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and Business
Chapter 3
Mathematics of Finance
Contents
1. Percentages
2. Compound Interest
3. Geometric Series
4. Mathematics of Finance Applications: Investment
appraisal
3.1
Percentages
Objectives
1. Understand what a percentage is.
2. Solve problems involving a percentage increase or
decrease.
3. Write down scale factors associated with percentage
changes.
4. Work out overall percentage changes.
5. Calculate and interpret index numbers.
6. Adjust value data for inflation.
The word ‘percentage’ literally means ‘per cent’, i.e. per
hundredth
Whenever any numerical quantity increases or decreases, it is
customary to refer to this change in percentage terms.
In general, if the percentage rise is r% then the final value
consists of the original (100%) together with the increase
(r%), giving a total of
In general, the scale factor for an r% decrease is
We consider the calculation of overall percentage changes.
Applications of percentages in macroeconomics:
1. Index numbers
2. Inflation
Index numbers
Notice that both shares are given the same index number of
100 in April, which is the base month. This creates ‘a level
playing-field’, enabling to monitor the relative performance of
the two shares.
Nominal data are the original, raw data. These are based on the
prices that prevailed at the time.
Real data are the values that have been adjusted to take inflation
into account.
The price (in thousands of dollars) of an average house
Compound Interest
Objectives
1. Understand the difference between simple and
compound interest.
2. Calculate the future value of a principal under
annual compounding.
3. Calculate the future value of a principal under
continuous compounding.
4. Determine the annual percentage rate of interest
given a nominal rate of interest.
Suppose that someone gives you the option of receiving $500
now or $500 in 3 years’ time.
Which of these alternatives would you accept?
In 3 years
The type of compounding in which the interest is added on
with increasing frequency is called continuous com pounding.
The amount
invested first
exceeds $2100 some
time during the
179th day.
For banks A, B and C, the future values can be worked out
using the formula
Geometric Series
Objectives
1. Recognize a geometric progression.
2. Evaluate a geometric series.
3. Calculate the total investment obtained from a
regular savings plan.
4. Calculate the instalments needed to repay a loan.
Consider the following sequence of numbers:
2, 6, 18, 54, . . .
2 + 6 + 18 + 54 + 162 + 486 =
Application of geometric series involving savings
The bank calculates the interest charged during the first month based on the
original loan.
At the end of the month, this interest is added on to the original loan and the
repayment is simultaneously deducted to determine the amount owed.
The bank then charges interest in the second month based on this new amount
and the process is repeated.
Provided that the monthly repayment is greater than the interest charged each
month, the amount owed decreases and eventually the debt is cleared.
Determine the monthly repayments needed to repay a $100 000
loan which is paid back over 25 years when the interest rate is
8% compounded annually.
The monthly repayment on a 25-year loan of $100 000 is
$780.66, assuming that the interest rate remains fixed at 8%
throughout this period.
The debt only falls by about $1500 to begin with, in
spite of the fact that over $9000 is being repaid each
year!
Total reserves of a non-renewable resource are 250 million
tonnes. Annual consumption, currently at 20 million tonnes
per year, is expected to rise by 2% a year. After how many
years will stocks be exhausted?
Current annual extraction of a non-renewable resource is 40 billion
units and this is expected to fall at a rate of 5% each year. Estimate
the current minimum level of reserves if this resource is to last in
perpetuity (that is, for ever).
3.4
Mathematics of Finance
Applications:
Investment appraisal
Objectives
1. Calculate present values under discrete and
continuous compounding.
2. Use net present values to appraise investment
projects.
3. Calculate the internal rate of return.
4. Calculate the present value of an annuity.
5. Use discounting to compare investment projects.
6. Calculate the present value of government
securities.
The following two formulas were used to solve compound interest
problems
P = principal
S = future value
r = interest rate
t = time
Of particular interest is the case where S, r and t are given, and P
is the unknown to be determined.
In this situation we know the future value, and we want to work
backwards to calculate the original principal.
This process is called discounting and the principal, P, is called
the present value.
The rate of interest is sometimes referred to as the discount rate.
Equations are rearranged to produce explicit formulas for the
present value under discrete and continuous compounding:
Find the present value of $1000 in 4 years’ time if the discount
rate is 10% compounded
(a) semi-annually
(b) continuously
The difference between the present value of the revenue and the
present value of the costs, is known as the net present value
(NPV ).
and
$21 109.19 − $20 000 = $1109.19
respectively.
(e) 13%
Let us suppose that the interest rate is high at, say, 13%. The
price of the bond is relatively low.
Moreover, one might reasonably expect that, in the future,
interest rates are likely to fall, thereby increasing the present
value of the bond. In this situation an investor would be
encouraged to buy this bond in the expectation of not only
receiving the cash flow from holding the bond but also
receiving a capital gain on its present value.