INTRODUCTORY MATHEMATICAL ANALYSIS

For Business, Economics, and the Life and Social Sciences

Chapter 5
Mathematics of Finance

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance

Chapter Objectives
• To solve interest problems which require
logarithms.
• To solve problems involving the time value of
money.
• To solve problems when interest is compounded
continuously.
• To introduce the notions of ordinary annuities
and annuities due.
• To learn how to amortize a loan and set up an
amortization schedule.
2011 Pearson Education, Inc.
Chapter 5: Mathematics of Finance

Chapter Outline

5.1) Compound Interest

5.2) Present Value
5.3) Interest Compounded Continuously
5.4) Annuities
5.5) Amortization of Loans

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance

5.1 Compound Interest

• Compound amount S at the end of n interest
periods at the periodic rate of r is as
S  P 1  r 
n

Example 1 – Compound Interest

Suppose that $500 amounted to $588.38 in a

savings account after three years. If interest was
compounded semiannually, find the nominal rate of
interest, compounded semiannually, that was
earned by the money.

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.1 Compound Interest
Example 1 – Compound Interest

Solution:
There are 2 × 3 = 6 interest periods.
5001  r   588.38
6

1  r  6  588.38
500
588.38
1 r  6
500
588.38
r 6  1  0.0275
500

The semiannual rate was 2.75%, so the nominal

rate was 5.5 % compounded semiannually.

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.1 Compound Interest

Example 3 – Compound Interest

How long will it take for $600 to amount to $900 at an

annual rate of 6% compounded quarterly?
Solution:
The periodic rate is r = 0.06/4 = 0.015.
900  6001.015 
n

1.015  n  1.5
ln1.015   ln1.5
n

n ln1.015  ln1.5
ln1.5
n  27.233
ln1.015
It will take 27.233 .
 6.8083  6 years, 99.7
1
months
4 2 months

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.1 Compound Interest

Effective Rate
• The effective rate re for a year is given by
n
 r
re  1    1
 n

Example 5 – Effective Rate

To what amount will $12,000 accumulate in 15 years

if it is invested at an effective rate of 5%?
Solution:S  12,0001.05   $24,947.14
15

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.1 Compound Interest

Example 7 – Comparing Interest Rates

If an investor has a choice of investing money at 6%
1
compounded daily or 8 % compounded quarterly,
6
which is the better choice?
Solution:
Respective effective rates of interest are
365
 0.06 
re  1    1  6.18% and
 365 
4
 0.06125 
re  1    1  6.27%
 4 

The 2nd choice gives a higher effective rate.

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance

5.2 Present Value

• P that must be invested at r for n interest periods
so that the present value, S is given by
P  S 1  r 
n

Example 1 – Present Value

Find the present value of $1000 due after three

years if the interest rate is 9% compounded
monthly.
Solution:
For interest rate, r  0.09 / 12.  0.0075
Principle value is P  1000  1 . 0075  36
.  $764.15

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.2 Present Value

Example 3 – Equation of Value

A debt of $3000 due six years from now is instead
to be paid off by three payments:
• $500 now,
• $1500 in three years, and
• a final payment at the end of five years.
What would this payment be if an interest rate of
6% compounded annually is assumed?

Note: The single payment due now must be such that it would grow
and eventually pay off the debts when they are due. That is, it must
equal the sum of the present values of the future payments.

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.2 Present Value

 Solution:
The equation of value is

so

Thus, the final payment should be $475.68.

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.2 Present Value

Net Present Value

Net Present Value  NPV   Sum of present values - Initial investment

Example 5 – Net Present Value

You can invest $20,000 in a business that guarantees

you cash flows at the end of years 2, 3, and 5 as
indicated in the table. Year Cash Flow
2 $10,000
3 8000
5 6000

Assume an interest rate of 7% compounded annually

and find the net present value of the cash flows.

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.2 Present Value
Example 5 – Net Present Value

Solution:
NPV  10,0001.07   80001.07   60001.07 
2 3 5
 20,000
 $457.31

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance

5.3 Interest Compounded Continuously

Compound Amount under Continuous Interest
• The compound amount S is defined as
kt
 r
S  P 1  
 k
Example 1 – Compound Amount

If $100 is invested at an annual rate of 5%

compounded continuously, find the compound
amount at the end of
a. 1 year.
S  Pe rt  100e  0.05  1  $105.13
b. 5 years.
S  100e  0.05  5   100e 0.25  $128.40
2011 Pearson Education, Inc.
Chapter 5: Mathematics of Finance
5.3 Interest Compounded Continuously

Effective Rate under Continuous Interest

• Effective rate with annual r compounded
continuously is re  e r  1.
Present Value under Continuous Interest
• Present value P at the end of t years at an
annual r compounded continuously is P  Se .  rt

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.3 Interest Compounded Continuously

Example 3 – Trust Fund

A trust fund is being set up by a single payment so
that at the end of 20 years there will be $25,000 in
the fund. If interest compounded continuously at an
annual rate of 7%, how much money should be paid
into the fund initially?

Solution:
We want the present value of $25,000 due in 20
years.
P  Se  rt  25,000e   0.07  20 
 25,000e 1.4  $6165

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance

5.4 Annuities
Present Value of an Annuity
• The present value of an annuity (A) is the sum
of the present values of all the payments.

A  R 1  r   R 1  r   ...  R 1  r 
1 2 n

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.4 Annuities

Example 1 – Present Value of Annuity

Find the present value of an annuity of $100 per
1
month for 3 years at an interest rate of 6%
2
compounded monthly.

Solution:
For R = 100, r = 0.06/12 = 0.005, n = ( 3 1 )(12) = 42
2
A  100a __
42 0.005

From Appendix B, a . .798300

 37 __
42 0.005
Hence,
A  100 37.798300   $3779.83

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.4 Annuities

Example 3 – Periodic Payment of Annuity

If $10,000 is used to purchase an annuity consisting
of equal payments at the end of each year for the
next four years and the interest rate is 6%
compounded annually, find the amount of each
payment.

Solution:
For A= $10,000, n = 4, r = 0.06,
10,000  Ra__
4 0.06

A 10,000 10,000
R    $2885.91
a__ a__ 3.465106
n r 4 0.06

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.4 Annuities

Amount of an Annuity
• The amount S of ordinary annuity of R for n
periods at r per period is
S R
 1 r   1
n

r
Example 5 – Future Value of an Annuity

Find S consisting of payments of $50 at the end of

every 3 months for 3 years at 6% compounded
quarterly. Also, find the compound interest.

Solution: For R=50, n=4(3)=12, r=0.06/4=0.015,

S  50 __  5013.041211  $652.06
12 0.015

Compund Interest  652.06  12 50   $52.06

2011 Pearson Education, Inc.
Chapter 5: Mathematics of Finance
5.4 Annuities

Example 7 – Sinking Fund

A sinking fund is a fund into which periodic
payments are made in order to satisfy a future
obligation. A machine costing $7000 is replaced at
the end of 8 years, at which time it will have a salvage
value of $700. A sinking fund is set up. The amount in
the fund at the end of 8 years is to be the difference
between the replacement cost and the salvage value.
If equal payments are placed in the fund at the end of
each quarter and the fund earns 8% compounded
quarterly, what should each payment be?

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.4 Annuities
Example 7 – Sinking Fund

Solution:
Amount needed after 8 years = 7000 − 700 = $6300.
For n = 4(8) = 32, r = 0.08/4 = 0.02, and S = 6300,
the periodic payment R of an annuity is

6300  Rs ____
32 0.02

S 6300
R   $142 .45
s ____ s ____
n r 32 0.02

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance

5.5 Amortization of Loans

Amortization Formulas

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.5 Amortization of Loans

Example 1 – Amortizing a Loan

A person amortizes a loan of $170,000 by obtaining
a 20-year mortgage at 7.5% compounded monthly.
Find
a.monthly payment,
b.total interest charges, and
c.principal remaining after five years.

2011 Pearson Education, Inc.

Chapter 5: Mathematics of Finance
5.5 Amortization of Loans
Example 1 – Amortizing a Loan

Solution:
a. Monthly payment:
 0.00625 

R  170,000   $1369.51
 240 
 1   01..00625 
b. Total interest charge:

2401369.51  170,000  $158,682.40

c. Principal value:

 1  1.
0 . 00625  180

1369.51   $147,733.74

 0.00625 

2011 Pearson Education, Inc.