4

Mathematics of Finance

Simple Interest
Compound Interest
Annuities
Amortization and Sinking Funds

4.1
Simple Interest
Compound Interest
Effective Rate of Interest
Continuous Compounding of Interest

Simple Interest Formulae

Simple interest is the interest that is

computed on the original principal only.

If I denotes the interest on a principal P
(in dollars) at an interest rate of r per year
for t years, then we have
I = Prt
The accumulated amount A, the sum of the

principal and interest after t years is given by

A = P + I = P + Prt
= P(1 + rt)
and is a linear function of t.

Example
A bank pays simple interest at the rate of 8% per year for

certain deposits.
If a customer deposits $1000 and makes no withdrawals
for 3 years, what is the total amount on deposit at the end
of three years?
What is the interest earned in that period?
Solution
Using the accumulated amount formula with P = 1000,
r = 0.08, and t = 3, we see that the total amount on
deposit at the end of 3 years is given by

A P (1 rt )
1000[1 (0.08)(3)] 1240
or $1240.

Example
A bank pays simple interest at the rate of 8% per year for

certain deposits.
If a customer deposits $1000 and makes no withdrawals
for 3 years, what is the total amount on deposit at the end
of three years?
What is the interest earned in that period?
Solution
The interest earned over the three year period is given by

I Prt
1000(0.08)(3) 240
or $240.

Applied Example: Trust Funds

An amount of $2000 is invested in a 10-year trust fund

that pays 6% annual simple interest.

What is the total amount of the trust fund at the end of 10
years?
Solution
The total amount is given by

A P (1 rt )
2000[1 (0.06)(10)] 3200
or $3200.

Compound Interest
Frequently, interest earned is periodically added to the

principal and thereafter earns interest itself at the same

rate. This is called compound interest.
Suppose $1000 (the principal) is deposited in a bank for a
term of 3 years, earning interest at the rate of 8% per year
compounded annually.
Using the simple interest formula we see that the
accumulated amount after the first year is
A1 P (1 rt )
1000[1 0.08(1)]
1000(1.08) 1080
or $1080.

Compound Interest
To find the accumulated amount A2 at the end of the

second year, we use the simple interest formula again, this

time with P = A1, obtaining:
A2 P (1 rt ) A1 (1 rt )
1000[1 0.08(1)][1 0.08(1)]
1000(1 0.08)2 1000(1.08) 2 1166.40
or approximately $1166.40.

Compound Interest
We can use the simple interest formula yet again to find

the accumulated amount A3 at the end of the third year:

A3 P(1 rt ) A2 (1 rt )
1000[1 0.08(1)]2 [1 0.08(1)]
1000(1 0.08)3 1000(1.08)3 1259.71
or approximately $1259.71.

Compound Interest
Note that the accumulated amounts at the end of each year

have the following form:

A1 1000(1.08)
A2 1000(1.08)2

A1 P (1 r )
or:

A3 1000(1.08)3

A2 P(1 r ) 2
A3 P (1 r )3

These observations suggest the following general rule:

If P dollars are invested over a term of t years earning

interest at the rate of r per year compounded annually,
then the accumulated amount is

A P(1 r )t

Compounding More Than Once a Year

The formula

A P (1 r )t

was derived under the assumption that interest was

compounded annually.
In practice, however, interest is usually compounded more
than once a year.
The interval of time between successive interest
calculations is called the conversion period.

Compounding More Than Once a Year

If interest at a nominal rate of r per year is compounded m

times a year on a principal of P dollars, then the simple

interest rate per conversion period is
r
Annual interest rate
i
m
Periods per year
For example, if the nominal interest rate is 8% per year,
and interest is compounded quarterly, then

or 2% per period.

r 0.08
i
0.02
m
4

Compounding More Than Once a Year

To find a general formula for the accumulated amount, we

apply

A P (1 r )t

repeatedly with the interest rate i = r/m.

We see that the accumulated amount at the end of each
period is as follows:
A1 P (1 i )
2
Second Period: A2 A1 (1 i ) [ P (1 i )](1 i ) P (1 i )
2
3
Third Period: A3 A2 (1 i ) [ P (1 i ) ](1 i ) P (1 i )

nth Period:
An An 1 (1 i ) [ P (1 i ) n 1 ](1 i ) P(1 i ) n
First Period:

Compound Interest Formula

There are n = mt periods in t years, so the accumulated

amount at the end of t years is given by

r
1
m

A P

Where n = mt, and

A = Accumulated amount at the end of t years
P = Principal
r = Nominal interest rate per year
m = Number of conversion periods per year
t = Term (number of years)

Example
Find the accumulated amount after 3 years if $1000 is

invested at 8% per year compounded

a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily

Example
Solution
a. Annually.
Here, P = 1000, r = 0.08, and m = 1.
Thus, i = r = 0.08 and n = 3, so
r

A P 1
m

0.08
1

1000

1000(1.08)3
1259.71
or $1259.71.

Example
Solution
b. Semiannually.
Here, P = 1000, r = 0.08, and m = 2.
Thus, i = 0.08/2 and n = (3)(2) = 6, so

A P

r
1
m

0.08
1

1000

1000(1.04)6
1265.32
or $1265.32.

Example
Solution
c. Quarterly.
Here, P = 1000, r = 0.08, and m = 4.
Thus, i =0.08/4 and n = (3)(4) = 12, so

A P

r
1
m

0.08
1

1000

1000(1.02)12
1268.24
or $1268.24.

12

Example
Solution
d. Monthly.
Here, P = 1000, r = 0.08, and m = 12.
Thus, i =0.08/12 and n = (3)(12) = 36, so

1000

0.08
1

12

36

0.08

1000 1

12

1270.24

36

r
A P 1
m

or $1270.24.

Example
Solution
e. Daily.
Here, P = 1000, r = 0.08, and m = 365.
Thus, i =0.08/365 and n = (3)(365) = 1095, so

r
A P 1
m

or $1271.22.

0.08

1000 1

365

1095

0.08

1000 1

365

1271.22

1095

Present Value
Consider the compound interest formula:

A P

r
1
m

mt

The principal P is often referred to as the present value,

and the accumulated value A is called the future value,

since it is realized at a future date.
On occasion, investors may wish to determine how much
money they should invest now, at a fixed rate of interest, so
that they will realize a certain sum at some future date.
This problem may be solved by expressing P in terms of A.

Present Value

Present value formula for compound interest

P A 1 i
Where

r
m

and

n mt

Examples
How much money should be deposited in a bank paying a

yearly interest rate of 6% compounded monthly so that

after 3 years the accumulated amount will be $20,000?
Solution
Here, A = 20,000, r = 0.06, m = 12, and t = 3.
Using the present value formula we get

P A

r
1
m

20,000

16,713

mt

0.06
1

12

(12)(3)

Examples
Find the present value of $49,158.60 due in 5 years at an

interest rate of 10% per year compounded quarterly.

Solution
Here, A = 49,158.60, r = 0.1, m = 4, and t = 5.
Using the present value formula we get

P A

r
1
m

mt

49,158.60

30, 000

0.1
1
4

(4)(5)

Continuous Compounding of Interest

One question arises on compound interest:

What happens to the accumulated amount over a

fixed period of time if the interest is compounded
more and more frequently?
Weve seen that the more often interest is

compounded, the larger the accumulated amount.

But does the accumulated amount approach a limit

when interest is computed more and more

frequently?

Continuous Compounding of Interest

Recall that in the compound interest formula

A P 1
m

mt

the number of conversion periods is m.

So, we should let m get larger and larger (approach
infinity) and see what happens to the accumulated
amount A.

Continuous Compounding of Interest

If we let u = m/r so that m = ru, then the above formula

becomes

u rt

1
or A P 1

u
The table shows us that when u gets
larger and larger the expression
1
A P 1
u

1
1

urt

approaches 2.71828 (rounding to

five decimal places).
It can be shown that as u gets
larger and larger, the value of
the expression approaches the
irrational number 2.71828
which we denote by e.

10

1
1

2.59374

100

2.70481

1000

2.71692

10,000

2.71815

100,000

2.71827

1,000,000

2.71828

Continuous Compounding of Interest

Continuous Compound Interest Formula

A = Pert

where
P = Principal
r = Annual interest rate compounded
continuously
t = Time in years

A = Accumulated amount at the end

of t years

Examples
Find the accumulated amount after 3 years if $1000 is

invested at 8% per year compounded (a) daily, and

(b) continuously.
Solution
a. Using the compound interest formula with P = 1000,
r = 0.08, m = 365, and t = 3, we find

A P

r
1
m

mt

0.08

1000 1

365

(365)(3)

1271.22

b. Using the continuous compound interest formula with

P = 1000, r = 0.08, and t = 3, we find

A = Pert = 1000e(0.08)(3) 1271.25
Note that the two solutions are very close to each other.

Present Value
with Continuously Compounded Interest
If we solve the continuous compound interest formula

A = Pert
for P, we get
P = Aert
This formula gives the present value in terms of the future
(accumulated) value for the case of continuous
compounding.

Applied Example: Real Estate Investment

Blakely Investment Company owns an office building

located in the commercial district of a city.

As a result of the continued success of an urban renewal
program, local business is enjoying a mini-boom.
The market value of Blakelys property is

V (t ) 300,000e

t /2

where V(t) is measured in dollars and t is the time in

years from the present.
If the expected rate of appreciation is 9% compounded
continuously for the next 10 years, find an expression
for the present value P(t) of the market price of the
property that will be valid for the next 10 years.
Compute P(7), P(8), and P(9), and then interpret your
results.

Applied Example: Real Estate Investment

Solution
Using the present value formula for continuous
compounding
P = Aert
with A = V(t) and r = 0.09, we find that the present value of
the market price of the property t years from now is

P (t ) V (t )e 0.09t
300, 000e 0.09t

t /2

Letting t = 7, we find that

P(7) 300, 000e 0.09(7)

or $599,837.

7 /2

599,837

(0 t 10)

Applied Example: Real Estate Investment

Solution
Using the present value formula for continuous
compounding
P = Aert
with A = V(t) and r = 0.09, we find that the present value of
the market price of the property t years from now is

P (t ) V (t )e 0.09t
300, 000e 0.09t

t /2

Letting t = 8, we find that

P (8) 300, 000e 0.09(8)

or $600,640.

8/2

600, 640

(0 t 10)

Applied Example: Real Estate Investment

Solution
Using the present value formula for continuous
compounding
P = Aert
with A = V(t) and r = 0.09, we find that the present value of
the market price of the property t years from now is

P (t ) V (t )e 0.09t
300, 000e 0.09t

t /2

Letting t = 9, we find that

P (9) 300, 000e 0.09(9)

or $598,115.

9/2

598,115

(0 t 10)

Effective Rate of Interest

The last example demonstrates that the interest actually

earned on an investment depends on the frequency with

which the interest is compounded.
For clarity when comparing interest rates, we can use
what is called the effective rate (also called the annual
percentage yield):
This is the simple interest rate that would produce the
same accumulated amount in 1 year as the nominal rate
compounded m times a year.
We want to derive a relation between the nominal
compounded rate and the effective rate.

Effective Rate of Interest

The accumulated amount after 1 year at a simple interest

rate R per year is

A P (1 R )

The accumulated amount after 1 year at a nominal interest

rate r per year compounded m times a year is

m
r

A P 1
m

Equating the two expressions gives

P(1 R ) P

r
1
m

r
1 R 1
m

Effective Rate of Interest Formula

Solving the last equation for R we obtain the formula for

computing the effective rate of interest:

reff 1 1
m

where
reff = Effective rate of interest
r = Nominal interest rate per year
m = Number of conversion periods per year

Example
Find the effective rate of interest corresponding to a

nominal rate of 8% per year compounded

a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily

Example
Solution
a. Annually.
Let r = 0.08 and m = 1. Then
1

0.08

reff 1
1
1

1.08 1
0.08
or 8%.

Example
Solution
b. Semiannually.
Let r = 0.08 and m = 2. Then
2

0.08

reff 1
1
2

1.0816 1
0.0816
or 8.16%.

Example
Solution
c. Quarterly.
Let r = 0.08 and m = 4. Then
4

0.08

reff 1
1
4

1.08243 1
0.08243
or 8.243%.

Example
Solution
d. Monthly.
Let r = 0.08 and m = 12. Then
12

0.08

reff 1
1
12

1.08300 1
0.08300
or 8.300%.

Example
Solution
e. Daily.
Let r = 0.08 and m = 365. Then
365

0.08

reff 1
1
365

1.08328 1
0.08328
or 8.328%.

Effective Rate Over Several Years

If the effective rate of interest reff is known,

then the accumulated amount after t years on

an investment of P dollars can be more readily
computed by using the formula
A P (1 reff )t

Applied Example: Real Estate Investment

Solution
From these results, we see that the present value of the
propertys market price seems to decrease after a certain
period of growth.
This suggests that there is an optimal time for the owners
to sell.
You can show that the highest present value of the
propertys market value is $600,779, and that it occurs
at time t 7.72 years, by sketching the graph of the
function P.

Example: Using Logarithms in Financial Problems

How long will it take $10,000 to grow to $15,000 if the

investment earns an interest rate of 12% per year

compounded quarterly?
Solution
Using the compound interest formula

A P

r
1
m

with A = 15,000, P = 10,000, r = 0.12, and m = 4, we obtain

15,000 10,000

0.12
1

15,000
(1.03)
1.5
10,000
4t

4t

Example: Using Logarithms in Financial Problems

How long will it take $10,000 to grow to $15,000 if the

investment earns an interest rate of 12% per year

compounded quarterly?
Solution
(1.03) 4 t 1.5
Weve got
4t

ln(1.03) ln1.5

Taking logarithms
on both sides

4t ln1.03 ln1.5

logbmn = nlogbm

ln1.5
4t
ln1.03
So, it will take about 3.4

years for the investment

to grow from $10,000 to
$15,000.

ln1.5
t
3.43
4 ln1.03

4.2
Annuities
Present value of Annuity
Future value of Annuity

Future Value of an Annuity

The future value S of an annuity of n payments of

R dollars each, paid at the end of each investment

period into an account that earns interest at the
rate of i per period, is

(1 i ) n 1
S R

Example
Find the amount of an ordinary annuity consisting of 12

monthly payments of $100 that earn interest at 12% per

year compounded monthly.
Solution
Since i is the interest rate per period and since interest is
compounded monthly in this case, we have
0.12
i
0.01
12
Using the future value of an annuity formula, with

R = 100, n = 12, and i = 0.01, we have

(1 i ) n 1
(1 0.01)12
1
S R
100
1268.25

i
0.01

or $1268.25.

Present Value of an Annuity

The present value P of an annuity consisting of n

payments of R dollars each, paid at the end of

each investment period into an account that earns
interest at the rate of i per period, is

1 (1 i ) n
P R

Example
Find the present value of an ordinary annuity consisting of

24 monthly payments of $100 each and earning interest of

9% per year compounded monthly.
Solution
Here, R = 100, i = r/m = 0.09/12 = 0.0075, and n = 24, so

1 (1 i ) n
1 (1 0.0075) 24
P R
100
2188.91

i
0.0075

or $2188.91.

Applied Example: Saving for a College Education

As a savings program towards Albertos college education,

his parents decide to deposit $100 at the end of every

month into a bank account paying interest at the rate of
6% per year compounded monthly.
If the savings program began when Alberto was 6 years
old, how much money would have accumulated by the
time he turns 18?

Applied Example: Saving for a College Education

Solution
By the time the child turns 18, the parents would have
made
(18 6) 12 144
deposits into the account, so n = 144.
Furthermore, we have R = 100, r = 0.06, and m = 12, so
0.06
i
0.005
12
Using the future value of an annuity formula, we get

(1 i ) n 1
(1 0.005)144
1
S R
100
21,015

i
0.005

or $21,015.

Applied Example: Financing a Car

After making a down payment of $4000 for an automobile,

Murphy paid $400 per month for 36 months with interest

charged at 12% per year compounded monthly on the
unpaid balance.
What was the original cost of the car?
What portion of Murphys total car payments went
toward interest charges?

Applied Example: Financing a Car

Solution
The loan taken up by Murphy is given by the present
value of the annuity formula

1 (1 i ) n
1 (1 0.01) 36
P R
400
12,043

i
0.01

or $12,043.
Therefore, the original cost of the automobile is $16,043
($12,043 plus the $4000 down payment).
The interest charges paid by Murphy are given by
(36)(400) 12,043 = 2,357
or $2,357.

4.3
Amortization and Sinking Funds

Amortization Formula

The periodic payment R on a loan of P dollars

to be amortized over n periods with interest

charged at the rate of i per period is

Pi
R
1 (1 i ) n

Applied Example: Home Mortgage Payment

The Blakelys borrowed $120,000 from a bank to help

finance the purchase of a house.

The bank charges interest at a rate of 9% per year on the
unpaid balance, with interest computations made at the
end of each month.
The Blakelys have agreed to repay the loan in equal
monthly installments over 30 years.
How much should each payment be if the loan is to be
amortized at the end of term?

Applied Example: Home Mortgage Payment

Solution
Here, P = 120,000, i = r/m = 0.09/12 = 0.0075, and
n = (30)(12) = 360.
Using the amortization formula we find that the size of
each monthly installment required is given by
Pi
(120,000)(0.0075)
R

965.55
n
360
1 (1 i )
1 (1 0.0075)
or $965.55.

Applied Example: Home Affordability

The Jacksons have determined that, after making a down

payment, they could afford at most $2000 for a monthly

house payment.
The bank charges interest at a rate of 7.2% per year on the
unpaid balance, with interest computations made at the
end of each month.
If the loan is to be amortized in equal monthly
installments over 30 years, what is the maximum amount
that the Jacksons can borrow from the bank?

Applied Example: Home Affordability

Solution
We are required to find P, given i = r/m = 0.072/12 = 0.006, n
= (30)(12) = 360, and R = 2000.
We first solve for P in the amortization formula

R 1 (1 i ) n
i

Substituting the numerical values for R, n, and i we obtain

2000 1 (1 0.006) 360

0.006

294, 643

Therefore, the Jacksons can borrow at most $294,643.

Sinking Fund Payment

The periodic payment R required to accumulate

a sum of S dollars over n periods with interest

charged at the rate of i per period is

iS
R
(1 i ) n 1

Applied Example: Sinking Fund

The proprietor of Carson Hardware has decided to set up

a sinking fund for the purpose of purchasing a truck in 2

years time.
It is expected that the truck will cost $30,000.
If the fund earns 10% interest per year compounded
quarterly, determine the size of each (equal) quarterly
installment the proprietor should pay into the fund.

Applied Example: Sinking Fund

Solution
Here, S = 30,000, i = r/m = 0.1/4 = 0.025, and n = (2)(4) = 8.
Using the sinking fund payment formula we find that the
required size of each quarterly payment is given by

iS
(0.025)(30,000)
R

3434.02
n
8
(1 i ) 1 (1 0.025) 1
or $3434.02.

Exercise 1
Simple Interest
A company borrows $1,000,000
for 1 month at a simple interest rate of
9% per annum. How much must the
company pay back at the end of 1
month?
Answer : $1,007,500

Exercise 2
Simple Interest
Lily want to buy a stereo set worth
$500 in 9 months time. How much
should she invest at 3% simple interest
to have the money then?

Answer : $489

Exercise 3
Compound Interest
If $1000 is invested at 4% compounded
(a) Annually (b) Semiannually
(c) quarterly
(d) Monthly
What is the amount after 3 years?
How much interest is earned?
Answer:
(a)
$1124.86; interest earned is $124.86
(b)
$1126.16; interest earned is $126.16
(c)
$1126.82; interest earned is $126.82
(d)
$1127.27; interest earned is $127.27

Exercise 4
Compound Interest
How long will it take for an
investment to triple in value if it earns
5% compounded monthly?

Answer: approximately 22 years.

Exercise 5
Effective Rate of Interest
Find the effective rate of
interest corresponding to a
nominal rate of 17.5% per year
compounded monthly

Answer: 18.97%

Exercise 6
Future Value of an Annuity
Mary decides to put aside $100 every
month in an insurance fund that pay 8%
compounded monthly.
After making 8
deposits, how much money does Mary have?

1 i
S R
i

Answer: $818.92

Exercise 7
Present Value of an Annuity
Amber agrees to give the building fund
$1000 at the end of each year for the next 5
years. Tania wants to match Ambers gift,
but wants to make a lump-sum contribution
today. If the current rate is 9% per year
compounded annually, how much should
Tania contribute?
n

1 (1 i )
PR

Answer: $3889.65

Exercise 8
Annuity (Time)
How long would it take to save
$500,000 if you place $500 per month in an
account paying 6% compounded monthly?

1 i
S R
i

Answer: almost 30 years (359.25 months)

Exercise 9
Sinking fund Payment
Sheila wants to invest an amount every
3 months so that she will have $12,000 in 3
years to buy a new car. The account pay 8%
compounded quarterly. How much should
she deposit each quarter to have $12,000
after 12 deposits?
Answer: $894.72

Si
R
n
1 i 1

Exercise 10
Amortization
Mr. and Mrs. David have just purchased a
$300,000 house and have made a down
payment of $60,000. They can amortize the
balance at 6% for 30 years.
(a) What are the monthly payments?
(b) What is their total interest payment?
C) outstanding balance after 10 years.
Answer: (a) $1438.92
(b) $278,011.20

Pi
R
1 (1 i ) n

End of
Chapter