BUSINESS MATHEMATICS

PROGRAM

BACHELOR’S
DEGREE IN
MARKETING
PROFESSOR: Daniel González
ACADEMIC COURSE: 2021- 2022 (BCN)

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BUSINESS MATHEMATICS

04
FINANTIAL AND INVESTMENT OPERATIONS

4.1 EQUIVALENT RATES

During the last lesson we revised the mechanics of the simple and compound capitalisation laws to
be able to find equivalent amounts of money in different moments of time.

However, we used to work with annual rates. In this section, helping ourselves with concepts we
already saw in Lessons 2 and 3 we are going to find out how to obtain equivalent rates for different
periodicities (e.g., find the equivalent monthly rate given an annual rate or vice versa).

To find equivalent interest rates first we should define the capitalisation system: simple or
compound. From now on, to understand the formulas that will come next, we will use the notation
P1 for the interest rate of the period whose duration is bigger, P2 for the interest rate of the period
whose duration is smaller and n for the number of periods P2 included in P1.

For example, if we want to convert a monthly interest rate to its annual equivalent, we will have
that P1 is the annual interest rate (bigger duration), P2 is the monthly interest rate (smaller
duration) and n=12, since we have 12 months in 1 year.

Therefore, with the simple capitalisation law, we find equivalent interest rates with different
periodicities with the following formulae:

𝑃1 = 𝑃2 ∗ 𝑛

𝑃1
𝑃2 =
𝑛

While for the compound capitalisation law the formulae are:

𝑃1 = (1 + 𝑃2)𝑛 − 1

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𝑛
𝑃2 = √1 + 𝑃1 − 1

These equivalences will be fundamental to solve financial problems provided that in many occasions
we will need to convert the interest rate before doing some other operations.

4.2 KEY ELEMENTS IN FINANCIAL

OPERATIONS
Any financial operation should have 4 key elements perfectly defined that will make it different
from any other operation:

• Initial capital (C0): Capital that is transacted at the beginning of an operation.

• Interest rate (i): Quantity that compensates the postponement or anticipation of
capitals.
• Duration (n): Number of periods the operation lasts.
• Periodicity: Time gap that goes by between the periodic payments.

A fundamental thing to do the correct calculations with financial operations is that the three last
variables are expressed in the same time units. This is, if the interest rate provided is annual, the
duration should be expressed in years and the periodicity (periodic payments) will be done every
year. If the initial situation does not provide us this circumstance, the rule is to use the periodicity
to determine the units of the other variables (the periodicity cannot be changed because is part of
the agreement in a financial operation but the other two can be converted). In the previous section
we have defined how to find equivalent interest rates and expressing the duration in a different time
unit is a trivial calculation.

4.3 ANNUAL PERCENTAGE RATE (APR)

CONCEPT
Financial products can be quite difficult to compare considering their different conditions
(commissions, maturity, interest rates, periodicity…). To illustrate this idea let’s consider two
different options to get a 10.000€ loan.

Bank 1:

• The origination fee to get the loan equals to 0,5% of the borrowed quantity. This
quantity should be paid when the loan starts.
• To return the loan, an annual fee of 2.200€ should be paid during 5 years.

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Bank 2:

• The origination fee to get the loan equals to 1,5% of the borrowed quantity. This
quantity should be paid when the loan starts.
• To return the loan, a monthly fee should be paid during 4 years. The fee of the first
month equals to 200€ and it will be increasing 0,5% every month.

As you can see it is not trivial to compare those two options since their conditions are quite different.
Quite often, individuals asking for credit are not familiar with financial laws and, therefore, they
could be easily tricked by experts on this area. To prevent this situation, many countries force
financial entities to provide the Annual Percentage Rate (APR) of all the financial products they
offer. This rate allows the client to compare different financial products in the same fair conditions.

So, for the operation with Bank 1 the cash-flows for the client would be the following:

Today: +9.950€ (10.000€ he gets minus the 0,5% commission paid at the beginning)
Year 1: -2.200€
Year 2: -2.200€
Year 3: -2.200€
Year 4: -2.200€
Year 5: -2.200€

Therefore, the APR is calculated as follows:

2.200 2.200 2.200 2.200 2.200

9.950 = + + + +
(1 + 𝐴𝑃𝑅)1 (1 + 𝐴𝑃𝑅)2 (1 + 𝐴𝑃𝑅)3 (1 + 𝐴𝑃𝑅)4 (1 + 𝐴𝑃𝑅)5

You may relate this formula with the NPV (Net Present Value) concept we will see in next section.
Actually, the APR is the annual rate you need to apply to make both the quantity received and the
quantity returned equivalent.
In general, isolating APR in this equation is not possible and we need to use numerical methods to
approximate it. However, there are some software able to calculate this value.

In this case: APR=0,0344=3,44%.

In the second example, calculations are slightly more complicated because the payments are done
monthly instead of yearly. Nevertheless, we can apply the same method to get the Monthly
Percentage Rate of this financial operation and then transform it to APR using what we learned in
Section 1.

Now, cash-flows will be the following (remember each month we pay a fee 0,5% higher than last
month):

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Today: 9.850€ (10.000€ he gets minus the 1,5% commission paid at the beginning)
Month 1: 200€
Month 2: 201€
Month 3: 202,01€
Month 4: 203,02€
…
Month 48: 252,83€

Just by solving the same kind of equation we did before we get a monthly rate equal to 0,003748.
Applying the formula in section 1:

𝐴𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = (1 + 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑅𝑎𝑡𝑒)12 − 1 = (1 + 0,003748)12 − 1 = 𝟎, 𝟎𝟒𝟓𝟗

So, the APR for this credit is 4,59% which is larger than the APR calculated with Bank 1
conditions.

Just as a comment this doesn’t necessarily mean that we should always go for the option with the
lowest APR (although it is recommended). Imagine, for example, that you want the money for an
investment that will not produce positive cash-flows until the 3rd year. Then, if one bank offers you
the possibility to postpone payments until the 3rd year while other doesn’t you may have no choice
even if the APR of this second option is lower.

As it has been said, the purpose of this APR concept is to compare different financial operations
with just one indicator in order to make it easier for people who is not used to work with financial
mathematics.

4.4 METHODS FOR INVESTMENT SELECTION

This section will cover some of the more frequently used methods to assess the convenience of an
investment or to compare investments involving different cash-flows.

4.4.1 NET PRESENT VALUE (NPV)

To assess whether an investment is convenient or not it makes sense to consider the present value
of all the future cash-flows that will be generated thanks to this investment and then compare it
with the initial expenditure.

The formula to calculate the NPV of an investment is the following:

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛

𝑁𝑃𝑉 = −𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 + + + ⋯+
(1 + 𝑖)1 (1 + 𝑖)2 (1 + 𝑖)𝑛

Where,

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Initial expenditure: Refers to the amount of money necessary to carry out the investment

CFn: Cash-flow expected in the n-th period. It is calculated by adding the revenues and subtracting
the expenses for the whole period. Normally, the length of the periods considered is a year.

i: This item is called discount rate and the criteria to fix it is subjective and could differ from person
to person. It can be fixed, for instance, as the return expected by an investment with similar risk
(not always easy to quantify) or the return that can be obtained by an almost risk-zero operation
(easier to know).

A positive NPV is interpreted as follows: the present value of all the cash-flows generated by the
investment are larger than the initial expenditure. Therefore, this investment is advisable.

Obviously, the opposite conclusions could be drawn for negative NPV values.

Nevertheless, this criterion might be not enough to choose between two (or more) investment
alternatives. Choosing the highest NPV is not always a reasonable strategy.

For example, consider these two alternatives:

Investment 1 Investment 2

Initial Expenditure 100.000€ 1.000.000€

NPV 20.000€ 20.500€

Probably you would prefer to spend your money in Investment 1. The NPV is just slightly smaller
compared to Investment 2 but the difference is that initially you need to invest much less money
(i.e., investing in 1 would allow you to have 900.000€ extra to invest somewhere else).

So, this is a valid criterion to check the convenience of a particular investment or to compare two
(or more) investments with similar initial expenditures. However, to assess investments with
substantially different initial expenditures we might need another tool.

4.4.2 INTERNAL RETURN RATE (IRR)

Conceptually, the IRR has the same intuition as the APR seen in Section 2. The only difference is
that IRR is used to check how profitable is the money you invest, and APR is used to check how
expensive it is for you to borrow money.

Therefore, the IRR is the discount rate at which the Cash-Flows generated by an investment equal
the initial expenditure. In other words, which rate makes the NPV equal to zero.

𝐶𝐹1 𝐶𝐹2 𝐶𝐹𝑛

0 = −𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 + 1
+ 2
+⋯+
(1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅) (1 + 𝐼𝑅𝑅)𝑛

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As it happened in Section 2 isolating IRR from this equation is only manageable in few situations.
In general, you need a software that approximates the answer.

This figure shows the relationship of three of the components used in this Section 3 (NPV, IRR and
discount rate). As you can observe any positive NPV shows that the IRR of the investment is bigger
than the discount rate used to perform this NPV calculation. Inversely, a negative NPV indicates
that IRR < Discount rate.

4.5 METHODS FOR LOAN AMORTIZATION

In this last section we are going to review the different methods used for redeeming loans.
Depending on the country, some methods are more popular than others.

4.5.1 FRENCH METHOD

The French loan is characterised by a constant fee over the whole period. This constant fee is
calculated with the following formula:

𝑖 ∗ (1 + 𝑖)𝑛
𝐹𝑒𝑒 = 𝐶0 ∗
(1 + 𝑖)𝑛 − 1

Where,

C0 = The total amount of money borrowed

i = The interest rate applied

n = Number of periods to pay the loan back

Here, it is crucial to link the i and the n with the same periodicity (i.e., if the interest is a monthly
rate the number of periods should be expressed in months while if the interest is an annual rate the
number of periods should be expressed in years).

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After calculating the fee to be paid periodically, the following table could be calculated to track the
state of the loan over the whole period. Let’s review it with an example:

C0 = 100,000€

i = 2% annual interest rate

n = 4 years

First of all let’s calculate the annual fee:

0,02 ∗ (1 + 0,02)4
𝐹𝑒𝑒 = 100,000 ∗ = 26,262.38€
(1 + 0,02)4 − 1

Now, let’s calculate some interesting values to track the state of the loan at the end of every year:

Fee Interests Amount amortised Pending amount

Y0 - - - 100.000

Y1 26.262,38 0,02*100.000=2.000 26.262,38-2.000=24.262,38 100.000-24.262,38=75.737,62

Y2 26.262,38 0,02*75.737,62= 1.514,75 26.262,38-1.514,75=24.747,62 75.737,62-24.747,62=50.990,00

Y3 26.262,38 1.019,80 25.242,58 25,747,43

Y4 26.262,38 514,95 25.747,43 0

Some comments about the amortisation table:

• The fee is the addition of two different concepts: part of the fee is used to pay the
interests generated by the loan and the rest is used to amortise it.
• The interests generated in every period are calculated using the interest rate over
the last pending amount available.
• The pending amount is calculated by subtracting the amount amortised in year n to
the pending amount in year n-1.
• Last column is useful in order to know which is the pending amount you would need
to pay in case you want to fully amortise the loan at any moment of time.

4.5.2 AMERICAN METHOD

The American method is easier to calculate and quite different in terms of periodic payments in
comparison with the French one. Amortising a loan by this method means that during the

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established period you will only be paying interests, and at the end of that period you will return
the total amount of the quantity borrowed.

So, the only calculation that needs to be made here is the periodic payment of interests that needs
to be done. This is as easy as multiplying the quantity borrowed times the interest rate applied.
Let’s take the example on the last section to draw the amortization table:

Fee Interests Amount amortised Pending amount

Y0 - - - 100.000

Y1 2.000 2.000 0 100.000

Y2 2.000 2.000 0 100.000

Y3 2.000 2.000 0 100.000

Y4 102.000 2.000 100.000 0

4.5.3 GERMAN METHOD

The German method consists on a series of payments which has a common amortization fee and a
decreasing interest fee, which leads to an overall total fee which decreases over time. We will
illustrate it with the same example used in previous sections.

Obviously, the formula to calculate this constant amortization fee (do not mix it up with the total
fee) you just need to calculate the quotient between the quantity borrowed and the number of
periods:

𝐶0
𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝐹𝑒𝑒 =
𝑛
In this case:

100.000
𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝐹𝑒𝑒 = = 25.000
4

Fee Interests Amount amortised Pending amount

Y0 - - - 100.000

Y1 2.000+25.000=27.000 100.000*0,02=2.000 25.000 75.000

Y2 1.5000+25.000=26.500 75.000*0,02=1.500 25.000 50.000

Y3 26.000 1.000 25.000 25.000

Y4 25.500 500 25.000 0

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To calculate the values of the different columns the same logic used for the French method holds.
However, now the constant item is the amount amortised (not the Total Fee) while the item you
need to calculate is this Total Fee (not the amount amortised). As you can observe, this method
implies decreasing total fees over time.

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