Maths (Investment and Finance Presessional)

Maths Review
(Presessionals)
Marco Alberto De Benedetto

Queen Mary University of London
September 2016
(Queen Mary University of London)
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Aims of the Lecture
The aim of this lecture is a review of some basic mathematical

concepts.
In particular, in this lecture we will review the concepts of:
Functions (linear, quadratic, hyperbolic, exponential and logarithmic);
Derivatives and rules of dierentiation;
Matrices;
Principles of Finance;
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September 2016
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Functions
Linear Function
A linear function takes the form:

y = c + mx
(1)
where y is the dependent variable; x is the independent variable; c is the

constant - intercept or value of y when x = 0; and m is the slope of the
line or gradient and it is calculated as:
y
=m
x
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Functions
Linear Function
According to m, a linear function can be graphically represented as:

y = c + mx
Example
y = 2 + 3x
y
16
14
12
10
8
6
4
2
-5
-4
-3
-2
-1
-2
-4
-6
-8
-10
-12
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Functions
Linear Function
y =c
mx
Example
y = 2 3x
y
16
14
12
10
8
6
4
2
-5
-4
-3
-2
-1
-2
-4
-6
-8
-10
-12
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Mathematical Review: Functions

Linear Function
y = c + mx
with m = 0
Example
y =2
y
3.0
2.5
2.0
1.5
-5
-4
-3
-2
-1
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Functions
Quadratic Function
A quadratic function takes the folllowing form:

y = ax 2 + bx + c
(2)
A quadratic function, according to a can be linear, convex and concave;
Example
if a = 0, the function above is a linear function.
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Functions
Quadratic Function
Example
if a > 0 as for example in y = x 2 + 4x + 3 this is a convex function
graphed as below:
y
40
30
20
10
-5
-4
-3
-2
-1
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Functions
Quadratic Function
This convex function has the following properties:

1
Domain: 8x 2 R
It is positive for x
It intersecates axis x at two points: ( 3, 0) and ( 1, 0); also it

intersecates axis y at the point (0, 3)
It has a minimum at ( 2,
3 and x
1).
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Functions
Quadratic Function
Example
x 2 + 6x
if a < 0 as for example in y =

graphed as below:
5 this is a concave function
x
-5
-4
-3
-2
-1
-10
-20
-30
-40
-50
-60
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Functions
Quadratic Function
This concave function has the following properties:

1
Domain: 8x 2 R
It is positive for 1
It intersecates axis x at two points: (1, 0) and (5, 0); also it

intersecates axis y at the point (0, 5)
It has a maximum at (3, 4).
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Functions
Hyperbolic Function
An Hyperbolic function takes the following form:

y=
1
+c
a + bx
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Functions
Hyperbolic Function
Example
y=
1
3 +x
+2
y
4
-5
-4
-3
-2
-1
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Functions
Exponential Function
An Exponential function takes the following form:

y = ax
(4)
It is a function where a constant base - a - is raised to a variable

exponent - x. It is commonly used to express growth rates such as
interest compounding and depreciation. This function y = ax has
the following properties:
The domain of this function is the set of all real numbers: 8x 2 R.
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Functions
for a > 1 the function is increasing
Example
y = 5x
y 3000
2000
1000
-5
-4
-3
-2
-1
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Functions
for a < 1 the function is decreasing
Example
y = 0.6x
y 12
10
8
6
4
2
-5
-4
-3
-2
-1
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Functions
Logarithmic Function
The inverse of an exponential function x = ay is called logarithmic

function
A Logarithmic function looks like:
y = loga x
(5)
With a > 0 and a 6= 1. In other words, the logarithm of a number is the

exponent to which the base a of the logarithm must be raised to get that
number.
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Functions
A logarithmic function as y = loga x has the following properties:

Domain 8x 2 R with x > 0 ! D (0 + ). In other words, we can
only plug positive numbers into a logarithm. We cannot plug in zero
or a negative number.
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Functions
If a > 1 the function is increasing and concave
Example
y = log3 x
y
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.8
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Functions
If a < 1 the function is decreasing and convex
Example
y = log0.5 x
y
1
0
1
-1
-2
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Functions
Fact
Remenber that there are a couple of special logarithms that arise in many
places. These are:
lnx = loge x this log is called natural logarithm
logx = log10 x this log is called common logarithm
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Functions
More properties of logarithms:

1
loga (xy ) = loga x + loga y
loga ( yx ) = loga x
3
4
loga y
loga x n = n loga x
p
loga n x = n1 loga x
loga 1 = 0
loga a = 1
loga (am ) = m
loge (e bx ) = bxloge e = bx
1 = bx
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Functions
More Examples
Examples
The graph of the function y =
x 2 + 2x + 3
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Functions
More Examples
Examples
The graph of the function y =
p
2
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Functions
More Examples
Examples
The graph of the function y = x 3
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Derivatives
Concept of Derivative
Given the function y = f (x ) as

y = 3x 2
(6)
Question: What is the marginal impact of x on y ? In other words, what

is the marginal variation of y due to a marginal variation of x?
Answer: this impact is what we call derivative and can be calculated as:
f 0 (x ) =
dy
= 6x
dx
(7)
It tells us that, when x changes by 1, y changes by 1 times 6.
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Derivatives
Geometric Meaning of Derivative
The geometric meaning of the derivative

df (x )
dx
is the slope of the line tangent to y = f (x ) at x.
f 0 (x ) =
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(8)
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Derivatives
Lets look for this slope at P.

Notice that the Secant line through P and Q has slope:
f (x + 4x ) f (x )
f (x + 4x )
=
(x + 4x ) x
4x
f (x )
(9)
We can approximate the Tangent line through P by moving Q towards P,

decreasing 4x. In the limit as 4x ! 0, we get the tangent line through
P with slope:
f (x + 4x ) f (x )
lim
(10)
4x
4x !0
We thus dene the derivative as the following limit:
f (x + 4x )
4x
4x !0
f 0 (x ) = lim
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f (x )
(11)
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Derivatives
Note that given

f (x + 4x )
4x
4x !0
f 0 (x ) = lim
f (x )
If the limit as 4x ! 0 at a particular point does not exist - i.e., if the

function is not dierentiable - f 0 (x ) is for sure undened and not
continuos at that point. This because dierentiable functions are a
sub-set of continuos functions.
The process of going from f (x ) ! f 0 (x ) is called dierentiation.
We derive all the basic dierentiation formulas using this denition.
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Derivatives
Example
For f (x ) = x 2 we will have:
f (x + 4x )2 x 2
4x
4x !0
2
[x + 2(4x )x + 4x 2 ] x 2
= lim
4x
4x !0
2(4x )x + 4x 2
= lim
4x
4x !0
= lim 2x + 4x = 2x as expected
f 0 (x ) =
lim
4x !0
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Dierentiation
Dierentiation Formulas
In this section we will see some basic computation formulas that will
allow us to actually compute some derivatives:
y = k =) y 0 = 0
y = x =) y 0 = 1
y = loga x =) y 0 =
1
x
y = log f (x ) =) y 0 =
y = kf (x ) =) y 0 = kf
1
f 0 (x )
f (x )
0 (x )
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Dierentiation
y = kx n =) y 0 = nkx n
y = x n =) y 0 = nx n 1
p
m
y = n x m =) y 0 = p
n
n xn
p
1
y = 2 x =) y 0 = 2 p
2 x
y = f (x )n =) y 0 = nf (x )n
f 0 (x )
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Dierentiation
y = f (x )
g (x ) =) y 0 = f 0 (x )
g 0 (x )
y = f (x ) g (x ) =) y 0 = f (x ) g (x ) + f (x ) g 0 (x )
0
f (x ) g (x )+f (x ) g 0 (x )
g (x )2
y=
f (x )
g (x )
y=
1
=) y 0 = [ff ((xx)])2
f (x )
1
1
0
x =) y =
x2
1
n
0
x n =) y =
x n +1
y=
y=
=) y 0 =
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Dierentiation
y = f [g (x )] =) y 0 = f 0 (g (x )) g 0 (x )
y = ax =) y 0 = ax
y=
ex
y0
log a
ex
=) =
y = af (x ) =) y 0 = af (x ) f 0 (x ) log a
y = e f (x ) =) y 0 = e f (x ) f 0 (x )
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Dierentiation
Dierentiation Formulas: The Chain Rule
Suppose that we have a composite function y = f (u ) where u = g (x ) so

that
y = f [g (x )]
(12)
We can get the derivative of this function by applying the Chain Rule:
dy
dy
=
dx
du
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du
dx
(13)
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Dierentiation
Second order derivatives
Given the function

y
= kx n =) y 0 = nkx n 1 First order derivative (FOD)

=) y 00 = n(n 1)kx n 2 Second order derivative (SOD)
Fact
The FOD is the slope of the primitive function and it tells whether this
function is increasing or decreasing in x; while the SOD is the slope of
the rst derivative and it tells us if the primitive function is convex or
concave.
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Dierentiation
Maxima and Minima
In order to classify a point as a maximum or a minimun you need to follow

two steps:
1
Finding the FOCs: f 0 (x ) = 0 and evaluate them in x = x0 where x0 is

the critical point. Recall that
If f 0 (x0 ) > 0 =) increasing function
If f 0 (x0 ) < 0 =) decreasing function
Finding the SOCs, i.e, compute the second derivatives and

00
If f (x ) > 0 =) convex function (minimum)

00
If f (x ) < 0 =) concave function (maximum)
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Dierentiation
Maxima and Minima
If f 0 (x ) > 0 and =) f 00 (x ) > 0 =)Function increasing at an

increasing rate
If f 0 (x ) > 0 and =) f 00 (x ) < 0 =)Function increasing at a
decreasing rate
If f 0 (x ) < 0 and =) f 00 (x ) < 0 =)Function decreasing at an
increasing rate
If f 0 (x ) < 0 and =) f 00 (x ) > 0 =)Function decreasing at a
decreasing rate
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Matrices
Denitions
A Matrix m*n is a set of m n real numbers ordered by rows and

columns:
2
3
a11 a12 a13
Am n = 4 a21 a22 a23 5
a31 a32 a33
(14)
If m = n the matrix is a Square Matrix with number of rows equal to the

number of columns.
In a square matrix only, the elements aij with i = j identify the principal
diagonal (in bold)
2
3
2 1
1
5 0 5
A3 3 = 4 3
(15)
1 1
4
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Matrices
Denitions
A Symmetric Matrix is a matrix in which the elements opposed to

the principal diagonal are the same:
A3
1 2
=4 2 0
3 5
3
3
5 5
1
(16)
A Symmetric Matrix coincides with its Transpose, which is the

matrix obtained by changing the columns in rows. For example, given
the symmetric matrix above, its transpose will be:
2
3
1 2
3
AT = 4 2 0 5 5
(17)
3 5 1
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Matrices
Denitions
A Null Matrix is a matrix in which the elements are all zero.

An Identity Matrix is a matrix which has 1 on the principal diagonal
and zero everywhere else.
2
3
1 0 0
I =4 0 1 0 5
(18)
0 5 0
A Diagonal Matrix is a matrix which has a number on the principal

diagonal and zero everywhere else.
A Matrix is said Antisymmetric if it is square and if the elements
o-diagonal are the opposite of each other:
2
3
1 6
1
2 5
AS = 4 6 3
(19)
1 2 5
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Matrices
Addition and Subtraction of Matrices
In order to add (subtract) two matrices, the two matrices need to have the
same dimension. The addition (subtraction) is done by adding
(subtracting) each element of one matrix (from) to the corresponding
element of the other. For example, given two matrices A and B:
2
3
2
3
2
3
8 9 7
1 3 6
8+1 9+3 7+6
A4 3 6 2 5+B 4 5 2 4 5 = 4 3+5 6+2 2+4 5
4 5 10
7 9 2
4 + 7 5 + 9 10 + 2
2
3
9 12 13
(20)
A+B = 4 8 8 6 5
11 14 12
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Matrices
Scalar Multiplication
Multiplication of a Matrix A by a scalar K eR - a simple number - involves

multiplication of every element of the matrix by the scalar:
2
3
2
3
a11 a12 a13
ka11 ka12 ka13
A3 3 = 4 a21 a22 a23 5 K = 4 ka21 ka22 ka23 5
(21)
a31 a32 a33
ka31 ka32 ka33
Example
3
2
3
6 9
6 8 9 8
A = 4 2 7 5 8 = AK = 4 2 8 7 8 5
8 4
8 8 4 8
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Matrices
Multiplication of Matrices
Multiplication of two matrices A and B is done by multiplying each row of

A by each column of B and summing the elements. The principle of
conformability says that two matrices A and B may be multiplied i the
number of columns of A is equal to the number of rows of B; i.e., if
A(m p ) and B (p n ) =) A B = C (m n ) ;
Example
A(2
3)
1
0
=) C (2
2 3
1 4
4)
0+2
0 1
and B (3
0
4) 4
1
1
3 1+6
4 0 3
Maths Review
3
4
1
3
1
3
1 2
2 5 5
0 1
(22)
1 + 4 + 0 2 + 10 + 3
0 2 0
5 4
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Matrices
Determinant of a Matrix
It is possible to associate to each matrix a number called Determinant of

the Matrix. Lets see how to calculate the determinant of a matrix.
The Second-Order Determinant, i.e., the determinant of a Matrix
A(2 2 ) , is derived by subtracting the product of the second diagonal
from the product of the principal diagonal:
Example
A2
a11 a12
a21 a22
=) det jAj = a11 a22
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a12 a21
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(23)
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Matrices
Recall that the Determinant is a single number - scalar - and it is

dened only for square matrices.
If the Determinant of a matrix is zero, the matrix is termed Singular,
which is a matrix in which there exists linear dependence between at
least two rows or columns;
If the Determinant is dierent from zero, the matrix is Nonsingular
and all rows and columns are linearly independent.
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Matrices
The Third-Order Determinant, i.e., the determinant of a Matrix A(3 3 ) ,

can be computed in dierent ways.
Sarrus Method, consists in adding to the matrix the rst two
columns and compute the determinant as the sum of the products of
the principal diagonals minus the sum of the products of the second
diagonals.
Example
A3
3
2
3
8 3 2
8 3 2 8 3
= 4 6 4 7 5 =) det jAj = 4 6 4 7 6 4 5
5 1 3
5 1 3 5 1
= [(8 4 3) + (3 7 5) + (2 6 1)]
(8 7 1) + (2 4 5)]
= 63
Maths Review
(24)
[(3 6 3) +
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Matrices
Rank of a Matrix
The Rank of a matrix is the maximum number of linearly independent

rows or columns present in the matrix. It is, in other words, the maximum
number of non-null vectors extracted from the matrix. Let (A) be the
rank of the matrix A and n the dimension of the matrix.
if (A) = n =) the Matrix is singular and it has maximum rank;
if (A) < n =) the Matrix is non-singular and contains linearly
dependent vectors;
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Matrices
Rank of a Matrix
To nd the Rank of the following Matrix

2
1
2
A(3 4 ) = 4 2 0
0 4
1
1
3
3
3
1 5
7
we need to nd the number of square sub-matrices contained in it with

determinants dierent from zero.
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Matrices
Rank of a Matrix
All the sub-matrices (3 3) have determinant equal to zero:

2
3
1
2
1
1 5 =) det jB j = 0
B (3 3 ) = 4 2 0
0 4
3
2
3
1
2 3
1 5 =) det jC j = 0
C (3 3 ) = 4 2 0
0 4
7
2
3
2
1 1
1
1 5 =) det jD j = 0
D (3 3 ) = 4 0
4
3
7
2
3
1
1 3
1 5 =) det jE j = 0
E (3 3 ) = 4 2 1
0 3
7
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Matrices
Rank of a Matrix
Therefore, the Matrix A cannot have Rank 3. However, since the rst
submatrix (2 2) below, has determinant dierent from zero, Matrix A
has Rank 2:
1
2
a (2 2 ) =
=) det jaj = 4 6= 0
2 0
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Matrices
Adjoint Matrix
Given a Matrix A, in order to nd its Adjoint Matrix, we need to follow

two steps:
1
Compute its Cofactor Matrix
Transpose the Cofactor Matrix.
In other words, the Adjoint Matrix is the Transpose matrix of the

Cofactor Matrix
Example
Given a Matrix A
3
2 3 1
A=4 4 1 2 5
5 3 4
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(25)
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Matrices
Adjoint Matrix
Example
and its Cofactor
2
1
6
3
6
6
3
C =6
6
3
6
4
3
1
Matrix C :
4 2
5 4
2 1
5 4
2 1
4 2
2
4
1
4
1
2
4 1
5 3
2 3
5 3
2 3
4 1
the Adjoint matrix is C T :

AdjA = C T
2
=4 6
7
Maths Review
7 2
7
2
7
7=4 9
7
7
5
5
6
3
0
3
7
9 5
10
3
9 5
3
0 5
9 10
(26)
(27)
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Matrices
Inverse Matrix
Let A be a Matrix and A
its inverse.
Remember that when you multiply a matrix by its inverse, you get the
Identity Matrix I :
I =A A 1
(28)
Denition
The Inverse Matrix A
can be dened as it follows:

A
1
AdjA
det jAj
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Matrices
Inverse Matrix
Example
Lets nd the inverse of the following matrix
2
3
4
1
5
1 5
A=4 2 3
3
1 4
(30)
First, we need to check whether it is a square matrix because square

matrices only can have the inverse (and that is a square matrix
3x3)
Second, we need to make sure that the determinant is non-zero,
because only non-singular matrices can have the inverse (and it is
non-singular as its determinant =98)
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Matrices
Inverse Matrix
Third, we need to compute the Cofactor

2
2
2 1
3 1
6
3
3
4
1
4
6
6
4
4
5
1
5
C =6
6
3
3 4
1 4
6
4
1
5
4
5
4
3 1
2 1
2
Matrix of A, that is:

3
3
7 2
1
7
13 11
7
1
7 = 4 1 31
1 7
7
16 6
5
1
3
Fourth, we transpose C to get the adjoint

2
13 1
4
11 31
AdjA =
7 7
Maths Review
3
7
7 5
14
Matrix AdjA:
3
16
6 5
14
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Matrices
Inverse Matrix
Fifth, we get the Inverse Matrix A

the AdjA by det1[A ] :
Inverse Matrix A
Finally, if you do A A
by multiplying each element of
3
13/98 1/98 16/98
= 4 11/98 31/98 6/98 5
7/98 7/98 14/98
(31)
you must get I if the inverse is correct.
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Principles of Finance
Capital Budgeting;
Interest rates : simple and compound interest rates;
Depreciation.
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Capital Budgeting
One of the most crucial decisions made in the business world is an

investment decision, where investors have to choose the most worthy
project to fund.
Given that alternative investment opportunities dier in many aspects,
such as the level of risk associated with them, and their capacities to
yield future returns, the criteria for choice would be to assess carefully
the proposed alternatives, and select the potentially most protable.
Cash ow analysis is most helpful in determining the protability of
capital.
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The Net Present Value Rule

Two Basic Principles
Present value is the value that has today a ow of future wealth. For
example, if I invest in a building that tomorrow will give me 100, the
value today of 100 is the PV.
Future value is the value that has in the future an amount of money
invested today. For example, if we denote the future value of 100
with FV , this will be equal to:
FV = $ 100 (1 + r )t
this is the value that at time t a current amount of 100 will have.
Here there is as implicit the basic principle of nance: the time value
of money according to which a dollar invested today is worth more
than a dollar tomorrow because it can immediately gain interest.
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In fact, there are two basic principles to follow to fully understand how the
net present value rule works:
1 A pound today is worth more than a pound tomorrow.
Because, by using such pound today - instead of tomorrow - one can
invest it immediately and begin to earn interest immediately. In order
to compare money today with money that we will receive tomorrow,
we have to use a discount interest, r , which may be seen as the
opportunity cost of capital:
1
C1
1+r
where C1 is the expected payo one year from now;
PV =
(32)
1/(1 + r ) is the so-called discount factor;

r is the current interest rate, or discount rate or the opportunity cost of
capital; it is the return foregone by investing in the project rather than in
equivalent risk securities (the return oered by equivalent investments).
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Example
For example, lets suppose that we are investing 400,000 at 5% interest
for one year. A year from now we will get:
400, 000(1 + 0.05) = $ 420, 000 = FV
(33)
This is the future value of 400,000 invested today. Because of the time
value of money - according to which one pound today is worth more than
one pound tomorrow - 420,000 next year must be worth less than 420,000
today. How much less? the answer is
400, 000 =
420, 000
= PV
1 + .05
(34)
400,000 because investors can put 400,000 today, earn 5% interest and
get 420,000 next year.
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To value investment, the Net Present Value NPV is:

NPV =
1
C1 + C0
1+r
(35)
where C0 is usually a negative number (is the initial cost of the

investment).
Maths Review
September 2016
63 / 110

2 A safe pound is worth more than a risky pound. Individuals

dislike risk. Hence, risky projects whose payos are uncertain should
be discounted by higher discount rates than the rates of safe
investments, r , otherwise the investment in the risky project will be
no beneciary.
1
C1
(36)
PV =
1 + (r + )
where is a measure of risk.
Maths Review
September 2016
64 / 110

Decision Rules for Capital Investment:
a. Choose investments with positive NPVs. Among these,

choose the one associated with the maximum NPV , and
invest up to the point where NPV = 0.
b. Rate of Return Rule (ROR): Choose investments that
oer rates of returns in excess of their opportunity costs of
capital. Among those, choose the one associated with the
highest dierences. The ROR can be computed as:
Prots = Revenues
ROR =
Costs
(37)
Revenues Costs
Costs
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(38)
September 2016
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The opportunity cost of capital is a very important concept. Suppose

you may invest today 100,000 and that the expected payo of this
investment is 110,000. This means that the Expected return of this
investment is:
110, 000 100, 000
= 10%
(39)
ERI =
100, 000
Suppose that the expected return of an investment with equivalent risk
(i.e., in common stock) or opportunity cost of capital is 15%.
Therefore, the PV of our investment is obtained by discounting the
expected payo by the OCC
PV
NPV
110, 000
= $ 95, 650
(1 + 0.15)
= 95, 650 100, 000 = $ 4, 350
Maths Review
September 2016
(40)
66 / 110

It is not worth to undertake this investment because of two reasons:

(a) NPV < 0
(b) The Rate of Return <Opportunity cost of capital (10% < 15%)
Maths Review
September 2016
67 / 110

More than Two Periods
However, people lives more than two periods.

We extend the decisional problem to more than two periods and we
show how to use the Net Present Value rule in practice.
PV of Annuities and Perpetuities(assets that produces a stream of
cash ow)
We know that the present value of an asset that produces a certain cash
ow (C1 ) one year from now is
PV =
1
C1
1 + r1
(41)
where r1 is the interest rate between t and t + 1.

Maths Review
September 2016
68 / 110

Similarly, the present value of an asset that produces a cash ow 2 years

from now can be written as:
PV =
1
C2
(1 + r2 )2
(42)
1/(1 + r2 )2 is the discount factor for the year 2 Cash ow;

r2 is the annual interest paid on the money invested for 2 years.
Note that, between t and t1 you get C0 + C0 r2 and between t1 and t2 you
get also (C0 + C0 r2 )r2
If you sum all, you get: C0 + C0 r2 + (C0 + C0 r2 )r2 This is equal to
C0 (1 + r2 ) +C0 r2 (1 + r2 ) = (1 + r2 )(C0 + C0 r2 ) = C0 (1 + r2 )2
Maths Review
September 2016
69 / 110

Thus, the present value of an asset that produces an extended stream

of cash ows is:
PV
1
1
1
1
C1 +
C2 +
C3 + .. +
Cn
2
3
1 + r1
(1 + r2 )
(1 + r3 )
(1 + rn )n
n
1
C
(43)
=
t t
t =1 (1 + rt )
which is called the Discounted cash ow (DCF) formula.

And the formula for the NPV:
n
NPV = C0 +
t =1
n
1
1
Ct =
C
t
t t
(1 + rt )
t =0 (1 + rt )
Maths Review
September 2016
(44)
70 / 110

Valuing Perpetuities
In the following subsections, DCF formulas for very common

typologies of assets are provided.
Perpetuities are essentially bonds (government securities) that oer a
xed income (coupon payment) for each year to perpetuity and there is no
obligation for the government to repay the nominal value. In this case,
both the cash ow and the interest rate are constant, say C and r
respectively. Substitute these information in equation 11 to obtain:
PV =
1
1
1
1
C+
C+
C + .... +
C
2
3
1+r
(1 + r )
(1 + r )
(1 + r )n
Maths Review
September 2016
(45)
71 / 110

and rearranging:
PV =
setting
1
1
1
1
C 1+
+
+ .... +
2
1+r
(1 + r ) (1 + r )
(1 + r )n
1
1 +r
1
(1 + r )n
(46)
= x yields
PV = xC 1 + x + x 2 + .... + x n
Maths Review
+ xn
(47)
September 2016
72 / 110

Actually we know that the sum in bracket is a sum of an innite geometric

expansion, which equals:
1 + x + x 2 + .... + x n
+ xn =
1
1
(48)
By substituting this expression in equation (47), yields:

1
PV = xC
(49)
and, substituting for x:

1
PV =
C
1+r
"
1
1
Maths Review
1
1 +r
(50)
September 2016
73 / 110

and, rearranging:
PV =
1+r
1
C
1+r
r
(51)
which, at the end of the day, gives:

PV =
C
r
Maths Review
(52)
September 2016
74 / 110

Hence, the present value of a perpetuity, is simply the value of the

constant cash ow, over the rate of return it pays forever. It tells us the
value of a stream of payments starting one year from now and lasting
forever. Notice that the last formula may be used as an inverse formula:
r=
C
PV
(53)
Example
What is the present value of a perpetuity that oers 1 billion every year
for all eternity, with a perpetual discount rate of 10%?
Answer:
$ 1 billion
PV perpetuity =
= $ 10 billion
0.10
Maths Review
September 2016
75 / 110

Valuing Growing Perpetuities
Often, for such perpetuities, instead of having a xed income, you have an
income which grows at a constant rate, g (that is the growth rate in costs
in the economy). If this is the case, the PV formula will look like:
PV =
1
1
1
1
C1 +
C2 +
C3 + .... +
Cn
2
3
1+r
(1 + r )
(1 + r )
(1 + r )n
(54)
because payments are not equal across periods. However, we know that
payments are growing at a constant annual rate of g . Therefore:
C2 = (1 + g )C1
C3 = (1 + g )2 C1
..................
Cn = (1 + g )n C1
Maths Review
September 2016
76 / 110

and, of course, we can use this information in the PV formula:

PV =
(1 + g )
(1 + g )2
(1 + g )n 1
1
C1 +
C
+
C
+
....
+
C1 (55)
1
1
1+r
(1 + r )2
(1 + r )3
(1 + r )n
Rearranging as in the previous case:

PV =
1
(1 + g )n
1+g
(1 + g )2
C1 1 +
+
+
....
+
1+r
(1 + r ) (1 + r )2
(1 + r )n
Maths Review
1
1
(1 + g )n
(1 + r )n
(56)
September 2016
77 / 110

Setting now
1 +g
1 +r
= x yields:
PV =
PV =
1
1 +r C1
1
1 +r C1
PV =
1
1 +r C1
PV =
1
1 +r C1
1 + x + x 2 + .... + x n
+ xn
1
1 x
1
( i11++gr )
1 +r
r g
Hence, after working a bit with algebra, you obtain:

PV =
C1
r
(57)
Of course, this formula may be used only if r > g . Notice also that the
present value depends on the value of the cash ow one earns after 1 year.
Maths Review
September 2016
78 / 110

Example
What is the present value of a perpetuity which gives 1 billion each year,
assuming an interest rate of 10% and a constant growth rate of 4% per
year?
Answer:
$ 1 billion
PV =
= $ 16.667 billion
0.10 0.04
Maths Review
September 2016
79 / 110

Valuing Annuities
An Annuity is an asset that pays a xed sum each year for a specied
number of years only (for example the mortgage of the house). In such a
case, n is not going to innity in the following formula:
PV =
1
1
1
1
C+
C+
C + .... +
C
1+r
(1 + r )2
(1 + r )3
(1 + r )n
(58)
This simply changes the expression of the geometric expansion, which is

not innite in such a case, but rather a nite one:
PV =
setting
1
1 +r
1
1
1
1
+ .... +
C 1+
+
2
1+r
(1 + r ) (1 + r )
(1 + r )n
(59)
= x yields
PV = xC 1 + x + x 2 + .... + x n
Maths Review
(60)
September 2016
80 / 110

Valuing Annuities
The sum in brackets is known that represents the sum of an nite

geometric expansion, which equals:
1 + x + x 2 + .... + x n
1 xn
1 x
(61)
By substituting this expression in equation above for the PV, yields:

1 xn
1 x
PV = xC
(62)
and, substituting back for x:

1
PV =
C
1+r
"
1
1
Maths Review
#
1 n
1 +r
1
1 +r
(63)
September 2016
81 / 110

Valuing Annuities
and, by rearranging:
PV =
PV =
(1 + r )n 1
1
C
1+r
r (1 + r )n 1
(1 + r )n
1
C
1+r
r (1 + r )n
1
r (1 + r )n
(64)
(65)
which, at the very very end of the day, gives:

PV = C
1
r
1
r (1 + r )n
Maths Review
(66)
September 2016
82 / 110

Valuing Annuities
Example
What is the present value of an annuity which pays 5,000 a year for the
next 5 years, if the interest rate is 7%?
Answer:
PV = 5, 000
1
0.07
1
0.07(1 + 0.07)5
Maths Review
= $ 20, 501
September 2016
83 / 110
Internal Rate of Return (1)
The Internal rate of return (IRR) is another method that helps to

determine whether a proposed investment is worthwhile.
The method is supposed to utilize the rate of return on invested
capital that the proposed project is hoped to yield.
It is the rate that equates the cash outows and inows at their
present value.
Maths Review
September 2016
84 / 110
Internal Rate of Return (2)
In other words it is the rate at which the net present value would
equal zero since there would be no dierence in the equality of the
two cash ows:
NPV =
FV
(1 + IRR )n
I0 = 0
The primary criterion is that the internal rate of return has to be

equal to or greater than the rms required cost of capital.
In particular, the rate of return will be:
r=
FVk I0
k FVk
Maths Review
September 2016
85 / 110
Example (IRR)
Example
A proposal for an investment project calls for $ 15,000 in initial capital. It
promises that its returns will be as follows in the next ve years,
respectively: $3,600, $4,200, $5,500, $6,300, $7,500. n=5;
FVk = FV1 , FV2 , FV3 , FV4 , FV5 ; I0 = $12, 000. What would be the
internal rate of return?
Maths Review
September 2016
86 / 110
Solution (IRR)
Solution
FVk = 3, 600 + 4, 200 + 5, 500 + 6, 300 + 7, 500 = $27, 100

k FVk = $91, 200
r=
27, 100 15, 000

= 13.27%
91, 200
Maths Review
September 2016
87 / 110
Protability Index
Instead of taking the zero dierence between th cash inows and

outows, where the IRR has to make that dierence nonexistent,
another criterion is used to assess the worthiness of the new
investment proposal.
The protability index (PI) is dened as the ratio of the present value
of the returns to the initial investment.
In other words, the ratio of the inows to the outows in their current
values is:
PVci
PI =
I0
The criterion for accepting a new investment proposal is that PI has
to be at least equal to or greater than 1.
Maths Review
September 2016
88 / 110
Example (PI)
Example
Assume that the present value of the cash inows generated by the project
is $ 194,596 and the proposed capital to be invested is $ 200,000.
Compute the PI.
Maths Review
September 2016
89 / 110
Solution (PI)
Solution
PI =
194, 596
= .97
200, 000
Solution
The project would be rejected based on the PI being less than 1.
Maths Review
September 2016
90 / 110
Simple and Compound Interest

Compounding Intervals
So far we have called interest rate a gure, r . However, what does it

mean? The annual interest is the sum of money that the investor will have
back after a year, if she lends an amount A:
B
A
rA
|{z}
|{z}
=
+ |{z}
Sum after a year
Initial Sum
Interest
(67)
In such a case, the interest rate, r , is said to be simple, because you are
not earning interest on interest: the interest is paid only on the initial
investment. When instead you are earning interest on interest, as well as
interest on the initial investment, the interest is called compound
interest.
Maths Review
September 2016
91 / 110

See the table below for example, showing the value of $100 invested at
10% simple and compound interest:
Maths Review
September 2016
92 / 110

Compound interest versus simple interest. Growth of $100 invested at

simple and compound interest. The longer the funds are invested, the
greater the advantage with compound interest.
Maths Review
September 2016
93 / 110

Notice that discounting is a process of compound interest, since you earn

interest on interest:
A !
B = A + rA
B = A(1 + r )
B
!
C = B + rB
C = B (1 + r )
C = A(1 + r )2
C
D
after t
FV = A(1 + r )t
Maths Review
September 2016
(68)
94 / 110

Interest in Continuos Time
France and Germany most corporations pay interest on their bonds

annually, while in the USA and Britain most pay interest
semi-annually.
In the latter case, it is not necessary to wait the entire year to begin
to earn interest on interest: after six months it is possible to re-invest
the entire amount you earn. In such a case, the interest rate is half of
the annual rate; however, one can invest twice, earning:
A 1+
r
2
(69)
instead of:
A (1 + r )
(70)
at the and of the year.

Maths Review
September 2016
95 / 110

Note that equation (69) gives a higher amount of money with respect to
equation (70): this is because the investor is earning interest on interest
now even inside each year.
Maths Review
September 2016
96 / 110

Any compounding intervals is possible. In general, an investment of A at

rate r per annum, compounded m times a year amounts, by the end of the
year, to:
r m
(71)
A 1+
m
What if we can compound m times a year and we consider t years?
Equations (68) are now:
A ! B = A 1+
B
r m
m
C = B 1 + mr
C = A 1 + mr
C
after t
m
2m
D
FV = A 1 +
r tm
m
(72)
Maths Review
September 2016
97 / 110

Suppose that m goes to innity (in other words, you are going to earn
interest on interest every moment). In this case, it is easy to calculate the
value. To see this, in the following expression:
r
m
tm
FV = A 1 +
r
m
tmr
r
FV = A 1 +
1
x
FV = A 1 +
(73)
divide and multiply the exponent by r :
Set now
r
m
= x1 :
Maths Review
(74)
xtr
(75)
September 2016
98 / 110

Notice now that if m goes to innity, so does x. It is known that

lim
x !
1+
1
x
=e
(76)
Hence:
FV = Ae tr
Maths Review
(77)
September 2016
99 / 110
Concluding Remarks: Where Net Present Values Came

From?
The idea is that nancial managers want to undertake positive NPV
projects. So, they calculate the NPV carefully. But NPVs can be
positive for two reasons:
Overcondence of managers: they really expect to earn substantial
economic rents
Bias and errors in forecasting cash ows.
Good managers know that and as a consequence they try to invest in

areas where the company has competitive advantages with respect to
other companies. For this reason, they are very concerned about
corporate strategies which tries to identify capabilities of the rm and
uses these in markets where economic rents can be generated.
Maths Review
September 2016
100 / 110
Depreciation
All assets have a certain useful life during which they can provide
services or revenues.
Under normal circumstances, an assetsability to provide useful and
meaningful production tends to decrease throughout its useful life,
down to a point when its value for production becomes insignicant.
The gradual loss of value in an assets ability to produce is called
depreciation.
Maths Review
September 2016
101 / 110
The Straight Line Method (1)
The straight-line method is simple and straightforward.

It assumes that depreciation occurs in equal amounts for each year of
the assets life, and therefore the accumulated depreciation is
distributed evenly throughout the life span of the asset.
Maths Review
September 2016
102 / 110
The Straight Line Method (2)
So in this case, the accumulated depreciation (Dk ) is a simple

product of the number of years (k) and the rate of depreciation (R).
Dk = kR
where each R is:
R=
n
where C is the initial cost of the asset, whereas S is the scrap value at the
end of the useful life of the asset.
Maths Review
September 2016
103 / 110
Example
Example
Diving equipment was purchased for $23,000. It has a useful life of 6
years, after which its value is estimated to be $8,000. Use the straight-line
method to gure out its full depreciation record.
Maths Review
September 2016
104 / 110
Solution
Solution
R=
S
n
23, 000
8, 000
6
Maths Review
= $2, 500
September 2016
105 / 110
The Fixed-Proportion Method (1)
The xed-proportion method requires that the scrap value be positive.

It cannot be used for assets which are used up completely so that
their residual values become zero.
Because it is one of the deminishing rate methods, depreciation is
usually higher in the early years and lower in the later years of an
assets life.
Maths Review
September 2016
106 / 110

It is assumed that depreciation occurs as a xed percentage (d), so
that the depreciation in any year (Rk ) is a constant proportion of the
book value at the beginning of that year, which is pratically equal to
the book value at the end of the preceding year (Bk 1 ).
Rk = d
Bk
The successive book values throughout an assets useful life would be:
Bk = C (1
d )k
and by the same logic, the scrap value would be:

S = C (1
Maths Review
d )n
September 2016
107 / 110
The accumulated depreciation (Dk ) would normally be equal to the

dierence between the original cost (C)and the book value at any
point:
Dk = C Bk
Dk = C
C (1
d )k
Dk = C [1
(1
d )k ]
Maths Review
September 2016
108 / 110
Example (Scrap Value)
Example
What is the xed percentage od depreciation (d) for a piece of equipment
purchased at $25,000 which has a scrap value of $3,500 after 10 years?
Maths Review
September 2016
109 / 110
Solution
Solution
S = C (1
d )n ! 3, 500 = 25, 000(1
Maths Review
d )10 ! d = .18 or 18%
September 2016
110 / 110

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Maths Review

Marco Alberto De Benedetto

(Queen Mary University of London)

Aims of the Lecture

The aim of this lecture is a review of some basic mathematical

(Queen Mary University of London)

A linear function takes the form:

where y is the dependent variable; x is the independent variable; c is the

(Queen Mary University of London)

According to m, a linear function can be graphically represented as:

(Queen Mary University of London)

(Queen Mary University of London)

Mathematical Review: Functions

(Queen Mary University of London)

A quadratic function takes the folllowing form:

A quadratic function, according to a can be linear, convex and concave;

(Queen Mary University of London)

(Queen Mary University of London)

This convex function has the following properties:

It intersecates axis x at two points: ( 3, 0) and ( 1, 0); also it

(Queen Mary University of London)

if a < 0 as for example in y =

5 this is a concave function

(Queen Mary University of London)

This concave function has the following properties:

It intersecates axis x at two points: (1, 0) and (5, 0); also it

It has a maximum at (3, 4).

(Queen Mary University of London)

An Hyperbolic function takes the following form:

(Queen Mary University of London)

(Queen Mary University of London)

An Exponential function takes the following form:

It is a function where a constant base - a - is raised to a variable

(Queen Mary University of London)

for a > 1 the function is increasing

(Queen Mary University of London)

for a < 1 the function is decreasing

(Queen Mary University of London)

The inverse of an exponential function x = ay is called logarithmic

With a > 0 and a 6= 1. In other words, the logarithm of a number is the

(Queen Mary University of London)

A logarithmic function as y = loga x has the following properties:

(Queen Mary University of London)

If a > 1 the function is increasing and concave

(Queen Mary University of London)

If a < 1 the function is decreasing and convex

(Queen Mary University of London)

(Queen Mary University of London)

More properties of logarithms:

loga (xy ) = loga x + loga y

(Queen Mary University of London)

(Queen Mary University of London)

(Queen Mary University of London)

(Queen Mary University of London)

Given the function y = f (x ) as

Question: What is the marginal impact of x on y ? In other words, what

It tells us that, when x changes by 1, y changes by 1 times 6.

(Queen Mary University of London)