Financial Mathematics and Investments

Chapter Objectives

Review the mathematics underlying time value of money problems

Discuss criteria for selecting investments for reallocating consumption
Describe the basic types of investments and their attendant characteristics
Discuss common performance measurements used to compare investments

Introduction
During adult life people make consumption and investment decisions to balance
their need for immediate consumption with the desire to accumulate wealth. Investing,
purchasing appropriate amounts of life, health and annuity coverage and engaging in
financial planning provides certainty to a family's future consumption pattern.
This chapter focuses on two issues underlying this life-long process. First, we
describe the importance of the time value of money and the mathematical techniques
used to solve a variety of time value of money problems. Second, we introduce
investment topics, describe different types of investments, suitability for different
purposes, their associated risk and measurements of performance. The goal is to
provide a background in investment topics and to describe alternatives cash value life
insurance for saving. The chapter presents examples solved algebraically and by a
popular computer spreadsheet program. Computer spreadsheet programs can be used
effectively in solving financial problems and as a tool in making long-term projections
and decisions.1

1Lotus 1-2-3 spreadsheet formulas are used - a product of Lotus Development Corp. Other
spreadsheet programs have similar formulas and work just as well.

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Financial Mathematics and Investments

Financial Planning Issues

1) How does the time value of money influence financial planning decisions?
The amount of interest paid on investments influences the amount that needs to be
deposited on a periodic basis to meet certain financial goals. Inflation and deflation can
also modify the purchasing power of the dollar especially over long periods of time.
2) What investments can be substituted for cash value life insurance allowing
consumers to allocate lifetime consumption? Cash value life insurance has a unique
function and a shared function. No other contract can promise a death benefit whenever
death occurs (the unique function). Other investments, however, compete with its
shared function, accumulating saving. Alternative investments include stocks, bonds,
U.S. Treasury securities and collectibles. Each investment has specific characteristics
with respect to liquidity, risk and return.
3) How do consumers make intelligent long-term projections of income,
expenses and investment returns? Long-term financial planning is difficult because the
future is unknown. Individuals, however, must make intelligent decisions based upon
incomplete information and they must make projections based upon reasonable
assumptions of future conditions. Personal computers and spreadsheet software
simplifies the process allowing for changes in income and expense patterns and
providing instantaneous recalculation of results based upon the changes made in the
assumptions or formulas.

Financial Mathematics

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Financial Mathematics and Investments

The impact of compound interest on making financial decisions is significant

especially when long periods are involved. For the purpose of this discussion, the
reader is assumed to be somewhat familiar with present value and future value
concepts. We provide only a brief review of these concepts.2
Future value of $1
When money is invested at a positive interest rate, the sum grows to a larger
amount, the future value, by a specific factor (1 + i)n. This relationship is expressed
algebraically as:
FV = PV x (1 + i)n

Formula 1

where
FV = future value amount
PV = present value amount
i = interest rate
n = the number of periods the money is to be invested at rate i.
For an example, if $1,000 is deposited at an interest rate of 7 percent for one
period (in this example, one year), the future value will be $1,070. If the $1,070 is now
invested for one year at 7 percent, the original $1,000 will grow to $1,144.90. This can
be calculated by using Formula 1:
FV = $1,000 x 1.07 x 1.07 or
FV = $1,000 x 1.072
FV = $1,000 x 1.1449
FV = $1,144.90
Many financial problems can be solved with Formula 1.
Example 1

2For a detailed source see Elbert B. Greynolds, Jr., Julius S. Aronofsky and Robert J. Frame,
Financial Analysis Using Calculators: Time Value of Money (New York: McGraw-Hill, 1980).

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Financial Mathematics and Investments

How much will a depositor accumulate at the end of four years if $1,500 is
deposited now at 8 percent interest compounded annually?
FV = PV x (1 + i)n
FV = $1,500 x (1.08)4
FV = $1,500 x 1.3604
FV = $2,040.60
Example 2
What yearly rate of return is generated if $1,500 grows to $2,000 in five years
when interest is compounded annually?3
FV = PV x (1 + i)n
$2,000 = $1,500 (1 + i)5
$2,000 / $1,500 = (1 + i)5
1.333 = (1 + i)5
1.3331/5 = (1 + i)
i = 1 - 1.3331/5
i = 0.059
Use the following spreadsheet formula to calculate future value factors. For 8 percent for 4 periods (see
Example 1) use: +(1+.08)^4 = 1.3604
The 5th root of 1.333 or the periodic growth rate for Example 2 is: 1.333^(1/5) = 1.059

Present value of $1
The process of calculating the future value of an amount growing at some stated
rate can be reversed. This concept is called present value. One question answered with
present value is how much must be deposited so the investment will grow to a stated
amount at some future point. Calculating the present value (Formula 2) of an amount is
just the inverse of calculating the future value amount.

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Financial Mathematics and Investments

PV = FV x [1 / (1 + i)n]

Formula 2

Example 3
How much money must be deposited today so that in 10 years $20,000 will be
accumulated if the interest rate is 12 percent?
PV = FV x [ 1 / (1 + i)n ]
PV = $20,000 x [1 / (1 + .12)10]
PV = $20,000 x 0.322
PV = $6,440.00
Present values and present value factors are used extensively in calculating life
insurance premiums and the reader should be familiar with and be able to solve
problems using formulas 1 and 2.4
Use the following spreadsheet formula to calculate present value factors. For 6 percent for 5 periods use:
+1/((1+.06)^5) = 0.7472

Annuities
Not all cash flows occur as one lump sum. Many investments involve a series of
equal payments . Streams of equal payments are called annuities.5 One must be
careful when analyzing annuities. Single payments or streams of payments can occur at
the end of a period or at the beginning of a period, thus affecting the compounding
process. When a payment is made at the end of a period, as in the present value and
future value calculations discussed above, the annuity is called an ordinary annuity.

3To solve for i, one may simply use future value time value of money tables. (See the book's
appendix for selected factors.) Look for approximately 1.333 in the table for five periods. The result is
found at 6 percent.
4These and other formulas are reproduced in Appendix to this text.

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Financial Mathematics and Investments

When the payment occurs at the beginning of the period, the annuity is called an
annuity due. Formulas 3 and 4 provide the formulas for calculating the present value of
an annuity and an annuity due.

PVa = A x

n
S
t=1

[1 / (1 + i)]t

Ordinary Annuity Formula 3

n-1
PVd = A x S
[1 / (1 + i)]t + 1
Annuity Due Formula 4
t=1
(note: replace "S" with mathematical sum sign in above 2 equations.)
An example will help distinguish between the two. If people receive an annuity (A
= $100) consisting of two payments and the discount rate is 10 percent, the respective
present values of the ordinary annuity and the annuity due are computed as follows:
Ordinary annuity:
PVa = ($100 x .909) + ($100 x .826)
PVa = $173.50
Annuity due:
PVd = ($100 x 1.00) + ($100 x .909)
PVd = $190.90
In the ordinary annuity calculation the first payment is discounted one year and
the second payment is discounted two years. In the annuity due calculation, payment is
received at the beginning of the period and the present value of the first payment is
equal to $100. The second payment is only discounted for one year.

5This is a financial definition of an annuity. The term is also used in life insurance to describe a

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Financial Mathematics and Investments

Tables are constructed to provide present value and future value annuity factors
consisting of sums of the present value and future value factors. By looking at the above
example, the sum of the present value factors in the ordinary annuity case is equal to
1.735 (.909 + .826) and the sum of the annuity due factors equal 1.909 (1.00 + .909).
The factors 1.735 and 1.909 appear in their respective tables for a two-year annuity
under the discount rate of 10 percent. The formulas to calculate the time value of money
factors are found in Appendix ?? to this book.
Table 1 demonstrates how the present value of an annuity and how the present
value of an annuity due may be calculated using a spreadsheet program. The method
demonstrated assumes that your computer software calculates the present value of a
stream of equally spaced, regular or irregular dollar amounts. The @NPV function
performs the task in Lotus 1-2-3 and other programs. Refer to Table 1 which shows the
calculation of the present value of a hypothetical education fund. In the years 1993
and 1994 we assume that $7,000 is needed for expenses. We calculate the present
value of the stream of payments at the beginning of each year.
The formula used for the ordinary annuity for 1992 (cell D8) in Table 1 is equal to
@NPV($D$3,D6...$F$6) and equals the sum of the present value of the numbers found
in D6, E6 and F6. The discount rate is found in cell D3.6 The formula for the annuity

specific type of contract, as defined in Chapter 5.

6The "$" sign is used in formulas to fix cell as an absolute reference if the formula is copied.

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Financial Mathematics and Investments

due (cell D10) is equal to +D6+@NPV($D$3,E6...$F$6). This adds the number found in
cell D6 to the present value of education amounts found in cells E6 and F6.7
Table 1 Illustration of an Annuity and Annuity Due
1
2
3
4
5
6
7
8
9
10
11

A
B
C
D
Present Value of Education Fund
Inv. Rate
Education Expense
PV of Education Fund
Annuity
Annuity Due

1992
0

1993
7,000

1994
7,000

12,396

13,016

6,667

13,016

13,667

7,000

0.05

Example 4
If Mr. Wilkinson wants to retire in 10 years with $100,000 dollars in savings, how
much must be deposited at the end of each year (PMT) so that the $10,000 will be
available? Assume a 7 percent annual interest rate.
FVa = PMT x FVAF at 7% for 10 periods
$100,000 = PMT x 13.816
PMT = $100,000 / 13.816
PMT = $7,237.98
where
FVAF = Future value annuity factor
Mr. Wilkinson will have $100,000 available at the end of 10 years if $7,237.98 is
deposited at the end of each period and if funds deposited earn 7 percent.
Example 5

7The formula in F10 is +F6 since the present value of one payment received immediately is equal
to that number.

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Financial Mathematics and Investments

How much will the annual payment be if $50,000 is borrowed to purchase a

house over 30 years at a 10 percent annual rate? Each loan payment is made at the
end of the year.
PVa = PMT x PVAF at 10% for 30 periods
$50,000 = PMT x 9.4269
PMT = $50,000 / 9.4269
PMT = $5,303.97
where
PVAF = Present value annuity factor
Thus, at 10 percent the bank is indifferent between receiving $50,000 now or
$5,303.97 at the end of each year for the next 30 years.
Example 6
If Mrs. Webster can afford a payment of $200 at the end of each year for 12
years, what is the maximum that can be borrowed if the interest rate is 12 percent?
PVa = PMT x PVAF at 12% for 12 periods
PVa = $200 x 6.194
PVa = $1,238.80
At a 12% loan rate, Mrs. Webster makes 12 - $200 annual payments to repay the
$1,238 loan.
The following spreadsheet formulas calculate the present value and future value of an annuity:
@FV(payments, interest, term) Future Value of an annuity (payments made at the end of the period.
@PV(payments, interest, term) Present Value of an annuity (payments made at the end of the period.
@NPV(interest, range) Net Present Value of a range of amounts (payments are made at the end of
period.
@TERM(payments, interest, future value) Calculates the number of payments made at the end of period
necessary to accumulate the future value at the interest rate.
To adjust for an annuity due use:
@FV(payments, interest, term)*(1+interest)
@PV(payments, interest, term)*(1+interest)
@TERM(payment, interest, future value/(1+interest))

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Financial Mathematics and Investments

Example 7 - Mortgage Balance Calculator8

While constructing your financial plan, you may need to calculate the remaining
balance of a loan. We present a generalized mortgage calculator. Some money
management programs have this function built in, but escrow amounts, private
mortgage insurance and other loan peculiarities often result in only a close
approximation of your actual results. Refer to Table 2 which shows the results of
calculating the remaining balance at the end of each year for a $80,000, 10 year
(payable at the end of each year), 10 percent mortgage loan.
Table 2 Mortgage Calculator
A
B
C
D
1 Mortgage Calculator
2
3
4 Assumptions:
5
Principal
80,000
6
Interest Rate
0.100
7
Years
10
8
Payments per Yr.
1
9
10 Output:
11
Total # Payments
10
12
Rate per period
0.1
13
PV. factor
6.145
14
Periodic Payment 13,020
15
16
17

Balance End
Per. of Period
0
80,000
1
74,980
2
69,459
3
63,385
4
56,704
5
49,355
6
41,270
7
32,378
8
22,596
9
11,836
10
0

The mortgage payment is equal to the principal amount divided by the present value of an annuity factor
@PV(1,interest,term) calculates the present value of a $1 annuity.
80000/@PV(1,0.1,10) = 13020

8Some of this material is adapted with permission from Dorfman, Mark S. and Adelman, Saul W.,
The Dow Jones-Irwin Guide to Life Insurance, Dow Jones-Irwin, Chicago, IL, 1988.

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Financial Mathematics and Investments

The following formula alternatively can be used to calculate the mortgage payment:
@PMT(principal, interest, term)
The outstanding principal balance at the end of the year is calculated by subtracting the principal
payment from the beginning principal amount:
beginning principal - (payment - (beginning principal x interest rate))

Investing - Reallocating Consumption

Any savings program represents a reallocation of consumption. Saving for
college or a home means postponing current consumption to allow future consumption
to take place. From the standpoint of financial efficiency, determining the goal for saving
also determines the investment strategy and the savings medium used. If the savings
goal is short term, for example, the investor would not choose to put funds in hard to
liquidate investments or whose liquidation causes adverse tax consequences. When
people save or reallocate consumption to the future, funds are invested to take
advantage of growth opportunities. A variety of investments with different risk, return
and liquidity characteristics compete with cash value life and annuity contracts for
personal savings. Some of these investments including cash value life insurance enjoy
a favorable tax status.
Making investment decisions requires the simultaneous consideration of the
following four characteristics:

liquidity
safety
current yield and growth potential
taxability.

Liquidity

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Financial Mathematics and Investments

Liquidity means an investment can be turned into cash quickly without suffering a
decline in value attributed solely to changing the investment into cash. This concept is
distinguished from a change in the value solely due to market conditions.
Example 8
A $1,000, 8% coupon, 30 year bond is purchased at 100% of its maturity value or
$1,000. If market interest rates decline to 6%, the market price of the bond will increase.
The bond is considered liquid since an active secondary financial market exists allowing
easy cash sales. A small transaction charge reduces the proceeds. The increase in the
bond's value is due to market conditions. The existence of an active secondary financial
market enhances the bond's liquidity.
The most liquid investments, such as bank deposits, may be turned into cash
quickly without penalty. Investments in publicly traded securities are easily marketable.
When securities are bought or sold, transaction costs usually apply and there is a slight
delay in obtaining the cash after the sale. Certificates of deposit (CDs) can be converted
to cash quickly but "substantial" penalties may apply if the CDs are cashed in before
maturity. Investments in real estate or business ventures are less liquid than publicly
traded securities. Cash sales of real estate or business assets often require a long time,
a considerable concession in price and the payment of substantial transaction costs.
Investments with maximum liquidity typically have lower rates of return than less
liquid investments. Maximum current liquidity is not required for investments made to
finance retirement income, especially when the investments are made during middle
age. As one approaches retirement years, a portion of one's investments should be
systematically switched from illiquid to liquid investments.

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Financial Mathematics and Investments

Safety
Safety - or its opposite, "riskiness" - relates to the variability of realized and
expected returns. The return on a safe investment held to maturity can be predicted
accurately in advance and the possibility of monetary loss is low. Short-term U.S.
government obligations, Treasury notes, are often spoken of as being risk free because
the return is predictable and the chance of loss is assumed nonexistent. Long-term U.S.
government bonds and notes are subject to loss of value when interest rates rise, but
are assumed to have no risk of default. The greater the riskiness of an investment, the
greater the variation in possible gains or losses. As a general rule, the greater the
investment's safety, the lower its expected return. While safety is important in saving for
retirement, maximum safety is not required. The investor may be willing to sacrifice
some safety to achieve greater yield.
Figure 1 provides a list of common investments arrayed by risk. U.S. Treasury
bills are considered to be virtually risk free, while common stocks (especially of small,
newer companies) are the highest risk investments.

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Financial Mathematics and Investments

FIGURE 1
Relative Risk of Common Investments
Low Risk:
U.S. Treasury bills
Commercial paper
Long-term government bonds
High Risk:
Long-term corporate bonds
Preferred stock
Common stock

Risk or the uncertainty associated with an investment's results can be

categorized in a variety of ways and arises from several sources. The following
categories describe the more important sources of risk:

purchasing power risk

market risk
interest rate risk
issue specific risk.

Purchasing power risk. The loss of purchasing power caused by the general rise
in prices is one risk investors must be concerned about, especially over long time
periods. If prices increase, the purchasing power of a fixed amount of principal
declines. Typically, investors seek investments producing rates of return that, at least,
compensate for lost purchasing power. These investments are considered "hedges
against inflation." Investors must realize that these investments do not guarantee a
stable purchasing power level, but provide the opportunity to achieve the results.
Fixed types of securities such as bonds, CDs, savings accounts and life
insurance cash values (in traditional products) are not good hedges against inflation.
Equity investments are better inflation hedges than fixed investments. However, no sure
hedge exists against inflation. In times of low or moderate levels of inflation, a portfolio

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Financial Mathematics and Investments

of equity investments may increase in value and offset the effects of the reduction in
purchasing power. However, in times of rapid inflation, the value of stock tends to fall
dramatically if the government uses monetary policy to fight general price increases.
Market risk. Market risk refers to the general trend of changes in the value of the
securities market. Market risk may be the result of inflationary expectations, political
announcements, the risk of war, unexpected insolvencies or default, changes in
international monetary exchange rates or comparative advantage shifts in the
expanding global economy. Investors summarize these trends by labeling the market a
"bull" or a "bear" market. If the market, as measured by one of the many indexes, is
falling it is labeled a bear market, if rising, a bull market. Thus, an investor is subject to
market risk due to timing of the purchases or sales.
Example 9
Harry Smith needs to liquidate a sufficient amount of shares in a high quality
mutual fund to replace the roof on his house. Because a bull market has existed for two
years, Harry only needs to liquidate 100 shares to pay for his roof. If a bear market
existed for two years, Harry would have to liquidate 200 shares to produce the required
amount of cash.
Interest rate risk. Changes in the level of interest rates can increase or decrease
investment value. An inverse relationship exists between investment values and
changes in interest rates. If interest rates decline, investment values increase. If interest
rates increase, investment values decline.
Example 10

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Financial Mathematics and Investments

Sara Butler purchased a high quality $1,000 bond. The bond pays $80 interest
per year (8% coupon). If interest rates increase such that a comparable bond yields
12%, the value of Sara's bond falls. Since the bond pays only $80 annually, the value
(what someone would pay for it) declines to produce a yield of 12 percent.
current yield before = 8% ($80 / $1000)
current yield after = 12% ($80 / $666.66)
Price x 0.12 = $80.00
Price = $80 / 0.12
Price = $666.66
The longer the maturity, the more sensitive is this relationship. The price of a 30
year bond changes more dramatically than that of a 10 year bond since both market
values equal the present value of all future cash flows.
Example 11
Compare the difference in market value of a $1,000, 8% bond purchased at par.
If prevailing rates of return change to 12% from 8%, the following theoretical market
value results.
The present value of $80 for 10 years plus a maturity value for $1,000 at 12%
equals $774. The present value of $80 for 30 years plus a maturity value for $1,000 at
12% equals $678.

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Financial Mathematics and Investments

Year Payment
PV
1
80
0.893
2
80
0.797
3
80
0.712
4
80
0.636
5
80
0.567
6
80
0.507
7
80
0.452
8
80
0.404
9
80
0.361
10 1,080
0.322
Sum of PV amounts

Pmt x PV
71.43
63.78
56.94
50.84
45.39
40.53
36.19
32.31
28.85
347.73
773.99

Year

Payment
PV
1
80
0.893
2
80
0.797
3
80
0.712
4
80
0.636
5
80
0.567
6
80
0.507
7
80
0.452
8
80
0.404
9
80
0.361
10
80
0.322
11
80
0.287
12
80
0.257
13
80
0.229
14
80
0.205
15
80
0.183
16
80
0.163
17
80
0.146
18
80
0.130
19
80
0.116
20
80
0.104
21
80
0.093
22
80
0.083
23
80
0.074
24
80
0.066
25
80
0.059
26
80
0.053
27
80
0.047
28
80
0.042
29
80
0.037
30 1,080
0.033
Sum of PV amounts

Pmt x PV
71.43
63.78
56.94
50.84
45.39
40.53
36.19
32.31
28.85
25.76
23.00
20.53
18.33
16.37
14.62
13.05
11.65
10.40
9.29
8.29
7.40
6.61
5.90
5.27
4.71
4.20
3.75
3.35
2.99
36.05
677.79

The above table shows the calculation on a year by year basis. Alternatively,
present value of annuity factors may be used to discount the annual payment. Present
value of $1 factor may be used to discount the $1,000 maturity amount.
Issue specific risk. Issue specific risk, default or financial risk arises from
changes in the issuer's financial condition. These changes may lead to less security for
bond holders, a reduction in the dividend amount to stockholders, not paying or

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Financial Mathematics and Investments

defaulting on bond interest payments and the inability to retire or refinance outstanding
debt. Issue specific risk may reduce if the profitability of the firm improves. Therefore,
issue specific risk focuses on the timing and magnitude of expected cash flows and its
certainty.
Example 12
Purchasers of Rydex bonds have increased their required rate of return to 15
percent. This increase is the result of Rydex's rise in the proportion of debt to equity
financing. Bond holders view the issue as more risky since the amount of debt has
increased in the capital structure and it is more difficult to make the required interest
payments.
Current yield and growth potential
Current yield and growth potential may be combined and spoken of as the total
return on an investment. Total return is always of concern because if one investment is
chosen, another must be forgone. Holding other factors constant, rational investors
choose investments with the highest total return. However, other factors cannot be held
constant in the real world, nor can investors ever have all the information needed to
make the optimal choice. The theory that rationality is bounded by the costs of acquiring
information applies to investment decision making. In general, the higher an
investment's potential total return, the less its safety. If an investor wants more return it
will be accompanied by more risk.
Tax Aspects of Investments
The possibility of deferring or eliminating federal, state and/or local taxes is a
consideration in many savings decisions and is especially germane to a discussion of

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Financial Mathematics and Investments

saving for retirement. As Chapter 11 explains, investments may have no tax advantages
and be fully taxable, produce tax free income or produce tax deferred income.9
Taxable Investments. Investments with no tax advantage require owners to pay
tax on current income and pay tax on any capital gains when sold. Taxable investments
are not limited to common or preferred stock but include investments such as rare
coins, art work and antiques.
Example 13
Jake purchases 100 shares of Rydex stock for $32. During the year he receives
a $1.50 per share dividend. Jake must report $150 as dividend income. Next year, Jake
sells the stock for $36 per share. Assuming no transaction costs, the capital gain of
$400 ([$36 - $32] x 100 shares) is taxable in the year sold.
Tax deferred vs. tax free investments. An important distinction exists between tax
deferred and tax free investments. Tax free investments such as state and local bonds
generally are free of federal income taxes. However, any capital gains and losses are
treated as taxable events. Tax-deferred income arises when income that otherwise
would be currently taxed is given special treatment, delaying imposition of the tax.
Ultimately however, the tax must be paid. Important sources of tax-deferred income
include the cash value of life insurance contracts, annuities and U. S. Savings Bonds.10
Depending on the type of plan, the amount contributed to the tax advantaged account is

9A mathematical example of the value of tax deferred income is given in the appendix to Chapter
11. Also see: M. S. Dorfman and S. W. Adelman, "Comparing the TDA to a Non-TDA Investment
Program for Accumulating and Liquidating Wealth," CLU Journal, January 1983, p. 40.
10The cash value increases of life insurance contracts are tax deferred. If the contract matures
as a death claim, the policy face including the cash value is usually paid tax free to the beneficiary.

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Financial Mathematics and Investments

deductible for income tax purposes. In such cases, when a taxable event occurs, all
funds received are taxable since no tax was ever paid on the principle or investment
earnings. Examples of tax deductible and tax deferred investments include the
individual retirement account (IRA) under certain circumstances, the Section 401(k) plan
and the Section 403(b) plan.11 The IRA and 403(b) plans have tax penalties if
withdrawals are made before age 59 1/2.12
A Numerical Comparison. Assume an individual earns $4,000 and has three
options for investing the money. The three options include 1) a fully taxable investment,
2) an investment with investment earnings tax deferred and 3) an investment with the
tax on current income and investment earnings deferred. Table 3 shows the results of
using $4,000 of before tax income to make the various investments.

11The IRA and the 403(b) plans are described in Chapter XX.
12See Chapter XX for a discussion of the taxation of IRAs and other tax advantaged
investments.

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Financial Mathematics and Investments

TABLE 3
COMPARISON OF INVESTMENT RESULTS
BASED ON TAX METHOD
Current Income
Fully
Tax Deferred
Reduced and
13
14
Taxable
on Earnings
Tax Deferred15
Amount Before Tax $ 4,000
$ 4,000
$ 4,000
Tax Rate
0.30
0.30
0.30
Invested Funds
2,800
2,800
4,000
Rate of Return
0.08
0.08
0.08
Year
Account Balance Account Balance Account Balance
1
$ 2,957
$ 3,024
$ 4,320
2
3,122
3,266
4,666
3
3,297
3,527
5,039
4
3,482
3,809
5,442
5
3,677
4,114
5,877
6
3,883
4,443
6,347
7
4,100
4,799
6,855
8
4,330
5,183
7,404
9
4,572
5,597
7,996
10
4,828
6,045
8,636
11
5,099
6,529
9,327
12
5,384
7,051
10,073
13
5,686
7,615
10,878
14
6,004
8,224
11,749
15
6,340
8,882
12,689
16
6,695
9,593
13,704
17
7,070
10,360
14,800
18
7,466
11,189
15,984
19
7,884
12,084
17,263
20
8,326
13,051
18,644
Taxation
Taxes paid
Taxes payable
Taxes payable
method
on earnings
on total amount
= 0.30 x (13,051= 0.30 x 18,644
2,800)
Penalties may apply
when withdrawn early.
Wealth
After Taxes
$8,326
$ 9,976
$ 13,051
This example assumes all funds are withdrawn at the end of 20 years.

13Investments such as CDs and mutual funds.

14Investments such as cash value life insurance and Series EE Bonds.
15Investments such as tax-deferred IRA, 401(k) and 403(b) plans.

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Financial Mathematics and Investments

In the first option, the fully taxable investment, only $2,800 is invested since
taxes must be paid on the $4,000 of income. Taxes at the rate of 30 percent are also
paid on investment income earned each year. With the second option, where only
investment earnings are tax deferred, $2,800 is invested since tax must be paid on the
$4,000 of earnings. In this case, investment earnings are tax deferred - tax is paid on
earnings only when withdrawn. The original $2,800 is not taxable at withdrawal since it
has already been taxed. The third option defers tax on current income and investment
earnings. Taxes are paid on current income (the $4,000) and investment earnings when
withdrawn. Table 3 shows that wealth after taxes is maximized if current taxable income
is reduced by the contribution and earnings are deferred until withdrawn. A fourth option
is also illustrated by Table 3. If a tax-free investment is made with after tax dollars
($2,800), the resulting wealth after 20 years equals $13,051.16
Basic Types of Investments
Investments may be divided into two categories - fixed income investments and
equity investments.
Fixed Income Investments
Fixed income investments pay the investor a fixed rate of interest over the life of
the investment. The principle amount is returned at maturity. Common fixed income
investments include bank passbooks, CDs, corporate bonds, municipal bonds, U.S.
Treasury Securities and traditional cash value life insurance. Most fixed income
investments may be purchased directly or indirectly using a mutual fund. A mutual fund

16Tax free investments usually pay lower rates of return. For the purpose of this comparison, the

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Financial Mathematics and Investments

pools the assets of many investors and purchases the securities in the financial
markets.
Bank instruments. Saving accounts, some checking accounts, CDs and money
market accounts are fixed investments. Return of principal is guaranteed and relatively
low amounts of interest are paid. These alternatives are highly liquid. And, there is low
risk associated with these types of investments since the principal amount is not subject
to market fluctuation and there is little or no cost for withdrawing the funds except early
withdrawal penalties. These investments are typically guaranteed up to $100,000 by the
Federal Deposit Insurance Corporation (FDIC).
Corporate Bonds. Corporate debt obligates the issuer to pay a stated interest
amount (coupon rate) on the principal until the investment matures. At maturity the
principal or face amount is returned. The quality of corporate bonds vary according to
the credit worthiness of the issuer, the interest rate, the maturity date, sinking fund
provisions and callable features.
Mortgage bonds are secured by real and fixed property owned by the
corporation. Debentures are unsecured debt based on the faith in the issuer's earning
capacity. Upon default, there is less security for the debenture owner than the mortgage
bond holder.
Many bonds contain a callable provision. If a bond is callable, the issuer can
retire the bond before the maturity date. Issuers call outstanding issues to take
advantage of lower interest rates. For example, if Acme Corporation has an outstanding

tax free investment also earns 8 percent.

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Financial Mathematics and Investments

12% bond and interest rates decline to 8%, it is advantageous to retire the 12% debt
and refinance it at the lower rate. Many callable bonds provide creditors with a measure
of call protection for the first 5 to 10 years of the issue. Investors lower their required
rate of return in exchange for such call protection. Most bonds are retired or called
before they mature. Either the issuer repurchases them in the financial markets or
exercises the bond's call provision.
Often bonds require a sinking fund. Sinking funds require systematic retirement
of a bond issue or the accumulation of a fund for ultimate retirement. Sinking funds
protect bond holders by requiring the firm to set-aside sufficient cash or to repurchase
the bonds in the financial markets.
Deep-discount or zero coupon bonds pay a low or zero interest rate for the use of
the funds. The market price for these bonds can be well below its face amount which
produces the investor's required yield. With a zero coupon bond, instead of the bond
paying a competitive interest rate (coupon percent), the bond holder receives his return
from capital appreciation (approaching the maturity value of the bond) instead of current
income.
Example 14
The market price of a 20 year, $1,000, zero coupon bond equals $61.10 (0.0611
x $1,000) if the investor's required rate of return is 15 percent. [1 / (1.15)20 = 0.0611]
The market price of the same bond with only 10 years until maturity is $247.18
(0.2471 x $1,000). [1 / (1.15)10 = 0.2471]
Municipal Bonds. Cities, towns, states, housing authorities and political
subdivisions can issue municipal bonds. Interest paid on municipal bonds is exempt

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Financial Mathematics and Investments

from federal income tax. Some issues are also exempt from state and local taxes. When
an investor sells a municipal security, capital gains (or losses) are taxable events.
Municipal bonds are attractive to people in high marginal tax brackets. Depending upon
the person's marginal tax bracket, more wealth may be accumulated by investing in
municipals than in a comparable risk taxable investment. If a person is subject to a low
marginal tax rate, more wealth may be kept by making taxable investments and paying
the applicable tax.
Example 15
Jake has the opportunity to purchase a tax free investment yielding 8 percent or
a taxable investment yielding 10 percent. His marginal tax rate is 30 percent. The after
tax yield of the tax free investment is equal to 8% since no tax is paid. The after tax
yield on the taxable investment equals 7% [0.10 x (1 - 0.30)]. Jake should invest in the
tax free investment since it has a greater after tax yield.
In order to make the taxable investment attractive, it must yield greater than
11.43 percent [0.08 / (1 - 0.30)]. If the taxable investment yields 11.43% the after tax
yields of both investments are equivalent [0.1143 x (1 - 0.30) = 0.08].
U.S. Treasury Securities. The United States Government finances its $3 trillion
debt by selling Treasury bills, notes and bonds. Table 4 presents a schedule of
Treasury Securities based upon the type, maturity, minimum purchase and the
frequency of issue.

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Financial Mathematics and Investments

Type

Table 4
Treasury Bills, Notes and Bonds
Maturity

Treasury Bills

3, 6 and 12 months

Treasury Notes

2 or 3 years

4 - 10 years
Treasury Bonds

Over 10 years

Minimum Purchase/
Issued
$10,000 (sold in multiples
of $5,000) 3 and 6 month
bills issued weekly
(Monday); 12 month sold
monthly.
$5,000 (sold in multiples of
$5,000) 2-year notes
monthly; 3-year notes
quarterly.
$1,000 (sold in multiples of
$1,000); Sold quarterly.
$1,000 (sold in multiples of
$1,000); Sold quarterly.

Treasury bills, notes and bonds can be purchased directly from the Federal
Reserve through the Treasury Direct System or indirectly through banks and brokerage
houses. Treasury bills are zero coupon instruments sold at a discount. Notes and bonds
have a stated coupon and pay interest semiannually. New notes and bonds cannot be
redeemed before their stated maturity. However, notes and bonds are actively traded in
the secondary markets.17
Purchasing Treasury bills at a discount raises the effective return. If a $10,000, 1
year bill is purchased with an 8% coupon, the purchase price equals $9,200 since the
interest is subtracted from the face amount. The effective return equals 8.69% ($800 /
$9,200) not 8% ($800 / $10,000).

17Secondary markets exist to provide a marketplace to buy and sell securities after they are sold
by the issuer.

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Financial Mathematics and Investments

Since the Federal Government is the issuer, income is exempt from state and
local taxes and no risk of default exists. There is, however, risk associated with general
economic conditions and reinvestment risk. That is, if the owner sells the security before
maturity, the price received is a function of the prevailing interest rates and the maturity
date. Also, when the security matures or is sold, there is risk associated with the
financial environment at the time of reinvestment.
The Treasury yield curve is reported in publications such as the Wall Street
Journal on a daily basis and shows the relationship of yield to maturity. The publication
also supplies information concerning new issues, sales in the secondary market and the
results of Treasury auctions. Figure 2 shows the yield curve of at the close of business
on Thursday March 14, 1991.
Figure 2 Treasury Yield Curve
Friday, March 15, 1991, 1990 (Wall Street Journal)

U.S. Savings Bonds. Series EE and Series HH U.S. Savings bonds can be
purchased and sold from financial institutions with no transaction costs. Series EE

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Financial Mathematics and Investments

bonds are issued on a discount basis. Interest accrues over time increasing the bond's
redemption value. The purchase price of the bond is 1/2 the face amount.
Denominations range from $50 to $10,000. An annual purchase limit of $30,000 (face
amount) applies. If there are co-owners, the limit is doubled.
If the Series EE bond is held less than five years, the bond currently pays a rate
of 4.16 percent (held six months). The rate gradually increases based upon the holding
period to the minimum rate at 5 years. When the Series EE bond is held five years or
longer, the interest is set at the higher of 1) 85 percent of the average return
(compounded semi-annually) on 5 year marketable Treasury securities or 2) the
minimum rate (currently 6 percent).
No state or local income taxes apply to interest earned. Federal income tax on
any accrued interest can be deferred until the bonds are cashed or they mature. The
U.S. Treasury sets the maturity date and the minimum interest percent when issued. If
bonds are held past maturity, no interest accrues unless the maturity date is extended.
Series HH bonds pay current income semiannually. Series HH bonds are only
available through the exchange of Series EE bonds and are issued by the Federal
Reserve Banks and the Bureau of Public Debt. Purchasers of Series EE bonds may
defer income tax on earnings by purchasing HH bonds. Then, when the HH bond
matures or is redeemed, income tax on the deferred earnings must be paid. The current
income paid by the HH bond is taxable income.
The denomination and the purchase price are equal for Series HH bonds. They
have a 10 year term to maturity and do not earn market interest rates. Currently, the

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Financial Mathematics and Investments

owner receives a semiannual payment of $15.00 for each $500 denomination or 6

percent annually. These payments are subject to Federal income tax when received.
Example 16
Randy Turnup has a $5,000 Series EE bond which is currently worth $5,500. It is
11 years old. No income tax has been paid on accrued earnings. Randy exchanges the
Series EE bond for an HH bond. Each year Randy receives $330 ($15 x 2 x $5,500 /
500) from the semiannual payments and reports $330 in taxable income. When the HH
Bond matures or is cashed in, $3,000 must be reported in taxable income ($5,500 $2,500 purchase price). The $3,000 is the deferred earnings on the EE Bond.
Equity Investments
Equity investments, such as common stock, entitle the investor to the residual
earnings of the company. These investments have no stated maturity date and do not
guarantee a specific rate of return. Equity investments can be purchased directly in the
secondary markets or indirectly through a mutual fund.
Common Stock. When investors buy common stock, they receive a proportionate
share in the ownership of the corporation. That means after all obligations are met, the
owner has a claim on the residual assets or income of the company. Common stock
owners control the organization through their voting power and bear the major portion of
the business risk, but usually benefit the most from the gains.
Common stockholders receive benefits in two ways. First, if the company pays
cash dividends, stockholders receive a portion of the company's earnings. Second, if
the price of the stock increases, the wealth of the owner increases and the security can
be sold in the secondary capital markets. The first income source is referred to a

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Financial Mathematics and Investments

dividend income and the second as capital gains. If the company performs poorly,
dividends may be reduced or eliminated and the value of the stock may decline
producing capital losses.
Dividends may be paid in cash, may be reinvested (if a reinvestment plan exists)
or be paid by a stock split or dividend. Stock splits or dividends increases the number of
outstanding shares while the value of each outstanding share declines by a
proportionate amount. Stock splits and dividends by themselves do not increase the
wealth of the owner, but they give recognition to past earning retentions. Cash
dividends and capital gains (or losses) are taxable events and are reported annually.
Preferred Stock. Preferred stockholders receive a fixed payment even though the
security represents equity capital. Preferred stock does not have a maturity date like
bonds, but can be convertible and callable. If a 7%, $100 par value preferred stock is
purchased, the corporation promises to pay $7 each year after the debt holders are paid
but before any payment to the common stockholders. If the preferred stock is
convertible, it may be exchanged for common stock. Preferred stockholders typically do
not have voting rights unless the dividends are cumulative and have not been paid. Any
past due cumulative preferred stock dividends must be paid before the common
stockholders receive any dividend distribution.
Refer to Table 5 which reviews the characteristics of several alternate
investments to cash value life insurance. All of the investments have a different set of
attributes relative to liquidity, safety, current yield, potential growth and tax. Since the
investor must make investment choices to meet financial goals, one investment type

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Financial Mathematics and Investments

may not meet all savings needs efficiently and therefore, savings strategy may rely on
multiple types of investments.
TABLE 5
CHARACTERISTICS OF SELECTED INVESTMENTS
Type

Liquidity

Safety

Current Yield

Growth
Potential
Cash value
amount
scheduled.

Tax

Whole Life
Insurance

Cash value is
highly liquid.

Cash value
amount
scheduled.

Cash value
amount
scheduled.

Universal Life
Insurance

Highly liquid.
Fees may
apply to
withdrawals

Cash value
based on
investment
results.

Based on
investment
results. Added
to cash value.

Based on
investment
results.

Corporate
Bonds

Active
secondary
market.
Commission
paid on
transaction.
Active
secondary
market.
Commission
paid on
transaction or
direct
purchases.
Active
secondary
market.
Commission
paid on
transaction.
Active
secondary
market.
Commission
paid on
transaction.

Ranges from
high grade to
"junk."

Based on
coupon rate.

Value inversely
related to
interest rates.

No default risk.

Based on
coupon rate.

Value inversely
related to
interest rates.

No state and
local tax on
interest.
Capital gains
taxable.

Low to high
risk depending
on issue.

Based on
dividend
payment.

High growth
possible.
Depends on
issue.

Tax on
dividends and
capital gains.

Low to high
risk depending
on issue.

Based on
coupon rate.

Limited due to
fixed
distribution.

Tax on
dividends and
capital gains.

U.S.
Treasuries

Common
Stock

Preferred
Stock

No tax as cash
value
increases.
Possible tax on
surrender.
No tax as cash
value
increases.
Possible tax on
surrender.
Current
income and
capital gains
taxable.

Performance Measurements
People need to monitor and measure accurately the performance of their
investments. Since one goal of the investor is to maximize the rate of return and capital

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Financial Mathematics and Investments

gains of the investment, it is important to calculate and know their rate of return. The
following section provides a description of various performance measures with
examples. These measures include the price / earnings ratio (P/E), the current yield, the
holding period return and yield and, the yield to maturity. In addition, the difference
between after-tax and before-tax yields and returns are discussed along with basic
portfolio and diversification concepts and the mathematics of dollar cost averaging.
Price earnings ratio (P/E)
The P/E ratio is calculated by dividing the current market price of a share of
common stock by its earnings per share. The P/E ratio measures the willingness of
investors (in market price) to pay for the right to the future earnings of the corporation.
current market price
P/E ratio = ------------------------------------- Formula 5
earnings available for
common shareholders

Example 17
Ardmore stock is selling for $26.00. Over the latest 12 months, Ardmore earned
$2.20 per share. The P/E ratio is equal to 11.81 ($26.00 / $2.20).
A high P/E ratio usually signals investors expect the earnings of the corporation
to grow and they are willing to increase the price in order to participate in the expected
profitability of the firm. Lower P/E ratios may be found where the company pays out
most of its earnings in current dividends, is quite stable in earnings or investors feel it
has little future growth prospects. P/E ratios of a particular stock should be compared to
similar companies and to past information to become more familiar with the markets
assessment of the stock's performance and to spot any trends based on this calculation.
The reciprocal of the P/E ratio is the earnings to price ratio (E/P). The earnings to price

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Financial Mathematics and Investments

ratio provides the stockholder with the earnings rate of return relative to the market price
of the stock.
Example 18
The earnings to price ratio for Ardmore is 8.46% ($2.20 / $26.00). Based upon
the stock price, $2.20 of earnings is generated on a $26.00 investment. The investor
does not receive the $2.20. The dividend actually paid may be greater or less than the
earnings per share.
Current yield
The current yield measures the annual benefit an investor receives from
investment income. The current yield is equal to the actual dividend or interest received
divided by the current market price. The current yield does not include any rate of return
for expected capital gains although the market price reflects investor's expectations of
future payments as well as market value adjustments.
investment income (annual)
Current Yield = --------------------------------current market price

Formula 6

Example 19
The current distribution of Ardmore's 7% preferred stock (par value equals $100)
is $7.00. The current market price is $82.00. The current yield is 8.53% ($7.00 /
$82.00).
Holding period yields and return
Investments are typically held over long periods of time and investors benefit not
only from the annual distribution of dividends and interest, but their wealth increases or
decreases based upon the security's underlying market value. The holding period yield

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Financial Mathematics and Investments

(HPY) and the holding period return (HPR) are useful in calculating the geometric rate
of return or the growth rate of the investment.
Total current value
of the investment
Holding period return (HPR) = --------------------------------Original amount of
investment

Formula 7

Holding period yield (HPY) = HPR - 1

Formula 8

Example 20
Six years ago Randal Smith purchase 100 shares of Ardmore stock at $18.00.
He has reinvested all dividends through Ardmore's reinvestment plan. He now owns 187
shares at the $26.00 current market price. His original investment was $1,800 (100 x
$18.00). The current value is $4,862 (187 x $26.00). With a holding period of 6 years,
the HPR is 2.70 ($4,862 / $1,800). The HPY is 1.70 (2.70 - 1). Randal's stock is worth
2.7 times the amount paid and will receive 1.7 times his investment in new wealth.

Randal's geometric rate of return is the annual rate of return making an

investment of $1,800 grow to $4,862 in 6 years. The annual geometric rate of return is
18.01 percent calculated as follows.
$4,862 = $1,800 (1 + X)6
$4,862 / $1,800 = (1 + X)6
2.70 = (1 + X)6
2.701/6 = (1 + X)
X + 1 = 1.1801
X = 18.01%
The annual rate of return is calculated by using the following formula:

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Financial Mathematics and Investments

+((4862/1800)^(1/6)) -1 = 0.1801
Yield to maturity
The yield to maturity is used with investments paying an amount annually with
the principal paid to the investor upon maturity. Bonds and other debt securities fall into
this category. Bonds pay a fixed coupon rate annually based upon the par or face
amount of the bond.18 The bond matures at a stated date at which time, the par
amount is returned to the investor. The yield to maturity measures the rate of return of
the bond based upon its purchase price if the bond is held to maturity. If the bond is sold
before maturity, the market price is paid based upon prevailing economic conditions.
The yield to maturity is equal to the internal rate of return (IRR) on the
investment. The IRR may be calculated directly or an estimating formula may be used.
Yield to maturity (estimate) =
annual coupon interest

Formula 9

+ (discount
or
/ number of years to maturity)
- (premium

--------------------------------------------------------------------------------------(current market price + par value) / 2

Example 21
Assume a 8.5% bond (par $1,000) is currently selling for $802 and has 12 years
to maturity. The discount is $198 ($1,000 - $802). The yield to maturity is 11.27 percent
and the current yield is 10.60 percent.
85 + (198 / 12)
----------------------

85 + 16.5
----------------

= 11.27%

18Most bonds pay 1/2 the coupon rate on a semi-annual basis.

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Financial Mathematics and Investments

(802 + 1000) / 2

901

The current yield is 10.60% (85 / $802).

If the current market price is $1,037, the premium is $37. The yield to maturity is
8.042 percent and the current yield is 8.196 percent.
85 - (37 / 12)
-----------------------(1,037 + 1000) / 2

85 - 3.083
------------1,018.5

= 8.042%

The current yield is 8.196% (85 / $1,037).

If the market price of the bond is selling at a price equal to par, the coupon rate
equals the yield to maturity. If the market price increases, the yield to maturity
decreases - an inverse relationship. If market interest rates increase, the bond's market
price decreases. The amount of change is a function of time to maturity and the
magnitude of the interest rate change.
Alternatively the internal rate of return may be calculated by using the following
spreadsheet formula:
@IRR(guess, range) where guess is a starting interest rate for the estimating procedure and range is the
range of cells containing the periodic cash flows.

After tax yields and rates of return

As noted above, investors need to be sensitive to after tax investment results. It
is difficult to compare investments if the tax obligations vary. Therefore, to compare
investments with different tax obligations, an after tax rate should be used. However,
the applicable tax rate and the timing of the adjustment depends upon the investment's
taxability. Investments are either taxable currently, tax free or tax deferred. Capital gains
are usually taxable, but in some cases taxes may be deferred. Some investments made
with before tax dollars are taxable when constructively received.
Example 22

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Financial Mathematics and Investments

Arnold buys 100 share of stock with after-tax income. Any dividends are taxable
in the year received. When Arnold sells the stock, taxable gains or losses will be
realized.
Arnold also makes contributions to a 403(b) plan. Payroll amounts are invested
on a before tax basis. Any earnings or capital gains in the plan are deferred until
distributions are made.
Both investments may be generating the same before tax rate of return.
However, the after tax consequences are different.
The after tax yield on a fully taxable investment equals its before tax yield
multiplied by 1 minus the tax rate.
Example 23
Arnold invests in a tax free municipal bond. If the bond pays 7.35 percent of its
market price, the after tax yield is 7.35 percent.
An alternative common stock investment is yielding 5.23 percent. Arnold is in the
28 percent marginal tax bracket. His after tax dividend yield is calculated by the
following.
yield x (1 - tax rate) =
5.23% x (1 - 0.28) = 3.76%
Basic Portfolio and Diversification Concepts
Prudent investors do not purchase one type of security or buy only the stock of
one firm. Investors build diversified portfolios of securities. A portfolio is a group of
investments exhibiting different characteristics. Diversification strategies stabilize the
total value of the investments and their distributions and minimize loss potential.
Unfortunately, diversification often limits the growth potential of the portfolio's value.

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Financial Mathematics and Investments

Diversification may result from a variety of strategies including the following

approaches:

purchasing different types of investments such as common and

preferred stock, bonds, U.S. Treasuries, real estate and collectibles.

purchasing securities based on differing lengths of maturity.

purchasing different investments within a class of security such as

speculative versus "blue chip" common stocks.

purchasing securities based upon liquidity (the ease of turning it into

cash) and whether the investment is fixed (pays fixed interest rates) or
variable (the value changes based on market conditions).

The above strategies are not independent, mutually exclusive or exhaustive. A

portfolio may possess all of the above characteristics in an attempt to meet the person's
financial goals. The basic idea behind diversification is to add individual investments to
the portfolio that tend to stabilize value, earnings or payments. These investments are
said to be negatively correlated. Negatively correlated investments move in opposite
directions.
Example 24
Randy Azwald purchased 100 shares each of two common stocks for $32 and
$18 respectively for $5,000 ($3,200 + $1,800). One year later the price of the $32 stock
equals $40 while the $18 stock fell to $10. The total value of the portfolio now is $5,000
($4,000 + $1,000). The value of the portfolio remains the same as these two stocks are
negatively correlated.

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Financial Mathematics and Investments

Investment and diversification strategies can depend on a person's stage in their

life cycle. When young people invest, their strategy should focus on long-term results,
the maintenance and improvement of purchasing power and an emphasis on receiving
capital gains. Older people should focus on the stabilization of investment value and
generating current income while trying to maintain or improve purchasing power.
Dollar cost averaging
One strategy used by people with a long-term investment horizon is called dollar
cost averaging. Dollar cost averaging calls for a periodic investments to be made in a
mutual fund or other security. Given a fixed amount of dollars to invest, the number of
shares a person can purchase is a function of the share price. As the share price
increases or decreases, the number of shares one can purchase decreases or
increases respectively. Over a long enough time and in a cyclical market, the average
share purchase price tends to be lower than the average market price. Table 6
illustrates this process. If $400 is invested each month as the share price of the
common stock increases and decreases, a different number of shares purchased
results. Over this short period of time, the average market value at the end of the 12
month period is higher than the average share purchase price. Even though the investor
derives benefits from dollar cost averaging, the strategy does not protect an investor in
a continually down market or from selecting poor investments. It also does not help the
investor when there is a requirement to sell in a temporarily depressed market at which
time, the market value could be less than the cost.
TABLE 6
EXAMPLE OF DOLLAR COST AVERAGING
Periodic

Purchase

- 39 -

Shares

Total

Financial Mathematics and Investments

Period
1
2
3
4
5
6
7
8
9
10
11
12

Investment
400
400
400
400
400
400
400
400
400
400
400
400
-----------$4,800

Price
32.00
32.50
31.00
29.00
25.00
28.25
30.00
33.00
34.00
35.50
38.00
39.00

Average Market Price

(5,886.38 / 150.93)
Average Share Cost
(4,800 / 150.93)

Purchased
12.50
12.31
12.90
13.79
16.00
14.16
13.33
12.12
11.76
11.27
10.53
10.26
-----------150.93

Value
400.00
806.25
1,169.04
1,493.62
1,687.60
2,306.99
2,849.90
3,534.89
4,042.01
4,620.33
5,345.71
5,886.38

$39.00
$31.80

Life Insurance as an Investment

The main purpose of life insurance is to produce dollars to solve financial
problems when the insured dies. Term insurance contracts provide pure protection
since there is no accumulation in cash values. Whole life policies are a blend of
protection and savings due to the necessity of funding a death claim when the death
occurs, not if the death occurs.19 Part of the life insurance contract is unique in that it
cannot be duplicated by any other financial product. No other financial product can
guarantee the payment of thousands of dollars whenever a death occurs - even if the
contract has just begun. The life insurance contract also has a shared function - the
accumulation of dollars. Even though the main purpose for the accumulation is to
produce an affordable plan for life-long insurance protection, the cash value may be

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used for other purposes and may be withdrawn. This use of the cash value provides
much flexibility but imposes upon life insurance the character of an alternate
investment. When the cash value life insurance is purchased, the life insurance and
saving decision is intimately entwined.
In the material in this chapter, we have described alternative investments that
reasonably substitute for the life insurance product and their characteristics. We now
describe the characteristics of the life insurance products. Measuring the cost of life
insurance, making comparisons and calculations of rates of return are fully developed in
Chapter 6.
Traditional Cash Value Life Insurance
There are advantages and disadvantages of using the traditional cash value life
insurance product for savings. These advantages and disadvantages are summarized
below.
Advantages of saving using life insurance
Forced savings. The constant reminder to pay the premium notice is one
advantage of the cash value life insurance product. Many people do not have the self
discipline to set money aside without external persuasion.
Professional investment and diversification. For those having the discipline to
save, the expertise in developing an investment strategy, building a portfolio, selecting
individual securities and monitoring its performance may be lacking. Life insurance

19The mathematics of life insurance is fully developed in Chapters XX, XX and XX.

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offers instant diversification, regardless of the cash value amount and professional
investment management of the funds.
Favorable tax treatment. As of this writing, the periodic increase in cash value is
tax deferred. When the policy is surrendered, the cash value amount in excess of the
policy's cost basis is taxable. If the policy matures because of a death claim, the death
benefits (which include the cash value amount) can be paid to the beneficiary tax free.
The tax aspects of life insurance are fully explored in Chapters 3 and 4.
Low risk. Historically, life insurance products have proven to be safe. Newly
developed life insurance guarantee funds exist to protect policyholders in the event of
bankruptcy providing further security. The regulation of the life insurance industry has
created a secure environment for the policyowner. Life insurance investments and the
company's overall financial stability are reviewed by state regulators to spot abnormal or
dangerous trends. Because of investment restraint and necessity to invest in
conservative securities, low risk - low return investments are made.
Creditor protection. The cash value contained in life insurance is treated
favorably by the states in the event of bankruptcy. Depending upon state law, the cash
value of the life insurance product is protected from the claims of the owner's creditors.
Disadvantages of saving with life insurance.
The disadvantages of saving using traditional cash value life insurance include
the high initial transaction costs, the reduced rate of return compared to alternative
investments and the erosion of purchasing power in an inflationary environment.
Transaction cost. Traditional whole life insurance is heavily front-end loaded. For
the first several years, a large percentage of the premium pays for commission to the

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sales agent and the overhead of the insurer. The cash value amount increases slowly
during the first several years while increasing faster in the later years. If the owner
surrenders the policy in its early years, a large "loss" may occur since much of the
premium paid for expenses instead of going into the cash value. Therefore, the decision
to purchase cash value life insurance should assume a long contractual relationship for
reasonable financial results to occur.
Return potential. Alternative investments may generate a higher after-tax rate of
return. Because of regulatory constraints and the need to protect principle amounts,
insurers invest in relatively low risk - low return investments. Insurers retain the risk of
investment loss and cannot afford a reduction in asset values. Insurers must have the
cash available to pay death claims, make policy loans and pay surrender values when
policyowners terminate contracts.
Purchasing power. The purchasing power of the dollars produced by fixed face,
guaranteed cash value life insurance contracts can be substantially eroded by inflation
especially over long periods of time. Traditional cash value life insurance contracts
provide a schedule of guaranteed policy values based on the policy's duration. The face
amount is fixed as part of the contract. Dividend options and the exercise of policy riders
can increase both the death benefit and cash value amounts. At a 7 percent inflation
rate, the number of dollars will approximately double to purchase the same basket of
goods 10 years earlier. This fact underscores the fact that financial plans should be
reviewed at least annually.
Universal Life Insurance

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The nontraditional life insurance products including variable life, universal life and
variable - universal life insurance are designed to overcome the perceived
disadvantages associated with traditional cash value life insurance products and
compete favorably for a method of savings.
The nontraditional contracts retain all of the advantages of traditional life
insurance but investment risk is shifted from the insurer to the policyowner. In return for
the opportunity to earn competitive market rates of return and provide an inflation
hedge, ULI contracts allow the policyowner to participate in the risks as well as the
rewards. Variable life, universal life and variable - universal life insurance products are
described in detail in Chapter XX.

REVIEW QUESTIONS
1. Why are time value of money calculations important in financial planning?
2. Life insurance products can be broken into a unique and a shared function. What is
the unique function and shared function of the life insurance product? Explain.
3. Distinguish between the process of calculating the present value of $1 and
calculating the future value of $1.
4. What is the difference between an annuity and an annuity due? Identify a cash flow
following an annuity pattern and one following the annuity due pattern.
5. What four factors should be investigated before any investment is made? Explain
each. Provide examples of situations where an investment need does not match the
investment's characteristics. What problems result from this mismatch?

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6. What is meant by purchasing power risk, market risk, interest rate risk and issue
specific risk? Explain each.
7. What is the difference between tax deferred and tax free investments? What
financial factors go into the decision to invest in one versus the other?
8. What is the difference between a fixed income and equity investment? What can an
investor expect to receive from each?
9. Describe a U.S. Treasury bill, note and bond. Why are Treasury bills discounted and
notes and bonds pay semi-annual interest? Do you pay taxes on interest? Capital
gains?
10. Describe the relationship between maturity and yield.
11. How can the tax on U.S. saving bond series EE interest be postponed?
12. Compare traditional life insurance as an investment to bonds and stocks.
13. What is the basic idea behind building portfolios of securities? What is meant by
diversification?
14. Summarize the advantages and disadvantages of using traditional and nontraditional
life insurance policies for saving.
BIBLIOGRAPHY
Branch, Ben, Investments Principles and Practices (2nd Edition), Dearborn
Financial Services Publishing, 1989.
Greynolds, Elbert B. Jr., Aronofsky, Julius S. and Frame, Robert J., Financial
Analysis Using Calculators: Time Value of Money, (New York: McGraw-Hill, 1980).
Widicus, Wilbur W. and Stitzel, Thomas E., Personal Investing (5th Edition), Irwin
Publishing Company, Homewood, IL, 60430, 1989.

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