FINANCIAL MATHEMATICS

1.0 INTRODUCTION
Financial Mathematics is a collection of mathematical techniques that find applications in Finance
related areas.
1.1 INTEREST
Introduction
Interest is amount one earns when a sum of money is invested in a bank account or otherwise. The
term can also be used to mean what is paid over and above a sum of money one borrows.
The amount which is borrowed or invested is called the principal.
Either way there are two ways of dealing with (calculating) interest. These are:
a) Simple interest
b) Compound interest
1.1.1 Simple interest
Simple interest is interest calculated on a fixed principal amount.
For a principal P, invested at a rate of R% per annum, over T years, simple interest I is given by

Example 1
How much interest would K10,000 earn at 8% per annum simple interest over 15 years?
Solution:

TASK 1
Jamadi wants to earn K500,000 in interest so that she can have enough money to buy a good used
car. She puts K800,000 into an account that earns 6.5% p.a. simple interest. How long will she
need to leave her money in the account to earn the K500,000 interest?
TASK 2
A man invests 10,000 in a bank account for 3 years at 5% simple interest. After the 3 years he is
enticed to put all the money back into the account because the bank has offered him 10% p.a.
simple interest. If he does not withdraw any money, calculate the total amount he will have in the
account after a further 3 years.
1.1.2 Compound interest
While simple interest calculates the interest on a fixed principal period after period, compound
interest arises when interest earned in one period is added to the principal, so that the interest that
has been added also earns interest.
Example 2
Calculate total interest and the amount in the account earned when K1000 is invested at 10%
compound interest for 4 years.

Compound interest formula and calculation

Assuming a sum P is invested in an account at a rate of r% for t years, the accrued (sometimes
called the terminal) amount A in the account after t years is given by:

TASK 3
K300,000 is invested for 4 years at 10% compound interest. Find the terminal value and interest
gained after the 4 years.
Example 3
Kuganizira Ltd sells company vehicles to the officers using the vehicles when the car is 4 years
old. The car is sold to the employee at 10% the purchase cost. Charles is using one such vehicle
which cost the company Mk8,500,000 to buy and he is looking forward to buying it in three years
from now. In order not to miss the chance, he has been advised to set aside some money for the
purpose. How much should he invest into an account now to buy the vehicle if the fund he is to
use pays 12% compound interest per annum.
Solution.

TASK 4
Ethel left K150,000 in her account at the bank, while going on study in the UK two years ago. She
has come back and has found a total amount of K174,960.00. What was the rate of interest
assuming the rate never changed in the period?
TASK 5
Wonga has identified a fund which pays a good 14% compound interest. She has K450,000 which
she can invest. For how long should she invest the money to realize a total of K900,000 to buy a
dream plot.
Compounding at shorter periods
Apart from the annual basis, compounding can be at shorter periods like half-year, quarterly,
monthly, weekly, or even daily.
When compounding is done more frequently than once a year, it earns even higher interest
amounts. As it will be demonstrated in the example below, the shorter the compounding period in
the year, the larger the amount relatively.
Note:
In general, if an amount P is invested under compound interest which is done n times in year at a
rate of r% per annum, over t years, then the accrued amount is given by

Example 4
300 000 is invested at 12% per annum. Find the amount at the end of 4 years if compounding is:
a) annually
b) ½ year
c) quarterly
d) monthly
Solution:

The effective rate of interest (ERI)

Compound interest results in a higher terminal value because of the fact that interest earns further
interest when it is added back to the principal. The given annual rate is called the nominal rate and
the rate final rate resulting from compounding is called the effective rate of interest sometimes also
called the Actual percentage Rate (APR).
Example 5
Given a nominal rate of r=12% per annum, find the effective interest rate if compounding is done
a) Quarterly
b) Monthly for one year
Solution

1.2 DEPRECIATION
Any asset purchased and is being used, will get worn out or lose its value at a certain rate during
its lifetime.
Depreciation is the term used to mean the part or proportion of the asset being consumed away
or the loss in value.
For example, a bus bought by Axa now at say K20,000,000 will be worth only 12,000,000 in 3
years’ time due to wear and tear. The 8,000,000 declines in value is the depreciation over the 3
years.
Note that when depreciation is allowed for (charged), the value of the asset or loan amount
declines. The resulting value is called The Net Book Value (NBV).
There are several techniques which can be used to calculate depreciation. These include
i. Straight line depreciation
ii. Sum of digits
iii. Reducing balance
1.2.1 Straight line depreciation
Straight line depreciation is when the value of an asset is reduced by fixed equal amounts over the
life of the asset.
The amount of depreciation charged each year under straight line depreciation, also called the
annual depreciation value, is calculated as follows

Scrap value is the residual value of an asset after its useful period. It is usually measured by how
much it can fetch if sold after its useful life.
Example 6
A machine needs to be depreciated from K25,000 to K5000 over a period of 5 years using straight
line method. Find:
a) Depreciation charge per annum
b) The net book value at the end of 3 years
Solution:

1.2.2 Sum of digits

The “sum of digits” technique of calculating depreciation uses the digits of the years (i.e., year 1,
2, 3, 4, etc.) of the useful life of the asset in reverse as weights to calculate depreciation charge for
the years. If the asset is to be depreciated over 3 years, the first year gets a weight of 3, the second
2 and the last gets 1. This way depreciation is high in the early years of an asset.
Example 7
Based on example above calculate the depreciation charges for each year and then calculate the
NBV.
1.2.3 Reducing balance method
Under reducing balance method depreciation for each year is a proportion of the net book value as
at the beginning of that year. The proportion or rate remains fixed unless deliberately changed
For an asset with an Original Book Value B, depreciating at a rate of r%, the depreciated value or
NVB of the asset at the end of the nth year is given by:

Example 8
A main frame computer costing K220,000 will depreciate to a scrap value of K12000 in 5 years
a) If reducing balance method is used find the depreciation rate?
b) What is the book value of the computer at the end of the 3rd year? What is the depreciation
charge for the year?
c) How much more would the book value be at the end of the 3rd year if we use straight line
method?
Solution:
1.3 DISCOUNTING
Discounting is connected to the concept of time value of money. Time value of money refers to
the fact that the same amount of money occurring at different time points will have different values
or will purchase different quantities of similar goods due to among many factors, inflation.
Specifically, Money loses value with time. The idea that money available at the present time is
worth more than the same amount in the future due to its potential earning capacity makes it
difficult to compare sums of money realized at different times. This concept is referred to as time
value of money. Discounting helps to determine this time value of money.
Definition
Discounting is the process of measuring how much a future sum of money is worth now. In other
words, discounting is the process for finding the present value of money.
Note that discounting is the reverse of compounding.
Given a future sum A, discounted a rate r% for n periods, its Present Value is given by:
Example 9
Mrs Kalima expects to earn K500,000 from her maize seed project this time next year. Find the
present value of the earnings if the rate of interest on the market is 10%
Solution

TASK 6
Mr. Kalima intends to sell his pickup 3 years from now for about K700,000. Advise him as to how
much that sum is worth now if the rate of interest is 8%
TASK 7
A departmental store advertises goods at K70,000.00 deposit and 3 further equal annual payments
of K50,000.00. If the discount rate is 8%, calculate the present value of the goods.
Discounting Factors
A discounting factor the is the present value of one unit currency (One Shilling in our case)

Example 10
Use discounting factors to calculate the Present values of the cash flow in TASK 7 above.
Solution
While discounting factors can be calculated on a calculator using the formula presented above,
tables of already calculated discounting factors are available as shown below. Note that the factors
are calculated to three decimal places only.
1.4 CAPITAL (INVESTMENT) APPRAISAL
Capital appraisal (or investment appraisal) is process used to determine whether long term
investments such as new machinery, replacement of machinery, new plants, new products, and
research development projects are worth pursuing.
Many formal methods are used in capital appraisal and the common ones include:
• the payback period
• The Net present value (NPV)
• Internal rate of return
 • Accounting rate of return
• Return on capital employed
1.4.1 The pay back method
Payback period refers to the period of time required for the return on an investment to "repay" the
sum of the original investment. For example, a K200,000 investment which returned K50,000 per
year would have a four-year payback period. Payback period intuitively measures how long
something takes to "pay for itself."
In essence, shorter payback periods are preferable to longer payback periods.
Example 11
A business project is being considered which requires K240,000 initial capital outlay. Net revenues
over the following 4 years of K80,000.00, K70,000, K50,000.00 and K65000.00 respectively.
Calculate the payback period state whether the project is worthwhile if the expected payback
period is three years or less.
Solution

Advantages of payback period

Payback period has the following advantages:
i) It is simple to calculate
ii) It is easy to understand
iii) It is practical (It uses actual cash flows) the payback period itself can be set to reflect reality.

Disadvantage of payback period

it ignores the time value of money.
1.4.2 The net present value of cash flows
A project is expected to have cash outflows and cash inflows. A net present value (NPV) of a
project is the sum of the present values of all cash flows associated with the project.
A project would be considered worthwhile if the net present value is positive.
Example 12
Consider the example 11 and decide whether or not the project is worthwhile using the NPV
technique given the cost of capital on the market is 13%
Solution

.
TASK 8
Chikondi is buying a machine costing K120,000 for a small-scale business. In order to run it he
will spend K85,000 in the first year, K30,000 in the second, k15,000 in the third year and a further
K15,000 in the fourth year. Revenues expected from the business are K80,000, K120,000,
K100,000 and K65,000 in the 1st, 2nd, 3rd, 4th years respectively. If the cost of capital is at 15%
per annum, advise Chikondi as to whether the business is viable.
1.4.3 The Internal Rate of Return (IRR)
The internal rate of return is a discounting rate which would give an NPV of Zero.
When calculated the decision on whether to proceed with the project or not is determined by
comparing the IRR with the known desired rate of interest. If this rate is higher than the cost of
capital or desired rate, the project is considered viable.
Techniques for calculating the IRR
The internal rate of return can be calculated using either algebraic or the graphical techniques
The algebraic method
Example 13
A person invests K500 000 in a project. If the project gives a net inflow of K700 000 for 1 year
only, find the IRR. Using the IRR decide if the project is worthwhile given a cost of capital of 12%
on the market.
Solution

Since the cost of capital is the IRR is greater than the cost of capital (12%) then the project is
worthwhile.
Therefore IRR =40%. The rate on the market is 12% project worthwhile.
TASK 9
A project requires an initial investment of MK500,000 and yields MK300,000 and MK250,000 in
the 1st and 2nd years respectively. Calculate the IRR and comment on the project considering the
rate of interest on the market is 20%.
The graphical technique
Procedure:
􀁸 Choose any two different discount rates different (neither of them should equal the desired
discounting rate)
􀁸 Draw a pair of axes (NPV against discounting rate). Plot two sets of points (rate and
corresponding NPV) on a graph.
􀁸 Draw a line through the two points and note the point where the graph cuts the discount rate
axis. The value of the discount rate coordinate for this point is the IRR
Example 14
Calculate the IRR for the project in TASK 9 above.
Solution:

Example 15
Calculate the IRR for problem in TASK 9 using the formula.
Solution
From the solution of example 14, a = 6%; A = 5517.98
b = 7%; B = -1266.49

1.5 ANNUITIES
An annuity is a sequence of fixed amounts of payments at regular intervals.
1.5.1 Classification of annuities
Based on time of payment/receipt
- Ordinary annuity-an annuity in which payments are made at the end of time interval
- Due annuity-an annuity in which payments are made at the beginning of the time interval
Based on term of the annuity
- Certain annuity- dates of beginning and ending of the annuity are fixed
- Contingent annuity- annuity whose end date depends on some uncertain event to occur
Perpetuity an annuity which goes on indefinitely.
Example 16
George is buying a plasma screen worth K460,000 and has agreed to pay a deposit of K100,000
and the balance in 12 equal monthly instalments. Identify the annuity part.
Solution.
Balance after the deposit = K460,000 – 100,000 = 360,000
Instalment: = 360,000/12
= 30,000 per month
The annuity is the sequence of the K30,000s payable every month.
1.5.2 Areas of application
A lot of payments or receipts occur in form of annuities. Good examples are pension payments
over time, insurance premium payments, settlement of consumer goods bills inform of instalments
for a number of months.
Of interest are the future value to which these sums accumulate and of course given a number of
payments, their net present value. Further analyses also deal with the problems of determining how
much payments should made be to accumulate to a desired value.
The basic tools in dealing with annuities include the geometric progression, compounding and
present values.
1.5.3 Future (maturity) value of an annuity
There are basically two methods for calculating the future value of an annuity.
a) Creating an annuity schedule which shows the value of the fund period by period taking into
account new payments at each period and all accumulating interests.
b) Considering accrued value of each payment as a term of a geometric progression (GP) and using
the formula of sum of terms a GP to find the total maturity value of the payments
Example 17
Mr. Yona is investing a fixed amount of K50,000 into a fund every year in advance for 5 years. If
the fund earns an interest of 6.5% per annum:
a) Construct a schedule to show the value of the fund at the end of each year.
b) Use an appropriate formula to calculate the value of the fund at the end the five years.
Solution
1.5.4 Present value of an annuity
Apart from the future value of an annuity another important concept is that of the present value of
the annuity. The calculation can involve discounting factors or another formula derived from the
geometric progression formula.
Calculation (discounting factors)
Assuming the same stream of fixed amounts A set aside for n years, the present value (actually the
net present value) of these amounts can be shown to be

Factoring out A we have

The part in brackets is simply cumulative discounting factor which can be obtained for a calculator
or standard tables.
Example 18
A man will earn K200,000 in rentals at the beginning of each year for five years. Find the present
value of the rentals if the cost of capital is 8%.
Not that the rentals are at the start of the year and therefore the first figure has discounting factor
= 1 because it is at Present or “now”.
Using geometric progression
If viewed a geometric progression point of view:

Example 19
A lady is promised a fixed monthly salary of K15,000 for the next 5 years following her injury
which incapacitated her. Find the present value of the monthly salaries if the rate of interest on the
market is 6% per annum
Solution
This is a case for a geometric progression particularly because of the many terms involved (60)
and very few tables can give that many discounting factors). Salaries are paid in arrears.
1.5.5 The present value of a perpetuity.
As stated above a perpetuity is an annuity which goes on indefinitely.

Example 20
A mineral prospecting company discovers rare earth mineral whose belt runs into the home of Mr.
Chimbuzi,s family land. To be able to extract the mineral they must negotiate a payment in order
to have the Chimbuzi’s family relocate. They agree on a payment of K100,000 to the family at the
beginning of each year for as long as they mine the mineral. Experts estimate that the mineral
deposits are in abundance that they cannot estimate the years it will last. Estimate the present value
of the payments to the Chimbuzi’s if interest rate is 7%.
1.5.6 Amortization and sinking fund.
Amortization is the term used to mean reducing or wiping out a debt or a sum of money over time
through an annuity. When a debt has been wiped out by amortization it is said to be amortized.
The amount A necessary to amortize a debt P over n years at an interest rate i=r% is given by.

Example 21
A company borrows K5, 000, 000 with interest at 5% compounded 6-monthly is amortized by
equal semiannual payments over the next three years. Find the value of each semi-annual payment.
Solution
Let the semi-annual payment be A

A sinking fund is an annuity set aside to help repay a debt or buy an asset. Typically, one is
required to make periodic payments into the fund and normally these payments would earn an
interest. The payments would be made in such away as that future value would be sufficient to pay
the debt or for the asset.
Example 22
Chiko wants to buy a car estimated to cost K850,000 car in 18 months’ time. The plausible way to
save money for it is to set aside a certain amount of money on a monthly basis and invest it at an
interest-bearing account, The account possible is one at a bank paying an interest rate of 12% per
annum Compounded monthly.
a) How much should Chiko be setting aside each month,
b) Prepare a sinking fund schedule for the first six months.
Solution
a) Interest =12% pa; therefore, monthly rate =12% ÷ 12 = 1%
Let the amount to be set aside be A
Assuming the amounts are invested at the start of each month, the future value F, of
the streams of money is

This is a geometric a geometric progression and the future value is the sum of the n terms (number
of payments or instalments).

(b) The sinking fund schedule is as follows

Sinking fund Table
ASSIGNMENT 1
1. An employee, who received fixed annual increments had a final salary of K90,000 after 10
years. If her total salary was K650,000 over the 10 years what was her initial salary?
2. A firm buys a power press for 32,500 which is expected to last for 20 years and to have a scrap
value of K7,500. If depreciation is on a straight-line method how much is the deprecation charge
per year.
3. Insert 5 numbers between 8 and 26 such that the resulting series is an AP
4. Which term in the GP 2, 4, 8, 16 is 1024
5. A local bank is advertising that you can double your money in eight years if you invest with
them. Suppose you have K2000 to invest. What interest (simple) rate is the bank offering
6. Wezi has K50,000 to invest, and two funds that she can use are available: one at Last Discount
house offering 14% simple interest and the other at Fist Discount House which pays 6% interest.
Wezi only needs to earn K4,500 in interest this year and she really wants to try both banks How
much should she put in each fund
7. A company sets up a sinking fund and invests K10,000.00 each year for 5 years a 9%. Compound
interest, what will the fund be worth after 5 years?
8. Calculate the sum of the terms in the following sequence: 1, ½, ¼, 1/8, 1/16......
9. Mr. Banda’s company is considering an investment costing K5.6 million which would earn
K1.6million cash per annum for five years. The Company expects to make a return of at least 11%
per annum. Assess whether or not the project is viable.
10. At the beginning of each year a company sets aside K2 million out of its profits to form a
reserve fund. This is invested at 10% p.a. compound interest. What will be the value of the fund
after four years?
11. On 1 January 2003, K0.2 million was invested. It remained invested and on 1 January of each
successive year, K0.1 million was added to it. What sum would have accumulated by 31 December
2007 if interest was compounded each year at 10% p.a.?
12. K4 million is borrowed from a building society, repayable over 20 years at 14% p.a. compound
interest. How much must be repaid each year?
13. A firm has bought an asset worth K500,000 which has a life of 10 years where its scrap value
will be zero. As per its practice the firm will sell the asset at the end of the 5th year and it wishes
to select a depreciation technique, which will result in a lowest NBV at the time of selling in order
not to overvalue the asset. Calculate the NBV at the end of 5 years using the straight line, sum of
digits and reducing balance techniques and suggest the suitable technique, according to the firms
wish.
14. Find the PV of a debt K2500.00 taken out over 4 years (with no intermediate payments) where
the borrowing rate is 12% and the worth of money (Discounting rate) is 9.5%. How much is the
cost of this debt?
15. Find the present value of 150,000 to be received in 5 years’ time. Rate of interest is 12% (use
the discounting factor method)