CHAPTER 4:

MATHEMATICS OF FINANCE
Given a choice, would you prefer to receive $1000 today or $1000 in 1 year? Even
though the amounts are the same, it is preferable to receive $1000 today, so that you
can invest the sum in a bank and earn interest on the investment over time.

Interest is a fee paid by borrowers to lenders for using money temporarily. Interest is an
expense when we borrow money and an income when we invest money. Many
business transactions involve either lending money to or borrowing money from a
financial institution, such as a bank or a credit union.

For example, when we invest money, a financial institution uses our money, and
therefore pays us interest for the use of the money for the time period it has been
invested. Similarly, when we borrow money from a financial institution, we pay interest
to them for the use of the money for the time period borrowed, unless otherwise
specified.
 In both cases, when money is returned after a period of time, interest is added to the
original amount borrowed. Therefore, as time goes by, the value of money increases by
the amount of interest earned for that period.

This is called the time value of money: money grows with time when it is invested or
borrowed at a particular interest rate.
THE TIME VALUE OF MONEY
Financial mathematics are tools used in the valuation and the determination of yields
on investments and costs of financing arrangements.

The notion that money has a time value is one of the most basic concepts in investment
analysis.

Making decisions today regarding future cash flows requires understanding that the
value of money does not remain the same throughout time.

In the most general sense, the phrase time value of money refers to the fact that a
dollar in hand today is worth more than a dollar promised at some time in the future.

On a practical level, one reason for this is that you could earn interest while you
waited; so a dollar today would grow to more than a dollar later.
Reason 1: opportunity cost

One dollar one year from now is not as valuable as one dollar today.

After all, you can invest a dollar today and earn interest so that the value it grows to
next year is greater than the one dollar today.

This means we have to take into account the time value of money to quantify the
relation between cash flows at different points in time.
Reason 2:
Cash flows are uncertain.

Expected cash flows may not materialize.

Uncertainty stems from the nature of forecasts of the timing and the amount of cash flows.

We do not know for certain when, whether, or how much cash flows will be in the future.

This uncertainty regarding future cash flows must somehow be taken into account in assessing
the value of an investment.

The time-value-of-money mathematics allows an evaluation and comparison of investments

and financing arrangements .
Interest is the compensation for the opportunity cost and any uncertainty.

Interest is the price paid for the use of a sum of money over a period of time.

It is the charge for exchanging money now for money later.

Principal is the original sum of money lent (borrowed or invested) .

E.g Let’s say that someone is willing to lend money, but that they require repayment
of the $100 plus some compensation for the opportunity cost and any uncertainty
the loan will be repaid as promised.

The amount of the loan, the $100, is the principal.

The compensation required for allowing someone else to use the $100 is the
interest.
Looking at this same situation from the perspective of time and value, the amount
that you are willing to lend today is the loan’s present value.

The amount that you require to be paid at the end of the loan period is the loan’s
future value.

Therefore, the future period’s value is comprised of two parts:

Future value = Present value + Interest

Future Value is the amount an investment is worth after one or more periods.

Present value is the value today. It is just the reverse of future value.
The interest is compensation for the use of funds for a specific period.

It consists of :

(1) compensation for the length of time the money is borrowed; and

(2) compensation for the risk that the amount borrowed will not be repaid exactly as
set forth in the loan agreement.
Simple interest :Interest earned only on the original principal amount invested.

It is simple because it repeats itself in exactly the same way from one period to the next
as long as you take out the interest at the end of each period and the principal remains
the same.

In simple interest calculations, interest is calculated only on the initial amount

invested or borrowed at the specified simple interest rate for the whole term.
For this reason, simple interest is usually used for short term investments or loans.
Under simple interest, money grows linearly
Simple Interest Example:

• Mr. X wanted to buy a leather sofa for his new family room. The cost of the sofa was
Birr 10,000.He was short of cash and went to his local bank and borrowed Birr
10,000 for 6 months at an annual interest rate of 12%. Find the total simple interest
and the maturity value of the loan.

• Calculate the amount of interest earned from an investment of $1750 for 9 months
at 4.5% p.a.

• Calculate the amount of interest charged on a loan of $3200 at 6% p.a. for 125 days.

• Calculate the amount of interest earned on an investment of $2275 earning interest

at 0.75% p.m. for 90 days.
• How much money must Mr. Z has to invest today at 6% simple interest if he is to receive Birr
3,100 as an amount in 4 years?

• A 5-month term deposit at Andrew's bank offers a simple interest rate of 3.5% p.a. If Andrew
earned an interest amount of $75 over the 5-month period, how much did he deposit in this
term deposit?
• How long will it take if Birr 20,000 is invested at 5% simple interest to double in value?

• The simple interest charged on a short-term loan of $30,000 at 8.1% p.a. was $1900.

• (i) What was the term expressed in months?

• (ii) What was the term expressed in days (rounded up to the next day)?

• At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?

• Calculate the rate of simple interest per annum offered on savings of $2900 if the interest
earned is $170 over a period of 8 months.
DETERMINING THE FUTURE VALUE
Suppose you deposit $1,000 into a savings account at a Bank and you
are promised 10% interest per period.

At the end of one period, you would have $1,100.

This $1,100 consists of the return of your principal amount of the investment (the
$1,000) and the interest or return on your investment (the $100).

Let’s label these values: $1,000 is the value today, the present value, PV.

$1,100 is the value at the end of one period, the future value, FV.

10% is the rate interest is earned in one period, the interest rate, i.
In terms of our example,
FV = $1,000 + ($1,000 × 0.10) = $1,000(1 + 0.10) = $1,100

If the $100 interest is withdrawn at the end of the period, the principal is left to
earn interest at the 10% rate.

Whenever you do this, you earn simple interest.

FV = PV(1 + rt)
Selena received an amount of $700 from a pawnbroker at an interest
rate of 1.5% p.m. Calculate the maturity value of her loan and amount
of interest she would have to pay at the end of four months.

At the end of ten months, Gwyneth had $2264.50 in a fund that was
growing at a simple interest rate of
8% p.a.
(i)What was the principal amount invested?
(ii)What was the interest earned?
In the previous section, you learned that money grows linearly when invested over a
period of time at a simple interest rate.

Have you ever wondered if money can grow exponentially?

This section will teach you a method to have your money grow in leaps and bounds! It
uses the concept of compound interest, where interest is earned upon interest.

Compound interest is often remarked as being an extremely powerful force.

If, both the principal and the interest are left on deposit at the Savings Bank, the balance
earns interest on the previously paid interest, referred to as compound interest.

For long term investments or loans, compound interest is used, where interest is calculated
on the amount borrowed or invested in addition to the interest earned periodically.

Compound interest :Interest earned on both the initial principal and the interest reinvested
from prior periods.

Earning interest on interest is called compounding because the balance at any time is a
combination of the principal, interest on principal, and interest on accumulated interest (or
simply, interest on interest).
If you compound interest for one more period in our example, the original $1,000
grows to $1,210.00:

FV = Principal + First period interest + Second period interest

= $1,000.00 + ($1,000.00 × 0.10) + ($1,100.00 × 0.10)
= $1,210.00

The present value of the investment is $1,000, the interest earned over two years is
$210, and the future value of the investment after two years is $1,210.
FV = $1,210.00
The balance in the account two years from now, $1,210, is comprised of three parts:

The principal, $1,000.

Interest on principal: $100 in the first period plus $100 in the second period.

Interest on interest: 10% of the first period’s interest, or $10.

To determine the future value with compound interest for more than two periods,
we follow along the same lines:
FV = PV(1 + i)N

The value of N is the number of compounding periods.

A compounding period is the unit of time after which interest is paid at the rate i.
The relation between the present value and the future value after two periods,
breaking out the second period interest into interest on the principal and interest
on interest, is
X1 2
X1 2
A period may be any length of time: a minute, a day, a month, or a year.

The important thing is to make sure the same compounding period is reflected
throughout the problem being analyzed.

FV = PV(1 + i)N
The term “(1 + i)N” is referred to as the compound factor.

It is the rate of exchange between present dollars and dollars N compounding periods
into the future.

FV = PV(1 + i)N is the basic valuation equation—the foundation of financial

mathematics.

It relates a value at one point in time to a value at another point in time, considering
the compounding of interest.
For example:

The value of $1,000, earning interest at 10% per period, 10 periods into the future
is $2,593.70.

Which is

FV = $1,000(1 + 0.10)10 = $1,000(2.5937) = $2,593.70

the $2,593.70 balance in the account at the end of 10 periods is comprised of three
parts:

1.The principal, $1,000.

2.Interest on the principal of $1,000: $100 per period for 10 periods or $1,000.

3.Interest on interest totaling $593.70.

The relation between present and future values for a principal of $1,000 and interest
of 10% per period through 10 compounding periods is shown graphically
Compounding More than One Time per Year

An interest rate takes two forms: nominal interest rate and effective interest rate.

Nominal rates are interest rates "as stated" without adjustment for the full effect of
compounding (also referred to as the nominal annual rate).

An interest rate is called nominal if the frequency of compounding (e.g. a month) is

not identical to the basic time unit in which the nominal rate is quoted (normally a
year).

The nominal interest rate does not take into account the compounding period.

The effective interest rate does take the compounding period into account and thus is
a more accurate measure of interest charges.
A compounding period is the span of time between when interest was last
compounded and when it will be compounded again.

For example, annual compounding means that a full year will pass before interest is
compounded again.
DETERMINING THE PRESENT VALUE

Now that we understand how to compute future values, let’s work the process in
reverse.

Here we are given the future value and have to figure out the present value.

But we can use the same basic idea from the future value problems to solve
present value problems.

Compounding translates a value in one point in time into a value at some future
point in time.

The opposite process translates future values into present values: Discounting
translates a value back in time.
Finding present values is called discounting, and it is the reverse of
compounding.

If you know the PV, you can compound to find the FV; or if you know the FV,
you can discount to find the PV.
 Present value (or discounted value or principal) can be calculated by
rearranging the future value formula FV = PV(1 + i)N

The term in brackets is referred to as

the discount factor since it is used to
translate a future value to its
equivalent present value.
Equivalent Rates

Some times it is helpful to convert interest rates from, for example, a compounded
quarterly basis to a compounded annually basis, from a compounded quarterly
basis to compounded monthly basis, etc.

Different rates that have the same value are equivalent rates.

Although we can use any length time period, we usually use a 1-year time interval.
Examples:
1. What rate compounded monthly is equivalent to 8% compounded quarterly?
Examples
• How long will it take to accumulate Birr 650 if Birr 500 is invested at 10%
compound quarterly?

• Birr 2000 is deposited in an account. After one year of monthly compounding, the
balance in the account is Birr 2,166. What is the annual percentage rate for this
account?
Nominal interest rate vs Effective interest rate
Nominal means ”in name only”.

Nominal interest rate is also defined as a stated interest rate.

This interest works according to the simple interest and does not take into account the
compounding periods.

Effective interest rate tells you exactly how much interest is.

Effective interest rate is the one which caters the compounding periods during a
payment plan.

It is used to compare the annual interest between loans with different compounding
periods like week, month, year etc.
In general stated or nominal interest rate is less than the effective one. And the later
depicts the true picture of financial payments.

Example: A credit card company charges 21% interest per year, compounded
monthly. What effective annual interest rate does the company charge?
j = 0.21 per year
m = 12 months per year
f= [ 1 + (.21 / 12) ] 12 - 1
= [1 + 0.0175 ] 12 - 1
= (1.0175)12 - 1 = 1.2314 - 1
= 0.2314 = 23.14%
The more often compounding occurs, the higher the effective interest rate.
Effective rates are used to compare competing interest rates
offered by banks and other financial institutions.

Example:
An investor has two opportunities to invest his money. The first investment
opportunity (Opp A) pays 15% compounded monthly and the second investment
opportunity (Opp B) pays 15.2%% compounded semiannually. Which is the better
investment, assuming all else is equal.
 Continuous Compounding
Continuous compounding is the mathematical limit that compound interest can
reach if it's calculated and reinvested into an account's balance over a theoretically
infinite number of periods.

While this is not possible in practice, the concept of continuously compounded

interest is important in finance.

Instead of calculating interest on a finite number of periods, such as yearly or

monthly, continuous compounding calculates interest assuming constant
compounding over an infinite number of periods.
 The formula for compound interest over finite periods of time takes into
account three variables:
PV = the present value of the investment
j = the stated interest rate
t = the time in years

FV=PV (e jt)

If $1,000 is deposited in an account for five years with interest

of 12% per year, compounded continuously,
FV = $1,000e5(0.12) = $1,000(e0.60) = $1,000(1.82212)
FV= $1,822.12
Multiple Rates
In our discussion thus far, we have assumed that the investment will earn the same
periodic interest rate, i.

We can extend the calculation of a future value to allow for different interest rates
or growth rates for different periods.

Suppose an investment of $10,000 pays 9% during the first year and 10% during
the second year. At the end of the first period, the value of the investment is
$10,000 (1 + 0.09), or $10,900.

During the second period, this $10,900 earns interest at 10%. Therefore, the future
value of this $10,000 at the end of the second period is

FV = $10,000(1 + 0.09)(1 + 0.10) = $11,990

 We can write this more generally as
FV = PV(1 + i1)(1 + i2)(1 + i3). . .(1 + iN)

where iN is the interest rate for period N.

Consider a $50,000 investment in a one-year bank certificate of deposit (CD) today and
rolled over annually for the next two years into one-year CDs.

The future value of the $50,000 investment will depend on the one- year CD rate each
time the funds are rolled over.
Assuming that the one-year CD rate today is 5% and that it is expected that the one-year
CD rate one year from now will be 6%, and the one-year CD rate two years from now
will be 6.5%, then we know

FV = $50,000(1 + 0.05)(1 + 0.06)(1 + 0.065) = $59,267.25

Examples

1. Find the present value of a loan that will amount to Birr 5,000 in four years if
money is worth 10% compounded semi annually.

2. How much must be deposited now in an account paying 6% compounded

monthly in order to have just 20,000 Birr in the account 4 years from now?

3. If money worth 14% compounded semi-annually, would it be better to

discharge a debt by paying Birr 500 now or Birr 600 eighteen months from now?

4. . How much should be deposited in an account paying 8% compounded

quarterly in order to have a balance of Birr 8,000 nine years from now?
THE TIME VALUE OF A SERIES OF CASH FLOWS
Applications in finance may require the determination of the present or future value of
a series of cash flows rather than simply a single cash flow. E.g Bond Payments

The principles of determining the future value or present value of a series of cash flows
are the same as for a single cash flow, yet the math becomes a bit more cumbersome.

Suppose that the following deposits are made in a bank account paying 5% interest,
compounded annually:
What is the balance in the savings account at the end of the second year if no
withdrawals are made and interest is paid annually?

Let’s simplify any problem like this by referring to today as the end of period 0, and
identifying the end of the first and each successive period as 1, 2, 3, and so on.

Represent each end-of-period cash flow as “CF” with a subscript specifying the
period to which it corresponds. Thus, CF0 is a cash flow today, CF1 is a cash flow at
the end of period 1, and CF2 is a cash flow at the end of period 2, and so on.
The last cash flow, $1,500, was deposited at the very end of the second period—the
point of time at which we wish to know the future value of the series.

Therefore, this deposit earns no interest. In more formal terms, its future value is
precisely equal to its present value.

Today, the end of period 0, the balance in the account is $1,000 since the first deposit
is made but no interest has been earned.

At the end of period 1, the balance in the account is $3,050, made up of three parts:
1.The first deposit, $1,000.
2.$50 interest on the first deposit.
3.The second deposit, $2,000.
The balance in the account at the end of period 2 is $4,702.50, made
up of five parts:

1.The first deposit, $1,000.

2.The second deposit, $2,000.

3.The third deposit, $1,500.

4.$102.50 interest on the first deposit, $50 earned at the end of the first period,
$52.50 more earned at the end of the second period.

5.$100 interest earned on the second deposit at the end of the second period.
These cash flows can also be represented in a time line.

A time line is used to help graphically depict and sort out each cash flow in a series.

From this example, you can see that the future value of the entire series is the sum of
each of the compounded cash flows comprising the series.
To determine the present value of a series of future cash flows, each cash flow is
discounted back to the present, where the beginning of the first period, today, is
designated as 0.

As an example, consider the previous problem from a different angle.

Instead of calculating what the deposits and the interest on these deposits will be
worth in the future, let’s calculate the present value of the deposits.

The present value is what these future deposits are worth today.

In the series of cash flows of $1,000 today, $2,000 at the end of period 1, and
$1,500 at the end of period 2, each are discounted to the present, 0, as follows:
The present value of the series is the sum of the present value of these three
cash flows, $4,265.30.
This equation tells us that the present value of a series of cash flows is the sum of
the products of each cash flow and its corresponding discount factor.
Annuity

Assets such as bonds provide a series of cash inflows over time, and obligations such
as auto loans, student loans, and mortgages call for a series of payments.

If the payments are equal and are made at fixed intervals, then we have an annuity.

For example, $100 paid at the end of each of the next 3 years is a 3-year annuity.

If payments occur at the end of each period, then we have an ordinary (or deferred)
annuity. Payments on mortgages, car loans, and student loans are generally made at
the ends of the periods and thus are ordinary annuities.
If the payments are made at the beginning of each period, then we have an annuity due.

Rental lease payments, life insurance premiums, and lottery payoffs are examples of
annuities due.

Ordinary annuities are more common in finance

Future value of an ordinary annuity
Future value of ordinary due
Because each payment occurs one period earlier with an annuity due, the payments
will all earn interest for one additional period.

Therefore, the FV of an annuity due will be greater than that of a similar ordinary
annuity.
Present Value of an Ordinary Annuity
Present Value of Annuities Due
Because each payment for an annuity due occurs one period earlier, the payments
will all be discounted for one less period.

Therefore, the PV of an annuity due must be greater than that of a similar ordinary
annuity.
PERPETUITIES
In the previous section we dealt with annuities whose payments continue for a
specific number of periods—for example, $100 per year for 10 years.

However, some securities promise to make payments forever.

For example, in the mid-1700s the British government issued some bonds that never
matured and whose proceeds were used to pay off other British bonds.

Since this action consolidated the government’s debt, the new bonds were called
“consols.”

The term stuck, and now any bond that promises to pay interest perpetually is called
a consol, or a perpetuity.
A consol, or perpetuity, is simply an annuity whose promised payments extend out
forever.

Since the payments go on forever, you can’t apply the step-by-step approach.
However, it’s easy to find the PV of a perpetuity with the following formula:

The interest rate on the consols was 2.5%, so a consol with a face value of $1,000
would pay $25 per year in perpetuity.
Amortized Loan

An extremely important application of compound interest involves loans that are

paid off in installments over time.

Included are automobile loans, home mortgage loans, student loans, and many
business loans.

A loan that is to be repaid in equal amounts on a monthly, quarterly, or annual basis

is called an amortized loan.
For example, suppose a company borrows $100,000, with the loan to be repaid in 5
equal payments at the end of each of the next 5 years.

The lender charges 6% on the balance at the beginning of each year.

Here’s a picture of the situation:

Our task is to find the amount of the payment, PMT, such that the sum of their PVs
equals the amount of the loan, $100,000:
With Excel, you would use the PMT function: =PMT(I,N,PV,FV) = PMT(0.06,
5,100000,0) = −$23,739.64.

Thus, we see that the borrower must pay the lender $23,739.64 per year for the next 5
years.

Each payment will consist of two parts—part interest and part repayment of principal.
This breakdown is shown in the amortization schedule.

Even though the loan payment each year is the same, the proportion of interest and
principal differs with each payment.

The interest component is relatively high in the first year, but it declines as the loan
balance decreases.
End