Administration I

 Lecturer for the semester:

– Dr Jo Drienko
– [email protected]
– Office: 4.45 CBE Building
– Consultation times: Tuesdays 12:30-1:30pm
– Consultations start in week two
– All consultations (including consultations with
tutors) will be conducted over Zoom – the
Zoom links are already available on Wattle
1
Administration II
 Lecture arrangements
– One two-hour lecture each week + Workshop
 Lectures will be on-campus and recorded (echo360)
 Workshops will be on-campus and recorded
 Content in the workshops?
 You need to enrol in one tutorial
 Tutorials start next week, in-person only (not recorded)
 There is no quiz next week, however, please see
outline for details regarding the quiz schedule

2
Administration III
 Assessment:
– Tutorial Quizzes in Tutorials (35%)
 Five tutorial quizzes (7% each) during the semester
 ALL redeemable against the final exam
 Each quiz is out of 10 marks, no quiz retakes
 Every 10-minute quiz will run at the end of the tute
 You must attend the tutorial you are enrolled in to
take the quiz – no exceptions!
 The content for the quizzes will be limited to the
material for the topic on which the tutorial is held
– Final Exam (65% or more)
3
 Lecture 1
The Time Value of Money: An
Introduction to Financial Mathematics
1. Lecture Overview
This week will provide you with an introduction to
financial mathematics. The lecture is designed to
ensure you have the tools necessary to calculate
the value of financial instruments later in the
course. Today’s lecture will consider:
– Why a dollar received today is worth more than a
dollar received any time after today
– How to calculate what a dollar received at some time
in the future is worth today

5
2. The Time Value of Money
 If we receive $1 today, we can invest it,
earn interest and end up with more than
$1 at any time in the future
 Given this, if offered the choice, you would
prefer receiving $1 today over receiving $1
at some future date

6
2.1 Future Value of a Single Cash Flow
Example 1:
We received $1 today and decided to deposit it in the
bank for a period of 2 years. If, during this time, the $1
earns interest at a rate of 10% per annum (calculated
at the end of each year), what is it’s value in 2 years’
time?

7
2.1 Future Value of a Single Cash Flow
Future Value = F0 * (1 + r)n
FV = $1 * (1 .1)2
= $1.21
With the compound interest, interest in the second period
included an amount earned on the interest we were paid in the
first period (i.e. in the second period, we earned 10% interest on
the $0.10 interest from the first period, or an extra 1c)

8
2.2 Present Value of a Single Cash Flow
Using the same time value of money idea, we also
know that we would have to put an amount less
than $1 in the bank in order to receive $1 from the
investment in the future. Exactly how much less
than $1 we would need to deposit in the bank
initially depends on:
– How long we are going to leave it there
– How much interest we will earn in the mean time

Consider the following example

9
2.2 Present Value of a Single Cash Flow
Example 2:
Calculate how much we would need to invest
today in an investment that earns 10% per annum
(calculated at the end of each year), in order to
receive $1 in 2 years’ time

10
2.2 Present Value of a Single Cash Flow
Present Value = FV / (1 + r)n
PV = 1 / (1.10)2
= 0.8265 or 82.65c

What about the FV and PV of multiple cash flows?

11
2.3 Future Value of Multiple Cash Flows
Example:
You will make three bank deposits in the next 3 years,
with the first deposit to be made exactly 1 year from
today. Further details of these deposits are provided in
the table below. Calculate the total value of these
deposits in exactly 3 years’ time given interest is paid at
a rate of 10% per annum (calculated at the end of each
year)
Time 1 year 2 years 3 years

Deposit $100 $200 $500

Amount

12
 2.3 Future Value of Multiple Cash Flows
Solution:
In answering this question, it is useful to draw a timeline:
We want to calculate the total
value of the 3 deposits here.

t=0 t=1 t=2 t=3

Deposit $100 Deposit $200 Deposit $500

We can see from the timeline that, in exactly 3 years’ time:

– The first deposit ($100) will have been in the bank for exactly two years;
– The second deposit ($200) will have been in the bank for exactly one year;
and,
– The third deposit ($500) will be deposited in the bank immediately before
the time at which we wish calculate the total value
– More importantly, timelines show the spacing between cash flows (useful
later in the lecture when identifying what interest rate to use in calculations)
13
2.3 Future Value of Multiple Cash Flows
Solution:
Given this, we can calculate the total value of these
deposits in exactly three years’ time as follows:
FV3 = $100(1.1)2 + $200(1.1) + $500
= $121 + $220 + $500
= $841

14
2.3.1 Present Value of Multiple Cash Flows

When calculating the present value of

multiple cash flows:
– Discount each cash flow individually and sum
the resultant values to calculate the present
value
– A shortcut method exists IF all the cash flows
are of identical size (stay tuned)

15
2.3.1 Present Value of Multiple Cash Flows
Example
I expect to receive the following cash flows over the
next four years
Time 1 year 2 years 3 years 4 years
Cash Flow $300 $290 $500 $580

What is the present value of these cash flows given

they are received at the end of the relevant year and
the interest rate is 10% p.a.?

16
2.3.1 Present Value of Multiple Cash Flows
Solution
While the cash flows are evenly spaced, they are not
of the same dollar value. Therefore, they are not an
annuity and, in order to calculate their present value,
we must discount them individually before summing
them
300 290 500 580
PV    
(1.10) (1.10) (1.10) (1.10) 4
2 3

 $1, 284.20

17
2.4 Future Value of Multiple (Equal)
Cash Flows
Now, let’s say that the amounts we are to deposit
are equal in value. Let’s say we plan to deposit
$100 at the end of each year for the next 3 years.
A finite number of cash flows that are equal in their
amounts and are evenly spaced are called
annuities. There are 3 types of annuities, which
we will now consider in turn:
– Ordinary Annuities
– Annuities Due
– Deferred Annuities

18
2.4.1 Future Value of Annuities
1) Ordinary Annuity
An ordinary annuity is one where the time between now and
the first cash flow is the same as the time separating each
subsequent cash flow. Diagrammatically, an ordinary annuity
comprising n cash flows of $F can be shown as:
…..…………..
$F $F $F $F $F

t=0 t=1 t=2 t=3 t=4 …..………….. t=n

An example of an ordinary annuity is the series of

repayments made on a bank loan

19
2.4.1 Future Value of Annuities
2) Annuity Due
An annuity due is one where the first cash flow occurs
immediately. However, the time between the first cash flow
and the second cash flow is the same as the time separating
all subsequent cash flows. Diagrammatically, an annuity due
comprising n cash flows of $F can be shown as:

$F $F $F $F $F …..………….. $F

t=0 t=1 t=2 t=3 t=4 …..………….. t=n-1 t=n

An example of an annuity due is rent paid on a residential

property

20
2.4.1 Future Value of Annuities
3) Deferred Annuity
A deferred annuity is one where the first cash flow occurs at some time
in the future, but the time between now and the first cash flow does not
equal the time separating each subsequent cash flow
Diagrammatically, a deferred annuity comprising n cash flows of $F
that commences in m periods can be shown as:

…..………….. $F $F $F …..………….. $F

t=0 …..………….. t=m t=m+1 t=m+2 …..…………..

t=m+n-1

An example of a deferred annuity is a “buy now pay later”

scheme often promoted by retail outlets

21
2.4.1 Future Value of Annuities
To find the future value of an annuity comprising n
cash flows of $F immediately following the last cash
flow, we can either compound each individual cash
flow, or we can apply the formula below:
Future value of an ordinary annuity:
 (1  r ) n  1 
FV  F  
 r 
 FS n r

22
2.4.1 Future Value of Annuities
Example:
Calculate the future value in 3 periods’ time of an
ordinary annuity comprising 3 payments of $500.
These payments are made at the end of each
period, and the interest rate is 8% per period

23
2.4.1 Future Value of Annuities
Solution:
Approach 1: Compounding each cash flow individually
FV  500(1.08)2  500(1.08)  500
 $1, 623.20
Approach 2: Using the Future Value of an Annuity Formula
 (1.08)3  1 
FV  500  
 0.08 
 $1, 623.20

24
2.4.2 Future Value of Annuities

 (1  r ) n  1 
FV  F  
 r 
 FS n r

25
2.5 Present Value of Annuities
The formula used to calculate the present
value of an annuity differs based on the type
of annuity being considered. Let’s consider
each type of annuity in turn

26
2.5.1 Present Value of Annuities
1) Ordinary Annuity
Recall that an ordinary annuity is one where the time
between now and the first cash flow is the same as the time
separating each subsequent cash flow. To calculate the
present value of an ordinary annuity comprising n cash
flows of $F, we use the following equation:
F F F
PV    ........... 
(1  r ) (1  r ) 2
(1  r ) n
1  (1  r )  n 
F 
 r 
 FAn r

27
2.5.1 Present Value of Annuities
Ordinary Annuity Example
The present value of an ordinary annuity comprising 10
annual cash flows of $500 each is calculated as follows
given an interest rate of 10% p.a.:

1  (1  r )  n 
PV  F  
 r 
1  (1.10) 10 
 500  
 0.10 
 $3, 072.28

28
2.5.2 Present Value of Annuities
2) Annuity Due
Recall that an annuity due is one where the first cash flow
occurs immediately. To calculate the present value of an
annuity due comprising n cash flows of $F, we use the
following equation:
F F F
PV  F    ........... 
(1  r ) (1  r ) 2
(1  r ) n 1
1  (1  r )  ( n 1) 
FF 
 r 
 F  FAn 1 r

29
2.5.2 Present Value of Annuities
Annuity Due Example
The present value of an annuity due comprising 10 annual cash
flows of $500 each is calculated as follows given an interest rate of
10% p.a.:
1  (1  r ) 
 ( n 1)
PV  F  F  
 r 
1  (1.10) 9 
 500  500  
 0.10 
 $3,379.51

When we compare this with the present value of the ordinary annuity
from a previous slide, we see the present value of the annuity due is
higher. Why?

30
2.5.3 Present Value of Annuities
3) Deferred Annuity
Recall that a deferred annuity is simply an annuity that
commences as some time in the future. To calculate the
present value of a deferred annuity that commences in m
periods and comprises n cash flows of $F, we use the
following:
1  (1  r )  n 
F 
r
PV   
(1  r ) m 1

31
2.5.3 Present Value of Annuities
Deferred Annuity Example
The present value of a deferred annuity commencing in 5
years that comprises 10 annual cash flows of $500 each is
calculated as follows given an interest rate of 10% p.a. :

1  (1.10) 10 
500  
 0.10 
PV 
(1.10) 4
 $2, 098.41

What about if there are an infinite number of cash flows?

32
2.6 Present Value of Perpetuities
A perpetuity is a series of equally spaced cash flows of
same dollar value that continues on forever. As with
annuities, perpetuities can be broken into three types
based on the time until the first cash flow occurs,
namely:
– Ordinary Perpetuities
– Perpetuities Due
– Deferred Perpetuities

33
2.6.1 Present Value of Perpetuities
1) Ordinary Perpetuity
Ordinary Perpetuity: The time between now and the first cash
flow is the same as the time separating subsequent cash
flows. The only difference between an ordinary perpetuity
and an ordinary annuity is that, in the case of the ordinary
perpetuity, cash flows continue forever. The present value of
an ordinary perpetuity comprising individual cash flows of $F
is calculated as:

F
PV 
r

34
2.6.1 Present Value of Perpetuities
Ordinary Perpetuity Example
The present value of an ordinary perpetuity that comprises
annual cash flows of $500 each is calculated as follows
given an interest rate of 10% p.a.:

500
PV 
0.1
 $5, 000

35
2.6.2 Present Value of Perpetuities
2) Perpetuity Due
Perpetuity Due: The first cash flow occurs immediately. The
only difference between a perpetuity due and an annuity
due is that, in the case of the perpetuity due, cash flows
continue forever. The present value of an annuity due
comprising individual cash flows of $F is calculated as:

F
PV  F 
r

36
2.6.2 Present Value of Perpetuities
Perpetuity Due Example
The present value of a perpetuity due that comprises annual
cash flows of $500 each is calculated as follows given an
interest rate of 10% p.a.:
F
PV  F 
r
500
 500 
0.1
 $5,500

37
2.6.3 Present Value of Perpetuities
3) Deferred Perpetuity
Deferred Perpetuity: A perpetuity that commences some time
in the future, but the time between now and the first cash flow
does not equal the time separating each subsequent cash
flow. The only difference between a deferred perpetuity and a
deferred annuity is that, in the case of the deferred perpetuity,
cash flows continue forever. The present value of a deferred
annuity commencing in m periods and comprising individual
cash flows of $F is calculated as:
F 
 r 
PV 
(1  r ) m 1
38
2.6.3 Present Value of Perpetuities
Deferred Perpetuity Example
The present value of a deferred perpetuity that commences in
4 years and comprises annual cash flows of $500 each is
calculated as follows given an interest rate of 10% p.a.:
F
PV  r
(1  r ) m 1
500
 0.1 3
(1.10)
 $3, 756,57

39
3. Interest Rates for Time Value of Money
Calculations
In time value of money calculations, it is very important to
ensure that each piece of information included in calculations
is expressed (and thought of) in terms of the time frame.
Consider the following examples
Example 1:
When calculating the present (or future) value of a single cash
flow, if the number of periods (n) is expressed in terms of the
number of years till the cash flow is received, then the interest
rate (r) used must also be expressed as a rate applied once a
year. In the case of a single cash flow, n and r could also be
expressed as semi-annual figures, etc and the answer would
be the same
40
3. Interest Rates for Time Value of Money
Calculations
Example 2:
When calculating the present (or future) value of an annuity /
perpetuity, both n and r must be expressed in terms of the
same time as the period between each cash flow. So, if cash
flows are monthly, n should represent the number of months
and r should be the monthly interest rate
We already know how to convert n from the number of years
to the number of months, but how do you convert r from an
annual rate to a monthly rate? USE THE INTEREST RATE
WHEEL!!!! Before we look at the wheel, let’s familiarize
ourselves with some interest rate terminology

41
3. Interest Rates for Time Value of Money
Calculations
First, consider the difference between annual effective, annual
nominal and periodic interest rates:
– Annual effective interest rate: An interest rate where the frequency
of charging / payment matches the period specified by the interest
rate. In other words, the rate is quoted annually and is applied
annually
– Annual nominal interest rate: An interest rate where interest is
charged more frequently than the time period specified in the
interest rate. For example, 12% p.a. compounded monthly is an
example of a nominal interest rate
– Periodic interest rate: The rate of interest applied per compound
period in the case of a nominal interest rate. For example, if the
interest rate is 12% p.a. compounded semi-annually, the periodic
interest rate is 12%/2 = 6% per six-months

42
3. Interest Rates for Time Value of Money
Calculations
How do we know which rate to use?
Recall the earlier discussion on using information in the
equations that is expressed in terms of the same time frame.
More specifically:
 Use an annual effective rate to calculate future or present value
when:
– You have an annuity / perpetuity with annual cash flows. Here,
you must also have n expressed in terms of number of years
– You have multiple uneven cash flows / a single cash flow and you
want to express n in terms of the number of years
– Tip: Use a timeline! Annual spacing between cash flows indicates
that an annual effective rate should be used

43
3. Interest Rates for Time Value of Money
Calculations
 Use a periodic interest rate when:
– You have an annuity / perpetuity with cash flows paid
less than annually. Here, the periodic rate must be
expressed as frequently as the cash flows. For example:
 If you have an annuity paid monthly, you must use a monthly periodic
interest rate and a monthly value of n
 If you have an annuity paid quarterly, you must use a quarterly period
interest rate and a quarterly value of n
 Tip: Use a timeline! For example, a weekly spacing between
cash flows indicates that a weekly periodic rate should be used

44
 3. Interest Rates for Time Value of
Money Calculations
If you have an annuity / perpetuity:
– You must use an interest rate of the same frequency of the cash flows,
and you must use a value of n calculated based on the same period (in the
case of annuities). For example:
 If you have monthly cash flows for 5 years, you must use a monthly interest
rate and n = 5*12 = 60
 If you have yearly cash flows for 5 years, you must use an annual effective
interest rate and n = 5
 If you have quarterly cash flows forever, you must use a quarterly interest rate

Hint: Never use an annual nominal rate for direct calculations!

45
3. Interest Rates for Time Value of Money Calculations
Interest Rate Wheel

Annual Effective Rate

re  (1  rp ) n  1 rp  (1  re )1/ n  1

rn n
Periodic Rate re  (1  ) 1 rn  n[(1  re )1/ n  1] Periodic Rate
n

rn
rp  rn  rp  n
n

Annual Nominal Rate

Where: re = annual effective rate

rn = nominal annual rate
rp = periodic rate (eg monthly, quarterly, etc)
n = number of compounding periods per annum
46
3. Interest Rates for Time Value of Money
Calculations
Examples
 Calculate the annual effective interest rate given an
interest rate of 12% p.a. compounded quarterly
– Conversion: rn to re
rn n
re  (1  ) 1
n
0.12 4
 (1  ) 1
4
 0.1255
 12.55% p.a.

47
3. Interest Rates for Time Value of Money
Calculations
Examples (Continued)
 Calculate the 6-month interest rate given an interest rate
of 10% p.a.
– Conversion: re to rp

rp  (1  re )1/ n  1
 (1.10)1/ 2  1
 0.0488
 4.88%

48
3. Interest Rates for Time Value of Money
Calculations
Examples (Continued)
 Calculate the monthly periodic interest rate given an
interest rate of 9% p.a. compounded monthly
– Conversion: rn to rp
rn
rp 
n
0.09

12
 0.0075
 0.75%

49
3. Interest Rates for Time Value of
Money Calculations

50
4. Interest Rates for Time Value of Money
Calculations

51