MATHEMATICS OF FINANCE.

The notion that money has time value is one of the basic concepts of finance. Most businessmen will
agree that a shilling in hand today is better than one next year, because as soon as money is received it’s
put into profitable opportunities.

Simple and Compound interest.

If an amount of UGX p is invested today, a return of i per period is expected on this amount and if at the
end of each period we reinvest the interest earned during the period then after the end of the first period
we will have an amount p+ p∗i ¿ p(1+i) because p∗i is the interest earned in that period. Now that the
amount p ( 1+ i )∗i= p ( 1+i )( 1+i )= p(1+i)2 . Now the amount p(1+i)2 will earn a return at the rate of i

during the third period and so the amount at the end of the third period will be p(1+i)2+ p (1+ i)2=
2 3
p ( 1+ i ) ( 1+i )= p(1+i) extending this logic to n periods, the amount at the end of n periods will be
n
A=P(1+i) ,where A is known as compound amount and this formula is known as compound amount
formula. This formula states that if an amount of UGX p is invested today and the compound interest of i
is considered, then the value of the above investment after n periods will be P(1+i )n . in case of simple
interest, the value of investment after n years will be

p+ p∗i∗n=p (1+i∗n).

Present value

We may be interested in the present worth (or present value) of an amount of A that will be available to
us after n periods. Since A=P(1+i)n,it follows that

A
p= n
(1+ r)

Thus, present value of A will always be less than A ,because (1+r )n will always be greater than one.For
1
n>1 .The term n is known as the discount-factor and tables are available that give the value of the
(1+r )
discount factor for various values of i∧n .

Examples (i). Calculate the present value of $1 received 4 years from now at a discount rate of 6%.

1
 A 1 1
Solution: present value is given by p= n A=1, i=0.06∧n=4 hence
p= n=
(1+ r) (1+ 0.06) [1.06]4
=0.792

(ii) Calculate the present value of $100 received 4 years from now at the discount rate of 6%

A
Solution p= n
= A∗discount factor=100 X 0.792=79.20.
(1+ r)

(iii) ) Calculate the present value of $100 to be received at the end of the year and $200 at the end of 2
years at a discount rate of 6%

100 200
Solution p= + =94.34+178.00=$272.34
(1.06) (1.06)2

Annuities

Annuity means equal investment at equal intervals for a designated period of time. The investment is
generally assumed to be made at the end of each period. Thus the basic feature of an annuity is periodic
payments. As an example, suppose an investor has planned to invest in the public provident fund scheme,
whereby he is required to make payments of $p at the end of each period for n periods and gets an interest
ofi per annum.The investor is interested in knowing as to how much he will get at the end of the nth
period. Thus he is interested in the terminal value of the investments he is making over a period of time.
The investment plan and the amount accumulated at the end of the nth period are given below:

Period 1st 2nd 3rd (n-1)th nth

Amount invested p p p p p
Number of years (n−1) (n−2) (n−3) 1 0
for which the
amount will earn
interest
The accumulated p(1+i)
n−1
p(1+i)
n−2
p(1+i)
n−3
p(1+i) p
amount at the
end of the
nthperiod

Thus the total amount at the end of the nth period will be:

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A= p(1+i)n−1+ p(1+i)n−2+ p(1+i)n−3+………………. + p(1+i)+ p … … … … ..(1)

Multiply equation 1 by (1+i) and we get

n
A ( 1+i )= p(1+i) + p (1+i)
n−1
+ p(1+i )
n−2
+…….+ p(1+i)2+ p ( 1+ i ) … … .(2)

If subtract (1) from (2) and we get A ( 1+i )− A=p (1+i)n −p

n n
P [ ( 1+i ) −1] (1+ I ) −1
Solving for A we get A= so the terminal value of annuity= p tables for
i i
n
(1+ I ) −1
calculating annuity factor for various values of i∧n .
i

Example

i. An investor deposits $1000 in saving institution each payment is made at the end of the year.
If the payments deposited earn 6% interest compounded annually, how much will he receive
at the end of the year?

Solution:

n 10
(1+ I ) −1 1.790848−1
Terminal value of annuity= p =1000 (1.06) −1 ==1000[ ]=13,180.80
i 0.06 0.06

ii. An individual plans investing $100 per year in a savings plan that earns 5% interest
compounded annually. Calculate the sum of annuity payments at the end of 10 years.

10
(1.05) −1
Solution: Terminal value= 100 =$1,257.7
0.05

Present value of Annuity.

The present value of an annuity is obtained by the addition of the present value of each of the
individual annuity payments.

The payments of amount p are being made at the end of each period. Hence, we find out the
present value of each of these payments as shown below:

Period 1 2 3 ( n−1 ) th nth

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 Amount of p p p p p
payments
Present value p p p p p
(1+i) (1+i)
2
(1+i)
3
(1+i)
n−1
(1+i)
n

Hence, present value (PV) of annuity is:

p p p p p
PV= + 2 + 3 +…..+ n−1 + n ………………….. (3)
(1+i) (1+i) (1+i) (1+i) (1+i)

Multiply the equation 3 by(1+i):

p p p
PV( 1+i )= p+ + 2 +……. + n−1 ………………………… (4)
( 1+i ) (1+i) (1+i)

p
Subtract (3) from (4) we get PVi= p− n
(1+i)

P [1−(1+i)¿¿−n]
PV = ¿
i

Example (i) calculate the present value of $1 per year for three years at 6%

1 1 1
Solution PV= + 2 + =2.673
1.06 (1.06) (1.06)3

1[1−(1.06)¿¿−3]
Also from formula PV= =2.673 ¿
0.06

ii. A project offers an annual return of $250,000 for four years. if the cost money is
15%,calculate the present value of the project.

1[1−(1.15)¿¿−4]
Solution: PV=250,000 ¿ =713,750
0.15

iii. Determine the present value of receiving $100 per year for 10 years with interest at 6% per
annum.

Solution; present value of an annuity PV=100 ¿ ¿ ¿ =100(7.3601) =736.

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Perpetuities’

An annuity which goes on forever is called is called perpetuity. The present value of perpetuity of a $
P p p
per year is: PV= + 2 +……..= , the present value of $ 5 per year for ever at 6% discount
(1+i) (1+i) i
5
rate is= = $ 83.33
0.06

Continuous compounding

Earlier we have derived the formula for annual compounding A=P(1+i)n where iis the annual rate
of interest is. If instead of annual compounding we break down a year into f periods and we
i
compound at the end of every period, then we have a rate of interest per period equal to and this
f
will be compounded for a total of periods n∗f (since in each year there are f periods).Hence

n∗f
numberof periods i
A=P(1+rate of interest per period ) =p (1+ )
f

¿
Thus A=p e =Terminal value of the investment p under conditions of continuous compounding.

−¿
The present value p= A e

Example 1. If £100 is deposited in a savings account at 5% interest on quarterly basis. Calculate the
terminal value at the end of one year and at the end of three years.

Solution:

n∗f 1∗4
i 0.05
Terminal value = p(1+ ) , at the end of one year we have 100(1+ ) = £ 105.09
f 4

3∗4
0.05
At the end of three years we have 100(1+ ) = £ 116.075.
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Example 2. (i) Calculate the terminal value of £ 100 at the end of twenty years if interest is
compounded continuously at 5%

Solution:

5
 ¿
Terminal value A=p e = 100e 0.05∗20=271.82.it may be observed that the figure above is comparable
with annual and semiannual compounding

Terminal value (annual compounding) =100(1.05)20 =265.33

40
0.05
Terminal value (semiannual compounding) =100(1+ ) =268.51
2

II. Calculate the present value if £ 1000 is to be received at the end of ten years with a discount
rate of 20% compounded continuously.

Solution (Exercise)

−¿ A 1000
Present value p = A e = ¿ = =
e e20∗10

Applications to investment decisions.

The present value concept is an extensively used concept in accepting/rejecting of long term
investments. Long term investments are those investments whose benefits accrue for more than one
year. These benefits are measured in terms of net cash inflows generated by the project over the
useful economic life of the project. The following technique that use present value concept and are
hence known by the name of discounted cash flow techniques are used in accepting or rejecting an
investment proposal.

1. Net present value

2. Internal rate of return (IRR)
3. Discounted payback period.

Net present value.

The net present value of an investment proposal is the discounted value of all its future net cash flows less
the original investment in the project.

Consider a project that has the following cash inflows over its useful economic life. The project’s initial
investment is I.

Period 1 2 3 n
Cash flows R1 R2 R3 Rn

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For the above project, net present value is defined as below:

n
Ri
NPV =∑ −I Where i is an appropriate discount rate. If NPV for an investment proposal is
i (1+i)t
positive, the project is accepted; otherwise it is rejected.

Example; Consider an investment proposal that has an initial investment of $20,000 and it generates the
following net cash inflows

Period 1 2 3 4
Cash flows 5000 5000 10000 10000

Will you accept the above proposal at i=10 % ?

Solution: The net present value (NPV) of the above proposal is:

5000 5000 10000 10000

+ + + 4 -20000=23020.96-20000=3020.96 since NPV is positive,
(1+0.1) (1+0.1)2 ¿ ¿ ¿ (1+0.1)
we may accept the proposal.

Internal rate of return.

The internal rate of return (IRR) is the discount rate that equates the present value of the expected cash
inflows to the initial investment. In other words, it is the discount rate, at which NPV is zero.
Symbolically,

n
R
NPV= ∑ (1+ ir)t −I Where r is known as IRR.For accepting an investment proposal, calculated IRR
i

is compared with the investor’s minimum acceptable rate of return. If the calculated IRR is greater than
the minimum desired rate of return, the project is accepted; otherwise it’s rejected. In the equation above
the r is calculated by trial and error method and some cases by factorization.

Example: Consider the earlier project with an initial investment of $20,000.If the investor desires a
minimum rate of return of 12% will you accept the project?

Solution: IRR will be calculated from the following equation:

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 5000 5000 10000 10000
+ + + 4 =20000 by trial and error r =16 %
(1+r ) (1+r )2 ¿ ¿ ¿ (1+r )

Since IRR= 16%, and desired minimum rate of return is only 12%, the project should be accepted.

Discounted pay Back period.

The payback period is defined as the number of years required to recover the original investment. In case
of discounted pay back period. We consider the discounted present values of future cash inflows and find
out the number of years required to recover the initial investment. If discounted payback period is less
than the desired payback period, the project is accepted.

Consider the following investment proposal with an initial investment of $ 24.370

Period 1 2 3 4 5
Net cash 10,000 10,000 10,000 10,000 10,000
inflows
Present value 9091 8264 7513 6830 6209
at i=10 %
Cumulative 9091 17355 24868 31698 37907
Present value

The number of years required to recover the initial amount is 3 years. Hence, the discounted payback
period is 3 years. If the desired maximum payback period is 4 years, the proposal is accepted because the
calculated discounted payback period is less than the limit set by management.

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