Lecture notes Exponentials and

Logarithms
(Chapter 10)
Kevin Wainwright
April 26, 2014

1 Simple Compound Interest

Suppose you have x dollars to invest at an interest rate of r percent
per year. In one year you will have y dollars, where
y = x + rx = x(1 + r)
in two years
y = [x(1 + r)] (1 + r) = x(1 + r)2
in three years
y = x(1 + r)2 (1 + r) = x(1 + r)3
The present value (PV) of y 3 years from now is
y
x= 3
= y(1 + r) 3
(1 + r)
PV: Tells you "how much to invest now" in order to have y dollars in
3 years.

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1.1 Compounding Within a Year
1. (a) Semi-annual compounding
at six months
r xr
y =x 1+ =x+
2 2
at one year
h r i r r 2
y = x 1+ 1+ =x 1+
2 2 2
(b) Monthly compounding
r 12
y = x 1+ for one year
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r 12 r r 24
y = x 1+ 1+ =x 1+ for two years
12 2 12
r 12n
y = x 1+ for n years
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1.2 Converting Compound Interest into an An-

nual Yield
Suppose you are o¤ered a choice:
1. 10% compounded semi-annually, or
2. 10.2% annually
Which would you choose?
We know for semi-annual
2
r 2 :10
y = x 1+ =x 1+ = (1:05)2 x
2 2
y = 1:1025x

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 Yield = y - principal = y x
Yield = 1:1025x x = 0:1025x or you can earn 10.25% annually
since 10.25% > 10.20% =)=) Pick option (1)

1.3 Continuous Compounding

1. (a) Daily interest for one year
r 365
y =x 1+
365
Suppose x=$1 and r=100% (or r=1)
365
1
y =1 1+ = $2:71456
365

(b) Compound hourly (365 x 24=8760)

8760
1
y =x 1+ = $2:71812
8760
or if m
1
y =1 1+
m
if we let m =) in…nity (1)
m
1
y= 1+ =) 2:71828:::=e
m

for any r as m ! 1 fand x = $1g

m
1
y= 1+ =) er
m

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2 The Number "e"
The number e = 2:71828::: is the value of $1 compounded continuously
for one year (or one period) at an interest rate of 100%.
Continuous compounding at r percent for t years of a principal
equal to x
y = xert
The present value of y is
y rt
x= = ye
ert
which tells you the amount needed to invest today that will be worth
y dollars in t years of continuous compounding
Present Value (xert ) Graphically

dy
Slope = dt = rxert

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3 Derivative rules of e
1.
dy
y = ex dx = ex

2.
dy
y = ef (x) dx = f 0 (x)ef (x)

3. Examples:
dy
(a) y = e3x dx = 3e3x
rt dy rt
(b) y = e dt = re
1) e(t t)
2 dy 2
(c) y = ae(t t)
dt = a (2t

4.
1 1
e = t0 e0 = 1
e1

3.1 Growth Rates

Given
y = xert
The change in y is
dy
= rxert = ry
dt
However, the percentage change in y, or the "growth rate" is
in y dy
Growth Rate = u
y y
Therefore
dy
rxert dt
Growth Rate = = =r
y xert
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Where r is the continuous rate of growth of y over time. NOTE: the
growth rate is constant, however, the slope of y = xert is not constant.

4 Logarithms
4.1 Common Log (or log base 10)
Given
102 = 100
The exponent 2 is de…ned as the logarithm of 100 to the base 10.
eg.
log 1000 = 3 because 103 = 1000
log 10 = 1 because 101 = 10
log 1 = 0 because 100 = 1
log 0:1 = 1 because 10 1 = :1
log 0:01 = 2 because 10 2 = :001

4.2 Natural Logarithm

If y = ex ln y = ln ex = x where ln is the logarithm to base e

4.3 Rules of Logarithms

1. ln(AB) = ln A + ln B
A
2. ln B = ln A ln B

3. ln(Ab ) = b ln A

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4.3.1 Example:
ln(x3 y 2 ) = 3 ln x + 2 ln y

4.3.2 Other Properties

if x = y then ln x = ln y
if x > y then ln x > ln y

**ln( 3) does NOT exist!! You cannot take a logarithm of a

negative number.
**ln(A + B) 6= ln A + ln B!!!

5 Derivatives of the Natural Logarithm

dy 1 dx
1. y = ln x dx = x or dy = x

dy a 1
2. y = ln ax dx = ax = x

OR y = ln ax = ln x + ln a
n o
dy 1 d(ln a)
dx = x since dx =0

3. y = ln(x2 + 2x)
dy 1 2x+2 1 1
dx = (x2 +2x) (2x + 2) = x2 +2x = x+2 + x

OR y = ln(x2 + 2x) = ln [(x + 2) x] = ln(x + 2) + ln x

dy 1 1
dx = x+2 + x

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6 Optimal Timing Problems

6.1 The Forest Harvesting Problem

Assume a stand of trees grows according to the following function
n o
3
Volume = V (t) = Ae t measured in (ft)

Question: When is the best time to harvest the stand of trees?

For simplicity, assume that the price per ft3 for lumber is $1 and
it remains constant over time
if the market rate of interest is r gthen the problem is to choose a
time to harvest the trees that maximizes the present value of the asset

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at any time, t0 the present value is:
rt0
P V = V (t0 ) e
rt
= Ae t0
e
rt
P V = Ae t

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 Optimal harvest time: t3 n 0 o
V3
Maximum present value: PV3 V3 = r
At V1 the growth rate of trees exceeds the growth rate of a …nancial
0
asset since V1V(t)
1
>r

Present Value is
rt
P V (t) = V (t)e
n o
rt
P V (t) = Ae t V (t) = Ae t

dP V
Max PV with respect to t dt =0

dP V
= Ae t rt 2 r =0
dt t
dP V
= 0 If 2 r = 0
dt t
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Therefore r
= r or t =
t2 r

Logarithmic Approach

rt
ln P V = ln(e t )= rt
t
d(ln P V ) dP V
= = 2 r=0
dt dt t( r )
= =r t=
t2 r

t2 = growth rate of the value of uncut trees

r = growth rate of the optimally invested money

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 t2= the growth in your wealth from leaving trees uncut
r = Growth in your wealth if you cut down the trees, sell them,
and put the money into a savings account paying ert
Comparative Statistics: if interest rate rises: r ! r0 then the opti-
mal cutting time falls: t ! t0

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