Topic 2

Intro. To Fin.
Math
BFF1001 & BFB1001

1
In this lecture session:

1. Value Vs Price

2. Time Value of Money

3. Introducing Timelines to understand FV

& PV
Value Vs Price
 Why study Financial Math?
Value Vs Price

Financial math is about Valuation.

 Value is defined as the worth of assets or liabilities: the total of
what the asset can earn over the period held, the total of what
a liability costs over the period held.

 Asset: earns money/cash inflow. Liability: costs money/cash outflow

 The first step in establishing value is to estimate the components of

cash flow (money streams) that arise from financial and tangible
products, both assets and liabilities.

 Examples of financial products: loans, shares, bonds.

 Examples of real assets: Real estate and equipment (that represent

investable, tangible projects).
You are buying a business which has a value of $10,000. This is
an asset. Which of the following is the best price you can pay for
it to make a profit?

A. $10,000

B. $10,001

C. $10,002

D. $10,003

E. None of these answers

You are buying a business which has a value of $10,000. Which of the
following is the best price you can pay for it to make a profit?

A. $10,000

B. $10,001

C. $10,002

D. $10,003

E.None of these answers

Answer: E None of these answers.

When buying, Price < Value. None of these prices are less than the value, so do
not buy.
 Why study Financial Math?
Value Vs Price

 The value established could be a present value or a future value.

 Value is termed by a number of names; including fundamental value, true

value, intrinsic value and economic value.

Ultimately, value is important because it is used to make buying and

selling decisions of financial products and real assets.

Value needs to be distinguished from the concept of “Price”.

 The price of a financial product or real asset is what it trades at in a market

as a function of it’s supply and demand.

* Subject link: Price as a function of supply and demand

is developed further in Macroeconomics

 The value of an asset, i.e. what it is worth, is one factor that influences the
supply and demand of the asset and thus it’s price. There are other factors
that affect supply and demand.
 Why study Financial Math?
Value Vs Price

Critical Thinking: Value can be compared to Price to justify buying or selling

decisions of assets, depending on the perspective of a buyer or seller:

 Value < Price, the asset can be termed “over-priced”

• A buyer wouldn’t buy; they pay more than what the asset can earn. A
seller would sell; they receive in price more than the asset can earn if
kept.

 Value > Price, the asset can be termed “under-priced”

• A buyer would buy; they pay less than what the asset can earn. A
seller wouldn’t sell; they receive in price less than what the asset earns
if kept.

 This process of comparing value to price aids in understanding one of the

most widely used and important capital budgeting (investment) metrics:
Net Present Value (NPV) taught in Week 5.

In this topic, we introduce a key foundation of finance; the financial

math used to establish value.
 Why study Financial Math?
Value Vs Price

Critical Thinking Conclusion: Why is valuation important in

finance? It enables us to answer the following questions
 As a buyer: What price should I pay for this investment?

Ans: A price not over the asset’s value. Value sets a price ceiling.

The best buy price is $0, but it is unlikely a seller would sell for that.
The best price to buy at, is the lowest price a seller is willing to sell at.
 As a seller: What price should I sell this asset for?

Ans: A price over the asset’s value. Value sets a price floor.

The best selling price is as high as possible, the highest price a buyer
is willing to pay.
Time Value of
Money
 Time Value of Money

The time at which money is earned or paid affects it’s value or cost.

 Money earned sooner or today, is greater in value to the recipient

than if received at a later date. This applies to assets.

 Money paid sooner or today is greater in cost to the payer, than if

paid at a later date. This applies to liabilities.

This is intuitively true…

 would you prefer to receive $1,000 now OR

*Subject link: Utility is a
 wait 10 yrs. to receive the $1,000. concept from economics

Why would we prefer the earlier option? Because of the Utility of money.

 Utility = Satisfaction

 The sooner we get paid money, the greater our satisfaction as we can
choose to spend/invest that money earlier and vice versa.
 Time Value of Money

When assets or liabilities are valued, the time value of money is

considered.

Let us examine the impact of money utility on holders of assets

and liabilities …
 Asset holder = you are receiving money

 Liability holder = you are paying money

How does the concept of money utility affect your preference of cash
flow timing as an asset holder or liability holder?
You lend $100 to Jason at 10% p.a. How frequently would you like
him to pay you interest?

A. Annually

B. Semi-annually

C. Monthly

D. Fortnightly

E. Weekly

F. Jason doesn't have to pay you interest, he's your CE!

You lend $100 to Jason at 10% p.a. How frequently would you like him
to pay you interest?

A. Annually
B. Semi-annually
C. Monthly
D. Fortnightly
E. Weekly
F. Jason doesn't have to pay you interest, he's your CE!

Answer: E Weekly

When receiving cash inflow from an asset/investment, there is

greater utility/satisfaction in receiving the money sooner rather
than later.
Future cash flow that is received sooner, has more value to you
today.
Jason lends you $100 at 10% p.a. How frequently would you like to pay the
interest?

A. Annually

B. Semi-annually

C. Monthly

D. Fortnightly

E. Weekly

F. You don't need to pay Jason interest, you're his student!

Jason lends you $100 at 10% p.a. How frequently would you
like to pay the interest?

A.Annually
B. Semi-annually
C. Monthly
D. Fortnightly
E. Weekly
F. You don't need to pay Jason interest, you're his
student!

Answer: A Annually

When dealing with future cash outflow, there is greater

utility/satisfaction in delaying payment as long as possible.
The further into the future you can delay payment, the lower the
perceived cost is to you today.
 Time Value of Money

Given that money has different value dependent on the time it

is earned or paid, three central rules arise for valuation:
1. Money can be only be combined and compared if earned at the
same time period. (when they have the same time value)

2. Valuation can be at a future period to cash flows; calculating

a Future Value (FV) given periodic growth on an investment is
called compounding. Often used to work out what capital
accumulates to in the future given re-investment of a periodic
return. E.g. …
• An interest bearing deposit account with a bank
• A sinking fund or investment fund which earns a periodic
return and re-invests that return.

“Compound interest is the eighth wonder of the world. He who

understands it, earns it, he who doesn't pays it.” - Albert Einstein.
 Time Value of Money

3. Valuation can be at a past period to cash flows;

calculating a Present Value (PV) by diminishing cash flows
in the future to reflect the time value of money is called
discounting. For example…
• In capital budgeting, we discount the cash flows of
assets to establish PV today so as to compare value with
today’s price.
• We can discount cash flows of comparable liabilities to
work out the Present Value of cost and identify which is
cheaper.
 Time Value of Money

When cash flow is compounded by a periodic interest rate, a future value

(FV) is obtained. We start with a single cash flow, compounded over time
to a future value:

When money is discounted, a present value (PV) is obtained. We start

with a single cash flow, discounted over time to a present value:

Where …

i is the interest rate for FV and the discount rate for PV, per payment.

n is the number of periods/payments to the PV and FV

Introducing
Timelines to
understand FV & PV
 Cash Flow Time Lines
Learning how to draw time lines of cash flows is a vital first step to
correctly understand valuation. It is a pictorial view of timing and
cash flows incurred for assets and liabilities we are trying to value.

E.g. You opened a bank account three years ago with an initial
deposit of $1,000. It calculates and pays interest at 10% p.a. at the
end of each year. The cash flows to you can be represented as
follows …
Year 0 Year 1 Year 2 Year 3

-$1,000 $100 $110 $121

(Deposit) (interest on (interest on (interest on
$1,000) $1,100) $1,210)
+
$1,000
*Concept Check: What is Year 0? (receiving your
When does the timeline end? initial deposit at
investment end)
 Cash Flow Time Lines

What is the Future Value in 3 years time of $1,000 invested

into a term deposit today, earning 10% interest per annum,
paid annually?
 PV= $1,000, n = 3 years, i = compound rate per yr. = 10%

What is the Present Value of $1,331 received in 3 years time

using a 10% per annum discount rate?
 FV= $1,331, n = 3 years, i = discount rate rate per yr. = 10%
 Cash Flow Time Lines

You invest $100 today in a fund for 2 years, that earns 6% p.a.
interest, paid and re-invested monthly.
• What is the total number of interest payments, what is n?
• What is the interest rate per payment?, what is i?

You invest $100 today in a fund for 3 years that earns 6% p.a.
interest, paid and re-invested quarterly.
• What is the total number of interest payments, what is n?
• What is the interest rate per payment?, what is i?