Chapter 3: Mathematics of finance

Nguyen Thi Minh Tam

ntmtam.vnua@gmail.com

November 7, 2020
1 3.1 Percentage

2 3.2 Compound interest

3 3.3 Geometric series

4 3.4 Investment appraisal

3.1 Percentage

Example 1.
a) A firm’s annual sales rise from 50 000 to 55 000 from one year
to the next. Express the rise as a percentage of the original.
b) The government imposes a 15% tax on the price of a good.
How much does the consumer pay for a good priced by a firm
at $1360?
c) Investments fall during the course of a year by 7%. Find the
value of an investment at the end of the year if it was worth
$9500 at the beginning of the year.
Note.
If the percentage rise is r %, then the scale factor is
r
1+
100
If the percentage decrease is r %, then the scale factor is
r
1−
100
The final value = the scale factor × the original

the final value

The original =
the scale factor
Example 2.
a) The value of a good rises by 13% in a year. If it was worth
$6.5 million at the beginning of the year, find its value at the
end of the year.
b) The GNP of a country has increased by 63% over the past
five years and is now $124 billion. What was the GNP five
years ago?

Example 3.
a) Current monthly output from a factory is 25 000. In a
recession, this is expected to fall by 65%. Estimate the new
level of output.
b) After a 15% reduction in a sale, the price of a good is $39.95.
What was the price before the sale began?
Index number

An index number is the measure of change in a variable (or

group of variables) over time.
It is typically used in economics to measure trends in a wide
variety of areas including: stock market prices, cost of living,
industrial or agricultural production, and imports.
When finding index numbers, a base year is chosen and the
value of 100 is allocated to that year.
index number = scale factor from base year × 100
Example 4. The following table shows the values of household
spending (in billions of dollars) during a five-year period. Calculate
the index numbers when Year 1 is taken as the base year and give
a brief interpretation.
Example 5. The following table shows the index numbers of the
output of a particular firm for two consecutive years. Use these
index numbers to find the percentage change in output from
a) Y2Q1 to Y2Q4
b) Y1Q1 to Y2Q4
c) Y1Q1 to Y2Q1
 It is possible to create sensible index numbers to measure the
variation of a bundle of goods over time.
Laspeyre index: An index number for groups of data which are
weighted by the quantities used in the base year.
Paasche index: An index number for groups of data which are
weighted by the quantities used in the current year.

Example 6. Suppose that a firm buys three product. The

following table shows the number of each type bought in Year 1
together with the unit prices of each item in Year 1 and Year 2.
The total purchase cost in Year 1 is

20 × 8 + 35 × 18 + 10 × 6 = 850

If we assume that the firm buys the same number of each

type in Year 2, the total cost would be

20 × 10 + 35 × 23 + 10 × 5 = 1055

Taking the base year as Year 1, the index number in Year 2 is

1055
× 100 = 124.1 ←− Laspeyre index
850
If the quantities bought in Year 2 are those shown in the
following table

then the current weighted index in Year 2 is

17 × 10 + 38 × 23 + 12 × 5
×100 = 129.9 ←− Paasche index
850
Inflation

The annual rate of inflation is the average percentage change

in a given selection of these goods and services, over the
previous year.
Inflation distorts economic magnitudes, making them look
bigger than they really are. Economists deal with this by
distinguishing between nominal and real data.
- Nominal data are the original, raw data.
- Real data are the values that have been adjusted to take
inflation into account.
Example 7. Table 3.11 shows the average annual salary (in
thousands of dollars) of employees in a small firm, together with
the annual rate of inflation for that year. Adjust these salaries to
the prices prevailing at the end of Year 2 and so give the real
values of the employees’ salaries at constant ‘Year 2 prices’.
Comment on the rise in earnings during this period.
3.2 Compound interest

Simple interest

Simple interest is the interest that accrues on a given sum in a

set time period.
It is not reinvested along with the original capital.
The amount of interest earned on a given investment each
time period will be the same if the total amount of capital
invested and interest rates do not change.

Example 8. An investor puts $20,000 into a deposit account and

has the annual interest paid directly into a separate current
account and then spends it. The deposit account pays 8.5%
interest. How much interest is earned in the fifth year?
Compound interest

Compound interest is the interest which is added to the initial

investment every time it accrues.
The interest added in one time period will itself earn interest
in the following time period.

Example 9. If $600 is invested for 3 years at 8% interest

compounded annually at the end of each year, what will the final
value of the investment be?
Compound interest formula

Consider an investment at compound interest where:

P is the principal (the initial sum invested),
S is the future value (the final value of the investment),
r is the interest rate per time period (as a decimal fraction)
n is the number of time periods.
The compound interest formula is

S = P(1 + r )n

Example 10. Find the value, in 10 years’ time, of $1000 invested

at 8% interest compounded annually.
Example 11. A principal of $25 000 is invested at 12% interest
compounded annually. After how many years will the investment
first exceed $250 000?

Example 12. A principal, $30, is invested at 6% interest for two

years. Determine the future value if the interest is compounded
a) annually
b) semi-annually
c) quarterly
d) monthly
d) weekly
Note:
The future value rises as the frequency of compounding rises.
The type of compounding in which the interest is added on
with increasing frequency is called continuous compounding.
The future value, S, of a principal, P, compounded
continuously for t years at an annual rate of r is

S = Pe rt

Example 13. Determine the rate of interest required for a

principal of $1000 to produce a future value of $4000 after 10
years compounded continuously.
APR, AER

Annual percentage rate (APR) is the annual rate of interest

paid for a loan, taking into account the compounding over a
variety of time periods.
The phrase ‘annual equivalent rate’ (AER) is frequently used
when applied to savings.

Example 14. Determine the annual percentage rate of interest if

the nominal rate is 12% compounded quarterly.
3.3 Geometric series

Geometric progression, Geometric series

A geometric progression is a sequence of the form

a, ar , ar 2 , . . . , ar n , . . .

where a and r are real numbers.

r is called geometric ratio.
A sum of the consecutive terms of a geometric progression is
called a geometric series.
Example 15. Decide which of the following sequences are
geometric progressions. For those sequences that are of this type,
write down their geometric ratios.
a) 3, 6, 12, 24, . . .
b) 5, 10, 15, 20, . . .
c) 1, −3, 9, −27, . . .

The sum of the first n terms of a geometric progression

 n 
2 n−1 r −1
a + ar + ar + . . . + ar =a , r 6= 1
r −1
Example 16. A person saves $100 in a bank account at the
beginning of each month. The bank offers a return of 12%
compounded monthly.
a) Determine the total amount saved after 12 months.
b) After how many months does the amount saved first exceed
$2000?
Example 17. A person requests an immediate bank overdraft of
$2000. The bank generously agrees to this but insists that it
should be repaid by 12 monthly instalments and charges 1%
interest every month on the outstanding debt. Determine the
monthly repayment.

Example 18. It is estimated that world reserves of oil currently

stand at 2625 billion units. Oil is currently extracted at an annual
rate of 45.5 billion units and this is set to increase by 2.6% a year.
After how many years will oil reserves run out?
3.4 Investment appraisal

In Section 3.2 the following two formulas were used to solve

compound interest problems

S = P(1 + r )n (discrete compounding)

rt
S = Pe (continuous compounding)

When S, r and t are given, P is computed by

P = S(1 + r )−n (discrete compounding)

−rt
P = Se (continuous compounding)

In this case,
- the principal, P, is called the present value,
- the rate of interest is sometimes referred to as the discount
rate.
Example 19. Find the present value of $1000 in four years’ time if
the discount rate is 10% compounded
a) annually
b) semi-annually
c) continuously

The net present value

The net present value (NPV) of an investment project is the

difference between the present value of the revenue and the
original cost.
A project is considered worthwhile when the NPV is positive.
If a decision is to be made between two different projects,
then the one with the higher NPV is the preferred choice.
The internal rate of return

The internal rate of return (IRR) is the annual rate which,

when applied to the initial outlay, yields the same return as
the project after the same number of years.
The investment is considered worthwhile if the IRR exceeds
the market rate.

Example 20. An investment project requires an initial outlay of

$8000 and will produce a return of $17 000 at the end of five
years. Use the
a) net present value
b) internal rate of return
methods to decide whether this is worthwhile if the capital could
be invested elsewhere at 15% compounded annually.
Example 21. A firm needs to choose between two projects, A and
B. Project A involves an initial outlay of $13 500 and yields $18
000 in two years’ time. Project B requires an outlay of $9000 and
yields $13 000 after two years. Which of these projects would you
advise the firm to invest in if the annual market rate of interest is
7%?
Consider the case of a sequence of payments over time. The
simplest cash flow of this type is an annuity, which is a sequence of
regular equal payments.

Example 22. Find the present value of an annuity that yields an

income of $2000 at the end of each month for 10 years, assuming
that the interest rate is 6% compounded monthly.
Example 23. A firm has a choice of spending $10 000 today on
one of two projects. The revenue obtained from these projects is
listed in Table 3.28. Assuming that the discount rate is 15%
compounded annually, which of these two projects would you
advise the company to invest in?
Exercises

Exercise 3.1, 3.1*: 8, 12-15 (page211-212), 4,8 (page 213,214)

Exercise 3.2, 3.2*: 7, 9, 12-15 (page 227), 1-3 (page 228)
Exercise 3.3, 3.3*: 2, 5, 7 (page 238-239), 2, 8 (page 239- 240)
Exercise 3.4, 3.4*: 1, 2, 4, 9, 11 (page 253-254), 8 (page 255)