MATHEMATICS

OF FINANCE
NAME OF PROJECT: PRESENTED BY: PRESENTED TO:
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 PRESENTED BY:

DEEPANSHU ADITYA GARV RAKSHIT

(318) SAINI SANWARIA RAWAT
(345) (853) (1209)
INDEX Time value of money:
01 Introduction &
Relevance

Compounding
02
Techniques

03 Discounting Techniques

Applications of Time
04
Value of Money
 TIME VALUE CONCEPT
OF MONEY
The Time Value of Money Present v/s Future
(TVM) is a foundational Value: Money available
financial principle that today is worth more than
explains how the value of the same amount in the
money changes over time. future because it can be
This concept states that a invested to earn returns.
sum of money has a
different value now than it Discounting and
will in the future because of Compounding:
its earning potential. TVM involves discounting
future cash flows to
In essence, TVM is essential
present value or
in all areas where financial
compounding current cash
decisions involve different
flows to future value.
time periods, helping
individuals and businesses
make informed financial
choices.
 RELEVANCE

Investment Loan and Retirement Capital

Decisions Mortgage and Savings Budgeting
TVM helps in Calculations
It is crucial in Planning Companies use
evaluating the determining fair loan TVM helps TVM to assess
profitability of repayments, as it individuals project
investments by accounts for the understand how feasibility,
comparing interest accrued over current savings ensuring the
current costs with time. grow over time to future returns
future returns. meet future justify the
financial goals. present costs.
COMPOUNDING
TECHNIQUE
The compounding technique is used to find out the FV of a
present money. It is the same as the concept of compound
interest, wherein the interest earned in a preceding year is
reinvested at the prevailing rate of interest for the remaining
period. Thus, the accumulated amount (principal + interest) at
the end of a period becomes the principal amount for
calculating the interest for the next period.

The compounding technique to find out the FV of present money can be

explained with reference to :

1.The FV of a single present cash flow

2.The FV of a series of cash flows
THE FUTURE VALUE OF SINGLE
CASHFLOW
The future value (FV) of a single cash flow is a critical concept in finance, representing the amount
of money that an investment made today will grow to over time, given a specific interest rate and
compounding period. The formula for calculating the future value of a single cash flow is:
n
FV=PV×(1+r) ; where

• FV = future value of the investment

• PV = present value or initial amount invested
• r = annual interest rate (expressed as a decimal)
• n = number of compounding periods (years)

Importance of Future value of single cashflow:

• The future value calculation is essential for understanding how investments grow over time.
• Compounding can significantly increase returns due to "interest on interest."
• Continuous compounding provides an even higher return compared to standard compounding
methods.
ILLUSTRATION
Find the compound amount of Rs. 4,000 invested for 7 years at 6% compounded
annually and semi-annually?
SOLUTION
Case 1: Compounded
n
FV=PV(1+r)
annually
7

=4000(1+0.06)

Case =4000x1.5036
2: Compounded semi-annually
=Rs.6014.52
n
FV=PV(1+r)
14

=4000(1+0.06/2)
=4000x1.5126
=Rs.6050.36
THE FUTURE VALUE OF SERIES OF
CASHFLOW
To calculate the future value (FV) of a series of cash flows, you can use the following principles and
formulas, depending on whether the cash flows are uniform (equal amounts) or non-uniform
(varying amounts).Future Value of Uniform Cash Flows (Annuity)
When you have a series of equal cash flows, the future value can be calculated using the formula
for the future value of an ordinary annuity:
n
FV=A×[(1+r)−1​]
r
where:
• A = amount of each cash flow (payment)
• r = interest rate per period (expressed as a decimal)
• n = total number of cash flows

Importance of Future value of single cashflow:

• Aids in comparing potential returns from different investment opportunities.
• Emphasizes the significance of compounding over time for growing investments.
• Identifies potential cash shortages or surpluses, allowing proactive financial adjustments.
ILLUSTRATION
A deposit of Rs.1,000 each year is to be made at the end of each of
the next 3 years from today. Calculate the future value of a series?

SOLUTION
To calculate the future value of a series of deposits of 1,000 each year is to
be made at the end of each of the next 3 years from today.

3
FV=1000×[(1+0.05)−1​] /0.05
= 1000×[1.157625−1​]/0.05
= 1000×0.157625/0.05
=157.625/0.05
= Rs.3152.50
THE EFFECTIVE RATE OF INTEREST
The effective rate of interest is the annually compounded rate of interest that is equivalent to an
annual interest rate compounded more than once per year. The effective rate of interest and the
nominal rate of interest are equal whenever they generate the same FV.

n
Effective Rate of Interest= (1+r) - 1
where,
r = normal rate of interest p.a
n = number of compounding periods per year
Importance:
• Comparison Tool: The effective interest rate allows borrowers and
investors to compare different financial products more accurately. For
instance, two loans may have the same nominal interest rate but different
compounding frequencies, leading to different effective rates
• Real Return Measurement: It provides a more accurate measure of
returns on savings or investments by factoring in compounding, which
can significantly affect total earnings over time
In summary, the effective interest rate provides a comprehensive view of
financial products by incorporating compounding effects, making it essential
for informed financial decision-making
ILLUSTRATION
A deposit of Rs. 10,000 is made in a bank for a period of 1 year. The bank offers two options :
(i) to receive interest at 12% p.a. compounded monthly or
(ii) to receive interest at 12.25% p.a. compounded half-yearly.
Which option should be accepted?

SOLUTION
Option (i): Rate of interest 12% p.a. compounded monthly
m
Effective rate =(1+r/m) -1
1
=(1+0.12/12)
2 -1
=1.1268-1
=12.68%

Option (ii): Rate of interest 12.25% p.a. compounded half-yearly

m
Effective rate=(1+r/m) -1
2
=(1+0.1225/2)-1
=1.1263-1
=12.63%
 DISCOUNTING
TECHNIQUE
Discounting involves calculating the present value of a future
sum of money or series of cash flows by applying a discount
rate. The discount rate represents the opportunity cost of
capital, reflecting the return that could be earned if the
money were invested elsewhere.
The present value is calculated by discounting
n
technique by
applying:

PV= FV/(1 + r)

The discounting technique to find out the PV can be

explained in terms of :
(i) The PV of a future sum
(ii) The PV of a future series
THE PRESENT VALUE OF A SINGLE
CASHFLOW
The present value (PV) of a single cash flow determines how much a future sum of money is worth
today, given a specific discount rate. The formula for calculating the future value of a single cash flow
n
is:
PV= FV/(1+r) ; where
• FV = future value of the investment
• PV = present value or initial amount invested
• r = annual interest rate (expressed as a decimal)
• n = number of compounding periods (years)
The present value of a single cash flow is crucial for several reasons:
• Investment Decision-Making: Investors use present value calculations to assess whether an
investment will yield returns that exceed their required rate of return. By comparing the present
values of different investment opportunities, investors can make more informed choices.
• Loan and Mortgage Analysis: When evaluating loan agreements or mortgages, borrowers can
determine how much they should be willing to pay today for future cash flows, helping them
understand the true cost of borrowing.
ILLUSTRATION
Find the present value of Rs. 6,000 due in 20 years at 5%,if compounded:
(a) annually (c)quarterly
(b)semi-annually (d)monthly

Solution
Case(a): Annually Case(c): Quarterly
n n
PV=FV/(1+r) PV=FV/(1+r)
20
80

=6000/(1+0.05) =6000/(1+0.0125)
=6000/2.653 =6000/2.701
=Rs.2261.34
Case(b): Semi-Annually =Rs.2221
Case(d): Monthly
n n
PV=FV/(1+r) PV=FV/(1+r)
40 240
=6000/(1+0.004)
=6000/(1+0.025) =6000/2.713
=6000/2.685 =Rs.2211.6
=Rs.2234.58
THE PRESENT VALUE OF A SERIES
OF CASHFLOW
The present value (PV) of a series of cash flows is a financial concept that calculates the current
worth of future cash inflows or outflows, discounted back to the present using a specified interest
rate. This calculation is essential for understanding the value of future payments in today's
terms.

where:
Ct = cash flow per period t
r = discount rate per period
n = total number of periods
ILLUSTRATION
A student is awarded a scholarship and two options are placed before him:
(i) to receive Rs.1,100 now; or
(ii)receive Rs.100 p.m. at the end of each of next 12 months.
Which option be chosen if the rate of interest is 12% p.a.?

SOLUTION
Option I: The amount of Rs. 1,100 receivable now is already expressed in the present money
and, therefore, does not require any adjustment.
Option II: There is an annuity of Rs.100 for a period of next 12 months. The rate
of interest is 12% p.a. The position can also be expressed as an annuity of 12
periods at rate of interest 1%.
Now, looking at the present value annuity factor table:

Present value of annuity=100x11.255

=Rs. 1125.5
Since, the present value in option II is higher than the present value in option I,
the student should choose the option II.
PERPETUITY
A perpetuity may be defined as an infinite series of equal cash flows occurring at
regular intervals. It has indefinitely long life. This concept is crucial for valuing
investments that promise to deliver consistent payments indefinitely, such as
certain types of bonds or real estate income.
The present value of perpetuity can be calculated using the formula:

PV=Annual cash flow/r ; where

PV= Present value
r= Rate of dicounting

Benefit:
1.Risk Assessment: The discount rate applied in perpetuity calculations
reflects the risk associated with future cash flows, allowing investors to
assess potential returns against risks effectively.
2.Long-term Financial Planning: Perpetuities support long-term
financial planning and retirement strategies by providing a reliable
income source that can be factored into future financial needs.
ILLUSTRATION
A finance company makes an offer to deposit a sum of Rs. 1,100 and then receive a
return of Rs. 80 p.a. perpetually. Should this offer be accepted if the rate of interest
is 8%?
Will the decision change if the rate of interest is 5%?
SOLUTION
A person should accept the offer only if the PV of the perpetuity is more than the initial deposit of
Rs.1,100.
When rate of interest is 8%
Present value of annuity= 80/0.8
= Rs.
1000
When rate of interest is 5%
Present value of annuity= 80/0.5
= Rs.
The
1600offer need not be accepted at 8% rate of interest because the PV of the
perpetuity is only Rs.1,000. It means that the depositor has to pay Rs.1,100 today
and will be receiving only Rs.1,000 in real terms. However, if the rate of interest
reduces to 5% p.a. then the offer is acceptable as the PV of the
perpetuity now is Rs.1,600 and the depositor will be benefited by Rs.500 in the long
run.
THE PRESENT VALUE OF AN
ANNUITY DUE
An annuity due is a series of payments made at the beginning of each period.
In annuity due, the first cashflow occurs now and the last cashflow will occur in the
beginning of the nth year i.e. at time n – 1.

The present value of an annuity due Is given by the formula :

PV = Annuity Amount × PVAF

(r,n × (1+ r)
)
The present value of a single cash flow is crucial for several reasons:
1.Valuation of Cash Flows : It helps determine the current worth of future payments
made at the beginning of each period, providing an accurate financial picture.
2.Investment Decision-Making : It enables comparison of investment options and
helps assess profitability by factoring in the time value of money.
ILLUSTRATION
If Rs. 1,000 is receivable at the beginning of each of the next 4
years, starting from now, and the annual interest rate is 6%, how
would you calculate the present value of these cash flows?

SOLUTION

PV = Annuity Amount × PVAF(r,n) × (1 + r)

=1,000x(3.465)x(1 +0.06)
= Rs.3,673.
THE PRESENT VALUE OF A GROWING
PERPETUITY
A growing perpetuity may be defined as an infinite series of periodic cash flows which grow at a
constant rate per period.
The summation of infinite series of ever increasing cash flows at the rate of growth, g, can be
calculated as follows : 1
PV = Cash flow /(r – g)
where, 1
cash flow = The cash flow at the end of the first period,
r= rate of interest,
g= growth rate in perpetuity amount.
Importance:
1.Long-Term Valuation : The present value of a growing perpetuity helps determine the
current value of a series of cash flows that continue indefinitely, growing at a constant rate.
This is useful for valuing assets like stocks or businesses with expected perpetual growth.
2.Investment Analysis : It aids in assessing the sustainability and attractiveness of long-term
investments by accounting for future growth in cash flows, which helps in making informed
financial decisions.
ILLUSTRATION
A company is expected to declare a dividend of Rs.2 at the end of
first year from now and this dividend is expected to grow 10%
every year. What is the present value of this stream of dividend if
the rate of interest is 15%?

SOLUTION
The present value for this dividend stream can be calculated as follows
: 1

PV = Cashflow /(r – g)
= 2/(0.15–0.10)
= Rs.40
Applications of Time Value of Money
The concept of Time Value of Money (TVM) is one of the most fundamental
principles in finance, and it plays a pivotal role in how individuals,
businesses, and governments make financial decisions. The central idea
behind TVM is that money available today is worth more than the same
amount in the future. This is because money today can be invested or
used to generate additional income or returns. Over time, money loses
value due to inflation, opportunity costs, and the potential earning
capacity of money.

TVM is based on the premise that a dollar received today can be

reinvested to earn interest, dividends, or capital gains, making it more
valuable than a dollar that will be received in the future. As a result,
understanding TVM helps businesses and investors make more informed
decisions about investments, loans, and financial planning.

In practical terms, TVM affects a wide range of financial decisions, such as

investment valuation, loan structuring, retirement planning, and business
budgeting.
IMPLIED INTEREST
Implied interest refers to the rate of return or interest that can be inferred from the
relationship between the present value (PV) and future value (FV) of an investment
or loan. The implicit rate of interest can be ascertained with the help of:
n
FV = PV × (1 + r)
Where FV is future value, PV is present value, r is the interest rate, and n is the
number of periods.
Application:
• Discounted Cash Flow (DCF) models: Calculating the implied
interest rate or yield of an investment using its future cash flows
and current market price.
• Bonds: The yield (implied interest rate) of a bond can be
calculated based on the bond’s face value, coupon rate, and
market price.
ILLUSTRATION
In setting up an educational fund, a person agrees to make five annual payments of Rs.5,000
each into a college fund programme. The first payment is to be made 12 years from now and the
‘college fund programme’ wishes that upon making the last payment, the amount available
should have grown to Rs.30,000. What should be the minimum rate of return on this fund?

SOLUTION
The amount of Rs.30,000 can be considered as the future value of the annuity of Rs.5,000
Consider this equation to find out the future value of the annuity.

FV = Annuity Amount × (R,N)

CVAF (R,N)

30,000(R,N)
= 5,000 × CVAF
6 = CVAF
From looking at the 5th year row in Table A-2, the value 6 falls between the table value of 5.985 and
6.105 in the 9% column and 10% column respectively. Hence, the rate of return on this annuity is
slightly higher than 9%. So, the college fund programme must earn a rate of return of slightly higher
than 9% on the annual deposit to accumulate a target amount of 30,000. In this case, the fact that
the annuity starts from 12 years from now is irrelevant in computing the interest rate because the
annuity table compounds only during the interval period over which the annuity payments are being
made
Number of Periods
Period refers to the number of time intervals (e.g., years, months, quarters)
over which an investment grows or a loan is paid back.

Application:
• Loan amortisation: In loans, the number of periods determines
how long you will pay the loan and how interest accumulates.
• Investment growth: The length of time over which an
investment earns compounded interest (e.g., quarterly, annually).
• Financial Planning: TVM helps individuals and businesses in
budgeting and forecasting future cash flows. It allows for
comparisons between different cash flows occurring at different
times by calculating their present values
ILLUSTRATIONS
Rs. 1,000 is deposited into an interest-bearing account that pays 10%
interest compounded yearly. The investor’s goal is Rs.1,500. How many
years must the principal earn compound interest before the desired
amount is realised?

SOLUTION
In order to find out the time period over which Rs. 1000 would compound to Rs.
1500 at 10%p.a., we would use formula:
n
FV = PV(1 +
n
r)
1,500/1,000 = (1 + .10)
n
1.5 = (1 + .10)
Referring to the future value table, value that equals or approximates the computed value of
1.5 is 1.611, which corresponds to 5 years. If Rs.1,000 principal is left at 10% interest for 5
years, the resulting compound amount will be Rs.1,611. This exceeds the desired Rs.1,500. If
the same principal was left at 10% interest for only 4 years, the compound amount available
will be only Rs.1,464. The investor should leave the deposit for the entire fifth year because of
the assumption of compounding only at the end of each year, and he will then receive an
amount of Rs.1,611.
CAPITAL RECOVERY
Capital recovery refers to the process of recovering the initial investment or capital
outlay over time through a series of equal payments or returns. It is commonly used
to assess how long it will take to recover the cost of an investment and is often used
in capital budgeting and asset valuation.

Key Applications:
• Capital Budgeting: Companies use capital recovery methods to evaluate long-
term investments and assess whether a project will generate sufficient returns
to justify the initial investment.
• Depreciation and Amortisation: When purchasing assets like machinery,
companies recover the cost through depreciation (for physical assets) or
amortisation (for intangible assets), spreading the expense over the asset's
useful life.
• Loan Payments: In loans, capital recovery ensures that the borrower repays
both the principal and interest over time.
ILLUSTRATION
A sum of Rs. 1,00,000 is borrowed today and is to be repaid in five equal
instalments, payable at the end of each of the next five years. The
repayment is structured in such a way that the interest at 10% per annum
for the intervening periods is also repaid. How much should each
instalment be?"

SOLUTION
PV = Annuity Amount ×(r,n)PVAF
Annuity Amount= PV/PVAF
(r,n)

Referring to PVAF table, annuity factor is 3.791

Annuity= 100000/3.791
=Rs. 26378
So, the amount of Rs.26,378 if paid at the end of each next 5 years then the initial loan of
Rs.1,00,000 together with interest at 10% will be repaid.
DEFFERED PAYMENT
Deferred payments refer to the practice of postponing payments to a future date, often
used in contracts, loans, and credit agreements. This allows borrowers or consumers to
delay payments for goods or services until a specified future period.

Key Applications:
• Loans and Mortgages: In loans or mortgages, deferred payments allow borrowers
to delay their first payment for a certain period (e.g., 6 months to 1 year) after
receiving the loan. This is common in student loans or mortgages.
• Supplier Credit: Businesses sometimes negotiate deferred payment terms with
suppliers, allowing them to receive goods now and pay for them later.
• Installment Plans: Consumers may purchase items through installment plans,
where payments are deferred and spread over a series of future dates.

Impact on Financial Calculations:

Deferred payments affect the cash flow and interest calculations because payments are
postponed. For example, in loans with deferred payments, interest may still accrue
during the deferment period, impacting the total repayment amount.
ILLUSTRATION
A loan of Rs.1,00,000 is taken on which interest is payable @ 10%. However, the repayment is to
start only at the end of third year from now. What should be the annual payment if the total loan
and interest is to be repaid in six instalments ?

SOLUTION
In order to find out the annual repayment amount starting from the end of third year from now, the
following procedure may be adopted :
Step 1: Find out the total amount due at the end of 2nd year i.e. in the beginning of the 3rd year
from now at 10%. This can be ascertained with the help of this Equation
n
FV = PV(1 + r)
2
= 1,00,000 (1 +
0.10)
Step =
2:Rs.
Now, Rs. 1,21,000 is the PV of the annuity of 6 year period at 10% interest. The annuity
1,21,000
amount can be ascertained
PV = Annuity Amount ×(r,n)
PVAF = 1,21,000/4.355 = Rs.
Therefore, Annuity
Thus, the amount of Rs. 27,784 payable every year for 6 years starting from the 3rd year will repay
27,784
not only the loan of Rs. 1,00,000 but also the total interest for 8 years (i.e. delayed period of 3 years
and 6-year annuity period)
Thank you