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Mathematics of Finance

Section 5.1 Simple Interest

Section 5.2 Compound Interest

Section 5.3 Annuities and Sinking Funds

Section 5.4 Present Value of an Annuity and

Amortization

Simple Interest

Simple interest is most often used for loans of shorter

duration.

The money borrowed in a loan is called the principal.

The number of dollars received by the borrower is the

present value.

In a simple interest loan, the principal and present value

are the same.

The interest rate is the fee for a simple interest loan and

usually is expressed as a percent of the principal.

Simple interest is paid on the principal borrowed and

not paid on interest already earned.

Section 5.1

Simple Interest

I = Prt

where P = principal (amount borrowed)

r = interest rate per year (in decimal form)

t = time in years.

The simple interest of a loan can be calculated using the

following formula.

Example

An individual borrows $300 for 6 months at 1% simple

interest per month. How much interest is paid?

SOLUTION

Remember to check that r and t are consistent in time

units. Here, it will be months.

I = Prt = 300 0.01 6 = $18

Another Example

Jane borrowed $950 for 15 months. The interest was

$83.13. Find the interest rate.

SOLUTION

First, determine the information we have been given.

P = 950

t = 15/12 = 1.25 years

I = 83.13

Using I = Prt, we need to find r

83.13 950 (1.25)

1187.5

83.13

0.07

1187.5

r

r

r

=

=

= =

The interest rate was 7%.

Future Value

A loan made at simple interest requires that the borrower pay

back the sum borrowed (principal) plus the interest. This total

is called the future value, or amount and is equal to P + I.

A = P + I

= P + Prt

= P(1 + rt)

where P = principal or present value

r = annual interest rate (in decimal form)

t = time in years

A = amount or future value

Total Number of Compounding Periods

Annual Interest rate expressed as a percent

Present Value: What it is worth to you right now

Amount of the payment being made if any.

Future Value: What it will be worth to you

in the future

The number of payments per year

The number of compounds per year.

Is Interest/Payment due at the beginning or

end of the compound period?

Example

Find the amount (future value) of a $2400 loan for 9 months

at 11% interest.

SOLUTION

We need to find A which equals P + I = P + Prt.

Now, determine the information we have been given.

9

12

2400, 0.11, and 0.75 years P r t = = = =

Find I: I = 2400(0.11)(0.75) = 198

Now, find A: A = 2400 + 198 = 2598

A could have also been found

using the formula A = P(1 + rt)

2400(1 0.11(0.75))

2400(1 0.0825)

2400(1.0825)

2598

A= +

= +

=

=

Simple Discount

The simple discount loan differs from the simple interest

loan in that the interest is deducted from the principal and

the borrower receives less than the principal.

This type of loan is referred to as a simple discount note.

The interest deducted is the discount.

The amount received by the borrower is the proceeds.

The discount rate is the percentage used.

The amount repaid is the maturity value.

Simple Discount Note

D = Mdt

PR = M D

= M Mdt

= M(1 dt)

where M = maturity value (principal)

d = annual discount rate (in decimal form)

t = time in years

D = discount

PR = proceeds or amount the borrower receives

Example

Find the discount and the amount a borrower receives (proceeds)

on a $1500 simple discount loan at 8% discount rate for 1.5

years.

Example

A bank paid $987,410 for a 90-day $1 million treasury

bill. What was the simple discount rate?

Example

A bank wants to earn 7.5% simple discount interest on a

90-day $1 million treasury bill. How much should it bid?

SOLUTION

First, determine what information is given.

90

360

1, 000, 000, 0.075, and 0.75 years M d t = = = =

We need to find the proceeds which equals PR.

| |

( )

90

360

1, 000, 000 1 (0.075)

1, 000, 000 1 0.01875

1, 000, 000 0.98125

981, 250

PR

(

=

=

=

=

The bank should bid $981,250.

Example

How much should a bank bid on a 30-day $2 million

treasury bill if the bank wants to earn 5.125% on its money.

HW 5.1

Pg 348-350 1-32, 34-64 even

Compound Interest

Section 5.2

Suppose you deposit money into a savings account, the bank

will typically pay you interest for the use of your money at a

specific period of time, say every three months. The interest

is usually credited to your savings account at each time

period. At the next time period, the bank will pay interest on

the new total, this is called compound interest.

Amount of Annual Compound Interest

When P dollars are invested at an annual interest rate r and

the interest is compounded annually, the amount A at the end

of t years is

A = P(1 + r)

t

Example

Suppose $800 is invested at 6%, and it is compounded

annually. What is the amount in the account at the end

of 4 years?

SOLUTION `

First, determine the information that is given.

P = 800, r = 0.06, and t = 4

4

800(1.06) 800(1.26248) 1009.98 A= = =

There will be $1009.98 in the account after 4 years.

Amount (Future Value)

The general formula for finding the amount after a specified number

of compound periods is

A = P(1 + i)

n

where r = annual interest rate

m = number of times compounded per year

i = r/m = interest rate per period

n = mt, the number of periods, where t is the number of years

A = amount (future value) at the end of n compound periods

P = principal (present value)

Example

Suppose $800 is invested at 12% for 2 years. Find the amount

at the end of 2 years if the interest is compounded (a)

annually, (b) semiannually, and (c) quarterly.

SOLUTION

First, determine what information is given then use A = P(1 + i)

n

.

P = 800, r = 0.12, and t = 2 years.

2 2

800(1 0.12)

a) 1, so

8

0.12/1 0.

00(1.12) 800(1.2544) 1003.5

12, 2;

2 A

m i n

= + = = =

= = = =

4 4

800(1 0.06) 800(1.06) 800(1.26248)

b) 2, so 0.12/ 2 0.06, 4;

1009.98

m

A

i n

= + = =

=

=

= = =

8 8

800(1 0.03) 800(1.03) 800(1.26677)

c) 4, so 0.12/ 4 0.03, 8;

1013.42

m

A

i n

= + = =

=

=

= = =

Total Number of Compounding Periods

Annual Interest rate expressed as a percent

Present Value: What it is worth to you right now

Amount of the payment being made if any.

Future Value: What it will be worth to you

in the future

The number of payments per year

The number of compounds per year.

Is Interest/Payment due at the beginning or

end of the compound period?

(compounds per year)(# of years)

Annual Interest rate expressed as a percent

Present Value: What it is worth to you right now

0

Future Value: What it will be worth

Compounds per year

Always on End

Example

Suppose $800 is invested at 12% for 2 years. Find the amount at

the end of 2 years if the interest is compounded (a) annually

1(2) 1 compound every year for two years

12 Yearly interest rate

-800 The amount being invested today Present Value

0 No regular payments are being made

What we want to solve for Alpha Enter

1

There is 1 compound per year

1

1003.52

Example

Suppose $800 is invested at 12% for 2 years. Find the amount at

the end of 2 years if the interest is compounded (b) semiannually

2(2) 2 compound every year for two years

12 Yearly interest rate

-800 The amount being invested today Present Value

0 No regular payments are being made

What we want to solve for Alpha Enter

2

There are 2 compound per year

2

1009.98

Example

Suppose $800 is invested at 12% for 2 years. Find the amount at

the end of 2 years if the interest is compounded (c) quarterly.

4(2) 4 compound every year for two years

12 Yearly interest rate

-800 The amount being invested today Present Value

0 No regular payments are being made

What we want to solve for Alpha Enter

4

There is 4 compound per year

4

1013.42

1(5) 1 compound every year for five years

What we want to solve for Alpha Enter

-100 We do not know the present value so use $100

0 No regular payments are being made

If we started with $100 and we want to double it?

1

There is 1 compound per year

1

14.8698355

200

Vocabulary

Nominal Rate

Compound rate that

returns the same total

value as a simple

interest investment.

Effective Rate

simple interest rate

that produces the

same total value of

investment per year

as the compound

interest.

Effective Rate

The effective rate of an annual interest rate r compounded m

times per year is the simple interest rate that produces the same

total value of investment per year as the compound interest.

If money is invested at an annual rate r and compounded m

times per year, the effective rate, x, in decimal form is

x = (1 + i)

m

1 where i = r/m

Example

The Mattson Brothers Investment Firm advertises Certificates of

Deposit paying a 7.2% effective rate. Find the annual interest

rate, compounded quarterly, that gives the effective rate.

SOLUTION

If we let i = quarterly rate, then

4

4

4

0.072 (1 ) 1

1.072 (1 )

1.072 1

1.017533 1

0.017533

i

i

i

i

i

= +

= +

= +

= +

=

The annual rate = 4(0.017533) = 0.070133 = 7.013% (rounded).

The annual rate just found is also called the nominal rate.

HW 5.2

Pg 359-360 1-17 odd, 18-63 every 3

rd

Ordinary Annuity

An annuity refers to equal payments paid at equal time

intervals.

The time between successive payments is called the

payment period.

The amount of each payment is the periodic payment.

The interest on an annuity is compound interest.

An ordinary annuity is an annuity with periodic payments

made at the end of each payment period.

Section 5.3

Future Value (Amount)

Payments are made at the end of each period.

where i = interest rate per period

n = number of periods

R = amount of each periodic payment

A = future value of amount

(1 ) 1

n

i

A R

i

(

+

=

(

Example

How much money will you have when you retire if you save $20

each month from graduation until retirement? Lets assume you

start saving at age 22 until age 65, 43 years, and the interest rate

averages 6.6% annual rate compounded monthly.

SOLUTION

The periodic rate = 0.066/12 = 0.0055 since payments are

made monthly. The number of periods is n = 12(43) = 516.

The periodic payments are R = 20. Substitute these values

into the formula for future value.

516

(1 ) 1 (1.0055) 1

20 57, 997.30

0.0055

n

i

A R

i

( ( +

= = =

( (

You will accumulate $57,997.30 in 43 years.

How much money will you have when you retire if you save $20 each

month from graduation until retirement? Lets assume you start saving at

age 22 until age 65, 43 years, and the interest rate averages 6.6% annual

rate compounded monthly.

12(43) 12 compounds every year for 43 years

6.6 Yearly interest rate

0 The amount being invested today Present Value

-20 You are putting 20 per month in the account

What we want to solve for Alpha Enter

12

There is 12 compound per year

12

57997.30

1(20) 1 compounds every year for 20 years

8.5 Yearly interest rate

0 The amount being invested today Present Value

-2000 You are putting 2000 per year in the account

What we want to solve for Alpha Enter

1

There is 1 compound per year

1

96754.03

Sinking Funds

A sinking fund refers to a fund that is created when an amount of

money will be needed at some future date. For example, a family

may need a new car in 3 years, or a company may expect to

replace a piece of equipment in the future.

Formula for Periodic Payments of a Sinking Fund

where A = value of the annuity after n payments

n = number of payments

i = periodic interest rate

R = amount of each periodic payment

(1 ) 1

n

Ai

R

i

=

+

Example

Darden Publishing Company plans to replace a piece of

equipment at an expected cost of $65,000 in 10 years. The

company establishes a sinking fund with annual payments.

The fund draws 7% interest, compounded annually.

What are the periodic payments?

SOLUTION

First, determine the information that is given.

10

65, 000, 0.07, and 10

65000(0.07) 4550

4704.54

(1.07) 1 0.9671513

A i n

R

= = =

= = =

HW 5.3

Pg 372-374 1-47 odd

Present Value

Section 5.4

The present value of an annuity is the lump sum payment

that yields the same total amount as that obtained through

equal periodic payments made over the same period of time.

The present value of an annuity is

where i = periodic rate

n = number of periods

R = periodic payments

P = present value of the annuity

(1 ) 1 1 (1 )

(1 )

n n

n

i i

P R R

i i i

( (

+ +

= =

( (

+

Example

Find the present value of an annuity with periodic payments

of $2000, semiannually, for a period of 10 years at an interest

rate of 6% compounded semiannually.

SOLUTION

Use the values given, R = 2000, i = 0.06/2 = 0.03 and n = 20

in the formula for present value.

20 20

20

(1 ) 1 (1.03) 1 1 (1 0.03)

2000 2000

(1 ) 0.03(1.03) 0.03

2000(14.8774749) 29754.95

n

n

i

P R

i i

( ( ( + +

= = =

( ( (

+

= =

The present value of the annuity is $29,754.95. This lump sum

will accumulate the same amount in 10 years as investing $2000

semiannually for 10 years.

Equal Periodic Payments

The amount needed to provide equal periodic

payments can be found using the formula

or equivalently,

where P = amount needed in the fund

R = amount of periodic payments

i = periodic interest rate

n = number of payments

(1 ) 1

(1 )

n

n

i

P R

i i

( +

=

(

+

1 (1 )

n

i

P R

i

( +

=

(

Example

Find the present value of an annuity (lump sum investment)

that will pay $1000 per quarter for 4 years. The annual

interest rate is 10%, compounded quarterly.

SOLUTION

16

0.01

Given 1000, 0.025, and 16 quarters,

4

1 (1.025)

1000

0.025

1000(13.0550027) 13, 055

R i n

P

= = = =

(

=

(

= =

A lump sum investment of $13,055 will provide $1000 per

quarter for 4 years.

Amortization

The amortization of a debt (repayment of a debt) requires no

new formula because the amount borrowed is just the

present value of an annuity.

Amortization of a Loan (Debt Payments)

The amount borrowed, P, is related to the periodic payments, R,

by the formula

where i = periodic interest rate

n = number of payments

Note: This is the present value formula for an ordinary annuity.

(1 ) 1 1 (1 )

(1 )

n n

n

i i

P R R

i i i

( (

+ +

= =

( (

+

Example

A student obtained a 24-month loan on a car. The monthly

payments are $395.42 and are based on a 12% interest rate.

What was the amount borrowed?

SOLUTION

Since the amount borrowed is the present value of the

annuity, we have

395.42

0.12

0.01

12

24

R

i

n

=

= =

=

(Monthly rate)

(Number of months)

24

1 (1.01)

395.42

0.01

395.42(21.2433873)

8400.06

P

(

=

(

=

=

The amount borrowed was $8400.

Balance of an Amortization

The balance after n periods is the amount of compound

interest minus the amount of an annuity. Mathematically we

can find the balance using the formula

(1 ) 1

Balance (1 )

n

n

i

P i R

i

(

+

= +

(

where P = the amount borrowed

i = periodic interest rate

n = number of time periods elapsed

R = monthly payments

Example

A family borrowed $60,000 to buy a house. The loan was for

30 years at 12% interest rate. The monthly payments were

$617.17. What is the balance of their loan after 2 years?

SOLUTION

12

12

60, 000, 1% per month, 617.17, 24 months P i R n = = = = =

24

24

(1.01) 1

Balance 60, 000(1.01) 617.17

0.01

60, 000(1.26973) 617.17(26.9734649)

76,184.08 16, 647.21

59,536.87

(

=

(

=

=

=

The part of the loan repaid is the equity which after

2 years is is 60,000 59,536.87 = $463.13.

This is the balance of the

loan after two years.

HW 5.4

Pg 389-391 1-47 Odd

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