Chapter 5

Financial mathematics

©2019 John Wiley & Sons Australia Ltd

 Learning objectives

After studying this presentation, you should be able to:

5.1 discuss cash flows, interest and the time value of
money
5.2 solve simple interest problems
5.3 compute the prices of discount securities
5.4 understand the compound interest formula so
that you can calculate both future and present values
5.5 calculate both present and future values of annuities
 Learning objectives

5.6 calculate both present and future values of unequal

amounts
5.7 apply the annuity and single sum formulas to
calculate the price of a general bond.
 Cash flows, interest and the time value of
money

• Cash flows are funds flowing into or out of a business;

that is, cash receipts or expenses.
• The reasons we deal with cash are that we want to be
able to compare values at different points in time, we
want to be able to reduce multiple flows to single values
and we want to be able to make rational decisions.
• Interest is the price charged for the temporary use of
money.
• Interest performs an allocative role in economies.
 Cash flows, interest and the time value of
money cont’d
• Interest rates are set by the interaction of supply and
demand.
• Put more explicitly, the level of interest rates stems
from individuals’ time preference for consumption and
production opportunities facing entrepreneurs and
investors.
• The time value of money is the concept that a dollar is
worth more the sooner it is received.
• This is because the dollar represents purchasing power
which may be rented out to others and earn a return, if
the owner does not need it immediately for
consumption.
Cash flows, interest and the time value of
money

• Thus, the principle with the time value of money is

that money received now is worth more than the
same amount received in the future because of the
return that could be earned on the money between
now and the future date.
 Simple interest

• Simple interest is interest calculated on the

principal sum borrowed.
• The equation for the calculation of simple interest
is given by equation 5.1:

Interest = Pin

• where P is the principal sum borrowed, i is the

simple interest rate and n is the number of periods.
 Simple interest

• Simple interest is applied to many sorts of bank deposits,

such as savings accounts and term deposits, as well as
many types of loans. Debenture and commercial loans on
an interest-only basis also operate on a simple interest
basis.
 Simple interest

• Future and present amounts of a single sum

‒ The future value of a single sum calculated using simple
interest is given in equation 5.2:
Principal + interest = FS
= P + Pin
= P(1 + in)
FS = P(1 + in)

‒ Where FS is the sum that must be repaid.

 Simple interest

‒ The present value of a single sum calculated using

simple interest is given in equation 5.3:

FS
P=
(1 + in)
 Simple interest

• An Application Of Simple Interest: Pricing Commercial

Bills
‒ Some of the most important rules for solving
commercial bill pricing problems are:
• Interest rates are quoted on a simple annual basis
and pro-rated for the actual period of the loan
• Pro-rating takes place on the basis of the exact
number of days divided by 365
 Simple interest

• In a leap year, 29 February is charged for if the loan

is outstanding over this day, but the year is still
assumed to have 365 days.
‒ With these rules to hand, some commercial bill
problems may be illustrated.
 Simple interest

• An application of simple interest: calculating the proceeds

from a commercial bill
‒ Demonstration problem 5.3
• The inputs for this problem are as follows:
• FS = $40,000; in = 5.6% and; n = 90/365

$40 000 $40,000

P= (1 + 0.056 x 90 ) = (1 + 0.0138) = $39,455.51

365
 Simple interest

• An application of simple interest: calculating the interest

rate of a commercial bill
‒ Demonstration problem 5.4
• The inputs for this problem are as follows:
• P = $97 600; FS = $100 000 and n = 180/365
 Simple interest

• The yield is the amount produced or the return based on

the initial investment; yields are normally expressed as
percentages.
• Yield can be thought of as the effective cost to the
borrower.
• A discount rate (in relation to pricing a security) is the
percentage difference between the face value and the
purchase price of the security.
 Simple interest

• While a yield relates to P or the actual amount borrowed, a

discount relates to the face value of the future value or
future sum, FS, of the bill.
• In Australia, we normally trade money market securities in
terms of yield. However, in some other economies (e.g.
USA), short-term securities are traded on a discount basis.
 Simple interest

• The formula for calculating the selling price (or present

value) of a money market security using a discount basis
is given in equation 5.4:

– Where SP is the selling price and FS is the face value

(or sum that must be repaid).
 Compound interest

• Compound interest is the interest calculated on the actual

amount outstanding each period.
• Compound interest is based on the idea that, while
interest charged on an outstanding principal amount or
debt remains unpaid, interest should be charged on that
new part of the debt as well as the original principal.
 Compound interest

• Using Time Lines

‒ A time line is a diagrammatic representation of cash
flows either received or paid or both.
‒ A time line may look like this, where PV equals present
value (value at time zero) and FV is the future value at
the end of the denominated time periods:
 Compound interest

• Future and present value of single sum

‒ For the compound interest equations, we refer to PV rather
than P because the discounting and compounding processes
have more applications than simply calculating loans.
‒ The formula for calculating FV of a single sum using
compound interest is give below:

‒ Where is the future value at the end of the period ,

is the present value and is the
compounding rate.
 Compound interest

• Future and present value of single sum

• Demonstration problem 5.6
• The inputs for this problem are as follows:
• PV = $20 000; k = 7 and n = 5.

FV5 = 20 000(1.07)5
= 20 000(1.4025) = $28 051
 Compound interest

• Future and present value of single sum

‒ Demonstration problem 5.7
• The inputs for this problem are as follows:
• PV = $20 000; k = 0.07/12 and n = 5*12
FVn = 20 000 (1 + 0.058)60
= 20 000 (1.4148)
= $28 296
 Compound interest

• Future and present value of a single sum

– The FV equation may be manipulated so that it will give
the PV of a future sum.
• The present value of a single sum calculated using
compound interest is given in equation 5.6:
 Compound interest

• Future and present value of a single sum

– Demonstration problem: 5.8
• The inputs for this problem are as follows:
• PV = $60 000; k = 0.06/12 and n = 3*12.
 Compound interest

• Nominal and effective interest rate

– The nominal rate is the advertised or quoted rate that
does not reflect the impact of a multiple compounding
periods during the year.
– The effective rate reflects the impact of multiple
compounding during the year.
– The equation for the effective annual rate is:
 Compound interest

– is the annual effective rate, j is the nominal annual

rate and m is the number of compounding
periods each year.
 Compound interest

• Nominal and effective interest rates

‒ Demonstration problem 5.9
• The inputs for this problem are as follows:
• j = 12% and; m = 12.
 Future and present value of several equal
sums
• An annuity is a series of equal cash flows that are evenly
spaced over time.
• There are 4 types of annuities:
‒ Ordinary Annuity where the payments flow at the end of
each even-length period.
‒ Annuity Due where the first payment is received on the
day of valuation.
‒ Deferred Annuity where the first payment is deferred for
a period greater than the subsequent even-length periods.
‒ Perpetuity where the cash flows continue forever.
Future and present value of several equal
sums
• Ordinary annuities
‒ Equations 5.8 and 5.9 are used to calculate the PV
and the FV of ordinary annuities respectively:

• Where PVA is the present value of an ordinary

annuity at the end of period n, FV An is the future
value of an annuity at the end of period n, C is the
cash flow, and k is the discount factor.
 Future and present value of several equal
sums

• Ordinary annuities
‒ Demonstration problem 5.10
• The inputs for this problem are as follows:
• C = $10 000; k = 6% and; n = 5.
Future and present value of several equal sums

• Ordinary annuities
‒ Demonstration problem 5.11
• The inputs for this problem are as follows:
• C = $20 000; k = 8% and n = 18
 Future and present value of several equal
sums

• Ordinary annuities
‒ Just as with the FV and PV of a single sum, tables are
available to provide the compounding and discount
factors for the calculation of FVs and PVs of ordinary
annuities.
 Future and present value of several equal
sums

• Other types of annuities

‒ Annuity due
• An annuity due is only an ordinary annuity with an
extra payment added on the front end of the series
of cash flows.
• The equation for calculating the FV of an annuity
due is:

• Where FV AD is the future value of an annuity due, C

is the periodic cash flow, and k is the discount rate
(compounding rate).
 Future and present value of several equal
sums

• Other types of annuities

‒ Annuity due: Demonstration problem 5.12
• The inputs for this problem are as follows:
• C = $60 000; k = 5% and; n = 21
 Future and present value of several equal
sums

• Other types of annuities

‒ Annuity due
• The equation for calculating the PV of an annuity
due is:

• Where PVAD is the present value of an annuity due.

 Future and present value of several equal
sums
• Other types of annuities
‒ Annuity due - Demonstration problem 5.13
• The inputs of this problem are as follows:
• C = $60 000; k = 5% and n = 21.
 Future and present value of several equal
sums

• Other types of annuities

‒ Deferred annuity
• A deferred annuity has its first payment made after
several periods have elapsed.
• The equation of calculating the PV of an annuity due
is:

• Where PV AB is the present value of deferred annuity

and b is the number of periods before the annuity
begins.
 Future and present value of several equal
sums
• Other types of annuities
‒ Deferred annuity: demonstration problem 5.14
• The inputs for this problem are as follows:
• C = $60000; k = 5%; n = 21 and; b = 2.
Future and present value of several equal sums

• Other types of annuities

‒ Perpetuity
• A perpetuity is a series of regular equal payments
that continue forever.
• The equation for calculating PV of a perpetuity is:

• Where PVP is the present value of a perpetuity, C is

the periodic cash flow and k is the discount rate.
 Future and present value of several equal
sums

• Other types of annuities

‒ Perpetuity: demonstration problem 5.15
• The inputs for this problem are as follows:
• C = $0.2 and; k = 5%.
 Present and future value of unequal sums

• A stream of unequal amounts is not an annuity and

cannot be manipulated by the use of annuity equations.
• Thus, any problem with different amounts must be solved
using the single-sum equations for either the FV or PV, as
required.
 Solving cash flow problems

• A few steps to follow when solving cash flow problems

are:
‒ Draw a time line and insert the cash flows
‒ Identify what component of the required
information is unknown
‒ Decide the class of problem and apply the
appropriate equation
‒ Write down the equation(s), manipulate them so
that the unknown value is on the left-hand side,
insert the values as given and solve.