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Mathematics for Finance: Basic Concepts

1. Time-Line 2. Compound Interest (a) Compound interest in case of a simple cash flow (b) Compound Value of an Annuity (c) Compounding more than once a year (d) Continuous Compounding (Daily Compounding) (e) Sinking fund (f) Doubling period: Rule of 72 & Rule of 69 (g) Finding the Compounded Average Growth Rate (CAGR) (h) Effective Vs. Nominal Rate 3. Present Value (a) Present Value of a Lump Sum (b) Present Value of an Annuity (c) Capital Recovery Factor 4. Annuity Due (a) Present Value of an Annuity Due (b) Compound Value of an Annuity Due 5. Growing Annuities (a) Present Value of Growing Annuity

6. Perpetuities & Growing Perpetuities 1. Time-Line: Dealing with cash flows that occur at different points in time is made

easier using a time- line that shows both the timing and the amount of each cash flow in a stream. Thus, a cash flow stream of Rs 1000/- at the end of each of the next 4 years can be depicted on a time-line as below:
1000

1000

1000

1000

Year 1

Year 2

Year 3

Year 4

In the above figure, 0 refers to right now. A distinction must be made between a period of time and a point in time. The portion of the time-line between 0 and 1 refers to period 1. The cash flow that occurs at the point in time "1" refers to the cash flow that occurs at the end of period 1. Cash flows can be either positive or negative; positive cash flows are called cash inflows and negative cash flows are called cash outflows.

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Mathematics for Finance: Basic Concepts

2.

Compound Interest: The notion of compound interest is central to the

understanding of the mathematics for finance. The term implies that interest on the principal for a period is added to the principal for the next period, and so on. As a result, interest is also earned on interest. (a) Compound interest in case of a simple cash flow: Suppose a person has

taken a loan of P @ r% p.a. for two years with interest compounded annually. The Future Value (FV) or Terminal Value (TV) at the end of year 1 would be: FV1 = Principal (P) + Interest on P = P + Pr = P (1+r) Similarly, the Future Value at the end of year 2 would be Principal amount at the beginning of year 2 plus interest thereon: FV2 = FV1 + FV1r = P (1+r) + P (1+r) r 2 = P (1+r)(1+r) = P (1+r) Thus, Future Value at the end of year n would be: FVn = P (1+r) or = P*FVIF (n, r) where FVIF (n, r) = Future Value Interest Factor for n years @ r%. Q: Mr. X deposited Rs.75,000/- in a company fixed deposit for a period of 10 years that pays interest @ 12%p.a., compounded annually. What amount would he receive at the end of year 10? A: Given: P=Rs.75,000/-; An A10
n n

r=12%p.a. ;

n=10 years.

Required: A10

(b)

= P (1+r) 10 = 75,000 (1+0.12) or 75,000*FVIF (10, 12%) = 75,000* 3.1058 = Rs.2,32,939/Compound Value of an Annuity: Annuity is a fixed amount of payment (or

receipt) paid (or received) in each year (period) over a specified period of time. E.g.: Recurring deposit with a Bank. Suppose, Rs 10,000/- is being deposited for a period of 3 years (at the end of each year) with the deposit earning interest @ 6% p.a. The compound value of this stream of annuity of Rs 10,000/- along with the interest thereon would amount to Rs 31,836/-. (See figure below)

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Mathematics for Finance: Basic Concepts

10,000 0 1

10,000 2

10,000 3

10,000*(1.06) = 11,236 10,000*(1.06) = 10,600 10,000*(1.06) = 10,000 31,836


Mathematically, Compound value (Future Value) of an annuity is given as follows (also see appendix for derivation of the formula):
0 1

FV of an Annuity = P

n (1+ r ) 1 r

(c)

Compounding more than once a year (Multi-period compounding):


n*m

Future Value at the end of n years where interest is paid m times a year is: FVn = P*(1+r/m) (d)

Continuous Compounding (Daily Compounding):


rn

As m approaches infinity (), the term (1+r/m) approaches e


m

(where e =2.71828

and is defined as e = limit (1+1/m) . Thus future value, in case of Daily Compound is: A=Pe (e)
rn

Sinking fund: How much amount should be kept aside each year, which

together with the interest thereon, is equal to a target amount. Q: Suppose the target amount required to be saved by the end of 6 years is

Rs.55,800/- and the rate of interest is 6% p.a., what amount should be invested every year, which together with the interest thereon is equal to the target amount? A: Given: FV6 = 55,800/-; n = 6 years; r = 6% p.a. FV6 = P * FVIFA (6,6%) 55,800 = P * 6.9753 P= 55,800/6.9753 = Rs. 8,000/- (approx.) Required: P

(f)

Doubling period: Investors commonly ask:

How long would it take to

double the amount at a given interest rate? The following thumb rules gives us the approximate doubling period: Rule of 72: Divide 72 by the interest rate

If r = 8%; then the doubling period = 72/8 = 9 years (approx) If r = 4%; then the doubling period = 72/4 = 18 years Rule of 69 (more accurate): 0.35+ 69/Interest Rate

If r = 8%, then the doubling period = 0.35 + 69/8 = 8.975 years If r = 10%, then the doubling period. = 0.35 + 69/10 = 7 years (g) Finding the Compounded Average Growth Rate (CAGR): Suppose the Years Sales (Rs. Lacs) 1991 50 1992 57 1993 68 1994 79 1995 86 1996 99

CAGR of the following sales figures have to be calculated.

1. Find ratio of Sales of Last year (1996) to first year (1991) = 99/50 = 1.98 2. Use FVIF table and look at row for year 5 (6-1) till you find the value nearest to 1.98, and then read the interest rate corresponding to that value. That would be the CAGR. (h) Effective Vs. Nominal Rate: When interest is compounded more than once

in a given period of time, it is called Multi-period Compounding. If r is the nominal interest rate for a period, the effective interest rate (r*) will be more than the nominal interest rate, since interest on interest within a year will also be earned. EIR = (1+r/m)
m

-1 is compounded quarterly

Q: A bank offers interest @8% p.a. which compounding. What is the effective rate of interest? A: EIR = (1+r/m) 1 4 = (1+0.08/4) 1 = 1.0824 - 1 = 0.824 = 8.24%
m

3.

Present Value: Cash Flows may occur at different time period in the future.
nd

Cash flow occurring at the end of 2

year is not equal to the cash flow occurring at

the end of one year because of Time Value of Money (TVM). Why a cash flow in the future is worth less than a similar cash flow today? red = P Preference for present consumption over future consumption: People would have to be offered more in the future to give up present consumption.

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Inflation: The value of currency decreases over time. The greater the inflation, the greater the difference in value between a cash flow today and the same cash flow in the future.

Uncertainty: A promised cash flow might not be delivered for a number of reasons: the promisor might default on the payment, the promisee might not be around to receive payment; or some other contingency might intervene to prevent the promised payment or to reduce it. Any uncertainty (risk) associated with the cash flow in the future reduces the value of the cashflow.

The process by which future cash flows are adjusted to reflect these factors is called discounting, and the magnitude of these factors is reflected in the discount rate. The discount rate incorporates all of the above-mentioned factors. Thus, the cash flows in different time period have to be made comparable by converting them into present values. discount rate. (a) Present Value of a simple cash flow: Discounting a cash flow converts it The process of calculating the present value of the future Cash Flows is called discounting and the interest rate used for discounting is called the

into present value rupees and enables the user to do several things. First, once cash flows are converted into present value rupees, they can be aggregated and compared. Second, if present values are estimated correctly, the user should be indifferent between the future cash flow and the present value of that cash flow. From our understanding of compound value, we know that FVn = P (1+r) , hence P = FVn /(1+r) Or FV*PVIF (n, r) where PVIF (n, r) = Present Value Interest Factor for n years @ r%. Q: Find the present value of Rs.50,000/- to be received at the end of 10 years,
n n

discounting rate being 12% p.a. A: FV = 50,000; n = 10 years; r = 12% Requi P = FV*PVIF (10, 12%) = 50,000 * 0.3220 = Rs.16,100/-

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(b)

Present Value of an Annuity: The present value of an annuity may be

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estimated by discounting each of the cash flows back to the present and aggregating the present values as shown below: 10,000 0
10,000*(1.06) = 9,434 10,000*(1.06) = 8,900 10,000*(1.06) = 8,396 26,730
-3 -2 -1

10,000 2

10,000 3

Mathematically, present value of an annuity is given as follows (also see appendix for derivation of the formula):

PV of an Annuity = A
(c)

(1+r) 1 r(1+ r )
n

Capital Recovery Factor: It is the inverse of the Present Value Interest

Factor Annuity and is useful in determining the income to be earned to recover an investment at a given interest rate. Q: Mr. X plans to invest Rs.10,000/- @ 10% pa. for a period of 4 years. What

income should he earn from the investment so as to recover his investment over the next 4 years? A: P = 10,000; n = 4 years; r = 10% Required = A P = A*PVIFA (n, r) 10,000 = A*PVIFA (4,10%) A = 10,000/PVIF (4,10%) = 10,000/3.1699 = Rs.3,155/4. Annuity Due: The concepts of compound value and present value of an annuity discussed so far are based on the assumption that the series of payments (receipts) are made at the end of each period. Such payments can however, be made at the beginning of the period as well e.g. Instalments for TVs. Such series of fixed payments starting at the beginning of each period for a specified number of periods is called an Annuity Due. To illustrate this effect, consider the following annuity of Rs. 1000/- at the end of each year for the next 3 years. 10,000 0 1 10,000 2 10,000 3

Contrast this with an annuity of Rs. 1000/- at the beginning of each year for the next

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3 years, with the same discount rate.

10,000 0

10,000 1

10,000 2 3

Since the first of these annuities occurs right now, and the remaining cash flows take the form of an end-of-the-period annuity over 2 years. (a) Present Value of Annuity Due: In general, the present value of a beginning-

of-the-period annuity over n years can be written as follows:


(1+r)n 1 r(1 = n ) r

PV of Annuity Due = A+ A

This present value will be higher than the present value of an equivalent annuity at the end of each period. (b) Compound Value of Annuity Due: The future value of a beginning-of-the-

period annuity typically can be estimated by allowing for one additional period of compounding for each cash flow:

FV of Annuity Due = A(1+r)


end of each period. 5.

(1+r) - 1 r

This future value will be higher than the future value of an equivalent annuity at the Growing Annuities: A growing annuity is a cash flow that grows at a

constant rate for a specified period of time. If A is the current cash flow, and g is the expected growth rate, the time-line for a growing annuity appears as follows: A(1+g) A(1+g)
2

A(1+g)

A(1+g)

Note that, to qualify as a growing annuity, the growth rate in each period has to be the same as the growth rate in the prior period Limited

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Present Value of a Growing Annuity: In most cases, the present value of a growing annuity can be estimated by using the following formula:

(1+g) 1n (1+r) PV of a Growing Annuity = A(1+g) rg

The present value of a growing annuity can be estimated in all cases, except when the growth rate is equal to the discount rate. In such a case, the present value is equal to the nominal sums of the annuities over the period, without the growth effect. PV of a Growing Annuity for n years (when r=g) = n A Note: This formula works even when the growth rate is greater than the discount rate. 6. Perpetuities: Perpetuity is a constant cash flow at regular intervals forever.

The present value of perpetuity can be written as:

PV of Prepetuity =

A r

where A is the perpetuity. The future value of perpetuity is infinite. Q: Assume that you have a 6% irredeemable preference share of face value Rs

1000/-. The value of this preference share, if the discount rate is 9%, is as follows: A: Value of Irredeemable Preference Share = Rs 60 / 9% = Rs 667/-

The value of Irredeemable Preference Share will be equal to its face value if the coupon rate is equal to the discount rate. 5. Growing Perpetuities: A growing perpetuity is a cash flow that is expected to

grow at a constant rate forever. The present value of a growing perpetuity can be written as:

PV of a Growing Perpetuity =

CF1 (r-g)

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where CF1 is the expected cash flow next year, g is the constant growth rate and r is the discount rate. While a growing perpetuity and a growing annuity share several features, the fact that a growing perpetuity lasts forever puts constraints on the growth rate. It has to be less than the discount rate for this formula to work. Q: SBL Ltd. paid dividends of Rs 2.50/- per share last year and expects that it

will grow by 6% next year and were expected to grow at the same rate in the long term. The rate of return required by investors on stocks of equivalent risk was 14%. What should be the value of SBL share? A: Previous Dividend per share = Rs 2.50 Expected Growth Rate in Earnings and Dividends = 6% Expected Dividend (next year) = 2.50*(1.06) = Rs 2.65 Discount Rate = 14% Value of Stock = Rs 2.65/ (14%-6%) = Rs 33.125 Problems: Q-1. Mr. A deposited an amount of Rs. 2,50,000/- with Citibank as a fixed deposit for a period of 3 years. The Bank pays interest @ 8% p.a. compounded quarterly. Calculate the amount, which he shall receive on maturity of the fixed deposit. Omega Ltd. invests Rs. 50,000/- at the end of each year for a period of 4 years. The investment earns a rate of interest of 12% p.a. What is the amount accumulated at the end of the 4 year period. Calculate the present value of Rs. 75,000/- received (a) at the end of one year; (b) at the end of 5 years; (c) at the end of 12. Assume the discounting rate as 12%. How long will it take to double your money, if it earns interest @ 12% annually. Reliance Industries Ltd. has issued 50,00,000 Non-Convertible Debentures of Rs. 100/- each to be repaid at the end of 7 years. How much amount should the company set aside in the Debenture Redemption Account so as to meet the redemption liability. Assume the interest rate as 12% p.a. You are faced with two situations: (a) to in cur an immediate expenditure of Rs. 10,000/- or (b) to make the payment of Rs. 2310/- at the end of each year

Q-2.

Q-3.

Q-4. Q-5.

` Q-6.

for a period of 5 years. Which of the two options is better, assuming the discounting rate of 12%. Q-7. Find the Present Value of the following cash flow, assuming the discounting rate of 14%: Year 0 1 2 3 4 5 6 7 8 Q-8. Q-9. Cash Flow -10,000 -1,000 -4,000 15,000 17,600 25,600 35,000 65,900 96,000

The current market price of a share of Escorts Limited is Rs. 170/-, which used to be Rs. 10/- 25 years ago. Find the CAGR. ABC Limited has borrowed Rs. 50,000/- to buy a second hand car. The loan carries an interest rate of 4% p.a. and has to be repaid in 25 equal yearly installments. Find the amount of each installment.

Q-10. If the nominal rate of interest is 24%, calculate the effective interest rate when the interest is compounded (a) semi-annually; (b) Quarterly & (c) Monthly.

***

Appendix
(1) Compound Value of an Annuity:
1 2 n-1

Let Sn be the compound value of an Annuity. Sn = P+P (1+r) + P (1+r) + + P (1+r) = P+P {(1+r) + (1+r) + +(1+r) } Multiply both sides of Eqn. 1 with (1+r), we get Sn (1+r) = P (1+r) +P {(1+r) + (1+r) + +(1+r) } Subtract (2) from (1)
S - S (1+r)= [P+P {(1+r) + (1+r) + +(1+r)n-1}] - [P (1+r) - P {(1+r)2 + (1+r)3 + P (1+r)n] n n
2

n-1

.
n

(1)

. (2)

Sn - Sn (1+r) = P- P (1+r) r Sn = P (1+r)


n

-P

(1+ r ) 1 FV of an Annuity = P r

(2)

Present Value of an Annuity:


-1 -2 -n

Let Vn be the compound value of an Annuity. Vn = A(1+r) + A(1+r) + + A(1+r)


-1 -2 -n

= A {(1+r) + (1+r) + + (1+r) } Multiply both sides with (1+r), we get


-1 -2

.
-n

(1)

Vn (1+r) = A {1 + (1+r) + (1+r) + + (1+r) } Subtract (2) from (1)


-1 -2 -n

. (2)
-1 -2 -n

Vn - Vn (1+r) = A {(1+r) + (1+r) + + (1+r) } - A {1 + (1+r) + (1+r) + + (1+r) } - Vn r = A {(1+r) } - A Vn r = A - A {(1+r) } = A {1 - 1/(1+r) } = A {(1+r) 1} /{r(1+r) }
n n n -n -n

(1+r) 1 PV of an Annuity = A n r(1+ r )

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3)

Present Value of a Growing Annuity

PVGA = A(1+g) + A(1+ g) + ........ + A(1+ g) 2 n (1+r) (1+r) (1+r) (1+ g) Multiply both sides by , we get (1+ r )
2

..(1)

3 n+1 A(1+g) A(1+ g) A(1+ g) (1+g) .(2) + ........ + + PVGA = 3 2 n+1 (1+r) (1+r) (1+r) (1+r)

Subtract (2) from (1)

PVGA 1 =

(1+g) (1+r) 1-

A(1+g) A(1+ g) n+1 (1+r) (1+r)


n

n+1

PVGA = A(1+g)

(1+g) (1+r)n (r-g)

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