Quantitative Techniques for Banking

Post Graduate Diploma

(Banking & Finance)
Term 1
Prof. Prashant Verma
Phone: +91149302459 Email: [email protected]
 TIME VALUE OF MONEY

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Objective

1. The time value of money concept

2. Relationship between present and future value.
3. Distinguish between an ordinary annuity and an annuity due.
4. NPV and IRR
5. Discounts and percentages
6. Simple and compound interest
7. Stocks and shares
8. EMI calculations/ amortization schedule

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 The Interest Rate

Will Rs.10,000 today same as Rs.10,000 in 5 years?

Obviously, Rs 10,000 today is more valuable.

You already recognize that there is TIME VALUE

TO MONEY!!

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 Why TIME?

Why is TIME such an important element in

your decision?

TIME allows you the opportunity to postpone

consumption and earn INTEREST.

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 Examples of Time Value of Money
Saving Account
Interest increases the amount with time
Loan
Payment amount
Retirement Annuity
Pays out constant amount per month
Pays out an amount that increases with inflation
per month

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 Types of Interest

Simple Interest
Interest paid (earned) on only the original amount, or principal,
borrowed (lent).

Compound Interest
Interest paid (earned) on any previous interest earned, as well as on
the principal borrowed (lent).

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 Interest

% interest

Time over which it is compounded

Day, Week, Month, quarter or year
Be careful with interest
Credit card statement 1.9% per month = 22.8% per year
simple interest, IS=ni
Credit card statement 1.9% per month = 25.34% per year
compound interest,
Total compounded interest = P (1 + r/m) (mt) - P
For P= Re 1; time = 1 year IC=[(1+i)m-1]

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 Some Nomenclature

V = Future value
P =Present value
r =nominal interest rate (% per annum)
i = interest rate for interest period = r /n
ny = no. of years
m = Number of periods per year
n = no. of interest periods = ny * m

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 Solved Example : Interest

Value when simple interest is considered:

V=P+Prn
= P(1 + r n )

1. An amount of Rs.5,000 is invested at a rate of 8 per cent per

annum. What will be the value of the investment in 5 years
time, if simple interest is added once at the end of the
period?
2. Calculate the value of the following, assuming that simple
interest is added:
(a) Rs.20,000 invested for 5 years at 5 per cent per annum;
(b) Rs.50,000 invested for 3 years at 6 per cent per annum;
(c) Rs.30,000 invested for 6 years with 1 per cent interest per
quarter.

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 Compound Interest
After 1 year,
P + P i n = P + P i = P( 1+ i)
During the second year
P + P r
P( 1+ i) + P( 1+ i) r = P( 1+ i) (1 + i) = P (1 + i )2
Similarly for n years:

Vn = P (1 + i )n
An amount of Rs.5,000 is invested at a fixed rate of 8 per cent
per annum. What amount will be the value of the investment in
5 years time, if the interest is compounded:
(a) annually?
compounding at
(b) every 6 months? intervals
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With slight modifications, the basic formula can be made to deal with
compounding at intervals other than annually. Since the compounding is
done at 6-monthly intervals ( of annual) , interest rate for the period will
be = r/n = 8/2 = 4 per cent; will be added to the value on each occasion.
Hence, we use i = r/2 = 0.04. Further, there will be ten additions of interest
during the five years, and so n = 10. The formula now gives:

V = P(1+ i)10 = 5,000 (1 + .04)10 =7,401.22

In a case such as this, the r= 8 per cent is called a nominal annual rate, and
we are actually referring to i = 4 per cent per 6 months.

What is the effective interest rate in above question? What is the annual
ratio?
Annual Ratio
The annual ratio: We can find the effective annual rate of
for 2 period
interest by considering the impact of two 4 per cent increases per year
on an initial value of Rs.1:
Value at the end of 1 year = P (1 + r )2 = 1x (1+ .04)x (1+ .04) = 1.0816
Annual ratio = 1.0816 = (1+ 0.0816) hence effective rate of interest is not 8
per cent per annum but from 8.16 per cent
 Quiz

An investor is considering two ways of

investing Rs. 20,000 for a period of 10 years:
option A offers 1.5 per cent compounded every 3
months;
option B offers 3.2 per cent compounded every 6
months.
Which is the better option?

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 Find the effective annual rates of interest
corresponding to the following:
(a) 3 per cent every 6 months;
(b) 2 per cent per quarter;
(c) 1 per cent per month.

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 V = P (AnnualRatio)n

Over 5 years a bond costing Rs. 1,000

increases in value to Rs. 1,250. Find the
effective annual rate of interest.
The 5-year ratio V/P = (AnnualRatio)n
= 1,250/1,000 = 1.25 = (annual ratio)5.
Hence, the annual ratio
5
= 1.25 = 1.0456 = (1+ r) ,
giving an effective annual rate of 4.56 per cent.
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 V = P (AnnualRatio)n

If house prices rise by 20 per cent per annum,

find:
(a) the equivalent percentage rise per month;
(b) the percentage rise over 9 months
V = P(1+ i)12 = P (monthly ratio)12
Where V =120, P=100
12
(a) Monthly ratio = 1.2 = 1.2 1/12= 1.0153, and the monthly
rate is 1.53 per cent.
(b) Nine-month ratio = V = P (monthly ratio)9
1.0153 9 = 1.1465, and the 9-month rate = 14.65 per cent.
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 (a) Find the effective annual rate if an
investment of Rs.500 yields Rs.600 after 4
years.
(b) If prices rise by 5.8 per cent over a year,
find the percentage rise over 6 months.

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 Present Value/Future Value

Determine the Present Value of an investment (or

payment) in the Future.
You are due a Rs.10,000 signing bonus to be paid to you after
you have completed 2 years of service with your new company.
What is the present value of that bonus given 7% interest?
Determine the Future Value of an investment made
today
What is Rs.10,000 worth if kept in a bank for 10 years at 3% per
year (compound) interest
Present value of retirement fund is Rs.300,000. What will it be
worth when I am 64 years old.

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 Student Loan

Bank gives Rs.10,000 in August 2009. Collects

interest at 5% until graduation in August 2013.
What amount the student owe upon
graduation?

F=P x (1+i)n =Rs.10,000 (1+0.05)4 = Rs.12,160

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 DEPRECIATION

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 Depreciation
The same basic formula can be used to deal with
depreciation, in which the value of an item goes
down at a certain rate. We simply ensure that the
rate of interest is negative.
Question:
A company buys a machine for Rs. 20,000. What will
its value be after 6 years, if it is assumed to
depreciate at a fixed rate of 12 per cent per annum?

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 A piece of capital equipment is purchased for
Rs. 120,000 and is to be scrapped after 7
years. What is the scrap value if the
depreciation rate is 8 per cent per annum?

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 In practice, rates of depreciation change over the lifetime of
an item. A motor car costing Rs. 21,000 may depreciate by 15
per cent in the first year, then by 10 per cent per annum in
each of the next three years, and by 5 per cent per annum
thereafter. Find its value after 8 years.

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 In practice, rates of depreciation change over the lifetime of
an item. A motor car costing Rs. 21,000 may depreciate by 15
per cent in the first year, then by 10 per cent per annum in
each of the next three years, and by 5 per cent per annum
thereafter. Find its value after 8 years.

P = 21,000, r = -0.15 for n = 1, then r = -0.1 for

n = 3, and finally r = -0.05 for n = 4
V = 21,000 *0.85 *0.903 *0.954 = Rs.
10,598.88
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 A machine depreciates by 20 per cent in the
first year, then by 10 per cent per annum for
the next 5 years, and by 2 per cent per annum
thereafter. Find its value after 7 years if its
initial price is Rs. 720,000.

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 The other type of problem associated with
depreciation is to work out how long it will take for
the value to drop to a particular level. Suppose a
machine valued at Rs. 500,000 depreciates at 6 per
cent per annum. How many years will it take for its
value to reduce to, say, Rs. 100,000?

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 More complex investments

A man invests Rs. 3,000 initially and then Rs.

1,800 at the end of the first, second and third
years, and finally Rs. 600 at the end of the
fourth year. If interest is paid annually at 6.5
per cent, find the value of the investment at
the end of the fifth year.

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 SINKING FUND

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 Sinking fund
A sinking fund is a special type of investment
in which a constant amount is invested each
year, usually with a view to reaching a
specified value at a given point in the future.
Questions need to be read carefully in order
to be clear about exactly when the first and
last instalments are paid.

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 A company needs to replace a machine
costing Rs. 50,000 in 6 years time. To achieve
this it will make six annual investments,
starting immediately, at 5.5 per cent. Find the
value of the annual payment.

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 GEOMETRIC PROGRESSIONS

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 A sinking fund could easily run for 20 years or
more in fact, the endowment element of
some mortgages is a very common example of
a sinking fund that would typically run for 20
25 years. In such cases Geometric Progression
is useful.

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 A, AR, AR2, AR3, . .+Arn-1.
Sum of the series is :

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 If six annual instalments of Rs.800 are made,
starting immediately, at 5 per cent per annum,
the value of the investment immediately after
the sixth instalment is given by the following
expression. Use GP theory to evaluate it.
Rs.800(1.055 + 1.054 + 1.053 + 1.052 + 1.05 + 1)

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 PRESENT VALUES

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 Using First Principle

Find the present value of:

(a) Rs. 200 payable in 2 years time, assuming that an
investment rate of 7 per cent per annum, compounded
annually, is available;
(b) Rs. 350 receivable in 3 years time, assuming that an
annually compounded investment rate of 6 per cent
per annum is available.

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 The present value of a quantity, Rs. V,
discounted at r per cent for n years is given by:

These approximate values can be obtained from PV table

thereby simplifying the calculations considerably

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 Calculate the present values of the following amounts. Use PV
tables where you can, and first principles otherwise:
(a) Rs.12,000 payable in 6 years time at a rate of 9 per cent;
(b) Rs.90,000 payable in 8 years time at 14 per cent;
(c) Rs.80,000 payable in 5 years time at 6.3 per cent;
(d) Rs.50,000 payable in 4 years and 3 months time at 10 per
cent.

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 NET PRESENT VALUES

In many situations, there are a number of financial inflows and outflows

involved, at a variety of times. In such cases, the net present value (NPV)
is the total of the individual present values, after discounting each.

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 A company can purchase a machine now for Rs.10,000. The
company accountant estimates that the machine will
contribute Rs.2,500 per annum to profits for five years, after
which time it will have to be scrapped for Rs.500. Find the
NPV of the machine if the interest rate for the period is
assumed to be 5 per cent. (Assume, for simplicity, that all
inflows occur at year ends.)

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 The fact that the middle four inflow values are the same
(Rs.2,500) means that the cumulative present value table
(provided in your exam) can be used to calculate the total PV
arising from an inflow of Rs.2,500 at a constant interest rate of
5 per cent for each of 4 years, starting at the end of the first
year:

3.546 is discount factor obtained from CPV table 5% against 4 years

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 ANNUITY

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 Examples of Annuities

Student Loan Payments

Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings

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 NPV of Annuity

The NPV of a Rs.1 annuity over t years at

interest rate r, with the first payment 1 year
after purchase.

Factor for NPV

This can also be referred from cumulative present

value tables can also be used

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 An investor is considering two annuities, both of which will
involve the same purchase price. Annuity A pays Rs. 5,000
each year for 20 years, while annuity B pays Rs. 5,500 each
year for 15 years. Both start payment 1 year after purchase
and neither is affected by the death of the investor. Assuming
a constant interest rate of 8 per cent, which is the better?

Using tables, the cumulative PV factors are

9.818 for A and
8.559 for B.
Hence
PV of annuity A = 5,000 * 9.818 = Rs. 49,090, and
PV of annuity B = 5,500 *8.559 = Rs. 47,074.50

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 You will notice that there is some loss of
accuracy, due to rounding errors, when tables
are used.
Using the above formula:

Refer Cumulative
PV table to
confirm this value

NPV = X* Factor for NPV =

NPV of annuity A = 5,000 * 9.818 = Rs. 49,090, and

NPV of annuity B = 5,500 *8.559 = Rs. 47,074.50

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 An investment is due to give payoffs with an NPV calculated at
Rs.20,000 and an assumed constant interest rate of 6 per cent
per annum. What annuity lasting for 10 years is equivalent to
the investment, in that it has the same NPV?

If the annuity pays Rs.x at the end of each of the next 10

years, then tables give its NPV as 7.360x. Hence:
7.360x = 20,000
x = 2,717.39
The equivalent annuity is thus Rs.2,717.39

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 An annuity pays Rs.12,000 at the end of each year until the death of the
purchaser. Assuming a rate of interest of 6 per cent, what is the PV of the
annuity if the purchaser lives for: (a) 10 years; and (b) 20 years after
purchase?
In order to practise both methods, use the tables in (a) and the formula in
(b)
(a) If n = 10 and rate is 6 per cent, from tables the annuity factor is 7.360:
PV = 12,000 *7.360 = Rs.88,320
(b) If n = 20, from the formula:
PV = 12,000 * (1/0.06 - 1/ (0.06(1.06)20)
= Rs.137,639.05

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 Tends
PV of a perpetuity to Zero

An investor is considering two annuities of perpetutiy , both

of which will involve the same purchase price. Annuity A pays
Rs. 5,000 each year, while annuity B pays Rs. 5,500 each year.
Both start payment 1 year after purchase and neither is
affected by the death of the investor. Assuming a constant
interest rate of 8 per cent, which is the better?

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 Loans and mortgages : repayment mortgages

A certain amount, Rs. M, is borrowed to be repaid over n years;

Interest (at a rate r) is added to the loan retrospectively at the end of each
year; and
A constant amount, Rs. P, is paid back each year by the borrower, usually
in equal monthly instalments (EMI).
Viewed from the standpoint of the lender, a repayment mortgage is an
annuity.
The lender pays the initial amount (M ) for it and in return receives a
series of constant annual payments (P ) for n years. The relationship
between these variables is given by putting M equal to the present value
of the annuity, using either tables or formula as appropriate

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 (a) A 30,000 mortgage is taken out on a property at a rate of 12 per cent
over 25 years. What will be the gross monthly repayment?
(b) After 2 years of the mortgage, the interest rate increases to 14 per
cent: recalculate the monthly repayment figure.

(a) Equating present values gives:

giving P = 30,000/7.843139 = Rs. 3,825 per annum (nearest Rs.) and a

monthly repayment of Rs. 318.75 (to two d.p.)

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 After 2 years, immediately after the second
annual repayment, the amount still owing is:

Rs. 30,000 in 2 yrs @ 12% - 1st EMI for 1 yr @12% - 2nd EMI

The mortgage now has 23 years to run and at 14 per

cent interest we have:

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 What are stocks?

A stock is a share in the ownership of a company. Stock represents a

claim on the companys assets and earnings.
As an owner (shareholder), you are entitled to your share of the
companys earnings as well as any voting rights attached to the
stock.
At some point every company needs to raise money. Companies can
either borrow it from somebody or raise it by selling part of the
company.
By issuing stock, the company does not have to pay back the money
or make interest payments.
By issuing stock, the company does not have to pay back the money
or make interest payments.
If the company does well, the stock will probably increase in value.
If the company does not do well, the shareholder may lose the
money he or she invested.

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 What are stocks?

IPO stands for Initial Public Offering. Its the first time the stock is
available to the public to purchase.
The stock exchange itself is a secondary market. The primary
market is the brokers.
A dividend is money that a company pays to its stockholders from
the profits it makes.
Not all companies pay dividends to their stockholders. The only way
shareholders in these companies make money is to sell the stock at
a higher amount than they bought it at on the open market.
Common stock is the type most people purchase. It represents
ownership of a company and a claim on part of the profits.
Investors get one vote per stock.
Preferred stocks dont have the same voting rights, but investors
are usually guaranteed a fixed dividend. If the company is
liquidated, they are paid off first.

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 Net Present Value: Project Evaluation:
Discounted Cash Flow
The difference between the market value of a
project and its cost
Discounted Cash Flow (DCF) Valuation:
Step 1: to estimate the expected future cash
flows.
Step 2: to estimate the required return for
projects of this risk level.
Step 3: to find the present value of the cash flows
and subtract the initial investment.
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 NPV Decision Rule

If the NPV is positive, accept the project

A positive NPV means that the project is
expected to add value to the firm and will
therefore increase the wealth of the owners.
Since our goal is to increase owner wealth,
NPV is a direct measure of how well this
project will meet our goal.

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 Computing NPV for the Project

You are looking at a new project and you have

estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120;
Year 2: CF = 70,800;
Year 3: CF = 91,080;
Your required return for assets of this risk is 12%.
NPV = 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 165,000 = 12,627.42
Do we accept or reject the project?

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 Calculating NPVs with a Spreadsheet

Using the NPV function

The first component is the required return
entered as a decimal
The second component is the range of cash flows
beginning with year 1
Subtract the initial investment after computing
the NPV

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 Internal Rate of Return

Definition: IRR is the return that makes the NPV = 0

Decision Rule: Accept the project if the IRR is
greater than the required return
This is the most important alternative to NPV
Often used in practice
Intuitively appealing
Based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
Compute using trial and error process
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1. find a discount rate at which NPV is small and positive;
2. find another (larger) discount rate at which NPV is small and
negative;
3. On graph use linear interpolation between the two to find the
point at which NPV is zero

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 Find the IRR for the following project:

The question offers no guidance as to what

discount rates to try, so we will select 5 per cent
randomly. Since 5 per cent turns out to give a
positive NPV we now randomly select 10 per cent
in the hope that it will give a negative NPV

9.7

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 Calculating IRRs With A Spreadsheet

You start with the cash flows the same as you

did for the NPV
You use the IRR function
You first enter your range of cash flows, beginning with the
initial cash flow
You can enter a guess, but it is not necessary
The default format is a whole percent you will normally
want to increase the decimal places to at least two

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