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4

Mathematics of Finance

• Compound Interest
• Annuities
• Amortization and Sinking Funds
• Arithmetic and Geometric
Progressions
4.1
Compound Interest
Simple Interest Formulas
• Simple interest is the 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 the
principal and interest after t years is given
by
A = P + I = P + Prt
= P(1 + rt)
and is a linear function of t.
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

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

or $240.
Applied Example: Trust Funds
• An amount of $2000 is invested in a 10-year
trust fund that pays 6% annual simple interest.
• What is the total amount of the trust fund at
the end of 10 years?
Solution
• The total amount is given by

or $3200.
Compound Interest
• Frequently, interest earned is periodically added to the
principal and thereafter earns interest itself at the
same rate. This is called compound interest.
• Suppose $1000 (the principal) is deposited in a bank
for a term of 3 years, earning interest at the rate of 8%
per year compounded annually.
• Using the simple interest formula we see that the
accumulated amount after the first year is

or $1080.
Compound Interest
• To find the accumulated amount A2 at the end
of the second year, we use the simple interest
formula again, this time with P = A1, obtaining:

or approximately $1166.40.
Compound Interest
• We can use the simple interest formula yet
again to find the accumulated amount A3 at
the end of the third year:

or approximately $1259.71.
Compound Interest
• Note that the accumulated amounts at the end of
each year have the following form:

or:

• These observations suggest the following general


rule:
– If P dollars are invested over a term of t years earning
interest at the rate of r per year compounded
annually, then the accumulated amount is
Compounding More Than Once a Year
• The formula

was derived under the assumption that


interest was compounded annually.
• In practice, however, interest is usually
compounded more than once a year.
• The interval of time between successive
interest calculations is called the conversion
period.
Compounding More Than Once a Year
• 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

• For example, if the nominal interest rate is 8% per


year, and interest is compounded quarterly, then

or 2% per period.
Compounding More Than Once a Year
• To find a general formula for the accumulated
amount, we apply

repeatedly with the interest rate i = r/m.


• We see that the accumulated amount at the
end of each period is as follows:
Compound Interest Formula
 There are n = mt periods in t years, so the accumulated
amount at the end of t years is given by

Where n = mt, and


A = Accumulated amount at the end of t
years
P = Principal
r = Nominal interest rate per year
m = Number of conversion periods per year
t = Term (number of years)
Example
• Find the accumulated amount after 3 years if
$1000 is invested at 8% per year
compounded
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily
Example
Solution
a. Annually.
Here, P = 1000, r = 0.08, and m = 1.
Thus, i = r = 0.08 and n = 3, so

or $1259.71.
Example
Solution
b. Semiannually.
Here, P = 1000, r = 0.08, and m = 2.
Thus, and n = (3)(2) = 6, so

or $1265.32.
Example
Solution
c. Quarterly.
Here, P = 1000, r = 0.08, and m = 4.
Thus, and n = (3)(4) = 12, so

or $1268.24.
Example
Solution
d. Monthly.
Here, P = 1000, r = 0.08, and m = 12.
Thus, and n = (3)(12) = 36, so

or $1270.24.
Example
Solution
e. Daily.
Here, P = 1000, r = 0.08, and m = 365.
Thus, and n = (3)(365) = 1095, so

or $1271.22.
Continuous Compounding of Interest
• One question arises on compound interest:
– What happens to the accumulated amount over
a fixed period of time if the interest is
compounded more and more frequently?
• We’ve seen that the more often interest is
compounded, the larger the accumulated
amount.
• But does the accumulated amount approach
a limit when interest is computed more and
more frequently?
Continuous Compounding of Interest
• Recall that in the compound interest
formula

the number of conversion periods is m.


• So, we should let m get larger and larger
(approach infinity) and see what happens
to the accumulated amount A.
Continuous Compounding of Interest
• If we let u = m/r so that m = ru, then the above formula becomes

 The table shows us that when u gets


larger and larger the expression
u
 1
1  
u  u
10 2.59374
approaches 2.71828 (rounding to
five decimal places). 100 2.70481
1000 2.71692
 It can be shown that as u gets
larger and larger, the value of 10,000 2.71815
the expression approaches the 100,000 2.71827
irrational number 2.71828… 1,000,000 2.71828
which we denote by e.
Continuous Compounding of Interest

• Continuous Compound Interest Formula


A = Pert
where
P = Principal
r = Annual interest rate compounded
continuously
t = Time in years
A = Accumulated amount at the end
of t years
Examples
• Find the accumulated amount after 3 years if $1000 is
invested at 8% per year compounded (a) daily, and
(b) continuously.
Solution
a. Using the compound interest formula with P = 1000,
r = 0.08, m = 365, and t = 3, we find

b. Using the continuous compound interest formula with


P = 1000, r = 0.08, and t = 3, we find
A = Pert = 1000e(0.08)(3) ≈ 1271.25
Note that the two solutions are very close to each
other.
Effective Rate of Interest
• The last example demonstrates that the interest
actually earned on an investment depends on the
frequency with which the interest is
compounded.
• For clarity when comparing interest rates, we can
use what is called the effective rate (also called
the annual percentage yield):
– This is the simple interest rate that would produce the
same accumulated amount in 1 year as the nominal
rate compounded m times a year.
• We want to derive a relation between the
nominal compounded rate and the effective rate.
Effective Rate of Interest
• The accumulated amount after 1 year at a
simple interest rate R per year is

• The accumulated amount after 1 year at a


nominal interest rate r per year compounded
m times a year is
• Equating the two expressions gives
Effective Rate of Interest Formula
• Solving the last equation for R we obtain the
formula for computing the effective rate of
interest:

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 nominal rate of 8% per
year compounded
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily
Example
Solution
a. Annually.
Let r = 0.08 and m = 1. Then

or 8%.
Example
Solution
b. Semiannually.
Let r = 0.08 and m = 2. Then

or 8.16%.
Example
Solution
c. Quarterly.
Let r = 0.08 and m = 4. Then

or 8.243%.
Example
Solution
d. Monthly.
Let r = 0.08 and m = 12. Then

or 8.300%.
Example
Solution
e. Daily.
Let r = 0.08 and m = 365. Then

or 8.328%.
Effective Rate Over Several Years

• If the effective rate of interest reff is


known, then the accumulated
amount after t years on an
investment of P dollars can be more
readily computed by using the
formula
Present Value
• Consider the compound interest formula:

• 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.
• On occasion, investors may wish to determine how
much money they should invest now, at a fixed rate of
interest, so that they will realize a certain sum at some
future date.
• This problem may be solved by expressing P in terms of
A.
Present Value

• Present value formula for compound interest

Where and
Examples
• How much money should be deposited in a bank
paying a yearly interest rate of 6% compounded
monthly so that after 3 years the accumulated
amount will be $20,000?
Solution
• Here, A = 20,000, r = 0.06, m = 12, and t = 3.
• Using the present value formula we get
Examples
• Find the present value of $49,158.60 due in 5
years at an interest rate of 10% per year
compounded quarterly.
Solution
• Here, A = 49,158.60, r = 0.1, m = 4, and t = 5.
• Using the present value formula we get
Present Value
with Continuously Compounded Interest
• If we solve the continuous compound interest
formula
A = Pert
for P, we get
P = Ae–rt
• This formula gives the present value in terms
of the future (accumulated) value for the case
of continuous compounding.
Applied Example: Real Estate
Investment
• Blakely Investment Company owns an office building
located in the commercial district of a city.
• As a result of the continued success of an urban renewal
program, local business is enjoying a mini-boom.
• The market value of Blakely’s property is

where V(t) is measured in dollars and t is the time in years


from the present.
• If the expected rate of appreciation is 9% compounded
continuously for the next 10 years, find an expression for
the present value P(t) of the market price of the property
that will be valid for the next 10 years.
• Compute P(7), P(8), and P(9), and then interpret your
results.
Applied Example: Real Estate
Investment
Solution
• Using the present value formula for continuous
compounding
P = Ae–rt
with A = V(t) and r = 0.09, we find that the
present value of the market price of the property
t years from now is

• Letting t = 7, we find that

or $599,837.
Applied Example: Real Estate
Investment
Solution
• Using the present value formula for continuous
compounding
P = Ae–rt
with A = V(t) and r = 0.09, we find that the
present value of the market price of the property
t years from now is

• Letting t = 8, we find that

or $600,640.
Applied Example: Real Estate
Investment
Solution
• Using the present value formula for continuous
compounding
P = Ae–rt
with A = V(t) and r = 0.09, we find that the
present value of the market price of the property
t years from now is

• Letting t = 9, we find that

or $598,115.
Applied Example: Real Estate
Investment
Solution
• From these results, we see that the present
value of the property’s market price seems to
decrease after a certain period of growth.
• This suggests that there is an optimal time for
the owners to sell.
• You can show that the highest present value
of the property’s market value is $600,779,
and that it occurs at time t ≈ 7.72 years, by
sketching the graph of the function P.
Example: Using Logarithms in Financial
Problems
• 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 the compound interest formula

with A = 15,000, P = 10,000, r = 0.12, and m =


4, we obtain
Example: Using Logarithms in Financial
Problems
• 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
• We’ve got Taking logarithms
on both sides

logbmn = nlogbm

 So, it will take about 3.4


years for the investment
to grow from $10,000 to
$15,000.
4.2
Annuities

 (1  i )n  1  (1  0.01)12  1 
S  R   100    1268.25
 i   0.01 

1  (1  i )  n  1  (1  0.01) 36 
P  R   400    12,043
 i   0.01 
Annuities
• An annuity is a sequence of payments made at regular
time intervals.

• The time period in which these payments are made is


called the term of the annuity

Examples:
1. Regular deposits to a savings account
2. Monthly home mortgage payments
3. Monthly insurance payments
Annuities
1. The terms are given by fixed time intervals(annuity certain).

2. The period payments are equal in size.

3. The payments are made at the end of the payment


period(ordinary annuity)

4. The payment periods coincide with the interest conversion period


(simple annuity).
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
account that earns interest at the rate
of i per period, is
Example
• Find the amount of an ordinary annuity consisting of
12 monthly payments of $100 that earn interest at 12%
per year compounded monthly.
Solution
• Since i is the interest rate per period and since interest
is compounded monthly in this case, we have

• Using the future value of an annuity formula, with


R = 100, n = 12, and i = 0.01, we have

or $1268.25.
Present Value of an Annuity

• The present value P of an annuity


consisting 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
Example
• Find the present value of an ordinary annuity
consisting of 24 monthly payments of $100
each and earning interest of 9% per year
compounded monthly.
Solution
• Here, R = 100, i = r/m = 0.09/12 = 0.0075, and
n = 24, so
Applied Example: Saving for a
College Education
• As a savings program towards Alberto’s
college education, his parents decide to
deposit $100 at the end of every month into a
bank account paying interest at the rate of 6%
per year compounded monthly.
• If the savings program began when Alberto
was 6 years old, how much money would have
accumulated by the time he turns 18?
Applied Example: Saving for a College Education
Solution
• By the time the child turns 18, the parents
would have made

deposits into the account, so n = 144.


• Furthermore, we have R = 100, r = 0.06, and m
= 12, so

• Using the future value of an annuity formula,


we get
Applied Example: Financing a Car
• After making a down payment of $4000 for an
automobile, Murphy paid $400 per month for
36 months with interest charged at 12% per
year compounded monthly on the unpaid
balance.
• What was the original cost of the car?
• What portion of Murphy’s total car payments
went toward interest charges?
Applied Example: Financing a Car
Solution
• The loan taken up by Murphy is given by the present value of
the annuity formula

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 = 2,357or $2,357.
4.3
Amortization and Sinking Funds

Pi (120,000)(0.0075)
R n
 360
 965.55
1  (1  i ) 1  (1  0.0075)

iS (0.025)(30,000)
R   3434.02
(1  i )  1 (1  0.025)  1
n 8
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
Applied Example: Home Mortgage
Payment
• The Blakelys borrowed $120,000 from a bank
to help finance the purchase of a house.
• The bank charges interest at a rate of 9% per
year on the unpaid balance, with interest
computations made at the end of each month.
• The Blakelys have agreed to repay the loan in
equal monthly installments over 30 years.
• How much should each payment be if the loan
is to be amortized at the end of term?
Applied Example: Home Mortgage
Payment
Solution
• Here, P = 120,000, i = r/m = 0.09/12 = 0.0075,
and
n = (30)(12) = 360.
• Using the amortization formula we find that
the size of each monthly installment required
is given by

or $965.55.
Applied Example: Home
Affordability
• The Jacksons have determined that, after
making a down payment, they could afford at
most $2000 for a monthly house payment.
• The bank charges interest at a rate of 7.2% per
year on the unpaid balance, with interest
computations made at the end of each month.
• If the loan is to be amortized in equal monthly
installments over 30 years, what is the
maximum amount that the Jacksons can
borrow from the bank?
Applied Example: Home Affordability
Solution
• We are required to find P, given i = r/m = 0.072/12 =
0.006, n = (30)(12) = 360, and R = 2000.
• We first solve for P in the amortization formula

• Substituting the numerical values for R, n, and i we obtain

• Therefore, the Jacksons can borrow at most $294,643.


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
Applied Example: Sinking Fund
• The proprietor of Carson Hardware has
decided to set up a sinking fund for the
purpose of purchasing a truck in 2 years’ 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 (equal) quarterly installment the
proprietor should pay into the fund.
Applied Example: Sinking Fund
Solution
• Here, S = 30,000, i = r/m = 0.1/4 = 0.025, and n
= (2)(4) = 8.
• Using the sinking fund payment formula we
find that the required size of each quarterly
payment is given by

or $3434.02.
4.4
Arithmetic and Geometric Progressions
Arithmetic Progressions
• An arithmetic progression is a sequence of
numbers in which each term after the first is
obtained by adding a constant d to the
preceding term.
• The constant d is called the common
difference.
• An arithmetic progression is completely
determined if the first term and the common
difference are known.
nth Term of an Arithmetic
Progression
• The nth term of an arithmetic
progression with first term a and
common difference d is given by
an = a + (n – 1)d
Example

• Find the twelfth term of the arithmetic progression


2, 7, 12, 17, 22, …
Solution
• The first term of the arithmetic progression is a1 = a = 2, and
the common difference is d = 5.
• So, upon setting n = 12 in the arithmetic progression formula,
we find
an = a + (n – 1)d
a12 = 2 + (12 – 1)5
= 57
Sum of Terms in an Arithmetic
Progression
• The sum of the first n terms of an
arithmetic progression with first
term a and common difference d is
given by
Example
• Find the sum of the first 20 terms of the
arithmetic progression
2, 7, 12, 17, 22, …
Solution
• Letting a = 2, d = 5, and n = 20 in the sum of
terms formula, we get
Applied Example: Company Sales
• Madison Electric Company had sales of $200,000 in its first
year of operation.
• If the sales increased by $30,000 per year thereafter, find
Madison’s sales in the fifth year and its total sales over the
first 5 years of operation.
Solution
• Madison’s yearly sales follow an arithmetic progression, with
a = 200,000 and d = 30,000.
• The sales in the fifth year are found by using the nth term
formula with n = 5.
• Thus,
an = a + (n – 1)d
a5 = 200,000 + (5 – 1)30,000
= 320,000
or $320,000.
Applied Example: Company Sales
• Madison Electric Company had sales of $200,000 in its first
year of operation.
• If the sales increased by $30,000 per year thereafter, find
Madison’s sales in the fifth year and its total sales over the
first 5 years of operation.
Solution
• Madison’s total sales over the first 5 years of operation are
found by using the sum of terms formula.
• Thus,

or $1,300,000.
Geometric Progressions
• A geometric progression is a sequence of
numbers in which each term after the first is
obtained by multiplying the preceding term by
a constant.
• The constant is called the common ratio.
• A geometric progression is completely
determined if the first term a and the
common ratio r are given.
nth Term of a Geometric
Progression
• The nth term of a geometric
progression with first term a and
common ratio r is given by
Example
• Find the eighth term of a geometric progression whose first
five terms are 162, 54, 18, 6, and 2.
Solution
• The common ratio is found by taking the ratio of any term
other than the first to the preceding term.
• Taking the ratio of the fourth term to the third term, for
example, gives

• Using the nth term formula to find the eighth term gives
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
Example
• Find the sum of the first six terms of the
geometric progression 3, 6, 12, 24, …
Solution
• Using the sum of terms formula

with a = 3, r = 6/3 = 2, and n = 6, gives


Applied Example: Company Sales

• Michaelson Land Development Company had sales of


$1 million in its first year of operation.
• If sales increased by 10% per year thereafter, find
Michaelson’s sales in the fifth year and its total sales over
the first 5 years of operation.
Solution
• The sales follow a geometric progression, with first term a =
1,000,000 and common ratio r = 1.1.
• The sales in the fifth year are thus

or $1, 464,100.
Applied Example: Company Sales

• Michaelson Land Development Company had sales of


$1 million in its first year of operation.
• If sales increased by 10% per year thereafter, find
Michaelson’s sales in the fifth year and its total sales over
the first 5 years of operation.
Solution
• The sales follow a geometric progression, with first term a =
100,000,000 and common ratio r = 1.1.
• The total sales over the first 5 years of operation are

or $6,105,100.
End of
Chapter