Business finance

FINANCIAL MATHEMATICS

Refer text - Chapter 4

 Overview

• Revision on Time value of money

– Present values & Future values
• Effect of multiple compounding periods in
a year
• Annuities
– Present values & future values
• Perpetuity

2
 Cash flow
types

Single cash Multiple cash

flows flows

Mixed stream
Annuities
cash flows

Ordinary
Annuity Due
Annuity

Perpetuity

3
 Time Value of Money
0 1 i = 20%

$100 $120
COMPOUNDING
Taking money up in time

FV  PV (1  r )t

$100 $120
DISCOUNTING
Taking money down in time
FV PV  FV (1  r )t
PV  or
(1  r )t 4
 Future Value of a Single Cash flow –
Exercise 1

Your bank is offering you the opportunity to place

$10,000 in the bank at 8% p.a. What will be the
accumulated amount of this investment after 5
years if interest is compounded annually?

FV  PV(1  r ) t

FV  10000(1  0.08) 5

FV  $14,693.28

5
 Present Value of a Single Cash flow –
Exercise 2
Find the present value (discounted value) of
$7,000 payable in 4 years using a discount rate of
15% p.a.

FV
PV 
(1  r ) t

7000
PV 
(1  0.15) 4

PV  $4,002.27
6
 Compounding periods

When compounding periods are other than annually

eg: semi-annually, quarterly, monthly, etc. Adjust the
per period interest rate and the corresponding number
of periods.

Semi-annually : multiply years by 2

divide interest by 2

Quarterly : multiply years by 4

divide interest by 4

Monthly : multiply years by 12

divide interest by 12 7
 Exercise 3
Determining FV Compounding frequencies
Compare investing $2,000 at 8% p.a. for 10 years
compounding (a) semi-annually and (b) quarterly.
(a) PV = 2000 r = 0.08  2 = 0.04
t = 10  2 = 20
FV  PV(1  r ) t

FV  2000(1.04) 20
FV  $4,382.25

(b) PV = 2000 r = 0.08  4 = 0.02

FV  2000(1.02) 40 t = 10  4 = 40
FV  $4,416.08
8
 Nominal & Effective Interest Rates
Nominal rate – interest rate stated on a per annum basis
Effective rate – nominal rate adjusted for compounding
effects
Example:
12% p.a. compounded semi-annually
12% = nominal rate
The effective per annum rate = 12.36% p.a.

One year nominal No. of

rate m compounding
 NIR  periods in a
EAR  1   1 year
 m 
9
 Determine the most effective deposit scheme

• 15% p.a. interest compounded annually

• 14.7 % p.a. interest compounded semi-
annually
• 14.5 % p.a. interest compounded quarterly
• 14.3 % p.a. interest compounded monthly
• 14 % p.a. interest compounded daily

10
 Mixed stream cash flows – Exercise 4

• If you deposit $1,000 today, $1,500 in one

year, $2,000 in two years and $2,500 in
three years in an account paying 10%
interest per annum.
• How much do you have in the account at
the end of the third year?

11
 Example 4 continued
Step 1: Draw a time line for time comparability
FV3=1000(1.1)3 = $1331

FV3= 1500(1.1)2 = $1815

FV3= 2000(1.1)1 = $2200

$1000 $1500 $2000 FV3 = $2500

0 1 2 3
3 years of growth 2 years of growth 1 year of growth Time comparable

Step 2: sum up
FV= $1331+$1815+$2200+$2500=$7,846
 Annuities
What is an Annuity?
A a stream of equal cash flows at a regular
interval.

REMEMBER
- Stream of Cash flows
- Equal Amounts
- Regular Intervals

13
 Ordinary Annuity – Exercise 5
First payment occurs at the end of the first period
EXAMPLES ?

If we have an annuity of $100 that starts at the end of the

year for the next 4 years with i = 12%:
0 1 2 3 4
r = 12%
100 100 100 100

The accumulated value (future value) of an ordinary annuity:

 (1  r )t  1  (1.12) 4  1
FV  PMT    100   $477.93
 r   0.12 
14
 Future value of an Ordinary annuity -
Exercise 6
To provide for the ultimate purchase of a home, a man
deposits $3,000 at the end of every 6 months into a
savings account paying 14% p.a. compounded semi-
annually. After 8 years, how much does he have to deposit
for a house?

PMT = 3000 r = 14%  2 = 7% s.a. t = 8 2 = 16

 (1  r ) t  1
FV  PMT  
 r 
 (1.07)16  1
FV  3000 
 0 .07 

FV = $83,664.16
15
 Present value of an ordinary annuity

For PV of an annuity, we have to discount each

cashflow back to year 0:
0 1 2 3 4 r = 12%
100 100 100 100

PV  CF1  CF2  CF3  CF4

100 100 100 100
PV    
(1.12)1 (1.12)2 (1.12)3 (1.12)4

1  (1  r ) t 
PV  PMT  
 r 

16
 Present value of an Ordinary Annuity -
Exercise 7
What is the present value of a sand quarry that will yield an
annual end of year income of $55,000 for the next 12 years
and then be worthless if money is worth 15% p.a.
compounded annually?
0 1 2 3 … 12 r = 15%
55000 55000 55000 55000

1  (1  r )  t 
PV  PMT  
 r 
1  (1.15) 12 
PV  55000 
 0 .15 
PV  $298,134
17
 Exercise 8
If you were the winner of a contest and was offered one of
two options as prize money.
Either $10,000 at the end of each year for the next 20
years or $80,000 in cash now.
If money is worth 13% p.a. to the contest winner, which
option is better?

PV of $10,000 annuity
PMT = 10000 r = 13% t = 20

1  (1.13) 20 
PV  10000   $70,247.52
 0.13 
What is your decision?
18
 Exercise 9
A businessman has incurred a debt of $30,000 that is to be
repaid in monthly instalments. What monthly payment is
necessary to fully repay his debt in one and a half years if
the loan is charged at 12% p.a. compounding monthly.
r = 12% p.a.
0 1 2 3 … 18 months
= 1% p/month
PV = 30000 PMT PMT PMT PMT

PV
PMT 
1  (1  r ) t 
 
 r 
30000
PMT   $1,829.46
1  (1.01) 18

 
 0.01 
19
 Future Value of an Annuity Due –
Exercise 10
First payment occurs at the beginning of the first
period e.g. rent.
You pay your landlord $9,600 p.a. in rent. If you
could earn 12% p.a. elsewhere, what is the
accumulated value of your payments after 3
years?
 (1  r ) t  1
FV  PMT (1  r )  
 r 
 (1.12) 3  1
FV  9600(1.12)    $36,281.55
 0.12 
20
Present Value of an Annuity Due – Exercise 11

Instead of paying $7,000 a year in rent at the

beginning of each year for the next 10 years, it is
decided to purchase a house. If money is worth
12% p.a., what would be the equivalent value to
10 years rent?
0 1 2 … 9 10 r = 12%
7000 7000 7000 7000
PV = ?

1  (1.12) 10 
PV  7000(1.12)    $44,297.75
 0.12  21
 Perpetuity - Exercise 12
A company is expected to pay a dividend of
$0.50 per share every 6 months indefinitely. If
money is worth 6% p.a. compounded semi-
annually, what should an investor be willing to
pay for the company’s shares?

This is an example of a Perpetuity. An Annuity

which goes on indefinitely

PMT
PV 
r

22