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35 views13 pages

Chapter 3 Part2 Stu

thnmkjh

Uploaded by

diectran.2210
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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MATHEMATICS

FOR BUSINESS
Chapter 3
Mathematics of
Finance
Outlines

● Percentages
● Compound interest
● Geometric series
● Investment appraisal
3.3 Geometric series

❖ Geometric progression: A sequence of numbers with a constant ratio


between consecutive terms; the nth term takes the form, arn-1

▪Example
2; 4 (22); 8 (23); 16 (24); 32 (25);... is a geometric progression

❖ A Geometric ratio is the ratio between two numbers in a geometric


sequence.

▪Example
2; 4 (22); 8 (23); 16 (24); 32 (25);... → ratio: r = 2
❑ The sum of the first n terms of a geometric progression
in which the first term is a1, and the geometric ratio is r, is:

𝑎1 (rn −1)
σ𝑛𝑖=1 𝑎𝑖 = a1 + a1r + a1r2 + a1r3 + ... + a1rn-1 =
𝑟−1

Example: Find the value of the geometric series


1000 + 1000(1.03) + 1000(1.03)2 + . . . + 1000(1.03)9
1000 (1.0310 −1)
➢S = = 11463.88
1.03−1
❖ In this section we focus on two applications of geometric series into finance:
savings and loans.

❑ Savings: Imagine simply one decides to invest regularly an equal amount of


money into a bank account in order to meet some future financial commitment.
This is sometimes referred to as a sinking fund!

➢ If each payment is made at the beginning of the periods, then the accumulated
amount, after n periods, will be calculated by
𝟏+𝒓 𝒏 −𝟏
S = A(1+r) + A(1+r)2 + ... + A(1+r)n = A(1+r)
𝒓

➢ If each payment is made at the end of the periods, then the accumulated
amount is
𝟏+𝒓 𝒏 −𝟏
S = A + A(1+r) + A(1+r)2 + ... + A(1+r)n-1 = A
𝒓

where A is payment. However, if there is no other specification, as for savings,


payments are usually made at the beginning of each period.
❑ Loans: one needs an amount of money right now and decides to borrow it
from a bank. The loan is promised to pay back by a series of repayments (or, also
called, an annuity) made at equal time intervals. Such an annuity can be thought
of as the opposite of a sinking fund!

➢ If each repayment is made at the end of the periods, then the actual value of A
debt, after n repayments made, is

𝟏− 𝟏+𝒓 −𝒏
L= A(1+r)-1 + A(1+r)-2 + ... + A(1+r)-n = A
𝒓

➢ If each repayment is made at the beginning of the periods, then

𝟏− 𝟏+𝒓 −𝒏
L = A + A(1+r)-1 + A(1+r)-2 + ... + A(1+r)-(n-1) = A(1+r)
𝒓

Analogously, as for loans, if there is no other specification, repayments are


usually made at the end of each period.
Example
1/ An individual saves $5000 in a bank 𝟏+𝒓 𝒏 −𝟏
a/ S = A(1+r)
account at the beginning of each year 𝒓
𝟏+𝟖% 𝟏𝟎 −𝟏
for 10 years. No further savings or = 5000(1+8%) = 78227.44
𝟖%
withdrawals are made from the account.
Determine the total amount saved if the b/ S = A(1+r)
𝟏+𝒓 𝒏 −𝟏
annual interest rate is 8% compounded: 𝒓
8% 𝟏+𝟖%/𝟐 𝟏𝟎𝒙𝟐 −𝟏
(a) Annually (b) semi-annually. = 5000(1+ ) = 154846.01
2 𝟖%/𝟐
Example

2/ Determine the monthly repayments 𝟏− 𝟏+𝒓 −𝒏


L=A
needed to repay a $125 000 loan which 𝒓
𝟏− 𝟏+𝟕% −𝟐𝟎𝒙𝟏𝟐
is paid back over 20 years when the 125000 = A
𝟕%/𝟏𝟐
interest rate is 7% compounded →A=
annually. Round your answer to 2
decimal places.
3.4 Invesment Appraisal
• P = principal
S = future value
r = interest rate
t = time
• In this section we know the future value, and we want to
work backwards to calculate the original principal. This
process is called discounting and the principal, P , is
called the present value. The rate of interest is
sometimes referred to as the discount rate.

𝑆
❑ S = P(1+r)t → P= = S(1+r)-t
1+𝑟 𝑡

❑ S = Pert → P = Se-rt
Example

1/ Determine the present value of


➢ S = 7000; t = 2; r = 8%
$7000 in 2 years’ time if the discount 8%
rate is 8% compounded (a) P = 7000(1 + )-2x4 = 5974.43
4
(a) quarterly (b) P = 7000e -2x8% = 5969.01
(b) continuously
❖ Present values are a useful way of appraising investment projects.
➢Two ways of assessing individual projects are based on Net Present Value
(NPV) and Internal Rate of Return (IRR).

❑ Net Present Value is the difference the present value of the revenue and
the present value of the costs.

▪NPV = PV - P0

where PV is present value


P0 is initial outlay
When a project has :
+ NPV > 0 : project is accepted (PV > P0)
+ NPV = 0 : neutral
+ NPV <0 : project is not accepted (PV < P0)
❑ Internal rate of return is the annual rate which, when applied to the initial
outlay, yields the same return as the project after the same number of years.

➢ IRR is used when NPV = 0

▪ A project is considered worthwhile if the IRR is larger than market rate.

❖ It is often that if a decision is to be made between two different projects


then the one with higher NPV or IRR is the better choice.

✓ In practice, other factors such as risk need to be taken into account


before a decision is made.
Example
A project requiring an initial outlay of
$15,000 is guaranteed to produce a
return of $20,000 in 3 years’ time. Use (a) NPV = PV – P0 = 20000(1+5%)-3 –
the 15000 = 2276.75 ( >0 )
- Net Present Value ➢ Project is accepted
- Internal Rate of Return
methods to decide whether this (b) 20000 = 15000(1+IRR)3
IRR = 0.1 = 10% ( > 5%)
investment is worthwhile (i.e., the NPV is
➢ Project is accepted
positive) if the prevailing market rate is
5% compounded annually.

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