BCO126 Mathematics of Finance

3 ECTS
SPRING SEMESTER 2022
(week 1)

Dr. Daniel Biggemann

Dr. Daniel Biggemann
Academic Background
• Ph.D. Physics, State University of Campinas (Brazil)
• M.Sc. Physics
• MBA, Catholic University of Bolivia – Harvard Business School

Professional Experience
• Consultant UNDP, Independent Evaluation Office
• CEO, Pioneer Mining Inc.
• Research Director, Santa Lucia Mining
• Nationalwide Research Coordinator, Cath. Univ. Bol.
• Researcher, Max Plack Institut for Microstructure Physics
• Researcher, Brazilian Synchrotron Light Lab.
• Researcher visitor, Mat. Sci. Dept., Erlangen-Nürnberg University
Mathematics of Finance
What is Business?
• Finance
• Mathematics
• Working together
Mathematics of Finance – Description
• Success in finance means mastering its maths.
• This course covers FM at an introductory level.
• Mathematical finance is a field of applied mathematics,
concerned with mathematical modeling of financial
markets.
• This course reviews the basic theory of financial mathematics
covering the concept of rate of return, the understanding of
interest rates and their use in discounting future cash flows.
• Other concepts that are dealt with in detail are the effects of
compounding interest, the pricing and evaluation of bonds
and perpetuities and annuities.
• The course concludes with the concept of future value and the
effects of regular savings and pricing of pension plans and other
future cash flows.
Mathematics of Finance – Objectives
• Evaluate and assign a single value to a series of contingent cash
flows under different assumptions on the time value of money.
Familiarize students with treatments of percentages.
• Enable students to perform present and future value calculations
using discount factors in simple and compound interest.
• Familiarize students with the time value of money concept as well
as present and future value.
• Enable students to calculate and manipulate future value factors
and annuity factors for annual and other periods calculating
future value, savings outcomes and future revenue projections in a
perfect world.
• Explain the use of the calculator to solve financial problems.
• Prepare students for Business.
• Finance which will reinforce the knowledge base from this course.
Mathematics of Finance – Outcomes
• Understand the concept of time value of money.
• Define the concept of rate of return of a project in finance.
• Distinguish between simple and compound interest rates.
• Assess the present value of future cash flows and the future
value of regular savings, annually and periodically.
• Understand the perpetuity and annuity and their factors.
• Demonstrate an ability to apply the technical skills related to
the course in a practical context.
• Assess the future revenue generation of a regular savings scheme
and the amount needed to be saved over time to meet a future
series of payments.
• Understand the process of investments appraisal and
projects classification.
• Determine percentage calculations and discounting.
Course Content
Unit 1: Introduction to mathematics for finance
• What finance is all about.
• The goal of finance: The relative valuation. The math for finance
role.
• Investments, projects and firms:
o A project as a set of cash flows.
o Financial projects: Capital Budgeting.
o Business projects: Loans and financial claims (Bonds and
Stocks).
• The basic scenario: perfect markets, certainty and constant
interest rates.
Course Content
Unit 2: Time value for money and the rate of return
• The concept of time value for money.
• The concept of future value invested or borrowed today.
• The concept of present value of an amount to be paid or received
at a certain time in the future.
• The elements of a project: principal, cash flows, time and interest
rate:
o Interest rate: definition.
o Interest rate quotation for any span of time.
o Principal, cash flows, time and interest rate designations.
• Decimals and percentages.
• Returns, net returns and rate of return.
• Risk and return.
Course Content
Unit 3: Simple interest rate
• The simple interest rate: definition.
• The graph of simple interest versus time.
• Rate of return in simple interest rate.
• Future value or accumulated value in simple interest rate. The
accumulated factor in simple interest rate.
• Present value or discounted value in simple interest rate. The
discount factor in simple interest rate
Course Content
Unit 4: Compound interest rate
• The compound interest rate: definition.
• The graph of compound interest versus time.
• Future value or accumulated value in compound interest rate. The
accumulated factor in compound interest rate:
o Compound interest rate constant.
o Compound interest rate not constant.
• Present value or discounted value in compound interest rate. The
discount factor in compound interest rate:
o Compound interest rate constant.
o Compound interest rate not constant.
• Multi-period compounding interest.
• Rate of return in compound interest rate.
Course Content
Unit 5: Net Present Value in Capital Budgeting
• The future cash flows estimations of a project and the discount
rate.
• Investment appraisal and projects classification: Net Present
Value of a project in Capital Budgeting
• Net Present Value as an indicator of decision making in Capital
Budgeting.
• Internal rate of return (IRR) of a project.
• Payback period of a project.
Course Content
Unit 6: Perpetuities
• The shortcut formulas for present and future value.
• Annual simple perpetuities:
o Perpetuity concept.
o Present Value (PV) of perpetuities starting in one year.
o PV of perpetuities starting today.
o PV of perpetuities starting in future years.
• • Periodic simple perpetuities:
o Periodic payments and periodic rates.
o PV of periodic perpetuities with various starting dates.
• Perpetuities with growth:
o Annual and periodic perpetuities with geometric growth (g<r).
o Annual and periodic perpetuities with arithmetic growth.
Course Content
Unit 7: Annuities
• Annuities: definition and classification
o Definition and calculation of annuity factors for integer year
periods.
o Application of annuity factors to loans and as revenue
generation from lump sum investments.
o PV of annuities starting in future years.
• Future Value factors
o Calculation of future value of regular savings.
o Present value to Future Present Value to revenue stream.
o Time lines for investments and revenue.
o Desired revenue in future and savings levels to achieve this
revenue stream.
o Pension generation with and without inflation adjustments.
Course Content
Unit 7: Annuities (continued...)
• Growth:
o Factoring geometric growth into annuities (inflation
protection).
o Factoring geometric growth into savings plans.
o Deriving savings schemes from future revenue requirements.
Bibliography
1. Makgwale, Wilson (2012). Financial Mathematics Made Easy. 1st
Edition TNL Publishers.
2. Zima, Petr (2007). Mathematics of finance. New York: McGraw-
Hill Ryerson Ltd (or later editions) (2011).
3. Hastings, Kevin J. (2016). Introduction to Financial Mathematics.
Boca Raton (FL): CRC Press (Taylor and Francis Group).
4. Capinski, M. and Zastawniak, T. (2012) Mathematics for Finance:
An Introduction to Financial Engineering. 2nd Edition Berlin:
Springer Undergraduate Mathematics Series.
5. Joshi, M.S. (2008) The Concepts and Practice of Mathematical
Finance. 2nd Edition. Cambridge: Cambridge University Press.
6. Wiersema, U.F. (2008) Brownian Motion Calculus, 1st Edition.
Hoboken: Wiley.
Assessment Methodology

Task Date Percentage

Mid-term Assessment Week 6 (28.02-06.04) 40%
Final Assessment Week 13 (02.05-08.05) 60%

2 h – written examination
Rules inside the classroom

📵 at least silent Cheating

🚭 🚫🧨
🕰❓ Suggestions?
🤔
What is Finance?
• Finance is the study of how people and businesses evaluate
investments and raise capital to fund them.
→ How to get and use money.
• Three questions addressed by the study of finance:
1. What long-term investments should the firm undertake?
(capital budgeting decisions: how to spend the money?)
2. How should the firm fund these investments? (capital
structure decisions: how to get the money?)
3. How can the firm best manage its cash flows as they arise in its
day-to-day operations? (working capital management
decisions: how to manage cash (liquid) money?)
The goal of finance
• Finance (using mathematics) is necessary for us to decide where to
invest our money.
• Where we should borrow money on one time basis -simple and
compound interest and as an annuity- more than one payment.
• With the math of finance we can find what is the best option for us
from the economical point of view.
The relative valuation
A point of view is needed to valuate a company.
• The firm´s financial worth is determined comparing the firm with
its competitors.
• There are some indicators such as ratios (price, earnings, etc…)
• An absolute valuation gives no information of the firm
compared with another average company.
• A relative valuation model can be used, for example, to assess the
value of the company's stock price compared to the industry
average.

What do we need to do that? Math of finance!!!

A very easy example
• We are buying a car
o How it looks / Brand
o Technology / Accessories
o Technical description
• Price > Money value > Monetary value
• In 2020: 30,000 €, but today?
• 3 reasons why the price is not the same:
o Interest/interest rate – cost of money
o Inflation – money losing value over time
o Depreciation – things are used

• How does the price change? RATE of change!

Four basic principles of finance
• Money has a time value.
o A dollar received today is more valuable than a dollar received
in the future (due to interests, investment returns,…)
• There is a risk-return trade-off.
o One shall take extra risk only if one expects to be compensated
for extra return.
• Cash flows are the source of value.
o Profit is an accounting concept designed to measure a
business’s performance over an interval of time.
o Cash flow is the amount of cash that can actually be taken out of
the business over this same interval.
• Market prices reflect information.
o Investors respond to new information by buying and selling
their investments.
Investments
• The money is invested to have a return. The higher the return, the
higher the risk (mining company)... Have in mind your invest goal
and thus your risk tolerance.
• A good practice: risk diversification. The risk is always present
where an investment is done, but the best way to spread the risk is
to diversify the investments. Never put all the eggs in the same
basket!!!
• The inflation is there: is your invest has no return rate, your
money will be worth less.
A project: a set of cash flows
An investment is done to run a project.
• How much investment will be needed?
• How does the money will be managed?
• A set of financial decisions must be done
Capital budgeting decision
o Decision to invest in tangible or intangible assets
o Also called the investment decision
o Also called capital expenditures or (CAPEX)
o Tangible Assets (example)
• Expand Stores @ $800 million
o Intangible Assets
• New Drug R&D @ $800 million
 Capital budgeting and Financial decisions
• Capital budgeting in financial management is related to a strategic
plan for business growth, such as acquisition of assets.
• Financing decisions define how a plan will be followed for paid for
- sometimes it's paid through debt or retaining earnings of the
company or new investors.
Company Investment decisions Financing decisions
Facebook Acquires WhatsApp for $22 billion Pays for the purchase with
a mixture of cash and
Facebook shares
Fiat – Chrysler Announces plans to spin off its Ferrari Repays €2.5 billion of
luxury car unit medium term debt
Tesla Spends $250 million largely on Raises over $300 million
manufacturing in Berlin by the sale of new shares
Vale Sets aside $2.6 billion to develop its Maintains credit lines of $5
huge coal mine in Mozambique billion with its banks
A quick quiz…
• Intel decides to spend $1 billion to develop a new microprocessor.
• Volkswagen borrows 350 million euros (€350 million) from
Deutsche Bank.
• Royal Dutch Shell constructs a pipeline to bring natural gas
onshore from a production platform in Australia.
• Avon spends €200 million to launch a new range of cosmetics in
European markets.
• Pfizer issues new shares to buy a small biotech (BioNTech)
company.
Investment and Financial decisions

Company
Assets

Investment decision

Debt Equity

Financing decision
Types of Business
Features of the business

Sole
Partnership Coorporation
propiertorship

Wo owns the
The manager Paertners Shareholders
business?

Are manager(s)
and owner(s) No No Usually
separate?

What is the owner

Unlimited Unlimited Limited
´s liability?

Are the owner and

business taxed No No Yes
separatey?
Briefly: cooperatives
An autonomous association of persons united voluntarily to meet
their common economic, social, and cultural needs and aspirations
through a jointly-owned enterprise.
• Coffee, cocoa small producers...
• Handmakers (jewerly)
A simple exercise…
You are a shareholder in a corporation. The corporation earns $8 per
share before taxes. After it has paid taxes, it will distribute the rest of
its earnings to you as a dividend. The dividend is income to you, so
you will then pay taxes on these earnings. The corporate tax rate is
25% and your tax rate on dividend income is 20%.
How much of the earnings remains after all taxes are paid?
The role of the financial manager
(1) Cash raised from investors.
(2) Cash invested in firm.
(3) Cash generated by operations.
(4a) Cash reinvested.
(4b) Cash returned to investors.

(2) (1)

Firm´s Financial
Financial manager (4a)
operations markets

(3)
(4b)
The financial manager
Remuneration:
• Salary
• Bonus
• Shares
Refers to anyone responsible for significant corporate investment
or financing decision.
Manager should keep resources of the business in balance.

Need to obtain resource <=> how to finance the

resource
Capital budgeting
decision
Decision as to which real
assets the firm should acquire
Financing decision
Decision as to how to raise
the money to pay for
investments in real assets
Our basic scenario
Perfect market
• Understood as a market where the sellers of a product or service
are free to compete fairly.
• The sellers and buyers have access to a complete information.
o Internet makes the rules easier in the creation to play in a
perfect market.
• Certainly of the data.
• Constant interest rates.