Mathematics of Finance

Afrin Sadia Rumana

Lecturer, Faculty Of Business Studies
Bangladesh University of Professionals (BUP)
 Contents

 Simple Interest
 Compound Interest
 Arithmetic and Geometric Progressions
 Simple Interest
 Simple interest is the interest that is computed on the
original principal only.
 If I denotes the interest on a principal P (in dollars) at
an interest rate of r per year for t years, then we have
I = Prt
 The accumulated amount A, the sum of the principal
and interest after t years is given by
A = P + I = P + Prt
= P(1 + rt)
and is a linear function of t.
 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( I  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.
 Applied Example: Trust Funds
 An amount of $2000 is invested in a 10-year trust fund
that pays 6% annual simple interest.
 What is the total amount of the trust fund at the end of 10
years?
Solution
 The total amount is given by

A  P ( I  rt )
 2000[1  (0.06)(10)]  3200
or $3200.
 Compound Interest
 Frequently, interest earned is periodically added to the
principal and thereafter earns interest itself at the same
rate. This is called compound interest.
 Suppose $1000 (the principal) is deposited in a bank for a
term of 3 years, earning interest at the rate of 8% per year
compounded annually.
 Using the simple interest formula we see that the
accumulated amount after the first year is
A1  P(1  rt )
 1000[1  0.08(1)]
 1000(1.08)  1080
or $1080.
 Compound Interest
 To find the accumulated amount A2 at the end of the
second year, we use the simple interest formula again, this
time with P = A1, obtaining:
A2  P(1  rt )  A1 (1  rt )
 1000[1  0.08(1)][1  0.08(1)]
 1000(1  0.08)2  1000(1.08)2  1166.40

or approximately $1166.40.
 Compound Interest
 We can use the simple interest formula yet again to find
the accumulated amount A3 at the end of the third year:
A3  P(1  rt )  A2 (1  rt )
 1000[1  0.08(1)]2 [1  0.08(1)]
 1000(1  0.08)3  1000(1.08)3  1259.71

or approximately $1259.71.
 Compound Interest
 Note that the accumulated amounts at the end of each year
have the following form:
A1  1000(1.08) A1  P (1  r )
A2  1000(1.08)2 or: A2  P (1  r ) 2
A3  1000(1.08)3 A3  P (1  r )3
 These observations suggest the following general rule:
✦ If P dollars are invested over a term of t years earning
interest at the rate of r per year compounded annually,
then the accumulated amount is

A  P(1  r )t
 Compounding More Than Once a Year
 The formula
A  P (1  r )t

was derived under the assumption that interest was

compounded annually.
 In practice, however, interest is usually compounded more
than once a year.
 The interval of time between successive interest
calculations is called the conversion period.
 Compounding More Than Once a Year

 If interest at a nominal rate of r per year is compounded m

times a year on a principal of P dollars, then the simple
interest rate per conversion period is
r Annual interest rate
i
m Periods per year
 For example, if the nominal interest rate is 8% per year,
and interest is compounded quarterly, then
r 0.08
i   0.02
m 4
or 2% per period.
 Compounding More Than Once a Year

 To find a general formula for the accumulated amount, we

apply
A  P (1  r )t

repeatedly with the interest rate i = r/m.

 We see that the accumulated amount at the end of each
period is as follows:

First Period: A1  P (1  i )
Second Period: A2  A1 (1  i )  [ P (1  i )](1  i )  P (1  i )
2

Third Period: A3  A2 (1  i )  [ P (1  i ) ](1  i )  P (1  i )

2 3

 
 
nth Period: An  An 1 (1  i )  [ P (1  i ) n 1 ](1  i )  P(1  i ) n
 Compound Interest Formula
 There are n = mt periods in t years, so the accumulated
amount at the end of t years is given by

mt
 r
A  P 1  
 m
where
A= Accumulated amount at the end of t years
P= Principal
r= Nominal interest rate per year
m= Number of conversion periods per year
t= Term (number of years)
 Example
 Find the accumulated amount after 3 years if $1000 is
invested at 8% per year compounded
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily
 Example
Solution
a. Annually.
Here, P = 1000, r = 0.08, m = 1, and t = 3, so
mt
 r
A  P 1  
 m
(1)(3)
 0.08 
 1000  1  
 1 
 1000(1.08)3
 1259.71

or $1259.71.
 Example
Solution
b. Semiannually.
Here, P = 1000, r = 0.08, m = 2, and t = 3, so
mt
 r
A  P 1  
 m
(2)(3)
 0.08 
 1000  1  
 2 
 1000(1.04)6
 1265.32

or $1265.32.
 Example
Solution
c. Quarterly.
Here, P = 1000, r = 0.08, m = 4, and t = 3, so
mt
 r
A  P 1  
 m
(4)(3)
 0.08 
 1000  1  
 4 
 1000(1.02)12
 1268.24

or $1268.24.
 Example
Solution
d. Monthly.
Here, P = 1000, r = 0.08, m = 12, and t = 3, so
mt
 r
A  P 1  
 m
(12)(3)
 0.08 
 1000 1  
 12 
36
 0.08 
 1000 1  
 12 
 1270.24
or $1270.24.
 Example
Solution
e. Daily.
Here, P = 1000, r = 0.08, m = 365, and t = 3, so
mt
 r
A  P 1  
 m
(365)(3)
 0.08 
 1000 1  
 365 
1095
 0.08 
 1000 1  
 365 
 1271.22
or $1271.22.
 Continuous Compounding of Interest
 One question arises on compound interest:
✦ What happens to the accumulated amount over a fixed
period of time if the interest is compounded more and
more frequently?
 We’ve seen that the more often interest is compounded,
the larger the accumulated amount.
 Continuous Compounding of Interest
 Recall that in the compound interest formula

mt
 r
A  P 1  
 m

the number of conversion periods is m.

 So, we should let m get larger and larger (approach
infinity) and see what happens to the accumulated
amount A.
 Continuous Compounding of Interest
 If we let u = m/r so that m = ru, then the above formula
becomes
u rt
 1
urt
 1  
A  P 1   or A  P  1   
 u  u  
 The table shows us that when
u gets larger and larger the u
u  1
expression  1  1  
u  u
1  
 u 10 2.59374
approaches 2.71828 (rounding 100 2.70481
to five decimal places).
1000 2.71692
 It can be shown that as u gets
10,000 2.71815
larger and larger, the value of
the expression approaches 100,000 2.71827
the irrational number 1,000,000 2.71828
2.71828…
Continuous Compounding of Interest

 Continuous Compound Interest Formula

A = Pert
where
P = Principal
r = Annual interest rate compounded
continuously
t = Time in years
A = Accumulated amount at the end
of t years
 Examples
 Find the accumulated amount after 3 years if $1000 is
invested at 8% per year compounded (a) daily, and
(b) continuously.
Solution
a. Using the compound interest formula with P = 1000,
r = 0.08, m = 365, and t = 3, we find
mt (365)(3)
 r  0.08 
A  P  1    1000  1    1271.22
 m  365 

b. Using the continuous compound interest formula with

P = 1000, r = 0.08, and t = 3, we find
A = Pert = 1000e(0.08)(3) ≈ 1271.25
Note that the two solutions are very close to each other.
 Effective Rate of Interest
 The last example demonstrates that the interest actually
earned on an investment depends on the frequency with
which the interest is compounded.
 For clarity when comparing interest rates, we can use
what is called the effective rate (also called the annual
percentage yield):
✦ This is the simple interest rate that would produce the
same accumulated amount in 1 year as the nominal rate
compounded m times a year.
 We want to derive a relation between the nominal
compounded rate and the effective rate.
 Effective Rate of Interest
 The accumulated amount after 1 year at a simple interest
rate R per year is
A  P (1  R )
 The accumulated amount after 1 year at a nominal interest
rate r per year compounded m times a year is
m
 r
A  P 1  
 m
 Equating the two expression gives
m
 r
P (1  R )  P  1  
 m
m
 r
1  R  1  
 m
 Effective Rate of Interest Formula
 Solving the last equation for R we obtain the formula for
computing the effective rate of interest:

m
 r
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
nominal rate of 8% per year compounded
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily
 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 5, page 264

 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%.
 Effective Rate Over Several Years

 If the effective rate of interest reff is known,

then the accumulated amount after t years on
an investment of P dollars can be more readily
computed by using the formula

A  P (1  reff )t
 Present Value
 Consider the compound interest formula:

mt
 r
A  P 1  
 m
 The principal P is often referred to as the present value,
and the accumulated value A is called the future value,
since it is realized at a future date.
 On occasion, investors may wish to determine how much
money they should invest now, at a fixed rate of interest,
so that they will realize a certain sum at some future date.
 This problem may be solved by expressing P in terms of A.
 Present Value

 Present value formula for compound interest

P  A 1 i
n

Where r and n  mt
i
m
 Examples
 How much money should be deposited in a bank paying a
yearly interest rate of 6% compounded monthly so that
after 3 years the accumulated amount will be $20,000?
Solution
 Here, A = 20,000, r = 0.06, m = 12, and t = 3.
 Using the present value formula we get

 mt
 r
P  A 1  
 m
 (12)(3)
 0.06 
 20,000  1  
 12 
 16,713
 Examples
 Find the present value of $49,158.60 due in 5 years at an
interest rate of 10% per year compounded quarterly.
Solution
 Here, A = 49,158.60, r = 0.1, m = 4, and t = 5.
 Using the present value formula we get

 mt
 r
P  A 1  
 m
 (4)(5)
 0.1 
 49,158.60 1  
 4 
 30, 000
 Present Value
with Continuously Compounded Interest
 If we solve the continuous compound interest formula

A = Pert
for P, we get
P = Ae–rt
 This formula gives the present value in terms of the future
(accumulated) value for the case of continuous
compounding.
 Applied Example: Real Estate Investment
 Blakely Investment Company owns an office building
located in the commercial district of a city.
 As a result of the continued success of an urban renewal
program, local business is enjoying a mini-boom.
 The market value of Blakely’s property is

V (t )  300,000e t /2

where V(t) is measured in dollars and t is the time in years

from the present.
 If the expected rate of appreciation is 9% compounded
continuously for the next 10 years, find an expression for
the present value P(t) of the market price of the property
that will be valid for the next 10 years.
 Compute P(7), P(8), and P(9), and then interpret your
results.
 Applied Example: Real Estate Investment
Solution
 Using the present value formula for continuous
compounding
P = Ae–rt
with A = V(t) and r = 0.09, we find that the present value of
the market price of the property t years from now is
P (t )  V (t )e 0.09t
 300, 000e 0.09t  t /2
(0  t  10)
 Letting t = 7, we find that

P(7)  300, 000e 0.09(7)  7 /2

 599,837

or $599,837.
 Applied Example: Real Estate Investment
Solution
 Using the present value formula for continuous
compounding
P = Ae–rt
with A = V(t) and r = 0.09, we find that the present value of
the market price of the property t years from now is
P (t )  V (t )e 0.09t
 300, 000e 0.09t  t /2
(0  t  10)
 Letting t = 8, we find that

P (8)  300, 000e 0.09(8)  8/2

 600, 640

or $600,640.
Applied Example 8, page 266
 Applied Example: Real Estate Investment
Solution
 Using the present value formula for continuous
compounding
P = Ae–rt
with A = V(t) and r = 0.09, we find that the present value of
the market price of the property t years from now is
P (t )  V (t )e 0.09t
 300, 000e 0.09t  t /2
(0  t  10)
 Letting t = 9, we find that

P (9)  300, 000e0.09(9)  9/2

 598,115

or $598,115.
 Applied Example: Real Estate Investment
Solution
 From these results, we see that the present value of the
property’s market price seems to decrease after a certain
period of growth.
 This suggests that there is an optimal time for the owners
to sell.
 Example: Using Logarithms in Finance
 How long will it take $10,000 to grow to $15,000 if the
investment earns an interest rate of 12% per year
compounded quarterly?
Solution
 Using the compound interest formula
mt
 r
A  P 1  
 m
with A = 15,000, P = 10,000, r = 0.12, and m = 4, we get
4t
 0.12 
15,000  10,000  1  
 4 
15,000
 1.03 
4t
 1.5
10,000
 Example: Using Logarithms in Finance
 How long will it take $10,000 to grow to $15,000 if the
investment earns an interest rate of 12% per year
compounded quarterly?
Solution
 We have
 1.03  1.5
4t

 Taking the logarithm on each side of the equation gives

ln  1.03  ln1.5
4t

4t ln1.03  ln1.5
ln1.5
t  3.43
4 ln1.03

 So, it will take approximately 3.4 years for the investment

to grow from $10,000 to $15,000.
Example 11, page 268
 Arithmetic Progressions
 An arithmetic progression is a sequence of numbers in
which each term after the first is obtained by adding a
constant d to the preceding term.
 The constant d is called the common difference.
 An arithmetic progression is completely determined if the
first term and the common difference are known.
nth Term of an Arithmetic Progression

 The nth term of an arithmetic progression

with first term a and common difference d
is given by
an = a + (n – 1)d
 Example
 Find the twelfth term of the arithmetic progression
2, 7, 12, 17, 22, …
Solution
 The first term of the arithmetic progression is a1 = a = 2,
and the common difference is d = 5.
 So, upon setting n = 12 in the arithmetic progression
formula, we find
an = a + (n – 1)d
a12 = 2 + (12 – 1)5
= 57
Sum of Terms in an Arithmetic Progression

 The sum of the first n terms of an arithmetic

progression with first term a and common
difference d is given by
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
 Applied Example: Company Sales
 Madison Electric Company had sales of $200,000 in its
first year of operation.
 If the sales increased by $30,000 per year thereafter, find
Madison’s sales in the fifth year and its total sales over the
first 5 years of operation.
Solution
 Madison’s yearly sales follow an arithmetic progression,
with a = 200,000 and d = 30,000.
 The sales in the fifth year are found by using the nth term
formula with n = 5.
 Thus,
an = a + (n – 1)d
a5 = 200,000 + (5 – 1)30,000
= 320,000
or $320,000.
 Applied Example: Company Sales
 Madison Electric Company had sales of $200,000 in its
first year of operation.
 If the sales increased by $30,000 per year thereafter, find
Madison’s sales in the fifth year and its total sales over the
first 5 years of operation.
Solution
 Madison’s total sales over the first 5 years of operation are
found by using the sum of terms formula.
 Thus,
n
Sn  [2a  ( n  1)d ]
2
5
 [2(200,000)  (5  1)30,000]
2
 1,300,000
or $1,300,000.
 Geometric Progressions
 A geometric progression is a sequence of numbers in
which each term after the first is obtained by multiplying
the preceding term by a constant.
 The constant is called the common ratio.
 A geometric progression is completely determined if the
first term a and the common ratio r are given.
 nth Term of a Geometric Progression

 The nth term of a geometric progression with

first term a and common ratio r is given by
an  ar n 1
 Example
 Find the eighth term of a geometric progression whose
first five terms are 162, 54, 18, 6, and 2.
Solution
 The common ratio is found by taking the ratio of any term
other than the first to the preceding term.
 Taking the ratio of the fourth term to the third term, for
example, gives
6 1
r 
18 3
 Using the nth term formula to find the eighth term gives
81
n 1 1 2
an  ar so, a8  162   
 3 27
Sum of Terms in a Geometric Progression

 The sum of the first n terms of a geometric

progression with first term a and common
ratio r is given by

 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
progression 3, 6, 12, 24, …
Solution
 Using the sum of terms formula

 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
 Applied Example: Company Sales
 Michaelson Land Development Company had sales of
$1 million in its first year of operation.
 If sales increased by 10% per year thereafter, find
Michaelson’s sales in the fifth year and its total sales
over the first 5 years of operation.
Solution
 The sales follow a geometric progression, with first term
a = 1,000,000 and common ratio r = 1.1.
 The sales in the fifth year are thus

a5  1,000,000(1.1) 4  1, 464,100

or $1, 464,100.
 Applied Example: Company Sales
 Michaelson Land Development Company had sales of
$1 million in its first year of operation.
 If sales increased by 10% per year thereafter, find
Michaelson’s sales in the fifth year and its total sales
over the first 5 years of operation.
Solution
 The sales follow a geometric progression, with first term
a = 100,000,000 and common ratio r = 1.1.
 The total sales over the first 5 years of operation are

1, 000, 000  1  (1.1) 5 

S5   6,105,100
1  1.1
or $6,105,100.