TMAN625 Week 2

Week 2: Annual Analysis
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Tasks for the week:
z z
Read this content, Read chapter 3 sections 3.3 through 3.4, skim sections 3.3.5 & 3.3.6
z Read the article: Bankrate.com "7 Psychological Money Traps and How to Avoid Them", 10/16/2008. Retrieved on 1/27/2012 from http://www.bankrate.com/finance/personal-finance/7psychological-money-traps-and-how-to-avoid-them-1.aspx#1 z z
Participate in the Week 2 Conference Submit Assignment 2 in the Assignment/Gradebook area.
Last week, the content was limited to translating between present values and future values using time value of money (TVOM) equations. This week we expand this to include periodic payments plus the use of spreadsheet software functions to perform the calculations. This weeks, content (and sections 3.3 and 3.4 in the textbook) are limited to annual payments only. Next week we will expand this to periods other than years. The primary purpose of this weeks content is to bridge between the TVOM concepts, equations and spreadsheet functions. Investments and loans are like two sides of a coin. One side is the borrower and the side is the loaner. All that changes is the direction of the flow of funds that is indicated by the signs of the monetary values. A loan received by a borrower is positive (in their pocket), but to the lender, it is negative (out of their pocket). Payments made by the borrower are negative (out of their pocket), and to the lender receiving these they are positive (into their pocket). An investment requires funds to move out of ones pocket (negative) into the bank account, stock or other fund. When the results of the investment are received by the individual, they are positive. The basic terminology for Time Value of Money analysis is shown in the following table. Terms, Symbols and Acronyms Initial value, upfront value, present value Final or future value Payment (disbursement or receipt) Interest rate Number of planning periods P or PV F or FV A or pmt r or i or rate n or nper
1.
Planning Period or Time Horizon
Planning periods obviously have length. They can be years, decades, quarters, months, days, or any units that is reasonably equal in length. Months do not all contain the same number of days, but are considered reasonably equal. Quarters are normally defined as 13 weeks to make them equal in length but 365 days does not divide equally into 4 periods (365/4 = 91.25 days). Excel does contain the capability to analyze unequal time periods but we will not be using this. Although planning periods have length, financial analysis most commonly focuses on the end of periods. Loans payments and investment deposits are typically done at the end of a period; say end of
http://tychousa1.umuc.edu/TMAN625/1206/9045/class.nsf/Course+Content/B10854BE15...
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month or end of year. There are special cases where is appropriate to consider the beginning of a period. For instance, if one is withdrawing funds from a college fund or the like, the funds would often be withdrawn at the beginning of a period to pay tuition, meaning they would not earn interest in that period. The end of a period is identical to the start of the next period. December 31st of one year (12:60 or 23:60 in a 24 hour clock) is identical to January 1st at 0:00 of the following year. Sometimes it is easier to restate beginning of year payments or withdrawals as the end of the previous year, or vice versa. Because time periods can start at any time, they are normally just stated as period 0, period 1, up to period n, which is the last period in a planning horizon. Annual periods can be defined as ending on December 31st, April 15, or any other date. Months can be considered as starting or ending on the 1st. 10th, 16th or last day. Financial analysis ignores this and simply uses period numbers of 0,1,2,3, etc. The following illustrates this for a six period monthly situation. Financial analysis seldom considers the particular date, only the period numbers. Date Period Disbursements Receipts Cash Flow
7/15/2012 8/15/2012 9/15/2012 10/15/2012 11/15/2012 12/15/2012 1/15/2013
0 ($500) ($500)
1 ($100) ($100)
2 ($100) ($100)
3 ($100) ($100)
4 ($100) ($100)
5 ($100) ($100)
6 ($100) $250 $150
The length of a financial analysis is referred to alternatively as the planning horizon, time span, project length or others. It is simply the number of periods. The above is considered as having 6 periods even though with period 0, there are seven columns. The end of period convention makes period 0 to have zero length. With the above in mind, the following terms can be defined: Present as used in present period and present value or such terms as initial value, initial deposit, and initial withdrawal is the end of period 0. If an upfront investment is needed, or loan received, it would be on this present date, which again is the end of period 0. Future as in future value, or sometimes ending value, is the last period of the planning horizon. There will be situations where one wants the value at the end of year 10 in a 30 year planning horizon (as in a 30 year mortgage). Year 10 is in the future and equations for FV can be used to find the value in year 10, but this should be labeled as the Year 10 value or the future value in year 10, rather than simply the future value. Periodic Payments, which can be deposits or withdrawals, are made in period 1 through and including the last period n. A payment is not made in period 0 as that is considered the present value, initial deposit, or loan value and therefore is considered as separate. But Payments are made in the last period, and any other deposit or withdrawal in the last period is in addition to the period n payment. This is shown above in period 6 where $100 is deposited and $250 is withdrawn and the net amount received in period 6 is $150. Also note that since the values are deposits that come out of ones pocket , they are entered as negative numbers. The withdrawal in year 6 that goes into ones pocket is positive. If you take out a loan on a home or car, on the closing date, which is the present (end of period 0), you receive the loan (so it is positive), and the first payment (negative) is normally one period later, or the end of period 1. I once had a banker infer that they were doing me a favor by my not having to make a payment for 30 days, but in fact, that is standard operating procedure in finance. Further note that interest paid or earned is calculated at the end of a period based on the balance at the end of the previous period (same as start of the present period). In the above example,
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interest on the $500 would be paid/earned at the end of period 1. In period 6, interest would be paid/earned on the balance at the end of period 5, and the payment and withdrawal in period 6 would not be included in the interest calculations since they were not involved during the period 6, only at the last instant.
2.
Spreadsheet Functions: Present Value and Future Value
Last week the calculation of present and future values was performed using the TVOM equations FV= PV*(1+r)^n and PV=FV/(1+r)^n. Present and future vales can also be calculated using the spreadsheet functions named FV (Future Value) and PV (Present Value) and shown below in a spreadsheet format. =FV(rate,nper,pmt,pv,type) where rate is interest rate, nper is number of periods (years, months, weeks, etc) pmt is payment made per period (can be equal or unequal) pv is the value at the end of period 0 (the present time) type indicates end of period (0) or beginning of period (1) payments. =PV(rate,nper,pmt,fv,type) where rate is interest rate, nper is number of periods (years, months, weeks, etc) pmt is payment made per period (can be equal or unequal) fv is the value at the end of period 6 type indicates end of period (0) or beginning of period (1) payments.
The following example shows how the examples from last week can be calculated using the spreadsheet functions and leads to three important points for functions. If you have $500 and invest it at 4% for 6 years, the future value FV is: FV = $500 x (1+4%)6 = $632.66 FV= FV(4%,6,,500) = -$632.66 First note that since there are no payments in addition to the initial deposit (the PV) that the payment argument is skipped by the two commas side-by-side. Essentially this says that the default value is zero. Second, only end of period payments will be considered this week, the type value in the spreadsheet function is zero. Since zero is the default value, this argument can be omitted as is done in the above and following examples. If payments were made at the beginning of periods, a Type = 1 would be specified. Finally, note that the result of the function is negative. Functions include an indication of which direction that funds are flowing. A negative value indicates that funds are being paid out and is often described as coming out of your pocket. A positive value indicates that funds are received or into your pocket. So in this example, $500 goes into your pocket initially and at the end of year 6, the
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negative sign indicates that $632.66 comes out of your pocket. In contrast, if the function was entered as FV= FV(4%,6,,-500) = $632.66, the negative sign on the 500 indicates that you paid $500 out of your pocket, and the positive value of $632.66 will go into your pocket. The PV function works similarly. Last week an example was: If you expect to have $10,000 in five years, and a rate of 4% is used, this would be valued at $8219.27 today. PV = $10,000 / (1+4%)5 = $8,219.27 Using the PV function, this would be: PV = PV(4%,5,,10000) = -$8,219.27 The FV argument being a positive 10000 indicates that $10,000 will be received in 5 years, and that to receive this, the negative amount of $8219.27 has to be paid out of your pocket today. This is an investment situation where you receive a future value in 5 years of $10,000 for an investment (paid out) today of $8,219.27. If this was alternatively entered with the signs reversed as PV = PV(4%,5,,-10000) = $8,219.27, the interpretation is a loan situation where you will pay out $10,000 out of your pocket in 5 years to receive a loan of $8,219.27 today. This loans and investments use the same equations or function, but with functions the signs are used to indicate the direction in which funds flow. We will now look at the following categories of loans/investments in more detail.
z z z z
No periodic payments Equal periodic payments Unequal periodic payments Perpetuity: Interest only payments that can go on forever
3.
No Periodic Payments
This first situation is for the same situation as above with no periodic payments, but will also include calculations for rates and number of periods.
3.1. Determining PV and FV

The first calculation below transforms a deposit (out of ones pocket) in a fund of $100 to its equivalent future value in five years or $127.63. As described above, the functions results in a sign difference that indicates whether the result is received or paid out. The second example starts with a future value five years hence of $100 and computes its value today of $78.35. The last calculation, a check on the first FV calculation, starts with the future value of $127.63 that was calculated in the first example and calculates the PV, which is $100.00 as it should be.
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3.2. Determining Rate

If the present value and future value are known, the rate that would achieve this can be calculated by rearranging the equation FV = PV *(1+r)^n to be: FV = PV * (1+r)^n (1+r)^n = FV/PV 1+r = (FV/PV)^(1/n) r= (FV/PV)^(1/n) -1
If PV = $10, FV= $100 and n= 20, then r = (100/10)^(1/20) -1 = 12.2% Equivalent results can be obtained using the Rate function in a spreadsheet as shown below. Note that in the function, either the PV or FV must be a negative value. If the initial value is paid out is negative then the FV that is received is positive, or vice versa. The negative sign in prefacing the C24 in row 28 achieves this.
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3.3. Determining Number of Periods

An equation can be derived for determining the number of periods when given the present value, future value and rate using logarithms. FV = PV * (1+r)^n FV/PV = (1+r)^n ln(FV/PV) = n x ln(1+r) n= ln(FV/PV) / ln(1+r)
The function in spreadsheets for logarithms is LN. If PV = 10, FV= 100 and rate = 5%, then n = LN(100/10)/LN(1+5%) = 47.19 years The NPER function makes this easier as show below but note that the PV and FV must have opposite signs, while in the equation, they have the same signs. The negative sign prefacing C36 in row 40 achieves this.
A video showing the use of spreadsheet functions for the previous no periodic payments situation can be viewed at: No Payments
4.
Periodic equal payments Annuities and Loans
Most loans and investments have periodic payments. The textbook shows how equations and tables can be used when including payments. The complexity grows rapidly and an equation for determining the rate becomes near impossible (textbooks typically do not try), which makes spreadsheet functions more attractive and definitely less error prone. The equations and functions are
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as follows: With Equal Periodic Payments (Disbursements or Receipts) =FV(rate,nper,pmt,PV) =A*((1+i)^N-1)/i) =PV(rate,nper,pmt,FV) =A*((1+i)^N -1)/(i* (1+i)^N) =RATE(nper,pmt,pv,fv) not available =NPER(rate,pmt,PV,FV) not available =PMT(rate,nper,pv,fv) =F*(i/((1+i)^N -1)
FV PV r nper pmt
F P i N A
4.1. Determine Future Value

Consider the following cash flows over 6 years for an account with 5% interest. Initially $500 is deposited (out of your pocket), then withdrawals of $80 per year are made (into your pocket) through year 6. Period Cash Flow 0 ($500) 1 $80 2 $80 3 $80 4 $80 5 $80 6 $80
The FV of this cash flow can be obtained by the following function by inserting the interim equal payments (receipts since positive) as the third argument: =FV(5%,80, -500) The positive result will be $125.89 that you would receive at the end of year 6 (into your pocket). Suppose that the monthly withdrawals (receipts) were $100 instead of $80. Period Cash Flow 0 ($500) 1 $100 2 $100 3 $100 4 $100 5 $100 6 $100
Then the future value would be =FV(5%,80,-500) = -$10.14, a negative value indicating that you would need to deposit this amount at the end of year 6. Understanding can be facilitated by tabulating the payments. Tabulations are typically created from the prospective of the fund, not you the individual (they do not have to be) so the $500 that comes out of ones pocket is a positive balance in the bank account or investment fund. In the tabulation below, the interest in period 1 of $25 was computed by =5%*500, and the Balance in period 1 is calculation by =500 -80 + 25. With drawals ($80) ($80) ($80)
Period 0 1 2 3
Interest $25.00 $22.25 $19.36
Balance $500.00 $445.00 $387.25 $326.61
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4 5 6
($80) ($80) ($80)
$16.33 $13.15 $9.80
$262.94 $196.09 $125.89
Note that all the equations did not have to be typed in separately in the spreadsheet. Once the equations are entered for the first 2 periods (1 and 2) as shown below using cell addresses and $ signs on the rate, the remaining cells then can be filled by shading these and dragging down through the remaining rows.
4.2. Determine Present Value

Consider the following cash flow where $50 is deposited each year for six years and then $250 is received in year 6 ($250 is the Future Value which does not include the $50 payment in year 6). The question then is what deposit or receipt is needed today (year 0) to make this work at a rate of 5%.
The result of $34.23, being positive, indicates that this amount can be received today in addition to the $250 in year 6. Note the result if the payment deposit is changed to $30:
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When the payments are reduced to $30, the result is negative indicating that $34.28 would have to be deposited up front to receive $250 in six years. This illustrates the usefulness of the sign conventions in functions.
4.3. Determine Number of years

Suppose that a deposit of $1,000 is made in year 0 plus annual deposits of $500 are made to an account that pays 6% interest annually. The NPER function can be used to determine the number of years to achieve (and receive) a future value of $5000.
In 6.1 years, the $5,000 will be achieved and can be withdrawn.
4.4. Determine Rate of Interest

Suppose that a deposit of $1,000 is made today (PV), payments of $500 are made each year, and it is desired to attain (receive) $5,000 in 5 years. The rate to accomplish this is determined as follows:
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4.5. Determine Payment

Suppose that a find pays 6% interest and $1,000 is deposited initially and the goal is to receive $5,000 in 5 years. The amount of the annual payments to do this is $649.59 and is determined as follows:
A video showing the use of spreadsheet functions for equal periodic payments can be viewed at: Equal Payments Lets jump right in, feet first, into a typical real-worldish situation.
5.
Example: Tectra Nologian
Tectra Nologian, just out of a technology management program, has landed a good job. Her initial salary was $60,000 per year. Tectra decided she would immediately start an investment program by investing in an annuity 10% or her salary or $6,000 each year starting at the end of her first year on the job. She has been quoted a rate of 5 percent annually on her investment.
5.1. Future Value with equal periodic payments

With this information, she wants to look at what funds she will have accumulated after 30 years of employment. Amount invested each year is constant: $6,000 Interest rate: 5% Initial investment: $0 Time frame: 30 years
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Since a fixed amount is invested each period (a year in this case), and interest is earned on this each year which is added to the investment, this is described as annual payments with annual compounding. The tabular description of this follows. In year 1, it shows a payment of $6,000 into the annuity and since it is at the end of the year, there is no interest. So the value at the end of year 1 is $6,000. In year 2, $6,000 more is invested, plus $300 interest (5% x $6,000) is earned and added to the annuity yielding a total of $12,300. In year 3, another $6,000 is added in addition to $615 in interest yielding $18,915. Continue this for 30 years, and the annuity has grown to a value of $398,633. Payment at end of period $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 Interest During Period $0 $300 $615 $946 $1,293 $1,658 $2,041 $2,443 $2,865 $3,308 $3,773 $4,262 $4,775 $5,314 $5,880 $6,474 $7,097 $7,752 $8,440 $9,162 $9,920 $10,716 $11,552 $12,429 $13,351 $14,318 $15,334 $16,401 $17,521 $18,697 Future Value $0 $6,000 $12,300 $18,915 $25,861 $33,154 $40,811 $48,852 $57,295 $66,159 $75,467 $85,241 $95,503 $106,278 $117,592 $129,471 $141,945 $155,042 $168,794 $183,234 $198,396 $214,316 $231,031 $248,583 $267,012 $286,363 $306,681 $328,015 $350,415 $373,936 $398,633
Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
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The tabulation approach is only one way of determining this. Alternatives are using tables, equations or a spreadsheet function. Here we will only show the spreadsheet function. One can use the Future Value (FV) function to determine the future value since the payment is constant for all periods (years). =FV(rate,nper,pmt,pv) where rate is interest rate, nper is number of periods pmt is payment made each period (must be a constant amount for the PV function) pv is the amount at the end of period 0 so it is the initial value.
So for this problem, the following data would be entered: =FV(5%,30,-6000,0) = $398,633 This of course results in the same amount as determined in the above tabulation. Note that Tectra makes the $6,000 payment to someone else so it is negative. (enter -6000, not -$6000 or $6,000)
5.2. Add Signing Bonus

If Tectra received a signing bonus of $1,000 up front (year 0), and invested it up front in the annuity, the tabular display and alternative spreadsheet function (below) would be as follows: Add initial investment in year 0 Annual payment $6,000 at the end of year 1 Interest Rate 5% Initial investment $1,000 at end of year 0 Time frame 30 years
Year 0 1 2 3 4 5 6 7 8 9 10 11 12
Payment at end of period $1,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000
Interest During Period $0 $50 $353 $670 $1,004 $1,354 $1,722 $2,108 $2,513 $2,939 $3,386 $3,855 $4,348
Future Value $1,000 $7,050 $13,403 $20,073 $27,076 $34,430 $42,152 $50,259 $58,772 $67,711 $77,096 $86,951 $97,299
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13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30
$6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000 $6,000
$4,865 $5,408 $5,979 $6,578 $7,206 $7,867 $8,560 $9,288 $10,052 $10,855 $11,698 $12,583 $13,512 $14,487 $15,512 $16,587 $17,717 $18,903
$108,164 $119,572 $131,550 $144,128 $157,334 $171,201 $185,761 $201,049 $217,101 $233,957 $251,654 $270,237 $289,749 $310,236 $331,748 $354,336 $378,052 $402,955 $402,955 =FV(5%,30,-6000,-1000)
Over 30 years, the $1000 up front resulted in an increase of $402,955 - $398,633 = $4,322. If Tectra starts saving at age 25 and works until 65, the years would be 65-25 = 40 and yields as follows, without the $1,000 up front: =FV(5%,40,-6000,0) = $724,799 This is a substantial increase from the $398,633 for 30 years. The major increases show the effect of compounding interest.
5.3. Determine Payment

Tectras company stock price has returned an average of 10% annually for the past 10 years, so lets change the interest rate to 10% annual interest and see what happens if she invested in company stock. =FV(10%,40,-6000,0) = $2,655,555 Wow! $2.5 million. But maybe it is a little risky to assume that the 10% will continue. If Tectra has a goal of attaining a $1 million retirement fund in 40 years, how much will she have to invest at 5% to achieve this? This amount is determined with the Payment function which shows the size of equal payments needed to convert a present value to a future value: =PMT(rate,nper,PV,FV) =PMT(5%,40,0,1000000) = -$8,278 This suggests that if she invests in a plan that pays 5% annually, a retirement plan of depositing $8,278 annually would result in $1 million in 40 years.
5.4. Determine Rate
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Tectra decided that $8,278 a year is too much per year. Since she is young and would have time to recover from an investment gone sour, she want to know the interest rate she would need to achieve the $1,000,000 with an annual payment of $6,000? For this the RATE function would be used: =RATE(nper,pmt,PV,FV) =RATE(40,-6000,0,1000000) = 6.29% If she can find an investment that yields a 6.29% return, her retirement plan of depositing $6,000 annually would result in $1 million dollars in 40 years. Maybe she could invest partially in company stock and partially in the 5% guaranteed plan. That encourages her to see what interest rate she would need if she invested only $5,000 annually with nothing upfront. =RATE(40,-5000,0,1000000) = 7.01% If she can arrange her investments to yield a 7.01% return, her retirement plan of depositing $5,000 annually would result in $1 million dollars in 40 years. One last alternative; suppose that she has an inheritance that she could invest and was curious how much upfront she would need to invest to achieve the $1 million in forty years with $6,000 annual payments and 5% annual interest. This would use the PV function: =PV(rate,nper,pmt,fv) =PV(5%,40,-6000,1000000) = -$39091 Therefore, if she opened the account with an investment of $39,091, earned 5% annually, and made annual payments of $6,000, she would achieve $1 million in 40 years. As a check, =FV(5%,40,-6000,-39091) = $999,999 This is a dollar less that $1 million because the $39,091 was rounded off from $39,091.16 The above has illustrated how any one of the five variables (RATE, NPER, PV, PMT, FV) can be determined if the other four are known. It is emphasized that this is for the situation where all payments are equal. We will look at non equal payments next. Note that a good way to solve problems is to list which of the four variables that you know and then solve for the one you do not know. It is critical that the signs in the function be used correctly. When one invests. money, it leaves your pocket and goes into someone elses pocket so it is negative. When you receive funds at the end of an investment plan, or upfront with a loan, it goes into your pocket so is positive. A video showing the use of spreadsheets for the Tecta Nologian example can be viewed at: Tectra Nologian
6.
Unequal Payments
Payments for loans are typically equal (at least planned that way), but sometimes have variations. They can vary each period, and withdrawals from a fund can vary each period. This is the unequal payment category. Suppose that $250,000 is needed the first year to set up an organization (office facilities, etc.), $100,000 in the second and third year to do development work and then $300,000 and $400,000 in years 4 and 5 to get a product introduced to the market. Consider that a loan is being sought (or an investment from say from a venture capitalist) of some unknown amount to cover the five years of startup costs. The question then is, how much money will be needed upfront to fund this if an interest rate of 5% is used? The payments in each year all differ so the PV spreadsheet function cannot be used. Fortunately, there is another one named NPV. It has the arguments =NPV(Rate, Values). The NPV function was created for use in proposal analysis, not for loan or investment annuities, and when using
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these for loan and investment annuities, it needs to be prefaced by a minus sign as shown below. Later in this course, we will see where this minus sign is not needed for proposal calculations. To reiterate, when loan and investment annuity payments are not equal, the PV function cannot be used and so the NPV function is used, but it needs to be prefaced with a minus sign. The present value of the above example is computed as:
An up front amount of $975,403 would be needed at 5% interest to cover the 5 years. Note that the values in cells C4 through G4 can b entered by entering the first and last cell address separated by a colon. Or all the values can all be listed, either as cell addresses or the actual numbers. Equivalency was discussed last week. In this example, the equivalent future value of $1,244,889 is the amount that would have to be deposited at the end of the development project (instead of the PV at the beginning) to cover the five years of expenditures. Also an equivalent equal annual payment of $225,294 can be calculated using the PMT function and the present value . This indicates that an annual equal payment of $225,294 would also pay the development costs, although since year one requires $350,000, a cash deficit would occur in year 1. A video showing the use of spreadsheets functions for unequal payments can be viewed at: UnEqual Payments
7.
Gradients
If a series of revenues, cost or cash flows increase by a predictable amount each period, it is called a gradient. These can be linear or geometric. A gradient is described as linear when each period increases by a fixed amount. An example using a $2 gradient would be $12, $14, $16, $18, etc. A geometric gradient is where the values increase by a fixed percentage each period. An example using a 10% gradient would be $100.00, $110.00, $121.00, $133.10, 146.41, etc. Equations are available for gradients and are shown on page 113 in Table 3.6, but the complexity of these make using a tabulation and the NPV function advisable.
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7.1. Linear Gradients

Following is an example for Tectra Nologian where the assumption is that her annual deposit in the retirement fund will grow by $500 per year over the 40 years. It starts at $6,000 in year 1, grows to $6,500 in year 2, etc. The Balance in years 2-40 is the balance from the previous year added to the deposit and interest for the current year.
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Alternatively, only the deposits could be tabulated (no interest and balance) and the NPV function could be used to find the present value of the deposits, followed by the future value function to get the same result. This is shown in rows 48 and 49.
7.2. Geometric Gradients

A geometric gradient increase for Tectra Nologians situation would result when from making her annual deposit being a percentage of her salary. Suppose that she expects her salary to increase 3% annually over a 40 year career and she invests 10% of her salary annually. If the salary increases by 3% annually, the annual deposit in the retirement fund would increase by 3% as well. This therefore would be a 3% geometric gradient. In the table below, the deposits starts at $6,000 in year 1 (10% of $60,000), increase by 3% of $6,000 in year 2 or $180 to be $6,180. Adding the previous years balance of $6,000 to the present years deposit of $6,180 and interest of $3000 yields $12,480. This continues for the 40 years
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These tabulations are lengthy, but formulating the first few rows and then shading and dragging down to get the remaining rows makes it simpler. Or the NPV or the deposits followed by the FV can ber uses as show in rows 97 and 98. Equations can be used but they also are lengthy and error-prone when creating them. Following is an example for the geometric gradient, which is a simpler than the linear gradient.
A video showing the preparation of spreadsheets for gradients can be viewed at: Gradients
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8.
Perpetuities (not included the textbook)
University and non-profit endowments usually are funded with an investment from which the interest on the investment goes to the university or nonprofit organization. For instance, someone donates $10,000,000 to a college and if the investment earns 6% interest, the college would receive periodic income (a payment) of $600,000 annually, forever. The initial value of $10 million never changes over time since only interest is paid out, and therefore the future value is forever $10 million. The word forever characterizes a perpetuity fund. The equation for payment A each period for a standard perpetuity of amount P and interest rate i is: A=P*i If $4 million was invested in a perpetuity fund that earned 5% interest annually, the benefactors would receive $4 million * 5% = $200,000 annually. Note the amount invested stays and is unchanged forever. Rearranging this equation gives the equation to determine the needed initial value of perpetuity: P = A/i Therefore, if a payment of $100,000 per year is desired, the amount invested at 8% interest would need to be: P=$100,000/.08 = $1,250,000 Because of inflation, sometimes perpetuities are set up to provide an increasing payment over time. In this case, part of the interest is retained to gradually build the investment so future value is greater than present value. This is labeled as a growing perpetuity. If i is the interest rate and r is the inflation rate, the payout or payment A is computed as: A = P x (i r) For a $1 million PV, I = .07 and r = .03: A=$1,000,000 * (.07 - .03) = $40,000 The initial value P, invested at 8% interest, which would be needed to achieve payments of say $50,000 today and have payments grow 3% a year to cover inflation, is: P=$100000 / (.08 - .03) = $2,000,000
Perpetuities are also relevant for business investments such as a coal mine that will payout for a very long time. Public organizations use perpetuities to analyze returns form long term investments such as highways, dams, airports, etc. The annual benefits from the investment are considered the perpetuity payouts No spreadsheet functions exists for perpetuities; only the following equations. These calculations are shown in the following video: Perpetuity Constant payment forever A Annual Payment = P*r =F*r P Present Value = P/r= F/r r Perpetuity Rate r = A/P = A/F Growing payment forever
8/17/2012
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A P r g
Annual Payment Present Value Perpetuity Rate Growth Rate
= P/(r-g) = A/(r-g) = (A-P * g)/r =(A-P*r)/g
9.
Concluding Comments
We now have the mechanics for most any investment or loan situation. Next week we will look in more detail at interest rates and time periods with period lengths other than annual.
8/17/2012

TMAN625 Week 2

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TMAN625 Week 2

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Week 2: Annual Analysis

Week 2: Annual Analysis

Participate in the Week 2 Conference Submit Assignment 2 in the Assignment/Gradebook area.

Planning Period or Time Horizon

Week 2: Annual Analysis

6 ($100) $250 $150

Week 2: Annual Analysis

Spreadsheet Functions: Present Value and Future Value

Week 2: Annual Analysis

3.1. Determining PV and FV

Week 2: Annual Analysis

3.2. Determining Rate

Week 2: Annual Analysis

3.3. Determining Number of Periods

Periodic equal payments Annuities and Loans

Week 2: Annual Analysis

4.1. Determine Future Value

Interest $25.00 $22.25 $19.36

Balance $500.00 $445.00 $387.25 $326.61

Week 2: Annual Analysis

($80) ($80) ($80)

$16.33 $13.15 $9.80

$262.94 $196.09 $125.89

4.2. Determine Present Value

Week 2: Annual Analysis

4.3. Determine Number of years

In 6.1 years, the $5,000 will be achieved and can be withdrawn.

4.4. Determine Rate of Interest

Week 2: Annual Analysis

4.5. Determine Payment

Example: Tectra Nologian

5.1. Future Value with equal periodic payments

Week 2: Annual Analysis

Week 2: Annual Analysis

5.2. Add Signing Bonus

Week 2: Annual Analysis

5.3. Determine Payment

5.4. Determine Rate

Week 2: Annual Analysis

Week 2: Annual Analysis

Week 2: Annual Analysis

7.1. Linear Gradients

Week 2: Annual Analysis

7.2. Geometric Gradients

Week 2: Annual Analysis

Week 2: Annual Analysis

Week 2: Annual Analysis

Perpetuities (not included the textbook)

Week 2: Annual Analysis

Annual Payment Present Value Perpetuity Rate Growth Rate

= P/(r-g) = A/(r-g) = (A-P * g)/r =(A-P*r)/g

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