CHAPTER 5: Mathematics of Finance

Introduction
Mathematics and commerce are intertwined in such that one cannot function without the
other. Commercial institutions like banks offer financial services like investments, credit
cards and loans to help people with money matters.

SIMPLE INTEREST
Interest is a sum of money received or paid for the use of someone else’s money. For
commercial institutions like banks, interest is also paid for the services rendered.
Interest maybe overlooked when the amount borrowed is very small. However, this is
not the case when thousands or even millions are borrowed.
Principal is the original amount borrowed, deposited, or invested.
Rate of interest is the percent of the principal paid per time period.
Time is the number of years, months or days.
Simple interest is the interest earned at the end of the allotted time between the lender
and the borrower. The formula is given below:

𝐼 = 𝑃𝑟𝑡 where: I – simple interest

P – principal
r – rate of interest
t – time in years
Example:

How many months will it take Php 15,000 to earn Php56.25 at 1.5% simple interest
rate?
Given: P = Php 15,000
𝐼 = Php 56.25
r = 1.25% = 0.0125
Required: time (t)
Solution: 𝐼 = 𝑃𝑟𝑡
56.25=15,000(0.0125) t
56.25
t= = 0.25 𝑦𝑒𝑎𝑟𝑠
15,000(0.0125)

12𝑚𝑜𝑠
t = 0.25 𝑦𝑒𝑎𝑟𝑠 ( ) = 3𝑚𝑜𝑛𝑡ℎ𝑠
1𝑦𝑟
Maturity Value
Is the total amount when the principal is added to the interest. Its formula is given
below:

M=P+I = P(1+rt) where: M – maturity Value

P – Principal
I – Interest

To illustrate, a man deposited Php50,000 at 1.25 % for 1 year. Find the simple interest
and the maturity value.
Given: P=Php50,000
r=1.25%
t=1 year
Required: I

Solution: M= P(1+rt)

= 50,000(1+(0.0125x1))
M = Php50,625

COMPOUND INTEREST
Compound interest is the interest earned on previously earned interest added to the
principal. For compound interest, present value will be used instead of the principal.
Aside from present value and rate of interest, compound interest will use the following
terms:
1. Frequency of conversion (m) – the number of times the interest will be added to
the present value. It may be annually or effective (1), semi-annually (2), quarterly
(4), bi-monthly (6), or monthly (12)
2. Nominal rate (j) – annual interest rate
3. Periodic rate (i) – annual interest rate per frequency of conversion
4. Number of conversions (n) – product of frequency of conversions and time
The maturity value of compound interest is given by:

𝑗 𝑚𝑡
M=P(1 + ) where: P = present value
𝑚 j = annual interest rate
m = frequency of conversions
t = time
 𝑗
To make calculations easier, 𝑖 = 𝑚 𝑎𝑛𝑑 𝑛 = 𝑚𝑡 Thus, the formula becomes:

𝑀 = 𝑃(1 + 𝑖 )𝑛
Example:
Anthony Villadon plans to invest Php100,000 in a business venture. He is offered 6%
compounded semi-annually. How much will he receive at the end of 3 years?
Given: P=Php100,000
j=6%
m=2 (semi-annually)
t=3 years
Required: M
𝑗 0.06
Solution: 𝑖 =𝑚= = 0.03
2
n=mt = 2(3) =6

𝑀 = 𝑃(1 + 𝑖)𝑛
= 100,000(1 + 0.03)6 = 𝑃ℎ𝑝119405.23

Summary
Simple interest calculates for the added amount only once for the given time.
Compound interest involves more complex calculation since when applicable, it
calculates interest based on previously earned interest within the time given.

STOCKS AND BONDS

Stocks indicate ownership, including claims on the assets and earnings, in a company
or corporation. Stock price is the highest or lowest amount someone is willing to pay for
the stocks.
Shares, are slightly different from stocks. They are a portion of the ownership of a
company or corporation.
Dividend is the monetary portion of the corporation’s earning’s decided by its Board of
Directors, which is a group of individuals elected to represent stockholders in meetings.
They decide what policies to implement for the benefit of the company.
Dividend yield is the stock’s dividend as a percentage of the stock price.
𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑒𝑎𝑟𝑙𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
dividend yield = 𝑥100% = 𝑥100%
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Dividend payout ratio measures the percentage of net income that is distributed to
shareholders in the form of dividend during the year.
𝑡𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑥100%
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
Examples:
1. Five hundred shares of ABC Incorporation are owned by Reiner. Each share pays
Php50 in annual dividends. If the current stock price is Php550, what is the dividend
yield?
𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
dividend yield = 𝑥100%
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒

𝑃ℎ𝑝50
dividend yield = 𝑥100 = 9%
𝑃ℎ𝑝550

2. Sette Co. has a current market price per share of Php250. As of last year, it paid
Php250,000 in dividends with 1,000 shares outstanding. Find the yield of the
dividend.
𝑦𝑒𝑎𝑟𝑙𝑦 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
dividend yield= 𝑥100%
𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑃ℎ𝑝250,000
1,000
dividend yield= 𝑥100% = 100%
𝑃ℎ𝑝250

3. Tully’s Bed and Breakfast has several shareholders. It is reflected on her income
statement that she has a net income of Php10,000 and issued Php3,000 of
dividends to her shareholders during the year. What percent of her net income is
paid to her shareholders?

𝑡𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑥100%
𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑃ℎ𝑝3,000
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑦𝑜𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝑥100% = 30%
𝑃ℎ𝑝 10,000
BONDS
Bonds are long term debt instruments that promise a fixed income in the form of
interest. The interest that bonds typically carry is paid semi-annually. The
coupon payment is the interest paid to the bondholder. The formula is as
follows:

𝐶𝑃 = 𝐹𝑟
Where: CP – coupon payment
F – face value
r – coupon rate
The bond price is calculated by obtaining the present value of the bond’s cash
flows. The formula is shown below:
𝑟 −2𝑡
1 − (1 +
𝐶𝑃
[ 2) ] 𝐹
𝐵0 = 𝑟 +
2 𝑟 2𝑡
2 (1 + )
2
Where: B0 – Bond price
CP – coupon payment
r – coupon rate
F – par or face value
t – time
Examples:
1. A semi-annual coupon bond has a face value of Php25,000. It has a 8%
coupon rate and 5 years remaining until its maturity. If the required rate of
return is 5%, find the a) coupon payment and b) bond price.
a. CP=Fr
CP= (Php25,000) (0.08) = Php 2,000

b.
𝑟 −2𝑡
𝐶𝑃 1 − (1 + 2) 𝐹
𝐵0 = [ 𝑟 ]+
2 𝑟 2𝑡
(1 +
2 2)
0.05 −2(5)
𝑃ℎ𝑝2,000 1 − (1 + 2 ) 𝑃ℎ𝑝2,000
𝐵0 = [ ]+ = 𝑃ℎ𝑝10,314.46
2 0.05 0.05 2(5)
2 (1 + 2 )
There are many ways to earn money. Stocks indicate ownership, including the assets
and earnings of a company. Bonds promise a fixed income in the form of interest. Both
are risky investments. However, the riskier the investments get, the bigger thr chances
of adding to the original investment.

Summary

The interest earned from both simple and compound interest is not the only means to
make money grow. Stocks and bonds can also make money grow. There are many
stocks and bonds to choose from. It is entirely up to the discernment of an individual
where to put his or her hard-earned money to generate larger interest.