Math Fundamentals for

Capital Market
 Learning Objectives

Calculate simple and Convert values today into Understand how to

compound interest rates a future value and vice- calculate an annuity and
versa what discounted cash
flow is

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 Math Warm Up

X 2 % 2X + 1 = Y

Exponents / Roots Percentages Solving Equations

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 Simple Interest

Simple Interest Earned Each Period = Rate of Interest X Principal

Example: Principal: $100 Year Interest Principal

Interest Rate: 5% per annum 1 $5

Total Periods: 5 years 2 $10

3 $15

4 $20

5 $25 $100

Total $125

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 Future Value and Present Value

The value of a dollar today and the value of a dollar a year from now are different.

Opportunity cost of not having

that dollar now

Inflation – purchasing power Time Value of Money

Uncertainty – default risk

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 Future Value in a Simple Interest World

FV = PV X (1 + i X n) Example: If you invest $100 today with a 5% interest

rate per year. How much will you have in five years?

FV: Future value

PV: Present value PV = $100

i: Interest per period i = 5%

n: Number of periods n = 5 years

FV = $100 x (1 + 5% x 5) = $125

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 Present Value in a Simple Interest World

FV Example: If you are going to receive $100 five years

PV =
from now, how much is that worth today, assuming
(1 + i X n)
5% annual interest?

PV: Present value FV = $100

FV: Future value i = 5%

i: Interest per period n = 5 years

n: Number of periods PV = $100 / (1 + 5% x 5) = $80

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 Compound Interest

Compound Interest Earned Each Period = Rate of Interest X (Principal + Previously earned interest)

Total
Example: Year Principal + Interest
Interest

Principal: $100 0 $0 $100 X 5% = $5

Interest Rate: 5% per annum 1 $5 $105 X 5% = $5.25

Total Periods: 5 years 2 $ 10.25 $ 110.25 X 5% = $5.51

3 $ 15.76 $ 115.76 X 5% = $5.79

4 $ 21.55 $ 121.55 X 5% = $6.08

5 $ 27.63 $ 127.63

Total

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 Simple Interest Versus Compound Interest

Example: Principal: $100

Interest Rate: 5% per annum

Compound vs Simple

1200
Compound Simple
1000

800

600

400

200

0
0 5 10 15 20 25 30 35 40 45 50
Years

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 Compound Interest Frequency

Annual Compounding Semi-annual Compounding

Total Total
Year Principal + Interest Year Principal + Interest
Interest Interest

0 $0 $100 0 $0 $100

0.5 $2.5 $102.5

1 $5 $105 1 $5.06 $105.06

1.5 $7.69 $107.69

2 $10.25 $110.25 2 $10.38 $110.38

2.5 $13.14 $113.14

3 $15.76 $ 115.76 3 $15.97 $115.97

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 Nominal Rate and Effective Rate

Nominal Interest Effective Interest

Stated interest rate How much interest would be

without compounding earned if the interest were
compounding

Formula for converting Nominal Rates (rnom), compounding at f times a year into an Effective Rate (reff) is:

rnom f
reff = (1 + ) −1
f

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 Math of Compounding

rnom f
reff = (1 + ) −1
f

Example: 5% Nominal Rate would equal:

Formula Effective Rate

Compounded annually (1 + 0.05 / 1)1 - 1 5%

Compounded semi-annually (1 + 0.05 / 2)2 - 1 5.06%

Compounded quarterly (1 + 0.05 / 4)4 - 1 5.09%

Compounded monthly ? ?

Compounded daily (1 + 0.05 / 365)365 - 1 5.13%

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 The Language of Compounding

01 Compounding period • 5% per year

Effective Rate
not given • 1% per month

02 Compounding period
given, nominal vs.
• 8% per year, compounded
semi-annually
Nominal Rate
effectove not stated

03 Interest rate stated as • Effective 5% per year

Effective Rate
effective rate compounded monthly

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 The Language of Compounding

Lending Deposit
Nominal Rate (Annual Percentage Rate) Effective Rate (Annual Percentage Yield)

Credit Card Term Deposit

• 18% per year, • Effective 3.5% per year,
compounded daily compounded semi-annually

Effective rate is higher than 18% Nominal rate is lower than 3.5%

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 Future Value with Compounding

n×f Example: If you invest $100 today with an 5%

i
FV = PV × 1+ nominal rate compounded semi-annually. How much
f
will you have in five years?

FV: Future value PV = 100

PV: Present value i = 5%
i: Nominal rate per year f=2
f: Frequency n=5
n: Number of years
5% 5 × 2
FV = 100 × 1+ = 128.01
2

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 Present Value with Compounding

FV −n × f Example: If you are going to receive $100 five years

i
PV = OR = FV × 1 + from now, how much is that worth today, assuming a
n×f f
i
1+ 5% nominal rate per year?
f

PV = 100
PV: Present value
i = 5%
FV: Future value
f=1
i: Nominal rate per year
n=5
f: Frequency

n: Number of years 5% −5 × 1
PV = 100 × 1 + = 78.35
1

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 Discount Factor

Discounting: Reducing future cash flows to their value currently.

Example: If you are going to receive $100 five years from now, how much does that worth today, assuming
a 5% annual interest?

FV −n × f
i
PV = OR = FV × 1 + 5% −5 × 1
n×f f PV = 100 × 1 + = 78.35
i 1
1+
f

Discounted Value: PV Discounted Value = 78.35

Discount Rate / Internal Rate of Return (IRR): i Discount Rate / IRR = 5%

−n × f
Discount Factor: 1+
i 5% −5 × 1
f Discount Factor = 1 + = 0.7835
1

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 Annuity

Example: If you are going to receive 5% annual

A series of equal payments interest for 5 years, what is the annuity factor?

Year Discount Factor

At equal time periods
1 0.9524 (1 + 5%)-1

2 0.9070 (1 + 5%)-2
For a fixed number of years
3 0.8638 (1 + 5%)-3

4 0.8227 (1 + 5%)-4
Annuity factor: The total of the discount
5 0.7835 (1 + 5%)-5
factors in each period.
Total 4.3295 Annuity Factor

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 Discounted Cash Flow (DCF) and Annuities

Discounted Cash Flow (DCF): Estimate the value of an investment based on expected future cash flows.

Example: A company invested in a plant that is

No. of Year Interest Rate / Year
expected to:
20 5%
Earning (FV): $1 million per year
Annuity Factor 12.4622
Expected life: 20 years

Discount rate: 5%

Look for the annuity factor in the attached PV of the Plant = $1,000,000 x 12.4622
Annuity Table and calculate the present value = $12,462,200
of the plant.

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 Net Present Value (NPV)

Net Present Value (NPV) is the value of all future cash flows over the entire life of an investment
discounted to the present.

Example Year 0 1 2 3

• Initial investment: $1,000

Cash Flow (FV) -1,000 400 400 400
• Annual cash flow: 400
Discount Factor 0.9524 0.9070 0.8638
• Discount rate: 5%
• Total period: 3 Years PV Year 1 380.95

PV Year 2 362.81

Discount Factor = (1 + 5%)-n PV Year 3 345.54

NPV 89.30 Positive NPV

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 NPV Decision Rule

Companies may look at the cost-benefit of a project by using the NPV decision rule.

Projects with a positive NPV add value

return enough cash to more than cover the PROCEED
cost of the project.

Projects with a negative NPV fail to return

REJECT
enough cash to cover the of the project.

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 Changing Rates of Interest

Where the rate of interest

5% 5% 5% 7% 7%
changes over time, compound
interest at the old rate up to the Year 1 Year 2 Year 3 Year 4 Year 5
date of the change and then use
the new rate. $5 $5.25 $5.51 $5.90 $6.31

100 x 5% 5 x (1+5%) 5.25 x (1+5%) 5.51 x (1+7%) 5.90 x (1+7%)

Example:

Principal: $100

Interest Rate:
• 5% per annum for the first 3 years
• 7% per annum for the last 2 years

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 Changing Rates of Interest

Where the rate of interest

5% 5% 5% 7% 7%
changes over time, compound
interest at the old rate up to the Year 1 Year 2 Year 3 Year 4 Year 5
date of the change and then use
the new rate. $5 $5.25 $5.51 $5.90 $6.31

$5 $5.25 $5.62 $6.01

Example:
100 x 5% 5 x (1+5%) 5.25 x (1+7%) 5.62 x (1+7%)
Principal: $100

Interest Rate:
• 5% per annum for the first 3 years
• 7% per annum for the last 2 years

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 Changing Rates of Interest

Where the rate of interest

5% 5% 5% 7% 7%
changes over time, compound
interest at the old rate up to the Year 1 Year 2 Year 3 Year 4 Year 5
date of the change and then use
the new rate. $5 $5.25 $5.51 $5.90 $6.31

$5 $5.25 $5.62 $6.01

Example:
$5 $5.35 $5.72
Principal: $100
$7 $7.49
Interest Rate:
• 5% per annum for the first 3 years $7
• 7% per annum for the last 2 years
Total Interest $32.54

Total $132.54

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