3/14/2020

Slide 2.1

Lecture 4
(17/3/2020)

Chapter 3
Mathematics of Finance
Contents
Section 3.3. Geometric series
Section 3.4. Investment appraisal

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012

Slide 1.2

Section 3.3.
Geometric series
Geometric progression, evaluating geometric series

and calculating:
the total investment from a regular savings plan,
the installment needed to repay a loan

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Slide 1.3

Geometric progression
Any sequence in which terms are calculated by multiplying
their predecessor by a fixed number is called a geometric
progression. The fixed number / the multiplicative factor is
called a geometric ratio.
Example page 230: a, ar , ar2, ar3, ….; 1000, -100, 10, -1, …

Geometric series
Example page 231: Evaluate a + ar + ar2 + ar3, ….;
1000, -100, 10, -1, …
𝑟 𝑛 −1
𝑎 + 𝑎𝑟 + 𝑎𝑟 2 + … . + 𝑎𝑟 𝑛−1 = 𝑎 , 𝑓𝑜𝑟 𝑟 ≠ 1.
𝑟−1

Applications: Savings and loan

(use the link http://dictionary.cambridge.org/dictionary/english
to find out the meaning and pronunciation of a new word)

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012

Slide 1.4

Savings: Discussion about sinking fund, page 232

Savings plan is to save equal amounts a of money and to put

these into a bank account at equal time periods. Suppose the
interest rate r (in %) is constant, then total savings after n
periods is:
𝒒𝒏 −𝟏
𝒂𝒒 + 𝒂𝒒𝟐 + … . + 𝒂𝒒𝒏 = 𝒂𝒒 𝒒−𝟏
if a is put in the beginning at each period,
𝑞 𝑛 −1
𝒂 + 𝒂𝒒 + 𝒂𝒒𝟐 + … . + 𝒂𝒒𝒏−𝟏 = 𝒂 𝑞−1
if a is put in the end at each period,
where q = (1+r) is the scale factor for a time period under
discrete compounding and q = er under continuous
compounding. Example and practice problem pages 233-234.
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Slide 1.5

Loan: Discussion about repayment of a loan, page 234

Repayment plan is to repay an original loan L by equal

installments a to the bank at equal time periods. Suppose
interest rate r (in %) is constant, then total repayment after n
periods is: 𝑅 = 𝑎 + 𝑎(1 + 𝑟) + 𝑎 1 + 𝑟 2 + … . + 𝑎(1 + 𝑟)𝑛−1 =
(1+𝑟)𝑛 −1
𝑎 (why?)
𝑟
𝑛
At the end of nth period, initial debt L becomes 𝐿 1 + 𝑟 (?)
𝑛 (1+𝑟)𝑛 −1
The debt at the end of nth period is: 𝐿 1 + 𝑟 -𝑎 .
𝑟
Then a can be determined provided the loan is repaid totally
𝑳 𝟏+𝒓 𝒏
after n periods: 𝒂= (𝟏+𝒓)𝒏 −𝟏
𝒓

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012

Slide 1.6

Loan: Example and practice problem pages 235 -236

L= $100000, r = 8%, n = 25
𝑳 𝟏+𝒓 𝒏 𝟏𝟎𝟎 𝟎𝟎𝟎 𝟏+𝟎.𝟎𝟖 𝟐𝟓 684 874.5204
𝒂 == (𝟏+𝒓)𝒏 −𝟏 = 𝟏.𝟎𝟖𝟐𝟓 −𝟏
= 73.106 = $9367.89
𝒓 𝟎.𝟎𝟖
a = 12x implies x = 9367.888/12 = $780.66

Table 3.19 End of year Outstanding debt

page 236 1 98632.08
2 97154.73
3 95559.18
5 91975.20
10 80184.14
20 37403.21
25 0

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Slide 1.7

Other applications: Examples and practice problem pages

237 -238

Key terms: page 238

Exercise 3.3*: problems 2, 4, 5, 8, pages 239 - 240

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012

Slide 1.8

Section 3.4.
Investment appraisal
Calculating present values under d.c & c.c, appraising investment
projects, calculating internal rate of return

and
calculating present value of an annuity, comparing
investment projects using discounting, calculating
present value of government securities (bonds)

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Slide 1.9

Calculating the present value of a future value under

discrete compounding & continuous compounding

P = principal or present value, S = future value at the end of

tth period, r% = interest rate, t = time or number of time
periods.
Determining P is the discounting process:
𝑟 𝑡 𝑟 −𝑡
𝑆 = 𝑃 1 + 100 ⟹ 𝑃 = 𝑆 1 + 100 for discrete compounding,
𝑆 = 𝑃𝑒 𝑟𝑡/100 ⟹ 𝑃 = 𝑆𝑒 −𝑟𝑡/100 for continuous compounding.

Example and practice problem page 242.

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012

Slide 1.10

Appraising investment projects using net present values

Discussion on the net present value (NPV), page 242

NPV= Present value of the return – Present value of the cost.
NPV > 0 means the project is profitable.

Discussion on the internal rate of return (IRR), page 243

IRR= Annual rate giving the same return (to the same initial
outlay and after the same number of years)
“IRR > The market rate “ means the project is profitable.

Using NPV and IRR for appraising an investment project

Example and practice problem pages 243-244.

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Slide 1.11

Calculating the present value of an annuity

Annuity = Sequence of regular equal payments (see page 246)
Regularity means payments are made at the same time of time
periods (i.e., at the end or at the beginning of time periods…)

Present value of annuity (payments are made at the end of time

periods) is
−𝑛
𝑟 −1 𝑟 −2 𝑟
𝑆 1+ +𝑆 1+ + ⋯+ 𝑆 1+
100 100 100
𝑟 −𝑛
𝑟 −1 1 + − 1
= 𝑆 1+ 100
100 𝑟 −1
1+ −1
100
Cash flow: Example and practice problem pages 246 - 247.

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012

Slide 1.12

t present value
1 9345.794393
Cash flow: Example and 2 8734.387283
practice problem 3 8162.978769
pages 246-247. 4 7628.952120
5 7129.861795
S = 10000 6 6663.422238
r% = 7% 7 6227.497419
8 5820.091046
9 5439.337426
10 5083.492921
Present value
of annuity 70235.81541

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Slide 1.13

Revenue flow: Example and practice problem pages 248-249

Initial outlay = $20 000, r (%) = 11%.
Revenue Discounted revenue
t Project A Project B Project A Project B
1 6000 10000 5405.405 9009.009
2 3000 6000 2434.867 4869.734
3 10000 9000 7311.913 6580.722
4 8000 1000 5269.847 658.730
Total 27000 26000 20422.034 21118.19

NPV of Project A = $422.034 < NPV of Project B = $1118.19

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012

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Computing IRR of an investment project

Example and practice problem pages 249-250
a. Initial outlay = $20000, returns: $8000 and $15000 at the end
of 1st year and 2nd year.
−1 −2
𝑟 𝑟
20000 = 8000 1 + + 15000 1 +
100 100
or 2𝑟 2 + 320𝑟 − 3000 = 0 ⇒ 𝑟 = 𝟖. 𝟗 % 𝑜𝑟 − 168.9 (%)
b. Initial outlay = $5000, returns: $1000, $2000 and $3000 at the
end of 1st year, 2nd year and 3rd year.
−3
𝑟 −1 𝑟 −2 𝑟
5000 = 1000 1 + +2000 1 + + 3000 1 +
100 100 100
Use the trial and error method:
r% 5% 6% 7% 8% 9% 10%
value 5358 5242 5130 5022 4917 4816
IRR  8%.
For a more accurate, try values between 8% and 9%.
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Calculating present values of government bonds

Discussion on government bonds: page 251
Example and practice problem pages 252-253
10-year bond is originally offered at $5000 with annual return of
9%. Assuming that the bond has 4 years before redemption.
Calculate its present value provided the prevailing interest rate
is: 5%, 7%, 9%, 11% and 13%.
Present value
End of
year Cash flow 5% 7% 9% 11% 13%
1 450 429 421 413 405 398
2 450 408 393 379 365 352
3 450 389 367 347 329 312
4 5450 4484 4158 3861 3590 3343
Total present value 5709 5339 5000 4690 4405

Discussion on the speculative demand and the interest rate, page 252.

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012

Slide 1.16

Key terms: page 253

Exercise 3.4*: problems 2, 4, 6, 8, 10 pages 255 - 256

Formal mathematics: pages 257 - 258

Jacques, Mathematics for Economics and Business, 7th edition © Pearson Education Limited 2012