Module 3

TIME VALUE OF MONEY

Time value of money - The time value of money (TVM) is the concept that money you have
now is worth more than the identical sum in the future due to its potential earning capacity. This
core principle of finance holds that provided money can earn interest, any amount of money is
worth more the sooner it is received. TVM is also sometimes referred to as present discounted
value.

Definition of Terms
 Compounding - Process of accumulating interest in an investment over time to
earn more interest
 Interest on interest - Interest earned on the reinvestment of previous interest payments
 Discounting - Discounting is the process of determining the present value of a
payment or a stream of payments that is to be received in the future.

There are five (5) variables that you need to know:

1. Present value (PV) - This is your current starting amount. It is the money you have in
your hand at the present time, your initial investment for your future.
2. Future value (FV) - This is your ending amount at a point in time in the future. It
should be worth more than the present value, provided it is earning interest and growing
over time.
3. The number of periods (n) - This is the timeline for your investment (or debts). It is
usually measured in years, but it could be any scale of time such as quarterly, monthly,
or even daily.
4. Interest rate (i) - This is the growth rate of your money over the lifetime of
the investment. It is stated in a percentage value, such as 8% or .08.
5. Payment amount (PMT) - These are a series of equal, evenly spaced cash flows.

Future Value Formula

FV = PV × (1 + i)n

Present Value Formula

PV = FV × (1 + i)-n
Perpetuity - Perpetuity in the financial system is a situation where a stream of cash flow
payments continues indefinitely or is an annuity that has no end. In valuation analysis,
perpetuities are used to find the present value of a company’s future projected cash flow stream
and the company’s terminal value. Essentially, a perpetuity is a series of cash flows that keep
paying out forever.
Formula:
Present value - PV = C / r

Where:
 PV = Present value
 C = Amount of continuous cash payment
 r = Interest rate or yield
Module 4
DISCOUNTED CASH FLOWS VALUATION

Definition of Terms
1. Annuity - A level stream of cash flows for a fixed period of time
2. Annuity Due - An annuity for which the cash flows occur at the beginning of the period.
3. Perpetuity / Consol - An annuity in which the cash flows continue forever.

Compounding Periods
1. Effective Annual Rate (EAR)
- The interest rate expressed as if it were compounded once per year.
- Used to compare two alternative investments with different compounding periods
2. Annual Percentage Rate (APR)
- The annual rate quoted by law
- APR = periodic rate X number of periods per year
- Periodic rate = APR / periods per year

Loan Types
1. Pure Discount Loans - Borrower receives the money today and repays a single lump
sum at some time in the future.
2. Interest Only Loans - Borrower to pay interest each period and to repay the entire
principal at some point in the future.
3. Amortized Loans - Lender may require the borrower to repay parts of the loan amount
over time
114
Chapter 6

Mathematics of Finance

We will look at the mathematics of finance.

6.1 Simple and Compound Interest

We will look at two ways interest calculated on money. If principal (present value)
amount 𝑃 invested at interest rate 𝑟 per year over time 𝑡, simple interest, 𝐼, is

𝐼 = 𝑃 𝑟𝑡

and total accumulated amount, 𝐴, is

𝐴 = 𝑃 + 𝐼 = 𝑃 + 𝑃 𝑟𝑡 = 𝑃 (1 + 𝑟𝑡).

If 𝑚 is interest periods per year, and 𝑛 = 𝑚𝑡 is total number of interest periods, total
accumulated amount assuming compound interest is
)𝑚𝑡
𝑟
(
𝐴=𝑃 1+ = 𝑃 (1 + 𝑖)𝑛 .
𝑚
If interest rate 𝑟 compounded continuously, total accumulated amount after 𝑡 years

𝐴 = 𝑃 𝑒𝑟𝑡

where 𝑒 = 2.718...

Exercise 6.1 (Simple and Compound Interest)

1. Simple Interest: 𝐴 = 𝑃 + 𝑃 𝑟𝑡.

(a) If $700 is invested at 11% simple interest, calculate its value after 8 years.
𝐴 = 𝑃 + 𝑃 𝑟𝑡 = 700 + 700(0.11)(8) = 1116 / 1216 / 1316

115
116 Chapter 6. Mathematics of Finance (LECTURE NOTES 7)

(b) If $221 is invested at 15% simple interest, its value after 2.5 years is
𝐴 = 𝑃 + 𝑃 𝑟𝑡 = 221 + 221(0.15)(2.5) = 303.88 / 476.2 / 486.2
(c) If $5 is invested at 45% simple interest, its value after 13.1 years is
𝐴 = 𝑃 + 𝑃 𝑟𝑡 = 5 + 5(0.45)(13.1) = 34.48 / 47.34 / 86.22
( )𝑚𝑡
𝑟
2. Compound Interest: 𝐴 = 𝑃 1 + 𝑚
= 𝑃 (1 + 𝑖)𝑛 .

(a) If $321 is invested at 2.5% interest compounded quarterly, calculate its

value after 7 years.
( )𝑚𝑡 ( )4(7)
𝑟 0.025
𝐴=𝑃 1+ 𝑚
= 321 1 + 4
= 372.18 / 382.18 / 392.18
Calculator: 321 ∗ (1 + 0.025/4) ∧ (4 ∗ 7)

(b) If $113 is invested at 2.5% interest compounded monthly, calculate its value
after 3.7 years.
( )𝑚𝑡 ( )(12)3.7
𝑟 0.025
𝐴= 1+ 𝑚
= 113 1 + 12
= 123.94 / 125.81 / 127.81
Calculator: 113 ∗ (1 + 0.025/12) ∧ (12 ∗ 3.7)

(c) If $121 is invested at 3% annual interest compounded daily (assume 365

days per year), calculate its value after 4 years.
( )𝑚𝑡 ( )(365)4
𝑟 0.03
𝐴= 1+ 𝑚
= 121 1 + 365
= 116.43 / 126.43 / 136.43
Calculator: 121 ∗ (1 + 0.03/365) ∧ (365 ∗ 4)

(d) If $700 is invested at 11% interest compounded yearly (or annually), cal-
culate its value after 8 years.
( )𝑚𝑡 ( )1(8)
𝑟 0.11
𝐴= 1+ 𝑚
= 700 1 + 1
= 1513.18 / 1613.18 / 1713.18
(e) If $700 is invested at 11% interest compounded monthly, calculate its value
after 8 years.
( )𝑚𝑡 ( )(12)8
𝑟 0.11
𝐴= 1+ 𝑚
= 700 1 + 12
= 1580.88 / 1680.88 / 1780.88

3. Compound Interest (Continuously): 𝐴 = 𝑃 𝑒𝑟𝑡

(a) If $2000 is invested at 7% interest compounded continuously, calculate its

value after 3 years.
𝐴 = 𝑃 𝑒𝑟𝑡 = 2000𝑒0.07(3) = 2267.36 / 2367.36 / 2467.36.
Calculator: 2000𝑒 ∧ (0.07 ∗ 3)

(b) If $1500 is invested at 6.5% interest compounded continuously, calculate

its value after 3.5 years.
𝐴 = 𝑃 𝑒𝑟𝑡 = 1500𝑒0.065(3.5) = 1883.19 / 1967.36 / 2267.36.
(c) If $700 is invested at 11% interest compounded continuously, calculate its
value after 8 years.
𝐴 = 𝑃 𝑒𝑟𝑡 = 700𝑒0.11(8) = 1687.63 / 1967.36 / 2267.36.
Section 1. Simple and Compound Interest (LECTURE NOTES 7) 117

(d) An amount $700 invested at 11% simple interest ($1316) is

lesser / greater
than $700 invested at 11% interest compounded annually ($1613.18)
lesser / greater
than $700 invested at 11% interest compounded monthly ($1680.88)
lesser / greater
than $700 invested at 11% interest compounded continuously ($1687.63)
after 8 years.

4. Related questions.

(a) Interest rate, 𝑟?

i. If 𝐴 = 700, 𝑃 = 15, 𝑡 = 10 years, interest compounded yearly
( )𝑚𝑡 ( )1(10)
Since 𝐴 = 𝑃 1 + 𝑚𝑟 , then 700 = 15 1 + 𝑟
1
or (1 + 𝑟)10 = 700
15
or taking tenth root of both sides,
( )1/10 ( )1/10
700 700
1+𝑟 = 15
or 𝑟 = 15
− 1 ≈ 0.15 / 0.39 / 0.47.
Calculator: (700/15) ∧ (0.1) − 1

ii. If 𝐴 = 700, 𝑃 = 15, 𝑡 = 10 years, interest compounded monthly

( )𝑚𝑡 ( )12(10) ( )120
Since 𝐴 = 𝑃 1 + 𝑚𝑟 , 700 = 15 1 + 𝑟
12
or 1 + 𝑟
12
= 700
15
or taking 120th root of both (
sides, )
( )1/120 ( )1/120
𝑟
1 + 12 = 700 15
or 𝑟 = 12 700
15
− 1 ≈ 0.15 / 0.39 / 0.47.
Calculator: 12 ∗ ((700/15) ∧ (1/120) − 1)

(b) Number of interest periods, 𝑛 = 𝑚𝑡?

i. If 𝐴 = 700, 𝑃( = 15, )𝑟 = 0.08 interest compounded yearly
𝑚𝑡 ( )𝑚𝑡
𝑟 0.08 700
Since 𝐴 = 𝑃 1 + 𝑚 , 700 = 15 1 + 1 or (1 + 0.08)𝑚𝑡 = 15
or taking natural logs of both sides,
ln(1 + 0.08)𝑚𝑡 = ln 700
15
or 𝑚𝑡 ln(1 + 0.08) = ln 700
15
ln 700
or 𝑛 = 𝑚𝑡 = 15
ln 1.08
≈ 48 / 50 / 52.
Calculator: ln(700/15)/ ln(1.08)

ii. If 𝐴 = 700, 𝑃( = 15, )𝑟 = 0.08 interest compounded monthly

𝑚𝑡 ( )𝑚𝑡 ( )𝑚𝑡
𝑟 0.08
Since 𝐴 = 𝑃 1 + 𝑚 , 700 = 15 1 + 12 or 1 + 0.08
12
= 700
15
or (taking natural
)𝑚𝑡
logs of both sides,
( )
0.08
ln 1 + 12 = ln 700
15
or 12𝑡 ln 1 + 0.08
12
= ln 700
15
700
ln
or 𝑛 = 12𝑡 = ln(
15
≈ 563 / 578 / 589.
1+ 0.08
12 )
Calculator: ln(700/15)/ ln(1 + 0.08/12)

(c) Principal, 𝑃 ?
i. If 𝐴 = 700, 𝑡 = 5 years, 𝑟 = 0.08 interest compounded yearly
( )𝑚𝑡 ( )1(5)
𝑟 0.08
Since 𝐴 = 𝑃 1 + 𝑚
, 700 = 𝑃 1 + 1
118 Chapter 6. Mathematics of Finance (LECTURE NOTES 7)

or 𝑃 = 700(1 + 0.08)−5 ≈ 476.41 / 500.00 / 528.89.

Calculator: 700 ∗ 1.08 ∧ (−5)

ii. If 𝐴 = 700, 𝑡 = 5 years, 𝑟 = 0.08 interest compounded monthly

( )𝑚𝑡 ( )12(5)
𝑟 0.08
Since 𝐴 = 𝑃 1 + 𝑚
, 700 = 𝑃 1 + 12
( )−60
0.08
or 𝑃 = 700 1 + 12
≈ 469.85 / 499.00 / 518.89.
Calculator: 700 ∗ (1 + 0.08/12) ∧ (−60)

(d) Other. Two hundred dollars ($200) is deposited monthly into account pay-
ing 6.25% compounded monthly. After 3 years, accumulated amount is put
into 2-year certificate which pays 8% compounded quarterly. Determine
final (accumulated
)𝑚𝑡 amount.
( )12(3)
𝑟
𝐴= 1+ 𝑚 = 200 1 + 0.0625
12
≈ 241.13 / 375.89
Calculator: 200 ∗ (1 + 0.0625/12) ∧ (36)
( )𝑚𝑡 ( )4(2)
𝐴 = 1 + 𝑚𝑟 = 241.13 1 + 0.08 4
≈ 282.52 / 375.89
Calculator: 241.13 ∗ (1 + 0.08/4) ∧ (8)

5. Using the TI–83 Calculator: Compound Interest. Determine the future value of $700 which is invested at
11% interest which is compounded monthly after 8.3 years.

∙ Press APPS ENTER FINANCE ENTER TVM Solver ENTER.

∙ Set the TVM Solver parameters as N = 8.3, I% = 11, PV = −700, PMT = 0, FV = 0, P/Y = 1, C/Y
= 12. Arrow back to FV and then press ALPHA ENTER. The answer FV = 1737.01 appears.

N stands for number of years. I% is the yearly interest rate. PV stands for “present value” and is typed in as
a negative number because it is considered as an “outflow” of cash. PMT is the “payment amount”, which,
in this case, does not apply and so is set to zero. FV is “future value” and is the variable we are trying to
determine in this question. P/Y is the “number of payment periods per year”, which, in this case, does not
apply and so is set to one. C/Y is the “number of compounding periods per year”.

6.2 Ordinary Annuities

We will look at annuities (a sequence of payments made at regular time inter-
vals); more specifically, ordinary annuities (annuity where interest on payments com-
pounded at same time payment made). If principal (present value) amount 𝑃 invested
at interest rate 𝑟 per year over time 𝑡, 𝑚 is interest periods per year, and 𝑛 = 𝑚𝑡 is
total number of interest periods, future value of an ordinary annuity,
⎡( )𝑚𝑡 ⎤
𝑟
⎢ 1+ − 1⎥ (1 + 𝑖)𝑛 − 1
[ ]
𝑚
𝐴 = 𝑝⎣ 𝑟 ⎦=𝑝
𝑚
𝑖

payments to a sinking fund,

⎡ ( ) ⎤
𝑟 [ ]
𝑚 𝑖
𝑝= 𝐴 ⎣( =𝐴
⎢ ⎥
)𝑚𝑡
(1 + 𝑖)𝑛 − 1
⎦
1 + 𝑚𝑟 −1
Section 2. Ordinary Annuities (LECTURE NOTES 7) 119

ordinary annuity formula,

⎡( )𝑚𝑡 ⎤
𝑟
1+ − 1⎥ (1 + 𝑖)𝑛 − 1
)𝑚𝑡 [ ]
𝑟
(
𝑚 𝑛
𝐴 =𝑃 1+ +𝑝⎢ 𝑟 ⎦ = 𝑃 (1 + 𝑖) + 𝑝
𝑚 𝑖
⎣
𝑚

present value of an ordinary annuity,

⎡ ( )−𝑚𝑡 ⎤
𝑟
⎢1 − 1 +
[ ]
𝑚 1 − (1 + 𝑖)−𝑛
𝑃 = 𝑝⎣ =𝑝 .
⎥
𝑟
𝑖
⎦
𝑚

Exercise 6.2 (Ordinary Annuities)

[ 𝑚𝑡
]
(1+ 𝑚𝑟 ) −1
[
(1+𝑖)𝑛 −1
]
1. Future value of an annuity: 𝐴 = 𝑝 𝑟 =𝑝 𝑖
𝑚

(a) Future value of 5 year term annuity, $100 paid each quarter, earning in-
terest [at 8.5% annually,
] compounded
[ quarterly,
] is
𝑟 𝑚𝑡 0.085 4(5)
( 𝑚 ) −1
1+ ( 1+ 4 )
−1
𝐴=𝑝 𝑟 = 100 0.085 ≈ 2260.21 / 2460.21
𝑚 4
Calculator: 100 ∗ ((1 + 0.085/4) ∧ (20) − 1)/(0.085/4)

(b) Future value of 3 year term annuity, $120 paid each month, earning interest
at 9.5%
[ annually, ]compounded
[ monthly, ]is
𝑚𝑡 12(3)
(1+ 𝑚𝑟 ) −1 (1+ 0.095
12 )
−1
𝐴=𝑝 𝑟 = 120 0.095 ≈ 4975.89 / 5075.89
𝑚 12
Calculator: 120 ∗ ((1 + 0.095/12) ∧ (36) − 1)/(0.095/12)

(c) Future value of 3.2 year term annuity, $105 paid each day, earning interest
at 6.5%
[ annually, ]compounded
[ daily (365 days),
] is
𝑟 𝑚𝑡 0.065 365(3.2)
(1+ 𝑚 ) −1 (1+ 365 ) −1
𝐴=𝑝 𝑟 = 105 0.065 ≈ 135, 313.40 / 136, 313.40
𝑚 365
Calculator: 105 ∗ ((1 + 0.065/365) ∧ (365 ∗ 3.2) − 1)/(0.065/365)
[ ]
( 𝑚𝑟 ) [
𝑖
]
2. Payments to sinking fund: 𝑝 = 𝐴 𝑚𝑡 = 𝐴 𝑛
(1+𝑖) −1
(1+ 𝑚𝑟 ) −1

(a) Lab of computers replaced in 3 years time for anticipated (future) cost
of $25,000 where $25,000 accumulated over 3 year period through equal
installments made at end of each month. If yearly interest rate is 8.5%,
size of [each installment
] is [ ]
( 𝑚𝑟 ) ( 0.085
12 )
𝑝=𝐴 𝑚𝑡 = 25000 12(3) ≈ 612.11 / 613.11 / 614.11
(1+ 𝑚𝑟 ) −1 12 )
(1+ 0.085 −1
Calculator: 25000 ∗ (0.085/12)/((1 + 0.085/12) ∧ (36) − 1)
120 Chapter 6. Mathematics of Finance (LECTURE NOTES 7)

(b) Quarterly annuity required (future) sinking fund of $30,000, needed after
5 years,
[ if yearly interest
] rate
[ is 7.5%, is ]
(𝑚)
𝑟
( 0.075
4 )
𝑝=𝐴 𝑟 𝑚𝑡
= 30000 4(5) ≈ 1250.14 / 1350.14
(1+ 𝑚 ) −1 ( 1+ 4 )
0.075
−1
Calculator: 30000 ∗ (0.075/4)/((1 + 0.075/4) ∧ (20) − 1)
[ 𝑚𝑡
]
(
𝑟
)𝑚𝑡 (1+ 𝑚𝑟 ) −1
3. Ordinary annuity formula: 𝐴 = 𝑃 1 + 𝑚
+𝑝 𝑟
𝑚

(a) If $700 is invested now at 11% interest compounded quarterly and also
$120 is added each [quarter, calculate
] value of investment after 8 years.
𝑟 𝑚𝑡
( )𝑚𝑡 (1+ 𝑚 ) −1
𝐴 = 1 + 𝑚𝑟 +𝑝 𝑟 =
𝑚
[ 4(8)
]
(
0.11
)4(8)
4 )
(1+ 0.11 −1
700 1 + 4
+ 120 0.11 ≈ 7700.08 / 8075.89
4
Calculator: 700 ∗ (1 + 0.11/4) ∧ (32) + 120 ∗ ((1 + 0.11/4) ∧ (32) − 1)/(0.11/4)

(b) If $600 is invested now at 1% interest compounded semiannually and also

$100 is added every [six months,]calculate value of investment after 5 years.
𝑚𝑡
( )𝑚𝑡 (1+ 𝑚𝑟 ) −1
𝐴 = 1 + 𝑚𝑟 +𝑝 𝑟 =
𝑚
[ 2(3)
]
(
0.01
)2(5)
2 )
(1+ 0.01 −1
600 1 + 2
+ 100 0.01 ≈ 700.08 / 1653.49
2
Calculator: 600 ∗ (1 + 0.01/2) ∧ (10) + 100 ∗ ((1 + 0.01/2) ∧ (10) − 1)/(0.01/2)
[ ]
1−(1+ 𝑚
𝑟
)
−𝑚𝑡 [ ]
1−(1+𝑖)−𝑛
4. Present value of an annuity: 𝑃 = 𝑝 𝑟 =𝑝 𝑖
𝑚

(a) Present value of 5 year term annuity, $100 paid each quarter, earning 8.5%
yearly [interest, compounded
] [ quarterly,−4(5)
is ]
1−(1+ 𝑚 )
𝑟 −𝑚𝑡
1−(1+ 0.085 )
𝑃 =𝑝 𝑟 = 100 4
0.085 ≈ 1415.59 / 1615.59
𝑚 4
Calculator: 100 ∗ (1 − (1 + 0.085/4) ∧ (−20))/(0.085/4)

(b) Present value of 3 year term annuity, $120 paid monthly, earning 9.5%
yearly [interest, compounded
] [ monthly, −12(3)
is ]
1−(1+ 𝑚 )
𝑟 −𝑚𝑡
1−(1+ 12 )
0.095
𝑃 =𝑝 𝑟 = 120 0.095 ≈ 3546.14 / 3746.14
𝑚 12
Calculator: 120 ∗ (1 − (1 + 0.095/12) ∧ (−36))/(0.095/12)

(c) Present value of 7 year term annuity, $97 paid monthly, earning 9.5% yearly
interest,
[ compounded ] daily
[ (365 days), is ]
1−(1+ 𝑚 )
𝑟 −𝑚𝑡
1− ( 365 )
1+ 0.095 −365(7)
𝑃 =𝑝 𝑟 = 97 0.095 ≈ 180, 006 / 181, 006
𝑚 365
Calculator: 97 ∗ (1 − (1 + 0.095/365) ∧ (−365 ∗ 7))/(0.095/365)
Section 3. Consumer Loans and APR (LECTURE NOTES 7) 121

6.3 Consumer Loans and APR

Annual percentage rate (APR) or effective interest rate allows consumers to compare
different interest rates. Assuming principal (present value) amount is 𝑃 , interest rate
is 𝑟 per year, 𝑚 is interest periods per year, APR is
)𝑚
𝑟
(
𝐴𝑃 𝑅 = 1 + − 1 = (1 + 𝑖)𝑚 − 1
𝑚
amortization, amount of payments to retire a load,
⎡ ( ) ⎤
𝑟 [ ]
𝑚 𝑖
𝑝=𝑃 =𝑃
⎢ ⎥
)−𝑚𝑡 ⎦
1 − (1 + 𝑖)−𝑛
⎣ (
𝑟
1− 1+ 𝑚

amortization, number of payments to retire a load,

( )
𝑝
ln
( )
𝑝
𝑝−𝑃 ( 𝑚
𝑟
) ln 𝑝−𝑃 𝑖
𝑛= ( ) =
ln 1 + 𝑟 ln(1 + 𝑖)
𝑚

Amortization table or amortization schedule is also discussed.

Exercise 6.3 (Consumer Loans and APR)

( )𝑚
1. 𝐴𝑃 𝑅 = 1 + 𝑚𝑟 − 1 = (1 + 𝑖)𝑚 − 1.
Which is larger: 10% compounded monthly or 10.2% compounded quarterly?
(a) After 1 year, $1 invested 10% compounded monthly,
( )𝑚𝑡 ( )12(1)
𝑟 0.10
𝐴=𝑃 1+ 𝑚
= 1 1 + 12
≈ 1.084713 / 1.094713 / 1.104713
Calculator: 1 ∗ (1 + 0.10/12) ∧ (12)
so interest
( earned
)𝑚 in one year is this amount subtract $1,
𝑟
𝐴𝑃 𝑅 = 1 + 𝑚 − 1 ≈ 0.1047 / 0.1147 / 0.1247 or 10.47%
Calculator: (1 + 0.10/12) ∧ (12) − 1

(b) After 1 year, $1 invested 10.2% compounded quarterly,

( )𝑚𝑡 ( )4(1)
𝑟 0.102
𝐴=𝑃 1+ 𝑚
= 1 1 + 4
≈ 1.085968 / 1.095968 / 1.105968
Calculator: (1 + 0.102/4) ∧ (4)
so interest
( earned
)𝑚 in one year,
𝑟
𝐴𝑃 𝑅 = 1 + 𝑚 − 1 = 0.105968 / 0.115968 / 0.125968 or 10.60%
Calculator: (1 + 0.102/4) ∧ (4) − 1

(c) Consequently, 10% compounded monthly (APR: 10.47%) is

less / more than 10.2% compounded quarterly (APR: 10.60%).
[ ]
( 𝑚𝑟 )
2. Amortization, amount of payments to retire a loan: 𝑝 = 𝑃
1−(1+ 𝑚 )
𝑟 −𝑚𝑡
122 Chapter 6. Mathematics of Finance (LECTURE NOTES 7)

(a) Car loan of $25,000 repaid monthly over 3 year period, yearly interest
8.5%. [Amount of each ] installment
[ ]
( 𝑚𝑟 ) 12 )
( 0.085
𝑝=𝑃 = 25000 ≈ 769.19 / 789.19
1−(1+ 𝑚 )
𝑟 −𝑚𝑡
12 )
1−(1+ 0.085
−(12)3

Calculator: 25000 ∗ (0.085/12)/(1 − (1 + 0.085/12) ∧ (−36))

(b) House loan of $125,000 repaid quarterly over 20 year period, yearly interest
7.5%. [Amount of each ] installment
[ ]
( 𝑚𝑟 ) ( 0.075 )
𝑝=𝑃 = 125000 4
≈ 1906.99 / 3029.08
1−(1+ 𝑚 )
𝑟 −𝑚𝑡
1−(1+ 0.075
4 )
−(4)20

Calculator: 125000 ∗ (0.075/4)/(1 − (1 + 0.075/4) ∧ (−80))

(c) Amortization table.

Loan of $5,000 repaid quarterly over 1.5 year period, yearly interest 8.5%.
Amount[ of each installment
] [ ]
( 𝑚𝑟 ) ( 0.085
4 )
𝑝=𝑃 = 5000 ≈ 896.40 / 989.19
1−(1+ 𝑚 )
𝑟 −𝑚𝑡
4 )
1−(1+ 0.085
−(4)1.5

Calculator: 5000 ∗ (0.085/4)/(1 − (1 + 0.085/4) ∧ (−6))

payment amount interest principal balance

1 896.40 106.25 790.15 4209.85
2 896.40 89.45 806.95 3402.90
3 896.40 72.31 824.09 2578.81
4 896.40 54.80 841.60 1737.21
5 896.40 36.92 859.48 877.73
6 896.40 18.65 877.75 0
0.085
To begin, interest = 5000 × 4
= 106.25, then principal = 896.40 − 106.25 = 790.15,
0.085
and balance = 5000 − 790.15 = 4209.85, then interest = 4209.85 × 4
≈ 89.45 and so on.

(d) True / False. Amortization determines sequence of payments (annuity)

equivalent to present lump sum, whereas sinking fund determines annuity
equivalent to future lump sum.
( )
𝑝
ln ln( 𝑝−𝑃 𝑖)
𝑟 ) 𝑝
𝑝−𝑃 ( 𝑚
3. Amortization, number of payments to retire a loan: 𝑛 = =
(
ln 1+ 𝑚𝑟
) ln(1+𝑖)

(a) Number of quarterly( $1000 payments

) to repay car loan of $25,000, 8.5%:
1000
( )
ln 𝑝 ln
𝑟 )
𝑝−𝑃 ( 𝑚 1000−25000 ( 0.085
4 )
𝑛= = ≈ 36.03 / 36.89 or 37 payments
(
ln 1+ 𝑚𝑟
) ln(1+ 0.085
4 )
Calculator: ln(1000/(1000 − 25000 ∗ 0.085/4))/ ln(1 + 0.085/4)

(b) Number of monthly (

$1000 payments) to repay house loan of $125,000, 7%:
1000
( )
ln 𝑝 ln
𝑟 )
𝑝−𝑃 ( 𝑚 1000−125000 ( 0.07
12 )
𝑛= = ≈ 224.58 / 225.34.45 or 225 pay-
( ln 1+ 𝑚𝑟
) ln( 1+ 0.07
12 )
ments
Calculator: ln(1000/(1000 − 125000 ∗ 0.07/12))/ ln(1 + 0.07/12)
CHAPTER 8
 Creditor / lender - Person or firm making the
loan
 Debtor / Borrower - Corporation borrowing
the money
- Debt is not an ownership interest in the firm
- Dividends paid to stockholders are NOT tax
deductible
- Unpaid debt is a liability of the firm
 Short-term debt - Maturities of one year or
less
 Long-term debt - Maturities of more than one
year.
 Public Issue - Offer placed to the public
 Private Issue - Bond directly placed with a
lender
TERMS AND SECURITY
 Indenture - Written agreement between the
corporation and the lender detailing the terms
of the debt issue
OWNERSHIP
 Registered form - Registrar of a company
records who owns each bond, and bond
payments are made directly to the owner
of record.
 Bearer form - Bond issued without record
of the owner’s name, payment is made to
whomever holds the bond.
DEBT SECURITY
 Debenture - Unsecured debt, usually with a
security of 10 years or more
 Note - Unsecured debt, usually with maturity
of less than 10 years
 Collateral - Securities that are pledged as
security for payment of debt
 Collateral Trust bonds - Involve a pledge of
common stock held by the corporation
 Mortgage Securities (mortgage trust
indenture / trust deed) - Secured by a
mortgage on the real property of the borrower
 Blanket Mortgage - Pledges all the real
property owned by the company
SENIORITY AND REPAYMENT
 Seniority - Preference in position over other
lenders.
 Subordinated debt - Must give preference to
other specified creditors
 Sinking Fund - An account managed by the
bond trustee for early bond redemption
CALL PROVISION
 Call provision - Agreement giving the issuer
the option to repurchase a bond at a specific
price prior to maturity.
 Call premium - The amount by which the call
price exceeds the par value of the bond
 Deferred call provision - Bond call provision
prohibiting the company from redeeming the
bond prior to a certain date.
 Call protected bond - Bond during period in
which it cannot be redeemed by the issuer
 Make-whole call - Bondholders receive
exactly what the bonds are worth if they are
called.
COVENANTS
 Protective Covenants - Part of the indenture
limiting certain actions that might be taken
during the terms of the loan, usually to protect
the lender’s interest
 Negative Covenant
-Thou shalt not” type of covenant
-Limits or prohibits actions that the company
might take.
 Positive Covenant
-“thou shalt” type of covenant.
-Specifies an action that the company agrees
to take or a condition the company must abide
by.
BOND RATINGS – INVESTMENT
 High Grade
 Moody’s Aaa and S&P AAA –
capacity to pay is extremely strong
 Moody’s Aa and S&P AA – capacity
to pay is very strong
 Medium Grade
 Moody’s A and S&P A – capacity to
pay is strong, but more susceptible to
changes in circumstances
 Moody’s Baa and S&P BBB –
capacity to pay is adequate, adverse
conditions will have more impact on
the firm’s ability to pay
BOND RATINGS – SPECULATIVE
 Low Grade -
 Moody’s Ba, B, Caa and Ca S&P BB,
B, CCC, CC
 Considered speculative with respect to
capacity to pay. The “B” ratings are
the lowest degree of speculation.
 Very Low Grade
 Moody’s C and S&P C – income
bonds with no interest being paid
 Moody’s D and S&P D – in default
with principal and interest in arrears
 Junk Bonds
 Low-grade bonds
DIFFERENT TYPES OF BONDS
 Treasury Issues - Coupon bonds with no
default risk (government pays), Exempt from
state income tax
 Municipal notes / bonds - Exempt from
federal and state taxes
 Zero Coupon Bonds - Bond that makes no
coupon payments, and priced at a deep
discount.
 Floating rate bonds (floaters) - Coupon
payments are adjustable (tied to an interest
rate index)
 Inflation-linked bond - Coupons that are
adjusted according to the rate of inflation
 Collar (on floating rates) - Upper and lower
rates on the coupon bond. (floor and ceiling)
Features of Floating-rate bonds
• Holder has a right to redeem the note at par on
the coupon payment date after some specified
amount of time.
• The coupon has a floor and ceiling
 Structured Notes - Bonds that are based on
stocks, bonds, commodities, or currencies.
 Convertible bond - Swapped for a fixed
number of shares of stock any time before
maturity at the holder’s option
 Put bond - Allows the holder to force the
issuer to buy the bond back at a stated price
BOND PRICE REPORTING
 Asked Price - The price a dealer is willing to
take for a security
 Bid-ask spread - Difference between bid
price and asked price
 Bid Price - The price a dealer is willing to pay
for a security
BOND PRICING
 Bell-wether bond - Very last ordinary bond
listed ; Bond’s yield that is usually reported in
the news
 Clean Price - Price of a bond net of accrued
interest ; Price that is usually quoted
 Dirty price (full invoice price) - Price of a
bond including accrued interest. ; Price the
buyer actually pays
INTEREST RATES
 Real Rates - Interest rates or rates of return
that have been adjusted for inflation.
 Nominal rates - Interest rates or rates of
return that have not been adjusted for
inflation.
 Fisher Effect - The relationship among
nominal returns, real returns, and inflation.
DETERMINANTS OF BOND YIELDS
• Term structure of interest rates -
Relationship between nominal interest rates
on default-free, pure discount securities and
time to maturity; that is the pure time value of
money.
• Inflation premium - Portion of a nominal
interest rate that represents compensation for
expected future inflation
• Interest rate risk premium - Compensation
investors demand for bearing interest rate risk
• Default risk premium - Portion of a nominal
interest rate or bond yield that represents
compensation for the possibility of default
• Treasury Yield Curve - Plot of the yields on
Treasury notes and bonds relative to maturity
• Taxability premium - Portion of a nominal
interest rate or bond yield that represents
compensation for unfavorable tax status
• Liquidity premium - Portion of a nominal
interest rate or bond yield that represents
compensation for lack of liquidity.
 CHAPTER 9
STOCK VALUE
 Zero Growth - Firm will pay a constant
dividend forever
Example: Preferred Stock
P0  D R
 Constant Growth - Firm will increase the
dividend by a constant percent every
period
Gordon Growth Model
D (1  g) D
Pˆ0  0  1
R-g R-g
 Non-constant Growth - Dividend growth
is not consistent initially, but settles down
to constant growth eventually
PV of ALL Dividends
• Growing Perpetuities - An asset with cash
flows that grow at a constant rate forever
• Dividend Growth Model - A model that
determines the current price of a stock as its
dividend next period divided by the discount
rate less the dividend growth rate
*Preferred stock have zero growth and thus
constant through time.
*The growth rate cannot exceed the required
return indefinitely, but it certainly could do for
some number of years.
COMPONENTS OF REQUIRED RETURN
 Dividend Yield - A stock’s expected cash
dividend divided by its current price
 Capital Gains Yield - The rate at which
the value of an investment grows.
STOCK VALUATION USING COMPARABLES
 PE ratio (Price / earnings) - Ratio of a
stock’s price per share to its earnings per share
Sources: similar companies, industry average,
historical values
 Price – Sales Ratio - Price per share on the
stock divided by sales per share
Used if earnings are unreliable / negative
 Forward P/E - P/E ratio that is based
on future earnings
 Target Prices - Forecast prices based
on estimated P/E
STOCK FEATURES
• Common Stock - Equity without priority for
dividends or in bankruptcy
Shareholder Rights
 Cumulative Voting - a shareholder may cast
all votes for one member of the board of
directors ; Elections done all at once
 Straight Voting - A shareholder may cast all
votes for each member of the board of
directors ; Elections done one at a time
• Staggered Elections - Only a fraction of the
directorships are up for election at a particular
time.
• Classified Boards - Directors are placed into
different classes with terms that expire at
different times
Effects of Staggering
 Difficult for a minority shareholder to elect a
director when there is cumulative shareholder.
 Takeover attempts are less likely to be
successful
Proxy Voting
• Proxy - A grant of authority by a shareholder
allowing another individual to vote is or her
share.
• Proxy fight - If shareholders are not satisfied
with management, an “outside” group of
shareholders may try to obtain votes via
proxy.
CLASSES OF STOCK  Dealer - An agent who buys and sells
securities from inventory
• Some firms have more than one class of
 Broker - An agent who arranges security
common stock, often created with unequal
transactions among investors
voting rights
• Member - As of 2006, the owner of a trading
OTHER SHARE RIGHTS license in NYSE
• Designated market makers (DMMs) -
 Share proportionately in dividends paid Members who act as dealers in particular
 Share proportionately in assets remaining stocks. (formerly known as: specialists)
after liabilities have been paid in a liquidation • Floor brokers - Members who execute
 Vote on stockholder matters of great customer buy and sell orders.
importance. • Supplemental Liquidity providers (SLPs) -
Preemptive right - The right to share Investment firms that are active participants in
proportionately in any new stock sold. stocks assigned to them.
DIVIDENDS • Order flow - Flow of customer orders to buy
and sell securities
• Payments by a corporation to shareholders • DMM’s post - Fixed place on the exchange
 Unless a dividend is declared by the floor where the DMM operates.
board of directors of a corporation, it • Inside quotes - Highest bid quotes and the
is not a liability of the corporation. lowest ask quotes for a security.
 Payment of dividends by the • Electronic Communications Networks
corporation is not a business expense. (ECNs) - Websites that allow investors to
 Dividends received by individual trade directly with one another
shareholders are taxable
PREFERRED STOCK FEATURES
 Preferred Stock - Stock with dividend
priority with common stock, normally with a
fixed dividend rate, sometimes with no voting
rights
 Must receive a dividend before holders
of common shares are entitled to
anything.
 May be described as debt in disguise
(equity bond)
 Unpaid dividends are not debts of the
firm.
STOCK MARKETS
 Primary Markets - Market in which new
securities are originally sold to investors
 Secondary Markets - Market in which
securities are traded among inspectors.