An introduction to the Mathematics of

Corporate Finance/Financial Arithmetic

Dr Vasos Pavlika
[email protected]
 What we need to know
 You will soon see that Financial computations rely heavily on and
understanding of three topics:
 Percentages
 A geometric progression
 The future value of money.
 If one understands these three topics one can solve most (if not
all) appraisal type (valuing) problems arising in Finance.
 We may also need to review some iterative techniques along the
way.
□ Bisection (just to be mentioned)
□ Linear Interpolation (with proof)
□ The Newton-Raphson Method (with proof, code)
□ The Secant Method (with proof, code)
 Compounding

 Compounding is powerful.
 Time is either your
enemy or your friend
 This is the core element of
investing
The Magic of Compound Interest
As you can see it is better to start
saving early, in this example you have
only invested $20.000 in the case on
the left ending with $151,400.

In the right example (starting later )

you invested $60,000 and accumulated
$156,116.
 Time Value of Money
 Fundamental building block
 £100 today or £105 next year?

 What if interest rates are 2%? (£102.00)

 What if interest rates are 5%? (£105.00)
 What if interest rates are 10%? (£110.00)
 Time Value of Money
 Future Value of money:
□ Deposit £1,000 at 5% for 2 years
1. Simple interest:
□ £1,000 (principle) + £50 (year 1 interest) + £50 (year 2 interest)
□ In this case you do not earn interest on the interest.
2. Compounded interest:
□ £1,000.00 becomes £1,050.00 in year 1 and £1,102.5 0 in year 2
□ How, £1,000 * (1 + 5%)2 = £1,102.50
3. Continuous compounding:
□ £1,000 * e(2*5%) = £1,105.17, we will derive this expression shortly.
 Quick questions
1. £100 grows at 4% for 3 years
a) Simple interest, the interest =£100(0.04)(3)=£12.00
b) Compound interest £100(1  0.04) 3  £112 .49
c) Continuous interest. (Exponential interest) £100e ( 3)( 0.04 )  £112 .75

2. £2,000 grows at 7% with compound interest

a) 5 years (Answer: £2805.10)
b) 30 years (Answer: £15,224.51)
 Time Value of Money Notation and formula
 Compound interest formula:

FV  PV (1  r ) n

 FV = Future Value
 PV = Present Value
 r = interest rate (required rate of return)
 n = periods (does not have to be years we will investigate this
further shortly).
 Present value
 Present Value (PV) is a formula used in Finance that calculates
the present day value (its worth, now, TODAY) of an amount
which is received at a future date. The premise of the equation
is that there is "time value of money“.
 Time value of money is the concept that receiving something
today is worth more than receiving the same item at a future
date.
 The presumption is that it is preferable to receive £100 today
than it is to receive the same amount one year from today, but
what if the choice is between £100 present day or £106 a year
from today?
 A formula is needed to provide a quantifiable comparison
between an amount today and an amount at a future time, in
terms of its present day value.
 Future Value of money
 You win the lottery today a total of £2.8m (million)
 You plan to retire in 20 years from now
 You put it in 20 year government bonds which yields 2% per
annum (tax free)
□ a bond issued by a country's government, promising to repay borrowed
money a fixed rate of interest at a specified time.
 Assuming you re-invest all the money at the interest rate of 2%
how much will your retirement fund be worth in 20 years time?
 Future Value of money
 You win the lottery today £2.8m
 You plan to retire in 20 years from now
 Assuming you want to retire with £3m in 20 years how much
should you invest in 2% government bonds today?
 How much do you have left to spend?
 Using the formula for present value we see this is
3m  PV (1.02) 20
PV  2.02m
3.00m  2.02m  £981,086.00
 The Power of Compounding
 Compounding is very sensitive to:
1. Time (living a long time/starting early) and
2. Small changes in the interest rate

 Do not ignore small differences in rate – it all adds up in the

end!

 Clearly this is NOT linear i.e. 10 years at 4% gives $48,024 and

10 years at 8% gives $115,892, which is more than double, etc
 Discounting
 “Compounding” grows values forward with time
 “Discounting” shrinks values backwards with time

 In Corporate Finance we expect to receive or pay cash in the future

and need to know its value today

If rates are 5%, £100 today grows into £105 in one year

? If rates are 5% £105 in year 1 is worth what today?

 Discounting: Present Value of money
 We can know this future value of money in present value terms:

PV  FV (1  r ) n

 We can calculate the value of £10,000 in 5 years in today's

money terms

□ Assuming a 6% interest rate per year

 PV = £10,000 / (1 + 6%)5 = £7,472.58, so £10,000 is only worth

£7,472.58 today, this is key, please stop and think about this.

 Higher interest rates reduce present values. What does this last
 How much should you pay for a stream of cash flows?
 Assume a fixed interest rate of 5% p.a.
Year 1 Year 2 Year 3 Year 4 Year 5

Cash flow 500 500 500 500 500 + 10,000

Present Value 500 / (1 + 5%) 500 / (1 + 5%)2 500 / (1 + 5%)3 500 / (1 + 5%)4 10,500 /(1+ 5%)5

Present Value 476.19 453.51 431.92 411.35 8227.03

 Sum of all present values = £10,000, this is the value of this

bond!
 It is quite common in finance to value a series of future cash
flows (CF), perhaps a series of withdrawals from a retirement
account, interest payments from a bond, or deposits for a
savings account.
 The present value (PV) of the series of cash flows is equal to the
sum of the present value of each cash flow, so valuation is
straightforward: find the present value of each cash flow and
then sum them.
 Annuities
 Often, the series of cash flows is such that each cash flow has
the same future value.

 When there are regular payments at regular intervals and each

payment is the same amount, that series of cash flows is
an annuity.

 Most consumer loan repayments are annuities, as are, typically,

instalment purchases, mortgages, retirement investments,
savings plans, and retirement plan payouts.

 We will have tutorial on these topics in future weeks where we

will see what type of Mathematics we require to manipulate
them.
 How do we value a bond?
 A £10,000 par bond pays a coupon of 5% (5% of £10,000 = £500) (and
on maturity pays back the £10,000).
 Assume an interest rate of 2% p.a.
 What is the value of the bond? Sum of PVs is £11,414.04 (this is the
value of these cash flows today and the value of the bond)

Year 1 Year 2 Year 3 Year 4 Year 5

Cash flow 500 500 500 500 500 + 10,000

Present Value 500 / (1 + 2%) 500 / (1+ 2%)2 500 / (1+ 2%)3 500 / (1+ 2%)4 10,500 / (1 + 2%)5

Present Value 490.20 480.58 471.16 461.92 9,510.17

 Sum of present values = £11,414, this is how much the bond is worth
 Annuities
 Many financial instruments pay a constant cash flow over
several periods
 Think of mortgage payments for example
 We can use the annuity formula to calculate the value of these
cash flows

 PV  CF 1  1 
 this will be demonstrated using a
r  (1  r ) n
   Geometric Progression.

 Proof of formula required (to be done shortly)

 This is often written in a slightly different form when one looks
at texts on financial computations.
 Annuity example

 Instrument pays £500 for the next 5 years

 Assume the interest rate of 2% p.a.

Year 1 Year 2 Year 3 Year 4 Year 5

Cash flow 500 500 500 500 500

CF  1 
PV  
 1 
r  (1  r ) n 

500  1 
PV  1    £2,357
5 
2%  (1  2%) 
 Deriving the annuity formula
CF CF CF CF
PV   2
 3
 ..... 
1  r (1  r ) (1  r ) (1  r ) n
 1 1 1 1 

 CF   2
 3
 .....  
n 
 1  r (1  r ) (1  r ) (1  r ) 
CF 1 a(1   n ) CF  1 
let , a  ,   Sn   1  
n 
1 r 1 r 1  r  (1  r ) 
i.e,
CF  1 
PV  1  
n 
r  (1  r ) 
 Net Present Value (NPV)
 Many investments involve non constant cash flows and even
negative cash flows over multiple periods. These are cash
outflows and inflows. That is they are revenues and costs.

 NPV = present value of cash flows that can be positive (or

negative (which as stated above are costs)).

 In fact this is one way you can value real businesses

□ For example the value of a gold mine is the present value of
future gold sales less the present value of the costs to dig the
gold out of the ground and the cost to clean the site after
using it to extract the gold.
 NPV example
 You buy a mining site, including exploration rights and there are
set up costs of £280m

 You expect to extract the following value of gold over the next 5
years, net of running costs:
□ £45m, £75m, £120m, £95m, £55m
□ At the end of year 5 you pay £30m clean up costs.
□ The site will then be handed back to authorities (as worthless).

 Is the project profitable? This is solved on slide 24

□ If interest rates are 5%
□ If interest rates are 10%
 Internal Rate of Return
 All investments should be assessed on the basis of NPV
□ If NPV > 0 project creates profit (value) and should be executed

 Can also use Internal Rate of Return (IRR) to assess whether

project should be undertaken
□ Useful for comparison purposes

 IRR = Discount rate which equates PV of cash inflows with PV of

cash outflows
□ In other words it is the rate at which the NPV = £0
 Internal Rate of Return example

With 5% interest rates With 10% interest rates

Time Cash flow/m PV Time Cash flow/m PV
0 -280 -280 0 -280 -280
1 45 42.86 =(45/1.05) 1 45 40.91=(45/1.10)
2 75 68.03=75/(1.05)^2 2 75 61.98
3 120 103.66 3 120 90.16
4 95 78.16 4 95 64.89
5 55 43.09 5 55 34.15
5 -30 -23.51 5 -30 -18.63
Total 32.29 Total -6.54

 At 5% rates the project has a positive NPV and should be taken, at 10% the project has a
negative NPV and should not be taken
 Thus there is an interest rate between 5% and 10% at which the decision to undertake
the project alternates from being yes to no – this is the “IRR”, that is there is a
percentage rate that gives an NPV value of £0.
 This percentage rate is call the Internal Rate of Return (the IRR).
 Internal Rate of Return (IRR) and
Net Present Value (NPV)
Net present value (NPV): the sum of the present values of all
cash inflows minus the sum of the present values of all
cash outflows.

The internal rate of return (IRR):

(1) the discount rate (i.e. the interest rate) that equates the
sum of the present values of all cash inflows to the sum
of the present values of all cash outflows;
(2) the discount rate that sets the net present value
equal to zero.

The internal rate of return measures the investment yield.

 IRR and NPV
Example: Yield on a single receipt.

An investor can purchase vacant land for £28,371 and expects

to sell it for £50,000 in 5 years. What is the expected IRR for
this investment?

1
PV  FV
(1  d )n

1
£28,371  £50,000
(1  d ) 5

Solving for d = 12%

We have determined the % that makes £50,000 worth £28,371

today, recall present and future value
 IRR and NPV for a single receipt
Example: NPV for a single receipt.

An investor can purchase land for £28,371 and expects to sell it for
£50,000 in 5 years. What is the expected NPV for this investment if the
investor discounts future cash flows at 15%?

1
NPV   PV  FV
(1  d )n

1
NPV  $28,371  $50,000
. )5
(1  015

NPV = -£28,371 + £24,858.84 = - £3,512.16

What does all this mean in simple terms? In 5 years at 15% interest,
£50,000 is only worth £24,858.84 today, so if one pays £28,371 for it
today, then the purchaser is making a loss. That is NPV<0
 IRR and NPV
Example: Yield on an Ordinary Annuity

An investor has the opportunity to invest in property costing £28,371 today.

The investment will provide £445.66 at the end of each month for the next
8 years. What is the (annual) IRR (compounded monthly) for this
investment? PMT=payment.
nk
1
PV  PMT 
d t
t 1
(1  )
k
96
1
£28,371  445.66
d t
t 1
(1  )
12
d
 0.9167%; d 11 .0%
12
To solve this we rewrite this as a GP, use the annuity formula
and then use an iterative technique to be discussed shortly
 Solution
 In solving this last expression using the annuity formula we get

 Where

 So we have to use an iterative scheme on an ordinary annuity.

 IRR and NPV
Example: NPV for an Ordinary Annuity

An investor has the opportunity to invest in land costing £28,371

today. The investment will provide £445.66 at the end of each
month for the next 8 years. What is the NPV for this investment if
the investor discounts future cash flows monthly at a 10% annual
rate?
96
1
NPV  £28,371445.66
0.10 t
t 1
(1  )
12

NPV = - £28,371 + £29,369.66 = £998.66

To obtain the £29,369.66=(£445.66)(65.90). The 65.90 comes from

using the annuity formula (i.e. the sum of GP formula).
 IRR and NPV
Example: What is the IRR for an investment that costs £96,000 today and
pays £1028.61 at the end of the month for the next 60 months and then pays
an additional £97,662.97 at the end of the 60th month?

nk
1 FV
PV  PMT  
d d
t 1
(1  ) t (1  ) nk
k k

60
1 £97,662.97
£96,000  £1,028.61 
d d
t 1
(1  ) t (1  ) 60
12 12
d/12 = 1.0921% ; d = 13.10%

Once again we use the annuity formula to simplify the first term on the
right, an iterative scheme is then used to solve for d/12 and hence for
d=13.10%.
The simplified equation
 IRR and NPV
Example: NPV for an ordinary annuity with an addition lump
sum receipt at the end of the investment term.

What is the NPV for an investment that costs £96,000 today

and pays £1028.61 at the end of the month for the next 60
months and then pays an additional £97,662.97 at the end of
the 60th month if the investor discounts expected future cash
flows monthly at the annual rate of 13.1047%?
nk
1 FV
NPV   PV  PMT  
d t d nk
t 1
(1  ) (1  )
k k
60
1 £97,662.97
NPV  £96,000  £1,028.61 
0.131047 t 0.131047 60
t 1
(1  ) (1  )
12 12

NPV = - £96,000 + £ 96,000 = £0

 IRR and NPV
Example: IRR for uneven cash flows.

What is the IRR for an investment that costs £100,000 today

and pays £20,000 one year from today; £35,000 two years
from today; and £75,000 three years from today?

£20,000 £35,000 £75,000

£100,000   2

(1  d ) (1  d ) (1  d )3

d  11 .59%

How do we determine d? We will use linear interpolation

or the Newton Raphson Method
See Newton_Raphson2.cpp, x0=2
 IRR and NPV
Example: IRR for uneven cash flows.

We thus obtain

£100,000(1  d ) 3  £20,000(1  d ) 2  £35,000(1  d )  £75,000

£100(1  d ) 3  £20(1  d ) 2  £35(1  d )  £75
20(1  d ) 3  4(1  d ) 2  7(1  d )  15
letting
D  1 d
f ( D )  20 D 3  4 D 2  7 D  15
 The Newton-Raphson Method
 Proof, we will show that:

 f ( Dn ) 
Dn 1  Dn   
 f ' ( Dn ) 

 Where the ‘ denotes differentiation with respect to D.

 At the end of the presentation we discuss numerical techniques
in more detail.
 Alternatively we could use Linear Interpolation

 Proof let us find the equation of the line connecting (a,f(a)) and
(b,f(b)), which is

 f (b)  f (a ) 
y x  C
 ba 
Where C is a constant, choosing any of the two points we get
(using (a,f(a)))

 f (b)  f (a) 
f (a )   a  C
 ba 
(b  a ) f (a )  (af (b)  af (a ))  C (b  a)
Alternatively we may use Linear Interpolation
 This gives C as:

 bf (a )  af (b) 
C  
 ba 
So that we obtain

 f (b)  f (a )  bf (a )  af (b)
y x 
 ba  ba

Now solve for x such that y=0, letting this value be x*, say, we get

af (b)  bf (a)
x* 
f (b)  f (a )
 IRR and NPV

Example: NPV for uneven cash flows.

What is the NPV for an investment that costs £10,000 today,

£8,000 one year from today, £5,000 two years from today and
pays £15,000 three years from today and £25,000 four years
from today if future cash flows are discounted at 10%?

£8,000 £5,000 £15,000 £25,000

NPV  £10,000   2
 3

1.1 1.1 1 .1 1.14

NPV = -£10,000 - £7,272.73 - £4,132.23 + £11,269.72 + £17,075.34

= £ 6,940.10
 IRR and NPV

Example: IRR for grouped cash flows.

Compute the IRR for an investment that costs £92,725.60

today and is expected to pay £10,000 at the end of the year for
the next three years; £15,000 at the end of years 4 and 5; and
£100,000 at the end of year 6.
3
£10,000 5 £15,000 £100,000
£92,725.60   t
 t

t 1 (1  d ) t  4 (1  d ) (1  d ) 6
d = 12%

This is not a trivial problem to solve numerically, using the

annuity equation we will have to solve iteratively an nth order
polynomial where n is the number of payment periods.
 IRR and NPV
Example: NPV for grouped cash flows.

Compute the NPV for an investment that costs £98,000 today and is
expected to pay £791.38 at the end of each month for 12 months; £850.73
at the end of each month for the following 12 months; £914.54 at the end
of each month for the following 11 months and a balloon payment of
£107,491.18 at the end of month 36 if the investor discounts future cash
flows monthly at a 13% annual rate.

NPV = - £554.17 = - £98,000 +

12
1 24
1 35
1 £107,491.18
£791.38  £$850.73 £914.54  
0.13 t 0.13 t 0.13 t 0.13 36
t 1
(1  ) t 13
(1  ) t  25
(1  ) (1  )
12 12 12 12
Net Present Value and Other Investment Criteria

More Examples
Vasos Pavlika
[email protected]
 More on NPV
 Question: are we creating value for the firm?
□ As we have seen the CRUCIAL part of appraising a project is the notion of
the future value of money, we must not forget about and of course the
risk (this is simply the interest rate).
 Net Present Value
 Other Investment Criteria
□ The Internal Rate of Return
□ The (Discounted) Payback Rule
□ The Average Accounting Return
□ The Profitability Index
 The Practice of Capital Budgeting
 Net Present Value
 The difference between the market value of a project and its
cost in creating it.
 Discounted Cash Flow (DCF) Valuation:
 We have seen that:
□ The first step is to estimate the expected future cash flows.
□ The second step is to estimate the required return for projects at this risk
level (i.e. interest).
□ The third step is to find the present value of the cash flows and subtract
the initial investment.
□ In other words sum the cash taking into account which are inflows and
which are outflows.
 NPV – Decision Rule
 If the NPV is positive, we accept the project
 A positive NPV means that the project is expected to add value
to the firm and will therefore increase the wealth of the owners.

 Since our goal is to increase owner wealth, NPV is a direct

measure of how well this project will meet our goal.
 Computing NPV for the Project
 You are looking at a new project and you have estimated the
following cash flows:
□ Year 0: CF = -£165,000 (called outflow)
□ Year 1: CF = £63,120;
□ Year 2: CF = £70,800;
□ Year 3: CF = £91,080;
 The risk is 12%.
 NPV = £63,120/(1.12) + £70,800/(1.12)2 + £91,080/(1.12)3 –
£165,000 = £12,627.42

 Do we accept or reject the project?

 Decision Criteria Test - NPV
 Does the NPV rule account for the time value of money? Yes
 Does the NPV rule account for the risk of the cash flows? Yes
 Does the NPV rule provide an indication about the increase in
value? Yes
 Should we consider the NPV rule as our primary decision
criteria? Yes, but be careful.
 Internal Rate of Return
 Definition: IRR is the return that makes the NPV = 0

 Compute using the Newton-Raphson method, Linear

Interpolation or secant method, that you should code in Matlab
or C++ or C or Python or R, I don’t mind which.

 Matlab is probably better to use for the Newton Raphson

technique as it can perform symbolic differentiation.
 Compute IRR

NPV Profile For The Project

70,000
IRR = 16.13%
60,000
50,000
40,000
30,000
NPV

20,000
10,000
0
-10,000 0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

-20,000
Discount Rate
 A quick deduction
If the discounted rate is GREATER than the IRR, we see immediately
from the INVERSE relation that the NPV will be negative and we do
not choose the project

If the discounted rate is LESS than the IRR, we see immediately from
the INVERSE relation that the NPV will be positive and we choose the
project
 NPV Vs. IRR
 NPV and IRR will generally give us the same decision
 Exceptions
□ Non-conventional cash flows – cash flow change signs more than once –
there might be several IRRs (depends on the order of the polynomial)
□ Mutually exclusive projects
− Initial investments are substantially different
− Timing of cash flows is substantially different i.e. the time periods are
not the same
 Whenever there is a conflict between NPV and another decision
rule, you should always use NPV
 It is the primary way that we evaluate projects.
 Non-conventional Cash Flows
 Suppose an investment will cost £90,000 initially and will
generate the following cash flows:
□ Year 1: £132,000
□ Year 2: £100,000
□ Year 3: -£150,000
 The required return is 15%;
 For this question there are two possible values for IRR = 0.1
(10%); 0.43 (43%).
□ This is a problem with using NPV
 Should we accept or reject the project?
 You need to recognize that there are non-conventional cash
flows and look at the NPV profile
 NPV Profile
IRR = 10.11% and 42.66%
$4,000.00

$2,000.00

$0.00
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($2,000.00)
NPV

($4,000.00)

($6,000.00)

($8,000.00)

($10,000.00)
Discount Rate
One can graph this quickly using desmos.com
 NPV vs. Other Rules

 Advantages of NPV  Disadvantages of NPV

□ Accounts for time value of □ Can be difficult to calculate
money and risk □ Typically we have a high order
□ Easy to get the first iterate in polynomial to manipulate but
an iterative scheme still trivial to solve
 Capital Budgeting In Practice
 We should consider several investment criteria when making
decisions
 NPV and IRR are the most commonly used primary investment
criteria
 Payback is a commonly used secondary investment criteria
Solving the IRR problem: Numerical Solutions of
Equations

Iteration: The Bisection

Method, Linear Interpolation
the Newton-Raphson method
and the secant method.
Iterative Methods
Suppose we wanted to find solutions to x = cos(x).

There is in fact no way to

express the solution in
an ‘exact’ way, i.e.
involving sums,
divisions, roots, logs,
trigonometric function, etc.

We instead have to use

)x
s(
numerical methods
x

co
y=

to approximate

=
y
the solution.
Iterative Methods (not Newton’s method)
The principle of iterative methods is that we start with some initial
approximation of the solution, and ‘iteratively’ i.e. repeat some process to
gradually and hopefully converge to the true solution.

Suppose we start (by observing the

graph) with an approximation of
x0 =0.5 (radians)

x
y=
We could use the iterative formula:
x)

xn+1 = cos(xn)
s(
co
=
y

You could do this on a calculator

using:
[0.5] [=]
[cos] [ANS]
[=] [=] [=] [=] [=] ...

x = 0.739085...
Iterative Methods
There are many different numerical methods that we could use.
Why do we have different methods?

1 Some converge to the solution more quickly than others.

Some methods may not converge at all for certain

2
equations/initial choice of x, either diverging, or oscillating
between values.

For this module we will be exploring 4 root-finding algorithms:

a. Interval Bisection (just to be mentioned)

b. Linear Interpolation
c. Newton-Raphson method
d. The secant method

These will be used to find the roots of functions, i.e. finding x for which f(x) = 0.
f(x) = 0

Root-finding algorithms find the root of a function!

We must write this as f(x) = 0 if not already in that form.

We want to solve... Use f(x) =

x = cos(x) f(x) = x – cos(x)
x2 = 2 f(x) = x2 – 2
x = x3 + 3 f(x) = x3 – x + 3
x2 = 2x – 6 f(x) = x2 – 2x + 6
Approach 1: Interval Bisection
This approach starts with an interval for which f(x) changes sign, then
halves this interval at each iteration. This is loosely an approach you
would have used previously as decimal search.
Suppose we know the root
So try the mid-
lies in the interval [a, b]
point. We find
We want to narrow this
f((a+b)/2) is
interval.
positive, so we
replace b with
(a+b)/2.
x
a a+b a+b a+b b
2 2 2
And repeat...
Example
Using the initial interval [2,3], find the positive root to the equation x2 = 7 to 2dp.

f(x) = x2 - 7
a b (a+b)/2 f((a+b)/2)
2 3 2.5 -0.75
2.5 3 2.75 0.5625
2.5 2.75 2.625 -0.109
2.625 2.75 2.6875 0.223
2.625 2.6875 2.65625 0.0557
...
2.64453125 2.646484375 2.645507813

We can stop at this point because:

Both the new bounds will be 2.65 to 2dp, so we know the solution
must be 2.65 to 2dp.
Analysis of the Bisection method

Failure Analysis:

Guaranteed to converge to a root provided that in the initial interval

[a,b], f(a) and f(b) have alternate signs, and f(x) is continuous. What
does this mean?

Other Comments:
Another advantage: Extremely simple to carry out. I often write code for the
Bisection method so as to obtain the first iterate on the Newton-Raphson
method or secant method etc.
Rate of Convergence:

Extremely slow rate of convergence. The error halves each time – we say
this is linear convergence.

Therefore in practice the Interval Bisection method tends never to be

used in earnest.
Definition in terms of limits of functions

The function f is continuous at some point c of its domain if the limit

of f(x), as x approaches c through the domain of f, exists and is equal
to f(c). In mathematical notation, this is written as
In detail this means three conditions: first, f has to be defined at c
(guaranteed by the requirement that c is in the domain of f).

Second, the limit on the left hand side of that equation has to exist.
Third, the value of this limit must equal f(c).
Approach 2: Linear Interpolation
Linear Interpolation builds on the method of Interval Bisection by
choosing a point (generally) better than the midpoint of the bounds.

x
a α c b

Initially the bound for our root is [a,b].

We establish c using linear interpolation,
we then determine the sign of f(c) and
subsequently adjust our interval
accordingly and iterate.
 The proof of the linear interpolation formula
Many finance courses do not include a proof of this technique, I find this
remarkable as it is quite trivial, a formula is quoted without discussing
its origin.

Suppose we have a line joining (a,f(a)) and (b,f(b)) and the line crosses
the x-axis at x=c. Thus by similar triangles (or noting that the gradients
are equal as we are on a line) it follows that, (with f(b)>0, f(a)<0)
Approach 2: Linear Interpolation
Show that the equation x3 + 5x – 10 = 0 has a root in the interval [1,2]. Using
linear interpolation, find this root to 1 decimal place. (Hint: use similar
triangles)
f(1) = -4, f(2) = 8
(2 – α1)/(α1 – 1) = 8/4

Solving α1 = 1.33333
(2,8)
f(1.333...) = -0.96296. Since this is
negative, Make new interval [1.333..., 2]

Eventually we find α3 = 1.4196.

We can check 1.4 is correct to 1dp by
looking at f(1.35) and f(1.45). Change of
sign means the root lies in [1.35, 1.45],
i.e. 1.4 is correct to 1dp.
x
1 α1 2

(1,-4)
Analysis of Linear Interpolation

Failure Analysis:

As with Bisection method, the technique is guaranteed to converge to a root

provided that in the initial interval [a,b], f(a) and f(b) have alternate signs and
f(x) is continuous.

Rate of Convergence:

The error of the approximation after each iteration is dependent on the

curvature of the function as you might expect, the more ‘linear’ the curve is,
the more it approximates a straight line, and hence the better linear
interpolation will be (which assumes a straight line in the region).

The rate of convergence is high when the second derivative at the root is
small (i.e. the gradient itself is not changing very much).
Approach 3: The Newton-Raphson Process
(also known as simply as Newton’s method)
Suppose we start with an
approximation of the root, x0.
y Diagrammatically this clearly

f(x)
is a “considerable” distance
from the required root.

y=
A seemingly sensible thing to
do is to follow the direction of
the line, i.e. use the gradient
of the tangent. We can keep repeating this
process to (hopefully) get
increasingly accurate
approximations.

x
x2 x1 x0
Approach 3: The Newton-Raphson Process
y
Formula:

f(x)
Using some coordinate
geometry:

y=
y – f(xn) = f’(xn)(x – xn)

But we are interested in

x = xn+1 where y = 0

-f(xn) = f’(xn)(xn+1 – xn)

which gives:

Newton-Raphson
x Procedure:
xn+1 xn xn+1 = xn - f(xn)/f’(xn)
Example
Lets look at a new example

Let f(x) =-12000+5000/(1+x)+5000/(1+x)^2+4000/(1+x)^3-2000/(1+x)^4

f’(x) = -5000/(1+x)^2-10000/(1+x)^3-120000/(1+x)^4-10,000/(1+x)^5

How do you get a first guess quickly?

I use the binomial theorem which I will show you.

 More on the Newton-Raphson Method

f(x)
f(xi )
xi 1 = xi -
f (xi )
f(xi)
x f x 
i, i

f(xi-1)


xi+2 xi+1 xi X

Figure 1 Geometrical illustration of the Newton-Raphson method.

 Derivation

f(x)

AB
f(xi) B tan(  
AC

f ( xi )
f ' ( xi ) 
xi  xi 1
C  A X f ( xi )
xi+1 xi xi 1  xi 
f ( xi )

Figure 2 Derivation of the Newton-Raphson method.

 Algorithm for Newton-Raphson Method

1.
Evaluate f (x)
2. Use an initial guess of the root, xi , to estimate the
new value of the root, xi 1 , from

f xi 
xi 1 = xi -
f xi 

3. Find the absolute relative approximate error a as

xi 1- xi
a =  100
xi 1
4. This is not my preferred error norm, it is better to calculate f(x) at the iterate
and see how much it differs from zero (in modulus) which is what we are trying to
solve.
 Step 4

Compare the absolute relative approximate error with

the specified relative error tolerance s .

Go to Step 2 using new

Yes
estimate of the root.
Is a s ?

No Stop the algorithm

Also, check if the number of iterations has exceeded the

maximum number of iterations allowed. If so, one needs
to terminate the algorithm and notify the user.
 Advantages

 Converges faster (quadratic convergence), if it converges.

 See additional document on quadratic convergence and the

secant method (which requires two guesses).

 The Newton-Raphson method requires only one guess.

 The Newton-Raphson is referred to as an open method as is

the secant method, whereas the bisection and linear
interpolation methods are referred to as closed methods as
the two iterates must enclose the root.
 Problems
1. Divergence at inflection points
Selection of the initial guess or an iteration value of the root that is
close to the inflection point of the function, then f x  may start to
diverge from the root in the Newton-Raphson method.

f x   x  1  0.512
3
For example, to find the root of the equation . 0

The Newton-Raphson method gives xn 1  xn 

x 3
n 3
 1  0.512
.2
3xn  1
Table 1 shows the iterates in determining the root of this equation.
The root starts to diverge at Iteration 6 because the previous estimate
of 0.92589 is close to the inflection point at x  1.
Eventually after 12 more iterations the root converges to the exact
value of x  0.2.
 Drawbacks – Inflection Points

Table 1 Divergence near inflection point.

Iteration xi
Number
0 5.0000
1 3.6560
2 2.7465
3 2.1084
4 1.6000
5 0.92589
6 −30.119
7 −19.746 Figure 8 Divergence at inflection point for
f x   x  1  0.512  0
3
18 0.2000
 Drawbacks – Division by zero at turning
points

2. Division by zero
For the equation
f x   x 3  0.03 x 2  2.4  10 6  0
the Newton-Raphson method
gives
xn3  0.03xn2  2.4  10 6
xn 1  xn 
3xn2  0.06 xn

For x0  0 or x0  0.02, the Figure 9 Pitfall of division by zero

denominator will equal zero. near a turning point
 Drawbacks – Oscillations near local
maximum and minimum

3. Oscillations near local maximum and minimum

Results obtained from the Newton-Raphson method may

oscillate about the local maximum or minimum without
converging to a root but converging on the local maximum or
minimum.
Eventually, it may lead to division by a number close to zero
and hence it may diverge.
For example for f x   x  2  0 the equation has no real
2

roots.
 Drawbacks – Oscillations near local
maximum and minimum

Table 3 Oscillations near local maxima and 6

f(x)
mimima in Newton-Raphson method. 5

f xn  a %
Iteration
Number xn 4

0 –1.0000 3.00
3

1 0.5 2.25 300.00 2

2

2 –1.75 5.063 128.571 11

3 –0.30357 2.092 476.47 4

x
4 3.1423 11.874 109.66 -2 -1
0
0 1 2 3
-1.75 -0.3040 0.5 3.142
5 1.2529 3.570 150.80 -1
6 –0.17166 2.029 829.88
7 5.7395 34.942 102.99 Figure 10 Oscillations around local
minima for f x   x  .2
2
8 2.6955 9.266 112.93
9 0.97678 2.954 175.96
 Drawbacks – Root Jumping

4. Root Jumping

In some cases where the function f x oscillates and has a number of roots,
one may choose an initial guess close to a root. However, the guesses may
“jump” and converge to another root. 1.5
f(x)

For example 1

f x   sin x  0 0.5

x
Choose -2
0
0 2 4 6 8 10
-0.06307 0.5499 4.461 7.539822
x0  2.4  7.539822 -0.5

It will converge to x0 -1

-1.5

instead of x  2  6.2831853 Figure 11 Root jumping from intended

location of root for
f x.  sin x  0
 Quadratic convergence and the secant method
 Look at the file in the folder entitled Quadratic convergence and
the secant method for this.
 The secant method
 What do we do if f’(x) (the derivative) is not easily evaluated?
 There are two related options available to you.
 Both options estimate the derivative of f(x) using a finite
difference approximation.
 The first option is called the secant algorithm.
 Instead of starting with one initial guess,  x0 , start with two, 
 and  x  0 (likexthe
1 bisection algorithms, but they do not have to
enclose the root, it is an open method).
 The formula for the secant algorithm is derived from the
Newton-Raphson method, so commencing with:
 The secant method

f ( xn )
x n 1  xn 
f ' ( xn )

 But as mentioned suppose it is difficult to determine f’(x) i.e.

the derivative.
 We can use a backward (or forward) difference approximation
to the derivative, in this technique we use the backward
difference i.e.
 The secant method

f ( x n )  f ( x n 1 )
f ' ( xn ) 
x n  x n 1

 substituting this into the Newton Raphson formula and

simplifying we get

( x n  x n 1 ) f ( x n )
x n 1  xn 
f ( x n )  f ( x n 1 )

 You should be able to modify your Newton's method code giving

the secant algorithm code without too much work.
 The drawback to the method is the need for 2 initial guesses
and the continual use of two values to get the next iterate.
 Code these methods in Matlab/C++. Labelling iterates is
important here
 The secant method continued

f ( x n )  f ( x n 1 )
f ' ( xn ) 
x n  x n 1

 The secant method is referred to as open method in numerical

analysis as it does not have to enclose the root as do the
bisection and linear interpolation methods which are referred to
as closed methods

( x n  x n 1 ) f ( x n )
x n 1  xn 
f ( x n )  f ( x n 1 )
More on the Time Value of Money

Vasos Pavlika
[email protected]
 Financial Mathematics/Arithmetic

 More on Financial
Mathematics/Arithmetic

89
 Financial Mathematics/Arithmetic

• Time Value of Money

• Interest:
– Interest Free Loans
– Simple Interest
– Compound Interest
• Effective Rates of Interest

90
 Time Value of Money: We should know this
now.
 Basic Questions that will be addressed:
□ How much is an investment option worth now?
□ How much is it worth in the future?
□ What are the true costs of loans?
□ How to compare different investment opportunities? (different costs and
different returns over time …)

91
Simple Interest

 Interest is paid (earned) only on the original amount or

principal borrowed (lent).

SI  P  i  t
SI = Simple Interest,
i = rate of interest (proportion, decimal, ratio)
t = number of time periods

92
Compound Interest

At = P (1+ i)t

At = Amount after t time periods

P = Principal or sum invested
i = rate of interest

93
Compound Interest
(1 + i)t = Compounding factor
 interest is paid on the total accumulation of capital
 interest is paid to date

94
How much would £100 earn over 5 years at
an interest rate of 10%?

At = P(1 + i)t
A5 = 100(1 + 0.1
0·1)5

A5  1001  1
5

A5  100  1  61051
A5  £161  05

95
 Compounding.
At = P(1 + i)t t factor Value

P = 100 0 (1 + i)0 £100

i = 0.1
1 (1 + i)1 £110
2 (1 + i)2 £121
3 (1 + i)3 £133·10
4 (1 + i)4 £146·41
5 (1 + i)5 £161·05
96
 If I invest £100 in a building society at 12% p.a., how much
would I have at the end of 4 years, if the investment
earned:
□ Simple interest?
□ Compound interest?

P = £100, i = 0.12, n = 4.

97
 Interest Rate

 The rate at which interest accrues has to be expressed as a rate

per unit interval of time.

 It is not restricted to one year: it could be a half-year, a quarter

of a year, an hour a minute or even continuously as we
discussed previously

98
 What is the accumulated value of £200 invested for 8 and
1/4 years, if the rate of interest is:
(a) 3% per half-year?
(b) 2% per quarter?

99
(a)
16 half - years
16
A16  200  (1.03)  £320.94

(b)
33 quarters
33
A33  200  (1.02)  £384.45

100
 Effective Rate of Interest

 The effective rate of interest is the actual rate of accumulation

over the stated time interval.

 In the previous example, we had effective rates of interest for a

half-year and a quarter of a year, respectively thus the
numerical value of the interest rate is NOT that which is stated.

101
Summary

 Simple Interest
SI  Pit
Accumulated _ Amountt  P  P  i  t  P(1  it )

 Compound Interest

At = P (1+ i)t

102
Exercises

1. If you invest £1,000 for 5 years, what is the value

accumulated if the interest rate is:
a) 3% per half-year;
b) 6% p.a. compounded quarterly?

In both cases what is the effective annual rate? Set as exercise.

Solution (a)
Solution (b)

103
 Effective interest rate
 (a) Solution
 (b) Solution APR
Financial Mathematics

 Nominal Interest Rates

 Annual Percentage Rates
 Continuous Compounding
 Discounting and Present Value

A good reference: - Time Value of Money, chapter 9,

sections 9.1 and 9.2 Burton et al., pages 266-274

105
Nominal Rate of Interest
• The nominal rate is the stated interest
rate for a unit interval of time, which
may be different from that used for
accumulating interest, e.g.
– 3% per half-year would be quoted as being
“6% per annum, payable half-yearly”.

– 2% per quarter would be quoted as being

“8% per annum, payable quarterly”.
106
• Let r be the nominal rate of interest per
annum that is payable x times a year.
• The equivalent or effective rate of
interest per annum ( i ) is given by:
x
 r 
i  1   1
 x
because:
x
 r 
1    1 i
 x
107
• If the effective annual interest rate is
6%, what is the nominal annual rate of
interest compounded semi-annually?

108
Finding the Annual Nominal Rate
2
 r
0.06  1    1
 2
 r
1.06  1  
 2
r  ( 1.06  1) * 2
r  0.059126  5.91%

109
• The accumulated amount of an
investment (P) at a nominal rate of
interest per annum, payable x times a
year (r) for t years is therefore given by:

xt
 r
At  P1  i   P1 
t

 x

110
If we invest £5,000 in a bank
deposit account paying 8% p.a.
compounded quarterly, how much
will we have accumulated at the
end of 5 years?

111
P = £5,000, r = 0.08, t = 5, x = 4
xt 45
 r  0.08 
A5  P1    5,000 * 1   
 x  4 

20
 5,000 * (1  0.02)  7,429.74

Thus, we will have £7,429.74.

112
Total Compound Interest after Period t

CI t  At  P
CI t  P(1  i ) t  P
where :
CI t  compound interest paid up to the end of period t
At  value at the end of period t

113
Annual Percentage Rate (APR)

• Finding the total compound interest paid

on £1 after successive time periods,
then expressing this value as a
percentage of the initial £1.

114
Annual Percentage Rate (APR)

APR  [1(1  i )t  1] 100

where:
APR  annual percentage rate
i  compound (monthly, quarterly, etc.) interest
t  number of compounding periods (months, quarters,
etc.) within a year

115
• Find the APR on a 1 year loan at 24%
p.a. when the interest is paid monthly:

APR = [1(1 + 0.24/12)12 – 1] x 100 =

= [1(1.2682) – 1] x 100 = [0.2682] x 100

That is the APR is:

APR = 26.82% (slightly more than the
24% that is quoted), one has to be
careful with this when taking out loans 116
Continuous Compounding
• If interest is earned continuously, there
are infinite compounding periods within
a year or t years. As such the amount
accumulated at the end of t years at a
nominal rate r would be:
r t rt
At  P(e )  Pe
given that we have:
r
1 i  e
117
• If £5,000 is invested at nominal rate of
8% p.a. payable continuously, how
much is it worth at the end of 5 years?

Thus, P = £5,000, r = 0.08, t = 5:

A5  5,000  e 0.085  7,459.12

118
Present Value:
What a future sum of money
is worth in today’s terms
Discounting:
Reducing the value of a
future sum of money to
today’s value (the opposite
of compounding)
119
 Compounding: At  P  (1  i ) t

t
Therefore P  (1  i )  At

So that
At 1
P  At  t
(1  i ) t (1  i )

t
Discounting: P  At (1  i )

120
Present Value

• The process of converting a future

amount of money into a present value
equivalent is referred to as
discounting.

• What value, P, must be invested now in

order to obtain a particular future value,
At (i.e. the value of tomorrow’s money
today)? 121
 Present Value Again - PV
Present Value  Future Amount  Discount Factor
1
P  At 
1  i t

or
At
P xt
 r  (when compound x times in
1   each of t years)
 x 
122
Practice Exercises
1. What is the present value of £1,000
receivable 5 years from now invested
at a rate of 10% p.a.?

2. Find the present value of £10,000

payable in 5 years’ time if the discount
rate is 12% p.a. compounded
quarterly?
123
 1, 000
1. P  5
 £620.92
(1.1)
If the rate was to changed to 12% p.a.:
1, 000
P 5
 £567.43
(1.12)
Note that the higher the discount rate,
the lower the present value...

124
2.
10,000 10,000
P  
0.12 45 1.03 20
(1  )
4
 £5,536.76

125
 Exercises
1. A credit card company charges 24% p.a. What is the effective
yearly interest rate if:
□ The company compounds monthly? (26.82%)
□ Daily? (27.11%)
□ Continuously?

126
 More exercises.
3. What is the value today of £10,000 due in five years if:
□ interest is compounded semi-annually at 10% p.a.; (£6139,13)
□ interest is compounded quarterly at 10% p.a.;
□ interest is compounded monthly at 10% p.a;
□ interest is compounded continuously at 10% p.a.

127
More on Financial Mathematics

 Investment Appraisal
□ Introduction
□ Non-discounting Techniques
□ Net Present Value (NPV) and Internal Rate of Return (IRR),
this we have already looked at.

128
Investment Appraisal
 Aim: appraise and/or rank different investment projects in order
to decide:
□ Whether or not to go ahead with them; and/or
□ Which one(s) to choose.
 Non-discounting techniques:
□ Payback Period, Average Rate of Return
 Discounting techniques:
□ NPV, IRR

129
Payback Period (PBP)
• The payback period is the time needed for the
nominal cash generated by a project (sum of
the yearly cash flows) to be equal to the cash
injection needed to start the project.
• In other words, payback occurs during the
year in which positive cumulative cash flows
is first achieved, which means when the NPV
value becomes positive.
• It is simply the time it takes for you to pay
back the cash flows.
130
• A project will cost £100,000 today and
will yield revenues of £20,000, £50,000
and £100,000 at the end of this year
and subsequent years.

• How long is the payback period?

131
 £ (000s)
Now -100
1 + 20 so what is remaining -80
2 + 50 so what is remaining -30
3 + 100 so what is remaining 70

2 years + 30/100 of year 3 => 2 years plus 3/10 of year 3 or

2 years and close to 4 (3/10)*12) months

I did this using linear interpolation (2,-30) -> (3,70), the line will make the
amount borrowed equal to zero when t=2.3 years, so 2 years and 0.3 of a
year which is almost 2 years and 4 months.

I am not too keen on this but this is what Finance people to!
132
 PBP – Decision Criterion
The decision criterion is given as a
maximum number of years, or cut-off
period, above which capital investment
proposals should be rejected.
That is the Time for NPV=0

Implication:
the shorter the payback
period - the better the
project
133
Comments on Payback
Method
• Easy to calculate but very crude method
of investment appraisal
• Ignores cash flows after payback
• Can lead to a misleading conclusion
because it does not take into account
the time value of money

134
Average Rate of Return (ARR)

 ARR is the average percentage return per time period

(normally one year) on the initial capital outlay over the
expected life of the project:

 As with PBP, note that only nominal values are

considered...

total cash inflows - initial capital outlay

ARR   100  length of project
initial capital outlay

135
Recall the last example:
Period £ (000s)
Now -100
1 30
2 50
3 80

What is the ARR?

Answer:
((30+50+80)-100)/100*(100/3)=20%

136
Net Present Value (NPV)
 We already know that a project is assessed by assuming a
discount rate and then calculating the present values (PV) of all
the inflows and outflows of the project

 The algebraic sum of the Present values of the cash inflows

(revenues) and the Present Values of the cash outflows (costs)
is the Net Present Value (NPV)

137
Net Present Value (NPV)

 NPV > 0  Value created for the company

 Project with largest NPV according to the assumed rate of
interest is the most profitable:

 n
1 
NPV   A0    At  t 
t 1  (1  i ) 

138
Where:
 An = sum of money due in n time periods (future
amount)
 i = interest rate per time period used in the
discounting process (i.e. discount rate)
 t = end of time period in question
 n = number of time periods
 A0 = initial capital outlay

139
A project has the following cash flow (£)
Now Yr 1 Yr 2
-1200 700 800
 What is the NPV if the discount rate is:
(a) 5%
(b) 10%
(c) 15%
(d) 18%
(e) 20%?

140
 700 800
 1,200    1,200  666.67  725.62  192.29
NPV ( i=5%) = (1.05) 1
(1.05) 2

700 800
NPV ( i = 10%) =  1, 200  1
 2
 1,200  636.36  661.16  97.52
(1.1) (1.1)

700 800
NPV (i = 15%) =  1,200  (1.15) 1

(1.15) 2
 1,200  608.70  604.91  13.61

700 800
NPV (i= 18%)=  1,200  1

(1.18) (1.18) 2
 1,200  593.22  574.55  32.23

700 800
NPV( i = 20%) =  1,200  1
 2
 1,200  583.33  555.56  61.11
(1.20) (1.20)

141
Comments
 The NPV at 10% is lower than the NPV at 5% ...

 NPV falls as the discount (interest) rate rises.

142
NPV and Discount Rate
 The higher the rate of discount we use in calculating the NPV,
the lower the value of NPV, i.e. there is an inverse relationship
 For a given discount rate, the discount factor falls progressively
more rapidly as time increases.
 For any given time period, the discount factor falls progressively
more rapidly as the discount rate increases

143
NPV and Discount Rate
Net Present Value=f(Discount Rate) as a function of Discount rate

250
200
150 IRR
Net Present Value

100
50
0
-50
-100
5 8 10 12 15 18 20

Discount Rate (i)

NPV(i)=0144
 Internal Rate of Return (IRR)

 As we know The Internal Rate of Return (IRR) is the discount

rate (i) which makes the net present value of a project equal to
zero (i.e. it is the effective interest rate you are earning on the
money you invest in the project).

145
Practice Exercises
1 - A property company can buy an office-building now for
£300,000. It will cost £100,000 to refurbish it, which will be
paid at the end of year 1.

The company expects to rent it out for £100,000 in year 2,

£200,000 in year 3 and £300, 000 in year 4

□ What is the NPV of this project, assuming a discount rate

of 6% per year? This is easy to do!! The IRR may be more
difficult.

146
2 - A project has the following cash flows (negative values
being costs and positive values being revenues- all in £’s).

Now Yr 1 Yr 2
-1,300 850 600

a. Compute the NPV using discount rates 5% and 10%

respectively.

b. Give a lower bound and an upper bound for the IRR (i.e. say
between which values the IRR lies, without computing the
IRR).

147
Summary – the fundamental
formulae
An = P (1+ i)n An  Pe rn

An
P
(1  i ) n
total return - initial capital outlay
ARR   100  time period of project
initial capital outlay

 1  n
NPV   A0    At  t 
t 1  (1  i ) 
148
Financial Arithmetic

 Internal Rate of Return (IRR)

 General Comments on Investment Appraisal
Criteria
 Depreciation

149
Internal Rate of Return (IRR)

 We recall that

□ The Internal Rate of Return (IRR) is the

discount rate (i) that makes the net present
value of a project equal to zero.

150
IRR – Recall
Relationship Between Discount Rate and Net Present Value

250
200
150 IRR
Net Present Value

100
50
0
-50
-100
5 8 10 12 15 18 20

Discount Rate

NPV=0
151
 Calculating the IRR
 Project has at most 2 years of cash flow after an initial
investment:
□ Write NPV as a function of the discount rate i
□ By making NPV equal to zero, the equation (quadratic (2 years) or linear
(1 year)) can be solved.

 What if the Project has more than 2 years of cash flow:

□ Solve by an iterative technique as we have already discussed.
□ The problem may be on how we get the initial guess, we will look at how
we do this later in the lecture.
□ We have looked at this using the binomial theorem

152
• A project has the following cash flows
(negative values being costs and
positive values being revenues- all in £).
Now Yr 1 Yr 2
-1200 700 800

• What is the IRR?

153
Write the NPV(i)=0 and solve for i:
700 800
 1,200   2
0
(1  i ) (1  i )
 12(1  i ) 2  7(1  i )  8  0
x  (1  i ) :
 12 x 2  7 x  8  0
 7  49  384
x
 24
x  1.158694  i  15.869% pa

154
Iterative techniques can be used if project has more than 2
periods)

1. Calculate the NPV with two different discount rates, such that one (R1)
gives a positive and the other (R2) a negative NPV
2. Calculate IRR by using the formula:

Note: This is only an approximation! It comes from Linear Interpolation

NPVRate1
IRR  Rate1   ( Rate2  Rate1 )
NPVRate1  NPVRate 2

Many finance books quote this to be remembered, please do not do

this, this comes from the equation of a straight line or using
similar triangles as I have mentioned.

155
– If you recall from one of the examples previously
we calculated the NPV when i=0.15, which was
13.61 and when i=0.18 it was -32.23.
– We can thus get a feel for the interpolation
method:
13.61
IRR  0.15   (0.18  0.15)
13.61  32.23
IRR  0.158907
IRR  15.8907%

156
Comments on Using the IRR

 IRR is a good indicator of the overall effective rate of

return that can be achieved for a particular project.
 It can be used to compare investment opportunities
(choose the one with the highest IRR).

157
 Comments on Using the IRR

 However,
□ the IRR is very sensitive to any change in future cash flows;
□ there may be more than one IRR for a project.

158
 General Comments on Investment Appraisal

 A firm’s preference on appraisal criteria needs to be clear:

□ Value creation NPV
□ Overall rate of return IRR
□ Shortest period to recover investment
payback period…

159
Depreciation
 Just as some investments grow at a simple or compound rate
due to interest rates on an initial amount, other investments
might decline as a result of depreciation:
□ book value of capital equipment and other assets reduce through simple
‘wear and tear’

160
Straight line depreciation
 Reduces the value of capital by the same absolute amount each
year

initial value -scrap value

Annual depreciation 
estimated life span

161
Let us consider a piece of equipment in a
production line that costs £40,000 and has
estimated scrap value of £10,000 and useful
life of 10 years. If we applied a straight line
depreciation , the annual depreciation
would be:
£40,000 - £10,000
Annual depreciation 
10
Annual depreciation  £3,000 per annum

162
However, most capital items do not depreciate in
a linear fashion...
Reducing Balance Depreciation:

At  P  (1  i )t
At  depreciated value after t periods
P  initial value
i  rate of depreciation (decimal)

All we are doing is reducing by a percentage i% per time period.

163
Practice Exercise

 A company purchases a capital item for £50,000:

□ Use linear depreciation to find annual depreciation if
the item is expected to last 5 years and have a scrap
value of £10,000.
□ Use the reducing-balance method of depreciation to
find the value of the item after 5 years with a
depreciation rate of 20% p.a.
□ Use the reducing-balance method to find the rate of
depreciation, i, required to give a depreciated value of
£20,000 after 5 years.
□ this gives r=16.74%
164
Financial Mathematics
Week 3 Lecture 1

 Regular Payments
□ Annuities, Sinking Funds

165
Regular Payments-Annuity

Characteristics:
– Fixed amount
– Paid at specified time period at equal intervals
– Fixed rate of interest

Cash-flow takes the form of a geometric

progression:
t Now 1 2 3 ……….. n-1
£ a ar ar2 ar3 ……….. arn-1
166
Sum (Sn) of a finite geometric
progression:
Sn = a + ar + ar2 + ar3 +…+ arn-1
n
(1  r )
Sn  a
1 r
a = the common factor of the series (1st term)
r = the common ratio
n = the number of terms in the series
167
Suppose you deposit £P at the beginning of each
year in a savings account earning i% p.a.
How much money will you have at the end of 6
years?
1 2 3 4 5 6 End
P P(1+i)6
P
P(1+i)6 - 1
P
P(1+i)6 - 2
P
P(1+i)6 - 3
P
P(1+i)6 - 4
P P(1+i)6 - 5

168
A6 = P (1+i)6 + P (1+i)5 +
P (1+i)4 + P (1+i)3 + P (1+i)2 +
P (1+i)1

= P(1+i) × [(1+i)5 +(1+i)4 + (1+i)3

+
(1+i)2 + (1+i)16+ 1]
(1  (1  i ) )
A6  P (1  i ) 
1  (1  i )

169
Sinking Fund
 Regular savings arrangement with a financial institution.
 An amount P is saved regularly for a specified period at a fixed
rate.
 The accumulated capital over the period is then computed as
just described.

170
Annuities

 Are usually offered by insurance companies

 Are attractive to retired people to supplement any pension
provision:
□ An investor pays a lump sum (initially).
□ In return, the investor receives regular payments of a fixed amount
over a specified time period.
□ The lump sum (at the beginning of the agreed payments) to be paid
is the present value of the annuity (sum of the discounted future
income streams).

171
 How much should I pay as a lump sum for an annual
annuity of £5,000, starting at the end of year 1 and
continuing for 12 years altogether?

 Assume that the annual rate of discount is 10%.

172
Year 0 Year 1 Year 2 … Year 12

??? 5,000 5,000 5,000

5,000
(1+0.1)

5,000
(1+0.1)2

5,000
(1+0.1)12
 1 1 1
PV  5,000   5,000   ...  5,000 
1  0.10 1  0.102
1  0.1012

n 1 5,000 1
(a, ar ,..., ar  a , r  , n  12)
1.1 1.1

12
 1 
1  
5,000  1.1 
PV  S12    £34,068.46
1.1 1
1
1.1
So I should pay £34,068.46 for the annuity
174
 General Comments on
Annuities
1- Same general formula for the sum of a geometric
progression is used. Since values are discounted
and the common ratio is 1
(1  i )
2- Ordinary Annuity (Payments)
Payments occur at the end of each period
3- Annuity (Payments) Due
Payments occur at beginning of each period

175
 How much would you pay now (beginning
of the month) for an annuity, which pays
£1,000 at the end of each month for 10
years, if the current interest rate is 12%
p.a. compounded monthly?

176
Now(0) 1 2 3 …….. 119 120

1000
1000
(1  0.01)
1000
1000
(1  0.01) 2

1000 1000
(1  0.01) 3
……...

1000
1000
(1  0.01)120

177
 1000 1000 1000 1000
PV   2
 3
 .....  120
1.01 1.01 1.01 1.01

  1  
120

1    
1000   1.01    £69,700.52
PV  
1.01  1 
 1  
 1.01 

178
Summary

 Sinking Fund
□ Accumulation
□ Equal payments (P) at equal intervals and a fixed rate (i), i.e. regular
payments
□ Typical questions:
− How much will it accumulate after n periods?
− How much to invest so as to accumulate a certain amount after n
periods?
□ Note that start and end dates are important…

179
 Summary (cont.)
 Annuities
□ Present Value

□ As with sinking fund: equal payments (P) at equal intervals

and fixed rate (i) so we have Regular Payments
□ Payment date defines type of annuity

□ Typical questions:
− How much to pay now for an income flow?
− How much would the payments be if a sum is invested in an
annuity?

□ In practice, as it is a PV problem, the choice of discount rate

is crucial in the computation. 180
Exercises

1. A Company has a loan stock of £2m that will mature

exactly five years from now. Both interest payments and
sinking fund attract an interest rate of 10% p.a. and the
company can repay the loan in 6 instalments (the first
one is due now), how much needs to be paid annually
to meet the liability (capital repayment and interest
payment)?

181
2. How much would you pay now for an annuity, which pays
£1,000 per month for the next 10 years, if the current interest
rate is 6% p.a. compounded monthly?

3. Suppose you had a lump sum of £50,000 to invest in an annuity

that will pay a monthly income for 10 years. If the issuing
insurance company uses a nominal interest rate of 7% p.a.
compounded monthly, how much would your monthly
income be?

182
4.UBM has a liability of £2,000,000 that is due exactly five
years from now. If the rate of interest is 15% p.a., and the
company can make 5 deposits into a sinking fund (the first
one due one year from now), what sum should be set
aside annually to meet the liability when it falls due?

183
Financial Mathematics/Arithmetic

 Regular Payments
□ Mortgages
− Repayment
− Interest Only

184
Regular Payments

Characteristics:
– Fixed amount
– Paid at specified time period at equal intervals
– Fixed rate of interest

Cash-flow again takes the form of a geometric

progression:
t Now 1 2 3 ……….. n-1
£ a ar ar2 ar3 ……….. arn-1
185
Sum (Sn) of a finite geometric
progression:
Sn = a + ar + ar2 + ar3 +…+ arn-1
n
(1  r )
Sn  a
1 r

a = the common factor of the series

r = the common ratio
n = the number of terms in the series
186
Repayment Mortgage
• When a mortgage is taken out on a
property it can be repaid as a series of
regular payments.
• The mortgage is thus the present value
of all future instalments.

187
 Suppose I estimate that I can afford to repay £400 a
month for 20 years. Interest is calculated at 12% p.a.,
payable monthly.

 How large a mortgage can I afford?

188
Mortgage = PV of Repayments

400 400 400 400

PV   2
 3
 ... 
1.01 1.01 1.01 1.01240
 400 1 
a  ; n  240; r  
 1.01 1.01 
240
 1 
1  
400  1.01 
PV    £36,327.77
1.01 1
1
1.01
189
Interest Only Mortgage
• Only the interest is paid over the mortgage period.
• The capital (loan) is paid as a lump sum at the end
of the mortgage period and is normally
accumulated by a regular savings arrangement.

• The monthly cost of the mortgage is thus the

monthly interest plus the amount to be
accumulated (in a sinking fund):
Monthly Cost = Interest + Savings Amount

190
 Let us consider the offer of a 20-year interest only
mortgage of £80,000 and a savings plan into which one
pays a fixed amount at the end of each month to repay
the full £80,000.

 The interest rate charged on the mortgage is 4% p.a.

(compounded monthly) with payment starting at the end
of the first month. If the estimated effective interest rate
of the savings plan is 0.5% per month, what is the total
monthly cash outflow?

191
How much should be saved monthly?

 Let P = payment into investment plan (into the sinking

fund)

 Total value of payments = 80,000 (value to be

accumulated in 20 years = 240 months)

 rate = 0.5% per month

192
1 2 3 ……….... 240
P P(1.005)239
P P(1.005)238
P P(1.005)237
.
.
.
. P(1.005)0

80,000 = P + P(1.005) + …+ P(1.005)237 + P(1.005)238 + P(1.005)239

1 - 1.005 240
80,000  P   P  462.04
1 - 1.005
80,000
P  £173.15
462.04

193
How much is the monthly interest?
0.04
80,000   £266.67
12

The total monthly expense is therefore:

monthly interest + monthly savings =

= £266.67 + £173.15 that is: £439.82

194
 Exercises

1. I intend to take out an interest only mortgage for

£90,000 over 20 years. The interest rate is 4% p. a.
compounded monthly. To finance the repayment
of the £90,000, I intend to take out a monthly
investment policy. The policy pays an interest rate
of 5% p.a. compounded monthly. Assume that the
policy will pay out at exactly the same time as I
make my final payment. Calculate my total
monthly mortgage expenses, if I adopt this
strategy.

195
2. Alternatively, I could take a repayment mortgage.

If the interest rate on the repayment mortgage is

4.5% per annum compounded monthly calculate:
- whether or not this is a cheaper option;
- difference between the two alternatives.

196
Financial Mathematics

 Regular Payments

□ Review of Basic Formulation

□ Value of Bonds

197
Regular Payments

Characteristics:
– Fixed amount
– Paid at specified time period at equal intervals
– Fixed rate of interest

Cash-flow takes the form of a geometric

progression:
t Now 1 2 3 ……….. n-1
£ a ar ar2 ar3 ……….. arn-1
198
a = the common factor of the series
constant)
1
r = the common ratio ( (1+i) or (1 )i )
n = the number of terms in the series

Sum (Sn) of a finite geometric

progression:
Sn = a + ar + ar2 + ar3 +…+ arn-1
n
(1  r )
Sn  a
1 r
199
Bonds

• Government and companies issue bonds

with the objective of raising money from the
public.

• Our aim is to determine the fair value or

price of the bond on the date of issue, which
is equal to the present value of all future
income that arises from the bond.
200
 Definitions - 1

• Price or Value of the Bond

– is the PV of the bond’s future cash flow

• Face Value (denomination) of the Bond

– is the nominal value written on the bond

201
Definitions - 2
Redemption Date
□ Is the future date at which the capital
value of the bond is redeemed (paid
back).
Redemption Value
□ is the capitalamount of the bond that
will be redeemed on the redemption
date.
□ is usually equal the face value (the bond
is then referred to as “redeemed at par”).

202
 Definitions - 3

Coupon Rate
□ is the rate of interest that is used to
compute the interest payments on the face
value
Coupon Value = Face Value × Coupon Rate

Market (discount) Rate

□ is the rate of interest that is used to
discount the cash flows, i.e. the rate of
interest investors can expect to receive in
investments of the level of risk of this bond
203
Example

The government issues a £100 bond at 12%

(payable annually) redeemable in 5 years
at par.
What is the price of the bond if the
purchaser expects a return of 10% p.a.
compounded annually?

204
 The bond gives you 2 streams of cash flows, as follows:
1. Interest payments at the end of the each year (coupons);
2. The redemption value at the end of the 5 years.

 The government uses the coupon rate of 12% to compute

the interest that is due.
□ Interest = 12% of £100 = 0.12  £100 = £12

 The redemption is at par: £100 is paid after 5 years.

205
 The regular coupon payments represent a geometric
progression. The sum of their present values is thus
calculated using the formula for the sum of a geometric
progression (Sn).

 The redemption value represents one payment received

on the redemption date. Thus, we need to calculate its
present value.

 The value or price of the bond is the sum of these two

present values.

206
 The bond cash flow is:

Now
year

0 1 2 3 4 5
1212121212+100 (£)

To find the price of the bond, we need to compute

the present value of the above cash flow.

207
The discount rate is 10%, so the PV of the payments made over 5 years is:
12 12 12 12 12 100
PV  1
 2
 3
 4
 5

(1.1) (1.1) (1.1) (1.1) (1.1) (1.1) 5

12  1 1 1 1  100
PV   1  1  2  3  4  
(1.1)  1.1 1.1 1.1 1.1  (1.1) 5
1 2 3 4
12   1   1   1   1   100

PV   1             5
1.1   1.1   1.1   1.1   1.1   1.1

Geometric Progression

208
 PV of Redemption amount

PV of Coupons

12  (1  ( ) )  100
1 5
PV     5 
1.1

1.1  (1  )  1.1
1
1. 1

 £45.489  £62.092  £107.58

209
In order to raise £8m, a company plans to issue bonds with
face value of £100 and a coupon rate of 6% p.a. paid half
yearly to be redeemed at par in 10 years’ time (so the 8m is
gotten back after 10 years). Which value should you be
willing to offer on these bonds, if market interest rates are
10% p.a. and you believe there is no risk of default?

After 3 years of holding the bond, you decide to sell it. If

interest rate at the time is 8% p.a., how much is the bond
worth then?

210
0 1 2 3 4 5 6 … 20

3 3 3 3 3 3 …. £ 3+100

6% pa paid half-yearly = 3% per half year

3% of £100 = £3 (coupon value)

211
  1 
1
3  1.0520  100
Bond Value = 
1.05  1  1
 20
 £75.08
 1.05
 1.05 
i=10%pa

After 3 years the bond value is (20-6=14)

 1 
1  100
3 1.0414
   £89.44
1.04  1  1  1.04
14

 1.04  i=8%pa

212
Financial Mathematics - basic
formulae
rn
An = P (1+ i) n An  Pe
An
P (1  r n )
(1  i ) n
Sn  a
1 r
If:
Rate1 gives a positive NPVRate1
Rate2 gives a negative NPVRate2

NPVRate1
IRR  Rate1   ( Rate2  Rate1 )
NPVRate1  NPVRate 2
213
Revision Question 1
 A building society charges interest on mortgages at a rate of
5.4% per annum, compounded monthly.
 Calculate the effective annual rate of interest.

214
 12
 0.054 
1    1 i
 12 
1.055357  1  i
i  5.536% p.a.

215
A self-employed software designer wishes to start a
personal pension plan based on monthly payments
into a pension fund. She will make 300 payments
until her retirement date, when the last of her
contributions will be made.
If the fund expects an interest rate of 12% p.a. and
she expects to live for 20 years after retirement,
how much should her monthly contribution to the
fund be in order to generate £2,000 per month
pension benefits commencing one month after her
retirement until death? Interest rates are expected
to remain at the same level after her retirement.

216
n1= 300 months
additional life expectation:
n2=20 x 12= 240 months

1 ... 300 301 ... 540

P ... P 2000... 2000
Acc. PV

217
The monthly contribution to the
pension fund (P):
 1 
1  1.01300  1 
2000 1.01 240
P    
 1  1.01  1.01  1  1 
 1.01 

1,878.84663P  £181,638.83
P  £96.68
218
Exercises (to prepare for tutorials)
1. A bond with a face value of £100 is
redeemed at par in 15 years. The
coupon rate is 8%, paid annually. The
first coupon is due one year from now.
Calculate the value of the bond to an
investor who wants to earn interest of
9% per annum.

219
2.What price should the government set for a bond, which has
nominal value of £100, a coupon of 10% p.a. (paid twice
yearly i.e.5% each time) and is redeemed at par in 10 years’
time, if alternative investments of similar risk level offer
12% p.a. compounded twice yearly?

220
3.The government offers a 10 year nominal
£100 bond with a coupon of 10% (2
payments a year at 5%).
Redemption can be either at par after 5
years or at £120 after 10 years. What price
should an investor, who wants a return of
12% p.a. compounded quarterly, be willing
to pay for the bond?

221
4. I inherited a £5,000 bond with a coupon rate of 10% p.a.
compounded semi-annually, which is redeemable at par
in 5 years time. Assuming that the first payment, which I
receive from the bond will be in six months time, and
that the discount rate is 8% p.a., compounded semi-
annually, calculate the present value of my inheritance.

222
5. A project requires an initial investment of £15,000. It will
return an income of £2,000 payable at the end of each
year for the next 10 years.
 Assuming a discount rate of 5% p.a., what is your
evaluation of this project?
 Would your assessment change if the assumed discount
rate were 6% p.a.?

223
 Given your previous calculations, what can you say about
the internal rate of return (IRR) of this project?

224
6. A man aged 29 has taken out a repayment mortgage for
£180,000. The interest rate is 5.4 % per annum,
compounded monthly. He will make the first repayment
one month from now, and the final repayment 25 years
from now. Calculate the amount of the monthly
payments.

225