Mathematics of Finance
Simple Interest
Compound Interest
Annuities
Amortization and Sinking Funds
4.1
Simple Interest
Compound Interest
Effective Rate of Interest
Continuous Compounding of Interest
Example
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 three years?
What is the interest earned in that period?
Solution
Using the accumulated amount formula with P = 1000,
r = 0.08, and t = 3, we see that the total amount on
deposit at the end of 3 years is given by
A P (1 rt )
1000[1 (0.08)(3)] 1240
or $1240.
Example
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 three years?
What is the interest earned in that period?
Solution
The interest earned over the three year period is given by
I Prt
1000(0.08)(3) 240
or $240.
A P (1 rt )
2000[1 (0.06)(10)] 3200
or $3200.
Compound Interest
Frequently, interest earned is periodically added to the
Compound Interest
To find the accumulated amount A2 at the end of the
Compound Interest
We can use the simple interest formula yet again to find
Compound Interest
Note that the accumulated amounts at the end of each year
A1 P (1 r )
or:
A3 1000(1.08)3
A2 P(1 r ) 2
A3 P (1 r )3
A P(1 r )t
A P (1 r )t
or 2% per period.
r 0.08
i
0.02
m
4
apply
A P (1 r )t
nth Period:
An An 1 (1 i ) [ P (1 i ) n 1 ](1 i ) P(1 i ) n
First Period:
A P
Example
Find the accumulated amount after 3 years if $1000 is
Example
Solution
a. Annually.
Here, P = 1000, r = 0.08, and m = 1.
Thus, i = r = 0.08 and n = 3, so
r
A P 1
m
0.08
1
1000
1000(1.08)3
1259.71
or $1259.71.
Example
Solution
b. Semiannually.
Here, P = 1000, r = 0.08, and m = 2.
Thus, i = 0.08/2 and n = (3)(2) = 6, so
A P
r
1
m
0.08
1
1000
1000(1.04)6
1265.32
or $1265.32.
Example
Solution
c. Quarterly.
Here, P = 1000, r = 0.08, and m = 4.
Thus, i =0.08/4 and n = (3)(4) = 12, so
A P
r
1
m
0.08
1
1000
1000(1.02)12
1268.24
or $1268.24.
12
Example
Solution
d. Monthly.
Here, P = 1000, r = 0.08, and m = 12.
Thus, i =0.08/12 and n = (3)(12) = 36, so
1000
0.08
1
12
36
0.08
1000 1
12
1270.24
36
r
A P 1
m
or $1270.24.
Example
Solution
e. Daily.
Here, P = 1000, r = 0.08, and m = 365.
Thus, i =0.08/365 and n = (3)(365) = 1095, so
r
A P 1
m
or $1271.22.
0.08
1000 1
365
1095
0.08
1000 1
365
1271.22
1095
Present Value
Consider the compound interest formula:
A P
r
1
m
mt
Present Value
P A 1 i
Where
r
m
and
n mt
Examples
How much money should be deposited in a bank paying a
P A
r
1
m
20,000
16,713
mt
0.06
1
12
(12)(3)
Examples
Find the present value of $49,158.60 due in 5 years at an
P A
r
1
m
mt
49,158.60
30, 000
0.1
1
4
(4)(5)
A P 1
m
mt
becomes
u rt
1
or A P 1
u
The table shows us that when u gets
larger and larger the expression
1
A P 1
u
1
1
urt
10
1
1
2.59374
100
2.70481
1000
2.71692
10,000
2.71815
100,000
2.71827
1,000,000
2.71828
A = Pert
where
P = Principal
r = Annual interest rate compounded
continuously
t = Time in years
Examples
Find the accumulated amount after 3 years if $1000 is
A P
r
1
m
mt
0.08
1000 1
365
(365)(3)
1271.22
Present Value
with Continuously Compounded Interest
If we solve the continuous compound interest formula
A = Pert
for P, we get
P = Aert
This formula gives the present value in terms of the future
(accumulated) value for the case of continuous
compounding.
V (t ) 300,000e
t /2
P (t ) V (t )e 0.09t
300, 000e 0.09t
t /2
7 /2
599,837
(0 t 10)
P (t ) V (t )e 0.09t
300, 000e 0.09t
t /2
8/2
600, 640
(0 t 10)
P (t ) V (t )e 0.09t
300, 000e 0.09t
t /2
9/2
598,115
(0 t 10)
A P (1 R )
A P 1
m
P(1 R ) P
r
1
m
r
1 R 1
m
reff 1 1
m
where
reff = Effective rate of interest
r = Nominal interest rate per year
m = Number of conversion periods per year
Example
Find the effective rate of interest corresponding to a
Example
Solution
a. Annually.
Let r = 0.08 and m = 1. Then
1
0.08
reff 1
1
1
1.08 1
0.08
or 8%.
Example
Solution
b. Semiannually.
Let r = 0.08 and m = 2. Then
2
0.08
reff 1
1
2
1.0816 1
0.0816
or 8.16%.
Example
Solution
c. Quarterly.
Let r = 0.08 and m = 4. Then
4
0.08
reff 1
1
4
1.08243 1
0.08243
or 8.243%.
Example
Solution
d. Monthly.
Let r = 0.08 and m = 12. Then
12
0.08
reff 1
1
12
1.08300 1
0.08300
or 8.300%.
Example
Solution
e. Daily.
Let r = 0.08 and m = 365. Then
365
0.08
reff 1
1
365
1.08328 1
0.08328
or 8.328%.
A P
r
1
m
15,000 10,000
0.12
1
15,000
(1.03)
1.5
10,000
4t
4t
ln(1.03) ln1.5
Taking logarithms
on both sides
4t ln1.03 ln1.5
logbmn = nlogbm
ln1.5
4t
ln1.03
So, it will take about 3.4
ln1.5
t
3.43
4 ln1.03
4.2
Annuities
Present value of Annuity
Future value of Annuity
(1 i ) n 1
S R
Example
Find the amount of an ordinary annuity consisting of 12
(1 i ) n 1
(1 0.01)12
1
S R
100
1268.25
i
0.01
or $1268.25.
1 (1 i ) n
P R
Example
Find the present value of an ordinary annuity consisting of
1 (1 i ) n
1 (1 0.0075) 24
P R
100
2188.91
i
0.0075
or $2188.91.
(1 i ) n 1
(1 0.005)144
1
S R
100
21,015
i
0.005
or $21,015.
1 (1 i ) n
1 (1 0.01) 36
P R
400
12,043
i
0.01
or $12,043.
Therefore, the original cost of the automobile is $16,043
($12,043 plus the $4000 down payment).
The interest charges paid by Murphy are given by
(36)(400) 12,043 = 2,357
or $2,357.
4.3
Amortization and Sinking Funds
Amortization Formula
Pi
R
1 (1 i ) n
965.55
n
360
1 (1 i )
1 (1 0.0075)
or $965.55.
R 1 (1 i ) n
i
294, 643
iS
R
(1 i ) n 1
iS
(0.025)(30,000)
R
3434.02
n
8
(1 i ) 1 (1 0.025) 1
or $3434.02.
Exercise 1
Simple Interest
A company borrows $1,000,000
for 1 month at a simple interest rate of
9% per annum. How much must the
company pay back at the end of 1
month?
Answer : $1,007,500
Exercise 2
Simple Interest
Lily want to buy a stereo set worth
$500 in 9 months time. How much
should she invest at 3% simple interest
to have the money then?
Answer : $489
Exercise 3
Compound Interest
If $1000 is invested at 4% compounded
(a) Annually (b) Semiannually
(c) quarterly
(d) Monthly
What is the amount after 3 years?
How much interest is earned?
Answer:
(a)
$1124.86; interest earned is $124.86
(b)
$1126.16; interest earned is $126.16
(c)
$1126.82; interest earned is $126.82
(d)
$1127.27; interest earned is $127.27
Exercise 4
Compound Interest
How long will it take for an
investment to triple in value if it earns
5% compounded monthly?
Exercise 5
Effective Rate of Interest
Find the effective rate of
interest corresponding to a
nominal rate of 17.5% per year
compounded monthly
Answer: 18.97%
Exercise 6
Future Value of an Annuity
Mary decides to put aside $100 every
month in an insurance fund that pay 8%
compounded monthly.
After making 8
deposits, how much money does Mary have?
1 i
S R
i
Answer: $818.92
Exercise 7
Present Value of an Annuity
Amber agrees to give the building fund
$1000 at the end of each year for the next 5
years. Tania wants to match Ambers gift,
but wants to make a lump-sum contribution
today. If the current rate is 9% per year
compounded annually, how much should
Tania contribute?
n
1 (1 i )
PR
Answer: $3889.65
Exercise 8
Annuity (Time)
How long would it take to save
$500,000 if you place $500 per month in an
account paying 6% compounded monthly?
1 i
S R
i
Exercise 9
Sinking fund Payment
Sheila wants to invest an amount every
3 months so that she will have $12,000 in 3
years to buy a new car. The account pay 8%
compounded quarterly. How much should
she deposit each quarter to have $12,000
after 12 deposits?
Answer: $894.72
Si
R
n
1 i 1
Exercise 10
Amortization
Mr. and Mrs. David have just purchased a
$300,000 house and have made a down
payment of $60,000. They can amortize the
balance at 6% for 30 years.
(a) What are the monthly payments?
(b) What is their total interest payment?
C) outstanding balance after 10 years.
Answer: (a) $1438.92
(b) $278,011.20
Pi
R
1 (1 i ) n
End of
Chapter