CHAPTER 5

DISCOUNTING AND ACCUMULATING

Miss Sarah Nadirah Mohd Johari, 2020

INTRODUCTION
• Look into present values and accumulations of a series of payments
and continuous payments.

PRESENT VALUES OF CASHFLOWS

• Must find the discounted present value of cashflows due in the
future.
• It is important to differentiate between discrete and continuous
payments.

Miss Sarah Nadirah Mohd Johari, 2020

DISCRETE CASHFLOWS
• We have seen present value of a cashflow, 𝐶, due at time 𝑡 is 𝐶𝑣 𝑡 that
we assume the working in years and effective rate of interest is
constant over the period.
• What if we have two payments, 𝐶1 due at time 𝑡1 , and 𝐶2 due at time
𝑡2 ?

Miss Sarah Nadirah Mohd Johari, 2020

EXAMPLE 1
Under its current rent agreement, a company is obliged to make annual
payments of RM7,500 for the building it occupies. Payments are due on
1 January 2006, 1 January 2007 and 1 January 2008. If the company
wishes to cover these payments by investing a single sum in its bank
account that pays 7.5% pa compound, what sum must be invested on 1
January 2005?
DISCRETE CASHFLOWS
• If the effective interest rate is not constant, then we could write the
present value in terms of the function 𝑣(𝑡)
• Present value of a series of payments of 𝑐1 , 𝑐2 , … , 𝑐𝑛 due at times
𝑡1 , 𝑡2 , … , 𝑡𝑛 is: 𝒏

𝒄𝒕𝟏 𝒗 𝒕𝟏 + 𝒄𝒕𝟐 𝒗 𝒕𝟐 + ⋯ + 𝒄𝒕𝒏 𝒗(𝒕𝒏 ) = ෍ 𝒄𝒕𝒋 𝒗(𝒕𝒋 )

𝒋=𝟏
• If the number of payments is infinite,
∞
the present value will be:
෍ 𝑐𝑡𝑗 𝑣(𝑡𝑗 )
𝑗=1
provided that this series converges.

Miss Sarah Nadirah Mohd Johari, 2020

EXAMPLE 2
Find the value at time 𝑡 = 0 of RM250 due at time 𝑡 = 6 and RM600
due at time 𝑡 = 8 if 𝛿 𝑡 = 3% 𝑝𝑎 for all 𝑡.
CONTINUOUSLY PAYABLE CASHFLOWS
(PAYMENT STREAMS)
• Suppose that 𝑇 > 0 and that between times 0 and 𝑇, an investor will
be paid money continuously, the rate of payment at time 𝑡 being
𝑅𝑀 𝑝(𝑡) per unit time. What is the present value of this cashflow?

Miss Sarah Nadirah Mohd Johari, 2020

CONTINUOUSLY PAYABLE CASHFLOWS
(PAYMENT STREAMS)
If 𝑴(𝒕) denotes the total payment made between time 0 and time 𝒕, then:
𝝆 𝒕 = 𝑴′ 𝒕 𝒇𝒐𝒓 𝒂𝒍𝒍 𝒕

If 𝟎 ≤ 𝜶 ≤ 𝜷 ≤ 𝒕, the total payment received between time 𝜶 and time 𝜷

is:
𝜷 𝜷
𝑴 𝜷 − 𝑴 𝜶 = න 𝑴′ 𝒕 𝒅𝒕 = න 𝝆 𝒕 𝒅𝒕
𝜶 𝜶
Rate of payment at any time is simply the derivative of the total amount
paid up to that time and the total amount paid between any two times is
the integral of the rate of payments over the appropriate time interval.

Miss Sarah Nadirah Mohd Johari, 2020

CONTINUOUSLY PAYABLE CASHFLOWS
(PAYMENT STREAMS)
EXAMPLE
If the rate of payment is a constant RM24 pa, then in any one year, the
total amount paid is RM 24 but this payment is spread evenly over the
year.

In half year, the total paid is?

In one month, the total paid is ?

Miss Sarah Nadirah Mohd Johari, 2020

EXAMPLE 3
A life office starts issuing a new type of 10-year savings policy to young
investors who pay weekly premiums of RM 10. Assuming that the life
office sells 10,000 policies evenly over each year and that no
policyholders stop paying premium, what will the rate of premium
income be for the life office during the first few years?
 CONTINUOUSLY PAYABLE CASHFLOWS
(PAYMENT STREAMS)
• Between time 𝑡 and 𝑡 + 𝑑𝑡, the total payment received is 𝑀 𝑡 + 𝑑𝑡 −
𝑀(𝑡). If dt is very small, this is approximately 𝑀′ 𝑡 𝑑𝑡 or 𝜌 𝑡 𝑑𝑡
• Therefore, we may consider the PV of the money received between times 𝑡
and 𝑡 + 𝑑𝑡 as v t 𝜌 𝑡 𝑑𝑡:
𝑻
𝑷𝑽 = න 𝐯 𝒕 𝝆 𝒕 𝒅𝒕
𝟎
• If 𝑇 is infinite:
∞
𝑷𝑽 = න 𝐯 𝒕 𝝆 𝒕 𝒅𝒕
𝟎

Miss Sarah Nadirah Mohd Johari, 2020

CONTINUOUSLY PAYABLE CASHFLOWS
(PAYMENT STREAMS)
• By combining the results for discrete and continuous cashflows:
∞ ∞
𝑷𝑽 = ෍ 𝑐𝑡𝑗 𝑣(𝑡𝑗 ) + න 𝐯 𝒕 𝝆 𝒕 𝒅𝒕
𝑗=1 𝟎

• Assuming a constant interest rate:

∞ ∞
𝑷𝑽 = ෍ 𝑐𝑡𝑗 𝑣 𝑡𝑗 + න 𝒗𝒕 𝝆 𝒕 𝒅𝒕
𝑗=1 𝟎

Miss Sarah Nadirah Mohd Johari, 2020

EXAMPLE 4
A company expects to receive for the next five years a continuous
cashflow with a rate of payment of 100 × 0.8𝑡 at time 𝑡 (years).
Calculate the present value of this cashflow assuming a constant force
of interest of 8% pa.
VALUING CASHFLOWS
• Considering times 𝑡1 and 𝑡2 , where 𝑡2 is not necessarily greater than
𝑡1 . The value at time 𝑡1 of the sum 𝐶 due at time 𝑡2 is defined:
a) If 𝑡1 ≥ 𝑡2 , the accumulation of 𝐶 from time 𝑡2 until time 𝑡1
b) If 𝑡1 < 𝑡2 , the discounted value at time 𝑡1 of 𝐶 due at time 𝑡2
• In both cases, the value at time 𝑡1 of 𝐶 due at time 𝑡2 :
𝑡2
𝐶𝑒𝑥𝑝 − න 𝛿 𝑡 𝑑𝑡
𝑡1
𝒕𝟐 𝒕𝟏
Note that, if 𝒕𝟏 > 𝒕𝟐 , ‫𝜹 𝒕׬‬ 𝒕 𝒅𝒕 = − ‫𝜹 𝒕׬‬ 𝒕 𝒅𝒕
𝟏 𝟐

Miss Sarah Nadirah Mohd Johari, 2020

VALUING CASHFLOWS
• Since:
𝑡2 𝑡2 𝑡1
න 𝛿 𝑡 𝑑𝑡 = න 𝛿 𝑡 𝑑𝑡 − න 𝛿 𝑡 𝑑𝑡
𝑡1 0 0
• The value at time 𝑡1 of 𝐶 due at time 𝑡2 :

𝑣 𝑡2
𝐶
𝑣 𝑡1

1
which can be written in the form 𝐶 = 𝐶𝑣 𝑡2 𝐴(0, 𝑡1 )
𝐴(𝑡1 ,𝑡2 )

Miss Sarah Nadirah Mohd Johari, 2020

VALUING CASHFLOWS
• The value at a general time 𝑡1 of a discrete cashflow of 𝑐𝑡 at time 𝑡
and a continuous payment stream at rate 𝜌 𝑡 per time:
∞
𝑣 𝑡 𝑣 𝑡
෍ 𝑐𝑡 +න 𝜌 𝑡 𝑑𝑡
𝑣(𝑡1 ) −∞ 𝑣(𝑡1 )
• If all the payments are due at or after time 𝑡1 , their value at time 𝑡1
may also be called discounted value and if they are due at or before
time 𝑡1 , their value may be referred to as their accumulation.
• If 𝑡1 = 0 and all the payments are due at or after the present time,
their value may also be described as (discounted) present value

Miss Sarah Nadirah Mohd Johari, 2020

VALUING CASHFLOWS
• The value at any time 𝑡1 of a cashflow may be obtained from its value
𝑣 𝑡2
at another time 𝑡2 by applying the factor :
𝑣 𝑡1

𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡1 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡2 𝑣 𝑡2

=
𝑜𝑓 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑜𝑓 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑣 𝑡1
or
𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡1 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡2
[𝑣 𝑡1 ] = 𝑣 𝑡2
𝑜𝑓 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑜𝑓 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤

Miss Sarah Nadirah Mohd Johari, 2020

VALUING CASHFLOWS
• By choosing time 𝑡2 as the present time and letting 𝑡1 = 𝑡:

𝑉𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑡 𝑡ℎ𝑒 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑡𝑖𝑚𝑒 1

=
𝑜𝑓 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑜𝑓 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝑣 𝑡

Miss Sarah Nadirah Mohd Johari, 2020

CONSTANT INTEREST RATE
• Assume the interest rates remain constant.
𝑃1 = 𝑋𝑣 𝑛 𝑃2 = 𝑋 𝑃3 = 𝑋(1 + 𝑖)𝑛

-n 0 n

• If the present value of a series of definite payments at a particulate

date is 𝑋, then:
✓The accumulated value at a date 𝑛 years later: ?
✓The present value at a date 𝑛 years earlier: ?

Miss Sarah Nadirah Mohd Johari, 2020

EXAMPLE 5
Under its current rent agreement, a company is obliged to make annual
payments of RM7,500 for the building it occupies. Payments are due on
1 January 2004, 1 January 2005 and 1 January 2006. The nominal rate
of interest is 8% per annum, convertible quarterly. Find:
1. The present value of these payments on 1 January 2003
2. The accumulated value of the payments on 1 January 2007
EXAMPLE 6
The force of interest takes the following values:

𝛿 𝑡 = 0.04 0 < 𝑡 ≤ 10
𝛿 𝑡 = 0.001(𝑡 − 10)2 +0.04 10 < 𝑡

Calculate the accumulation of RM150 from time 𝑡 = 0 to time 𝑡 = 20.

PAYMENT STREAMS
• The present value of a continuous payment stream received from
time 0 to time 𝑇, where the rate of payment at time 𝑡 is 𝜌 𝑡 is given
by:
𝑻
𝑷𝑽 = න 𝐯 𝒕 𝝆 𝒕 𝒅𝒕
𝟎

Miss Sarah Nadirah Mohd Johari, 2020

PAYMENT STREAMS
• Consider a continuous payment stream paid at a rate of 𝜌 𝑡 from
time 𝑎 to time 𝑏, during which time the force of interest is 𝛿(𝑡).
• Present value at time 𝑎 of this payment stream:
𝒃 𝒕
𝑷𝑽𝒕=𝒂 = න 𝝆 𝒕 𝒆𝒙𝒑 − න 𝜹 𝒔 𝒅𝒔 𝒅𝒕
𝒂 𝒂
• The accumulate value at time 𝑏 of this payment stream:
𝒃 𝒃
𝑨𝑽𝒕=𝒃 = න 𝝆 𝒕 𝒆𝒙𝒑 න 𝜹 𝒔 𝒅𝒔 𝒅𝒕
𝒂 𝒕

Miss Sarah Nadirah Mohd Johari, 2020

EXAMPLE 7
The force of interest at time 𝑡, where 0 ≤ 𝑡 ≤ 10, is given by 𝛿 𝑡 =
0.07. Calculate the accumulation value at time 10 of the payment
stream 10𝑒 0.05𝑡 which is received between time 5 and 10.
EXAMPLE 8
The force of interest is:
𝛿 𝑡 = 0.01𝑡 + 0.04 0 ≤ 𝑡 ≤ 5
Calculate the present value at time 0 of the payment stream 0.5𝑡 + 2,
which is received between time 0 and time 5.
SUDDEN CHANGES IN INTEREST RATES
• Where the force of interest is not a continuous function of time, it is
necessary to break up the calculations at the points where the
interest rate changes.
• Where payments do not start immediately, the appropriate discount
factor must be included.

Miss Sarah Nadirah Mohd Johari, 2020

EXAMPLE 9
Calculate the present value as at 1 January 2005 of the following
payments:
i. A single payment of RM2,000 payable on 1 July 2009
ii. A single payment of RM5,000 payable on 31 December 2016.
Assume effective rates of interest of 8% per annum until 31 December
2011 and 6% per annum thereafter.
INTEREST INCOME
• Consider now an investor who wishes not to accumulate money but
to receive an income while keeping his capital fixed at 𝐶. If the rate of
interest is fixed at 𝑖 per time unit, and if the investor wishes to receive
income at the end of each time unit, it is clear that the income will be
𝑖𝐶 per time unit, payable in arrear, until such time as the capital is
withdrawn.

Miss Sarah Nadirah Mohd Johari, 2020

INTEREST INCOME
• If interest is paid continuously with force of interest 𝛿 𝑡 at time 𝑡,
then the income received between times 𝑡 and 𝑡 + 𝑑𝑡 will be
C𝛿 𝑡 𝑑𝑡. The total interest income from time 0 to time 𝑇:
𝑇
𝐼 𝑇 = න C𝛿 𝑡 𝑑𝑡
0
• If the investor withdraws the capital at time 𝑇, the present values of
the income and capital at time 0 are:
𝑇
𝑃𝑉 = 𝐶 න 𝛿 𝑡 𝑣(𝑡)𝑑𝑡 = 𝐶𝑣(𝑇)
0

Miss Sarah Nadirah Mohd Johari, 2020

INTEREST INCOME
• Since:
𝑇 𝑇 𝑡
න 𝛿 𝑡 𝑣(𝑡)𝑑𝑡 = න 𝛿 𝑡 𝑒𝑥𝑝 − න 𝛿 𝑠 𝑑𝑠 𝑑𝑡
0 0 0

𝑡 𝑇
= exp − න 𝛿 𝑠 𝑑𝑠
0 0

= 1 − 𝑣(𝑇)
• Obtain:
𝑇
𝐶 = 𝐶 න 𝛿 𝑡 𝑣(𝑡)𝑑𝑡 + 𝐶𝑣(𝑇)
0

Miss Sarah Nadirah Mohd Johari, 2020

EXAMPLE 10
An investor deposits RM2,000 in a bank account and receives income
at the end of each of the next three years. The rate of interest is 4% pa
effective. The investor withdraws the capital after three years. Find:
1. Investor receives at the end of each year.
2. Present value of the interest received
3. Present value of the capital received after three years