Topic Two: Financial Mathematics I

FINC2011
Readings BMA Chapter 2.1-2.3
 Learning Objectives

◮ Draw a timeline illustrating a given set of cash flows.

◮ Evaluate and apply the concept of the time value of money
◮ Understand and apply the concepts of present and future values
◮ Calculate the present value or future value of the following:
◮ A single sum
◮ An uneven stream of cash flows, starting either now or sometime in the future
◮ An annuity, starting either now or sometime in the future
◮ PV of an infinite stream of cash flows that grow at a constant/growing rate each period
◮ Several cash flows occur at regular intervals, which grow at a constant rate each period

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 The aim of financial mathematics

◮ The aim of financial mathematics is to convert single or multiple cash flows that will be
received at different points in time to one number.

◮ This number represents the value of all cash flows from an asset or liability at a given point
in time.

◮ This is typically used to:

◮ Make a rational choice between different options

◮ Determine the maximum amount an investor is willing to pay or forego for an asset - the intrinsic
value of the asset

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 Draw a timeline

◮ A timeline is a linear representation of the timing of potential cash flows.

◮ Assume that you made a loan to a friend. You will be repaid in two payments, one at the
end of each year over the next two years.
◮ Inflows are positive cash flows (+)

◮ Outflows are negative cash flows (-)

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 Draw a timeline - Example

◮ Assume that you are investing $10,000 today and that the project will pay you in two annual
$6,000 payments.

◮ The first cash flow at date 0 (today) is represented as a negative-sum because it is an

outflow.
◮ Timelines can represent cash flows that take place at the end of any time period - a month,
a week, a day, etc.

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 The Three Rules of Time Travel

Financial decisions often require combining cash flows or comparing values. Three rules
govern these processes.

The Three Rules of Time Travel

Rule1 Only values at the same point in

time can be compared or com-
bined
Rule2 To move a cash flow forward in
time, you must compound it.
Rule3 To move a cash flow backward
in time, you must discount it.
Future value of a Cash flow
FVn = C × (1 + r )n
Present value of a Cash flow
PV0 = C ÷ (1 + r )n = (1+r
C
)n

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 Rule 1: Comparing and Combining Values

◮ A dollar today and a dollar in one year are not equivalent.

◮ It is only possible to compare or combine values at the same point in time.

◮ To evaluate a stream of cash flows, we need to bring each cash flow to the same point in
time.

◮ Future value (FV) measures the value of cash flows at the end of a specified period (usually
in the future).

◮ Present value (PV) measures the value of future cash flows at the beginning of a specified
period.

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 Rule 2: Moving Cash Flows Forward in Time

◮ To move a cash flow forward in time, you must compound it.

◮ Compounding is the process of earning interest over time
◮ This is to measure the Future Value of a Single Cash Flow

FVn = PV0 × (1 + r )n

Time 0 1 2 3 4 N

Cash Flow CF0 FVn ?

This is also the PV0

FVn = value of investment at the end of period n

PV0 = original principle or present value
CF = cash flow
r = the rate of interest per period
n = the number of periods
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 FV of a Single Cash Flow

Problem
Suppose you invest $1, 000 in an account paying 10% interest per year. How much will
you have in the account in seven years? In 20 years? In 75 years?

Solution

7 years: $1000 × (1.10)7 = $1948.72

20 years: $1000 × (1.10)20 = $6727.50
75 years: $1000 × (1.10)75 = $1, 271, 895.37

Note that at 10% interest, your money will nearly double in 7 years. After 20 years, it will
increase almost sevenfold. This is the power of compounding.

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 Rule 3: Moving Cash Flows Back in Time

◮ To move a cash flow backward in time, we must discount it.

◮ The process of converting a future cash flows to a PV is called discounting, and the interest
rate r is also known as the discount rate.
◮ This is to measure the Present Value of a Single Cash Flow

FVn
PV0 =
(1 + r )n

Time 0 1 2 3 4 N

Cash Flow PV0 ? FVn

◮ The further in the future a dollar will be received (higher n ), the less it is worth today. The
higher the discount rate (higher r ), the lower the present value.
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 PV of a Single Cash Flow

Problem
Suppose you are offered an investment that pays $10, 000 in five years. If you expect to
earn a 10% return, what is the value of this investment today?

Solution

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 Valuing a Stream of Cash Flows

◮ What if we have a stream of cash flows? Realistically, we are likely to have multiple cash
flows in most situations (e.g. a project that lasts for years)
◮ To deal with this, we can apply the single cash flow formulas to each point of the time.
◮ And remember, according to Rule 1, we want all cash flows to be taken to the same point
in time.

E.g. Present Value of a Cash Flow Stream

N
󰁛 N
󰁛 CFn
PV = PV (CFn ) =
(1 + r )n
n=0 n=0
CF0 CF1 CF2 CFN
PV = + + + ··· +
(1 + r )0 (1 + r )1 (1 + r )2 (1 + r )N

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 Present Value of a Stream of Cash Flows

Problem
You have just graduated and need money to buy a new car. Your rich uncle Henry will lend you the
money if you agree to pay it back within four years. Based on your earnings and living expenses, you
think you will be able to pay him $5000 in one year, and then $8000 each year for the next three
years. How much can you borrow from him if uncle Henry would otherwise earn 6% per year on his
savings?

Solution

5000 8000 8000 8000

PV0 = + + +
(1 + 0.06)1 (1 + 0.06)2 (1 + 0.06)3 (1 + 0.06)4
= 4716.98 + 7119.97 + 6716.95 + 6336.75
The University of Sydney = 24, 890.65 12 / 38
 Future Value of a Stream of Cash Flows

Problem
Let’s say that if your uncle kept his $24, 890.65 in the bank today earning 6% interest, in four years,
he would have

FVn = PV0 × (1 + r )n ⇒ FV4 = $24, 890.65 × (1.06)4 = $31, 423.87 in four years

Suppose that Uncle Henry gives you the money and then deposits your payments to him in the bank
each year. How much will he have four years from now?

Solution
FV4 =5000 × (1 + 6%)3
+8000 × (1 + 6%)2
+8000 × (1 + 6%)1
+8000
=31, 423.88
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 Level cash flows: annuities and perpetuities

◮ Many situations exist where businesses and individuals would either receive or pay con-
stant amounts for a length of time, examples:
◮ A company must make a stream of constant payments on a bank loan for a period of time

◮ Individual investors may make constant payments on a home or car loans or invest a fixed
amount year after year saving for retirement

◮ If CF1 = CF2 = · · · = CFN , is there an easier way to do the calculation?

0 1 2 3 4 N

? CF1 CF2 CF3 CF4 CFN

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 Annuities Features

If there is a series of cash flows that satisfy the following conditions, we have an annuity
pattern:
1. Finite life / Finite number of periods
2. Regular payment intervals / Payments are equally spaced
3. Constant dollar value of payment / Level cash flows

Rather than calculating the present value of each cash flow individually, we can calculate
the PV in one step using the annuity formula.
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 PV of Annuities
0 1 2 3 N −1 N

? C C C C C

C C C C
PV = + + + ··· +
(1 + r ) (1 + r )2 (1 + r )3 (1 + r )N
󰁫 󰁬
C 1 1 1 1
= × 1+ + + + · · · +
1+r (1 + r )1 (1 + r )2 (1 + r )3 (1 + r )N−1
󰀥 1
󰀦
C 1− (1+r )N 1 (1 + aN )
= 1
Let a = , then by geometric series 1 + a + a2 + · · · + aN−1 =
(1 + r ) 1 − (1+r (1 + r ) (1 − a)
)

◮ Simplify the equation to find the Annuity Formula:

󰀗 󰀘 󰁫 󰁬
1 − (1 + r )−N 1 1
PV = C × or C × 1−
r r (1 + r )N

◮ Note, the formula will give the PV one period before the first payment

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 PV of Annuities - Example 1

Problem
What is the present value of $9000 paid at the end of each of the next 88 years if the
interest rate is 10% per year? (Draw a timeline first).

Solution
󰀗 󰀘
1 − (1 + r )−N
PV0 = C ×
r

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 PV of Annuities - Example 2

Problem
You are the lucky winner of the $30 million state lottery. You can take your prize money
either as (a) 30 payments of $1 million per year (starting today), or (b) $15 million paid
today. If the interest rate is 8%, which option should you take?

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 PV of Annuities - Example 2

Solution
Step 1: Identify an Annuity Pattern:
󰀗 󰀘
1 − 1.08−29
PV ( 29 yrs annuity of $1 million per year) = 1m × = 11.16m
0.08

Step 2: Include the first cash flow at time 0.

PV (30yrs) = 11.16m + 1m = 12.16m

Therefore, choose option (b) as 15m > 12.16m today

Note: If cash flows are an annuity in which the first payment begins immediately, some-
times called an annuity due.

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 Ordinary Annuity vs. Annuity Due

◮ ordinary annuities - cash flows occur at the end of each period

◮ annuity due - cash flows occur at the beginning of each period

◮ Examples for an annuity due:

◮ rent or lease payments are typically made at the beginning of each period rather than at end
◮ A stream of prepayments of the work
◮ For calculation: we can always value an annuity due as an ordinary annuity plus a one-off
payment at t = 0

󰀗 󰀘
1 − (1 + r )−N
PV0 = C + C0
r

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 FV of Annuities

◮ Future value annuity calculations involve finding what a savings or investment activity is
worth at some future point

◮ e.g., saving periodically for a holiday, car, house, or retirement

◮ We can derive the future value annuity equation from the present value annuity equation

󰀗 󰀘
(1 + r )N − 1 1󰁫 󰁬
FVN =C × or C× (1 + r )N − 1
r r

Note: the FV formula will give the value at the time of the last payment, i.e. there is a cash
flow at time N. But there is no cash flow at time 0.

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 FV of Annuities - Example

Problem
Ellen is 35 years old, and she has decided it is time to plan seriously for her retirement. At
the end of each year, until she is 65, she will save $10, 000 in a retirement account. If the
account earns 10% per year, how much will Ellen have saved at age 65?
In this case, it is helpful to keep track of both the dates and Ellen’s age:

Solution
󰀗 󰀘
(1 + r )N − 1
FV (Age 65) = C ×
r

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 Perpetuities

0 1 2 3 4

? CF1 CF2 CF3 CF4

◮ A perpetuity is the constant stream of cash flows that goes on for an infinite period (forever)
◮ The equation for the present value of perpetuity can be derived from the present value of
an annuity equation with n tending to infinity:
󰀗 󰀘
1 1
PV = C × 1−
r (1 + r )∞
(1 − 0)
=C×
r
C
=
r
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 Perpetuities Features

To use the perpetuity formula, the cash flows need to satisfy the following conditions:
1. Infinite life / Forever
2. Regular payment intervals / Payments are equally spaced
3. Constant dollar value of payment / Level cash flows

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 Perpetuities - Example

Problem
You are a student committee member, and you are asked to provide a budget for an
ongoing graduation party. Assume the party costs $30,000 per year forever. If the
university can earn an 8% return per year on investing, how much will you need to ask
from a donor today? Assume the first party is in one year.

Solution

C $30, 000
PV = = = $375, 000
r 0.08

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 Cash flows that grow at a constant rate

◮ In addition to constant cash flow streams, one may have to deal with cash flows that grow
at a constant rate over time
◮ These cash-flow streams are called growing annuities or growing perpetuities

◮ Example of growing annuities:

◮ Multiyear product or service contracts with cash flows that increase each year at a constant rate

◮ Example of growing perpetuities:

◮ An endowment ( or scholarship) that is adjusted for inflation

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 Growing Perpetuities

◮ Assume you expect the amount of your perpetual payment to increase at a constant rate,
g.
0 1 2 3 4

? CF1 CF2 CF3 CF4

Which equals to CF1 CF1 (1 + g) CF2 (1 + g) CF3 (1 + g)

or CF1 CF1 (1 + g)1 CF1 (1 + g)2 CF1 (1 + g)3

CF1
PV0 = (where r > g)
r −g
Features:
◮ Infinite Life
◮ Regular payment intervals / Payments are equally spaced
◮ Payment Amount ($C/F): Payments increasing at the growth rate g
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 Growing Perpetuities - Example

Problem
Continuing from the graduation party example. Let’s say that your supervisor reviewed
your report and found you did not factor in inflation on the cost of the party in future years.
Although $30, 000 is adequate for next year’s party, your supervisor estimate that the
party’s cost will rise by 4% per year after that. How much do you need to raise now?

Solution
C1
PV =
r −g

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 PV of Growing Annuities

The present value of a growing annuity with the initial cash flow c, growth rate g, and
interest rate r is defined as:
󰀥 󰀕 󰀖N 󰀦
C1 1+g
PV0 = 1− (where r > g)
(r − g) 1+r

Features on Cash Flow:

◮ Finite Life

◮ Regular payment intervals / Payments are equally spaced

◮ Payment Amount ($C/F): Payments increasing at the growth rate g

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 PV of Growing Annuities - Example

Problem
Ellen considered saving $10, 000 per year for her retirement. Although $10, 000 is the
most she can save in the first year, she expects her salary to increase each year so that
she will be able to increase her savings by 5% per year. With this plan, if she earns 10%
per year on her savings, how much will Ellen have saved at age 65?

Solution
󰀗 󰀓 󰀔30 󰀘
1 1.05
PV0 = $10, 000 × 1−
0.10 − 0.05 1.10

= $10, 000 × 15.0463

= $150, 463

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 FV of Growing Annuities

Ellen’s proposed savings plan is equivalent to having $150, 463 in the bank today. To
determine the amount she will have at age 65, we need to move this amount forward 30
years:

FV = $150, 463 × 1.1030

= $2.625 million in 30 years

Ellen will have saved $2.625 million at age 65 using the new savings plan. This sum is
almost $1 million more than she had without the additional annual increases in savings.

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 Deferred Annuity

◮ That is all the building blocks!!!

◮ All the timeline variations can be solved by using a combination of the formulas we have
discussed so far.
Let’s try to solve this:
0 1 2 3 4 N

? CF1 CF2 CFn

󰀗 󰀘
1 − (1 + r )−(N−3+1)
PV2 = C
r
PV2
PV0 =
(1 + r )2
* This could also become Deferred (Growing) Perpetuity, etc.
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 Present Value and the NPV Decision Rule

◮ Now we understand how to calculate the time value of money. Let’s recall last week’s
discussion on how managers make investment decisions. Assume we only consider the
shareholder theory as the manager’s goal.

◮ The Net Present Value (NPV) of a project or investment is the difference between the
present value of its benefits and the present value of its costs.

NPV = PV ( Benefits ) − PV ( Costs )

NPV = PV ( All project cash flows )

◮ To make a financial decision: Accept those projects with positive NPV.

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 NPV - Example

Problem
You have saved up $25, 000 for a new car. A car dealer is offering a car you want for a
price of $25, 000 with 4% financing for one year or a cash price of $23, 500.

Solution

$25, 000
PVCost of 0% deal today = = $24, 038.46
1.04
The cost in today’s dollars is $24, 038.46. This is greater than the cash price today. Taking
the cash deal

$24, 038.46 − $23, 500 = $538.46 today

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 Financial calculators
Self-Learning through Canvas - Textbook Resources (Optional)

◮ If you choose, you can use a financial calculator for this course. However, you need to learn by
yourselves. In general,
◮ To calculate FV on a financial calculator, you will input:
◮ PV = Present value
◮ r or y = Period interest rate
◮ n = Number of periods
◮ Press ”calculate” and then the FV button and your answer will be NEGATIVE
◮ Calculators are programmed to have cash outflows entered as negative and inflows as positive.
◮ If you enter the PV as positive, the calculator assumes that you have received a loan that you
will have to repay at some point. The negative sign on the future value indicates that you would
have to repay the loan
◮ If you enter the PV as negative, the FV will compute as a positive number.
◮ When writing your answers to problems and questions, always give your answer as a positive number.
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 Homework - A mixture of C/F patterns

Use what we’ve discussed today, spend some time to think about how would you calculate the PV or
FV of the following cash flow patterns. Assuming X, and Y are constant cash flows where X ∕= Y.

Situation 1: Find PV0

Time 0 1 2 3 4 5 N

Cash Flow ? X X X X X X (Assume X ∕= Y)

Y

Situation 2: Find PV0

Time 0 1 2 3 4 5 N

Cash Flow ? X X X Y Y Y (Assume X ∕= Y)

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 Homework - A mixture of C/F patterns

Situation 3: Find FVN

Time 0 1 2 3 4 5 N

Cash Flow X X X Y Y Y (Assume X ∕= Y)

?

Situation 4: Find PV0

Time 0 1 2 3 4 5 N

Cash Flow ? A B C Y Y Y
(Assume A ∕= B ∕= C ∕= X ∕= Y)

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 Homework - A mixture of C/F patterns

Situation 5: Find PV0

Time 0 1 2 3 4 5 6

Cash Flow ? X X X X Y Y (Assume X ∕= Y)

Situation 6: Find FVN

Time 0 1 2 3 4 N −1 N

Cash Flow X X X X X ?

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