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Introduction to Spreadsheet Modeling

Module 004 Introduction to

Spreadsheet Modeling

At the end of this module you are expected to:

1. Determine the components of spreadsheet models
2. Create and analyze different spreadsheet models to make important business
decisions such as cost projections and break even analysis
3. Discuss the time value of money and apply its concepts in business or
personal investments.

A. Basic Spreadsheet Modeling

Spreadsheet models, like most mathematical models, deal with inputs, decision
variables, and outputs. For the purposes of the model, inputs are given fixed values. The
decision variables are obviously those variables that a decision maker can control.
Determined by the decision variables and the inputs are the outputs which are ultimately
the values of interest.
Let us assume that a manager needs to order for a particular seasonal product. The
said product is set to be discontinued soon, so this will be the only order that the manager
will need to make for the product. The following are the inputs: the per item or unit
variable cost ordered, the fixed cost of the order, the price charged per item sold, per item
salvage value if there is anything left in inventory after the product has been taken out of
the shelves, and finally the demand for the product. The number of items to be ordered is
the decision variable. The ultimate value of interest is the profit (or loss) - the key output –
from the product. The said output can also be broken down into contributors to these
outputs which are sales revenue, total ordering cost and the leftover salvage value. All of
these need to be calculated to achieve profit.
The process of placing inputs and decision variables into a spreadsheet, relating
them appropriately through the use of formulas, in order to obtain outputs is called
spreadsheet modeling. After completing this process, the manager, analyst, or decision
maker can proceed in several directions. A sensitivity analysis can be performed to see the
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changes in the input or decision variables when one or more outputs change. Subject to
certain constraints, another way or direction is to obtain the values decision variables that
either minimize or maximize a certain output. The creation and use of charts to graphically
show particular parameters are related in the model.
Getting the logic correct and the production of useful results is a big part of
spreadsheet modeling. Good spreadsheet modeling practices and the readability of your
spreadsheet models should be foremost in your mind. This is because other people will
read and try to make sense of the spreadsheet models you have created. The following
features will help ensure and improve readability:

• Make a logical and clear lay-out of the overall model

• Separate different parts of a model, if possible in multiple worksheets
• In the different sections of the model, make the headings clear for all the inputs,
decision variables and outputs.
• Range name usage
• Use of formatting features like font styles, font sizes, coloring, indentation, etc.
• Usage of cell comments
• For explanations or assumptions, use text boxes

It is very important to consider that if no one can understand what you have in your
spreadsheet model then even when you have ensured correctness of your logic and
formulas you will not get very far. The flexibility of spreadsheets is the source of its
power. Much like a big canvass, a blank spreadsheet is just waiting for someone to
inject useful data and formulas. A lot is allowed in spreadsheets, almost anything.
However, its power can be abused if there is no overall plan for what needs to be
done. Therefore, you need to plan ahead, and when your plan starts to go sideways,
or it does not look good after you fill in the spreadsheet, you need to revise your
plan immediately.

The following example will illustrate a process of building a spreadsheet model

where it is built according to stages. First is to build a model that is correct, although not
very readable. We then modify the model at each subsequent stage to make it more
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readable. Although, you do not really need to go through each and all of the stages when
you finally build your own model. Often, there is no problem if you target the last stage
right away once you already get more familiar the modeling process.

Example 1

It is February, and the yearly Collegiate Basketball League is down to the

final four teams. Jordan Clark is a T-shirt vendor who is planning to order T-shirts
with the logos of the final four teams. Mr. Clark plans to order these from a
manufacturer and resell the shirts to fans. The fixed cost of any order is P750.00,
the variable cost per shirt to Mr. Clark is P8.00 and Mr. Clark’s selling price is
P18.00. However, charging will only be done a week after the tournament. Mr. Clark
anticipates that after that time interest in the shirts will already subside, so he
would like to sell the remaining shirts if any, at P6.00 each. He is confident that
during the regular price week demand for the shirts will be 1500 pieces. Given that
figure, he plans to order 1450 pieces of shirts, but he wants to experiment with
the demand which is uncertain and also with his order quantity. To do this he needs
to build a spreadsheet model. Here is how he should proceed:

Objective: To make a spreadsheet model in all of the stages,

ensuring that it is correct in each stage and being more
readable and flexible in each stage as it progresses.

Solution: Although the model is built for generality it is fairly

simple to see the logic behind the model. The formulas allow
that the order quantity be less than, equal to, or greater than
demand. When the demand is less than the order quantity, Mr.
Clark will sell all of the shirts for the P18.00 regular price and
all leftovers at P6.00 only. But if the demand is greater than the
quantity ordered, Mr. Clark will only sell all shirts at P18.00

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per piece. This can be implemented in Excel with an IF

function.

Figure 1 shows a first attempt at a spreadsheet model.

One must enter a possible demand in cell B3, and in cell B4 a
possible order quantity, and to finally compute for profit in cell
B5 with this formula:

=-750-8*B4+IF(B3>B4,18*B4,18*B3+6*(B4-B3))

The formula gets the difference of the fixed and variable costs

and then according to the logic described adds the revenue.

Figure 1 Base Model

Excel Function: IF
Excel’s IF function has the syntax:
=IF (condition, result If True, If False)

Any expression that is either true or false is the condition. The

expressions result. If True and result If False are two expressions that can be
any expression to be entered in a cell. It could be numbers, text, or other
Excel functions or other If functions. Do note that when neither of the two
expressions is text, it must be enclosed in double quotes as this example:
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=IF(Score>=90,”A”,”B”)

Combinations of conditions which are complex can also be a condition

with the use of the keywords AND or OR thereby making the syntax as:

=IF(AND(Score1<60,Score2<60),”Fail”,”Pass”)

Figure 1, although entirely correct is not very readable or flexible for

the reason that it breaks a rule that should never be broken. Inputs or input
values should NEVER be hard coded in the formulas; this is the rule in
spreadsheet models. Input values should be stored in separate cells and just
place cell references in the formulas about the inputs.

Figure 2 Model with Input Cells

The model in Figure 2 shows a solution to the broken rule in Figure 1.

The inputs have now been placed in the range B3:B6 and the profit formula
now read:

=-B3-B4*B9+IF(B8>B9,B5*B9,10*B8+B6*(B9-B8))

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This is the exact same formula as in Figure 1but is more flexible now.
The profit automatically recalculates when inputs are changed. Most
important of all is that inputs are no longer hard coded in the formula. Yet
still despite being more flexible, the profit formula is not very readable. To
make it more readable, you must use range names.

Figure 3 Model with Range Names in Profit Formula

Given that range names are already used for cells B3 to B6, B8 and B9,
the model in Figure 3 looks exactly the same as that of Figure 2 but the
formula in cell B10 will now look like:

=-Fixed_Cost-Variable_Cost*Order+IF(Demand>Order,Selling_Price*Order,
Selling_Price*Demand+Discount_price*(Order-Demand))

The formula above although quite long, is now easier to read. And if
Mr. Clark or the decision maker wants to see the breakdown of profit into its
various costs and revenues it can be shown in the following figure:
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Figure 4 Model with Intermediate Outputs

The formulas in cells B12, B13, B15, and B16 of Figure 4 are pretty
straightforward. B12 is obviously the fixed cost, B13 is the variable cost
multiplied by the order, B15 is the selling price multiplied by the order, and
B16 is the discount price multiplied by the number of shirts that went on
discount which is none. The profit formula now in cell B17 is:

=-(B12+B13)+(B15+B16)

Range names can in principle still be used for intermediate output

cells but always decide on how many range names you will use as it may
already become overly done more than it would only need to be. Now, given
this model of Mr. Clark, let us say that his assistant is presented with this
model how would he or she know which cells are inputs, decision variables,
or outputs? To clearly show these another improvement in the model can be
implemented with the use of labels and color-coding.

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Figure 5 below shows a blue-red-gray color-coding style and the

descriptive labels appearing in boldface.

Figure 5 Model with Category Labels and Color Coding

Input cells in Figure 5 are represented by blue cells, the decision

variable is represented by the red cell, and the all-important output is
represented by the gray cell. This coding style is not the holy grail which
means you can make your own style but just remember to keep it consistent.
Compared to Figure 1, Figure 5 is much more readable and flexible. A lot can
still be done to improve the model like data tables or charts, but Figures 1 to
5 will suffice for now.
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B. Cost Projections

Our next example and discussion will be on Excel’s charting capabilities with
a goal of obtaining a graphical image of the projected costs.

Example 2

Furniture Company named Furniture Nation produces a lot of custom-made

items for their customers. Their best seller is their bookshelf which they make from
mahogany or narra trees. The company expects that wood prices will increase in the
near future. The following table shows the labor hours and board-feet requirement
for a bookshelf, the current cost per labor hour and per board-foot, and the expected
annual increase of these costs.

Our goal will be to create a model that will enable the company to
experiment on labor costs and growth rates in wood for the manager to see
numerically and graphically how the costs of their bookshelves will vary in the
coming years.

_Resource ________ ___Mahogany_______________Narra_______________Labor______

Required per bookshelf 30 30 16
Current Unit Cost $5.50 $4.30 $18.50
Anticipated annual cost increase 2.4% 1.7% 1.5%
Table 1 Input Data for Bookshelf Manufacturing

For the purposes of enhancing spreadsheet skills, in this example we will

separate the business objectives from the excel objectives. The business objectives
of the company are for the model to allow the company decision makers to see
numerically and graphically how the costs of manufacturing bookshelves increase in
the future, and to make the company answer what-if questions with the model. The
excel objectives, aside from learning good spreadsheet practices, is with the careful

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usage of relative and absolute addresses be able to copy formulas, and from multiple
series of data to be able to create line charts.

Solution

The solution starts by listing the key variables in a table before the actual
start of spreadsheet model development. In doing so, you are forced to examine
which are inputs, which are decision variables, which are outputs, and the roles of
these variables.

_________________________________________________________________________________________
_______
Input Variables Labor and wood requirements per bookshelf, current unit
costs of labor and wood, anticipated unit cost annual increase
Output Variables Projected total bookshelf cost, and projected unit costs of labor
and wood
________________________________________________________________________________________________
Table 2 Key Variables for Bookshelf Manufacturing example

The model’s reasoning is pretty straightforward. First is to project into the

future the unit costs of labor and wood. For any year, the unit costs must be
multiplied to the required number of board-feet and the labor hours per bookshelf.
The final step is to add the wood and labor costs to get the total cost of a bookshelf.

Developing the spreadsheet model

Let us develop the spreadsheet model using the following steps:
1.) Inputs–Inputs in a model are usually entered in the upper-left corner of a
worksheet. As we have discussed, standard coloring of inputs is color blue, but
you can develop your own as long as the input cells are distinguished in some
way. Inputs should be grouped logically and are expected to have appropriate
labels. Informational labels are important documentation for spreadsheet
models. Explicitly entering inputs in input cells ensures easy reference in Excel
formula.
2.) Design output table–When structuring outputs you should plan ahead. In our
example, we have a table that shows a row for every year in the future with year
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0 corresponding to the current year, columns B-D which are three rows
corresponds to the projected unit costs, and for total bookshelf costs are two
columns E-F. Headings should reflect the design, but this certainly is not the only
possible design. What is important is before diving in, you should already have
some logical design in mind.

Figure 6 Bookshelf Cost Model

3.) Projected unit costs of wood– In the range B19:F25, the dollar values are all
calculated from Excel formulas. In our example (Figure 6), the logic is
straightforward, but you must always have a strategy in mind before entering
formulas. You enter a single formula that you are then able to copy is how you
should always try to design your spreadsheet. This actually saves work and
lessens errors. In columns B and C, for the costs per board foot enter the formula
=B9in cell B19 then copies it to cell C19. Now in cell B20 enter the general
formula =B19*(1+B$10) and then copy it to the range B20:C25. It is already

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assumed that you already know the rules for absolute and relative addresses
which means a dollar sign for absolute, and no dollar sign for relative.
Excel Tip:
To facilitate copying relative and absolute addresses are used in Excel
formulas. An absolute address is a column or row that is appended or preceded
with a dollar sign. It does not change when copied. A relative address is when no
dollar sign precedes a row or column address. This makes the said address
change when copied. If your keyboard’s F4 key works you should be able to get a
short-cut on the relative and absolute addresses when you select a cell in a
formula and repeatedly press F4.
4.) Projected unit labor costs–For the calculation of projected hourly labor costs,
in cell D19, enter the formula =B13and then in cell D20 enter the formula
=D19*(1+B$14) after which copy it down column D until D25.
5.) Projected bookshelf costs –The sum of both labor cost and wood cost make up
each bookshelf cost. By carefully using absolute and relative addresses, you will
be able to enter a single formula for both types of wood and for all the projected
years. In cell E19, enter the formula =B$5*B19+B$6*$D19and then copy itto
the range E19:F25. This formula considers that units of wood and labor hours
per bookshelf is at rows 5 and 6 while labor costs current and projected are in
column D. All other references are relative to allow copying.
6.) Chart–Any table of data gets additional value with the use of a chart especially in
the world of business. Charting in Excel is a skill worth mastering. Some
possibilities will be shown in our example, but you can always experiment with
other possibilities on your own. Now create the chart. Select the range E18:F25
which certainly includes the labels in row 18. The next step is to click on the
Insert ribbon also known as the Insert tab then click on the Line dropdown list
or the Insert Line or Area Chart dropdown. After which from the dropdown list
go to “2-D line” and select “Line with Markers”. Then in an instant, you get the
chart that you want. One series for Mahogany and the other series for Narra.
When you select or highlight the chart, a Chart Tools ribbon appears. Depending
on your version of Excel, you either get 2 or 3 tabs from the Chart Tools. These
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are the Design, Layout, and Format tabs. In other versions the tabs are Design
and Format. The most important is the Select Data button from the Design Tab.
From the Select Data, you will be able to choose data ranges for charting in case
the default choices of Excel are wrong. The default choices are actually based on
the range you select when you created the chart.

Figure 7 Bookshelf Model with Chart

Now click on “Select Data” to see the dialogue box of Figure 8. The left
side shows one or multiple series that you can control being charted. On the right

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side the data used for the horizontal axis is what you can control. There is also an
Edit option in the Select Data dialogue box.

Figure 8 Select Data Source dialogue box

Figure 9 Edited Horizontal Axis Labels

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Upon clicking on the Edit button, an Axis Labels dialogue box appears and
upon selecting A19:A25 your horizontal labels are now correct with the current
year being zero (0) instead of one (1) when it was not corrected yet. Another
example of editing is when you double-click on the Vertical Axis you can rescale
it to start at $300.00 instead of $0.00 by editing or formatting using the Format
Axis.

Figure 10 Edited Chart using Format Axis

Professional looking charts are always a plus factor. Be sure to allot time in fine-
tuning your charts. Excel charts are much more informative to a decision-maker
or manager than the table of numbers it is based from. The purpose of
permitting experimentation with various scenarios is what many models are
built for. Models should be built in such a way that managers or decision-makers
only needs to enter any desired values in the input cells then all the outputs
including the chart will automatically change or update. Take for example how

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the chart and the data table are affected if the anticipated increases in wood
costs are twice as high. The immediate effect is shown in the following figure:

Figure 11 Higher increases in Wood Cost

By carefully constructing your model, meaning you have not buried in

the formulas numbers like the annual increase in wood cost, the decision-
maker will be able to answer many what-if questions with just a few strokes
of the keyboard.

C. Break-even Analysis

For most business problems it is a requirement to find the appropriate level

of a certain activity. It will certainly be along the lines of maximizing profit or minimizing
costs. Another level that a company or a business would like to look at would be its break-
even level. Break-even is where the business experiences no profit and no loss at the same
time.
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Example 3

Hand-knitted sweaters are the expertise of HQ Sweaters Company.

They plan to launch a direct mail campaign with a printed catalogue of its
products. Catalog printing cost is $20,000.00 plus $0.10 per catalog. Mailing
costs which includes postage, buying names from a mail-order database, and
order forms is $0.15 per catalog. A $0.20 in extra costs per direct reply
envelope used by a respondent as this is planned to be included by the
company to be used in its mailings. $40 is the average order size of a
customer. Because of labor and material costs, the company’s variable cost
per order is $32 which on average is about 80% of the order’s value. 100,000
catalogs are what the company plans to mail. The following questions are
what the company wants to be answered through the development of a
spreadsheet model:

1) How is profit affected by a change in the response rate?

2) The company breaks-even at what response rate?
3) Should the company proceed with the mailing if they estimate a response
rate of 3%?

Business Objective: To determine the company’s profit by creating a model.

Excel Objective: To learn range names and how to work with them.

Solution:

It is important to place key variables in a Table. In our example, all

variables are designated either as input variables, decision variables, or
output variables. There typically is a key output variable, in our example, it is
profit which is of utmost concern. It is also known as the objective variable.
Therefore, we must distinguish the key output variable from other output
variables to be calculated along the way.

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________________________________________________________________________________________________
Input Variables Various unit costs, average order size, response rate
Decision Variable Number mailed
Key Output Variable Profit
Other Output Variables Number of responses, revenue, and cost totals _______
Table 3 Key Variables in HQ Sweaters Problem

Figure 12 HQ Sweaters Model

Note that the model in Figure 12 uses the blue (inputs) - red (decision
variable) – gray (bottom line output) format we have previously discussed.
The range names are shown by the list to the right.

Excel Tip:

The first step in creating a range name is by highlighting the cells

(either a single cell or range of cells), clicking on the Name Box just to the left
of the Formula Bar, and then typing or entering a range name. Another way is
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to use labels as range names when the cells to be range-named appear next
to a column or row of labels.

After highlighting the labels and cells to be range named, in the

Formulas tab or ribbon select Create From Selection and make sure that you
check the appropriate box in the resulting dialogue box. Since the labels are
to the left of the cells to be named then the left column box should be
checked.

Figure 13 Range Name create Dialog Box

After creating range names, pasting the range names for documentation
purposes is very simple. Just select the Use in Formula from the Formulas tab and click the Paste
List option. This list though is not automatically updated whenever you change, add, or delete any
of the range names which means you have to do the same process again.

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Figure 14Paste Name Dialog Box

Let us now answer the questions of our example.

Figure 15HQ Sweaters Model 3% Response Rate

At 3% Response rate the company will experience a negative profit of

$21,600.00 which is dramatically down from a positive profit of $17,400 at 8% Response rate as
shown in Figure 12. This already shows that profit is directly proportional to changes in the
Response rate. This means that an increase in response rate increases profit while a decrease in
response rate also decreases profit. Now, the question is at what Response rate will the company
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break-even? Since we are able to play around with the input value of the Response rate you will
discover that the company experiences break-even at roughly 5.77% Response rate (5.769231%
to be exact) as evidenced by Figure 16.

Figure 16HQ Sweaters Model Break-even Level

D. Time Value of Money

Not all people know that money aside from its own face value has a time
element of value. Your P1000 today is not the same as your P1000 next year or
P1000 five years, ten years, and so on. Would you prefer to receive P1000 today or
P1100 exactly a year from now? If the prevailing interest rate is 10%, then you may
want to receive P1100 a year from now. This is the concept of interest rate. Interest
rate is that percentage of an amount lent, deposited (bank pays savers interest for
keeping money in their account), or borrowed (the principal amount) that a lender
charges or a borrower pays.
This concept is particularly important for investment decisions to be made
by business owners, managers, and business organizations.

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Net Present Value

The net present value or NPV is simply the value of a stream of cash
flows received at different points in time measured in today’s current value or
present value of a currency or money.
Suppose that you are the business owner, or an investment manager
and you have to decide on which of the following investment is better to undertake:

• Investment 1 requires a P10,000 outflow of cash today and P14,000 two

years from now. One year from now a yield P24,000 will be generated by this
investment.
• Investment 2 requires today a P6,000 cash outflow and P1,000.00 two years
from now. One year from now a yield P8,000 will be generated by this
investment.

To effectively determine which investment is better, you must

compare the cash flow values received at different points in time. This is where the
concept of net present value becomes very useful.
If you have P1 today and you invest it at an annual interest rate of r
percent, then your peso will grow to 1+rpesos in the first year, (1+r)2 in two years,
and so on. In some sense, you can say that P1 today equals P(1+r) a year from now
and P(1+r)2two years from now. In general therefore, we can say that P1 today is
equal to P(1+r)n with n representing years from now. This can be expressed in the
following equation:

P1 now = P(1+r)n received n years from now

When we divide both sides of the equation by (1+r)n we get the

following important equation:

1/(1+r)n now = P1 received n years from now

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This result tells us how to compute the NPV of any sequence of cash
flow in today’s peso. Converting any cash flow to today’s peso is made easy by
multiplying (1+r)n to the cash flow received n years from now.
To find the investment’s NPV you need to add up the value (in today’s
peso) of the cash flows. Assuming that r is equal to 0.2, we can calculate the NPV for
the two investments in question as follows:
_24,000_ -14,000_
Investment1NPV = -10,000 + (1+0.20) + (1+0.20)2 = P277.78
1

_8,000_-1,000__
Investment2NPV = -6,000 + (1+0.20)1 + (1+0.20)2 = -P27.78

It is very important to note that when NPV is greater than zero, the
project or investment will increase the value of the company, investments or
projects with NPV lower than zero decreases the value of a company, while projects
or investment where NPV is equal to zero keeps the value of a company unchanged.
Given these, it is very clear to see that Investment 1 is the better choice.

Computing NPV in a spreadsheet

Figure 17 NPV Computation

To determine our example’s NPV in Excel, start by assigning the range
name r_ to the interest rate in cell C3. Input the corresponding cash flows of Investment 1
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and Investment 2 in their proper placement according to the Time 0, 1, and 2. 0 being
current or present year, 1 for 1 year from now, and 2 for 2 years from now. Note that cash
flows are both inflows and outflows of cash.
The PV formula in cell C7 is =C5/(1+r_)^C$4the caret symbol ^ raises
a number to a power. In this case since it is the current year it is raised to zero. To get the
PV for the remaining years, year 1 and year 2 for both Investment 1 and 2 copy this formula
clicking C7:E8.
Finally, for the NPV in cell A5 we compute for the NPV of Investment 1
by adding the PV of each year 0-2 in C7:E7 with the formula =SUM (C7:E7) while for
Investment 2 NPV simply copy this formula in cell A5 to cell A6.
Excel’s NPV function is a little tricky as its formula does not consider
the current year of our example. It uses the syntax NPV (rate, range of cells) but it
automatically assumes that the first cash flow is one year from now which is not applicable
to our example. To compute the actual NPV the formula in cell C11 would be
=C7+NPV(r_,D5:E5)the range doe not include the value in C5 as it is already in the present
year’s value but adding C7 which has the formula =C5/(1+r_)^C$4it somewhat converts
the value into a PV or NPV value. After which simply copy the formula in cell C11 to C12.
You will now see that both computations in A5 and A6 produce the same result or values in
C11 and C12. The decision can now be made by the business owner or manager on which
investment to take.
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References and Supplementary Materials

Books and Journals

1. Albright, S.C., & Winston, W.I. (2012). Management Science Modeling (4th ed.). Boston, MA:
South-Western, Cengage Learning.

2. Ragsdale, C. (2018). Spreadsheet Modeling and Decision Analysis: A Practical Introduction

To Business Analytics (8th ed.). Boston, MA: Cengage Learning

Online Supplementary Reading Materials

1. Interest rate; Retrieved
fromhttps://en.wikipedia.org/wiki/Interest_rate;September2, 2018
2. interest rate; Retrieved from https://dictionary.cambridge.org/us/dictionary/
english/interest-rate; September 2, 2018
3. Interest Rate; Retrieved fromhttps://www.deposits.org/dictionary/term/interest-
rate/; September 2, 2018
4. Understanding the Time Value of Money; Retrieved from
https://www.extension.iastate.edu/agdm/wholefarm/html/c5-96.html; September 2,
2018

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