Fin1Fof: Fundamentals of Finance

FIN1FOF
FUNDAMENTALS OF
FINANCE
Topic 3: Financial
Mathematics
Concept Framework of FM:3-6-1
Max Value of Firm
Investment Management Capital Operation Income Mananagement
Financial Structure WC Cash management

Management
Time Value Risk and leverage

Financial Analysis
Efficient Finance Market

La Trobe Business School
TOPIC2 综合课堂练习 1 ：
资料：已知某企业 2000
年、 2001 年有关资料如右表：
（金额单位：万元）
要求：运用杜邦分析法对该
企业的净资产收益率及其增减
变动原因分析。

Topic Overview
3.1 The time value of money
3.2 Single cash flows
3.3 Multiple cash flows
3.4 Perpetuities and annuities
3.5 Solving for other variables
3.6 Interest rates
La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 4

Prescribed reading
Berk, J., DeMarzo, P., Harford, J.,
Ford, G., Mollica, V. and Finch, N.
Fundamentals of Corporate Finance
(2nd edition)
Pearson Australia, 2014
Chapters 3, 4 and 5

3.1.1 COST-BENEFIT ANALYSIS
 We saw in Topic 1 that the corporate
objective is to maximise the value of the firm
Dollar Dollar The decision will
value of
benefits
> value of
costs
 increase the value
of the firm
 However, financial decision-making involves

more than just comparing numbers of
dollars
 To evaluate the costs and benefits of a
decision, we must value the options in the
same terms – cash today
 If the costs and benefits of a decision occur
at the same point in time, and there is a
competitive market that allows us to express
those costs and benefits in terms of a dollar
value, the comparison is easy
 In financial decision-making, your subjective
view of the desirability of something is
irrelevant – if there is a competitive market
in which that thing can be exchanged for
cash, decisions should be based on dollar
value
Lecture Example 3.1

You win a competition on your local radio
station. As your prize, you can choose
between two tickets to see Bruce Springsteen
or Snoop Dogg. You are a Springsteen fan
and you hate Rap music. Springsteen tickets
can be bought and sold on eBay for $80 each,
Snoop Dogg tickets for $120 each. Which do
you choose?
A Bruce Springsteen B Snoop Dogg
3.1.2 CASH FLOWS AT DIFFERENT TIMES
 It is much more difficult to make decisions
involving cash flows at different points in time
 This is because money has time value
 This means that a dollar today is worth more
than a dollar tomorrow (because today’s
dollar can be invested and will grow to more
than one dollar tomorrow)
 Hence, the interest rate is a measure of the
time value of money at any given time
Lecture Example 3.2

YouToday
are given the opportunity to invest
One year
$100,000, with a guaranteed return of
$105,000
-$100,000 in one year. +$105,000
Today One year
Would you undertake this investment?
C-$100,000
Don’t know It is impossible +$105,000
to answer
Wouldthis question
you without
undertake this knowing the
investment?
interest rate – the rate of return you
Yes get B
A could fromNothe next Don’t
C best know
alternative
investment
Lecture Example 3.3

YouToday
are offered the investment described
One year in
Lecture Example 3.2. Alternatively, your bank
offers an interest rate
-$100,000 on deposits+$105,000
Investment of 10% p.a.
-$100,000
Today Bank -$110,000
One year
Would you undertake this investment if the
-$100,000 Investment +$105,000
interest rate is 10% p.a.?
Would you undertake this investment?
B No $100,000 invested at 10% would
A Yes be worth B No$110,000 Don’t
C in oneknow
year
 Lecture Example 3.3 shows that, if the
interest rate is 10% p.a., $100,000 today is
equivalent to $110,000 in one year
 More generally, we use r to denote the
interest rate for a given period, and
therefore we can exchange $1 today for
(1 + r) dollars in the future (since they are
equivalent in value)
 (1 + r) is the interest rate factor which can
be used to convert cash flows across time
3.1.3 FUTURE VALUE OF A CASH FLOW TODAY
 We can use the interest rate factor to
convert from a cash flow today to an
equivalent cash flow one period in the
future (the future value):
FV  C  1  r 
 The future value of $100,000 invested at

10% p.a. for one year is equal to:
FV  100,000  1  0.10   $110,000
3.1.4 PRESENT VALUE OF A FUTURE CASH FLOW
 We can also use the interest rate factor to
convert a future cash flow to a present value
C
PV 
1 r
 The present value of $110,000 received in
one year, at 10% p.a. interest, is equal to:
110,000
PV   $100,000
1  0.10
3.1.4 PRESENT VALUE OF A FUTURE CASH FLOW
 The present value of the investment in
Lecture Example 3.2 is equal to:
105,000
PV   $95,454.55
1  0.10
 We have therefore converted the benefit of
the investment ($105,000 in one year) to an
equivalent amount of cash today
 Since the cost ($100,000) is also in terms of
cash today, we can directly compare them
3.1.5 NET PRESENT VALUE
 The net present value of an investment is the
difference between the present value of the
benefits and the present value of the costs
NPV  PV  Benefits   PV  Costs  (3.1)
 The NPV of the investment is equal to:

NPV  $95,454.55  $100,000  $4,545.45
 The NPV is negative, and therefore value
will be lost if the investment is undertaken
3.1.6 RULES OF FINANCIAL DECISION-MAKING
Rule 1
Itis only possible to compare or combine
values at the same point in time
Rule 2
To calculate the value of a cash flow at an
earlier point in time, you must discount it
Rule 3
To calculate the future value of a cash flow,
you must compound it
3.1.7 COMPOUNDING
 Compounding means calculating a future
value over many periods by repeatedly
applying the calculation we did earlier
 Consider an investment of $1000 at 10%
p.a. for 2 years:
0 1 2
$1000 FV1 FV2

 Interest is earned in the 1st year, and then
the total amount earns interest in the 2nd year
3.1.7 COMPOUNDING
Lecture Example 3.4

0 1 2
$1000 FV1 FV2

 How much is in the account after 1 year
(FV1) if the interest rate is 10% p.a.? $1100
 How much is in the account after 2 years
(FV2)? $1200? $1210
FV2  1100  1  0.10   $1210
3.1.7 COMPOUNDING
 In each period, interest is earned on the
present value and all interest earned in prior
periods – this can result in substantial
growth over long periods of time
 E.g. $100,000 at 10% p.a. for 40 years
Without compounding, this will grow to
$100,000 + (40 x $10,000) = $500,000
With compounding, this will grow to over $4.5
million
3.1.8 DISCOUNTING
 Discounting means calculating a present
value, many periods earlier, by repeatedly
applying the calculation we did earlier
 Consider $1000 to be received in 2 years,
where the interest rate is 10% p.a.
0 1 2
PV0 PV1 $1000

 The $1000 is discounted once to get PV1,
and this value is discounted again to get PV2
3.1.8 DISCOUNTING
 As we shall see in later topics, present
value is calculated more often in finance
than future value
 Most financial decisions involve comparing
cash flows that occur at different points in
time
 The usual way we do is to convert them all
to today’s dollars – i.e. discount them to a
present value – so that a comparison can
be made
3.1.8 DISCOUNTING
Lecture Example 3.5

0 1 2
PV0 PV1 $1000
 What is the value

1000
of the $1000 in PV1   $909.09
one year (PV1)? 1.10
 What is its 909.09
value today PV0   $826.45
(PV0)?
1.10
3.1.9 MOVING CASH FLOWS ACROSS TIME
 We will use a number of formulas from the
text book in throughout the remainder of this
topic to solve time value of money problems
 However, we can see from what we have
done so far that we can move any cash flow
at any period of time to an equivalent cash
flow at any other period of time
 This is done by either compounding or
discounting, depending on which direction
we need to move in time
 Given a cash flow at a particular point in
time, if you need to find an equivalent cash
flow at a later point in time (i.e. move to the
right along the time line):
$
you multiply the cash flow by the interest

rate factor (1 + r) a total of n times, where n
is the number of periods you want to move
in time.
 Given a cash flow at a particular point in
time, if you need to find an equivalent cash
flow at an earlier point in time (i.e. move to
the left along the time line):
$
you divide the cash flow by the interest rate

factor (1 + r) a total of n times, where n is
the number of periods you want to move in
time.
理解增长与规模的关系
FV=C(1+r)*n
FV/C=(1+r)*n
Fammous“72” Principle 如何计算翻一番？

2 ≈ (1 ＋ 1%)72 或者 2 ≈ (1 ＋ 1%*n)72/n
FIN3BFI Banking and Financial Institutions – Topic 2 –

La Trobe Business School 27
Financial statement analysis
理解增长率与存长的关系
FV=C(1+r)*n FV/C=(1+r)*n
Fammous“72” Principle 如何计算翻一番？

2 ≈ (1 ＋ 1%)72 或者 2 ≈ (1 ＋ 1%*n)72/n
中国经济的 GDP 何时赶上美国的 GDP ？

2013 年中国 GDP8.3 万亿，美国 GDP15.83 万亿
8.3(1 ＋ 7.8%) n=15.83(1+2.2%)n
2 ≈ [(1+7.8%)/(1+2.2%)]n=(1+5.4%)n
n ≈13
FIN3BFI Banking and Financial Institutions – Topic 2 –

La Trobe Business School 28
Financial statement analysis
3.2.1 FUTURE VALUE OF A SINGLE CASH FLOW
 The general formula for the future value of a
single cash flow is:
FVn  C   1  r 
n
(3.1)
where C = the present cash flow

r = the interest rate per period
n = the number of periods
FVn = the future value of cash flow
C in period n

3.2.1 FUTURE VALUE OF A SINGLE CASH FLOW
Lecture Example 3.6

What is the future value of $1000 invested for
4 years at an interest rate of 8% p.a.?
FV4  C   1  r 
n
 1000  1.08   $1360.49

4

3.2.2 PRESENT VALUE OF A SINGLE CASH FLOW
 The general formula for the present value of
a single cash flow is:
These two
C C
PV  PV  n  C n  1  r 
versions are n
(3.2)
mathematically
equivalent, but
 1  r  1  r 
you may find
one or the where C = the future cash flow
other more r = the interest rate per period
convenient in n = the number of periods
some
situations PV = the present value of cash
flow C paid in n periods
3.2.2 PRESENT VALUE OF A SINGLE CASH FLOW
Lecture Example 2.7

What is the present value of $4000 to be
received in 7 years if the interest rate is 5%
p.a.?
C 4000
PV    $2842.73
 1 r   1.05 
n 7

3.2.3 FREQUENCY OF COMPOUNDING
 It is important to note that the r and n relate
to compounding periods – not years
 A compounding period is the length of time
over which interest accrues, and is often
less than a year
 Since interest rates are usually quoted as
per annum (p.a.) – i.e. per year – and
periods of time are also usually quoted in
years, we need to convert the interest rate
and the time period in order to find r and n
For example, interest could compound: To calculate r in the PV

and FV formulas:
Semi-annually Twice a year
Divide the annual interest
Quarterly 4 times a year rate by the number of
periods per year
Monthly 12 times a year
To calculate n in the PV
Fortnightly 26 times a year and FV formulas:
Weekly 52 times a year Multiply the number of

years by the number of
Daily 365 times a year periods per year
Lecture Example 2.8

Redo Lecture Example 3.6 (the future value of
$1000 invested for 4 years at an interest rate of
8% p.a.), with semi-annually compounding.
What isFV
the  C   1 r 
interest rate 8%
n per
4
compounding period (r)?
 4%
2
 1000  1.04   $1368.57
8
What is the number of periods (n)? 4  2  8

Lecture Example 2.9

Redo Lecture Example 2.7 (the present value of
$4000 to be received in 7 years with an interest
rate is 5% p.a.), with quarterly compounding.
What is the interest

C rate per
4000 5%
PV 
compounding  (r)?
period
 1.25%
 $2824.87
n
 1 r   1.0125 
28 4
What is the number of periods (n)? 7  4  28

3.2.4 CONTINUOUS COMPOUNDING
 In theory, compounding periods could
become infinitely small, and the number of
compounding periods infinitely large
 This is called continuous compounding
 Although interest can’t literally be calculated
in this way, many financial valuations
involving growth in value other than from
interest (e.g. share price changes) are
based on the concept of continuous
compounding
 The formula for future value of a cash flow,
based on continuous compounding is:
FV  C  e APRY
where FV = the future value

C = the present cash flow
e = the base for natural
Note that this logarithms (≈ 2.7182818)
could be a APR = The Annual Percentage
fractionRate
La Trobe Business School Y = the number of years
FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 38
Lecture Example 3.10

What is the future value of $2000, continuously
compounded at 5% p.a. for 3 years?
APR Y
Follow these steps on the
FV  PVe BAII Plus calculator…
 2000e0.053 0 . 1 5
2ND LN ×
 $2323.67
2 0 0 0 =
(The “second function” for the LN button raises e

to the power of the number shown on the
display.)
 The formula for present value of a cash
flow, based on continuous compounding is:
C
PV 
e APRY
where PV = the present value
C = the future cash flow
e ≈ 2.7182818
APR = the Annual Percentage Rate
Y = the number of years

How much needs to be invested to grow to $500
over 6 months, if the continuously compounded
growth rate is 10% p.a.?
FV This is one way to
PV  calculate this on the BAII
e APR Y Plus calculator…
500
 0.10.5 0 . 0 5
e 2ND LN ÷
 $475.61 5 0 0 = 1/x

3.3.1 FUTURE VALUE OF MULTIPLE CASH FLOWS
 Generally, if we need to find the future
value of a series of cash flows, we can do
so by repeatedly using the formula for the
future value of a single cash flow (3.1)
 This converts all cash flows to a common
point in time (Rule 2)
 Only then can the cash flows be summed
to find the future value of the entire series
of cash flows (Rule 1)

3.3.1 FUTURE VALUE OF MULTIPLE CASH FLOWS

What is the future value of the following series
of cash flows (as at time period 5) if the
interest rate is 6% p.a., compounding
annually?
Year Cash flow Calculation FV 5
1 400 400(1.06)4 504.99

2 250 250(1.06)3 297.75
3 320 320(1.06)2 359.55
4 180 180(1.06)1 190.80
Total 1353.09
3.3.2 PRESENT VALUE OF MULTIPLE CASH FLOWS
 Similarly, if we need to find the present
value of a series of cash flows, we can do
so by repeatedly using the formula for the
present value of a single cash flow (3.2)
 This converts all cash flows to a common
point in time – time 0, or today (Rule 3)
 Then the cash flows can be summed to
find the present value of the entire series
of cash flows (Rule 1)

3.3.2 PRESENT VALUE OF MULTIPLE CASH FLOWS

What is the present value of the following
series of cash flows (as at time period 0) if the
interest rate is 6% p.a., compounding
annually?
Year Cash flow Calculation PV
1 400 400(1.06)-1 377.36
2 250 250(1.06)-2 223.50
3 320 320(1.06)-3 268.68
4 180 180(1.06)-4 143.58
Total 1011.11
3.3.3 EQUIVALENCY OF PRESENT AND FUTURE
VALUES
Use the formulas for the present and future
value of a single cash flow (3.1 and 3.2) to
demonstrate that the solutions to Lecture
Examples 3.12 and 3.13 are equivalent
PV  1353.09  1.06 
5
 $1011.11
FV  1011.11 1.06   $1353.09

5

3.4.1 PRESENT VALUE OF A PERPETUITY
 Many applications of financial
mathematics involve periodic cash flows
where the size of the cash flow remains
constant, or grows at a constant rate
 Valuing these cash flows would be
tedious, using the techniques in the
previous section, but fortunately there are
some short-cuts which enable these
valuations to be done with just one or two
calculations
 One such application involves a
perpetuity, which is constant stream of
equal cash flows continuing forever
0 1 2 3
C C C
 Note that the first cash flow occurs at the

end of the first period of the perpetuity – the
formulas we will use for perpetuities and
annuities will be based on this assumption
 It makes no sense to talk about the future
value of a perpetuity – this would be an
infinite number that would occur an infinite
period of time in the future – but we can
calculate the present value of a perpetuity
 This is because cash flows in the far
distant future are discounted so heavily so
that their contribution to the present value
of the perpetuity approaches zero

 The formula for the present value of a
perpetuity is:
C
PV  (4.4)
r
where PV = the present value
C = the constant cash flow (with
the first cash flow occurring
one period in the future)
What is the present value of $200 to be paid
every six months in perpetuity, with the first
payment six months from now, if the interest
rate is 12% p.a., compounded semi-annually?
What is the interest
C 200 rate per 12%
PV  
compounding period (r)?  $3333.33 6%
2 r 0.06

3.4.2 PRESENT VALUE OF A
GROWING PERPETUITY
 Sometimes we need to find the present
value of an infinite stream of cash flows that
will grow at a constant rate in perpetuity
 The most common application is the
valuation of shares based on constantly
growing dividends (covered in Topic 3)
 We can find the present value as long as
the future cash flows are being discounted
at a greater rate than their growth rate
We can use
3.4.2 PRESENT VALUE OF A this second
GROWING PERPETUITY version if we
know the
 The formula for the present current cash
flow, but not
value of a growing perpetuity is: the next one.
C1 C0  C1 g
1
PV   
PV (4.7)
r g r g
where C01 = the most recent
first cash cash
flow (oneflow
period
C1 = in the
the next
future)
cash flow (in one period)
g = the growth rate (where r > g)
3.4.2 PRESENT VALUE OF A
GROWING PERPETUITY
What is the present value of a growing
perpetuity with semi-annual payments, an initial
payment of $200 in six months and growing at
2% every six months, if the interest rate is 12%
p.a.?
C1 200
PV    $5000
r  g 0.06  0.02

3.4.3 PRESENT VALUE OF AN ANNUITY
 An annuity is similar to a perpetuity, in
that it is a constant stream of equal cash
flows, except that it only occurs for a fixed
period of time
0 1 2 3 4
C C C C
 Once again, note that the first cash flow
occurs at the end of the first period of the
annuity
 It would be quite possible to calculate the
present value of an annuity by repeatedly
using the formula for the present value of
a single cash flow, and then summing the
present value of each cash flow; i.e.
C1 C2 Cn
PV    ...  (4.3)
   1 r 
1  r 2
 1 r 
n
but it can be shown that this can be

simplified to a single formula
 The formula for the present value of an
annuity is:
1 1 
PV  C   1   (4.5)
r   1 r  n 
 
where C = the constant cash flow (with
the first cash flow occurring one
period in the future)

You have just won a “$30 million” lottery. You
can choose to receive $1 million per year for
the next 30 years (with the first payment in a
year’s time) or $12 million up-front. You can
invest your money at 8% p.a. Which do you
prefer?
A $1 million per year (first payment in 1
year)
B $12 million up-front

1 1 
PV  C   1  
r   1 r  n 
 
1  1 
 1,000,000  1  
0.08   1.08  30 
 
 $11,257,783
B $12 million up-front is preferable

You have just won the lottery from Lecture
Example 3.17. You can choose to receive $1
million per year for the next 30 years (with the
first payment today) or $12 million up-front.
(Your rate is still 8% p.a.) Which do you prefer?
A $1 million per year (first payment today)
B $12 million up-front


The “$1 million per year” option consists of a
single cash flow of $1 million today, plus a 29-
year annuity (because the first cash flow of this
annuity occurs one period in the future), and we
can calculate the answer accordingly
This is a common situation in finance, and is
referred to as an annuity due, whereas the
annuity formula we use (with the first cash flow
in one period) is for an ordinary annuity
1  1 
PV  $1 m  1   $1 m
0.08   1.08  
29
 
 $11,158,406  $1,000,000
 $12,158,406
A $1 million per year for 30 years (first

payment today) is preferable to $12
million
3.4.4 FUTURE VALUE OF AN ANNUITY
 The formula for the future value of an
annuity (the value of the cash flow stream at
the end of the annuity) is:
1
FV  C   1  r   1
r
n
  (4.6)
where C = the constant cash flow (first

cash flow one period in the future)

You are 25 years old, and have decided to
make annual end-of-year deposits of $12,000
into a bank account paying 12% p.a. How
much will you have when you retire at age 65?
1
FV  C   1  r   1
r
n
 
 12,000 
1
0.12
 1.12   1  $9,205,097
40
 

Redo Lecture Example 3.19, but now you will
save $12,000 per year via monthly deposits into
an account paying 12% p.a. compounding
monthly. How much will you have at age 65?
Adjust for monthly pmts: r = 12% / 12 = 1%
C = $12,000 / 12 = $1000 n = 40 × 12 = 480
FV  1,000 
1
0.01
 1.01  1  $11,764,773
480
 
3.4.5 PRESENT VALUE OF A GROWING ANNUITY
 Just as some finance applications involve a
growing perpetuity, there are other
situations involving an annuity (i.e. a finite
series of payments) where the payments
grow over the life of the annuity
 It would be time-consuming to calculate
each cash flow (based on the growth rate)
and then discount each of them to a present
value, before summing them – but once
again, there is formula providing a short-cut
 The formula for the present value of a
growing annuity is:
1   1 g  
n
PV  C1   1     (4.8)
r  g   1 r  
where C1 = the first cash flow of the annuity

g = the growth rate

You are offered the opportunity to pay $1500
for an investment that will pay you $150 in one
year. This payment will then grow at 5% per
year for the following 9 years (i.e. a total of 10
payments). Your opportunity cost is 4% p.a.
What is the NPV of this investment? Would
you undertake this investment?
A Yes B No C Don’t know

1   1 g  
n
PV  C1   1    
r  g   1 r  
1   1.05  
10
 150   1    
0.04  0.05   1.04  
 $1506.34
NPV = 1506.34 – 1500 = $6.34 A Yes

3.5.1 REARRANGING FORMULAS
 If you have a formula with one unknown
variable, and that variable only appears
once, rearranging the formula should allow
you to solve for that variable
 E.g. we can derive Formula 3.2 from 3.1:
FV  PV   1  r 
n
Substituting PV for C
FV
 PV  Dividing both sides of
 1 r 
n the equation by (1 + r)n

3.5.2 SOLVING FOR THE RATE OF RETURN

An investment will cost you $1000 and will
return $2000 in 5 years. What is the annual
rate of return?
1/ n
 FV 
FV  PV  1  r 
n
 r 
 PV 

1
1/ n 1/5
 FV   2000 
r   1    1  14.87%
 PV   1000 
3.5.3 SOLVING FOR THE ANNUITY CASH FLOW

You take out a $250,000 mortgage loan,
repayable over 20 years at an interest rate of
12% p.a., compounding monthly. What is the
monthly repayment?
We first adjust for r = 12% / 12 = 1%

monthly payments: n = 20 × 12 = 240
This problem is easily solved using a financial
calculator, but can solved using Formula 4.5
3.5.3 SOLVING FOR THE ANNUITY CASH FLOW
1 1 
C
PV
PV  C   1   
r   1 r  n


 1 1 
1 
 
  1 r 
n
r

250,000
C (4.9)
1  1 
1 240   $2752.72
0.01   1.01 
 
3.5.4 SOLVING FOR THE NUMBER OF PERIODS
 We can solve for FV  PV   1  r 
n
the number of
periods by   1  r  BL
E n

FV
rearranging
Formula 3.1 and I N A PV
 FV 
then solving
AMn ln  1  r   ln  
 PV 
using logarithms
E X

O T
You will not
 FV 
ln 
 PV  
N
need to do this
in this subject
n 
ln  1  r 
3.5.5 SOLVING FOR THE RATE OF RETURN FOR
AN ANNUITY
1
PV  C   1 
1 

Because r
appears twice
B L

E
r   1 r  n 
  in Formula
4.5, the only IN A
A
way to compute the rate of return on anM
X
annuity is to solve for r in the above
E
O T
equation using a financial calculator, a
spreadsheet, or trial and error
 N
You will not need to do this in this subject
3.6 Interest rates
3.6.1 ANNUAL PERCENTAGE RATE (APR)
 Interest rates can be quoted in different
ways, and we need to know how to interpret
them and convert between them
 So far we have mainly concentrated on the
interest rate per compounding period – the
discount rate (r) used in most TVM formulas
 Banks usually quote an annual interest rate
(the APR, or Annual Percentage Rate), and
they should also tell you how often interest is
compounded
3.6 Interest rates
3.6.2 INTEREST RATE PER COMPOUNDING PERIOD
 As we seen, to find the interest rate per
compounding period, we divide the APR by
the number of compounding periods per year
 The formula for finding the interest rate per
compounding period is:
APR
r 
m
where m = the number of compounding
periods per year
3.6 Interest rates
3.6.3 EFFECTIVE ANNUAL RATE (EAR)
 The problem with the APR is that it ignores
the effect of compounding
 For example, consider 10% p.a. compounded
annually
these interest rate quotes:
10% p.a. compounded
 They are clearly different quarterly
quotes, but they have the 10% p.a. compounded
same APR (10%) daily
 This makes comparisons between rates with

different compounding periods difficult
3.6 Interest rates
 If you need to compare alternative financing
arrangements, the best method is to convert
the quoted rate, or APR, to an Effective
Annual Rate (EAR)
 The EAR tells you how much you are
effectively paying or receiving, taking into
account the effect of compounding
 The EAR is the annually-compounded APR
that would leave you in the same position in
terms of interest paid or received
3.6 Interest rates
 The formula for Effective Annual Rate is:
m
 APR 
EAR   1   1 (5.3)
 m 
where EAR = The Effective Annual Rate

APR = The Annual Percentage
Rate
m = the number of compounding
periods per year
3.6 Interest rates

Would you prefer to borrow at 10%
compounded annually or 9.7% p.a.
compounded quarterly?m
10%
AEAR compounded
APR  annually
 1 1  
 m 
B 9.7% compounded
4 quarterly
 0.097 
C   1  between
Indifferent  the
1  10.06%
two
 4 
A 10% compounded annually is preferable
3.6 Interest rates
3.6.4 AMORTISING LOANS
 Most loans are either interest-only loans or
amortising loans
 With an interest-only loan, each repayment
comprises interest accrued since the last
payment – at the end of the loan period, the
principal borrowed is still outstanding
 With an amortising loan (and mortgage loans
are the prime example), each repayment
comprises both interest and principal – at the
end of the loan period, the loan is fully repaid
3.6 Interest rates
 Lecture Example
1  1 
3.23 was an $250,000  $2752.72  1  
0.01   1.01 240 
 
example of this
 The PV of the repayments equals the
amount borrowed, with nothing owing at the
 end
Each payment includes interest and principal:
 The principal is repaid over the life of loan
 Less interest is accrued each period; hence
less and less of each payment is interest and
more and more is repayment of principal
3.6 Interest rates

Consider the loan in Lecture Example 3.23 – a
$250,000 mortgage (amortising) loan to be
repaid via monthly payments of $2752.72 over
20 years at 12% p.a., compounding monthly
Create a spreadsheet showing:
 how much of each repayment is interest
 how much of each repayment is principal
 how much is owed at the end of each month
3.6 Interest rates

Month Payment Interest Principal Balance
250,000.00
1 2752.72 2500.00 252.72 249,747.28
2 2752.72 2497.47 255.25 249,492.03
3 2752.72 2494.92 257.80 249,234.23
238 5419.42
239 2752.72 54.19 2698.53 2720.90
240 2752.72
2748.11 27.21 2720.90
2725.51 0
-4.62
3.6 Interest rates
Lecture Example 3.26 The amount owing

is the present value
How much is owing on
of the remaining
the loan after 5 years?
180 payments:
1 1 
PV  C   1  
r   1 r  
n
 
1  1 
 2752.72   1 180 
 $229.361.21
0.01  1.01 
3.6 Interest rates
3.6.5 REAL AND NOMINAL INTEREST RATES
 So far we have restricted our discussion to the
nominal interest rate, which is the quoted or
observable interest rate paid or received
 Because we normally experience inflation,
which reduces the purchasing power of dollars
over time, the nominal interest rate does not
represent the increase in purchasing power
from an investment
 The rate that measures the increase in
purchasing power is the real interest rate
3.6 Interest rates
 The relationship between the nominal and
real interest rate is as follows:
1  rn   1  rr   1  π 
rn  rr  π
where rn = nominal interest rate
rr = real interest rate
π = the expected inflation rate
 The second formula above is a convenient
approximation when interest rates are low
3.6 Interest rates

If the nominal rate is 12% and the expected
inflation rate is 3%, what is the approximate real
interest rate? What is the exact real interest rate?
rr  rn  π  12%  3%  9%
1  rn   1  rr   1  π 
1  rn 1.12
 rr  1  1  8.74%
1 π 1.03
3.6 Interest rates
3.6.6 THE TERM STRUCTURE OF INTEREST RATES
 Until now we have treated “the interest rate” as
a single variable, but interest rates usually vary
across different financial assets
 Interest rates may reflect different variables,
such as credit risk, but the most important
variable is the term to maturity
 The relationship between interest rates and
term to maturity – the pattern of different rates
applying to different maturities – is referred to
as the term structure of interest rates
3.6 Interest rates
 The term structure of interest rates can be
represented graphically, via a yield curve
Interest rate The yield curve
shows the interest
rate, or yield, that
is currently
available for
otherwise identical
Maturity
securities with
different maturities
Short-term Medium-term Long-term

3.6 Interest rates
 Yield curves can take on a variety of shapes.
Commonly observed shapes include:
Interest rate
An upward
sloping yield
curve is referred
to as “normal”
because it is the
most commonly
Maturity observed shape
Positive or “normal”
3.6 Interest rates
Interest rate
When there is
little or no
difference
between short-
and long-term
rates, the yield
Maturity curve is referred
to as flat
Flat
3.6 Interest rates
Interest rate
A downward
sloping yield
curve is referred
to as “inverse”
because it is the
opposite of a
Maturity “normal” curve
Negative or “inverse”
3.6 Interest rates
Interest rate
A humped yield
curve, or other
non-standard
shape, usually
occurs when
there are varying
Maturity expectations
about future
Humped
rates
3.6 Interest rates
3.6.7 INTEREST RATE DETERMINATION
 Interest rates are set by the RBA, which uses
the cash rate to implement monetary policy
Monetary policy Cash rate

The main tool used to The rate charged on
influence economic growth, overnight loans between
inflation and unemployment financial institutions
 The cash rate is a very short term rate, but

as a result of market forces, changes in
the cash rate flow on to longer-term rates
3.6 Interest rates
 Long-term rates, and therefore the term
structure of interest rates and the shape of
the yield curve, are largely determined by
investor expectations regarding future
interest rates
 This is based on the assumption that capital
markets are perfect and that investors are
indifferent between investments with
differing maturities – they will always choose
the investment providing the highest return
3.6 Interest rates
Lecture Example 3.28 A

If short-term rates and long-term rates are equal
(say, 5% p.a.) but you expect short-term rates to
go up in the future (to 6%), would
you would
you prefer…
A series of successive
single long-term
B
A
short-term
investment?investments
A series
You could thenof“roll
successive
over” your short-term
B
short-term
investments andinvestments?
get higher rates in the future

3.6 Interest rates
Lecture Example 3.28 B
If you (and everyone else as smart as you)
prefers to invest short-term rather than long-
term, but there are still people who want to
borrow long-term, what will happen to long-term
interest rates?
A Increase Long-term rates would
B Decrease
increase until they are high enough to attract
investors,
C Remain at which point short-term investments
the same
do not provide higher returns
3.6 Interest rates
 As a result of this process, we would expect
current long-term rates to be the geometric
average of expected future short-term rates
 If this were not the case, arbitrage
opportunities would exist – arbitrageurs
could borrow at the point on the yield curve
where rates are lowest and invest where
they are highest, and the resulting market
forces would restore an equilibrium in which
the above prediction holds
3.6 Interest rates
 The question then is…
Why is an upward- Is it reasonable to assume
sloping yield curve that, most of the time,
considered investors expect interest rates
“normal”? to up rather than down?
 Probably not
As a result, those
In addition to investor wanting to borrow
expectations, something else long-term have to
is causing them to prefer offer higher rates to
short-term investments attract investors
3.6 Interest rates
 The reason is that long-term investments are
riskier than short-term investments
 Small changes in interest rates cause a much
greater change in the value of a long-term
investment than a short-term investment
 Because of this preference for short-term
investments, yields on long-term investments
will be somewhat higher than the predicted
yield based on purely on expectations
3.6 Interest rates
 This phenomenon results in higher yields
for long-term securities, but has little effect
on short term securities
Observed
Interest rate
yield curve
“Pure expectations” yield curve
Maturity
3.6 Interest rates
 The “upward bias” to what would otherwise
be a flat yield curve may help to explain why
an upward sloping yield is most commonly
seen
Interest rate
Observed
yield curve
“Pure expectations” yield curve
Maturity
3.6 Interest rates
 This hypothesis does not preclude an inverse
yield curve, but predicts that the yield curve
will be flatter (less negative) as a result
Interest rate
Observed yield curve
“Pure
expectations”
yield curve
Maturity
Topic 2 Appendices
Appendix 3.1 Detailed reading guide
Appendix 3.2 Further study and
Assessment
Appendix 3.3 Financial calculator
guide
Appendix 3.4 General calculator guide
Appendix 3.1
DETAILED READING GUIDE
Chapter Sections Pages
3 3.1, 3.3 and 3.4 65 – 68, 73 – 83
Not examinable: Section 3.2.
4 All 90 – 111
Not examinable: “Solving for the discount rate of an annuity”
and “Solving for the number of periods” (pp. 111 –115).
5 All 127 – 148
Not examinable: “Present value of a cash flow stream using a
term structure of discount rates” and “The yield curve and the
economy” (pp. 142 – 143).
*Note that Section 5.4 is not specifically covered in the Topic 2
lecture slides but is prescribed reading for later topics.
Appendix 3.2
FURTHER STUDY & ASSESSMENT
FIN1FOF Workbook
Questions 31 – 90 (pages 13 to 29 inclusive)
Textbook Questions/Problems (Berk 2nd
edition)
Chapter 3 – Problems 1-3, 9-11, 13-22
Chapter 4 – Review Questions 2-7
– Problems 3-15, 18-28, 30, 32, 34
Chapter 5 – Review Questions 5-9
– Problems 2-3, 5, 10-12, 26-27, 30
Appendix 3.2
FURTHER STUDY & ASSESSMENT
MyFinanceLab
Tutorial 2
Tutorial 3
Tutorial Quiz 2 (Tutorial 3)
Tutorial Quiz 3 (Tutorial 4)
Mid-semester Test
Final Examination
Appendix 3.3
FINANCIAL CALCULATOR GUIDE
Although not required for this subject, many
students find a financial calculator easier to use
in many situations instead of formulas, or use it
to double check the results from using formulas
The following slides demonstrate how to solve
selected Lecture Examples from Topic 2 using a
financial calculator
Buttons shown are for the Texas Instruments
BAII Plus, although others are similar
Appendix 3.3
There are five TVM (time value of money)

buttons on a financial calculator:
N I/Y PV PMT FV
For TVM calculations, you input four of the

variables and ask the calculator to compute the
value of the fifth variable
In many situations, you only need three input
variables, so the fourth can be set to zero or
you can clear all TVM values before you begin
Appendix 3.3
Lecture Example 3.5

4 years at an interest rate of 8% p.a.?
2ND FV This first step clears all TVM values from previous entires
4 N The next three steps input the number of periods, the

interest rate per period and the present value, respectively
8 I/Y
1 0 0 0 PV The last step computes the future

value, which appears as a negative
CPT FV number (if the present value is positive, the future
value is negative, and vice versa)
Appendix 3.3
Lecture Example 2.7

What is the present value of $4000 to be
received in 7 years if the interest rate is 5%
p.a.?
2ND FV For the remaining examples shown in this appendix,
it is assumed that you will clear all TVM values using
7 N this step, or else explicitly enter 0 for the variable
not being used. For example, instead of …
5 I/Y 2ND FV
you could enter…
4 0 0 0 FV
0 PMT
CPT PV In this example and get the same result.
Appendix 3.3
Lecture Example 2.8

4 years at an interest rate of 8% p.a., if interest
is compounded semi-annually?
8 N If interest compounds more than once per year, we

need to work out r (in this case, 4%) and n (8 years)
4 I/Y and enter the problem as if it was 4% p.a. for 8 years
1 0 0 0 PV
CPT FV
Appendix 3.3

What is the present value of $1 million per year
for the next 30 years (with the first payment in a
year’s time), if the interest rate is 8% p.a.?
3 0 N In this case the payment has been entered in

millions of dollars, so the answer will be in millions
of dollars ($11.26). To get the answer in dollars,
8 I/Y
you can enter the payment as 1000000, or
multiply the answer by 1 million.
1 PMT
For Lecture Example 3.18, enter the number of
CPT PV payments as 29 and then add $1 m to the answer.
Appendix 3.3

You are 25 years old, and have decided to save
$12,000 per year by making monthly deposits
into an account paying 12% p.a. compounding
monthly. How much will you have at age 65?
4 8 0 N Due to monthly
compounding, we are
1 I/Y entering the problem as if
it was $1000 per year at
1 0 0 0 PMT 1% p.a. for 480 years.
The answer is the same.
CPT FV
Appendix 3.3

An investment will cost you $1000 and will
return $2000 in 5 years. What is the annual
rate of return?
5 N Either the present

value or the future
value needs to be
1 0 0 0 PV
entered as a negative
number (using the +/-
2 0 0 0 +/– FV button) – otherwise
you will get an error
CPT I/Y message
Appendix 3.3

What is the monthly repayment on a $250,000
mortgage loan, repayable over 20 years at an
interest rate of 12% p.a., compounding
monthly?
2 4 0 N
1 I/Y
2 5 0 0 0 0 PV
CPT PMT
Appendix 3.4
GENERAL CALCULATOR GUIDE
Rounding errors
It is important to avoid rounding errors
whenever possible. Minor rounding errors will
not be penalised in this subject if it is clear that
the correct technique has been used, but major
rounding errors (especially errors so great that
it hard to be sure that the correct technique
has been used) will be penalised.
Appendix 3.4
Rounding errors
The best way to avoid rounding errors is to
never write down an intermediate answer and
then later enter it in your calculator. You should
keep intermediate answers in the calculator.
The following slides show three different ways
to solve Lecture Example 3.23 (using the BAII
Plus, but others are similar), avoiding the
necessity to write down intermediate answers
and therefore avoiding rounding errors.
Appendix 3.4
Algebraic Operating System

Before looking at these examples, it is important
to understand two different ways in which
calculators perform operations:
Chain – Operations are carried out in
the order in which they are entered
AOS – Operations are carried out in the
mathematically correct order (e.g. multiplication
is done before addition)
Appendix 3.4

Scientific calculators use AOS. Simple
calculators, and many financial calculators,
generally use the Chain system. The BAII
Plus, and most advanced financial calculators,
can be set to either.
All of the following examples assume your
calculator is set to use AOS. If your calculator
uses the Chain system you probably need to
use a lot more brackets to get the right answer.
Appendix 3.4

The following is a simple test to determine
which system your calculator uses (or has
been set to use). Enter the following
calculation:
1 + 2 × 3 =
If your answer is 9, your calculator uses the

Chain system. If your answer is 7 (which is the
correct answer) your calculator uses AOS.
Appendix 3.4

To set the BAII Plus to AOS, use the following
steps:
2ND .
If you want to change the number of

decimal places, at this point enter
↑ n ENTER
where n in this case is the number of
2ND ENTER
decimal places you want (e.g. 4).
2ND CPT
Appendix 3.4
Lecture Example 3.23 – Using brackets
The calculation becomes 250000/(1/0.01*(1-1/1.01^240))
and is entered as follows. If you are using the Chain
system, you need 250000/(1/0.01*(1-(1/(1.01^240)))) - i.e.
you need more brackets.
2 5 0 0 0 0 ÷ (
1 ÷ 0 . 0 1 × (
1 – 1 ÷ 1 . 0 1
yx 2 4 0 ) ) =
Appendix 3.4
Lecture Example 3.23 – Using the memory
If you find brackets tedious, you can minimise them by
storing intermediate answers in the calculator’s
memory. The following steps also reduce the use of
brackets by changing the order of some of the steps.
1 – ( 1 ÷ 1 . 0
1 yx 2 4 0 ) = ÷
0 . 0 1 = STO 1 2
5 0 0 0 0 ÷ RCL 1 =
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FIN1FOF

Investment Management Capital Operation Income Mananagement

Financial Structure WC Cash management

Time Value Risk and leverage

Efficient Finance Market

La Trobe Business School

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 4

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 5

 However, financial decision-making involves

Lecture Example 3.1

Lecture Example 3.2

Lecture Example 3.3

 The future value of $100,000 invested at

NPV  PV  Benefits   PV  Costs  (3.1)

 The NPV of the investment is equal to:

$1000 FV1 FV2

Lecture Example 3.4

$1000 FV1 FV2

PV0 PV1 $1000

Lecture Example 3.5

PV0 PV1 $1000

 What is the value

you multiply the cash flow by the interest

you divide the cash flow by the interest rate

Fammous“72” Principle 如何计算翻一番？

FIN3BFI Banking and Financial Institutions – Topic 2 –

Fammous“72” Principle 如何计算翻一番？

中国经济的 GDP 何时赶上美国的 GDP ？

FIN3BFI Banking and Financial Institutions – Topic 2 –

where C = the present cash flow

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 29

Lecture Example 3.6

 1000  1.08   $1360.49

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 30

Lecture Example 2.7

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 32

For example, interest could compound: To calculate r in the PV

Weekly 52 times a year Multiply the number of

Lecture Example 2.8

What is the number of periods (n)? 4  2  8

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 35

Lecture Example 2.9

What is the interest

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 36

where FV = the future value

Lecture Example 3.10

(The “second function” for the LN button raises e

Lecture Example 3.11

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 41

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 42

Lecture Example 3.12

1 400 400(1.06)4 504.99

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 44

Lecture Example 3.13

FV  1011.11 1.06   $1353.09

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 46

 Note that the first cash flow occurs at the

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 49

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 51

La Trobe Business School FIN1FOF Fundamentals of Finance – Topic 2 – Financial Mathematics 54

but it can be shown that this can be

Lecture Example 3.17