Chapter 8

Mathematics of Finance
Slides 1

• Interest; principal; interest rate

• Simple interest; compound interest
• Comparison
• Single Payment computations
• Compound amount formula; examples
• Present value
• Applications of compound amount formula
• Effective interest rates
 This Section
• Is about future or present values but because
of a series cash flow along the time

• Annuities and their future value

• Annuities and their present value
Annuities and their Future value

An annuity is a series of periodic payments.

• monthly car payment,
• regular deposits to savings accounts,
• insurance payments.
We assume that an annuity involves a series of equal
payments. All payments are made at the end of a
compounding period.

Ex: Payments R, each of which equals $ 1000 at the end of

each period
Example
A person plans to deposit $ 1000 in a tax-exempt
savings plan at the end of this year and an equal sum
at the end of each year following year. If interest is
expected to be earned 6 % per year compounded
annually, to
What sum will the investment grow at the time of the
4th deposit?
i=6% R=1000 n=4
Example (Contd.)

First deposit earns interest for 3 years,

4th deposit earns no interest.
The interest earned on first 3 deposits is $ 374.62

The procedure used in the above example is not practical when

dealing with large number of payments.
 Solution Via Formula

é n ù
Sn = Rê
(1+i) -1
ú
• Formula ê ú
i
ë û

• Sum of Annuity =>

• Sum of series of $ 1000 periodic payments at
é 4 ù
6% for 4 years ê (1+0.06) -1ú
Sn = 1000 =
ê 0.06 ú
ë û
Examples

Deposit $ 50 in a savings account for the next 6 years.

Interest is earned at the rate of 8% per year
compounded quarterly.
What should her account balance be after 6 years?
Examples

Deposit $ 50 in a savings account for the next 6 years.

Interest is earned at the rate of 8% per year
compounded quarterly.
What should her account balance be after 6 years?

R= 50 n=6x4=24 i=8%/4=2%=0.02

Future value or sum of annuity =

What is the sum of payments with interests
in the future

é n ù
Sn = Rê
(1+i) -1
ú
ê i ú
ë û
• NOW

• WHAT AMOUNT TO DEPOSIT TO ACHIEVE A GOAL?

– R=?
 Size of annuity
é ù
é n ù ê ú
Sn = Rê
(1+i) -1
ú R = Sn ê 1 ú
ê ú ê n ú
ë
i
û ê (1+i) -1
ú
ë i û
• Series of deposits to accumulate some future
some of money is called “sinking fund”
• Sinking fund factor
Question

A company wants to establish a sinking fund

Annual deposits will be made for the following 9 years.
Deposits earn interest at the rate of 8 % per year
compounded annually
How much money must be deposited each year in
order to have $ 12 million dollars at the time of the
10th deposit.?
Question

A company wants to establish a sinking fund

Annual deposits will be made for the following 9 years.
Deposits earn interest at the rate of 8 % per year
compounded annually
How much money must be deposited each year in
order to have $ 12 million dollars at the time of the
10th deposit.? é ù
ê ú
ê 1 ú
R = 120000
ê 10 ú
ê (1.08) -1
ú
ë 0.08 û
Question CHANGE

A company wants to establish a sinking fund

Annual deposits will be made for the following 9 years.
Deposits earn interest at the rate of 8 % per year
compounded QUATERLY
How much money must be deposited each year in
order to have $ 12 million dollars at the time of the
10th deposit.?
FOLLOW UP 8.3
Attempt Question 2
Attempt Question 4
Attempt Question 6
Attempt Question 10
Question 12
NOTE SOMETHING ODD!!!
PAYMENTS START IN 1 MONTH !!!
ANNUITY DUE
 3 Years R=1000 i=10%
• Future Value Using Timeline?
• Payment in the start of the month
• Payment at the end of the month
 Future value of annuity
• In ordinary Annuity
• Payments ‘R’ are made at the end of the
period.

• In Annuity Due
• Payments ‘R’ are made at the end of the
period.
FUTURE VALUE OF ANNUITY DUE

é n ù
Sn = Rê
(1+i) -1
ú(1+ i)
ê i ú
ë û
 QUESTION
• Calculate the future value of 12 monthly
deposits of $500 if each payment is made on
the first day of the month and the interest
rate per month is 1.1%. Also calculate the
total interest earned on the deposits if the
whole amount is withdrawn on the last day of
12th month.
 QUESTION
• Calculate the future value of 12 monthly
deposits of $500 if each payment is made on
the first day of the month and the interest
rate per month is 1.1%. Also calculate the
total interest earned on the deposits if the
whole amount is withdrawn on the last day of
12th month.
é ù
12

Sn = 500 ê
(1+0.011) -1
ú(1+ 0.011) = 6446.78
ê 0.011 ú
ë û
 So….
• Covered how a series of payments total to a
sum in the future
• You use compounding for each payment and
find the total value of annuites after n number
of years.

• NOW
 BACK TO THE “$100 now vs. $110 in a year”
Example

• Now instead of 110 after a year What if the

person says

• “I’ll give it you 10 rs every year for the next

10 years”
 Recap
• Simple Interest
– “Interest Amt = P + Pin”
• Compound Interest
– Compound Amt = P(1+i)n
• Compound Amt. is received in the future so it
can be considered future value
• Principle can be considered as present value
 Recap
• Single Payment
– FV=PV(1+i)n
– PV=1/(1+i)n
• Multiple Payments (Annuities)
é n ù
• FV of Annuity Due=
Sn = R ê(1+i) -1
ú(1+ i)
ê i ú
ë û
• FV of Annuity
Annuities and their Present value

There are applications which relate an annuity to its present

value equivalent.
• Lottery Payment
• Interested in knowing the size of a deposit which will
generate a series of payments (an annuity) for college,
retirement years, …
• As A BANKER
• Given that a loan has been made, we may be interested in
knowing the series of payments (annuity) necessary to
repay the loan with interest.
• “Amortization”
Annuities and their Present value

The present value of an annuity is an amount of money

today which is equivalent to a series of equal
payments in the future.

An assumption is that: the final withdrawal would

deplete the investment completely.
 Example
A person recently won a state lottery. The terms
of the lottery are that the winner will receive
annual payments of $ 20000 at the end of this
year and each of the following 3 years.

If the winner could invest money today at the rate

of 8 % per year compounded annually, what is
the present value of the four payments?
Annuities and their Present value

If A defines the present value of the annuity, we might

determine the value of A by computing the present
value of each 20000 payment.

PV = FV/(1+i)n <- Single Payment

MULTIPLE PAYMENTS?
Formula

As with the future value of an annuity, we can find the

general formula for the present value of an annuity.
In case of large number of payments the method of
example is not practical, so if

é n ù
PVn = Rê
(1+i) -1
ú
ê i n
ú
ë (1+i) û
Example 17

2) Parents of a teenager girl want to deposit a sum of

money which will earn interest at the rate of 9 % per
year compounded semi-annually. The deposit will be
used to generate a series of 8 semi annual payments
of 2500 beginning 6 months after the deposit. These
payments will be used to help finance their
daughter’s college education. What amount must be
deposited to achieve their goal? How much interest
will be earned?
Determining the size of an annuity
“AMORTIZATION”
Given A, to find R = size of the corresponding annuity.

QUESTION:
given a loan of $ 10000 which is received today, what
quarterly payments must be made to repay the loan in 5 years
if interest is charged at the rate of 10 % per year, compounded
quarterly?

The process of repaying a loan by instalments is called as

amortizing a loan.
 You are a Banker
• A friend comes to you and asks you to lease a
Honda city worth 1.75 million to you. You tell
him that the interest rate that the bank will
charge is 12% per annum compounded
monthly. He pays you 0.75 million as down
payment. Now he wants to know how much he
must pay the bank each month if he wants to
return the money in 1 year.
• Calculate how much extra money he must pay
• You buy a Motor Bike for Rs.130000 at annual
installments, Rs 30000 has been paid as a
down payment and rest is paid in 12 equal
installments. The rate of interest is 18% per
year . Calculate the monthly installment.
 Cost Benefit Analysis

Evaluation of Project Feasibility

 Cash

• CASH OUTFLOW
– Cash going out of your pocket (Investment)
• CASH INFLOW
– Cash you are receiving (return from the project)

• NET PRESENT VALUE = PV OF CASH INFLOW +

PV OF CASH OUTFLOW
 Discounted Cash Flow Method
• Project requires some investment (Outflow)

• Project promises some return in the form of

cash (inflow)

• A desire a rate of return.

• What is the Net Present Value??

 Project to Build A Disco
• Investment
• Original Investment 100,000

• Return
• Rs. 20000 from renting it out every month for 5
months

• You desire 10% per month interest (Desired Rate of

Return) (Minimum required return) (Profit)
• What is the present value of all the cash flows
that will be receive from the disco.
• What is the present value of cash I invested

• What is the NET PRESENT VALUE?

 Step 1: Make a time line and show cash
inflow and outflow

20,000 20,000 20,000 20,000 20,000

Rs100000
 Step 2: Calculate Present Value of Cash
inflow and outflow

20,000 20,000 20,000 20,000 20,000

Rs100000
 Step 2: Calculate Present Value of Cash
inflow and outflow

20,000 20,000 20,000 20,000 20,000

Rs100000

PV=S/(1+.1)1
2000/(1+.1)2
2000/(1+.1)3
2000/(1+.1)4
2000/(1+.1)5
Cash inflow PV
75815.7
 Step 2: Calculate Present Value of Cash
inflow and outflow

20,000 20,000 20,000 20,000 20,000

Cash out flow PV

Rs - 100000

PV=S/(1+.1)1
2000/(1+.1)2
2000/(1+.1)3
2000/(1+.1)4
2000/(1+.1)5
Cash inflow PV
75815.7
 Step 2: Calculate Present Value of Cash
inflow and outflow

20,000 20,000 20,000 20,000 20,000

Cash out flow PV

Rs - 100000

PV=S/(1+.1)1
2000/(1+.1)2
2000/(1+.1)3
2000/(1+.1)4
2000/(1+.1)5
Cash inflow PV
NET PRESENT VALUE = -100000 + 758615.6=-24184.26
75815.7
 Step 2: Calculate Present Value of Cash
inflow and outflow

20,000 20,000 20,000 20,000 20,000

Cash out flow PV

Rs - 100000
IF NET PRESENT VALUE IS
PV=S/(1+.1)1 NEGATIVE THEN THE PROJECT
2000/(1+.1)2 SHOULD NOT! BE UNDERTAKEN
2000/(1+.1)3
2000/(1+.1)4
2000/(1+.1)5
Cash inflow PV
NET PRESENT VALUE = -100000 + 758615.6=-24184.26
75815.7
 Step 2: Calculate Present Value of Cash
inflow and outflow

20,000 20,000 20,000 20,000 20,000

Cash out flow PV

Rs - 100000
NEGATIVE NPV MEANS the
PV=S/(1+.1)1 project is NOT giving you your
2000/(1+.1)2 desired 10% return
2000/(1+.1)3
2000/(1+.1)4
2000/(1+.1)5
Cash inflow PV
NET PRESENT VALUE = -100000 + 758615.6=-24184.26
75815.7
 Step 2: Calculate Present Value of Cash
inflow and outflow

20,000 20,000 20,000 20,000 20,000

Cash out flow PV

Rs - 100000
NOTE: CAN BE SOLVED USING
PV=S/(1+.1)1 PV of Annuity Formula because
2000/(1+.1)2 “SAME” payments per month
2000/(1+.1)3
2000/(1+.1)4
2000/(1+.1)5
Cash inflow PV
NET PRESENT VALUE = -100000 + 758615.6=-24184.26
75815.7
 Net Present Value
• IF NEGATIVE REJECT PROJECT
• IF POSITIVE ACCEPT PROJECT
• IF ZERO THE INTEREST RATE IS CALLED THE
INTERNAL RATE OF RETURN.
Irregular Payments