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Financial Mathematics

Financial Mathematics
Jonathan Ziveyi1
1 University of New South Wales
Risk and Actuarial Studies, Australian School of Business
j.ziveyi@unsw.edu.au

Module 3 Topic Notes

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Financial Mathematics

Plan
Module 3: Loan Valuation and Project Appraisal Techniques
Introduction
Allowing for Tax
Analysis of Loan Schedules and Repayments
Sinking Funds
Loans at a Flat Rate of Interest
Loan Valuation Example
Fixed Income Securities and Bonds
Pricing Bonds
Bond Valuation Example
Definitions of Yield, IRR and MIRR Rates
Investment Decision Criteria
Sensitivity of Results and Duty of Disclosure
Project Appraisal Example
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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Introduction

Evaluation of a project Objective of a project appraisal:

value a given project: how much is it worth?

compare different projects based on certain criteria:


which project is the best?

make a recommendation based on certain criteria:


should we invest in that project?

This involves determining net cash flows:


gains:

minus costs:

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sales
salvage value of assets
expenses
transaction costs
taxes
depreciation of assets
cost of debt

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Introduction

Financing a project There are several ways of financing a project:


for an individual

for a company

personal wealth
personal loan
equity (shares)
debt (loans, bonds)

for a government

taxes
debt (treasury bonds)

The analysis of loans and bonds is necessary in order to be able to


build the cash flow model. Note that bonds are nothing else than
larger scale, tradable loans.
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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Introduction

Plan of this module


1. Introduction
2. Allowing for Tax
3. Analysis of Loan Schedules and Repayments
4. Sinking Funds
5. Loans at a Flat Rate of Interest
6. Loan Valuation Example
7. Fixed Income Securities and Bonds
8. Pricing Bonds
9. Bond Valuation Example
10. Definitions of Yield, IRR and MIRR Rates
11. Investment Decision Criteria
12. Sensitivity of Results and Duty of Disclosure
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13. Project Appraisal Example

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Allowing for Tax

Allowing for tax Tax is a very important consideration when


analysing a cash flow:

when and how much tax is paid influences the profitability of a


security or project
the tax rate depends on the type of cash flows:

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income (e.g. interest, dividends, rents, . . . ), or


capital gains (e.g. increase of the value of a share or property,
above par redemption payments, . . . )

the tax rate depends on the individual considered (person or


company)

tax is usually paid with a lag that also depends on the


individual considered

income and capital losses are usually allowed to be offset


against gains to derive tax benefits

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Allowing for Tax

Allowance for taxation in price/yield calculations

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tax payments are nothing else than additional (negative) cash


flows

in case of losses that can offset gains, tax benefits can be


added as positive cash flows
(the government wont pay any money, but a loss means tax
that otherwise would have been paid will not be paid)

in many cases price and yield calculations allowing for tax can
be done analytically (using financial mathematics formulae),
"by hand" and using a calculator

larger/more complicated models can be easily done using a


spreadsheet model or other relevant software.

transaction costs are similar costs that need to be allowed for

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Allowing for Tax

Depreciation Schedules and Tax Many projects involve an


investment in capital equipment. For taxation purposes this is
depreciated usually on two (alternative) bases:

Prime Cost (level over life of equipment), or

Diminishing Value (constant percentage of written down value


WDV)

Taxable income is income minus expenses:

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expenses include interest costs and depreciation

net cash flow is the cash payments less taxation expense

in case of deferral (or lag) for taxation payments, treat as two


different cash flows

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Loans Definitions:

Consider a loan of amount L made at time 0 with repayments


of K1 , K2 ,. . . ,Kn at times 1, 2, . . . , n

Equation of value
L = K1 v + K2 v 2 + . . . + Kn v n

Each loan repayment Kt can be decomposed into

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at effective rate i.

a principal component (which amortises the loan)


an interest component (which pays the interest due since the
last repayment)

The amount that still need to be reimbursed after a payment


is called the outstanding balance

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Denote:
It

the interest component of the t th payment

PRt the principal repaid in the t th payment

OBt the outstanding balance immediately after the t th


payment

Interest in t th payment is simply the previous outstanding balance


multiplied by the rate of interest
i OBt1
Principal repaid should just be the difference between the actual
payment and the interest component
Kt It
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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

If we work recursively we have

at time 0
OB0 = L

at time 1
I1 = iOB0 = iL
PR1 = K1 I1 = K1 iOB0
OB1 = OB0 (1 + i) K1 = OB0 (K1 iOB0 )
= OB0 (K1 I1 ) = OB0 PR1

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and then we move forward to the next time period

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

In general we have
It+1 = iOBt
PRt+1 = Kt+1 It+1
OBt+1 = OBt (1 + i) Kt+1 = OBt (Kt+1 It+1 )
= OBt PRt+1
Total repayments
KT =

Xn

Kt

IT =

Xn

It

total interest
and

L = KT IT =

n
X
t=1

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PRt

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Numerical example Example: Consider a loan of $1000 repaid by 5


equal installments of principal and interest at the end of each year
for 5 years with an interest rate of 5%. Determine the repayments.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Loan Schedule In practice it is often much easier to set out all the
information in a "loan schedule" providing information (for each
period) on:

Payments

Interest Due

Principal Repayments

Principal Outstanding

(and any other important items)

This is usually presented in a table computed with the help of R or


a spreadsheet.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Example For the $1000 5 year loan with level repayments, what are
the interest and principal components in each year? Give a
repayment schedule.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

In order to determine a given line of the loan schedule, one needs


only the principal outstanding at the beginning (or the end) of the
period. This can be determined directly via:

the prospective method,


OBt =

n
X

Ks v st {= Kant i if repayments are equal}

s=t+1

or the retrospective method


t

OBt = L (1 + i)

t
X

Ks (1 + i)ts {= L (1 + i)t Kst i }

s=0

Both methods yield the same result.


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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Numerical example (retrospective method) Consider a loan of


$1000. For the first year the repayment was $200, and the interest
charged was 5%
For the second and third years the repayment was $150 p.a., and
interest charged was 4% p.a. What is the loan outstanding at the
end of the third year?

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sinking Funds

Sinking Funds Consider the following situation:

Company A has borrowed an amount L (from a bank, by


issuing a bond, etc. . . ) and will need to reimburse the loan
after n years

in the mean time, it needs to pay interest at a rate i each year


to the lender(s)

Company A wants to set up payments to a fund that will


accumulate to the amount of the loan at time n in order to
ensure the reimbursement

this fund earns interest at a rate j not necessarily equal to i.


Usually, j < i.

Such a fund is called a sinking fund.


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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sinking Funds

In order to accumulate to L, level payments to the sinking fund


need to be equal to
L
,
sn j
which means that the total payment for each time unit is
iL +

L
.
sn j

The first component is the interest component, paid to the lender,


and the second is the principal component, paid to the sinking
fund.

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Does a sinking fund lead to higher repayments than when the


loan is reimbursed gradually using the amortisation method?

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sinking Funds

Sinking fund example A loan of $1000 is to be repaid by 5 annual


payments, beginning one year after the loan is made. The lender
wants annual payments of interest only at a rate of 7% and
repayments of the principal in a single lump sum at the end of 5
years.
The borrower can accumulate principal in a sinking fund earning an
annual interest rate of 6%, and decides to do this with 5 level
deposits starting one year after the loan is made. Determine the
repayment and model the cash flows of this transaction in a
spreadsheet.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sinking Funds

Example

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Loans at a Flat Rate of Interest

Loans at a Flat Rate of Interest The interest charge I is given by


I =Lf n
where:

L is the loan amount

f is the flat rate of interest

n is the duration of loan (in time units of the flat rate of


interest)

Loan Repayments R are given by


R=

L+I
n

where n is the number of level instalments.


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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Loans at a Flat Rate of Interest

Numerical example A lawnmower worth $400 is offered for sale on


the following terms:
10% deposit, flat interest of 10% p.a. with monthly repayments
over 30 months.
Determine the repayment and the effective annual rate of interest.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Loans at a Flat Rate of Interest

Usage Easier to understand, but presents serious problems:

the "real" rate of interest is usually much higher than what


the flat rate suggests

flat rate loans do not encourage earlier payments (the amount


of interest that has to be paid is fixed)

Flat rates of interest are not used everywhere:

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because of the problems described above, it is forbidden is


some countries (mainly developed, such as in Australia)

however, it is widely used in developing countries (mainly by


microcredit institutions)

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Loan Valuation Example

Example - Loan Valuation - Spreadsheet A loan of nominal amount


$500,000 was issued bearing interest of 8% per annum payable
quarterly in arrears. The loan will be repaid at $105% by 20 annual
installments, each of nominal amount $25,000, the first repayment
being ten years after the issue date. An investor, liable to both
income tax and capital gains tax, purchased the entire loan on the
issue date at a price to obtain a net effective annual yield of 6%.
Find the price paid, given that his rates of taxation for income and
capital gains are 40% and 30% respectively.
What is the price paid allowing for taxation? Develop a spreadsheet
model for the loan allowing for both income and capital gains
taxation.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Loan Valuation Example

Model with Tax on Interest and CGT This is much more


complicated.

price depends on CGT and CGT depends on price. . .

capital repayments occur over time

We can solve this with a spreadsheet.

Set a dummy figure as the price

Given a price we can determine if a CGT is due for each


repayment:

+
face value reimbursedt
P
CGTt = 30% actual paymentt
500000

we have then (net receipts):


CFt = APRt + It TIt CGTt

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Loan Valuation Example

We solve then for the correct price:

Calculate the PV of the net receipts

Calculate in a cell the difference between the PV and the Price


(which should be equal)

Using the solver, target a difference of 0

You may need to constraint the interest rate and the price to
be positive.

Note:
(x y )+ = max(x y , 0).

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Fixed Income Securities Broad range of securities with fixed


income:
bonds (or notes, or debentures), issued by

types of bonds

short term (e.g. Australian Treasury note, or promissory note)


vs long term (e.g. Australian Treasury bond)
virtually risk free to very risky (junk bonds)
coupon bonds or zero-coupon bonds (ZCB)
indexed bonds, or real return bonds

but also

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the government
private companies

certificates of deposit (tradable or not)


. . . (see readings)

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Government Bonds
Government Bonds:

borrow money from investors to fund spending plans

also provide low risk securities (liquidity on the market, and


determination of the structure of interest)

both short and long term


(in Australia: Treasury Notes and Treasury Bonds)

consist of both coupon and capital payments


(in Australia: usually interest only until maturity)
for (Commonwealth) Government Bonds in Australia

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usually semiannual coupons


coupons are paid on the 15th of each relevant month.
yields are quoted as nominal p.a. with the same frequency as
the coupon payments

Other conventions: see Broverman and Sherris

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Bond basics Pays coupon (interest) to purchaser a certain number


of times a year, of amount
Fc
paid p times per year
p
where
F is the face value (par value)
c is the annual coupon rate
p is the frequency of payments
Payments will continue during the term to maturity of the bond
(denoted by n).
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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Maturity, redemption and principal amortisation

Maturity is the date when the bond is redeemed


(reimbursed)
The redemption amount FR at maturity is not always equal to
the face value. We have

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R = 1: the bond is redeemed at par


R < 1: the bond is redeemed below par
R > 1: the bond is redeemed above par

Sometimes, principal is reimbursed before maturity. Again, the


amount of face value can be reimbursed at par, or
below/above par.

A bond is essentially a loan that is amortised in a single lump


sum payment (at maturity) and/or by earlier payments.

Being able to differentiate between face value redemption and


capital gain/loss (above/below par reimbursements)
is important for accounting, yield and tax purposes.

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Numerical example A 3 year bond with a face value of $100,000


pays annual coupons at a rate of 10% p.a. The bond is
1. entirely redeemed at maturity with a payment of $120,000;
2. redeemed by 2 payments of $65,000 each at the end of the
second and third year, each for half of the bonds face value.
For both cases, establish a loan schedule showing interest
payments, principal repayments and capital gains.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

The price of a bond

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as usual for securities, the price of a bond is essentially the


present value of its future cash flows

the rate, called yield, at which cash flows are discounted is a


critical assumption

it is usually quoted along with the price of the bond (both


values are equivalent ways of quoting the price of a bond)

it is usually of the same type as the coupon rate (semiannual


nominal for US/CA/AU, sometimes also annual in EU)

the yield usually depends on the current structure of interest,


as well as the risk associated to the bond as perceived by the
market (note also some rating agencies rate bonds AAA to C)

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

On coupon dates For a bond at yield i (p) = pi whose redemption


and face values are the same (R = 1) we have:
P = Fcanp i + Fvinp
= Fcanp i + F (1 ianp i )
= F + F (c i) anp i

A par bond must have c = i

A bond with c > i trades at a premium

A bond with c < i trades at a discount

If R 6= 1, the price is the PV of the future CF (simple application of


compound interest techniques)

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

Between Coupon dates

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in practice bonds are traded between coupon payment dates

the seller will require the interest accumulated since the last
coupon date to be paid by the buyer

if the sale is too close to the next coupon payment (in


Australia, 7 days or less), the bond becomes ex-interest,
which means that the next coupon payment will still be paid
to the seller, even if the bond is not his property any more

the general pricing approach is to discount the bond cash flows


to the next coupon payment date (including the coupon
payment at that date), and then further discount this present
value this to the (prior) sale date

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

The RBA formula


The RBA uses the following formula to value Treasury Bonds when
maturity is between n and n + 1 semesters:
f

P = vi d [C + Gan i + 100v n ]
where:

C is the next coupon payment (zero if ex-interest)

G is the regular semi annual coupon payment

f is the number of days until the next payment

d is the number of days in the current half year

(this is identical to the general formula given in Broverman)

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

Market price Two bonds with the same cash flows and the same
yield will have a different purchase price if coupons payment dates
are different, which may be confusing. Hence, bonds are usually
quoted at a market price. We distinguish:
Price-plus-accrued:

the price with accrued interest (coupon) - see previous slide


the purchase price
also: "dirty price", "full price", or "flat price"

Market price

price as quoted ( smoothed price)


accrued interest is removed
market price = dirty price accrued interest = P tFc

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also: "clean price"

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

Numerical example Consider a Government bond paying semi


annual interest of 10% p.a. on 15-April and 15-October each year.
It is redeemable at par on 15 Oct in 6 years time. Find the purchase
and market prices to yield 8.5%p.a. (semi-annual) on 30 June.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

Optional redemption dates In general the redemption date may:

be fixed (most of the bonds)


vary at borrowers option

on or after certain date


no final date (undated)
between two dates

at lenders option

An uncertain redemption dates means that lenders (buyers) cant


easily determine yields at the purchase date. In such a case, they
can still determine:

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a maximum price, for given yield, or

a minimum yield, for given price

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

Example - Loan Valuation - "by hand" [UNSW Final Exam 2006] A


bond with a nominal face value of $100, 000 is redeemable by two
payments, one in 5 years time and the other in 10 years time. The
payment in 5 years time is for a nominal amount of $40, 000 and in
10 years time for a nominal amount of $60, 000. Redemption
payments are payable at $105 per $100 nominal face value.
Coupons are paid on the bond at 6% p.a semi-annually based on
the nominal amount outstanding. Tax is paid on the coupons at a
rate of 30% and tax is paid on capital gains at a rate of 15%.
Capital losses are assumed to be offset against other capital gains
of the investor.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

1. Determine the price to be paid by an investor to earn a gross


yield of 6.5% p.a. (semi-annual).
2. Determine the price to be paid by an investor to earn a net of
tax (after tax) yield of 5% p.a. (semi-annual) allowing only for
tax on the coupons.
3. Determine the price to be paid for the bond to yield an net of
tax return of 4% pa. (semi-annual) allowing for tax on
coupons and capital gains.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

1. Price to earn a gross yield of 6.5% p.a. (semi-annual) (note the


yield and coupons are semi-annual so work in half years)
0.06
(40,000) a10 + 40,000 (1.05) v 10
2
0.06
6.5
+
(60,000) a20 + 60,000 (1.05) v 20 at
%
2
2
= 1,200 8.422395 + 42,000 0.726272

Price =

+1,800 14.539346 + 63,000 0.527471


= 10,106.874 + 30,503.431 + 26,170.823 + 33,230.689
= 100,011.82

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

2. Gross yield of 5% p.a. (semi-annual), tax on the coupons


0.06
(40,000) a10 + 40,000 (1.05) v 10
2
0.06
5.0
+ (1 0.3)
(60,000) a20 + 60,000 (1.05) v 20 at
%
2
2
= 840 8.752064 + 42,000 0.781198

Price = (1 0.3)

+1260 15.589162 + 63,000 0.610271


= 7,351.7337 + 32,810.333 + 19,642.3445 + 38,447.0694
= 98,251.48

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

After tax return of 4% p.a. (semi-annual), tax on coupons and


capital gains
Price = (1 0.3)

0.06
(40,000) a10
2


+40,000 (1.05) v
+ (1 0.3)

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40000
0.15 40,000 (1.05)
P v 10
100000

0.06
(60,000) a20
2


+60,000 (1.05) v
at

10

20


60000
0.15 60,000 (1.05)
P v 20
100000
4.0
%
2

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

We have
P = 840 8.982585 + [42,000 0.15 (42,000 0.4P)] 0.820348
+1260 16.351433 + [63,000 0.15 (63,000 0.6P)] 0.672971
and thus
(1 0.049221 0.060567) P = 7,545.371 + 29,286.4236
+20,602.8056 + 36,037.597
93,472.197
= 105,000.
P =
0.890212

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Definitions Yield rate

effective "average" rate of interest over the whole (time)


length of an investment:
yield rate =

accumulated value
investment cost

1/length of investment

Net Present Value (NPV)

present value of inflows (gains) minus outflows (expenses and


investment costs), or net cash flows

must be calculated using a relevant rate of interest


(reflecting risk and cost of capital)

Internal Rate of Return (IRR)

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rate of interest such that the NPV is 0

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Numerical example Consider the following two cash flows:

0
1
2
3
4
5

Option 1
-1000.00
100.00
200.00
300.00
400.00
500.00

Option 2
-1000.00
533.20
350.00
250.00
150.00
50.00

For option 1, the IRR is 12.01%. Consider the yield:


P

Inflows accumulated @ IRR


1000

Yield = IRR!
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1/5

1 =

1762.90
1000

1/5

1 = 12.01%

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

What if it is not possible to reinvest inflows at a rate equal to IRR?


For option 1
P

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Inflows accumulated @ 3%
1000

1/5

1 =

1561.37
1000

1/5

1 = 9.32%

the yield is much lower

but the IRR does not change

if the reinvestment rate is different from the IRR, the yield is


not equal to the IRR!

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Numerical example

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Reinvestment rates NPV and IRR

assume a homogeneous rate of interest for all cash flows:


(Accum. value @ IRR) = (Invmt cost)(1 + IRR)length of invmt

do not allow for a different reinvestment rate

Solution

MIRR:
(Accum. value @ reinv. rate) = (Invmt cost)(1+MIRR)length of invmt

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MIRR is a modified yield that takes into account the


reinvestment rates

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Multiple IRR If cash flows are non conventional (change sign more
than once), there may be several IRR...
Example:

t
0
1
2

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CFt
-59
= NPV(i):
154
-99

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Investment Decision Criteria

Decision criteria
1. Payback period

the amount of time until repayments accumulate (without


interest) to the initial investment

2. Discounted payback period

the amount of time until discounted repayments have a higher


PV than the initial investment
same idea as payback period, but taking the time value of
money into account

3. NPV (net present value)

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the present value of net cash flows

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Investment Decision Criteria

4. IRR (internal rate of return)

the rate of interest such that the NPV is 0

5. MIRR

a modified IRR that takes into account reinvestment rates

6. Profitability index

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the ratio
(PV of repayments) / (initial investment)
remember the NPV is the difference:
(PV of repayments) - (initial investment)

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Investment Decision Criteria

7. Dollar-weighted rate of return

The simple rate of interest such that the NPV is 0

8. Time-weighted rate of return

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returns over subsequent periods are compounded to yield an


average return
particularly used by investment funds to transform monthly
returns into longer term returns (semesterly, annual, . . . )

Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Investment Decision Criteria

Numerical example
In this example, what is the decision that the various decision
criteria that were introduced would yield?

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

Sensitivity of Results: Example Suppose your company is


considering the purchase a small insurer. You forecast the following
cashflows for this insurer over the next 5 years:

Premiums: 100m p.a.

Claims: 80m p.a.

Expenses: 5m p.a, increasing at 3% p.a.

Assume that these are all incurred at the middle of the year on
average.

At the end of the 5th year the business will be sold for a total
of 10m.

Find the NPV of this project at 6% p.a.

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

Sensitivity of our results to

discount rate assumption?


expense increase rate?

premium and claim changes?

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

7. Reporting
A Member must ensure that his or her reporting (whether oral or
written) in respect of Professional Services provided:
(a) is appropriate, having regard to:
1. the intended audience;
2. its fitness for the purposes for which such
reporting may be required or relevant;
3. the likely significance of the reporting to its
intended audience;
4. the capacity in which the Member is acting; and
5. any inherent uncertainty and risks in relation to
the subject of the report;
(b) complies with any relevant Professional Standards.
Institute of Actuaries of Australia Code of Professional Conduct
(November 2009, Section 7)
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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

Assess Extract of professional standards on economic valuations:


4.2 Scope of economic valuation
[. . . ]
The Member should ascertain the materiality limits that apply to
the economic valuation bearing in mind:

the quality of the data;

the intended use(s) of the economic valuation;

the degree of uncertainty; and

the sensitivity of the overall result to different assumptions.

Institute of Actuaries of Australia Guidance Note 552 on Economic


Valuations (July 2004)

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

And then communicate


3.3 Transparency
The models, methods and assumptions used for the economic
valuation should, as far as practical, be transparent, enabling
valuation results and sensitivities in the results to changes in
particular assumptions to be understood by the intended users of
the economic valuation.
Institute of Actuaries of Australia Guidance Note 552 on Economic
Valuations (July 2004)

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

Project Appraisal Example A company considers buying equipment


and then leasing it out to third parties. This project has the
following variables:

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

Loan schedule

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

Taxable income

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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

Net cash flows

NPV @ 18%: $161,745


IRR: 22.06%
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Financial Mathematics
Module 3: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

NPV check

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