Mathematics of Finance

- Basic Concepts

Time Line

Cash Flows at-the-end of Period

• Cash Flows of Rs 1000/- each at Year- end for 4 years
1000 1000 1000 1000

0 Period 1 1 Period 2 2 Period 3 3 Period 4 4

Cash Flows at-the-beginning of Period

• Cash Flows of Rs 1000/- each at Year-beginning for 4 years
1000 1000 1000 1000

0 Period 1 1 Period 2 2 Period 3 3 Period 4 4

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 Compound Interest/ Future Value

• Interest of previous period is added to the principal

while calculating the interest for the subsequent
period. Hence, interest is earned on interest as well.
• If “P” is the original amount borrowed @ “r” interest
rate for “n” years, then Terminal Value (TV or A) at the
end of year 1 would be:
• TV1 = Beginning Principal(BP) + Interest on BP
= P + Pr =P(1+r)
• Similarly, TV at the end of year 2 would be
• TV2 = Beginning Principal(BP) + Interest on BP
= P(1+r) + P(1+r)r = P(1+r)(1+r) = P(1+r)2
TVn = P(1+r)n or P*FVIF (n,r)
Mathematics of Finance: Basic Concepts 3

Compound Interest (Contd.)

Q: P = 80,000; n=5; r=14%pa Find TV5

A: TV5 = 80000(1+0.14)5 or 80000*FVIF (5,14%)
= 80000*1.925 = Rs 1,54,000/-

80,000 1,54,000

0 1 2 3 4 5

Rs 80,000/- becomes Rs 154,000/- after 5 years

@14%pa compounded annually.

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 Compound Interest (Contd.)

r n*m
Compounding “m” times a year TVn = P*(1+ )
m

Daily Compounding TVn = P*e r*n

Mathematics of Finance: Basic Concepts 5

Present Value

• Cash Flows may occur at different time period in the future.

Cash flow occurring at the end of 2nd year is not equal to the
cash flow occurring at the end of 1st year because of Time
Value of Money (TVM).

Preference for present consumption over future consumption.

Inflation

Uncertainty
• Thus, the cash flows in different time period have to be
made comparable by converting them into present values.
• 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 discount rate.

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 Present Value of a Single Cash Flow
• From our understanding of compound value, we
know that
TVn = P (1+r)n
hence
1 Discounting
P = TVn * Factor or
(1+r)n PVIF(n,r)

or TVn* PVIF (n, r)

Mathematics of Finance: Basic Concepts 7

Present Value of a Single Cash Flow

 What is the worth of Rs. 10,000/- received at the

end of 3 years from now @ 6% p.a.?

10,000

0 1 2 3

10,000
= 8,396
(1.06)3

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 Present Value of a Stream of Cash Flows
Most investment opportunities have multiple cash
flows that occur at different points in time.
0 1 2 N

C0 C1 C2 CN
C1
(1+r)1
C2
(1+r)2

CN
(1+r)N
C1 C2 C3 CN
PV= C0 + 1
+ 2
+ 3
+ ...... +
(1+r) (1+r) (1+r) (1+r)N

Mathematics of Finance: Basic Concepts 9

Present Value of a Stream of Cash Flows

You need money to buy a laptop. Your friend would lend to you @ 6%
interest rate. Based on your earnings, you can pay him Rs 5000 after one
year and Rs. 8000 each year for the next 3 years. How much can you
borrow now?
0 1 2 3 4
5000 8000 8000 8000
5000
(1.06)1
8000
(1.06)2

8000
(1.06)3
8000
(1.06)4

5000 8000 8000 8000

PV= 1
+ 2
+ 3
+
(1.06) (1.06) (1.06) (1.06)4
PV= 4,716.98 + 7,119.97 + 6,716.95 + 6,336.75=Rs. 24,890.65
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 Annuity
Annuity is a stream of N equal cash flows paid at regular
intervals.
0 1 2 3 N

C C C C

C C C C
PV= 1
+ 2
+ 3
+ ...... +
(1+r) (1+r) (1+r) (1+r)N

1 1 
PV of Annuity=C  - N 
 r r(1+r) 
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Annuity

You are a winner of a lottery of Rs 30 million. You can take

the prize money either as (a) 30 payments of Rs 1 million per
year (starting today) , or (b) Rs 15 million today. If the interest
rate is 8%, which option should you take?
0 1 2 3 29

1 Mn 1 Mn 1 Mn 1 Mn 1 Mn

Option A:
 1 1 
PV (29 yr Annuity of Rs1 Mn)= Rs. 1 Mn  - 29  = Rs.11.16 Mn
 0.08 0.08(1.08) 
Total PV of Cash Flow = Rs. 11.16 Mn + 1 Mn =12.16 Mn
Option B:

Total PV of Cash Flow = Rs. 15 Mn

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 Annuity

FV (Annuity) = PV(Annuity) *(1+r)N

1 1 
FV of Annuity = C  - N 
(1+r)N
 r r(1+r) 

1
FV of Annuity = C
r
(
(1+r)N -1 )

Mathematics of Finance: Basic Concepts 13

Annuity

Mr. Sairam is 35 years old now and wants to save

Rs. 10,000/- each year until he is 65 . If the account
earns 10% pa, how much will he have saved at age
65?
35 36 37 38 65
0 1 2 3 30
10,000 10,000 10,000 10,000

1
FV of Annuity = 10,000(
0.10
(
) (1.10)30 -1 )
FV of Annuity = 10,000(10) (16.4494 ) = 1.645Mn

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 Growing Annuity
Growing Annuity is a stream of N growing cash flows, paid
at regular intervals.
0 1 2 3 N

C C(1+g) C(1+g)2 C(1+g)N-1

C C(1+g) C(1+g)2 C(1+g)N-1

PV= + + + ...... +
(1+r)1 (1+r)2 (1+r)3 (1+r)N

C   1+g  
N

PV of Growing Annuity =  1- 
r-g   1+r  

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Growing Annuity

And Mr.Sairam’s salary is expected to increase and

hence his savings by 5% pa (after first year). How
much will he have now saved at age 65?
35 36 37 38 65
0 1 2 3 30
10,000 10,000(1.05) 10,000(1.05)2 10,000(1.05)29

10,000   1.05  
30

PV of Growing Annuity =  1-    = 1,50,464

0.10 - 0.05   1.10  


FV = 1,50,464*(1.10)30 = Rs. 2.625 Mn

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 Perpetuity
Perpetuity is a stream of equal cash flows at regular
intervals which lasts forever.
0 1 2 3
∞
C C C

C C C
PV= + + + ......∞
(1+r)1 (1+r)2 (1+r)3

C
PV=
r
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Perpetuity

You want to endow an annual MBA graduation party at your

alma amter. The event would cost Rs.50,000/- each year
forever. If the business school earns @ 8%p.a. on its
investments and the first party is in one year’s time, how
much will you need to donate to endow the party?

50,000 50,000 50,000

PV= + + + ......∞
(1.08)1 (1.08)2 (1.08)3
50,000
PV= = Rs.6,25,000
0.08

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 Growing Perpetuity
Growing Perpetuity is a stream of cash flows at
regular intervals and grows at a constant rate
forever.

0 1 2 3 4 ∞

C C(1+g) C(1+g)2 C(1+g)3

C C(1+g) C(1+g)2 C(1+g)3

PV= + + + ......∞
(1+r)1 (1+r)2 (1+r)3 (1+r)4

C
PV(Growing Perpetuity) =
r-g
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Growing Perpetuity

But then you are informed that the cost of the party would
increase by 4% per year, (after the first year).How much will
you now need to donate to endow the party?

50,000 50,000(1.04) 50,000(1.04)2

PV= + + + ......∞
(1.08)1 (1.08)2 (1.08)3

50,000
PV= = Rs.12,50,000 / −
0.08 - 0.04

You need to double the amount of your gift !!!

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