THE MATHEMATICS OF FINANCE

Introduction
Everybody uses money. Sometimes you work for your money and other times your
money works for you. For example, unless you are attending college on a full scholarship,
it is very likely that you and your family have either saved money or borrowed money, or
both, to pay for your education. When we borrow money, we normally have to pay
interest for that privilege. When we save money, for a future purchase or retirement, we
are lending money to a financial institution and we expect to earn interest on our
investment. We will develop the mathematics in this chapter to understand better the
principles of borrowing and saving. These ideas will then be usedto compare different
financial opportunities and make informed decisions

Simple Interest
In the business world, an investor who places capital in a productive enterprise
expects not only the eventual return of his capital but also additional payment. An
individual who lends his capital expects the debtor to pay back not only the money
originally borrowed but also an additional amount. This additional payment or amount is
called interest. The interest is the compensation that a borrower of capital pays to a
lender for its use. It can be viewed as a form of rent that the borrower pays to the lender
to compensate for the loss of opportunity to use the capital for other productive financial
transactions.
Therefore, interest is the fee paid for borrowed money. We receive interest whenwe
let others use our money (for example, by depositing money in a savings account or
making a loan). We pay interest when we use other people’s money (such as when
borrow from a bank or a friend).

Jeremy is 23 years old, and is a new engineer. She wants to prepare for her future.
She invests her first salary of 35,000.00 in a trust fund that pays 5% interest. She plans to
retire at age 60. How much money will she have on her retirement?

When someone deposits money in a bank, invests money in an investment house

or lends money to someone, he or she earns additional money from the amount
deposited, invested or borrowed, after a certain period of time. This is called interest.

In the problem above, the amount of 35,000 is the principal value of the
investment, 5% is called the interest rate.

Interest is defined as the cost of borrowing money. Interest is commonly calculated

using one of two methods: simple interest calculation or compound interest calculation.
Simple and compound interests are basic financial concepts. Being familiar with these
terms will help you make better decisions when taking out loan or making investments,
which may save you a lot of money in the long run.
 Simple interest. Interest is paid on the original principal only. The formula for
calculating the simple interest is:

Interest = Principal x interest rate x term of the loan

𝐼
𝐼 = 𝑃𝑟𝑡 𝑃=
𝑟𝑡

𝐼 𝐼
𝑡= 𝑟=
𝑃𝑟 𝑃𝑡

where P is the principal amount invested or borrowed, r is the interest rate, and t is the
time that money will be used or invested.

The value of cash at a specified date in the future is equivalent in value to a

specified sum today is called Future value. If the cash has a simple interest levied on
it, the future value is calculated using the equation:

Example 1:

Michael borrowed 5,000.00 with a simple interest rate of 5%. He will use the money
for 4 years. How much interest will Michael pay at the end of this period?

Solution: using I=Prt

I=Prt
I=(5,000)(0.05)(4)
I= 1,000
Example 2:

Marvin invested 20,000.00 for 5 years with simple interest of 10%. What is the future
value of this investment?

Solution:
FV=P (1 + rt)
FV=20,000(1+(.10)(5))
FV=20,000(1+0.5)
FV=20,000(1.5)
FV=30,000
 Example 2:
Natasha invests P250,000 in a building society account. At the end of the year
her account is credited with 2% interest. How much interest had her P250,000 earned in
the year?

Solution:
P = P250,000 r = 2% or 0.02 t = 1 year

𝐼 = 𝑃𝑟𝑡
= (250,000)(0.02)(1)
= 𝑃5,000
A business borrowed 10 million pesos from the bank. If he agrees to pay an 8%annual
rate of interest, calculate the amount of interest in (a) 5 years, (b) 10 years, and (c) 15
years.

Solution:
P = P10,000,000 r = 8%

For t = 5 years
𝐼 = 𝑃𝑟𝑡
= (10,000,000)(0.08)(5)
= 𝑃4,000,000.00

Compound Interest
- Is calculated on the principal amount and also on the accumulated interest of
previous periods and can thus be regarded as “interest of interest”. This compounding
effect can make a big difference in the amount of interest payable on a loan if
compared to interest computed using the simple method.

Compound interest is the interest earned not only on the original principal but also
on all interest earned previously. In other words, at the end of each year, the interest
earned is added to the original amount and the money is reinvested.

The formula for calculating the amount of money accumulated after n years,
including interest is

𝑟
𝐴 = 𝑃(1 + )𝑛𝑡
𝑛

Where P is the principal amount (initial amount you borrow or deposit), r is the
annual rate of interest, t is the number of years the amount is deposited or
borrowed and n is the number of times the interest is compounded per year.
 Compounded Frequency Number of compounding periods
(n)
Annually 1
Semi-annually 2
Quarterly 4
Monthly 12

Example 1

Dave invested 25,000 in a bank that pays 8% compounded quarterly for 5 years.
How much is his money in the bank after 5 years?
𝑟
Solution: Using the formula 𝐴 = 𝑃(1 + 𝑛)𝑛𝑡
P=25,000 r=0.08 n=4 t=5

Substitute all the values

𝑟
𝐴 = 𝑃(1 + 𝑛)𝑛𝑡

0.08 4(5)
𝐴 = 25000(1 + )
4

𝐴 = 25000(1 + 0.02)20
A=25000(1.02)20
A=25000(1.485947396) = 37148.68

Activity: Solve the following questions in a 1 whole sheet of paper that show your
solution.

1. Natasha invests P250,000 in a building society account. At the end of the year her
account is credited with 2% interest. How much interest had her P250,000 earned
in the year?

2. A business borrowed 10 million pesos from the bank. If he agrees to pay an 8%

annual rate of interest, calculate the amount of interest in (a) 5 years, (b) 10 years,
and (c) 15 years.

3. Jonathan deposits P5,000.00 in a savings account earning 2% interest

compounded annually.

4. Mr. Agoncillo deposited P16,400.00 in an account earning 3% interest,

compounded quarterly. How much is in the account at the end of 1 year?

5. Calculate the future value of P7,500 earning 9% interest, compounded daily, for 3
years.