BFW2140

Lecture Week 2

Corporate Financial
Mathematics I

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Lecture Week
2 Outline
Time Value Of • Simple Interest
Money : The and Compounding
Concept Interest

• Future Value And

• Future Value And
Present Value Of
Present Value Of A
Variable Cash
Single Cash Flow
Flows

• Annuity (Equal • Perpetuity

instalment cash (Forever flowing
flows) cash flows)

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 3

• A dollar received today is worth more than a dollar

received tomorrow. Why?

• The difference in value between money today and

money in the future is the time value of money.

• Today money is known as Present Value (PV) and

future money is known as Future Value (FV)
•Why is TVM important in Finance?
The Time
Value of
Money (TVM)
The Time Value of Money
• Timelines
• The ticks mark end of periods. For example:
• Time 0 is today (now), the end of year 0 = beginning of the year 1
• Time 1 is the end of the year 1
• Distinguishing Cash Inflows from Outflows
• Representing Various Time Periods
• Just change the label from “Year” to “Month” if monthly

Why is a timeline important in financial analysis?

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Simple interest and Compounding
Interest

• What is interest rate?

– The rate at which we can exchange money today for money
in the future by borrowing or investing
– A reward for forgoing the current consumption and
undertaking risk
• Interest is usually expressed as a rate per annum
– For example: 5% per annum which means you will get $5 in
interest per year for investing $100
• Two types of interest: Simple and Compounding interest

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Simple interest and Compounding
• Simple interest:
- Interest earned during the investment period is not reinvested.
- Interest is calculated only on original principal amount borrowed or invested, thus, same for
each period.
• Compound interest:
- The interest earned in one period is reinvested to grow at the same rate in the next period.
- The effect of earning “interest on interest”
Example1: Consider an original principal of $100, for 2 years at 10% pa, how much money will you have
in 2 years time? How much total interest will you earn?
 Simple interest=$100 x 0.1 x 2 = $20
Total amount (interest + principal) at the end of year 2 = $100 + $20 = $120
 Compounding interest = $100 x 0.1 = $10 ; $110 x 0.1 = $11; at the end of 2 years the interest earned =
$10 + $11 = $21
Total amount (interest + principal) at the end of year 2: $100 x 1.12 = $121.00
Extra $1in interest due to the impact of “compounding”

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FV of a single cash flow
Future value and compounding
• To calculate the FV of a cash flow C that happens in n
compounding periods from now with the interest rate per
period r, you must compound it

• (1 + r)n is also called the interest rate factor (FVIF)

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Example 2: Future Value of a Single CF
Suppose that you invest $1,000 in term deposit today at a
guaranteed fixed rate of 6% after tax for a period of 5 years.
How much will this amount grow to by the time the
investment account matures?
Answer:
FV = C x (1 + r )n
FV = 1,000 x (1 + 0.06)5
FV = 1,000 x (1.06)5 = $1,338.23

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Example 3: How
Long is the Wait?

• If you deposit $5,000 today in an

account paying 10%, how long
does it take to grow to $10,000?
• 5,000 (1.1)n = 10,000
• log5000 + n log 1.1 = log10,000
• nlog 1.1 = log10,000 / log5,000
• nlog 1.1 = log2
• n = log2 / log1.1
• =7.27 years

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Example 4: What
Average Annual Rate
of Return?

• If you invested $5,000 in the

shares of a company 18 years ago
and today your investment is
worth $50,000. What average
annual rate of return did you earn
on your investment?

5000(1 + r)18 = 50,000

(1 + r)18 = 50,000 / 5,000
(1 + r )18 = 10,000
1 + r = 10,0001/18
1 + r = 1.1365
r = 0.1365
=13.65%

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 PV of a single cash flow
Present value and discounting
– To calculate the value of a future cash flow at an earlier point in time, we
must discount it.

1/(1 + r)n is also called the discount factor (PVIF)

– Example5: You are considering investing in a savings bond that will
pay $15,000 in 10 years. If the competitive market interest
rate is fixed at 6% per year, what is the bond worth today?

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 Compounding and Discounting
Example 6: Suppose you have $8,375.92 in the bank today earning 6% interest. How
much will you have ten years from now?
Answer:
In 10 years you would have:
FV= $8,375.92×(1.06)10 = $15,000 in 10 years.
Example 6 A: Suppose you will be getting $15,000 in 10 years time from now. If the
bank interest rate will be at 6% per annum. What is the value of this
money today?
Answer:
PV = $10,000 / (1.06)10 = $8,375.92 Today

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Present value of Multiple Cash flows
Consider a stream of cash flows: C0 at date 0, C1 at date 1, and so on, up to CN at
date N
Draw a timeline:

We compute the present value of this cash flow stream in three steps
– Compute the present value of each cash flow
– Combine the present values

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Example 7: PV of Multiple Cash Flows
•from  need
You money to purchase a Honda Accord. You decided to borrow the required money
HSBC Bank and promise to pay back in four payments during the next four years. The
bank requested you to pay them back with an interest rate of 6% per annum. Based on your
earnings and living expenses, you plan to pay them $5000 in the first year, $7000 in the
second year and third year and to pay a final payment of $10000 in the fourth year. Calculate
how much can you borrow now to settle this loan according to your repayment plan?
ANSWER:
The cash flows that you plan to pay are as follows:
0 1 2 3 4
         
         
-PV 50000 7000 7000 10000

PV = = $24,745.23

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Future Value Of Multiple Cash Flows
Example 8: Suppose that you deposit at the end of each year for next four years the
following amounts that would earn an interest of 6% per annum; $5,000 in year 1,
$8,000 in years two and three and finally $10,000 in Year 4. How much money will
you have at the end of 4 years?
Answer:
0 1 2 3 4
         
         
50000 8000 8000 10000

Compute the future value of the variable annual deposits

= $5,000 (1+0.06)3 + $8,000 (1+0.06)2 + $8,000 (1+0.06)1 + $10,000
= $33,423.88

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Annuity (equal cash flows)
 An annuity is a stream of N equal cash flows paid at regular intervals
over a finite number of periods
 3 characteristics that makes a cash flow to be annuity
1. Fixed cash flow amounts
2. At regular intervals (per month or per year)
3. For a fixed number of periods (for 5 years or 10 years)

E.g. pensions, salaries, home loan payments, interest payments for bonds
– Assume the first payment takes place one period from today
– With annuities, we want to know how much we will have at the end of
all payments (FV), or what is the series of future payments worth to me
today (PV).

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Present Value of An Annuity

Where
– PV= present value of the annuity
– C= the cash flow received/paid under the annuity
– N= number of cash flows under the annuity
– r= the discount rate or interest rate

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Future Value of An Annuity

Where
– FV= Future value of the annuity
– C= the cash flow received/paid under the annuity
– N=number of cash flows under the annuity
– r= the discount rate or interest rate

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Example 9: Present Value of an Annuity
You are the lucky winner of the $30 million state lottery.
• You can take your prize money either as (a) 30 payments of $1
million per year (starting one year from now), or (b) $15 million
paid today.
• If the interest rate is 8%, which option should you take?

Answer:
PVA = 1,000,000/0.08 [ 1 – 1/(1.08)30]
= 12,500,000 (1 – 0.099377)
= $11,257,78 7.50
What does the $11.26m represent?

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Example 10: FV of an Annuity
Ellen is 35 years old now, and she has decided it is time to plan seriously
for her retirement. At the end of each year until she is 65, she will save
$10,000 in a retirement account. If the account earns 10% per year, how
much will Ellen have saved at age 65?

Ellen’s savings plan looks like an annuity of $10,000 per year for 30 years.

FVA = 10,000 x 1/0.1 [(1+0.1)30 – 1]

= 100,000 x (16.4494)
= $1,644,940.23

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Types of Annuities
• There are three main types of annuities:
– Ordinary annuity: when payments are made at the end of each period.

– Annuity due: when payments are made at the beginning of each period.

– Deferred annuity: the first payment won’t take place until some point
in the future.

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Annuity due

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Annuity due
ORDINARY ANNUITY ANNUITY DUE
When payments are made at the end of When payments are made at the
each period beginning of each period

Method of calculating PV or FV of an annuity due

• Calculate the PV or FV as if it was an ordinary annuity
• Then multiply the answer by (1+r)

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Example 11: Present Value of an Annuity due
You are the lucky winner of the $30 million state lottery. You can take your
prize money either as (a) 30 payments of $1 million per year (starting
today), or (b) $15 million paid today. If the interest rate is 8%, which
option should you take?

Answer:
PV of the $1million annuity due per option (a):

PVA = 1,000,000/0.08 [ 1 – 1/(1.08)30] (1+0.08)

= 12,500,000 (1 – 0.099377) (1.08)
= $11,257,78 7.50 (1.08)
= $12,158,406.01 > $11.26m in example 9
Why?

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VERY IMPORTANT
NOTE
• Always assume its an ORDINARY annuity.
• If nothing is said about
• the timing of cash flows.
• ALWAYS assume the cash flow occur at the END of
the period.

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Deferred Annuity
A deferred annuity is an annuity for which the first
cash flow occurs beyond the end of the first period

Method
• Calculate the “PV” of the ordinary annuity in the year
immediately before the cash flow commences
• Discount this lump sum back to time n= 0

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Example 12: Deferred annuity
Jason is to start a 6 month live-in training course in 4 months’ time. His father,
Sam, has promised him $200 per month as support payable at the start of each
month. If the interest rate is 12% per annum, payable monthly, how much money
will Sam need today to finance Jason’s allowance?

PV3 = $1,159.10 (using annuity formula, T = 6, r = 1%, C = $200)

PV0 = $1,159.10 / (1.01)3 = $1,125.01

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Perpetuity (FOR EVER FLOWING)
– A perpetuity is a stream of equal cash flows that occur at regular intervals and last forever
– Here is the timeline for a perpetuity:

– The first cash flow does not occur immediately; it arrives at the end of the first period (ordinary
perpetuity)
– Perpetuities can also be classified as ordinary, due or deferred perpetuities, depending on when
the payments commence or start.
– The difference between an annuity and a perpetuity is that an annuity ends after some fixed
number of payments while a perpetuity last forever.

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Present value of a Perpetuity
Using the formula for present value, the present value of a perpetuity with
payment C and interest rate r is given by:

Remember the formula values cash flows ONE period before the first Cash
flow.

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Example 13: Perpetuity
You want to endow an annual graduation party at your alma mater. You
want the event to be a memorable one, so you budget $30,000 per year
forever for the party. If the university earns 8% per year on its investments,
and if the first party is in one year’s time, how much will you need to
donate to endow the party?

ANSWER:
PV = C/r = $30,000 / 0.08 =$375,000 today

If you donate $375,000 today, and if the university invests it at 8% per year forever,
then the graduates will have $30,000 every year for their graduation party.

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Example 14: Deferred Perpetuity
Assuming an 8 per cent interest rate, calculate the present value of the following
streams of payments:
(a) $1,000 per year forever, with the first payment one year from today
(b) $500 per year forever, with the first payment two years from today
(c) $2,420 per year forever, with the first payment three years from today

Answer:
(a) PV (t=0)=12,500
(b) PV (t=0)=5,787.04
(c) PV(t=0)=25,934.5

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Summary

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 Next week:
Corporate Financial
End of Mathematics II

Lecture
Week 2
Thank you

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