Financial Mathematics

B.Com. (Hons.) IV Sem.

University of Delhi

Course Instructor
Dr. B. B. Mohapatra
Department of Commerce
Maharaja Agrasen College
(University of Delhi), Delhi
Unit iv: Mathematics of Finance

4.0 Rates of interest: Simple and compound

4.1 Rates of interest: Nominal, effective and their

inter-relationships in different compounding
situations.

4.2 Compounding and discounting of a sum using

different types of rates. Applications relating to
Depreciation of assets and Equation of value.

4.3 Types of annuities: ordinary, due deferred,

continuous, perpetual. Determination of future
and present values using different types of rates of
interest. Applications relating to Capital
expenditure, Leasing, Valuation of simple loans
and debentures, sinking fund. (excluding general
annuities).
Topics
.Present Value of an Amount:
Discrete Compounding
.Present Value of an Amount:
Continuous Compounding
.Equation Value
.Discounting
.Depreciation
Present Value
Present Value of an Amount: Discrete Compounding

We know that in case of discrete compounding the future value or

Amount S of a given Sum or Principal P, given r, m and t can be

& '(
calculated using the formula: ! = # $+' Alternatively,

S = P(1+i)n as i = r/m and n = m*t

Thus if we know S, i and n we can calculate P as follows;

!
P= $)* + Alternatively # = !($ + *).+

Here also manual calculation using ordinary calculator is difficult. Hence

we have to use preset value (PV) table. In fact, like that of compounded
future value table, we can construct one in excel. The PV table will

reveal what is the present value of 1 rupee invested at r% interest rate

for n number of periods.
Table 2: Present Value Table [! = #(# + &)() ]
n Interest Rates (i)

1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683

5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
Let us Solve a Few Examples

Q1. Mr. Arun is likely to receive INR 40,000 after

3 years. If the rate of interest is 10 per cent
per annum compounded annually. What is its
present value?
Ans: 30,053

Q2. Assume that a deposit is to be made at

year zero into an account earning 8 %
compounded annually. It is desired to
withdraw 2,00,000 three years from now
and 3,00,000 seven years from now. What
is the size of the year zero deposit that will
produce these future payments?
Ans: 3,33,813.57
Present Value
Present Value of an Amount: Continuous Compounding

We know that in case of continuous compounding the future

value or Amount S of a given Sum or Principal P, given r, and t

can be calculated using the formula:

! = # $%&
Thus if we know S, r and t we can calculate P as follows;

!
P = %& Alternatively # = !$'%&
$
Thus, given S, r and t, using the above formula we can calculate

P, if the $( , table or value is given to us.

Let us Solve a Few Examples

Q1. Mr. Arun is likely to receive INR 40,000 after 3 years. If

the rate of interest is 10 per cent per annum
compounded continuously. What is its present value?
Ans: 29,631.82

Q2. Assume that a deposit is to be made at year zero

into an account earning 8 % compounded
continuously for the 1st 3 years and annually for the
next 4 years. It is desired to withdraw 2,00,000
three years from now and 3,00,000 seven years
from now. What is the size of the year zero deposit
that will produce these future payments?
Ans: 3,30,784.96
Using the PV function in Excel, NPER, Rate, FV finding
One given the other 3.
Equation Value
An Equation value is an equation
which states that the total value of
one set of obligation is equal to the
total value of another set of obligation
on a particular date (called the date
of comparison or the focal date)
An Example
A debt of rupees 300 due 2 years from now and
another of rupees 500 due 7 years from now are to
be paid by a single payment after 3 years from now.
If the rate of interest is 5% per annum, how much
will be that payment?
Obligation Set 1: rupees 300 due 2 years from now
and rupees 500 due 7 years from now
Obligation Set 2: a single payment after 3 years
from now. (unknown, let it be X)
Focal Date: The Third year
0____1_____2_____3____4____5_____6____7
0____1_____2(300)_____3(x)____4____5_____6____7(500)
Obligation Set 1 Focal Obligation
Date Set 2
300 to grow for 1 year @5% + what on 3rd year will be The Unknown
come 500 in the 7th year i.e. in 4 years @5% year 3 value x
=
The Solution

300(1.05)1+500(1.05)-4 = x
x = 300(1.05)+500(.8227)
x= 315+411.35
x= 726.35
We can do it in excel by writing the
Formula
Let
C = Original Cost of the Asset/Book Value
S = Estimated Scrap/Salvage Value/Book
Value at nth year
W = Total Depreciation (or C-S)
D = Annual Depreciation
n = Useful life in Years

(C). Constant Percentage Method (or

(a). Straight Line
Diminishing Balance Method)
Method (b). Sum of
! = #(% − '))
*=
#−! +
= the Years r is the constant percentage or
) )
Digit the rate of Depreciation
Method
(a).Straight Line Method

$%& (
The Annual Depreciation (!) = ' = '
Thus in straight line method the annual depreciation is fixed for all the
years

An Example
A machine costing rupees 50,000 has a life of 5 years. The estimated scrap
value is rupees 10,000. Find the annual depreciation and construct a
schedule of depreciation over the life of the machine.
$%& ( )*,***%,*,***
Ans: The Annual Depreciation (!) = '
= '
= )
= -, ***

Depreciation Schedule
Date of
Year 3 Year 4 Year 5
Purchase (Year Year 1 Year 2
0)

Annual Depreciation (in Rs.) 0 8,000 8,000 8,000 8,000 8,000

Accumulated Depreciation
(in Rs.) 0 8,000 16,000 24,000 32,000 40,000

42,00
Book Value (in Rs.) 50,000 34,000 26,000 18,000 10,000
0
(b). Sum of the year digit Method
By this method, digits of the year are arranged in
descending order against years in ascending order. The
depreciation for respective years (Annual Depreciation)
is the fraction (f) of the cost of the asset (C) and that
fraction is given by the ratio of digit to sum of digit.
Annual Depreciation=f.C
[f=Digit of the year/Sum of the year]
This method typically assumes higher rates of
depreciation during the initial years.
Further this method assumes a zero scrap value
An Example
A machine which costs rupees 30,000, has a life span of 5
years and its scrap value is zero. Find the annual depreciation
for each year year
C: The Cost of Machine = 30,000
Year Digit of the Fraction (f) Annual Accumulated
Year in Depreciation Depreciation
Reverse (fXC)
Order
1 5 5/15 10,000 10,000
2 4 4/15 8,000 18,000
3 3 3/15 6,000 24,000

4 2 2/15 4,000 28,000

5 1 1/15 2,000 30,000
Sum of the Years Digit Total
= Depreciation
15 = 30,000
The cost of Machine = Total depreciation => The scrap value of the Machine
is zero
(c) Constant Percentage Method
Under this method Annual depreciation is a constant percentage of the
book value of the assets in the end of the preceding year or beginning of
the current year. Since the book value of the machine declines with each
successive year owing to depreciation, it is alternatively called the
Diminishing Balance Method.
Through this method we can calculate the amount of depreciation and
hence the book value of the machine for any year during its life. Also, book
value in the end of the life of the machine is the scrap value.
Suppose S: Book value of the Machine
C: the cost of the Machine
r: rate of depreciation which is constant through out the life of the
machine
Book value of the Machine in year 1 ending: S1 = C-Cr = C(1-r)1
Book value of the Machine in year 2 ending : S2 = C (1-r)-C (1-r)r =
C(1-r)2
Book value of the Machine in year 3 ending: S3 = C (1-r)2-C (1-r)2r=
C(1-r)3
…………………………….
……………………………..

Book value of the Machine in year n: S = C (1-r)n-1-C (1-r)n-1r= C(1-r)n

Thus S = C(1-r)n
Almost similar to the method of discounting given the discount rate
An Example

A machine costing rupees 25,000 depreciates at a constant rate of

5%. Find the depreciation amount for the 3rd year and also find its
scrap value, given its useful life as 5 years.
Solution
C = 25,000
r= .05 (i.e.5%)
Depreciation amount during the 3rd year = Book value of the
Machine During End of the third year - Book value of the Machine
during the end of the 2nd year i.e.
S2-S3
S2= C(1-r)2 = 25,000(1-.05)2= 22562.50
S3= C(1-r)3 = 25,000(1-.05)3= 21434.38
Depreciation amount in 3rd Year = 22562.50 – 21434.38=
1128.13
Scrap Value or Salvage Value is the Book Value during the end of the
last year (S5) = 25,000 (1-.05)5 = 19344.52
What if r is not given? How to calculate r?

We can do it in excel by writing the Formula or use the inbuilt

Function (DB)
Thank you