Topic Two

Financial Mathematics/Time Value of Money

Part 2
 Annuity Due

0 1 2 3
• The cash flows occur at the beginning of
each period, rather than at the end of each
period.
• This is an annuity due.
 Present Value – Annuity
• Annuity Due

0 1 2 3
• Ordinary Annuity

0 1 2 3
Which annuity has the larger PV?
 Present Value of An Annuity Due Example

An investor wants to buy a 3 period annuity that pays

$100 per year for the next three years, each
instalment being paid at the beginning of the year.
If a bank is prepared to pay interest at 12% p.a., how
much must be invested today?
 Present Value of An Annuity Due Example
 Finding PV the long way – treating each cash-flow
as a single sum

0 1 2 3

$100 $100 $100

$89.29

$79.92

$269.01
 Present Value of An Annuity Due Example

 1  (1  r )  n 
PV  PMT   PMT  
  r  
 1  (1.12)  2  
PV0  100  100 
  0.12  
PV0  100  1001.6901
PV0  100  169.01
PV0  $269.01

More generally, any n period annuity due can be treated

as a n-1 period ordinary annuity plus a payment/receipt at

t=0.
 Present Value of An Annuity Due Example
 You take out a $5000 loan with ten equal payments at the beginning of
each 6 months. The interest rate is 10% p.a. compounded half yearly.
How much are your repayments (i.e. what is the unknow PMT for this
annuity due)?
 Remember, we can treat this annuity as a single amount at T0 plus a nine
period ordinary annuity.
1  1  r  n 
PV  PMT  PMT  
 r 
1  1.059 
5000  PMT  PMT  
 0.05 
5000  PMT  PMT(7.108)
5000  1PMT  7.108PMT
5000  8.108PMT
PMT  5000/8.108
PMT  $616.67
 Future Value - Annuity
• Annuity Due

0 1 2 3
• Ordinary Annuity

0 1 2 3
Which annuity has the larger FV?
 Future Value of An Annuity Due Example
An investor pays 3 instalments of $100 each at the beginning of
each year into a savings account yielding 12% per year interest
compounded annually. What is the future value of the
investment at the end of three years?
 Want the FV at t=3
 The FV of an annuity formula gives the FV at the time the last
payment is made, which in this case is at the beginning of the
thrid (last) period. Since the question is asking for the FV at T 3
(i.e. at the end of Period 3, which is the end of the investment
period), the FV at the beginning of the third period must be
compounded forward to the end of the third period (i.e.
compounded forward one period as a single sum).
Future Value of An Annuity Due Example

 1  r n  1
FV  PMT   (1  r )
 r 
 1.12 3  1 
FV  100   (1.12)
 0.12 
FV  100[3.3744](1.12)
FV  337.44(1.12)
FV  $377.93
 Deferred Annuities
•A deferred annuity is a series of constant cash flows that occur at
the end of each period for some fixed number of periods
commencing some future period after period one.

0______1_______2 _____ 3 _____ 4___ _ 5__

$$ $$ $$
 Since under an ordinary annuity the first payment/receipt takes
palce at t=1 and in this case it takes place at t=3 we can say that the
annuity is deferred 2 periods.
Example
Let’s assume an investor wishes to invest a sum of money today which will
yield three equal instalments of $100, the first to be received three years
from today. If interest accrues at 12% p.a., what amount must be invested
today (i.e. what is the PV of this investment)?
Present Value of A Deferred Annuity Example
 Present value of an annuity deferred for three periods
at 12% p.a. ( the long way i.e treating each PMT as a
single sum)
0 1 2 3 4 5

$100 $100 $100

$71.18

$63.55

$56.74

$191.47
Present Value of A Deferred Annuity Example
Alternative approach (preferred)
Find the PV of the deferred annuity in 2 steps
Step 1. Find PV one period before the start of the annuity.
The ordinary annuity formula always assumes you are “standing” one period before the
start of the ordinary annuity.

0______1_______2 _____ 3 _____ 4___ _ 5__

$100 $100 $100

$240.19
Step 2. Find PV0 of this lump sum equivalent to $240.19 from period 2.

Step 1. Step 2.
PV2  100  0.12 
-3
1 - (1.12)
PV0  FV 1  r -n
 
PV0  240.19(1.12)  2
PV2  100[2.4019] PV0  240.19(0.7972)
PV2  $240.19 PV0  $191.47
Present Value of A Deferred Annuity Example
You receive an allowance of $500 per month. The first payment starts 6 months from today
and the last payment is exactly 2 years from today. Interest rates are 6% p.a. compounded
monthly. Find the PV of your allowance?
Find the PV of the deferred annuity in 2 steps
Step 1. Find PV one period before the start of the annuity.
The ordinary annuity formula always assumes you are standing one period before the start
of the ordinary annuity.
 0______1_______2 _____ 3 _____ 4_____ 5_____6_____7 ……....24
$500 $500 $500

$9041. 18
Step 2. Find PV0 of this lump sum equivalent of $9041.18 from period 5.
Step 1. Step 2.
PV  FV 1  r -n
PV5  500  0.005 
-19
1 - (1.005)
  PV0  9041.18(1.005) 5
PV0  9041.18(0.9753)
PV5  500[18.0823]
PV0  $8,818.50
PV5  $9,041.15
 Perpetuities
• A perpetuity is a series of constant cash-flows occuring at the
end of each period that goes on forever.
• The future value of a perpetuity cannot be calculated as the
cash flows are infinite.
• The present value of a perpetuity is calculated as follows:
PMT
PV 
r
Example
What is the PV of a $500 perpetuity discounted back to the
present at 8%?
PV = PMT / r = $500 / 0.08 = $6,250
 Present value of A Perpetuity Example
An investor wants to buy 1,000 non-redeemable 9% preference shares of $1 par
value each. If the return which he requires is 12% p.a. what is the present value of
the investment (i.e. what is the amount that has to be paid now (at T 0) for this
investment)?
A preference share pays a fixed amount to the holder each period, which in this
case is the 9% by the par value price of each share of $1. Therefore, if one buys a
1,000 of these shares one receives $90 every period (i.e. the dividend per share is
fixed at 9% of the par/face/issue value of $1. Therefore, the dividend per share
= 9 cents. Thus, the total dividend recieved = $0.09 x 1,000 shares = $90.00)
PV = PMT/r
PV0 = $90/ 0.12
PV0 = $750
Question: Ask yourself, what has happened to the price of these shares?
 Growing Perpetuity
A growing perpetuity is a series of constant cash-flows occuring at the end of each
period that goes on forever and grows by a fixed percentage each period.
The PV of a growing perpetuity formula is as follows:

PV0 = PMT0 (1+g)

(r – g)
 PMT0 is the most recently paid annuity payment and g is the constant growth rate in PMT

Example
If a company has just made an annuity payment of $10,000 and this is expected to
grow at a rate of 3% per year and the required rate of return is 8% p.a., then the
present value (current price) of this perpetual payment stream is?

PV0 = $10,000 (1+0.03) = $10,300 = $206,000.00

(0.08 – 0.03) 0.05
Therefore, the current price of this investment is $206,000.00
 Growing Perpetuities Example
If a company has just paid a dividend of $12 per share and this
dividend is expected to grow at the rate of 4% per year and the
required rate of return is 9% p.a., then the price of this share
(present value of this perpetual payment stream) is?
 PMT0 in this question can be written as the dividend payment
D0 (the most recently paid dividend).
PV = D0 (1+g)
(r – g)
PV = $12 (1.04) = $12.48 = $249.60
(0.09 – 0.04) 0.05

Therefore, the current price of this share is $249.60

 Comparing Interest Rates
 Need to be able to differentiate between the nominal interest rate, NIR,
the interest rate per compounding period, r, and the effective annual
interest rate, EFF.
• The nominal interest rate (NIR) is the quoted or stated interest rate
(usually per annum) ignoring how frequently interest is compounded.
• m = the number of compounding periods per year
• r = interest rate per compounding period  NIR 
r
 m 

 For example, if the nominal interest rate (NIR) is 12% p.a. and it is
compounded every quarter (m=4), then the interest rate per
compounding period (r) is 3% i.e 0.12/4
 The effective annual interest rate (EFF) is the equivalent interest rate
when interest is compounded once per year.
 When To Calculate
The Effective Interest Rate
 Note – you will only need to calculate effective interest
rates in regard to Topic 6 Weighted Average Cost of
Capital (WACC).
 EFF rate will need to be calculated when working out
the weighted average cost of financing used by a firm.
 EFF rate is only calculated for debt finance items e.g.
bank overdraft, mortgage, debentures/bonds, term
loans.
 EFF rate will need to be calculated when you’re
given an annual interest rate on a debt item but are
told interest is calculated/compounded more than
once per year.
 Calculation of The Effective Rate of Interest (EFF)
One dollar invested at EFF for one year must grow to the same amount as
one dollar invested at the NIR for one year compounded m times per year.

Effective rate of interest:

m
 NIR 
EFF  1   -1
 m 
Where NIR = nominal/stated/quoted interest rate
m = number of compounding periods per year

 When interest is compounded more frequently than annually, m>1 and the
EFF will be greater than the NIR.
 What Interest Rate Is Being Charged?

i. 8.25% compounded daily

vs
ii. 8.5% compounded annually

i. Effective annual rate (EFF) = [1 + 0.0825/365]365 – 1

= [1.000226]365 – 1
= 1.086 – 1 = 0.086 = 8.6% p.a.

ii. Effective annual rate (EFF) = [1 + 0.085/1]1 - 1

= [1.085]1 – 1
= 1.085 – 1 = 0.085 = 8.5% p.a.

 Therefore 8.5% compounded annually is cheaper than 8.25% compounded

daily.
 What interest rate is being charged?

• Consider the following interest rates quoted by three

banks:

i. Bank A: 15% compounded daily (m = 365)

ii. Bank B: 15.5% compounded quarterly (m = 4)

iii. Bank C: 16% compounded annually (m = 1)

What Interest Rate Is Being Charged?
365
 0.15 
i. EFFBank A  1   - 1  16.18%
 365 
4
 0.155 
ii. EFFBank B  1   - 1  16.42%
 4 
1
 0.16 
iii. EFFBank C  1   - 1  16%
 1 
What Rate Is Charged On Credit Cards?

Nominal Rate
Effective Rate
i. Westpac visa 17.9% p.a. 19.60% p.a.
 
ii. ANZ Gold Visa 18.5% p.a. 20.32% p.a.
 
iii. NAB Mastercard 16.65% p.a. 18.11% p.a.

 interest on these credit cards is calculated/compounded daily, i.e. m = 365

 
 Types of Loans
• A pure discount loan is a loan where the borrower
receives money today and repays a single lump sum
in the future.

• An interest only loan requires the borrower to pay

interest each period and to repay the entire principal
at some point in the future.

• An amortised loan requires the borrower to repay

both the principal and interest over time.
 Amortised Loan
In an amortised loan the amount borrowed
is the present value of all the repayments.

If one knows the:

•amount being borrowed (PV0)
•number of repayments (n)
•interest rate per compounding/repayment period (r)
one can then calculate the regular periodic payment (PMT)
using the PV of an ordinary annuity formula:

1  1  r  n 
PV  PMT  
 r 
 Example

You borrow $7 500 to buy a car and agree to repay the loan
by way of equal monthly repayments over 5 years. The
current interest rate is 12% per annum, compounded
monthly. What is the amount of each monthly repayment?
 r = 0.12/12 = 0.01, n = 5 years x 12 months per year = 60.
1 - (1.01) - 60 
$7 500  PMT  
 0.01 
$7 500  PMT [44.955]
PMT  $7500/44.955
PMT  $166.83
 Amortisation Loan
 In an amortised loan the outstanding principal just after a
payment has been made is equal to the present value of all the
payments yet to be made.
Example
A car loan of $10,000 is to be repaid by equal instalments of principal
and interest over five years at 10% p.a. compounding annually.
Find:
i. The annual instalment i.e the PMT.
ii. The interest and principal portion of the first two payments.
iii. If you win the lottery and repay the loan after the 3rd payment how
much will you need to repay? (Need to find the PV of the last two
PMTs).
 Solution
i. PV = $10,000, r = 0.10, n= 5
1  (1  r )  n 
PV0  PMT  

 r 

1  (1.10)  5 
10,000  PMT  

 0.10 

10,000  PMT 3.7908
10,000
PMT 
3.7908
 This PMT $
PMT is fixed 2the
for ,637 .97
life of the loan unless the interest rate or term to maturity change.
 Solution
ii.
Year 1
Interest = $1,000 (10,000 x 0.10)
Principal = $1,637.97 ($2,637.97 - 1000)

Year 2
Interest = $836.20
($10,000 - 1637.97 = $8,362.03
then 8,362.03 x 0.10 = $836.20)
Principal = $1, 801.77 ($2,637.97 - 836.20)
 Amortisation of A Loan
Year Beginning Total Interest Principal Ending
Balance Payment Paid Paid Balance
1 $10000.00 $2637.97 $1000.00 $1637.97 $8362.03

2 $8362.03 $2637.97 $836.20 $1801.77 $6560.26

3 $6560.26 $2637.97 $656.03 $1981.94 $4578.32

4 $4578.32 $2637.97 $457.83 $2180.14 $2398.18

5 $2398.18 $2637.97 $239.82 $2398.15 $0.03*

Totals $13189.85 $3189.85 $10000.00

* Due to rounding
 Solution
iii.
The balance outstanding on any loan at a given point in
time is the PV of all payments yet to be made.
If you have just made the 3rd payment then there are still
2 payments to be made.
 Therefore, we need to find the PV of the last two
PMTs.
PV3  2,637.97   1 - (1.1) -2 
 0.1 
PV 3  2,637.97[1.7355]
PV 3  $4,578.30
 Example
A housing loan of $350,000 is to be repaid by equal
instalments of principal and interest over 25 years at
7.8% p.a. compounding monthly.
Find:
i. The monthly instalment (PMT)
ii. The interest and principal portion of the 17th
payment
 Solution
i.
 PV0 = $350,000, r = 0.0065 (i.e. 0.078/12), n = 300 (i.e. 25 years x 12 months per year)

1  (1  r )  n 
PV0  PMT  

 r 

1  (1.0065) 300 
350,000  PMT  

 0.0065 

350,000  PMT 131.82
350,000
PMT 
131.82
PMT  $2,655.15
 Solution
ii.
The interest component of any payment is the interest owing on the amount
outstanding at the start of the repayment period. In this case interest depends on
the balance outstanding at end of period 16.
 After the 16th payment (PMT) n = 300 – 16 = 284 i.e. there are still 284
payments remaining, so we must find the PV of the last 284 PMTs.
0______1_________2 ________ 3…..…………16________17 …….…...300
$2655.15 $2655.15 $2655.15 $2655.15 $2655.15……….
 The amount outstanding on a loan is the PV of all payments yet to be made.

PV16  2655.15  1 - (1.0065) -284 

 0.0065 
PV 16  2655.15[129.4133]
PV 16  $343,612.00

Interest in 17th payment = 0.0065 x $343,612 = $2,233.48

Principal reduction of the 17th payment = $2,655.15 - $2,233.48 = $421.67
 Amortised Loan Example
 Borrowed amount = $200,000, monthly repayment (PMT) = ?, NIR
= 6.6% p.a compounded monthly, r = 0.066/12 = 0.0055 n = 25
years x 12 months per year = 300.

1  (1  r )  n 
PV0  PMT  

 n 

1  (1.0055) 300 
  200,000  PMT  

 0.0055 

200,000  PMT 146.74
200,000
PMT 
146.74
PMT
 $1,363.00 is  $1,363
the minimum .00 per month.
repayment
 Paying Extra
• What happens to the time taken to pay off the loan if you pay an extra
$100 per month over and above the required $1,363. Using a financial
calculator you would find the time taken to pay off the loan would fall
from 25 years to 21 yrs and 2 months.
• If you repay an extra $200 per month using a financial calculator you
would find the time taken to pay off the loan falls to 18.5yrs.
• How much interest has been saved by paying the extra $200 per month?
i. Total interest over 25 years: $1,363 x 300 months = $408,853, less
$200,000 originally borrowed = $208,853
i. Total interest over 18 yrs 6 months = $1,563 x 222 months = $346,696,
less $200,000 originally borrowed = $146,696
 Therefore, saving in interest = $62,157.
 The interest saving of $62,157 occurs over a period of 6.5 yrs.
 Interest Rates Rise
• If interest rates rise from 6.6% p.a to 8% p.a.

• What are the monthly repayments if term remains the

same (i.e. 25 years (or 300 PMTs))?
 Repayment must rise to $1,544 per month

• What happens to term of the loan if repayments do not

change from initial $1,363 per month.
 Term increases from 25 years to 48 years.
 Why It Is Better To Repay A Loan
Fortnightly Rather Than Monthly
 Loan of $200,000, NIR = 6.6% p.a., monthly repayments = $1,363
 n = 300 (monthly payments for 25 years), PMT = $1,363.00.
 What if fortnightly repayments of $681.50 are made? 
 Can solve for the number of fortnightly repayments (n) which is 539
 This means that the loan can be paid off in 20 yrs 9 months, rather than
25 years.

 (We are assuming fortnightly repayments are 50% of monthly payments.

By paying fortnightly we are actually paying 26x$681.50= $17,719 a
year, which is slightly greater than the amount if paying monthly (12x
$1,363 = $16,356). Therefore, strictly speaking, we will save due to both
the increased frequency of payments and the increased amount paid
annually).
 Why It Is Better To Repay A Loan
Fortnightly Rather Than Monthly
How much interest is saved by paying fortnightly instead of monthly?
Total interest = (payments x number of payments) – principal
For the monthly repayments this is ($1,363 * 300) - $200,000 = $208,900
For the fortnightly repayments this is ($681.50 * 539) - $200,000 =
$167,329
 By paying fortnightly we save $41,571 in interest.
 Why It Is Better To Repay A Loan
Fortnightly Rather Than Monthly
• How is the time and interest saved by paying fortnightly instead of
monthly?

• 01/01 15/01 31/01

1. $681.50 2. $681.50
 1. $1,363.00
 When a (half) payment is made half way through the month this means the
balance of the loan outstanding at the end of the month is slightly less than
what it otherwise would have been, meaning slightly more of the second
payment per month goes towards paying off the principal of the loan and
slightly less goes towards paying off interest (than would be the case with just
one payment at the end of the month). There is only a small difference each
month but over 20 or 30 years it makes a big difference.