Quantitative Methods

CH# 1 Financial Mathematics

Mathematics Marks
Basic mathematics 10
Financial mathematics 20
Calculus 10
Matrices and determinants 10
Statistics
Statistical methods 20
Methods of least square and regression 10
Probability and probability distribution 10
Sampling and decision making 10
Grid Weighting
Topics in this Chapter

1. Simple Interest
2. Compound Interest
3. Annuities
4. Sinking fund
5. Time Value of money
6. Net Present Value in investment Appraisal (NPV)
7. Present value of Annuity
8. Present value of Perpetuity
9. Equivalent annual costs
10. Internal rate of return

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CH# 1 Financial Mathematics

Interest

“Interest is the additional amount of money paid by the borrower to the lender for the use of money loaned
to him”.

When a person opens a savings account with a bank and deposits money into that account the bank will pay
the person money for saving with them. Similarly, if a person borrows money from a bank the bank will
expect that person to repay more than they borrowed. Money is not free to borrow. When a person or entity
borrows money the lender
will charge interest.

The total interest associated with a loan is the difference between the total repayments and the amount
borrowed.
There are two forms of interest:
• Simple interest; and
• Compound interest
1. Simple Interest
Simple interest is an interest which is charged on the fixed amount and it is not compounded.
Example 1
A person borrows Rs 10,000 at 10% with principle and interest to be repaid after 3 years.
Solution:
Amount owed at the start of year 1 10,000
Interest for year 1 (10%) 1,000
Interest for year 2 (10%) 1,000
Interest for year 3 (10%) 1,000
Total interest 3,000
Amount owed at the end of year 3 13,000
Formula: A = P(1+rn)
A=> Amount to be paid or received at the end of period n
P => Principal (amount borrowed or invested)
r => Period interest rate
n => Number of time periods that the loan is outstanding

Example 1
A = P(1+rn)
A= 10,000(1+0.1*3)
=13,000
Interest due on a loan I = Prn
Example 1
I = 10,000*.1*3
= 3,000

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Practice questions

Q.1 A person borrows Rs.500,000 for 3 years at an interest rate of 8%. What must he pay to clear the loan at
the end of this period?

Q.2 A person invests Rs. 50,000 for 5 years at an interest rate of 5%. What is the total interest received from
this investment?

Answer:
1. 620,000
2. 62,500
r and n should be compared with like to like. Usually annual interest rate is given in question if interest rate
is annual and time is not annual then time should be adjusted accordingly.
For example, interest rate is 6% and time is 6 months.
Period Less than a year:
• If quarterly then time will be divided by 4.
• If Semi annually or bi annually then time will be divided by 2.
• If monthly then time will be divided by 12.
Example 2
A person borrows Rs 10,000 at 10% simple interest for 6 months?

Solution:

A = P(1+rn)
A= 10,000(1+0.1*6/12)
=10,500

Practice questions
Q.1 A person borrows Rs. 75,000 for 4 months at an interest rate of 8%.
Q.2 A person borrows Rs.60,000 at 8%. At the end of the loan he repays the loan in full with a cash transfer
of Rs.88,800. What was the duration of the loan?
Q.3 A person invests Rs.90,000 for 6 years. At the end of the loan she receives a cash transfer of Rs.122,400
in full and final settlement of the investment. What was the interest rate on the loan?
Answer:
1. 77,000
2. 6 years
3. 6%
2. Compound Interest
Compound interest is where the annual interest is based on the amount borrowed plus interest accrued to
date.

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Example 3

Person borrows Rs 10,000 at 10% to be repaid after 3 years.

Rs
Amount owed at the start of year 1 10,000
Interest for year 1 (10%) 1,000
Amount owed at the end of year 1 (start of year 2) 11,000
Interest for year 2 (10%) 1,100
Amount owed at the end of year 2 (start of year 3) 12,100
Interest for year 3 (10%) 1,210
Amount owed at the end of year 3 13,310
The closing balance of 13,310 must be repaid to the lender at the end of the third year.

Formula: A = P(1+r) n
A=> Amount to be paid or received at the end of period n
P => Principal (amount borrowed or invested)
r => Period interest rate
n => Number of time periods that the loan is outstanding

Example 3
A = P(1+r) n
A= 10,000(1+0.1)3
A=13,310

Compound interest for non annual periods

It is important to remember that the rate of interest r must be consistent with the length of the period n.
If interest is charged on an annual basis the annual interest rate must be used but if interest is charged on a
six-monthly basis the six-monthly rate must be used.

n*m
Formula: A = P(1+r/m)
m => number of periods in a year.

Important points:
• If quarterly then 4 periods.
• If semi-annually or bi-annually then 2 periods.
• If monthly then 12 periods.

Example 4
A deposit 50,000 in a bank at an interest rate of 12% quarterly for 3 years. What will be the sum at the end
of 3 years?

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Solution
A= 50,000(1+.12/4)3*4
=71,285

Practice questions

1. A person borrows Rs.500,000 for years at an interest rate of 10%

2. A person invests Rs. 60,000 for 6 years at an interest rate of 6% compounded annually. What will
the interest at the end of 6 years?
3. Ali borrows 10,000 for 4 years at an interest rate of 6% monthly what will he pays at end of 4 years?

Answers
1. 1,296,871
2. 25,111
3. 12,705

Nominal and effective rate:

Nominal rate is the rate which is shown on the face of loan however the actual rate can be changed. This is
known as effective rate.
Formula:
R = (1+r) n -1
R => Rate is for longer period
r => rate is for short period
n => No. of period in one long period

Example 5
A company wants to borrow Rs.1,000. It has been offered two different loans. Loan A charges interest at
10% per annum and loan B at 5% per 6 months. Which loan should it take?

Solution
• Loan A 10%
• Loan B
R = (1+r) n -1
R = (1.05) ^2
R= 10.25%

Calculate n

Example 6
A man invested Rs.1,000 at 10% and received back Rs.2,595. How long was the money left on deposit?

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Solution

A = P × (1 + r) n

2,595 = 1,000 × (1.1) n

2,595 = 1.1𝑛𝑛
1,000

2.595 = 1.1𝑛𝑛
Take log of both sides log
2.595 = n log 1.1
log 2.595 = n
log 1.1
n = 10 years

Practice questions

1. A person borrows Rs.100,000 at an interest rate of 8% compounding annually. He repays Rs.

185,100 in full and final settlement at the end of the loan period. What is the duration of the loan?

2. A person borrows Rs. 100,000 at 5%. How long would it take the amount owed to double?

Answers
1. 8 years
2. 14.2 years
3. Annuities
Feature of annuities are:
• It is a series of payment
• At a regular interval
• For definite period

Example: 3,000 per month, 4,000 after every quarter etc.

Types of Annuity:

Ordinary annuity or Annuity Due or

Normal Annuity or Advanced Annuity

0 1 2 3 4 5 6 7 8 9 10

Advanced Normal

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Formula:

1. Ordinary Annuity 2. Annuity Due

A = X (1+r) n -1 A = X (1+r) n -1 × (1+r)

r r

A => sum of amount at the end of period.

X => Payment at regular interval
R => Interest rate
N => No. of period

Example 7

A savings scheme involves investing Rs.10,000 per annum for 5 years (on the last day of the year). If the
interest rate is 10% what is the sum to be received at the end of the 5 years?

Solution:

A = X (1+r) n -1
r

= 10,000 (1+0.1) 5 -1
0.1

= 61,051

Example 8

A savings scheme involves investing Rs.10,000 per annum for 5 years (on the first day of the year). If the
interest rate is 10% what is the sum to be received at the end of the 5 years?

Solution:

A = X (1+r) n -1× (1+r)

r

= 10,000 (1+0.1) 5 -1× (1+.1)

0.1
= 67,156

4. Sinking Fund:

A company wish to set a side a fixed amount of money at a regular interval to achieve a specific sum
after some period. This is known as sinking fund.
Formula:

A = X (1+r) n -1
r
A => sum required at the end of period.
X => Payment at regular interval
R => Interest rate
N => No. of period

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CH# 1 Financial Mathematics

Example 9

A company will have to pay Rs.5,000,000 to replace a machine in 5 years. The company wishes to save up
to fund the new machine by making a series of equal payments into an account which pays interest of 8%.
The payments are to be made at the end of the year and then at each year end thereafter. What fixed annual
amount must be set aside so that the company saves Rs.5,000,000?

Solution:

A = X (1+r) n -1
r

5,000,000= X (1+0.08) 5 -1
0.08

5,000,000 = X (5.867)

5,000,000 = X
(5.867)

852,282

Practice questions

1. A business wishes to start a sinking fund to meet a future debt repayment of Rs. 100,000,000 dues
in 10 years. What fixed amount must be invested every 6 months if the annual interest rate is 10%
compounding semi-annually if the first payment is to be made in 6 months?

2. A man wants to save to meet the expense of his son going to university. He intends to puts Rs. 50,000
into a savings account at the end of each of the next 10 years. The account pays interest of 7%. What
will be the balance on the account at the end of the 10-year period?

Answers
1. 3,024,803
2. 690,714

5. Time value of money?

One of the basic principles of finance is that a sum of money today is worth more than the same sum in the
future. If offered a choice between receiving Rs10,000 today or in 1 year’s time a person would choose
today.
 Compounding is the method which calculates the future value of sum invested today.
 Discounting is a method which calculates the present value of future sum. Discounting is the reverse
of compounding.

Discounting Formula:
P = A (1+r) -n
Example 10

A person expects to receive Rs 13,310 in 3 years. If the person faces an interest rate of 10% what is the
present value of this amount?

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Solution
A = P(1+r) -n

P= 13,310 (1+0.1)-3
P= 10,000

It is important to realise that the present value of a cash flow is the equivalent of its future value. Using the
above example to illustrate this, Rs 10,000 today is exactly the same as Rs 13,310 in 3 years at an interest
rate of 10%. The person in the example would be indifferent between the two amounts. He would look on
them as being identical.

Comparison of two or more investment or loan:

Example 11

A borrower is due to repay a loan of Rs 150,000 in 3 years. He has offered to pay an extra Rs 20,000 as
long as he can repay after 5 years. The lender faces interest rates of 10%. Is the offer acceptable?

Solution

Option I Option II
A = P(1+r) -n A = P(1+r) -n

P= 150,000 (1+0.1)-3 P= 170,000 (1+0.1)-5

P= 112,697 P= 105,557

Decision:

Option I is better. It has more worth now.

Practice Questions

1. An investor wants to make a return on his investments of at least 7% per year. He has been offered
the chance to invest in a bond that will cost Rs 100,000 and will pay Rs 150,000 at the end of five
years. In order to earn Rs 150,000 after five years at an interest rate of 7% the amount of his
investment now would need to be:

2. Bank A offers to earn on investment certificates Rs. 150,000 after 3 years if Ali invest 100,000 now
and bank B offers to earn on investment certificates Rs. 170,000 after 5 years if Ali invest 100,000
now. What is the interest rate offering both the bank?

Answer

1. 106,948 should invest for earning 150,000 however he has to invest only 100,000 so he earns more
than 7%.
2. Bank A 14.47% and Bank B 11.20%

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How to discount table?

Example 12

Calculate the present value of Rs 60,000 received in 4 years assuming a cost of capital of 7%?

Solution

P = 60,000 * 0.763
P = 45,780

6. Net Present Value (NPV)

The cost of capital “r” is the return required by the investor or company. For example, we purchase machine
for Rs. 100,000 now and we earn cashflow of Rs. 30,000 in 5 years. Sum of cashflow will be 150,000. If we
compare 150,000 with 100,000, we can not say that we earn profit or loss because 100,000 is pay now and
cashflow earn in five years times which has no same value today.
In this situation concept of time value of money.

Example 13

XYZ purchase machine today for Rs. 150,000. XYZ earns 30,000 in year 1 and after year 1 cashflow will be
reduced by 2,000. After 5 years it has residual value (Scrap value) 20,000. Investor required rate of return is
10%. What will be NPV now?

Solution

Description 0 1 2 3 4 5

initial Investment - 100,000

Scrap value 20,000

Cash flow 30,000 28,000 26,000 24,000 22,000

-100,000 30,000 28,000 26,000 24,000 42,000

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Discount factor 1 0.909 0.826 0.751 0.683 0.621

Present value - 100,000 27,270 23,128 19,526 16,392 26,082

NPV 12,398

Practice Questions

1. A company is considering whether to invest in a new item of equipment costing Rs.53,000 to make
a new product. The product would have a four-year life, and the estimated cash profits over the
four-year period are as follows.

Year Rs.
1 17,000
2 25,000
3 16,000
4 12,000

Calculate the NPV of the project using a discount rate of 11%?

2. A company is considering whether to invest in a new item of equipment costing Rs.65,000 to make
a new product. The product would have a three-year life, and the estimated cash profits over this
period are as follows.

Year Rs.
1 27,000
2 31,000
3 15,000
Calculate the NPV of the project using a discount rate of 8%?

Answer
1. 2,210
2. (1,515)

Decision Rule

Comparison Feasible

Higher of two NPV will be selected.

Accept Reject

Positive NPV Negative NPV

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Rules of NPV

1. Initial investment should be taken at 0 unless otherwise told.

2. Cash flow arising during the year. It will be assumed at the end of year.
3. Cashflow arises beginning of the year. It will be assumed it arises at the end of previous year.

7. Discounting Annuity

Normal / ordinary Advanced / Annuity due

1 − (1 + r) −n 1 − (1 + r) −n +1
r r

Example 14

XYZ will receive 10,000 each annually for 5 years at the rate of 10%. What will be present value if 10,000
receive
• At the end of year
• Beginning of year

Solution

Present Value = Annual CF * Annuity Factor

• = 10,000 × 3.791
= 37,910

• =10,000 × (3.170 +1)

=10,000 × 4.170
=41,700

Note: Solve this question with formula.

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Example 14

A company is considering whether to invest in a project which would involve the purchase of machinery
with a life of five years. The machine would cost Rs.356,000 and would have a net disposal value of
Rs.56,000 at the end of Year 5. The project would earn annual cash flows (receipts minus payments) of
Rs.100,000. Calculate the NPV of the project using a discount rate of 10 %.

Solution

Discount Present
Period Cash flow
factor (10%) value
Description
initial Investment 0 - 356,000 1 - 356,000
Scrap value 5 56,000 0.621 34,776
Cash flow 1-5 100,000 3.791 379,100

NPV 57,876

Practice Questions

1. A company is considering whether to invest in a project which would involve the purchase of
machinery with a life of four years. The machine would cost Rs.1,616,000 and would have a net
disposal value of Rs.301,000 at the end of Year 4. The project would earn annual cash flows (receipts
minus payments) of Rs.500,000. Calculate the NPV of the project using a discount rate of 10%
Answer
1. 174,519

8. Perpetuities

A perpetuity is a constant annual cash flow ‘forever’.

Normal Advanced

Annual Cash Flow × 1 Annual Cash Flow × (1 + 1)

r r

Example 14

2,000 in perpetuity, starting in Year 1 cost of capital = 8%

• At end of year
• Beginning of year

Solution

• = 2,000 × 1/.08
= 25,000

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• =2,000 × (1/.08 + 1)
=27,000

9. Equivalent annual costs

An annuity is multiplied by an annuity factor to give the present value of the annuity. This can work in
reverse. If the present value is known it can be divided by the annuity factor to give the annual cash
flow for a given period that would give rise to it.

Example 15

What is the present value of 10,000 per annum from t1 to t5 at 10%?

Solution

Time Cash flow Discount factor Present value

1 to 5 10,000 3.791 37,910

What annual cash flow from t1 to t5 at 10% would give a present value of 37,910?

37,910
Divide by the 5 years, 10% annuity factor 3.791
10,000

Example 16

A company borrows Rs 10,000,000. This to be repaid by 5 equal annual payments at an interest rate
of 8%. Calculate the payments?

Solution

Amount borrowed 10,000,000

Divide by the 5 years, 8% annuity factor 3.993
Annual repayment 2,504,383

Sinking Fund (Alternate Approach)

Step 1: Calculate the present value of the amount required in n years.

Step 2: Calculate the equivalent annual cash flows that result in this present value

Example 9 (Alternate Approach)

A company will have to pay Rs.5,000,000 to replace a machine in 5 years. The company wishes to save up
to fund the new machine by making a series of equal payments into an account which pays interest of 8%.
The payments are to be made at the end of the year and then at each year end thereafter. What fixed annual
amount must be set aside so that the company saves Rs.5,000,000?

Solution

Step 1:
= 5,000,000 (1.08)-5
= 3,402,916

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Step 2:

Present value 3,402,916

Divide by the 5 years, 8% annuity factor 3.993
Annual repayment 852,220

10. Internal rate of return (IRR)

The internal rate of return is therefore the discount rate that will give a net present value = Rs.0.

Comparison Feasible

Higher IRR IRR > Standard IRR

(Targeted IRR)

Formula

Example 16

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Practice Questions

Answers

1. 12.7% (at 15%)

2. 6.6% (at 15%)

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