A B C D E F G H

1 Ch 02 Mini Case 4/6/2003

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3 Chapter 2. Mini Case
4 Situation
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6 Assume that you are nearing graduation and that you have applied for a job with a local bank. As part of the bank's
7 evaluation process, you have been asked to take an examination which covers several financial analysis techniques. The first
8 section of the test addresses discounted cash flow analysis. See how you would do by answering the following questions.
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11 a. Draw time lines for (1) a $100 lump sum cash flow at the end of year 2, (2) an ordinary annuity of $100 per year for 3
12 years, and (3) an uneven cash flow stream of -$50, $100, $75, and $50 at the end of Years 0 through 3.
13 FUTURE VALUE
14 $100 lump sum at the end of year 2.
15 I%
16 Time period 0 1 2
17 FV at year end 100
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20 Ordinary annuity of $100 per year for three years.
21 I%
22 Time period 0 1 2
23 FV at year end 100 100 100
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25 Uneven cash flow stream.
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27 I%
28 Time period 0 1 2 3
29 FV at year end -50 100 75 50
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31 b. (1.) What is the future value of an initial $100 after 3 years if it is invested in an account paying 10 percent annual
32 interest?
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34 Interest rate 0.1 These are the basic inputs, in blue.
35 Cash flow 100
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37 Time period 0 1 2 3
38 FV at year end 100 110.00 121 133.10
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40 Note: This problem was solved using the formula, FVn = PV (1+I)n. However, there are a number of ways this problem
41 could have Wizard".
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43 First, you must select the Function wizard icon found in the toolbar at the top of the screen, which looks like this . This
44 button been solved. One of the most valuable features in Excel is the "Function" Wizard. Here is how to access and use the
45 "Function. On the left side of the dialog box is a menu entitled, "Function category", and on the right is a menu called
46 "Function name".
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 A B C D E F G H
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65 We will be selecting the "FV" function from the "Financial" category, and will be using the following dialog box to input our
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84 Notice that we entered a value instead of a cell reference as the input for the problem for instructional purposes instead of the
85 actual value. You should enter the cell value so that your spreadsheet can automatically reflect any changes to the input
86 data. This is one of the features that makes the spreadsheet such a valuable tool.
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88 Using the function wizard will yield the following result:
89 FV = $133.10
90 TABLE
91 Future Value Interest Factors
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94 With a spreadsheet, calculating FVIF's is a simple operation, and we can use it to graph the relationship between future
95 value, growth, interest rates, and time. A similar table can be found in the textbook, along with a corresponding graph.
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97 Period (n) 0% 5% 10% 15%
98 0 1.0000 1.0000 1.0000 1.0000
99 2 1.0000 1.1025 1.2100 1.3225
100 4 1.0000 1.2155 1.4641 1.7490
101 6 1.0000 1.3401 1.7716 2.3131
102 8 1.0000 1.4775 2.1436 3.0590
103 10 1.0000 1.6289 2.5937 4.0456
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105 GRAPH
106 Relationships among Future Value, Growth, Interest Rates, and Time
107
Relationships among Future Value, Growth, Interest Rate, and Time
$5.00

$4.00
$1
 A B C D E F G H
108 Relationships among Future Value, Growth, Interest Rate, and Time
109 $5.00
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112 $4.00
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Future Value of $1

115 $3.00

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$2.00
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120 $1.00
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123 $0.00
0 2 4 6 8 10 12
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125 Periods

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128 (2.) What is the present value of $100 to be received in 3 years if the appropriate interest rate is 10 percent?
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130 PRESENT VALUE
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132 Simply put, the present value is the value today of some future cash flow (or series of cash flows). The interest rate used to
133 "discount" a given cash flow is the opportunity cost rate, and is equivalent to the next best investment alternative of the same
134 risk.
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136 PROBLEM
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138 Interest rate 0.1
139 Cash flow 100
140 Number of Years Discounted Back
141 Time period 0 1 2 3
142 Present Value $75.13 82.64 90.91 100.00
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144 This problem can also be solved using the function wizard using a procedure similar to that for the FV function. Begin by
145 putting the pointer on the cell in which you want to display the result, in this case Cell C167. Then, after selecting the "PV"
146 function from the "Paste Function" box, the input data for the problem must be entered. Then click OK to get the result,
147 $75.13.
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 A B C D E F G H
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166 PV = $75.13
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169 c. We sometimes need to find how long it will take a sum of money (or anything else) to grow to some specified amount. For
170 example, if a company's sales are growing at a rate of 20 percent per year, how long will it take sales to double?
171 Finding Time to Double
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173 I= 0.2
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175 Time period 0 1 2 ?
176 Present Value $1.00 2.00
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178 Finding N, the number of 3.8 Use the function NPER, as shown below.
179 periods
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216 SOLVING FOR I
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218 PROBLEM
219 d. If you want an investment to double in three years, what interest rate must it earn?
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221 N 3
 A B C D E F G H
222 PV -1
223 FV 2
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Once again, Excel has a special function for this calculation. We suggest using either a financial calculator or the function
227 wizard to solve this type of problem, because of its complexity. The procedure can be carried out using the function wizard,
228 by selecting the "Rate" function from the list of financial functions in the "Paste Function" dialog box. Upon entering the
229 time, present value, and future value, the interest rate can be found. Note that you can either type the data in or else activate
230 the menu slot and then click on the appropriate cell.
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248 I = 25.99%
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251 We noted above the difficulty of solving this problem mathematically. This is because it involves taking the nth root of a value
252 (an operation which generally requires either a calculator or a computer). However, if you would like to know how to solve
253 the problem mathematically, the formula is: (FVn/PV)1/ n - 1, which is derived from the FV formula
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255 N 3
256 PV 1 I = 25.99%
257 FV 2
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260 e. What is the difference between an ordinary annuity and an annuity due? What type of annuity is shown below? How
261 would you change it to the other type of annuity? See Ch 02 Mini Case Show.ppt
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264 f. (1.) What is the future value of a 3-year ordinary annuity of $100 if the appropriate interest rate is 10 percent?
265
266 FUTURE VALUE OF AN ANNUITY
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268 As explained below, one way to solve this problem is to find the future value of each of the annuity payments. However, this
269 is somewhat tedious, especially if a lot of years are involved. In the following example, we use the input data of the interest
270 rate and time to calculate the future value in time period 3 of each individual cash flow. Lastly, we take the sum of all the
271 future values, which gives us the future value of the entire annuity.
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273 N 3
274 I 0.1
275 PMT 100
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277 Time period 0 1 2 3
278 CFn 0 100 100 100 Annuity's FV:
 A B C D E F G H
279 FV3 0 121 110 100 = $331.00
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An easier procedure is to solving for the future value of an annuity with the function wizard. This procedure is similar to
284 that of a lump sum future value. Whereas before we left the "Pmt" field blank, now we insert the annuity payment ($100 in
285 this case). First, we access the "FV" function box from the list of financial functions. Then, we input our new data. A key
286 thing to watch is the "Type" input box. Previously, we left this box alone. A "0" or no entry in the box indicates an ordinary
287 annuity, and a "1" indicates an annuity due. Though we can leave the box blank, it is a good habit to enter a "0" in the field.
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304 FV = $331.00
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306 PRESENT VALUE OF AN ANNUITY
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308 (2.) What is the present value of the annuity?
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310 N 3
311 I 0.1
312 PMT 100
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314 Time period 0 1 2 3
315 CFn 0 100 100 100 Annuity PV
316 PV3 0 90.91 82.64 75.13 = $248.69
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318 Or, you could use the function wizard for this ordinary annuity.
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 A B C D E F G H
336 PV = $248.69
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339 PROBLEM
340 (3.) What would the future and present values be if the annuity were an annuity due?
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343 The procedure for solving this problems follows the previous example with one notable exception. Since, the payments occur
344 at the beginning of each year, the first annuity payment occurs in time period 0, and the last occurs in time period 2.
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346 N 3
347 I 0.1
348 PMT 100
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350 Time period 0 1 2 3
351 CFn 100 100 100 0 Annuity FV
352 FV3 133.1 121 110 0 = $364.10
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354 Additionally, using the function wizard for this problem is exactly like above, but we enter a "1" instead of a "0" into the
355 "Type" field.
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375 FV = $364.10
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378 To find the present value of the annuity due, this problem is solved just like the previous problem, except that the payments
379 occur in periods 0 through 2.
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381 N 3
382 I 0.1
383 PMT 100
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385 Time period 0 1 2 3
386 CFn 100 100 100 0 Annuity PV
387 PV3 100.00 90.91 82.64 0.00 = $273.55
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389 Using the function wizard, we follow the same procedure as above, except remember to enter a "1" to tell Excel that this
390 problem has payments occurring at the beginning of the periods.
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 A B C D E F G H
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408 PV = $273.55
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412 UNEVEN CASH FLOWS
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414 g. Calculate the present value of the following cash flow stream, discounted at 10%.
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 A B C D E F G H
416 I = 10%
417 Time period
418 0 1 2 3 4
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420 0 100 300 300 -50
421 Cash Flows
422 PV of Cash Flows
423 0 90.91 247.93 225.39 -34.15
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425 NPV = $530.09
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427 As we show above, the first way to solve for the present value of this uneven cash flow stream is to use the time line to find the
428 present value of each of the cash flows in the periods in which they occur, then sum all the present values. This procedure
429 will yield the correct present value.
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432 This problem could also be set up in a column format; it is a matter of personal preference as to which format is easier to
433 interpret and use. Once we have converted our data into a data table, we can solve for the present value of each of the cash
434 flows (like we did previously) and add all of the present values together.
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436 I 0.1
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438 N CFn PV0
439 0 0 0.00
440 1 100 90.91
441 2 300 247.93
442 3 300 225.39
443 4 -50 -34.15
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448 PV of CF stream $530.09
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452 With, the financial calculator, we could enter each of these cash flows and the discount rate, and simply press NPV for the
present value of the cash flow stream. In Excel, we can perform a similar calculation by using the "NPV" function. While
453 this function is very similar, there is a key distinction. In the cash flow register of your calculator, the first entry you make
454 would be the cash flow to occur in time period zero. However, the "NPV" function interprets the first data entry as being the
455 cash flow in time period one. Therefore, the initial cash flow must be added seperately. In this particular example, the initial
456 cash flow is zero.
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461 Ranges from either the
462 time line or the columns
463 could be entered for
464 Value1, such as
465 B440:B443.
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471 PV = $530.09
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