Basic financial calculations

Session 2

Th. Warin 1
Overview
A few finance basics and their Excel
implementations
Net present value (NPV)
Internal rate of return (IRR)
Payment schedules and loan tables
Future value
Compounded interest

Th. Warin 2
Summary
1. Present Value and Net Present Value
2. Internal Rate of Return and Loan Tables
3. Multiple Internal Rates of Return
4. Flat Payment Schedules
5. Future Values and Applications
6. A Pension Problem – Complicating the Future-
Value Problem
7. Continuous Compounding
8. Discounting Using Dated Cash Flows
Th. Warin 3
Basic Financial Calculations

1. PRESENT VALUE AND NET

PRESENT VALUE

4
1. Present value and net present value
Both concepts are related to the value today of
a set of future anticipated cash flows.

Example: we are valuating an investment that promises $100

per year at the end of this and the next four years. We suppose
that there is no doubt that this series of 5 payments 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 investiment’s
opportunity cost, the alternative benchmark return to which we
want to compare the investment. We may calculate the value
of the investment by discounting its cash flows using this
opportunity cost as a discount rate.

Th. Warin 5
1. Present value and net present value
The present value of a series of cash flows is
the value today of the cash flows starting in
year 1
N t
CF
Present value = å (1+ r) t
t=1

The net present value is the present value and

the cost of acquiring the asset (the cash flow at
time zero)
N t N t
CF CF
Net present value = å = CF + åt 0 t
(1+ r)
t=0 (1+ r) t=1

Th. Warin 6
1. Present value and net present value
Computing the present value (equal cash flows)

Computing the present value (non equal cash

flows)

Th. Warin 7
1. Present value and net present value
Net present value
Using the same example, suppose that the series of
5 cash flows of $100 is sold for $250. What would
be the NPV?

Th. Warin 8
1. Present value and net present value
Present value of an annuity
Def.: an annuity is a security that 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 if
r, then the value today of the annuity is its present
value.
Def.: a growing annuity pays out a sum C that
grows at a periodic growth rate g.

Th. Warin 9
1. Present value and net present value
æ 1 ö
ç 1- n ÷
PV of finite annuity =
C
+
C
+... +
C
n
= Cç
(1+ r) ÷
1+ r (1+ r) (1+ r) çç r ÷÷
2

è ø

C C C
PV of infinite annuity = +
1+ r (1+ r ) 2
+... =
r

PV of finite growing annuity

é æ 1+ g ön ù
C ê1- ç ÷ú
C C(1+ g) C(1+ g)2 C(1+ g)n-1 êë è 1+ r ø úû
= + + +... + =
1+ r (1+ r)2 (1+ r)3 (1+ r)n r-g

PV of infinite growing annuity

C C(1+ g) C(1+ g)2 C 1+ g
= + + +... = , provided <1
1+ r (1+ r) 2
(1+ r)3
r-g 1+ r

Th. Warin 10
Basic Financial Calculations

2. INTERNAL RATE OF RETURN AND

LOAN TABLES

11
2. IRR and loan tables
The Internal Rate of Return (IRR) is defined as
the compound rate of retun r that makes the
NPV equal to zero:
N
CF t
CF0 + å t
=0
t=1 (1+ r)

Determining the IRR by trial and error using

Excel’s Goal Seek

Th. Warin 12
2. IRR and loan tables
The IRR is the compound rate of return paid by
the investment. It helps to make a loan table,
which shows the division of the investment’s
cash flows between investment income and
the return of the investment principal.

It could be access by the IRR function of excel,

with the loan tables (goal seek tool), or with
Excel’s rate function
Th. Warin 13
Basic Financial Calculations

3. MULTIPLE INTERNAL RATES OF

RETURN

14
3. Multiple internal rates of return
Sometimes a series of cash flows has more
than one IRR

Multiple internal rates of return

Bond cash flows: NPV crosses x-axis only once,

so there is only one IRR

Th. Warin 15
Basic Financial Calculations

4. FLAT PAYMENT SCHEDULES

16
4. Flat payments schedules
Another common problem is to compute a flat
repayment for a loan.

Example: you take a loan for $10000 at an interest

rate of 7% per year. The bank wants you to make a
series of payments that will pay off the loan and the
interest over 6 years. Using Excel’s PMT function, it is
possible to determine how much each annual
payment should be.

Th. Warin 17
Basic Financial Calculations

5. FUTURE VALUES AND

APPLICATIONS

18
5. Future values and applications
The future value of $10000 in 10 years at 10%
per year is:
FV =1000 *(1+10%)10 = 2593, 74

If you take into account the deposit of the

interests accumulated each year, the future
value is: 10
FV = å1000 *(1+10%)t
t=1

Th. Warin 19
Basic Financial Calculations

6. A PENSION PROBLEM –
COMPLICATING THE FUTURE-VALUE
PROBLEM
20
6. A pension problem
You are currently 55 years old and intend to retire at
age 60. To make your retirement easier, you intend to
start a retirement account
At the beginning of each oh years 1,2,3,4, you intend to
make a deposit into the retirement account that will earn
8% per year.
After retirement at 60 years old, you anticipate to live 8
more years. At the beginning of each year you intend to
withdraw 30000$. The account balance continue to earn
8%.
How much should you deposit annually in the
account?

Th. Warin 21
6. A pension problem
Solving the problem using Excel’s solver (in the
Tools menu)

Solving the problem using financial formulas

4
Initial deposit 12 30000
å (1, 08)4 - å (1, 08)t
t=0 t=5

12 4
Initial deposit = [å å
30000 1
t
] / [ t
]
t=5 (1, 08) t=0 (1, 08)

Th. Warin 22
Basic Financial Calculations

7.CONTINUOUS COMPOUNDING

23
7.Continuous compounding
You are deposit 1000$ in a bank account that pays 5%
per year. At the end of the year you will have
$1000*(1,05)=$1050. Now suppose that the bank
interprets « 5% per year » to mean that it pays you 2,5
percent interest twice a year. Thus after six months
you’ll have $1025, and after one year you will have
$1050,625.

If you get interest n times a year, your accretion at the

end of the year is
0, 05 n
$1000 *(1+ )
n
Th. Warin 24
7.Continuous compounding
As n increases, this amount gets larger,
converging to e0,05. When n is infinite, it is
called continuous compounding.

Multiple compounding periods

Th. Warin 25
7.Continuous compounding
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.

Calculating the continuously compounded return from

price data depends on the compounding method.

Th. Warin 26
Basic Financial Calculations

8. DISCOUNTING USING DATED

CASH FLOWS

27
28
8. Discounting using dated cash flows
With the previous examples, cash flows occured at
fixed periodic intervals
Two Excel functions allow to do computations on cash
flows which occur on specific dates that are not at
even intervals (NOTE: if you do not see these
functions, add them in by going to Tools/Add-ins, on
the tool bar and checking Analysis ToolPak).
Using XIRR to compute the annualized IRR

Using XNPV to compute the NPV

Th. Warin 29