2 FIN10002 Chapter1 2015 PDF

FINANCIAL
MATHEMATICS
Financial Mathematics
Swinburne University of Technology
page 2
Financial Statistics Notes
1. FINANCIAL MATHEMATICS
OBJECTIVES
On completion of this unit, using Microsoft Office Excel 2007 1 with the appropriate add-ons as
described below, students should be able to:
1. Calculate any one of Future Value (FV), Present Value (PV), interest rate (I) and number of
periods (N), given the values of the other three quantities for compound interest problems.
Distinguish between the nominal and effective rates of interest and calculate an effective rate of
interest equivalent to a stated nominal interest rate.
2. Calculate any one of PV, FV, I, N and PMT for annuity problems, ie problems using regular
payments, given appropriate numerical values of the other quantities.
3. Calculate the principal and interest components of any payment in a loan, determine the balance
of a loan after a payment has been made and calculate the total interest paid on a loan over any
given period.
4. Evaluate investment proposals using NPV and IRR methods.
Opening and preparing Microsoft Excel for data analysis

Step 1:
Opening
Microsoft
Excel.
To open EXCEL, click on the

icon, which appears in the Microsoft Office
icon bar on the right hand side of your screen.
Alternatively, if the icon bar is not displayed, click on the
select
followed
button and
by
and
The Microsoft Excel program will open, and a

spreadsheet will be displayed
While this textbook is written using Excel 2007 for Windows, if there are any major differences between it and
Excel 2010 or Excel for Macintosh computers, these will be announced on Blackboard.
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Step 2:
Checking
the
correct add-ins
are installed.
Press the
tab in the top left corner of the screen, which will bring up a
drop-down menu. Select and single-click the Excel Options tab at the below this
menu. This will bring up the dialog box shown below: click the Add-ins link in
the menu on the left side as shown.
To bring up a menu of possible add-ins, down the bottom of the resulting screen,
click Go.
Select the first two options: Analysis ToolPak and Analysis ToolPak - VBA as
shown below, then click OK.
If this has been done correctly, now whenever you click the
top of the Excel window, you should see an
tab at the
tab on the right of the screen.
Clicking on the
icon directly above it at any time will bring up the different
statistical data analysis options. You should usually only have to follow the above
process once for a given copy of Excel 2007 on a given computer. In subsequent
chapters of this text, we will see how to use these add-ins to help with statistical
data analysis.
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1.1.
Interest, Investments and Loans

Institutions or people who provide capital for businesses seek a return for the money lent. Similarly
when people borrow money they know there will be a cost involved. Interest is the return on investment
for the lender and a charge or cost for the borrower. It is really a measure of the time value of money, ie
the value to the lender of lending money over a period of time. Businesses often invest and borrow large
sums of money so the time value of money is an important consideration.
1.1.1.
Bonds and Debentures

Common types of investments involving simple interest are generally referred to as fixed interest
securities. A fixed interest security is an investment that pays a series of equal interest payments
(coupons) at predetermined regular intervals and repays the principal (face value of the investment) at
maturity. The money invested is secured by a document called either a bond or a debenture
Fixed interest investments include:
(i)
Commonwealth government bonds (1 to 10 years).
(ii)
Semi-government (state government) bonds.
(iii)
Finance company debentures.
(iv)
Bank term bonds.
Typically a minimum initial investment of $5,000 is required for government or semi-government bonds
and around $2,000 for debentures. Holders of bonds or debentures receive a fixed rate of interest over a
set period of time. The interest is generally paid twice yearly. The amount of interest payable is the
amount invested multiplied by the interest rate per period. The interest rate per period is the annual
interest rate divided by 2 when there are semi annual interest payments.
Example 1-1: A Fixed Interest Security
$100,000 Commonwealth Government Bond 8.00% p.a. semi annual 15 February, 2009.
Issuer
Commonwealth Government
Face Value
$100,000
Coupon Interest
8.00% p.a. semi annual interest
Maturity Date
15 February, 2009
Issue Date
15 February, 1999
An interest (coupon) payment of $4,000 (4% of $100,000) is made on 15 February and 15 August each
year. On maturity the face value of $100,000 and the last coupon payment is repaid to the holder of the
bond. As most government bonds are listed on the Australian Stock Exchange they can be bought and
sold through a stockbroker.
page 5
1.1.2.
Term Deposits
Financial institutions provide an investment called term deposits which offer higher interest rates than
ordinary saving deposits for cash investments. Term deposits guarantee a fixed rate of interest for any
period from one month to five years based on a specified minimum deposit. The interest calculated is
simple interest and is paid at the end of the investment period together with the original investment. For
longer investment periods and larger amounts invested the interest can be paid quarterly or monthly.
Term deposits now have a wider range of options such as compound interest, deferred interest payment,
annual interest payment and annual compound interest available to customers regarding the interest
earned.
As interest can now be calculated daily, with interest added daily to the original deposit, compound
interest (see section 1.2) is more relevant for term deposits than interest only.
1.1.3.
Personal Loans
The traditional personal loan was a simple interest loan. It was also called a flat rate loan as the interest
rate was fixed for the period of the loan, which generally ranged from two to five years.
To calculate the monthly repayments the interest due per year was multiplied by the number of years,
added to the amount borrowed and the total amount to be repaid was divided by the number of months in
the period of the loan.
As the monthly repayments remained the same for the life of the loan, the borrower had some degree of
certainty regarding repayments. However, this type of loan was more expensive than most borrowers
realised, as the repayments in simple interest loans have no effect on the amount of interest due. The
interest paid per year is a constant amount. It can be shown that the effective interest rate (the amount of
interest actually paid on a loan in a year) on a fixed rate loan is almost double the flat interest rate
quoted. Also there was very little to gain financially in repaying a flat rate personal loan prior to the
agreed date as the interest saved was generally less than expected because the conditions of the loan
often reduced the interest rate to be paid. In addition financial institutions generally applied a penalty to
compensate for their loss of interest by the early termination of the loan.
Even though there have been many changes to make personal loans more customer friendly in the last
ten to twenty years, applications for personal loans are less frequent than they used to be. For many
loans (up to $2,000 or even $5,000) banks may now suggest the use of credit cards rather than a personal
loan. This can be expensive borrowing. With few exceptions people borrow on the expectation that they
can repay the loan over a period of time. With credit card cash borrowing the interest is charged on a
daily basis with annual interest rates in excess of 15% p.a. There is also a compounding interest effect
for unpaid monthly balances.
A common type of small loan is a top up housing loan, ie the bank lends some extra money based on an
existing house mortgage. This is used by people who have an existing housing loan and are in need of
additional money for a new car, extensions to their house, a new boat, etc. This is the recommended
approach (even by banks) as interest rates for home loans are much lower than for personal loans.
Although personal loans are not so common today, they do still exist. Generally the level of the fixed
interest rate is determined by whether the loan is secured or unsecured and whether you choose a
variable rate or a fixed rate.
In late 2002 the National Bank of Australia had four categories of fixed rates ranging from 9.40% p.a. to
11.50% p.a. and four variable rates ranging from 8.25% p.a. to 13.00% p.a. The Commonwealth Bank
page 6
had a maximum annual percentage rate of 12.70% p.a. for personal loans. Most institutions charge fees
and administrative charges but there are generally no penalties for early repayment of loans.
1.1.4.
The Interest Rate per Period

The interest rate is usually quoted as a rate per annum (e.g. 10% p.a.). Interest rate for a period less than
a year can be calculated by dividing the annual interest rate by the number of periods that occur in the
year.
Interest rate per period =
annual interest rate

number of periods per year
Example 1-2
If 12% is the annual interest rate
(i)
What is the monthly rate?
(ii)
What is the quarterly rate?
Solution
(i)
(ii)
1.2.
Interest rate per month =
12%
12
= 1% per month
Interest rate per quarter =
12%
4
= 3% per quarter
Compound Interest
Most financial institutions now calculate the interest for savings and investments on the daily balance.
This usually means that the interest earned each day is added to the principal (ie the original investment).
A slightly higher amount of interest is then earned the next day on the principal plus the previous
interest. Interest is earned each compounding period on a new higher balance and so the interest for each
period increases.
This process is called compound interest. In some cases although the interest may be calculated on the
daily balance it is only compounded monthly or quarterly. In this topic we will assume that the period
used to calculate interest is the same as the compounding period.
1.2.1.
The Future Value of Investments

Example 1-3
$100,000 is invested at 4.25% p.a. compounded daily for 12 months. What would be the future value of
the investment at the end of the year?
The interest rate on a daily basis would be
4.25%
365
= 0.0116% per day.
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The example shown in Table 1.1 shows the daily interest paid increases from $11.64 per day to $12.15
over the 365 days because interest is earned each day on the investment plus the previous interest.
Table 1.1
Day 1
Day 2
Day 3
Investment = $100,000
Investment = $100,011.6438
Investment = $100,023.2890
Interest = 100,000 x 0.000116 = $11.6438

Interest = 100,011.6438 x 0.000116 = $11.6452
Interest = 100,023.2890 x 0.000116 = $11.6465
Day 10
Investment = $100,104.8433
Interest = 100,104.8433 x 0.000116 = $11.6560
Day 365
Investment = $104,329.1993
Interest = 104,329.1993 x 0.000116 = $12.1479
Future value of the investment
1.2.2.
= $104,329.20 + $12.15
= $104,341.35
Compound Interest Formula

There are many formulae for the various financial quantities. For example it can be shown that the future
value (FV) of a lump sum investment is given by:
FV = PV (1 + i ) n
PV
i
n
The present value (ie the amount invested or the cash outflow).
The interest rate per period
The number of periods.
In this subject however we will use the power of Microsoft Excel to perform these calculations so that
we can concentrate on the methods and applications of the financial problems.
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Using Microsoft Excel 2007 to solve

Example 1-3
Step 1:
Select the
appropriate cell.
Click on the cell of the spreadsheet where you want the answer to be
displayed. A black border should appear around the cell as shown below.
In this and subsequent examples, we will use cell A1 in the top left corner
of the spreadsheet, unless otherwise specified.
Note, however, that if you have already used the cell for a previous
financial calculation you need to either delete that result first or else use a
different cell of the spreadsheet.
Step 2:
Display
the
functions page Click the
and access list
of
financial
mathematics
functions.
button as shown below.
Scroll down to Financial and select it by clicking the mouse once.
(In future examples, we will assume the Financial functions are selected, but if
you cannot find the required function, you will need to do this again.)
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From the resulting list of financial maths functions given, scroll down to FV in
Step 3:
Using the FV this case, and then click OK.
function.
This will bring up the following dialog box.
page 10
Step 4:
Enter
Information.
In the Rate box, the interest rate is entered. This can be done in either of
two ways. First, we can enter the interest rate as a proportion; to do this we
would calculate 4.25 divided by 100 in this case, which gives 0.0425.
Alternatively, we can enter 4.25% with the percentage sign included; in
which case Excel will automatically convert it to a proportion as part of its
calculations. In the work that follows, we will always enter it in this second
way, with the percentage sign.
This value must then be divided by the number of compounding periods per
year (365 in this case since the interest is compounded daily). We therefore
enter 4.25%/ 365 into the Rate box, as shown below. (Notice that Excel
shows the actual value calculated for this interest rate on the right side of
the box).
In the Nper box, we type 1*365 in this case as total time is 1 year but this is
converted to days by multiplying by 365 so that the units here match the
units for how often the interest is compounded (daily).
Pmt is 0
Pv is -100000, the present value. This is negative as it is a cash outflow in
this case.
Type is 0 in this and all other examples in this text, as we will assume
payment occurs at the end of a payment period
Step 5:
Solve for FV.
Click OK
The future value should be $104,341.35
Example 1-4
What is the future value (accumulated sum) of $50,000 invested for five years at an interest rate of
6.75% p.a. compounded daily?
Note: Most investments are taxed on an annual basis. The effects of taxation on investment will not be
treated in this subject.
page 11
Solution.
Using Microsoft Excel 2007 to find the future value

Step 1:
Display the
Financial
functions menu.
Click the cell of the spreadsheet where you want you answer to appear (for
example, cell A1), ensuring first that you delete any value in that cell from
previous calculations if applicable.
Click the
button.
Step 2:
Using the FV
function.
Select FV from the drop-down menu to bring up the dialog box shown.
Step 3:
Enter
Information.
Enter the following information:
Step 4:
Solve for FV.
Rate is 6.75%/365 for the daily interest rate.

Nper is 5*365 for the total number of days.
Pmt is 0
Pv is -50000, the present value.
Type is 0
Click OK.
The future value would be $70,069.79
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1.2.3.
Nominal Interest Rate

When interest is compounded more than once a year, the stated annual interest rate is sometimes referred
to as the nominal interest rate. In Example 1-3 the nominal interest rate was 4.25% p.a. In other
situations such as credit cards the daily percentage rate may be quoted as 0.04178%. To obtain the
nominal rate (annual percentage rate) we would simply multiply the daily rate by 365 to obtain
15.25%p.a. Although investors seek the most favourable nominal rates they are generally more
concerned with effective interest rates.
1.2.4.
Effective Interest Rate

In Example 1-3 although the interest rate was 4.25% the total interest earned for the year on the
$100,000 investment was $4,341.35, which is 4.341%. This is called the effective interest rate. It is the
ratio of the actual interest earned for one year divided by the amount invested, and then converted to a
percentage
Effective Interest Rate (%) =
Compound Interest for a one year period

100
Principal
The effective rate is used for comparing different interest rates using different compounding periods.
Example 1-5
Calculate the effective interest rate if the nominal rate is 4.25% p.a. compounded daily.
Solution
Using Microsoft Excel 2007 to calculate the

effective interest rate, given the nominal rate and
compounding period.
Step 1:
Display
the
Financial
functions menu.
Step 2:
EFFECT
Function.
Select the cell of the spreadsheet in which you want the answer to appear,
ensuring you delete any previous answers. Click the
button.
Select EFFECT from the drop-down menu to bring up the dialog box
shown below.
page 13
Step 3:
Enter
Information.
Nominal_rate is 4.25%
Step 4:
Solve for the
effective
interest rate.
Click OK.
Npery is 365 because the interest being compounded daily means there are
365 compounding periods per year.
The effective interest rate is 0.043413 x 100 = 4.34%

Hint: If you have being doing a calculation involving a dollar amount in the same cell (for example,
calculation of a future value), you might find the answer at step 4 above appears as a dollar amount
which is clearly incorrect as an interest rate is a percentage! To prevent this happening, you can either
use a different cell in the spreadsheet, or before using the financial functions tab you can click the Home
tab
and then use the drop-down menu shown below to put Excel into General mode. Similarly, for all
financial calculations in Excel, you can do this if the answer is presented in a different format to the one
you require.
The compounding effect of the previous examples also applies to situations other than financial
investments such as:
(i)
House prices may average an annual growth rate of 10%.
(ii)
Population may be increasing at 1 % per annum.
(iii)
GDP may be growing at 2.5% per annum.
page 14
1.2.5.
The Present Value of an Investment

The Present Value (PV) of an investment is the amount that should be invested now (this is a cash
outflow and hence a negative value in Excel) to generate a future lump sum, given the interest rate per
annum, the compounding period and the term of the investment. It is typical of an investment strategy
for money that will hopefully grow into a larger amount to be used for future spending or for non-cash
investments such as property.
Example 1-6
(a)
How much would have to be invested now to accrue to $100,000 in 10 years if the interest rate
was 7.25% p.a. compounded daily?
Solution
a)
Using Microsoft Excel 2007 to calculate Present

Value of an Investment
Step 1:
Display
the
Financial
functions menu.
Step 2:
Using the PV
function
and
entering
information.
Click the cell of the spreadsheet where you want you answer to appear,
Step 3:
Solve for PV.
Click OK.
click the
button.
Select the PV option and enter the information in the resulting dialogue box
as shown below. Ensure that the Rate of 7.25% is divided by 365 and that
Nper is the number of years (10) multiplied by 365 since the interest is
compounded daily in this case.
The answer is $48,435.94; the negative sign indicates a cash outflow.

In practice interest rates would not stay fixed over a ten-year period unless it
was a special arrangement.
page 15
(b)
How much would have to be invested if interest was compounded on a monthly basis?
Solution
Step 1:
Select the PV
option.
Enter
Information.
Step 2:
Solve for PV.
Click the cell where you did the calculation for the previous example. In
this case, since we want to calculate the PV again and to use some of the
same information, do not delete your answer from this previous step. Click
the
button and the dialog box for calculating PV should open again.
Modify the information entered so that it is as shown below. Note that the
change is that in this case the Rate of 7.25% is divided by 12 and that Nper
is the number of years (10) multiplied by 12 since the interest is
compounded monthly in this case.
Click OK to find the Present Value.
The answer to PV changes to $48,538.22. Thus you need to invest $102.28

more to achieve the same goal if interest is compounded monthly instead of
daily.
1.2.6.
The Term of the Investment

In this situation PV, FV and i are known and it is desired to calculate how long (n) it will take the
investment to reach a target value. Although the interest on most investments is now compounded daily,
some problems will be presented where interest is compounded monthly or quarterly. In practice it
makes very little difference to the small investor.
Example 1-7
(a)
$18,000 is deposited in a credit union account at 5.05% compounded monthly, how long will it
take for the investment to reach $40,000?
page 16
Solution
Step 1:
Select
the
NPER option.
Enter
Information.
Step 2:
Solve for
NPER .
Select the appropriate cell (and delete any previous answer if applicable).
Click the
button, and in the resulting menu, select NPER. Enter the
information as shown below. Ensure that the Rate of 5.05% is divided by
12 since the interest is compounded monthly in this case.
Click OK.
The answer shown is 190.1434, but what units is this answer in? It is
actually in months in this case, because in the Rate box we entered the
monthly interest rate.
Step 3:
convert NPER
to years.
To convert the answer for NPER (190.1434 months) to years we need to

divide by 12.
We can do this calculation directly in Excel. For instance, if as shown
above, we calculated NPER in cell A1 we could use cell A2 (or any other
cell not yet used) to do this.
Click in cell A2. Type =a1/12
Press ENTER.
This tells us that it takes 15.85 years for the investment to reach $40,000.
Alternatively, we could have simply used our calculator to divide 190.14 by
12, also giving an answer of 15.85 years.
page 17
(b)
How long would it take if the interest was compounded on a daily basis?
Solution
Step 1:
Select
the
NPER option.
Enter
Information.
Step 2:
Solve for
NPER.
Click the
button, and in the resulting menu select NPER. Enter the
information as shown below. Note that in this case the Rate of 5.05%
is divided by 365 since the interest is compounded daily.
Click OK.
This answer is in days, so to convert to years, divide it by 365, which gives

15.81 years.
Thus it takes only ~ 0.04 years (~ 15 days) less time to reach the target sum when interest is
compounded on a daily basis compared to a monthly basis.
Hint: typing = and then an expression involving a cell reference (for example A1) will allow
you to do any basic calculations in Excel (for instance, converting between proportions and
percentages, or, as in this case, converting a time period into years).
If you want to change the number of decimal places given for an answer, you can highlight that
cell and click the
button to increase the number of decimal places and the
decrease the number of decimal places.
1.2.7.
button to
Doubling Time
The time required for an investment to double or treble is a special case of calculating the term of an
investment. In the case where we wish to double the investment it is not necessary to know the initial PV
of the investment.
If PV = 1 then when FV = 2 the investment has doubled. That is, for the investment to double the ratio
of FV to PV will be always be 2; similarly for trebling the ratio of FV to PV will be 3.
page 18
Example 1-8
If the interest on a current investment is compounded quarterly
(a)
Calculate the time for the investment to double if the interest rate is 6.78% p.a.
(b)
Determine also the trebling time.
Solution
(a)
Using Microsoft Excel 2007 to determine the time

required for an investment to double.
Step 1:
Select
the
NPER option.
Enter
Information.
Click the
button, and in the resulting menu, select NPER.
Enter the information as shown in box below.
Note that Rate is 6.78%/4 since interest is compounded quarterly.

Step 2:
Solve for
NPER.
Click OK to find the period of the investment.
The answer is 41.24 quarters. Dividing the result by 4 (either on your

calculator, or using a different cell of the spreadsheet), this is equivalent to
10.31 years.
page 19
Solution
(b)
Using Microsoft Excel 2007 to determine the time

required for an investment to treble.
Step 1:
Select
the
NPER option.
Enter
Information.
Because we will be using the same function and some of the same values as
in (a), do not delete the answer from (a) that you initially obtained using
NPER. Select the same cell in your spreadsheet and click the
button,
which should automatically bring up the dialog box for NPER that you
were working with before. Enter the values as below (so that the only
change from (a) is that Fv should now be 3).
Click OK
Step 2:
Solve for
NPER.
The answer is 65.36 quarters; dividing this result by 4 gives a final answer
of 16.34 years.
Answer:
10.31 years to double; 16.34 years to treble in value.
(Extra question: without using Excel, how long will it take for the investment to quadruple?)
1.2.8.
Interest Rates
Example 1-9
$5,000 was invested 10 years ago. The interest was compounded quarterly and the investment is now
worth $12,000.
(a) What is the interest rate per quarter?
(b) What is the interest rate per year?
(c) What is the effective interest rate per year?
page 20
Solution
a)
Using Microsoft Excel 2007 to find the interest rate

per year
Step 1:
Select the
RATE option.
Enter
Information.
Select the appropriate cell (A1 in this demonstration), click the

and in the resulting menu, select RATE.
Enter the information as shown below. Do NOT click OK yet!
button,
Notice that on the right side of the box is a bar with arrows at each end
(whereas this has not appeared in any other examples we did earlier). When
you see this, it means you need to scroll down further by clicking the down
arrow
at the bottom of this bar, to enter further information.
In this case, scrolling down we can see that we also need to fill out a Guess
box. Guess is an estimate of the interest rate; the default value in Excel is
to enter 0.1 (or 10%), which will usually give the correct answer. For all
examples in this subject, enter 0.1 unless we specify otherwise.
Step 2:
Solve for
RATE.
Click OK.
The answer is 2.21% per quarter.

Hint: In practice, it will be always be clear if a guess of 0.1 is not going to work, as in such cases the
Excel output will not give a numerical answer at all: it will instead say
need to try a different guess to estimate the interest rate (for example, 0).
, indicating that you
page 21
b) Annual interest rate is the interest rate per quarter multiplied by 4. Multiply 2.21% by 4, giving an
annual interest rate of 8.84%.
c)
Using Microsoft Excel 2007 to calculate the

effective interest rate.
Select a cell that you did not use for calculation of your answers to (a) or
Step 1:
Select the
EFFECT
option.
Enter
Information.
Step 2:
Solve
EFFECT.
(b)- in this demonstration. Click the

button, and in the resulting menu,
select EFFECT. Enter the values as shown below.
Here we are entering the annual rate of 8.84% in the Nominal_rate box.
Click OK.
for
The effective interest rate is 0.0914*100 = 9.14% per annum.
Reminder: As we saw in Example 1-3 the effective interest rate is the actual interest earned per annum
when interest is compounded more than once per year.
Compounding periods.
Traditionally these used to be annually, quarterly or monthly. More recently the banks have introduced
shorter periods such as fortnightly, to fit in with pay periods, and daily, especially for repaying
mortgages. The latter has had a considerable impact on the length of mortgages by more quickly
reducing the outstanding balance compared with less frequent compounding periods.
DO EXERCISE SET 1A ON PAGE 59
1.3.
Annuities
Annuities involve a cash outflow (PV) at the beginning of a time period or a cash inflow (FV) at the end
of a time period. The difference between compound interest and annuities is that an annuity involves a
regular sequence of payments (PMT) made at equal intervals of time and usually equal amounts.
Problems involving annuities link the sequence of payments with either a present value (cash outflow) or
a future value (cash inflow) but not both at the same time.
page 22
1.3.1.
Investments
Annuity style investments have applications in determining the future value or final balance in
superannuation and sinking fund type problems. In calculating the future value of an annuity there is an
option of whether the payment is made at the beginning or end of each particular time period. For
consistency in this course we assume the payment is made at the end of the time period. To ensure that
this happens when using the financial functions on Microsoft Excel, make sure that Type is always
specified as 0.
1.3.2.
The Future Value of an Investment

Consider the following 5 year investment plan:
A person decides to save $100 per week for 50 weeks each year for the next 5 years. The savings are
kept in shoe boxes at home and a formal investment is made at the end of each year when he has saved
$5,000.
At the end of the first year $5,000 is invested at a fixed rate of 6.5% p.a. for the remaining four years of
his plan. Interest is compounded on an annual basis. At the end of the four years the $5,000 will be
worth $6,432.33.
The plan is maintained for year 2. Another $5,000 is invested for the remaining three years of his plan at
6.5% p.a. compounded yearly. At the end of the three years this $5,000 will be worth $6,039.75.
The $5,000 saved during year 3 is invested for two years and will be worth $5,671.13.
The $5,000 saved during year 4 is invested for one year and will be worth $5,325.00.
There would be no time to invest the $5,000 saved during year 5. It would be worth $5,000.
At the end of the five year plan the total investment ie the future value of the investment plan would be:
$6,432.33 + $6,039.75 + $5,671.13 + $5,325.00 + $5,000 = $28,468.20
There would be a cash inflow of $28,468.20 to the investor. The future value of this investment plan is a
typical calculation of the future value of an annuity problem.
We have thus answered the question: What is the future value of payments of $5,000 per year for 5
years at 6.5% p.a. compounded yearly with the first payment being made at the end of the first year?
For the solution to this problem using Microsoft Excel, see Example 1-10 below.
page 23
Example 1-10
What is the future value of yearly payments of $5,000 for 5 years at 6.5%, compounded yearly?
Using Microsoft Excel 2007 to calculate annuities.

Step 1:
Select the FV
option,
enter
information.
Step 2:
Solve for FV.
Click the
button, and in the resulting menu select FV. Enter the
information as shown below.
Click OK to find the future value.
The answer is $28,468.20.
page 24
Example 1-11
Suppose the savings plan in Example 1-10 was modified slightly. If each month $416.67 was deposited
in an investment account for five years at an annual interest rate of 6.5% p.a. compounded monthly,
what will be the balance at the end of the five years?
(Note: $416.67 per month = $5,000 per year)
Step 1:
Select the FV
option,
enter
information.
Step 2:
Solve for FV.
Click the
button, and in the resulting menu, select FV. Enter the
Click OK to find the future value.
The answer is $29,447.72
page 25
Example 1-11 is slightly greater than the FV in Example 1-10. This is due to the fact that interest is
earned from the first month instead of the first year and since there are 12 compounding periods in the
year the effective rate of interest is more than the 6.5% p.a. of Example 1-10. (Verify that it is 6.70%.)
page 26
1.3.3.
The Payment per Period for an Investment

Example 1-12
How much money do you have to deposit at the end of each month to reach a target sum of $250,000 in
20 years, when the annual interest rate is 8.25% p.a. compounded monthly?
Solution
Step 1:
Select the PMT
option,
enter
information.
Step 2:
Solve for PMT.
Click the
button, and in the resulting menu, select PMT.
Enter the information as shown. Ensure that 0 is entered for Type.
Click OK.
The answer is $411.41 (Excel shows 411.41).
1.3.4.
The Number of Payments for an Investment

Example 1-13
How long would it take for monthly investments of $400 to reach a sum of $200,000 if the interest rate
remained fixed at 9.25% p.a. compounded monthly?
page 27
Solution
Step 1:
Select
the
NPER option,
enter
information.
Step 2:
Solve
NPER.
Click the
Enter the information as shown.
Click OK to find the length of the payment.

for
The answer is 205.74 months, which is equivalent to 17.15 years.
1.3.5.
The Interest Rate per Period for an Investment

Example 1-14
A payment of $3,000 per month was made into a superannuation fund. At the end of 4 years the
accumulated sum was $180,000. If the interest was compounded monthly
(a)
What was the interest rate per month?
(b)
What was the nominal interest rate?
(c)
What was the effective interest rate?
page 28
Solution
(a)
Interest rate per month
Step 1:
Click the
button, and in the resulting menu, select RATE
Select
the
For
NPer,
enter
4*12, then scroll down and enter the remaining
RATE option,
information
as
shown
below.
enter
information.
Step 2:
Solve for
RATE.
Click OK to find the monthly interest rate.
The answer given for the monthly interest rate is 1%. Here Excel has
rounded the answer to the nearest whole number. To get the answer
correct to two decimal places, click the
accurate answer of 0.92%.
(b)
tab twice to get a more
The nominal interest rate is 0.92 multiplied by 12 which is 11.04% per annum.
page 29
(c)
The effective interest rate
Step 1:
Click the
button, and in the resulting menu, select EFFECT. Enter
Select
the
EFFECT
option,
enter
information.
Step 2:
Solve
EFFECT.
Click OK.
for
The answer is 0.1162* 100 = 11.62% per annum.
1.3.6.
Endowments and Allocated Pensions

Endowments and allocated pensions are situations where a lump sum is invested to provide a series of
future payments. It is important to realise that we are concerned with the investment of a lump sum now
that will generate a future sequence of payments. It is a cash outflow now, ie (ie means that is) it is the
present value of a lump sum that generates the sequence of future payments. As such it is an application
of the present value of an annuity.
1.3.7.
The Present Value of an Endowment

Example 1-15
Your grandfather has promised to give you $2,000 at the end of each year of your three-year degree (He
knows that you will complete your degree on time). He wishes to invest a lump sum now (at the
beginning of your studies) to pay for this future sequence of payments.
If the interest rate is 5% p.a. compounded yearly he will need to invest $1,904.76 at the start of your
studies so that he can give you $2,000 at the end of the first year.
2000 FV
5 I
1 N
P/Y = C/Y=1
PV = -1904.76
He will need to invest a further $1,814.06 at the start of your studies so that he can give you $2,000 at
the end of the second year.
page 30
Change N to 2
Then PV = -1814.06
He will need to invest $1,727.68 at the start of your studies so that he can give you $2,000 at the end of
the third year.
Change N to 3
Then PV = -1727.68
Grandfather will need to invest a total of $5,446.50 = ($1,904.76 + $1,814.06 + $1,727.68) at the start of
your studies to be able to make the three future annual payments of $2,000.
The planning for this endowment is really calculating the Present Value of an annuity. We have
answered the question What is the present value (ie how much does the grandfather have to invest now)
of the endowments of $2,000 at the end of each year for the next three years?
Solution
Step 1:
Select the PV
option,
enter
information.
Step 2:
Solve for PV.
Click the
button, and in the resulting menu, select PV
Click OK to find the Present Value.
The answer is $5,446.50.
1.3.8.
The Number of Payments in an Allocated Pension

Example 1-16
A retiree has $300,000 to invest in an allocated pension. He wishes to receive a monthly payment of
$3,000. The fund is paying 6.0% p.a. compounded monthly. How long will the $300,000 last?
The lump sum of $300,000 invested now earns interest at the rate of 0.5% per month. The interest for the
first month would be $1,800 (0.5% of $300,000). As the interest is not sufficient to meet the monthly
payment of $3,000 the extra $1200 would be subtracted from the investment leaving $298,800. Interest
page 31
would be earned on $298,800 for the next month. This procedure continues until there is nothing left in
the investment fund. How long before the money runs out?
When the payments are calculated we assume that the interest rate remains unchanged during the term of
the pension. If the interest rate changes the term (ie length) of the loan would also change.
Solution
Step 1:
Select
the
NPER option,
enter
information.
Step 2:
Solve
NPER.
Click the
button, and in the resulting menu, select NPER
Enter the information as shown. PMT is positive, PV negative.
Click OK to find the term of the investment.

for
The answer is 138.98 months which is equivalent to 11.58 years.
1.3.9.
Repayments of Loans and Mortgages

The main application of the present value of an annuity is with interest-adjusted loans such as housing
loans. In this situation the present value is known as in Example 1-16 however it is money borrowed
rather than money invested. The interest rate and the term of the loan are negotiated and then used to
calculate the amount of the periodic repayment.
Unlike Example 1-16 the repayments are greater than the interest owed. Part of each repayment meets
the interest due with the balance of the repayment reducing the amount owed (the principal).
Note: When the payments are first calculated it is assumed that the interest rate remains unchanged
during the term of the loan. When the interest rate changes the payments and/or the term of the loan also
change.
Example 1-17
A home mortgage of $100,000 was obtained from a bank. The loan was for 25 years at 7.80% p.a.,
compounded monthly.
(a)
What are the monthly repayments?
(b)
What would be the total amount repaid?
(c)
How much interest was paid over the term of the loan?
page 32
Solution
(a) To find the monthly repayments
Step 1:
Click the
Select the PMT
option,
enter
information.
Step 2:
Solve for PMT.
Click OK to find the payment.
The answer is $758.61.

(b) Total amount repaid:
The number of payments made is 12 (monthly payments) over 25 years which results in 300
payments. Each payment is $758.61. Therefore, multiplying $758.61 by 300 results in a total
payment of $227,583
(c) How much of the total repaid is interest?
Having borrowed 100,000 we need to subtract this from the total payment to obtain the interest paid.
227583 - 100000 gives a result of $127,583
It is interesting to note that $100,000 is borrowed but $227,583 is repaid. That is why we own small
houses and banks have large buildings!
Reducing the Number of Repayments in a Loan

The previous example indicated that the amount of interest that is actually paid on a long term loan is
quite large compared to the amount borrowed. Many banks and financial advisers advertise that they
have strategies to substantially reduce both the amount of interest paid and the duration of the loan. In
most cases the plan is simply to pay an additional amount above the calculated repayment. The extra
amount is paid directly off the principal, thereby reducing the number of repayments and hence the total
interest paid.
Example 1-18
In Example 1-17 the monthly repayment was calculated to be $758.61 per month. Suppose that the
borrower decided to repay an extra $100 per month. What difference would this make to the duration of
the loan and the amount of interest paid?
page 33
Solution
New duration of the loan.
Step 1:
Click the
Select
the
NPER option,
Enter the information as shown.
enter
information.
Step 2:
Solve for
NPER.
Click OK.
The new duration of the loan is 218.38 months.

Step 3:
Calculate
number of
years.
In Excel or on your calculator, convert the number of months to years.

218.38 12 = 18.20 years.
Reduction in interest paid.

Calculate 218.38 858.61 = 187,503.25. This is the total amount repaid when payments are $858.61 per
month.
Now subtract the new amount repaid from the original amount repaid.
227,583 187,503 = $40,080 has been saved by increasing the repayments by $100 per month
Paying an extra $100 a week shortens the duration of the loan by 6.8 years and reduces the interest
payable by over $40,000!
The above example highlights the changes that occur when one of the loan variables changes. In recent
years interest rates on loans have decreased and borrowers have had the benefit of lower repayments, or
the ability to borrow larger sums of money.
As illustrated above it may be wiser to maintain the same repayment when interest rates fall. This would
mean that additional money is repaid off the loan with the result that even more would be saved on
interest payments.
Conversely if interest rates rise this can cause great hardship with borrowers. In some cases the original
repayments may not cover the interest due. When this happens the size of the debt will actually increase.
In the past many people have lost homes and properties in times of rising interest rates.
page 34
1.3.10. Highest Affordable Cost (Present Value of a Loan)

Financial institutions incurred many bad debts in the 1980's due mainly to excessive borrowing by firms
and individuals coupled with rising interest rates. Borrowers were often unable to service their debt.
Today financial institutions seem to be more diligent in their assessment of the borrower's ability to
repay the loan. Companies have to satisfy the lender that their cash flows and profitability would be
more than adequate to meet periodic repayments. Individuals have to provide a financial summary of
income, expenditure and existing debt before a loan is approved.
In housing finance, the maximum amount that can be borrowed is generally constrained by the condition
that repayments cannot be more than 30% of gross income. Once the maximum repayment is determined
the highest affordable cost (ie the largest possible loan) is then a function of the interest rates and the
term of the loan. That is the calculation of highest affordable cost is simply calculating the present value
of an annuity.
Example 1-19
A couple are in the market for a housing loan but are unsure how much they could borrow. Their
combined income is approximately $93,600 per year. They want a 15-year loan with fortnightly
repayments. The current rate of interest on housing loans is 6.7% p.a.
(a)
How much can they borrow?
Solution
Step 1:
Click the
button, and in the resulting menu, select PV.
Select the PV
Enter
the
information
as shown.
option,
enter
information.
Note that Rate is 15 years 26 fortnightly payments.
Pmt is -.39360026 (.3 as payment is limited to 30% of income), which
is fortnightly payments of $1080.
Step 2:
Solve for PV.
Click OK to find the amount that can be borrowed.
The answer is $265,495.
page 35
(b) As $265,495 is more than the couple had in mind what are the repayments if only
is borrowed?
Step 1:
Select the PMT
option,
enter
information.
Step 2:
Solve for PMT.
Click the
$200,000
Change the PV to 200000.
Click OK.
The repayments are $813.57 per fortnight.
1.3.11. Calculating the Interest Rate of a Loan

There do not appear to be many meaningful problems where it is necessary to calculate the interest rate
of a loan. The important questions are generally how much can be borrowed, how much are the
repayments and how long will it take to repay the loan. Of course interest rate variations affect all of the
above questions.
One of the problems with variable interest is that if interest rates are rising over time a situation is often
reached where borrowers are no longer able to repay a loan. A cautious borrower may be concerned
about how high interest rates would need to rise before he was unable to meet the repayments.
Example 1-20
Loan repayments on a $120,000 mortgage taken over 20 years at 6.78% p.a. compounded monthly
would be $914.58. Suppose the borrower is very concerned about the possibility of rising interest rates.
He knows that the maximum repayment he could afford is $1200 per month. What would be the rate of
interest charged if repayments were $1200 per month?
page 36
Solution
Step 1:
Select the
RATE option,
enter
information.
Step 2:
Solve for
RATE.
Click the
button, and in the resulting menu, select RATE.
For N type in 20*12 as shown since the loan is over 20 years and the
payments are monthly.
Then scroll down and enter the remaining information as shown.
Click OK followed by the

two decimal places.
button twice so that the answer is correct to
The monthly interest rate is 0.88%; multiplying this by 12 gives a

nominal annual interest rate of 10.56%.
The borrower was assured by the lenders that if he did proceed with the loan and interest rates rose then
the amount outstanding could be renegotiated as a different loan with different repayment terms.
To better understand the concept of mortgage repayments we need to examine more fully the operational
sequence in repaying a loan.
1.4.
Amortisation
When a loan is repaid by a sequence of equal periodic repayments each repayment can be split up into
the amount of interest due plus the amount repaid on the loan (principal). At each repayment the balance
owing on the loan can also be calculated.
Example 1-21
A loan of $100,000 is negotiated for 3 years at 9% p.a. compounded monthly.
(a)
Calculate the monthly repayments.
(b)
How much interest and principal are paid with the 10th repayment?
(c)
How much is still owed after the 10th repayment?
(d)
How much interest and principal have been paid during the first year?
(e)
How much interest and principal have been paid during the second year?
(f)
How much interest and principal have been paid during the third year?
(g)
How much interest and principal have been paid over the three years of the loan?
page 37
(h)
After the first year it is possible to increase the monthly repayment to $4,000. If this is
done how long will it now take to repay the loan and how much interest will be saved?
Solution
a) Monthly repayments
Step 1:
Click on cell A1 in your Excel spreadsheet. Click the
button, and in
Select the PMT
the
resulting
menu,
select
PMT.
Enter
the
information
as
shown
below.
option.
Enter
Information.
Step 2:
Solve for PMT.
Click OK to find the repayment amount.
The answer is $3179.97 per month.
page 38
(b) How much interest and principal are paid with the 10th repayment?
(c) How much is still owed after the 10th repayment?
Table 1.2
Payment
No
Loan ($)
Repayments
($)
Interest ($)
Principal
($)
Balance ($)
3,179.97
750.00
2,429.97
97,570.03
100,000.0
0
97,570.03
3,179.97
731.78
2,448.19
95,121.84
95,121.84
3,179.97
713.41
2,466.56
92,655.28
92,655.28
3,179.97
694.91
2,485.06
90,170.22
90,170.22
3,179.97
676.28
2,503.69
87,666.53
87,666.53
3,179.97
657.50
2,522.47
85,144.06
85,144.06
3,179.97,
638.58
2,541.39
82,602.67
82,602.67
3,179.97
619.52
2,560.45
80,042.22
80,042.22
3,179.97
600.32
2,579.65
77,462.57
10
77,462.57
3.179.97
580.97
2,599.00
74,863.57
11
74,863.57
3,179.97
561.48
2,618.549
72,245.08
12
72,245.08
3,179.97
541.84
2,638.13
69,606.95
38,159.68
7,766.59
30,393.05
TOTAL
Note: In the Table 1.2 all calculations were carried out using an accuracy of 2 decimal places. It is
possible that students may obtain slightly different answers if working with a different number of
decimal places due to rounding errors. Note that in this table the Repayment value of $3,179.97 is exact
as actual payments must be a whole number of cents. However all other quantities are the result of
rounding to two decimal places and so in general are not exact. The totals are the totals of the rounded
values. Hence the sum of the interest and principal totals is not exactly the sum of the payments.
Repeating this calculation using Excels financial functions may also lead to slightly different values.
Interest is calculated at the rate of 0.75% per month. At the end of each month the interest component is
subtracted from the repayment and the remainder reduces the principal, as in Table 1.2.
Notice how the amount of interest decreases each month accompanied by a corresponding increase in
the amount of principal repaid. At the beginning of each month there is a new balance, which attracts
interest at 0.75% per month and so the cycle continues until the loan has been repaid in full over the 36
months.
The 10th payment of $3,179.97 is split into $580.97 as interest, $2,599.00 as principal repaid and leaves
an outstanding balance of $74,863.57.
page 39
b) How much interest is repaid with the 10th payment?
Using Microsoft Excel

accumulated interest
Step 1:
Selecting
the
CUMIPMT
function,
entering
information.
2007
to
calculate
Select cell A2. Click the Formulas tab, and in the Financial functions
menu, select CUMIPMT. Enter information as shown below. This
function calculates the accumulated interest within a specified period. Since
we are interested in the interest repaid in the 10th payment then we need to
enter 10 as both the Start_period and the End_period in this case. Do
NOT click OK yet!
Notice that on the right side of the box is a bar with arrows at each end.
Therefore, you need to scroll down further by clicking the down arrow
the bottom of this bar, to enter further information.
at
In this case, scrolling down we can se we also need to fill out the Type box,
which, as usual is 0 here since as always, we are assuming payments occur
at the end of each period.
Step 2:
Solve
for
CUMIPMT.
Press OK.
The answer is $580.97.
page 40
How much principal is repaid with the 10th payment?
Using Microsoft Excel 2007 to calculate the amount

of principal repaid.
Step 1:
Selecting
the
CUMPRINC
function,
entering
information.
Step 2:
Solve for
CUMPRINC.
Select cell A3 of your spreadsheet. Click the

CUMPRINC option.
button and select the
Enter 9%/12 for the Rate, then scroll down using the arrow
to enter the
other values as shown. This function calculates the accumulated principal
within a specified period. Since we are interested in the principal repaid in
the 10th payment then we need to enter both the start and end period as 10,
as shown
Click OK
The answer is $2,599.00
page 41
c) How much is still owing after the 10th payment? (This is asking for the BALANCE)
Using Microsoft Excel 2007 to calculate the balance

owing.
Step 1:
Selecting
the
CUMPRINC
function,
entering
information.
There is no function in Excel to calculate this directly. Therefore we need

to calculate the amount of principal that has been paid in total across the
first 10 payment periods and then subtract this amount from the present
value, as this will tell us how much of the initial money borrowed is still
owing.
Select cell A4 of your spreadsheet. Click the
CUMPRINC option.
Enter 9%/12 for the Rate, then scroll down to enter the other values as
shown. Since we are interested in the total principal repaid in the first 10
payments, we need to enter the start period as 1 and the end period as 10, as
shown.
Step 2:
Finding
the
balance owing.
Click OK.
The total principal repaid after the first 10 payments is $25,136.47.

Therefore, since the PV was $100,000, the amount that is still owing after
the 10th payment is $100,000 - $25,136.47, which is equal to $74,863.53.
(d) How much interest and principal have been paid during the first year?
For investments that are financed by loans the interest paid is a tax deduction and investors may wish to
determine the accumulated interest paid over a period of time. From Table 1.2 the sum of the
repayments in the first year is $38,159.68 of which $7,766.59 is the total interest paid in the first year
with the remaining $30,393.05 being deducted from the amount borrowed.
page 42
Step 1:
Selecting
the
CUMIPMT
function,
entering
information.
Step 2:
CUMIPMT
function.
Select a cell in your spreadsheet, click the

CUMIPMT option. Enter 9%/12 for the Rate, then scroll down to enter
the other values as shown. Since we are interested in the total interest
repaid in the first year, and there are twelve repayments during the first
year, we need to enter the start period as 1 and the end period as 12, as
shown.
Click OK.
The interest paid during the first year is $7,766.58. (Note that this value
differs by $0.01 from that calculated using Table 1.2 previously; small
differences in answers like this are the result of rounding off during
calculations and are not of concern here.)
Step 1:
Selecting
the
CUMPRINC
function,
entering
information.
Step 2:
CUMPRINC
function.

CUMPRINC option. Enter 9%/12 for the Rate, then scroll down to enter
the other values as shown. Since we are interested in the total principal
repaid in the first year, we need to enter the start period as 1 and the end
period as 12, as shown.
Click OK.
The principal repaid in the first year is $30,393.10.
page 43
(e) How much interest and principal have been paid during the second year?
Step 1:
Selecting
the
CUMIPMT
function,
entering
information.
Step 2:
CUMIPMT
function.

the other values as shown. There are twelve repayments during the second
year - from payments 13 to 24. Therefore we enter the start period as 13and
the end period as 24.
Click OK.
The interest paid during the second year is $4,915.50.

Hint: since we used the CUMIPMT command previously with the same values except for the start
period and end period, to save time, if you use the same cell for this example without pressing delete
first, it will bring up the values from the previous step so that you only have to change the start period
and end period values in this case.
Step 1:
Selecting
the
CUMPRINC
function,
entering
information.
Step 2:
CUMPRINC
function.

the other values as shown.
Click OK.
The principal repaid in the second year is $33,244.18.
page 44
(f) How much interest and principal have been paid during the third year?
Step 1:
Selecting
the
CUMIPMT
function,
entering
information.
Step 2:
CUMIPMT
function.

the other values as shown. There are twelve repayments during the third
year - from payments 25 to 36. Therefore we enter the start period as 25and
the end period as 36.
Click OK.
The interest paid during the third year is $1,796.96.

Step 1:
Selecting
the
CUMPRINC
function,
entering
information.
Step 2:
CUMPRINC
function.

CUMPRINC option. Enter the values as shown.
Click OK.
The principal repaid in the third and final year is $36,362.72.
page 45
(g) How much interest and principal have been paid over the three years of the loan?
Step 1:
Selecting
the
CUMIPMT
function,
entering
information.
Step 2:
CUMIPMT
function.

the other values as shown. There are thirty six repayments during the
entire loan period - from payments 1 to 36. Therefore we enter the start
period as 1 and the end period as 36.
Click OK.
The interest paid during the loan period is $14,479.04.

Step 1:
Selecting
the
CUMPRINC
function,
entering
information.
Step 2:
CUMPRINC
function.

the other values as shown.
Click OK.
The total principal repaid during the term of the loan is $100,000, which is
to be expected as that was the amount borrowed.
(h) After the first year it is possible to increase the monthly repayment to $4,000. If this is done
how long will it now take to repay the loan and how much interest will be saved?
The interest saved can be calculated as the difference between the total payment under the original terms
and the total payment under the revised terms.
page 46
Step 1:
Select
the
NPER option,
enter
information.
Step 2:
Solve for
NPER.

button and select the NPER
option. Enter the information as shown.
From (d) the principal outstanding after one year is $100,000 - $30,393.10
= $69,606.90. Enter this amount as the Pv.
Enter 4000 (the new monthly repayment) as the Pmt.
Click OK.
The new number of repayments is 18.72, ie the time taken to repay the rest
of the loan is 18.72 months.
Step 3:
The interest saved can be calculated as the difference between the total payment under the original terms
and the total payment under the revised terms.
Original terms: total payment = 363,179.97 = 114,478.92.
Revised terms: total payment = 123,179.97 + 18.724,000 = 113,039.64.
Interest saved =
114,478.92 - 113,039.64 = 1,439.28 ie $1,439.28.
DO EXERCISE SET 1B ON PAGE 60
1.5.
Discounted Cash Flow Analysis

Capital budgeting, which involves planning and financing capital investments, is an important area of
managerial decision making. Some accounting methods such as pay back period and return on average
investment ignore the time value of money by failing to take account of cash flows generated by a
project over its expected life. Consequently most capital budgeting methods use discounted cash flow
analysis to evaluate the return from an investment with reference to profit objectives of the firm. To
determine the return on an investment we need to compare the present value of the initial investment
(cash outflow) with future cash inflows. It is a similar situation to annuities - dollars today are different
in value to dollars in the future because of the time value of money. The cash flows, which may be
debits or credits, can occur on a periodic basis. The basic time period for capital investments is generally
the financial year.
1.5.1.
The Cost of Capital

Future cash flows are discounted to present values by using an appropriate discount rate similar to an
interest rate. This discount rate is called the cost of capital. Other synonyms are the hurdle rate, the cut
off rate, the required rate and the target rate. In simple terms the cost of capital is the firm's cost of
obtaining funds. It is predetermined by management and takes into account the returns expected by
page 47
investors and the risk inherent in any project. It is a minimum rate that investors must earn in order to be
compensated for investing in the project. Obviously the current rate of interest for cash investment
would be a component of this discount rate.
1.5.2.
Net Present Value

Net Present Value (NPV) is the sum of the present values for cash inflows and outflows. The discounted
value of future cash flows is compared with the investment cost. A positive NPV indicates that the return
on the investment is better than the cost of capital. It is a signal that a particular investment proposal is
viable in the sense that the returns will exceed the cost of funds used to finance it.
NPV Criterion for Investment: If the NPV is positive, the investment is viable.
In companies where there may be many investment proposals the NPV is also a method of comparing
and ranking different proposals.
1.5.3.
Internal Rate of Return

Another method of evaluating investment proposals is called the Internal Rate of Return (IRR). The IRR
is the discount rate at which the net present value of all the cash flows is zero. If the future cash flows
are equal amounts the cash flow analysis is really an annuity.
When a particular investment proposal produces a positive NPV it means it is generating a rate of return
higher than the cost of capital. The calculation of the IRR will indicate exactly what the rate of return is
on the investment.
IRR Criterion for Investment: If IRR is greater than the cost of capital, the investment is viable.
When an analysis of a single investment proposal is undertaken NPV and IRR give consistent results.
However there can be some inconsistencies when trying to select among mutually exclusive projects
because of assumptions relating to reinvestment. A full discussion on this aspect of cash flows is beyond
the scope of this subject.
It should be noted that most projects have residual values at the end of their life and this amount should
also be included in the discounted cash flow analysis.
Example 1-22
Consider whether the following short-term investment proposal should be adopted. An initial investment
of $275,000 is required. The life of the proposal is for three years. The firm's cost of capital is 15% p.a.
The yearly cash flows for the investment proposal are $112,000 in year 1, $122,000 in year 2 and
$102,000 in the final year. There is also a $40,000 residual or scrap value at the end of the project. Is the
investment worthwhile?
Solution
Using 15% p.a.
(i) the PV of the $112,000 cash flow at the end of year 1 is $97,391.30.
(ii) the PV of the $122,000 cash flow at the end of year 2 is $92,249.53.
(iii) the PV of $102,000 cash flow + $40,000 residual value at the end of year 3 is $93,367.31.
page 48
1st
2nd
3rd
Cashflow(PV)
$97,391.30
$92,249.53
$93,367.31
(3rd year
includes the
Scrap value)
(FV)
$112,000
$122,000
$142,000
Total $283,008.14
The sum of the present value of the three future cash flows is $283,008.14, which is $8,008.14 more
than the initial investment of $275,000.
The positive Net Present Value (NPV) indicates that the investment proposal is returning better than the
required 15% so we could undertake the investment.
The Internal Rate of Return (IRR) is fairly messy to calculate but it should be obvious that it is
something more than 15%.
Solution
Using Microsoft Excel 2007 to calculate Net present

Value and Internal Rate of Return.
Step 1:
Set up your
Excel
spreadsheet.
Type the following written information into column A of your Excel

spreadsheet, as shown below.
page 49
Step 2:
Using the NPV
function to find
the total
cashflows
converted to the
PV at the time
of the initial
investment.
Select cell B1 in your spreadsheet, click the

button and select the NPV
option. This should bring up a dialog box as shown below.
For the Rate, type the cost of capital, which is 15% in this case.
Value1 is the cashflow at the end of year 1 here, so enter 112000
Value2 is the cashflow at the end of year 2, so enter 122000
(You will notice that a box for Value3 appears when you click in the Value2
box.)
Value3 is the cashflow at the end of year 3, which is $102,000 plus the residual
value of $40,000, so enter 142000
page 50
Step 3:
Finding the net
present value.
Click OK.
The value of $283,008.14 is the sum of the present values of the three future
cash flows.
To determine the NPV, we need to subtract the initial investment value from
this amount.
In this case, the initial investment was $27,5000, so first type that value into cell
B2 as shown below.
(Hint: after clicking in cell B2, if you select currency mode, it will present the
answer in dollars and cents, as shown above).
Net present value = the total converted cashflows minus initial investment.
This is B1-B2 above, so in cell B3, type =b1-b2
Press ENTER.
The NPV is $8,008.14
page 51
Step 4
Using the IRR
function.

button and select the IRR
In the values box, enter the list of cashflows enclosed in curly brackets { }
and separated by commas as shown below, staring with the initial
investment amount (which is negative), followed by the total cashflow for
each subsequent year.
Guess is an estimate of the IRR; it is generally acceptable to enter 0.1 (or
10%) here in all cases of calculating this in Excel, as Excel will then use
this as a starting estimate and carry out its own calculations to find the
correct value in practice anyway.
Step 5
IRR function.
Click OK.
The internal rate of return is 16.68%.
page 52
Example 1-23
An investment proposal will cost $200,000. The firm's cost of capital is 25% p.a. It is anticipated that
there will be a loss of $120,000 in the first year but profit for the next 9 years will be $100,000 per year.
At the end of the 10-year period there will be no residual value.
Solution
Step 1:
Set up your
Excel
spreadsheet
As in the previous example, start by typing the following written

information into column A of your Excel spreadsheet, as shown below.
page 53
Step 2:
Using the NPV
function to find
the total
cashflows
converted to the
PV at the time
of the initial
investment.

button and select the NPV
For the Rate, type the cost of capital, which is 25% in this case.
Value1 is the cashflow at the end of year 1, so enter -120000, since in the first
year there is a loss of $120000
Value2 is the cashflow at the end of year 2, so enter 100000
Since cashflows for nine successive years (which means year 2 through year 10)
were a profit of $100000 each time, enter 100000 for value 3 through value 10
Since you are entering a lot of cashflows you will need to regularly click the
at the right side of the dialog box after entering the first four cashflows, in order
to see the boxes in which to enter subsequent cashflows.
page 54
Step 3:
Finding the net
present value.
Click OK.
The value of $181,050.33 is the sum of the present values of the ten future cash
flows.
To determine the NPV, we need to subtract the initial investment value from
this amount.
In this case, the initial investment was $200,000, so first type that value into cell
B2 as shown below.
(Hint: after clicking in cell B2, if you select currency mode, it will present the
answer in dollars and cents, as shown above).
Net present value = the total converted cashflows minus initial investment.
This is B1-B2 above, so in cell B3, type =b1-b2 and press ENTER.
The NPV is -$18,949.67
page 55
Step 4
Using the IRR
function.

option.
button and select the IRR
In the values box, enter the list of cashflows enclosed in curly brackets { }
and separated by commas as shown below, staring with the initial
investment amount (which is negative), followed by the total cashflow for
each subsequent year.
For Guess, enter the usual default value of 0.1 (or 10%).
Step 5
IRR function.
Click OK.
The internal rate of return is 23.10%.
DECISION: As the NPV is negative, DO NOT INVEST. The return on capital is 23.10%, which is less
than the cost of capital of 25%.
DO EXERCISE SET 1C AND 1D ON PAGES 62 AND 63
page 56
GLOSSARY OF TERMS
Annuity
A series of equal payments made at regular intervals to repay a loan or to build

up a future lump sum such as superannuation or insurance payouts.
Compound
Interest
The amount of interest earned when the interest earned in the preceding period
is added to the investment and the interest earned in the next period is interest
on the investment plus the previous interest.
Effective Rate
The rate of interest actually earned in a year when interest is compounded

more than once a year. That is effective interest rate assumes that interest is
added to the principal and that the interest rate quoted remains constant for the
year.
Future
(FV)
The accumulated value of investments at some specified future time.
Value
Future Value of
an Annuity
The accumulated sum of all payments plus interest at some time in the future.
Interest
The amount charged to borrow or lend money. It depends on the length of time
money is borrowed or lent and the current interest rate.
Interest Rate
Indicates the rate at which interest accumulates. e.g. 10% p.a. i = interest rate
per annum ; r = interest rate per period.
Internal
Rate
Return (IRR)
A method of evaluating an investment proposal, which calculates the return on

the expected future cash flows.
Net
Present
Value (NPV)
A method of evaluating an investment proposal which involves comparing the

sum of the discounted value of all future cash flows with the initial investment.
Nominal Rate
The annual interest rate - it is generally given e.g. 10% p.a. It can also be
calculated by multiplying the interest rate per period by the number of periods
that occur within the year.
Present Value of
an Annuity
Present value of the sum of all payments of an annuity. In most cases the
present value is the amount borrowed.
Principal (PV)
The amount of money borrowed or invested. Also referred to as the present

value (PV) of money.
Rate per period
The annual or nominal interest rate divided by the number of periods in a year.
In most cases interest is now determined on a daily basis so the nominal rate is
divided by 365 to obtain the daily interest rate.
page 57
1.6.
References:
The references below provide discussion of the basic ideas but solve problems using formulae and
tables.
Students who use these books should concentrate on the basic principles and attempt the examples using
Microsoft Excel rather than trying to follow the detailed calculations.
McLean, A., & Stephens, B. (1996). Business mathematics and statistics. Melbourne: Longman.
Chapter 7, pages 123 - 137
Chapter 9, pages 150 159
Cissell, R. (1990). Mathematics of finance. 8th ed. Boston, Mass: Houghton.

Various parts of chapters 1 to 6.
Petty, J.W., Keown, A.J., Scott Jr, D.F., Martin, J.D., Martin, P., Burrow, M. & Nguyen H. (2009).
Financial Management: Principle and Applications, 5th edition, Australia, NSW: Pearson Education,.
Chapter 4
Ross, Thompson, Christensen, Westerfield and Jordan, (2001). Fundamentals of Corporate Finance, 2nd
edition, Sydney:McGraw Hill.
Chapters 5 and 7
Waxman, P.(1993). Business Mathematics and Statistics, 3rd Ed. New York; Sydney: Prentice Hall.
Chapters 10, 11 and 12.
page 58
1.7.
Exercises
Exercise Set 1A Compound Interest
Solutions can be found on page 65
1. Determine the future value of $50,000 invested for 5 years at 5.20% p.a. compounded daily.
2. What sum of money needs to be invested now at 6.75% p.a. compounded daily over 7 years to reach a
target amount of $100,000?
3. If house prices in a particular suburb are appreciating at 14% p.a. how long will it take for a house in
that suburb to double in price?
4. Your bank gives bonus interest on balances over $100 000. It lists the interest rate per annum and the
effective rate per annum for various investment amounts. Balances over $100,000 the interest rate per
annum is 4.30% compounded daily, what would be the effective rate per annum?
5. Find the effective rate corresponding to a nominal (or annual) rate of
a)
9.0% p.a. compounded daily.
b)
9.0% p.a. compounded monthly.
c)
9.0% p.a. compounded quarterly.
6. A company has negotiated an investment deal at a special rate of interest $1,000,000 will be invested for
the next 7 years. Interest will be adjusted quarterly. The investment will be worth $2,000,000 on
maturity.
a)
What is the interest rate per quarter?
b)
What is the nominal rate of interest?
c)
What is the effective rate of interest?
7. A Personal Deposit account associated with a superannuation fund has averaged 13.4% p.a. for the
last 5 years. Interest is compounded half yearly. Five years ago a retired person invested a lump sum
of $139,000. What would it be worth now?
8. Which interest rate provides the higher effective rate, 8% p.a. compounded quarterly or 7.85% p.a.
compounded daily?
9. A customer was overseas for a year and forgot about an outstanding balance of $1,500 on her credit
card. The interest was 15.25% p.a. compounded on a daily basis. What was the effective interest
rate? What is the balance after the year overseas?
10. A property valued at $600,000 is appreciating at 20% per annum. How long will it take to treble in
price?
11. An initial investment of $10,000 has grown to $14,714.59 over a five-year period. The interest was
compounded monthly.
a)
What is the monthly rate of interest?
b)
What is the nominal rate of interest?
c)
What is the effective rate of interest, and what does it tell us?
d)
How long would it take the investment to double?
12. How much money would you have to deposit in an investment account if you want to have $30,000 in 6
years when the annual rate is 6.25% compounded quarterly?
13. A property is valued at $457,000. Houses in the area are appreciating at approximately 11% per annum.
How long before the property is worth $750,000?
page 59
14. The population of Australia is approximately 18,000,000. How long will it take to double if the growth
rate is 1.1 % per annum?
15. $2,000 was deposited in the Bank of America in 1905. It has been accumulating interest at an average
rate of 3.5% p.a. compounded yearly. How much will the original deposit be worth on the deposit
anniversary in the year 2005?
16. $140,000 was placed in a Cash Management Fund with interest compounded daily. After 4 years the
deposit had grown to $185,000. What was the annual rate of interest? (Hint: you will need to enter 0 for
the guess in this particular example, as opposed to the usual default value of 0.1)
Exercise Set 1B Annuities
1. A company plans to deposit $1,500 at the end of each month in a special equipment fund. The fund
accumulates interest at a rate of 4.2% p.a. compounded monthly. How much would be in the fund at the
end of 3 years?
2. Monthly contributions of $400 were made to a superannuation fund for the last 10 years. The fund has
been averaging 10.57% p.a. compounded monthly. What would the lump sum be worth now?
3. How much money do you have to deposit at the end of each month to reach a target sum of $500,000 in
30 years time? The expected interest rate will average no less than 9.0% p.a. and will be compounded
monthly.
4. How long would it take for quarterly payments of $5,000 to reach a sum of $1,000,000 if the interest rate
was 7.85% p.a. compounded quarterly?
5. An investment of $1,200 per month was worth $85,000 after 5 years.
What was (i) the interest rate per period and (ii) the nominal interest rate?
6. How much will have to be invested now to provide half yearly payments of $10,000 for the next 20
years if the guaranteed rate of interest is 5% p.a. compounded half yearly?
7. $500,000 is deposited in an allocated pension fund. The interest rate is 5.9% p.a. compounded monthly.
How long will the deposit last if a payment of $2,800 per month is required?
8. The terms of a $125,000 home mortgage are 6.8% p.a. with monthly repayments of $954.17. How many
years will elapse before the loan is repaid? Suppose the borrower could afford to repay $1,200 per
month, how long would it now take to repay the loan?
9. If you are able to make quarterly payments of $3,000 for 20 years and the annual interest rate is 8.25%
p.a. compounded quarterly, how much money can you borrow?
10. How long will it take to accumulate a savings balance of $250,000 if you deposit $1,000 per month at an
annual interest rate of 5.75% compounded monthly? Suppose that you decided to deposit $1,250 per
month, how long would it now take?
11. $95,000 is borrowed at 7% p.a. adjusted fortnightly. What are the fortnightly repayments if the duration
of the loan is 25 years?
12. What annual interest rate is necessary to yield a $70,000 savings balance if you deposit $1,200 per
month over a period of 4 years? What interest would yield the same balance if $1,300 was deposited
each month over the same period? Assume interest is compounded monthly.
13. How long will it take to accumulate a savings balance of $350,000 if you deposit $2,000 per month at an
annual interest rate of 6.75% compounded monthly? Suppose that you decided to deposit $3,500 per
month, how long would it now take?
14. A superannuation fund claimed that $1,000 per month invested 10 years ago would be
$250,000 today. Assume that interest was compounded monthly what was:
(a)
worth
the interest per month?
page 60
(b)
nominal rate of interest?
(c)
the effective rate of interest?
15. A person borrows $9,000. She can only afford to make monthly repayments of $160. If it takes 6 years
to repay the loan, what is the nominal rate of interest.
16. A loan of $100,000 is negotiated at 8% p.a. adjusted monthly over a period of 25 years.
(a)
What are the monthly repayments?
(b)
How much interest is paid in the first year?
(c)
What amount is still owing after 10 years?
17. Your company takes a mortgage of $1,500,000 on a warehouse. The mortgage is financed at 12%p.a.,
adjusted quarterly over 20 years.
(a)
What are the quarterly repayments on the mortgage?
(b)
What is the total amount paid over 20 years?
(c)
What will be the total interest paid on the mortgage over 20 years?
(d)
How much interest is paid on the loan over the third year?
(e)
What is the amount owing on the mortgage at the end of the fourth year?
At the end of the fourth year (after making the 16th payment) your firm decides to make
repayments of $60,000 per quarter commencing next payment.
(f)
What is the remaining term of the mortgage given the increase in the repayments?
(g)
What are the savings in interest due to the decision to increase the repayment?
18. The Colonial Bank offered a borrower a $75,000 loan at 4.99% p.a. adjusted monthly for the first 12
months then 7.2% p.a. adjusted monthly for the rest of the repayment period. The period of the loan was
for 10 years.
(a)
What would the monthly payments be for the first 12 months? (In this calculation
assume that the lower interest rate of 4.99% applies for the full term of the loan).
(b)
How much would be owing at the end of 12 months?
(c)
What would be the new monthly repayments to ensure that the loan is repaid in 10
years?
19. A loan of $100,000 is negotiated at 8% per annum compounded monthly over 25 years.
(a)
What is the payment per month?
(b)
What is the total amount repaid over the duration of the loan?
(c)
How much interest is paid?
(d)
On the 60th monthly payment, how much would still be owing?
(e)
If after the 60th payment it was decided to increase your repayments by $500 per month,
how long will it take to repay the loan?
(f)
How much interest will be saved by increasing the repayments?
20. You are planning to buy a car. You have $5,000 deposit and you can afford repayments
of $400
per month. You would like to pay off the loan in 4 years. The best terms you are able to negotiate is a
loan that charges 9.7% p.a. compounded monthly; what is the most expensive car you can afford?
page 61
Exercise Set 1C Discounted Cash Flows

1. A company wishes to decide on the viability of an investment in a new plant. Their accountant
makes the following net cash flow projections on the investment. The final cash flow in year 6
includes a residual value.
YEAR
NET CASH FLOWS
($740,000)
($116,000)
$185,000
$205,000
$245,000
$270,000
$410,000
If the current cost of capital is 10% determine the IRR and the NPV for this proposal. Should
the company go ahead with the investment? Explain.
2. A company decides to borrow $750,000 to invest in new equipment, which it anticipates will
produce a return of $200,000 per year for 10 years. The company's cost of capital is 20% per annum.
Calculate the internal rate of return for this investment. What would be the investment decision?
3. A company is examining the following investment proposal with projected cash flows:
YEAR
NET CASH FLOWS
($1,050,000)
$221,000
$265,000
$185,000
$245,000
$270,000
$610,000
The final figure in year 6 includes the scrap value. If the firm's required rate of return is
15% p.a., determine the NPV and the IRR. Is the investment viable?
page 62
4. What is the IRR for an office building costing $1,150,000 if the cash flow over the next five years
is expected to be as follows:
YEAR
NET CASH FLOWS
$100,000
$95,000
$90,000
$90,000
$1,400,000
Property sold
5. Consider the following investment proposal: Set up costs of $340,000 in the first year followed by
an annual profit of $90,000 for the next 5 years. In the sixth year the business will be sold with a
residual value of $220,000. The required rate of return is 25%. What is the net present value and
internal rate of return for this investment? Is this project financially viable? Explain your answer.
6. Compare the following investment proposals using both NPV and IRR methods. The company's cost
of capital is 28% p.a. Year 6 cash flows include scrap value.
Year
Investment A
Investment B
Investment C
($1,000,000)
($1,000,000)
($1,000,000)
($250,000)
$200,000
$500,000
$500,000
$200,000
$500,000
$500,000
$200,000
$300,000
$500,000
$200,000
$100,000
$500,000
$200,000
$100,000
$500,000
$2,000,000
$500,000
7. What would equal cash flows for the next ten years have to be in order to reach a required rate of
return of 22% p.a. if the cost of the project was $2m?
page 63
Exercise Set 1D Mixed Revision

1. A bank's financial advisor suggested to a customer that he should take out a supplementary
home loan of $15,000 at 6.95% p.a. adjusted monthly for 5 years. What would be the monthly
repayments ?
2. Compare the following investment proposals using both NPV and IRR methods. The company's
cost of capital is 32% p.a. Year 5 cash flows include scrap value.
Year
Investment A
Investment B
Investment C
($1,000,000)
($1,000,000)
($1,000,000)
$100,000
$50,000
$500,000
$200,000
$50,000
$500,000
$500,000
$50,000
$500,000
$500,000
$400,000
$275,000
$2,000,000
$3,500,000
$250,000
3. How much must be invested now at 6.75% p.a. compounded monthly to provide an allocated
monthly pension of $3,200 for the next 20 years? If the interest rate was only 6.00% p.a.
compounded monthly how long would the pension last?
4. A loan was negotiated of $200,000 at 6.2% p.a. compounded monthly for 10 years.
(a) What are the monthly repayments?
(b) How much interest could be claimed on taxation during the first 12 months?
(c) At the end of the second year, the interest rate dropped to 5.95% p.a. compounded monthly.
(i)
How much was still owing after the 24th payment?
(ii)
What would be the new repayments?
5. A sum of $87,000 grew to $200,000 over 10 years. What was the nominal interest rate if the
interest was compounded daily? What was the effective rate of interest? Hint: enter 0.01 for the
guess in this question, as opposed to the usual default value of 0.1
6. If house prices were appreciating at 11% p.a. how long would it take for a property to double in
price?
page 64
ANSWERS TO SET 1A Exercises

Q1
FV is used
Future value= $64845.30

Q2
PV is used
Q3
Present value= $62346.89

NPER is used
Q4
Number of years= 5.29 years

EFFECT is used
Effective interest rate is 0.0439*100%=4.39% per annum

page 65
Q5
a EFFECT is used

b

c
Q6

a RATE is used
Interest rate per quarter is 0.0251*100=2.51% per quarter

b Nominal interest rate is 0.0251*4*100=10.03% per annum
c EFFECT is used
Effective interest rate is 0.1014*100=10.41% per annum
page 66
Q7
FV is used
Q8

EFFECT is used
With 8% p.a compounded quarterly

With 7.85% p.a compounded daily

So the answer is 8% p.a computed daily yields higher effect interest rate.
page 67
Q9
a EFFECT is used

b FV is used
Q10
Future value= S1747.06

NPER is used
Number of years= 6.026 years
page 68
Q11
a RATE is used
Monthly interest rate is 0.006458*100%=0.65% per monthly

b Nominal interest rate is 0.006458*12*100%=7.75% per annum
c EFFECT is used

d NPER is used
Q12
Number of payments period=107.65 months or 8.97 years

PV is used
page 69
Q13
NPER is used
Q14
Number of years=4.75 years

NPER is used
Q15
Number of years=63.36 years

FV is used
Q16
Future value =$62382.82

RATE is used
Note that in this calculation we need to set the guess values to zero otherwise it will not
perform the required calculation
Annual interest rate is 0.000191*365*100=6.97% Per annum
page 70
Answers to Set 1B Exercises

Q1
FV is used
Q2

FV is used
Q3
Future value =$84666.98

PMT is used
Payment= $273.11 per month
page 71
Q4
Q5
NPER is used
ii
Q6
Number of payment periods=82.03 quarters or 82.03/4=20.51 years

RATE is used
Interest rate=0.0055*100%=0.55 per month

The nominal interest rate is 0.5589*12%=6.59% per annum
PV is used
page 72
Q7
Q8
NPER is used
Number of payment periods= 428.89 months or 428.8894/12=35.74 years

NPER is used
ii
Number of payment periods=240 months or 20 years

NPER is used
Q9
Number of payment periods=157.91 months or 157.9062/12= 13.16 years

PV is used
Present value= S117,047.17

page 73
Q10
NPER is used
ii
Number of payment periods=164.73 months or 164.73/12=13.73 years

Again NPER is used
Q11
Number of payment periods=140.60 months or 140.5988/12=11.72 years

PMT is used
Payment =$309.72 per fortnight
page 74
Q12
RATE is used
ii
The annual interest rate = 0.008066*12*100%=9.68% per annum

Again RATE is used
The annual interest rate = 0.004808*12*100%=5.77% per annum
page 75
Q13
Q14
NPER is used
ii
Number of payment periods=122.17 months or 10.18 years

Again NPER is used
Number of payment periods=79.56 months or 6.63 years

RATE is used
b
c
Interest rate=0.01117*100%=1.12% per month

Annual interest rate=0.01117*12*100%=13.41% per annum
EFFECT is used
Effective interest rate=0.1427*100=14.27% per annum
page 76
Q15
Q16
RATE is used
The nominal interest rate i= 0.00708*12*100%=8.50% per annum

PMT is used
Payment=$771.82 per month

CUMIPMT is used
The interest paid =$7, 952.69
page 77
Q16
Q17
CUMPRINC
The total principal repaid after the first 120 payments or 10 years is $19236.69.
Therefore, since the PV was $100,000, the amount that is still owing after the 120th
payment is $100,000 - $19236.69, which is equal to $80,763.31
PMT is used
b
c
d
The monthly payment is $49, 667.62

Total paid over the 20 years is 49667.62*20*4=$3, 973, 409.60
Total interest paid over 20 years is =$3, 973, 409.60-$1,500, 000=$2, 473, 409.60
CUMIPMT is used
Interest paid in over the 3rd year is $173, 933.53
page 78
Q17
CUMPRINC is used
The total principal repaid after the first 16 payments or 4 years is $94, 084.63
Therefore, since the PV was $1, 500, 000, the amount that is still owing after the 16th
payment is $1, 500, 000 - $94, 084.63 which is equal to $1, 405, 915.37
NPER is used
41.07 quarters or 41.07/4=10.27 years

If we continue with the old scheme total payment would be=49667.62*20*8
=$3, 973, 409.60
If we continue with
667.62*16+60000*41.07
the
new
scheme
total
payment
would
be=49,
=$3, 258,881.92
Therefore the savings is the different between the total payment, which equals to $3,
973, 409.60-$3, 258,881.92=$741,527.68
Q18
PMT is used
The monthly payment is $795.12

page 79
Q18
Q19
CUMPRINC is used
The total principal repaid after the first 12 payments is $5933.48

Therefore, since the PV was $75, 000, the amount that is still owing after the 12th
payment is $75, 000 - $5933.48 which is equal to $69, 066.52
PMT is used
The new monthly payment is $870.78

PMT is used
b
c
The monthly payment is $771.82

Total amount paid over the duration of the load is 771.82*12*25, which equals to $231,
546.00
The interest paid is $231, 546.00-$100, 000, which equals to $131, 546.00
page 80
Q19
CUMPRINC is used
The total principal repaid after the first 60 payments is $7726.06

Therefore, since the PV was $100, 000, the amount that is still owing after the 60th
payment is $100, 000 - $7726.06 which is equal to $92, 273.94
NPER is used
Q20
It will take another 99.49 months or 8.29 years to repay the loan. So altogether it will
take 8.29+5=13.29 years to repay the loan
If we continue with the old scheme total payment would be=771.82*12*25
=$231, 546.00
If
we
continue
with
the
new
scheme
total
payment
would
be=771.82*60+1271.82*99.49
=$172, 842.57
Therefore the savings is the different between the total payment, which equals to $231,
546.00-$172, 842.57=$58, 703.43
PV is used
So we can borrow $15861.21.

As we have $5, 000, the most expensive car we can afford is $15, 861.21+$5, 000=$20,
861.21
page 81
Answers to Set 1C Exercises

Q1
NPV is used
First create the cash flows with initial investment in a column of a spreadsheet
This is the total cash flows converted to PV at the time of investment is $767, 878.92
Therefore the net present value is $767, 878.92-$740,000=$27, 878.92.
IRR is used
Therefore IRR is 10.88%

NPV > 0, the proposal is viable therefore company go ahead with the investment
Q2
IRR is used
First create a cash flows with initial investment in a column of a spreadsheet
IRR=0.2341*100%=23.41% per annum

Since the IRR is greater than the cost of capital, the investment is viable
page 82
Q3
NPV is used
This is the total cash flows converted to PV at the time of investment is $1,052,229.59
Therefore the net present value is $1,052,229.59-$1, 050,000=$2,229.59.
IRR is used
IRR is 0.1507*100%=15.07% per annum

NPV > 0, the proposal is viable.
Q4
IRR is used
IRR =0.1039*100%=10.39% per annum
page 83
Q5

NPV is used
This is the total cash flows converted to PV at the time of investment is $299,706.88
Therefore the net present value is $299,706.88-$340, 000=-$40, 293.12.
IRR is used
IRR=0.2030*100%=20.30% per annum

Since the NPV is less than zero, the proposal is not financially viable.
Q6
Therefore the net present value is $793, 752.37-$1,000, 000=-$206, 247.63.
IRR
page 84
IRR=0.2107*100%=20.07% per annum

NPV<0, the proposal is not financially viable do not invest
b
Therefore the net present value is $961, 148.56-$1,000, 000=-$38,851.44
IRR=0.2679*100%=26.79% per annum

NPV<0, the proposal is not financially viable do not invest
c
This is the total cash flows converted to PV at the time of investment is $1, 018, 895.50
Therefore the net present value is $1, 018,895.50-$1,000, 000=-$18, 895.50
IRR=0.2902*100%=29.02% per annum

Since NPV>0 the proposal is financially viable we can invest money.
page 85
Q7
If the future cash flows are equal amount then the cash flow analysis is really annuity
problem.
The cash flow amount=509, 789.96$
page 86
Answers to Set 1D Exercises

Q1

Q2
This is the total cash flows converted to PV at the time of investment is $1,
071,697.49
Therefore the net present value is $1, 071,697.49-$1,000,000=$71,697.49
IRR=0.3441*100%=34.41% per annum

b
This is the total cash flows converted to PV at the time of investment is

$1,093,438.65
page 87
Therefore the net present value is $1,039,438.65-$1,000,000=$39,438.65
IRR=0.3458*100%=34.58% per annum

c
This is the total cash flows converted to PV at the time of investment is

$1,036,107.28
Therefore the net present value is $1,036,107.28-$1,000,000=$36,107.28
IRR=0.3416*100%=34.16% per annum
Q3
All three proposals are viable since NPV is greater than zero for each proposal,
However the proposal (b) is the best as the NPV is height
PV is used
$420,851.06 is to be invested
page 88
Q3
NPER Is used
It will last for 214.88 months or 17.91 years

Q4
PMT is used

b
Interest paid for the first 12 months=$11981.17

c(1)
CUMPRINC is used
The total principal repaid after the first 24 payments is $30, 761.73.
Therefore, since the PV was $200,000, the amount that is still owing after the 24th
payment is $200,000 - $30,761.73, which is equal to $169,238.27
page 89
Q4
c(2)
PMT is used
Newly payment=$2219.91 per month

Q5
RATE is used
The nominal interest rate=0.000228*365*100%=8.33% per annum

b
Effective interest rate=8.69% per annum

Q6
It takes 6.64 years to double the price.
page 90

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FINANCIAL

Swinburne University of Technology

Financial Statistics Notes

Opening and preparing Microsoft Excel for data analysis

To open EXCEL, click on the

The Microsoft Excel program will open, and a

tab on the right of the screen.

Swinburne University of Technology

Financial Statistics Notes

Interest, Investments and Loans

Bonds and Debentures

Commonwealth government bonds (1 to 10 years).

Semi-government (state government) bonds.

Finance company debentures.

Bank term bonds.

8.00% p.a. semi annual interest

Swinburne University of Technology

Swinburne University of Technology

Financial Statistics Notes

The Interest Rate per Period

Interest rate per period =

annual interest rate

What is the monthly rate?

What is the quarterly rate?

Interest rate per month =

Interest rate per quarter =

The Future Value of Investments

Swinburne University of Technology

= 0.0116% per day.

Interest = 100,000 x 0.000116 = $11.6438

Interest = 100,104.8433 x 0.000116 = $11.6560

Interest = 104,329.1993 x 0.000116 = $12.1479

Future value of the investment

Compound Interest Formula

Swinburne University of Technology

Financial Statistics Notes

Using Microsoft Excel 2007 to solve

button as shown below.

Scroll down to Financial and select it by clicking the mouse once.

Swinburne University of Technology

This will bring up the following dialog box.

Swinburne University of Technology

Financial Statistics Notes

The future value should be $104,341.35

Using Microsoft Excel 2007 to find the future value

Enter the following information:

Rate is 6.75%/365 for the daily interest rate.

The future value would be $70,069.79

Swinburne University of Technology

Financial Statistics Notes

Nominal Interest Rate

Effective Interest Rate

Effective Interest Rate (%) =

Compound Interest for a one year period

Using Microsoft Excel 2007 to calculate the

Swinburne University of Technology

The effective interest rate is 0.043413 x 100 = 4.34%

House prices may average an annual growth rate of 10%.

Population may be increasing at 1 % per annum.