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CHAPTER 11

MATHEMATICS OF FINANCE

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 SYLLABUS CONTENT
CH TOPIC WEEK
1 Introduction to Financial Management 1
2 Financial Analysis (Financial ratio) 2
2 Financial Analysis (Sources and Uses Statement) 3
4 Working Capital Management 4
3 Financial Forecasting and Planning (Pro-Forma) 5
3 Financial Forecasting and Planning (Cash budget) 6
5 Cash Management 7
6&7 Marketable Securities Management & Accounts Receivable 8
8 Inventory Management 9
9 Short Term Financing 10
10 Long Term Financing 11
11 Mathematics of Finance 12
12 Capital Budgeting 2
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 CHAPTER OUTLINE

NO. CONTENT
1. Time Value of Money
2. Present Value and Future Value
3. Present Value Annuity and Future Value Annuity

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 TIME VALUE OF MONEY (TVM)

What is Time Value of Money?

 A concept on value of the money we have at different points of time

(i.e., the Ringgit one-year from now is not equal to the value of a
Ringgit to be received today).

 Everyone knows that money invested or deposited in a savings account

will earn interest and grow with time. Because of this fact, we prefers
to receive money today rather than the same amount in the future.

 The idea that money available at the present time is worth more than
the same amount in the future due to its potential earning capacity.
This core principle of finance holds that, provided that if money can
earn interest, any amount of money is worth more the sooner it is
received. Also referred to as "present discounted value".
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 TIME VALUE OF MONEY: ILLUSTRATION

What is Time Value of Money?

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 Simple Interest Versus Compound Interest

Simple Interest
 Interest is earned only on principal.

Example:
Compute simple interest on $100 invested at 6% per year
for three years.

1st yearinterest is $6.00

2nd year interest is $6.00
3rd year interest is $6.00
Total interest earned: $18.00

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 Simple Interest Versus Compound Interest

Compounding Interest
 Compounding is when interest paid on an investment during the first period
is added to the principal; then, during the second period, interest is earned
on the new sum (that includes the principal and interest earned so far).
 In simple interest calculation, interest is earned only on principal.
Example:
Compute compound interest on $100 invested at 6% for three years with
annual compounding.

1st year interest is $6.00 Principal is $106.00

2nd year interest is $6.36 Principal is $112.36
3rd year interest is $6.74 Principal is $119.11

Total interest earned: $19.10

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 FUTURE VALUE

 Is the amount a sum will grow to in a certain number of years when

compounded at a specific rate.
 Future Value can be computed using formula, table or calculator.

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 A) Future Value Using Formula

FVn = PV (1 + i) n

Where
FVn = the future of the investment at the end of “n” years
i = the annual interest (or discount) rate
n = number of years
PV = the present value, or original amount invested at the beginning of the
first year

Example: What will be the FV of $100 in 2 years at interest rate of 6%?

FV2= PV(1+i)2 = $100 (1+.06)2

$100 (1.06)2 = $112.36

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 Increasing Future Value (i.e., Changing I, N, and PV)

Future Value can be increased by:

Increasing number of years of compounding (n)
Increasing the interest or discount rate (i)
Increasing the original investment (PV)

Example
 You deposit $500 in a bank for 2 years … what is the FV at 2%? What is the
FV if you change interest rate to 6%?
 FV at 2% = 500*(1.02)2 = $520.2
 FV at 6% = 500*(1.06)2 = $561.8

 Others remain, but change time to 10 years. What is the FV now?

 FV at 6% = 500*(1.06)10= $895.42

 Others remain, but change contribution to $1500. What is the FV now?

 FV at 6% = 1,500*(1.06)10 = $2,686.27

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 B) Future Value Using Table

FVn = PV (FVIFi,n)

Where
FVn = the future of the investment at the end of n year
PV = the present value, or original amount invested at the beginning of
the first year
FVIF = Future value interest factor or the compound sum of $1
I = the interest rate
n = number of compounding periods

Example:
What is the future value of $500 invested at 8% for 7 years? (Assume annual
compounding). Using the tables, look at 8% column, 7 time periods to find the
factor 1.714

 FVn = PV (FVIF8%,7yr) = $500 (1.714) = $857

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 PRESENT VALUE

 Present value reflects the current value of a future payment or receipt.

 It can be computed using the formula, table or calculator.

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 A) Present Value using Formula

PV = FVn {1/(1+i) n}

Where
FVn = the future value of the investment at the end of n years
n = number of years until payment is received
i = the interest rate
PV = the present value of the future sum of money

Example
What will be the present value of $500 to be received 10 years from today if
the discount rate is 6%?

PV = $500 {1/(1+.06)10}
= $500 (1/1.791) = $500 (.558) = $279

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 B) Present Value using Table

PVn = FV (PVIFi,n)

Where
PVn = the present value of a future sum of money
FV = the future value of an investment at the end of an investment period
PVIF = Present Value interest factor of $1
I = the interest rate
N = number of compounding periods

Example
What is the present value of $100 to be received in 10 years if the discount rate is
6%?. Find the factor in the table corresponding to 6% and 10 years

PVn = FV (PVIF6%,10yrs.)
= $100 (.558)
= $55.80
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 ANNUITY

 An annuity is a series of equal dollar payments for a

specified number of years.

 Ordinary annuity payments occur at the end of each period.

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 FUTURE VALUE OR COMPOUND ANNUITY

 Depositing or investing an equal sum of money at the end of

each year for a certain number of years and allowing it to grow.

Example
What will be the FV of 5-year $500 annuity compounded at 6%?

FV5 = $500 (1+.06)4 + $500 (1+.06)3 +$500(1+.06)2 +

$500 (1+.06) + $500

= $500 (1.262) + $500 (1.191) + $500 (1.124)+

$500 (1.090) + $500
= $631.00 + $595.50 + $562.00 + $530.00 + $500
= $2,818.50

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 Illustration: Compound Annuity

Growth of a 5yr $500 Annuity Compounded at 6%

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 Future Value of Annuity Using Formula and Table

FV = PMT { (FVIFi,n -1) / i }

Where
FV n = the future of an annuity at the end of the nth years
FVIFi,n = future-value interest factor or sum of annuity of $1 for n years
PMT = the annuity payment deposited or received at the end of each year
I = the annual interest (or discount) rate
n = the number of years for which the annuity will last

Example
What will $500 deposited in the bank every year for 5 years at 6% be worth?

Simplified form of this equation is: FV5 = PMT (FVIFAi,n) or = PMT [ (1+i)n -1 ]

i
= $500 (5.637)
= $2,818.50
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 Future Value of Annuity: Changing PMT,N and I

a) What will $5,000 deposited annually for 50 years be worth at 7%?

 FV= $2,032,644
 Contribution = 250,000 (=5000*50)

b) Change PMT = $6,000 for 50 years at 7%

 FV = $2,439,173
 Contribution= $300,000 (=6000*50)

c) Change time = 60 years, $6,000 at 7%

FV = $4,881,122;
Contribution = 360,000 (=6000*60)

d) Change i = 9%, 60 years, $6,000

FV = $11,668,753;
Contribution = $360,000 (=6000*60)

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 PRESENT VALUE OF ANNUITY

 Pensions, insurance obligations, and interest owed on bonds are all

annuities. To compare these three types of investments we need to know
the present value (PV) of each.
 PV can be computed using calculator, tables or formula.

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 Present Value (PV) Using Formula

 PV of Annuity = PMT [1-(1+i) -n]

i
= 500 (4.212)
= $2,106

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 Present Value (PV) Using Table

 Calculate the present value of a $500 annuity received at

the end of the year annually for five years when the
discount rate is 6%.

PV = PMT (PVIFAi,n)
= $500(4.212) (From the table)
= $2,106

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 Annuities Due

 Annuities due are ordinary annuities in which all payments have been
shifted forward by one time period. Thus with annuity due, each annuity
payment occurs at the beginning of the period rather than at the end of the
period.

 Continuing the same example. If we assume that $500 invested every year
at 6% to be annuity due, the future value will increase due to compounding
for one additional year.
 FV5 (annuity due)

= PMT [ (1+ i )n -1] (1+i)

i
= 500(5.637)(1.06)
= $2,987.61 (versus $2,818.80 for ordinary annuity)

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