Fin Maths One Student Study Guide 2016

Financial
Mathematics1
COAF1105
Study guide
For
Accounting and Finance
W. Mawanza
2016 edition student manual
E-mail: wilfordma@hotmail.com
W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 1 of 63

Financial Maths – Course Overview
instructor: Mawanza E-mail: wilfordma@hotmail.com
Subject: Financial Mathematics1
Class: Accounting and Finance.
Purpose:
The goal of the course is to introduce the students to the modern mathematical concepts,
techniques and methods used in finance.
By the end of the course, students should have mastered the methods and techniques needed
to solve introductory business financial problems and have a thorough understanding of the
time value of money.
.
Topics:
1) Basic Mathematical Finance
 Definitions
 Time Value of Money
 Simple Interest and simple discount
2) Compound Interest and Equations of Value
 Compound Interest
 Annual Compounding
 Compounding period other than annual
 Annualized yield
 Continuous Compounding
3) Annuities
 Basic Concepts
 Ordinary Annuities Certain
 Annuities Due
 Deferred Annuities and Perpetuities
4) Loan Amortization
 Introduction
 Amortization schedule
 Buyer’s Equity and Seller’s Equity
 Sinking Funds
 General and Increasing Annuities
5) Money Market Securities
 The Financial System
 The Money Market and the Capital Market
 Interest bearing Money Market Securities
 Discount Securities
6) Capital Budgeting
 Capital Budgeting Principles
 Independent vs. Mutually Exclusive Projects
 Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Payback Period
 Discounted Payback Period
 Accounting Rate of Return (ARR)
 Modified Internal Rate of Return (MIRR)
7) Financial calculus
 Introduction to differential Calculus
 Differentiation using rules
 Application of differentiation in Economics and Finance
Assessment

Assessment will be based on the following weights:
End of Semester Exam 70%
Coursework: 30%
Recommended Reading List

1. An Introduction to Mathematical Finance by Sheldon M. Ross
2. Principles of Corporate Finance by Brealey and Myers
3. Fixed-Income Securities and Derivatives Handbook by MooradChoudhry
4. Fundamentals of Corporate Finance by Brealey and Myers
5. Practical Business Math Procedures by Jeffrey Slater
6. Any Relevant Material
IMPORTANT NOTE
The notes in this module are meant to guide you in your further reading. As such,
while as much detail as possible is covered, your participation in class discussions,
attentive listening to the lecturer and own independent study are all important for
your success.

Chapter 1: Basic Mathematical Finance
Introduction:
No business can exist without the information given by figures. Borrowing, using and
making money is the heart of the commercial world thus the principle of interest and
interest rate calculations are extremely important.
This leads into an examination of the principles involved in assessing the value of money
over time and how this Information can be utilized in the evaluation of alternate financial
decisions.
The time value of money

Interest is the compensation one gets for lending a certain asset. For instance, suppose
that you put some money on a bank account for a year. Then, the bank can do whatever
it wants with that money for a year. To reward you for that, it pays you some interest.
The asset being lent out is called the capital. Usually, both the capital and the interest are
expressed in money. However, that is not necessary. For instance, a farmer may lend his
tractor to a neighbor, and get 10% of the grain harvested in return. In this course, the
capital is always expressed in money, and in that case it is also called the principal.
Remember that the financial decision area is a minefield in the real world, full of tax
implications, depreciation allowances, investment and capital allowances etc.
The basic principles in financial decision making are established through the concept of
interest and present value: –
Definition of interest:
Interest is the price paid for the use of borrowed money
Interest is paid by the user of the money to the supplier of it. It is calculated as a fraction
of the amount borrowed or saved over a certain period of time. This fraction is also
known as interest rate and is expressed as a percentage per year (per annum).
Simple interest
Definition Simple interest is interest that is computed on the principal for the entire
term of the loan, and is therefore due at the end of the term.
 When money is borrowed for a loan or invested, interest accumulates. The
amount of interest I depends on:
• The amount of money borrowed or invested, the principal (in dollars);

•
The interest rate, r; that is, the fraction of the principal that must be paid
each period (say, a year) for the use of the principal (also called the period
interest rate) and
• The time,t,
 To calculate the simple interest, I, accumulated on the principal, P, over an
interval of t years at an annual interest rate of r, the formula:
I = P× r ×t , is used.
 The percentage interest rate must be expressed as a decimal for calculations. The
symbol p.a. used with interest rates denotes per annum meaning an annual or
yearly interest rate. Interest rates stated as flat rates are used in simple interest
calculations
Example1a
How much interest do you get if you put $1000 for two years in a savings account
that pays simple interest at a rate of 9% per annum? What if you leave it in the
account for only half a year?
If you leave it for two years, you get

I = Prt
=$1000*0.09*2
=$180
If you leave it for only half a year, then you get; ½ *0.09*1000 =$45
Notes
 The total amount of money that must be repaid on a loan or the total value of an
investment can be called the future value F.
F = principal + interest
F = P+I
F = P+Prt
F = P (1+rt)
 The principal is also called the present value.

 The date at the end of the term on which the debt is to be paid is known as the due
date or maturity date.

Class Exercises1A
1. A student borrows $600 to buy a camera. The loan is over two years, and the simple
interest rate is 6% per year. How much interest does the student pay? What is the total
amount of money repaid?
2. Suppose you put $1000 in a savings account paying simple interest at 9% per annum for
one year. Then, you withdraw the money with interest and put it for one year in another
account paying simple interest at 9%.How much do you have in the end?
3. How many days does it take for $1450 to accumulate to $1500 under 4% p.a. simple
interest
4. A bank charges simple interest at a rate of 7% p.a. on a 90-day loan of $1500. Compute
the interest.
5. A promissory note with a maturity value of $12 000 and an interest rate of 16% per
annum is sold three months prior to its due date. What is the present value on the day it
is sold?
Use of time lines

 The time line is one of the most important tools in time value of money analysis.
Cash flow time lines help to visualize what is happening in a particular problem
 Cash flows are placed directly below the tick marks, and interest rates are shown
directly above the time line; unknown cash flows are indicated by question marks.
 Inflows of money are indicated by an arrow from above pointing to the line, while
outflows are indicated by a downward pointing arrow below the time line.
PV or P
t=Term
,r =
Interest
Rate FV or
F=P {1+rt)

At the beginning of the term, the principal P (or present value) is deposited (or
borrowed) – that is, it is entered onto the line. At the end of the term, the amount or sum
accumulated, F (or future value) is received (or paid back). Note that the sum
accumulated includes the interest received. Remember that
Future value = Present value + Interest received.
Using a time line, example1a above may be represented as follows:
$1000
2years
9%
$1180
Class Exercises 1B
1. Calculate the simple interest and sum accumulated for $5 000 borrowed for
90 days at 15% per annum.
2. Brendan wants to have $15000 for a new boat in 10 years’ time. How much
should he invest at 5% per year to save this amount (assuming no
withdrawals are made and the interest rate does not change)?
NB. Includes the use of time line in your answers.
Simple discount
1. Interest calculated on the face (future) value of a term and paid at the beginning of the
term is called discount.
 Interest that has to be paid at the end of the term for which the loan (or
investment) is made. On the due date, the principal borrowed plus the interest
earned is paid back.
 The rate of interest i is the interest paid at the end of a time unit divided by the
capital at the beginning of the time unit. The rate of discount d is the interest
paid at the beginning of a time unit divided by the capital at the end of the time
unit. The discount factor D is the amount of money one needs to invest to get
one unit of capital after one time unit.
 In practice, there is no reason why the interest cannot be paid at the beginning
rather than at the end of the term. Indeed, this implies that the lender deducts
the interest from the principal in advance. At the end of the term, only the
principal is then due.

 Loans handled in this way are said to be discounted and the interest paid in
advance is called the discount. The amount then advanced by the lender is
termed the discounted value. The discounted value is simply the present value of
the sum to be paid back.
 Expressed in terms of the time line of the previous section, this means that we are
given F and asked to calculate P
P
, t years
d
F
 The discount on the sum F is then simply the difference between the future and
present values. Thus the discount (D) is given by. D = F − P.
 Simple discount rate d has been introduced which, by analogy with the interest
rate, is the fraction of the sum F per time period that must be paid. Discount rate
d is also expressed as a percentage
 The discount D in monetary terms is given by D = Fdt
(Compare to the formula for simple interest I = Prt) where d = simple discount rate and
the discounted (or present) value of P is
 P=F–D = F – Fdt = F(1 −dt)
 Present Value = Future Value − Future Value × discount rate × time.
The discount rate is now expressed as a percentage of the future value (and not as a
percentage of the present value as before); a minus sign appears in the formula. This
means that the discount, FV × d × t, is subtracted from the future value to obtain the
present value.
Money-market instruments that are traded on a discount basis are bankers’ acceptances
(referred to as BAs) and treasury bills. The value appearing on the acceptance or bill, the
so-called “face value”, is what the owner thereof will receive on the maturity date. On the
other hand, the price paid is the present value, which is calculated as described above
using the current rate as set by the market

Example 1b
Determine the simple discount on a promissory note of $3 000 due in eight months at a
discount rate of 15%. What is the discounted value of the note? What is the equivalent
simple interest rate r?
Solution
Now F = 3 000, d = 0,15 and t = 8/12 = 2/3
This is represented by a time line
??
8/12
d = 15%
F=$3000
Thus D = Fdt = 3 000 × 0, 15 × 2/3 = 300, that is, the simple discount is $300.
P = F – D = 3 000 – 300 = 2 700
The discounted value is $2 700. In order to determine the equivalent interest rate, r,we
note that $2 700 is the price now and that R3 000 is paid back eight months later.
I = F – P = 3 000 − 2 700 = 300

The interest is thus R300. The question can thus be rephrased as follows: What simple
interest rate, when applied to a principal of $2 700, will yield $300 interest in eight
months?
But I = Prt and with substitution we get, 300 = 2 700 × r × 2/3,

That is
r = 2/3× 300/2700 = 0,1667.
Thus the equivalent simple interest rate is 16, 67% per annum.
Hint
Note the considerable difference between the interest rate of 16, 67% and the discount rate
of 15%. This emphasizes the important fact that the interest rate and the discount rate are
not the same thing. The point is that they act on different amounts, and at different times –
the former acts on the present value, whereas the latter acts on the future value.
Exercise 1C
1. A bank’s simple discount rate is 18%. If you sign a promissory note to pay $4
000 in six months’ time, how much would you receive from the bank now?

What is the equivalent simple interest rate?
2. In return for a loan of $100 a borrower agrees to repay $110 after seven
months.
(a) Find the rate of interest per annum.
(b) Find the rate of discount per annum.
Counting days
With simple interest and simple discount calculations it is often important to know the
exact number of days between the beginning and end of the relevant term. For this
purpose, the convention is as follows:
To calculate the exact number of days between the beginning and end of the relevant
term, the day the money is lent (or deposited) is counted, but not the day the money is
repaid (or withdrawn).
Example 1c
Determine the number of days between 19 March and 11 September.
List the months and relevant number of days in each month, and then determine the
total.
Month Number of days
March 13 (including 19 March∗)
April 30
May 31
June 30
July 31
August 31
September 10 (excluding 11 September)
176
Class Exercise1D
1. Determine the number of days from 12 October 2005 to 15 May 2006
2. Suppose an investor wishes to purchase a treasury bill (with a par value, that is
face value, of $1 000 000, 00) maturing on 2 July 2000 at a discount rate of 16,
55% per annum and with a settlement date of 13 May 2000. What would the

required price be (this is present or discount value – also referred to as the
consideration)? What is the equivalent simple interest rate of the investment?
Equations of Value
An amount of money can have different values at different times, for a particular interest
rate. The value of money is dependent on its ability to earn interest. Equations of value
are used to compare the value of money at various times.
The concepts “present value” and “future value” of a particular debt or investment, and
the two are related by the equation
Future value = Present value + Interest
or, in symbols,
F = P + Prt = P (1 + rt).
Hence a particular investment has different values on different dates
For example, $1 000 today will not be the same as $1 000 in six-months’ time. In fact, if
the prevailing simple interest rate is 16% per annum, then, in six months, the $1 000 will
have accumulated to $1 080.
1 000 × (1 + 0, 16× 1/2) = 1 080
On the other hand, three months ago it was worth less – to be precise, it was worth$961,
54.
1 000/ (1 + 0, 16 × 1/4) = 961, 54
Represented on a time line, these statements yield the following picture
961, 54 now
3/12 6/12 years
D = 16% now
$1000 F=$1080
We can formulate the above results as two simple rules:

 To move money forward (determine a future value) where simple interest is
applicable, inflate the relevant sum by multiplying by the factor (1 + rt).
 To move money backward (determine a present value) where simple interest is
applicable, deflate the relevant sum by dividing by the factor (1 + rt).
Note: The second rule is equivalent to multiplying by a factor of (1 + rt) −1.

Class Exercise 1E
1. Jack borrows a sum of money from a bank and, in terms of the agreement, must pay
back $1 000 nine months from today. How much does he receive now if the agreed rate
of simple interest is 12% per annum? How much does he owe after four months?
Suppose he wants to repay his debt at the end of one year. How much will he have to
pay then?
2. Alick owes $500 due in eight months. For each of the following cases, what single
payment will repay her debt if money is worth 15% simple interest per annum?
(a) now
(b) six months from now
(c) in one year
3. Tracy owes NN Broker $5 000 due in three months and $2 000due in six months. Tracy
offers to pay $3 000 immediately if he can pay the balance in one year. NN agrees, on
condition that they use a simple interest rate of 16% per annum. They also agree that
for settlement purposes the $3 000paid now will also be subject to the same rate. How
much will Tracy have to pay at the end of the year?

Chapter 2: Compound interest and equations of Value
In compound interest, the interest earned by an invested amount of money (or principal)
is reinvested so that it too earns interest. That is, at the end of each interest period the
interest earned for that period is added to the principal so that the interest also earns
interest over the next interest period. In the same way, interest due on a debt at the end
of a period is subject to interest in the next period
For illustration purpose, you deposit $600 in a savings account that offers you interest of
10% per annum calculated annually. If you do not withdraw any of the interest, but allow
it to be added to the principal at the end of each year, how much would you have after
three years?
At the end of the first year, I1 = 600 × 0,1 × 1= 60.
The interest earned is $60. This $60 is now added to the principal, which becomes$660.
The interest earned in the second year isI2 = 660 × 0,1 × 1= 66.
The principal available for the third year is thus $726 (660 + 66).
Finally the interest for the third year is, I3 = 726 × 0,1 × 1= 72,60.
Thus after three years, your $600 investment will have grown to $798,60
(726+72,60)and the compound interest earned will be $198,60 (798,60 − 600).
The accumulated amount or compounded amount, F, has same meaning as future value.
The difference between the compounded amount and the original principal is called the
compound interest, I = F−P.
For an original principal of P invested at a periodic interest rate of i for n periods, the
compounded amount (or future value), F, is given by F = P (1 +r) n.
Derivation
 We start with our basic formula for simple interest: I = Prt, which we must apply
repeatedly.
 However, since we work with one period at a time, we may set t = 1. Starting with
a basic principal P and at an interest rate of r, the interest earned in the first
period is: I1 = Pr.
 Our basic principal invested for the second period (P2) is the sum of the original
principal and the interest earned, that is,
P2 = P + I1= P + Pr= P (1 + r).
 The interest earned in the second period is then I2 = P2r= P (1 + r) r
 (That is the simple interest formula applied with P (1 + r) instead of P, and t = 1).
Our basic principal for the third period (P3) is then

P3 = P2 + I2
= P (1 + r) + P (1 + r) r
= P (1 + r) (1 + r)

= P (1 + r) 2.
We could continue in this way but I’m sure that the formula is already evident, namely
that after the nth period, the accrued principal, or compounded amount (F), will be
F = P (1 + r) n.
The accrued compound interest is simply the difference between F and the original
principal invested, that is, F − P.
 The formula for compound interest is thus as follows’ = P (1 +i) n.

 For compound interest, we will use the symbol i for the interest rate and n for the
period.
Graphically it can be presented as in the timeline overleaf.
P or PV Horizon = n periods
1 period
,i per
period
F=FV
Let’s see how our formula works. Refer back to our last example where we used
P = 600, i = 0, 1 and n = 3. Now
F = P (1 + i) n
F = 600(1 + 0, 1)3
= 600(1, 1)3
= 798, 60.
We therefore obtain F= 798, 60 as before.
Present Value using compound Interest.

As was the case for simple interest, we may define the present value (P) as the amount
that must be invested (or borrowed) for n interest periods, at a rate of i per interest
period, in order to accumulate the amount F on the due date.
We obtain this by solving for P from the compound interest formula as follows:
If
F = P (1 + i) n, then P = F / (1 + i) n or P = F (1 + i)−n
The periodic interest rate can be found by dividing the annual interest rate, r, by the
number of periods in a year, , i.e. i= r/n

Hint:We must just remember that the interest rate for each period is determined by
dividing the annual interest rate by the number of compounding periods per year, while
the total number of compounding periods is the number of compounding periods per
year times the number of years’ for which the investment is made.
 To make it clearer, however, we will redefine the formula for compound interest
introducing some new symbols. It is still the same formula, but we now
differentiate clearly between the annual interest rate, jm, and the interest rate per
compounding period, i, as well as the term, t, in years, and m the number of
compounding periods
The new formula for compound interest is now as follows:
F = P (1 + i) n translates to
Similarly the Present value equations
P = F / (1 + i)n will translates to
P = F (1 + i)−n will be
From the above formulae, each of the unknown variables can be deduced, that is
n, tm and t
Class Exercise 1F
1. What is the present value if the compounded amount (future value) $10 000 is invested at
18% per annum for five years and interest is calculated monthly?

2. $2 000 is invested at 14% per annum for three years. Determine the accrued principal if
interest is calculated (and added to the principal)
(a) Yearly, (b) half-yearly, (c) quarterly, (d) daily.

Draw the time line in each case
3. $1 000 is invested for one year at 8% per annum but the interest is compounded
semi-annually (i.e. every six months). How much interest is earned? Compare the
interest earned to the simple interest which would be earned at the same rate in one
year.
4. Find the compounded amount on $5 000 invested for ten years at 7.5% per annum
compounded annually.
5. How much interest is earned on $9 000 invested for five years at 8% per annum and
compounded annually?
6. Clarissa invests $5000 at 6.2% p.a. with interest compounded monthly. What would her
investment be worth after five years? What amount of interest has been earned during the
five years?
7. Suppose that a capital of 500 dollars earns 150 dollars of interest in 6 years. What was the
interest rate if compound interest is used? What if simple interest is used?
8. How long does it take for $900 to accumulate to $1000 under an interest rate of 4% p.a.?
9. What annual rate of interest, compounded quarterly, would be required if an initial

investment of $3000 is to amount to $3500 after 5 years?
Annualized yield and continuous compounding

 In cases where interest is calculated more than once a year, the annual rate
quoted is the nominal annual rate or nominal rate.
 If the actual interest earned per year is calculated and expressed as a percentage
of the relevant principal, then the so-called “effective interest rate” is obtained.
This is the equivalent annual rate of interest – that is, the rate of interest actually
earned in one year if compounding is done on a yearly basis.
Example 1d
Calculate the effective rates of interest if the nominal rate is 15% per annum and interest
is calculated
a. Yearly
b. half-yearly

c. Quarterly
d. Monthly
e. daily
(a) If interest is calculated yearly, then there is, by definition, no difference

betweenthe nominal and effective rates, which are both 15% in this case.
b) We could use any principal, but it is convenient to choose P = $100.
For half-yearly compounding, jm = 0, 15, m = 2 and t = 1.
F = 100(1+015/2)2 = 115.56
The interest is 15, 56 (115, 56−100) and expressed as a percentage, this is

15,56%per annum (since P = 100), which is the effective rate
(c) For quarterly compounding, jm = 0,15, m = 4 and t = 1.

F = 100(1+.15/4) = 115.87
The interest is 15, 87 (115, 87−100) and the effective rate is 15, 87% per annum
Class to do the remaining
 From the above example you should note that, in order to calculate the effective
rate, we do not require the actual principal involved. In fact, it is convenient to
use P = 100, since the interest calculated then immediately yields the effective
rate as a percentage.
The interest rate (expressed as a percentage) is then

Jeff = F– 100
Therefore Jeff =
The value Jeff calculated in this way is called the effective interest rate expressed
as a percentage.

100 1 year atJeff m periods at jm/m
,i per
Period
F=100(1+jeff/100)
=100 + Jeff
=100+
F=100(1+jm/m) m
Class Exercise1G
1. Use the formula to calculate the effective interest rate Jeff (expressed as a percentage) if the
nominal rate is 22% and the interest is calculated
(a) half-yearly
(b) quarterly
(c) monthly
(d) Daily.
The effective rate for the investment for that year is the fraction by which your money
increased over the year. The increase in your money is the accumulated amount minus
the principal. The fractional increase is
= (F/p)-1
The effective interest rate expressed as a decimal is

Jeff = (F/P)-1 = since F = P (1+jm/m) m
 From this the nominal rate jm in terms of the effective rate Jeff can be
determined:
 Suppose we are given a nominal rate of jm and want to find the equivalent rate
jn. Both rates must produce the same fractional increase in money over a one-
year term.
They must therefore both correspond to the same effective rate.

 The nominal rate jn compounded n times per year is equivalent to the nominal
rate jm compounded m times per year.
Example 1e
Find the nominal rate compounded semi-annually that is equivalent to a nominal rate of
12% per year compounded quarterly.
Jn =2[(1+0.12/4)4/2-1] = 0.1218
A nominal rate of 12% compounded quarterly is equal to 12, 18% compounded semi-
annually.
Odd period calculations
Up to now we have assumed that the term for any money deposited or borrowed and
subject to compound interest, coincides with a whole number of compounding periods.
Stated mathematically, we assumed that n is an integer. Of course, in practice this is not
necessarily the case, unless all interest is credited on a daily basis. It could well be that
you wish to invest in a particular investment that credits interest on, say, the first day of
each month, but that you have the money available to do so in the middle of the month.
What happens to the odd half month?
Do you get no interest? Surely not!
Exactly what happens depends on the practice adopted by the particular financial
institution, and you are therefore advised to find out before investing your hard earned
money. In most cases, the odd periods are treated as simple interest cases, as illustrated
in the following example
Example 1f
An amount of $2 500 is invested on 15 May for five months in a special savings account
at an interest rate of 16% per annum, compounded monthly on the first day of each
month, while simple interest is applicable for the odd period calculations. How much
interest is received at the end of the term? Note that there are two odd periods involved
– at the beginning and at the end. The calculation thus requires three steps:
(a) Simple interest from 15 May to 1 June
(b) Compound interest from 1 June to 1 October
(c) Simple interest from 1 October to 15 October
The calculation proceeds as follows:

(a) 15 May to 1 June: Day number 152 (1 June) minus day number 135 (15 May)equals 17
days, thus 17 days’ simple interest.

F = P(1 + rt) = 2 500 (1 + 0,16 × 17/365 ) = 2 518,63
The 2 500 accumulated to 2 518,63
b) 1 June to 1 October: The amount of 2 518,63 is now invested for four months
at a nominal rate of 16% per annum, compounded monthly.
= 2518.63(1+0.16/12)(12*4/12) = 2 655,67
(c) 1 October to 15 October: Lastly, this amount earns simple interest for 14 days
F = P(1 + rt) = 2655,67(1 + 0,16 × 14/365)=$2671.97
Class Exercise H
Calculate the sum accumulated on a fixed deposit if $10 000 is invested on 15
March 2013 until 1 July 2015 and if interest is credited annually on 1 July at15,5%
per annum, with simple interest calculations for the odd periods.
Continuous Compound Interest
Continuous compounding can be thought of as making the compounding period

infinitesimally small; therefore achieved by taking the limit of n to infinity. One
should consult definitions of the exponential function for the mathematical proof
of this limit.
F = Pe rt,
Example1g
An amount of $2,340.00 is deposited in a bank paying an annual interest rate of
3.1%, compounded continuously. Find the balance after 3 years.
Use the continuous compound interest formula, F = Pe rt, with P = 2340, r =

3.1/100 = 0.031, t = 3
The balance after 3 years is approximately $2,568.06.
Equivalent continuous compounding rate
Class exercise1I
1. You are quoted a rate of 20% per annum compounded semi-annually. What is the

equivalent continuous compounding rate?
2. Suppose $12 000 was invested on 15 November 20.0 at a continuous rate of16%.
What would the accumulated sum be on 18 May 20.1? (Count the days exactly.)
3. You have two investment options:
(a) 19,75% per annum compounded semi-annually

(b) 19% per annum compounded monthly
Use continuous rates to decide which the better option is.
Applying equations of Value in Finance
Example 1h
An obligation of $50 000 falls due in three years’ time. What amount will be
needed to cover the debt if it is paid?
(a) in six months from now
(b) in four years from now
If the interest is credited quarterly at a nominal rate of 12% per annum? Draw the
relevant time line
Now
10 4
0 2 12 16quaters
$50 000
 To determine the debt if it is paid in six months (i.e. two quarters), we must
discount the debt back two-and-a-half-years from the due date to obtain the
amount due.
P = 50000(1+0.12/4)-(2.5*4) = 37 204.70
 To determine the debt, if it is allowed to accumulate for one year past the due
date, we must move the money forward one year to obtain.
S = 50 000(1+0.12/4)(1*4) =56 275.44

Exercise 1J
1. Tenesmus Sithole foresees cash flow problems ahead. He borrowed $10 000 one year ago
at 15% per annum, compounded semi-annually and due six months from now. He also
owes $5 000, borrowed six months ago at 18% per annum, compounded quarterly and due
nine months from now. He wishes to pay $4 000 now and reschedule his remaining debt so
as to settle his obligations 18 months from today. His creditor agrees to this, provided that
the old obligations are subject to 19% per annum compounded monthly for the extended
period. It is also agreed that the $4 000 paid now will be subject to this same rate of 19%
for evaluation purposes. What will his payment be in 18 months’ time?
2. Peter Penniless owes Wendy Worth $5 000 due in two years from now, and$3 000 due in
five years from now. He agrees to pay $4 000 immediately and settle his outstanding debt
completely three years from now. How much must he pay then if they agree that the
money is worth 12% per annum compounded half-yearly?
3. Three years ago Fiona Fin borrowed $4 000 from Martin Moneylender for five years at 12%
per annum compounded monthly. One year ago she borrowed $8 000 at 16% per annum
compounded quarterly, for five years. She agrees to repay her debt in two equal
instalments, one now and one in five years’ time from now. If Martin’s money is now worth
20% per annum compounded half-yearly, what is the amount of each payment?
4. Paul Poverty owes Winston Wealth $1 000 due in three years from now and $8 000 due in
five years from now. He wishes to reschedule his debt so as to pay two sums on different
dates, one, say X, in one year from now, and the other, which is twice as much (i.e. 2X), five
years later. Winston agrees, provided that the interest rate is 18% per annum, compounded
quarterly. What are Paul’s payments?

Chapter 3: Annuities
Definition
An annuity is a sequence of payments with fixed frequency, i.e., equal payments at equal
intervals of time.
 The payment interval of an annuity is the time between successive Payments

while term is the time from the beginning of the first payment interval to the end
of the last payment interval.
 The term annuity" originally referred to annual payments (hence the name), but it
is now also used for payments with any frequency. Annuities appear in many
situations; for instance, interest payments on an investment can be considered as
an annuity.
 An important application is the schedule of payments to pay off a loan.
 The word annuity" refers in everyday language usually to a life annuity. A life
annuity pays out an income at regular intervals until you die. Thus, the number of
payments that a life annuity makes is not known.
 An annuity with a fixed number of payments is called an annuity certain, while an
annuity whose number of payments depends on some other event (such as a life
annuity) is a contingent annuity. Valuing contingent annuities requires the use of
probabilities and this will not be covered in this module. These notes only looks
at annuities certain, which will be called annuity" for short.
Types of Annuities:
 Ordinary annuity- annuity where payments are made at the end of each payment
interval.
 Annuity due- annuity where payments are made at the beginning of the payment
interval
TERM
R R R R R R

Future value Ordinary annuities certain
Definition: Regular payments into a saving account. Interest grows the investment.
Derivation
F = P (1 + i)n and assume a regular payment of $1 for 4 years
 F= 1(1+i)3+1(1+i)2+1(1+i)1+1(1+i)0
 F= F1+F2+F3+F4
 F1= 1(1+i)n−1., F2 = 1(1+i)n−2; F3 = 1(1+i)n−3; Fn-1=1(1+i)[n−(n−1)]= 1(1+i)1
 Fn= 1(1+i)n−n
Hence the value of F at the end of n periods will be:
F= F1+F2+…Fn-1+Fn
F= (1+i)n−1 + (1 + i)n−2 + ・・・+ (1 + i)1 +1…………….i
Multiply the left and right side of the expression by (1 + i).
(1 + i)F= (1+i)n + (1 + i)n−1 + (1 + i)n−2 + ・・・+ (1 + i)2 + (1 + i)…ii
If we now subtract expression (1) from expression (2), we obtain

(1 + i)F − F = (1+i) n − 1
k
Since all other powers of (1+i) on the right-hand side become zero ((1 + i) − (1 + i) k
=0).
iF = (1+i)n − 1
Therefore
This formula is also known as the future value of an annuity
If the payment in dollars, made at each payment interval in respect of an ordinary

annuity certain at interest rate i per payment interval, is R, then the amount or future
value of the annuity after n intervals is

Hint:The annual interest rate jm compounded m times per yearjm/m is denoted by i while
the number of interest compounding periods tm is denoted by n.
Class Exercise 2A
1. Mrs Dooley decides to save for her daughter’s higher education and, every year, from the
child’s first birthday onwards, puts away $1 200. If she receives 11% interest annually,
what will the amount be after her daughter’s 18th birthday?
2. What is the accumulated amount (future value) of an annuity with a payment of $600
four times per year and an interest rate of 13% per annum compounded quarterly at the
end of a term of five years?
3. On 15 November in each of the years 1964 to 1979 inclusive an investor deposited $500
in a special bank savings account. On 15 November 1983 the investor withdrew his
savings. Given that over the entire period the bank used an annual interest rate of 7% for
its special savings accounts, find the sum withdrawn by the investor.
Present value of an annuity.

Definitions
The present value of an annuity is the amount of money that must be invested now, at i
percent, so that n equal periodic payments may be withdrawn without any money being
left over at the end of the term of n period
Since, …………………………………………………………………………………………………1
And given that future value of an annuity is ……………………….2

Substituting for F in equation 1 will give:
This can be reduced to or

If the payment is made at each payment interval for an ordinary annuity certain, at
interest rate i per payment interval, is R for a total of n payments, then the present value
is
Class Exercise 2B
1. Determine the present value of an annuity with semi-annual payments of $800 at
16% per year compounded half-yearly and with a term of ten years.
2. Max puts $3 000 down on a second-hand car and contracts to pay the balance in
24 monthly instalments of $400 each. If interest is charged at a rate of 24% per
annum, payable monthly, how much did the car originally cost when Max
purchased it? How much interest does he pay?
Annuities due
An annuity due is an annuity in respect of which paymentfalls due at the beginning of
each payment interval. A typical example of an annuitydue is the monthly rent for a
house.Deposits in savings, rent payments,and insurance premiums are examplesof
annuities due.
TERM
R R R R R R
0 1 2 3 n-2 n-1 n
Suppose we got an annuity for 5 payments
At T1: FV at T1 = R (1 + i)1 + R
At T2: FV at T2 = R (1 + i)2 + R(1 + i) + R
At T3: FV at T3 = R (1 + i)3 + R(1 + i)2 + R(1 + i) + R
At T4: FV at T4 = R (1 + i)4 + R(1 + i)3 + R(1 + i)2 + R(1 + i) + R
At T5: FV at T5 = R (1 + i)5 + R(1 + i)4 + R(1 + i)3 + R(1 + i)2 + R(1 +i)+R
If we look at the sequence of terms we see that:

FV = R (1 + i) + R (1 + i) 2 + R(1 + i)3 + R(1 + i)4 + R(1 + i)5
We can remove a common factor of (1 + i) to get:
FV = (1 + i)[R + R(1 + i) + R(1 + i)2 + R(1 + i)3 + R(1 + i)4]

Now we already know that for the square brackets we have a formula which
Says that
So we use this to get 1
This would be the same as moving all the payments to a future value at T4,, startingat
T0, and then adding one more period of interest to take this accumulated future
value to the end of the five year period. This is very important to remember, because
this is exactly how the future value formula works. If you understand fully how to
adjust the standard formula, then you won’t have major difficulties with the future
value formulae for finance.
 For the annuity due for n periodic payments into an account that pays an
effective i% per period, the Future value can be calculated using the formula:
This also follows that the Present Value of an annuity due can be generalized by the
following formula
, i.e.
PV (of annuity due with n periods)= First payment +PV (of ordinary annuity with (n − 1)
Deferred Annuities and Perpetuities
A deferred annuity is characterized by a payment which is made at some later date,

rather than the beginning or end of the time period. That is where the first payment is
made a number of payment intervals after the end of the first interest period. The
following formula calculates the present value of the deferred annuity:
All you have to do is to work from a base date that is one period before the first
payment so that ordinary annuities can be used and then discount to the actual
beginning
Where,
R = Payment
i = Interest rate according to the period.
n = total time period, and k = deferred periods

Perpetuity
Perpetuity is an annuity with payments that begin on a fixed date and continue forever.
That is, it is an annuity that does not stop.
Examples of perpetuities are scholarships paid from an endowment, the interest

payments from an amount of money invested permanently and the dividends on a share,
provided, of course, that the company does not cease to exist.
It is valued using the formula
Class Exercise 2C
1. Suppose that a court settlement results in a $750,000 award. If this is invested at 9%
compounded semi-annually, how much will it provide at the beginning of each half-
year for a period of 7 years?
2. A deferred annuity is purchased that will pay $10,000 per quarter for 15 years after
being deferred for 5 years. If money is worth 6%pa compounded quarterly, what is the
present value of this annuity?
3. How much money must be invested monthly into an ordinary annuity to realise $1 000
000 in 20 years’ time if the current rate of investment is calculated at an effective 9%
per annum compounded annually? (The payments stretch over the20 year period)
4. Bongiwe wants to save up some money so that she can give her unborn daughter $16
000 on her 16th birthday. On the day that her daughter is born, she starts making equal
monthly payments into an account that pays 8% p.a. compounded monthly. Her last
payment into this account is due one month before her daughter turns 16. Calculate
the size of the monthly payment
General and Increasing Annuities

Definition a series of payments where the payment periods do not match the interest
periods exactly is referred to as a general annuity

The best way of solving general annuity problems is to replace the specified interest rate
and period with an equivalent interest rate that corresponds to the period of the
payments. (You saw how to perform interest rate conversions of this kind in the previous
chapter using the conversion of interest rate formula as an aid.) Alternatively, the
payments may be replaced to coincide with the interest dates. The latter method is a
little more complicated. Generally, because the first method is sufficient, we shall confine
ourselves to an example using this method.
Example 2a
In terms of an agreement with his creditors, Ivan makes payments of $1 200 into an
account at the end of every two month period for five years. Determine the accumulated
value of these payments if interest is compounded quarterly at13,5% per annum.
TERM
1200 1200 1200 …….. 1200 1200
0 c 2 c 4 c 6 c c 58 c 60
Future value
The points at which interest is credited are indicated by c.

We must convert the interest rate that is compounded quarterly to compound every two
months (bi-monthly).
Thus
With n = 6
m=4
jm = 0,135
Therefore j6 = 0, 13425 = 13,425%.
This is the nominal annual rate for equivalent bi-monthly compounding. But be careful
– For the annuity calculation, we need to divide this by 6 to obtain the bi-monthly rate
for compounding. Do this to obtain 2, 2375299% per period.
 We now have to generate 30 bi annual periods from the 60 months in the
timeline.
 We have reduced it to an ordinary annuity with 30 payments at 2,237 . . .%
interest per period.
 Now future Value of an ordinary annuity

 The sum accumulated in five years is thus $50 534,440.
Definition: An increasing annuity is a series of payments that increases by a constant

amount with every payment.
 Suppose an annuity is payable annually for n years. The first payment is R, and
the amount of each subsequent payment increases by Q. The interest rate per
year is i.
 The time line is as follows:
R R+Q R+2Q……….. R+(n-2)Q R+(n-1)Q
0 1 2 3 n-2 n-1 n
From the above analysis we can derive the formula for an increasing annuity as

Example2b
You take out an endowment policy that stipulates that the first payment of $1
200 is due in one year and, thereafter, the payment is increased by $200 at the
end of every year. This policy matures in 20 years and the expected interest rate
per year is 15%. What amount could you expect to receive after 20 years?
 This is an increasing annuity with R = 1 200, Q = 200, n = 20 and i = 0, 15.
By substitution we get the answer to be $232 857,07.

Chapter 4 : Loan Amortizations inking funds
Definition
A loan is said to be amortized when all liabilities (that is both principal and interest) are
paid by a sequence of equal payments made at equal intervals of time
A loan of $180 000 is repaid by means of 10 semi-annual payments. Interest on the loan
is charged at 14% per annum compounded semi-annually. If the first payment was made
at the end of the first period (an ordinary annuity) the semi-annual payment will be
$25 627, 95:
The effective semiannual rate will be,i = 0, 14/2 = 0, 07
By substitution
Amortization Schedule
Initially, the total amount loaned (i.e. the present value at time zero) is owed. However, as
payments are made, the outstanding principal, or outstanding liability as it is also
known, decreases until it is eventually zero at the end of the term. At the end of each
payment interval, the interest on the outstanding principal is first calculated. The
payment R is then first used to pay the interest due. The balance of the payment is
thereafter used to reduce the outstanding principal. (If, for some reason or another, e.g.
by default, no payment is made, the interest owed is added to the outstanding principal
and the outstanding debt then increases. This will usually be accompanied by a rather
strongly worded letter of warning to the debtor!) Since the outstanding principal
decreases with time, the interest owed at the end of each period also decreases with
time. This means that the fraction of the payment that is available for reducing the
principal increases with time.

Present value 180,000.00
Interest rate /year 7%
No.years 10
Beginning Regula Principal

Time Balance payment Interest repaid
1 180,000 25,628 12,600 13,028

2 166,972 25,628 11,688 13,940
3 153,032 25,628 10,712 14,916
4 138,116 25,628 9,668 15,960
5 122,157 25,628 8,551 17,077
6 105,080 25,628 7,356 18,272
7 86,807 25,628 6,077 19,551
8 67,256 25,628 4,708 20,920
9 46,336 25,628 3,244 22,384
10 23,951 25,628 1,677 23,951
Total 0 180,000
 The interest due at the end of year one is: 0.07*180000=12600

 For the third year, the amount that must be paid as interest is:
0.07*153032=10712.24
 The principal repaid is the difference between the payment and the interest
due.(For example at the end of the first year, the principal repaid is 13028 (25628
−12600).)
 Outstanding principal at year beginning is equal to the previous principal at year
beginning minus principal repaid. (For example, at the beginning of the second
year, the outstanding principal is 166972 (180 000 −25628).)
 Also note that, owing to rounding errors, the total principal repaid is in error by
two cents.
Exercise 3A
1. Draw up an amortisation schedule for a loan of $4 000 for three years at 12% per
annum compounded half-yearly and repayable in six half-yearly payments.
2. A four-year loan of $5000 is repaid by equal annual payments at the end of each year.
Compute the annual payment on the basis of an interest rate of 6% p.a. and draw up
a loan schedule, showing the interest component of every payment and the
outstanding balance.

As stated above and as well illustrated in the above amortization schedule, the
outstanding principal decreases over the term from the amount initially borrowed to
zero at the end. In the case where the loan is used to buy property, this means that, as
the amount owed to the lender decreases, the fraction of the property that the buyer has
“paid off” increases until, at the end of the term, the buyer owes nothing on his property,
which is then paid off in full. At any stage during the term, the part of the price of the
property that the buyer has paid off is called the buyer’s equity, and the part of the price
of the property that remains to be paid is called the seller’s equity. Obviously, by
definition, we have the following relationship between the two:
Selling price = Buyer’s equity + Seller’s equity.
Exercise 3B
You purchase a small apartment for R180 000 with a down payment (often referred to as
a deposit) of R45 000. You secure a mortgage bond with a bank for the balance at 18%
per annum compounded monthly, with a term of 20 years. What are the monthly
payments? What is your equity in the house after 12 years?
Complex example
Edgar, a dynamic young executive, calculates that he can sell his house so as to have
$680 000 available for a down payment on a new house. The price that the seller is
willing to accept for Edgar’s dream house is $1 500 000. To this, Edgar will have to add
an extra $152 000 made up of estate agent’s commission, transfer fees and the premium
on an insurance policy that will cover the outstanding principal owed in the event of
Edgar’s death. His company will pay him a housing subsidy of $2 500 per month and also
has sufficient financial leverage to secure him the necessary mortgage bond at 12,5% per
annum (compounded monthly) for a period of 20 years. Assuming that Edgar is, for the
next few years, willing to commit himself to up to a third of his gross monthly salary of
$30 000, should he buy or not?
He will have to borrow a total of $972 000 (1 500 000 + 152 000 − 680 000). At 12,
5%per annum, over a period of 20 years, his monthly payment will be
Using the present value of an annuity formula you get

R = $11 043, 29.
From this, we must deduct his subsidy of $2 500, which means that Trevor must
contribute $8 543, 29 (11 043, 29−2 500). Since this is less than a third of his gross
monthly salary (30 000 ÷ 3 = 10 000), we would advise Edgar to buy. You will find a
similar example in the evaluation exercise
You may well argue that it is all very well doing such calculations, but everyone knows
that, nowadays, interest rates on mortgage bonds do not hold for very long. So what is

the point of talking about equal payments and, if the interest rate does change, how can
we handle it?
Yes, it is true that interest rates do change from time to time. But this implies that the
payments change accordingly, as you may possibly have experienced to your irritation if
you have a house with a mortgage bond on it. To recalculate the payments, we simply
work from the present value, which is the outstanding principal on the date from which
the change is implemented. It is usually assumed that the number of payments still due
remains the same, although, in some cases, the term of the loan may be extended. The
following example illustrates a calculation of this type:
Jonathan purchases an apartment by making a down payment of $160 000, and obtains
a 20-year loan for the balance of $480 000 at 13,5% per annum compounded monthly.
After four-and-a-half-years, the bank adjusts the interest rate to 14,5% per annum
compounded monthly. What is the new monthly amount that he must pay if the term of
the loan remains the same? Initially, the interest rate was 13,5% ÷ 12 per month and the
number of payments to be made was 20 × 12.
Using present value of an annuity
R = 480000/ [(1-1.01125^240)/.01125 = 5 795,40

Initially his payments were $5 795, 40. After four-and-a-half-years, the present value of
the loan is
P=5795.40[(1-1.01125^(240-54))/0.01125] = 450 841,86
But the outstanding principal of $450 841,86 must be amortized over 15.5 years at an
interest rate of 14,5% per annum compounded monthly.
Using present value of an annuity for 186 periods at an interest rate of 14.5/12
We get R =6 101,07
 When you consider all the preceding calculations for home loans, it is astounding
what you really pay for a home! In example above, we saw that after four-and a-half-
years and 54 payments, that is, after Jonathan had parted with $312 951,52 (54 × 5
795,40), he had paid off a mere R29 158,14 (480 000−450 841,86) of the amount he
originally borrowed.
 If we assume for now that the interest rate of 13,5% will remain fixed over the 20-
year term of the loan, Jonathan will, over the period, pay back a total amount of $1
390 896 (5 795,40 × 240) to redeem his loan. This is nearly three times more than the
amount originally borrowed. The total amount of interest he will pay is $910 896 (1
390 896 − 480 000). This is enough to discourage any prospective homeowner, or to
cause anyone who has already incurred such a debt to doubt his senses.

 However, you can take comfort in the fact that these figures look worse than they
really are. To put them into perspective, we must consider the effect of inflation.
 Inflation has the effect that the purchasing power of money today is much more than
it would be in, say, ten or 20 years from now. (Just think of how many sweets
$10bought you 20 years ago, and how little you get for it today!) This is also the case
with a loan. The R1 you borrow today is worth much more than the R1 you would
payback in ten or 20 years. We can therefore not simply add payments to be made
over a considerable period of time and compare the result to an amount received
today.
 All amounts must be discounted to the same base date. We do this as follows:
 Suppose the expected rate of inflation is r per period over the term of a loan with n
payments of R dollars each. Then the total value of the n payments in terms of the
dollar of today (taking inflation into account) is
 Tν = R[(1-(1+r)-n)/r).
Tr, the total real cost of the loan is the difference between the total value (Tν) of the
loan and the actual principal borrowed:
Tr = Tν − P
 This is simply the present value of the series of payments discounted at the inflation
rate.
 Tr is the total real cost of the loan, and we should compare this with the actual
principal borrowed. This is illustrated by the following example:
Exercise 3C
1. Suppose the interest rate on Jonathan’s loan of $480 000 will remain fixed at
13,5% for the full term of the loan. What is the total real cost of the loan if the
expected average rate of inflation over the term of the loan is: 5,5% per year.

Sinking funds
A Sinking fund is nothing other than a savings account used to accumulate the capital
needed to pay back the principal value of a loan at the end of the term of the loan. If it is
created for the replacement of, say, a machine, it is known as a replacement fund.
The concepts are illustrated in the following example.

Example 3b
A debt of $10 000 bearing interest of 14% per annum, to be paid half-yearly, must be
discharged by the sinking fund method. If the sinking fund earns interest at a rate of
12% per annum compounded quarterly, and the debt is to be discharged after five years,
determine the size of the quarterly deposits. What is the total yearly cost of the debt?
Now, if the payments into the sinking fund are R dollars each quarter, they must
accumulate, together with the interest earned at 12% per annum, to the amount of $10
000after five years. These payments constitute an ordinary annuity:
Using Future Value of an annuity:
R = 372,16
 The quarterly deposits are $372,16.

 The total yearly cost of the debt consists of the four quarterly deposits plus the
two half-yearly interest payments.
 I = Prt= 10 000 × 0,14 × 6/12 = 700
 The half-yearly interest payment is $700.
 Total yearly cost C = Interest + Sinking fund deposits
 = 2× 700 + 4 × 372,16 = 2 888,64.
 Thus the total yearly cost (C) is $2 888,64.

Exercise 3D
1. A company borrows $20 000 for six years at 16% per annum compounded quarterly. In
order to pay off the debt at the end of the six years, it establishes a sinking fund by
making equal annual deposits at the end of each year into a bank savings account
paying 12% per annum compounded annually. Determine the yearly deposits in the
fund. What is the total annual cost of servicing the debt?
2. Mr Wheel N Deal wishes to borrow $50 000 for five years for a business venture. The
Now Bank for Tomorrow is willing to lend him the money at 15% per annum if the
debt is amortised by equal yearly payments. However, Yesteryear’s Bank for Today will
lend the money at 14% per annum, provided that a sinking fund is established with it,
on which it will pay 11% per annum, to accumulate to the principal by the end of the
term, with equal annual deposits. What is the difference in total annual payments
between the two plans?

Chapter 5: Money Market Securities
The Financial System

The financial system of a country consists of lenders of funds (government, companies,
individuals, etc); borrowers of funds (from the same group as the lenders); and financial
institutions (banks, insurance houses, pension funds, etc) that match the funds of the
lenders to the requirements of the borrowers. The financial system facilitates the lending
and borrowing of money by the provision of money market instruments.
The types of financial instruments that most of us have to deal with in our capacity as
private individuals are generally nonmarketable. These include savings deposits, personal
loans, fixed deposits, mortgage loans and other lease agreements. By “nonmarketable” it
means that you cannot trade with them, that is, sell them or buy them from a third party.
Now the idea of selling (or buying) something like a loan sounds crazy but this is
essentially what the so-called “money market” is all about. The players in this market are
the corporate sector (ie large companies and corporations), the government sector (from
central to local), banks and other financial institutions such as insurance houses. And the
things in which they deal – the so-called “money market instruments” – apart from the
loans and deposits with which you are familiar, constitute a wide spectrum from short-
term instruments such as bankers’ acceptances (BAs) and treasury bills(TBs), to the very
long-term instruments that are typically stocks and debentures. We will discuss the
former, and more particularly their pricing (ie the determination of their present value),
by using discounting.
The instruments that are traded on the money market have the following characteristics:
 Short-term
 Marketable.
 Low risk ( risk-free )
 Highly liquid.
 Trade on a discount basis
Examples of the instruments that are traded on the money market include:
Treasury Bills (T-bills) are the most marketable of all the money market securities. They
are issued by the government to the public through the Central Bank as a means of
borrowing from the public. They are also used to control the money supply. The bill will
have a stated maturity value of, say $10 000 and a maturity date of 91 or 182 days. When

you buy the bill, you buy it at a discount to the stated maturity value and when it
matures you receive an amount which is equal to the maturity value (face value).
Pay a fixed amount at maturity. Make no regular interest payments, but sell at a discount.
Example: A Treasury bill that pays off $1000 at maturity 6 months from now sells for
$950 today. The $50 difference between the purchase price and the amount paid at
maturity is the interest on the loan.
Trade on a very active secondary market. Are the safest of all money market instruments,
since it is very unlikely that the Government will go bankrupt.
A Negotiable Certificate of Deposit (NCD) is a time deposit with a bank that is a

deposit which may not be withdrawn on demand. A firm may find that it has excess cash
that it may not require within the short-term period but may not be certain as to when
exactly the cash will be required. The firm may therefore deposit the money in an NCD.
Since it is negotiable, the firm can sell the NCD on the market at any time before the
maturity date. The value that the firm obtains when it sells the NCD will depend on the
number of days left to maturity and the discount rate at that time.
 Make regular interest payments until maturity.
 At maturity, return the original purchase price.
 Large CDs, with value over $100,000, trade on a secondary market.
 “Negotiable” means that the CD trades on a secondary market.
Commercial Paper consists of short-term, unsecured debt notes issued by large,

reputable companies instead of borrowing directly from banks. The firm must have a
bank line of credit which it can use to support the issue. The bank line of credit gives the
borrower access to cash to pay off the notes at maturity.
A Bankers' Acceptance arises from an order by a client firm to its bank to pay a sum of
money at a future date (which is similar to a post-dated cheque). The bank the “accepts
“the order by endorsing it and then assuming responsibility for payment to the holder of
the acceptance. The acceptance is also a negotiable instrument because its holder can
trade it on the secondary market at a discount from the face value. Acceptances are
used widely in exports and imports where the creditworthiness of the partners to the
trade is difficult to establish. Bank draft (like a check) issued by a firm and payable at
some future date. Stamped “accepted” by the firm’s bank, which then guarantees that it
will be paid.
Make no interest payments, but sell at a discount. Trade on a secondary market.

A Repurchase Agreement (repo) is a form of short-term borrowing (usually overnight)
used by dealers in T-bills. The dealer sells the T-bills to an investor on an overnight
basis. The dealer then agrees to buy back the bills the following day at a slightly higher
price. The difference in the price is the interest rate for the night. In essence, the dealer
obtains a one-day loan from the investor, using the T-bills as security for the loan. In a
reverse repo an investor locate a dealer with T-bills and negotiate to buy them. The
investor then agrees to sell them back to the dealer the following day at a slightly higher
price.
 Very short-term loans,
 often overnight,
 with Treasury bills as collateral,
The pricing of money market securities.
The concept of discounting is applied to the pricing of financial instruments found on

the money market. Firms as well as the government borrow money on a short-term
basis using money-market instruments such as Treasury Bills (T-Bills), certificates of
deposit ( CD ), bankers' acceptances (commercial paper) and trade bills (notes).
Treasury bills are issued by the Reserve bank when the government intends to borrow
money from the public. They are also used to control the money supply.
Commercial paperis created when large, reputable companies borrow money on a

short-term basis by issuing their own short-term notes to the investing public rather
than borrowing directly from the bank. Commercial paper is often supported by a bank
line of credit, which gives the firm access to cash that may be used to pay off the paper
at maturity. Commercial paper can be issued for up to 270 days, but it is often for less
than one or two months.
Trade bills, also known as bills of exchange, or promissory notes, are created when
firms sell goods on credit and the customer makes a signed undertaking to pay the
money on a specified future date, usually 30, 60, or 90 days from the date of signing.
This date is known as the maturity date. A trade bill is anegotiable instrument.This
means that it can be negotiated, or passed on to a third party at a discount before the
maturity date. The bill can be negotiated to a discount house or a bank. The bank will
then pay the face value of the bill, less the amount of the discount, or interest to be
charged for the period left to the maturity of the bill.

These instruments are known as discount instruments because they are traded on a
discount basis. Discount instruments have the following features:
1. The nominal value, or face value (N). This is the amount that will be received by the
holder when the security matures. It is therefore also the future value.
2. The discounted value (D). This is the price that must be paid today for the
instrument. It is therefore also the present value. The discount is the difference between
the nominal value and the discounted value:
3. The present value (P). This is the current market value of the instrument, also known
as the consideration.
Thus, D = N - P, and P = N - D. When the investor buys a discount instrument, they pay
an amount which is less than the nominal value, and when the instrument matures, they
receive the nominal value.
4. The discount rate (d). This rate is determined by market forces. The discount rate
depends on the difference between the nominal value and the market price of the
security.
5. The tenor (t).This is the number of days to maturity. Therefore the "full tenor" is the
whole maturity period.
Calculating the consideration on a discount security (P).
If we know the discount rate, d, which is also similar to the interest rate, the discount is
then found by using Equation.
D = Ndt
Equation
Since P = N - D, then P = N - Ndt.
Equation
P = N (1 - dt)
Let us try the following example:
Example 4a. A customer signed a promissory note agreeing to pay $100 000 in three
months' time. You then decide to discount the note with a bank at a discount rate of

22 %. How much would you receive from the bank now?
Solution.
P = N (1 -dt), N = 100 000, d = 0.22, and t = 3/12
Therefore: P = 100 000 (1 - 0.22 x 3/12) = $94 500.
You therefore receive $94 500.now from the bank and the discount on the face value
would be equal to $100 000 - $94 500.= $5500
Try the following exercise.
EXERCISE 2.1.. A discount security with a tenor of 91 days and a nominal value of
$1 000 000 is issued at a discount of 18%pa. What is the consideration ( issue price) of the
security?
Calculating the discount rate, d, to full tenor.

An investor may want to know the discount rate, d, given the full tenor, the face value,
and the issue price of a security. To get the discount rate we use the following formula:
Equation 2.3
d = (D / S) x (365 / t)
Where: D is the discount amount in dollars.

S is the nominal or face value,
t is the full tenor of the security.
Study the following example.
Example 4b. A discount security with a nominal value of $1 000 000 and a tenor of 90
days is issued at $ 946 845.00. Calculate the discount rate, d.
Solution.
D = 1 000 000 - 946 845 = 53 155. Therefore
d = 53 155 x 365
1 000 000 90
= 0.21557 = 21.56% pa
Now, try the following exercise.

EXERCISE 4A.

Assume that a discount security with 40 days to maturity and a face value of $2 000 000 is
traded at $1 962 450 in the money market. At what discount rate per year is it issued?
Equivalent simple interest rate (Yield).

The interest rate charged on a loan is not equivalent to the rate that is charged when a
bill is discounted before its maturity date. The difference arises from the fact that the
discount rate is calculated on the future value( D = Ndt), whereas the interest rate is
calculated on the present value( I = Pit).Infact, when a note is discounted, the interest
rate which is equivalent to the discount rate will be greater than the actual discount rate.
Let us look at the following example:

Example 4c
Determine the discount, the discounted value, and the equivalent simple interest rate on
a note of $35 000 which is due in 9 months at a discount rate of 26%.
Solution.
The simple discount, D, is found by:
D = Ndt, where N = 35 000, d = 0.26 , and t = 9/12 = 3/4

Therefore, D = 35 000 x 0.26 x 3/4 = $6 825
The discounted value, P, is found by :
P = N-D
= 35 000 - 6 825 = $28 175.
Since we know that S = P + I, then I = S - P. This means that the interest on the
note should be equivalent to the discount, that is :
I = 35 000 - 28175 = 6825.
Since the principal, P, is equal to $28 175, the equivalent simple interest rate is the rate
that will yield an interest amount of $6 825 when applied to this principal over a term of
9 months.
We know that I = Pit, therefore,
6 825 = 28 175 x i x 3/4 , solving for i,

6 825 = 21 131.25i
i = 0.32298
Thus, the simple interest rate which is equivalent to the discount rate of 26% is 32.30%.

Now, try the following exercise:
EXERCISE 4B:
Calculate the simple interest rate that is equivalent to a discount rate of 24% for seven
months.
The equivalent simple interest rate is the yield on the money market security. The yield is
not the same as the discount rate. Try the following exercise.
EXERCISE 4C Determine the discount, the discounted value, and the equivalent simple
interest rate (yield) on a note of $100 000 which is due in 65 days and can be discounted at
a discount rate of 26%.
A simpler way of finding the yield is to use the following formula:
Yield =S - P x 365
P t
The concept of the yield is applied widely in the calculation of bank yields. In this case it
is known as the bank discount yield. We explain this in the next section.
Treasury Bills.
When the government requires borrowing money on a short-term basis it issues
Treasury Bills (or T-bills). When the investors buy the bill, they buy them at a discount
from the stated maturity value (the nominal value). When the bill matures, the holder
receives the stated maturity value and the investors' profit is the difference between the
nominal value and the discounted value. The usual tenor of T-bills is 91 days or 182 days.
Investors may purchase the bills directly at auction or from a dealer on the secondary
market.
With respect to T-bills, there are three rates that you need to be aware of. These are :
1. The effective annual rate (EAR),

2. The bank discount yield ( rbd ),
3. The bond equivalent yield ( rey ).

Effective annual rate (EAR).
T-bills are traded on a discount basis using the bank discount yield, but this yield is
different from the effective annual rate or the bond equivalent yield. Let us study the
following example in order to understand this concept.
Example 4d
An investor buys a T-bill for $9450. The bill has a nominal value of $10 000 and a tenor
of 182 days. Calculate the bank discount yield.
Solution.
The discount on the bill is $10 000 - $9 450 = $550. Thus, on an investment of $9 450 for
182 days, the investor earns a return of 5.82% :
Dollars earned / dollars invested = 550 / 9 450 = 0.0582 for a period of 182 days.
We can annualize this return to find the effective annual rate (EAR) if we assume that
the same rate of return will be earned over the rest of the year. An amount of $1
invested today will increase to 1.0582 every six months as follows:
$1 x (1.0582) (1.0582) = $1.119787.
Now, if we deduct the principal invested we get $1.119787 - $1.00 = $0.119787. Thus,
the EAR will therefore be equal to 0.119787 = 11.98%.
The bank discount yield ( rbd ).

The bank discount yield is, however, less than the EAR. Because it is "annualized” using
simple interest over a period of 360 days, whereas the EAR is calculated on the basis of
365 days. Further, the EAR uses compound interest (interest for the first six months also
earns interest for the next six months).
Bank discount yield = N- P x 360

N t
Where N is the face value of the bill, P is the issue price, and t is the tenor of the bill. You
can see also that the denominator used in the case of the bank discount yield is the face
value, N, rather than the amount invested, P, which is used when we calculate the EAR.

In our example the bank discount yield will be found to be:
Bank discount yield = 10 000 - 9 450 x 360
10 000 182
= 0.10879 = 10.88%.
The bank discount yield is less than the EAR because we are calculating the yield using
the nominal value of $10 000 rather than the actual amount invested, $9 450.
Bid and Asked prices.

T-bills are traded on the basis of two quotations, the bid price and the asked price. The
bid price is the price at which the investor can sell the bill to a dealer in government
securities and the asked price is the price at which the investor can buy the bill from the
dealer. Dealers make their profits through the "spread" between the asked and the bid
prices of securities. Let us study the following example to grasp this concept better.
Example 4e.. Today is the 28th of October 2002 and a T-bill is quoted as follows:
Maturity : 29 January 2003.

Days to maturity : 92 days.
Bid : 11.15%.
Asked : 10.11%
Nominal value 10 000
Determine the asked price.
Solution.
The bank discount yield based on the asked price is 10.11% and the yield based on the
bid price is 11.15%. This also means that we can calculate the market price of the bill
based on either the asked price or the bid price.
The asked price that is the price at which investors can buy the bill, or the bid price, the
price at which investors can sell the bill to the dealers, will be found as follows:
P =10 000 x [ 1 - rbd x ( n / 360) ]

Where : rbd is the bank discount yield based on the asked price or the bid price, n is the
tenor of the bill, and P is the price of the bill. Thus, in our example, the asked price of the
bill is:
10 000 x [1 - 0.1011 x (92 / 360) ] = $9 741.63.
Now, we want you to try the following exercise using the data in Example 1.7.:
EXERCISE 4DFind the bid price of the bill based on the discount yield at bid.
The bond equivalent yield ( rey ).

The bond equivalent yield is the return on the bill over the remaining days to full tenor
multiplied by the 365. It is the yield, assuming that the bill is purchased at the asked
price. It is found using the following method:
Equation 2.7.
rbey = 10 000 - P x 365

P t
Where : P is the asked price.
Thus, in our example, the bond equivalent yield will be found to be :

rbey = 10 000 - 9 741.63 x 365
9 741.63 92
= 0.10522 = 10.52%.
The bond equivalent yield can be related to the bond discount yield using the following
formula:
rbey = 365 x rbd

360 - ( rbd x t )
Thus, using our example, the bond equivalent yield can be found to be :
Rey = 365 x 0.1011
360 - ( 0.1011 x 92 )
= 0.10522 = 10.52%.
The effective annual yield (EAR) based on the asked price of $9 741.63 is found to be :

EAR = 10 000 - 9 741.63 = 0.026522, or 2.6522%.
9 741.63
If we annualize this, we find it to be ( 1.026522 )365/92 = 1.109437, giving an effective

annual yield of 10.94%.
Let us summarize our results from this example:
1. Effective annual yield = 10.94%.

2. Bond equivalent yield = 10.52%.
3. Bond discount yield = 10.11%.
You can see from this example that the bank discount yield is always less than the bond
equivalent yield, which in turn is less than the effective annual yield

Chapter 6: Capital Budgeting
Definition- Capital budgeting is a process of allocating limited resources among the
best investment opportunities
Independent versus Mutually Exclusive Projects
Mutually exclusive projects are investments that compete in some way for a company’s
resources. A firm can select one or another but not both.
Independent projects, on the other hand, do not compete with the firm’s resources. A
company can select one, or the other, or both—so long as they meet minimum
profitability thresholds. A project whose acceptance (or rejection) does not prevent the
acceptance of other projects under consideration.
Contingent Projects
Contingent projects are those in which the acceptance of one project is dependent on
another project.
There are two types of contingency situations:
Projects that are mandatory
Projects that are optional
Why are these decisions important?
a) Scarce financial resources for assets which cannot be liquidated easily

b) they define the firm’s line of business
c) they affect the firm’s cash flows for many years

d) bad decisions can cause the firm’s downfall
Steps in the Capital Budgeting Process

1. Identify and estimate current and expected future cash flows.
2. Establish a decision rule (NPV, IRR, etc.)
3. Evaluate and rank the proposed projects.

4. Make a decision and monitor results.
5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or
payback < policy
Project Evaluation Models
o Payback period or PBP

o Net Present Value or NPV
o Internal Rate of Return or IRR
o Modified Internal Rate of Return or MIRR
The Payback Period Technique

The payback period of an investment is the length of time required for the cumulative
total net cash inflows from the investment to equal the total initial cash outlays. At that
point in time, the investor has recovered the amount of money invested in the project .
PAYBACK PERIOD
Payback period = Expected number of years required to recover a project’s cost.
Project L
Expected Net Cash Flow
Year Project L Project S
0 ($100) ($100)
1 10 (90)
2 60 (30)
3 80 50
PaybackL = 2 + $30/$80 years = 2.4 years.
PaybackS = 3 years.

Advantages
 Uses cash flows
 Is easy to calculate and understand
 Maybe used as a rough screening device.
Weaknesses of Payback:
 Ignores the time value of money. This weakness is eliminated with the
discounted payback method.

 Ignores cash flows occurring after the payback period.
 no economic rationale for target payback periods
Net Present Value

- The most theoretically correct model for evaluating investment opportunities; the
measure of value a project adds to the firm. (NPV) is the present value of the future after
-tax cash flows minus the investment outlay.
NPV = PV {cash inflows} - PV{cash outflows}
CFt
t 0 (1  r ) t
n
NPV 
CFt = forecasted after-tax operating Cash Flow (CF) at the end of year t
r = the required risk-adjusted rate of return
n = the economic life of the project
NPV measures present value of a project’s expected cash-flow stream at its cost of
capital.

It essentially estimates how much the project would sell for if a market existed for it
NPV of an investment project represents the immediate change in the wealth of the
firm’s owners if the project is accepted
If positive, the project creates value for the firm’s owners; if negative, it destroys value
The NPV rule takes into consideration the timing of the expected future cash flows. The
method attributes higher value to earlier cash flows.
The decision rules associated with NPV analysis:
NPV > $0  accept project
NPV < $0  reject project
NPV = $0  indifferent to project
Example
Project L
Expected Net Cash Flow
Year Project L Project S
0 ($100) ($100)
1 10 (90)
2 60 (30)
3 80 50
Project L:
0 1 2 3
100.00 10 60 80
9.09
49.59
60.11
NPVL = $ 18.79

NPVS = $??????
 If the projects are independent, accept both.
 If the projects are mutually exclusive, accept Project S since NPVS > NPVL.
 If the projects are mutually exclusive, accept Project S since IRRS > IRRL.
Note: NPV declines as k increases, and NPV rises as, k decreases
Advantages of NPV
1. Uses cash flow

2. Recognizes the time value of money
3. Is consistent with the firm goal of shareholder wealth maximization
Disadvantages of NPV
Requires detailed long term forecasts of the incremental benefits and costs
Internal Rate of Return Method

 The internal rate of return (IRR) method is a discounted cash flow method that
estimates the discount rate that causes the present value of subsequent net cash
inflows to equal the initial investment.
 The IRR is the discount rate at which the NPV of an investment will be equal to 0. This
is the discount rate at which the present value of the expected cash inflows from a
project equals the present value of the expected cash outflows. If this rate is higher
than the required rate-of-return, the investment is acceptable. If this rate is lower than
the required rate-of-return, the investment should not be made
 The internal rate of return (IRR) method estimates the discount rate that causes the
present value of subsequent net cash inflows to equal the initial investment. The NPV
of the Investment will be zero if we use this estimated rate as the desired rate of return
to compute the NPV.The IRR method evaluates capital investments by comparing the
estimated internal rate of return to the criterion rate of return. The criterion can be the

firm's desired rate of return, the rate of return from the best alternative investment, or
another rate the firm chooses to use for evaluating capital investments.
 Determining the Internal Rate of Return

Like the NPV method, the IRR method considers the time value of money, initial cash
investment and all cash flows after the investment. Unlike the NPV method, the
computation procedure of the IRR method does not use the desired rate of return to
compute the present values of net cash inflows.
 The IRR method determines an investment's rate of return that makes the present
value of net cash inflows after its initiation equal the investment's initial amount and
then compares the estimated rate of return with the required rate in assessing the
investment's desirability. In using this method, the investor considers the investment's
rate of return and how it compares to the firm's desired return.
The computation procedures for IRR vary somewhat with the pattern of net cash inflows
over an investment's useful life.
What is the NPV if PV{inflows} = PV{outflows}?
Thus,
CFt

n
NPV  0
t 0
(1  IRR ) t
or,
CFt
Initial Investment Outlay t 1
n
(1  IRR )t
How can we solve for IRR?
** Interpolation {class example}
IRR = R1 + NPV1 (R2 – R1)

NPV1 – NPV2

 R1 being the rate that gives a positive NPV1
 R2 being the rate that gives a negative NPV2
Cost of capital 10%
For example, calculate the IRR for the following project.
Initial Capital ($72)
Year1 to year 3 cash inflow $3.50
Year 3 disposable cash flow $ 100
Calculate the IRR of the project
Your answer should be 16.7 %
Accept if IRR≥ required rate of return
Reject if IRR≤ required rate of return
Advantages
 Uses cash flow
 Recognizes the time value of money
 Is in general consistent with the firm goal of shareholder wealth maximization
Disadvantages
 Requires detailed long term forecasts of the incremental benefits and costs
 Can involves tedious calculations

 Possibility of multiple IRRs
Modified IRR (MIRR)

The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two
weaknesses of the IRR. The MIRR correctly assumes reinvestment at the project’s cost of
capital and avoids the problem of multiple IRRs. However, please note that the MIRR is
not used as widely as the IRR in practice. IRR has a limitation in that it is possible for it to
give more than one answer. This will occur when there is more than one change in the

cash flows from positive to negative in any period. IRR is essentially calculating the rate
at a turn in the curve and so if the cash flows change from positive to negative during
the project, each turn will give another answer.
Note: The modified IRR assumes that the reinvestment of capital is done at the cost of
capital rate, rather than the IRR rate.
There are 3 basic steps of the MIRR:

1. Estimate all cash flows as in IRR.
2. Calculate the future value of all cash inflows at the last year of the project’s life.
3. Determine the discount rate that causes the future value of all cash inflows
determined in step 2, to be equal to the firm’s investment at time zero. This
discount rate is known as the MIRR.
Project L:
0 1 2 3
10%
-100.00 10 60 80.00
66.00
100.00 12.10
$ 0.00 = NPV $158.10 = TV of
PV outflows = $100 Inflows
TV inflows = $158.10.
MIRR = 16.5%
TV
PVcosts =
1  MIRR n
MIRRS = 16.9%.
MIRR is better than IRR because
1. MIRR correctly assumes reinvestment at project’s cost of capital.
2. MIRR avoids the problem of multiple IRRs.

PROFITABILITY INDEX (PI)
The profitability index, or PI, method compares the present value of future cash
inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of
the present value of cash flows (PVCF) to the initial investment of the project.
PVCF
PI 
Initial investment
In this method, a project with a PI greater than 1 is accepted, but a project is rejected
when its PI is less than 1. Note that the PI method is closely related to the NPV
approach. In fact, if the net present value of a project is positive, the PI will be greater
than 1. On the other hand, if the net present value is negative, the project will have a PI
of less than 1. The same conclusion is reached, therefore, whether the net present value
or the PI is used. In other words, if the present value of cash flows exceeds the initial
investment, there is a positive net present value and a PI greater than 1, indicating that
the project is acceptable.
PI is also known as a benefit/cash ratio.
Project L
0 10% 1 2 3
-100.00 10 60 80
PV1 9.09
PV2 49.59
PV3 60.11
118.79
PV of cashflows 118.79
PI    1.19
initial coast 100
Accept project if PI > 1.
Reject if PI < 1.0

Advantages
 Uses cash flows
 Recognizes the time value of money
 Is consistent with shareholder wealth maximization
Disadvantages
 Requires detailed Long term forecasts of the incremental benefits and costs.
Comparing NPV and IRR
Under the following assumptions, NPV and IRR will accept and reject the same projects:
1. independent projects
2. no capital rationing
Under the following assumptions, NPV and IRR may disagree regarding the ordering of
projects:
1. Mutually exclusive projects
2. 2. Capital rationing
Causes of potential disagreement between NPV and IRR:

 project size (scale) differences
 timing differences

Chapter7: Financial Calculus
Differential Calculus
The world is full of quantities which change with respect to each other—and
these rates of change can often be expressed as derivatives. It is often important
to understand and predict how things will change, and so derivatives are
important. For example in macroeconomics, the rate of change of the gross
domestic product (GDP) of an economy with respect to time is known as the
economic growth rate. It is often used by economists and politicians as a measure
of progress.
Differential calculus is about finding the rate of change of one quantity with
respect to another quantity.
Rules of Differentiation
Rule 1: For any Real number n, the derivative of f(x) = x n is

f´(x) = nxn-1 /
For example we proved that the derivative of x 2 = 2x
Rule 2: Derivative of a constant multiple:
The derivative of a constant multiplied by a function is equal to constant
times the derivative of a function. The derivative of c f(x) = c. f´(x)
That is
For example what is the derivative of 4x7 ( ) = = 4.7x6 = 28x6

Example 2: Find the derivative given that f(x)= 0.75/ = 0.75 (-
Rule 3: Derivative of a constant is equal to zero

Example : If f(x) = -3 , f’(x) = 0
Rule 4 The derivative of a Sum

Suppose f and g are differentiable functions. Then the derivative of f(x) + g(x) is
f’(x)+ g’(x)

f(x) - g(x) ] is f’(x) - g’(x)
Example: f(x) = x3 + 5x2 Find f’(x)
= = 3x2+ 10x
Rule 5 The Product rule

Let f, g be differentiable functions. Then the derivative of their product is gived
by:
Rule 6 ;Quotient Rule

Let f,g be differentiable functions. Then the derivative of their quotient is
Rule 7 ;Chain Rule

The chain rule allows us to differentiate the composition of two functions. The
composition of two functions g and f is ( f º g )(x) = f (g (x)).
Let f , g be differentiable functions. Then the derivative of their composition is
Application of Differentiation in Business and economics

Marginal cost:
In economics, the word marginal refers to a rate of change, that is, to a derivative.
Thus, if C(x) is the total cost of producing x items then C’(x) is the marginal cost,
i.e. the
Instantaneous rate of change of total cost C(x) with respect to the number of
items produced at a production level of x items.
Marginal cost is the change in cost resulting from one additional unit of output.
Marginal Cost Function- A manufacturer’s total Cost function C = f(x) gives the
total cost of producing and marketing x units of a product. The first derivative of
the cost function is a formula for the rate of change of cost with respect to the
number of units produced and it gives a good approximation of marginal cost.
We thus interpret = f’(x) as the marginal cost function ie the formula for
finding the change in cost that results from producing one additional unit of
output.
Example: A manufacturer of T- shirts finds that the weekly cost function for
manufacturing and marketing x- T shirts per week are, in dollars:
C(x) = 1000+ 40x + x2/5, Use the calculus methods to find
a. the marginal cost
b. The rate of change of cost when the level of production is 30-T shirts
per week
c. The Cost of Manufacturing the 31 st T-shirt.
Marginal revenue
The definition of the marginal revenue is similar as the one of the marginal cost.
If R(x) is the total revenue of producing x items then R’(x) is the marginal revenue,
i.e. instantaneous rate of change of total revenue R(x) which respect to the
number of items produced at a production level of x items.
Marginal Revenue Function is the formula for finding the change in revenue that
result from selling one additional unit of output.
Example: Example: A manufacturer of T- shirts finds that the weekly revenue
function for manufacturing and marketing x- T shirts per week are ,in dollars: R(x)
= 80x+ x2/10
a. Find the Marginal Revenue function: \
b. The rate of change of revenue when the level of production is 30 T-
shirts per week

Marginal profit
Total profit is the difference between the total cost and total revenue
P(x) = C(x)− R(x) ,and accordingly the marginal profit is
P’(x) = C’(x)− R’(x).
The exact profit of producing the (x +1) st item is P(x +1) − P(x).
The marginal profit function approximates exact profit of producing the (x +1)st
item, i.e.
R’(x) ≈ R(x +1)− R(x).
Comprehensive Example
The market research department of a company recommends manufacture and
marketing of a new toy-car. The finance department provides the following cost
function (in $s)
C(x) = 7 000 + 2x where €7000 is the estimate of fixed costs and $2 is the
estimate of variable cost per toy-car. The estimate of revenue function (in $) is
R(x) = x (10 − 0.001 x)
a) Find the marginal cost function C’(x) and interpret.
b) Find the marginal revenue function R’(x) and interpret.
c) Find marginal revenue at x = 2 000 , 5 000 , and 7 000. Interpret these
resultants.
d) Find the profit function P(x) and marginal profit function P’(x).
e) Find the marginal profit at x =1000, 4 000, and 6 000. Interpret these results.
Optimisation
Stationary Points
A stationary point sometimes occurs momentarily between increasing and
decreasing intervals. A stationary point is either
I. A local maximum (plural: maxima), a point that is higher than any
other points on the curve; Or
II. A local minimum (plural: minima) a point which is lower than any
other nearby points on the curve.
How do you determine the coordinates of Stationary Points?

If we have a sketch of a graph y = f(x) we may represent the f’(x) at any
point on y = f(x) by a tangent to the curve.
f(x) is stationery, f’(x) = 0 x
P R
f’(x) >0 f’(x) < 0 f’(x) >0
y
f(x) is f(x) is f(x) is
increasing
S increasing decreasing Q
f(x) stationary f’(x) = 0
Application of optimization in Economics

There are situations that require determining the value of a variable that will
maximise or minimize a function. E.g maximizing profit or minimizing cost. We
learnt that the marginal cost, revenue and profit functions can be successfully
approximated by the first derivative of the cost, revenue and profit functions
respectively. Crucial to success in solving these optimization problems, is setting
up the function to be investigated and then solve for f’(x) = 0
Example: Given the above revenue and cost functions, : R(x) = 80x+ x2/10 ; C(x)
= 1000+ 40x + x2/5 find the level of production at which profit is maximised and
the maximum profit.

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Financial

Accounting and Finance

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 1 of 63

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 2 of 63

Recommended Reading List

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 3 of 63

The time value of money

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 4 of 63

If you leave it for two years, you get

 The principal is also called the present value.

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 5 of 63

Use of time lines

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 6 of 63

Using a time line, example1a above may be represented as follows:

NB. Includes the use of time line in your answers.

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 7 of 63

 The discount D in monetary terms is given by D = Fdt

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 8 of 63

This is represented by a time line

P = F – D = 3 000 – 300 = 2 700

I = F – P = 3 000 − 2 700 = 300

But I = Prt and with substitution we get, 300 = 2 700 × r × 2/3,

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 9 of 63

(a) Find the rate of interest per annum.

(b) Find the rate of discount per annum.

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 10 of 63

Represented on a time line, these statements yield the following picture

We can formulate the above results as two simple rules:

Note: The second rule is equivalent to multiplying by a factor of (1 + rt) −1.

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 11 of 63

(b) six months from now

(c) in one year

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 12 of 63

Our basic principal for the third period (P3) is then

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 13 of 63

 The formula for compound interest is thus as follows’ = P (1 +i) n.

Graphically it can be presented as in the timeline overleaf.

Present Value using compound Interest.

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 14 of 63

The new formula for compound interest is now as follows:

Similarly the Present value equations

P = F / (1 + i)n will translates to

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 15 of 63

(a) Yearly, (b) half-yearly, (c) quarterly, (d) daily.

9. What annual rate of interest, compounded quarterly, would be required if an initial

Annualized yield and continuous compounding

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 16 of 63

(a) If interest is calculated yearly, then there is, by definition, no difference

For half-yearly compounding, jm = 0, 15, m = 2 and t = 1.

The interest is 15, 56 (115, 56−100) and expressed as a percentage, this is

(c) For quarterly compounding, jm = 0,15, m = 4 and t = 1.

The interest rate (expressed as a percentage) is then

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 17 of 63

The effective interest rate expressed as a decimal is

They must therefore both correspond to the same effective rate.

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 18 of 63

The calculation proceeds as follows:

W. Mawanza (Fin Maths 1 COAF 1105 notes) Page 19 of 63

F = P(1 + rt) = 2655,67(1 + 0,16 × 14/365)=$2671.97

Continuous Compound Interest

Continuous compounding can be thought of as making the compounding period

Use the continuous compound interest formula, F = Pe rt, with P = 2340, r =

Equivalent continuous compounding rate