LESSON TWO: MATHEMATICS OF FINANCE

3.0 INTRODUCTION

Mathematics of finance consist of mathematical formulae that bring into focus the
time value of money.

TIME VALUE OF MONEY is an important concept in financial decision making

on issues to do with cash flows which occur in future and different times but
decisions have to be made now. Financial managers must find a way of converting
the future cash flows to present worth using appropriate discounting tools.

- Financial decisions recognize that money has value over time. This means
that an amount of money now has greater value than the same amount at
some time in the future.
- This idea is based on the fact that, I you have ‘Ksh. X’ now you can make it
to work for you so that you can obtain ‘Ksh.X plus’ in the future.
- Given this situation lenders of money would also want to be compensated
financially for parting with the present consumption. The amount they
receive is known as the interest.
- Interest is a vital factor used in quantifying the time value of money. It
makes possible the conversion of the values of cash flows having different
timings to a desired point in time for the purpose of financial decision
making.
- Thus present values with the aid of interest rate can be converted to future
value and vice versa.

3.1 COMPOUND INTEREST

- Compound interest is charged and added to the principle from period to period i.e
both principle and interest form the basis of the next period interest calculation.
Thus, interest is being earned on interest.

3.1.1 Future Value of Lump Sum

It is one area in which compound interest principle is applied. It is where a single

lump sum is deposited in an account at a specified rate of interest per period. This
deposit is allowed to grow undisturbed while interest is assumed to be re-invested.

Illustration 1

Assume an amount of ksh. 1,000 is put in a fixed deposit account for 3 years at the
rate of 12% per annum. If the amount is left untouched, what will be the worth of
the investment at the end of the third year?

Suggested Solution
n
FVn=P (1+ r )

3
FV 3=1,000 ( 1+ 0.12 )

¿ 1404.93

Exercise; If the original investment were allowed to grow for ten years, what is
its worth at the end of ten years?

3.1.2 Frequency of Compounding

There are investments where interest is compounded more than once during the
year. The above formula is varied thus;

( )
mn
r
FVn=P 1+
m
Illustration Two

If interest on the above investment of ksh. 1,000 is to be compounded monthly,

what will be the value at the end of one year

Suggested Solution

At the end of one year the value will be;

( )
12∗1
0.12
FVn=1,000 1+
12

12
FVn=1,000 ( 1.01 )

FVn=1,126.83

3.1.3 Continuous Compounding

This is a situation where compounding periods are indefinitely short such that m is
the number of times a year interest is compounded approaches infinity.

Thus the formula is stated as;

mn
FVn=P ( e )

Illustration 3

What is the value at the end of three years of ksh. 1,000 deposited at 12% p.a with
interest compounded continuously?

Suggested Solution
mn
FVn=P ( e )

0.12∗3
FV 3=1,000 ( 2.71828 )

FV 3=Ksh .1433.33
3.1.4 Future Value with Regular Annual Investment

Here, there is initial deposit with additional of fixed amount at the end of each
period. The future value will be arrived at by use of the following formula;

FVn = (Po+p/r)(1+r)n-p/r

Where p is the regular addition which is assumed to be made at the end of

each period

Illustration 4

An investor made an initial deposit of ksh. 50,000 at the beginning of 2007. While
this amount remains invested, he plans to be adding ksh. 5,000 on January 1 each
year starting from January 1, 2008. Assuming interest is compounded each year at
the rate of 12% per annum, what will be the value of his investment on January 1,
2011?

Suggested solution

Substituting the value of po, p, r and n in the formula below, we have;

FVn = (Po+ p/r) (1+r)n- p/r

FV4 = (50.000+ 5,000/0.12)(1+0.12)4- 5,000/0.12

FV4 = (50,000+41,667)(1+0.12)4- 5,000/0.12

FV4 = (91,667)(1.5735) - 41,667

FV4 = 144,238- 41,667

=102,571

NB/ this formula can be used to calculate the amount that is added yearly to the
initial deposit.
3.1.5 Regular Annual Withdrawals

If p is allowed to be negative the same formula can be used to calculate the amount
that will be left from an initial investment given withdrawal of regular fixed
amount at the end of each period.

Illustration 5

A pensioner deposits ksh. 100,000 representing his gratuity in a bank account and
withdraws ksh. 15,000 at the end of each year beginning from the end of first year.
What will be the balance of his bank account after five years if the deposit is
inested at 12% per annum?

Suggested Solution

Po= ksh. 100,000 r = 0.12 n = 5 and p = ksh.15,000

FVn = (Po - p/r)(1+r)n + p/r

FV5 = (100,000-15,000/0.12)(1+0.12)5 + 15,000/0.12

= (100, 000 – 125,000)(1.12)5 + 125,000

= (-25,000)(1.7623) + 125,000

= -44,058 + 125,000 = 80,942

3.1.6 Purchase of an Annuity Contract (Reverse Insurance Policy)

The above formula can also be used by an annuitant to know the amount of regular
income receivable from an insurance company in consideration of payment of
capital sum
Illustration 6

You won ksh. 7M from betting. Being unemployed you wish to have a regular
income over the next ten years. You have been approached by a life insurance
company that sells annuity contracts and will pay you a fixed amount annually for
ten years. Your opportunity cost of funds is 12%. How much annual income will
you be receiving?

Suggested Solution

Po= 7M r = 0.12 n = 10yrs. Given the formula below,

FVn = (Po - p/r)(1+r)n + p/r

We have

0 = (7M - p/0.12)(1+0.12)10 + p/0.12

0= (7M – 8.33p)(1.12)10 + 8.33p

0= 21.7406M – 25.8713p + 8.33p

21.7406M = 17.5413p

p = 21.7406M/17.5413

p= 1.24M

This formula can be used to calculate how much initial investment is required (p o)
to produce a given expected regular and fixed annual income.

3.1.7 ANNUITY

This is a series of equal amounts of money to be paid or received each year for a
specified future period of time.
If payments or receipts is made at the end of each year it is known as ordinary
annuity. If the payment or receipt is made at the beginning of each year it is called
annuity due.

Illustration 7

Future value of an Annuity (ordinay)

Assuming you make up a savings program asking for deposit of ksh. 10,000 at the
end of each year for the next three years in an account paying 12% p.a
compounded annually. How much will you have at the end of the third year?

Suggested Solution

(1 + r)n - 1
FVAn = A *

= 10,000 [(1.12)3-1]

0.12

= 33,744

Illustration 8

Future Value of Annuity Due

Assuming the above annual cash flows occur at the beginning of each year. How
much will you have in the account at the end of the third year?

Suggested Solution

FVADn=A [ (1+r)n-1](1+r)

A=10,000, r=0.12, n=3yrs

= 33744(1.12) = ksh. 37, 793

Application of future value of an ordinary annuity formula to business

decision making;

Sinking Fund

At times it may be necessary to set up a sinking fund to provide either for

replacement of a plant at a future time or for the repayment of a loan where, for
example, interest is paid periodically but the principal will not be due until the
maturity date.

Since the amount set aside each year will be invested outside the business to earn
interest , the total of the amount so set aside can be less than the amount required
for the asset replacement or for the loan repayment.

This formula can be used to solve that problem of how much is required to be
invested each year in order to give a specified total sum in a given number of
years.

Exercise; A firm plans to set aside (out of its profit and loss account) ksh. 500,000
at the end of each year and to invest the equivalent amount outside the business.
This is to enable it replace one of its production machines in five years time. If the
investment is to earn 12% p.a. how much will be available at the end of the fifth
year for such replacement?

Illustration 9

Present value of an Ordinary Annuity

You want to open a savings account that will give you a guaranteed sum of Ksh.
10,000 p.a for the next three years. If the bank pays its customer 12% p.a on
savings account, how much do you have to put into the account immediately so
that you would have nothing in the account at the end of the third year?

PVAn= A [1-(1+r)-n]

PVA3= 10,000 [1-(1+0.12)-3]

0.12

PVAn= 10,000 [1-(1.12)-3]

0.12

= 24,017

Illustration 10
Present Value of an annuity due

PVADn= A + A [1-(1+r)-(n-1)]

Exercise; use the formula to solve the problem in illustration nine

Application to Business Problems

Loan Amortization

Illustration 11

Assume Equity Bank lends you 1M for a period of five years at 15% interest p.a to
be compounded annually. Repayment to be at the end of each year. To fully
recover for the lender both principal and interest set up a loan amortization table.

Suggested Solution

First step determine the amount of each instalment using the formula present value
of an ordinary annuity

PVAn= A [1-(1+r)-n]

1000000= A [1-(1+0.15)-5]

0.15

1000000 = A[0.5025/0.15]

A=298,329

Step two is the construction of the table

 Year Beginning Annual Install Annual Principle Ending
Loan Bal. Interest Repayment loan Bal.
1 1,000,000 298,329 150,000 148,329 851,671
2 851,671 298,329 127,751 170,578 681,093
3 681,093 298,329 102,164 196,165 484,928
4 484,928 298,329 72,739 225,590 259,338
5 259,338 293,329 38,901 259,428 (90)
Total 1,491,645 491,555 1000, 090

NB/ 1. The annual interest for each year is based on the amount of principal
outstanding at the beginning of each year

2. Interest charged is reducing over time while principal is increasing over time.
This is to reflect the fact that interest is based on the reducing balance of the
principal.

3.1.8 Perpetual Annuity

This is the ordinary annuity whose series of cash flows continues so long that an
end is not in sight

PVA∞ = A/r

Therefore, the present value of a perpetual (eternal) annuity is simply the annual
cash flow divided by the interest rate per annum

Illustration 12
If a man is promised the sum of Ksh. 10,000 per annum indefinitely at an interest
rate of 12 percent per annum, what will be the present value of this perpetual
annuity?

Suggested Solution

PVA∞ = A/r

=10,000/0.12 = 83.33

3.1.9 Stream of Uneven Cash Flows

These are cash flows that do not occur either strictly as lump sums or strictly as
annuities. Their pattern is irregular. The problems posed by their timings will be
treated later under the techniques of investment appraisal.

3.1.10 Unknown Variables

a) Rate

At times the rate of interest (discount) may be the only unknown variable in a
typical investment problem and this rate needs to be found

Illustration 13
An investment of Ksh. 20,000(now) is expected to yield Ksh. 80,000 in 5 years
time. What is the imprinted compound interest rate?

FVS5=Po(1+r)n

We have;

20, 000 (1+r)5=80,000

(1+r)5=80,000/20,000

1+r = 40.20

r = 1.3195-1

r= 31.95%

b) Number of Years

It may be necessary to know how long it may take an investment to grow given the
initial amount, its future value and the compound rate of interest

Illustration 14

How long will it take a deposit of ksh. 10,000 to grow to ksh. 50,000, given an
annual interest rate of 8% compounded annually?

Suggested Solution

10,000(1+0.08)n = 50,000

(1+0.08)n= 5

nlog(1.08) = log 5

n=log5/log1.08

n=20.91years
n=21years

NB/ searching for imputed interest rate in annual cash flows (regular and irregular)
situation involve trial and error process patterns with exact rate being computed
through linear interpolation. This will be dealt with later under (IRR)