Exercises

You are offered an asset costing $600 that has cash flows of $100 at the end of each of

1.
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?

You just took a $10,000, 5-year loan. Payments at the end of each year are (equal in
2
flat
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 ofered 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 1l years.

Ifyour 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 too smal-the
a
is
NPV negative:
is
46 Chapter
1
A B
1 Discount rate 15%
2 Initial payment 129.2852
3 NPV -226.52 <-- =B6+NPV(B1,B7:B17)
4
5 Year Cash flow
6 -1.000.00
7 1 100.00|<- 100
8 2 110.00<-- =B7*1.1
9 3 121.00<- =B81.1
10 4 133.10
1 5 146.41
12 161.05
13 7 177.16
14 8 194.87
15 214.36
6 10 235.79
17 11 259.37

4. The following cash-flow pattern has two IRRs. Use Excel to drawa 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%?

B
4 Year Cash flow
5 C -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 5is less than the principal at the beginning of the year):
 C D E G H
1 IRR? 10.00%
Division of payment
LOAN TABLE between:

Principal Payment
Year Cash flow Year at beginning at end of Interest Principal

3 of year year

-800 1 800.00 300.00 80.00| 220.00|

5 300 2 580.00 200.00 58.00 142.00
200 3 438.00 150.00 43.80 106.20
7 150 331.80 122.00 33.18 88.82

8 122 242.98 133.00 24.30 108.70

9 5 133 6 134.28 <-- Should be zero for IRR

Setting the IRR? cellequal 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.

B C E F G
1 IRR? 3.00%
Division of payment
LOAN TABLE between:

Principal Payment
Year Cash flow Year at beginning at end of Interest Principal

3 of year year

-800 800.00 300.00 24.00 276.00

5 300 2 524.00 200.00 15.72 184.28
1
6 200 339.72 150.00 10.19 139.81

7 3 150 4 199.91 122.00 6.00 116.00

8 4 122 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 isthe rate which makes the principal at the beginning
of year 6 equal to zero, This is shown in the printout above, in cell E9 gives the

principal at the beginning of year 6. Using the Goal Seek function of Excel, find this rate
(below we illustratehow the screen should look).

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

48 Chapter
1
A B C D H
1 IRR?
Division of payment
2 LOAN TABLE between.

Cash Principal Payment

Year Year at beginning at end Interest Principal
flow
3 of year of year

4 -800 1 800.00 300An

5 1 300 2 524.00

2 200 3 339.72
20
15
Goal Seek
7 3 150 4 199.91 12
Set cel: SE$9
8 4 122 5 83.91 13

5 133 6 46.57 To
yalue:
<
10 By changing $8$1
cel:
11

12 RR 5.07% This uses the Excel formula =RRB4:B9) oK Cancel

|13

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

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

You have justtaken a car loan of $15,000. The loan is for 48 months at an annual interest
8.
 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 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 shownyou have to
do this calculation for all 30 months):

D E G H
Payment
under
Month Cash payment Difference
deferred

2 payment plan
3 30,000 5,000 25.000<o- =E3-F3
4 1,050 -1,050< =E4-F4
5 2 1,050 -1,050
6 3 1,050 -1,050
7 4 0 1,050 -1,050
8 5 1,050 -1,050
9 6
ooo 1,050 -1,050
10 7 1,050 -1,050
11 8 1,050| -1,050
Slolololololololo
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 5years. 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 paymnent 15,000
2 lInterest 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
end of year interest
year
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
1 Monthly payment 250
2 Number of months 120
3
4 Effectivemonthly return?
5 Accumulation <-- =FV(B4,B2,-B1,1)

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

• (1 + monthly return) - 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.