Excel Application of Time Value of Money

2/9/2012
Concept of Time Value of Money Excel Application of Time Value of Money

Dr. Manvinder Singh Pahwa UPES, Dehradun
A rupee today is worth more than a rupee tomorrow

Therefore it can be concluded that money can be invested to grow to a bigger amount, and it has a time value
Financial Management : Dr. M.S. Pahwa
Future Value of Money

Assume Rs. 100 is to be invest in a bank which is paying 5% interest compounded annually, then by the end of the year investor will have: 100 + (5% of 100) i.e., 100 + 5 = Rs. 105 This Rs. 105 received at the end of the year will be referred to as Future Value of Money.
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Future Value
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Further if the money is invested for TWO years, the calculation will be: 100 + 5% of 100 = 105 Reinvested in the beginning of second year 105 + 5% of 105 = 110.25 Here comes the formula for compound interest: Amount = Principal (1 + Rate of interest)time
Financial Management : Dr. M.S. Pahwa 5

In mathematical sense, FV = PV (1 + r)n Where, FV = Future Value PV = Present Value r = rate of interest n= number of years
Future Value Table

The Future Value Table given at the end of the book can be constructed using MS Excel in some clicks only. For this following steps can be followed:
Put the cursor over here and drag it horizontally to copy it through all the rows from C to P. In year Zero that is present time the value of Re. 1 will be Re. 1 only
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Now i t will look like this
For inserting the formula come on cell B3 and put the formula as given. And press enter key.
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Drag the cursor horizontally to copy the formula for all the rates.
Then pull the cursor from here down vertically to copy the formulas throughout the table.
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Using Excel Formulas for Future Value

There is a built in function for future values i.e., FV as follows: =FV(RATE, NPER, PMT, -PV, TYPE) Where, FV = Future Value RATE = Interest Rate per period NPER = Total number of periods PMT = Either 0 or 1 (i.e., if payment is made every period or if it is an annuity put 1 if not put 0) [it will be ZERO here) PV = Present Value (it is taken in minus) TYPE = Either 0 or 1 (if payment is made in beginning of period or then (1) and at end of the year (0) [it will be ZERO here)
The Table is ready.
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Future Value of Annuity
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What is an Annuity?
Annuity is an amount given (or taken as the situation may be) at the beginning or end of every period for certain or uncertain period of time. Annuity may be for present value or for future value. Appendix A-3 at the end of the book shows the Future Value of Annuity.
Future Value of Annuity

In the previous situation the amount was deposited only one i.e., at the beginning of year and the future value of it after certain years was calculated. But if the same amount is deposited in the bank at the beginning /end of every year, for certain years, then it is called Future Value of Recurring Deposit or Future Value of Annuity.
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Understanding Future Value of Annuity
Verifying Future Value of Annuity with Table 3 Appendix A-3 shows the Future Value of Annuity. If 3 year row is seen with 8% column intersection, the value is 3.246. Now multiply this value 3.246 by 1.08 We get 3.50568 or 3.50 Why?
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Verifying Future Value of Annuity with Table 3
Future Value of Annuity using MS Excel
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Future Value of Annuity using MS Excel

What will be the future value of Re. 1 invested every year for 3 years @ 8% p.a.
This is assuming the payments are made at the end of the year and thats why type is 0 Press enter after bracket.
Financial Management : Dr. M.S. Pahwa 25 Financial Management : Dr. M.S. Pahwa 26
Assuming the payments of annuity are made at the beginning, type is taken as1 instead of 0. Press enter after bracket.
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Present Value
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Present Value of Money

Present Value is just the vice-versa of Future Value. It is to find out the present value of Rs. 110.25 to be received after 2 years if discounted at 5% per annum will be Rs. 100 100 = 110.25/(1+0.05)2 This Rs. 100 is referred to as Present Value of Rs. 110.25 to be received after 2 years.

Further if Rs. 100 is receivable after THREE years, the calculation will be: 100/(1 + 5%)3 = Rs. 86.3837 Here comes the formula for discounting : Amount = Principal /(1 + Rate of interest)time
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Present Value Table

The Present Value Table given at the end of the book in Appendix A-2 can be constructed using MS Excel in some clicks only. For this following steps can be followed:
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Apply the formula and press enter

Drag it horizontally and vertically further to prepare the entire table.
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Using Excel Formulas for Present Value

There is a built in function for future values i.e., PV as follows: =PV(RATE, NPER, PMT, -FV, TYPE) Where, PV = Present Value RATE = Interest Rate per period NPER = Total number of periods PMT = Either 0 or 1 (i.e., if payment is made every period or if it is an annuity put 1 if not put 0) [it will be ZERO here) FV = Future Value (it is taken in minus) TYPE = Either 0 or 1 (if payment is made in beginning of period or then (1) and at end of the year (0) [it will be ZERO here)
The Table is ready.
While using single cash flow, pmt and type are set to ZERO as above. These parameters are to be used only when there are annuities
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What is an Annuity?
As discussed earlier, annuity is an amount given (or taken as the situation may be) at the beginning or end of every period for certain or uncertain period of time. Annuity may be for present value or for future value. Appendix A-4 at the end of the book shows the Present Value of Annuity.
Present Value of Annuity
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Present Value of Annuity

In the previous situation the amount accrued only once i.e., at the beginning of the three and the present value of it was calculated. But if the same amount accrues at the beginning /end of every year, for certain years, then it is called Present Value of Annuity.
Understanding Present Value of Annuity

If ONE rupee accrues at the end of each year for 3 years at 8% interest, the present value will be: PV = FV[1/(1+r) + 1/(1+r)2 + 1/(1+r)3 ++ 1/(1+r)n] For the above example, PV = 1[1/(1+0.08)+ 1/(1+0.08)2 + 1/(1+0.08)3 PV = 2.5771
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PV of Annuity
Present Value of Annuity using MS Excel
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Present Value of Annuity using MS Excel

What amount should be invested @ 5% p.a. to generate Rs. 100 per year for 5 years?
Pmt (payment per year) No of years Rate of Discounting
type parameter tells MS Excel whether the cash flow occurs at the end (0) or at the beginning. Here it has been assumed that payments occur at the end of the year regularly.
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Present Value of Annuity for Payments at the beginning
If the payment of first installment is needed in the beginning of the year, the type parameter is to be changed from 0 to 1.
Present Value of Annuity for Payments at the Beginning
Present Value of Growing Annuities and Real Rate of Interest

The PV in Cell B5 is -454.60 which is higher than -432.95 as in the previous case. The reason being that since the first installment is received immediately, we need to deposit a higher amount so as to receive 5 installments of Rs. 100. The another way of looking to it is that we are actually depositing Rs. 354.60 (454.60 100) and receiving 4 installments of Rs. 100
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Growing Annuities
Growing Annuity is referred to as those annuities which have growth rates. Suppose Mr. Xs annual salary is Rs. 1,00,000 and his salary will grow @ 10% each year for 5 years. If the discount rate is 12%, what is the present value of his salary? This can be solved in the following steps:
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This is one way of finding working out the PV of salary. The other way is to find out the Real Rate of Interest and discount the real cash flow with Real Rate Interest.
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Interest Rates and Consumption

An interest rate measures the opportunity cost of immediate consumption. Interest rates fluctuate over time and in order to understand these fluctuations, consider what influences immediate consumption. One of the most important determinants of interest rates is expected inflation. Suppose the consumer price index is expected to jump because the price of goods and services are expected to increase. Consumers are now likely to accelerate consumption plans to avoid the likely price rises.
Real and Nominal Rate of Interest
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How would you expect interest rates to respond to this event?

If inflation expectations increase and there is a shift from savings to consumption. This will result in decrease in savings and further, the fixed income security prices will fall as there will be the selling / redemption of fixed interest bearing securities, therefore with rise in prices, the interest rate falls. Conversely, if prices falls, the interest rates will rise. Therefore interest rates increase with expectations of inflation.
The Fisher Equation
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Fisher Equation.. Contd.
Calculating Real Rate of Interest
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The difference is due to the approximation in calculating the real rate of interest by 1.12 / 1.10 = 1.0181818 only 1.018 as been taken for discounting.
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Future Value of Annuity Revised

The present age of an employee is 30 years and he will retire at the age of 60 years. The company has policy of deducting Rs. 11,000 as Provident Fund Contribution annually. The interest rate on such account is 9%. What will be the amount which the employee will be getting on his retirement on account of his PF?
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Solving the Annuity Payment

What will be the payments to be made to accumulate certain sum of money after certain years? For Example: A person wants to purchase a house of Rs. 10,00,000 after 5 years from now and the savings are to be started one year from today. How much the person should save each year to purchase the house if the savings earn @ 5%?
Solving the Annuity Payment. Continued

In this situation, the function called PMT is to be used. Following is the format: PMT(RATE, NPER, PV, FV, TYPE) Let us do it on MS Excel
Further if the person already has Rs. 1,00,000 with him then in such situation the amount required for house after 5 years will be less.
The amount available at present is shown here.
The same concept can be used to find out how much a company needs to save each year in order to redeem the debentures of Rs. Ten Lakhs
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Capital Recovery and Loan Amortization
For Example: How much amount should be recovered each year from the lender to recover a loan of Rs. 1,00,000 given at 12% interest in 5 years? CVF = 1/3.605 = 0.27739 =1000000.27739 =Rs. 27,739
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MS Excel Calculations:
Solving for Number of Periods in an Annuity If a person takes a loan of Rs. 10,00,000 and his payment capacity is Rs. 1,00,000 a year, then in what period will he be able to pay the principle and interest, if the interest rate is 10%? Formula: NPER(RATE, PMT, PV, FV, TYPE)
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Solving for Interest Rate in an Annuity A washing machine is costing Rs. 11,000 and the seller says that an installment of Rs. 1,500 per year for 10 years. For the interest rate the seller is showing the following calculations: 1500 10 = 15000 15000-11000 = 4000 So, Rs. 4,000 10 = Rs. 400 per year And 400 11,000 = 3.6%
Formula for Real Interest Rate

RATE(NPER, PMT, PV, FV, TYPE, GUESS)
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If the first installment is to be paid immediately after the purchase, the effective rate of interest can be calculated by changing TYPE parameter to 1 from 0
The same can also be calculated as offering a loan of Rs. 9,500 and taking 9 installments as both are one and the same thing. See formula above.
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Alternative Way
If it is assumed that the seller is actually charging 4.5% rate of interest then, the present value of the payments for purchasing the product should be equal to the price of the product. This means the present value of Rs. 1,500 if discounted @ 4.5% should be equal to Rs. 11,000, and if it is not, then seller is charging a higher rate.
Deferred Annuities
Any income flow which is beginning from a future date, but whose amount is to be calculated now is called Deferred Annuities.
If the present value of the installments paid in more than the price of the product, it means that the seller is charging more than what he is claiming.
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Revised Example: What will be the amount available to an employee at the time of his retirement at the age of 60, if Rs. 11,000 is deducted annually one year from now when his age is 30 years?
Further
Now the company wants to know that if this employee is to be offered Rs. 2 lakh each year after retirement and his life expectancy is 75 years, it means the company has to pay Rs. 2 lakhs to the employee for 15 years because he will retire at the age of 60 years. The management of the company wants to know how much amount should be deducted from the employees salary so that the company may be able to meet out its obligation without incurring any cost. The rate of interest now is 9% and the rate is expected to drop down to 7%.
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This has to be done in TWO steps:

Step 1: Find out the present value of Rs. 2 lakhs that will be paid to him for 15 years. Step 2: Find out the amount to be deducted each year to arrive the required amount. This can be done as follows:
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Present Value of Uneven Cash Flows

When the cash flow is not uniform, it may be difficult to find out the present value or the future value manually. The Present Value of uneven cash flows can be calculated using the function NPV as follows:
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Future Value of Uneven Cash Flows

There is no in-build function to calculate the future value of uneven cash flows. but it can be done by first calculating the present value at time zero and then take the present value to future value. This can be done following the steps from the previous example as under:
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Solving for Yield in an Uneven Cash Flows

Yield refers to the net rate of interest that a person will receive. For Example: An insurance policy states that if Rs. 7,000 is paid to it every year for 16 years, the insurance company will return Rs. 20,000 at the end of 4th year, 8th year, 12th year, 16th year and in 25th year it will pay Rs. 2,00,000. What is the yield of the investment plan? It can be calculated with the help of function IRR:
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End of the Session
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Excel Application of Time Value of Money

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2/9/2012

Concept of Time Value of Money Excel Application of Time Value of Money

A rupee today is worth more than a rupee tomorrow

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Future Value of Money

Financial Management : Dr. M.S. Pahwa

Future Value of Money

Future Value of Money

Future Value Table

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Now i t will look like this

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Using Excel Formulas for Future Value

The Table is ready.

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Future Value of Annuity

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Future Value of Annuity

Financial Management : Dr. M.S. Pahwa

Understanding Future Value of Annuity

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Verifying Future Value of Annuity with Table 3

Future Value of Annuity using MS Excel

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Future Value of Annuity using MS Excel

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Present Value of Money

Present Value of Money

Financial Management : Dr. M.S. Pahwa

Present Value of Money

Present Value Table

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Apply the formula and press enter

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Using Excel Formulas for Present Value

The Table is ready.

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Present Value of Annuity

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Present Value of Annuity

Understanding Present Value of Annuity

Financial Management : Dr. M.S. Pahwa

Financial Management : Dr. M.S. Pahwa

Present Value of Annuity using MS Excel

Financial Management : Dr. M.S. Pahwa