fhe | 6.1 INTRODUCTION Just about everyone becomes involved in transactions where interest rates affect the amount to be paid or received. For many, the largest such transaction is the purchase of a home. As we shall lear, a person who borrows $150,000 for such aa purchase and cancels the debt by making monthly payments over a period of 30 years, will pay back about $284,502 if the interest rate is 9 percent per year, compounded monthly. Not very many years ago, when the interest rate was about 12 percent, the corresponding payback would have been about $405,440. The size of these paybacks serves to show both the effect of compound interest and the effect of changes in interest rates. In this chapter, we first look at simple interest calcu- lation. We then turn to the major objective of the chapter, which is to develop and apply formulas for financial transactions that involve compound interest calcula- tions. In so doing, we shall ask and answer questions such as the following, for various interest rates and frequencies of compound 1, If $5,000 is deposited in a bank account now, what will be the amount in the account 10 years from now? How much must be deposited in a bank account now if the amount in the account 5 years from now is to be $10,000? 3. If $1,000 is added to an account every year, to what amount will the ‘account grow in 15 years 4. How much must be deposited in an account each year if the amount in the account at the end of 10 years is to be $15,000? 5. What sum deposited now will provide an income of $10,000 per year each year for the next 20 years? 6. If $100,000 is borrowed now to pay for a home, how much must be paid back euch month if the debt is to be cancelled in 20 years _ We shall also answer questions like the preceding if interest is compounded instantaneously (continuously) rather than at discrete points in time such as the end of each day, month, four months, six months, or one year. Extensive tabulations are available to aid in carrying out the calculations involved in financial tabulations. However we shall show how these calculations are easily carried out on i calculator and/or computer. We prefer this approach because even se ever the most extensive tabulations provide a limited cross section of interest rates andl st rates and 387 ‘Scanned with CamScannerant i) NONLNEAR RELATIONSHIPS TH APPLATIONS IN BUSINESS AND FINANCE 388 time periods. 1 is important, however, to und designed so that it is possible to learn the subject Py taingeither approach, Also, we should point out that compound interest caution involve exponents and, as a consequence, logarithms play a role in some of these calculations, 6.2 SIMPLE Interest rates are generally quoted in percentage form and, for use in calculations, INTEREST AND THE — must be converted to the equivalent decimal value by dividing the percentage by FUTURE VALUE 100: that is, by moving the decimal point in the percentage two places to the let —>— Interest rales ore converted to decimals by dividing the rate by 100. ———— Interest) equals Principal (P| times Roe (i) times Time (0). For example. 84% = 8.25% = 0.0825. Unless otherwise stated, a quoted rate is a rate per year. Thus $1 at & percent means that interest of $0.08 will be earned in a year, and $100 at this rate provides 100(0.08) = $8 in one year. Interest on $100 at 8 percent for 9 months is interest for 5 that is, 9 Interest = 100 (0.08) rs) = $6.00. 1 1 Interest = 1)(Rate)(Time in years). culations: tions: Interest, in dollars. ent Principal, the sum of money on which interest is. being eamedsé: = Rate of interest per period (assumed to'be one year) es ©. n= Number of years, or fraction of One year. 3 “Siple inierest tormus:| = Pi) “Thus interest on $600 at 7% percent for 10 months is computed usin P= 0, i = 0.075, and n = 10/12 year. This is 0" 1 6000.075)( *) $37.50. Ne ‘Scanned with CamScanner(CHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE 389 “The simple interest formula 7 = Pin involves four variables. Given any three The simple iterest formula of the four variables, we can solve the formula for the remaining fourth variable, bo soled for ony one ol its variables given the Example. Find the interest rate if $1,000 earns $45 interest in 6 months. other thee Here, 1 = 45, P = 1,000, and n = 6/12. = 0.5. Hence T= Pin 45 = 1,000(i)(0.5) 45 = 500i 45 _ wr! 0.09 o ‘To obtain the percent rate, the decimal rate, i = 0.09, is multiplied by 100. Thus {= 0.09 = 10000.09)% = 9%. ~ ‘The yield on the common stock of acompany is a percentage obtained by dividing the amount (called the di ‘shareholder receives per share of stock held by the price of a share of the stock. Thus yield is Tike an interest rate with the dividend analogous to the interest for n = | year and the price per share analogous to the principal. A stock market report showing GenElec 2.20 76 a means that at the time of the quotation, a share of General Electric stock sold for $76.00 and the annual dividend was estimated to be $2.20 per share. When time is siven in ds ren time is given in days, there are two ways of computing the interest: the exact method und the ordit ac rdinary method " exact method is used, then the time is (ohea cee aes ‘Scanned with CamScanner————— The ext method divides the number of days by 365 (366 in a leop year); the ordinary method divides by 360 ~\ —— Ordinory interest is 73:72 of cexoct interes aeGC™'"™“—_— a 1 NONUNEAR RELATIONSHIPS WITH APPLICATIONS IN BUSINESS AND FINANCE _ Number of days . eS but if the ordinary method is used, then Number of days, 360, Banks, for convenience, often count a year as twelve 30-day months, 360 days fo 7 a year. n= Example. Find the interest on $1,460 for 72 days at 10 percent interest using (a the exact method and (b) the ordinary method. In both methods, P = 1,460 and i = 0.1. For (a), 1= Pin 72 =(1 (0.1) (1,460)¢ o(B) = $28.80. On the other hand, for (b) 1 = Pin rR = (1,460)(0.1){ = n0.0( 22) = $29.20. “ As you can see from this example, the ordinary i i interest is interest. This will always be the case. Why? In fact ae _ Pi(Number of days/360) Pi(Number of days/365) _ 365 ~ 360 _ -5 So ary ime 73 Ordinary interest = (Bere interest). We will adopt the common practice of using ordinary inter i uae Practice of us sing ordinary interest unless otherwise ‘Scanned with CamScanner‘quapten 6 INTRODUCTION TO THE MATHEMATICS OF FIANCE a 7 $1,000 at 9 percent for 8 months is computed as = The Future Value interest on SI 8 Pin = 1,000.00)( 75) = $60 Lf interest is added to the principal, the sum is called the fut ! jure value, F.— foture vue 1 the sum of and the princapa pls terest ‘Thus Te 8 F = 1,000 + 1,000.08)(5) = 1,000 + 60 | = $1,060. | Z | Exumpic. Find the future value if $20,000 is invested at 6 percent for 3 months. Here, 3 months is 3/12 = 1/4 of a year, son = 1/4, Hence zo.nn + 0.06(1) | L 20,0001 + 0.015) $20,300. 7 4 " ——— Iris often helpful to visualize money transactions in a time diagram, In our Tine dugrons area welul giiment example, such a diagram is shown in Figure 6-1. Here we have started at vss! el m mane fe cnt with P = $20,000. drawn a fine pointing out to the unknown F in the hston lure three months hence, and indicated the 6 percent interest rate over the line ‘Scanned with CamScanner392 FIGURE 6-1 The future vole formule «on be solved for ony one of ils vorabes given the other three TABLE 6-1 IN BUSINESS AND FINANCE pat Il HONLNEAR RELATIONSHIPS WITH APPLICATIONS i= 6% | Fe? P = $20,000 a ee Months 0 i 2 ; F = $20,300.00 Table 6-1 shows a QBasic program to compute the future value, along with the results of running the program for the preceding example. ‘The future value formula F = P(L + in) also involves four variables. As with the simple interest formula, given any three of the four variables, we can solve for the remaining fourth variable. Exomple. Jan received $50 for a diamond at a pawn shop and a month later paid $53.50 to get the diamond back. Find the percent interest rate. Here, P = $50, F = $53.50, n= poe and the associated time diagram is shown in Figure 6-2, REM PROGRAM 6-1 REM Future Val CLS INPUT "Enter P, i, and n"; P, i, n FePfiat+i*n PRINT "The Future Value F PRINT USING "S###, ###. # Simple Interest j Enter P, i, and n? 20000, .06,.25 The Future Value F = $ 20,300.00 ‘Scanned with CamScannera ‘UUPTER 6 TRODUCTION TO THE MATHEMATICS OF smance Ke mm LS FIGURE 6-2 Pe $9 ————___ 2+ J F 2853.50 4 Months + ¢ oth 0 j= 84% el Therefore ose-afs (3) Dividing both sides by 50 yields 53.50 i B+ = Multiplying both sides by 12, we find (3) =12+i 50 12.84 = 12 +¢ 0.84 = i. “The last is the decimal rate, The percent rate is 100 times the decimal rate: The percent rate is 100 0.84 = 100(0.84)% = 84%. times the decimal rote = Exercise, Fran has placed $500 in an employees’ savings account that pays 8 percent simple interest. How long will it be, in months, until the investment amounts to $530? ‘Answer: 3/4 of a year = 9 months, Y p a ————— H the Previous exercise, $500 now amounts to $530 nine months from now if the 6.3 SIMPLE interest rate is 8 percent, In reverse, we say that the present value of $530 receivable DISCOUNT: PRESENT in 9 months is $500 now if the interest rate is 8 percent. This present value is VALUE ‘analogous to a principal, so we shall denote it by P. Inasmuch as F=P(I + in), ‘Scanned with CamScanner4 PART Il NONLINEAR RELATIONSHIPS WITH APPLICATIONS IN BUSINESS AND FINARCE we do not really need a separate formula for calculating the present value. However, The present valve He in practice, accountants and financiers use the present value concept so often that ae convenient to have such a formula, We obtain the present value formula by dividing both sides of the preceding expression by (1+ in). Thus ‘Thus the present value of $530 receivable 9 months from now if the interest rate Se ee ee cee eee is 8 percent is pa 530 1 + 0.08(9/12) = 1.06 = $500. ‘The time diagram for this example is shown in Figure 6-3, = Exercise. How much will Fran have to invest now in, eearloves, ‘8 percent me ‘account in order to have $600 a year from now? : ‘Answer: 600/1.08 = $555.56. J important in this chapter to keep in mind that a future amount of money, worth less than F now, ‘The sense of this is that certainly, in a business FIGURE 6-3 i= 8% F = $530 = $500 ‘Scanned with CamScanner(CHAPTER 6 INTRODUCTION TO THE wat ATHEMATICS OF fy NANCE 95 REM PROGRAM 6-2 REM Present Value -- Simple Interest cLS INpuT "Enter F, i, and n"; Fy ds peFsatitm PRINT “The Present Value Pew | pRINT USING "S###, ###. AF" P ‘enter F, i, and n? 5 08, . 75 | the Present Value P = § 500-00 L = ———— transaction, a person who promises to pay back $1 {000 to a lender at some time” TH tie vle of mney is in the future cannot expect to receive as much as $1,000 now, This principle is Pts i franl fften referred to as the time value of money. rsa. se. Find the present yalue of $1,000,at 9.percent due 8 months from now: ‘Answer: $943.40. : iS eae ‘Table 6-2 shows a QBasic program to compute the present value, along with the results of running the program for our previous example i ———— In many loans, the interest charge is computed not on the amount the borrower 6.4 BANK DISCOUNT but on the amount that is repaid later. A charge for a loan computed in this manner is called the bank discount, and“the amount the borrower receives IS~ called the proceeds of a loan. Proceeds begins with P and it is an amount revved now, The future amount to be paid back is F, now called the maturity value of Loon transcionsinvohe $1,000 is borrowed at 12 percent for he borrower receives "awit ave cater thos ihe prowee s borrowed ut _12 percent fo the borrower receives sors. P, and pays bac $1000" The proceeds will be $1,000 minus BM valve and prveds © imterest on $1,000. ‘This will be tater than presen a » P = 1,000 - 1,0000.12)() 12 1 1 t 1 P= F - F @d) (WW 1,000 - 60 = $940, ‘Scanned with CamScannerba PARTI NONLINEAR RELATIONSHIPS WITH APPLICATIONS IN BUSIMESS AND FINANCE Note that the $60 interest was subtracted from the maturity value of $1,000 t6 yet the proceeds of $940. ‘This is quite different from a future value transaction where the $60 interest would be added to the principal of $1,000 to get a future value of pe $1,060. To emphasize this difference, the interest rate was designated asd and iy invole intrest deduged in allCU the bank discount rate. ‘This method is also called interest deducted-in. advance because the interest amount is deducted from the maturity value F before ra oom — the proceeds P are given to the borrower. The example just completed shows that the borrower receives $940 but pays irae the maturity value $1,000. If the borrower wants to receive provee = $1,000, then 1,000 1,000 = FUL ~ 0,06) 1,000 = 0.94F 1,000 _ 0.94 $1,063.83 = F. ‘Thus the borrower who wants $1,000 now will pay back $1,003.83 six months from now. © Exercise, a) A borrower signs a note promising (0 pay a bank $5,000 ten mouths | - from now. How much will. the borrower receive if the discount rate is 8. perce? b) How much would the borrower have to repay in order to receive $5,000 now? Answer: a) $4,650, b) $5;376.34. SRE SENS Se ON SENS RUN RSS any ane on ymient in the future, so they ate Proceeds are an amount received now for Proweeds ore present valve ssed in the previous s amalagout @ present values whi wis mae uaveuer because the proc oblig to pay are always less than the present value of the obligation if, of couse, the same rate of interest is used in both calculations, cals Tron se futur ‘Scanned with CamScanner‘unpre 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE ‘nut would be the present value oF $1,000 payable tn 6 months at 12 Prontin What would percent simple ynterest” Answer: S848 49 1. proceeds shout be computed when the int Fase ate ora bank discount oF interest deducted asco ° value should be compated where the interest rate Wwe have just seen the difference between the bunk discount (proceeds) and the — 6.5 EFFECTIVE RATE: simple discount (present Value). These two methods can be compared trom an SIMPLE INTEREST cffective or true interest rate point of view. By the effective interest rate we “t + simple interest rate for one year —_. the actual true simple interest rate for one aa cxtal simple irs rte ‘id oF recived for one reat Interest amount for one year Amount borrower receives In the simple discount (present value) exercise of Section 6.4, we had = SL000,7 — 124. nm = 6/12, and computed P= $943.40. So the interest amount for one year is 12 2 (1,000.00 = 943. 4o( 2) = (56. on() 6 = $113.20, and 113.20 O30 0.12, or 12 percent, It will always be the ease with the simple discount that i, — 4 Why? Because the interest amow isc aryed against the actual amount (present value) UPC year) Pp Pi p i ‘Scanned with CamScanner- can e.aTiOnSs WITH APPLATIONS I BUSINESS AND FINANCE uer_NONUN 398 -thus the effective interest rate for a simple discount (present value) transact Lamopr is precisely the quoted rate ction In pee meqned oe on the or hard, for the bank discount (proceeds) example of Section 6,4, y rman ee reife ners, fxl F = $1,000. 12%, n = 6/12, and computed P = $940. Here the inter for one year is 7 12 (1,000, = 940) = (60)(2) 6 = $120.00, and 120 i, = = 0.12766, fe = Gag = 0.12766. — tn bork discount or 12.766 percent. This is more than the quoted rate of 12 percent, and this wilh voneciom, the quoted rie always be the case, Why? Because here the interest amount is charged against the ‘sion thon the efecve amount to be paid back (maturity value), not the actual amount received (proceeds). interest rate Writing i, as a function of F, d, and n, we have (Fd)(1_ year) FU — dn) Fd ~ FU = dn) ie Prarie. Use the preceding Equation (1) to calculate &, for our previous example | where d = 12 percent and n= 6/12. See Answer: 12.766 percent. = Eaige a) Find the present valuig and elfective rae of $1,000 due i. 4 months at {2percent interest. b) Find the proceeds and effecti ‘ate oF $1,000 due in 4 inonths. at a discount rate of 12 percent. ate Answer: a) $961.54, 12 percent. b) $960.00, 12.5 percent es An interesting application of (1) occurs when a lender wishes to determine the discount rate d that should be quoted in order to ree ive a desired effective rite Solving (1) for d, we have ‘Scanned with CamScanner(CHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE il = day = d i, = in = d d+ idn Returning to our example whi d or 11.321 percent. d+ ian) ere F 0.12 V+ (0.12)(6/12) 0.11321, = $1,000 and n wants to earn 12 percent true interest, then from (2) the discount rate should be 399 6/12, if the lender only — To eain o portclar fective rte, the associoted quoted discount rate will be smaller Exercise. Suppose lender wishes to.cam.15 percent tru interest on a 4-month asa ee peat Rice ee bl ced? 6.6 PROBLEM SET 6-1 In Problemy | through 10, find a) the interest and b) the amount for each of the principals for the stated rate and period: 1, $500; 7 percent; | year. $1,000; & percent; 1 year. $1,000; 9 percent; 6 months, 4 months. 2 3 4. $2,000; 6 percent; 6 months. 5. $100; 36 percer How many months will it take until the interest on $900) at 12 percent will be $1 le interest $500; 24 percent; 3 months. $200; 12 percent; 18 months, $500; 18 percent; 16 months. , $5,000; 24 percent; 3 years $4,000; 30 perwent; 2 years i} A credit card holder hay owed the eredit card com: pany $200 for hand! receives a bill containing ge of $3. Find the interest rate. ‘Scanned with CamScanner400 6.6 PROBLEM SET 6-1 (concluded) 13. Compute the yield of New E wland Electric Com. Pany stock from the following stock market report: New Eng lee 2.16 32 In solving Problems 15 through 2 4 - draw the associated tis ke at $ percent interest amount of $2,400? How many monthy will it for $2,000 t0 grow to 16. Fran deposits $1,000 in an employees* sa count at 6 percent, How many months will it be until the amount in the account ig $1,100? A. Dan buys a PY set pri $500 and is to pay this amount, plus interest, 3 months later, ‘The total bill wats $520, Compute the interest rate, V8. At what rate of interest will un investment of $1,000 for 2 yeary grow to the amount of $1,100? 19. Find the present value of $460 receivable 18 months Trom now if the interest rate is 10 percen 1. Find the present value of $1,000 receivable 2 from now if the interest rate is 8.5 percent. 1. Find the effective interest rate in Problem 23. %. Find the effective interest rate in Problem 24, 1B. Find the etfective interest rate in Problem 25, 3. What discount r: perce ie should a lender quote to earn 9 est on at 90-day transaction? true inte 3B. Run the computer program in Section 6,2 for Prob lems 1 through 10. 34 Run the co puter program in Section 6.3 for Probe 3. a Modity the computer programs in Sections 6.2 and 6.3 into single program that witl compute any one of the tour parameters FP, i given the other three. Include will allow n to be entered dir days. months, oF y! br Run the progeun Ho and 18 through 22. a for Problems 1 through PART II_NONLINEAR RELATIONSHIPS WITH APPLICATIONS IN BUSINESS AND FINANCE 14. How much must be deposited in an account pays 7 percent if interest of $100 is to be months? 21. How much will Sam have to invest now in an eu ployees’ savings account at 7 percent in order to have $1,000 in the account 18 months fron wo? n ¢ Problem 21.) How much would San have to invest if the interest rate were 10 percent’? BB. Find the proceeds of «$2,000, 18-month loan trom at bank if the discount rate is 12 perce 4, Find the proceeds of a $500, 9-month loan from a bank if the discount rate is 9 percent 35. Dan wants $2,000 now trom a bunk. 40 be re months from now. How much will the repayment be if the discount rate is 15 percent? 2. Fran signs « note promising to pay a bank $1,000 {en months from now and receives $900. Find the discount rate, 31. What discount rate should a tender quote to eam I Percent (rue interest on a 6-month transaction”? 2 What discount rate should a tender quote to earn 1S Percent true interest on a Omonth transaetion? 36. a) Maatty the computer progtany in Problem AStay for the bank discount }) Rom the program in (ay tor Py st he heer in (2) far Problems 23 thuonigh 37.) Write a computer Tete elt PRUE oder the est rate or a quoted div c by Rum the program Problems a a So MBS Poza in a Hor Problems 27 the 38. ay) We discount rate wan the u Program to determine 4 even effective rite im Gay bor » progran blems 40 through ‘Scanned with CamScannerCHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE 401 ‘To sce how compound interest works and develop a formula for computing the — 6.7 COMPOUND future value, suppose $5,000 is invested at 10 percent interest compounded INTEREST AND year. The amount at the end of the first year would be THE FUTURE Fy = 5,000 + 5,000(0.10)(1) uo = 5,000 + 500 = $5,500. This $5,500 becomes the principal at the beginning of the second year, and the amount at the end of the second year is ry 500 + 5,500(0.10)(1) 500 + 550 = $6,050 Thus in the second year, interest is cared on not only the $5,000 invested, but —=—— also on the $500 of interest earned in the first year. ‘This common practice of _ Cunpon nteres! wtlades computing interest on interest is called compounding interest interest wm the iret To obtuin a formula for computing the future value, we will again use as the interest rate per period. It will suffice for the moment to think of the period as being & year, and we will adjust our formula accordingly later when the period is something other than a year. Definition. i = Interest rate per period. Assuming, then, that the period is one year, a principal of $P will amount to Fy = PU +i! at the end of the first year. At the beginning of the second year, PUL + i) becomes the new beginning principal, which is multiplied by (1+ i) to find the future value at the end ofthe second year. Thus, Fr= PU + il +) = PU bi after two years. At the beginning of the third year, the new principal is PU + i)°, and to obtain the future value at the end of the third year, this must be multiplied by (+ i), Thus F PU + FU + = PU + it fer three years. Similarly the future value at the end of 10 years would be Fio = PU + i)". ‘Scanned with CamScanner402 FIGURE 6-4 TABLE 6-3 PART IL NONUNEAR RELATIONSHIPS WITH APPLICATIONS IN BUSINESS AD FINANCE In general, at the end of m years, the future value will be F, = PU + i". Conventionally the subscript on F,, is not written: Definition, Future value: F = P(L + i)". This last expre of i per period ‘ion is the future value of $P for n periods at an interest rate Example. Find the future value of $1,000 at 7 per We have P = $1,000, § = 0,07, and n = 10, so that F = 1,000(1 + 0.07)" = 1,000(1.07)'" P = $1,000 {R=? tt] vers 0 2 4 6 8 10 $1,967.15 Calculator Keystroke 107 2nd. then y* (or just y") 1.07 10 1.967151358 x 1.96715135% 1000 1000 = 1967.15135% ‘Scanned with CamScanner(CHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE 403 1,000(1 96715) $1,967.15. ‘The time diagram for this example is shown Figure 6-4. There are two ways to compute the answer to this example on a calculator, One ay is to calculate (1.07)'° and then multiply this by 1,000, as shown in Table 6-3. On the other hand, some calculators are programmed with the finan and then this example is solved as shown in Table 6-4 functions, * orcs, Uf $500 is invesed at 6 percent compounded anual. ‘what future value 30’years later? elie Answer: $2,871.75. Table 6-5 shows a QBasic program to compute the future value. along with the results of running the program for our preceding example, = TASLE 6-4 | 1000, then PV 1000 49, then % i 7 | 10, then 10 CPT, then FV 1967.151358 TABLE 6-5 Ee PROGRAM 6-3 REM Future Value -- Compound Interest cs INPUT "Enter P, i, and nt; P, iy n PEP tudtietn PRINT "The Future Value F PRINT USING "S###. HHH. AH": F Enter P, i, and n? 1000,.07, 10 The Future Value F = $ 1,967.15 ‘Scanned with CamScannerPART I NONUEAR RELATIONSHIPS WTH APPLAIONS IN BUSINESS AND FINANCE 6.8 THE Quoted interest rates are rates per year if not accompanied By a qualifying statement CONVERSION stich as 1% percent per month, In the absence of a qualifier, the quoted annual rate PERIOD is called the nominal rate and it is symbolized by J. The nominal rote isthe quoted anol rote Definition, Nominal rate = Rate per year Although the quoted nominal rate is per year, it is common practice to compound interest more frequently than once a year. Many banks compound interest on savings accounts on a daily basis (365: times a year). In other transactions, interest is compounded monthly, quarterly, or semiannually as shown in Table 6-6 Definition. Number of conversions per year = m. Find the future value of $500 at 8 percent compounded quarterly for 10 years. “There are four quarters in one year and 4(10) = 40 quarters in 10 years. Thus we multiply the number of years by the number of conversions per year. We shall now use this number of periods (40 quarters) as 1 in the future value formula TABLE 6 | = Daily 365 1 Monthly 2 | Quarterly 4 niannually 2 ‘Scanned with CamScanner(CHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE smmuch as the quoted 8 percent is. nominal or per-year rate. we divide 8 percent by the number of conversions per year to obtain = 2% per period. Using a calculator, we then have 0.08)" 500 (1 + =— (1) = 5001.02)" . = 500(2.208039665) = $1,104.02. On a calculator with preprogrammed financial functions, we would proceed as shown in Table 6-7. In summary. when interest is compounded more often than once a year, 7 is the total number of conversion periods. so that n= (Number of years\(Number of conversions per year) and Keysrake S00, then PV 500 | x & | x | 5 ‘ j then i 2 ‘s wo to . 10 4 4 then » “0 CPT. then FV 1104, 019832, 405 —>= ‘The interest rote per period isthe nomial rate divided by the number of periods per year. The total mmber of periods isthe numberof ‘years times the number of periods pr yar TABLE 6-7 ‘Scanned with CamScanner SqPART IL MONLINEAR RELATIONSHIPS WITH APPLICATIONS IN BUSINESS AND FINANCE Exercise, © 1f $800 is invested at 6 percent compounded semiannually, what will be | ‘the amount in 5 years? 1 Answer: $1,075.13. Example, Compute the future value of $5,000 at 9 percent compounded monthly for 10 years. Here we have n= (10 years)(12 months per year) = 120 and Hence s.a00 (1 + = $12,256.79. Bercise.. A bank pays 7.25 percent compotinded daily. on 90-day notice accounts. Af $500 is deposited in such an account, what will be'the amount in 90 days? (Use | 365 days per year.) sea fi | ‘Answer: $509.02 | 6.9 FINDING As with simple interest, the compound interest formula THE TIME AND eee THE INTEREST ena) RATE involves four variables, ‘Thus, on again, given any three of the variables, we can solve the formula for the remaining fourth variable. 7 hte value In particular, we can determine w if &, P, fd for ie we OW Many periods it will tke for P doll an amount of F dollars. and i are piven; that is, we kars deposited now at 7 pei nd nt to grow to, Laimph: AL 8 pe $2,000 to grow to $3 ent compounded an Ow mn oo eunded amually, how many years will it take tor a ‘Scanned with CamScannerCHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE We have 2.00001 + 0,08)" = (1.08)" 1.08)", ‘Taking the natural logarithm of both sides, In 1.5 = In (1.08)" = niin 1.08). Thus Int In 1.08 5.268 = n, so nis a bit more than 5" years, ‘To solve the preceding example on a calculator, we would proceed as shown in Table 6-8. H the calculator has preprogrammed financial functions, then we would proceed as shown in Table 6-9. $1,000 to grow to $2,000. Answer: About 8.043 years Calculator Display Keystroke 1.5, then In.x 0.405465 108 * (0.405465 108 108, then In 0.076961041 = 5.268446243 ———[SS____—ET— culutor Display Keystroke B then % i e 2000, then PV 2000 300, then FV, 3000 CPE, then n 5.264446243 Se eal’) ‘Scanned with CamScanner TABLE 6-8 TABLE 6 9 407408 The future value formula an be solved for the interest rate é given F, P, ond a, PART Il NONLINEAR RELATIONSHIPS WITH APPLICATIONS IN BUSINESS AND FINANCE i kt pound interest ‘The next example illustrates how to determine an unknown comp rate i given F, P, and n. 4 sum of money double Example, At what interest rate compounded annually will a in 10 years? Here double m and so on, and the ans $100 grows (0 $200, $25 grows to $50, $1 grows to $2, me required is the same in any doubling. We shall use $2. P= $l, F = PU 4 iy" PU + =F we have (DO + a = 2 (+o = 2 ‘Then, taking the natural logarithm of both sides, Indl + gy! = In2 lon +) = In In2 In + a = 10 To obtain (1 +), we must take the antilogarithm of both sides. ‘Thus b+ i= ete amo = manny 1.071773463 — 1 0.071773463 1 7A77T%, Ive the preceding cxample on a calculator, w ‘Table 6-10, which is precisely Table venience. If the ealeu © would proceed ay shown in Section 5.8 repeated here 1 financial function for con. = then we would Find the rate of interest that, a Sum of money in 10 years “Answar: 11-612 percent. compounded annually. wil seul ig ‘epling | ‘Scanned with CamScannerCHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE 409 TABLE 6 19) 2nd, then e* Keystroke calculator Display 2, then In 0.693147181 + 0.693147181 10 10 = 0.069314718 1,071773463 1.071773463 1 0.071773463 Keystroke 1, then PV 2. then FV 10, then 1 CPT, then % i 7.17734025 TABLE OH 6.10 PROBLEM SET 6-2 In Prublems 1 through 4, find the future value atthe st 1. $200; 20 1 $300; 10 {In Problems $ through , find the future 4. 8 percent compounded quarterly 5. susie x y 6 $250; 3 years: 12 peteent compounded monthly 9. How many annually for $5.00 WL How many years will itake dlutle at 10 perwen VW. Kind the rate of which a sum of money will py will rs: $ percent ears: @ percent to amount t0 $20,000? sum of ‘compounded ann crest _ compounded double im 20 y eat 7 percent compounded jated nominal interest rate compounded sn 4 ue using the appropriate interest 1 8 n a aly (onge a year? $400; 40 years: 8 pen $500; 15 years: 7 perce or of period ‘$600; 20 year; § pervent compounded sem $1,000; 10 years, Lo percent compounded quiaterty Find the rate of Jat which $5,000 will prowy to $12,000 pounded datly 0 Using 305 alays, ot A bank pays 9.25 percent tilieate accounts running {04 6 9 per year, compute the future value of a depo SSK) for 0 years, ‘Scanned with CamScanner410 PART II NOWLINEAR RELATIONSHIPS WITH APPLICATIONS IN BUSINESS AND FINANCE 6.6 PROBLEM SET 6-2 (concluded) compounde Mt VA bank pays 5.25 percent compounded daily on cer. 16. At what rate of interest compe ded annually tain accounts. Find the future value of a deposit of $1,000 grow to $5,000 in 10 years $2,000 for 45 days, 15. How many years will it take af 9 percent compounded annually for $5,000 to grow to $10,000? V7. Run the computer program in Section 6.7 for Prob- b) Run the program in (a) for Problems 5 through Jems 1 through 4. 16. - . ; - 18. a) Modify the computer program in Section 6.7 so Mos the program in a) 90 that you oo that it will compute any one of the three param- J and m into the program instead of ¢ and w ¢ progr c) for Problems 5 through eters F, i, and n, given P and the other two pa- a kon the program in (c) for Problems 5 throug rameters. ; 6.11 COMPOUND As with simple interest, we do not really need a separate formula for calculating DISCOUNT: the present value. However, it is convenient to have such a formula. So, dividing PRESENT both sides of the future value formula Aol F=PU +i" The future valve formula Dy (1 +)", we have ‘on be solved forthe Fl 7 present value P. given F, i =P oor. P = : ata a + iy a+a By the definition of a negative exponent, then, a+ FF a" Definition, Present value: P = F(I + iy", Compound discount factor = (1 + iy", Example. What is the present value of $2, 500 payable 4 ye. percent compounded quarterly? O° Payable 4 years trom now at & ‘Scanned with CamScannerCGHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE au Here the amount 4 years hence is F = $2,500. With quanerly compounding, 1 = (4 periods per year)(4 years) = 16 periods. 0.08 9 8 om, i ‘Therefore ~ q 2,500(1 + 0.02)" 2,500(0.728445814) 182111 On a calculator with preprogrammed financial functions, we would proceed as shown in Table 6-12. * Exercise. What is the present value, of $4,000 payable in 20 years at 8 percent’: compounded semiannually? E Answer: $833.16. ad Eruinpie. How much must be deposited riow in an account paying 7.3 percent compounded daily in order to have just enough in the account 3 years from now to make $10,000 available for investment in a business enterprise? TABLE 6-12 2500, then FV 2500 a 4 x 4 4 4 «then 1 16 1 8 8 ~ + 8 4 2 Pr, then PV, 1821114534 ‘Scanned with CamScanner412 PART NONLINEAR RELATONSHIS WITH APPLICATIONS 1M BUSWESS AND FIANCE TABLE 6-13. REM PROGRAM 6-4 REM Present Value -- Compound Interest cLs INPUT "Enter F, i, and n"; peFe a+i) 7m PRINT "The Present Value P PRINT USING "S###, ###. #4"; P Enter F, i, and n? 2500, 02,16 The Present Value P = $ 1,821.11 With one day as a period, = (365 days per year)(3 years) = 1,095 periods and 0.073 per year 365 conversions per year Hence P 10,000 (: + om) 365 = $8,033.39, Exercise. rebe ae How much must be deposited now, in an account paying 8 percent com: pounded monthly in order to have just enough in the account 5 years from now to | make a $10,000 down payment on a home? | Aaswer: —$6.712,10, Table 6-13 shows a QBasic program to compute the present value, along: with the results of running the program for our first example of this scetion 6.12 PROBLEM SET 6-3 In Problemy 1 through +. compute the present valu 1. $1,000 at 8 pereent compounded annually, due in 2. $2,000 at 7 poteent compen 20 year 10 years, AL annually, due in ‘Scanned with CamScannerCHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE 413 6.12 PROBLEM SET 6-3 (concluded) 3. $5,000 at 10 percent compounded semiannually, due 4, $4,004) at 12 percent compounded monthly, due in in 5 years. 3 years. 5, What sum of money deposited now at 8 percent com- 8 An account bearing interest at 6 percent compounded pounded quarterly will provide just enough money semiannually was established 100 yeary ago. ‘The ae tw pay a $1,000 debt due 7 years from now? count balance now is $9,030.55. What was the initial 6. What sum of money invested now at 12 percent com- amount when the account was established pounded monthly will provide just enough to pay a 9% Find the present value of $14X0 duc in 2 years at debt of $2,500 due in 3 years? 8 percent compounded daily. (Use 365 days in a IF output per laborhour increases by 5 percent com- year. pounded annually and is currently 100 units per la- 10. Find the present value of $2,000 due in 10) years at borhour, what was output per laborhour 5 years ago? 9 percent compounded monthly. a M1. Run the computer program in Section 6.11 for Prob- compute any one of the four parameters FP. f. Jems I and 2. and n, given the other three, b) Run the program 10, 12. a) Modify the computer program in Problem 18a of n (a) for Problems 3 through Problem Set 6-2 (Section 6.10) so that it will use of lack of comparability, it is hard to judge whether interest quoted at 8 6.13 EFFECTIVE = A percent compounded semiannually results in more or less interest than would be RATE: COMPOUND the case if the rate was 7.9 percent compounded monthly, To make the comparison INTEREST possible, we change both to their equivalent annual rates; these equivalents are called effective rates as in Section 6.5. For example, $1 at 8 percent compounded quarterly for one year would amount to 0.08\* i(14 (+58) 1.02)" 108243216, u which is the same ay the amount of $1 at a rate of 0.08243, or 8.243 percent for tone year. Similarly, by calculator, $1 at 7.9 percent compounded monthly for ane year would amount to 0.079)" F 1+ (+57) = 1081924169, ‘Scanned with CamScanner10 FINANCE a4 PART NONLINEAR RELATIONSHIPS WTH APPLIATIONS IN BUSINESS Nt percent for one year. 2 $1 at a rate of 8.192 Stein « equivale tof e 2 which is equivalent to the amount of $f tn times a YEA, In general, at nominal (annual) rate aa + a", The effective rote is the in one year, At the effective rate, rey $1 grows to equivalent canal simple Feltr interest rote. in a year, Hence btn =d+ i" neat t Effective Rate of / Compounded m Times a Year nedtin- Example. Find the effective rate of 24 percent compounded monthly Here, as usual, 24% TT ag = \ = 12 months in a year. Consequently (+ 0.02)" = 1 1268241795 — 1 0.268241795 = 26.824% On a caleutator with preprogrammed fin shown in Table 6-14, Tal functions, we would proceed as ‘Scanned with CamScanner‘GHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE TABLE 6-14 Keystroke 1, then PV 1 4 24 + . a4 iby 2 =, then % i 2 12, then n 2 CPT, then FV 1.268241795 - 1268241795 1 1 = (0.268241795 Example. Find the effective rate of 12 percent compounded annually, semi- annually. quarterly, monthly, semimonthly, weekly, and daily. In this case, 12% i : m where mr = 1, 2.4, 12. 24, 52, and 365, The results for ree dt ima are shown in Table 6-15. Note that r, increases as m increases, but the amount of increase in r, is gradually diminishing, especially after m = 12, What do you think will happen if we compounded by the hour, minute, or second? More will be said about this in Section 6.15. the effective rate of 15. percent compounded annually, semi- annually, quanerly, monthly, semimonthly, weekly, and daily. Answer: 15 percent, 15.563 percent, 15.865 percent, 10.075 percent, 16.129 percent, 16.158 percent, 16.180 percent. TABLE 6-15 =a 5 uns | 2s s epic Pazaoe | rassia | rz6n3% | 276% | t27se | 2.747% ‘Scanned with CamScanner 4sFINANCE a6, ARTI NONLIEAR RELATIONSHIPS WTH APPLATIONS IN BUSINESS AND 6.14 PROBLEM SET 6-4 In Problems | through 10, find the effective interest rate: 1.8 percent, compounded quarterly. 6. 7 percent, compounded quarterly. 210 percent, compounded semiannually. 1. 18 percent, compounded monthly. 3. 12 percent, compounded monthly. 8. 9 percent, compounded quarterly. 4.16 percent compounded quarterly. 9. 9 percent, compounded monthly. 5. 10 percent, compounded monthly. 10. 9 percent, compounded daily (365 days) UL. Find the effective rate of 11 percent compounded 12. Find the effective rate of 14 percent compounded annually, semiannually, quarterly, monthly, semi- annually, semiannually, quarterly, monthly, semi- monthly, weekly, and daily. monthly, weekly, and daily. 13. a) Write a computer program that will compute the b) Run the program in (a) for Problems 1 through, effective rate of interest. 12, 6.15 CONTINUOUS Before the appearance of modern high-speed data processing computers, calculation (INSTANTANEOUS) and recording of interest for even a few thousand bank accounts was tox costly in COMPOUNDING time to be done at frequent intervals. Consequently the commun practice was te compound quarterly—once every three months —and depositors who withires money from their accounts between interest dates did not receive interest tor the time between the last interest calculation and the date of withdrawal. Now. with high-speed computers, it is possible to calculate and add interest whenever any ‘um transaction takes place. A common practice currently is to compute mien from the day of deposit 10 the day of withdrawal, with interest componmina tat [ne number of compoundings in a year would tben be 365 (366 lige hese However, as stated in Section 6.2, banks may, for convenience. comme ee twelve 30-day months, 360 days for a year iis We start on our way toward continuous, or by recalling the number e, which is the base of the (Chapter 5). This constant, like the constant 2, ig therefore cannot be expressed exactly as a fraction welirately as needed for any applied problem, fantaneous, compounding system of natural, logarithnis 4 nonrepeating decimal m. However & can be To 12 decimat pr; = 2.7182 8182 g4sg 0 As we saw in Section 5.10, the value of ¢ can be ¢ of accuracy by calculating ‘an De Computed to any devired degree and expressed aces, ‘Scanned with CamScanner‘GHAPTER 6 INTRODUCTION TO THE MATHEMATICS OF FINANCE 47 ers using a sufficiently large value of mt. For example, with m = 200,000 1 so" + = 2.718) 7 ( ' m0) foals which is ¢ correct to nine decimal places. The important point to note is that the expression (: *) m, can be interpreted as the future value, F, of $1 at 100 percent interest (7 = 1.00) for one year, compounded m times a year. Thus, for example, $1 at 100 percent compounded monthly for a year would yield riled ‘This is illustrated in Figure 6-5, which shows 12 discrete points (that is, separated points) representing the 12 compoundings that make $1 at 100 percent grow to $2.61 in a year. If we compound $1 at 100 percent for a year with daily compoundings, m = 365 and r(i¢4)"=1 14h)" O.0s. nn Wj - 0.06, a, 0.07, 0.08, What nomin Br, = 0.12. Wor = 0, Mr = 0.09, 1 r= 0.10. ‘Scanned with CamScanner years and 6 months. is and 8 months, 5 percent: due in 12 years. 8. $3,000; 10 percent: due in 18 months. e nominal rates. Find the effective rate if interest is compounded continuously: compounded continuously will yield the effective rates in Problems 13 through 16?