L01B Topic 2

FIN702 – Corporate
Financial Management I
Topic 2: An Introduction
to Financial Mathematics
Copyright  2006 McGraw-Hill Australia Pty Ltd

PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder 3–1
Prepared by Dr Buly Cardak
Learning Objectives
• Understand and solve problems involving simple
interest and compound interest, including
accumulating, discounting and making
comparisons using the effective interest rate.
• Value, as at any date, contracts involving multiple

cash flows.
• Distinguish between different types of annuity

and calculate their present and future values.

Learning Objectives (cont.)
• Apply knowledge of annuities to solve a range of
problems, including problems involving principal-
and-interest loan contracts.
• Distinguish between ordinary and general

annuities and make basic calculations involving
general annuities.

Fundamental Concepts
• Cash flows — fundamental to finance, the
funds that flow between parties either now
or in the future as a consequence of a
financial contract.
• Rate of return — relates cash inflows to cash

outflows.
where:
C1  C0 C1 = cash inflow at time 1
r
C0 C0 = cash inflow at time 0
r = rate of return per period

Fundamental Concepts (cont.)
• Interest rate — special case of rate of return

(used when the financial agreement is in the
form of debt).
• Time value of money

– Money received now can be invested to earn additional
cash (interest).
– Relates to opportunity cost of giving up money or

resources for a period of time — either forgone
investments or consumption, whatever the next best
alternative is.

Time Value of Money
• An investment decision will involve an outlay of cash
made in one period with the expectation of cash inflows
in future periods.
• As a significant amount of time may elapse between the

outflow of cash and the subsequent inflows, the significance
of this time should be considered.
• To ignore differences in the timing of cash flows is to ignore

the importance of the time value of money.
• Cash flows that occur at different points in time cannot

simply be added together or subtracted — this is one of the
critical issues conveyed in this chapter.

Simple Interest
• Typically used when there is only a single
time period.
• Interest is calculated on the original sum

invested:
Interest  Principal  P   periods t   rate  r 
• Where S is the lump sum payable:
S  P  Ptr  P 1  rt 

Simple Interest: Present Value
• Present cash equivalent of an amount to be paid

or received at some future date, calculated using
simple interest.
• Formula:
where:
S P  present value
P S  payment at future date
1  rt  r  applicable interest rate
t  number of periods before payment

Compound Interest
• Compounding involves accumulating interest
on previous interest payments.
• This means that, unlike the case of simple

interest, previous interest payments will
generate further interest.
• This earning of interest on interest is one of

the key differences between simple interest
and compound interest.

Compound Interest (cont.)
• The backbone of many time-value calculations are the

present value (PV) and future value (FV) based on
compound interest.
• The sum or future value (S ) accumulated after

n periods is:
S  P 1  i 
n
where:
i = rate per period
n = number of periods

Compound Interest (cont.)
• The future value formula can be manipulated to

provide a formula to determine the present value.
• The present value of a future sum is:
S
P
1  i 
n
• It is important to understand that the PV and FV

formulas are the inverse of each other — one is
derived from the other.
Nominal and Effective Interest Rates
• Nominal rate
– Quoted interest rate where interest is charged or
calculated more frequently than the time period
specified in the interest rate.
• Effective rate
– Interest rate where interest is charged at the same
frequency as the interest rate quoted.
– Used to convert different nominal rates so that they

are comparable.

Nominal and Effective Interest
Rates (cont.)
• The distinction is important when interest is
compounded over a period different from that
expressed by the interest rate, e.g. more than
once a year.
• The effective interest rate can be calculated as:

m
 j
i  1    1
where:  m
j  nominal rate per period
m  number of compounding periods
which occur during a single nominal period
Example: Effective Annual Interest
Rate
Example 3.7:
Calculate the effective annual interest rates
corresponding to 12% p.a., compounding:
(a) semi-annually.
Solution: Using equation 3.6
m
 j
i  1    1
 m
2
 0.12 
  1  1.06   1  0.1236 (12.36%)
2
 1 
 2 
Rate (cont.)
Example 3.7 (cont.):
(b) quarterly.
m
 j
i  1    1
 m
4
 0.12 
  1  1.03  1  0.125509 (12.5509%)
4
 1 
 4 
Rate (cont.)
(c) monthly.
m
 j
i  1    1
 m
12
 0.12 
  1  1.01  1  0.126825 (12.6825%)
12
 1 
 12 
Rate (cont.)
(d) daily.
m
 j
i  1    1
 m
365
 0.12 
 1    1  0.127475 (12.7475%)
 365 
Real Interest Rates
• The ‘real interest rate’ is the interest rate after taking
out the effects of inflation.
• The ‘nominal interest rate’ is the interest rate before

taking out the effects of inflation.
• The real interest rate (i*) can be found as follows:
where:
 1 i  i*  real interest rate
i*    1 i  nominal interest rate
 1 p 
p  expected inflation rate
Annuities
• An annuity is a stream of equal cash flows,

equally spaced in time.
• We consider four types of annuities:

– Ordinary annuity
– Annuity due
– Deferred annuity
– Ordinary perpetuity

Ordinary Annuities
• Annuities in which the time period from the date of
valuation to the date of the first cash flow is equal to
the time period between each subsequent cash flow.
• Assume that the first cash flow occurs at the end of

the first time period:
0 1 2 3 4 5 6
$C $C $C $C $C $C

Valuing Ordinary Annuities
• Present value of an ordinary annuity:
C 1 
P  1    C  A  n, i 
1  i  
n
i 

where:
C  annuity cash flow
i  interest rate per compound period
n  number of annuity cash flows
• Using the present value of annuity tables, values of

A(n,i ) for different values of n and i can be found.

Example: Ordinary Annuities
Example 3.16:
• Find the present value of an ordinary annuity
of $5000 p.a. for 4 years if the interest rate
is 8% p.a. by:
• (a) Discounting each individual cash flow.
C C C C
P   
1  i 1  i  1  i  1  i 
2 3 4
$5000 $5000 $5000 $5000

   
1.08 1.08 1.08 1.084
2 3
 $16 560.63
Example: Ordinary Annuities (cont.)
is 8% p.a. by:
• (b) Using equation 3.19.
C 1  $5000  1 
P  1  n
 1  4
i  1  i   0.08  1.08 
 $5000  3.31212684
 $16 560.63
Example 3.16 (cont):
is 8% p.a. by:
• (c) Using Table 4, Appendix A and equation 3.20.
P  C  A  n, i 
 $5000  3.3121
 $16560.50

Annuity Due
• An annuity where the first cash flow is to
occur immediately:
0 1 2 3 4 5 6
$C $C $C $C $C $C $C
• An annuity due of n cash flows is simply an

ordinary annuity of (n – 1) cash flows, plus an
immediate cash flow of C.

Annuity Due (cont.)
• The present value of an annuity due:
C 1 
P  C  1  
i  1  i  
n 1
 
 C 1  A  n  1, i 

Deferred Annuity
• Annuity in which the first cash flow is to occur

after a time period that exceeds the time period
between each subsequent cash flow:
0 1 2 3 4 5 6 7 8
$C $C $C $C $C $C

Deferred Annuity (cont.)
• Present value of a deferred annuity:
C  A  n, i 
P
1  i 
k 1
where:
k  number of time periods until the first cash flow

Deferred Annuity (cont.)
• The present value of a deferred annuity involves
taking the present value of an ordinary annuity.
• This figure is a present value but, as the annuity

is deferred, we need to discount the PV further.
• If the first cash flow is k periods into the future,

we discount the PV by (k – 1) periods.

Ordinary Perpetuity
• An ordinary annuity where the cash flows are to
continue forever:
0 1 2 3 4 5 6
$C $C $C $C $C 
• The present value of an ordinary perpetuity:
where:
C
P C  cash flow per period
i
i  interest rate per period

Valuing Ordinary Annuities
• Future value of an ordinary annuity:
C
1  i   1  C  S  n, i 
n
S
i  
where:
• Using the future value of annuity tables, values of

S(n,i) for different values of n and i can be found.

Example: Ordinary Annuities
Example 3.20:
• Starting with his next monthly salary, Harold intends
to save $200 each month.
• If the interest rate is 8.4% p.a., payable monthly,
how much will Harold have saved after 2 years?
• Solution: Monthly interest rate is 0.4/12 = 0.7%.
Using equation 3.28, Harold’s savings will
amount to:
C
S  1  i   1
i
n
 
• Substituting the values we have:
S
$200
0.007
1.007   1
24
 
 $200  26.03492507
 $5206.99
• Thus, at the end of 2 years, Harold will have
saved $5206.99.

Principal-and-Interest Loans
• An important application of annuities is to loans
involving a sequence of equal cash flows, each
of which is sufficient to cover the interest accrued
since the previous payment and to reduce the
current balance owing.
• Such loans can be referred to as:

– Principal-and-interest loans
– Credit foncier loans
– Amortised loans

Principal-and-Interest Loans (cont.)
Example 3.22:
• Borrow $100 000.
• Make 5 years of annual repayments at a
fixed interest rate of 11.5% p.a.
• What is the annual repayment?
• Use the PV of annuity formula:
C 1 
P  1  
i  1  i  
n
 

Example 3.22 (cont):
• Substituting values:
C  1 
$100, 000  1  
0.115  1.115  
5
 
$100, 000
C 
3.64988
• Thus, annual repayments on this loan

are $27 398.18.

• Balance owing at a given date
– Equals the present value of the then-remaining
repayments
• Loan term required

– Solving for the required loan term n:
logC C  Pi 
n
log1  i 

• Changing the interest rate:
– In some loans (usually called variable interest rate loans),
the interest rate can be changed at any time by the lender.
• Two alternative adjustments can be made:

– The lender may set a new required payment which will
be calculated as if the new interest rate is fixed for the
remaining loan term.
– The lender may allow the borrower to continue making

the same repayment and, instead, alter the loan term
to reflect the new interest rate.

Summary
• Fundamental concepts in financial mathematics
include rates of return, simple and compound
interest.
• Valuation of cash flows:

– Present value of a future cash flow
– Future value of a current payment/deposit.
• Annuities are a special class of regularly spaced

fixed cash flows.


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FIN702 – Corporate

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Value, as at any date, contracts involving multiple

• Distinguish between different types of annuity

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Distinguish between ordinary and general

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Rate of return — relates cash inflows to cash

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Interest rate — special case of rate of return

• Time value of money

– Relates to opportunity cost of giving up money or

Copyright  2006 McGraw-Hill Australia Pty Ltd

• As a significant amount of time may elapse between the

• To ignore differences in the timing of cash flows is to ignore

• Cash flows that occur at different points in time cannot

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Interest is calculated on the original sum

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Present cash equivalent of an amount to be paid

Copyright  2006 McGraw-Hill Australia Pty Ltd

• This means that, unlike the case of simple

• This earning of interest on interest is one of

Copyright  2006 McGraw-Hill Australia Pty Ltd

• The backbone of many time-value calculations are the

• The sum or future value (S ) accumulated after

Copyright  2006 McGraw-Hill Australia Pty Ltd

• The future value formula can be manipulated to

• The present value of a future sum is:

• It is important to understand that the PV and FV

– Used to convert different nominal rates so that they

Copyright  2006 McGraw-Hill Australia Pty Ltd

• The effective interest rate can be calculated as:

• The ‘nominal interest rate’ is the interest rate before

• The real interest rate (i*) can be found as follows:

• An annuity is a stream of equal cash flows,

• We consider four types of annuities:

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Assume that the first cash flow occurs at the end of

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Using the present value of annuity tables, values of

Copyright  2006 McGraw-Hill Australia Pty Ltd

$5000 $5000 $5000 $5000

Copyright  2006 McGraw-Hill Australia Pty Ltd

• An annuity due of n cash flows is simply an

Copyright  2006 McGraw-Hill Australia Pty Ltd

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Annuity in which the first cash flow is to occur

Copyright  2006 McGraw-Hill Australia Pty Ltd

Copyright  2006 McGraw-Hill Australia Pty Ltd

• This figure is a present value but, as the annuity

• If the first cash flow is k periods into the future,

Copyright  2006 McGraw-Hill Australia Pty Ltd

• The present value of an ordinary perpetuity:

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Using the future value of annuity tables, values of

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Substituting the values we have:

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Such loans can be referred to as:

– Credit foncier loans

Copyright  2006 McGraw-Hill Australia Pty Ltd

• Use the PV of annuity formula:

Copyright  2006 McGraw-Hill Australia Pty Ltd