MATHEMATICS OF FINANCE

L5-6 Mathematics of Finance

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 Introduction
Mathematics of Finance enables a better
understanding of the principles of borrowing
and saving.
These ideas will then be used to compare
different financial opportunities and make
informed decisions.
To provide an understanding of the way
interest is used to evaluate investments and
loans over time.
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 Simple Interest SI
A type of interest that is charged (or paid) only on the
amount borrowed (or invested) and not on past
interest. The amount borrowed is called the principal,
P. The rate of interest (r%) is given as a percentage
per year, expressed as a decimal. The time t the
money is earning interest is calculated in years.
Therefore S.I. = P x r x t

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 Example 1
To buy furniture for a new apartment, Gideon Koech
borrowed $5000 at 8% simple interest for 11 months.
How much interest will he pay?
Solution:
SI = P r t
= 5000 x 8% x (11/12)
= $366.67.

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 Future/ Maturity Value for SI
A deposit of P dollars today at a rate of interest r for t
years produces interest of I= Prt.
The interest, added to the original principal P gives
P + Prt = P ( 1 + rt )
This amount is called the future value (A) of P dollars at
an interest rate r for time t in years. When loans are
involved, the future value is often called the maturity
value of the loan.
Therefore, A = P ( 1 + rt )

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 Find A for SI(future/ maturity value)
1. A loan of $2500 to be repaid in 8 months with
interest of 4.3% (Ans: $ 2571.67)

$ (2571.67 -2500)= $ 71.67 represents the interest

1. A loan of $11,280 for 85 days at 7% simple interest

(Ans: $ 11466. 43)

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 Compound Interest
With Compound Interest, interest is charged (or paid)
on interest as well as on the principal.
At the end of the period under consideration the
investor has the principal, interest on the principal and
any accumulated interest.
The future values refers to the value to which the
principal will grow over a period of time, at some
given rate of interest.
Compounding may be discrete involving addition of
interest per period at the end of each period

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 Future Value for CI: Formula

A=P(1+r)t
Where t is time in years
NB: Money grows more rapidly when interest is
compounded.

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 Example 1 with Solutions
A business invests $ 500 at 15% p.a. Find the future
value at the end of :
i)one year
A = 500 ( 1 + 0.15)1 =$ 575
ii) five years
A = 500 ( 1 + 0.15)5 =$ 1005.68
iii) ten years
A = 500 ( 1 + 0.15)10 =$ 2022.78
iv)Find the total interest over 10 years
Total interest = $2022.78- 500 = $ 1522.78

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 Multiple Compounding
Interest can be compounded more than once per year.
Common compounding periods include semiannually
(two periods per year), quarterly (four periods per
year), monthly (twelve periods per year), or daily
(usually 365 periods per year).
The interest rate per period, i, is found by dividing the
annual interest rate, r, by the number of compounding
periods, m, per year. To find the total number of
compounding periods, n, we multiply the number of
years, t, by the number of compounding periods per
year, m.

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 Formula Multiple & Continuous
Compounding

A = P ( 1 + r )mt
m
Future value for continuous compounding
A = P e rt

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 Example 2
An amount of $ 500 is invested in an account earning
interest of 4% p.a. Find the total amount after five years
in the account if interest is compounded:
i) Annually (Ans: )
ii) Semi-annually (Ans: )
iii) Quarterly (Ans: )
iv) Monthly (Ans: )
v) Continuously (Ans: )

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 Solutions:
i)Annually
A = 500( 1 + 0.04 )1x5 = $608.33

ii)Semiannually
A = 500( 1 + 0.04 )2x5 = $ 609.50
2
iii)Quarterly
A = 500( 1 + 0.04 )4x5 = $ 610.10
4

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 iv)Monthly
A = 500( 1 + 0.04 )12x5 = $ 610.50
12
iv) Weekly
A = 500( 1 + 0.04 )52x5 = $ 610.65
52
v) Daily
A = 500( 1 + 0.04 )365x5 = $ 610.69
365
vi) Continuously
A = 500 e 0.04x 5 = $ 610.70

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 Discounting: Present Value
Refers to computing the value of a future investment
as of the current time.
The value of the future investment as of the present
time is referred to as the present value of the
investment.
Let present value be PV and future value be FV
We have already seen that a principal sum P
compounded annually at r% will yield a future value
given by:

FV = PV ( 1 + r ) t

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 Discounting Formula
To find the PV of FV i.e. its value at the present time we
apply the concept of discounting using the formula:

PV = FV ( 1 + r )-t
Or
PV = FV
( 1 + r )t
The interest rate applied in discounting is known as
the rate of discount.
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 Multiple Discounting Formula

PV = FV 1+r -mt

m
or
PV = FV
1+r mt

For continuous discounting PV = FV e -rt

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 Example 3
Find the present value of $ 6000 to be paid in 3 years at
10% p.a. when interested is compounded:
i) Annually (Ans: $ 4,507.89 )
ii) Semi-annually (Ans: $ 4477.29)
iii) Quarterly (Ans: $ 4,461.33)
iv) Monthly (Ans: $ 4,450.44 )
v) Weekly (Ans: $ 4446.19)
vi) Continuously (Ans: $ 4,444.91)

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 Solutions:
i)Annually
PV = 6000 (1 + 0.1) -1x3 = $

ii)Semiannually
PV = 6000 1 + 0.1 -2x3
=$
2

iii)Quarterly
PV = 6000 1 + 0.1 -4x3
=$
4
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 Solutions ctd:
iv)Monthly
PV = 6000 1 + 0.1 -12x3
=$
12

v) Continuously
PV = 6000 e –0.1x3 = $

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 APPLICATIONS

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 1. Annuity
A stream of constant cash flows or equal cash
payments made at the end of equal periods of time

E.g. the payment plans for car loans, mortgages are

annuities
The borrower is expected to make equal payments in
equal periods of time for a specified length of time

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 Present Value of an Annuity

An = a 1 - 1
r ( 1 + r )n

where An is PV
a is the annuity
r % is the discount rate

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 Example 4
Find the present value of an annuity of $ 500 over a
period of 15 years at a discount rate of 10%

Solution: Applying the formula gives the annuity as:

An = $ 3,803.04

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 Future Value of an Annuity
Consider an investment project promising to yield a
sequence of equal payments of a at the end of each
year for n years. The future value Fn

Fn = a ( 1 + r )n - 1
r

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 Loan Amortization
This is the process of paying a loan by making regular
deductions on the principal. There are two main methods

1.Payment of a fixed amount of the principal PLUS

interest on the balance of the loan. This means that the
stream of payments will decline from one year to the
next.
2. Payment of a fixed stream of cash flow every year
throughout the repayment period i.e. annuity payment

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 Example 5: Method 1
Consider a loan of $ 20,000 to be paid annually over
a period of 5 years at 8% p.a. and an annual fixed
payment of the principal $ 4,000 plus annually
declining interest.

The amortization schedule is given:

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 Amortization Schedule
Year Beginning Principal Interest Total Balance of
Sum and Paid Paid on Payment Principal
Balance Balance

1 20,000 4,000 1,600 5,600 16,000

2 16,000 4,000 1,280 5,280 12,000
3 12,000 4,000 960 4,960 8,000
4 8,000 4,000 640 4,640 4,000
5 4,000 4,000 320 4,320 00
Totals 20,000 4,800 24,800

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 Method 2: PV of Annuity
Consider a loan of $ 20,000 to be repaid by a stream of
equal payments of $ a over a period of 5 years at 8%
p.a. We first determine a using the PV of annuity
formula.
An = a 1 - 1
r ( 1 + r )n

20000 = a 1 - 1
0.08 ( 1 + 0.08)5
a = $ 5,009.129
The loan will be repaid by an annual fixed stream of $
5, 09.129 for 5 years
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 Amortization Schedule
Year Beginning Principal Interest Total Balance of
Sum and Paid Paid on Payment Principal
Balance Balance
1 20,000 3,409.129 1,600 5,009.129 16,590.87
1
2 16,590.871 3,681.859 1,327.27 5,009.129 12,909.01
2
3 12,909.012 3,976.408 1,032.721 5,009.129 8,932.604
4 8,932.604 4,294.521 714.608 5,009.129 4,638.083
5 4,638.083 4,638.083 371.047 5,009.129 00
Totals 20,000 5,045.65 25,045.65

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 Group Exercise
A young man borrows $ 15,000 to purchase a car. The
loan agreement states that the loan must be paid in 4
equal instalments over a period of 4 years at an interest
rate of 10% p.a. How much will the young man pay
annually?

Prepare a loan amortization schedule for the car loan.

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 Solution PV of Annuity Method
We first determine a using the PV of annuity
formula.
An = a 1 - 1
r ( 1 + r )n

15,000 = a 1 - 1
0.10 ( 1 + 0.10)4

a = $ 4,732.0621

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 Amortization Schedule
Year Beginning Sum Principal Interest Paid Total Balance of
and Balance Paid on Balance Payment Principal

1 15,000 3,232.0621 1,500 4,732.0621 11,767.9379

2 11,767.9379 3,681.859 1,176.79379 4,732.0621 8,212.66959

3 8,212.66959 3,976.408 821.266959 4,732.0621 4,301.874449

4 4,301.874449 4,294.521 430.1874449 4,732.0621 000

Totals 15,000 3,938.2482 18, 928.2484

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 Exam Question

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