Basic Finance Sheet

Nottingham University Business School
2015 David P. Newton
BASIC FINANCE TECHNIQUES

This is a handout on some basics. It is not required reading; however, many of you in
the tutorials I gave after Lecture 2 had difficulties with some of the details in questions,
particularly with the one that was apparently the easiest: the first question (thats why I
set it). Its the easy things that most often catch people out.
I hope this extra handout will help. I guess you might find the section on continuous
compounding useful (note Figure 6).
There is no need to memorise formulae for elementary things such as conversion of rates
between different time periods (often, you can do this in your head); I needed to express
the methods on paper, you need to be able to perform the calculations in whatever
manner you prefer, so long as you can get the right answers.
David Newton
Discounted Cash Flow and Net Present Value

The concept underlying discounted cash flow (DCF), present value (PV) and net present
value (NPV) is one of the most important in basic finance. Mathematically, the process
is merely the inverse of that for compounding interest, with a discount rate substituted
for an interest rate. It is complicated by the difficulty of choosing an appropriate rate
at which to discount. Before you read on, remember that financial calculations can be
no more exact than the numbers fed into the equations; if the numbers are approximate
then so will be the answers from the equations!
People sometimes find themselves able to perform DCF, PV and NPV calculations but
are quietly puzzled by what they have done. Sometimes, this is because they have
forgotten the ideas of simple and compound interest (their textbooks proceed directly to
discounting) and theyre slightly embarrassed by not properly remembering what they
were taught at school. Sometimes, theyre happy with interest calculations and with the
mechanics of DCF and NPV but they dont see why any particular number should be
used as the discount rate - so they use a number they find in a textbook (ten percent is a
convenient figure!) or a number used by most people doing similar calculations in their
company or in their university.
To those who do not fully remember what they were taught about simple and compound
interest at school: dont worry; its here - and with the consolation that maybe there are a
few points not taught in school. There is more here than at first appears. For example,
consider some rate of interest on a loan say 0.5 p.a. (i.e. 50% interest per annum), for
six months only; would you prefer to be paid simple interest or compound interest?
Answer: for periods longer than the interest period (here = 1 year) you'd prefer
compounding but for lesser periods simple interest (surprisingly?) pays more! I leave it
to you to read on and check this.

Interest on Investments
Simple Interest
Suppose that today you borrow from me 100 and agree to repay me, one year from
today, with 100 plus one tenth (10%) of that amount as interest. The amount which
you would repay us would be calculated as:
100 (1 + 0.1) = 110.
Suppose, instead, that I agree to lend you the money for four years with "simple interest"
set at ten percent (10%) each year (in Latin: "per annum" or "p.a.") and that all money
owed to us should be paid together, after four years. The amount which you owed
would grow like this:
Today
100
1 Year
110
2 Years
120
3 Years
130
4 Years
140
After four years had passed, you would repay me with 140. Notice that after one year the
amount owed continues to grow by the same amount (10) each year; interest is only being
charged on the original sum (100), not on the amount owed in the previous year. For
example, after two years the amount owed is 110 plus ten percent of 100 (110 + 10 =
120) NOT 110 plus ten percent of 110. For this reason, it is called "simple interest".
If we represent time, measured in years, by the symbol t, then the amount owed may be
represented by the equation
Amount owed = 100(1+0.1t)
The sign may be dropped because we know our equations refer to financial value and
the particular currency used is irrelevant to our discussion. The interest rate (here: 0.1,
giving 10 interest on 100) can be replaced with a general symbol, r, to represent all
possible rates:
Amount owed = 100(1 + rt)
The "amount owed" could also be called the "future value" or "FV". To distinguish this
from future value using compound interest, which we will consider later, it will be called
FVsimple. The amount lent can be called the "present value" or "PV", allowing us to
write a general formula for the calculation of simple interest:
FVsimple = PV(1 + rt)

Example
PV
r
t
FVsimple
= 100
= 0.1
=4
= PV(1+rt)
= 100(1+0.4)
= 140
the amount initially lent

interest rate = 0.1 (as a percentage: ten percent)
since repayment will be made four years later
This is the result you have already seen: 100 lent

at simple interest of ten percent returns 140 after
four years.
Periodic versus Steady Accumulation of Simple Interest

Originally, I specified the amounts which you would owe me at the end of each
successive year (110, 120, 130 and 140). These amounts are represented in Figure
1.
Figure 1
Simple Interest on $100
150
FVsimple / dollars
140
130
120
110
100
90
0
Time / years
We could agree that the amount which you owe me increases only once per year. This
would be of practical importance if we also agreed that our arrangement could be
terminated by repayment of the amount owed at any time. In this case, the amounts
payable would change as represented in Figure 2. This would mean, in effect, that we
had agreed that the equation for calculating the amount owed would only apply when
whole numbers of years had passed. In other words, it would be understood that t in the
equation FVsimple = PV(1 + rt) could only be given an integer value (1, 2, 3, ...).
Look at Figure 2 and consider the amount payable if the full repayment
were to be made after one and a half years. If 1.5 is substituted for t in the
equation, the result is 100(1+0.15) = 115. Clearly, the agreement calls for
the true value of t to be rounded down to the nearest integer (1.5 replaced
by 1) so that the amount payable is 100(1+0.1) = 110.

Do note that Figure 2 could be wrongly interpreted as showing two values

for FV at each integer year (1, 2, 3, 4) but that what is meant is a sudden
change to the upper value (at 1 year, 110 is meant, at 2 years 120 is meant,
etc.)
Figure 2
Figure 3
Simple Interest on $100 (Periodic)
Simple Interest on $100 (Steady)
140
140
130
130
120
120
110
110
100
100
90
90
0
Time / years
Time / years
Alternatively, since the points on Figure 1 clearly all lie on one straight line, we could
agree that the amount which you owe increases steadily, as represented in Figure 3. Now
any value for t can be substituted into the equation FVsimple = PV(1 + rt) and the
correct answer, for steady accumulation of simple interest, is obtained.
In Figure 3, steadily accumulated simple interest at 0.10 p.a. (10% p.a.)
after one and a half years gives FVsimple = 100(1+0.15) = 115.
Now an important point will be emphasised, though it might not seem so at this stage. If
interest is accumulated steadily then future value can be calculated over a total time
which is not an integer multiple of the unit of time used in the interest rate. In plainer
English, using the example, even though the rate is 0.10 per year (10% p.a.), steadily
accumulated interest can be calculated for 1.5 years, or any other value, using the
equation given. Graphically, in Figure 1 only points at integer values of years are shown
but intermediate values can be calculated, as shown in Figure 3. A similar situation
exists for compound interest but in that case there is more possibility for confusion - and
then you may find that returning to consider simple interest may help you with
compound interest.

Conversion Of Simple Interest Rates To Different Time Periods

Usually, compound interest is used in finance. However, it is often the case that over
short periods of up to a few months simple interest is used. Although it may appear
logically inconsistent to mix simple and compound interest in a financial calculation, in
practical finance convenience is key; use of simple interest over short periods is little
different from using compound interest. Consequently, it is sometimes necessary to be
able to convert a simple interest over a certain period of time to its equivalent over a
different period.
Rather than immediately giving a formula for the conversion between interest rates over
different time periods, first Ill show you an example which may make the idea behind
that formula more obvious. The formula for calculating future values was derived
earlier:
FVsimple = PV(1 + rt)
Using this formula, if the simple interest rate per six month period is 10% then a debt of
100, without repayment, increases as shown in the table below. Taking as an example
the amount owed after two periods of six months, FV = 100(1+0.2) = 120. Clearly, we
can see that this is an annual interest rate of 20%.
6 month
Period
1
2
3
4
5
6
FV
110
120
130
140
150
160
12 month
Period
1
2
3
If the measurement of time in six month periods is replaced by measurement in years

then the periods 2, 4, 6 become 1, 2, 3 and the appropriate interest rate changes from
10% per period (of six months) to 20% per period (of one year). Repeating this using
two years instead on one, we get FV = 100(1+0.4) = 140. The number 0.4 is obtained
by multiplying 0.2 by 2 when a time period one years, or by multiplying 0.1 by 4 when a
time period is six months.
In converting from time periods measured in multiples of six months to time periods
measured in multiples of twelve months the interest rate changed from 10% per period
to 20% per period. To distinguish between the two rates and two time periods,
subscripts a and b will be given to r and t.

The general formula for conversion is:

Formula
ra t a rb t b
Example
(0.2)1= (0.1)2 = 0.2
Remember: ra and ta use a time period different from that used for rb and tb
If three of the variables in this equation are known then the fourth can be calculated.
For example, a rate of 20% p.a. (0.20) is equivalent to a six-month rate, r,
given by:
6
(0.20)
12
010
.
since
rb
ta
ra
tb
Similarly, if each month has 30 days then an interest rate of 6% (0.06) over
three months is equivalent to a rate, r over fifteen days, given by:
15
r
(0.06) 0.01
90
and, conversely, a rate of 1% (0.01) over fifteen days is equivalent to 6%
(0.06) over three months:
90
r
(0.01) 0.06
15
Compound Interest
Suppose that today we agree that I should lend you 100 for four years at 10% interest,
"compounded" annually, and that all money owed to me should be paid together, after
fours years; in other words, the same arrangement as described for simple interest, but in
this instance accumulating "compound" interest. The amount which you owed me
would grow like this:
Today
100
1 Year
110.00
2 Years
121.00
3 Years
133.10
4 Years
146.41
After one year, the amount owed is identical to that owed using simple interest; 100
plus 10% of 100. The difference between simple interest and compound interest is that
simple interest involves accumulating interest on the original sum (PV) only but
compound interest includes interest on the original sum and also interest on the interest
accumulated in earlier periods. Compound interest on 100 accumulates as shown
below:

Year 0 100
Year 1 10% interest is charged on 100 and so 100 becomes 110
Total: 110
Year 2 100 becomes 100 + 10 (100 plus interest, as before)
10 becomes 10 + 1 (10 interest from Year 1, PLUS interest on that)
Total: 121
Year 3 100 becomes 100 + 10 (100 plus interest, as before)
10 becomes 10 + 1 (10 interest from Year 1, PLUS interest on that)
10 becomes 10 + 1 (10 interest from Year 2 PLUS interest on that)
1 becomes 1 + 0.1 (1 interest from Year 2, PLUS interest on that)
Total: 133.1
Year 4
You may easily show that the sum of the figures above, plus 10% interest on
each, is 146.41.
Once you have appreciated how interest is charged on interest from earlier periods, a
more straightforward way of showing the compounding process is:
Time / years
0
1
2
3
4
Amount owed / dollars

100.00
100(1 + 0.1) = 110.00
110(1 + 0.1) = 121.00
121(1 + 0.1) = 133.10
133.1(1 + 0.1) = 146.41
Since the amount for each year is 1.1 times the amount for the preceding year, the
amount for any year in general, "t", is given by
Future value, FV = 100*(1+0.1)t = 100*1.1t
The value today (here 100) is the "present value", PV. Generalising to any interest
rate, r, and any value of t, we have
Future value, FV = PV(1 + r)t
As FVsimple has already been distinguished by its subscript, there is no need to specify
FVcompound and so FV will be used to represent future value under compound
interest. It is sometimes convenient to distinguish between future values at different
times using a subscript showing the time. For example, future values at one year and
two years could be represented by FV1 and FV2. Thus, in textbooks, you may see the
general equation written as FVt = PV(1 + r)t. , where you are expected to understand

that compound interest is meant and that the subscript, t, is just a label emphasising the
time for which a particular FV is calculated.
Before electronic calculators and computers were available, compound interest tables
were published to help with calculations of future values. These are also known as
tables of future values or tables of future value factors. Although such tables are now
practically redundant, you may still encounter them. A limited range of values are
shown in Table 1. You might like to check one or two of these, using a calculator or
computer, setting PV = 1 in the equation for FV.
Table 1
Future value of 1 after t Years (Compound Interest)
Rate:
Years
1
2
3
4
5
6
7
8
9
10
10%
20%
30%
40%
50%
1.1000
1.2100
1.3310
1.4641
1.6105
1.7716
1.9487
2.1436
2.3579
2.5937
1.2000
1.4400
1.7280
2.0736
2.4883
2.9860
3.5832
4.2998
5.1598
6.1917
1.3000
1.6900
2.1970
2.8561
3.7129
4.8268
6.2749
8.1573
10.6045
13.7858
1.4000
1.9600
2.7440
3.8416
5.3782
7.5295
10.5414
14.7579
20.6610
28.9255
1.5000
2.2500
3.3750
5.0625
7.5938
11.3906
17.0859
25.6289
38.4434
57.6650
For example, 100 invested at 50% p.a. compound interest

for ten years would become 100(57.6650) = 5,766.50.
Note that, to four decimal places, (1 + 0.50)10 = 57.6650.
In some textbooks, in which the numbers in the table are called
future value factors, or FVF, a pair of subscripts is used to
identify the interest rate per period and number of periods:
FVFi,n. Thus, FVF0.50,10 = 57.6650.
Reinforcing what will doubtless be asked in class: yes, do use a calculator with
"scientific functions"; in particular logarithm, exponential, power and roots (= 1/power).
A memory for equations which can be recalled & used is useful too.... but thatll get you
in trouble with university rules in examinations...

Periodic versus Steady Accumulation of Compound Interest

Compound interest was introduced using an interest rate of 0.10 p.a. (10% p.a.). This is
a convenient rate for both simple and compound interest because the numbers arising in
calculations quickly become familiar, making it easy to concentrate on finance rather
than arithmetic. Suppose we agree that the 100 we lent you should be charged at 50%
p.a. interest instead of 10%; a handsome arrangement for me! Also, it will make the
graphs I want to show you clearer. 100 at 10 % p.a. and 50% p.a. grows like this:
At 10% p.a.
At 50% p.a.
Today
1 Year
2 Years
3 Years
4 Years
100
110.00
121.00
133.10
146.41
100
150.00
225.00
337.50
506.25
These numbers can be calculated from FV = PV(1 + r)t
or read directly from Table 1 (multiplying by 100).
The amounts for 50% p.a. are represented in Figure 2-4 (the straight line for steady
simple interest at 50% is included, for comparison).
Figure 4
Compound Interest at 50% on $100
600
FV / dollars
500
400
300
steady simple
interest at
50%,
for
200
100
0
0
Time / years
You have seen how simple interest can be accumulated periodically or steadily. A
similar argument can be followed here. We could agree that the amount which you owe
increases only once per year, in which case, the amounts payable would change in stepwise fashion, as shown by one of the lines in Figure 5. This is periodic accumulation.
When simple interest was considered, the next stage in the argument, in effect,
concerned the smooth joining of the dots in the graph (Figure 1)! This did not seem
difficult, since the dots all fell on one straight line and the straight line was represented
by the equation for FVsimple. In Figure 4, the dots clearly do not lie on a straight line
but we do have an equation for the curve which joins them:
Future value, FV = PV(1 + r)t

This equation gives the smooth curve, for steady accumulation of compound interest,
shown in Figure 5. This is an important result. Even though interest is compounded
annually, compound interest can be accumulated and calculated for times which are not
integer numbers of years.
In Figure 5, steadily accumulated compound interest at 0.50 p.a. (50% p.a.)
after one and a half years gives FV = 100(1+0.50)1.5 = 183.71.
Alternatively, if the agreement were for periodic accumulation, with interest
added only at integer numbers of years, then the amount owed would have
been as shown by the stepped line (the amount owed jumps
discountinuously, as in Figure 2 for simple interest, but in order to make the
diagram clearer where this occurs, dotted lines have been drawn in this
case). The true value of t would be rounded down to the nearest integer
(1.5 replaced by 1) and the amount owed would then be given by
100(1+0.50)1 = 150. These results hold equally well if another time period
is used; for example, half-years instead of years. After a year and nine
months, FV = 100(1+0.50)1.75 = 203.31 but, with stepping every six
months, the true value of t would be rounded down to the nearest 0.5 (1.75
replaced by 1.5) and the amount owed would then be given by
100(1+0.50)1.5 = 183.71. Notice that at some level of accuracy, stepping
will, in effect, be used; compound interest may be charge to the nearest
month or to the nearest day but will not commonly be charged more
accurately.
Figure 5
Compound Interest at 50% on $100
Showing steady and periodic interest for both conpound and simple interest
800
DPN: these lines should come

out smooth, not dotted. Sorry...
poor drawing package!
FV / Dollars
600
400
200
0
0
Time / years
10

Conversion Of Compound Interest Rates To Different Time Periods

Suppose you have an interest rate of 0.21 (21%) over two years and you want to know
its equivalent compound rate per annum. These are familiar numbers; the first example
we looked at for compound interest was 0.10 p.a. (10% p.a.), which compounds to 0.21
(21%) over two years.
0.21 per two-year period is equivalent to 0.10 per one-year period
Consider what has been done here. The formula for future value, FV = PV(1 + r) t, has
been used twice to give expressions for FV which must be equal:
FV = PV(1 + r)t = PV(1 + 0.21)1
FV = PV(1 + r)t = PV(1 + 0.10)2
PV(1 + 0.21)1 = PV(1 + 0.10)2
(1 + 0.21)1 = (1 + 0.10)2
r is per two-year period; t = one period

r is per one-year period; t = two periods
PV appears on both sides and cancels:
(which is true!)
Given only one of 0.21 and 0.10, the other could have been calculated
The general formula for conversion is easily derived; the difficult part is in carefully
defining what is meant by the symbols in it. Since the future value formula is used
twice, subscripts will be given to r and t in order to distinguish two pairs of values: r a
and ta; rb and tb where ra is the interest rate per period of length ta; rb is the interest rate
per period of length tb.
Example:
ra = 0.10 per year (p.a.) ta = two years

rb = 0.21 per two-years tb = one two-year
(a and b are only labels, so it doesnt matter
which t, b pair takes which value).
The trick is to use the future value formula twice, for the same total period of time but
measured in different units of time, then equate the two results. The general formula for
conversion is then quickly found:
Equations
PV(1 ra ) t a PV(1 rb ) t b
(1 ra ) t a (1 rb ) t b
Example
PV(1 0.21)
(1 0.21)
PV(1 010
. )2
(1 010
. )2
If three of the variables in this formula are known then the fourth can be calculated.
Rearranging to show conversion from, say, ra to rb:
rb
(1 ra ) t a / t b
Formula for compound rate conversion
For example, a rate of 21% p.a. (0.21) is equivalent to a six-month rate, r,
11

given by:
(1 0.21)1/ 2 1 11
. 1 01
.
since rb
(1 ra ) t a / t b
Similarly, if each month has 30 days then an interest rate of 6% (0.06) over
three months is equivalent to a rate, r, compounded every fifteen days, given
by:
(to four decimal places)
r (1 0.06)15/ 90 1 106
. 1/ 6 0.0098
and, conversely, a rate of 0.976% (0.00976) compounded every fifteen days
is equivalent to 6% (0.06) over three months:
(to three decimal places)
r (1 0.0098) 6 1 0.060
A use closer to home is in credit card interest charged monthly; interest of
2% per month allowed to accumulate for twelve months would amount to
24% if simple interest were charged. However, compound interest is
charged and the equivalent annual rate is (1+0.02)12-1= 0.2682 (to four
decimal places) or 26.82% p.a.. If you are given the annual rate and want
to calculate the monthly rate then:
rb (1 ra ) t a / t b 1 (1 0.2682)1/12 = 0.02 per month (2% per month)
The application of compound interest rates converted between different units of time
becomes problematic if cash is withdrawn within the total period under consideration.
Heres why:
Suppose you have two bonds which give cash payments (called coupons)
every six months and one year respectively. This will happen for several
years (the exact number does not matter, for our purposes), starting with a
payment from one bond six months from now, followed by both bonds one
year from now. Payments are expressed as percentages of a fixed sum
(1,000): 5% per six-month period and 10.25% per annum. These rates are
equivalent, since 1.052 - 1 = 0.1025. However, the bonds are not
necessarily equally attractive investments; their worth depends on other
interest rates. Consider a one-year period. After six months, one bond pays
5% (50). Now, if this is re-invested somewhere at 5% per six-month
period then it will earn 5% of 5% (2.50) and after one year the owner of
the bond will have 50 (first coupon) + 2.50 (interest on first coupon) +
50 (second coupon) = 102.50, which is 10.25% of 1,000 and, hence,
there is no difficulty. However, if the first coupon (50) is re-invested at
more or less than 5% then clearly the outcome after a year will differ from
that from holding the 10.25% p.a. bond. Investors in bonds would not
consider the bonds equivalent just because their compound interest rates are
equivalent. The equivalence of the rates is based on the assumption that
interest is accumulated during each year.
12

Thus, compound interest rates can be converted readily to equivalent rates for different
time periods, but if cash payments are made within the longest time span covered by any
of the rates they are no longer fully comparable.
Nominal, Actual and Effective Interest Rates

Up to this point it has been emphasised that compound interest rates cannot be converted
to equivalent rates over shorter periods by simple division. Thus, a rate of 10% p.a. is
equivalent to 4.88% per six-month period; it is not equivalent to 5% per six-month
period (as would be the case if simple interest were being applied). However, it is
common practice to quote compound interest rates in a way which looks just like this!
Example: interest payments (called coupons) received by owners of
bonds may be quoted as 10% p.a., semi-annual. This is understood to
mean 5% every six months! Worse: it may be that someone writing
or talking about a well-known type of bond which pays interest semiannually, such as a US Treasury bond, may assume that you know that
10% coupon means 5% paid every six months. Note:
(1+0.10)1/2 - 1 = 0.0488 (to four decimal places).
(1+0.05)2 - 1 = 0.1025; 5% every six months is equivalent to 10.25% p.a.
A nominal interest rate quoted as 10% p.a. semi-annually is actually a rate of 5% per
six-month period. This is not a conversion to an equivalent rate as described previously;
the amount actually paid is 5% every six months. However, the actual rate can be
converted to an equivalent annual rate, as before:
Nominal rate
Actual rate
10% p.a. semi-annually

5% semi-annually (i.e. 5% per six-months)
The equivalent rate can be had from the equation rb (1 ra ) t a / t b

Substituting 0.05 for ra, 2 for ta (two six-month periods) and 1 for tb:
Equivalent rate = (1 0.05) 2 1 = 0.1025 p.a. (10.25% p.a.)
This rate is known as the effective interest rate and, if it is an annual rate, it is sometimes
called the annual percentage rate or APR. The nominal rate may alternatively be called
the stated interest rate. As long as you know how to calculate the effective rate, there is
no problem in quoting practically a nominal rate (assure yourself of this; it will be
referred to later when continuous compounding is considered)
A nominal rate of 10% p.a., with actual compounding periods of six months, three
months and one month converts into three different effective rates as follows:
semi-annual
0.1 2
= 1.1025
2
Effective rate = 10.25% p.a.
13

0.1 4
= 1.1038*
4
0.1 12
1
= 1.1047*
12
quarterly
monthly

* To four decimal places
Looking at these three results, it is easy to deduce the general equation for converting
nominal rates to effective rates. Taking a nominal interest rate which is actually divided
into parts (division by the integer m, say) then applied m times:
rno min al mt
m
reffective
1 reffective
rno min al mt
1
m
Continuous Compounding
We now have a formula for converting a nominal rate to an effective rate.
Mathematically, a time period can be sliced into as many shorter periods as you wish.
Imagine what happens when m is made larger and larger. This increases the power to
which the number in parentheses is raised, tending to produce a larger result but at the
same time the number in parentheses becomes smaller, which tends to produce a smaller
result. The net effect of these opposing tendencies is demonstrated below, using t = 1
and r = 0.1. The results were calculated, to eight decimal places, using a spreadsheet.
<see next page>
14

1
10
100
1,000
10,000
100,000
1,000,000
10,000,000
01
. m
m
1.10000000
1.10462213
1.10511570
1.10516539
1.10517037
1.10517086
1.10517091
1.10517092
1
The results obtained increase as m is increased. Notice, however, that they appear to be
approaching a limiting value.
An increase in m from 1 to 1,000,000 changes the result from 1.1 to
1.10517091 but a further increase of 9,000,000 only causes a change
in the last decimal place!
There is a number, used in mathematics, which is given its own symbol, e. The value
of e is approximately 2.71828. On your calculator you will almost certainly find the
exponential function, shortened to exp. Exp(0.1) means e to the power 0.1, which
may also be written e0.1. Now you might like to use a calculator or a spreadsheet to find
the value of e0.1. The answer, to eight decimal places, is 1.10517092, which is the result
we obtained by making m sufficiently large. Although this is a demonstration, not a
mathematical proof; but you will not be surprised to hear that no matter how large m is
made, the result will not exceed the limiting value which is equal to e0.1. Replacing the
specific values (t = 1, r = 0.1), in general the limit is e rt.
e is a constant found in Calculus. It cannot be expressed as a finite decimal
number but is approximately equal to 2.71828. It is also called the
exponential function and may be found as a function on calculators and in
spreadsheets, which will perform calculations to more decimal places than
the minimum needed for accuracy in finance. An alternative way of writing
ert is exp(rt).
Mathematically, the process of taking the process to its limit ( represents infinity) is
represented as shown below:
LIMIT
m
r mt
m
e rt
the subscript nominal would be clumsy

in this formula and so it has been omitted
15

This is called continuous compounding. It follows that future value with continuous
compounding at a nominal rate, r per period, is given by the equation:
PVe rt
FV
where r is understood to be the nominal rate
In continuous compounding, the time between successive compounding operations is

infinitesimally small; the number of compounding operations over the period of a
nominal rate is infinite. These are not practical operations! Yet we can comprehend the
summation of an infinite number of infinitesimally small compounding operations and,
more to the point practically, there is a formula for the result. Graphically, lines
representing compounding using progressively shorter periods shift to higher values of
FV but move no higher than the limit of the line for continuous compounding. This is
demonstrated in Figure 6.
Figure6
$100, r = 0.10 p.a. compound interest
FV / pounds
800
Compounding period decreased:

4years, 2 years, 1 year, 6 months, 3 months
and, finally, continuous compounding
600
1
2
4
400
200
0
0
9 10 11 12 13 14 15 16 17 18 19 20
Time / years
Continuous compounding is extremely useful in the derivation of formulae in advanced

finance; for example, in the pricing of options and other derivative instruments.
These have become so important in finance that you should not avoid understanding
continuous compounding.
The effective rate can be calculated for continuous compounding:
e rt
1 reffective
reffective
e rt 1
where r is understood to be the nominal rate
16

In the previous section I wrote that as long as you know how to calculate
the effective rate, there is no problem in quoting practically a nominal rate.
This was probably clear to you. A nominal rate of 10% p.a. semi-annually
gives an effective rate of 10.25% p.a. and FV = PV(1+0.1025). Practically,
therefore, you have the rate quoted and a formula for calculating future
value. Likewise, with continuous compounding you have a nominal rate
and a formula for calculating future value: FV = PVert. Therefore,
continuous compounding can be used practically.
The nominal rates used in continuous compounding can be converted to equivalent
nominal rates, continuously compounded over different time periods, and to equivalent
actual rates over finite periods (discontinuous rates, if you will!). Conversion between
continuously compounded rates is particularly convenient, and the equation reduces to
the same simple result as found for simple interest:
e ra t a
e rb t b
and so
ra t a
rb t b
For example, 20% per two-years, continuously compounded, is equivalent

to 10% annually, continuously compounded. Note that time periods in this
example are measured in units of 2 years and units of 1 year. You may
prefer to switch out of using t (retaining this for use with units of 1 year
only) and replace it with e.g. "n" periods, "m" periods, etc.
For conversion between continuously compounded rates and discontinuous
compounding rates the formula is:
e ra t a
rb
(1 rb ) t b
r t
exp a a
tb
switching to notation whereby exp(x) = ex
For example, 10% p.a., continuously compounded, is equivalent to

10.52% p.a. compounded annually (i.e. 10.52 % p.a.), since ta = tb = 1
and e0.1 - 1 = 0.1052 (to four decimal places). It is also equivalent to 5.13%
per semi-annual period compounded semi-annually (i.e. just 5.13% semiannually) since, in this case, ta = 1, tb = 2 and e0.05 - 1 = 0.0513 (to four
decimal places). Notice that if tb = 1, the formula for calculation of the
effective rate is obtained.
17

Discounting: DCF and NPV

Discounting is the process of calculating the present value of future cash flows and is a
fundamental financial technique. The description discounted cash flow is often
abbreviated to DCF. To an investor, a nominal amount of cash does not have the same
value at different times; generally, a dollar next year is worth less than a dollar today,
since a dollar could be invested today to repay more than a dollar next year. DCF is
important because it allows the values of future cash flows to be adjusted to a common
time. Bringing all values to a common time allows them to be summed, so that the total
present value of a series of cash flows, to be received at many different times, can be
calculated. This allows alternative investments to be compared.
Example. Would you prefer to receive one million pounds now
or ten years from now? If you take the money now, you can invest it.
If you are a cautious investor you bank the money and receive interest.
For simplicity, suppose you receive 10% p.a. compound interest, fixed
over ten years. If you leave all money in the bank, after ten years you
have a million pounds times (1+0.10)10, which is 2,593,742 pounds.
Clearly, your financial preference should be to receive one million
pounds now. If, instead, you are promised one million pounds now and
one million pounds ten years from now it would not be sensible to say
that your gain in value today is two million pounds. A better way would
be to determine how much money, put in the bank today, would yield a
million pounds after ten years, then add that amount to the million pounds
received today. A million pounds received ten years from now is the
equivalent of an amount in the bank today of one million divided by
(1+0.10)10, which is 385,543 pounds - making the value of the two receipts,
measured today, 1, 385,543 pounds. This is the basis of DCF.
When an initial cash investment is made (a negative cash flow), followed by cash
flows in later periods (preferably positive!), the sum of the discounted cash flows is
known as the net present value or NPV. NPV provides a useful way of evaluating
investments. The superiority of NPV over other methods for evaluation of investments
is covered in elementary textbooks as is its use making investment decisions.
The idea behind NPV follows from DCF and can be shown in a simple
example. Suppose you are considering an investment of one million pounds
today in a project. You expect the project to return a series of cash flows
annually for ten years, after which the project ends. You use the method of
discounted cash flow (DCF) to calculate the present value (PV) of the future
cash flows. You then compare this PV with your initial investment and, if the
PV is greater than your initial investment, you consider that the investment
would be profitable. Using NPV to express this comparison, you would write
NPV = -1,000,000 + PV. Then, the exact equivalent of the comparison is to
say that if NPV of the project is greater than zero (positive) you consider that
the investment would be profitable.
18

Although, in principle, DCF could involve using the mathematics of either compound
interest or simple interest, in practice the mathematics of compound interest is always
used. We already have formulae relating future value to present value. For
discontinuous compounding this is:
FVt
PV(1 r ) t
For a single future value, the formula showing discounting is easily obtained by
rearranging this formula:
PV
FVt (1 r ) t
FVt
(1 r ) t
Notice that the reciprocal of a number raised

to a power may be shown as a negative power
A crucial feature of both PV and FV is that present values and future values for the same
time are additive. If a series of expected cash flows are discounted back to the present
then the present value of the series is the sum of the present values of the individual cash
flows. This is important because it allows projects, each with cash flows expected at
many different times and in different amounts to be valued and, hence, compared. The
additivity of present values is easily demonstrated:
A cash flow of 110 one year from now, discounted at 0.10 p.a. (10% p.a.)
is worth 100 today. Similarly, 121 two years from now is also worth
100 today. Therefore, the series of cash flows, starting today and arriving
in consecutive years, 100, 110, 121, discounted at 10% p.a. is worth
300
PV 100
110
(1 010
. )
121
(1 01
. )2
100 100 100
300
There is only one present value for the series but more future values; one for each future
time. Cash flows are discounted back from future times to more recent times and
compounded forward to more distant times. For the series of cash flows in the example,
the future value after one year is 330 and the future value after two years is 363:
121
110 110 110 330
(1 01
.)
Here, 100 has been compounded forward, 110 does not need to be adjusted
and 121 has been discounted back.
FV1year
100(1 01
. ) 110
19

100(1 01
. ) 2 110(1 01
. ) 121 121 121 121 363
FV2 years
Here, 100 has been compounded forward two years, 110 has been
compounded forward one year and 121 did not need to be adjusted.
Notice how consistent and convenient PV and FV calculations are: PV and FV values
can be inter-converted before addition or afterwards, with no difference. The only rule
when moving between values at different times is that you must convert all cash amounts
to the same time before adding them.
The results in the example can be inter-converted by noting that:
300(1 01
. ) 330
330(1 01
. ) 363
330 / (1 01
. ) 300
363 / (1 01
. ) 330
It will be convenient to use continuous compounding and discounting when option

pricing theory is considered, in Part 2, and so well include the coresponding formulae
for continuous discounting. Weve slipped in a subscript, t, for FV, to fit with the 1 year
and two year examples, above, but you can drop it if you prefer (as we will do in
Powerpoint slides):
FVt
PVe rt
PV
FVt e rt
continuous compounding
FVt
e rt
continuous discounting
The annual cash flows 100, 110, 121 can be continuously discounted at
10% p.a. as follows (to two decimal places)
PV 100
110
.
e01
121
e0.2
100 99.53 99.07
298.60
It is convenient at this point to follow the convention in textbooks and switch from using
FV to C when representing a future cash flow, since the emphasis will now switch from
compounding forward (PV to FV) as the inverse of discounting back (FV to PV) to
discounting alone. It is helpful to be able to understand the algebraic representation of
the equations (in order to appreciate finance textbooks but also for their descriptive
convenience). For all cases other than continuous discounting:
PV
FVt
(1 r ) t
becomes
PV
Ct
(1 r ) t
and a general equation for calculation of present value, PV, by discounted

cash flow (DCF) from year 1 to year T is:
20

PV
C1
C2
C3
C4
(1 r )
(1 r ) 2
(1 r ) 3
(1 r ) 4
.....
CT
(1 r ) T
Another way of representing this is to use the mathematical symbol for

summation, . This is simply a shorthand way of writing the previous
equation:
t T
PV
t 1
Ct
(1 r ) t
Although this equation could easily be made to include the cash flow, C0 at
time, t=0 (now!), it is conventional to name the present value including this
term net present value (NPV). The slightly modified equations are:
NPV
C0
C1
C2
C3
C4
(1 r )
(1 r ) 2
(1 r ) 3
(1 r ) 4
t T
NPV
C0
t 1
.....
CT
(1 r ) T
Ct
(1 r ) t
Since (1+r)0 = 1, this can be represented more simply:

t T
NPV
t 0
Ct
(1 r ) t
A numerical example is already available in the form of the series of cash

flows introduced earlier:
PV
100
110
(1 010
. )
121
100 100 100
(1 01
. )2
300
Since the immediate cash flow, C0 = 100, is positive (an attractive

investment!) it is a moot but unimportant point whether or not the
description NPV should have been used here.
The corresponding equations for continuous compounding are similar:
PV
FVt
e rt
becomes
21
PV
Ct
e rt

and the general equation for calculation of present value is:
PV
C1
er
C2
e2r
t T
NPV
C0
t 1
C3
e 3r
C4
C
..... T
4
r
e
e rT
Ct
e rt
Again, since e0 = 1, this can be represented more simply:

t T
NPV
t 0
Ct
e rt
The mechanics of discounting have been explained, but how is the discount rate chosen?
If all that concerned us were money safely deposited in a bank (one which will not
default), discounting would be an uncomplicated process, using the same rate for
discounting as used for money on deposit. Discounting is far more useful. It can be
used in valuing projects, assemblies of projects or even companies; but these do not
have interest rates specifically describing them. In the next section, an overview of
discount rate selection will be given.
Choosing The Discount Rate and Understanding NPV

In order to understand NPV it is important to appreciate the way in which the discount
rate is related to risk. It is not essential to know the detailed mathematical formulations
of risk and rate of return before gaining an insight.
An important characteristic of NPV is the combination of cash flows from different
times into a single valuation. Since discounting over several periods is not the main
concern in this section, however, simple examples will be given using only cash flows
today and one year from today, in order to make the examples clearer
The discount rate for a particular investment is chosen by considering what else might
be done with the cash instead of committing it to that investment. For a sensible
comparison, the appropriate discount rate is the best rate of return available, chosen
from alternative investments of comparable risk. You can reach this conclusion by
thinking about different types of investment. First, suppose you have cash which you
could invest in one of several banks for one year. You ask the banks what rate of
interest each would pay if you deposited your cash with them over this period. These
particular banks offer you identical services and you believe they are all equally unlikely
to fail but they offer you different interest rates on your cash. Sensibly, if you deposited
22

your cash you would do so at the highest rate. Likewise, you would use the highest
interest rate as the discount rate which you would apply to investments which you
consider to have the same risk as depositing your money in the bank. The NPV of
investing cash in the bank giving the best rate would be zero (of course, since you
discount at that rate!) and the NPV of investment in one of the other banks would be
negative. NPV in this situation is a measure of the value of investing your cash in a
bank compared with investment in the best bank.
For example, suppose you have 1,000,000 in cash, the best rate offered is
0.10 p.a. (10% p.a.). and another, inferior rate offered is 0.0975 p.a. (9.75%
p.a.). If you deposit your cash at the inferior rate then after one year you
would have 1,097,500. The net present value of this investment would be
calculated like this (to the nearest ):
NPV
1,000,000
1,097,500
(1 010
. )
1,000,000 997,727
2,272
This is a negative NPV and shows that you should not invest at the inferior
rate
Now suppose that an alternative investment becomes available. You might decide to use
the same discount rate to value that investment:
Suppose the new investment is for one year and offers a return of
1,600,000 on 1,000,000 invested.
NPV
1,000,000
1,600,000
(1 010
. )
454,545
This means that if you consider the alternative investment to be as safe as depositing
your money in the best bank, you would confidently expect to receive, after one year,
the same amount which you would have received from the bank had you invested
1,454,545. In other words, you would expect the alternative investment to bring you
additional present value of 454,545 and so you would consider it a very good
investment.
This is obvious if you split the numbers as follows:
1,000,000(1+0.10) =1,100,000
454,545(1+0.10) = 500,000
The first equation is equivalent to investment in the bank, the second shows
the extra value acquired by investing in the alternative proposition, which
has a present value of 454,545 and a future value of 500,000.
23

If the alternative investment really is only as risky as investment in the bank, then the
NPV analysis above is correct. However, what should you do if you think the
alternative investment is more risky? Presumably, you would no longer think it worth an
extra 454,545? In general, the more risky the investment the higher the rate of return
required by investors. Suppose, for the moment, you are able in some way to classify
investments according to their risk (we need to introduce portfolio theory and capital
asset pricing). It would be reasonable to associate the same discount rate with all
investments having the same risk. Suppose the risk of the alternative investment is
classed with investments requiring a discount rate of 0.30 p.a. (30% p.a.). This would
mean that you would deem a return of 30% to be just sufficient, no more and no less, to
compensate you for taking the risk of the alternative investment.
A return of 1,600,000 on an investment of 1,000,000, discounted at
0.30 p.a. (30% p.a.) gives an NPV of:
1,600,000
230,769
(1 0.30)
The NPV is positive; the investment is a good one, though not as
attractive as it would have been if its risk had been as low as an
investment in the bank! You would expect to receive 1,300,000 for
an investment of comparable risk. For this alternative investment you
expect to receive 1,300,000 plus the equivalent of investing an extra
230,769 at the same level of risk, since:
NPV
1,000,000
1,000,000(1+0.30) = 1,300,000
230,769(1+0.30) = 300,000
NPV is a tool for decision making. The discount rate is chosen either by direct
comparison with another investment yielding a known rate of return and considered to
be of comparable risk, or by statistical methods using data from many investments to
define risk and relate it to expected rates of return. A positive NPV is value in excess of
that which you ought to expect, given the level of risk implied by the discount rate. By
choosing a discount rate you are, knowingly or unknowingly, also choosing to compare
the investment with some other investment (discount rate is sometimes called the
opportunity cost of capital, expressing the idea of a return foregone by investing in an
alternative project). The comparison could be with a particular investment, such as a
similar project already undertaken within a company, or it could be with a theoretical
project of the same risk. The combination of many investments of differing risk and
return in order to determine a relationship between risk and return are considered in
textbooks under the Capital Asset Pricing Model but need not concern us here.
Suppose you use the bank deposit rate as the discount rate and obtain a positive NPV for
a project. If it is of equally low risk then the project is a better investment than
depositing with the bank; if not, then it merely promises a better return but no account
has been taken of the greater likelihood that its promised cash flows might not arrive in
full or on time! In the same way, if you use the rate of return from another project as the
24

discount rate, then NPV shows whether the new investment is inferior (negative NPV),
equal (NPV is zero) or superior (positive NPV) to that project if the risks are equal. This
means the project discount rate must be chosen with care. If, for example, a poorly
performing project were chosen for comparison then many later projects would be
judged favourably but if one were chosen which had delivered an exceptionally high rate
of return then few later projects would have positive values of NPV! Rather than
comparing a single past project, therefore, decision makers may set a benchmark rate
(a minimum acceptable return) as a practical way of using NPV to rank projects.
Compared with this benchmark, positive NPV projects will be acceptable; the higher the
NPV the more valuable the investment
In order to set a benchmark rate as close as possible to a rate truly reflecting the risk of a
company project, it is necessary to look outside the company. It may be that the
company takes on higher (or lower) risk on projects at the benchmark rate of return than
is generally the case for other companies in its industry. If an industry-wide estimate of
appropriate return for a given level of risk can be determined, then it can be used as the
discount rate, in preference to a company-specific rate. However, financial details of
companies projects may be hard to come by, making it impossible to determine the
relationship. Stock price data, though, are readily available for many large companies,
and it is possible to determine the appropriate return for a given level of risk for
investment in other companies shares in the same industry on a stockmarket at a
particular time.
Why does it matter that the rate be as close as possible to a rate truly reflecting the risk
of a company project? Isnt a rate typical for the company perfectly acceptable or even
more appropriate? An example will show why it is important to use discount rates
reflecting risk as closely as possible:
Two projects are under evaluation. They are equally risky and the
correct discount rate, to take this level of risk into account, is 0.20 p.a.
(20% p.a.). You are considering the effects of setting a benchmark rate
at either 0.10 p.a. (10% p.a.) or 0.30 p.a. (30% p.a.). The cash flows and
discounted cash flows are as follows:
25

PROJECT 1
Year:
Cash flow:
Discounted at 10%
Discounted at 20%
Discounted at 30%
0
1
-250
336
-250 305.45
-250 280.00
-250 258.46
2
0
0
0
0
3
0
0
0
0
4
0
0
0
0
0
-250
-250
-250
-250
2
0
0
0
0
3
0
0
0
0
4
0
0
0
0
5
49.77
30.90
20.00
13.40
NPV
86.36
50.00
21.87
PROJECT 2
Year:
Cash flow:
Discounted at 10%
Discounted at 20%
Discounted at 30%
1
0
0
0
0
5
746.50
NPV
463.52 213.52
300.00 50.00
201.05 -48.95
When the correct discount rate is applied, the projects are assessed as having equal
value (50.00). However, if the company used a benchmark rate of ten percent per
annum Project 2 would be assessed as considerably more valuable than Project 1
(213.52 contrasted with 86.36). Conversely, if the company used a benchmark rate of
thirty percent per annum Project 2 would be rejected (NPV = -48.95) while Project 1
would still offer positive value compared with the benchmark (NPV = 21.87).
Assuming that managers discount at rates properly chosen to reflect risk, company
shareholders can delegate operations to them with a simple instruction: maximise NPV!
The central idea which has been discussed in this section is that for each level of risk
there is, in principle, an appropriate discount rate; the greater the risk, the greater the
discount rate. Viewed in this way, investors assess the level of risk and are seeking
extra value at this level of risk. If the NPV is negative, the investment is not sufficiently
attractive to justify the risk taken. If the NPV is zero then the investment gives no better
return than appropriate for the risk taken. If the NPV is positive, an investment has been
found which gives a better return than necessary to compensate for its risk and is,
therefore, attractive to an investor. One consequence is sometimes not understood.
Consider two projects, both lasting one year, discounted at different rates in order to
reflect their different levels of risk. It so happens that the projects have the same
positive NPV. Therefore, they are equally valuable now to an investor. The projects
start and finish at the same times. Suppose they are both completed successfully with
cash flows as expected. They are not then equally valuable. Here are the data:
26

NPV analysis at the start

Discount rate p.a.
Initial investment
Received at end
NPV
Project 1
0.1
100,000
132,000
20,000
Outcome if cash flows are as expected

Rate of return
32.00%
Project 2
0.6
100,000
192,000
20,000
92.00%
The projects required the same initial investment, were for the same period and had the
same NPV; and yet one gave a return of 32% while the other gave a return of 92%.
How do we reconcile these rates of return with the equal values of NPV?
The answer lies in the incorporation of risk into NPV. At the end of the project the
outcome is certain, at the start it was not. At the start, the NPV calculations took into
account the different levels of risk of the projects. At the start of the projects when the
NPVs were calculated, cash flows as expected was only one of a large number of
different possible outcomes. The discount rates for the projects reflected the
possibilities that the projects would not give the expected outcomes; the amounts which
would actually be received and when they might be received were both uncertain.
Project 2 was deemed more risky than Project 1 and, hence, was assigned a higher
discount rate. The NPV of Project 1 shows that the project was equivalent to having an
extra 20,000 to invest at 10% p.a. at its level of risk. The NPV of Project 2 was also
equivalent to having an extra 20,000 to invest but at 60% p.a. and the appropriate (but
different) level of risk.
You now know the principle behind the selection of appropriate discount rates and the
interpretation of NPV.
Special Cases of PV Formulae: Annuities, Perpetuities and Growing Perpetuities

There are several well-known formulae which simplify the calculation of PV and NPV
in special cases. They are worth knowing and are especially important in bond price
calculations. The formulae will be described in this section, and their use in simple
valuation of stocks and bonds are addressed in many textbooks. A good book for those
who fancy themselves as investment bankers or consultants in the 21st century is the one
used by Rothschilds for their graduate recruits:
Corporate Financial Strategy, Keith Ward, Butterworth Heinemann, ISBN 0
7506 0657 7.
It is often the case that cash payments are made as a fixed amount at regular intervals;
for example, 10,000 on January 1st every year for fifteen years. If the discount rate is
27

8% and the first payment is to be received one year from now (so today is January 1st!)
then the present value of the expected future cash flows is the sum of fifteen terms:
PV
10,000
108
.
10,000
10,000
....
2
108
.
108
. 15
10,000
1
108
.
1
108
. 2
....
1
108
. 15
A series of equal cash flows equally spaced over time, such as this, is called an annuity.
There is no need to add all the terms because there is an elementary formula which gives
the same result more easily:
PV
10,000
1
1
0.08
(108
. )15
85,595
In words: at a discount rate of 8% p.a., an annuity of 10,000 p.a. for fifteen years, with
the first payment to be made one year from now, is worth 85,595 (to the nearest pound)
The general form of this equation is:
PVannuity
where
C
1
1
r
(1 r ) T
C is the cash flow paid each time period (for example, each year)
r is the discount rate, as a decimal, for the period between payments
T is the total time over which the annuity will be paid
You should have no difficulty applying this formula as long as you remember to use the
same time measurement for each of C, r and T. If the cash flows, C, are paid annually
then the discount rate should be per annum and the time, T, should be measured in years.
This was done in the example of a fifteen-year annuity, above. If, however, payments
are made monthly then r should be a monthly discount rate and T should be expressed in
months.
For example, an annuity of 100 p.a. for ten years at a discount rate of
0.10 p.a. (10% p.a.) is worth 614.46, since:
PV
C
1
1
r
(1 r ) T
100
1
1
01
.
(1 01
. )10
614.46
A perpetuity is a special case of annuity in which payments are supposed to be made

forever. On reflection, you may find this idea surprising; but, nevertheless, perpetuities
have been issued. In practice, the issuer may buy back the perpetuity after many years,
using the same formula for valuation as when the perpetuity was issued. The classic
28

example of a perpetuity is the issue of consols by the British Government, to help

finance war against Napoleon. Consols were bonds which were purchased from the
government and which paid a fixed sum at regular periods without end.
The general equation for valuing perpetuities is:
PVperpetuity
C
r
If you are comfortable with the idea of infinity in mathematics then look at the equation for
the present value of an annuity, given earlier. Imagine T becoming larger. As T increases so
the second term in brackets becomes smaller. Taken to the limit of infinite T, the second term
vanishes to zero, leaving the formula for a perpetuity shown above.
For example, a perpetuity of 100 p.a. at a discount rate of 10% (0.10) is

worth 1,000, since:
PV
C
r
100
01
.
1,000
The value of cash paid either from an annuity or from a perpetuity decreases as time
passes, since the cash amount is fixed. Elementary formulae are also available for
valuing annuities and perpetuities whose payments increase each period to (1+g) times
the amount in the preceding period (in other words, payments increase by 100g% each
period). A general formula for the present value of the series of growing cash amounts
is given below. The series terminates after a finite number of terms if it is a growing
annuity or contains an infinite number of terms if it is a growing perpetuity:
PV
C
(1 r )
C(1 g)
(1 r ) 2
C(1 g) 2
..... etc.
(1 r ) 3
The formulae for valuing an annuity and a perpetuity are summarised, below, with those
for a growing annuity and a growing perpetuity:
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29

Constant Payment
Payment Grows By g Each Period
Annuity
(1 g) T
1
r g
(1 r ) T
C
1
1
r
(1 r ) T
C
r
Perpetuity
C
r g
Notice that the formulae including growth reduce to those for constant payment if g is
made equal to zero.
One pitfall must be avoided in using the formula for a growing perpetuity: the formula is
invalid unless the growth rate, g, is less than the discount rate, r. Think what this means.
The series can be written as:
C(1 g) C(1 g) 2
PV(1 r ) C
..... forever (!)
(1 r )
(1 r ) 2
By taking a factor of (1+r) to the left hand side of the equation, the effect of changing
the relative sizes of g and r on the terms in the series becomes easier to understand. If g
is less than r, the terms become progressively smaller and they add up to a finite result.
However, if g is greater than r, the terms become progressively larger and so the sum of
the series increases without limit - it becomes infinite! If g is equal to r, the terms stay
constant and so, again, the sum of the series increases without limit. If you set g equal to
r in the formula for the present value of a growing perpetuity then division by zero
results. To a mathematician this could imply an infinite result, which is correct.
However, if you set g greater than r, you obtain a negative result which is not the correct
answer (the correct answer is infinite!). Beware the second pitfall of believing that the
invalidity of the formula when g is greater than r can be proven using the formula itself.
The derivation of the formula includes the limitation that g must be less than r and so the
formula cannot be invoked to prove its own invalidity outside that condition!
A perpetuity of 100 p.a. at a discount rate of 10% (0.10) and a growth rate
of 15% (0.15) is worth an infinite amount! British government consols
proved to be reliable investments; you might guess that either the issuer of
this perpetuity would not continue to make the payments .... or no one could
afford to buy it, if it were properly valued! Now contrast the result given
by the usual formula:
PV
C
(r
g)
100
(0.10 0.15)
200
This is incorrect; the formula does not apply!
30

Basic Finance Sheet

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2015 David P. Newton

BASIC FINANCE TECHNIQUES

Discounted Cash Flow and Net Present Value

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the amount initially lent

This is the result you have already seen: 100 lent

Periodic versus Steady Accumulation of Simple Interest

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Do note that Figure 2 could be wrongly interpreted as showing two values

Simple Interest on $100 (Periodic)

Simple Interest on $100 (Steady)

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Conversion Of Simple Interest Rates To Different Time Periods

If the measurement of time in six month periods is replaced by measurement in years

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The general formula for conversion is:

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Amount owed / dollars

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For example, 100 invested at 50% p.a. compound interest

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Periodic versus Steady Accumulation of Compound Interest

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DPN: these lines should come

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Conversion Of Compound Interest Rates To Different Time Periods

r is per two-year period; t = one period

ra = 0.10 per year (p.a.) ta = two years

Formula for compound rate conversion

For example, a rate of 21% p.a. (0.21) is equivalent to a six-month rate, r,

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Nominal, Actual and Effective Interest Rates

10% p.a. semi-annually

The equivalent rate can be had from the equation rb (1 ra ) t a / t b

Effective rate = 10.25% p.a.

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Effective rate = 10.38% p.a.

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the subscript nominal would be clumsy

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where r is understood to be the nominal rate

In continuous compounding, the time between successive compounding operations is

Compounding period decreased:

Continuous compounding is extremely useful in the derivation of formulae in advanced

where r is understood to be the nominal rate

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For example, 20% per two-years, continuously compounded, is equivalent

switching to notation whereby exp(x) = ex

For example, 10% p.a., continuously compounded, is equivalent to

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Discounting: DCF and NPV

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Notice that the reciprocal of a number raised

100 100 100

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It will be convenient to use continuous compounding and discounting when option

100 99.53 99.07

and a general equation for calculation of present value, PV, by discounted

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Another way of representing this is to use the mathematical symbol for

Since (1+r)0 = 1, this can be represented more simply: