44 Chapter 2 Time Value of Money

with numbers as inputs; the actual function itself is in Cell G30. Cell E31 shows how the formula would look with cell references as inputs, with the actual function in Cell G31. We always recommend using cell references as inputs to functions, because this makes it easy to change inputs and see the effects on the output. Notice that when entering interest rates in Excel, you must input the actual number. For example, in cell C15, we input 0.05, and then formatted it as a percentage. In the function itself, you can enter 0.05 or 5%, but if you enter 5, Excel will think you mean 500%. This is exactly opposite the convention for financial calculators.

Comparing the Procedures

The first step in solving any time value problem is to understand the verbal description of the problem well enough to diagram it on a time line. Woody Allen said that 90% of success is just showing up. With time value problems, 90% of success is correctly setting up the time line. After you diagram the problem on a time line, your next step is to pick an approach to solve the problem. Which of the approaches should you use? The answer depends on the particular situation. All business students should know Equation 2-1 by heart and should also know how to use a financial calculator. So, for simple problems such as finding the future value of a single payment, it is probably easiest and quickest to use either the formula approach or a financial calculator. For problems with more than a couple of cash flows, the formula approach is usually too time-consuming, so here either the calculator or spreadsheet approaches would generally be used. Calculators are portable and quick to set up, but if many calculations of the same type must be done, or if you want to see how changes in an input such as the interest rate affect the future value, the spreadsheet approach is generally more efficient. If the problem has many irregular cash flows, or if you want to analyze many scenarios with different cash flows, then the spreadsheet approach is definitely the most efficient.

The Power of Compound Interest

Suppose you are 26 years old and just received your MBA. After reading the introduction to this chapter, you decide to start investing in the stock market for your retirement. Your goal is to have $1 million when you retire at age 65. Assuming you earn a 10% annual rate on your stock investments, how much must you invest at the end of each year in order to reach your goal? The answer is $2,490.98, but this amount depends critically on the return earned on your investments. If returns drop to 8%, your required annual contributions will rise to $4,185.13. If returns rise to 12%, you will need to put away only $1,461.97 per year. What if you are like most of us and wait until later to worry about retirement? If you wait until age 40, you will need to save $10,168 per year to reach your $1 million goal, assuming you earn 10%, and $13,679 per year if you earn only 8%. If you wait until age 50 and then earn 8%, the required amount will be $36,830 per year. While $1 million may seem like a lot of money, it wont be when you get ready to retire. If inflation averages 5% a year over the next 39 years, your $1 million nest egg will be worth only $149,148 in todays dollars. At an 8% rate of return, and assuming you live for 20 years after retirement, your annual retirement income in todays dollars will be only $15,191 before taxes. So, after celebrating graduation and your new job, start saving!
See FM12 Ch 02 Tool Kit.xls for all calculations.