7mathematics of Finance2

MATHEMATICS of
FINANCE
Interest
interest may be defined as the charge for using the borrowed money.
It is an expense for the person who borrows money and income for the
person who lends money. Interest is charged on principal amount at a
certain rate for a certain period. For example, 10% per year, 4% per quarter
or 2% per month etc. Principal amount means the amount of money that is
originally borrowed from an individual or a financial institution. It does not
include interest. In practice, the interest is charged using one of two
methods. These are:
simple interest method

compound interest method
These two methods are briefly explained below:

Simple interest method:
Under this method, the interest is charged only on the amount originally lent
(principal amount) to the borrower. Interest is not charged on any
accumulated interest under this method. Simple interest is usually charged
on short-term borrowings.
Simple interest formula:

Simple interest can be easily computed using the following formula:
Where;
I = Simple interest in dollars
P = Principal amount
i = rate of interest
n = number of periods
Example 1:
A loan of $10,000 has been issued for 6-years. Compute the amount
to be repaid by borrower to the lender if simple interest is charged @ 5% per
year.
Solution:
P = $1,000; i = 5%; n = 5
By putting the values of P, i and n into the simple interest formula:
I=P×i×n
= $10,000 × 5% × 6
= $10,000 × .05 × 6
= $3,000
At the end of sixth year, the amount of $13,000 ($10,000 principal + $3,000
interest for six years) will be repaid to the lender.
Compound interest method:
Compounding of interest is very common. Under this method, the
interest is charged on principal plus any accumulated interest. The
amount of interest for a period is added to the amount of principal to
compute the interest for next period. In other words, the interest is
reinvested to earn more interest. The interest may be compounded monthly,
quarterly, semiannually or annually. Consider the following example to
understand the whole procedure of compounding.
Example 2:
Suppose, you have deposited $100 with a bank for five years at a rate of 5%
per year compounded annually. The interest for the first year will be
computed on $100 and you will have $105 ($100 principal + $5 interest) at
the end of first year. The interest for the second year will be computed on
$105 and at the end of second year you will have $110.25 ($105 principal +
5.25 interest). The interest for the third year will be computed on $110.25
and at the end of third year you will have $115.76 (110.25 principal + 5.51
interest). The following table shows the computation for 5-year period of
investment.
Under compound interest system, when interest is added to the principal
amount, the resulting figure is known as compound amount. In the above
table, the compound amount at the end of each year have been computed in
the last column. Notice that the compound amount at the end of a year
becomes the principal amount to compute the interest for the next year.
Compound amount and compound interest formula:

The above procedure of computing compound amount and compound interest
is lengthy and time consuming. Fortunately, the formulas are available to
compute compound amount and compound interest for any number of periods.
Compound amount formula:
Where;
A = Compound amount
P = Principal amount
i = rate of interest
n = number of periods
Compound interest formula:
Compound interest = Compound amount – Principal amount
Example 3:
The City Bank has issued a loan of $100 to a sole proprietor for a
period of 5-years. The interest rate for this loan is 5% and the interest
is compounded annually. Compute
compound amount
compound interest
Computation of compound amount:

A = P(1 + i)n
= $1,000 × (1 + 5%)5
= $1,000 × (1 + .05)5
= $1,000 × (1.05)5
= $1,000 × 1.276
= $1,276
Computation of compound interest:
Once the compound amount has been computed, the amount of

interest earned over the investment period can be computed by
subtracting principal amount from the compound amount. In this
example, the principle amount is $1,000 and the compound amount
computed above is $1,276. The amount of compound interest for the
fiver year period can be computed as follows:
Compound interest = Compound amount – Principle amount
= $1276 – $1,000
= $276
Use of future value of $1 table to compute compound amount:
The shortest and easiest method to compute compound amount is to

use the future value of $1 table. This table contains the value of (1 +
i)n for a given value of i and n. After locating the value of (1 + i)n in the
table, the principal amount is simply multiplied with the value to find the
compound amount. The principal amount is then subtracted from
compound amount to get the amount of compound interest for the given
interest rate and time period.
= $1,000 × (1 + 5%)5
= $1,000 × 1.276*
= $1,276
Compound interest : $1,276 – $1,000 = $276

*Value of (1 + 5%)5 from future value of $1 table: 5 periods; 5% interest
rate.
The future value tables are widely used in accounting and finance to
save time and avoid unnecessary computations.
Compound interest is greater than simple interest:
Compound interest is greater than simple interest. The reason is very

simple. Under simple interest system, the interest is computed only on
principal amount whereas under compound interest system, the
interest is computed on principle as well as on accumulated interest.
Consider the following example for the explanation of this point:
Example 4:
A woman has deposited $6,000 in a saving account. Bank pays
Interest at a rate of 9% per year.
Required: Compute the amount of interest that will be earned over 12-year
period:
if the interest is simple?
if the interest is compounded annually?
Solution:
(1) Simple interest:
= $6,000 × 0.09 × 12
= $6,480
(2) Compound interest:
= $6,000 × (1 + 9%)12
= $6,000 × 2.813*
= $16,878
Compound interest = $16,878 – $6,000
= $10,878
Notice that compound interest is more than simple interest by $4,398 ($10,878 –
$6,480).
*Value of (1 + 9%)12 from future value of $1 table: 12 periods; 9% interest rate.

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MATHEMATICS of

simple interest method

These two methods are briefly explained below:

Simple interest formula:

Compound amount and compound interest formula:

Compound amount formula:

Compound interest = Compound amount – Principal amount

Computation of compound amount:

Once the compound amount has been computed, the amount of

Compound interest = Compound amount – Principle amount

The shortest and easiest method to compute compound amount is to

Compound interest : $1,276 – $1,000 = $276

Compound interest is greater than simple interest. The reason is very

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