Financial Mathematics

Session 06
RA Mislihah,MM
Time value of Money..

A $ today is worth more

than a $ tomorrow.
Question:
Would you prefer $100 today or $100 after 1 year?
$100 today is worth more than $100 in a year time, because:
1. We can at least earn some interest by putting $100 into a
bank account
2. Inflation may mean less purchasing power of $100 in the
future
Time value of Money..

A $ today is worth more than a $ tomorrow.

Future Value = Present value + Required Compensation

Simple Interest:
FV = PV (1+ i . t)

Compund Interest:
FV = PV (1+ i)t

• FV = Future value = Pt
value of the money after a period of time
• PV= Present value = Initial Principal (P0)
the amount invested (or borrowed) initially
• i = Interest rate
percentage of the principal/year
• t = Time / Period
period of time over which the money is lent/invested (borrowed)
Time value of Money..

A $ today is worth more than a $ tomorrow.

Future Value = Present value + Required Compensation

You save in a savings account, Rp 100.000.

It earns simple interest at 5% per annum.
Calculate the future value of the account after 6 years.

FV = PV (1+ i . t)
FV = 100.000 (1+0.05*6) = 130.000
Time value of Money..

A $ today is worth more than a $ tomorrow.

Future Value = Present value + Required Compensation

You save in a savings account, Rp 100.000.

It earns compound interest at 5% per annum.
Calculate the future value of the account after 6 years.

FV = PV (1+ i)t

FV = 100.000 (1+0.05) 6= 134.009,56

Simple Interest vs Compound Interest

Simple Interest Compound Interest

• Future Value: • Future Value:

FV = PV (1+ i . t) FV = PV (1+ i)t

• Present value: • Present value:

PV = FV / (1 + i. t) PV = FV / (1+ i)t

• Total Interest: I = PV . i . t • Total Interest: I = FV - PV

 Does compounding matter?
Invest $100 in 10% annual rate
2000

1500 Fc
Fs
F ($)

1000

500

0
0 5 10 15
Year 20 25 30

• What about 100 years?

• Simple interest = $____
10 every year, it becomes1,100
$_____
• Compounding = $_______
1, 378, 061
• Future Value with Tax:

FV = PV (1+ (i(1-tax)))t

You save Rp 12,500,000 in a bank for five years. The bank offers 8% per annum
interest rate. The government imposes a final tax for the interest income by
20%. Calculate the future value of the account after 5 years.
EXERCISE
1) Calculate the future value of £6,000 that is expected to be
received in three years’ time with compound interest of
7.5% per annum.
2) A bank offers to lend you $ 85,000; the loan calls for
payments of $120,000 for 4 years. What interest rate
(compounding) is the bank charging you?
3) You are going to save your Rp. 10,000,000 in a bank. The
bank offers a fix interest rate 10% per annum (excluded
interest tax 20%) as long as you don't draw your money.
After how many years your saving account balance become
Rp 15,000,000?
Compounding
daily, monthly, quarterly and semi annually
• Calculate the future value of $6,500 to be received in two years’ time
when the interest rate is 8% per annum, compounded daily.
FV = PV(1+ i)t You ALWAYS need to make sure that
the interest rate and the time period
FV = PV (1+ i/m)n match.
m= convertion period per year If you are looking at annual periods,
n=mxt you need an annual rate.
If you are looking at monthly periods,
FV = 6,500(1+ 0.08/365)2(365) = 7,627.68 you need a monthly rate.
 Interest rates are usually cited as nominal
rates of interest expressed as per annum
figures (iNom), as stated in contracts, and
Try: quoted by banks and brokers

$6,500 is invested for two years at 8% p.a.

Calculate the total value of the investment when compounded
a) Annually FV = 6,500 (1+ 0.08)2
b) Semi-annually FV = 6,500 (1+ (0.08/2))4
c) Quarterly FV = 6,500 (1+ (0.08/4))8
d) Monthly FV = 6,500 (1+ (0.08/12))24
e) Daily (assume a year consists of 365 days) FV = 6,500 (1+ (0.08/365))365x2

• Calculate the future value of $6,500 to be received in two years’ time when
the interest rate is 8% per annum, compounded daily, if government
imposed 5% tax on interest income?
FV = 6,500(1+ ((0.08/365)(1-0.05))2(365) = 7,566.92
Annual Percentages Rate (APR)
Example:
Two banks quote the following nominal interest rates on savings account:
“Tabungan Harian” Bank A : 6.60% eff compounded daily
“Tabungan Maksima” Bank B: 6.65% eff compounded monthly.

Which bank pays the most interest?

• To compare rates with different nominal rates (iNom) and different

compounding periods  use APR.
• Annual Percentages Rate (APR) = Effective Annual Rate (EAR) = eff%

FV  PV (1  i / m) mt
m
 i 
APR  1    1
 m
FV  PV (1  APR) t
Annual Percentages Rate (APR)
Example:
Two banks quote the following nominal interest rates on savings account:
“Tabungan Harian” Bank A : 6.60% eff compounded daily
“Tabungan Maksima” Bank B: 6.65% eff compounded monthly.

Which bank pays the most interest?

365
 6.6% 
APRA  1    1  1.0682  1  0.0682  6.82%
 365 
12
 6.65% 
APRB  1 

  1  1.0686  1  0.0686  6.86%
12 

m
 i 
APR  1    1
 m
ANNUITIES
To provide for future education costs, a family consider to save a single
deposit of $2,000 annually for a period of 10 years.
Calculate the value of the fund at the end of 10 years, assumed the saving’s
interest rate 7.5% p.a.

ANNUITIES = Series of equal payment (deposit or withdrawals)

made at equal intervals of time.
 (1  i ) t  1
FV  A 
 i 
1  (1  i )  t 
PV  A 
 i 
ANNUITIES
To provide for future education costs, a family consider to save a single
deposit of $2,000 annually for a period of 10 years.
Calculate the value of the fund at the end of 10 years, assumed the saving’s
interest rate 7.5% p.a.

 (1  7.5%)10  1
FV  2,000    28.294,17
 7. 5% 

 (1  i ) t  1
FV  A 
 i 
1  (1  i )  t 
PV  A 
 i 
ANNUITIES - exercises
1) Your employer pays Rp 800.000.00 every months for 10 years for your
pension fund. Assuming interest rate of 7% per annum (compounded
monthly) and tax free, how much is the present value of your pension
fund?
1  (1  (0.07 / 12))
120

PV  800.000  
 (0.07 / 12) 

2) A mortgage of Rp 200.000.000 is to be repaid over 5 year period at fixed

interest rate of 8%. Calculate the monthly repayments.

1  (1  (0.08 / 12)) 60   (1  i ) t  1

200.000.000  A 
 (0.08 / 12)  FV  A 
200.000.000  i 
A
1  (1  (0.08 / 12)) 60 
  1  (1  i )  t 
 (0.06 / 12)  PV  A 
 i 
ANNUITIES
Two type of annuity:
• start next period (ordinary annuity)
• beginning of the period (annuity due).
PROJECT EVALUATION CRITERIA:

NPV & IRR

Project Evaluation Criteria

Consider Project A with the prospective cash flows:

-$1,000
$650
$600

T=0 T=1 T=2

Invest
Investor
ornot
notin
inthe
theproject?
project?

Net Present Value (NPV) and Internal Rate of

Return (IRR) are some of techniques used to
appraise investment projects.
 RULES:
• Invest in the project if NPV >0
If there are some alternative projects: choose higher NPV

• Invest in the project if IRR > i* (market or required

rate of interest)
If there are some alternative projects: choose higher IRR
Project Evaluation Criteria NPV (Net Present Value)

Consider Project A with the prospective cash flows: Assumes:

i = 5% p.a
-$1,000
$650
$600

T=0 T=1 T=2

i= 5% Decision Rule:
• Invest in the project if NPV >0
t Pt PV • If there are some alternative
projects: choose higher NPV
0 -1000 -1000 (Adds most value)
1 600 571.43
2 650 589.57
NPV = 161.00
Project Evaluation Criteria NPV (Net Present Value)

Consider Project A with the prospective cash flows: Assumes:

i = 5% p.a
-$1,000
$650
$600

T=0 T=1 T=2

-$1,000
PV = 600/(1+5%)
571.43

PV = 650/(1+5%)2
589.57
+
NPV = 161
Project Evaluation Criteria NPV (Net Present Value)

Exercise:
The net cash flow for two projects, A and B, is as follows:
Year 0 1 2 3 4
Project-A -10,000 -3,000 3,000 6,000 8,000
Project-B -5,000 -2,000 3,000 3,000 5,000

Use the NPV criterion to decide which project is the most

profitable if a discount rate of 6% is used.

PV
0 1 2 3 4 NPV
Project-A -10,000 -2,830.19 2,669.98 5,037.72 6,336.75 1,214.27
Project-B -5,000 -1,886.79 2,669.98 2,518.86 3,960.47 2,262.52
Project Evaluation Criteria
Consider Project A with the prospective cash flows:
-$1,000
$650
$600

T=0 T=1 T=2

Invest
Investor
ornot
notin
inthe
theproject?
project?

Net Present Value (NPV) and Internal Rate of

Return (IRR) are some of techniques used to
appraise investment projects.
Project Evaluation Criteria IRR (Internal Rate of Return)

Consider Project A with the prospective cash flows:

-$1,000
$650
$600

T=0 T=1 T=2

-$1,000
PV = 600/(1+i)
PV1

PV = 650/(1+i)2
PV2
+ Internal Rate of Return (IRR) is a rate of
NPV = 0 interest, which discount all the project’s cash
flows, to a net present value of zero
i = ???
Project Evaluation Criteria IRR (Internal Rate of Return)

Consider Project A with the prospective cash flows:

-$1,000
$650
$600

T=0 T=1 T=2

Calculate IRR  use EXCEL or Linear Interpolation
i= 5% i= 20% (i1  NPV2 )  (i2  NPV1 )
IRR 
NPV2  NPV1
t Pt PV t Pt PV
(5%  48.61)  (20% 161)
0 -1000 -1000 0 -1000 -1000 IRR   16.52%
1 600 571.43 1 600 500  48.61  161
2 650 589.57 2 650 451.39  i1 where the NPV1 > 0, and i2 where the
NPV = 161.00 NPV = -48,61
NPV2 <0
 The best estimate is obtained by as
close as possible to the point 0.
Project Evaluation Criteria IRR (Internal Rate of Return)

Accept the project if the IRR is greater than the market rate of
interest (i*)!

If IRR > i*, we accept the project

For example:
Required rate of return
for this project is 12%. (i  NPV2 )  (i2  NPV1 )
IRR  1
NPV2  NPV1
Then we should accept
(5%  48.61)  (20% 161)
this project since the IRR IRR   16.52%
 48.61  161
(16.52%) is greater than 12%.
Calculating NPV & IRR with Excel

=NPV(0.05,B1:C1)-1000 =IRR(A1:C1,0)
EXERCISES
NEXT WEEK
• Quiz : Persiapan UTS
• Open Book, Bawa Scientific Calculator & Penggaris

• Bahan Latihan Persiapan UTS

• Exercises di slide FM + Quiz/ Latihan Tutorial
• Exercises @ Textbook
• Exercises @ e-book:
• Address: 10.10.200.235/ebook
• User id: NIP+huruf pertama nama
• Password : PMBS
• Dari luar kampus: 115.124.85.181/ebook
Terminology

Bunga Flat
vs
Bunga Efektif

Bunga Fix
vs
Bunga Floating
a) Calculate the present value of receiving $6,000 in three years’
time with simple interest of 7.5% p.a.
b) Calculate the present value of receiving $6,000 in three years’
time when the interest rate is 7.5% p.a, compounded annually.
c) Find the compound interest rate required for $1,000 to grow to
$2,000 in five years?
d) A Bank pays 5% interest, compounded annually. How long will it
take for $1,000 to grow to $2,000
1. You plan to go to France in September 2015. To minimize the
currency risk, you plan to buy € 360 per year. If the expected
average deposit interest rate around 2% p.a (net). How much
money will be available for your holiday?
2. A bank offers to lend you $ 85,000; the loan calls for
payments of $120,000 for 4 years. What interest rate is the
bank charging you?
3. In September 2018, your company plans to build small hall.
The cost of land & building is $ 75,000. With expected
average deposit interest rate around 3% p.a (net). How much
money do you have to save now?
4. You plan to buy a house. The price is IDR 300 million. A
mortgage offering (KPR) by Bank ABC required 20% down
payment, with interest rate 10% p.a. If you want to repay the
loan within 5 years, how much money do you need to pay your
mortgage every month?
5. One Real Estate gives a very interesting advertising written in a
very colorful banner as follows:
“Buy now, Get 1 free house 7 years later”
If the price of land is $200.000 while the price of building is
$100.000 with expected average deposit interest rate around
3% p.a (net), how much discount do actually you get ?
End.