BUSINESS MODELLING

Instructors’ materials to accompany Swift: Quantitative Methods for Business, Management and Finance, © Louise Swift and Federica Spiezia (Palgrave, 2001).

BM
4 Time and money
Whilst compound interest will be a new subject for most students and the
mathematical content is not that difficult, the wording and ideas of
payments, annuities, loans and bonds may cause problems, particularly for
non-English speaking students. We encourage the student to work out the
appropriate expressions themselves, by logic, rather than remembering
formulae.
The financial functions in Excel can be useful although care must be
taken to enter the right values in the right places as the terminology is
often confusing.

ASSESSMENT 1
Simple interest, compound interest, non-annual compounding and the effective rate.
To avoid learning a new formula we use the same formula for non-annual
compounding as for annual compounding but work in payment periods rather than
years.
1. a. The second one, because the interest is paid more frequently and so can be
reinvested sooner.
b. The second one for similar reason to a., i.e. because the 3% paid at the end of
each year is 3% of the accumulation of the previous end-year balance and the
3% mid-year interest payment, so over a year more than 6% of the previous
end-year balance is received.
2. a. 100(1 ⫹ 0.12)10 ⫽ 100 · 1.1210 ⫽ 100 · 3.1058 ⫽ 310.58
b. 300(1 ⫹ 0.05)3 ⫽ 300 · 1.1576 ⫽ 347.28
c. This is 5 ⫻ 12 ⫽ 60 time periods at a rate of 1% each period.
500 · 1.0160 ⫽ 500 · 1.8167 ⫽ 908.35
The effective annual rate is:

i ⫽ (1. 0.12)12 ⫺ 1 ⫽ 1.0112 ⫺ 1 ⫽ 0.1268

d. 4 ⫻ 4 ⫽ 16 periods, each at 12 ⫽ 3% ⫽ 500 · 1.0316 ⫽ 802.35

i ⫽ (1 ⫹ 0.12)4 ⫺ 1 ⫽ 1.034 ⫺ 1 ⫽ 0.1255

 126 BM BUSINESS MODELLING

e. i ⫽ (1 ⫹ 0.15)4 ⫺ 1 ⫽ 1.03754 ⫺ 1 ⫽ 0.1587

Instructors’ materials to accompany Swift: Quantitative Methods for Business, Management and Finance, © Louise Swift and Federica Spiezia (Palgrave, 2001).

3. There are 24 monthly periods, and the interest rate for each is 12 ⫽ 0.75% so

5000 ⫽ P(1.0075)24

P ⫽ (1.0075)24 ⫽ £4179.16

4. We need to solve:
5000 ⫽ 3000(1 ⫹ r)3
ASSESSMENT 1

5 ⫽ (1 ⫹ r)3

r ⫽ (5)3 ⫺ 1 ⫽ 0.1856

The rate of interest payable annually must be 18.56%. The nominal rate, payable
monthly which is equivalent to an annual (=effective) rate of 18.56% is r, such
that

0.1856 ⫽ (1 ⫹ 12)12 ⫺ 1

Solving for r gives

√1.1856 ⫽ 1 ⫹ 12

1.014288 ⫽ 1 ⫹ 12

r ⫽ 0.1715

ASSESSMENT 2
Present values. The net present value and internal rate of return of a project. We
calculate the IRR by trial and error.

1. ii(i) (1.09)5 ⫽ $3574.62

i(ii) Regard this as 5 ⫻ 4 ⫽ 20 quarterly periods, each paying 9%, i.e. the
present value is

(1.0225)20 ⫽ $3524.49
 BM 4 TIME AND MONEY 127

(iii) 5 ⫻ 12 ⫽ 60 monthly periods each paying 12%, i.e. the present value is
Instructors’ materials to accompany Swift: Quantitative Methods for Business, Management and Finance, © Louise Swift and Federica Spiezia (Palgrave, 2001).

1.007560 ⫽ $3512.85

2. The discount rate is 1% per month so the present value of £500 in 6 months’
time is

(1.01)6 ⫽ £471.02

and of £525 in 9 months’ time is

(1.01)9 ⫽ £480.03

He should choose the first payment method.

3. Regard the discount rate as 3% a quarter. Eighteen months comprise 6 quarters so
the present value of $6250 in 18 months’ time is

(1.03)6 ⫽ $5234.28
ASSESSMENT 2

This is more, and therefore preferable to receiving $5000 now.

4. Year end £ Present value £
0 ⫺20 000 ⫺20,000

2 8000 (1.03)2 ⫽ 7540.77

4 14,000 14 000 ⫽ 12,438.82

NET PRESENT VALUE: ⫺20.41

As the net present value of the project at a discount rate of 3% is negative, a
discount slightly smaller than 3% may give a positive NPV for the project.
The NPV at 2.5% is 297.82, so the internal rate of return is between 2.5%
and 3%.
5. This question illustrates the idea that methods of evaluating investments need not
agree, and that other factors, in particular, the sum invested, may be important.
The point here is that although project C has the highest IRR, it only ties up
£20,000 which explains why the NPV, which reflects the amount invested, is
lower.
Project A is more attractive than B using both NPV and IRR, therefore we
need only compare project A with project C.
If we had £50,000 and we invested it in project A, it would be equivalent to a
return of 5.5% (the IRR) over the period of the project.
If, on the other hand, we had £50,000 and we invested in project C, it would
be equivalent to a return of 8.6% on only £20,000. The remaining £30,000 would
 128 BM BUSINESS MODELLING

have to be invested in the savings account, at 2% interest, and so the total return
would be
Instructors’ materials to accompany Swift: Quantitative Methods for Business, Management and Finance, © Louise Swift and Federica Spiezia (Palgrave, 2001).

8.6 ⫻ 20 ⫹ 2 ⫻ 30 ⫽ 4.64%

Project A is therefore a better investment.

ASSESSMENT 3
Series of payments: sums accrued and present values. The only new mathematical
device in this section is the geometric series which some students will have met
before. The main problem seems to be, not in summing the series, but in finding
which geometric series is required in the first place. Many students prefer to
calculate the present value of each payment separately instead of using the geometric
series formula, even for long series when it is particularly tedious and time-
consuming.
1. a. a ⫽ 500 · 1.1
R ⫽ 1.1
n ⫽ 11

a · Rn ⫺ 1 = 500 · 1.1 · (1.111⫺ 1) ⫽ 10 192.14

b. a ⫽ 20

R ⫽ 10

This geometric series continues indefinitely and |R| ⬍ 1, so it sums to:

1 ⫺ R ⫽ 1 ⫺ 10 ⫽ 200

c. a ⫽ 1.05

R ⫽ 1.052

n ⫽ 8

a · Rn ⫺ 1 ⫽ 1.05 · (1.052)8 ⫺ 1 ⫽ 1110.21

2. The value of the investment immediately after Rebecca’s 18th birthday will be:
800 ⫹ 800 · 1.08 ⫹ 800 · 1.082 ⫹ . . . ⫹ 800 · 1.0817
 BM 4 TIME AND MONEY 129

which is a geometric series of 18 terms, with a ⫽ 800 and R ⫽ 1.08, and so is

Instructors’ materials to accompany Swift: Quantitative Methods for Business, Management and Finance, © Louise Swift and Federica Spiezia (Palgrave, 2001).

800 · 1.0818 ⫺ 1 ⫽ 29 960.19

3. Let X be the sum saved at the end of each month. There are 24 monthly
instalments and the monthly interest rate is 1%, so we need to solve
3000 ⫽ X ⫹ X · 1.01 ⫹ X · 1.012 ⫹ . . . ⫹ X · 1.0123
The right-hand side is a geometric series, with a ⫽ X, R ⫽ 1.01 and n ⫽ 24, so
the equation becomes:

3000 ⫽ X · 1.0124 ⫺ 1 and X ⫽ 3000 · 0.01 ⫽ 111.22

You should save £111.22 a month.

4. We would expect the market price to be the present value of the series of
receipts.
It is probably easiest to show these in a table as follows. The discount rate is
3% per 6-month period.
End of . . . Amount received Present value
ASSESSMENT 3

6 months £4 1.03

1 yr £4 1.032

1 yr 6 months £4 1.033

· · ·
· · ·
· · ·

9 years £4 ⫹ £100 1.0318 ⫹ 1.0318

The market value is therefore

1.03 ⫹ 1.032 ⫹ . . . ⫹ 1.0318 ⫹ 1.0318

All but the last term form a geometric series, with a ⫽ 1.03, R ⫽ 1.03, n ⫽ 18,

so the market value is

1.03 · (1.03)18 ⫺ 1 ⫹ 1.0318 ⫽ 55.01 ⫹ 58.74 ⫽ £113.75

5. Suppose the annual instalment is X. The mortgage is to be repaid in 20 annual

instalments at an interest rate of 10%, so the present value of the repayments is
 130 BM BUSINESS MODELLING

1.1 ⫹ 1.12 ⫹ . . . ⫹ 1.120

Instructors’ materials to accompany Swift: Quantitative Methods for Business, Management and Finance, © Louise Swift and Federica Spiezia (Palgrave, 2001).

We require this to be equal to £25,000, so X is the solution of:

25 000 ⫽ 1.1 ⫹ 1.12 ⫹ . . . ⫹ 1.120

The right-hand side is a geometric series, with a ⫽ 1.1, R ⫽ 1.1 and n ⫽ 20, so:

25 000 ⫽ 1.1 · (1.1)20 ⫺ 1 ⫽ 8.51356X

therefore:

X ⫽ 8.51356 ⫽ 2936.49

The annual instalment must be £2936.49.

6. The equation to solve is now:
ASSESSMENT 3

25 000 ⫽ X ⫹ 1.1 ⫹ . . . ⫹ 1.119

The right-hand side is a geometric series with a ⫽ X, R ⫽ 1.1 and n ⫽ 20. Therefore:

25 000 ⫽ X (1.1)20⫺ 1 ⫽ X · 9.36492

X ⫽ 9.36492 ⫽ £2669.54

Alternatively, each start of year instalment (new method) must have equivalent
present value to the corresponding end of year instalment (old method) and so

end of year ⫽ start of year

so we need only divide our solution to Question 5 by 1.1 to obtain this new
instalment.
7. The net present value of the project is (in £thousand)

NPV ⫽ ⫺400 ⫺ 1.06 ⫺ 1.062 ⫺ 1.063

NPV ⫽ ⫹200 ⫹ 1.06 ⫹ . . . ⫹ 1.069

This involves two geometric series and is equivalent to

 BM 4 TIME AND MONEY 131
Instructors’ materials to accompany Swift: Quantitative Methods for Business, Management and Finance, © Louise Swift and Federica Spiezia (Palgrave, 2001).

NPV ⫽ ⫺400 (1.06)4 ⫺ 1 ⫹ 200 (1.06)10 ⫺ 1

NPV ⫽ ⫺1469.20 ⫹ 1560.34 ⫽ £91.14

The internal rate of return is the discount rate at which NPV ⫽ 0 which we need
to find by trial and error. For instance, to evaluate the NPV at a rate of, say, 7%
we substitute 1.07 for 1.06 in both terms of the expression for NPV above. Some
results are
discount rate % first term £ second term £ NPV £
ASSESSMENT 3

5 ⫺1489.30 1621.56 132.26

6 ⫺1469.20 1560.34 91.14
7 ⫺1449.73 1503.05 53.32
8 ⫺1430.84 1449.38 18.54
9 ⫺1412.52 1399.05 ⫺13.47
It seems that NPV is a decreasing function of discount rate. (This need not be the
case because the NPV in this example is the difference between two geometric
series, each of which decreases with an increase in discount rate.) From the above
NPVs it appears that the IRR lies between 8% and 9%. The NPV at 8.5% is
£2.20. We conclude that the IRR is a little over 8.5%.
8. This is included in an attempt to ground the work in reality. It is not difficult to
find advertisements for loans or mortgages quoting a nominal rate usually payable
monthly and also stating the effective rate (APR in the UK).
A clever student could also confirm calculations of the amount of the
repayment as well.