Chapter 6

MATHEMATICS OF FINANCE

I. Overview

Mathematics of finance is the application of mathematical methods to financial

problems like investment where it is an asset or item acquired with the goal of generating
income or appreciation. To compute the generating income, we need to understand how
interest works wherein this is the focus of this chapter. Interest is the cost of borrowing
money, where the borrower pays a fee to the lender for the loan. The interest, typically
expressed as a percentage, can be either simple or compounded. Simple interest is based
on the principal amount of a loan or deposit. In contrast, compound interest is based on
both the initial principal and the accumulated interest from previous periods. Compound
interest can be thought of as “interest on interest,” and will make a sum grow at faster rate
than simple interest.

II. Desired Learning Outcomes

At the end of this chapter, the student should be able to:

1. differentiate simple and compound interest; and

2. solve problems involving simple interest discounting and compound interest.

III. Take off/ Motivation

Fill in words that are associated with the word “Interest”

INTEREST
IV. Content Focus

Interest

Interest is a fee paid for the use of one’s money. Suppose a debtor borrows money
from an investor, then he must pay back the original amount borrowed plus an additional
sum called interest. The original amount loaned is the principal. At any time after the
investment of the principal, the sum of the principal and the interest due is called the
amount. The interest rate per period is the ration of interest for the period to the principal.

LESSON 1. SIMPLE INTEREST

Remember

Simple interest is computed by the formula, I=Prt P = Principal

r = Interest rate
s
where P is the principal, r is the interest rate for 1 year and t is the t = length of time
length of time expressed in years. If the interest is due at the end of the time expressed in years
period, then the interest payment is called Simple Interest.
I = Interest

Illustration.

A man borrows ₱8,000 for 2 years at a simple interest rate of 4%. How much
interest does he pay?
Solution:
4
Given: P = ₱8,000 ; r = 4 % or = 0.04 ; t = 2 years
100
I=?
I = Prt
= 8,000 x 0.04 x 2
= 640

The rate r expressed as a decimal number or fraction and the time, t, is expressed in
years. Thus, if the time is given in months or days, it can be converted to year by using these
formulas:
 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑚𝑜𝑛𝑡ℎ𝑠
a. t =
12
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠
b. t =
360

8 2
Examples: 8 months = = 𝑦𝑒𝑎𝑟
12 3

120 1
120 days = = 𝑦𝑒𝑎𝑟
360 3

Note: Unless specified, 360 days is used in all simple interest applications.

Illustration:
1. Find the interest of ₱ 8,700 at 3 ½ % for 2 months

Solution:
Given:
3½ 2 1
P= ₱ 8,700 ; r =3 ½ % or 0.035 ; t = or year
100 12 6
I=?
I=Prt
1
= 8700 x 0.035 x
6
= ₱ 50.75

2. Jither Ken borrows ₱10,000 for 30 days at a simple interest rate of 5%. How much
interest does he pay?

Solution:
5 30 1
Given: P= ₱ 10,000 ; r = 5 % or 0.05 ; t = or year
100 360 12
I=?
I=Prt
1
= 10,000 x 0.05 x
12
= ₱ 41.67

Finding the value of Principal, Rate and Time

Derived Formulas:

𝐼
a. P =
𝑟𝑡
 𝐼
b. r =
𝑃𝑡
𝐼
c. t =
𝑃𝑟

Illustrations:

a. At a simple interest rate of 12%, how much would one have to invest for
two years to earn ₱1,800 interest?

Solution:
12
Given: I = 1,800 ; r = 12% or or 0.12 ; t = 2 years ; P = ?
100
𝐼
P=
𝑟𝑡
1,800 1,800
P= = = 7,500
0.12 𝑥 2 0.24

b. Richard deposits ₱6,000 and earns 300 interest after 2 years. Find
Richards interest rate.

Solution:
Given: I = 300 ; P = 6,000 ; t = 2 years ; r = ?
𝐼
r=
𝑃𝑡
300 300
r= = = 0.025
6000 𝑥 2 12,000
r = 0.025 x 100
r = 2.5%

c. How many years will it take for ₱15,000 to earn ₱300 if it is invested
at 2% simple interest?

Solution:
2
Given: I = 300 ; P = 15,000 ; r = 2% or = 0.02 ; t = ?
100
𝐼
t=
𝑃𝑟
300 300
t= = =1
15,000 𝑥 0.02 300
 t = 1 year

d. How much was borrowed if the interest at 1% after 3 months is ₱200

Solution:
1 3 1
Given: I = 200 ; r = 1% or or 0.01 ; t = or years ; P =
100 12 4
?
𝐼
P=
𝑟𝑡
200 200
P= 1 = = ₱80,000
0.01 𝑥4 0.0025

e. How many months will it take for ₱ 9,000 to earn ₱600 if it is

invested at 7% simple interest?

Solution:
Given: P = ₱ 9,000; r = 7% or .07; I = ₱ 600 t =?
𝐼
t=
𝑃𝑟
600
=
9000 𝑥 .07
600
‘ =
630
= .9524 year or 11.43 months (.9524 x12 = 11.43
months)
f. Benny lends his ₱30,000 cash to joey for 6 months. What is the
interest rate if joey pays the amount with interest of ₱2,000.

Solution:
6 1
Given: I = ₱2,000 ; P = ₱30,000; t = 6 months or or ; r =
12 2
?
𝐼
r=
𝑃𝑡
 2,000 2,000
r= 1 = = 0.333…
30,000 𝑥 15,000
2

r = 0.333 x 100
r = 33.3%

Maturity Value and Future Value

Maturity Value -- the total amount a borrower needs to pay its lender which is the
sum of the amount borrowed and its interest.
Future Value -- the sum of the principal and interest in an investment

Both are calculated using the formula: F = P + I

Where;
F = the amount after earning interest or the Accumulation
P = principal amount
I = interest

Accumulation – is the process of determining the amount F of a given principal P

due at a specified time t.
Illustration:
1. A businessman borrows ₱4,200 for 3 years at 5.5% simple interest.
what amount must he repay
Solution:
5.5
Given: P = ₱4,200 ; r = 5.5% or = 0.055 ; t = 3 years
100
I=?
I = Prt
= 4,200 x 0.055 x 3
= 693
F=P+I
F = 4,200 +693
F = ₱4, 893

2. Accumulate ₱ 9,000 for 30 days at ½ %

Solution:
 ½ 30
P= ₱ 9,000; r = ½% or = 0.005; t = 30 days = or
100 360
1
year
12
I=?
I = Prt
1
= 9,000 x 0.005 x
12
= 3.75
F=P+I
F = 9,000 + 3.75
F = ₱9,003.75

Discounting – is the process of determining the present value PV of any amount due in
the future.
𝑨
To discount on amount A for t years, means to solve P applying the formula: P =
(𝟏+𝒓𝒕)
Illustrations:

1. If money is worth 7.5% simple interest, find the present value of

₱11,000 which is due at the end of 2.5 years

Solution:

7.5
Given: F = 11,000 r = 7.5% or = 0.075 t = 2.5 years
100
𝐹
P=
(1+𝑟𝑡)
11,000
P=
(1+0.075 𝑥 2.5)
11,000
P=
(1+0.1875)
11,000
P=
(1.1875)
P = ₱9,263.16

2. Discount ₱500 for 2 years at 6% simple interest

 Solution:

6
Given: F = 500 r = 6% or = 0.06 t = 2 years
100
𝐹
P=
(1+𝑟𝑡)
500
P=
(1+0.06 𝑥 2)
500
P=
(1+0.12)
500
P=
(1.12)
P = ₱446.43

LESSON 2. COMPOUND INTEREST

In transactions covering an extended period of time, interest may be handled in different
ways, whenever at stipulated intervals during the term of an investment, the interest due is
added to the principal and thereafter erans interest, the sum which represents the increase in
the original principal at the end of the term is called compound interest. The total amount due
is the sum of the original principal and the compound interest.

Compound Interest is the interest resulting from periodic addition of simple interest to
the principal.
when interest is periodically added to the principal, and this new sum is used as the new
principal for a certain period, the resulting value is called the final or compound amount and
us designated F.

illustrative Example. Find the compound interest on ₱1,000 for 3 years at 9% converted
annually

Solution:

The original principal is ₱1,000.00

Interest for 1 year on ₱1,000.00 at 9% -- ₱ 90.00
Amount at the end if the first year or new principal
₱1,000 + ₱90.00 -- ₱1,090.00
Interest on the new principal for 1 year is ₱ 1,090 x 9% -- ₱98.10
Amount at the end of the second year is
₱1,090 + ₱98.10 -- ₱1,118.10
Interest on the new principal for 1 year is
 ₱1,188.10 at 9% -- ₱106.929
Amount at the end of the third year is
₱ 1,188.10 + ₱106.929 -- ₱ 1,295.03

The procedure used in the computation of the compound interest in the above illustration
is known as the direct method.

The number of time interest is converted in one year is called the frequency of coversions.
The time between successive conversions of interest into principal is called the conversion
period of interest into principal is called the conversion period or interest period. Conversion
Periods are Monthy (m = 12), quarterly (m = 4), semi-annually (m = 2), and annually (m =
1). The rate of interest is usually stated as an annual rate. By”interest or money worth 8%” is
meant 8% compounded annually. Otherwise, the frequency of conversion will always be
always be indicated, i, e. 9% compounded quarterly, 10% compounded semi-annually, etc.

Computation of the compound amount by the direct method is tiresome and time
consuming. We shall develop a fundamental formula and introduce tables which will greatly
facilitate computations.

The fundamental formula for compound amount is: F = P(1 + i)n

Where

F = Compound amount/ Accumulation

P = Original Principal
r = Interest rate
m = Number of conversion periods
i = interest per conversion period which is equal to nominal rate (r) divided by
conversion period (m)
𝒓
i=
𝒎
t = time expressed in years
n = total number of conversion periods for the whole term; number of conversion
periods per year (m) multiplied by the time (t)
n=mxt
1
Illustrative Example 1. Find the compound interest on ₱1,000 at the end of 8 years at
2
8% compounded quarterly.

Solution:

P = ₱1,000 r = 8%
1
m=4 t=8 yrs.
2
 8% 1
i= = 2% n = (4) ( 8 2) = 34 interest periods
4

From the formula F= P(1 + i)n we have the compound amount

F = 1,000 (1 +0.02)34

= 1, 000 (1.960676)

F = ₱1,960.68, the Compound Amount

The compound interest is F – P thus, ₱1,960.68 – 1,000 = ₱960.68

Illustrative Example 2. Accumulate ₱ 5,000 for 25 years at 9% compounded

monthly.

Given:
P = ₱5, 000 m = 12
r = 9% t = 25
3
i = = 4% or 0.0075%
n = (25)(12) = 300
Solution:
F = P(1 + i)n

= ₱5,000 (1+ 0.0075)300

= ₱5,000 (9.408415)
F = ₱47,042.08

Illustrative example 3. Find the compound amount and interest if ₱ 5,000 is vested
at 8% compounded quarterly for 5 years and 6 months.
Given: P = ₱5,500 r = 8%
6
t = 5 years & months or 5 m=4
12
Solution:
6
n = m x t = (4) (5 ) = 22
12
𝑟 .08
i= = = 0.02
𝑚 4

F = P (1 + i)n

= P5, 500 (1 + 0.02)22

= P8 ,502.89, compound amount

I=F–P

= P8, 502.89 – P5, 500

= P3, 002.89, compound Interest

Present Value of F and Compound Discount

The present value at compound interest of a given sym of money is the principal ( P)
which, if invested now at the given rate, would amoun to (F) after n interest periods.
Therefore, to discount an amount F for n conversion periods means to find its present
value P on a day which is n periods before F is due.

From F = P ( 1+ i)n, the present value P is obtained by

𝐹
P= or P = F(1 + i)-n
(1+𝑖 )𝑛

The discount of F can be solved by D = F – P, where

P = principal or present value

F = amount due in the future

i = interest per conversion period which is equal to nominal rate (r) divided by conversion
𝒓
period (m). i=
𝒎

n = total number of conversion periods for the whole term; number of conversion periods
per year (m) multiplied by the time (t). n = m x t

The negative exponent is used to indicate that a sum due in the future is to be
discounted. The knowledge of present value is a powerful tool in economic analysis. This
concept enables the economic analyst to calculate amount of meny due in the future and
determine how much it is worth now.

Illustrative example 1. Find the present value of ₱5,000 due in 4 years if money is
worth 8% compounded semi-annually.

Given:
F = ₱5,000 n = (2) (4) = 8 t=4
8%
i= = 2% m=2
2
Solution:
P = F(1 + i)-n
= ₱5,000 (1 + 0.04)-8
= ₱5,000 ( .730690)
= ₱3,653.45

Illustrative Example 2. Find the present value of ₱20,000 due at the end of 30
years at 9% compounded monthly.

Given:
F = ₱20,000 n = (12) (30) = 360 t = 30
9% 3
i= = % or 0.0075 m = 12
12 4
Solution:
P = F(1 + i)-n
= ₱20,000 (1 + 0.0075)-360
= ₱20,000 ( .067886)
= ₱1, 357.72