Finite Math

5.1 Notes

Name______________________

Simple interest
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Interest Formula:
I=Prt
Where I = _________________________________
P= __________________________________
r = __________________________________
t = __________________________________
This is the interest (I) on a principle (P) at an interest rate (r) per year for t
years.
Accumulated Amount Formula:
A= P+I
= P+Prt
= P(1+rt)
Where A = _________________________________
I = _________________________________
P= __________________________________
r = __________________________________
t = __________________________________
This is the sum of the principle and interest after t years. (This formula is a
linear function of t.)
In business applications, we are normally interested in the case in which t
is positive, so only the part that lies in Quadrant I is of interest to us.

Finite Math

5.1 Notes

Name______________________

Example 1
A bank pays simple interest at the rate of 8% per year for certain deposits. If
a customer deposits $1000 and makes no withdrawals for 3 years, what is
the total amount on deposit at the end of 3 years? What is the interest
earned in that period of time?
Solution:
We have P = 1000, r = 0.08, and t = 3.
To calculate total amount on deposit at the end of 3 years, we use the
accumulated amount formula:
A = P(1+rt)

To the interest earned in that period of time, we use the interest formula:
I = Prt

Compound Interest
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Now we need to find a formula for the accumulated amount for compounded
interest.
Example 2
Suppose $1000 (the principal) is deposited in a bank for a term of 3 years,
earning interest at the rate of 8% per year (called the nominal, or stated,
rate) compounded annually.
Solution:
We will use the accumulated formula we already have A = P(1+rt).
First Year:
A1 = P(1 + rt)

Second Year:

A2 = P(1 + rt) = A1(1 + rt)

Finite Math

Third Year:

5.1 Notes

Name______________________

A3 = P(1 + rt) = A2(1 + rt)

See a pattern???
First year:
A1 = 1000(1 + 0.08), or A1 = P(1 + r)
Second year:
A2 = 1000(1 + 0.08)2, or A2 = P(1 + r)2
Third year:
A3 = 1000(1 + 0.08)3, or A3 = P(1 + r)3
Hence the formula for accumulated amount formula for compound interest
is:
A = P(1 + r)t
This is the accumulated amount when P dollars is invested over a term of t
years, earning interest at the rate of r per year compounded annually
(______________________________________________).
Realistically interest is compounded more than once a year so use formula:
A = P(1 + i)t
Where

Example 3
For example, if the nominal interest rate is 8% per year (r = 0.08) and
interest is
compounded quarterly (m = 4),
then
Or 2% per period.

Finite Math

5.1 Notes

Name______________________

Continuous Compounding of Interest

Formula:
A = Pert

Effective Rate of Interest

Effective Rate
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The effective rate is also called the annual percentage yield.
To derive a relationship between the nominal interest rate, r per year
compounded m times, and its corresponding effective rate, R per year, lets
assume an initial investment
of P dollars.

Finite Math

5.1 Notes

Name______________________

If the effective rate of interest reff is known, then the accumulated amount
after t years on an investment of P dollars may be more readily computed by
using the formula
A = P(1 + reff)t
Present Value
The compound interest Formula A = P(1 + i)n, which expresses the
accumulated amount at the end of n periods when interest at the rate of r is
compounded m times a year.
The principal P is often referred to as the present value, and the
accumulated value A is called the future value, since it is realized at a
future date.
In certain instances, an investor might wish to determine how much money
he should invest now, at a fixed rate of interest, so that he will realize a
certain sum at some future date.
This problem may be solved by expressing P in terms of A. Thus, from
Formula A = P(1 + i)n , we find the present value formula for compound
interest:
P = A(1 + i)n
r
Here, as before, i = m , where m is the number of conversion periods per
year.
Present value formula for continuous compound interest:
P=
Aert
Using Logarithms to Solve Problems in Finance:
How long will it take $10,000 to grow to $15,000 if the investment earns an
interest rate of 12% per year compounded quarterly?
Solution:
Using A = P(1 + i)n with A = 15,000, P = 10,000, r = 0.12, and m = 4, we
obtain
0.12 4 t
15,000=10,000 1+
4

Finite Math

( 1.03 )4 t =

5.1 Notes

Name______________________

15,000
=1.5
10,000

Then take the logarithm on each side of the equation gives:

ln(1.03)4t = ln 1.5
4t ln 1.03 = ln 1.5
ln 1.5
4 t=
ln1.03
t=

ln 1.5
3.43
4 ln 1.03

So it will take approximately 3.4 years for the investment to grow from
$10,000 to $15,000.