Basic Financial Math

• This chapter and the next extend the use of

mathematics and look at aspects of financial
analysis typically undertaken in a business
organization.
 Percentage changes
• The formula required for calculating the
percentage change is as follows.
𝐂𝐡𝐚𝐧𝐠𝐞
Percentage change = * 100%
𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐕𝐚𝐥𝐮𝐞

𝑷𝒆𝒓𝒄𝒆𝒏𝒕 𝑪𝒉𝒂𝒏𝒈𝒆
• Amount of change = * Original value
𝟏𝟎𝟎

• Note that it is the original value that the change

is compared with and not the final value when
calculating the percentage change.
 Problems involving Percentages
• Problem: If my investment portfolio was worth
$100,000 and there was a growth of 5%, how
much is it worth now?
• The growth or increase (amount of change) is
calculated as
5
5% of $100,000 = * $100,000 = $5,000
100
Hence, there is an increase of $5,000
Therefore, the portfolio is now worth
= $100,000+$5,000 = $105,000
 Problems involving Percentages
• Problem: If sales receipts in year 1 are $500,000
and there was a percentage decrease of 10% in
year 2, what are the sales receipts in year 2?
• The decrease (amount of change) is calculated as
10
10% of $500,000 = * $500,000 = $50,000
100
Hence, there is a decrease of $50,000 in year 2
Therefore, the sales receipts in Year 2
= $500,000-$50,000 = $450,000
 Problems involving Percentages
• Problem: Fred‘s salary is now $60,000 per annum after
an annual increase of 20%. Suppose we wanted to
know his annual salary before the increase.
• Let A be Fred’s initial salary before increase
Then A + 20%*A = 60,000
1*A + 20%*A = 60,000
20
A+ A = 60,000
100
A + 0.2A = 60,000
A(1+0.2) = 60,000
1.2A = 60,000
60000
A= = 50,000
1.2
• Problem: A television has been reduced from
$490.99 to $340.99. What is the percentage
reduction in price to three decimal places?
• Difference in price = $(490.99 – 340.99) =
$150.00
𝐂𝐡𝐚𝐧𝐠𝐞
• Percentage reduction = * 100%
𝐎𝐫𝐢𝐠𝐢𝐧𝐚𝐥 𝐕𝐚𝐥𝐮𝐞
𝟏𝟓𝟎
• = * 100%
𝟒𝟗𝟎.𝟗𝟗

=30.551%
 Discounts
• A business may offer a discount on a price to
encourage sales. The calculation of discounts
requires an ability to manipulate percentages.
 Discounts
• Problem: A travel agent is offering a 17%
discount on the brochure price of a particular
holiday to America. The brochure price of the
holiday is $795. What price is being offered by
the travel agent?
• Discount (Amount of change) = = 17% of $795
17
= * 795 = $135.15
100
• Price offered = $(795 – 135.15) = $659.85
Quicker percentage change calculations
• If something is increased by 10%, we can
calculate the increased value by multiplying by
(1 + 10%) = 1 + 0.1 = 1.1.
• We are multiplying the number by itself plus 10%
expressed as a decimal.
• For example, a 15% increase on $1000
=1000 + 15%*1000 = 1000(1+15%) = 1000(1+.15)
= $1000 * 1.15 = $1150

• In the same way, a 10% decrease can be

calculated by multiplying a number by (1 – 10%) =
1 – 0.1 = 0.9.
 Problems involving Percentages
• Problem: If my investment portfolio was worth
$100,000 and there was a growth of 5%, how
much is it worth now?
• The growth or increase (amount of change) is
calculated as
100,000 (1 + .05)
= 100,000*1.05
= $105,000
 Discounts
• Problem: A travel agent is offering a 17%
discount on the brochure price of a particular
holiday to America. The brochure price of the
holiday is $795. What price is being offered by
the travel agent?
• Discount Price offered = 795(1-0.17)
• = 795*0.83 = $659.85
Profits
 Profits

• Cost Price + Profit = Selling Price

OR
• Selling Price – Profit = Cost Price
 Profit margin, Profit Markup
• Profit Margin is the retailer’s profit dollars expressed as
a percentage of their RETAIL SELLING PRICE on the
store’s shelf.
• %MARGIN = PROFIT DOLLARS / RETAIL (SELLING) PRICE
• Profit Margin = % Profit Margin* SP
• ~~~
• Profit Markup is the retailer’s same profit
dollars expressed as a percentage of what they paid the
vendor (wholesale price) / manufacture cost.
• %MARKUP = PROFIT DOLLARS / COST PRICE
• Profit Markup = % Profit Markup* CP
• Example: Let’s say a retailer buys a product
from the wholesaler for $5 and then sells
it for $7.50.
• The retailer’s profit on the sale = 7.50 – 5 =
$2.50
2.50
• Retailer’s % Profit Margin = *100 = 33%
7.50

2.50
• Retailer’s % Profit Markup = *100 = 50%
5
 Profit Margin
• Problem: Delilah's Dresses sells dresses at a 10% profit margin.
The dress cost the shop $100. Calculate the profit margin made by
Delilah's Dresses.
Since we do not know the SP, let us say the SP is 𝒙
Profit Margin = 10%* 𝒙 = 0.10 𝒙 (Remember profit margin is always
calculated on the SP)
SP – CP = Profit
𝒙 – 100 = .10 𝒙
𝒙 - .10 𝒙 - 100 = 0
𝒙(1-.10) – 100 = 0
.90 𝒙 = 100
100
𝒙= = 111.11
.90

𝒙 = Selling Price = $111.11

Therefore, Profit = SP-CP = 111.11 – 100 = $11.11

 Profit Margin
• Problem: A skirt which cost the retailer $75 is sold at a
profit of 25% on the selling price. Calculate the profit
made.
Since the SP is not given to us,
Let the SP = 𝒙
Then profit (margin) = 25%* 𝒙 =0.25x
SP – CP = Profit
𝒙 – 75 = .25 𝒙
𝒙 - .25 𝒙 -75 = 0
𝒙(1 - .25) = 75
.75 𝒙 = 75
𝒙 = Selling Price = $100
Therefore, Profit = $100 – $75 = $25
 Markup
• Problem: A computer software retailer uses
a markup rate of 40%. Find the selling price
of a computer game that cost the
retailer $25.
The markup is 40% of the $25 cost, so the
markup is = 40%*25 = $10
Then the selling price, being the cost plus
markup, is = 25 + 10 = $35
The item sold for $35.
• Problem: A golf shop pays its wholesaler $40 for
a certain club, and then sells it to a golfer
for$75. What is the markup percent?
First, we'll calculate the markup in absolute terms:
SP – CP = Profit (Markup)
75 – 40 = $35
To find the Markup percent, remember that
Markup is always calculated on the Cost Price
35
= *100 = 87.5%
40
• The markup percent or rate is 87.5%.
• Problem: A shoe store uses a 40% markup on cost. Find the cost
of a pair of shoes that sells for$63.
This problem is somewhat backwards. They gave you the selling price,
which is cost plus markup, and they gave you the markup rate, but
they didn't tell you the actual cost or markup.

Let " 𝒙 " be the cost. Remember Markup always calculated on the CP
Then the markup, being 40% of the cost, is 40%* 𝒙 = 0.40 𝒙.
Remember SP = CP+markup

Selling price of $63 is the sum of the cost and markup, so:

63 = 𝒙 + 0.40 𝒙 = 𝒙 (1+0.40) = 1.40 𝒙

1.40 𝒙 = 63
63
𝒙= = 45
1.40
• The shoes cost the store $45.
INTEREST
• Very often, financial mathematics deals with
problems of investing money, or capital. If a
company (or an individual investor) puts some
capital into an investment, a financial return
will be expected.
• One of the most basic uses of mathematics in
finance involves calculations of INTEREST.
• Interest is the amount of money which an
investment earns over time.
• The most fundamental of interest calculations
is SIMPLE INTEREST.
 Simple Interest
• If a sum of money is invested for a period of time, then
the amount of simple interest which accrues is equal to
the principal invested * interest rate * time invested.

• We can write this as a formula.

𝑃𝑟𝑡
• Interest earned = , where
100
P = the original sum invested
r = the interest rate quoted as per annum
t = the number of periods (normally years)
• The Amount accrued after t periods
Amount = Principal + Interest earned
• A single principal sum that is deposited today
in a savings account is said to have a Future
Value (FV) over time. We call the present sum
of money invested as the Present Value (PV).
• For example, a principal of $100 (present
value) deposited in a savings account that
pays 5% per annum, will become $105 (future
value) in one year’s time.
• Problem: How much will an investor have
after five years if he invests $1,000 at 10%
simple interest per annum?
Using the formula A = P + Interest
A = P + I where I = Prt
P = $1,000, r = 10% = 0.10, t = 5
Interest I = 1000*0.10*5 = $500

Amount A = $1,000 + 500 = $1,500

• The rate of interest is usually quoted as a
percentage; 9% corresponds to a value of 0.09.
• You have to be careful that the rate of interest is
quoted using the same time unit as the period.
The period is normally measured in years, and
the interest rate is quoted per annum (“per
annum" is Latin for “per year").
• However, if , for example, the sum of money is
invested for 3 months and the interest rate is a
3 1
rate per annum, then t = years =
12 4
• If the investment period is 197 days and the rate
197
is an annual rate, then t =
365
 Compound Interest
• In the previous section, you have studied
about simple interest. When the interest is
calculated on the Principal for the entire
period of loan, the interest is called simple
interest
• But if this interest is due (not paid) after the
decided time period, then it becomes a part of
the principal and so is added to the principal
for the next time period, and the interest is
calculated for the next time period on this
new principal. Interest calculated, this way is
called compound interest.
 Compound Interest
• The time period after which the interest is
added to the principal for the next time period
may be one year, six months or three months
and the interest is said to compounded,
annually, semi-annually or quarterly,
respectively. (Note that simple interest and
compounded interest are equal for the 1st year
if interest is compounded annually).
 Compound Interest

• Interest is normally calculated by means of

compounding.
• Compounding means that, as interest is
earned, it is added to the original investment
and starts to earn interest itself.
• The basic formula for compound interest
when the interest is compounded annually, is
Amount= P(1 + r)t
 Concept of Compounding
• If a sum of money, the principal, is invested at
a fixed rate of interest such that the interest is
added to the principal and no withdrawals are
made, then the amount invested will grow by
an increasing number of dollars in each
successive time period, because interest
earned in earlier periods will itself earn
interest in later periods.
 Compound Interest
Amount= P(1 + r)t
Where

• P is the Principal (the initial sum you borrow or

deposit)
• r is the annual rate of interest (percentage)
• n is the number of years the sum is deposited or
borrowed for
• A is the amount of money accumulated after n
years, including interest.
• Problem: Suppose that $2,000 is invested at 10%
compound interest for 3 years. What will be the
amount accrued at the end of the period?
Amount after t periods = P(1 + r)t
P = 2000 r = 10% = .10 t=3
= 2000(1+.10)3
= 2000(1.10)3
= 2000 * 1.331
= 2,662
The interest earned over three years is $662. The
investment is worth $2,662 after 3 years.
Withdrawals of Principal or Interest
• If an investor takes money out of an
investment, it will cease to earn interest. Thus,
if an investor puts $3,000 into a bank deposit
account which pays interest at 8% per annum,
and makes no withdrawals except at the end
of year 2, when he takes out $1,000, what
would be the balance in his account after four
years?
P = 3000 r = 8% = .08 t = 2 years
Amount accrued at the end of 2 years
= 3000(1.08)2 = $3499.20
The investor withdraws $1000
New Principal = 3499.20 – 1000 = 2499.20
Amount accrued at the end of another 2 years
=2499.20(1.08)2 = $2,915.07
• Problem: At what annual rate of compound
interest will $2,000 grow to $2,721 after four
years?

A = 2721 P = 2000 t=4 r=?

Amount= P(1 + r)t
2721 = 2000(1+r)4
2721 2721
= (1+r)4 Same as (1+r)4 = = 1.3605
2000 2000

Taking the 4rth root on both sides of the equation,

4
(1+r) = 1.3605 = 1.08
r = 1.08 – 1 = .08 = 8%
Frequent compounding of interest
• What if interest is paid more frequently - not just once
a year.
• If the amount is calculated by compounding n times
per year at a rate r , the amount after t years is
𝑟 nt
A = P(1+ )
𝑛

• Interest paid Annually A = P(1+r)t (Formula remains

the same)
𝑟
• Interest paid Quarterly A = P(1+ )4t
4
𝑟 12t
• Interest paid Monthly A = P(1+ )
12
 Nominal Rate
• Nominal Interest rate is the interest
rate expressed as per annum even
when the interest is compounded
over periods of less than one year.
• Problem: If you deposit $4000 into an
account paying 6% annual interest
compounded quarterly, how much money will
be in the account after 5 years?
𝑟 nt
• A= P(1+ )
𝑛
• P = $4000 r = 6% = .06 n=4 t=5
.06 20
• A= 4000(1+ )
4
• A = $5387.42
• Problem: How many years does it take $1300, invested
at 9% per annum, compounded monthly, to increase to
$2000? (Round to the nearest tenth of a year)
𝑟 nt
• A= P(1+ )
𝑛
• We have P = $1300, A = $2000, 𝑟 = 9% = .09, n= 12
since interest is compounded monthly, and there are
12 months in a year.
.09 12t
• 2000 = 1300(1+ )
12
2000 .09 12t 12 .09 12t
• = (1+ ) =( + )
1300 12 12 12

20 12+.09 12t 12.09 12t

• = ( ) = ( )
13 12 12

• We now need to solve for t, which is in the exponent.

20 12.09 12t
= ( )
13 12
• Taking logs on both sides,
20 12.09 12t
log = log [( ) ]
13 12
20
log = 12t log (1.0075)
13
20
log( )
13
Hence, t =
12log(1.0075)
~ 4.8044 (~ means approximately)
~ 4.8 years (rounded to the nearest tenths)
You can verify that your answer is correct by
plugging in the values into the RHS of the
formula, and seeing if A is indeed around $2000.
 Key Terms
• The term 'present value' simply means the
amount of money which must be invested
now for n years at an interest rate of r%, to
earn a given future sum of money (future
value) at the time it will be due.
 Compounding
• As we have seen, the basic principle of
compounding is that, as interest is earned, it is
added to the original investment and starts to
earn interest itself.
• If we invest $P now for n years at r% interest per
annum, we should obtain $P(1 + r)n in n years'
time.
Compounding formula A = P(1 + r)n
• Thus if we invest $10,000 now for four years at
10% interest per annum, we will have a total
investment worth
$10,000 × 1.104 = $14,641 at the end of four years.
 Discounting
• Discounting is the reverse of compounding. The
discounting formula is
𝑨
P= 𝒏
𝟏+𝒓
• The basic principle of discounting is that if we
wish to have $A in n years' time, we need to
invest a certain sum P now at an interest rate of
r% in order to obtain the required sum of money
in the future.
• P is the Present Value
• A is Future Value (the amount to be received
after n periods)
• For example, if we wish to have $14,641 in four years'
time, how much money would we need to invest now
at 10% interest per annum?
𝑨
P= 𝒏
𝟏+𝒓
where A=14,641 n=4 r=10% = .10
𝟏𝟒,𝟔𝟒𝟏
P=
𝟏+.𝟏𝟎 𝟒
14,641
= = $10,000
1.4641

• $10,000 now, with the capacity to earn a return of 10%

per annum, is the equivalent in value of $14,641 after
four years. We can therefore say that $10,000 is the
present value and $14,641 is the future value.
• When you move a payment forward in time, it
accumulates;
• When you move it backward, it is discounted.
 Growth and Depreciation
• In our daily life, we come across terms like
growth of population, plants, viruses etc. and
depreciation in the value of articles like
machinery, crops, motor cycles etc.
• The problems of growth (appreciation) and
depreciation can be solved using the formula
of compound interest derived earlier.
 Growth and Depreciation
• If P is the Present value, and A is its value after
n time periods (Future Value), and r is the
rate of growth/depreciation for the period,
then we can write
• FV = PV(1 + r)t in case of growth
• FV= PV(1 - r)t in case of depreciation
 Growth
• Problem: The population of a city is 9765625.
What will be its population after 3 years, if the
rate of growth of population is 4% per year?
• FV = PV(1 + r)t
• PV = 9765625 r = 4% = .04 t = 3
• FV = 9765625(1+.04)3
• FV = 10985000
• The population of the city after 3 years will be
10985000
 Depreciation
• A company buys a machine for $20,000. What
will its value be after 6 years, if it is assumed to
depreciate at a fixed rate of 12 per cent per
annum?
• FV= PV(1 - r)t
• PV = 20,000 r = -12% = -.12 t = 6
• FV = 20,000(1- .12)6
• =20,000(.88)6
• =20,000*0.4644041 = 9,288.08
The machine’s value in 6 years’ time will therefore
be $9,288.08
 Changes in the Rate of Interest
• If the rate of growth/depreciation varies for each conversion
period, or the interest rate changes during the period of an
investment, then the compound interest formula must be
amended slightly. Amount is the FV and P is the PV.
• Amount = P(1 + r1)t1 (1 + r2)t2 (1 + r3)t3 etc. for growth
• Amount = P(1 - r1)t1 (1 - r2)t2 (1 - r3)t3 etc. for depreciation
• where
• r1 = the initial rate of interest
• t1 = the number of years in which the interest rate r1 applies
• r2 = the next rate of interest
• t2 = the number of years in which the interest rate r2 applies
• …….. and so on.
 Changes in the Rate of Interest
• Problem: A motor car costing $21,000 may
depreciate by 15 per cent in the first year, then by
10 per cent per annum in each of the next three
years, and by 5 per cent per annum thereafter.
Find its value after 8 years.
• FV= PV(1 - r1)t1 (1 - r2)t2 (1 - r3)t3
• FV = 21,000(1 - 0.15)1*(1 - 0.10)3 * (1 - 0.05)4
• FV = 21,000(.85)1*(.90)3 * (.95)4
• = 21,000 * 0.85 * 0.903 * 0.954 = $10,598.88
• Problem: If $8,000 is invested now, to earn
10% interest for three years and 8%
thereafter, what would be the size of the total
investment at the end of five years?
Amount= P(1 + r1)t1 (1 + r2)t2 (1 + r3)t3 etc. for
growth
A = 8,000(1+.10)3 * (1+.08)2
= 8,000 * 1.103 * 1.082
= $12,419.83
 Inflation
• The same compounding formula can be used to
predict future prices after allowing for inflation.
Inflation is the general increase in prices of goods
and services in an economy over time, and the
fall in the purchasing value of money (each unit
of currency buys fewer goods and services).
• A chief measure of price inflation is the inflation
rate which is expressed as a %. If it is 3%, this
means that on average, the price of products and
services we buy is 3% higher than a year earlier.
• Or, in other words, we would need to spend 3%
more to buy the same things we bought 12
months ago.
 Inflation
• For example, if we wish to predict the salary of an
employee in five years' time, given that he earns
$8,000 now and wage inflation is expected to be
10% per annum, the compound interest growth
formula would be applied as follows.
Amount= P(1 + r)t
P = 8000 r = 10% = .10 t = 5
A = 8000(1+.10)5
= 8000(1.10)5
= $12,884.08
 Inflation
• Problem: An item of equipment costs $6,000
now. The annual rates of inflation over the next
four years are expected to be 16%, 20%, 15% and
10%. How much would the equipment cost after
four years?
FV= PV(1 + r1)t1 (1 + r2)t2 (1 + r3)t3 etc. for growth or
inflation
A = 6,000(1 + .16)1 * (1 + .20)1 * (1 + .15)1 * (1 +
.10)1
= 6,000 * 1.16 * 1.20 * 1.15 * 1.10
= $10,565.28
 Real Interest Rate
• The nominal interest rate doesn’t tell the whole
story, because inflation reduces the lender's or
investor’s purchasing power so that they cannot
buy the same amount of goods or services at
payoff or maturity with a given amount of money
as they can now.
• The real interest rate is so named because it
states the “real” rate that the lender or investor
receives after inflation is factored in
• Nominal interest rate – Inflation = Real interest
rate
 Real Interest Rate
• Example:
• If a bond that compounds annually has a 6%
nominal yield and the inflation rate is 4%, then
the real rate of interest is only 2%.
 Effective Rate of Interest
• We saw that the NOMINAL RATE is the
interest rate expressed as a per annum
figure, eg 12% pa even though interest may
be compounded over periods of less than
one year.

• The nominal rate can be converted into an

effective annual rate of interest.
 Effective Rate of Interest
𝒓 𝒏
Effective rate of interest: (1 + R) = (𝟏 + ), where
𝒏
• R is the effective rate
• r is the nominal annual rate
• n is the number of periods in a year.
– n=12 when compounded monthly;
– n=4 when compounded quarterly;
– n=2 when compounded half-yearly
• Problem: A building society offers investors 10%
per annum interest payable half-yearly. What is
the Effective annual rate of interest?
𝒓 𝒏
• Effective rate of interest: (1 + R) = (𝟏 + )
𝒏
r = 10% = .10 n = 2 (2 periods in a year) R=?
(1+R) = (1+.05)2 = 1.052
1+R = 1.1025
R = 1.1025 – 1
= 0.1025
= 10.25% per annum
• Problem: Consider the following nominal rates:
16.8% p.a. compounded annually.
16.4% p.a. compounded monthly.
16.5% p.a. compounded quarterly.
a) Determine the effective interest rate of each of
the nominal rates listed above.
b) Which is the best interest rate for an investment?
c) Which is the best interest rate for a loan?
• Ans: a) 16.8%, 17.7%, 17.5%
• b) 16.4% p.a. compounded monthly
• c) 16.8% p.a. compounded annually
• The chief advantage to knowing the difference
between nominal, real and effective rates is
that it allows consumers to make better
decisions about their loans and investments.
• For example, a loan with frequent
compounding periods will be more expensive
than one that compounds annually.
• Or a bond that only pays a 1% real interest
rate may not be worth investors' time if they
seek to grow their assets over time.