MATHEMATICS OF FINANCE (OLD FIN 210; NEW FIN 233 )

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MATHEMATICS OF FINANCE

The issue of Time Value of Money (TVM) has to do with the simple fact
that money has different value at different times which has nothing to do
with inflation but investment. That means, if you invest certain amount of
money at a particular time, same money will increase in value if it
generates extra money, i.e. gain or interest rate. This idea can better be
expressed under the next Topic – “Compounding.“

If you deposit an amount in bank savings account, you will get a return on your
deposit. however, the amount you will get depends on the nature of interest rate
payable to you. It is either at compound rate or simple interest rate. The
compound interest rate pays higher than the simple interest rate.

Illustration 2.1
I want to save (i.e. invest) N 1000 for 3 years in my Savings Account. How much should
I expect at the end of the 3 r d year if interest rate on Savings Account is 10%?

Solution:

Apparently, the question is silent as to whether I should apply the simple

interest rate or compound interest rate. If I choose to explore both, I would have
two answers viz:

(i) Simple Interest Rate:

Sn = P +PRT …(2.1)

= N 1000 + N 1000 (3)

= N 100 + N 300
 = N 1,300

Where,

Sn = future sum expected in 3 years time

P = Principal Invested (or saved)

R = Annual interest rate on saving

T = Period of investment

(ii) Compound Interest rate

Cv = P (1 + r) n …(2.2)

where:

Cv =Compound value or future value (FV) = ?

P = Lumpsum (or principal) invested = N 1,000

R = Annual interest rate = 10 % or 0.1

N = Period of investment. = 3 years

n
Cv = P (1 + r)

Cv = N 1000 (1.10) 3

= N 1000 (1.3310)

= N 1,331

Thus, it is obvious that when Compound interest rate is applied rather than simple
rate for the computation of a future sum expected from a principal investment, the
compound rate will always produce higher future value.

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This represents the reverse of compounding in that expected future (or compound)
value receivable in “n” years will now be discounted down to its present value
(today).

In other words, discounting looks at the present value (PV) equivalent of the
sum of money to be received in the future.
The discounting formula is:

P = Cv

(I +r)n …(2.6)

NB: this is got from the original formula Cv(1+r) n , having made “p” the
subject of the formula.

Illustration 2.2
Aderibigbe have just received a promise of N 35,000 receivables in ten(10) years’
time from today. What is the present worth of that promise to Aderibigbe now that
you are a “financier” if the ruling interest (discount) rate is 8%

Solution
Where:

P = Pv (i.e. Present value of a principal to be same as the principal.

For e.g. Pv of N 100)

Pv = Cv
n
(1 +r)

Cv = 80%(.08)

n = 10 years

Pv = ?

Pv = N 35,000

(1.08) 1 0

= N 35,000

2.156 = N 16,211.80
So far we have assumed a lump sum (i.e. once payment/receipts ) in our various
estimations. For instance we recalculated future (or compound) value of money
saved/invested and the present value of a future (or compound) sum, while
employing the formula:
n
- Cv = P(1 + r)
-
P = Cv
n
(1+r)

Cases abound where payments or receipts are not done once but many times. To such
Payment/Receipts, we cannot apply the lump sum formulae but the annuity formulae
– where the set of expected figures are Regular , Constant and Periodic .

Annuity
Annuity indicates an array (or set)or Regular, Periodic and Constant sums of
money either payable or receivable. The P A Y A B L E element connotes investment,
which is expected to grow; while the R E C E I V A B L E sum of money is expected to
be “ S T A T I C ” (i.e. do not grow) and abounds in the future.

It is crucial to note that “Annuities” do not necessarily connote “Annual” sums

of money. Though it can easily be misconstrued to be that. An analogy can be
drawn to the instance that “the fact that Mr. A, belongs to the same family as
Mr. B, does not necessarily indicate that they are “familiar” – family and
familiar represents different things.
As such, annuities could be; weekly, monthly, bi-annually, annually, etc., so
long the sums involved are regular, periodic and constant – it is an annuity!

What is an Annuity?
We can use the illustration below to explain.

Illustration2.3

Assuming one expects N 1000 annually for the next 5 years. The total absolute sum of
N 5000 (i.e. N 1000 x 5 years) can be given in four (4) different ways or scenarios

Yr.1 Yr.2 Yr.2.5 Yr.3 Yr.4 Yr.5 Total

 N N N N N N N

Scene 1 1000 1000 - - 2000 1000 5000

Scene 2 1000 1000 - 750 1250 1000 5000

Scene 3 1000 1000 1000 - 1000 1000 5000

Scene 4 1000 1000 - 1000 1000 1000 5000

Clearly, scenario (4) only satisfies the three (3) basic conditions of regularity,
constancy and periodicity – hence it is the only annuity.
The relevance of the above analysis is borne out of the fact that only annuities
can use the “scientific” formula, i.e. the * CVA and *PVA respectively. Where a
stream of cash flow cannot satisfy the three (3) basic conditions as mentioned
above, we apply “manual” formula individually to each period cash flow

Illustration 2.4
Chief Akintade is both an investor and a pensioner. He plans to invest the
stream of cash flows in schedule A {i.e.(i) and (ii)}; and receive as pension
schedule B {i.e.(iii) and (iv) below. Solve for the 5 year- year cash flows in
both instances if his time preference rate is 8%.

Year1 Year2 Year3Year 4 Year 5

N N N N N
Schedule A (i) 10,00010,00010,00010,000 10,000
(Investments) (ii) 10,00010,00010,0009,000 10,000

schedule B (iii) 8,000 8,000 8,0008,000 8,000

Pensions (iv) 8,000 8,000 7,0008,000 8,000
Receivable

Hint
- The scientific formula (CVA) and PVA) may only be applied to schedule A
(i) and schedule B (iii) because they are annuities.
- Schedule A(ii) and Schedule B (iv) have their equal chain of cash flows
broken in the 4 t h and 3 r d year respectively by a different sum each.

Solution :

Schedule A(i):

CVA = K (1 + r) n – 1
r …(2.7)

where: K = Annuity
CVA = Compound value of annuity
K = N 10,000
r = 8% (.08)
n = 5
CVA = ?
CVA = N 10,000 (1.08) 5 - 1
0.08

= N 10,000(5.8666)

CVA = N 58,666
Schedule A:
(ii): We have apply the “manual” lump sum formula to each annual cash flow
{i.e. CV = P(1 + r) n }

Year 1 N 10,000 (1.08) 4 = 13,604.89

Year 2 N 10,000 (1.08) 3 = 12,597.12
Year 3 N 10,000 (1.08) 2 = 11,664.00
Year 4 N 9,000 (1.08) 3 = 9,720.00
Year 5 N 10,000 (1.08) 0 = 10,000.00
Total(CV) 557,586.01

Schedule B (iii)

PVA = K 1-(1+r) - n
r …(2.8)

where PVA = Present value of Annuity.

K = N 8000
r = 8%
n = 5
PVA = ?

PVA = N 800 1-(1 08) - 5

08
= N 8000 (3.99927)
PVA = N 1,941.60

[1] COMPOUND VALUE OF ANNUITY (CVA) :

Illustration 2.5
Mr. Olowa Olalekan is nursing a plan to deposit (or invest) N 15,000 at the end
of each year for the next five (5) years. How should Mr. Olowa expect to receive
at the end of fifth year. (Assume interest rate on saving is 6%)
Solution: Applying the scientific formula :

CVA = (1 + r) n – 1
r

K = N 15,000
r = 6%(.06)
n = 5
CVA = ?

CVA = N 15,000 (1.06) 5 - 1

.06

= N 15,000 (5.6371)
CVA = N 84,556.39

[2] Solving for K

Illustration 2.6
Miss. Oseni Fisayo has a master plan to accumulate the sum of N 100,000 over
the next eight (8) years. How much should Miss. Fisayo SINK annually in
order to realize her dream. (if interest rate is 12%)?

Solution:
From the CVA formula above, solve for K

CVA CVA = N 100,000

r = 12%(.12)
K = (1 +r) n -1 n = 8
r k = ?

N 100,000

(1.12) 8 -1
.12

= N 100,000 = N 8,130.28
(12.2997)

[3] P R E S E N T V A L U E OF A N N U I T Y (PVA)

Illustration 2.7
Chief Agaren Peter is a pensioner and he expects to receive N20,000 annual
pension for the next five years from his former employer. What is the present
worth of the five – year pension plan if his time preference rate is 8%?

Solution
Applying the “scientific” formulae

PVA = K 1 - (1 +r) - n
r

K = N 20,000
r = 8% (.08)
n = 5
PVA = ?
PVA = N 20,000 1-(1 08) - 5
.08

= N 20,000 (3.9927) = N 79,854

[4] Solving for K under PVA

Illustration 2.8
Chief Adebanwo (an old lay about) deposited his gratuity in M. Orioye
Bank Ltd.; at 12% interest rate. What is the fixed amount that he must
withdraw at the end of each year, if the whole deposit will be spent at the
end of the 5 t h year?

Solution:

PVA

K= 1-(1+r) - n
r …(2.9)

PVA = N 100,000
r = 12% (.12)
n = 5
k = ?

K = N 100,000

1-(1.12) - 5
12
 = N 100,000
(3.6048)

= N 27,740.97

[5] PRESENT VALUE OF A PERPETUAL ANNUITY

Illustration 2.8
(i) If Segun Oni expects an annual income of N 12,000 (interest Rate being
10%) Indefinitely, what should be the present worth of such annuity?
(ii) What is the Present Value of a bond that offers an
annual return of N 12,000 in perpetuity at 10% interest rate per annum.

Solution [to (i) and (ii) ]

K= annual income or annual return

PVA = K
r …(2.10)

= N 12,000
10
PVA = N 120,000

[6] OTHER MISCELLANEOUS CONCEPTS AND CALCULATIONS

Our aim here is to summarily touch those, equally important, aspect
of financial Mathematics, which were purposely omitted for the sake of
comprehension and better treatment. They are treated as follows:-
- The use of Investment /Payment Schedules.
- Deferred Annuities
- Annuity Due (or Annuity in Advance) i.e. CVA D u e
- Annuity Due (of Annuity in Advance) i.e. PVA D u e
- Solving for interest rate (r ) and number of years(n) in our treated
formulae.
- Etc.

The use of Investment/Payment Schedules

Where financial obligations are to be settled or provisions are to be made, they
could call for the use of Tables – particularly where more than two years are
involved.

We particularly highlight two of such types of schedules i.e.:

- Sinking Fund Schedules; and
- Amortization schedule.
Sinking Fund Schedule

Sinking funds are annuities invested to meet future/targeted sum. This targeted
sum is same as CVA (earlier treated in this chapter). The accumulated CVA is
normally utilized to provide for the purchase of a future key asset, to pay – off a
single matured (principal) debt etc.

Illustration 2.10
The Faculty of Business plans that about N1 million would be needed to provide
for a facility- wide computer net – work. You as a “financier” have been invited
to suggest how the plan would work. You have advised an annual savings for
four years at 10% interest rate to meet the target.
(a) How much should be saved per annum?
(b) Show the sinking fund table.
Solution:
(a) CVA = K (1+r) n - 1
r

CVA = N 1,000,000
r = 10% (.10)
n = 4 years
CVA
K =
(1+r) n -1
r

K = N 1,000,000

(1.10) 4 -1
.10

= N 1,000,000
(4.641) = N 215,470.80

Sinking Fund Schedule

A B C = D = A+B+C
(op. Bal or Interest on Annuity C/.Bal or
starting sum) Op.Bal (10%) Or “k” Accum. Sum
1 215,470.80 215,470.80
2 215,470.80 21547.08 215,470.80 452,488.68
 3 452,488.68 45248.868 215.470.80 713208.348
4 713208.348 71320.8348 215,370.80 N1,000,00

Amortization Schedule

Amortization is quite relevant to Pensioners, for example who might secure (or
gain) a terminal sum, a surrender value or any form of lump sum, due, usually to
earlier contributions to the scheme during their working days.

The sum so secured, usually, a relatively huge amount may be deposited in bank
and withdrawn at an equal installment over a given period of time.

On the other hand, one may have incurred a loan to be repaid or Amortized
equally over same period.

Both situation calls for the use of PVA formula while solving for “K”

Illustration 2.11
Faculty of business now owes a debt of N 5000,000 to be repaid in five annual
installments at 8% interest rate:
(a) How much should be repaid annually?
(b) Show also the amortization table for (a) above.

Solution:
Applying the “scientific” formula

PVA = K 1-(1+r) - n
r

PVA

K (1+r) n -1
r

Where PVA = N 500,000

r = 8%
n = 5 years
K = ?

K = N 500,000

1-(1.08) - 5
.08
 = N 500,000
(3.9927)

N 125,228.23

AMORTIZATION SCHEDULE
Period A B C= B + D D= E = A-D
Op. Bal. Int. rate “K’ = C –B princ. C/. Bal.

Of principal 8% on Annuity i.e. Element Of Princ.

Owing op. Bal. Princ. + Int. Of ‘K’ Not yet pd.

1 500,000 40,000 12,228.23 85,228.23 414,771.77

2 414,771.77 33,181.742 125,228.23 92046.49 322725.28

3 322725.28 25818.023 125,228.23 99410.21 223315.07

4 223315.07 17865.21 125,288.23 107363.02 115,952.05

5 115,952.05 9276.164 125,288.23 115958.07 (Approx.)Nil

Deferred Annuities

Annuities are not necessarily paid or received in the first year-to-year “n”. Payment
or receipt of annuities could commence after the first year. In that case there is
need to modify our (scientific) formula to reflect the new scenario.

Illustration 2.12
If Jide Ogundiran wants to receive a regular annual income of N 30,000 for
seven years. How much will he deposit today at 8% interest rate in order to
cater for such withdrawals. Assuming the first withdrawal starts in four year’s
time.

Solution:

PVA = N 30,000 1-(1.08) - 1 0 – N 30,000 1-(1.08) - 3

 .08 .08

= N 30,000(6.710) – N 30,000(2.5771)

= N 201303 – N 77313

.;; PVA ( 1 0 - 3 ) = PVA 7 = N 123,990

Annuity Due

CVA An Due = K 1-(1+r) n + 1 –(1+r)

PVA An Due = K (1+r)-(1+r) - ( n - 1 )

Illustration2.13

I want to invest N 10,000 annually for next 5 years at 6% interest. Because of an

immediate windfall N 10,000 received today, I wish to commence my investment now
and continue for the next 5 years. Find what this amount will accumulate to at the
end of 5 t h year.

Solution:

CVA An Due = K (1+r) n + 1 –(1+r)

Where K = N 10,000

n = 5
 r = 6%(.06)

.. CVA An Due = N 10,000 (1.06) 5 + 1 -- (1.06)

.06

= N 10,000(5.97532)

=N 59,753.19

Illustration2.14

I have just won a lottery, which entitles me an annual collection of N 5,000 for the
next 6 years starting from today. If annual interest rate is *%, what is the present
worth of the lottery won?

Solution:

PVA An Due = K (1+r)-(1+r) - ( n - 1 )

where: K = N5000

r = 8%(.08)

n = 6 years

PVA An Due = ?

PVA An Due = N 5000 (1.08) – (1.08) - 6 - 1

.08
 = N 500(4.9927)

= N 24963.55

*****Pls. mind some Answers here!!

(1) You have just won N 5,000 Hw much money will you have at the end of ten
years, if you invest at 6% compounded annually.
Answer: N 8,954.24

(2) Ten years from now; the unpaid Principal of the Mortgage on your house will
be N 8,995. How much do you have to invest today i.e. once at 6% interest
compounded annually to be able to repay the N 8,995 in 10 years
Answer: N 5022.76

(3) You plan to save N 500 each year for the next 10 years. How much will you
have, if interest on you savings is 6% compounded annually
Answer: N 6,590

(4) If as in (2) above the mortgage balance outstanding in 10 years will be N

8,995, how much do you have to invest each year for the next ten years
to just repay the mortgage if your savings earn 6% compounded
annually.
Answer: N 682.43

(5) If you receive N 20.00 and invest it at 6%, how much can you withdraw each
year to exactly exhaust the sum in 10 years.

Answer: N 2717,36.

(6) You estimate that for ten years after you retire, you require an income of N
2,760 per annum, what is the sum which you must invest i.e. (PVA) on
retirement at 6% to just meet this requirement.

Answer: N 20,314
(7) Exactly ten years from now, Iheanacho Dennis will start receiving a pension of
N 3,000 a year. The payment will continue for 16 years. How much is the
pension worth i.e. (PVA) now, if Iheanacho’s time preference rate is 10%

Answer: N 9,954

(8) At age 25, how much should one invest each year in order to have N 100,000
at age 40, assume 10% compound annual growth rate.

Answer: N 3,147.38

(9) At age, 25, what lump sum should be made to accumulate N 100,00 at age 40,
assuming a compound growth rate of 10% per annum.

Answer: N 23,940

(10) James Olufemi’s father has promised to give him N 100,000 in cash on your
25 t h birthday. Today is his 16 t h birthday. His father wants to know two
things:

(a) If he decides to make annual payments into a fund, how much will each has
to be, if the fund pays 8%?
Answer: N 8,007.

(b) If he decides to invest lump sum in the account now and let it compound
Annually; how much will the sum be?
Answer: N 50,025

(11) If an amount of N 80,000 is deposited in a fixed deposit for seven years at

10%
Compound ROI. How much can one withdraw each year to have exactly zero,
in the account at the end of 7 t h year?

Answer: N 16,432.44

(12) All Weather Bank pays 12% and compound interest quarterly. If
N 1000 are deposited initially. How much would this grow to at the end of five
years?
 Answer: N 1806.11

(13)a. Ogunkayode Akeem plans to place N 3,000 at the end of each of the next
years into an investment, paying 12% annual interest. He does not intend to
make any withdrawal during the period.

(i) How much will be available to Ogukayode at the end of the 4 t h Year?
Answer: N 14,337.98

(ii)If Ogunkayode were to place the funds into an investment at the beginning
of each year, how much would be available at the

end of the 4 t h year?

Answer: N 16,058.54.

(b) Using a 12% annual ROI. Calculate the value of N 8,000 to be received

two years from today if discounting takes place:

(i) Annually Answer: N 6,377.55

(ii) Quarterly Answer N 6,315.27

(iii) Monthly Answer N 6,300.53

© What effect does frequency of Discounting and Compounding have on

present value?

Answer - reduces PV

- increases CV

(14) How long would it take for an initial investment to double at 15% percent
compound annually?
Answer: 4.96 year

(15) Would you prefer to receive four annual payments of N 1000 or five annual
payments of N 850 if the interest rate is 13.5%.
(16) A loan of N 750,000 is to be paid back in four equal annual installments.

You are required to show how much each installment would be and the
amortization schedule to liquidate the loan at 17 percent compounded
Annual.

(17) Ifeoma is considering selecting between three investments in which to invest

her N 50,000 for three years.
(i) A fixed deposit with AF Merchant Bank which currently attract
interest at the rate of 25% per annum.

(ii) An investment with Park Funds Limited which currently attract

interest at the rate 25% compounded quarterly.

(iii) A savings accounting with Saket Commercial Bank, which currently

attract interest at the rate of 24/12% compounded monthly. Which of
the invests should Ifeoma select?

(18) Joseph’s uncle who died recently wants an estate worth N 20 million.
However, the will of Joseph’s uncle did not leave Joseph out. Joseph is to be
paid N 20,000 annually commencing at the end of this year for the next 10
years. Joseph has decided to immediately invest any amount received at
interest rate of 25% per annum. Calculate how much Joseph’s investment
would have accumulated at the end of ten years.

(19) Ajoke needs to invest N 10,000 now up till four ears time so that she can meet
a regular annual commitment from 5 years time up till 10 years time. Ajoke
can currently earn 24% on her investment. Calculate Ajoke annual
commitment.

(20) Find the Pv of a perpetual annuity of N 10,000 @ 5% interest rate.

1.

Compound Value – Using continuous compounding.

 CV =Pe r n …(2.10)

Where,

P = Principal deposited or invested

e = 2.7183

r = Annual rate or interest

n = No of years.

Illustration 2.16

If Chief Tommy invests N 5000 @ an annual interest of 6% in a bank, where

Compounding is done continuously through the year . Find both the compound
value and the EROI at the end of the year.

Solution

CV = Pe r n

= N 5000 (2.7183) . 0 6 x 1

= N 5000 (1.061837)

= N 5,309.18

EROI = e r
- 1

= 2.7183 . 0 6

= 1.061837 - 1

= .061837

= 6.18%
Solving for “n”

Illustration 2.17

How long will it take an initial investment to triple if r = 12%

Answer = N 1 (1.2) n = N 3

(1.12) n = N 3

N 1

(1.12) n = N 3

n log (1.2) = log 3

n = log 3/log (1.2)

n = 9.69 years (Approx.)

CHECK: = N 3(Approx.)

(1.12) 6 . 6 9

.: n =9.69 years

Illustration 2.18

Find “n” if Miss. Osobu Ifedolapo invests N 10,000 annually @ 12% annual interest
rate to derive N 50,000 at the end of “n” years.

i.e. CVA = K (1 +r) n –1

r
 N 50,000

N 10,000 = (1.12) n -1

.12

5 = (1.12) n -1

.12

12(5) = (1.12) n -1

0.6 = (1.12) n -1

0.6+1 = (1.12) n

1..6 = (1.12) n

Log 1.6 = n log (1.12)

.: Log 1.6

Log1.12 = n

0.2041

0.0492 = n

.:n = 4.15(Approx)

Finding the value of Interest rate (r):

Illustration 2.19

find the rate interest at which N 6,000 will grow to N 10,000 in 5 year’s time

Solution :-
Cv = P(1+r) n (i)

N 10,000 = N 6,000 (1+r) (ii)

N 6,000 = (1+r) 5 (iii)

1.6667 = (1+r) 5 (iv)

 1.667 = 1+r

1.107 –1 = r

.: r = .1076

= 10.76% (Approx.)

CHECK:

N 10,000 = N 000(1.107) 5

i.e. N 10,000 = N 600 (1.6666667)

Multi Period Compounding

Illustration 2.20

Find out the compound value of N 1,000 (interest rate being 12 percent per
annum) if Compounded annually, semi annually, quarterly and monthly for 2
years.
(i) Annual Compounding
Cv = N 1,000(1.12) 2

= N 1,000 x 1.254

= N 1,254

= N 1,254

(ii) Half – yearly compounding

2 x2
Cv N 1,000 1 +.12

= N 1,000 (1.06)4

= N 1,000 x 1.262

= N 1,262

(iii) Quarterly compounding

2 x4
Cv = N 1,000 1 +.12

4
 = N 1,000(1.03)8

= N 1,000 x 1.267

= N 1.1267
2 x12
(iv) Monthly compounding 1 +.12
12

Cv = N 1,000

= N 1,000(1.01)24

= N 1,000 x1.270= N 1,270

Some Practice Questions

Your brother has just celebrated his 30 t h birthday and plans to retire at the age of 65.
He wants to be able to withdraw N 10,000 from the savings account at the end of
each year for 10 years following his retirement (the first withdrawal will be made at
the end of his 65 t h year). The savings account pays 9.50 per cent interest
compounded annually. He wants to make equal annual deposit at the end of each
year. His question to you are:

(a) If he starts making the deposits at the end of this year and continues until he
is 65 years the last deposit will made at his 65 t h birthday), what is the amount
of the annual deposit?
(b) Suppose he has just inherited a large sum of money and has decided to make
one lump sum payment at the end of this year to cover his retirement needs.
What amount would he have to deposit?