Mathschapter Four

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CHAPTER FOUR: Mathematics of Finance

4.1. OBJECTIVES OF THE CHAPTER

Up on completion of this chapter, you should be able to:


 Understand the key aspects of time value of money
 Know what is simple and compound interests are and their computation
 Know the principles of compounding and discounting
 Know the characteristics and objectives of ordinary annuities
 Perform computations relating to future value and present value of an annuity
 Understand the nature and computations related to mortgage loans.

4.2. Overview of Mathematics of Finance

I n this chapter we will introduce you to the mathematical methods and formulas that are useful in operation
of one’s own business.

From the financial stand point business transactions may be considered as inflows and outflows of funds over
time. Funds must be borrowed on long term, a year or longer basis to replace improve, or add to existing
facilities such as buildings, equipment, and machinery. Funds must also be borrowed on short term, less than
a year basis to meet immediate needs such as raw materials or obligations such as payroll. But money has
time value, that is, a birr today is worth more than a birr tomorrow, which is expressed in terms of interest
charges. Since the use of money bears interest, management needs to optimize the employment of investible
funds; it must evaluate a wide array of investment opportunities and choose the one which is most profitable.
Optimal allocation of investible funds requires the use of interest formulas. Dear learners, at this juncture, we
shall deal with simple interest, future and present value under simple interest, compound interest, compound
interest future and present value, annuity and other uniform payment formulas. Finally, we shall discuss a few
special cases relating to the sinking fund and mortgages.

4.3. Common terms

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To facilitate further studies in mathematics of finance, it is a must to have common understanding of
what the following terms mean.
i) Principal amount(p)
Is the amount of money that is initially being considered to be invested or deposited. It
might be an amount to be invested or loaned or the initial value or cost of plant or
machinery. Thus, if an individual was considering a bank loan of say Birr 50,000, this
would be referred to as the principal amount to be borrowed.
ii) Number of time periods (n)
The number of time periods over which an amount of money are being invested or
borrowed is normally a number of years, it could represent other time periods, such as a
number of quarters and months.
iii) Rate of interest (i)
Interest is the name given to proportionate amount of money which is added to some
principal amount (invested or borrowed). It is normally denoted by symbol r and
expressed as a percentage rate per annum. For instance, if Birr 100 is invested at an
interest rate of 10% per annum, it will accrue birr 100 + (10% x 100) = Birr 110 at the
end of one year.
iv) Accrued amount (A)
Generally refers to a principal amount after some time has elapsed for which interest has
been calculated and added.

4.4. kinds of interest

When an amount of money is invested over a number of years, the interest earned van be seen from
two perspectives.

4.4.1. simple interest

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Simple interest is a fixed percentage of the principal, P0 , which is paid to an investor each year,
irrespective of the number of years the principal has been left on deposit; that is, money invested at
simple interest will increase in value by the same amount each year. So, if the investor is paid a fixed
annual amount, i% of P0 , then the amount of simple interest, I, received over t years is given by the
formula

I = P0 x r x t

Therefore, the total value after t years, Pt is the principal plus interest and is given by
Pt = P0 +  P x r x t 
P1 = P0  1 + rt  ................................4.1

When the total value (future value), the interest rate and time are known, the principal
(Present value) may be calculated by rewriting formula (4.1) as

P0  1 + rt  = Pt
Pt
P0 = .....................................4.2
1 + rt
Simple interest is where any interest earned is not added back
to the principal amount invested. If for instance, birr 1000 is invested at 10% simple interest per
annum. The following table shows the state of the investment, year by year:

Table 4.1 Computation of Simple interest

Amount on which
Year interest is calculated Interest earned Cumulative amount
1 Birr 1,000 10%of Birr 1000 = 100 Birr 1,100
2 Birr 1,000 10%of Birr 1000 = 100 Birr 1,100
3 Birr 1,000 10%of Birr 1000 = 100 Birr 1,100
4 Birr 1,000 10%of Birr 1000 = 100 Birr 1,100

a) computation of the amount of simple interest

Assume that a person deposit a sum of money p in a saving account or borrow a sum of money p
from a lending institution. Then p is referred to as the principal. When money is borrowed a fee is

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charged which is called interest. Interest is usually computed as a percentage of the principal over a
given period of time. Dear learners, unless otherwise stated, the interest rate is an annual rate.

In general, if a principal p is borrowed at a rate r, then after t years the borrower will owe the lender
an amount A that will include the principal p plus the interest I. Since p is the amount that is
borrowed now and A is the amount that must be paid back in the future, p is often referred to as the
present value and A as the future value and is given by the following formulas respectively.

A= P+
Simple Interest
I
I=Pxrxt
= Where P+
Px I = amount of interest rxt
P = principal
A= r = annual simple interest rate P (1
+ rt) t = time in years

(Simple interest future value amount)

A P(1 + rt)
=
1 + rt 1 + rt
A
P= (Simple interest present value formula)
1 + rt

Given any three of the four variables A, P, r, and t, we can solve for the fourth. At this juncture,
however, you need to bear in mind that the time may be given in months, weeks or days. In simple
interest formula, t must be in years, and so conversion must be made.

Example 1

Mr. Abule borrowed a principal of Birr 1000 at 8% per year simple interest. Find the future value
after;

i) two yers
ii) three months
iii) 180 days

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Solution

Given

P =Birr 1,000

r = 0.08 per annum (8/100)

t = 2 years

i) A = P (1 + rt)
= 1,000 (1 + (0.08 x 2))
= 1,000 (1 + 0.16)
= 1,000 (1.16)
= 1,000 (1.16) = Birr 1,160
ii) A = P (1 + rt)

Here the time period is three months. So, conversion into years must be made and hence three
months corresponds to 3/12 = 0.25 year.
A = 1,000 (1 + (0.08 x 0.25))
= 1,000 (1 + 0.02)
= 1,000 (1.02)
= 1,000 (1.02) = Birr 1,020
iii) A = P (1 + rt)

Once more again, we have to convert 180 days into years. By assuming a year to have 360 days, 180
days corresponds to t = 180/360 = 0.5 year. Thus, from the simple interest formula

A = 1,000 (1 + (0.08 x 0.5))


= 1,000 (1 + 0.04)
= 1,000 (1.04)
= 1,000 (1.04) = Birr 1,040

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 Self check exercises 4.1

1. What rate of interest let a sum of money to double in 5 years?

2. How long does it take for a sum of money to triple at a 5% simple interest rate?

3. A saving account opened 3 months ago now has a balance of Birr 20,400. If the bank
pays 8% simple interest, how much money was deposited?

4. Find the amount that an investor should deposit in a bank today if he needs Birr 20,000
in 3 months at a simple interest rate of 9%.

5. What percentage of simple interest return must a firm get on their deposit if it wants its
Birr 25,000 to grow to birr 26,500 in 6 months?

6. Mr. Bitew wanted to buy a new car for his family. The cost of the car was Birr 250,000.
He was in short of cash and went to his local bank and borrowed Birr 150,000 for 6
years at an annual interest rate of 12%. Find the total simple interest and the maturity
value of the loan.

4.4.2. Compound Interest

Dear learners, at this juncture we need to have a look at another kind of interest computation.

If the interest which is due is added to the principal at the end of each interest period, then this
interest as well as the principal will earn interest during the next period. In such a case the interest is
said to be compounded.

The result of compounding interest is that starting with the second compounding the account earns
interest on interest in addition to earning interest on principal.

The sum of the original principal and all the interest earned is the Compound Amount. The
difference between compound amount and the original principal is the Compound interest.
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Example

Suppose that Birr 1,000 is invested at 10% compound interest. This situation can be described using
the following table, which shows the state of the investment year by year.

Table 4.2 Computation of Compound interest


Amount on which
Year interest is calculated Interest earned Cumulative amount
accrued
1 Birr 1,000 10% of Birr 1,000 = 100 Birr 1,100
2 Birr 1,100 10% of Birr 1,000 = 110 Birr 1,210
3 Birr 1,210 10% of Birr 1,000 = 121 Birr 1,331
4 Birr 1,331 10% of Birr 1,000 = 133.10 Birr 1,464.10

The difference between the methods of interest computation can easily be seen by comparing the
above two tables. By looking at the table, you can recognize that the amount on which simple
interest is calculated is always the same, while the amount varies year after year for compound
interest.

a) Amount of compound 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 payment period. Interest paid on
interest reinvested is called compound interest. Since interest rates are generally quoted as annual
nominal rates, the rate per compounding period is found by dividing the annual nominal rate by the
number of compounding periods per year.

The rate per period is equivalent to a nominal rate of 12% compounded for various periods is given
in the following table.

Table 4.3 Determination of conversion periods

12% interest compounded m (conversion period) i = r/m%

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Annually 1 12 or 0.12
Semi – annually 2 6 or 0.06
Quarterly 4 3 or 0.03
Monthly 12 1 or 0.01 as follows
 Compound interest future value can be computed
Weekly 52 12/52 = 0.23 or 0.0023
Daily 365 12/365 = 0.033 or 0.00033
A = P (1 + r/m)tm = P (1 + i) n i = r/m
In
Where
r = annual nominal rate
m = number of compounding periods per year
i = rate per compound period
n = total number of compounding periods
p = principal or present value
A = amount or future value at the end of n periods

general, if P is the principal earning interest compounded m times a year at an annual rate of r, then i
= r/m, the rate per period, the amount A at the end of each period is

A = P (1 + i) 1 at the end of 1st period

= P (1 + i) 2at the end of 2nd period

= P (1 + i) 3 at the end of 3rd period

= P (1 + i) n at the end of nth period

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Example

What are the compound amount and compound interest at the end of one year if Birr 10,000 is
borrowed at 8% compound quarterly?

Solution

P = Birr 10,000 Total number of conversions = 4

r = 8% t = one year

Total number of conversion periods (m) = 4 times = quarter

r 8%
.
i = m = 4 = 2%

Original principal………………………………………………..Birr 10,000

Add: interest for the 1st quarter, I = Br. 10,000 x .02……………Br. 200

Principal at the end of 1st quarter……………………………Br.10,200 = Br.10,000(1.02)1

Add: Interest for the 2nd quarter, 10,200 x .02…………………..Br. 204

Principal at the end of 2nd quarter……………………….......Br.10,404 = Br.10,000 (1.02)2

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Add: Interest for the 3rd quarter, 10,404x.02…………………….Br. 208.08

Principal at the end of 3rd quarter……………………………Br.10,612.08 = Br.10,000(1.02)3

Add: Interest for the 4th quarter, 10,612.08 x .02………………..Br. 212.2416

Principal at the end of 4th quarter………………………….Br.10,824.3216 = Br.10,000(1.02)4

(Amount at the end of the year)

 If we summarize the above computations, we will come up with a pattern that leads to a general
formula for computing compound interest:

 1st quarter: S = 10,000 (1.02)1


 2nd quarter: S = 10,000 (1.02) (1.02) = 10,000 (1.02)2
 3rd quarter: S = 10,000 (1.02) (1.02) (1.02) = 10,000 (1.02)3
 4th quarter: S = 10,000 (1.02) (1.02) (1.02) (1.02) = 10,000 (1.02)4

Therefore, for the above question, the amount is equal to

A = P (1 + I) n

= 10,000 (1.02)4

= 10,824.3216 Birr

F Compound Interest = Compound Amount - Original Principal

= 10,824.3216 - 10,000

= Birr 824.3216

Dear learners, compound amount can also be computed using Logarithm as follows.

A = 10,000 (1.02)4

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log A = log 10,000 + log (1.02)4

= log 10,000 + 4 log 1.02

= 4 + 4 (0.0086)

= 4+ 0.0344

log A = 4.0344

A = antilog 4.0344

= Br.10,824.30

EXAMPLE

Find the compound amount compound interest resulting from the investment of Birr 1000 at 6% for
10 years,

A. Compounded annually. E. compounded weekly


B. Compounded semiannually. F. Compounded daily
C. G. C
o
 Rules of Logarithms
m
p
1. log aa = 1
o
2. logmp = p logm
u
3. logmn = logm + logn
n
4. logm/n = logm - logn
d
e
d
Compounded quarterly. hourly
D. Compounded monthly. H. Compounded continuously

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Solution

A. P = Birr 1,000 A = p (1+i) n

t = 10 years = 1,000 (1.06)10

m=1 = Birr 1,790.85

r = 6%

A =? Compound interest = Compound amount - Principal

i = 6% = 1,790.85 - 1000

n = 10 = Birr 790.85 Birr

Solution

B. P = Birr 1,000 A = p (1+i) n

r = 6% = 1,000 (1.03)20

Solution m=2 = Birr 1,806.11

C. t = 10 years Compound interest = Compound amount - Principal


P = Birr 1,000 A = 1,000 (1.06) 40
i = 3% = 1,806.11 - 1000
r = 6% = Birr 1,814.02
Solution
n = 20 = Birr 806.11
m=4
D. P = Birr 1000 A = 1,000 (1.005) 120
t = 10 years Compound interest = Compound amount - Principal
r = 6% = Birr 1,819.40
Solution i = .015 = 1814.02 - 1000
t = 10 years
E. nP==40Birr 1000 A = 1,000 (1.0012)=520Birr 814.02
m=12 Compound interest = Compound amount - Principal
r = 6% = 1,821.49 Birr
i = .005 = 1,819.40 - 1000
t = 10 years
Solution Pn==Birr
1201000 = Birr
A = 1,000 (1.0001644) 3650 819.40
m=52 Compound interest = Compound amount - Principal
F. r = 6% = Birr 1,822.03
Solution i = .0012 = 1821.49 - 1000
t = 10 years
n = 520 = Birr 821.49
m=365
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i = .01644% = 1,822.03 - 1000

n = 3650 = Birr 822.03


G. P = Birr 1000 A = 1,000 (1.00000685)687,600
Solution
r = 6% = Birr 1,822.12
H .
tP==10Birr
years
1000 = 1,000 e.06x10 = 1000 e.6
(1+i) n
=
(1+r/m) m=
mt
r = 8760
6% Compound interest = Compound amount - Principal
= Birr 1,822.12
it ==.000685%
10 years ==
Compound interest 1,822.12 - 1000
Compound amount - Principal
nm==87600
infinite = Birr
1,822.12 - 1000 = Birr 822.12
822.12

mt mt
 r  1
1    1 
 1  m  x
 1
1    1
rxt 1  
f(x) =  x  x if x  1   approaches infinity  x x
 x
becomes closer to rt
2.71828 = e
 1  x 
 1   
Let m/r = x as m x    x  

r/m = 1/x = m = rx  e rt

A = Pert

B) TIME COMPUTATION

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EXAMPLE

1. How many years will it take for Birr 12,000 to grow to 24,000 when interest is 7% per
annum compounded annually?

Given

P = 12,000
A = 24,000
i = r/m = 0.07/1 0.07
n=?

Solution

A = P (1 + i) n
24,000 = 12,000 (1 +0.07) n dividing both sides by 12,000, we obtain,
2 = (1 + 0.07) n  taking logarithm of both sides
Log 2 = log 1.07 n  using log rule that log a b = b log a
Log 2 = n log 1.07  dividing both sides by log 1.07, we obtain
Log 2/log 1.07 = n

0.3010
n= = 10.24 years
0.0294
C) INTEREST RATE

EXAMPLE

What annual rate of interest compounded quarterly should one obtain if he/she wants to double
his/her investment in five years?

Here, if P is the principal, then A = 2P and n = 4 x 5 = 20, we want to find i/4 in the equation. i.e.
interest for a quarter.

2P P(1+i) 20
=
P P

2 = (1 + i) 20  taking logarithm of both sides


Log 2 = log (1 + i) 20  using log rule that log a b = b log a
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Log 2 = 20 log (1 + i)  dividing both sides by 20, we obtain
Log 2/20 = Log (1 + i)

0.3010
= Log (1 + i)
20
0.01505 log (1 + i)
1 + i = Antilog 0.01505
1 + i = 1.0353
i = 1.0353 – 1 = 0.0353

Hence, annual rate of interest needed to double the principal in 5 years is 4i = 4 x 0.0353 = 0.1412 or
14.12%.

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 Self check exercises 4.2

1. How much money should be deposited in a bank paying interest at a rate of 6%


compounded monthly so that at the end of 3 years accumulated amount is Birr 20,000?

2. How long will it take for Birr 40,000 to amount to Birr 70,000 if it is invested at 7%
compounded quarterly?

3. A firm wishing to have enough money for a retiring manager 17 years from now decided to
buy a Birr 30,000 face value zero coupon bond. If the money is worth 10% compounded
annually, what should they pay for the bond?

4. How long will it take to accumulate Birr 650 if Birr 500 is invested at 10% compound
quarterly?

5. Birr 2000 is deposited in an account. After one year of monthly compounding, the balance
in the account is Birr 2,166. What is the annual percentage rate for this account?

6. A person deposits Birr 10,000 in a savings account that pays 6% compounded semi-
annually. Three years later, this person deposits an additional Birr 8,000 in the savings
account. Also, at this time, the interest rates changes to 8% compounded quarterly. How
much money is in the account 5 years after the original Birr 10,000 is deposited?

4.5. Present Value

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Frequently it is necessary to determine the principal P which must be invested now at a given rate of
interest per conversion period in order that the compound amount A be accumulated at the end of n
conversion periods. This process is called discounting and the principal is now a discounted value of
a future income A.

A = P (1+i) n dividing both sides by (1+i) n leads to

A
P = (1  i ) = p = A (1+i)-n
n

Present values of a compound amount:

P = A (1+i)-n

Where:

p = principal / present value

A = compound amount (or future value)

i = interest rate per conversion period

n = total number of conversion periods

Example

Find the present value of a loan that will amount to Birr 5,000 in four years if
money is worth 10% compounded semi annually.

Solution

A = 5,000 Birr

t = 4 years

m=2

r = 10%

P =?

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P = A (1+i)-n

= 5,000 (1.05)-8

= Birr 3,384.20

 Self check exercises 4.3

1. How much must be deposited now in an account paying 6% compounded monthly in


order to have just 20,000 Birr in the account 4 years from now?

2. If money worth 14% compounded semi-annually, would it be better to discharge a debt


by paying Birr 500 now or Birr 600 eighteen months from now?

3. How much should be deposited in an account paying 8% compounded quarterly in


order to have a balance of Birr 8,000 nine years from now?

4.6. Effective Rate

Obviously, for a stated annual interest rate, the amount of interest accumulated depends upon the
frequency of conversion. This is because interest which has been earned subsequently earns interest
itself. When interest is compounded more than once a year, the stated annual rate is called a
Nominal Rate. The effective rate corresponding to a given nominal rate r converted m times a year
is the simple interest rate that would produce an equivalent amount of interest in one year.
Effective rates are, therefore, the simple interest rates that would produce the same return in one year
had the same principal been invested at simple interest without compounding.

If P = Principal, A = Amount, r = nominal rate, m = number of conversion periods per year, the
compound interest for one year on principal p is,

I=A-P

= p (1 + r/m) m - p
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Compound int erest I
=
The effective rate of interest is (re)= principal P . From the above statement:

I = p (1 + r/m) m - p

= P [(1+r/m) m - 1) Divide both sides by p

r m
I/p =
P 1+
[( ) ]
m
−1

m
r
re =
( )
1+
m
−1

= (1+i) m - 1

In continuous compounding case:

A = Pert for one year A = Per

I=A-P

= Per - p, multiplying both sides by 1/p

1/p x I = P (er-1) x 1/p

re = er-1

c Effective rates are used to compare competing interest rates offered by banks and other
financial institutions.

Example

1. What is the effective rate of money invested at 6% compounded quarterly?

Solution

R = 6% re = (1+r/m)m-1

m=4

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.06
= (1+ 4 ) 4 - 1

= (1.015)4 -1

re = 6.14%

2. An investor has two opportunities to invest his money. The first investment opportunity
(opportunity A) pays 15% compounded monthly and the second investment opportunity
(opportunity B) pays 15.2% compounded semiannually. Which is the better investment,
assuming all other things constant?

Solution

Nominal rates with different compounding periods cannot be compared directly. We must first find
the effective rate of each nominal rate and then compare the effective rates to determine which
investment will yield the larger return.

Effective rate for investment opportunity. A Effective rate for investment opportunity B

re= (1+r/m)m - 1 re= (1+r/m)m - 1

115 12  115
2

(
1+
12 )−1 1 

 1
12 
12
(1. 0125 ) −1 (1.076) 2  1
= 16. 075 % = 15.778%

Since the effective rate for A is greater than the effective rate for B, Investment opportunity A is the
preferred investment.

 Self check exercises 4.4

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1. A bank states that the effective interest on savings accounts that earn continuous
interest is 10%. Find the nominal rate.

2. Find the effective rate of interest corresponding to a nominal rate of 9% per year
compounded;
A) Semi annually
B) Quarterly
C) Monthly

3. A saving account opened 3 months ago now has a balance of Birr 20,400. If the bank
pays 8% simple interest, how much money was deposited?

4.7. ANNUITIES

The term annuity is derived from the Latin word annum which means annual payment of a fixed
amount. But as a matter of practice, it means any periodical 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 or to
meet some amount of accumulations.

4.7.1. Characteristics of Annuity

Annuity is recurring payment of fixed amount payable either annually, semi annually, quarterly,
monthly or the like. It warrants accounting for compound interest at an agreed time. Annuity is paid
against a lump sum received at present or a compounded amount receivable after a certain period. It
is paid either for a certain number of periods or till the happening of certain contingent event or
forever. Its payment starts either immediately or remains deferred for a certain period for fulfillment

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of certain conditions. The payment is made at the end of every period and sometimes at the
beginning.

4.7.2. Objectives of an annuity

An annuity is meant to charge an existing debt in certain number of installments inclusive of


compound interest at a stipulated rate. Similarly, annuity might also be used to create a fund to
redeem a liability or to replace an asset in the future without disturbing the financial position of a
person. An annuity is also applicable for someone or firm to secure a regular income for one’s bread
or any other purpose. Finally, an annuity is a good mechanism for determining the value of the
regular installments payable or receivable under a contract or to determine the present value to be set
aside under a contract.

4.7.3. Amount (FUTURE VALUE) of an ordinary annuity

Dear learners, in this we will consider ordinary annuities that are certain and simple, with periodic
payments that are equal in size in other words, we will deal with annuities that are subject to the
following conditions.

i) The terms are given by fixed time intervals


ii) The periodic payments are equal in size
iii) The payments are made at the end of the payment periods
iv) The payment periods coincide with the interest conversion periods

EXAMPLE 1

1. What is the amount of an annuity if the size of each payment is Birr 100 payable at the end of
each quarter for one year at an interest rate of 4% compounded quarterly?

Solution
Periodic payment (R) = Birr 100
Payment interval = conversion period = quarter
Nominal (annual rate), r = 4%

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Interest rate per conversion period (i) = r/m = 4%/4 = 1%
Future value of (sum of) an annuity =?
Term one year

Now 1 2 3 4
0 100Birr 100 Birr 100 Birr 100 Birr

Birr 100

Birr 100 (1.01)1

Birr 100 (1.01)2

Birr 100 (1.01)3

Birr 100 (1.01)4

A = Birr 406.04
Compound interest = Amount - R (n)

= 406.04 - 100(4) = Birr 6.04

Taking

R = amount of periodic payment


I = interest rate per payment period
n = total number of payment periods
A = Future value (Amount) of an Ordinary Annuity at the end of its term.

Last payment R
The second payment from the last R(1+i)1
TheUniversity,
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The second payment R(1+i)n-2
The first payment R(1+i)n-1
A = R + R (1 + i) 1 + R (1+i) 2 + ------ + R (1+i) n-2 + R (1+i) n-1 ……………………. (1) Multiplying
each side of the equation by 1+i, we obtain

A (1+i) = R (1+i) + R (1+i) 2 + R (1+i) 3 + ---- + R (1+i) n-1 + R (1+i) n ……………………. (2) Then
subtracting the first equation from the second equation, we have

A (1+i) = R (1+i) + R (1+i) 2 + ------ + R (1 + i) n-1 + R (1+i) n


- A = R + R (1+I) 1 + R (+i) 2 + ---- + R (1+i) n-1
A (1+i) - A = R (1+i) n-R
A [1+i-1] = R [(1+i) n-1]

(1+i)n −1
A (i) = R [(1+i) n-1] dividing both sides by i, we have, A =
R [ i ]
1−(1+i)−n
P= R [ i ] (1 + i) n -1]
i = future value factor.
4
[(1. 01) -1]
For the above example: A = 100 0 . 01 = Birr 406.04

EXAMPLE 2

A newly married couple are both working and decide to have Birr 1000 at the end of a month for a down
payment on a home. The account earns 12% compound monthly. How large a down payment will they
have saved in three years?

Solution

R = Birr 1000 Compound interest = A - R(n)

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t = 3 years. [ (1 + i) n - 1]
A=
m = 12 i = 43,076.88 - 36,000
1000 [ (1.01) 36 - 1]
=
n = 36 0.01 = Birr 7,076,88
= Birr 43,076.88
r = 12%

i=1%

A =?
EXAMPLE 3

Awash International Bank (AIB) pays interest at 8% per annum compounded semi annually. If Mr.
Shemsu places Birr 5,000 in AIB at the end of every 6 months, how much will be in his account after
5 years?

Solution

The case is an ordinary annuity consisting of 10 payments of Birr 5,000 each earning 0.04 interest
per period. Thus, the required amount is given by,

[ (1 + i) n - 1]
A=
i
Where, R = 5,000
n = 10 and
0.08
I= = 0.04
2

 1 + 0.04 10    1.04  10 - 1 


Therefore, A =   - 1 = 5,000  
 0.04    0.04 
 

= 5,000 (12.006107) = Birr 60, 030.535

4.7.4. Sinking fund (increasing annuity)

A Sinking fund is a fund in to which equal periodic payments are made in order to accumulate a
specified amount at some point in the future. Sinking funds are generally established in order to
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satisfy some financial obligation or to reach some financial goal. If the payments are to be made in
the form of an ordinary annuity, then the required periodic payment into the sinking fund can be
determined by reference to the formula for the amount of an ordinary annuity. That is, if

 1 + i  n -1
 
A=R 
i

Then,
A
R=
  1 + i  n -1
 
i
 i 
R=A  
  1 + i  n  1
 

Example

1. What monthly deposit will produce a balance of Birr 100,000 after 10 years? Assume that the
annual percentage rate is 6% compounded monthly. What is the total amount deposited over the
10-year period?

Solution

A = Birr 100,000  i 
R=A  
  1 + i  n - 1
t = 10years  

m = 12  0.005 
R = 100,000  
  1.005 120 - 1 
r = 6%  

R =? R = 100,000  0.006102 
R = Birr 610.21

The total amount deposited over the 10-yr period is 120 (610.21) = Birr 73,225.
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 Self check exercises 4.5

1. A newly married couple are both working and decide to have Birr 1000 at the end of a
month for a down payment on a home. The account earns 12% compound monthly.
How large a down payment will they have saved in three years?

2. A person deposits Birr 500 a year for 10 years in to an account that pays 6%
compounded annually. After 10 years the person transfers the money into another
account that pays 8% compounded quarterly. The money is left in the second account for
8 years. What is the balance after the 18-year period?

3. Debebe wants to settle a debt of Birr 12,000 to be paid 10 years from now. If deposit
earns interest at the rate of 5% compounded annually, how much money should he
deposit at the end of each year for the coming 10 years?

4. A loan of 15,000 with interest rate of 10% compounded semi annually must be paid off
in one payment after 3 years. In order to settle this amount, quarterly payments are to be
placed in sinking fund which pays 16% compounded quarterly how much should each
quarterly payment be?

5. Mrs. Hiwot has planned to save Birr 25,000 which she would like to reach 10 years from
now. During the first 5 years, she is financially able to deposit only Birr 100 each month
into the saving account. What must her monthly deposit over the last 5 years be if she is
to reach her goals? The account pays 12% interest compounded monthly.

6. 20 Birr is deposited at the end of each quarter for 5 years in Commercial Bank of
Ethiopia (CBE) which pays 12% interest compounded quarterly. If CBE decides to
increase its nominal interest rate to 16% compounded quarterly after 3 years,

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A.) What will be the amount of the annuity at the end of the 5 year term?
B.) What is the total interest that is earned?

7. An employee deposits Birr 150 at the end of each month in a credit union saving plan
that pays an interest rate of 12% compounded monthly. If the monthly periodic payments
have increased to Birr 200 after the 8th payment,

A) What is the balance after one year?


B) What is the amount of interest that is earned?

4.7.5. Sinking Fund Schedule

The accumulation of value in a sinking fund is illustrated by a sinking fund schedule.

Example

Mr. Gedion wishes to set aside semiannual payments to purchase machinery after two years (two
years from now). The machinery's estimated cost is Birr 5000. Each payment earns interest at
12%compounded semiannually.

A) Find the semiannual payment


B) Find the total interest earned
C) Prepare a sinking fund schedule

Solution
 i 
R=A  
A = Birr5000 A)   1 + i  n - 1
 
t = 2 years
m=2  .06 
= 5000  
r = 12%   1.06  4 - 1 
 
i= 6% = Birr 1,142.96

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n= 4
R=? B) Interest = Amount - R (n)

= 5000 - 1,142.96(4)

= Birr 428.16

C)

Payment Payment (R) Interest* Total


number

1 Birr 1,142.96 Birr 0 Birr 1,142.96

2 Birr 1,142.96 Birr 68.58 Birr 2,354.50

3 Birr 1,142.96 Birr 141.27 Birr 3,638.73

4 Birr 1,142.96 Birr 218.32 Birr 5000.01

Birr 428.16

* Interest = balance xi

4.7.6. Present Value of an Ordinary Annuity

The present value of an ordinary annuity is the amount of money today, which is equivalent to the
sum of a series of equal payment in the future. It is the sum of the present values of the periodic

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payments of an annuity, each discounted to the beginning of an annuity. The present value represents
the amount that must be invested now to purchase the payment due in the future.

In short, PV of an ordinary annuity can be computed in two ways:

1) Discounting all periodic payment to the beginning of the term individually.


2) Discounting the amount of an ordinary annuity to the beginning of the term.

Example

What is the PV of an annuity if the size of each payment is Birr 200 payable at the end of each
quarter for one year and the interest rate is 8% compounded quarterly?

Solution

R = Birr 200 r = 8%

m=4 t = 1yr

P =?

P______________________________________________________A
0 1 2 3 4
196.10 = 200 (1.02)-1 ……...200

192.23 = 200 (1.02)-2……………………200

188.46 = 200 (1.02)-3………………………………….200

184.77 = 200 (1.02)-4……………………………………………… 200


Birr 761.56

Equivalently: Find the FV of the ordinary annuity using the formula A = R [(1+i)n - 1]

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(1+i)n −1
A=
R [i ]
 (1.02)4 - 1 
200  
 0.02 

= Birr 824.32

Discount this future value to the present value taking it as single FV.

P = 824.32 (1.02)-4

= Birr 761.56

We have seen that the future value of an ordinary annuity after n payment periods is A = R [(1+i) n -
1], and also we have seen that the PV of a lamp sum investment after n periods with interest rate i
per period is: P (1+i) n. The future value of an annuity and the future value of the lamp sum payment
should be equal at the end of n periods; thus,

R (1 + i) n = 
  
R  (1 + i) n -1 

Devidingbothsidesby(1 + i) ngives
i
R 1 - (1 + i)-n 
P=   (OR)
i
If we multiply the FV of an Ordinary annuity by the compound discount factor
we have the present value of an annuity.

R (1 + i)-n  1 (1 + i)-n


P=  
i
R (1 + i) n (1 + i)-n -1 (1 + i)-n 
=  
i
R (1 + i)0 -1 (1 + i)-n 
 
=
i

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 1 - (1 + i)-n 
P = R  
 i 

Using the above formula; the PV of the former example is computed as:
R = Birr 200  1 - (1 + i)-n 
P = R  
r = 8%  i 
m=4
 1 - (1.02)-4 
t = 1yr P = 200  
 0.02 
P =?
= 200 (3.08773)

= Birr 761.55

4.7.7. Amortization (Decreasing Annuity)

Amortization means retiring a debt in a given length of time by equal periodic payments that include
compound interest. After the last payment, the obligation ceases to exist-it is dead-and it is said to
have been amortized by the payments.

In amortization our interest is to determine the periodic payment, R, so as to amortize (retire) a debt
at the end of the last payment. Solving the PV of ordinary annuity formula for R in terms of the other
variables, we obtain the following amortization formula:

 i 
R = P  
1 -  1 + i  - n 
 

Where:

R = periodic payment

P = PV of loan

i= interest rate per period

n = number of payment periods

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Example

1. Suppose you borrow Birr 5000 from a bank and agree to repay the loan in five equal installments
including all interests due. The bank’s interest charges are 5% compounded annually. How much
should each annual payment be in order to retire the debt including the interest in 5 years?

Solution

PV = Birr 5000 r = 5%
t = 5years R =?
m=1

 0.05 
R = 5,000  
1 -  1.05  -5 
 

= 5000(.230975)

Interest = (1,154.87 X 5) – 5000

= Birr 774.35

Example 2

Maritu signed a loan for Birr 10,000. The loan is to be repaid with equal yearly payments for the first
three years and equal yearly payments twice as large for the next four years. If the interest rate is
12% compounded annually, find the yearly payments. Assume each payment is made at the end of
each year.

Solution

Draw the time line as follows.

0 1 2 3 4 5 6 7
x x x 2x 2x 2x 2x

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Dear learners, here, you can observe that x denotes the first three annual payments and 2x denotes
the remaining payments. Then we choose a comparison payment. If the comparison point chosen
is to be the end of the third year, then the annuity consisting of three payments of x Birr each must
be brought forward to the comparison point. This is done by multiplying x by the future value factor
of an ordinary annuity. Also, the annuity consisting of four payments of 2x Birr each must be
brought back to the comparison point. This done by multiplying 2x by the present value factor of an
ordinary annuity. Finally, Birr 10,000 must be brought forward to the comparison point by
multiplying it by future value factor of a single deposit. Hence, the equation of value is,

 (1 + 0.12)3 - 1   1 - (1 + 0.12)-4 
x   + 2x   = 10,000 (1 + 0.12)3
 0.12   0.12 

 (1 + 12)3 - 1   1-(1+.12)-4 
x   + 2x   = 10,000(1+.12)3
 .12  .12 
x (3.374400) + 2x (3.037349) = 10,000 (1.404928)
Solving for x, we have
3.3744x + 6.074698x = 14,049.28
x = Birr 1,486.84

 (1 + 0.12)3 - 1   1 - (1 + 0.12)-4 
x   + 2x   = 10,000 (1 + 0.12)3
 0.12   0.12 

x (3.374400) + 2x (3.037349) = 10,000 (1.404928)


Solving for x, we have
3.3744x + 6.074698x = 14,049.28
x = Birr 1,486.84

4.7.8. AMORTIZATION SCHEDULE

EXAMPLE

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Ato Kebebew borrowed Birr 7000. The loan plus the interest is to be repaid in equal quarterly
installments made at the end of each quarter during a 2 year interval. The interest rate is 16%
compounded quarterly.

A) Find the quarterly payment


B) Find the interest accumulated
C) Prepare an amortization schedule

Solution

P = Birr 7000 A)
 i 
r = 16%, i = 4% R = P 
 1 -  1 + i  -n 
m=4  
t = 2 years, n = 8  
.04
R =? R = 7000  
 1 -  1.04  -8 
 
R = Birr 1,039.69

B) Interest accumulated = R (n) - A

= 1,039.69(8) - 7,000

= Birr 1317.52

C) Amortization schedule

Payment Payment Interest Principal reduction Balance


No.
0 Birr 7,000.00

1 Birr 1,039.69 Birr 280.00 Birr 759.69 6,420.31


2 1,039.69 249.61 790.08 5,450.23

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3 1,039.69 218.01 821.68 4628.55
4 1,039.69 185.14 854.55 3774.00
5 1,039.69 150.96 888.73 2885.27
6 1,039.69 115.41 924.28 1960.99
7 1,039.69 78.44 961.25 999.74
8 1,039.69 39.99 999.74 0.00
Birr 1,317.56

4.7.9. Mortgage Payments

In atypical house purchase transaction, the home-buyer pays part of the cost in cash and borrows the
remained needed, usually from a bank or a savings and loan association. The buyer amortizes the
indebtedness by periodic payments over a period of time. Typically, payments are monthly and the
time period is long-30 years is not unusual.

Mortgage payment and amortization are similar. The only differences are
 The time period in which the debt/loan is amortized/repaid
 The amount borrowed.
 In mortgage payments m is equal to 12 because the loan is repaid from monthly salary, but in
amortization m may take other values.

In Mortgage payments we are interested in the determination of monthly payments.

Taking A = total debt


R = monthly mortgage payment
r = stated nominal rate per annum
n = 12 x t

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R can be determined as follows:

 r/12   i 
R= A   (OR) R =A  
 1 -  1 + r/12  -n  1 -  1 + i  -n 
   

1 −( 1 + i )−n
Similarly
A=R [i ]

Example

Mr. X purchased a house for Birr 115,000. He made a 20% down payment with the balance
amortized by a 30 yr mortgage at an annual interest of 12% compounded monthly.

A) What is the amount that Mr. X should pay monthly so as to retire the debt at the end of the 30 th
yr?
B) Find the interest charged.

Solution

Selling price = Birr 115,000 r = 12% i= 1%

Down payment = (20%) 23,000 m = 12 t = 30yrs

Mortgage (A) = Birr 92,000 n= 360

R =?

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 i 
R= A 
 1 -  1 + i  -n 
 

 .01 
R = 92,000  
 1 -  1.01 -360 
 

= 92,000 (.010286125)
= Birr 946.32

Interest = Actual payment - Mortgage (loan)


= (946.32 X 360) - 92000
= Birr 340,675.20 - 92,000
= Birr 248,675.20

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 Self check exercises 4.6

1. What is the cash value of a car that can be bought for Birr 200 down payment and Birr
82 a month for 18 months, if money is worth 12% interest compounded monthly?

2. How much should you deposit in an account paying 6% compounded quarterly in order
to be able to withdraw Birr 1000 every 3 months for the next 3 years?

3. What is the present value of an annuity of seven payments of Birr 1000 each made at the
end of each quarter with an interest rate of 12% compounded monthly?

4. At the time of retirement, a person has Birr 200,000 in an account that pays 12%
compounded monthly. If he decides to withdraw equal monthly payments for 10 years,
at the end of which time the account will have a zero balance, how much should he
withdraw each month?

5. Mrs. Almaz purchased a house for Birr 50,000. She made an amount of down payment
and pay monthly Birr 600 to retire the mortgage for 20 years at an annual interest rate of
24% compounded monthly.

Required: Find the mortgage, down payment, interest charged, and the percentage of the
down payment to the selling price.

CHAPTER SUMMARY

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 Mathematics of finance deals with time value of money. A birr today is better than one birr
tomorrow. The reason is a birr earned today earns an interest which makes it value more than a
birr.

 There are two types of interest. Simple interest and compound interest. Simple interest is the
case where any interest earned is not added back to the principal amount invested.

 Compound interest is the case where interest earned the previous interest period earns another
interest for the next interest period.

 Annuity is any periodical 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 or to meet some amount of
accumulations.

 Annuity is used to create a fund to redeem a liability or to replace an asset in the future without
disturbing the financial position of a person. An annuity is also applicable for someone or firm
to secure a regular income for one’s bread or any other purpose. Finally, an annuity is a good
mechanism for determining the value of the regular installments payable or receivable under a
contract or to determine the present value to be set aside under a contract.

 A sinking fund is created through periodical contributions of equal amount for a certain period
with a view to raising an accumulated sum inclusive of compound interest at a certain rate per
annum to meet the redemption of an existing debt or replacement of an existing asset.

 A sinking fund payment is funds in to which equal periodic payment are made. An account that
is established for accumulating funds to meet future obligations debts is called is called a
sinking Fund. It involves determination of the periodic payment (R) to accumulate a future
value (S).

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 The present value of an ordinary annuity is the sum of the present values of all the payments,
each discounted to the beginning of the term of the annuity.

 Amortization means retiring a debt in a given length of time by making equal periodic payments
that include compound interest. After the last payment, the obligation ceases to exist and is said
to have been amortized by periodic payments.

 In a typical home purchase transaction, the home buyer pays part of the cost in cash and
borrows the remaining needed; usually from bank or savings and loan associations. The buyer
amortizes the indebtness by periodic payments over a period of time.

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