Chapter 6. Evaluating the Financial Impact of Loans and Investments

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1 Chapter 6 Evaluating the Financial Impact of Loans and Investments

2 Chapter Introduction Fundamental financial calculations used to evaluate different financing options Developing an amortization table a listing by period of the cash inflows and outflows Excel tools for calculating depreciation (technique used to allocate costs of an asset over its useful life) Ramifications of cash flows; tools for analyzing the financial viability of a project Succeeding in Business with Microsoft Excel

3 Chapter Introduction (continued) Functions covered in this chapter: CUMIPMT, CUMPRINC, FV, IPMT, IRR, ISNUMBER, NPER, NPV, PMT, PPMT, PV, RATE, SLN To go to Level 1, click here To go to Level 2, click here To go to Level 3, click here Succeeding in Business with Microsoft Excel

4 Functions Covered in this Chapter CUMIPMT CUMPRINC FV IPMT IRR ISNUMBER NPER PMT PPMT PV RATE SLN Succeeding in Business with Microsoft Excel

5 Level 1 Objectives: Calculating the Values for Simple Financial Transactions Understand how simple interest and compound interest are calculated Determine the value of a loan payment Analyze positive and negative cash flows Determine the future value and the present value of a financial transaction Determine the interest rate and the number of periods of a financial transaction Succeeding in Business with Microsoft Excel

6 Understanding How Interest Is Calculated Factors that can affect interest How long do you want to borrow the money? What level of risk is the lender assuming in lending the money? What are the current monetary policies and levels of supply and demand to borrow versus lend money? Ways interest is accounted for Simple interest Compound interest Succeeding in Business with Microsoft Excel 2010 Level 1 home 6

7 Calculating Simple Interest Paid solely on the amount of the original principal value Simple interest = Principal * Interest rate per time period * Number of time periods Succeeding in Business with Microsoft Excel 2010 Level 1 home 7

8 Calculating Compound Interest Adding interest earned each period to the principal for purposes of computing interest for the next period Has greater total value than simple interest Used by most financial institutions Annual percentage yield (APY) Equivalent yearly simple interest rate, taking compounding into account Annual percentage rate (APR) Reflects interest being paid on actual amount borrowed Succeeding in Business with Microsoft Excel 2010 Level 1 home 8

9 Reviewing Alternative Financing Options Excel s financial functions perform calculations to help determine the most feasible financing option PMT RATE NPER PV FV Succeeding in Business with Microsoft Excel 2010 Level 1 home 9

10 Using the PMT Function to Determine a Loan Payment Finds value of payment per period, assuming are constant payments and constant interest rate for duration of loan PMT(rate,nper,pv,fv,type) Succeeding in Business with Microsoft Excel 2010 Level 1 home 10

11 Using the PMT Function to Determine a Loan Payment Succeeding in Business with Microsoft Excel 2010 Level 1 home 11

12 Arguments of the PMT Function rate nper pv fv type Interest rate per compounding period Number of compounding periods Present value Future value (compounded amount) Designates when payments are made Type 0 end of period Type 1 beginning of period Succeeding in Business with Microsoft Excel 2010 Level 1 home 12

13 Understanding Cash Flow (Inputs And Outputs) Succeeding in Business with Microsoft Excel 2010 Level 1 home 13

14 Specifying Consistent Units of Time Financial functions apply the interest rate per period and the payment per period to the principal value over a specified number of periods Succeeding in Business with Microsoft Excel 2010 Level 1 home 14

15 Determining the Value of the Loan Payment Succeeding in Business with Microsoft Excel 2010 Level 1 home 15

16 Using a Financial Function with Cell Referencing Succeeding in Business with Microsoft Excel 2010 Level 1 home 16

17 Using the RATE, NPER, PV, and FV Functions Succeeding in Business with Microsoft Excel 2010 Level 1 home 17

18 Determining the Future Value of a Financial Transaction Succeeding in Business with Microsoft Excel 2010 Level 1 home 18

19 Determining the Present Value of a Financial Transaction Succeeding in Business with Microsoft Excel 2010 Level 1 home 19

20 Determining the Interest Rate of a Financial Transaction Succeeding in Business with Microsoft Excel 2010 Level 1 home 20

21 Determining the Number of Periods of a Financial Transaction Succeeding in Business with Microsoft Excel 2010 Level 1 home 21

22 Writing Formulas for Other Loan Options Down payment Balloon payment Mortgage fees Adjust present value (pv) to reflect exact value of the loan Specify negative future value (fv) Adjust the pv of the loan by subtracting the fees from the loan amount Recalculate the interest rate using the same payments and loan periods, with the new pv amount Succeeding in Business with Microsoft Excel 2010 Level 1 home 22

23 Selecting a Financing Option Succeeding in Business with Microsoft Excel 2010 Level 1 home 23

24 Level 1 Summary Basic Excel functions for calculating the elements of a loan (PMT, RATE, NPER, PV, FV) How these functions affect positive and negative cash flows of a financial institution Succeeding in Business with Microsoft Excel

25 Level 2 Objectives: Creating a Projected Cash Flow Estimate and Amortization Table Set up an amortization table to evaluate a loan Calculate principal and interest payments Calculate cumulative principal and interest payments Set up named ranges for a list Calculate depreciation and taxes Succeeding in Business with Microsoft Excel

26 Designing the Cash Flow Estimate of a Worksheet Amount of money coming in or out of a company each year Combination of revenues and expenses with the effects of required capital investment and financing Succeeding in Business with Microsoft Excel 2010 Level 2 home 26

27 Identifying the Missing Data Elements Depreciation is the process by which a company spreads the expense of an asset over its useful life. Succeeding in Business with Microsoft Excel 2010 Level 2 home 27

28 Identifying the Missing Data Elements Succeeding in Business with Microsoft Excel 2010 Level 2 home 28

29 Identifying the Missing Data Elements Succeeding in Business with Microsoft Excel 2010 Level 2 home 29

30 Setting Up an Amortization Table Standard method of detailing a loan transaction Lists, for each specific loan period, the remaining principal and the value of the payment apportioned to interest expense and to principal pay down Succeeding in Business with Microsoft Excel 2010 Level 2 home 30

31 Setting Up an Amortization Table Succeeding in Business with Microsoft Excel 2010 Level 2 home 31

32 Calculating Principal and Interest Payments IPMT function Calculates the value of the interest payment for a specified period IPMT(rate,per,nper,pv,fv,type) PPMT function Calculates the value of the principal payment for a specified period PPMT(rate,per,nper,pv,fv,type) Succeeding in Business with Microsoft Excel 2010 Level 2 home 32

33 rate per Arguments of the PPMT and IPMT Functions Interest rate per period Period for which interest or principal amount will be calculated nper Total number of periods in the financial transaction pv fv type Value at the beginning of the financial transaction Value at the end of the financial transaction Payment type of 0 or 1 (made at beginning or end of each period, respectively) Succeeding in Business with Microsoft Excel 2010 Level 2 home 33

34 Succeeding in Business with Microsoft Excel 2010 Level 2 home 34

35 Succeeding in Business with Microsoft Excel 2010 Level 2 home 35

36 Calculating Principal and Interest Payments Between Two Periods CUMIPMT function Automatically calculates interest values between two periods CUMIPMT(rate,nper,pv,start_period, end_period,type) CUMPRINC function Automatically calculates principal values between two periods CUMPRINC(rate,nper,pv,start_period, end_period,type) Succeeding in Business with Microsoft Excel 2010 Level 2 home 36

37 Calculating Principal and Interest Payments Between Two Periods Succeeding in Business with Microsoft Excel 2010 Level 2 home 37

38 Calculating Principal and Interest Payments Between Two Periods Succeeding in Business with Microsoft Excel 2010 Level 2 home 38

39 Calculating Principal and Interest Payments Between Two Periods Succeeding in Business with Microsoft Excel 2010 Level 2 home 39

40 Calculating Depreciation Using the SLN Function Straight line depreciation method Approximation of actual depreciation allowed by the tax code Allocates value of an asset evenly throughout the life of the asset =SLN(cost,salvage,life) Cost Initial cost of the asset Salvage Value at the end of depreciation Life Number of periods over which the asset is depreciated Succeeding in Business with Microsoft Excel 2010 Level 2 home 40

41 Calculating Depreciation Using the SLN Function Succeeding in Business with Microsoft Excel 2010 Level 2 home 41

42 Alternative Depreciation Options Provided in Excel Function Definition Syntax Double-declining balance Sum of the years digits Fixed-declining balance Variable-declining balance Computes depreciation at an accelerated rate Depreciation apportioned based on declining fractional amount of asset s life Returns depreciation of asset for a specified period using fixed-declining balance method Returns depreciation of asset for a specified period using double-declining balance method DDB(cost,salvage,life, period,factor) SYD(cost,salvage,life, per) DB(cost,salvage,life, period,month) VDB(cost,salvage,life, start_period,end_period, factor,no_switch) Succeeding in Business with Microsoft Excel 2010 Level 2 home 42

43 Calculating Taxes Succeeding in Business with Microsoft Excel 2010 Level 2 home 43

44 Completing the Analysis Succeeding in Business with Microsoft Excel 2010 Level 2 home 44

45 Level 2 Summary Amortization tables Calculating principal and interest payments with PPMT and IPMT Calculating cumulative principal and interest payments with CUMPRINC and CUMIPMT Calculating depreciation using the straight line method Calculating taxes Succeeding in Business with Microsoft Excel

46 Level 3 Objectives: Evaluating the Financial Viability of Alternative Project Options Set up a worksheet to analyze profitability Calculate the net present value Calculate the internal rate of return Calculate the return on investment Determine the payback period Succeeding in Business with Microsoft Excel

47 Setting Up a Worksheet to Analyze Profitability Succeeding in Business with Microsoft Excel 2010 Level 3 home 47

48 Setting Up a Worksheet to Analyze Profitability Succeeding in Business with Microsoft Excel 2010 Level 3 home 48

49 Calculating Net Present Value (NPV) Uses expected cash flows and applies a minimum rate of return (hurdle rate) to discount these cash flows into current (present) value dollars Enables you to see current worth of projected cash flows NPV(rate,value1,value2, ) Has several requirements Succeeding in Business with Microsoft Excel 2010 Level 3 home 49

50 Setting Up a Table of Hurdle Rates Succeeding in Business with Microsoft Excel 2010 Level 3 home 50

51 Calculating the Internal Rate of Return (IRR) Considers the cash flows and discounts them back to the present value Calculates rate at which the discounted cash flows in and out are equal IRR(values,guess) Succeeding in Business with Microsoft Excel 2010 Level 3 home 51

52 Calculating the Internal Rate of Return (IRR) Succeeding in Business with Microsoft Excel 2010 Level 3 home 52

53 Creating a Chart Showing the Hurdle Rate Versus NPV Succeeding in Business with Microsoft Excel 2010 Level 3 home 53

54 Return on Investment (ROI) Sum of the cash flows, excluding initial investment, divided by the investment value Succeeding in Business with Microsoft Excel 2010 Level 3 home 54

55 Calculating the ROI Succeeding in Business with Microsoft Excel 2010 Level 3 home 55

56 Determining the Payback Period Payback period Time it will take to earn sufficient profits so the loan can be paid back Payback year Year in which cumulative total cash flow is greater than or equal to $0 Succeeding in Business with Microsoft Excel 2010 Level 3 home 56

57 Determining the Payback Period Succeeding in Business with Microsoft Excel 2010 Level 3 home 57

58 Evaluating the Results of the Analysis Succeeding in Business with Microsoft Excel 2010 Level 3 home 58

59 Level 3 Summary Exploration of the profitability of a financial venture by: Calculating the NPV Calculating the IRR Determining the ROI Determining the payback period Succeeding in Business with Microsoft Excel

60 Chapter Summary Calculating the values for simple financial transactions Creating a projected cash flow estimate and amortization table Evaluating the financial viability of alternative project options Succeeding in Business with Microsoft Excel

Excel Tutorial 9: Working with Financial Tools and Functions TRUE/FALSE 1. The fv argument is required in the PMT function.

Excel Tutorial 9: Working with Financial Tools and Functions TRUE/FALSE 1. The fv argument is required in the PMT function. ANS: F PTS: 1 REF: EX 493 2. Cash flow has nothing to do with who owns the money.