Unit 2

Financial Mathematics

Nguyen Tai Vuong

School of Economics and Management
HUST

Learning Objectives

After completing this uint, students will be able to:

1. Perform calculations for interest rates and

rates of return.
2. Calculate simple and compound interest
amounts for one or more time.
3. Understand cash flows and how to
graphically represent them.
4. Derive and use factors to account for the
time value of money
5. Use multiple factors and spreadsheet
functions to find equivalent amounts for
cash flows that have nonstandard placement
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 Unit Outline

2.1 Interest Computing

2.2 Cash Flows and Economic Equivalence
2.3 Single Payments Factors P/F & F/P
2.4 Uniform Series A/P & P/A
2.5 Uniform Series A/F & F/A
2.6 Factor Values for Untabulated i or n
2.7 Arithmetic Gradients
2.8 Geometric Gradients

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2.1 Interest Computing

 The time value of money (TVM) is the most

important concept

 TVM explains the change in the amount of

money over time for funds owed by (or owned
by) a corporation (or individual)
 Corporate investments are expected to earn a
return
 Investment involves money
 Money has a ‘time value’

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 Interest and Interest Rate
 Interest – the manifestation of the time value of
money
• Fee that one pays to use someone else’s money
• Difference between an ending amount of money and a
beginning amount of money

 Interest = amount owed now – principal

 Interest rate – Interest paid over a time period

expressed as a percentage of principal

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (%) = × 100%

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Rate of Return
 Interest earned over a period of time is
expressed as a percentage of the original
amount (principal)
interest accrued per time unit
Rate of return (%) = x 100%
original amount

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 Interest Rate vs Rate of Return
Interest paid Interest earned

Interest rate Rate of return

 Borrower’s perspective – interest rate paid
 Lender’s or investor’s perspective
1-7
– rate of return
earned
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Simple and Compound Interest

 Simple Interest
Interest is calculated using principal only
Interest = (principal)(number of periods)(interest
rate)
I = P.n.i
Example: $100,000 lent for 3 years at simple i = 10% per
year. What is repayment after 3 years?

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 Simple and Compound Interest
 Compound Interest
Interest is based on principal plus all accrued interest
That is, interest compounds over time
Interest = (Principal + all accrued interest)(interest rate)
𝒕 𝟏

𝑰𝒕 = 𝑷 + 𝑰𝒋 × 𝒊
𝒋 𝟏

Total due after n years = Principal x (1 + interest rate)n years

𝒏
𝑻𝒐𝒕𝒂𝒍 𝒅𝒖𝒆 = 𝑷 𝟏 + 𝒊

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Compound Interest Example

 100,000 lent for 3 years at i = 10% per year
compounded. What is repayment after 3 years?

Interest, year 1: I1 = 100,000(0.10) = $10,000

Total due, year 1: T1 = 100,000 + 10,000 = $110,000
Interest, year 2: I2 = 110,000(0.10) = $11,000
Total due, year 2: T2 = 110,000 + 11,000 = $121,000
Interest, year 3: I3 = 121,000(0.10) = $12,100
Total due, year 3: T3 = 121,000 + 12,100 = $133,100

Compounded: $133,100 Simple: $130,000

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 Simple vs Compound Interest

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Rule of 72
 How much time required for a principal amount (P) to
double with compound interest (i)?
𝒏
𝑻𝒐𝒕𝒂𝒍 𝒅𝒖𝒆 = 𝑷 𝟏 + 𝒊
𝒏
𝟐𝑷 = 𝑷 𝟏 + 𝒊
log 𝟐
𝒏=
log(𝟏 + 𝒊)

𝟕𝟐
𝒏≈
𝒊
n: number of time periods
i: compound interest in percent
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 Active Learning 1
1. Durco Automotive needs a $1 million balance in its
contingency fund 3 years from now. The CFO (chief
financial officer) wants to know how much to deposit now
into Durco’s high-yield investment account.
Determine the amount if it grows at a rate of 20% per
year (a) simple interest, and (b) compound interest.

2. A company that manufactures general-purpose

transducers invested $2 million 4 years ago in high-yield
junk bonds. If the bonds are now worth $2.8 million, what
rate of return per year did the company make on the
basis of (a) simple interest, and (b) compound interest?

Finanical Mathematics 2-13

Nominal and Effective Interest Rate

The terms ‘nominal’ and ‘effective’ enter into consideration

when the interest period is less than one year.

New time-based definitions to understand and remember

Interest period (t) – period of time over which interest is expressed.

For example, 1% per month.

Compounding period (CP) – Shortest time unit over which interest is charged or earned.
For example, 10% per year compounded monthly.

Compounding frequency (m) – Number of times compounding occurs within the interest
period t.
For example, at i = 10% per year, compounded monthly
interest would be compounded 12 times during the one-
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year interest period.
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 Understanding Interest Rate Terminology
A nominal interest rate (r) is obtained by multiplying an interest rate that
is expressed over a short time period by the number of compounding
periods in a longer time period:
That is:
r = interest rate per period x number of compounding periods
Example: If i = 1% per month, nominal rate per year is
r = (1)(12) = 12% per year
Effective interest rates (i) take compounding into account
(effective rates can be obtained from nominal rates via a formula
to be discussed later).

IMPORTANT: Nominal interest rates are essentially simple interest

rates. Therefore, they can never be used in interest formulas.
Effective rates must always be used hereafter in all interest formulas.

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More About Interest Rate Terminology

There are 3 general ways to express interest rates as shown below

Sample Interest Rate Statements Comment

i = 2% per month When no compounding period
(1)
i = 12% per year is given, rate is effective

i = 10% per year, comp’d semiannually When compounding period is given

(2)
i = 3% per quarter, comp’d monthly and it is not the same as interest
period, it is nominal

i = effective 9.4%/year, When compounding period is given

comp’d semiannually and rate is specified as effective
(3)
i = effective 4% per quarter, over the stated period.
comp’d monthly comp’d semiannually and
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comp’d monthly are redundant
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 Effective Annual Interest Rates

Nominal rates are converted into effective annual rates via the equation:

ia = (1 + i)m – 1
where ia = effective annual interest rate
i = effective rate for one compounding period
m = number times interest is compounded per year
Example: For a nominal interest rate of 12% per year, determine
the nominal and effective rates per year for (a) quarterly, and
(b) monthly compounding

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Effective Interest Rates

Nominal rates can be converted into effective rates
for any time period via the following equation:

i = (1 + r / m)m – 1
where i = effective interest rate for any time period
r = nominal rate for same time period as i
m = no. times interest is comp’d in period specified for i

Example: For an interest rate of 1.2% per month, determine the

nominal and effective rates (a) per quarter, and (b) per year

Solution:

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 Active Learning 2
Tesla Motors manufactures high-performance battery electric vehicles.
An engineer is on a Tesla committee to evaluate bids for new-generation
coordinate-measuring machinery to be directly linked to the automated
manufacturing of high-precision vehicle components. Three bids include
the interest rates that vendors will charge on unpaid balances. To get a
clear understanding of finance costs, Tesla management asked the
engineer to determine the effective semiannual and annual interest rates
for each bid. The bids are as follows:
Bid 1: 9% per year, compounded quarterly
Bid 2: 3% per quarter, compounded quarterly
Bid 3: 8.8% per year, compounded monthly
(a) Determine the effective rate for each bid on the basis of semiannual
periods.
(b) What are the effective annual rates? These are to be a part of the final
bid selection.
(c) Which bid has the lowest effective annual rate?
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Effective Interest Rate for Continuous

Compounding
 Continuous compounding is present when the duration of
compounding period (CP) becomes infinitely small and the
number of times interest is compounded per period (m),
becomes infinite.
𝒉
Recall math: lim 1 + = 𝒆 = 𝟐. 𝟕𝟏𝟖𝟐𝟖 +
𝒉→ 𝒉

𝒓 𝒎
Effective interest for a period 𝒊= 𝟏+ −𝟏
𝒎
as m approaches infinity, put = ,

𝒓 𝒎 𝒉𝒓 𝒉 𝒓
lim 𝒊 = lim 1 + − 𝟏 = lim 1 + − 𝟏 = lim 1+ −𝟏
𝒎→ 𝒎→ 𝒎 𝒉→ 𝒉 𝒉→ 𝒉

𝒊 = 𝒆𝒓 − 𝟏
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 Active Learning 3

(a) For an interest rate of 18% per year, compounded

continuously, calculate the effective monthly and annual
interest rates.

(b) An investor requires an effective return of at least 15%.

What is the minimum annual nominal rate that is
acceptable for continuous compounding?

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2.2 Cash Flows and Economic

Equivalence
 Cash Flows Terms:
 Cash Inflows – Revenues (R), receipts, incomes, savings
generated by projects and activities that flow in.
 Plus sign used

 Cash Outflows – Disbursements (D), costs, expenses, taxes

caused by projects and activities that flow out.
 Minus sign used

 Net Cash Flow (NCF) for each time period:

NCF = cash inflows – cash outflows = R – D

 End-of-period assumption:
Funds flow at the end of a given interest period
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 Commonly used Symbols
t = time, usually in periods such as years or months
P = value or amount of money at a time t designated as
present or time 0
F = value or amount of money at some future time, such
as at t = n periods in the future
A = series of consecutive, equal, end-of-period
amounts of money
n = number of interest periods; years, months
i = interest rate or rate of return per time period;
percent per year or month

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Cash Flows Diagrams

What a typical cash flow diagram might look like?

Draw a time line

Always assume end-of-period cash flows

Time
0 1 2 … … … n-1 n
One time
period
F = $100
Show the cash flows (to approximate scale)

0 1 2 … … … n-1 n
Cash flows are shown as directed arrows: + (up) for inflow
P = $-80
- (down) for outflow

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 Cash Flow Diagram Example
End Year Income Cost Net Cash Flow
-7 $0 $ 2,500
-6 750 100
-5 750 125
-4 750 150
-3 750 175
-2 750 200
-1 750 225
0 750 250
1 900 275

- Compute net cash flow at each year end?

- Plot observed net cash flows over last 8 years.
- Show present worth (P) arrow at present time, t = 0
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 Economic Equivalence
 Definition:
 Combination of interest rate (rate of return)
and time value of money to determine
different amounts of money at different
points in time that are economically
equivalent

 How it works:
 Use rate i and time t in upcoming relations
to move money (values of P, F and A)
between time points t = 0, 1, …, n to make
them equivalent (not equal) at the rate i
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2.3 Single Payment Factors (F/P and P/F)

Single payment factors involve only P and F. Cash flow
diagrams are as follows:

Formulas are as follows:

F = P(1 + i)n P = F(1 + i)-n
Three ways of computing:
(1) Mathematic equation
(2) Excel spreadsheet
(3) Factors with compound interest tables
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 F/P and P/F Factors: Notation and Equations

(3) (1) (2)

Terms in parentheses or brackets are called factors. Values are in tables for i
and n values
Factors are represented in standard factor notation such as (F/P,i,n),
where letter to left of slash is what is sought; letter to right represents what is given

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Active Learning 4
A person deposits $5000 into an account which pays
interest at a rate of 8% per year. Calculate the amount in
the account after 10 years?

The cash flow diagram is:

Solution:

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 Active Learning 4
A small company wants to make a single deposit now so it will
have enough money to purchase a backhoe costing $50,000
five years from now. If the account will earn interest of 10% per
year, calculate the amount that must be deposited now?

The cash flow diagram is: Solution:

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2.4 Uniform Series Involving P/A and A/P

 The uniform series factors that involve P and A are derived as
follows:
(1) Cash flow occurs in consecutive interest periods
(2) Cash flow amount is same in each interest period

A = Given A=?

0 1 2 3 … n 0 1 2 3 … n

P=? P = Given

1+𝑖 −1 𝑖 1+𝑖
𝑃=𝐴 𝐴=𝑃
𝑖 1+𝑖 1+𝑖 −1

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 A = Given
i% How to obtain
0 1 2 3 … n
equivalence P/A?
P=?

𝑃=𝐴 +𝐴 + 𝐴 + ⋯+𝐴

𝑃=𝐴 + + + ⋯+ (2)

𝑃=𝐴 + + ⋯+ + (3)

Subtract (3) – (2):

𝑃=𝐴 𝑖≠0

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P/A and A/P Factors: Notation and Equations

P = A(P/A,i,n) Standard Factor

A = P(A/P,i,n)
Notation

Note: P is one period Ahead of first A value

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 Active Learning 5
 A chemical engineer believes that by modifying the
structure of a certain water treatment polymer, his
company would earn an extra $5000 per year. At an
interest rate of 10% per year, how much could the
company afford to spend now to just break even over a 5-
year project period?

Solution:

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2.5 Uniform Series Involving F/A and A/F

 The uniform series factors that involve F and A are derived as

follows:
(1) Cash flow occurs in consecutive interest periods
(2) Last cash flow occurs in same period as F

A = Given A=?

0 1 2 3 … n 0 1 2 3 … n

F=? F = Given

1+𝑖 −1 𝑖
𝐹=𝐴 𝐴=𝐹
𝑖 1+𝑖 −1

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 F/A and A/F Factors: Notation and Equations

F = A(F/A,i,n) Standard A = F(A/F,i,n)

Factor Notation
Note: F takes place in the same period as last A

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Active Learning 6
 An industrial engineer made a modification to a chip
manufacturing process that will save her company
$10,000 per year. At an interest rate of 8% per year, how
much will the savings amount to in 7 years?

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 2.6 Factor Values for Untabulated i or n

3 ways to find factor values for untabulated i or n values

Use formula
Use spreadsheet function with corresponding P, F, or A value set to 1
Linearly interpolate in interest tables

Formula or spreadsheet function is fast and accurate;

Interpolation is only approximate

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Excel Function

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 Linear Interpolation

𝑓=𝑓 + 𝑓 − 𝑓

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Example: Untabulated i

Determine the value for (F/P, 8.3%,10)

Formula: F = (1 + 0.083)10 = 2.2197 OK

Spreadsheet: = FV(8.3%,10,,1) = 2.2197 OK

Interpolation: 8% ------ 2.1589

8.3% ------ x
9% ------ 2.3674

x = 2.1589 + [(8.3 - 8.0)/(9.0 - 8.0)][2.3674 – 2.1589]

= 2.2215 (Too high)

Absolute Error = 2.2215 – 2.2197 = 0.0018

1-42
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 2.7 Arithmetic Gradients
Arithmetic gradients change by the same amount each
period
The cash flow diagram for the PG
of an arithmetic gradient is: G starts between periods 1 and
2
PG = ? (not between 0 and 1)

1 2 3 4 n This is because cash flow in year 1

0
is usually not equal to G and is
handled separately as a base
G
2G
amount
3G
(n-1)G Note that PG is located Two
Periods Ahead of the first
change that is equal to G
Standard factor notation is
Finanical Mathematics PG = G(P/G,i,n) 2-43

Obtain Equation
𝑃 =𝐺 + + + ⋯+ (1)

𝑃 (1 + 𝑖) = 𝐺 + + ⋯+ + (2)

Subtract (2) – (1):

𝑃 = −
( )

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 Typical Arithmetic Gradient Cash Flow
PT = ?

i = 10%
0 1 2 3 4 5

400
450
Amount in year 1 500
is base amount 550
600

This diagram= this base amount plus this gradient

PA = ? PG = ?
i = 10% i = 10%

+
0 1 2 3 4 5 0 1 2 3 4 5

Amount 400 400

50
400 400 400 100
in year 1
150
is base PA = 400(P/A,10%,5) PG = 50(P/G,10%,5) 200
amount
Finanical Mathematics
PT = PA + PG = 400(P/A,10%,5) + 50(P/G,10%,5) 2-45

Converting Arithmetic Gradient to A

Arithmetic gradient can be converted into equivalent A value using G(A/G,i,n)

i = 10% i = 10%
0 1 2 3 4 5 0 1 2 3 4 5

G
2G A=?
3G
4G
General equation when base amount is involved is
A = base amount + G(A/G,i,n)

For decreasing gradients,

0 1 2 3 4 5
change plus sign to minus
4G
3G
2G
G
A = base amount - G(A/G,i,n)
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 Converting Arithmetic Gradient to A

𝑖 1+𝑖
𝐴 =𝑃
1+𝑖 −1

𝐴 = − x
( )

𝐴 =𝐺 −
( )

Finanical Mathematics 2-47

Active Learning 7
Calculate the present worth of $400 in year 1 and amounts
increasing by $30 per year through year 5 at an interest rate of
12% per year?

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 2.8 Geometric Gradients
Geometric gradients change by the same percentage
each period
Cash flow diagram for present worth of geometric gradient

Note: g starts between

periods 1 and 2

There are no tables for geometric factors

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How to obtain Pg
𝐴 𝐴 (1 + 𝑔) 𝐴 (1 + 𝑔) 𝐴 1+𝑔
𝑃 = + + + ⋯+
1+𝑖 1+𝑖 1+𝑖 1+𝑖

( ) ( )
𝑃 =𝐴 + + + ⋯+ (2)

Multiply both sides by (1 + g)∕(1 + i), subtract Equation (2) from the result

𝑃 =𝐴 g≠𝑖

𝑃 =𝐴 g=𝑖
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 Active Learning 7

Find the present worth of $1,000 in year 1 and amounts

increasing by 7% per year through year 10. Use an interest
rate of 12% per year.

Pg = ?
Solution:
i = 12%
1 2 3 4 10
Pg = 1000[1-(1+0.07/1+0.12)10]/(0.12-0.07)
0
100 = $7,333
1070
0 1145
g = 7%

1838 To find A, multiply Pg by (A/P,12%,10)

Finanical Mathematics 2-51

Unknown Recovery Period n

 Unknown recovery period problems involve solving
for n, given i and 2 other values (P, F, or A)
 Like interest rate problems, they usually require a trial & error
solution or interpolation in interest tables)
 Procedure: Set up equation with all symbols involved and
solve for n
Example:
A contractor purchased equipment for $60,000 that provided
annual income of $8,000. At an interest rate of 10% per year, find
the length of time required to recover the investment?

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 Unknown Interest Rate i
 Unknown interest rate problems involve solving for i,
given n and 2 other values (P, F, or A)
 Usually requires a trial and error solution or interpolation in
interest tables
 Procedure: Set up equation with all symbols involved and
solve for i
Example:
A contractor purchased equipment for $60,000 which provided
income of $16,000 per year for 10 years. Find the annual rate of
return of the investment?

Finanical Mathematics 2-53

Introduction to Spreadsheet Functions

Excel financial functions
Present Value, P: = PV(i%,n,A,F)
Future Value, F: = FV(i%,n,A,P)
Equal, periodic value, A: = PMT(i%,n,P,F)
Number of periods, n: = NPER((i%,A,P,F)
Compound interest rate, i: = RATE(n,A,P,F)
Compound interest rate, i: = IRR(first_cell:last_cell)
Present value, any series, P: = NPV(i%,second_cell:last_cell) +
first_cell

Example: Estimates are P = $5000; n = 5 years; i = 5% per year. Find

A in $ per year?
Function and display: = PMT(5%, 5, 5000) displays A = $1154.87

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 F/P and P/F for Spreadsheets
Future value F is calculated using FV
function:
= FV(i%,n,,P)

Present value P is calculated using PV

function:
= PV(i%,n,,F)
Note the use of double commas in each function

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Exercise 1

The offshore design group at Bechtel just purchased

upgraded CAD software for $5000 now and annual
payments of $500 per year for 6 years starting 3
years from now for annual upgrades. What is the
present worth of the payments if the interest rate is
8% per year?
Hint: - draw cashflows
- calculate present value

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 Exercise 2
An engineering company in Wyoming that owns 50 hectares
of valuable land has decided to lease the mineral rights to a
mining company. The primary objective is to obtain long-term
income to finance ongoing projects 6 and 16 years from the
present time. The engineering company makes a proposal to
the mining company that it pay $20,000 per year for 20 years
beginning 1 year from now, plus $10,000 six years from now
and $15,000 sixteen years from now.
1. Plot the project’s cashflow?
2. If the mining company wants to pay off its lease
immediately, how much should it pay now if the
investment is to make 16% per year?

Finanical Mathematics 2-57

Exercise 3

Fujitsu, Inc. has tracked the average inspection cost

on a robotics manufacturing line for 8 years. Cost
averages were steady at $100 per completed unit
for the first 4 years, but have increased consistently
by $50 per unit for each of the last 4 years. What is
the present worth of inspection cost?

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