Maths CH 4@2014

Chapter Four
Mathematics of Finance
 The basic concept of mathematics of finance is that money has time
value.
 In principle money of today is not equal with money of tomorrow
 Today money worth than tomorrows money
 That is, a bird at hand worth two in the forest.
 To bridge this gap, the concept of interest was introduced
 Interest is the price paid for the use of a sum of money over a period
of time.
 It is the charge for exchanging money now for money later.
 There re two ways of computing interest
 Simple interest.
 Compound interest.
Simple Interest
 case when interest is paid on the initial amount only and not on
subsequently accrued interest
 Principal:-the original sum of money lent (borrowed or invested)
 Interest rate:- a percentage of the principal for a specified period
of time which is generally a year.
 Future amount or maturity value :-The sum of the original
amount (principal) and the total interest. A = P + I
Simple interest is generally used only on short term notes often of
duration less than one year
 Simple interest is given by the formula: I = Prt
Where P= principal amount/ original amount borrowed or invested
r = Simple interest rate per year (expressed in decimal)
t= duration of the loan or investment in years
I = amount of interest in Birr.
 Taking P= principal, r = rate of interest, t = time in years and A = amount,
their relationship is as follows:
regular
Example 1: Mr. X wanted to buy a leather sofa for his new family room. The
cost of the sofa was Birr 10,000. He was short of cash and went to his local
bank and borrowed Birr 10,000 for 6 months at an annual interest rate of
12%. Find the total simple interest and the maturity value of the loan.
Example 2:-How long will it take if Birr 20,000 is invested at 5% simple
interest to double in value?
Example 3:-At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?
Example 4: How much money must Mr. Z has to invest today at 6% simple
interest if he is to receive Birr 3,100 as an amount in 4 years?
 When time over which interest is paid is given in months, t is simply the
number of month divided by 12.
 If time is given as a number of days, then one of two methods of
computing t may be used:
 Ordinary interest year - uses a 360 - day year, t= #of days/360
 Exact time- uses a 365-day year, t = #of days/365
regulr
Example 5:- Find the interest on Birr 1,000 at 5% for 45 days.
CEP
Example 1: You borrow $10,000 for 3 years at 5% simple annual

interest. Interest = prn = 10,000 x 0.05 x 3 = 1,500
Example 2: You borrow $10,000 for 60 days at 5% simple interest
per year (assume a 365 day year).
Interest = prn = 10,000 x 0.05 x (60/365) = 82.1917
Example 3: At what interest rate will Birr 6,000 yield 900
Birr in 5 years time?
 Compound Interest:- case when the interest for each period is
added to the principal in computing the interest for the next period.
 Compound Amount:-the sum of the original principal and all the
interest earned
 Compound interest:-the difference between compound amount
and the original principal
The compound interest method is generally used in long-term
borrowing.
 Interest period or conversion period or compounding period:-the time
interval between successive conversions of interest into principal.
In Short, Amount with compound interest is calculated as:
regular
Example 1:- Find the compound amount compound interest resulting from
the investment of Birr 1000 at 6% for 10 years, Compounded annually,
Compounded semiannually, compounded quarterly, Compounded monthly,
compounded weekly, Compounded daily, Compounded hourly,
Compounded continuously (instantaneously).
Example 2:-How long will it take to accumulate Birr 650 if Birr 500 is
invested at 10% compound quarterly?
Example 3:- 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?
CEP
Example 1: Find the compound amount compound interest resulting from the
investment of Birr 1000 at 6% for 10 years, compounded annually,
semiannually, quarterly, monthly, weekly, daily, hourly and continuously
(instantaneously)?
Example 2:-How long will it take to accumulate Birr 650 if Birr 500 is invested
at 10% compound quarterly?
Example 3:- 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?
Present Value
 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 Amount, A.
REGULR
Example 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?
Example 2:- 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.
Example 3: 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?
ANNUITIES
 An annuity is a sequence of EQUAL, PERIODIC PAYMENTS.
 The payments may be made weekly, monthly, quarterly, semi-annually,
annually or for any fixed period of time.
 PAYMENT PERIOD:- The time between successive payments.
 PERIODIC PAYMENT or PERIODIC RENT:-Each payment made

periodically and it is denoted by R.
 TERM of an annuity:-The time from the beginning of the first

payment period to the end of the last period.
There are two Types of Annuity
 ORDINARY ANNUITY:- equal periodic payments in which each
payment is made at the end of the period.
 ANNUITY DUE:- equal periodic payments in which each
payments are made at the beginning of the payment period.
AMOUNT (FUTURE VALUE) OF AN ORDINARY ANNUITY

 The amount (future value) of an ordinary annuity is the sum of all
payments plus all interests earned.
Example 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?
Example 2:- A person deposits Birr 200 a month for four years in to an
account that pays 7% compounded monthly. After the four years, the person
leaves the account untouched for an additional six years. What is the balance
after the 10 year period?
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 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 a mount of an ordinary
annuity. That is, if
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?
Example 2:-Mrs. X has a saving goal of Birr 25,000 which she

would like to reach 10 years from now. During the first five
years she is financially able to deposit only Birr 100 each month
into the savings account. What must her monthly deposits over the
last five years be if she is to reach the goal? The account pays 12% interest
compounded monthly.
Sinking Fund Schedule
 The accumulation of value in a sinking fund is illustrated by a
sinking fund schedule.
Example: A business man 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
Present Value of an Ordinary Annuity
It 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 payments of an
annuity, each discounted to the beginning of an annuity.
Example 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?
Example 2:-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 quarterly?
Example 3:- A business person's debt is payable as follows: Birr 2,000 1

year from now and Birr 5,000 5 years from now. The business person
wants to repay the debt as follows: a Birr 1,000 payment now, a Birr 2,000
payment 2 years from now, a Birr 1,000 payment 3 years from now, and
the last payment 4 years from now. If the interest rate is 12% compounded
annually, find the amount of the last payment.
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

Example 1:- Suppose you borrow Birr 5000 from a bank and agree to repay
the loan in five equal installment including all interests due. The banks 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?
Example 2:- 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?
AMORTIZATION SCHEDULE
Ato Abebe 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
Mortgage Payments
 In a typical 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.
 payments are monthly and the time period is long-30 years is usual.
 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 is 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
Example 1:- 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 30th yr.?
b) Find the interest charged.
Example 2:- Mrs. Y 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.

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Chapter Four

Example 1: You borrow $10,000 for 3 years at 5% simple annual

 PAYMENT PERIOD:- The time between successive payments.

 PERIODIC PAYMENT or PERIODIC RENT:-Each payment made

 TERM of an annuity:-The time from the beginning of the first

AMOUNT (FUTURE VALUE) OF AN ORDINARY ANNUITY

 A Sinking fund is a fund in to which equal periodic payments are made

If the payments are to be made in the form of an ordinary annuity,

Example 2:-Mrs. X has a saving goal of Birr 25,000 which she

Example: A business man wishes to set aside semiannual payments to

Example 2:-What is the present value of an annuity of seven payments of

Example 3:- A business person's debt is payable as follows: Birr 2,000 1

In amortization our interest is to determine the periodic payment, R

 Mortgage payment and amortization are similar.

Taking A = total debt

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