UTM – Hanoï IUT de Toulon

Financial Mathematics
Course
François Lacroux

1
FINANCIAL MATHEMATICS
F. LACROUX, UNIVERSITY OF TOULON

Course 0 - Introduction

PRESENTATION

 Topic
 Your core business…

 Goal
 Understanding : Thinking is more important than calculating…
 Applying : more exercises, less course…

2
SUMMARY

 Program
Interest, capitalization, discounting : single flow

Interest, capitalization, discounting : multiple flows

Loans

Return on Investments

TOOLS

 Financial calculator
 Dedicated device
 Smartphone App

3
 Course #1:
Interest & discounting
(single flow)

4
FINANCIAL MATHEMATICS
F. LACROUX, UNIVERSITY OF TOULON

Course 1 – Interest and capitalization

Single flow

PRESENTATION

 Time is money…
All equivalent

Yesterday Tomorrow
Today

5
PRESENTATION

The future amount is greater than the present amount Interest

Today
Tomorrow

The present amount is lower than the future amount Discounting

INTEREST

 If you make a deposit on a « special » account, the bank will pay

something to you ; this payment is the INTEREST

 You « rent » your money to the bank, so you get a rent for that !

 The interest is given by a percentage of the deposit

6
 CALCULATION OF THE FUTURE VALUE

Deposit value

Day, Month,
Duration
Future Value Quarter,Year

SIMPLE
Spend it
INTEREST
How to use it
Interest
?
COMPOUND
Keep it
INTEREST

NOTATIONS

 The amount  The interest rate : r

 The deposit (= capital) : C  Use of calculators :
 The period : ([time])  When you pay : negative number
 The time  When you get some money : positive
number
 N : number of periods
 Graphics :
 0 : Present value
4000
 Examples : C(0), C(12), C(6/12), C(0.25)

-1000 -1000 -1000 -1000 6

7
 SIMPLE INTEREST

DEFINITION

 « Simple interest » means that you prefer to use the money given by the
interest, rather than saving it

 It is used for short periods

8
BASIC FORMULA

 The interest is purely proportional to the interest rate

 Capital : C(0)
 Interest : 𝑛. 𝑟
 n : number of periods
 r : interest rate of the period
 Total value : 𝐶 𝑛 𝐶 0 𝐶 0 𝑛 𝑟
9

HOW MUCH WILL I GET IN THE FUTURE ?

 Goal  To find C(n)

𝐶 𝑛 𝐶 0 1 𝑛. 𝑟
 Examples :
 After 1 year with an annual rate of 10%, 1000$ of deposit will make :
𝐶 1 𝐶 0 1 𝑛 𝑟 → 𝐶 1 1000 1 1 10% 1,100$
 After 30 months with a monthly rate of 1%, 1000$ of deposit will make
𝐶 30 𝐶 0 1 30 𝑟 → 𝐶 30 1000 1 30 1% 1,300$
10

9
 HOW LONG DOES IT TAKE TO GET A CERTAIN AMOUNT FROM A
GIVEN DEPOSIT AND A GIVEN RATE ?

 Goal  To find n

𝐶 𝑛 𝐶 0 1 𝑛. 𝑟 ↔ 𝑛 1 /𝑟

 Example :
 I make a deposit of 1000$. With an interest rate of 10%/year, how long will it take
for me to get 2000$ ?

𝑛 1 /𝑟 → 𝑛 10 𝑦𝑒𝑎𝑟𝑠 11

WHAT MUST BE THE RATE TO GET A CERTAIN AMOUNT FROM A

GIVEN DEPOSIT AND A GIVEN PERIOD ?
 Goal  To find r

𝐶 𝑛 𝐶 0 1 𝑛. 𝑟 ↔ 𝑟 1 /𝑛

 Example :
 I make a deposit of 1000$. What must be the annual interest rate if I want to get
2000$ in 12 years ?

𝑟 1 /𝑛 → 𝑟 0.0833 8.33%
12

10
HOW MUCH MUST BE MY DEPOSIT IF I WANT TO GET A CERTAIN
AMOUNT TOMORROW ?

 Process of discounting
 Goal  To find C(0)
𝐶 𝑛 𝐶 0 1 𝑛. 𝑟 → 𝐶 0 𝐶 𝑛 / 1 𝑛. 𝑟
 Example :
 How much must be my deposit if I want to have 5000$ in 2 years with a 12%
interest rate :
,
𝐶 0 → 𝐶 0 4,032.26 $
%
13

HOW TO INCLUDE THE INFLATION RATE ?

 The inflation rate (notation : i) results in the depreciation of the money

 The interest rate will be affected by the inflation, just like any other good

 The « net » interest rate is a difference between the gross interest rate and
the inflation rate :
𝑟 𝑖
𝑟 ~𝑟 𝑖
1 𝑖
14

11
HOW TO CALCULATE AN INTEREST RATE FOR A PART OF THE
DURATION SCALE ?
 Sometimes, it is necessary to calculate an interest rate for a smaller period than the usual scale :
 Months instead of years
 Days instead of months

 You must therefore calculate an equivalent interest rate : 𝑟

where p is the number of sub-periods in the period
 Examples
%
 Annual rate = 10% ; Monthly rate : 𝑟 0.833%
%
 Annual rate = 10% ; Daily rate : 𝑟 0.028%
15

APPLICATION

 Application #1

16

12
 COMPOUND INTEREST

17

DEFINITION

 « Compound interest » means that you prefer to save the money given
by the interest, rather than using it  you keep the money in the bank

 It is the “standard” behavior

 used for any kind of period
 … but especially valuable for long periods and/or big amounts

18

13
 BASIC FORMULA

 The interest is more than proportional to the interest rate

 Capital : C(0)
 Interest : 1 𝑟
 n : number of periods
 r : interest rate of the period
 Total value : 𝐶 𝑛 𝐶 0 1 𝑟
19

HOW MUCH WILL I GET IN THE FUTURE ?

 Goal  To find C(n)

𝐶 𝑛 𝐶 0 1 𝑟
 Examples :
 After 1 year with an annual rate of 10%, 1000$ of deposit will make :
𝐶 1 𝐶 0 1 𝑟 →𝐶 1 1 10% 1,100$ ( Equivalent to the
simple interest)
 After 30 months with a monthly rate of 1%, 1000$ of deposit will make
𝐶 30 𝐶 0 1 1% → 𝐶 30 1000 1.01 1,347.85$ 20

14
HOW LONG DOES IT TAKE TO GET A CERTAIN AMOUNT FROM A
GIVEN DEPOSIT AND A GIVEN RATE ?

 Goal  To find n
ln 𝐶 𝑛 ln 𝐶 0
𝐶 𝑛 𝐶 0 1 𝑟 ↔𝑛
ln 1 𝑟
 Example :
 I make a deposit of 1000$. With an interest rate of 10%/year, how long will it take
for me to get 2000$ ?
 7.27  7 years
ln 2000 ln 1000  0.27*12 = 3.24  3 months
𝑛 7.27  0.24*30 = 7.2  7 days
ln 1 10% 21

WHAT MUST BE THE RATE TO GET A CERTAIN AMOUNT FROM A

GIVEN DEPOSIT AND A GIVEN PERIOD ?

 Goal  To find r
𝐶 𝑛 𝐶 𝑛 /
𝐶 𝑛 𝐶 0 1 𝑟 ↔𝑟 1 1
𝐶 0 𝐶 0

 Example :
 I make a deposit of 1000$. What must be the annual interest if I want to get
2000$ in 12 years ?

𝑟 /
1 →𝑟 /
1 5.94% 22

15
HOW MUCH MUST BE MY DEPOSIT IF I WANT TO GET A CERTAIN
AMOUNT TOMORROW ?

 Process of discounting
 Goal  To find C(0)
𝐶 𝑛 𝐶 0 1 𝑟 →𝐶 0 𝐶 𝑛 / 1 𝑟
 Example :
 How much do I have to deposit if I want to have 5000$ in 2 years with a 12%
interest rate :

𝐶 0 𝐶 𝑛 / 1 𝑟 → 𝐶 0 3,985.97$
%
23

HOW TO INCLUDE THE INFLATION RATE ?

 No difference with the simple interest

 The net interest rate is a difference between the gross interest rate and
the inflation rate :
𝑟 𝑖
𝑟 ~𝑟 𝑖
1 𝑖
24

16
 HOW TO CALCULATE AN INTEREST RATE FOR A PART OF THE
PERIOD ?

 Two different ways :

 The equivalent interest rate :

𝑟 1 𝑟 / 1
 The proportional interest rate :

𝑟 𝑟/𝑝  Same formula then the simple interest

 Examples
%
 Annual rate = 10% ; Monthly rate ; proportional : 𝑟 0.833%
25

 Annual rate = 10% ; Monthly rate ; equivalent : 𝑟 1 𝑟 / 1 1 10% 1 0.797%

COMPARISON BETWEEN SIMPLE AND COMPOUND INTEREST

 In the short term, the two rates are merely similar  that is why in such
cases, calculating a simple interest rate may be sufficient

 But if
 The duration is longer
 The amount is bigger
… The difference grows
26

17
 APPLICATION

 Application #2

27

18
 Course #2:
Interest & discounting
(multiple flows)

19
FINANCIAL MATHEMATICS
F. LACROUX, UNIVERSITY OF TOULON

Course 2 –
Interest and capitalization
Multiple flows

A NEW SITUATION

Year 0 1 2 3 4 5

 From one unique financial flow... C(0)

 To many regular financial flows… A1 A2 A3 A4 A5

C(0)

20
MANY DIFFERENT APPLICATIONS

 Loans
 Pension annuity
 Financial investments
 Investment selection
 Etc.

HOW TO CALCULATE THE VALUE

AT A GIVEN DATE ?

 Time is money…

 So 2 financial flows coming from 2 different periods are not equal

 If you want to compare them, you must make them equal by neutralizing the cost of
time

21
THE BASIC PRINCIPLE :
MAKING ALL THE FLOWS COMPARABLE

Year 0 1 2
FLOW
ONE

Présent value C(0) (no flow) (no flow)

Présent value C(0) A1 A2

FLOWS

+
MANY

A(1)/(1+r)
+
A(2)/(1+r)²

THE CLASSIC CASE : THE « ORDINARY » ANNUITY

First
annuity in Ex : 1st annuity one year after the deposit
périod 1

Annuity
Ex : always one year between Same = Same Ex : always 1 year
interval period
the annuities PMT

Same
Ex : 1000$ per year flow
A1 = A2 = A3 = A4 = …
6

22
 WHAT IS THE PRESENT VALUE OF A
FUTURE SEQUENCE OF FLOWS ?

1 1 𝑟
𝐶 0 𝐴
With : 𝑟
A : constant annuity
r : interest rate
n : number of periods ( = last flow)

0 1 2 3 4 5
Year
A1 A2 A3
Current
Value

WHAT IS THE PRESENT VALUE OF A

FUTURE SEQUENCE OF FLOWS ?

What must be my deposit today if I want to get a 5000$ income

every year during 5 years with an interest rate of 8% ?

.
𝐶 0 𝐴 =5000 =19,963.55$
.

23
 WHAT IS THE FUTURE VALUE OF A
FUTURE SEQUENCE OF FLOWS ?

1 𝑟 1
𝐶 𝑛 𝐴
With : 𝑟
A : constant annuity = PMT
r : interest rate
n : number of periods ( = last flow)

0 1 2 3 4 5
Year
A1 A2 A3

Future
Value
9

WHAT IS THE FUTURE VALUE OF A

FUTURE SEQUENCE OF FLOWS ?

What will be my future available balance if I make a yearly deposit of 10,000$

during 5 years with an interest rate of 7% ?

.
𝐶 𝑛 𝐴 =10,000 =57,507.39$
.

10

24
WHAT IS THE ANNUITY (PMT) ?

You know the 1 𝑟 1

𝐴 𝐶 𝑛 /
future value 𝑟
A?
You know the 1 1 𝑟
present value 𝐴 𝐶 0 /
𝑟

11

WHAT IS THE ANNUITY (PMT) ?

How much will I get every year during 5 years if I make an initial deposit of 10,000$
with an annual interest rate of 5.5% ?
𝐶 0 10000
𝐴 2,341.76$
1 1 𝑟 1 1 0.055
𝑟 0.055
How much do I have to deposit every year during 4 years
if I want to have 20,000$ at the end with an annual interest rate of 6% ?
𝐶 𝑛 20000
𝐴 4,571.83 $
1 𝑟 1 1 0.06 1
𝑟 0.06
12

25
WHAT IS THE PERIOD ?

𝐶 𝑛 𝑟
ln 1
You know the 𝑛 𝐴
future value ln 1 𝑟

n?
𝐶 0 𝑟
You know the ln 1
𝑛 𝐴
present value ln 1 𝑟
13

WHAT IS THE PERIOD ?

How long does it take to get 20,000$ if you deposit 2,000$ /year with an
interest rate of 7%?

, .
𝑛 7,84
.

 7.84  7 years
 0.84*12 = 10.08  10 months
 0.08*30 = 2.4  2 days
14

26
 WHAT IS THE PERIOD ?

How long does it take to spend 15,000$ if you withdraw 2,000$ /year
with an interest rate of 6%?

𝐶 0 𝑟 15,000 0.06
ln 1 ln 1
𝐴 2,000
𝑛 10,26
ln 1 𝑟 ln 1 0.06

 10.26  10 years
 0.26*12 = 3.12  3 months
 0.12*30 = 3.6  3 days 15

WHAT IS THE INTEREST/DISCOUNT RATE ?

You know the 𝐶 0 1 1 𝑟

present value
𝐴 𝑟 It is
A? impossible
to
You know the 𝐶 𝑛 1 𝑟 1 calculate r
future value
𝐴 𝑟
 To find an approximate value of r, you must either
 Use a financial calculator
 Or use linear interpolation, i. e., trying to find r by a “test & try” process 16

27
 WHAT IS THE INTEREST/DISCOUNT RATE ?

 Example : what is the interest/discount rate to find if I want to get a total amount of
20,000$ after 10 years with an annual deposit of 1,700 $ ?

2% 10,949721too low
4% 12,0061071too high
3% 11,4638793too low
𝐶 𝑛 1 𝑟 1 20,000 3,50% 11,7313932too low
11,76
𝐴 𝑟 1,700 3,60% 11,785754too high
3,55% 11,7585375too low
Exact value : 3,56134373864%
17

HOW TO PROCEED WHEN THE PERIODS ARE SMALLER THAN THE

PERIOD OF THE INTEREST/DISCOUNT RATE ?

 Example : in a life insurance contract, you will have a monthly deposit, while the
interest rate is annual

 In that case, you must convert

 The annuity  you must calculate the “annuity” for the “real” period
 The rate  you must calculate a rate for the “real” period
 The period  you must count the number of “real” periods

18

28
HOW TO PROCEED WHEN THE PERIODS ARE SMALLER THAN THE
PERIOD OF THE INTEREST/DISCOUNT RATE ?

 Example : what must be my initial deposit if I want a monthly income of 500$ for 10
years, with a rate of 8% ?
 In that case, you must convert
 A  you must calculate the “annuity” for the “real” period  monthly income  500$
 r  you must calculate a rate for the “real” period  Equivalent rate
/
𝑟 1 𝑟 1 1 0.08 1 0.006434
 n  you must count the number of “real” periods  n = 10 x 12 = 120

1 1 0.006434
𝐶 0 500 41,210.74
0.006434 19

ANNUITY DUE

 The difference with the “ordinary annuity” is the moment where the
payment is done
 Ordinary annuity : end of the period
 Annuity due : beginning of the period

20

29
A PARTICULAR USE OF THE ANNUITY DUE : THE DISCOUNT

 The “discount” is an abatement of the price of a future debt due to an anticipated

payment
 it represents the fact that “time is money” : the amount of a debt today is smaller
than the amount of this debt tomorrow

 Example : anticipated payment of a bill by a customer

21

THE DISCOUNT

 Discount is merely useful for short-term debts

 Use of “simple interest” rather than “compound interest” (d is for discount rate)
𝐶 0 𝐶 𝑡 1 𝑑. 𝑡

 Application :
The discount rate of a firm is 2% per year. A customer is supposed to pay a bill of
20,000$ in 3 months, but he prefers to pay now. How much will he save ?

𝐶 0 20,000 1 2% 19,900
He will save 100$
22

30
 ANNUITY DUE – GENERAL CASE

1 𝑟 1
 Future value 𝐶 𝑛 𝐴 1 𝑟
𝑟
1 1 𝑟
 Present value 𝐶 0 𝐴 1 𝑟
𝑟

23

DEFERRED INTEREST

 Example – present value : what must be my deposit today if I want to get a 5000$
income every year (annuity due) during 5 years with an interest rate of 8% ?

.
𝐶 0 5000 1 0.08 21,560.63$
.

 Example – future value : What will be my future available income if I make a yearly
deposit of 10,000$ (annuity due) during 5 years with an interest rate of 7% ?
.
𝐶 𝑛 𝐴 =10,000 1 0.07 61,532.91$
.
24

31
INFINITE INCOME
 Instead of being finite, the sequence of flows is infinite

 The present value of an infinite sequence of regular flows is given by :

𝐴
𝐶 0
𝑟
 Example : what is the amount to deposit to have an infinite annual income of 1000$
with an annual rate of 5% ?
1000
𝐶 0 20,000$
5% 25

APPLICATION

 Application #3

26

32
Course #3:
loans

33
FINANCIAL MATHEMATICS
F. LACROUX, UNIVERSITY OF TOULON

Course 3 - Loans

SOME DIFFERENT APPLICATIONS

 Your core business…

 Consumers
 Consumer loans
 Mortgage loans
 Payday loans

 Firms
 Investment loans
2

34
INITIAL SITUATION AND NOTATIONS

 A unique borrower and a unique lender

 At the beginning  During the loan

 The amount of the loan: C  The balance = capital due at date n = 𝐶 also called
 The duration: N OVERALL BALANCE (OVB)
 The nominal rate: r  The payment = amount to pay for period n (𝑃𝑀𝑇 )
 The payment: PMT  The interest = interest to pay for period n (𝐼𝑁𝑇 )
 The amortization = part of the capital to pay for
period n (𝐴𝑀𝑂𝑅𝑇 )
3

AMORTIZATION TABLE

 The amortization table describes the « loan lifecycle »

n OVB Amortization Interest Annuity

0 𝐶
1 𝐶 Due capital Due interest Due payment = capital + interests
𝐴𝑀𝑂𝑅𝑇 𝐼𝑁𝑇 𝐴𝑀𝑂𝑅𝑇 𝐼𝑁𝑇
2 𝐶 𝐶 – 𝐴𝑀𝑂𝑅𝑇
…
N 0
4

35
DIFFERENT TYPES OF LOANS

Only the interests Interests only

What do you
want to pay A constant part of Constant
until the the capital amortization
maturity ?

A constant amount Constant payment Standard

5

INTERESTS ONLY

Principle
Advantages

The capital is not paid back during the • Low amounts

process, but only at the end • Only expenses
• Simple assessment
• Convenient for short terms needs
Who ?
Consumers
Firms
Disadvantages
• Very risky (“balloon effect”)
• Higher cost (interests are always paid on the same
What for ?
amount)
• Payday loans
• Cash credit loans 6

36
FORMULAS

The interest is always the same : C x r

Note : i𝑓 𝑡ℎ𝑒 𝑟𝑎𝑡𝑒 𝑖𝑠 𝑎𝑛𝑛𝑢𝑎𝑙, 𝑦𝑜𝑢 𝑚𝑢𝑠𝑡 𝑐𝑜𝑛𝑣𝑒𝑟𝑡 𝑖𝑡 𝑤𝑖𝑡ℎ 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑟𝑎𝑡𝑒𝑠
𝑃𝑀𝑇 𝐶 𝑟 𝑟 1 𝑟 / 1

The capital is always the same : 0

The payment is the same over time, except for the last term
7

AMORTIZATION TABLE

n Balance Principal Interest Payment

0 𝐶

1 𝐶 0 𝐶. 𝑟 𝐶. 𝑟

2 𝐶 0 𝐶. 𝑟 𝐶. 𝑟

N 𝐶 𝐶 𝐶. 𝑟 𝐶 𝐶. 𝑟

Constant

37
 CONSTANT AMORTIZATION

Principle
Advantages
The principal (=amortization) is the
same over time, but the interest • Regularity
decreases • No balloon effect
• Declining payments (interesting for investments)
Who ?
The consumers
The firms
Disadvantages

• High payments at the beginning

What for ? • Not so interesting for taxes
• Investments
• Individual loans
• Short term assets 9

FORMULAS

𝐶 The interest decreases over time (it is calculated from the balance)
𝑃𝑀𝑇 𝐶 .𝑟
𝑁 Principal (=amortization) is always the same : C/N

The payments decrease over time

10

38
AMORTIZATION TABLE

n Balance Principal Interests Payment

0 𝐶

1 𝐶 𝐶 𝐶 r 𝐶
𝐶 r
𝑁 𝑛
2 𝐶 𝐶 𝐶 r 𝐶
𝐶 𝐶 𝐶 r
𝑁 𝑁 𝑛
3 𝐶 𝐶 𝐶 r 𝐶
𝐶 𝐶 𝐶 r
𝑁 𝑁 𝑛
N 𝐶 𝐶 𝐶 𝐶
𝐶 𝐶 𝑟 1 r
𝑁 𝑁 𝑛 𝑛
11

Constant

CONSTANT PAYMENT

Principle
Advantages
• Regularity
The payment is the same for every • Predictability
period • Relatively low amounts
• Flexibility
Who ?
The consumers
The firms
Disadvantages

• Inflation (if the incomes remain constant)

What for? • Variable incomes (growing company, irregular activity)
• Consumer loans
• Home loans
• Small business loans 12

39
 FORMULAS

𝐶 The payment is always the same BUT…

𝑃𝑀𝑇 • The part of interest decreases over time
1 1 𝑟 • The part of the capital increases over time
𝑟

The payment is the same over time

13

AMORTIZATION TABLE
n Balance Principal Interests Payment

0 𝐶
𝐶
1 𝐶 𝑃𝑀𝑇 𝐶 𝑟 𝐶 r
1 1 𝑟 /𝑟
𝐶
2 𝐶 𝐶 𝑃𝑀𝑇 𝐶 𝑟 𝑃𝑀𝑇 𝐶 𝑟 𝐶 r
1 1 𝑟 /𝑟
𝐶
3 𝐶 𝐶 𝑃𝑀𝑇 𝐶 𝑟 𝑃𝑀𝑇 𝐶 𝑟 𝐶 r
1 1 𝑟 /𝑟
𝐶
N 𝐶 𝐶 𝑃𝑀𝑇 𝐶 𝑟 𝑃𝑀𝑇 𝐶 𝑟 𝐶 r
1 1 𝑟 /𝑟

14

Constant

40
FIXED RATES OR ADJUSTABLE RATES ?

Type Principle Advantages Disadvantages

Fixed rates
The rate never changes Regularity Lack of flexibility
(CPM)

The rate changes

Adjustable rates
according to Flexibility Unpredictability
(ARM) predefined rules
15

ARM – TYPES OF ADJUSTMENT

 Type of adjustment
 Unlimited
 Capped
 Maximum and minimum rates
 Evolving of a reference index

 Variables of adjustment
 Payment  The payment will evolve but the duration remains the same
 Maturity  The payment will remain the same, but the duration (= maturity) evolves

16

41
ARM – TYPES OF ADJUSTMENT
 A loan with adjustable rates can be considered as a sequence of loans
with fixed rates
 When the rate changes, you make a new calculation depending on the
new conditions :
Same duration Same payment

C = balance C = balance
n2 = maturity n2 = [new calculation]
r2 = new rate r2 = new rate 17

PMT2 = [new calculation] PMT2 = PMT1

TRADE-OFF

 If allowed in the initial contract, some loans with a fixed rate may be
renegotiated.

 In that case, the process is similar to a change in the rate of a loan with
adjustable rate
 You may select the same duration with a lower payment
 Or you may select a shorter duration with a similar payment
18

42
THE INFLUENCE OF INFLATION

 In the case of an ARM, the inflation will result in a rise in the adjustable rates

 In any case (CPM or ARM) the influence of inflation is different according to the situation

The incomes rise as inflation

Lower cost for the
borrower
Situation ?

The incomes don’t rise

Higher cost for the
borrower 19

THE INFLUENCE OF OTHER COSTS

Fees Exit fees Insurance
Amounts to pay at the Amounts to pay when you Insure the borrower
beginning of the loan: want to stop your current (… but also the bank !)
What is it ?
administrative fees, loan (anticipated payback or
application fees, etc. renegotiation)
The initial available amount In case of renegotiation, the You have an additional
is lower amount to borrow is higher insurance cost every
Consequences
month, which increases
your payment
𝐶 𝐶 𝑓 𝐶 𝐶 𝑒𝑓 𝑃𝑀𝑇 𝑃𝑀𝑇 𝐼𝑁𝑆
Formulas

20

43
 THE TOTAL COST OF A LOAN AND THE EAPR

 In order to help the consumer to have a comprehensive view of a loan, it

is possible to calculate two more indicators:

 The total cost of the loan

 Includes the interest, the different types of fees, the insurance.

 The Effective Annual Percentage Rate

 Defines the “real” interest rate, including all the expenses (fees, insurance, etc.)
 The EAPR nullifies the difference between the initial amount and all the payments (including all 21

the expenses  The EAPR is the IRR of the loan)

THE TOTAL COST OF A LOAN AND THE EAPR

 Total cost:  EAPR

𝑃𝑀𝑇
𝑇𝐶𝐿 𝑓 𝑖𝑛𝑠 𝐼𝑁𝑇 𝐶 0
1 𝐸𝐴𝑃𝑅

With K different types of fees

22

44
BARGAING PROCESS WITH THE CUSTOMER

 When a consumer (or a firm) needs a loan, he may test differents banks in
order to select the best offer.

 The bargaining conditions may include:

 The duration
 The rate
 The fees
 Renegotiation

23

CRITERIA

Example Duration Rate Fees Renegotiation

10.000$
5 years Ex : 4 years Ex : 3% Ex : 100$ Never
Short term
5% PMT : 230.29$ PMT = 176.37$ INT = 1322$ interesting
PMT = 188,71$ (+22%) - 71ct TCL = +8% (small amount
of iterests)

100,000$
15 years Ex : 12 years Ex : 5% Ex : 200% fees
Long term
6% PMT = 975.85 PMT = 790.79$ INT = 51,894$ Interesting
PMT = 843.86$ (+16%) -53$ f = 200 (depending on
-6,29% TCL = +0.39% the Interests)
24

45
 APPLICATION

 Application #5

25

46
Course #4:
ROI

47
FINANCIAL MATHEMATICS
F. LACROUX, UNIVERSITY OF TOULON

Course 4 – Return on investment (ROI)

A NEW GOAL

 When you plan to make an investment, the only question that matters is : is it
worth ?

 Process : you must

 Assess the value of all the flows to insure that you have a return on investment
 Concept of Net Present Value (NPV)
 And/or compare the rate of this investment to the rate you might get with a « secure »
investment
 Concept of Internal Rate of Return (IRR)

48
A NEW SITUATION

Year 0 1 2 3 4 5

 From many regular financial flows… A1 A2 A3 A4 A5

C(0)
A1 A3 A4 A5
 To many irregular financial flows
… Which may be positive or not C(0) A2
3

THE INITIAL DATA REQUIRED TO ASSESS AN INVESTMENT

OPPORTUNITY

 The initial cost of the investment : 𝐼

 The future cash-flows of the investment : 𝐹 or 𝐶𝐹

 The discount rate : r

 The rate of a « secure investment » in the market
 OR the rate of return you want to reach

 The duration of the project (number of time periods) : T

49
NET PRESENT VALUE

 The Net Present Value is the present cost of all the cash flows :

𝐹
𝑁𝑃𝑉 𝐼
1 𝑟

 Example : what is the NPV of an investment of 10,000$ on 3 years with the following
cash-flows F1=2000, F2=4000, F3=6000 and a discount rate of 4% :

2,000 4,000 6,000

𝑁𝑃𝑉 10,000 918.54
1 0.04 1 0.04 1 0.04
5

THE DECISION

 The NPV is the criterion you use to make the decision :

The return is
NPV>=0 GO !
interesting
Investment
?
The return is not
NPV<0 STOP !
interesting

50
COMPARISON

What happens to the NPV if the value of the element…

Element increases ? decreases ?

r More difficult to win !

T More cash flows

F Higher cash flows

CALCULATING THE « REAL » RETURN RATE OF THE INVESTMENT :

INTERNAL RATE OF RETURN (IRR)

 The IRR is the rate that nullifies the NPV :

𝐹
𝐼 0
1 𝐼𝑅𝑅

 It cannot be calculated directly without an App/calculator

51
THE DECISION

The return is
IRR > [goal] GO !
interesting
Investment
?
The return is not
IRR < [goal] STOP !
interesting

SOME PARTICULAR FEATURES

 IRR is a nth root, so in some situations, you may have

 No IRR
 The investment is not interesting
 Multiple IRRs
 in Excel, it is possible to calculate the « nearest » value : =IRR([CF],[nearest approximation])

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52
WHEN IRR AND NPV ARE NOT CONSISTENT

 If you have 2 investment projects, A and B, you may have :

 NPV(A) > NBV(B)
 And IRR(B) > IRR(A)

 In such cases, two possible ways to select the investment :

 Choose the higher NPV
 Use other criteria

11

OTHER CRITERIA

 Sometimes, the return rate is not the most important criterion to consider, in the case
where IRR and NPV are opposite, but also in other cases
 Risky environment
 Need for a future capital
 …

 You may prefer to optimize :

 The smallest capital to invest  Profitability index
 The lowest duration to get your money back  Payback period

12

53
OTHER CRITERIA : THE PROFITABILITY INDEX

 A rate of return calculated from the NPV

𝑁𝑃𝑉
𝑃𝐼 1
𝐼
 Advantage : based on the initial investment : the lower the investment, the greater the
PI

 Example (previous data) :

918.54
𝑃𝐼 1 1.092
10,000 13

OTHER CRITERIA : THE PAYBACK PERIOD

1. Calculate the cumulate amount of the discounted cash-flows

2. Find the year where the initial investment is paid back
3. Make a proportion calculus to find the payback period

Years Cumulate CF
𝑛 𝐶𝐶𝐹 𝐶𝐶𝐹 𝐼
The investment is
𝑃𝐵𝑃 𝐼 paid back during
𝑛 1 𝐶𝐶𝐹 𝐶𝐶𝐹 𝐼 year n

𝐼 𝐶𝐶𝐹
𝑃𝐵𝑃 𝑛
𝐶𝐶𝐹 𝐶𝐶𝐹 14

54
OTHER CRITERIA : THE PAYBACK PERIOD
2,000 4,000 6,000
 Example 𝑁𝑃𝑉 10,000 918.54
1 0.04 1 0.04 1 0.04

Years CF Cumulate
Years Cumulate CF
CF
𝑛 𝐶𝐶𝐹
1 1923.07 1923.07
𝑃𝐵𝑃 𝐼
2 3698.22 5621.30
𝑛 1 𝐶𝐶𝐹
3 5333.97 10955.28

10000 5621.30
𝑃𝐵𝑃 2 2,82 2 𝑦𝑒𝑎𝑟𝑠 𝑎𝑛𝑑 295 𝑑𝑎𝑦𝑠
10955.28 5621.30
15

COMPARING INVESTMENTS
 If the duration is the same
 The bigger the NPV (or the IRR), the more interesting the investment

 If the duration is different :

 Replacement chain method
 Find a common multiple (Ex : project A : 3 years, project B : 2 years  Smaller Common Multiple : 6)
 Make the project comparable by repeating them as much as necessary (Ex : project A : 2 times ; project B : 3 times)
 Equivalent-Annual-Annuity
 Compare the annuity of both the projects with :
 Present value : the NPV
 Future value : 0
 Duration : the duration of the investment
 Rate : the discounting rate you choose
 The higher the annuity, the most interesting the project

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 APPLICATION

 Application #4

17

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