Pr esent val ue Cal c ul at i ons

I nt r oduc t i on.
The following two decision criteria are used for investments:
NPV I

C
t
(1r)
t
0
Invest until the return on the investment is equal to the return in
financial markets.
The fundamental vaue of an asset is given by:
=price. PV

C
t
1r
t
1
Here we look at how to perform the calculations:
if there is only one cash flow involved, but this cash flow may occur
several periods into the future:
NPV I
C
(1r)
n 0
if there is more than one cash flow in the future:
NPV I
C
1r

C
(1r)
2
..
C
(1r)
n
clearly we can just calculate it as a sum of individual cash flows but we
will show how one can, under certain circumstances, use annuities to
simplify the calculations.
Calculate the return on investments if there are:
One future payment in n periods
Several payments in the future
2
Cal c ul at i on of pr esent and f ut ur e val ues of si ngl e c ash
f l ow s.
Below we show have to calculate present value for cash flows several
periods into the future.
Key assumption in all calculations:
Interest rates are the same in each period.
Fut ur e val ue.
How much will an initial amount grow to after n years at an interest of r%.
?
n 1 0 2 Time
Kr X
Consider the case of investing 100 for four years at a rate of 5%:
121.55 5.79 115.76 4
115.76 5.51 110.25 3
110.25 5.25 105 2
105 5 100 1
Amount at
then end
of the year
Interest
earned
Amount at
beginning of
the year
Year
Note:
It is assumed that the interest earned is reinvested in an asset earning
the same rate of return, i.e. here the interest earnings are reinvested at
5%.
3
In symbolic notation we have that the value after n years is:
X(1+r)
n-1
+rX(1+r)
n-1
=X(1+r)
n
rX(1+r)
n-1
X(1+r)
n-1
n
. . . .
X(1+r)
3
+rX(1+r)
3
=X(1+r)
4
rX(1+r)
3
X(1+r)
3
4
X(1+r)
2
+rX(1+r)
2
=X(1+r)
3
rX(1+r)
2
X(1+r)
2
3
X(1+r)+rX(1+r) =X(1+r)
2
rX(1+r) X(1+r) 2
X+rX =X(1+r) rX X 1
Amount at then end
of the year
Interest
earned
Amount at
beginning of
the year
Year
So the future value of X dollars compound n periods from now earning r% in
interest is:
FV X1 r
n
4
Example.
Consider the case where you can invest kr. 100 at 6% for five years.
Thus after 5 years you have 133.82. FV 1001.06
5
133.82
Excel function:
FV
Returns the future value of an investment based on periodic, constant payments and a constant
interest rate.
Syntax
FV(rate,nper,pmt,pv,type)
For a more complete description of the arguments in FV and for more information on annuity
functions, see PV.
Rate is the interest rate per period.
Nper is the total number of payment periods in an annuity.
Pmt is the payment made each period; it cannot change over the life of the annuity. Typically,
pmt contains principal and interest but no other fees or taxes. If pmt is omitted, you must include
the pv argument.
Pv is the present value, or the lump-sum amount that a series of future payments is worth right
now. If pv is omitted, it is assumed to be 0 (zero), and you must include the pmt argument.
Type is the number 0 or 1 and indicates when payments are due. If type is omitted, it is assumed
to be 0.
At the beginning of the period 1
At the end of the period 0
If payments are due Set type equal to
Remarks
Make sure that you are consistent about the units you use for specifying rate and nper. If
you make monthly payments on a four-year loan at 12 percent annual interest, use
12%/12 for rate and 4*12 for nper. If you make annual payments on the same loan, use
12% for rate and 4 for nper.
For all the arguments, cash you pay out, such as deposits to savings, is represented by
negative numbers; cash you receive, such as dividend checks, is represented by positive
numbers
5
Excel:
Method 1:
Formula in B4: FV(B3;B2;0;B1)
133.82 Future value 4
6% Interest rate 3
5 Number of periods 2
100 Amount of initial cash: 1
B A Row/columns
Notice the 0 for the amounts paid each period.
Notice that the initial amount is given by B1.
Method 2:
Formula B4: B1*(1+B3)^B2 5
133.82 Future value 4
6% Interest rate 3
5 Number of periods 2
100 Amount of initial cash: 1
B A Row/columns
6
Finding the interest rate or return.
Sometimes the future value, FV, and the initial value, X, is known and we
want to find the rate of return:
FV X1 r
n
1 r
n

FV
X
r
n
FV
X
1r
(
FV
X
)
1
n
1
Consider the case where we know that we receive 133,82 in five years time
from an investment of 100 today.
Formula in B4: (B3/B1)^(1/B2)
6% Interest rate 4
133.82 Future value 3
5 Number of periods 2
100 Amount of initial cash: 1
B A Row/columns
An alternative method is to use the spreadsheet function RATE.
7
RATE
Returns the interest rate per period of an annuity. RATE is calculated by iteration and can have
zero or more solutions. If the successive results of RATE do not converge to within 0.0000001
after 20 iterations, RATE returns the #NUM! error value.
Syntax
RATE(nper,pmt,pv,fv,type,guess)
For a complete description of the arguments nper, pmt, pv, fv, and type, see PV.
Nper is the total number of payment periods in an annuity.
Pmt is the payment made each period and cannot change over the life of the annuity. Typically,
pmt includes principal and interest but no other fees or taxes. If pmt is omitted, you must include
the fv argument.
Pv is the present value the total amount that a series of future payments is worth now.
Fv is the future value, or a cash balance you want to attain after the last payment is made. If fv is
omitted, it is assumed to be 0 (the future value of a loan, for example, is 0).
Type is the number 0 or 1 and indicates when payments are due.
At the beginning of the period 1
At the end of the period 0 or omitted
If payments are due Set type equal to
Guess is your guess for what the rate will be.
If you omit guess, it is assumed to be 10 percent.
If RATE does not converge, try different values for guess. RATE usually converges if
guess is between 0 and 1.
Remark
Make sure that you are consistent about the units you use for specifying guess and nper. If you
make monthly payments on a four-year loan at 12 percent annual interest, use 12%/12 for guess
and 4*12 for nper. If you make annual payments on the same loan, use 12% for guess and 4 for
nper.
8
Formula in B4: RATE(B2;0;B1;B3)
6% Interest rate 4
133.82 Future value 3
5 Number of periods 2
-100 Amount of initial cash: 1
B A Row/columns
Note that the second parameter is 0, i.e. there are no intermediate cash
flows.
Note that the initial cash flow is set to -100, i.e. a cash outflow, either
the initial cash inflow or the cash outflow should be coded as negative.
Finding the number of periods.
Recall that:
FV X1 r
n
FV X1 r
n
lnFV lnX n ln1 r
n
lnFV lnX
ln1 r

ln
(
FV
X
)
ln
(
1 r
)
Using the above figures we have:
Formula in B4: ln(B2/B1)/ln(1+B3)
5 Number of periods 4
6% Interest rate 3
133.82 Future value 2
100 Amount of initial cash: 1
B A Row/columns
Again one can alternatively use one of the build-in-functions:
9
NPER
Returns the number of periods for an investment based on periodic, constant payments and a
constant interest rate.
Syntax
NPER(rate, pmt, pv, fv, type)
For a more complete description of the arguments in NPER and for more information about
annuity functions, see PV.
Rate is the interest rate per period.
Pmt is the payment made each period; it cannot change over the life of the annuity. Typically,
pmt contains principal and interest but no other fees or taxes.
Pv is the present value, or the lump-sum amount that a series of future payments is worth right
now.
Fv is the future value, or a cash balance you want to attain after the last payment is made. If fv is
omitted, it is assumed to be 0 (the future value of a loan, for example, is 0).
Type is the number 0 or 1 and indicates when payments are due.
At the beginning of the period 1
At the end of the period 0 or omitted
If payments are due Set type equal to
Formula in B4: nper(B3;0;B1;B2)
5 Number of periods 4
6% Interest rate 3
133.82 Future value 2
-100 Amount of initial cash: 1
B A Row/columns
10
Pr esent val ue.
Definition of present value:
The present value of an amount due n years in the future is the amount
which, if it was on hand today, would grow to equal the future amount when
invested at the opportunity rate.
FV
n 1 0 2 Time
Kr ?
But future value is what X, in the FV value function, will grow to in n years
(compound periods), so by the above definition we have that X is the present
value. So:
FV PV1 r
n
PV
FV
1r
n
11
Let us calculate the present value of 100 received in four years time:
82.2703 86,3838/(1.05) 86.3838 1
86.3838 90,703/(1,05) 90.703 2
90.703 95,24/(1,05) 95.2381 3
95.2381 100/(1,05) 100 4
Amount at the
beginning of
the year
Discount
factor
Amount at end
of the year
Year
100
4
1
0 2
Time
3
95,24 90,70 86,38 82,27
PV at different times
Notice that 82,2703 1,05
4
100
FV/(1+r)
4
0
FV/(1+r)
4
(FV/(1+r)
3
)/(1+r) FV/(1+r)
3
1
FV/(1+r)
3
(FV/(1+r)
2
/(1+r) FV/(1+r)
2
2
FV/(1+r)
2
(FV/(1+r))/(1+r) FV/(1+r) 3
FV/(1+r) FV/(1+r) FV 4
Amount at the
beginning of the
year
Discount Amount at end of
the year
Year
12
Consider the case, as above, where we want to calculate the Present value
of 133.82 received in five years with an interest rate of 6%.
Formula in B4: (B1/(1+B2)^B3
100 Present value 4
5 Number of periods 3
6% Interest rate 2
133.82 Future value 1
B A Row/columns
Again we can also use the a build-in-function PV ( p dansk NV):
13
PV
Returns the present value of an investment. The present value is the total amount that a series of
future payments is worth now. For example, when you borrow money, the loan amount is the
present value to the lender.
Syntax
PV(rate,nper,pmt,fv,type)
Rate is the interest rate per period. For example, if you obtain an automobile loan at a 10 percent
annual interest rate and make monthly payments, your interest rate per month is 10%/12, or
0.83%. You would enter 10%/12, or 0.83%, or 0.0083, into the formula as the rate.
Nper is the total number of payment periods in an annuity. For example, if you get a four-year
car loan and make monthly payments, your loan has 4*12 (or 48) periods. You would enter 48
into the formula for nper.
Pmt is the payment made each period and cannot change over the life of the annuity. Typically,
pmt includes principal and interest but no other fees or taxes. For example, the monthly
payments on a $10,000, four-year car loan at 12 percent are $263.33. You would enter -263.33
into the formula as the pmt. If pmt is omitted, you must include the fv argument.
Fv is the future value, or a cash balance you want to attain after the last payment is made. If fv is
omitted, it is assumed to be 0 (the future value of a loan, for example, is 0). For example, if you
want to save $50,000 to pay for a special project in 18 years, then $50,000 is the future value.
You could then make a conservative guess at an interest rate and determine how much you must
save each month. If fv is omitted, you must include the pmt argument.
Type is the number 0 or 1 and indicates when payments are due.
At the beginning of the period 1
At the end of the period 0 or omitted
If payments are due Set type equal to
Formula in B4: PV(B2;B3;0;B1)
100 Present value 4
5 Number of periods 3
6% Interest rate 2
133.82 Future value 1
B A Row/columns
14
Mor e f r equent c ompound per i ods.
So far we have assumed that the returns are received once a year at the end
of the year. What happens if you receive interest more than once a year, e.g.
once a month. First some important terms:
Nominal interest rate:
This rate does not include compounding, for example a bank may state that
you earn 12% per annum paid monthly. This is equivalent to being paid 1%
per month, and it does not reflect the amount of interest earned over the
year!
Effective interest:
Is the rate that would have produced the future value under annual
compounding. In the above example the effective rate is:
(1.01)
12
-1 =12.68%
If you invest $1 at the beginning of the year and receive 1% per month in
interest which is reinvested at the rate of 1% per month then you have
1 +.1268 =1.1268 after one year.
Note that the effective interest rate is always at least as large as the nominal
interest rate since you earn interest on the interest during the year.
15
Example - semiannual compounding.
Nominal rate =5%
Earn 2.5% for half a year
After half a year you receive interest which is reinvested
"Period" refers to compound period
121.84 118.87x2.5=121.8404 118.87
118.87 115.97x2.5=2.899 115.97 4
115.97 113.41x2.5=2.8285 113.41
113.14 110.38x2.5=2.7595 110.38 3
110.38 107.69x2.5=2.6922 107.69
107.69 105.06x2.5=2.6265 105.06 2
105.06 102.5x2.5=2.5625 102.5
102.5 100x2.5 100 1
Amount at the
end of the
period
Interest earned Amount at the
beginning of
the year
Year
The future value from annual compounding is 121.55.
From above we have that the formula for the future value is:
r
nom
= Annual nominal interest rate
m =number of compound periods per year
n =number of years
FV PV 1
r
nom
m
nm
PV
FV
[
1
r
nom
m
]
nm
Note that is equal to the effective annual rate [
1
r
nom
m
]
m
1
From above we have:
100
(
1
0.6
2
)
42
121.8403
16
Cont i nuous Compoundi ng.
From above we have that the effective rate of interest is:
[
1
r
nom
m
]
m
1
where m is the number of compound periods. We can rewrite the expression
in the following way:
[
1
r
nom
m
]
m
rnom
r
nom
1
define then we have: w
m
r
nom
([
1
1
w
]
w
)
r
nom
1
Note that as m w .
Recall that e is defined as:
e
l
lim 1
1
l
l
2.71828
Letting m (and therefore w) go to infinity we get the effective annual rate with
continuous compounding:
w
lim
([
1
1
w
]
w
)
r
nom
1 e
r
nom
1
And the future present values with continuos compounding are:
FV PVe
nr
nom
PV FVe
nr
nom
17
Summar y.
Assumptions: All cash flows are reinvested at the rate r.
Pr esent and f ut ur e val ues of si ngl e c ash f l ow s.
Future value: FV X 1 r
n
Present value: PV
X
1r
N

FV
1r
n
Fr equent c ompound per i ods.
Key words: Nominal and effective interest rates.
Future value: FV X 1
r
nom
m

mn

Present value: PV
X
1
rnom
m

nm
Continuos compounding.
Effective annual rate: e
r
nom
Future value: PVe
r
nom
n
Present value: FVe
r
nom
n
18