A B C D E F G H

1 4/11/2010
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3 Chapter 4. Mini Case
4 Situation
5 Assume that you are nearing graduation and have applied for a job with a local bank. As part of the
6 bank's evaluation process, you have been asked to take an examination that covers several financial
7 analysis techniques. The first section of the test addresses discounted cash flow analysis. See how
8 you would do by answering the following questions.
9
10 a. Draw time lines for (1) a $100 lump sum cash flow at the end of Year 2, (2) an ordinary annuity of $100
11 per year for 3 years, and (3) an uneven cash flow stream of -$50, $100, $75, and $50 at the end of Years 0
12 through 3.
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15 FUTURE VALUE
16 $100 lump sum at the end of year 2.
17 I%
18 Time period 0 1 2
19 FV at year end 100
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22 Ordinary annuity of $100 per year for three years.
23 I%
24 Time period 0 1 2
25 FV at year end 100 100 100
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28 Uneven cash flow stream.
29 I%
30 Time period 0 1 2 3
31 FV at year end -50 100 75 50
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33 b. (1.) What's the future value of an initial $100 after 3 years if it is invested in an account paying 10%
34 annual interest?
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36 Interest rate 0.1 These are the basic inputs, in blue.
37 Cash flow 100
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39 Time period 0 1 2 3
40 FV at year end 100 110.00 121 133.10
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42 Note: This problem was solved using the formula, FVn = PV (1+I) N. However, there are a number of
43 ways the problem could have used Excel's "Wizard Function".
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45 First, you must select the Function wizard icon found in the toolbar at the top of the screen, which looks
46 like this: fx. When you get the "Insert Function " dialog box, select the category for Financial Functions,
47 as shown below.
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71 After selecting the category for Financial functions, scroll down until you can selet the FV function, as
72 show below. Alternatively, select the menu Formulas, then then select Financial, then pick FV.
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After selecting the "FV" function from the "Financial" category, we will be using the following dialog box
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to input our data.
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119 Notice that we entered a value instead of a cell reference as the input for the problem for instructional
purposes. It's really better to enter cell values so that your spreadsheet can automatically reflect any
120 changes to the input data. This is one of the features that makes the spreadsheet such a valuable tool.
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123 Using the function wizard yields the following result:
124 FV = $133.10
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126 Future Value Interest Factors
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128 With a spreadsheet, calculating FVIF's is a simple operation, and we can use it to graph the relationship
129 between future value, growth, interest rates, and time. A similar table can be found in the textbook,
130 along with a corresponding graph.
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132 Period (N) 0% 5% 10% 15%
133 0 1.0000 1.0000 1.0000 1.0000
134 2 1.0000 1.1025 1.2100 1.3225
135 4 1.0000 1.2155 1.4641 1.7490
136 6 1.0000 1.3401 1.7716 2.3131
137 8 1.0000 1.4775 2.1436 3.0590
138 10 1.0000 1.6289 2.5937 4.0456
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141 Relationships among Future Value, Growth, Interest Rates, and Time
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143 Relationships among Future Value, Growth, Interest Rate, and Time
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145 $5.00
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147 $4.00
148 Future Value of $1
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156 $0.00
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158 Periods
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b. (2) What is the present value of $100 to be received in 3 years if the appropriate interest rate is 10%?
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165 PRESENT VALUE (PV)
166 Simply put, the present value (PV) is the value today of some future cash flow (or series of cash flows).
167 The interest rate used to "discount" a given cash flow is the opportunity cost rate, and is equivalent to
168 the next best investment alternative of the same risk.
169 PROBLEM
170
171 Interest rate 10%
172 Cash flow 100
173 Number of Years Discounted Back
174 Time period 0 1 2 3
175 PV $75.13 82.64 90.91 100.00
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177 This problem can also be solved using the function wizard using a procedure similar to that for the FV
178 function. Begin by putting the pointer on the cell in which you want to display the result. Then, after
179 selecting the "PV" function from the "Paste Function" box, the input data for the problem must be
180 entered. Then click OK to get the result, $75.13.
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204 PV = $75.13

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205
206 c. We sometimes need to find how long it will take a sum of money (or anything else) to grow to some
207 specified amount. For example, if a company's sales are growing at a rate of 20% per year, how long will
208 it take sales to double?
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210 Finding Time to Double
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212 I= 0.2
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214 Time period 0 1 2 ?
215 Present Value $1.00 2.00
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217 Finding N, the number of 3.8 Use the function NPER, as shown below.
218 periods
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242 SOLVING FOR I
243 PROBLEM
244 d. If you want an investment to double in three years, what interest rate must it earn?
245
246 N 3
247 PV -1
248 FV 2
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250 Once again, Excel has a special function for this calculation. We suggest using either a financial
251 calculator or the function wizard to solve this type of problem, because of its complexity. The procedure
252 can be carried out using the function wizard, by selecting the "Rate" function from the list of financial
253 functions in the "Paste Function" dialog box. Upon entering the time, present value, and future value,
254 the interest rate can be found. Note that you can either type the data in or else activate the menu slot
255 and then click on the appropriate cell.
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280 I = 25.99%
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282 We noted above the difficulty of solving this problem mathematically. This is because it involves taking
283 the Nth root of a value (an operation which generally requires either a calculator or a computer).
284 However, if you would like to know how to solve the problem mathematically, the formula is (FVn/PV) (1/N) -
285 1, which is derived from the FV formula.
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287 N 3
288 PV 1 I = 25.99%
289 FV 2
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291
e. What is the difference between an ordinary annuity and an annuity due? What type of annuity is
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shown below? How would you change it to the other type of annuity? See Ch 04 Mini Case Show.ppt
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f. (1.) What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate is 10%?
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298 FUTURE
payments.VALUE OFthis
However, AN is
ANNUITY
tedious, especially if a lot of years are involved. In the following example,
299 we use the input data of the interest rate and time to calculate the future value in time period 3 of each
300 individual cash flow. Lastly, we take the sum of all the future values, which gives us the future value of
301 N 3
302 I 0.1
303 PMT 100
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305 Time period 0 1 2 3
306 CFt 0 100 100 100 Annuity's FV:
307 FV3 0 121 110 100 = $331.00
308
309 An easier procedure is to solving for the future value of an annuity with the function wizard. This
310 procedure is similar to that of a lump sum future value. Whereas before we left the "Pmt" field blank,
311 now we insert the annuity payment ($100 in this case). First, we access the "FV" function box from the
312 list of financial functions. Then, we input our new data. A key thing to watch is the "Type" input box.
313 Previously, we left this box alone. An "0" or no entry in the box indicates an ordinary annuity, and a "1"
314 indicates an annuity due. Though we can leave the box blank, it is a good habit to enter a "0" in the
315 field.
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339 FV = $331.00
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341 PRESENT VALUE OF AN ANNUITY
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343 f. (2.) What is the present value of the annuity?
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345 N 3
346 I 0.1
347 PMT 100
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349 Time period 0 1 2 3
350 CFt 0 100 100 100 Annuity PV
351 PV3 0 90.91 82.64 75.13 = $248.69
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353 Or, you could use the function wizard for this ordinary annuity.
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376 PV = $248.69
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379 f. (3.) What would the future and present values be if the annuity were an annuity due?
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381 The procedure for solving this problems follows the previous example with one notable exception. Since, the
382 payments occur at the beginning of each year, the first annuity payment occurs in time period 0, and the last occ
383 in time period 2.
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385 N 3
386 I 0.1
387 PMT 100
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389 Time period 0 1 2 3
390 CFt 100 100 100 0 Annuity FV
391 FV3 133.1 121 110 0 = $364.10
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393 Additionally, using the function wizard for this problem is exactly like above, but we enter a "1" instead of a "0" in
394 the "Type" field.
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418 FV = $364.10
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420 To find the present value of the annuity due, this problem is solved just like the previous problem,
421 except that the payments occur in periods 0 through 2.
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423 N 3
424 I 0.1
425 PMT 100
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427 Time period 0 1 2 3
428 CFt 100 100 100 0 Annuity PV
429 PV3 100.00 90.91 82.64 0.00 = $273.55
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431 Using the function wizard, we follow the same procedure as above, except remember to enter a "1" to
432 tell Excel that in this problem the payments occur at the beginning of the periods.
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456 PV = $273.55
457 g. What is the present value of the following uneven cash flow stream? The appropriate interest rate is 10%,
458 compounded annually.
459
1 I = 2 10%3 4 5
460
$100 $200 $200 $200 $200
461 Time period
462 0 1 2 3 4
463
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464 0 100 300 300 -50 $0
465 Cash Flows
466 PV of Cash Flows

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467 0 90.91 247.93 225.39 -34.15
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469 NPV = = of PVs = $530.09
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471 As we show above, the first way to solve for the present value of this uneven cash flow stream is to use
472 the time line to find the present value of each of the cash flows in the periods in which they occur, then
473 sum all the present values. This procedure will yield the correct present value.
474
format is easier to interpret and use. Once we have converted our data into a data table, we can solve
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for the present value of each of the cash flows (like we did previously) and add all of the present values
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477 I 0.1
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479 N CFN PV0
480 0 0 0.00
481 1 100 90.91
482 2 300 247.93
483 3 300 225.39
484 4 -50 -34.15
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486 PV of CF stream = $530.09
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488 With, the financial calculator, we could enter each of these cash flows and the discount rate, and simply
489 press NPV for the present value of the cash flow stream. In Excel, we can perform a similar calculation
490 by using the "NPV" function. While this function is very similar, there is a key distinction. In the cash
491 flow register of your calculator, the first entry you make would be the cash flow to occur in time period
492 zero. However, the "NPV" function interprets the first data entry as being the cash flow in time period
493 one. Therefore, the initial cash flow must be added seperately. In this particular example, the initial
494 cash flow is zero.
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496 Or
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517 PV = $530.09
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520 h. (1.) Identify (a) the stated, or quoted, or nominal rate (i Nom) and (b) the periodic rate (iPER).
521
522 Inputs
523 INOM (quarterly) 0.1 This is the rate stated in contracts.
524 m=periods/yr 2 This is the number of periods per year, m.
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526 The periodic is associated with the number of compounding periods per year. M = 4 quarterly, 12 for monthly, an
527 360 or 365 for annual compounding.
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529 IPER = inom/m
530
531 IPER = 10% / 2
532 IPER = 5%
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h. (2.) Will the future value be larger or smaller if we compound an initial amount more often than annually, for
535 example, every 6 months (semiannually), holding the stated interest rate constant? Why?
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538 Larger, because interest is earned on interest.
539 The effective annual rate is the annual rate that causes the PV to grow to the same FV as under multiple
540 compounding periods.
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542 EFF% = (1+ INOM/M)M
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544 EFF% = (1 + (10%/2))^2 - 1
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546 EFF% = 10.25%
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548
549 SEMIANNUAL AND OTHER COMPOUNDING PERIODS
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551 h. (3.) What is the future value of $100 after 5 years under 12% annual compounding?
552
553 N 3
554 I 0.12 FV = $140.49
555 PV 100
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557
558 What is the FV with semiannual compounding?
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560 N (years x 2) 6
561 I (I per year/2) 0.06 FV = $141.85
562 PV 100
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564
565 What is the FV with quarterly compounding?
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567 N (years x 4) 12
568 I (I per year/4) 0.03 FV = $142.58
569 PV 100
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571
572 What is the FV with monthly compounding?
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574 N (years x 12) 36
575 I (I per year/12) 0.01 FV = $143.08
576 PV 100
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578
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580 What is the FV with daily compounding?
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582 N (years x 365) 1095
583 I (I per year/12) 0.000328767 FV = $143.32
584 PV 100
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586 I. Will the effective annual rate ever be equal to the nominal (quoted) rate? Only if the compounding period is eq
587 to 1 year.
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589 j. (1.) What would the required payment be on a $1,000 loan that is to be repaid in three equal installments at the
590 of each of the next three years if the interest rate is 10%?
591
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593 N 3 PMT = $402.11 Total pmts Tot. int. paid
594 I 0.1 $1,206 $206
595 PV 1000
596 Now, construct an amortization table for the loan described above.
597
598 j. (2.) What is the annual interest expense for the borrower, and the annual interest income for the lender, du
599 Year 2?
600
601 N Beg. Amt. Payment Interest Principal End. Amt.
602 1 $1,000.00 $402.11 $100.00 $302.11 $697.89
603 2 $697.89 $402.11 $69.79 $332.33 $365.56
604 3 $365.56 $402.11 $36.56 $365.56 $0.00
605
606 Payment Distribution
607 Paym ent
608 $450.00 Note: See Columns
609 through R for a 30 y
$400.00
610 mortgage example.
$350.00
611
$300.00
$250.00 Principal
$200.00 Interest

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$100.00
$50.00
 Payment Distribution
Paym ent

$450.00
$400.00
$350.00
A B C D E F G H
612 $300.00

613 $250.00 Principal

614 $200.00 Interest
615 $150.00
616 $100.00
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$50.00
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619 $0.00
1 2 3
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621 Year
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626 k. On January 1, you deposit $100 in an account that pays a nominal (or quoted) interest rate of 11.33463%, with
interest added (compounded) daily. How much will you have in your account on October 1, or 9 months later? (2
627
days)
628
629
630 0 1 2 3 4 5 273
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632 100
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635 I 0.00031054
636 N 273
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638 FV $108.85
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640 l. (1.) What is the value at the end of Year 3 of the following cash flow stream if the quoted interest rate is
641 compounded semiannually?
642
643 Annual rate = 10%
644 Periods per year = 2
645 Periodic rate = 5%
646
647
648 Years 0 0.5 1 1.5 2 2.5 3
649 Periods 0 1.0 2 3.0 4 5.0 6
650 Cash Flow 0 100 0 100 0 100
651
652 There are two approaches. First, you could simply find the future value of each cash flow using the
653 period rate and compounded for the appropriate number of periods, as shown below.
654
655 Periods 0 1.0 2 3.0 4 5.0 6
656 FV of CF $121.55 $110.25 $100.00
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658 Total FV = = $331.80
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660 Alternatively, you could calculate the annual effective rate and use this to find the future value of a 3-year annuity
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662 Annual effective rate = 10.25%
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664 FV = $331.80
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666 l. (2.) What is the PV of the same stream?
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668 Using the first approach, we find the present value of each individual cash flow using the periodic rate
669 and the number of periods.
670
671 Periods 0 1 2 3.0 4 5.0 6
672 PV of CF $90.70 $82.27 $74.62
673
674 Total FV = $247.59
675
676 In the second approach, we use the annual effective rate to find the present value of a 3-year annuity.
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678 PV = $247.59
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680 l. (3.) Is the stream an annuity? No, because we don't have a payment for each compounding period.
681
682
683
l. (4.) An important rule is that you should never show a nominal rate on a time line or use it in calculations un
684 what condition holds? (Hint: Think of annual compounding, when i NOM = EAR = iPER.) What would be wrong
685
your answer to questions l(1) and l(2) if you used the nominal rate (10%) rather than the periodic rate (i NOM/2 = 10%
686 5%)? Use the nominal rate only for annual compounding.
687
688
689 m. Suppose someone offered to sell you a note calling for the payment of $1,000 in 15 months (or 456 days). Th
offer to sell it to you for $850. You have $850 in a bank time deposit that pays a 6.76649% nominal rate with daily
690
compounding, which is a 7% effective annual interest rate, and you plan to leave the money in the bank unless y
691 buy the note. The note is not risky--you are sure it will be paid on schedule. Should you buy the note? Check th
692 decision in three ways: (1) by comparing your future value if you buy the note versus leaving your money in the
693 bank, (2) by comparing the PV of the note with your current bank account, and (3) by comparing the EFF% on the
694 note versus that of the bank account.
695
696 See which provides the greater future wealth
697
698 0 1 2 3 4 5 456
699
700 850
701
702 I 0.00018538
703 N 456
704
705 Bank account: FV $924.97 < $1,000, so buy the note.
706
707
708 See which has the greater present value
709
710 0 1 2 3 4 5 456
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713
714 I 0.00018538
715 N 456
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717 PV of the note: PV $918.95 > $859 cost, so buy the note.
718
719 See which has the higher effective rate of return, EFF%
720
721 0 1 2 3 4 5 456
722
723 850 1000
724
725 N 456
726
727 I 0.035646% per day
728
729 EAR 13.89% > 7% so buy the note.

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interest rate457
is 10%,
458
459
460
461
462
463
464
465
466

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467
468
469
470
471
472
473
474
475
476
477
478
479
480
481
482
483
484
485
486
487
488
489
490
491
492
493
494
495
496
497
498
499
500
501
502
503
504
505
506
507
508
509
510
511
512
513
514

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 I
515
516
517
518
519
R
). 520
521
522
523
524
525
rterly, 12 for526
monthly, and
527
528
529
530
531
532
533
534
often than annually, for
? 535
536
537
538
539
under multiple
540
541
542
543
544
545
546
547
548
549
550
551
552
553
554
555
556
557
558
559
560
561
562
563

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 I
564
565
566
567
568
569
570
571
572
573
574
575
576
577
578
579
580
581
582
583
584
585
mpounding 586period is equal
587
588
589 at the end
equal installments
590
591
592
593 Tot. prin. pd
594 $1,000
595
596
597
ncome for the598lender, during
599
600
601
602
603
604
605
606
607
Note: See608Columns M
through609R for a 30 year
mortgage 610example.
611

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 I
612
613
614
615
616
617
618
619
620
621
622
623
624
625
626
rate of 11.33463%, with
r 1, or 9 months later? (273
627
628
629
630
631
632
633
634
635
636
637
638
639
640 rate is 10%,
quoted interest
641
642
643
644
645
646
647
648
649
650
651
652
653
654
655
656
657
658
659

39 of 42
 I
660 annuity.
value of a 3-year
661
662
663
664
665

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666
667
668
669
670
671
672
673
674
675
676
677
678
679
nding period.680
681
682
683
use it in calculations unless
What would 684 be wrong with
685
periodic rate (i NOM/2 = 10%/2 =
686
687
688
months (or 456 days). They
689
% nominal rate with daily
690
ney in the bank unless you
691Check the
buy the note?
692 in the
aving your money
693 on the
mparing the EFF%
694
695
696
697
698
699
700
701
702
703
704
705
706
707
708
709
710
711
712

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713
714
715
716
717
718
719
720
721
722
723
724
725
726
727
728
729

42 of 42