INSTITUT SUPERIEUR DE GESTION

Course: Financial Mathematics

Lecturer: Mr. Akum Oben

Specialty: All

Level: HND 1

EFFECTIVE ANNUAL RATE (ACTUAL ANNUAL RATE)

Sometimes, interest rate is quoted as an annual percentage rate (APR) with an associated
compounding interval. When interest is paid at an interval of more than once per year, the
yield per unit of currency invested is more than when it is paid annually. This is
represented by the effective annual rate.

i mn
REAR = (1+ ) -1 Where: m = number of compounding period,
m
n = loan duration in years, i = Annual percentage rate
Exercises:

1) Bank of America’s one-year CD offers 5% APR, with semi-annual compounding.

If you invest $10,000, how much money do you have at the end of one year? What
is the actual annual rate of interest you earn?
2) Bank pays an annual interest of 4% on 2-year CDs and you deposit $10,000. What
is your balance two years later?
3) (A) $10 M in 5 years from now. Or (B) $15 M in 15 years from now. Which is
better if r = 5%?

Solution

1) Quoted APR (RAPR) = 5% is not the actual annual rate.

5%
It is only used to compute the 6-month interest rate as follows: = 2.5%.
2

Investing $10,000, at the end of one year you have:

FV= 10,000(1 + 0.025)(1)(2) = 10,506.25.

In the second 6-month period, you earn interest on interest therefore, the actual annual
i 1 2
rate also called the effective annual rate (EAR), is gotten as: rEAR = (1+ ) * -1 = ( 1+
m
0.05 2
) -1
2

rEAR = (1 + 0 .025)2 −1= 5.0625%.

2) FV = PV × (1+i)n

FV = $10 ,000* (1 + 0.04)2 = $10,816.

3)
1 1
PVA = FVA = $10 * = ($10)(0.7835) = $7.836
( 1+ r ) n ( 1+ 0.05 ) 5
1
PVB = 15 * = $15 * (0.4810) = $7.218
( 1+ 0.05 ) 15
Conclusion: A is better because it has a higher PV.

ANNUITIES
An annuity is a series of fixed payments or receipts occurring over a specified
number of periods which could be weekly, monthly, quarterly or yearly at equal
intervals example, a regular deposit to a savings account, pension payment and
insurance payment etc.
There are two types of annuities on the basis of when payment is done that is;
 Ordinary annuity: In an ordinary annuity, the receipts or payments are
made at the end of each payment period.
 Annuity Due: in an annuity due, the receipts or payment are made at the
beginning of the next payment period.
 Determination of the Future Value of an Ordinary Annuity
Here, receipts or payments are due at the end of the periods.
Consider a depositor who deposits 50,000FCFA every year in a saving account
with a bank for
4years receiving 10% interest per annum. What is the future value of the
deposits?

Solution

0 1 2 3 4 (years)

50,000 50,000 50,000 50,000 (Deposits)

50,000
55,000
60,500
66,550

The future value of the ordinary annuity at 10% per annum for

4years (FVA4) = 232,050FCFA

Generally, the future value of an ordinary annuity can be determined by the formula:

( 1+ i ) n−1
FVAn = R ={ }
i

Where; R = Periodic deposits or receipts,

n = number of years or period

i = interest rate
 ( 1+ 0.1 ) 4−1
FV4 = 50000( ¿ = 50000(4.641)
0.1

FV4 = 232,050FCFA

Determination of future value of an Annuity Due

In this case, series of equal receipts or payments are made at the beginning of each period
in contrast to the case of an ordinary annuity seen above. The determination of future
value here requires compounding of the last deposit thus the formula is given as;

( 1+ i ) n−1
FVAD = R *( )(1+i)
i
Example:

Consider again, the depositor who deposits 50,000FCFA every year in a saving account
with a bank for four years receiving 10% interest per annum. What is the future value of
an annuity due of the deposits?

Solution:

FVAD4 = 50000(4.641) (1.1) = 255,255FCFA

 Solution

0 1 2 3 4 5 (years)

50,000 50,000 50,000 50,000 (Deposits)

55,000
60,500
66,550
73,205

The future value of the annuity due at 10% per annum for

4years (FVAD4) = 255,255FCFA

Exercise:

1) 13500fcfa is invested every 3 months at 4% compounded quarterly. How

much will the annuity be worth in 5 years?
2) Determine the future value of an annuity due for 22000fcfa semi -annual
deposit at 12% interest rate for 4 years.
Solution
1. This is the case of an ordinary annuity with compounding done 4 times in a
year.

( 1+i ) n−1
FV = R( )
i
 R= 13,500
0.04
i= = 0.01
4
n= 4 * 5 = 20

( 1+ 0.01 ) 20−1
FV = 13,500 ( )
0.01

0.2202
FV= 13,500( )
0.01

FV= 13,500(22.02) = 297,270 fcfa.

2. This is the case of an annuity due with compounding done 2 times in a year.

( 1+i ) n−1
FVAD = R( ) (1+i)
i
R = 22,000
0.12
i= = 0.06
2
n= 2 * 4 = 8

( 1+0.06 ) 8−1
FVAD =22000( )(1+0.06)
0.06

0.5938
= 22000( )(1.06)
0.06

= 22000(9.8967) (1.06)

= 230,791fcfa.

Present Value of an Ordinary Annuity

1
1−
PVA = PMT *( ( 1+ i ) n )
i
 Example :

What is the PV of 500,000,000 payable at the end of each 3 years given D.R of 10%

SOLUTION

1
1−( )
PVA = PMT *( ( 1+i ) n )
i

P = 500,000,000 i= 0.1 n=3

1
1−
PVA = 500,000,000*( ( 1+ o .1 ) 3 )
0.1

0.2487
=500,000,000 *( )
0.1

= 500,000,000* 2.487 = 1,243,500,000frs

Present value of an Annuity Due

1
1−( )
PVA due = PMT* ( ( 1+i ) n ) * (1+i)
i
 INSTITUT SUPERIEUR DE GESTION

Course: Financial Mathematics

Lecturer: Mr. Akum Oben

Specialty: All

Level: HND 1

LESSON 3

INVESTMENT APPRAISAL

It is a means of assessing whether an investment project is worth undertaking or not.

Investment therefore assumes that the investment will yield future income streams.
Investment appraisal is all about assessing these income streams against the cost of the
investment

INVESTMENT APPRAISAL TECHNIQUES

These are capital budgeting techniques for investment appraisal which includes:

 Net Present Value (Discounted Cash Flow)

 Accounting Rate of Return (Return on capital employed: - ROCE)
 Payback period
 Internal Rate of Return and
 Profitability Index
 They include discounted and non-discounted cash flow methods. They guide the
investment decisions of entities.

 Net Present Value (NPV) – DISCOUNTED CASHFLOW METHOD

The net present value method involves estimating a project’s future cash flows by
discounting these cash flows at the firm’s cost of capital and then subtracting the initial
cost of the investment from the present value.

The decision rule under the NPV technique is that, accept a project if the NPV is
greater than or equal to zero. When more than one alternative is involved, choose the
project with the highest NPV.

Example1:

Mr. Akum Ndip is not certain whether to invest in a new plant to supply relief materials
to an NGO in his village. The actual cost of this investment is estimated at 75,000,000frs
and the cash flow to be generated from this project is given as follows

Year 1 2 3 4 5

Cash Flow 30,000 28,000 22,000 17,000 12,000

(000)

It is envisaged that the plant will be redundant after 5 years but will have a scrap value of
13,000,000frs upon disposal at the sixth year. If the cost of acquisition of capital is 10%.
Using the NPV technique should Mr. Akum Ndip continue with his intentions?

Solution

1
i = 0.1, d.f =
( 1+ i ) n

Year C.F(000) d.f PV (000) Cum PV (000)

0 (75,000) 1 (75,000) (75000)

 1 30,000 0.9091 27273 (47727)

2 28,000 0.8264 23139.2 (24587.8)

3 22,000 0.7513 16528.6 (8059.2)

4 17,000 0.6830 11611 3551.8

5 12,000 0.6209 7450.8 11002.6

6 13,000 0.5645 7338.5 18341.1

NP 18341.1
V

Conclusion: Since NPV is greater than zero Mr. Ndip should continue with the project.

Payback Period:

The payback period refers to the amount of time it takes for the initial cost of an
investment to be recovered from its operating cash flows. Requires information on the
returns the investment generates. This method is especially important when the capital
invested is borrowed. The payback period will aid in analyzing whether or not the cash
flow generated will cover the capital borrowed within the loan period.

Example2:

Sonia and Rachael are in to construction project as their major activity but can only go
operational in 3 years. An initiative was proposed by Sonia’s uncle to invest in a cosmetic
business but they are yet to consider following their major activity plan. the following
cash flows for the proposed business is as follows:

Year 0 1 2 3 4 5 6
Net cash Flows (20,000) 5000 5000 5000 6000 3000 2000
(000)

Should they embark on this project?

Solution

Year Net Cash Flows(000) Cum C.F(000)

0 (20,000) (20,000)

1 5000 (15,000)

2 5000 (10,000)

3 5000 (5000)

4 6000 1000

5 3000 4000

6 2000 6000

5000
PBP = 3years +( ) (12months) = 3 years + 10months
6000

Since payback period is greater than the duration within which they are prepared to give
out their money, the project will be rejected.

Draw Backs of the PBP techniques:

- It is biased against cash flow after the payback period

- Does not take in to consideration the time value of money
- Does not make provision for the element of risk
  Discounted Pay Back Period

The discounted payback period is also concerned with the duration within which the
initial cost of a project will be recovered but however considers the time value of money
and the risk factor but also biased against cash flows after the discounted payback period.

 Accounting Rate of Return (ARR) – Return on Capital Employed(ROCE)

It is also known as Return On Capital Employed (ROCE). It is a non-discounted cash

flow method that considers the total profitability of a project over its entire life period.
It computes the proposal’s annual net profit as a percentage of average initial cost of
investment.

Example3:

A Bus transport project has an initial cost of 5,500,000frs and a promissory annual cash
flow of 2,440,000frs for five (5) years beginning from year 1. The items purchased has a
resale value of 500,000frs in year five when the project ends. The asset is depreciated on
a straight line basis.

(i) What is the estimated return on capital employed?

(ii) Considering an alternative of investing the money in a bank promising 5%
interest, which project is more feasible?

Solution:

AAP
(i) ROCE = X 100
ICI

Where : ROCE= Return on Capital Employed, AAP= Average Annual Profit

ICI = Initial Cost of Investment,

AAP = Average Cash flow – Depreciation – Taxes

 Total Cash flow
Average Cash flow= = 2,440,000
No of years

initial Cost −Scrap Value 5,500 ,00−500,000

Depreciation = = = 1000,000
life span 5

AAP = 2,440,000- 1,000,000 = 1,440,000

1,440,000
ROCE = X 100 = 26.2%
5,500,000

ii) Since ROCE of the bus transport project (26.2%) is greater than the promising bank
interest of 5%, invest in the bus transport project.

 INTERNAL RATE OF RETURN (IRR)

It allows the risk associated with an investment project to be assessed. The IRR is the rate
of interest (or discount rate) that makes the net present value = to zero

The IRR is important in the following ways:

- Helps measure the worth of an investment

- Allows the firm to assess whether an investment in the machine, etc. would yield a
better return based on internal standards of return
- Allows comparison of projects with different initial outlays
- Set the cash flows to different discount rates

 PROFITABILITY INDEX

Allows a comparison of the costs and benefits of different projects to be assessed and
thus allow decision making to be carried out
NPV
Profitability Index =
ICI

Where NPV = Net Present Value

ICI = Initial Cost of Investment