Mathematics of Finance

Chapter 3
 Mathematics of Finance
 3.1 Simple and Compound Interest
 3.2 Future Value of an Annuity
 3.3 Present Value of an Annuity and
Amortization

2
 3.1 Simple and Compound
Interest
 Interest: The fee paid to use someone else’s money.
 Principal: The amount borrowed or deposited.
 Simple Interest: Interest paid only on the principal.

...Frequently charged on loans of a year or less.

 Compound Interest: Interest is paid on interest as

…well as on principal.
 Rate of interest: Given as a percent per year,
...expressed as a decimal (6% = .06)

3
 Simple Interest
SIMPLE INTEREST
 The product of the principal P, rate r, and time in years t gives
simple interest, I:
I = Prt

 If P and r are known, then I is a function of t

 For example, assume that P = 500 and r =.12 then,
I = 500(.12)t or I = 60t

4
 Simple Interest – Future Value
FUTURE OR MATURITY VALUE FOR SIMPLE INTEREST
 The future value (A) of P dollars invested at simple interest r
for t years.
A = P(1 + rt)
 Ex: Solve for A. Suppose $3,000 is placed in a savings account
that pays 6% simple interest. What is the balance in the account
after 7 months.
A  30001  (0.06  7 12)  $3105
 How much interest was earned?
$3105 - $3000 = $105
5
 Simple Interest – Future Value
 Ex: Solve for r. Suppose $3,000 is placed in a savings account.
If the balance in the account after 7 years is $5000, what simple
interest rate did we earn ?

5000  3000(1  7 r )
5000  3000  21000r
2000
 r  .095 or 9.5%
21000
6
 Simple Interest – Future Value
and Time
 With simple interest and only simple interest, the future
value (A) is a linear function of time.
 Ex: Suppose $1,000 is placed in a savings account. that
pays 6% simple interest. Write the future value as a
function of time.

A  1000(1  (0.06t ))  1000  60t

7
 Simple Interest – Future Value
and Time
Year Value
1000 + 60t
0 1000
1 1060 2000

2 1120 1500
3 1180
Value

1000
4 1240
500
5 1300
6 1360 0
0 2 4 6 8 10 12
7 1420
Time
8 1480

8
 Simple Interest – Present Value
 A sum of money that can be deposited today to
yield some larger amount in the future is the
present value of that future amount.
Present Value for Simple Interest
The present value P of a future amount of A dollars
at a simple interest rate r for t years is
A
P
1  rt

9
 Simple Interest – Present Value
 Tuition of $1769 will be due when the spring term
begins in 4 months. What amount should a
student deposit today, at 3.25%, to have enough
to pay the tuition?
A = 1769, r = .0325, t = 4/12
A 1769
P   1750.04
1  rt  4
1  .0325   
 12 

10
 Simple Discount Notes
 Interest is deducted in advance from the loan amount
before giving the balance to the borrower.
 The full value of the note must be paid at maturity.
 Bank Discount (or discount): The money that is deducted
in advance.
 Proceeds: The money actually received by the borrower.

11
 Simple Discount Notes
 Consider a loan of $3000 at 6% for 9 months

Simple Interest Note Bank Discount Note

Interest on the note 3000(.06)(9/12) = $135 3000(.06)(9/12) = $135
Borrower receives $3000 $2865
Borrower pays back $3135 $3000
“Actual” interest 135 135
 .06  .0629
rate 3000  9 12  2865  9 12 
I  Prt
I
r
Pt 12
 Simple Discount Notes

Discount
If D is the discount on a loan having a maturity value A at
a rate of interest r for t years, and if P represents the
proceeds, then
P=A–D

13
 Now You Try
 John Matthews signs a $4200 note (A) at the bank, which
charges a 12.2% discount rate (r). Find the net proceeds (P)
if the loan is for 10 months (t). Find the actual interest rate
(to the nearest hundredth) charged by the bank.

14
 Compound Interest
 Normally used for loans or investments of a year or more.
 Interest is paid (or charged) on interest as well as on
principal.
 A = Compound amount at the end of n periods (future
value)
 P = principal (present value)

 r = annual interest rate

 m = number of compounding periods in 1 year

 i = interest rate per compounding period (r/m)

 t = number of years

 n = total number of compounding periods (tm)

15
 Compound Interest
 Compound amount (future value) when interest is
compounded m times per year.
A  P 1  i 
n

r
Where i  , n  tm
m

16
P = $1,000, r = 10%, t = 20, m = 1
A B C
1 year compound simple
2 1 1100 1100
3 2 1210 1200
4 3 1331 1300
5 4 1464.1 1400
6 5 1610.51 1500
19 18 5559.92 2800
20 19 6115.91 2900
21 20 6727.50 3000

17
 P = $1,000, r = 10%, t = 20

8000
7000
6000
5000
compound
4000
simple
3000
2000
1000
0
0 5 10 15 20 25
t

18
 Compound Interest - continued
 Ex: Suppose $3,000 is placed in a savings account.
If the annual interest rate is 6%, and interest is
compounded semiannually, what is the balance in
A  P 1  i 
n
the account after 7 years?
 P = 3000

 i = r/m = 0.06/2 = 0.03

 n = tm = 72 = 14 interest periods.

A  3000(1  0.03)14  $4537.77

19
 Now You Try
Find the compound amount for each of the following deposits.
A  P 1  i 
n

1. $15,000 @ 4.6% compounded semiannually for 11 years.

2. $9100 @ 6.1% compounded quarterly for 4 years.

20
 Compound Interest – Effective
Rate
 Nominal rate (r) – The stated interest rate to be
paid on an investment. Sometimes called Annual
Percentage Rate, or APR.
 Effective rate (rE) – The actual increase in an
investment. Higher than the nominal rate if
interest is compounded. Sometimes called Annual
Percentage Yield, or APY.
m
 r
rE  1    1
 m
21
 $1,000 investment
Example Month compounded simple
1 1005.00
 r = 6% 2 1010.03
3 1015.08
 m = 12
4 1020.15
 calculate rE
5 1025.25
12
 .06  6 1030.38
rE  1   1 7 1035.53
 12  8 1040.71
 1.06168  1  .06168 9 1045.91
10 1051.14
or, 6.168%
11 1056.40
12 1061.68 1060
22
 Now You Try
 The Flagstar Bank in Michigan offered a 5-year
certificate of deposit (CD) at 4.38% interest
compounded quarterly. On the same day on the
internet, Principal Bank offered a 5-year CD at 4.37%
interest compounded monthly. Find the APY (effective
rate) for each CD. Which bank pays a higher APY?

23
 Compound Interest – Present
Value
 My daughter would like to have $5,000 six years from
now to put down on a new car. What amount deposited
today at 6% compounded monthly will amount to $5,000
in 6 years?
 A = 5,000, i = .06/12 = .005, n = 6  12 = 72, P = ?

A  P 1  i 
n
(compound interest)

A
P  A 1  i 
n
P or
1  i 
n

(Remember, i = r m and n = mt)

24
 Compound Interest – Present
Value

P  A 1  i 
n

72
 .06 
P  5000 1  
 12 
P  $3, 491.51
 $3,491.51 deposited today at 6% compounded monthly
will amount to $5,000 in six years.

25
 Now You Try
 Bill Poole wants to have $20,000 available in 5 years
for a down payment on a house. He has inherited
$15,000. How much of the inheritance should he invest
now to accumulate the $20,000 if he can get an interest
rate of 8% compounded quarterly?

26
 Compound Interest – Using logs
 How long will it take for $600 to amount to $900 at an
annual rate of 8% compounded quarterly ?
 i = 0.08/4 = 0.02. Let n be the number of interest periods it
takes for a principal of P = $600 to amount to A = $900
then,
900  600(1  0.02) n
900
1.02 n

600
1.02n  1.5
27
 Compound Interest – Using logs

1.02n  1.5
To solve for n we first take the natural logs (ln) of both sides:

ln( 1.02) n  ln 1.5

n ln 1.02  ln 1.5
ln 1.5
Solve for n: n  20.475
ln 1.02
n = 20.475 quarterly interest periods, or 20.475/4 = 5.1188 years

28
 Now You Try
 Suppose a conservation campaign coupled with higher
rates causes the demand for electricity to increase at
only 2% per year, as it has recently. Find the number
of years before the utilities will need to double their
generating capacity.

29
Simple & Compound Interest –
Summary

Simple Interest Compound Interest

A  P 1  rt  A  P 1  i 
n

A
P  A 1  i 
n
P
1  rt
m
 r
rE  1    1
 m

30
 3.2 Future Value of an Annuity
 Annuity – A sequence of equal payments made at equal
periods of time.
 Ordinary Annuity – Payments are made at the end of

the time period, and the frequency of the payments is

the same as the frequency of the compounding.
 Sinking Fund – Periodic payments are made to meet

some future obligation (college savings plan).

 Amortization – Periodic payments are made to

dispose of a present obligation (car loan). Section 5.4

31
 3.2 Future Value of an Annuity
 Payment period – The time between payments.
 Term – The time from the beginning of the first payment
period to the end of the last payment period.
 Future value of the annuity – The sum of the compound
amounts of all the payments, compounded to the end of
the term (The final sum on deposit.).

32
 Future Value of an Annuity;
Sinking Fund
 If you deposit $100 at the end of each year for 4 years in a
savings account that pays 10 % per year how much will you
have at the end of 4 years?
1 2 3 4 Year

0 100 100 100 100

$100
100(1.1) = 110
100(1.1)2 = 121
100(1.1)3 = 133.10
$464.10

33
 Future Value of an Annuity;
Sinking Fund

 1  i n  1 
S  R 
 i 
 Where:
 S is the future value;

 R is the payment;

 i is the interest rate per period;

 n is the number of periods

34
 Future Value of an Annuity;
Sinking Fund
 Previous example: If you deposit $100 at the end of each year
for 4 years in a saving account that pays 10 % per year how
much will you have at the end of 4 years?

 1  i n  1 
S  R 
 i 
1  .10 
4
1
S  100  $464.10
.10

35
 Example
 To meet college expenses for their newborn child, Bob and
Kathy decide to invest $600 every six months in an ordinary
annuity that pays 8% annual interest, compounded semi-
annually. What is the value of the annuity in 18 years?
 
36
 i = .08/2 = .04 1  .04 1
 n = 2(18) = 36
S  600
0.04
 R = 600

 600 77.59831385 
 $46,558.99

36
 Example 2
 A company wants to have $1,500,000 to replace old
equipment in 10 years. How much must be set aside
annually in an ordinary annuity at 7% annual interest?
 i = .07  1  i n  1 
S  R 
 n = 10 i
 
 S = 1,500,000
S
 Solve for R
R 
1  i   1
n

37
 Example 2
 i = .07 1,500,000 1,500,000
n = 10 R 
1  .07   1 13.81644796
 10
 S = 1,500,000
 Solve for R .07
R  108,566.25

The company needs to invest $108,566.25 each year to

accumulate $1.5m in 10 years

38
 Retirement – Bill & Mary
 Bill and Mary both graduated from UCF with similar
degrees, and obtained similar jobs. Bill immediately began
putting $200 per month into an ordinary annuity paying
8% interest compounded monthly for his retirement.
Mary, on the other hand, decided to put off retirement
planning for the current time.
 Ten years later, Bill stopped paying into his annuity and
decided to let the money sit and continue earning interest.
In the meantime, Mary decided to start a retirement
account, and began investing $200 per month into an
annuity paying 8% interest compounded monthly.
 Another 20 years goes by. How much money do Bill and
Mary have in their retirement accounts?
39
 Retirement - Bill
Ordinary annuity for 10 years
R  200, i  .08 12, n  120
 1  i n  1  1  .08 12 120  1 
S  R   200    $36,589.21
 i   .08 12 
Compound interest for 20 more years
P  36,589.21, i  .08 12, n  240
A  P 1  i   36,589.211  .08 12 
n 240
 $180, 267.82

40
 Retirement - Mary
Ordinary annuity for 20 years
R  200, i  .08 12, n  240
 1  i n  1  1  .08 12 240  1 
S  R   200    $117,804.08
 i   .08 12 

After graduating 30 years ago, Bill invested $24,000 and now

has $180,267 in his retirement account. Mary contributed
$48,000 and now has $117,804 in her retirement account.
What if they decide to postpone retirement for 10 more
years?
41
 Retirement - Mary
Bill – continues earning compound interest for 10 years
A  180, 267.82 1  .08 12 
120
 $400,129.71
Mary – continues contributing $200 per month into her
ordinary annuity for 10 more years (30 years total)
 1  .08 12 360  1 
S  200    $298,071.89
 .08 12 
Bill’s total contribution = $24,000
Mary’s total contribution = $72,000

42
 Now You Try
 A 45-year-old man puts $1000 in a retirement account at
the end of each quarter until he reaches the age of 60 and
makes no further deposits. If the account pays 8% interest
compounded quarterly, how much will be in the account
when the man retires at age 65?
 $1000 each quarter from age 45 to 60 (15 years)

 Account pays 8% interest compounded quarterly.

 Value at age 65?

43
 Future Value of an Annuity Due
 Annuities in which payments are made at the beginning of each
time period.
 The future value of an annuity due of n payments of R dollars
at the beginning of consecutive interest periods, with interest
compounded at the rate of i per period is

 1  i n1  1
S  R R
 i 

44
 Now You Try
 Bill is paid on the first day of the month and $80 is
automatically deducted from his pay and deposited in a savings
account. If the account pays 2.5% interest compounded
monthly, how much will be in the account after 3 years and 9
months?

 1  i n1  1
S  R R
 i 

45
 3.3 Present Value of an Annuity;
Amortization
 You’ve just inherited a large amount of money from your dear
Aunt Sally! The only stipulation is that you can’t touch the
money for 20 years, and it must be deposited into a savings
account that pays 6 percent annual interest compounded
annually. You have 2 payment options to choose from:
1. 20 annual deposits of $35,000 (20  $35,000 = $700,000);
2. A lump-sum deposit of $400,000
 Present value of an annuity – The amount that would have to
be deposited in one lump sum today (at the same compound
interest rate) in order to produce the same balance at the end of
t years.

46
 Present Value of an Annuity
 Future value of 20 annual deposits (n) of $35,000 (R) at 6%
annual interest (i) compounded annually:
 1  i n  1 1  .06   1
20

S  R   35, 000  $1, 287, 495.70

 i  .06

 What lump sum deposit at i = .06 and n = 20, would amount to

$1,287,495.70?
 Present value of an annuity (P)

47
 Present Value of an Annuity
 The present value P of an annuity of n payments of R dollars
each at the end of consecutive interest periods with interest
compounded at a rate of interest i per period is
1  1  i  n 
P  R 
 i 

1  1  .06 20 
P  35, 000   Therefore, a lump sum deposit of
 .06  $401,450 would equal the future
value of the annuity described.
P  35, 000 11.47   401, 450
48
 Present Value of an Annuity
 Determine the present value (P) of an annuity that pays $100 per
month for 10 years at 5% interest compounded monthly.
R = $100, i = .05/12, n = 120

  .05 120 
1   1   
P  100  
12    $9428.14
 .05 
 12 
 

49
 Present Value of an Annuity;
Amortization
Car Payments
 A car costs $32,000. After a down payment of $2000, the
balance ($30,000) will be paid off in 60 equal payments
with interest of 6% per year on the unpaid balance. What
is the monthly payment?
 A single lump sum payment of $30,000 today would pay
off the loan. So, $30,000 is the present value of an annuity
of 60 monthly payments with i = .06  12 = 0.005. Thus,
 P = 30,000, n = 60, i = .005. Solve for R...

50
 Present Value of an Annuity;
Amortization
 P = 30,000, n = 60, i = .005. Solve for R

1  1  .005 60 
30, 000  R  
 .005 
30, 000  R  51.726 
R  $579.98

51
 Amortization
 The process of gradually reducing a debt through installment
payments of principal and interest, versus paying off the debt all
at once.
 The periodic payment needed to amortize a loan may be found,
as in the car payment example, by solving the present value
equation for R.
P
R 
1  1  i  n  1  1  i  n 
P  R   
 i   i 

52
 Amortization
AMORTIZATION PAYMENTS
 A loan of P dollars at interest rate i per period may be amortized

in n equal payments of R dollars made at the end of each period,

where
P Pi
R 
1  1  i  n 
 
n
  1  1  i
 i 

53
 Amortization
 Bob & Kathy bought a house for $250,000. After a down
payment of $25,000 they financed the remaining $225,000 for
30 years at 6% annual interest.
1. Calculate their monthly mortgage payments.

Pi 225,000 .005
R   $1,348.99
1  1  i  1  1.005
n 360

54
 Amortization
 Bob & Kathy bought a house for $250,000. After a down
payment of $25,000 they financed the remaining $225,000 for
30 years at 6% annual interest.
2. How much of their first mortgage payment went towards
paying interest, and how much went toward the principal?
I  Pr t
1
I  225, 000 .06     $1,125
 12 
 $1,125 went toward interest
 $1349 - $1125 = $224 toward the principal.
55
 Amortization Table
Payment Amount of Interest Portion to Principal at
Number payment for Period Principal End of Period
0 $225000.00
1 $1349.00 $1125.00 $224.00 224776.00
2 1349.00 1123.88 225.12 224550.88
3 1349.00 1122.75 226.25 224324.63
4 1349.00 1121.62 227.38 224097.26
5 1349.00 1120.49 228.51 223868.74
180 1349.00 802.02 546.98 159856.61
360 1337.63 6.65 1330.98 0.00

56
 Now You Try
 Kareem Adams buys a house for $285,000. He pays $60,000
down and takes out a mortgage at 6.9% on the balance. Find his
monthly payment and the total amount of interest he will pay if
the length of the mortgage is:
a. 15 years
b. 20 years

57