Financial Mathematics

ACTL2111 Financial Mathematics for Actuaries

Eric Cheung

UNSW Sydney
Risk and Actuarial Studies, UNSW Business School

Module 2: Loan Valuation and Project Appraisal Techniques

1/64
 Financial Mathematics

Plan
Module 2: Loan Valuation and Project Appraisal Techniques
Introduction
Allowing for Tax
Analysis of Loan Schedules and Repayments
Sinking Funds
Loans at a Flat Rate of Interest
Loan Valuation Example
Fixed Income Securities and Bonds
Pricing Bonds
Bond Valuation Example
Definitions of Yield, IRR and MIRR Rates
Investment Decision Criteria
Sensitivity of Results and Duty of Disclosure
Project Appraisal Example
2/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Introduction

Evaluation of a project
Objective of a project appraisal:
I value a given project: how much is it worth?
I compare different projects based on certain criteria:
which project is the best?
I make a recommendation based on certain criteria:
should we invest in that project?
This involves determining net cash flows:
I gains:
I sales
I salvage value of assets
I minus costs:
I expenses
I transaction costs
I taxes
I depreciation of assets
3/64 I cost of debt
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Introduction

Financing a project
There are several ways of financing a project:
I for an individual
I personal wealth
I personal loan
I for a company
I equity (shares)
I debt (loans, bonds)
I for a government
I taxes
I debt (treasury bonds)
The analysis of loans and bonds is necessary in order to be able to
build the cash flow model. Note that bonds are nothing else than
larger scale, tradable loans.
4/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Allowing for Tax

Allowing for tax

Tax is important consideration when analysing cash flow in
practice:
I when and how much tax is paid influences the profitability of
a security or project
I the tax rate depends on the type of cash flows:
I income (e.g. interest, dividends, rents, . . . ), or
I capital gains (e.g. increase of the value of a share or property,
above par redemption payments, . . . )
I the tax rate depends on the individual considered (person or
company)
I tax is usually paid with a lag that also depends on the
individual considered
I income and capital losses are usually allowed to be offset
against gains to derive tax benefits
5/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Allowing for Tax

Allowance for taxation in price/yield calculations

I tax payments are nothing else than additional (negative) cash
flows
I in case of losses that can offset gains, tax benefits can be
added as positive cash flows
(the government won’t pay any money, but a loss means tax
that otherwise would have been paid will not be paid)
I in some cases price and yield calculations allowing for tax can
be done analytically (using financial mathematics formulae),
”by hand” and using a calculator
I larger/more complicated models can be easily done using a
spreadsheet model or other relevant software.
I transaction costs are similar costs that need to be allowed for

6/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Allowing for Tax

Depreciation and Tax

Many projects involve an investment in capital equipment. For

taxation purposes this can be depreciated.

Taxable income is income minus expenses:

I expenses include interest costs and depreciation
I net cash flow is the cash payments less taxation expense

7/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Loans
Definitions:
I Consider a loan of amount L made at time 0 with repayments
of K1 , K2 ,. . . ,Kn at times 1, 2, . . . , n
I Equation of value

L = K1 v + K2 v 2 + . . . + Kn v n at effective rate i.
I Each loan repayment Kt can be decomposed into
I a principal component (which amortises the loan)
I an interest component (which pays the interest due since the
last repayment)
I The amount that still need to be reimbursed after a payment
is called the ‘outstanding balance’

8/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Denote:
I It the interest component of the t th payment
I PRt the principal repaid in the t th payment
I OBt the outstanding balance immediately after the t th
payment
Interest in t th payment is simply the previous outstanding balance
multiplied by the rate of interest

i × OBt−1

Principal repaid should just be the difference between the actual

payment and the interest component

Kt − It

9/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

If we work recursively we have

I at time 0
OB0 = L
I at time 1

I1 = iOB0 = iL
PR1 = K1 − I1 = K1 − iOB0
OB1 = OB0 (1 + i) − K1 = OB0 − (K1 − iOB0 )
= OB0 − (K1 − I1 ) = OB0 − PR1

I and then we move forward to the next time period

10/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

In general we have
It = iOBt−1
PRt = Kt − It
OBt = OBt−1 (1 + i) − Kt = OBt−1 − (Kt − It )
= OBt−1 − PRt
Total repayments
n
X
KT = Kt
t=1
total interest
n
X
IT = It
t=1
and
n
X
L = K T − IT = PRt
t=1
11/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Numerical example
Consider a loan of $1000 repaid by 5 equal installments of principal
and interest at the end of each year for 5 years with an effective
interest rate of 5% p.a.. Determine the repayments.

12/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Loan Schedule

In practice it is often much easier to set out all the information in

a ”loan schedule” providing information (for each period) on:
I Payments
I Interest
I Principal Repayments
I Outstanding balance
I (and any other important items)
This is usually presented in a table computed with the help of R or
a spreadsheet.

13/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Example
For the $1000 5 year loan with level repayments, what are the
interest and principal components in each year? Give a repayment
schedule.

14/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

In order to determine a given line of the loan schedule, one needs

only the principal outstanding at the beginning (or the end) of the
period. This can be determined directly via:
I the prospective method,
n
X
OBt = Ks v s−t {= Kan−t i if repayments are equal}
s=t+1

I or the retrospective method

t
X
t
OBt = L (1 + i) − Ks (1 + i)t−s {= L (1 + i)t − Kst i }
s=1

Both methods yield the same result.

15/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Analysis of Loan Schedules and Repayments

Numerical example (retrospective method)

Consider a loan of $1000. For the first year the repayment was
$200, and the interest charged was 5% p.a..
For the second and third years the repayment was $150 p.a., and
interest charged was 4% p.a.. What is the loan outstanding at the
end of the third year?

16/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sinking Funds

Sinking Funds
Consider the following situation:
I Company A has borrowed an amount L (from a bank, by
issuing a bond, etc. . . ) and will need to reimburse the loan
after n years
I in the mean time, it needs to pay interest at a rate i each year
to the lender(s)
I Company A wants to set up payments to a fund that will
accumulate to the amount of the loan at time n in order to
ensure the reimbursement
I this fund earns interest at a rate j not necessarily equal to i.
Usually, j < i.
Such a fund is called a sinking fund.
17/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sinking Funds

In order to accumulate to L, level payments to the sinking fund

need to be equal to
L
,
sn j
which means that the total payment for each time unit is
L
iL + .
sn j

The first component is the interest component, paid to the lender,

and the second is the principal component, paid to the sinking
fund.

18/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sinking Funds

Question: Does a sinking fund lead to higher repayments than

when the loan is reimbursed gradually using the amortisation
method at rate i?

19/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sinking Funds

Sinking fund example

A loan of $1000 is to be repaid by 5 annual payments, beginning
one year after the loan is made. The lender wants annual
payments of interest only at a rate of 7% and repayments of the
principal in a single lump sum at the end of 5 years.
The borrower can accumulate principal in a sinking fund earning an
annual interest rate of 6%, and decides to do this with 5 level
deposits starting one year after the loan is made. Determine the
repayment and model the cash flows of this transaction in a
spreadsheet.

20/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sinking Funds

Example

21/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Loans at a Flat Rate of Interest

Loans at a Flat Rate of Interest

The interest charge I is given by

I =L×f ×n

where:
I L is the loan amount
I f is the ‘flat’ rate of interest
I n is the duration of loan (in time units of the flat rate of
interest)
Loan Repayments R are given by
L+I
R=
N
where N is the number of level instalments.
22/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Loans at a Flat Rate of Interest

Numerical example
A lawnmower worth $400 is offered for sale on the following terms:
10% deposit, flat interest of 10% p.a. with monthly repayments
over 30 months.
Determine the repayment and the effective annual rate of interest.

23/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Loans at a Flat Rate of Interest

Usage
Easier to understand, but presents serious problems:
I the ”real” rate of interest is usually much higher than what
the flat rate suggests
I flat rate loans do not encourage earlier payments (the amount
of interest that has to be paid is fixed)
Flat rates of interest are not used everywhere:
I because of the problems described above, it is forbidden is
some countries (mainly developed, such as in Australia)
I however, it is widely used in developing countries (mainly by
microcredit institutions)

24/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Loan Valuation Example

Example - Loan Valuation - Spreadsheet

A loan of nominal amount $500,000 was issued bearing interest of

8% per annum payable quarterly in arrears. The loan will be repaid
at $105% by 20 annual installments, each of nominal amount
$25,000, the first repayment being ten years after the issue date.
An investor, liable to both income tax and capital gains tax,
purchased the entire loan on the issue date at a price to obtain a
net effective annual yield of 6%. Find the price paid, given that his
rates of taxation for income and capital gains are 40% and 30%
respectively.
What is the price paid allowing for taxation? Develop a
spreadsheet model for the loan allowing for both income and
capital gains taxation.

25/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Loan Valuation Example

Model with Tax on Interest and CGT

This is much more complicated.
I price depends on CGT and CGT depends on price. . .
I capital repayments occur over time
We can solve this with a spreadsheet.
I Set a dummy figure as the ‘price’
I Given a ‘price’ we can determine if a CGT is due for each
repayment:
 +
face value reimbursedt
CGTt = 30%× actual paymentt − ×P
500000
I we have then (net receipts):

CFt = APRt + It − TIt − CGTt

26/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Loan Valuation Example

We solve then for the correct price:

I Calculate the PV of the net receipts
I Calculate in a cell the difference between the PV and the
Price (which should be equal)
I Using the solver, target a difference of 0
I You may need to constraint the price to be positive.
I Note:
(x − y )+ = max(x − y , 0).

27/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Fixed Income Securities

Broad range of securities with fixed income:
I bonds (or ‘notes’, or ‘debentures’), issued by
I the government
I private companies
I types of bonds
I short term (e.g. Australian Treasury note, or promissory note)
vs long term (e.g. Australian Treasury bond)
I virtually risk free to very risky (junk bonds)
I coupon bonds or zero-coupon bonds (ZCB)
I indexed bonds, or real return bonds
I but also
I certificates of deposit (tradable or not)
I . . . (see readings)

28/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Government Bonds
Government Bonds:
I borrow money from investors to fund spending plans
I also provide low risk securities (liquidity on the market, and
determination of the structure of interest)
I both short and long term
(in Australia: Treasury Notes and Treasury Bonds)
I consist of both coupon and capital payments
(in Australia: usually interest only until maturity)
I for (Commonwealth) Government Bonds in Australia
I usually semiannual coupons
I coupons are paid on the 15th of each relevant month.
I yields are quoted as nominal p.a. with the same frequency as
the coupon payments
I Other conventions: see Broverman and Sherris
29/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Bond basics

Pays coupon (‘interest’) to purchaser a certain number of times a

year, of amount
Fc
paid p times per year
p
where

F is the face value (par value)

c is the annual coupon rate
p is the frequency of payments

Payments will continue during the ‘term to maturity’ of the bond

(denoted by n).

30/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Maturity, redemption and principal amortisation

I ‘Maturity’ is the date when the bond is ‘redeemed’

(reimbursed)
I The redemption amount FR at maturity is not always equal to
the face value. We have
I R = 1: the bond is redeemed at par
I R < 1: the bond is redeemed below par
I R > 1: the bond is redeemed above par
I Sometimes, principal is reimbursed before maturity. Again,
the amount of face value can be reimbursed at par, or
below/above par.
I A bond is essentially a loan that is amortised in a single lump
sum payment (at maturity) and/or by earlier payments.

31/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Fixed Income Securities and Bonds

Numerical example
A 3 year bond with a face value of $100,000 pays annual coupons
at a rate of 10% p.a. The bond is
1. entirely redeemed at maturity with a payment of $120,000;
2. redeemed by 2 payments of $65,000 each at the end of the
second and third year, each for half of the bond’s face value.
For both cases, establish a loan schedule showing interest
payments, principal repayments and capital gains.

32/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

The price of a bond

I as usual for securities, the price of a bond is essentially the

present value of its future cash flows
I the rate, called ‘yield’, at which cash flows are discounted is a
critical assumption
I it is usually quoted along with the price of the bond (both
values are equivalent ways of quoting the price of a bond)
I it is usually of the same type as the coupon rate (semiannual
nominal for US/CA/AU, sometimes also annual in EU)
I the yield usually depends on the current structure of interest,
as well as the risk associated to the bond as perceived by the
market (note also some rating agencies rate bonds AAA to C)

33/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

On coupon dates

For a bond with coupon rate r = c/p and yield j = i (p) /p (both
per coupon payment period of length 1/p year) whose redemption
and face values are the same (R = 1), we have:

P = Fr anp j + Fvjnp
= Fr anp j + F (1 − j anp j )
= F + F (r − j) anp j
I A par bond must have r = j
I A bond with r > j trades at a ‘premium’
I A bond with r < j trades at a ‘discount’
If R 6= 1, the price is still the PV of the future cashflows.

34/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

Between Coupon dates

I in practice bonds are traded between coupon payment dates

I the general pricing approach is to discount the bond cash
flows to the next coupon payment date (including the coupon
payment at that date), and then further discount this present
value this to the (prior) sale date
I the seller is essentially requiring the interest accumulated
since the last coupon date to be paid by the buyer
I however, if the sale is too close to the next coupon payment
(in Australia, 7 days or less), the bond becomes ‘ex-interest’,
which means that the next coupon payment will still be paid
to the seller, even if the bond is not his property any more

35/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

The RBA formula

The RBA uses the following formula to value Treasury Bonds when
maturity is between m and m + 1 semesters:
f 
P = vjd C + Fr am j + 100vjm


where:
I C is the next coupon payment (zero if ex-interest)
I Fr is the regular semi annual coupon payment
I f is the number of days until the next payment
I d is the number of days in the current half year
I j is the effective interest rate per half year

36/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

Market price

Bonds are usually quoted at a ‘market’ price. We distinguish:

I Price-plus-accrued:
I the price with accrued interest (coupon) - see previous slide
I the purchase price
I also: ”dirty price”, ”full price”, or ”flat price”
I Market price
I price as quoted (““smoothed”” price)
I accrued interest is removed:

market price = dirty price − accrued interest = P − tFr

where t = 1 − df
I also: ”clean price”

37/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

Numerical example
Consider a Government bond paying semi annual interest of 10%
p.a. on 15-April and 15-October each year. It is redeemable at par
on 15 Oct in 6 years time. Find the purchase and market prices to
yield 8.5% p.a. (compounded semi-annually) on 30 June.

38/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Pricing Bonds

Optional redemption dates

In general the redemption date may:

I be fixed (most of the bonds)
I vary at borrower’s option
I on or after certain date
I no final date (undated)
I between two specified dates
An uncertain redemption dates means that lenders (i.e. buyers)
can’t easily determine yields at the purchase date. In such a case,
they can still determine:
I a maximum price, for given yield, or
I a minimum yield, for given price

39/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

Example - Loan Valuation - ”by hand”

[UNSW Final Exam 2006] A bond with a nominal face value of

$100, 000 is redeemable by two payments, one in 5 years time and
the other in 10 years time. The payment in 5 years time is for a
nominal amount of $40, 000 and in 10 years time for a nominal
amount of $60, 000. Redemption payments are payable at $105 per
$100 nominal face value. Coupons are paid on the bond at 6% p.a
semi-annually based on the nominal amount outstanding. Tax is
paid on the coupons at a rate of 30% and tax is paid on capital
gains at a rate of 15%. Capital losses are assumed to be offset
against other capital gains of the investor.

40/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

1. Determine the price to be paid by an investor to earn a gross

yield of 6.5% p.a. (semi-annual).
2. Determine the price to be paid by an investor to earn a net of
tax (after tax) yield of 5% p.a. (semi-annual) allowing only
for tax on the coupons.
3. Determine the price to be paid for the bond to yield a net of
tax return of 4% p.a. (semi-annual) allowing for tax on
coupons and capital gains.

41/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

1. Price to earn a gross yield of 6.5% p.a. (semi-annual)

(Note: the yield and coupons are semi-annual so work in half years)

0.06
Price = (40,000) a10 + 40,000 (1.05) v 10
2
0.06 6.5
+ (60,000) a20 + 60,000 (1.05) v 20 at %
2 2
= 1,200 × 8.422395 + 42,000 × 0.726272
+1,800 × 14.539346 + 63,000 × 0.527471
= 10,106.874 + 30,503.431 + 26,170.823 + 33,230.689
= 100,011.82

42/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

2. Gross yield of 5% p.a. (semi-annual), tax on the

coupons

0.06
Price = (1 − 0.3) (40,000) a10 + 40,000 (1.05) v 10
2
0.06 5.0
+ (1 − 0.3) (60,000) a20 + 60,000 (1.05) v 20 at %
2 2
= 840 × 8.752064 + 42,000 × 0.781198
+1260 × 15.589162 + 63,000 × 0.610271
= 7,351.7337 + 32,810.333 + 19,642.3445 + 38,447.0694
= 98,251.48

43/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

After tax return of 4% p.a. (semi-annual), tax on coupons

and capital gains

0.06
Price = (1 − 0.3) (40,000) a10
2  
10 40000
+40,000 (1.05) v − 0.15 40,000 (1.05) − P v 10
100000
0.06
+ (1 − 0.3) (60,000) a20
2  
60000
+60,000 (1.05) v 20 − 0.15 60,000 (1.05) − P v 20
100000
at
4.0
%
2
44/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Bond Valuation Example

We have

P = 840 × 8.982585 + [42,000 − 0.15 (42,000 − 0.4P)] × 0.820348

+1260 × 16.351433 + [63,000 − 0.15 (63,000 − 0.6P)] 0.672971

and thus

(1 − 0.049221 − 0.060567) P = 7,545.371 + 29,286.4236

+20,602.8056 + 36,037.597
93,472.197
P = = 105,000.
0.890212

45/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Definitions
Yield rate
I effective ”average” rate of interest over the whole (time)
length of an investment:
 1/length of investment
accumulated value
yield rate = −1
investment cost

Net Present Value (NPV)

I present value of inflows (gains) minus outflows (expenses and
investment costs), or net cash flows
I must be calculated using a relevant rate of interest
(reflecting risk and cost of capital)
Internal Rate of Return (IRR)
I rate of interest such that the NPV is 0
46/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Numerical example
Consider the following two cash flows:

Option 1 Option 2
0 -1000.00 -1000.00
1 100.00 533.20
2 200.00 350.00
3 300.00 250.00
4 400.00 150.00
5 500.00 50.00

For option 1, the IRR is 12.01%. Consider the yield:

P 1/5  1/5
Inflows accumulated @ IRR 1762.90
−1 = −1 = 12.01%
1000 1000
47/64 Yield = IRR!
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

What if it is not possible to reinvest inflows at a rate equal to IRR?

For option 1
P 1/5  1/5
Inflows accumulated @ 3% 1561.37
−1 = −1 = 9.32%
1000 1000

I the yield is much lower

I but the IRR does not change
I if the reinvestment rate is different from the IRR, the yield is
not equal to the IRR!

48/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Numerical example

49/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Reinvestment rates
IRR
I assume a homogeneous rate of interest for all cash flows:

(Accum. value @ IRR) = (Invmt cost)(1 + IRR)length of invmt

Ido not allow for a different reinvestment rate
NPV
I similar problem arises as the same rate is used for all cash
flows
Solution: Modified IRR (MIRR) as alternative:
I MIRR is calculated from

(Accum. value @ reinv. rate) = (Invmt cost)(1+MIRR)length of invmt

I MIRR is a modified yield that takes into account the
50/64 reinvestment rates
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Definitions of Yield, IRR and MIRR Rates

Multiple IRR
If cash flows are non conventional (change sign more than once),
there may be several IRR...
Example:

t CFt
0 -59
=⇒ NPV(i):
1 154
2 -99

51/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Investment Decision Criteria

Decision criteria I

1. Payback period
I the amount of time until repayments accumulate (without
interest) to the initial investment
2. Discounted payback period
I the amount of time until discounted repayments have a higher
PV than the initial investment
I same idea as payback period, but taking the time value of
money into account
3. NPV (net present value)
I the present value of net cash flows

52/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Investment Decision Criteria

Decision criteria II

4. IRR (internal rate of return)

I the rate of interest such that the NPV is 0
5. MIRR
I a modified IRR that takes into account reinvestment rates
6. Profitability index
I the ratio
(PV of repayments) / (initial investment)
I remember the NPV is the difference:
(PV of repayments) - (initial investment)

53/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Investment Decision Criteria

Decision criteria III

7. Dollar-weighted rate of return

I The simple rate of interest such that the NPV is 0
8. Time-weighted rate of return
I returns over subsequent periods are compounded to yield an
‘average’ return
I particularly used by investment funds to transform monthly
returns into longer term returns (semesterly, annual, . . . )

54/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

Sensitivity of Results: Example

Suppose your company is considering the purchase a small insurer.

You forecast the following cashflows for this insurer over the next 5
years:
I Premiums: 100m p.a.
I Claims: 80m p.a.
I Expenses: 5m p.a, increasing at 3% p.a.
I Assume that these are all incurred at the middle of the year
on average.
I At the end of the 5th year the business will be sold for a total
of 10m.
Find the NPV of this project at 6% p.a.

55/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

Sensitivity of our results to

I interest rate assumption?
I expense increase rate?
56/64
I premium and claim changes?
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

7. Reporting
A Member must ensure that his or her reporting (whether oral or
written) in respect of Professional Services provided:
(a) is appropriate, having regard to:
1. the intended audience;
2. its fitness for the purposes for which such
reporting may be required or relevant;
3. the likely significance of the reporting to its
intended audience;
4. the capacity in which the Member is acting; and
5. any inherent uncertainty and risks in relation to
the subject of the report;
(b) complies with any relevant Professional Standards.
Institute of Actuaries of Australia Code of Professional Conduct
(November 2009, Section 7)
57/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

Assess
Extract of professional standards on economic valuations:
4.2 Scope of economic valuation
[. . . ]
The Member should ascertain the materiality limits that apply to
the economic valuation bearing in mind:
I the quality of the data;
I the intended use(s) of the economic valuation;
I the degree of uncertainty; and
I the sensitivity of the overall result to different assumptions.

Institute of Actuaries of Australia Guidance Note 552 on Economic

Valuations (July 2004)

58/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Sensitivity of Results and Duty of Disclosure

And then communicate

3.3 Transparency
The models, methods and assumptions used for the economic
valuation should, as far as practical, be transparent, enabling
valuation results and sensitivities in the results to changes in
particular assumptions to be understood by the intended users of
the economic valuation.
Institute of Actuaries of Australia Guidance Note 552 on Economic
Valuations (July 2004)

59/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

Project Appraisal Example

A company considers buying equipment and then leasing it out to
third parties. This project has the following variables:

60/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

Loan schedule

61/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

Taxable income

62/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

Net cash flows

NPV @ 18%: $137,037

IRR: 22.06%
63/64
 Financial Mathematics
Module 2: Loan Valuation and Project Appraisal Techniques
Project Appraisal Example

NPV check

5e+05
0e+00

IRR
NPVs

-5e+05

0.0 0.1 0.2 0.3 0.4 0.5

interest_rates

64/64