MATHEMATICS OF FINANCE Riffat Mughal

Source: Mr. Adnanullah Class Notes

MATHEMATICS OF FINANCE

Interest is the fee which is paid for having the use of money
The amount of money that is invested is called the principle amount
(p)
The interested rate specifies the rate at which interest accumulates (i)
Simple interest = p i n
Simple interest = principle amount * interest rate per time
period * number of time period
Simple interest
p
I

0 1 2 3 4 5 n
Compound interest
p
Sn

0 1 2 3 4 5 n
Annuities and Future value
R R R R R
Sn

0 1 2 3 4 5 n
Annuities and Present value
A R R R R

0 1 2 3 4 5 n
PROBLEM 1
A company has issued a 5 year loan of $90,000 to a new vice
president to finance a home improvement project. The terms of
the loan are that it is to be paid back full at the end of five
years with simple interest computed at the rate of 8 percent
per year. Determine the interest which must be paid on the loan
for the five year period.
I=pin
P =90,000
n=5
i = 8 % = .08
I = 90,000 * 5 * .08 = 36000
PROBLEM 2
A student has received a $30,000 loan from a wealthy
aunt in order to finance his four year college program.
The terms are that the student repay his aunt in full at the
end of 8 year with simple interest computed at a rate of
4 % per year. Determine the interest which must be paid
on the 8 year loan.
I = pin
p=30,000
I = 4 % = 0.04
n=8
I= 30,000 * 0.04 *8=9600
A $10,000 certificate of deposit earns interest of 8 %
percent per year, compounded semiannually. Complete the
following table with regard with regard to semiannual
compounding. What is total interest over the 2-year period?

Semiannual (p) Principle (I) Interest ( s = P + I)

period Compound
Amount
1 $10,000 $400 $10,400.00

2 $10,400 $416 $10816.00

3 $10816 $432.64 $11248.64

4 $11248.64 $449.94 $11698.58
COMPOUND AMOUNT:
Assume that a sum of money is invested and that is earn interest which
is compounded. One question related to such an investment is, What
will be the value of the investment to be in the future? The value of the
investment is the original investment plus any interest earn. We call this
the compound amount.
 The compound amount at the end of the period was calculated
as
s = p + p i = p(1+i)
P= principle Amount
i = interest rate
n= compounding period
What will be the compound amount after two year
s = p(1 + i) + i[p(1+i)]
s = p(1+i)(1+i) = p(1+i)2
What will be the compound amount after three year
s = p(1 + i)2 + i[p(1+i)2]
s = p(1+i)2 (1+i) = p(1+i)3
What will be the compound amount after four year
s = p(1 + i)3 + i[p(1+i)3]
s = p(1+i)3 (1+i) = p(1+i)4
What will be the compound amount after ‘n’ year
s = p(1 + i)n
COMPOUND AMOUNT
If an amount of money p earns interest compounded at a rate of i
percent per period, it will grow after n periods to the compound
amount s, where
s = p(1+i)n
 Problem 3
Q# A sum of $8,000 is invested in a saving account which
pays interest at a rate of 9 present per year compounded
annually. If the amount is kept on deposit for six 6 years,
what will the compound amount equal? How much interest
will be earned during the 6 year?

P= 8,000 , i =9% =0.09 , n= 6

S = p(1 + i)n
S= 8000(1 + .09)6
S=13416.800
interest earned during the 6 year = 13416.800-8,000=5416.8
 PROBLEM 4
A sum of $25,000 is invested in a savings account which pays interest
at a rate of 8 percent per year compounded annually. If the amount
is kept on deposit for 15 years, what will be the compound amount
equal ? How much interest will be earned during the 15 year

P= 25,000 , i =8% =0.08 , n = 15

S = p(1 + i)n
S= 25000(1 + .08)15
S=79304.23
interest earned during the 6 year = 79304.23-25,000= 54304.23
 PROBLEM 5
Q# An individual invests $25,000 in a money market fund which
is expected to yield interest at a rate of 12 percent per year
compounded quarterly. If the interest remains stable to what
amount should the $25,000 grow over the next 5 years? How
much interest will be earned during this period.
P=25,000 i = 12% n=5
i nm
S  p (1 )
m
.12 4  5
S  25000(1  )  45152.78
4
Interest during this period  45152.78 - 25000  20152.78
PROBLEM 6
If a consumer price are increasing at a rate of 6
percent compounded semiannually, an item which
cost $25 today will cost what amount in 10 years.
p= $25, i =6%=0.06, n = 10, m= 2
i mn
S  p (1  )
m
0.06 210
S  25(1  )  25(1  .03) 20
2
S  25(1.03)  45.15
20
 PROBLEM 7
What sum must be deposit today at 9 percent per year
compounded semiannually if the goal 8 years from today is
to have a compound amount of $100,000? How much
interest will be earn during this period?
i nm
S  p(1  )
m
0.09 82
100,000  p(1  )
2
S=100,000 , n =8 , i =9%
100,000  p(2.0223)
100,000
p
2.0223
p  494486.65
A sum of 40,000 earns interest at a rate of 10 percent per year
compounded quarterly. How long it will take for the investment to
grow to $100,000?

S = 100,000 , I =10% , p = 40,000 , m=2 ,n=?

i nm
S  p(1  )
m
.1 n4
100,000  40,000(1  )
4
2.5  1.025 4 n
ln(2.5)  ln(1.025) 4n
ln(2.5)  4  n  ln(1.025)
ln(2.5)
 4n
ln(1.025)
37.10788  4  n
n  9.276
Q#28 pg 319 if $ 40 0,000 is to grow to $7500,000
over a 10-year period, at what annual rate of interest
must it to be invested, given that interest is compounded
semiannually?
P = 400,000 S=750,000 n = 10 m=2
i nm
S  p(1  )
m
750,000
 ( 1 2i )102
400,000
i
1.875  (1  ) 20
2
i
1.031929  1 
2
i
0.031929 
2
i  0.063859
nominal interest rate on an investment on an investment
is 16 percent per year. Determine the effective
annual interest rate if
a) Interest is compounded semiannually.
b) Interest is compounded quarterly.

Nominal Interest 16% m2 i  16%

effect interest rate 0.16 2
r  (1  ) 1
i n m 2
p(1  r)  p (1  )
n
r  0.169858
m
i m4 i  16%
(1  r)  (1  ) m
m 0.16 4
i m r  (1  ) 1
r  (1  )  1 4
m r  0.169858
Annuities and their future value.
A series of periodic payment is called Annuities

R=$1000 R=$1000 R=$1000 R=$1000

0 1 2 3 4 5

$1,000
$ 1,000.00
$1,000(1.06)1
$ 1,060.00
$1,000(1.06)2
$1,123.60
$1,000(1.06)3 $1.191.02
$4,374.62
 R R R R Sn

0 1 2 3 4 5
Let
R= amount of an annuity
I = interest rate per period
n = number of annuity payments (also the number of compounding period)
Sn = sum (future value) of the annuity after n periods (payments)

S n = R + R(1+i) + R(1+i)2 + R(1+i)3 + . . . . . . . . . . + R(1+i) n-1

i) S n = R(1 + (1+i) + (1+i)2 + (1+i)3 + . . . . . . . . . . + R(1+i) n-1)
Multiply by ( 1+i) both side
(1+i)S n =(1+i) ( R(1 + (1+i) + (1+i)2 + (1+i)3 + . . . . . . . . . . + R(1+i)
n-1)

S n + i S n =(1+i) ( R(1 + (1+i) + (1+i)2 + (1+i)3 + . . . . . . . . . . +

R(1+i) n-1)
ii) S n + i S n = R[(1+i) + (1+i)2 + (1+i)3 + . . . . . . . . . . + R(1+i) n)
S n = R [(1+i)n -1]
i
A person wishes to deposit $5,000 per year in a saving account which earns
interest of 8 percent per year compounded annually. Assume the first deposit is
made at the end of this current year and additional deposit at the end of each
following year.
a) To what sum will be inverted grow at the time of the 10th deposit.
How much interest will be earn.
R  $ 5,000 i  8%  0.08 n  10
R [ (1  i )  1]n
Sn 
i
5,000 [ (1  0.08)10  1]
Sn 
0.08 S n =72432.812
Sn  72432.812

5000 5000 5000 5000 5000 5000 5000 5000 5000 5000
 A mother wishes to set up a saving account for her son’s education. She
plane investing $750 when her son is 6 month months old and every 6
months thereafter. The account earns interest of 8 % per year,
compounded semiannually.
a) To what amount will the account grow by the time of her son’s 18th
birthday?
b) How much interest will be earned during this period?

R  $ 750 i  8%  0.08 n  18
R [ (1  i / m) nm  1]
Sn  Interest earn during this period=
i/m 58198.73 – (750)*18*2 =31198.73

750 [ (1  0.08 / 2)182  1]

Sn 
0.08 / 2
Sn  58198.73 S n=58198.73

750 750 750 750 750 750

How much deposit at the end of each year if the
objective is to accumulate $100,000 by the time of fifth
deposit? Assume interest is earn at the rate of 15% per
year compounded annually. How much interest will be
earn on the deposit?

Sn = $100,000 n=5 i=15% = 0.15 R=?

R [ (1  i ) n  1]
Sn 
i
R [ (1  0.15)5  1]
100, 000 
0.15
100, 000  R (6.7423) S n=100,000
R = 14831.733
R R R R R
A family wants to begin saving for a trip to Europe. The trip is
planned for three years from now, and the family wants to
accumulate $10,000 for the trip . If 12 deposit are made
quarterly to an account which earn interest at the rate of 8% per
year compounded quarterly, how much should each deposit
equal? How much interest will be earned on their deposits?

S n = 10,000., n=3, m=4, i =8*% =0.08 R=?

R [ (1  i / m) nm  1]
Sn 
i/m
R [ (1  0.08 / 4)34  1]
10, 000 
0.08 / 4
R[(1.02)12  1] How much interest during this period
10,000 = =10,000 – 12(745.5959) = 1052.8484
.02
10,000 = R (13.412)
R =745.5959
 Annuities and their Present Value.
The present value of an Annuity.
The present value of the Annuity is an amount of money today which is equivalent to a
series of equal payment in future
A Sn

R R R R R R R R

R = amount of an annuity.
i = interest rate per compounding period.
Sn = R(1+i)n -1
n = number of annuity payment.
i
A = Present value of the annuity.
Look at the Fig, we can think of Sn as being the equivalent future value of the annuity.
If we know the value of Sn = , the present value of A of the annuity should simply be
the present value of Sn , or
A = Sn (1+i) –n
Substituting the expression for Sn
A = [(1+i)n - 1]
i (1 + i)n
 Determine the present value of a series of 10 annual payments of
$25,000 each which begins 1 year from today. Assume interest of
9% per year compounded annually
A=?

25000 25000 25000 25000 25000 25000 25000 25000 25000 25000

0 1 2 3 4 5 6 7 8 9 10

n
(1+i) -1
A=R[ n
]
i(1+i)
(1+0.09)10 -1
A = 25000 [ 10
]
i (1+0.09)
A =160441.44
Determine the present value of a series of 60 monthly
payment of $2500 each which begins 1 months from
today. Assume interest of 12% per year compounded
monthly.
R=$2500, m=12, n= 5, m*n=60, i =12%, i/m =1% =0.01 A= ?

(1+i/m) nm -1
A=R[ nm
]
i/m(1+i/m)
0.12 60
(1+ ) -1
A = 2500 [ 12 ]
.12 0.12 60
(1+ )
12 12
0.08166966
A = 2500[ ]
0.0181669
A =112387.99
Given $250,000 today, determine the equivalent series of 10
annual payments which could be generated beginning in 1 year.
Assume interest is 12 percent compounded annually.

A =$250,000 , i=12% =0.12 , n=10

(1+i) n - 1
A = R[ n
]
i(1+i)
(1+.12)10 - 1
250,000 = R [ 10
]
0.12(1+0.12)
R = 44246.04
 Given $250,000 today, determine the equivalent series
of 24 semiannual payments which could be generated
beginning 6 months from today. Assume interest of 9
percent per year compounded annually.

A = $250,000 , n = 12 , m = 2 , n*m = 24 , I = 9% = 0.09 , i/m = 9%/2=4.5%

(1+i/m) nm - 1
A = R[ nm
]
i/m(1+i/m)
(1+.09/2) 24 - 1
250,000 = R [ 24
]
0.09/2(1+0.09/2)
R = 17246.75
Determine the monthly car payment necessary to repay a $15,000
automobile loan if interest is computed at 12 % per year
compounded monthly. Assume the period of the loan is 3 years
b) How much interest will be paid over the 3-year period?

A=15,000 , I = 12% = 0.12/4 = 0.03 , n*m = 3*12 = 36

nm
(1+i/m) - 1
A = R[ n m
]
i/m(1+i/m)
36
(1+0.01) - 1
15,000 = R [ 36
]
0.01(1+0.01)
R = 498.21
Interest will be paid over the period =498.21*36-15000=2940.96