Comparing investments

Cash flow diagrams in progress. Comments / corrections are welcome. Please post in New in Wiki - Comparing Investments.

This article shows how to compare the past performance of two investments. Solutions are provided to allow the reader to duplicate the results with a spreadsheet.

There are many online financial calculators that do exactly what this article describes. However, the reader is placing full confidence that the math behind the online calculator (1) is accurate and (2) uses assumptions expected by the reader. There should be no surprises, especially when finances are involved. Having your own spreadsheet clearly defines the situation. What-if scenarios are easily done, especially since the data can be manipulated to see trends with a simple chart.

Caveat: Past performance is no guarantee of future performance. Interpretation of results is the responsibility of the reader. If there are any questions, please don't hesitate to ask in the forum for guidance.

Microsoft Excel was used for this article. However, Open Office Calc will work equally well and is a free application that is supported on several operating systems. Open Office financial functions are very similar to Microsoft's functions.

To use this article, copy the formulas from the example tables below and paste into a spreadsheet. The examples are also available for download at the bottom of this page.

Present Value
In order to evaluate a financial investment, prices are referenced as if the money is invested today. The amount of money that must be invested today is called present value. Using the same point in time allows comparison between different financial instruments, e.g. an "apples-to-apples" comparison.

The equation for Present Value can be expressed as :
 * {| style="border:1px solid darkgray;"

where
 * align="left" |PV = FV * 1 / (1 + i)N -or- PV = FV * (1 + i)-N
 * }
 * PV is the present value (amount of money today)
 * FV is the future value (amount of money at some point in the future)
 * i is the interest rate
 * N is the number of periods

The graph below shows the general idea. The slope of the line depends on the interest rate (i) and the number of payments (N).


 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * +Equate Future Prices to the Present
 * Reference future values to present value.png
 * }

Fundamental Property #1
The first important property of present value is that the higher the interest rate (or discount rate ), the lower the present price.

The higher the interest rate, the less that has to be invested today to achieve the same value in the future.


 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * +Increasing the interest rate lowers the price.
 * Increases in the interest rate lowers the price.png
 * }

Fundamental Property #2
The second important property of present value is that for a given interest rate (or discount rate), the farther into the future the investment will be received, the lower the present value.

Longer term investments have more time for the interest to accumulate, resulting in fewer dollars that need to be invested.


 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * +The longer the investment time, the lower the price.
 * Longer investement time - lower price.png
 * }

Cash Flow Diagrams
(in process) --LadyGeek 00:20, 17 March 2010 (UTC)

Sign Convention
Financial functions use a standard sign convention to indicate the direction of cash flow.


 * A positive sign is used for money that flows into our hand.
 * A negative sign is used for money that flows out of our hand.

Whether a cash flow is an inflow (+) or outflow (-) depends on your perspective. For example, money paid on a loan (outflow) is negative.

Note:
 * One wrong sign will change the computed results and give an incorrect answer.
 * If you consistently change all signs in the problem, you switch roles (for example, switching from being the borrower to being the lender)
 * In all problems, both signs must be used. Sometimes the other sign is in the answer.

Financial variables
There are six financial variables.


 * 1) PV: The first unequal money in or out of the cash flow diagram is the Present Value.
 * 2) FV: The last unequal money in or out of the cash flow diagram is the Future Value.
 * 3) PMT: A fixed amount received in each period is the Payment.
 * 4) Type: Money received at the “end of the period” is Excel Type = 0. Money received at the “beginning of the period” is Excel Type = 1.
 * 5) N: Number of periods.
 * 6) I: Interest rate per period.

N and I must be expressed in the same terms. If N is years, then I must be expressed in years. If N is months, then I must be expressed in months.

How to Compare Investments

 * 1) Sum the individual cash flows (every payment and any final value) in today's price for each investment.
 * 2) Compare the prices.

Comparing Interest Rates

 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * +Compare the offered price to the present value.
 * Compare offered price to present value.png
 * }

Example 1
An investing opportunity offers to pay $500 at the end of each year for the next 20 years. At the end of 20 years, the value of this investment is zero, it can not be sold.

For example: You loan your friend some money. In 20 years when the debt is repaid, its value is zero.

The purchase price of this opportunity is $5,300.

If the investor wants a 5.5% interest rate, is this a good investment?

Solution: (insert cash flow diagram here) --LadyGeek 21:56, 15 March 2010 (UTC)


 * I = 5.5 (this is the APY)
 * N = 20 (each period is one year)
 * PMT = 500 (sign is positive because money flows into our hand)
 * FV = 0 (there is no last period unequal amount received)
 * Type = 0 (end of period payments)
 * PV = (solve for this)

With Excel:


 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center"|Present Value
 * align = "center"|Excel Formula
 * align = "center" style="color:red"|($5,975.19)
 * align = "center"|=PV(5.5%,20,+500)
 * }
 * }

The PV of this investment is $5,975.19. The sign is negative because we should pay (money out of our hand) this much today to buy this investment. Forgetting the sign, this investment is worth $5,975.19.

Since we can buy an investment worth $5,975.19 for only $5,300, it is a good investment.

Example 2
An investing opportunity offers to pay $100 per year for the next 5 years and an additional $1,000 at the end of 5 years. The purchase price is $1,243.83.

If the investor wants a 6.25% interest rate, is this a good investment?

Solution: (insert cash flow diagram here) --LadyGeek 21:56, 15 March 2010 (UTC)


 * I = 6.25 (this is the APY)
 * N = 5 (each period is one year)
 * PMT = 100 (sign is positive because money flows into our hand)
 * FV = 1000 (sign is positive because money flows into our hand)
 * Type = 0 (end of period payments)
 * PV = (solve for this)

With Excel:


 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center"|Present Value
 * align = "center"|Excel Formula
 * align = "right" style="color:red"|($1,156.90)
 * =PV(6.25%,5,100,1000,0)
 * }
 * }

The PV of this investment is $1,156.90. Remember the negative sign only tells us that the money flows out of our hand to buy it, nothing more. Ignore the sign, this investment is worth $1,156.90.

Example 3
Would you like to receive $15,000 today or $18,000 in four years?

The answer depends on the interest rate. If you can find an investment with good interest rate, it will be better to take the $15,000 today. How do you find the interest rate to invest $15,000 today?

Use a starting guess of 4%. The present value of $18,000 received four years from now is $15,386.48. Since the present value is higher than $15,000 (receiving $386.48 more) it is still better to receive $18,000 in four years.

With Excel:


 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center"|Present Value
 * align = "center"|Excel Formula
 * align = "center"|$15,386.48
 * align = "center"|=PV(4%,4,0,-18000)
 * }
 * }

Now, let Excel remove the guess work and find where it would be more beneficial to receive the $15,000 now.

Use the Goal Seek function (see Excel help for details) to set the value of Cell F13 to zero by adjusting Cell C13.

With Excel (displayed):
 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center"|Rate
 * align = "center"|PV
 * align = "center"|Purchase Price
 * align = "center"|Difference
 * 4.0%
 * $15,386.48
 * $15,000.00
 * $386.48
 * 4.7%
 * $15,000.00
 * $15,000.00
 * $0.00 
 * }
 * $0.00 
 * }

Excel formulas (copy these into your spreadsheet):


 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center"|
 * align = "center"|Rate (Column C)
 * align = "center"|PV (Column D)
 * align = "center"|Purchase Price (Column E)
 * align = "center"|Difference (Column F)
 * Row 12
 * align = "right"|0.04
 * =PV(C12,4,0,-18000)
 * align = "center"|15000
 * =D12-E12
 * Row 13
 * align = "right"|0.0466
 * =PV(C13,4,0,-18000)
 * align = "center"|15000
 * =D13-E13
 * }
 * =D13-E13
 * }

If you can get more than 4.7% for your investment now, take the $15,000.

Comparing Interest Rates and Maturity Dates

 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * +Compare with different interest rates and maturity dates.
 * Compare two investments.png
 * }

Example 4
Which is better: $140,000 paid over the next 36 months or $160,000 paid over the next 60 months? Clearly $160,000 is better than $140,000 but what is the interest rate on the deferred funds to get the additional $20,000?

Phrased differently, what is the interest rate for the first investment (36 months) to match the 60 month investment ($160,000)?

The interest rate where it would be worthwhile to take the $140,000 in 36 months is 14.90%.

How:

Find the interest rate where the present value of both investments are equal. In other words, make the present value of the two investments in the figure above equal height by adjusting the interest rate (ignore the FV height difference, the graph is easier to read this way). Adjust the interest rate for both investments simultaneously to find where the arrows align.

Let Excel do the work. Use the Goal Seek function (see Excel help for details) to set the value of Cell P11 to zero by adjusting Cell K11.

Displayed values:


 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center"|Effective Annual Yield
 * align = "center"|Nominal Interest Rate
 * align = "center"|Monthly Interest Rate
 * align = "center"|36 Month Investment
 * align = "center"|60 Month Investment
 * align = "center"|Difference
 * align = "right"|15.96%
 * align = "right"|14.90%
 * align = "right"|1.24%
 * align = "center"|$112,346.88
 * align = "center"|$112,346.88
 * align = "center"|($0.00)
 * }
 * }

Cell Formulas:
 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center"|
 * align = "center"|Effective Annual Yield (Column K)
 * align = "center"|Nominal Interest Rate (Column L)
 * align = "center"|Monthly Interest Rate (Column M)
 * align = "center"|36 Month Investment (Column N)
 * align = "center"|60 Month Investment (Column O)
 * align = "center"|Difference (Column P)
 * align = "center"|Row 11
 * align = "right"|0.15957
 * =NOMINAL(K11,12)
 * align = "center"|=L11/12
 * align = "center"|=PV(M11,36,-140000/36)
 * align = "center"|=PV(M11,60,-160000/60)
 * align = "center"|=N11-O11
 * }
 * }

There is an important assumption that exemplifies the need for caution. Nowhere does it say that the interest is an annual rate! This problem is stated in months, and the solution is a rate per month. That's how the PV equation works. All time periods must be the same. If the reader interpreted this as annual rate, a significant error of 1.06% results.

There are 2 columns of interest here. Effective Annual Yield and Nominal Interest Rate, which are explained below. The Goal Seek function was used to find the annual yield, which flows into the monthly rate.

Compounded Interest Rates
As shown in Example 4, the time period and type of interest (compounded or simple) needs to be clearly defined. Use Excel to convert between an annual yield and the rate for the period of interest.

Caution: There is a difference between interest rate and yield.

Yield
Yield is defined as the return on an investment. It is computed by determining the interest rate that will make the present value of the cash flow from an investment equal to its price. This is shown mathematically as:
 * {| style="border:1px solid darkgray;"


 * align="left" |p = C1/(1 + y) + C2/(1 + y)2 + C3/(1 + y)3 + ... +CN/(1 + y)N
 * }

where
 * p = Price
 * Ct = Cash flow in year t
 * y = Yield (interest rate used to determine the price of the investment)
 * N = Number of years

The yield calculated above is also called the internal rate of return.

If the equation is confusing, just remember that interest rate is used to determine the yield of an investment. For example, CDs often quote both the periodic interest rate and the effective annual yield. The higher interest rate is the effective annual yield.

Periodic Interest Rate
By definition, the periodic rate is the annual rate divided by the number of periods per year. So multiply the periodic rate by the number of periods per year to get the annual rate. For example, if we have an annual interest rate and want to find the semiannual interest rate, just divide the annual rate by 2.

However, simply multiplying the periodic rate by the number of periods per year introduces an error when compounding. The annual interest rate needs to be converted into an effective annual yield, which results in the following exponential equation:


 * {| style="border:1px solid darkgray;"

where
 * align="left" |Effective annual yield = (1 + Periodic Interest rate)m + 1
 * }
 * m = Frequency of payments per year

Note: Excel functions RATE and  IRR return the periodic rate, while  XIRR returns the annualized yield.

Approximating the Interest Rate
More often than not, monthly interest rates are obtained from the effective annual yield by simply dividing by the number of periods. For example, a monthly interest rate is usually taken as the annual rate / 12.

For typical interest rates, simple multiplication is often close enough to the exponential equation. It produces the result with a lot less work if you don't have a calculator that can do exponential and logarithmic functions.

For example, 3% per year is 0.25% per month by division, and 0.246627% per month by the exponential formula- a difference of only 0.0034 percentage points.

Going the other way, 0.25% per month is 3% by multiplication or 3.041596% by exponential formula.

It's possible that the use of simple multiplication in certain contexts (such as monthly vs. annual interest rates) is traditional and dates back to the pre-calculator era.

Consequences of Approximation Errors
Caution is advised when approximating interest rates for large amounts of funds over long periods of time.

For example, a home mortgage is available for an annual interest rate of 12%. However, it's not clearly stated whether the rate is compounded yearly or monthly. The difference is only


 * {| style="border:1px solid darkgray;"


 * align="left" |0.0511 % per month = 1 % (12% / 12) - 0.949% (NOMINAL(0.12,12)/12)
 * }

Compounding over 16 years results in an overpayment by the homeowner of several thousand dollars. See the forum discussion for details. Information was missing to fully define the problem, but it is an example of why the investor needs to understand the implications of approximating interest rates.

Example 5
Show the monthly interest rates for a given effective annual yield. Conversely, show the effective annual yield for a monthly interest rate.

Displayed values:
 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * width="10%"|
 * align = "center" |Annual Yield (Column K)
 * align = "center" |Nominal Monthly Rate
 * align = "center" |
 * align = "center" |Monthly Rate (Column N)
 * align = "center" |Effective Annual Yield
 * align = "center"|Row 22
 * align = "right"|10%
 * align = "center"|0.80%
 * align = "right"|2.0%
 * align = "center"|26.82%
 * align = "center"|Row 23
 * align = "right"|8%
 * align = "center"|0.64%
 * align = "right"|1.5%
 * align = "center"|19.56%
 * align = "center"|Row 24
 * align = "right"|6%
 * align = "center"|0.49%
 * align = "right"|1.1%
 * align = "center"|14.03%
 * align = "center"|Row 25
 * align = "right"|4%
 * align = "center"|0.33%
 * align = "right"|1.0%
 * align = "center"|12.68%
 * align = "center"|Row 26
 * align = "right"|2%
 * align = "center"|0.17%
 * align = "right"|0.5%
 * align = "center"|6.17%
 * }
 * align = "right"|1.0%
 * align = "center"|12.68%
 * align = "center"|Row 26
 * align = "right"|2%
 * align = "center"|0.17%
 * align = "right"|0.5%
 * align = "center"|6.17%
 * }
 * align = "center"|6.17%
 * }

Cell formulas:
 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * width="10%"|
 * align = "center" |Annual Yield (Column K)
 * align = "center" |Nominal Monthly Rate
 * align = "center" |
 * align = "center" |Monthly Rate (Column N)
 * align = "center" |Effective Annual Yield
 * align = "center"|Row 22
 * align = "right"|0.1
 * =NOMINAL(K22,12)/12
 * align = "right"|0.02
 * align = "center"|=EFFECT(N22*12,12)
 * align = "center"|Row 23
 * align = "right"|0.08
 * =NOMINAL(K23,12)/12
 * align = "right"|0.015
 * align = "center"|=EFFECT(N23*12,12)
 * align = "center"|Row 24
 * align = "right"|0.06
 * =NOMINAL(K24,12)/12
 * align = "right"|0.011
 * align = "center"|=EFFECT(N24*12,12)
 * align = "center"|Row 25
 * align = "right"|0.04
 * =NOMINAL(K25,12)/12
 * align = "right"|0.01
 * align = "center"|=EFFECT(N25*12,12)
 * align = "center"|Row 26
 * align = "right"|0.02
 * =NOMINAL(K26,12)/12
 * align = "right"|0.005
 * align = "center"|=EFFECT(N26*12,12)
 * }
 * align = "right"|0.01
 * align = "center"|=EFFECT(N25*12,12)
 * align = "center"|Row 26
 * align = "right"|0.02
 * =NOMINAL(K26,12)/12
 * align = "right"|0.005
 * align = "center"|=EFFECT(N26*12,12)
 * }
 * align = "center"|=EFFECT(N26*12,12)
 * }

Unequal Payments
The present value formula can only be used if all payments are the same amount. Suppose you have a series of payments that vary every period? The theory is the same- sum the present value of the individual cash flows (payments). The only difference is that you need to use a present value function for each payment.

Example 6
Suppose you have the opportunity to purchase an investment which promises to make the following payments every quarter (3 months, see table below). If a 12% interest rate is desired, what is the most that you should pay for it?

You should pay at most $8,212.79.

How:

First, note that neither the type of interest nor the period of time is stated. For this problem, it's 12 % per year, but the quarterly interest is defined as 3% = 12% / 4. This is simple interest, no compounding is used.

Since the payments vary every 3 month period, the present value of each payment is calculated. Then, the payments are summed to get the total present value. Excel already has a function that will do the individual calculations for you, called Net Present Value. Note that the answers match (Sum of Column F with Net Present Value in Cell G20).

Displayed values:
 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center" |
 * align = "center" |Interest Rate (Quarterly) (Column C)
 * align = "center" |3 Month Period (Column D)
 * align = "center" |Payment (Column E)
 * align = "center" |Present Value (Column F)
 * align = "center" |Net Present Value (Column G)
 * align = "center"|Row 20
 * align = "center"|0.03
 * align = "center"|1
 * align = "center"|1000
 * align = "right"|$970.87
 * align = "right"|$8,212.79
 * align = "center"|Row 21
 * align = "center"|0.03
 * align = "center"|2
 * align = "center"|1200
 * align = "right"|$1,131.12
 * align = "right"|
 * align = "center"|Row 22
 * align = "center"|0.03
 * align = "center"|3
 * align = "center"|1500
 * align = "right"|$1,372.71
 * align = "right"|
 * align = "center"|Row 23
 * align = "center"|0.03
 * align = "center"|4
 * align = "center"|1700
 * align = "right"|$1,510.43
 * align = "right"|
 * align = "center"|Row 24
 * align = "center"|0.03
 * align = "center"|5
 * align = "center"|1800
 * align = "right"|$1,552.70
 * align = "right"|
 * align = "center"|Row 25
 * align = "center"|0.03
 * align = "center"|6
 * align = "center"|2000
 * align = "right"|$1,674.97
 * align = "right"|
 * align = "right"|Sum of Present Value:
 * align = "right"|$8,212.79
 * align = "right"|
 * }
 * align = "right"|$1,674.97
 * align = "right"|
 * align = "right"|Sum of Present Value:
 * align = "right"|$8,212.79
 * align = "right"|
 * }
 * align = "right"|Sum of Present Value:
 * align = "right"|$8,212.79
 * align = "right"|
 * }

Cell formulas:
 * {| style="margin:1em auto 1em auto;" cellpadding= "3" border="1" style="border:1px solid black; border-collapse: collapse;"


 * align = "center" |
 * align = "center" |Interest Rate (Quarterly) (Column C)
 * align = "center" |3 Month Period (Column D)
 * align = "center" |Payment (Column E)
 * align = "center" |Present Value (Column F)
 * align = "center" |Net Present Value (Column G)
 * align = "center"|Row 20
 * align = "center"|0.03
 * align = "center"|1
 * align = "center"|1000
 * align = "center"|=PV(C20,D20,0,-E20)
 * align = "center"|=NPV(C20,E20:E25)
 * align = "center"|Row 21
 * align = "center"|0.03
 * align = "center"|2
 * align = "center"|1200
 * align = "center"|=PV(C21,D21,0,-E21)
 * align = "center"|
 * align = "center"|Row 22
 * align = "center"|0.03
 * align = "center"|3
 * align = "center"|1500
 * align = "center"|=PV(C22,D22,0,-E22)
 * align = "center"|
 * align = "center"|Row 23
 * align = "center"|0.03
 * align = "center"|4
 * align = "center"|1700
 * align = "center"|=PV(C23,D23,0,-E23)
 * align = "center"|
 * align = "center"|Row 24
 * align = "center"|0.03
 * align = "center"|5
 * align = "center"|1800
 * align = "center"|=PV(C24,D24,0,-E24)
 * align = "center"|
 * align = "center"|Row 25
 * align = "center"|0.03
 * align = "center"|6
 * align = "center"|2000
 * align = "center"|=PV(C25,D25,0,-E25)
 * align = "center"|
 * align = "right"|Sum of Present Value:
 * align = "center"|=SUM(F20:F25)
 * align = "center"|
 * }
 * align = "center"|=PV(C25,D25,0,-E25)
 * align = "center"|
 * align = "right"|Sum of Present Value:
 * align = "center"|=SUM(F20:F25)
 * align = "center"|
 * }
 * align = "right"|Sum of Present Value:
 * align = "center"|=SUM(F20:F25)
 * align = "center"|
 * }

Both Present Value and Net Present Value assume that the interest rate is defined. Suppose that you only have the payments. How do you calculate the interest?

Not a problem. Just use the Internal Rate of Return function, IRR, to find the yield (internal rate of return). Finding the solution is somewhat more complicated and best left to Excel. Refer to Microsoft's help for information on the IRR function. Pay special attention to setting up the problem. The sum of the income and payments must be zero for the function to work.

Excel Functions
Microsoft's help files are well documented with working examples for each function. If using Open Office, Microsoft descriptions may be more informative. Enable browser cookies to view.
 * PV, Present Value.
 * NPV, Net Present Value
 * IRR, Internal Rate of Return
 * XIRR, Internal Rate of return for cash flows that are not periodic
 * Effect, Convert to Effective annual yield from the periodic rate
 * Nominal, Convert to Periodic interest rate from the effective annual yield
 * RATE, Interest rate per period of an annuity

Forum Discussions

 * $140,000 over 3 years or $160,000 over 5 years
 * New in Wiki - Comparing Investments, forum discussion