CHAPTER 2
Mathematics of Finance
n later chapters of this book, we will see how investment decisions made by
I financial managers, to acquire capital assets such as plant and equipment,
and asset managers, to acquire securities such as stocks and bonds, require
the valuation of investments and the determination of yields on investments.
In addition, when financial managers must decide on alternative sources
for financing the company, they must be able to determine the cost of those
funds. The concept that must be understood to determine the value of an
investment, the yield on an investment, and the cost of funds is the time
value of money. This simple mathematical concepts allows financial and
asset managers to translate future cash flows to a value in the present, trans-
late a value today into a value at some future point in time, and calculate
the yield on an investment. The time-value-of-money mathematics allows
an evaluation and comparison of investments and financing arrangements
and is the subject of this chapter. We also introduce the basic principles of
valuation.
THE IMPORTANCE OF THE TIME VALUE OF MONEY
Financial mathematics are tools used in the valuation and the determination
of yields on investments and costs of financing arrangements. In this chapter,
we introduce the mathematical process of translating a value today into a
value at some future point in time, and then show how this process can be
reversed to determine the value today of some future amount. We then show
how to extend the time value of money mathematics to include multiple cash
flows and the special cases of annuities and loan amortization. We then show
how these mathematics can be used to calculate the yield on an investment.
The notion that money has a time value is one of the most basic con-
cepts in investment analysis. Making decisions today regarding future cash
flows requires understanding that the value of money does not remain the
same throughout time.
11
12 BACKGROUND
A dollar today is worth less than a dollar some time in the future for
two reasons:
Reason 1: Cash flows occurring at different points in time have different
values relative to any one point in time. One dollar one year from now
is not as valuable as one dollar today. After all, you can invest a dollar
today and earn interest so that the value it grows to next year is greater
than the one dollar today. This means we have to take into account the
time value of money to quantify the relation between cash flows at dif-
ferent points in time.
Reason 2: Cash flows are uncertain. Expected cash flows may not mate-
rialize. Uncertainty stems from the nature of forecasts of the timing and
the amount of cash flows. We do not know for certain when, whether,
or how much cash flows will be in the future. This uncertainty regarding
future cash flows must somehow be taken into account in assessing the
value of an investment.
Translating a current value into its equivalent future value is referred to
as compounding. Translating a future cash flow or value into its equivalent
value in a prior period is referred to as discounting. This chapter outlines the
basic mathematical techniques used in compounding and discounting.
Suppose someone wants to borrow $100 today and promises to pay
back the amount borrowed in one month. Would the repayment of only the
$100 be fair? Probably not. There are two things to consider. First, if the
lender didn’t lend the $100, what could he or she have done with it? Second,
is there a chance that the borrower may not pay back the loan? So, when
considering lending money, we must consider the opportunity cost (that is,
what could have been earned or enjoyed), as well as the uncertainty associ-
ated with getting the money back as promised.
Let’s say that someone is willing to lend the money, but that they require
repayment of the $100 plus some compensation for the opportunity cost
and any uncertainty the loan will be repaid as promised. The amount of the
loan, the $100, is the principal. The compensation required for allowing
someone else to use the $100 is the interest.
Looking at this same situation from the perspective of time and value,
the amount that you are willing to lend today is the loan’s present value.
The amount that you require to be paid at the end of the loan period is the
loan’s future value. Therefore, the future period’s value is comprised of two
parts:
Future value = Present value + Interest
Mathematics of Finance 13
The interest is compensation for the use of funds for a specific period. It con-
sists of (1) compensation for the length of time the money is borrowed; and
(2) compensation for the risk that the amount borrowed will not be repaid
exactly as set forth in the loan agreement.
DETERMINING THE FUTURE VALUE
Suppose you deposit $1,000 into a savings account at the Surety Savings
Bank and you are promised 10% interest per period. At the end of one
period, you would have $1,100. This $1,100 consists of the return of your
principal amount of the investment (the $1,000) and the interest or return
on your investment (the $100). Let’s label these values:
$1,000 is the value today, the present value, PV.
$1,100 is the value at the end of one period, the future value, FV.
10% is the rate interest is earned in one period, the interest rate, i.
To get to the future value from the present value:
FV = PV + (PV × i)
↑ ↑
Principal Interest
This is equivalent to
FV = PV(1 + i)
In terms of our example,
FV = $1,000 + ($1,000 × 0.10) = $1,000(1 + 0.10) = $1,100
If the $100 interest is withdrawn at the end of the period, the principal
is left to earn interest at the 10% rate. Whenever you do this, you earn
simple interest. It is simple because it repeats itself in exactly the same way
from one period to the next as long as you take out the interest at the end
of each period and the principal remains the same. If, on the other hand,
both the principal and the interest are left on deposit at the Surety Savings
Bank, the balance earns interest on the previously paid interest, referred to
as compound interest. Earning interest on interest is called compounding
because the balance at any time is a combination of the principal, interest
on principal, and interest on accumulated interest (or simply, interest on
interest).
