Mathematics of Finance

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Mathematics Of Finance

Mathematics II
Maths of Finance

 The first step in time value analysis is to set up a time line, which helps in
visualising what is happening in a particular problem.

 E.g., consider the diagram below where Present Value (PV) represents a
$100 that is on hand today and Future Value (FV) is the value that will be in
the account on a future date:

Periods 0 5% 1 2 3
|_________|___________|__________|
Cash PV=$100 FV=?

 The intervals from 0-3 are time periods such as years or months. Cash flows
are shown directly below the marks, and the relevant interest rate is shown
just above the time line.
Time 0 5% 1 2 3
|__________|__________|__________|
Amount at beginning $100  $105  $110.25  $115.76
of period

 Interest earned in the first year is $100(0.05) = $5, so the amount at the end
of year 1 (or t = 1) is:

 FV1 = PV + INT
= PV + PV(I)
= PV (1 + I)
= $100(1 + 0.05) = $100(1.05) = $105

 The second year starts with $105, interest of 0.05($105) = $5.25 is earned
on the now larger beginning-of-period amount, and end the year with
$110.25. Interest during Year 2 is $5.25 and it is higher than the first year’s
interest as $5(0.05) = $0.25 interest is earned on the first year’s interest.
This is called ‘compounding’ and interest earned on interest is called
‘compound interest’.

 This process continues and since the beginning balance is higher in each
successive year, the interest earned each year increases.
Sec 5.1: Mathematics of Finance

Formulas : S :
FV

Interest is compounded
k times a year.
At what nominal rate of interest compounded yearly
will money double in 8 years.

S
Suppose $500 amounted to $588.38 in a savings account after
three years. If interest was compounded semiannually, find the
nominal rate of interest , compounded semiannually, that was
earned by the money.
S
How long will it take $600 to amount to $900 at an annual
rate of 6% compounded quarterly?

S
Effective Interest Rate

This is the simple annual interest rate. If interest is


compounded at the nominal rate r , the effective
interest rate is the simple annual interest rate r that is
actually earned.

If interest is compounded k times a year and r is the


annual interest rate then
Example

What effective rate is equivalent to a nominal interest


rate of 6% compounded
Semiannually.
How many years will it take money to double at
an effective interest rate of r?

S
If an investor has a choice of investing money at 6% compounded daily or 6.5% compounded quarterly, which is the better choice?

We compute the effective interest rate for both


investments and see which is larger.
For daily compounding,

For quarterly compounding,

So the quarterly compounding is the better option !


5.2 Present value:

The principal P that must be invested at an annual rate


r where interest is compounded k times a year S given
by

And is called the present value of S.


Example #1: Find the present value of $1000 due after
three years if the interest rate is 9%compounded monthly.

Solution:
S=1000; P=?
r=0.09 k=12
kt=3(12)=36

764.15
Example # 2-Single-Payment Trust Fund

A trust fund for a child’s education is being set-up by a


single payment so that at the end of 15 years there will
be $50,000. If the fund earns interest at the rate of 7%
compounded semiannually, how much money should
be paid into the fund?
Solution:
S=50,000rR=0.07 , k =2, t =15
P=
=
Example # 3: Comparing Investments

Suppose you had the opportunity of investing the


$5000 in a business such that the value of the
investment after five years would be $6300. On the
other hand you could instead put the $5000 in a
SAVINGS ACCOUNT THAT PAYS 6% compounded
semiannually. Which investment is better?
Business investment value=$6300
Savings account=
So savings account gives a better return
Equations of value:
Total Payments = Total Debt

All amounts to be computed at the same point in


time!
Suppose that Mr. Smith owes Mr. Jones two sums of
money:$1000, due in two years, and $600, due in five
years. If Mr Smith wishes to pay off the total debt now
by a single payment, how much should the payment
be? Assume an interest rate of 8% compounded
quarterly.
Solution
PV of 1000 is P=

The single payment x due now must be such that it would grow and
eventually pay off the debts when they are due. That is, it must equal
the sum of the present values of the future payments.
we have

This equation is called an equation of value.

The equation above shows that the value now of all payments under
one method must equal the value now of all the payments under the
other method.
Equations of Value

Qs 1. A debt of $7000 due in 5 years is to be paid by a


payment of $3000 now and a second payment at the
end of 5 years. How much should the second payment
be if the interest rate is 8% compounded monthly.

Let x = payment after 5 years,


The equation of value is:
Periods 0 8% 1 2 3 4 5
|_________|___________|__________|__________|__________|

3000( Payment)
x(Payment)


7000(Debt)
Qs 2.A debt of $3500 due in 4 years and $5000 due in six years is
to be repaid by a single payment of $1500 now and three equal
payments that are due each consecutive year from now. If the
interest rate is 7% compounded annually, how much are each of
the equal payments?
Let x = Each payment.
Equation of value at year 3 is:

On solving, x = 1715.44 dollars.


|_____|_________|__________||_________|___________|___________
0 1 2 3 4 5 6
1500 X x x 3500
5000
Net Present Value

If an initial investment will bring in payments at future


times, the payments are called cash flows. The net
present value, denoted NPV, of the cash flows is
defined to be the sum of the present value of the cash
flows, minus the initial investment.
 If NPV>0----profitable investment
 If NPV<0----non-profitable investment
Example :Consider r = 0.07
compounded annually and an
amount of $ 20000 available.
Given the following table representing cash flow find the Net Present Value.
NPV=19542-20000= - 457
Yr Cash flow PV
2 10000 1000

3 8000

5 6000 6000

19542
Assignment 24

1. Suppose that over a six-year period ,1,000 dollars accumulated to 1,959


dollars in an investment certificate in which interest was compounded
quarterly.
(a)Find the nominal rate of interest, compounded quarterly, that was
earned. (Round your answer to 2 decimal places.)
(b) Find the effective annual rate (EAR) rounded to 2 decimal places.

2. How many years will it take for a principal of P to double if money is worth
12 % compounded monthly? Give your answer to the nearest month.

3. To what sum will $2000 amount in eight years if invested at a 6% effective


rate for the first four years and at 6 %compounded semiannually thereafter.

4. An investor has a choice of investing a sum of money at 8% compounded


annually or at 7.8% compounded semiannually. Which is the better of the two
rates?
Assignment 24
5. A debt of $750 (due in 10 years) and $250 (due in 12 years) is to be repaid by a
single payment now. How much is the payment if an interest rate of 8%
compounded quarterly is assumed?

6. A debt of $600 due in three years and $800 due in four years is to be repaid by a
single payment two years from now. If the interest rate is 8% compounded
semiannually, how much is the payment?

7. An initial investment of $35,000 in a business guarantees the following cash flows


Year Cash Flow
5 $13,000
6 $14,000
7 $15,000
8 $16,000

Assume an interest rate of 4% compounded quarterly. (a) Find the net present value
of the cash flows. (b) Is the investment profitable?

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