CHAPTER FOUR

MATHEMATICS OF FINANCE

Introduction -From a financial stand point business transactions may be considered as inflows
and out flows of funds overtime. Funds must be borrowed on long term, a year or longer basis to
replace, improve or add to the existing facilities such as buildings, equipment, and machinery.
Funds must also be borrowed on short term, lessthan a year basis to meet immediate needs such
as row materials or obligations such as payroll (employee’s salary).

But money has a time value i.e. “a birr today is more worth than a birr tomorrow”, which is
expressed interms of interest charges.

4.1 Important points in mathematics of finance

1. Principal amount (P)- is the amount of money that is initially being considered. It is the
amount to be invested or loaned (borrowed). For instance, an individual (Mr. X borrowed
$20,000 from bank).
2. Number of time periods (n)- number of periods over which amount of money is being
invested or borrowed. Normally denoted by the symbol “n”. It could be represented other
forms of time period i.e. number of quarters, and number of months.
3. Rate of interest (i)- is a proportion amount of money which is added to some principal
amount (invested or borrowed). Denoted by “r” and expressed as a percentage rate per
annum. Example: Birr 1,000 invested at a rate of 10% per year (annum). It will
accumulated Birr 1,000+ (1,000*10%) i.e. 1,100.
4. Accrued amount(A)- the amount of money after some time has elapsed for which interest
has been calculated and added. (FV/FA).
4.2 Simple interest

Any interest earned is not added back to the principal amount invested or borrowed. Simple
interest is used only (mostly) on short-term periods especially, duration for less than a year.
Suppose a person borrow (deposit) a sum of money “P” from a lending agent, then “P” is
referred as the principal. When the money is borrowed, there is a fee charged, this fee is called
interest rate. (Computed in percentage rate), of a principal over a given period of time (t or n).

Simple interest is calculated as I = P .r .t

Where:P = Principal
r= annual simple interest rate
t = time period in years
The principal “P” is borrowed at a rate of “r” then after “t” year the borrower will owe an
amount “A” which includes the principal “P” and interest rate “i”

I = P.r.t

A=P+I

A = P + (P.r.t)

A = P(1+rt)

Where;P = principal or present value

r = annual interest rate
t = time period
A= amount or feature value
A = P(1+rt)
P = A/1+rt

A = p+p.r.t

r = A-P/Pt

A = p+ prt

t = A-P/ pr

Example 1- Compute the interest on $480 at 6 1/4 percent for 9 months?

Example 2- Compute the interest on $1000 at 10% for:

a. Six months
 b. Four months
c. One year
d. Two months

When t is given by days we can use two methods i.e.

A. Exact method- when a year is taken by 365 days

i.e. t = number of days /365

B. Ordinary method (often called Banker’s rule) – when a year is taken by 360 days

Example 3- Find the interest on $2,000 for 82 days at 10% interest rate by using;

a. The exact method

b. Ordinary method

Example 4- Find the interest on $4500 for 122 days at 5% interest rate by using;

a. The exact method

b. The ordinary method
i. Computing time (t)

If we are given rate of interest, principal, and interest earned we can calculate for time required
to earn the given interest. By using the following formula

t = I/pr

Example 1- How long it takes until the principal on $900 at 12% interest will be collected $135?

Example 2- Find the number of months if $10,000 earns $500 interest at 5% interest rate; use

a. The exact method

b. The ordinary method
ii. Computing rate of interest(r)
If we are given interest earned, principal, and time we can calculate about rate of interest.

r= I/pt
Example 1- Find the rate of interest if $1,000 earns $45 interest in 6 months?

Example 2- Find the rate of interest if $45,000 earns $3,200 interest in 3 months?

4.2.1 The future value

If a principal “P” is borrowed at a rate “r” then after “t” years the borrower will owe an amount
“A” that will include the principal “P” and interest “i” the lender will have an amount in the
future “A” we call it future value “FV”/A

Future value is the present amount plus the interest earned from it.

A= P + I

A = P + Prt

A = P(1+rt)

Example 1- A principal of Birr 10,000 is borrowed at 8% per year simple interest. Find the
future value after;

i. One years
ii. Three months
iii. 180 days (use ordinary method)

Example 2- Find the amount due on a loan of $1500 at 16% simple interest at the end of 3
months.

Example 3- If you want to earn an annual rate of 20% on your investment, how much should you
pay for a note that will be worth $10,000 in 9 months?

Example 4- If you must pay $750 for a note that will be worth $900 in 6 months, what annual
simple interest rate will you earn?

Example 5- Aman borrowed $20,000 from bank and 6 months later he paid $20,600 to the bank.
Find the rate of interest
Example 6-Biruk has deposited $8,000 in Dashen International Bank that pays 7% interest. How
long it will be in months until the deposit becomes $8,675?

Properties of exponential function

For “a” and “b” positive, a ≠ 1 and b ≠ 1 and x and Y are real numbers; then

1. a0 = 1
2. ax.ay = a x+y
x
a x− y
3. y = a
a
4. (a x ) y a xy
5. (ab) x =a x bx
x x
a a
6. ( ) = x
b b
1
7. a−x = x
a
4.3Compound interest

If at the end of a payment period the interest due is reinvested at the same rate, then the interest
as well as the original principal will earn interest during the next period. Interest paid on interest
reinvested is called Compound interest.
The practice of computing interest on interest and principal
The interest earned on a sum of money in a given time period is added to the original principal.
This new amount serves as the new principal for the next period.

When this procedure continues for successive periods, the final result is called the compound
amount.

The difference between the compound amount and the original principal is the compound
interest. The time interval between successive additions of interest is known as the conversion
period.
In general, if “P” is the principal earning interest compounded “m”, times a year at annual rate of
interest, “r” then the amount “A” at the end of each period is;
A = P (1+i)1 - end of the first period

A = (P (1+i) (1+i)) = P (1+i¿ ¿ 2 - end of the second year

A = (P (1+i¿ ¿ 2 (1+i)) – end of the third year

A = P ( 1+i¿ ¿ n

Where;r = annual interest rate

m = number of compounding periods per year
i = rate per compounding period
n= total number of compoundingperiods
P = principal or present value
A = Amount or future value

r Where;r=annual rate
i=
m
m=number of compounding period per year

n = m*tm = number of compounding period per year

Where;
t = number of years

4.3.1 Future value (FV) of compound interest

Example 1- If Birr 10,000 is invested at 8% compounded;

i. Annually
ii. Semi-annually
iii. Quarterly
iv. Monthly; what is the amount after 5 years?

Example 2- If $4,000 is invested at 10% compounded;

i. Annually
ii. Semi-annually
iii. Quarterly
 iv. Monthly, what is the amount after 6 years?
A. Computing present value (principal)
A
A = P (1+i¿ ¿ n P= n
(1+i)
Example 1- How much money should be deposited in a bank that pays 6% per annum; so that
after 4 years the amount will be Birr 25,000 when the interest is compounded;

a. Annually
b. Quarterly
a. Annuities

A periodic payment of a fixed amount made at a regular interval of say one year, half year, a
quarter or a month, to discharge one’s obligation under a contract requiring compound interest at
a certain rate.
Future value of Annuity
The amount (future value) of an annuity is the sum of all payments plus all interest earned.
c. Example 1- What is the amount of annuity at the end of 3 years of $100 is
deposited every 6 months in an account earning 6% compounded semiannually
Monthly