Chapter IV Mathematics of finance

CHAPTER FOUR
MATHEMATICS OF FINANCE

People generally earn money because they want to spend it. If they save it, rather than spend
it in the period in which it was earned, it is usually because they want it to spend in the future.
However, for most people present consumption is more desirable than future consumption if
only because the future is so uncertain. "Live and be merry, for tomorrow we may die," is a
rationale used over the ages to justify the urge to buy now rather than deferring gratification
to the future. For this reason, most of us would rather have a dollar today than a dollar a year
from today, and must be given something extra to get us to defer gratification.

Looking at the transaction from the borrower's perspective, there are consumers and
businesses (not to mention the deficit-ridden government) who really need that dollar today
and who are willing to promise to pay back more than that dollar in the future. Businesses can
invest borrowed funds in capital to create profits which are (hopefully) more than sufficient to
repay the borrowed funds (principal) plus INTEREST. Consumers and governments borrow
for various reasons but are expected to have income in the future sufficient to repay principal
and interest. Simply put, the basic concept of mathematics of finance is that money has time
value. That is, a bird at hand worth two in the forest.

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.

A savings institution pays interest to a depositor on the money in the savings account since
the institution has use of those funds while they are on deposit. Or, a borrower pays interest to
a lending agent for use of that agent’s fund over the term of loan.

Interest - Simple interest.

- Compound interest.

SIMPLE INTEREST-

When we borrow money the money borrowed or the original sum of money lent (borrowed or
invested) is called the principal. (The principal remains fixed during the entire interest
period). Interest is usually expressed as a percentage of the principal for a specified period of
time which is generally a year. This percentage is termed the interest rate. If interest is paid
on the initial amount only and not on subsequently accrued interest, it is called simple
interest.

However, if the interest for each period is added to the principal in computing the interest for
the next period, the interest is called compound interest.

The sum of the original amount (principal) and the total interest is the future amount or
maturity value or Amount. A = P + I

Simple interest is generally used only on short term notes often of duration less than one
year. The concept of simple interest, however, forms the basis for compound interest
concepts.

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 Chapter IV Mathematics of finance

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.

If a sum of money, P is invested at a simple interest its value increases by the same amount
each year. Therefore, there is a linear relationship between amount and time.
Taking P= principal, r = rate of interest, t = time in years and A = amount, their relationship is
as follows:

I = Prt --------------------------- 1
A=P+I
= P + Prt
A = P (1+rt) ----------------------2
P= --------------------------- 3

P= A
1  rt            4
r = I              5
Pt
t = I pr                6

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.
Solution
I = Prt A = P+I
. x 12
 10,000x 012 = 10,000 + 600
= Birr 600 = Birr 10,600 or

A = P (1+rt)

= 10,000 (1.06) = Birr 10,600

2. How long will it take if Birr 20,000 is invested at 5% simple interest to double in value?
Solution. I=A-p
t= = 40,000 - 20,000
P = 20,000 BIRR = 20,000
r = 5%
A = Birr 40,000

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 Chapter IV Mathematics of finance

t=?

3. At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?
Solution.
t=
P = Birr 6,000
I= Birr 900
=
t = 5 years
r =? = 3% annual rate

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?

Solution. A
P
P = Birr? 1  rt
A = 3,100 Br 3,100
=
t = 4 years 1 .06x 4
r = 6%  Birr 2,500

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:
# ofdays
 Ordinary interest year - uses a 360 - day year - t
360
When time is determined in this way, the interest is called ordinary simple interest.
 Exact time- uses a 365-day year = t = or a 366 for leap year. Interest
computed in this way (using exact time) is called exact simple interest.

5. Find the interest on Birr 1,000 at 5% for 45 days.

Solution
1. Using ordinary Interest year:
p = Birr 1,000 I = prt
r = 5% 45
= 1,000 x .05 x
t = 45 days 360
I= Birr 6.25

2. Using exact time:

I = Prt Always ordinary simple interest
is grater than exact simple
= 1,000 x .05 x
interest.
= Birr 6.16

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 Chapter IV Mathematics of finance

Compound Interest

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.

The compound interest method is generally used in long-term borrowing. There is usually
more than one period for computing interests during the borrowing time. The time interval
between successive conversions of interest in to principal is called the interest period or
conversion period or compounding period, and may be any convenient length of time. The
interest rates are always given as annual percentages; no matter how many times the interest is
compounded per year. Hence, interest rate must be converted in to or adjusted to the
appropriate interest rate per conversion period (i) for computational purposes; and we use the
number of conversion periods as time.

The i is equal to the stated annual interest rate /nominal rate (r) divided by the number of
r
conversion periods in one year (m) = i = .
m
Conversion # of conversions per year, m

Daily 365
Monthly 12
Quarterly 4
Semi annually 2
Annually 1

Example:

1. 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 # of conversions = 4
r = 8% t = one year
Total number of conversion periods (m) = 4 times = quarter
r 8%
i= . = = 2%
m 4

Original principal Birr 10,000

Add: interest for the first quarter, I = 10,000 x .02
Principal at the end of first quarter 200
Add: Interest for the second quarter, 10,200 x .02 10,200=10,000(1.02)1
Principal at the end of second quarter

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Add: Interest for the third quarter, 10,404x.02 204

Principal at the end of third quarter 10,404 = 10,000 (1.02)2
Add: Interest for the fourth quarter, 10,612.08 208.08
x .02 10,612.08=10,000(1.02)3
Principal at the end of fourth quarter
(Amount at the end of the year) 212.2416
Birr 10,824.3216 = 10,000(1.02)4

If we summarize the above computations, we will discern 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

In general, the compound amount can be found by multiplying the principal by (1+i) n where i
is the interest rate per conversion period and n is the total number of conversion periods.

In Short, Amount with compound interest is calculated as:

r tm
A = P (1 +  = P (1 + i) n
m
Where:
A = compound amount, after n conversion periods.
P = principal
r = stated annual rate of interest
m = number of conversion periods a year
t = total number of years
I = r/m = interest rate per conversion period
n = mt = Total number of conversion periods.
So, for the above question, the amount is equal to
A = P (1 + I) n
= 10,000 (1.02)4
= 10,824.3216 Birr

Compound interest = compound amount - original principal

= 10,824.3216 - 10,000
= Birr 824.3216

using logarithm Rules of log

A = 10,000 (1.02)4 1. log aa = 1
log A = log 10,000 + log (1.02)4 2. logmp = p logm
= log 10,000 + 4 log 1.02 3. logmn = logm + logn
= 4 + 4 (0.0086) 4. logm/n = logm - logn
= 4+ 0.0344
log A = 4.0344
A = antilog 4.0344
= 10,824.30

Logarithms and Anti Logarithms for the Solutions of Equations.

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 Chapter IV Mathematics of finance

1. ax = b 2x = 5
logax = logb Log2x = 5
xloga = logb Xlog2 = log5
log b log
5
x = log a x=
log 2
2. abx + c = d 4(3x) + 10 = 17
abx = d-c 4(3x) = 17-10
dc 4(3x) = 7
bx =
a 3x = 1.75
dc Log3x = log1.75
logbx = log --- k
a xlog3 = log1.75
xlogb = logk log1.75
x=
x= log 3

3. x3 = a x3 = 1,000
logx3 = loga logx3 = log1000
3 log x log a 3logx = log1000

3 3 log1000
logx 
logx = 3
3
logx =
x = antilogk 3
logx = 1
d
4. a = b(c+x) x = antilog1
(c+x)d = a/b = 10

log(c+x)d = loga/b 100 = 25(1+x)4

dlogc+x = loga-logb (1+x)4 = 100/25
log(1+x)4 = log4
logc+x = 4log1+x = log4
logc+x = k
c+x = antilogk log1+x =
x = antilogk-c log1+x = 0.60205999/4
log1+x = 0.150515
1+x = antilog0.150515
1+x = 1.4142
x=0.4142

2. Find the compound amount compound interest resulting from the investment of Birr 1000 at
6% for 10 years,
2.1. Compounded annually.

Solution
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

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n = 10 = 790.85 Birr

2.2. Compounded semiannually.

Solution
P = Birr 1,000 A = p(1+i)n
r = 6% = 1,000 (1.03)20
m=2 = Birr 1,806.11
t = 10 years Compound interest = compound amount - principal
i = 3% = 1,806.11 - 1000
n = 20 = Birr 806.11

2.3 compounded quarterly.

Solution
P = Birr 1,000 A = 1,000 (1.015)40
r = 6% = Birr 1,814.02
m=4
t = 10 years Compound interest = compound amount - principal
i = .015 = 1814.02 - 1000
n = 40 = Birr 814.02

2.4. Compounded monthly.

Solution
P = Birr 1000 A = 1,000 (1.005) 120
r = 6% = 1,819.40 Birr
t = 10 years
m=12 Compound interest = compound amount - principal
i = .005 = 1,819.40 - 1000
n = 120 = 819.40 Birr

2.5. If compounded weekly

Solution
P = Birr 1000 A = 1,000 (1.0012)520
r = 6% = 1,821.49 Birr
t = 10 years
m=52 Compound interest = compound amount - principal
i = .0012 = 1821.49 - 1000
n = 520 = Birr 821.49

2.6. Compounded daily

P = Birr 1000 A = 1,000 (1.0001644)3650
r = 6% = 1,822.03
t = 10 years
m=365 Compound interest = compound amount - principal
i = .01644% = 1,822.03 - 1000
n = 3650 = Birr 822.03

2.7. Compounded hourly

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P = Birr 1000 A = 1,000 (1.00000685)87,600

r = 6% = 1,822.12 Birr
t = 10 years
m= 8760 Compound interest =compound amount - principal
i = .000685% = 1,822.12 - 1000
n = 87600 = Birr 822.12 Birr

2.8. Compounded continuously (instantaneously).

(1+i) n = (1+r/m) mt
 1  1
f(x) =  1   x
if x approaches infinity  1   x becomes closer to 2.71828 = e
x x

Let m/r = x as m x 

r/m = 1/x = m = rx

P = Birr 1000 A = Pert

r = 6% = 1,000 e.06x10 = 1000 e.6
t = 10 years = Birr 1,822.12
m=infinite compound interest = compound amount - principal
1,822.12 - 1000 = Birr 822.12
3. How long will it take to accumulate Birr 650 if Birr 500 is invested at 10% compound
quarterly?
Solution
P = 500 A = p(1+i)n
A = 650 650 = 500 (1.025)n
r = 10% 1.3 = (1.025)n
i=2.5% log1.3= log(1.025)n
m=4
t=? n/m = log 1.3
n = log 1.025
n =? 10.625 quarters
= 10.625 quarters

4. 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?

Solution
P = Birr 2,000 A = p(1+i)n
A = Birr 2,166 2166 = 2000 (1+i)12
r =? 1.083 = (1+i)12
i=r/12 log1.083= log(1+i)12
t=1 =12log1+i

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 Chapter IV Mathematics of finance

m = 12 log 1.083
 log 1  i
12
0.0028857 = log1+i
anti log .0028857 = 1+i
1.0066667 = 1+i
.0066667 = i
.006667 x 12 = r = i x m
= 8% = r
5. 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?
Solution

3 years 2 years

P= Birr 10,000

10,000(1.03) 6 Birr 11,940.52

8,000.00
Birr 19,940.52

19,940.52(1.02)8
Birr 23,363.49
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 is 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= = p = A (1+i)-n
(1  i ) 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:
1. 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 P = A (1+i)-n

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 Chapter IV Mathematics of finance

t = 4 years = 5,000 (1.05)-8

m=2 = Birr 3,384.20
r = 10%
P =?
2. 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?

A = 20,000 Birr P = A (1+i)-n

t = 4 years = 20,000 (1.005)-48
m = 12 = Birr 15,742
r = 6%
P =?

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?
Solution:
We can solve this problem in two ways:
1) By finding the PV of 600 and compare it with 500
2) By finding the FV of 500 and compare it with 600.

1) A = 600 2) P = 500
t = 18 months = 1.5years t = 1.5 years
m=2 m=2
r = 14% r = 14%
p =? A =?
-n
P = A(1+i) A = P(1+i)n
= 600 (1.07)-3 = 500 (1.07)3
= Birr 489.78 = Birr 612.52
Since 489.78 < 500, it is better to pay Since 612.52 > 600, it is better to pay the
the debt after 18 months. debt after 18 months.

4. 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?
Solution:
A = Birr 8,000 P = A (1+i)-n
t = 9 years = 8,000(1.02)-36
n = 36 = 3,921.79 Birr
m=4
i=2%
r = 8%
P =?

Present value with continuous compounding

Equivalent Rates

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 Chapter IV Mathematics of finance

Some times it is helpful to convert interest rates from, for example, a compounded quarterly
basis to a compounded annually basis, from a compounded quarterly basis to compounded
monthly basis, etc. this is easily accomplished as long as we understand the concept of
equivalent interest rates, which is defined as follows:
If at the beginning of a specified time period, the same amount of money is invested at
various rates so that the resulting compound amounts are equal at the end of the time period,
then the interest rates are equivalent rates.
Although we can use any length time period, we usually use a 1-year time interval. Thus, if
Birr P is invested at annual rate r compounded m times a year, and another Birr P is invested
at annual rate s compounded k times a year, then the rates are equivalent as long as
P (1 +r/m) m = P (1 +s/k) k
Dividing both sides of the above equation by P gives the equivalent rates equation which can
be solved for either r or s, depending on which the unknown.
Use this equation to find equivalent rates: (1 +r/m) m = (1 +s/k) k

1. What rate compounded monthly is equivalent to 8% compounded quarterly?

Solution
(1+r/12)12 = (1+.08/4)4
= (1.02)4, solving for r, we take the 12th root of each side to obtain,
4 1/12
(1+r/12) = ((1.02) )
= (1.02)3
r/12 = (1.02)3 -1
= 1.006622 -1
r/12 = .006622
r = 12(.006622)
r = .079476
= 7.95%

2. What nominal annual rate of interest converted monthly corresponds to 16% converted
quarterly?
Solution
(1+r/12)12 = (1+.16/4)4
= (1.04)4, solving for r, we take the 12th root of each side to obtain, (1+r/12) =
4 1/12
[(1.04) ]
= (1.04)1/3
r/12 = (1.04)1/3 -1
= 1.013159404 -1
r/12 =. 013159404
r = 12(013159404)
r = .157912845
= 15.79%

Or, using logarithms

(1.04)4 = (1+i) 12
Log (1.04)4 = log (1+ i) 12
4 log (1.04) = 12 log (1+i)
4 (0.017033339) = 12 log (1+ i)
0.068133357 = 12 log (1 + i)
0.0056778 = log 1+ i
Antilog .0056778 = (1+ i)
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 Chapter IV Mathematics of finance

1.0131594 = 1+i
.1031594 = i
r=mxi
= 12 x .0131594
= 15.79%

A stated rate of 15.79% compounded monthly would earn interest equivalent to that earned
with a stated rate of 16% compounded quarterly.
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 it self. 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

Compound int erest I

The effective rate of interest is (re)=  . From the above statement:
principal P
I = p (1 + r/m) m - p
= P [(1+r/m) m - 1) Divide both sides by p

I/p = (since r = I/Pt,……and the time is 1….I/P1 = r: I/P)

r=
= (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

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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 Chapter IV Mathematics of finance

.06 4
= (1+ ) -1
4
= (1.015)4 -1
= 6.14%

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

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 inv. opp. A Effective rate for inv. opp. B
m
re= (1+r/m) - 1 re= (1+r/m)m - 1

= =

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

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

Solution.
re = er-1
.10 = er-1
1.1 = er
ln 1.1 = lner
ln1.1 = rlne
ln1.1 = r (1)
9.531% = r

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Chapter IV Mathematics of finance

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. The time
between successive payments is called the PAYMENT PERIOD for an annuity. Each
payment is called PERIODIC PAYMENT or PERIODIC RENT, and it is denoted by R. The
time from the beginning of the first payment period to the end of the last period is called the
TERM of an annuity. If payments are made at the end of each time interval, then the annuity
is called an ORDINARY ANNUITY. If payments are made at the beginning of the payment
period, it is called an ANNUITY DUE.

Geometric Series and Annuities

Geometric Series
A geometric progression is a sequence of numbers where each term after the first term is
found by multiplying the previous term by a fixed number called the Common ratio, r. It has
the form
a + ar + ar2 + ar3 +...+ arn-1.

Each term is a constant multiple, r, of the preceding term. If S n denotes the sum of the first n
terms of a geometric series, then
Sn = a + ar + ar2 + ar3 +...+ arn-1.

An alternative formula for evaluating Sn is derived as follows. Take the equation Sn = a + ar +

ar2 + ar3 +...+ arn-1 and multiply both sides by r to obtain rS n = ar + ar2 + ar3 +...+ arn-1

Now consider both equations:

Sn = a + ar + ar2 + ar3 +...+ arn-1

rSn = ar + ar2 + ar3 +...+ arn-1 + arn
Subtracting the second equation from the first, we would get
Sn - rSn = a - arn

Factoring both sides of this last equation gives us

Sn (1 – r) = a (1- rn)
Hence,

(Valid only if r ≠ 1.)

If r = 1, then Sn = arn. If the common ratio in a geometric progression is less than 1 in

modulus, (that is -1 < r <1), the sum of an infinite number of terms can be calculated. This is
known as the sum to infinity,
Provided -1 < r < 1

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 Chapter IV Mathematics of finance

ORDINARY ANNUITY

An ordinary annuity is a series of equal periodic payments in which each payment is made at
the end of the period.
In an ordinary annuity the first payment is not considered in interest calculation for the first
period (because it is paid at the end of the first period for which interest is calculated) and the
last payment doesn’t qualify for interest at all since the value of the annuity’s computed
immediately after this last payment is received.
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. 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%
Interest rate per conversion period (i) = r/m = 4%/4 = 1%
Future value of (sum of) an annuity =?
Term one year

1,2,3,4 - End of the quarter

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

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 O. Annuity at the end of its term.

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 Chapter IV Mathematics of finance

Last payment R
The second payment from the last R(1+i)1
The third payment from the last- R(1+i)2
|
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]

A (i) = R [(1+i) n-1] dividing both sides by i, we have, A =

(1 + i) n -1]
= future value factor.
i

For the above example: A = 100 = Birr 406.04

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
1.01)36 Compound interest = A - R(n)
R = Birr 1000 = 43,076.88 - 36,000
t = 3 years. = 7,076,88 Birr
m = 12
n = 36
r = 12%
i=1%
A =?
3. 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?
Solution
R = Birr 200 A4 = 200 [(1 + .07/12)48 – 1]
t = 4years 0.07/12
m = 12 = 200 (55.20924)
r = 7% = 11,041.85 Birr

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 Chapter IV Mathematics of finance

After the end of the fourth year, we calculate compound interest rate taking Birr 11,041.85 as
principal compounded monthly for 6 years.

P = 11,041.85 Birr A10 = 11,041.85 (1 + .07)72

t = 6years 12
m = 12 = 11,401.85 (1.5201)
I = 7% = Birr 16,784.77
A10 =?
4. 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?

Solution.

For the first 10 years:

R = Birr 500 A10 = 500 [(1.06)10 – 1]
t = 10years 0 .06
m=1 = 500 (13.180795)
r = 6% = Birr 6590.40
A10 =?

For the next 8 years, Birr 6590.40 is taken as single deposit (Principal) in an account which
pays 8% compounded quarterly.

P8 = A10 = Birr 6950.40

t = 8years A18 = A10 (1 +i) n
m=4 = 6950.40 (1.02) 32
r = 8% = 6950.40 (1.88454)
A18 =? A18 = Birr 12,419.87

The balance after 18 years is Birr 12,419.87 out of which Birr 7,419.87 (Birr 12,419.87 – Birr
5000) is interest earned.

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

A = R [(1+i) n –1]
i
Then A____
R = [(1+i) n - 1]
i

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 Chapter IV Mathematics of finance

R=

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 R=A[ i ]

n
(1+i) – 1
t = 10years
m = 12 = 100,000 [ .005 ]
(1.005)120 – 1
r = 6% = 100,000 (0.006102)
R =? = Birr 610.21

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

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.

Solution.

For the first five years

R = 100 A60 = 100 [(1.01)60 - 1]
t = 5years 0.01
m = 12 = 100 (81.6697)
r = 12% = Birr 8166.97
A60 =?

For the last five years:

The amount at the end of the first 5 years (Birr 8,166.97) serves as single principal and it
earns interest for the next five years.

A = 8,166.97 (1.01)60
= Birr 14,836.90

To determine the periodic payment we subtract 14,836.90 Birr from Birr 25,000 to obtain the
amount of an ordinary annuity for the last five years.

A60 = Birr 25,000 – Birr 14,836.90

= 10,163.10

R2 = 10,163.120 X .01___
(1.01) 60 – 1

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 Chapter IV Mathematics of finance

= Birr 124.44

The proper R is (if normally deposited the same amounts)

R = 25,000 [ .01 ]
(1.01)120 – 1
= Birr 108.68

3. XYZ Company purchased a tract of land under a purchase agreement which requires a
payment of Birr 500,000 plus 5% interest compounded annually at the end of 10 years. The
company plans to setup a sinking fund to accumulate the amount required to settle the land
purchase debt. What should the quarterly deposit into the fund be if the account pays 15%
interest, compounded quarterly?
Solution.
First we have to find the total debt at the end of five years as

A = P (1+i) n i = 5%
= 500, 000 (1+0.05)10
= Birr 814,447.31

The amount is taken as Future Value of an Ordinary annuity with r = 15% Compounded
quarterly for 10 years

A40 = Birr 814,447.31 R = 814,447.31

t = 10 years
m=4 = 9,088.80 Birr
r = 15%
i= 3.75%
R =?
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

Solution

A = Birr5000 a) R=

t = 2 years =

m=2 = Birr 1,142.96

r = 12% b) Interest = Amount - R (n)
i= 6% = 5000 - 1,142.96(4)
n= 4 = Birr 428.16
R=?
c)

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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 x i

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 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

1. 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) _ _ _ 200
-1

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]

A = 200 [(1.02)4 - 1]
.02
= Birr 824.32

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

P = 824.32 (1.02)-4
= 761.56

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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,

P (1+i) n = R [(1+i) n -1] Dividing both sides by (1+i) n gives

i
-n
P = R [1 – (1+i) ]
i
Or

If we multiply the FV of an O. annuity by the compound discount factor we have the present
value of an annuity.

P = R [(1+i) n -1] (1+i)-n

i
= R [(1+i) n (1+i)-n –1 (1+i)-n]
i
= R [(1+i) 0 – 1 (1+i)-n]
i

Using the above formula; the PV of the former example is computed as:

R = Birr 200 P = R [1 – (1+i)-n]

r = 8% i
m=4 = 200 [1 – (1.02)-4]
t = 1yr .02
P =? = 200 (3.08773)
= Birr 761.55

2. 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?
Solution.

Cash Value = down payment + PV of an O. annuity

= 200 + 82[1 – (1.01)-18]
.01
= 200 + 82(16.39827)
= 200 + 1,344.658
= Birr 1,544.658

3. 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?
Solution.
R = Birr 1000 PV = 1000[1 – (1.015)-12]
t = 3years .015

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 Chapter IV Mathematics of finance

m=4 = 1000(10.9075)
r = 6% = Birr 10, 907.50
PV =?

4. 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?
Solution
Since we have quarterly payment periods and monthly interest periods, we must change the
interest rate to coincide with the quarterly payment periods. Specifically, we must find the
equivalent interest rate compounded quarterly corresponding to 12% compounded monthly
and use it as r (i). Using the equivalent rate formula, we have
(1 +r/4)4 = (1 +.12/12)12
(1+ r/4)4 = (1.01)12
r/4 = (1.03)3 - 1  i = .030301

R = Birr 1000
i = .030301
n=7
P =?

= = Birr 6,223.22

5. 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, 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:

Where:
R = periodic payment
P = PV of loan
i= interest rate per period
n = number of payment periods

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
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 Chapter IV Mathematics of finance

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 = 5000[ .05 ]
t = 5years 1 – (1.05) -5
m=1 = 5000(.230975)
r = 5% = Birr 1,154.87
R =? Interest = (1,154.87 X 5) – 5000
= Birr 774.35
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?

Solution.

PV = Birr 200,000 R = 200,000 [ .01 ]

-120
t = 10years 1 – (1.01)
m = 12 = 200,000(0.014347)
r = 12% = Birr 2,869.42
R =?

3. An employee has contributed with her employer to a retirement program for 20 years
a certain amount twice a year. The contribution earns an interest rate of 10% compounded
semi annually. At the date of her retirement the total retirement benefit is Birr 300,000. The
retirement program provides for investment of this amount at an interest rate of 10%
compounded semi annually. Semi-annual payments will be made for 20 years to the employee
or her family in the event of her death.
1. What semi-annual payment should she make?
2. What semi-annual payment should be made for her?
3. How much interest will be earned on Birr 300,000 over the 40 years?
Solution.

Retirement plan

Employment period Retirement period

Pay Receive
0 20 40
R =? A = Birr 300,000
A = 300,000 PV = 300,000
t = 20 years t = 20 years
m=2 m=2
r = 10% r = 10%
R1 =? R2 =?

R = A[ i ] R2 = P20 [ i ]
(1+i) n –1 1 – (1+i) -n

= 300,000 ( .05 ) = 300,000 ( .05 )

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 Chapter IV Mathematics of finance

(1.05)40 – 1 1 – (1.05)-40
= Birr 2483.45 = Birr 17,483.45

Interest earned = (R2 x 40) - (R1 x 40)

= (17,483.45 x 40) - (2483.45 x 40)
= (15,000 x 40)
= Birr 600,000

4. Eden 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

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 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,

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

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

Solution
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Chapter IV Mathematics of finance

P = Birr 7000 a)

r = 16%, i = 4%

m=4

t = 2 years, n = 8 R = Birr 1,039.69

R =?
b) Interest accumulated = R (n) - A
= 1,039.69(8) - 7,000
= Birr 1317.52

c) Amortization schedule
Payment payment Interest Principal Balance
No. reduction
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
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

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

R can be determined as follows:

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 Chapter IV Mathematics of finance

Or

Similarly

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.

Solution

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

Down payment (20%) 23,000 m = 12
Mortgage (A) Birr 92,000 t = 30yrs n= 360
R =?

= 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

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.

Solution.

Selling price = Birr 50,000 Mortgage (A) = R [1- (1+i)-n]

Down payment =? i
Mortgage (A) =? = 600 [1- (1.02)-240]
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 Chapter IV Mathematics of finance

R = Birr 600 0.02

r = 24% i = 2% = Birr 29,741.13
m = 12 Down payment = Selling price – mortgage
t = 20 n = 240 = 50,000 – 29,741.13
= Birr 20,258.87
Interest charged = actual payment- mortgage
= 600 x 240 - 29,741.13
= 144,000 - 29741.13
= Birr 114,258.87

Percentage of down payment =

=
= 40.52%
3. Mr. Z has taken out a Birr 60,000, 20 year, 24% mortgage on his home.
a. How much will he pay each month to discharge this mortgage?
b. How much of the first payment is for interest and by how much does it reduce
the balance owed?
c. How much of the second payment is for interest and by how much does it
reduce the balance owed?

Solution.
a.
Mortgage (A) Birr 60,000
r = 24% i = 2%
m = 12
t = 20 years n = 240
= 60,000(.020174
= Birr 1,210.44
b. Interest = 60,000 X .02
= Birr 1,200
Reduction from the balance owed = Monthly payment – Interest
= 1210.44 – 1200
= Birr 10.44

c. Interest = (60,000 – 10.44) x .02

= Birr 1199.79

Reduction from Balance owed = 1210.44 – 1199.79

= Birr 10.65

4. Ato Tefera purchased a house for Birr 250,000. He made a 20% down payment, with a
balance to be amortized by a 30-year mortgage at annual interest rate of 12% compounded
monthly.

a. Determine the amount of his monthly mortgage payment

b. What is the total amount of interest Ato Tefera will pay over the life of the mortgage?
c. Determine the amount of the mortgage Ato Tefera will have paid after 10 years.

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 Chapter IV Mathematics of finance

d. What will be Ato Tefera's equity in the house at the end of 10 years?

Solution
Selling price = Birr 250,000 b. Interest=?
Down payment(20%)= 50,000 = total payment - mortgage
Mortgage Birr 200,000 = 2,057.23 x 360 - 200,000
r = 12% i = 1% = 740,602.80 - 200,000
m = 12 = Birr 540,602.80
t = 30 years n = 360
c. After 10 years there will remain (20 x 12)
a. R =? = 240 monthly payments of Birr 2,057.23 to
be made. The amount of the mortgage that is
still unpaid at this time is the PV of this
series of payments, that is;

= Birr 2,057.23
= Birr 186,836.43.
Thus after 10 years Ato Tefera will have
d. Equity in house = down payment
paid Birr 13,163.57 (Birr 200,000 -
+ paid amount
186,836.43) against the principal amount of
= Birr 50,000 + 13,163.57
the mortgage.
= Birr 63,163.57

5. Andinet and Florence are looking to purchase a home. They found one that they like that costs
Birr 150,000. They can get a 30-year mortgage at 9% and plan to make a down payment of
20% of the selling price.
a. What will be their monthly mortgage payment?
b. When Andinet and Florence go to the bank, they are offered an annual percent rate of 6%
if they take a 15-year loan rather than one for 30 years. Andinet and Florence are skeptical
because they can't afford to make twice the payment calculated for 30 years. In actual
fact, how much would their payment be if they repaid the mortgage in 15 years?
c. Andinet is 25 years old and wants to be a millionaire by the time he is 50. He is planning
to put aside a sum of money at the end of each year sufficient to accumulate a million Birr
in 25 years using an interest rate of 10%. How much must he put aside?
d. Considering your answer in part c above, suppose Andinet can only put aside Birr 10,000
per year. How high a rate of return must he realize to achieve his goal?

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