Professional Documents
Culture Documents
Mathematics of Finance
Mathematics of Finance
Mathematics of Finance
Mathematics of Finance
Compound Interest
Annuities
Amortization and Sinking Funds
Arithmetic and Geometric
Progressions
4.1
Compound Interest
Example
A bank pays simple interest at the rate of 8% per year for
certain deposits.
If a customer deposits $1000 and makes no withdrawals
for 3 years, what is the total amount on deposit at the end
of three years?
What is the interest earned in that period?
Solution
Using the accumulated amount formula with P = 1000,
r = 0.08, and t = 3, we see that the total amount on
deposit at the end of 3 years is given by
A P (1 rt )
1000[1 (0.08)(3)] 1240
or $1240.
Example
A bank pays simple interest at the rate of 8% per year for
certain deposits.
If a customer deposits $1000 and makes no withdrawals
for 3 years, what is the total amount on deposit at the end
of three years?
What is the interest earned in that period?
Solution
The interest earned over the three year period is given by
I Prt
1000(0.08)(3) 240
or $240.
A P (1 rt )
2000[1 (0.06)(10)] 3200
or $3200.
Compound Interest
Frequently, interest earned is periodically added to the
Compound Interest
To find the accumulated amount A2 at the end of the
Compound Interest
We can use the simple interest formula yet again to find
Compound Interest
Note that the accumulated amounts at the end of each year
A1 P (1 r )
or:
A3 1000(1.08)3
A2 P(1 r ) 2
A3 P (1 r )3
A P(1 r )t
A P (1 r )t
or 2% per period.
r 0.08
i
0.02
m
4
apply
A P (1 r )t
nth Period:
An An 1 (1 i ) [ P (1 i ) n 1 ](1 i ) P(1 i ) n
First Period:
A P
Example
Find the accumulated amount after 3 years if $1000 is
Example
Solution
a. Annually.
Here, P = 1000, r = 0.08, and m = 1.
Thus, i = r = 0.08 and n = 3, so
r
A P 1
m
0.08
1
1000
1000(1.08)3
1259.71
or $1259.71.
Example
Solution
b. Semiannually.
Here, P = 1000, r = 0.08, and m = 2.
Thus, i 0.08
and n = (3)(2) = 6, so
2
A P
r
1
m
0.08
1
1000
1000(1.04)6
1265.32
or $1265.32.
Example
Solution
c. Quarterly.
Here, P = 1000, r = 0.08, and m = 4.
Thus, i 0.08
and n = (3)(4) = 12, so
4
A P
r
1
m
0.08
1
1000
1000(1.02)12
1268.24
or $1268.24.
12
Example
Solution
d. Monthly.
Here, P = 1000, r = 0.08, and m = 12.
Thus, i 0.08
12 and n = (3)(12) = 36, so
1000
0.08
1
12
36
0.08
1000 1
12
1270.24
36
r
A P 1
m
or $1270.24.
Example
Solution
e. Daily.
Here, P = 1000, r = 0.08, and m = 365.
Thus, i 0.08
365 and n = (3)(365) = 1095, so
r
A P 1
m
or $1271.22.
0.08
1000 1
365
1095
0.08
1000 1
365
1271.22
1095
A P 1
m
mt
becomes
u rt
1
or A P 1
u
The table shows us that when u gets
larger and larger the expression
1
A P 1
u
1
1
urt
10
1
1
2.59374
100
2.70481
1000
2.71692
10,000
2.71815
100,000
2.71827
1,000,000
2.71828
A = Pert
where
P = Principal
r = Annual interest rate compounded
continuously
t = Time in years
Examples
Find the accumulated amount after 3 years if $1000 is
A P
r
1
m
mt
0.08
1000 1
365
(365)(3)
1271.22
A P (1 R )
A P 1
m
P(1 R ) P
r
1
m
r
1 R 1
m
reff 1 1
m
where
reff = Effective rate of interest
r = Nominal interest rate per year
m = Number of conversion periods per year
Example
Find the effective rate of interest corresponding to a
Example
Solution
a. Annually.
Let r = 0.08 and m = 1. Then
1
0.08
reff 1
1
1
1.08 1
0.08
or 8%.
Example
Solution
b. Semiannually.
Let r = 0.08 and m = 2. Then
2
0.08
reff 1
1
2
1.0816 1
0.0816
or 8.16%.
Example
Solution
c. Quarterly.
Let r = 0.08 and m = 4. Then
4
0.08
reff 1
1
4
1.08243 1
0.08243
or 8.243%.
Example
Solution
d. Monthly.
Let r = 0.08 and m = 12. Then
12
0.08
reff 1
1
12
1.08300 1
0.08300
or 8.300%.
Example
Solution
e. Daily.
Let r = 0.08 and m = 365. Then
365
0.08
reff 1
1
365
1.08328 1
0.08328
or 8.328%.
Present Value
Consider the compound interest formula:
A P
r
1
m
mt
Present Value
P A 1 i
Where
r
m
and
n mt
Examples
How much money should be deposited in a bank paying a
P A
r
1
m
20,000
16,713
mt
0.06
1
12
(12)(3)
Examples
Find the present value of $49,158.60 due in 5 years at an
P A
r
1
m
mt
49,158.60
30, 000
0.1
1
4
(4)(5)
Present Value
with Continuously Compounded Interest
If we solve the continuous compound interest formula
A = Pert
for P, we get
P = Aert
This formula gives the present value in terms of the future
(accumulated) value for the case of continuous
compounding.
V (t ) 300,000e
t /2
P (t ) V (t )e 0.09t
300, 000e 0.09t
t /2
7 /2
599,837
(0 t 10)
P (t ) V (t )e 0.09t
300, 000e 0.09t
t /2
8/2
600, 640
(0 t 10)
P (t ) V (t )e 0.09t
300, 000e 0.09t
t /2
9/2
598,115
(0 t 10)
A P
r
1
m
15,000 10,000
0.12
1
15,000
(1.03)
1.5
10,000
4t
4t
ln(1.03) ln1.5
Taking logarithms
on both sides
4t ln1.03 ln1.5
logbmn = nlogbm
ln1.5
4t
ln1.03
So, it will take about 3.4
ln1.5
t
3.43
4 ln1.03
4.2
Annuities
(1 i ) n 1
S R
Example
Find the amount of an ordinary annuity consisting of 12
(1 i ) n 1
(1 0.01)12
1
S R
100
1268.25
i
0.01
or $1268.25.
1 (1 i ) n
P R
Example
Find the present value of an ordinary annuity consisting of
1 (1 i ) n
1 (1 0.0075) 24
P R
100
2188.91
i
0.0075
or $2188.91.
(1 i ) n 1
(1 0.005)144
1
S R
100
21,015
i
0.005
or $21,015.
1 (1 i ) n
1 (1 0.01) 36
P R
400
12,043
i
0.01
or $12,043.
Therefore, the original cost of the automobile is $16,043
($12,043 plus the $4000 down payment).
The interest charges paid by Murphy are given by
(36)(400) 12,043 = 2,357
or $2,357.
4.3
Amortization and Sinking Funds
Amortization Formula
Pi
R
1 (1 i ) n
965.55
n
360
1 (1 i )
1 (1 0.0075)
or $965.55.
R 1 (1 i ) n
i
294, 643
iS
R
(1 i ) n 1
iS
(0.025)(30,000)
R
3434.02
n
8
(1 i ) 1 (1 0.025) 1
or $3434.02.
4.4
Arithmetic and Geometric Progressions
20
S20 [2 2 (20 1)5] 990
2
1,000,000(1 (1.1)5 )
S5
6,105,100
1 1.1
Arithmetic Progressions
An arithmetic progression is a sequence of numbers in
Example
Find the twelfth term of the arithmetic progression
n
Sn [2a ( n 1)d ]
2
Example
Find the sum of the first 20 terms of the arithmetic
progression
2, 7, 12, 17, 22,
Solution
Letting a = 2, d = 5, and n = 20 in the sum of terms
formula, we get
n
Sn [2a ( n 1)d ]
2
20
S20 [2 2 (20 1)5] 990
2
a5 = 200,000 + (5 1)30,000
= 320,000
or $320,000.
Geometric Progressions
A geometric progression is a sequence of numbers in
an ar n 1
Example
Find the eighth term of a geometric progression whose
18 3
Using the nth term formula to find the eighth term gives
an ar
n 1
so,
a8 162
81
27
a (1 r n )
if r 1
Sn 1 r
na
if r 1
Example
Find the sum of the first six terms of the geometric
a (1 r n )
if r 1
Sn 1 r
na
if r 1
with a = 3, r = 6/3 = 2, and n = 6, gives
3(1 26 )
S6
189
1 2
a5 1,000,000(1.1) 4 1, 464,100
or $1, 464,100.
S5
or $6,105,100.
6,105,100
End of
Chapter