Chapter 4 – Financial mathematics

Presentation by: James Williams

 Cash flows, interest and the time
value of money

 Cash flows are funds flowing into or out of a

business; that is, cash receipts or expenses.
 The reasons we deal with cash are that we want to
be able to compare values at different points in time,
we want to be able to reduce multiple flows to single
values and we want to be able to make rational
decisions.
 Interest is the price charged for the temporary use
of money.
 Interest performs an allocative role in economies.
 Cash flows, interest and the time
value of money

 Interest rates are set by the interaction of supply and

demand.
 Put more explicitly, the level of interest rates stems
from individuals’ time preference for consumption
and production opportunities facing entrepreneurs
and investors.
 The time value of money is the concept that a
dollar is worth more the sooner it is received.
 This is because the dollar represents purchasing
power which may be rented out to others and earn a
return, if the owner does not need it immediately for
consumption.
 Cash flows, interest and the time
value of money

 Thus, the principle with the time value of money is

that money received now is worth more than the
same amount received in the future because of the
return that could be earned on the money between
now and the future date.
 Simple interest

 Simple interest is interest calculated on the original or

principal sum borrowed.
 The equation for the calculation of simple interest is given
by equation 4.1:

 Simple interest is applied to many sorts of bank deposits,

such as savings accounts and term deposits, as well as
many types of loans. Debenture and commercial loans on
an interest-only basis also operate on a simple interest
basis.
 Simple interest
Future and present values of a single sum
 The future value of a single sum calculated using simple interest
is given in equation 4.2:

 The present value of a single sum calculated using simple

interest is given in equation 4.3:
 An application of simple interest:
pricing commercial bills

 Some of the most important rules for solving

commercial bill pricing problems are:
• Interest rates are quoted on a simple annual basis and
pro-rated for the actual period of the loan
• Pro-rating takes place on the basis of the exact
number of days divided by 365
• In a leap year, 29 February is charged for if the loan is
outstanding over this day, but the year is still assumed
to have 365 days.
 With these rules to hand, some commercial bill
problems may be illustrated.
An application of simple interest:
pricing commercial bills
 An application of simple interest:
pricing commercial bills

 The inputs for this problem are as follows:

P = $97600; FS = $100000 and; n = 180/365.
 An application of simple interest:
pricing commercial bills

 The yield is the amount produced or the return based

on the initial investment; yields are normally
expressed as percentages.
 Yield can be thought of as the effective cost to the
borrower.
 A discount rate (in relation to pricing a security) is
the percentage difference between the face value
and the purchase price of the security.
 While a yield relates to P or the actual amount
borrowed, a discount relates to the face value of the
future value or future sum, FS, of the bill.
 An application of simple interest:
pricing commercial bills

 In Australia, we normally trade money market

securities in terms of yield. However, in some other
economies (e.g. USA), short-term securities are
traded on a discount basis.
 The formula for calculating the selling price (or
present value) of a money market security using a
discount basis is given in equation 4.4:
 Compound interest

 Compound interest is the interest calculated on the

actual amount outstanding each period.
 Compound interest is based on the idea that, while
interest charged on an outstanding principal amount
or debt remains unpaid, interest should be charged
on that new part of the debt as well as the original
principal.
 Compound interest

Using time lines

 A time line is a diagrammatic representation of cash

flows either received or paid or both.
 A time line may look like this, where PV equals
present value (value at time zero) and FV is the
future value at the end of the denominated time
periods:
 Compound interest

Future and present value of single sum

 For the compound interest equations, we refer to PV

rather than P because the discounting and
compounding processes have more applications than
simply calculating loans.
 The formula for calculating FV of a single sum using
compound interest is given below:
 Compound interest
Future and present value of single sum

 The inputs for this problem are as follows:

PV = $20000; k = 7% and; n = 5.
 Compound interest
Future and present value of single sum

 The inputs for this problem are as follows:

PV = $20000; k = 0.07/12 and; n = 5*12.
 Compound interest

Future and present value of single sum

 The FV equation may be manipulated so that it will

give the PV of a future sum.
 The present value of a single sum calculated using
compound interest is given in equation 4.6:
 Compound interest
Future and present value of single sum

 The inputs for this problem are as follows:

PV = $60000; k = 0.06/12 and; n = 3*12.
 Compound interest

Nominal and effective interest rates

 The nominal rate is the advertised or quoted rate

that does not reflect the impact of multiple
compounding periods during the year.
 The effective rate reflects the impact of multiple
compounding during the year.
 The equation for the effective annual rate is:
 Compound interest
Nominal and effective interest rates

 The inputs for this problem are as follows: j = 12%

and; m = 12.
Future and present value of several
equal sums

 An annuity is a series of equal cash flows that are

evenly spaced over time.
 There are 4 types of annuities:
i. Ordinary annuity – where the payments flow at the
end of each even-length period
ii. Annuity due – where the first payment is received
on the day of valuation
iii. Deferred annuity - where the first payment is
deferred for a period greater than the subsequent
even-length periods
iv. Perpetuity – where the cash flows continue forever.
Future and present value of several
equal sums

Ordinary annuities

 Equations 4.8 and 4.9 are used to calculate the PV

and the FV of ordinary annuities respectively:
Future and present value of several
equal sums

Ordinary annuities

 The inputs for this problem are as follows:

C = $10000; k = 6% and; n = 5.
Future and present value of several
equal sums
Ordinary annuities Example 4.11

 The inputs for this problem are as follows:

C = $20000; k = 8% and; n = 18.
Future and present value of several
equal sums

Ordinary annuities

 Just as with the FV and PV of a single sum, tables

are available to provide the compounding and
discount factors for the calculation of FVs and PVs
of ordinary annuities.
Future and present value of several
equal sums

Other types of annuities

Annuity due
 An annuity due is only an ordinary annuity with an
extra payment added on the front end of the series
of cash flows.
 The equation for calculating the FV of an annuity
due is:
Future and present value of several
equal sums
Other types of annuities Annuity due

The inputs for this problem are as follows:

C = $60000; k = 5% and; n = 21.
Future and present value of several
equal sums
Other types of annuities
Annuity due

 The equation for calculating the PV of an annuity

due is:
Future and present value of several
equal sums

 The inputs for this problem are as follows:

C = $60000; k = 5% and; n = 21.
Future and present value of several
equal sums

Other types of annuities

Deferred annuity
 A deferred annuity has its first payment made after
several periods have elapsed.
 The equation for calculating the PV of an annuity
due is:
Future and present value of several
equal sums- Example 4.14

 The inputs for this problem are as follows:

C = $60000; k = 5%; n = 21 and; b = 2.
Future and present value of several
equal sums

Other types of annuities

Perpetuity
 A perpetuity is a series of regular equal payments
that continue forever.
 The equation for calculating PV of a perpetuity is:
Future and present value of several
equal sums
Perpetuity

 The inputs for this problem are as follows:

C = $0.2 and; k = 5%.
Present and future value of unequal
sums

 A stream of unequal amounts is not an annuity and

cannot be manipulated by the use of annuity
equations.
 Thus, any problem with different amounts must be
solved using the single-sum equations for either
the FV or PV, as required.
 Solving cash flow problems

 A few steps to follow when solving cash flow

problems are:
• draw a time line and insert the cash flows
• identify what component of the required information
is unknown
• decide the class of problem and apply the
appropriate equation
• write down the equation(s), manipulate them so that
the unknown value is on the left-hand side, insert the
values as given and solve.