ACFI2070 Module 1:

Financial mathematics
READINGS: CHAPTER 3, PEIRSON ET AL. 2015

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Module 1
Part 1: Time Value of money
Part 2: Conversion of different interest rates
Part 3: Annuities and their financial applications

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Part 1: The time value of money
Learning objectives
1. Understand the concept of time value of money
2. Distinguish simple interest and compound interest
3. Use simple interest to find the present value, accumulated
value, time period of investment and rate of return
4. Use compound interest to find the present value,
accumulated value, time period of investment and rate of
return

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 Time Value of Money
Which would you rather receive?

IOU $20
OR in one year Most important
concept in financial
asset evaluation

Why? Time Value of Money

Inflation
Opportunity Cost “Money today is worth
more than money in
Uncertainty
the future.”
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 Time Value of Money
Inflation
Represents a decline of the purchasing power of money, i.e. the amount of money required to
purchase the same goods and services increases as time goes.
Opportunity Cost
The highest price or rate of return (or benefit) that would be provided by an alternative course of
action.
The opportunity cost of giving up money for a period of time can be either forgone investment or
consumption. Eg, money received now can be invested to earn additional cash in the future.
Uncertainty
The absence of certainty; a lack of predictability.
Implication of the time value of money is that we can not validly add or compare cash
flows that occur on different dates.

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Time Value of Money
Present Value
Amount that corresponds to today’s value of a promised
future sum.

Future Value
Amount which a present sum will accumulate to at a future
date through the operation of interest.

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 PVs and FVs do not simply trade dollar for dollar.
The rate at which a PV should transform into a FV,
or vice versa, depends upon the time value of
money (usually expressed as r or i ).

FV
$
D

PV

Time
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Time Value of Money
§ In the current market, the rate of return on deposits
(a risk-free asset) is approximately 7% p.a

t=0 t=1 yr

$20 $21.40
Invest @ 7% = 20 x 1.07 = $20 (principal) + $1.40
(investment return)
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Simple Interest
During the entire term of the loan, interest is calculated on the original sum
invested.
Typically used only for a single time period.
If the transaction remains outstanding for more than one time period (i.e. multi-
period), $ interest remains constant each period.

Examples where simple interest is used:

Treasury notes, bills of exchange, promissory notes, various financial institution
deposits.
Typically short-term (money market) securities.
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Simple Interest Formulae
Generally for (t) time periods @ rate (r) per period:

FV = PV ( 1 + r*t ) Future Value

PV = FV / ( 1 + r*t ) Present Value

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Simple Interest Example
Two parents invested $1000 into a bank account for their
child when she was born. The bank account paid simple
interest of 6% p.a. The child is able to access the account on
her 21st birthday. What will be the future (accumulated)
value of this investment in 21 years?
P=$1000, r=6%, t=21
S = P ( 1 + r*t )
= 1,000 (1 + 0.06 * 21)
= $2,260
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Simple Interest Example
David purchases an investment of $1000 that pays $1300 in 3
yrs. What is the rate of return p.a., expressed using simple
interest language?
Aggregate INTEREST = S – P = 300
Given S = P ( 1 + r x t )
=P+( P x r x t)
S–P = P x r x t
So aggregate interest component
P x r x t = 300
i.e. 1000 x r x 3 = 300
r = 300 / 3000 = 10%= 0.10 i.e. 10 % p.a.

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Compound Interest
Compounding involves accumulating interest on previous interest payments, which
will generate further interest (interest is earned on the original investment AND
interest already earned, i.e. ‘interest on interest’).
Consequently, if the transaction remains outstanding for more than one time period
(i.e. multi-period), the $ interest charged will vary per period (unlike simple
interest).
Examples where compound interest used:
Compound interest convention is generally used with longer term situations e.g.
government and company bonds, debentures, shares.
Typically long-term (capital market) securities.

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Compound Interest
Generally for (n) time periods @ rate (i) per
period:
FV = PV ( 1 + i )n Future Value

PV = FV / ( 1 + i )n Present Value

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Compound interest example
If Pam invested $5,000 today for 2 years at a compound interest rate of 8%
per annum, what would the accumulated value be at the end of 2 years in
Pam’s account?
SOLUTION:
FV = PV ( 1 + i)n
PV = 5,000 i = 0.08 n = 2
FV = 5,000 ( 1 + 0.08) 2
FV = 5,832
Note: if a simple interest is earned instead,
FV = PV (1+ r x t) = 5000 (1+ 0.08 x 2) = 5,800

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 year Balance $ interest
0 5,000 0
1 5,000+8%*5,000 $400
=5,000*(1+8%)
=5,400
2 5,400*(1+8%) $432
=[5,000*(1+8%)]*(1+8%)
=5,000*[(1+8%)^2]
=5,832

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Simple vs. Compound Interest
Simple Compound Interest
Interest

Present Value P = S / (1 + r t) P = S / ( 1 + i )n

Future Value S = P(1 + r t) S = P ( 1 + i )n

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Simple vs. Compound Total Interest
Earned
30

25

20

15 Simple
Compound

10

0
Year 1 Year 2 Year 3 Year 4 Year 5

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Exercise 1: Compound interest
1. If you want to save up $5,832 in your account at the end of 2 years, and the
compound interest rate is 8% per annum, how much should you deposit
today?

2. If Jane deposits $10,000 into a bank account, and after 5 years the balance
accumulated in her account is $12,500, what rate of compound interest per
annum did Jane earn?

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 Part 2: Conversion of different interest
rates
Learning objectives
1. Use a nominal interest rate to determine the effective
interest rate
2. Understand and be able to calculate a real interest rate

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Nominal and effective interest rates
Nominal rate:
◦ Quoted interest rate where interest is charged or calculated more frequently
than the time period specified in the interest rate.
◦ For example: quoted interest rate is 12% per annum (but interest is
compounded monthly not annually)

Effective rate:
◦ Interest rate where interest is charged at the same frequency as the interest
rate quoted.
◦ Used to convert different nominal rates so that they are comparable.

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Nominal and effective interest rates
Loan of $100, with stated interest rate j = 12 % p.a.
Scenario 1: If interest compounds annually:
àEffective rate = nominal rate = 12%
àEnd of year 1: FV=$112 =$100 (1+12%)

Scenario 2: If the stated rate p.a. is ‘compounded quarterly’

àEffective rate = 12.55% (use the effective rate formula with m =4)
àEnd of year 1: FV=$112.55 (use the FV formula with compounding interest)

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Solution (quarterly compounded)
Quarter Balance Interest rate $ interest

1 100 0.03 $3
2 103 0.03 $3.09
3 106.09 0.03 $3.183
4 109.273 0.03 $3.278

Total interest earned = $12.551

Total investment = $100
Actual yearly rate of interest = 12.551/100 = 12.551%

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 Nominal and effective interest rates
The distinction is important when interest is compounded over a
period different from that expressed by the interest rate, e.g. more
than once a year.
The effective interest rate can be calculated as:
m
æ jö
i = ç1 + ÷ - 1
‘annualise periodic
è mø
interest rate’ where:
- i is the yearly
j = nominal rate per period
equivalent of j
m = number of compounding periods
which occur during a single nominal period
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 Example: effective annual interest rate
Calculate the effective annual interest rates corresponding to 12% p.a.,
compounding:

(a) semi-annually (2 times per year):

i = (1 + 0.12/2)2 – 1 = (1.06)2 – 1 = 0.1236
i = 12.36% p.a m
æ jö
(b) quarterly (4 times per year)
i = ç1 + ÷ - 1
è mø
i = (1 + 0.12/4)4 – 1 = (1.03)4 – 1 = 0.12550881
i = 12.55% p.a

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 Example: effective annual interest
rate
(c) Monthly (12 times per year)
i = (1 + 0.12/12)12 – 1 = (1.01)12 – 1 = 0.12682503
i = 12.68%
(d) Weekly (52 times per year) m
æ jö
i = (1 + 0.12/52)52 – 1 = 0.127340986 i = ç1 + ÷ - 1
i = 12.73% è mø
(e) Daily (365 times per year)
i = (1 + 0.12/365)365 – 1 = 0.127474614
i = 12.75%

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 Effective Interest Rate with Continuous
Compounding
What happens as the frequency of the compounding periods
approaches infinity?
In this case, it said to be continuously compounding and the
effective interest rate is:
i = ej - 1

Previous example, 12% p.a. continuous compounding (j =0.12):

i= ej - 1 = e0.12 - 1 = 12.7496852% p.a.

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 Exercise 2: Effective interest rate
a) If the nominal interest rate is 14% p.a. compounded quarterly, calculate the
effective quarterly rate?
b) If the nominal interest rate is 14% p.a. compounded quarterly, calculate the
effective annual rate?
c) If the nominal interest rate is 14% p.a. compounded quarterly, calculate the
effective monthly rate?

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 Exercise 3: Effective interest rate
Find the present value of an ordinary annuity of $5000 p.a. for 4 years if the interest
rate is 8% p.a. compounded monthly.

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Nominal and real interest rates
The real interest rate is the interest rate after taking out the effects of
inflation.
The nominal interest rate is the interest rate before taking out the effects
of inflation.
The real interest rate (i*) can be found by:

æ 1+ i ö
i* = ç ÷ -1 where:
è 1+ p ø i* = real interest rate
i = nominal interest rate
p = expected inflation rate

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 Exercise 4: Real interest rate
Laura is an investment adviser and believes a single $10,000 investment will
accumulate to a lump-sum of $25,937 after 10 years. What is the nominal
compounded rate of return p.a.? What is the likely real rate of return if inflation is
expected to be 4% p.a.?

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Part 3: Annuities and their financial
applications
Learning objectives
1. Distinguish between the different types of annuities
2. Solve problems to calculate the present value and future value of
annuities
3. Solve problems to find the size of the regular cash flow (C) and the
number of payments required for an annuity (n)
4. Apply your knowledge of annuities to solve problems regarding
principal and interest loan contracts

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 Valuation of contracts with
multiple cash flows
Value additivity principle
◦ Cash flows occurring at different times cannot be validly added
without accounting for timing.
◦ Only cash flows occurring at the same time can be added.
◦ Therefore, it is necessary to convert multiple cash flows into a
single equivalent cash flow (same point in time).
◦ Cash flows can be carried either forward in time (accumulated) or
back in time (discounted).

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Valuation of contracts with
multiple cash flows - example
Example 1: Your required rate of return is 10% p.a., and you are promised the
following cash flows at the end of following time periods:
Year 1: $200
Year 2: $600
Year 3: $50
Year 4: $1000
What is this stream of cash flows currently worth to you?

Calculate the PV of multiple cash flows.

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Valuation of contracts with
multiple cash flows
Once cash flows are all taken to the same point in time they can be
validly added together.
All cash flows are discounted back to present time (time 0)
PV = $200/(1.1) + $600/(1.12) + $50/(1.13) + $1000/(1.14)
= $1398.27
è Answer = $1398.27

Time 0 1 2 3 4

$600 $600 $50 $1000

PV=?

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Valuation of contracts with
multiple cash flows
Example 2: Your required rate of return is 10% p.a., and you are
promised $200 at the end of year for the next four years. What is it
currently worth to you?
PV = $200/(1.1) + $200/(1.12) + $200/(1.13) + $200/(1.14)
= $633.97
Is there a quicker way to do this?
Time 0 1 2 3 4

PV=? $200 $200 $200 $200

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 Annuities
An annuity is a stream of equal cash flows, equally spaced in time (cash flows
might be yearly, monthly, quarterly, weekly, etc).

We will look at calculating both the present value and the future
value/accumulated value of these streams of cash flows.

Time 1 2 3 ... n

Flow $C $C $C ... $C

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 Annuities
We consider four types of annuities:

◦ Ordinary annuity (‘in arrears’) - the cash flows occur at the end of each time period.

◦ Annuity due (‘in advance’) - the cash flows occur at the beginning of each time
period.

◦ Deferred annuity – an annuity where the payments are delayed and begin sometime
in the future.

◦ Ordinary perpetuity - an annuity where the payments last forever, an infinite series
of cash flows.

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 Ordinary annuities
Annuities in which the time period from the date of valuation
to the date of the first cash flow is equal to the time period
between each subsequent cash flow.
i.e. the first cash flow occurs at the end of the first time
period:

Time 0 1 2 3 ... n

Flow $C $C $C ... $C

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 Valuing ordinary annuities
Present value (PV) of an ordinary annuity:

Cé 1 ù
P= ê1 - ú = C ´ A ( n, i )
( )
n
i ê 1 + i úû
ë
where:
C = annuity cash flow
i = interest rate per compound period
n = number of annuity cash flows
Using the present value of annuity tables (textbook), values of A(n,i) for different
values of (n) and (i) can be found.

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 Example: ordinary annuities
Find the present value of an ordinary annuity of $5000 p.a. for 4 years
if the interest rate is 8% p.a.
è Can either discounting (finding present value) of each individual
cash flow and adding them together, or simply use the annuity
formula.
C é 1 ù
P= ê1 - ú = C ´ A ( n, i )
(1 + i )
n
i êë úû
where C=$5,000 i=0.08 n=4
è Solution: PV=16,560.63

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 Annuity due
Where the first cash flow is to occur immediately:
Time 0 1 2 3 ... n-1

Flow $C $C $C $C ... $C

An annuity due of (n) cash flows is simply an ordinary

annuity of (n – 1) cash flows, plus an immediate cash
flow of C.

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Annuity due - Alternative view
Ordinary Annuity ...

Time 0 1 2 ... n-1 n

Flow $0 $C1 $C2 . . . $Cn-1 $Cn

Annuity Due’s flows occur one period earlier each time...

Time 0 1 2 ... n-2 n-1 n

Flow $C1 $C2 . . . $Cn-1 $Cn

 Annuity due
The present value of an annuity due:
àAn annuity-due of n cash flows is simply an immediate cash flow plus
an ordinary annuity of (n – 1) cash flows.
𝐶 1
P = ×[1 − !"#
]+𝐶
𝑖 1+𝑖
OR
àAn annuity-due of n cash flows is simply an ordinary annuity of (n)
cash flows occurring one period earlier each time.
$ #
P = % × [1 − #&% !] × 1 + 𝑖

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Deferred annuity
Annuity which starts some time beyond the present period (there is a delay before
the first cash flow):
0 1 2 3 4 5 6 7 8
$C $C $C $C $C $C
Present value of a deferred annuity which has (n) cash flows but starts (k) periods
later
𝐶 1 1
P = ×[1 − ! ]×
𝑖 1+𝑖 (1 + 𝑖)"#$
Where C = cash flow per period,
n = number of cash flows,
i = interest rate per period,
k = number of periods until the first cash flow

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 Deferred annuity
Time 0 1 2 ... k-1 k ... n+k

Flow $C . . . $C
P𝑉(0) =? P𝑉 (k-1)
The PV is found in 2 steps:
First, find ‘PV’ of annuity component, using ordinary annuity formula. Note that
relative to time (0), this ‘PV’ is a FV, sitting at future time k-1 (NOT time k).
Second, discount this ‘PV’ back to time (0) (discounting for k-1 periods) to arrive at
the PV at time (0):
𝐶 1 1
P = ×[1 − ! ]×
𝑖 1+𝑖 (1 + 𝑖)"#$

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Deferred annuity

47
Key takeaway
All annuity formula (except for perpetuity) are based on the same formula:

Cé 1 ù
P= ê1 - ú = C ´ A ( n, i )
(1 + i )
n
i ê úû
ë
è you only need to know 1 formula
è an annuity due is an ordinary annuity accumulated by 1 period
è a deferred annuity is an ordinary annuity discounted by (k-1) periods
è draw a timeline

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 Perpetuity
An ordinary perpetuity is simply an ordinary annuity where the cash flows are to continue
forever.
i.e. where the number of cash flows (n) is infinite

0 1 2 3 4 5… ∞
®
$C $C $C $C $C... $C
The present value of an ordinary perpetuity:

P¥ = C/i
where:
Note: The present value of a perpetuity due C = cash flow per period
i = interest rate per period

P¥ = C/i +C

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 What about future values of annuities ?

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 Future value of ordinary
annuities
• Future value of an ordinary annuity: we can determine the
future value (accumulated value) of the stream of equal
payments using the following formula:

S=
C
i
[
(1 + i ) - 1
n
]
where:
C = annuity cash flow
i = interest rate per compound period
n = number of annuity cash flows

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 FV of an ordinary annuity
Example: $1,000 is deposited at the end of each month for the next 3 months
and the interest rate is 6% p.a., compounded monthly.
What is the accumulated future value by the end of month 3?

Answer:
!
𝑆= (1 + 𝑖)# −1
"
$%%%
𝑆= (1.005)( −1 = $3,015.03
%.%%'

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52
 Future value of annuity due
Where the first cash flow is to occur immediately:

Time 0 1 2 3 . . . n-1 n

Flow $C $C $C $C ... $C

The accumulated value is the accumulated value of an

ordinary annuity with interest added for the last time
period:

S =
C
i
[
(1 + i ) - 1 ´ (1 + i )
n
]
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 FV of an annuity due
Example : $1,000 is deposited at the beginning of each of next
3 months and the interest rate is 6% p.a., compounded monthly. What is the
accumulated future value by the end of month 3?

Answer:

S =
C
i
[
(1 + i ) - 1 ´ (1 + i )
n
]
1000
𝑆= (1.005)( −1 ×(1.005) = $3,030.10
0.005

54
Application of annuities – Bank loans
Mortgages
◦Makes equal monthly payments (assuming fixed interest
rates)
◦Each payment includes an interest payment and a
principal payment
◦Have a fixed maturity

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 Principal-and-interest loans
An important application of annuities is to evaluate loans involving
a sequence of equal cash flows, each of which is sufficient to cover
the interest accrued since the previous payment and to reduce the
current balance owing.

Such loans can be referred to as:

◦ principal-and-interest loans
◦ credit loans
◦ amortised loans.

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 Principal-and-interest loans
§Principal and Constant Payments
Principal equals to the present value of future constant payments
Cé 1 ù
P = ê1 - ú
(1 + i ) úû
n
i ê
ë
where P = Principal (initial balance)
C = constant payment (monthly, yearly etc)
n = number of payments made, given the term of the loan
i = interest rate charged on the loan (monthly, yearly etc)
P´i
C=
Hence, you also have æ 1 ö
ç1 - ÷
ç (1 + i ) ÷ø
n
è
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 Principal-and-interest loan example
Borrow $100 000.
Make 5 years of annual repayments at a fixed interest rate of
11.5% p.a.
What is the annual repayment?
Solution: P´i
C=
Applying the formula on the right-hand side: æ 1 ö
ç1 - ÷
ç (1 + i ) n ÷
C= $27,398.18 è ø

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 Principal-and-interest loans
§Balance owing at a given date:
◦ Suppose you want to refinance the loan and therefore need
to find out how much you still owe the current bank
◦ equals the present value of the remaining or future
repayments.

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Balance at a given date
Example: Consider the $100,000 loan repaid over 5 years @
11.5%p.a. from the previous example. What is the balance owing
after 3 years?

The balance after 3 years is the present value of the 2 years of remaining
payments. Use the formula for PV of ordinary annuity.
P = C/i x [ 1 – 1/(1+i)n]
Given C = 27,398.18, i = 0.115, n = 2 (2 future repayments)
P = 27398.18 / 0.115 [ 1 - 1 / 1.115 2 ]
= $46,610.34

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 Principal-and-interest loans
§Loan term:
◦ can be calculated by solving for (n) in PV of annuity
formula:
ln[C (C - Pi )]
n=
ln (1 + i )

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Solving for n
Start with the present value of Since ln 𝑥 # = 𝑛 ln 𝑥,
é ù
annuity formula: P = C ê1 - 1
ú 𝐶
(1 + i ) úû
n
i ê
ë n×ln(1 + 𝑖) = ln
𝐶 − 𝑃×𝑖

1 𝑃×𝑖
=1−
(1 + 𝑖)! 𝐶
Therefore,

𝐶
(1 + 𝑖)! = 𝐶
𝐶 − 𝑃×𝑖 ln
𝑛 = 𝐶 − 𝑃×𝑖
Take natural log on both sides: ln(1 + 𝑖)

𝐶
ln(1 + 𝑖)! = ln
𝐶 − 𝑃×𝑖

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 Principal-and-interest loans
§Changing the interest rate:
◦ In some loans (usually called variable interest rate loans), the interest rate can be
changed at any time by the lender.

ØTwo alternative adjustments can be made:

◦ The lender may set a new required payment (new C, same n if interest rate
changes), which will be calculated as if the new interest rate is fixed for the
remaining loan term.
◦ The lender may allow the borrower to continue making
the same repayment and, instead, alter the loan term
to reflect the new interest rate (same C, new n if the interest rate changes).

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Recap on annuities
Applying annuity calculation
1. When comparing mortgage/ term loans from different banks
2. When considering refinancing current mortgage/ term loan
3. When considering making additional mortgage payment

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