Professional Documents
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Chapter 4
Chapter 4
Mathematics of Finance
Compound Interest
Annuities
Amortization and Sinking Funds
Arithmetic and Geometric
Progressions
4.1
Compound Interest
mt m
m
r r
A P 1 reff 1 1
m m
(4)(3) 11
0.08 0.08
1000 1 1 1
4 1
1000(1.02)12 1.08 1
1268.24 0.08
Simple Interest Formulas
I Prt
1000(0.08)(3) 240
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
A P(1 rt )
2000[1 (0.06)(10)] 3200
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
A1 P(1 rt )
1000[1 0.08(1)]
1000(1.08) 1080
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:
A2 P(1 rt ) A1 (1 rt )
1000[1 0.08(1)][1 0.08(1)]
1000(1 0.08) 2 1000(1.08) 2 1166.40
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:
A3 P(1 rt ) A2 (1 rt )
1000[1 0.08(1)]2 [1 0.08(1)]
1000(1 0.08)3 1000(1.08)3 1259.71
or approximately $1259.71.
Compound Interest
Note that the accumulated amounts at the end of each year
have the following form:
A1 1000(1.08) A1 P(1 r )
A2 1000(1.08)2 or: A2 P(1 r )2
A3 1000(1.08)3 A3 P(1 r )3
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
A P(1 r )t
Compounding More Than Once a Year
The formula
A P(1 r )t
nth Period: An An 1 (1 i ) [ P(1 i ) n 1 ](1 i ) P(1 i ) n
Compound Interest Formula
There are n = mt periods in t years, so the accumulated
amount at the end of t years is given by
n
r
A P 1
m
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
n
r
A P 1
m
3
0.08
1000 1
1
1000(1.08)3
1259.71
or $1259.71.
Example
Solution
b. Semiannually.
Here, P = 1000, r = 0.08, and m = 2.
Thus, i 0.08
2
and n = (3)(2) = 6, so
n
r
A P 1
m
6
0.08
1000 1
2
1000(1.04)6
1265.32
or $1265.32.
Example
Solution
c. Quarterly.
Here, P = 1000, r = 0.08, and m = 4.
Thus, i 0.08
4
and n = (3)(4) = 12, so
n
r
A P 1
m
12
0.08
1000 1
4
1000(1.02)12
1268.24
or $1268.24.
Example
Solution
d. Monthly.
Here, P = 1000, r = 0.08, and m = 12.
Thus, i 0.08
12
and n = (3)(12) = 36, so
n
r
A P 1
m
36
0.08
1000 1
12
36
0.08
1000 1
12
1270.24
or $1270.24.
Example
Solution
e. Daily.
Here, P = 1000, r = 0.08, and m = 365.
Thus, i 0.08
365
and n = (3)(365) = 1095, so
n
r
A P 1
m
1095
0.08
1000 1
365
1095
0.08
1000 1
365
1271.22
or $1271.22.
Continuous Compounding of Interest
mt
r
A P 1
m
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 rt
1
urt
1 u
A P 1 or A P 1
u u
The table shows us that when u gets
larger and larger the expression
u u
1 1
1 1
u
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
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
mt (365)(3)
r 0.08
A P 1 1000 1 1271.22
m 365
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
A P(1 R )
The accumulated amount after 1 year at a nominal interest
rate r per year compounded m times a year is
m
r
A P 1
m
Equating the two expressions gives
m
r
P(1 R ) P 1
m
m
r
1 R 1
m
Effective Rate of Interest Formula
m
r
reff 1 1
m
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
1
0.08
reff 1 1
1
1.08 1
0.08
or 8%.
Example
Solution
b. Semiannually.
Let r = 0.08 and m = 2. Then
2
0.08
reff 1 1
2
1.0816 1
0.0816
or 8.16%.
Example
Solution
c. Quarterly.
Let r = 0.08 and m = 4. Then
4
0.08
reff 1 1
4
1.08243 1
0.08243
or 8.243%.
Example
Solution
d. Monthly.
Let r = 0.08 and m = 12. Then
12
0.08
reff 1 1
12
1.08300 1
0.08300
or 8.300%.
Example
Solution
e. Daily.
Let r = 0.08 and m = 365. Then
365
0.08
reff 1 1
365
1.08328 1
0.08328
or 8.328%.
Effective Rate Over Several Years
A P(1 reff )t
Present Value
P A 1 i
n
r n mt
Where i and
m
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
mt
r
P A 1
m
(12)(3)
0.06
20,000 1
12
16,713
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
mt
r
P A 1
m
(4)(5)
0.1
49,158.60 1
4
30, 000
Present Value
with Continuously Compounded Interest
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
V (t ) 300,000e t /2
P(7) 300,000e0.09(7) 7 /2
599,837
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
P(t ) V (t )e 0.09t
300, 000e 0.09t t /2
(0 t 10)
Letting t = 8, we find that
ln1.5
4t
ln1.03
So, it will take about 3.4
years for the investment ln1.5
t 3.43
to grow from $10,000 to 4 ln1.03
$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
Future Value of an Annuity
(1 i )n 1
S R
i
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
0.12
i 0.01
12
Using the future value of an annuity formula, with
R = 100, n = 12, and i = 0.01, we have
(1 i )n 1 (1 0.01)12 1
S R 100 1268.25
i 0.01
or $1268.25.
Present Value of an Annuity
1 (1 i ) n
P R
i
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
1 (1 i ) n 1 (1 0.0075) 24
P R 100 2188.91
i 0.0075
or $2188.91.
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
(18 6) 12 144
deposits into the account, so n = 144.
Furthermore, we have R = 100, r = 0.06, and m = 12, so
0.06
i 0.005
12
Using the future value of an annuity formula, we get
(1 i )n 1 (1 0.005)144 1
S R 100 21,015
i 0.005
or $21,015.
Applied Example: Financing a Car
1 (1 i ) n 1 (1 0.01) 36
P R 400 12,043
i 0.01
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
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
R 1 (1 i ) n
P
i
Substituting the numerical values for R, n, and i we obtain
iS (0.025)(30,000)
R 3434.02
(1 i ) 1 (1 0.025) 1
n 8
or $3434.02.
4.4
Arithmetic and Geometric Progressions
20
S20 [2 2 (20 1)5] 990
2
1,000,000(1 (1.1)5 )
S5 6,105,100
1 1.1
Arithmetic Progressions
a (1 r n )
if r 1
Sn 1 r
na if r 1
Example
Find the sum of the first six terms of the geometric
progression 3, 6, 12, 24, …
Solution
Using the sum of terms formula
a (1 r n )
if r 1
Sn 1 r
na if r 1
with a = 3, r = 6/3 = 2, and n = 6, gives
3(1 26 )
S6 189
1 2
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
a5 1,000,000(1.1)4 1, 464,100
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