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Diploma in Management Studies

Business Mathematics BUS003


Lecture 6 Mathematics of Finance
Topics to be discussed:
Simple Interest, Compound interest and
Continuous Compound of Interest
Present and Future Value
Annuities
Amortization and Sinking Funds
Arithmetic and Geometric Progression
Ref: Tan, Chapter 4
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Learning Outcomes
After this lecture, students should be able to:
Solve problems involving simple, compound,
continuous compounding of interest rate and compute
the effective rate of interest
Compute the present value for compound interest
Use logarithms to solve problems in finance
Calculate the amount , present value and future value
of an annuity
Calculate the amount of loan and monthly mortgage
payments and interest rate from monthly payments
Calculate loans or sinking funds amortized
over n period.
Find terms and compute partial sum of arithmetic
progression and geometric progression
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Simple Interest
Simple interest Interest that is
computed on the original principal only
If I denotes the interest on a principal P
(in dollars) at an interest rate of r per year
for t years, then we have I = Prt
The accumulated amount A, the sum of
th principal
the
i i l and
d iinterest
t
t after
ft t years, iis
A = P + I = P + Prt = P(1 + rt)

Example of Simple Interest


A bank pays simple interest rate of 8% per
year for deposits. If a customer deposits
$1000 ffor 3 years, what
h t iis th
the ttotal
t l amountt off
deposit at the end of 3 years? What is the
interest earned in that period of time?
P = 1000, r =0.08, t = 3
Total amount of deposit at the end of 3 years
is A = P(1 + rt) = 1000[1 + (0.08)(3)]
(0 08)(3)]=$1240
$1240.
The interest earned over the 3-year period is
given by I = Prt=1000(0.08)(3) = $240

Example of Simple Interest


An amount of $2000 is invested in a 10year trust
t t ffund
d th
thatt pays 6% annuall simple
i l
interest. What is the total amount of the
trust fund at the end of 10 years.
The total amount of the trust fund at the end
of 10 years is given by
A = P(1 + rt) = 2000[1 + (0.06)(10)] = $3200

Compound Interest
Earned interest that is periodically added to the principal
and thereafter itself earns interest at the same rate is
called compound interest
Example:
E
l $1000 iis d
deposited
it d iin a b
bank
k ffor a tterm off 3
years, earning interest rate of 8% per year compounded
annually. P = 1000, r = 0.08
The accumulated amount at the end of first year is A1 =
P(1 + rt) = 1000[1 + 0.08(1)] = $1080
At the end of the second year, the accumulated amount
is A2=P(1
P(1 + rt) = A1(1+rt) = 1000[1+0.08(1)][1+0.08(1)]
1000[1+0 08(1)][1+0 08(1)]
=1000(1.08)2 = $1166.40
The accumulated amount A3 at the end of the third year
is A3 = P(1 + rt) = A2(1 + rt) = 1000[1 + 0.08]3 = $1259.71
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Compound Interest
If P dollars is invested over a term of t years, earning
interest at the rate of r per year compounded annually,
then the accumulated amount is A = P(1
( + r))t
Interest may be compounded more than once a year.
The interval of time between successive interest
calculation is called the conversion period
If interest at a nominal rate of r per year is compounded
m times a year on a principal of P dollars, then the
simple interest rate per conversion period is

r
m
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Compounded Interest Formula


A = P(1 + i)n
Where i r , n=mt
n=mt, and
m
A = Accumulated amount at the end of n
conversion periods
P = Principal
r = Nominal interest rate per year
m = Number of conversion periods per year
t = Term (number of years)

Example of Compounded Interest


Find the accumulated amount after 3
years if $1000 is invested at 8% per year
compounded:
(a) annually,
(b) semiannually,
(c) quarterly,
(d) monthly and
(e) daily.
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Answers to Example of Compounded


Interest
(a) P = 1000, r = 0.08, m = 1. Thus i = r=0.08 and
n = 3. A = 1000(1 + 0.08)3 = $1259.71
(b) P = 1000,
1000 r = 0
0.08,
08 m = 2
2. Th
Thus
si=0
0.08/2
08/2 and n
0.08 6
= 3(2) = 6. A = 1000(1 + 2 ) = $1265.32
(c) P = 1000, r = 0.08, m = 4. Thus i = 0.08/4 and n
= 3(4) = 12. A = 1000(1 + 0.408 )12 = $1268.24
(d) P = 1000, r = 0.08, m = 12. Thus i = 0.08/12
and n = 3(12)
( ) = 36. A = 1000(1
( + 012.08 )36 = $
$1270.24
(e) P = 1000, r = 0.08, m = 365. Thus i = 0.08/365
and n = 3(365) = 1095.
.08 1095
A = 1000(1 + 0365
)
= $1271.22
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Continuous Compounding of Interest


The more often interest is compounded, the larger the
accumulated amount will be.
mt
r

n
From the compound interest A P(1 i ) P1

P(e)rt

As m gets larger and larger, A approaches


= Pert. In
this situation, we say that interest is compounded
continuously
The formula of Continuous Compounding of Interest is
A = Pert
where
h
P=P
Principal
i i l
r = Annual interest rate compounded continuously
t = Time in years
A = Accumulated amount at the end of t years.
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Example of Continuous Compound


Interest

Find the accumulated amount after 3 years if


$1000 is invested at 8% per year compounded
(a) daily (assume 365-day-year)
365 day year) and (b)
continuously.
(a) P = 1000, r=0.08, m = 365, and t = 3. Thus
i=0.08/365 and n=(365)(3)=1095, so that
0.08
A 10001

365

( 365 )( 3)

$1271.22

(b) P = 1000, r = 0.08 and t = 3, using the


continuous compound interest rate formula
A = 1000e(0.08)(3) = $1271.25.
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Effective Rate of Interest


The interest actually earned on an investment depends
on the frequency with which the interest is compounded.
The stated nominal interest rate of 8% does not reflect
the actual rate at which interest rate is earned.
The effective rate is the simple interest rate that would
produce the same accumulated amount in 1 year as the
nominal rate compounded m times a year. The effective
m
rate is also called the annual yield
r

Effective Rate of Interest Formula: reff 1 1


m
where reff= Effective rate of interest
r = Nominal interest rate per year
m = Number of conversion periods per year
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Example of Effective Rate of Interest


Find the effective rate of interest
corresponding to a nominal rate of 8% per
year compounded:
(a) annually
(b) semiannually
(c) quarterly
(d) monthly
(e) daily
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Solution to Example of Effective Rate


of Interest

(a) r = 0.08, m = 1, reff = (1+0.08) -1 = 0.08


0.08
(b) r = 0
0.08,
08 m = 2
2, reff = (1+
(1 2 )2 -1
1
= (1.04)2 1 = 0.0816
(c) r = 0.08, m = 4, reff = (1+0.08 )4 -1
4
= (1.02)4 1 = 0.0824
0.08
((d)) r = 0.08,, m = 12,, reff = ((1+ 12 )12 -1 = 0.0830

(e) r = 0.08, m = 365, reff = (1+

0.08 365
)
365

-1 = 0.0833
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Present Value
The compounded interest formula expresses the
accumulated amount at the end of n periods when
interest at the rate of r is compounded
p
m times a
year.
The principal 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.
Present Value Formula for Compound Interest:
P = A(1 + i)-nn
where P is the present value, A = accumulated
value, i = r/m, m is the number of conversion
periods per year.
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Example of Present Value


How much money should be deposited in a bank
paying interest at the rate of 6% per year
compounded
d d monthly
thl so th
thatt att th
the end
d off 3
years the accumulated amount will be $20,000?
r = 0.06, m = 12, so i = 0.06/12 and n = (3)(12) =
36. Given that A = 20,000
0.06
P 20,0001

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$16.712.90

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Using Logarithms to Solve Problems in


Finance: Example
How long will it take $10,000 to grow to $15000 if
the investment earns an interest rate of 12% per
year compounded
d d quarterly?
t l ?
A = 15000, P = 10000, r = 0.12 and m = 4. We
have 15000 = 10000(1 + 0.412 )4t
15000
(1.03)4t =
= 1.5. Taking logarithms on
10000
both side of the equations,
ln(1.03)4t = ln1.5 4tln1.03 = ln1.5
4t ln 1.5 t ln 1.5 3.43 years
ln 1.03

4 ln 1.03

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Exercise 6.1(a)
(a) Find the accumulated amount A if the
principal P $1000 is invested at the interest rate
r = 7% for t = 8 years compounded annually
(b) Find the effective rate corresponding to 10%
compounded semiannually.
(c) Find the present value of $40000 due in 4
years at r = 6% per year compounded
semiannually.

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Answers to Exercise 6.1(a)

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Exercise 6.1(b)
(a) To help finance the purchase of a new
house, a family have decided to apply for a
short term loan (a bridge loan) in the amount
off $120,000
$120 000 ffor a tterm off 3 months.
th If the
th
bank charges simple interest rate at the rate
of 10% per year, how much will the family
owe the bank at the end of the term?
(b) A family is planning to buy a house 4
years from now. Housing expert have
estimated that the cost of a home will
increase at a rate of 5% per year during that
period. If this prediction is true, how much
can the family expect to pay for a house that
currently costs $210,000?
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Answers to Exercise 6.1(b)

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An Annuity
An annuity is a sequence of payments made at
g
time intervals.
regular
The time period in which these payments are
made is called the term of the annuity.
The term can be a fixed time interval (annuity
certain), a time interval that begins at a definite
date but extends indefinitely (perpetuity) or one
that is not fixed in advance (contingent annuity).
An annuity in which the payments are made at
the end of each payment period is called an
ordinary annuity.
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Future Value of an Annuity


The future value S of an annuity of n payments
of R dollars each, paid at the end of each
investment period into an accounts that earns
interest at the rate of i per period, is

1 i n 1
S R

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Example of Future Value of An Annuity


Find the amount of an ordinary annuity of 12
monthly payments of $100 that earn interest at
12% per year compounded monthly.
Since i is the interest rate per period and the
interest is compounded monthly, i = 0.12/12 =
0.01. R = 100, n = 12, we have

100 1.01 1
S
$1268.25
0.01
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Present Value of Annuity


One may wish to determine the current value P
of a sequence of equal periodic payments that
will be made over a certain period of time
time. The
amount P is referred to as the present value of
an annuity
The present value P of an annuity of n
payments of R dollars each, paid at the end of
each investment period into an account that
earns interest at the rate of i per period, is
1 (1 i ) n
P R

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Example of Present Value of Annuity


Find the present value of an ordinary annuity of 24
payments of $100 each made monthly and earning
i t
interest
t att 9% per year compounded
d d monthly.
thl
R = 100, i = r/m = 0.09/12 = 0.0075, and n=24. So

100 1 1.0075
P
0.0075

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$2188.91

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Exercise 6.2(a)
(a) Find the amount (future value) of each ordinary
annuity
(i) $600 per quarter for 9 year at 12% per year
compounded quarterly
(ii) $200 per month for 20 year at 9% per year
compounded monthly
(b) Find the present value of each ordinary annuity
(i) $5000 twice a year for 8 years at 6% per year
compounded semiannually
(ii) $4000 a year for 5 years at 9% per year
compounded yearly
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Answers to Exercise 6.2(a)

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Exercise 6.2(b)
Linda has joined a scheme at her bank. At
th end
the
d off every month,
th December
D
b
through October inclusive, she will make a
deposit of $40 in her account. If the
money earns interest at the rate of 7% per
year compounded monthly, how much will
she have in her account on December 1 of
the following year?
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Answers to Exercise 6.2(b)

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Amortization of Loans
The annuity formulas may be used to answer
questions involving the amortization of
i t ll
installment
t lloans.
Amortization Formula:
The periodic payment R on a loan of P dollars
to be amortized over n periods with interest
charged at the rate of i per period is

Pi
1 (1 i ) n
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Example of Amortization of Loans


A sum of $50,000 is to be repaid over a 5-year
period through equal installments made at the
end
d off each
h year. If an interest
i t
t rate
t off 8% per
year is charged on the unpaid balance and
interest calculations are made at the end of each
year, determine the size of each installment so
that the loan (principal plus interest charges) is
amortized at the end of 5 years.
years
P = 50,000, i = r = 0.08 (m = 1), n = 5, we have
(50,000)(0.08)
R
$12,522.82
1 (1.08) 5
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Sinking Funds
A sinking fund is an account that is set up for a
specific purpose at some future date. We can
consider the amount to be accumulated by a
specific date in the future as the future value of
an annuity
Sinking Fund Payment:
The periodic payment R required to accumulate
a sum of S dollars over n periods with interest
charged at the rate of i per period is
Si
R
1 i n 1
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Example of Sinking Funds


The proprietor of a hardware firm has decided to
set up a sinking fund for the purpose of
purchasing a truck in 2 years
years time.
time It is expected
that the truck will cost $30,000. If the fund earns
10% interest per year compounded quarterly,
determine the size of each quarterly installment
the proprietor should pay into the fund.
S = 30,000,
30 000 i = r/m = 0
0.1/4
1/4 = 0
0.025,
025 n = (2)(4)=8
(2)(4)=8.
R

300000.025 $3434.02
1.0258 1
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Exercise 6.3(a)
(a) Find the periodic payment R required to
amortize a loan of P dollars over t years with
interest earned at the rate of r% per year
compounded m times a year.
(i) P = 5000, r = 4, t = 3, m = 4
(ii) P = 25000, r = 3, t = 12, m = 4
(b) Find the periodic payment R required to
accumulate a sum S dollars over t years with
interest earned at the rate of r% per year
compounded m times a year.
(i) S = 20,000, r = 4, t = 6, m = 2
(ii) S = 100,000, r = 4.5, t = 20, m = 6
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Answers to Exercise 6.3(a)

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Exercise 6.3(b): Loan Amortization


A sum of $100,000 is to be repaid over a 10year period through equal installments made at
the end of each year. If an interest rate of 10%
per year is charged on the unpaid balance and
interest calculations are made at the end of each
year, determine the size of each installments so
that the loan (p
(principal
p p
plus interest charges)
g ) is
amortized at the end of 10 year.

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Answers to Exercise 6.3(b)

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Arithmetic Progressions
An arithmetic progression is a sequence of
numbers in which each term after the first is
obtained
bt i d b
by adding
ddi a constant
t t d tto th
the
preceding term. The constant d is called the
common difference.
If a1, a2 a3, , an, is an arithmetic progression
with the first term a and common difference d,
then a1 = a, a2 = a + d,
a3 = a2 + d = a + d + d = a + 2d
a4 = a3 + d = a + 2d + d = a + 3d
an = an-1 + d = a + (n - 1)d (nth term)
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Sums of Terms in an Arithmetic


Progression
The sum of the first n terms of an arithmetic
progression with first term a and common
n
difference d is given by

Sn

2a n 1d

Example: Find the sum of the first 20 terms of


the arithmetic progression 2, 7, 12, 17, 22,
Letting
g a = 2, d = 5 and n = 20, we have
S20 = 20 [2(2) + (19)(5)] = 990

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Applied Example
A company had sales of $200,000 in its
first year of operation. If the sales
increased by $30
$30,000
000 per year thereafter
thereafter,
find Madisons sales in the fifth year and
its total sales over the first 5 years of
operation.
a = 200,000, d = 30,000, n = 5
a5 = 200,000
200 000 + (5 - 1)30,000
1)30 000 = $320
$320,000
000
S5 = (5/2) [2(200,000) + (5 - 1)30,000]
= $1,300,000
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Geometric Progressions
A geometric progression is a sequence of
numbers in which each term after the first is
obtained
bt i d b
by multiplying
lti l i th
the preceding
di tterm b
by a
constant r. The constant r is called the common
ratio.
If a1, a2, a3, , an, is a geometric progression
with the first term a and common ratio r, then
a1 = a,
a2 = a1r = ar,
a4 = a3r = ar3
a3 = a2r = ar2
an = an-1r = arn-1 (nth term)
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Sum of Terms in a Geometric


Progression
The sum of the first n terms of a geometric
progression with first term a and common
ratio r is given by
n
a 11 rr if r 1

Sn

if r = 1
na
Example: Find the sum of the first six terms
of the g
geometric p
progression
g
3, 6, 12, 24
a = 3, r = 6/3 = 2, n = 6
S6 = 3(1 26) = 189

1-2
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Applied Example
A company had sales of $1 million in its
first year of operations. If sales
i
increased
db
by 10% per year thereafter,
th
ft
find the companys sales in the fifth year
and its total sales over the first 5 years
of operation.
a = 1,000,000, r = 1.1, n = 5
a5 = 1,000,000(1.1)4 = $1,464,100
S5 = 1,000,000 [1 (1.1)5] = $6,105,100

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Exercise 6.4(a)
(a) Find the first five terms of the arithmetic
progression whose 4th and 11th terms are 30 and
107 respectively.
(b) Find the sum of the first 15 terms of the
arithmetic progression: 4, 11, 18,
(c) A tourist wish to go from the airport to his
hotel, which is 25 miles away. The taxi rate is
$1.00 for the first mile and $0.60 for each
additional
dditi
l mile.
il Th
The airport
i
t lilimousine
i also
l goes
to his hotel and charges a flat rate of $7.50.
How much money will the tourist save by taking
the airport limousine?
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Answers to Exercise 6.4(a) (a), (b)

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Answers to Exercise 6.4(a) (c)

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Exercise 6.4(b)
(a) For the geometric progression 4, 8, 16,
32 , find
32,
fi d th
the 7th term
t
and
d th
the sum off the
th
first seven terms.
(b) It has been projected that the
population of a certain city will increase by
8% each of the next 5 years. If the current
population is 200,000, what is the
expected population in 5 years?
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Answers to Exercise 6.4(b)

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