 -500
9 14-Feb-15 100
10 14-Feb-16 300
11 14-Feb-17 400
12 14-Feb-18 600
13 14-Feb-19 800
14 14-Feb-20 -1,800

Exercises

1. You are offered an asset costing $600 that has cash flows of $100 at the end of each of
the next 10 years.

a. If the appropriate discount rate for the asset is 8%, should you purchase it?
b. What is the IRR of the asset?

2. You just took a $10,000, 5-year loan. Payments at the end of each year are flat (equal in
every year) at an interest rate of 15%. Calculate the appropriate loan table, showing the
breakdown in each year between principal and interest.

3. You are offered an investment with the following conditions:

• The cost of the investment is 1,000.

• The investment pays out a sum X at the end of the first year; this payout grows at the
rate of 10% per year for 11 years.

If your discount rate is 15%, calculate the smallest X which would entice you to purchase
the asset. For example, as you can see in the following display, X = $100 is too small—the
NPV is negative:
46 Chapter 1

A B C
1 Discount rate 15%
2 Initial payment 129.2852
3 NPV -226.52 <-- =B6+NPV(B1,B7:B17)
4
5 Year Cash flow
6 0 -1,000.00
7 1 100.00 <-- 100
8 2 110.00 <-- =B7*1.1
9 3 121.00 <-- =B8*1.1
10 4 133.10
11 5 146.41
12 6 161.05
13 7 177.16
14 8 194.87
15 9 214.36
16 10 235.79
17 11 259.37

4. The following cash-flow pattern has two IRRs. Use Excel to draw a graph of the NPV of
these cash flows as a function of the discount rate. Then use the IRR function to identify
the two IRRs. Would you invest in this project if the opportunity cost were 20%?

A B
4 Year Cash flow
5 0 -500
6 1 600
7 2 300
8 3 300
9 4 200
10 5 -1,000

5. In this exercise we solve iteratively for the internal rate of return. Consider an investment
which costs 800 and has cash flows of 300, 200, 150, 122, 133 in years 1–5. Setting up
the loan table below shows that 10% is greater than the IRR (since the return of principal
at the end of year 5 is less than the principal at the beginning of the year):
47 Basic Financial Calculations

A B C D E F G H
1 IRR? 10.00%
Division of payment
2 LOAN TABLE between:
Principal Payment
Year Cash flow Year at beginning at end of Interest Principal
of year year
3
4 0 -800 1 800.00 300.00 80.00 220.00
5 1 300 2 580.00 200.00 58.00 142.00
6 2 200 3 438.00 150.00 43.80 106.20
7 3 150 4 331.80 122.00 33.18 88.82
8 4 122 5 242.98 133.00 24.30 108.70
9 5 133 6 134.28 <-- Should be zero for IRR

Setting the IRR? cell equal to 3% shows that 3% is less than the IRR, since the return of
principal at the end of year 5 is greater than the principal at the beginning of year 5.
By changing the IRR? cell, find the internal rate of return of the investment.

A B C D E F G H
1 IRR? 3.00%
Division of payment
2 LOAN TABLE between:
Principal Payment
Year Cash flow Year at beginning at end of Interest Principal
of year year
3
4 0 -800 1 800.00 300.00 24.00 276.00
5 1 300 2 524.00 200.00 15.72 184.28
6 2 200 3 339.72 150.00 10.19 139.81
7 3 150 4 199.91 122.00 6.00 116.00
8 4 122 5 83.91 133.00 2.52 130.48
9 5 133 6 -46.57 <-- Should be zero for IRR

6. An alternative definition of the IRR is the rate which makes the principal at the beginning
of year 6 equal to zero.9 This is shown in the printout above, in which cell E9 gives the
principal at the beginning of year 6. Using the Goal Seek function of Excel, find this rate
(below we illustrate how the screen should look).

9. In general, of course, the IRR is the rate of return that makes the principal in the year following
the last payment equal to zero.
48 Chapter 1

(Of course you should check your calculations by using the Excel IRR function.)

7. Calculate the flat annual payment required to pay off a 13%, 5-year loan of $100,000.

8. You have just taken a car loan of $15,000. The loan is for 48 months at an annual interest
rate of 15% (which the bank translates to a monthly rate of 15%/12 = 1.25%). The 48
payments (to be made at the end of each of the next 48 months) are all equal.

a. Calculate the monthly payment on the loan.

b. In a loan table calculate, for each month: the principal remaining on the loan at the
beginning of the month and the split of that month’s payment between interest and
repayment of principal.
c. Show that the principal at the beginning of each month is the present value of the
remaining loan payments at the loan interest rate (use either NPV or the PV
functions).

9. You are considering buying a car from a local auto dealer. The dealer offers you one of
two payment options:

• You can pay $30,000 cash.

• The “deferred payment plan”: You can pay the dealer $5,000 cash today and a payment
of $1,050 at the end of each of the next 30 months.

As an alternative to the dealer financing, you have approached a local bank, which is
willing to give you a car loan of $25,000 at the rate of 1.25% per month.
49 Basic Financial Calculations

a. Assuming that 1.25% is the opportunity cost, calculate the present value of all the
payments on the dealer’s deferred payment plan.
b. What is the effective interest rate being charged by the dealer? Do this calculation by
preparing a spreadsheet like this (only part of the spreadsheet is shown—you have to
do this calculation for all 30 months):

D E F G H
Payment
under
Month Cash payment Difference
deferred
payment plan
2
3 0 30,000 5,000 25,000 <-- =E3-F3
4 1 0 1,050 -1,050 <-- =E4-F4
5 2 0 1,050 -1,050
6 3 0 1,050 -1,050
7 4 0 1,050 -1,050
8 5 0 1,050 -1,050
9 6 0 1,050 -1,050
10 7 0 1,050 -1,050
11 8 0 1,050 -1,050

Now calculate the IRR of the difference column; this is the monthly effective interest rate
on the deferred payment plan.

10. You are considering a savings plan which calls for a deposit of $15,000 at the end of each
of the next 5 years. If the plan offers an interest rate of 10%, how much will you accumulate
at the end of year 5? Do this calculation by completing the following spreadsheet. This
spreadsheet does the calculation twice—once using the FV function and once using a
simple table which shows the accumulation at the beginning of each year.

A B C D
1 Annual payment 15,000
2 Interest rate 10%
3 Number of years 5
4 Total value $91,576.50 <-- =FV(B2,B3,-B1,,0)
5
Accumulation
Payment at Annual
Year at beginning of
year end of year interest
6
7 1 0 15,000 0.00
8 2 15,000 15,000 1,500.00
9 3 31,500
10 4
11 5
12 6
50 Chapter 1

11. Redo the previous calculation, this time assuming that you make 5 deposits at the begin-
ning of this year and the following 4 years. How much will you accumulate by the end of
year 5?

12. A mutual fund has been advertising that, had you deposited $250 per month in the fund
for the last 10 years, you would now have accumulated $85,000. Assuming that these
deposits were made at the beginning of each month for a period of 120 months, calculate
the effective annual return fund investors got.

Hint: Set up the following spreadsheet and then use Goal Seek.

A B C
1 Monthly payment 250
2 Number of months 120
3
4 Effective monthly return?
5 Accumulation <-- =FV(B4,B2,-B1,,1)

The effective annual return can then be calculated in one of two ways:

• (1 + monthly return)12 − 1: This is the compound annual return, which is preferable,

since it makes allowance for the reinvestment of each month’s earnings.
• 12*monthly return: This method is often used by banks.

13. You have just turned 35, and you intend to start saving for your retirement. Once you retire
in 30 years (when you turn 65), you would like to have an income of $100,000 per year
for the next 20 years. Calculate how much you would have to save between now and age
65 in order to finance your retirement income. Make the following assumptions:

• All savings draw compound interest of 10% per year.

• You make the first payment today and the last payment on the day you turn 64 (30
payments).
• You make the first withdrawal when you turn 65 and the last withdrawal when you turn
84 (20 payments).

14. You currently have $25,000 in the bank, in a savings account that draws 5% interest. Your
business needs $25,000, and you are considering two options: (a) Use the money in your
savings account. (b) Borrow the money from the bank at 6%, leaving the money in the
savings account.
51 Basic Financial Calculations

Your financial analyst suggests that solution (b) above is better. His logic: The sum of
the interest paid on the 6% loan is lower than the interest earned at the same time on the
$25,000 deposit. His calculations are illustrated below. Show that this logic is wrong. (If
you think about it, it couldn’t be preferable to take a 6% loan when you are getting 5%
interest from the bank. However, the explanation for this may not be trivial.)

A B C D E F
1 EXERCISE 14, financial analyst's calculations
2 Interest earned 5%
3 Interest paid 6%
4 Initial deposit 25,000
5 =PMT($B$3,2,-$B$4)
6 THE 6% LOAN
Principal at Payment at Repayment
Year Interest paid
beginning of year end of year of principal
7
8 1 25,000.00 13,635.92 1,500.00 12,135.92 <-- =C8-D8
9 2 12,864.08 13,635.92 771.84 12,864.08
10 Total interest paid 2,271.84
11
12 Savings Account
In savings End-year
In account at
Year account at interest
end of year
beginning of year earned
13
14 1 25,000.00 1,250.00 26,250.00
15 2 26,250.00 1,312.50 27,562.50
16 Interest earned 2,562.50

15. Use XIRR to compute the internal rate of return of the following investment:

A B
1 Date Cash flow
2 30-Jun-07 -899
3 14-Feb-08 70
4 14-Feb-09 70
5 14-Feb-10 70
6 14-Feb-11 70
7 14-Feb-12 70
8 14-Feb-13 1,070
52 Chapter 1

16. Use XNPV to value the following investment. Assume that the annual discount rate
is 15%.

A B
4 Date Cash flow
5 30-Jun-07 -500
6 14-Feb-08 100
7 14-Feb-09 300
8 14-Feb-10 400
9 14-Feb-11 600
10 14-Feb-12 800
11 14-Feb-13 -1,800

17. Identify the two internal rates of return of the investment in exercise 16.