2

Solution of problemsin interest

2.1 INTRODUCTION

The basicprinciples in the theory ofinterest are relatively few. In Chapter 1,

various quantitative measures of interest were analyzed. Chapter 2 discusses
general principles to be followed in the solution of problemsin interest. The
purpose of this chapter is to develop a systematic approach by which the basic
principles from Chapter 1 can be applied to more complex financial transactions.
With a thorough understanding of the first two chapters it is possible to solve
most problems in interest. Successive chapters have two main purposes:

1. To familiarize the reader with more complex types of financial transactions,

including definitions of terms, which occur in practice.

2. To provide a systematic analysis of these financial transactions, which will

often lead to a moreefficient handling of the problem thanresorting to basic
principles.

As a result of the second purpose above, on occasion, simplifying formulas

will be derived. Fortunately, the number of formulas requiring memorization is
small. Even so, a common source of difficulty for some is blind reliance on
formulas without an understanding of the basic principles upon which the
formulas are based. It is important to realize that problems in interest can
generally be solved from basic principles andthat in manycasesresorting to basic
principlesis not as inefficient as it mayfirst appear to be.

49
 50 The theory of interest

Frequently it is necessary to obtain numerical answers for problemsinvolving

interest. This need is considerably facilitated by the widespread availability of
inexpensive financial calculators and personal computers. The existence of these
modern tools has greatly reduced, or even eliminated, more cumbersome
computational and approximation approaches requiredin the past.
Computational problems in Chapters 1 and 2 can readily be solved using any
pocket calculator with exponential and logarithmic functions. From Chapter 3
forward the use of a financial calculator is recommended to take advantage of
special financial algorithms availabletherein.
This book does not directly address the use of personal computers to solve
computational problems in interest. However, standard spreadsheet software is
ideally suited to solve a wide-range of problems in interest involving discrete
processes. The majority of problems encountered in practical applications of
interest involve such processes. The reader is encouraged to practice developing
spreadsheetsolutions for various applications throughoutthe book.

2.2: THE BASIC PROBLEM

Broken downinto its simplest terms, an interest problem involves four basic
quantities:

1. The principal originally invested.

2. The length of the investmentperiod.
3. Therate (or force) ofinterest (or discount).
4. The accumulated valueofthe principal at the end of the investment period.

If any three of these quantities are known, then the fourth quantity can be
determined. In the problems involving accumulated values considered so far, No.
4 is the unknown quantity; whereas, in the problems involving present values,
- No. 1 is the unknown quantity. Section 2.4 considers the case in which No. is
the unknown, while Section 2.5 considers the case in which No. 3 is the
unknown.
The following observations may prove helpful in the solution of problems in
interest:
 Solution ofproblemsin interest 51

a) The length of the investment period is measured in time units. It was

mentioned in Chapter 1 that the fundamental measurement period is often
assumed to be one year, and many problems are worked with this as the time
unit, especially those involving effective rates of interest or discount.

However, if nominal rates of interest or discount are involved, often a time

unit other than one year is most advantageous. The most convenient time
unit to use is generally the interest conversion period. In problems involving
continuous interest, however, some other time unit, such as a year, must
typically be used.

b) The phrase “yield rate” is frequently encountered in many different types of

applications involving interest. A precise definition of yield rate and a
thorough examination of it will not be given until Chapter7.

However, at this early point in the book, it is sufficient to say that the “yield
rate” is that rate of interest which will establish an equivalency of value
between a financial value at one point in time and financial value at a
different point in time. As a very simple example, $100 at time t=0 is
equivalent in value to $110 at time t=1, if and only if the yield rate is equal
to 10%.

The conceptof “yield rate” also can be readily generalized to multiple values
or payments at various points in time. The reader will encounter several
examples of this type in Chapters 3 - 6.

c) An interest problem can be viewed from two perspectives, sinceit involves a

financial transaction between twoparties, the borrower and the lender. From
either perspective, the problem is essentially the same; however, the wording
of a problem may be different depending upon the point of view. Examples
and exercises phrased from both points of view appear, and the reader should
notlet the different phraseology be a source of confusion.
52. The theory ofinterest

As an example, recall the discussion in Section 1.7 involving the use of the
words “paid” or “credited.” To some readers the word “paid” may seem
more normal from the vantage point of the borrower, while “credited” may
seem more normal from the vantage point of the lender. Many other such
examples couldbecited.

Complex financial transactions often involve more than two parties. For
example, a business firm analyzing its rate of return on a major investmentin
a new plant is involved with a multiplicity of parties. However, the basic
principles developed to analyze two-party transactions can readily be
extended to analyze these more complex transactions.

d) In practical applications involving interest the terminology can become

confusing. Many terms have ambiguous meanings(e.g. see the discussion on
the use of the word “discount” in Section 1.7). Furthermore, as we shall see
in succeeding chapters some terms used unfortunately do not convey an
intuitive description of the transactions involved (e.g. see the discussion on
the terms “annuity-immediate” and “annuity-due” in Section 3.3). Finally,
many parties involved in financial transactions simply do not always use
terms with textbookprecision.

The reader is admonished in real-world applications to look beyond the stated

terms and be certain to understand the exact nature of the financial
transactionsin question. There simplyis not total consistency in terminology
among the large and diverse number of parties involved in financial
transactions involvinginterest.

2.3 EQUATIONS OF VALUE

It is a fundamental principle in the theory of interest that the value of an

amount of moneyat any givenpoint in time depends uponthetime elapsed since
the money waspaid in the past or upon the time which will elapse in the future
before it is paid. We have already seen this in many of the examples. and
exercises considered thusfar in the book.
This principle is often characterized as the recognition of the time value of
money. This process would be in contrast to financial calculations not involving
 Solution ofproblems in interest 53

the effect of interest, in which case it would be said that such calculations do not
recognize the time value of money. The reader is cautioned that “recognition of
the time value of money”reflects the effect of interest, but not the effect of
inflation which reduces the purchasing power of money over time. Inflation-
adjusted calculations will be discussed in Section 9.4.
As a consequence of the above principle, it is obvious that two or more
amounts of money payableatdifferent points in time cannot be compared untilall
the amounts are accumulated or discounted to a common date. This common date
is called the comparison date, and the equation which accumulates or discounts
each paymentto the comparison date is called the equation of value.
One device which is often helpful in the solution of equations of valueis the
time diagram. A time diagram is a one-dimensional diagram in which units of
time are measured along the one dimension and payments are placed on the
diagram at the appropriate points. Note that payments in onedirection are placed
on the top of the diagram and payments in the other direction are placed on the
bottom of the diagram. The comparison date is denoted by an arrow. Figure 2.1
is an example ofa time diagram usedin the solution of Example 2.1.
The time diagram is not necessary in the solution of equations of value; it is
merely an aid in visualizing the problem. With some practice the reader can
usually dispense with a time diagram on simpler problems. However, time
diagramsare often helpful in the solution of more complex problems.
One of. the properties of compound interest is that the choice of the
comparison date makes no difference in the answer obtained. Thus, there is a
different equation of value for each comparison date, but they all produce the
same answer. This important property of compoundinterestwill be illustrated in
the solution of Example 2.1.
‘The reader is cautioned that under other patterns of interest, e.g. simple
interest or simple discount, the choice of a comparison date does affect the
answer obtained. This illustrates once again the inherentinconsistency in using
simple interest or simple discount.
The reader should be aware that the problems involving accumulated values
and present values already considered in the first two chapters are examples of
equations of value. Example 2.1 illustrates a more general type of problem.
54 The theory of interest

Example 2.1 In return for a promise to receive $600 at the end of 8 years,
a person agrees to pay $100 at once, $200 at the end of 5 years, and to make a
further payment at the end of 10 years. Find the payment at the end of 10 years
if the nominalrate of interest is 8% convertible semiannually.

Weshall first work the problem with a comparison date of the present. The time
diagram is shownin Figure 2.1.

600

Figure 2.1 Time Diagram for Example 2.1

Since interest is convertible semiannually, we will count time periods in half-years.

The equationof valueis

100 + 200v° + Xv" = 600v"* at 4%

600v"° — 100 —200v"
X= >
v

_ 600(.53391) — 100 — 200(.67556)

45639
= $186.76.
We could also have chosen a different comparison date and obtained a different
equation of value. For example, if the comparison date were chosen to be the end of the
10th year, then the arrow in the time diagram would be under 10 and the equation of value
would be
100(1.04)”” + 200(1.04)'° + X = 600(1.04)'
X = 600(1.04)’ -100(1.04)”° - 200(1.04)'°
= 600(1.16986)—100(2.19112) —200(1.48024)
= $186.76.

Thus, the same answeris obtained. The two equations of value are equivalent. If both
sides of the first one are multiplied by (1.04), the secondoneis obtained. The reader can
verify that if other comparison dates are chosen, the same answeris obtained.
 Solution ofproblemsin interest 55

2.4 UNKNOWN TIME

As discussed in Section 2.2, if any three of the four basic quantities entering
into an interest problem are given, then the fourth can be determined. In this
section we considerthe situation in which the length of the investment periodis
the unknown.
The best method of solving for unknowntime involving a single paymentis
to use logarithms. This technique will be illustrated in Example 2.2. A more
general situation involving unknown time with multiple payments will be
considered in Section 3.6. Twointeresting and useful results can be developed to
supplementthe basic technique involving logarithmsjust described.
The first is to develop an index for the average length of a financial
transaction. This topic is important in more advanced financial analysis and is
considered in depth in Chapter 11. However,it is desirable to lay the groundwork
for that developmentat an early stage in the book.
Consider a situation in which several payments made at various points in
time are to be replaced by one payment numerically equal to the sum of the other
payments. The problem is to find the point in time at which the one payment
should be made such that it is equivalent in value to the payments made
separately.
Let amounts S,5p,--..5, be paid at times t,ty,....t, respectively. The
problem is to find time t, such that 5, +5, +---+5, paid at time t is equivalent to
the payments of 5,,5,,...,5, made separately.
The fundamental equation of valueis

(5, +5) +...45,)V¥o = svif ts,v2t. +---+5,vi (2.1)

which is one equation in one unknown t. This equation can readily be solved
using logarithms. .
Asa first approximation, t is often calculated as a weighted average of the
various times of payment, where the weights are the various amountspaid,i.e.

nr

Sit
Sit, +Syty te t+Syty _ 2 Wk
t= = 1, (2.2)
S,1 +S,2 t+,n z
Sk
2
56 The theory of interest

This approximation is denoted by f and the techniqueis often called the method
of equatedtime.
It is possible to prove that the value of f is always greater than the true value
oft, or, alternatively, that the present value using the method of equated time is
smaller than the true present value. This proof is given in Appendix 2 at the end
of the chapter.
The second is to analyze a frequently asked question which is how longit
takes money to doubleat a given rate of interest. We can analyze this problem as
follows:
(1+i)" = 2
or
nin(1+i) = In2

giving
In2
Se, 2.3
** Tn(l+i) 23)
It is possible to derive an approximation to the exact result given in formula
(2.3) as follows:

n= In 2
In(1 +i)
_ 6931 i
i In(1+i)

The second factor evaluated for i = 8% is 1.0395. Thus we have

21(1.0395)
uv

22
i
(2.4)
Formula (2.4) is frequently called the rule of 72, since n can be approximated
immediately by dividing 72 by the rate of interest expressed as a percentage(i.e.
as 100%).
 Solution ofproblems in interest 57

The rule of 72 produces surprisingly accurate results over a wide range of

interest rates. Illustrative values are provided in Table 2.1.

Table 2.1 Length of Time It Takes Money to Double

Rate of interest Rule of 72 Exact value

4% 18 17.67
6 12 11.90
8 9 9.01
10 7.2 7.27
12 6 6.12
18 8 4.19

Example 2.2 Find the length of time necessary for $1000 to accumulate to
$1500if invested at 6% per annum compounded semiannually.

Let n be the numberof half-years. The equationof value is

1000(1.03)" = 1500
(1.03)" = 15.
Using logarithms
n in 1.03 = In1.5
n= Inds _ 405465 _ 13.717.
In 1.03 029559
Thus, the length oftime is .5(13.717) = 6.859 years.

Example 2.3 Payments of $100, $200, and $500 are due at the ends of
years 2, 3, and 8, respectively. Assuming an effective rate of interest of5% per
annum, find the point in time at which a payment of$800 would be equivalent:
(1) By the method of equated time.
(2) By an exact method.

1. By the method of equated time using formula (2.2)

j= 100-2 + 200-3+500-8
= 6 years.
100 + 200 + 500
2. The exact equation of value is

800v' = 100v?+ 200v?+ 500v*

58 The theory of interest

or 4 = 100 (.90703) + 200 (.86384) + 500 (.67684)

= .75236
800

whichcan be solved for t

= —n_.75236 _ _ 7.28454 5.832 years.

In 1.05 04879

As expected, the true value off is less than the value using the method of equated time.

2.5 UNKNOWNRATE OF INTEREST

Section 2.4 considered the case in which the length of the investment period
is the unknown. In this section we consider the situation in which the rate of
interest is the unknown. Problems involving the determination of an unknown
rate of interest are widely encountered in practice, since it is often necessary to
compute the rate of return or yield rate involved in a particular transaction.
Techniques to solve for an unknownrate of interest will be considered again in
several later chapters for various important types of applications.
Wefirst consider two somewhat limited, but instructive, methods to use in
determining an unknownrate of interest which can be utilized in certain basic
types of problems. Thefirst of these is to solve the equation of value for i directly
using a calculator with exponential and logarithmic functions. This method will
work well if a single payment is involved and can occasionally be adapted to
other situations as well. This methodis illustrated in Example 2.4.
The second method is to solve the equation of value for i by algebraic
techniques. For example, an equation of value with integral exponents on all the
terms can be written as an nth degree polynomial in i. If the roots of this
polynomial can be determined algebraically, then i is immediately determined.
This method is generally practical only for small values of n. This method is
illustrated in Example 2.5.
It is obvious that simple techniques such as these can only be applied in
certain basic types of problems. More general methods are needed for more
complex types of problems. Financial calculators can solve a much wider array of
“unknownrate of interest” problems. Several such examples will be illustrated in
later chapters of the book.
Financial calculators use techniques and algorithms from numerical analysis
for successive approximation or iteration. In using iteration to solve for an
 Solution ofproblemsin interest 59

unknownrate of interest, a function involving i, denoted by /f(i), is determined

using an equation of value, and iteration is used to find a value of i such that
fi) = 0. Iteration methods are discussed in more detail in. Appendix E for the
benefit of readers who would like more insight into what is going on inside the
financial calculator’s “black box.”

Example 2.4 At what interest rate convertible quarterly would $1000

accumulate to $1600 in six years?

Let j = i7/4 sothat the equation of value becomes

y
1000(1+ j = 1600
or
1/24
j = (16) -1.

This equation can be solved directly, which gives

j = .019776.
The answeris

iM = 47 = 0791, or 7.91%.

Example 2.5 At what effective rate of interest will the present value of
$2000 at the end of two years and $3000 at the end offour years be equal to
$4000?

Anequation of value is

4000 = 2000’ + 300014

whichcan be rewritten as
3v4+2v-4 = 0.

This equation can be solved as a quadratic in v’, which gives

ye -2+V4+4-3-4
2:3
Since v’ > 0, only the positive root is meaningful, and we have

v= EAS = 868517
60 The theory of interest

or

(1+i”® = 1.151388

which gives
i = 0730, or 7.30% .

2.6 DETERMINING TIME PERIODS

In practical problems involvinginterest it is necessary to determine the exact

time period of an investment. Although there would appear to be no ambiguity in
this process, different methods of counting the days in a period of investment
havearisen in practice. Three methods are commonly encountered.
The first method is to use the exact number of days for the period of
investment and to use 365 days in a year. Simple interest computed onthis basis
is sometimescalled exact simple interest and is often denoted by “actual/actual.”
Appendix A contains a table numbering the days of the year, which facilitates
counting the number of days between two given dates.
The second method assumesthat each calendar month has 30 days and that
the entire calendar year has 360 days. Simple interest computed onthis basis is
sometimes called ordinary simple interest and is often denoted by “30/360.”
Appendix A cannot be used for calculations on this basis. However, a formula
for computing the numberof days between two givendatesis

360(¥, -¥,)+30(M,—M,)+(D,-D,) (2.5)

where Y, = year offirst date

M, = month offirst date
D, = dayoffirst date
Y, = year of second date
M, = month of second date
D, = day of second date.

The third methodis a hybrid anduses the exact numberof days for the period
of investment, but uses 360 days in a year. Simple interest on this basis is
 Solution ofproblems in interest 61

sometimescalled the Banker's Rule and is often denoted by “actual/360.” It will

be shown in the exercises that the Banker's Rule is always more favorable to a
lender than is exact simple interest. Also, it will be shown that the Banker's Rule
is usually more favorable to a lender than is ordinary simple interest, although
exceptions do exist.
In theory we could have a fourth method denoted by “30/actual” or “30/365.”
However, this method is almost never encounteredin practice.
A further complication arises in a leap year. In most cases, February 29 is
counted as a day and the year has 366 days. However, in some cases, February 29
is counted as a day, but the year is still counted as having 365 days. In other
cases, February 29 is not counted asday, i.e. no interest is earned. The author has
even encountered the assumption that all years have 365 1/4 days! A uniform
approach to leap year does not seem to have emerged and different calculation
bases are encountered in practice. It should be noted that under ordinary simple
interest (30/360), leap year is irrelevant.
The above terms and discussion have been couched in terms of simple
interest. However, the three commonly encountered calculation bases, i.e.
actual/actual, 30/360, and actual/360, also are used for calculating time periods
on a compoundinterestbasis.
The reader should also be aware that most financial calculators have day-
counting algorithms as part of their functionality. The exact steps and keystroke
entries required vary from calculator to calculator and the owner’s manual must
be consulted for the particular calculator being used.
It is assumed, unless stated otherwise, that in counting days interest is not
credited for both the date of deposit and the date of withdrawal, but for only one
of these two dates. If the difference in the two dates is calculated by normal
procedures, then this will be the result. However, situations are occasionally
encountered in practice in which interest is paid for both the date of deposit and
the date of withdrawal, resulting in one extra day's interest.
Notall practical problems involving interest require the counting of days.
Manyfinancial transactions are handled on a monthly, quarterly, semiannual, or
annual basis. In these cases the counting methods described in this section are
not required.
62. The theory of interest

Example 2.6 Find the amountof interest that $2000 deposited on June 17
will earn, if the money is withdrawn on September 10 in the same year and if
the rate ofsimple interest is 8%, on thefollowing bases:
(1) Exact simple interest (actual/actual).
(2) Ordinary simple interest (30/360).
(3) The Banker's Rule (actual/360).

1. From Appendix A, September 10 is day 253 and June 17 is day 168. The actual
numberofdaysin the period of investment is 253 — 168 = 85. Thus, the answeris
85
( ( ——
2000(.08)} 36) = $ $37.26
assuming that the year in question is not a leap year. Note that even if a table such as
Appendix A is unavailable, it is an easy matter to count the number of days and arrive
at 85.

2. Using formula (2.5), the numberof daysis

360(0) + 30(9 — 6) + (10-17) = 83.

Thus, the answeris
83
2000(.08)|}
( ( —~—
36*) = $ $36.89.

3. The counting has already been done above andthe answeris

85
2000(.08)| —— = $37.78.
( {=
Not surprisingly, the answer using the Banker's Ruleis greater than using either exact
simple interest or ordinary simple interest.

2.7 PRACTICAL EXAMPLES

Virtually everyone is exposed to interest calculations regularly in their

financial affairs. However, in practice interest calculations do not always follow
the exact procedures outlined in this book. The purpose of this section is to
familiarize the reader with some of the variations encountered in practice. The
examples in this section are by no means exhaustive, but they are illustrative of
some “real-world” applications of interest. Some terms for types of investments
with which the reader may be unfamiliar are usedin this section,e.g. “certificate
 Solution ofproblemsin interest 63

of deposit” and “money market fund.” Definitions of these terms are given in
Section 8.8.
Financial institutions will sometimes advertise two different rates on
deposits. For example, a bank may quote a certificate of deposit as having a
5.20% rate/ 5.30% yield.” What is the meaning attached to these two numbers?
In this example, the former numberis a nominalrate, while the latter is an annual
effective rate. The reader should verify that i) =.0520, is equivalent to i=.0530,
Interestingly, the frequency of compounding for the nominal rate is not always
explicitly stated in such advertisements.
In recent years, financial institutions have started referring to the secondrate
above as APY, which stands for annual percentage yield. This term is similar to
another term used for consumer loans called APR, which stands for annual
percentage rate. These two rates are used for disclosure purposes and will be
discussed further in Section 8.2 in connection with “truth-in-lending”
requirements.
Section 2.6 deals with some of the variations in counting days. One
advertisement the author has seen indicates that a savings bank credits. 6%
compounded daily which producesa yield of 6.27%. Using either a 360 or 365-
day year produces an answer of 6.18%. How can an answer of 6.27% be
obtained? After some trial anderror, it was discovered that the savings bank was
using a mix of 360-day and 365-dayyearsas follows:

365

[14325 -1 = 0627.

Wheninterest is not compounded daily, some interesting variations appear.

Consider an investment account which credits interest monthly and on which
deposits and withdrawals are occurring. One commonvariation credits interest
on the average daily balance. Another commonvariation credits interest on the
minimum daily balance. Yet a third variation credits interest on the beginning
balance, reduced by any withdrawals, but not incremented by any deposits. In
this latter case deposits do not start earning interest until the beginning of the
following month.
Even the frequency of compounding can be tricky. Usually compounding
occurs at some regular, predetermined interval. However, the author has
encountered money market funds which compoundinterest wheneverthe interest
64 The theory of interest

rate being credited is changed. Thus, in a month with unchangedratesinterest

would be compounded only once, while in another more volatile month interest
might be compounded as manyas six or more times.
It is also important to distinguish between rates of interest and rates of
discount. For example, the United States Government issues Treasury bills for
periods of 13, 26, and 52 weeks. Therates on “T-bills,” as they are often called,
are computed as rates of discount. On the other hand, rates on longer-term
Treasury securities are computed asrates ofinterest. Thus, rates on Treasury bills
cannot be directly compared with rates on longer-term Treasury securities unless
converted to equivalent rates. Treasury bills are discussed further in Section 6.2.
Rates of discount are also encountered in short-term commercial transactions.
For example,if $10,000 is borrowed on a discount basis at 12% for one month,
then the borrower receives $9900 immediately and repays $10,000 at the end of
the month. Such short-term transactionsare often computed on a simple discount
basis, as justillustrated. The net effect is equivalent to using a rate of discount
convertible at the same frequency as the term of the loan. Thus, if a stated rate,
such as the 12% used above, is used for loans of varying lengths, then the
equivalent effective rates will differ depending upon the length ofthe loans.
Credit cards have an interesting way of charging interest. The interest
generally is computed onthe ending balanceof the prior month. Thus,no interest
is assessed on new charges during a month for that month,i.e. interest does not
begin to be charged until the following month. In essence, this is an interest-free
loan from the date of charge until the end of the month. Persons who always pay
their credit card chargesin full each month are, in essence, borrowing money for
short periods of time without paying any interest at all. On the other hand, the
interest rate charged on those accounts which docarry outstanding balances from
month-to-month tends to be very high. -
Another feature that investors need to be careful to consideris a penalty for
early withdrawal. For example, such penalties apply to many certificates of
deposit. If a two-year certificate of deposit credits an annual rate of 6%, the
purchaseris likely to have a rude awakening upon surrenderingafter one year and
learning that less than 6% will be paid. The penalties for early withdrawal often
involve either a reduction in the credited interest rate, or not crediting interest for
a certain period of time, or some combination of the two. Other types of early
withdrawal penalties are also encountered.
 Solution ofproblemsin interest 65

Finally, geography may be an important consideration. The techniques and

examples provided in this book largely reflect financial calculations involving
interest as they are typically done in the United States. Practices in other
countries may well differ in certain respects. This factor is becoming increasingly
important with the significant globalization of financial markets in recent years.
These illustrations should give the reader a flavor of some of the types of
applications encountered. The fact that so many variations exist and that
consistent terminology is not used from situation to situation can make seemingly
simple financial analysis difficult. In real-world applications the reader is
cautioned to look below the surface and ascertain exactly how calculations
involving interest actually will be done. Otherwise, comparisons among various
options for borrowing and lending may well be flawed.

Example 2.7 You invest $5000 in a two-yearcertificate of deposit (CD)

crediting 6% convertible quarterly. If the CD is redeemedearly, the credited
rate will be reduced to 4% convertible quarterly for the final three months of
the period of investment. Find the.amount you would receive if the CD is
redeemed after 18 months.

The quarterly interest rate on the CD is y, =.06/4=.015, if no penalty applies, and

y, =.04/4=.01, if a penalty applies. The CD earns the full rate for five quarters and the
reducedrate for one quarter giving a redemption value of

5000(1.015)° (1.01) = $5440.28.

66 The theory of interest

APPENDIX 2

Derivation involving method of equated time

Consider s, quantities each equal to v',s, quantities each equal to v2, and so
forth until there are s, quantities each equal to v. The arithmetic mean of these
quantitiesis

SV
j +5,v2
2 +--+,n yim
8, +5, +5458,

The geometric mean of these quantities is

S+5y +Sp

™!

However, we know that the arithmetic mean of n positive numbers, not all of
which are equal, is greater than the geometric mean, and thus we have
t, L t
SV! +S,V2 +++-+5,0" >
al
4

StS, 4-45,

or
SVitS,v2+--+5,V"
ui 4. 0 > (s, +5, + eee +5,) Vv,
é

Theleft-handside is the true present value which exceedsthe present value given
by the method of equated time onthe right-hand side. Thus, the value of t from
formula (2.2) is always greater than the true value of t from formula (2.1).
 Solution ofproblems in interest 67

EXERCISES

2.3 Equations of value

In return for payments of $2000 at the end of four years and $5000 at the end often
years, an investor agrees to pay $3000 immediately and to make an additional payment
at the end of three years. Find the amountofthe additional paymentif i? = .06.

You have an inactive credit cart with a $1000 outstanding unpaid balance. This
particular credit card charges interest at the rate of 18% compounded monthly. You are
able to make a payment of $200 one month from today and $300 two months from
today. Find the amountthat you will have to pay three months from today to completely
pay off this credit card debt. (Note: Work this problem with an equation of value. You
will learn an alternative approachfor this type of problem in Chapter5.)

At a certain interest rate the present value of the following two paymentpatternsare
equal:
(i) $200 at.the end of 5 years plus $500 at the end of 10 years.
(ii) $400.94 at the endof 5 years.
At the same interest rate $100 invested now plus $120 invested at the end of 5 years
will accumulate to P at the end of 10 years. Calculate P.

An investor makes three deposits into a fund, at the end of 1, 3, and 5 years. The
amountof the deposit at time t is 100(1.025)’. Find the size of the fund at the end of 7
years, if the nominal rate of discount convertible quarterly is 4/41.

Whereas the choice of a comparison date has no effect on the answer obtained with
compoundinterest, the same cannot be said of simple interest. Find the amountto be
paid at the end of 10 years which is equivalent to two payments of $100 each,thefirst
to be paid immediately and the second to be paid at the end of 5 years. Assume 5%
simple interest is earned from the date each paymentis made and use a comparison date
of:
a) The endof 10 years.
b) The endof15 years.
68 The theory of interest

2.4 Unknowntime

Find how long $1000 should be left to accumulate at 6% effective in order that it will
amount to twice the accumulated value of another $1000 deposited at the same time at
4% effective.

You invest $3000 today and plan to invest another $2000 two years from today. You
plan to withdraw $5000 in n years and another $5000 in n + 5 years, exactly liquidating
your investment accountat that time. If the effective rate of discount is equal to 6%,
find n.

The present value of two payments of $100 each to be madeat the end of n years and 2n
years is $100. If i = .08, find n.

A paymentof n is made at the end of n years, 2n at the end of 2n years,..., n’ at the

end of n” years. Find the value of ¢ by the method of equatedtime.

10. You are asked to develop a rule of n to approximate how longit takes moneytotriple.
Find x, where is a positive integer.

11. A deposits 10 today and another 30 in five years into a fund paying simple interest of
11% per year. B will make the same two deposits, but the 10 will be deposited n years
from today and the 30 will be deposited 2 years from today. B’s deposits earn an
annual effective rate of 9.15%. At the end of 10 years, the accumulated value of B’s
deposits equals the accumulated value of A’s deposits. Calculate n.

12. Fund A accumulates at a rate of 12% convertible monthly. FundB accumulates with a
force of interest 6, = t/6. At time t = 0 equal deposits are made in each fund. Find the
next time that the two fundsare equal.

2.5 Unknownrate of interest

13. Find the nominal rate of interest convertible semiannually at which the accumulated
value of $1000 at the end of 15 years is $3000.

14. Find an expression for the exact effective rate of interest at which payments of $300 at
the present, $200 at the end of one year, and $100 at the end of two years will
accumulate to $700 at the end of two years.
 Solution ofproblemsin interest 69

You can receive oneof the following two paymentstreams:

(i) 100 at time 0, 200 at time n, and 300 at time 2n.
(ii) 600 at time 10.
At an annual effective interest rate of i, the present values of the two streamsare equal.
Given v" =0.75941, determinei.

16. It is known that an investment of $1000 will accumulate to $1825 at the end of 10
years. If it is assumedthat the investment earns simpleinterest at rate i during the Ist
year, 2i during the 2nd year, ..., 10i during the 10th year; find i.

It is known that an amount of moneywill doubleitself in 10 years at a varying force of

interest 6, = kt. Find an expressionfork.

The sum of the accumulated value of 1 at the end of three years at a certain effective
rate of interest i, and the present value of 1 to be paid at the end of three years at an
effective rate of discount numerically equal to i is 2.0096. Find therate i.

2.6 Determining time periods

If an investment was made on the day the United States entered World War II, i.e.
December 7, 1941, and was terminated at the end of the war on August 8, 1945, for
how many days was the moneyinvested:
a) On the actual/actual basis?
b) Onthe 30/360 basis?

20. A sum of $10,000 is invested for the months of July. and August at 6% simpleinterest.
Find the amountofinterest earned:
a) Assuming exactsimple interest.
b) Assuming ordinary simpleinterest.
c) Assuming the Banker's Rule.

21. a) Show that the Banker's Rule is always more favorable to the lender than is exact
simple interest.
b) Show that the Banker's Rule is usually more favorable to the lender than is
ordinary simple interest.
c) Find a counterexamplein (b) for which the opposite relationship holds.
70 The theory of interest

2.7 Practical examples

22. A bill for $100 is purchased for $96 three monthsbeforeit is due. Find:
a) The nominal rate of discount convertible quarterly earned by the purchaser.
b) The annual effective rate of interest earned by the purchaser.

23. A two-year certificate of deposit pays an annual effective rate of 9%. The purchaseris
offered two options for prepaymentpenalties in the event of early withdrawal:
A-— areductionin the rate of interest to 7%.
B — loss of three monthsinterest.
In orderto assist the purchaser in deciding which option to select, compute the ratio of.
the proceeds under Option A to those under Option B if the certificate of deposit is
surrendered:
a) At the end of 6 months,
b) Atthe end of 18 months.

24, The ABC Bank hasan early withdrawal policy for certificates of deposit (CDs) which
states that intereststill be credited for the entire length the moneyactually stays with the
bank, but that the CD nominal interest rate will be reduced by 1.8% for the same
number of months as the CD is redeemed early. An incoming college freshman invests
$5000 in a two-year CD with a nominal rate ofinterest equal to 5.4% compounded
monthly on September | at the beginning of the freshman year. The studentintended to
leave the money on deposit for the full two-year term to help finance the junior and
senior years, but finds the need to withdraw it on May 1 of the sophomore year. Find the
amountthat the student will receive for the CD on thatdate.

25. Many banks quote tworates ofinterest on certificates of deposit (CDs). If a bank quotes
5.1% compounded daily, find the ratio of the APY (annual percentage yield) to the
quotedrate for this CD.

26. A savings and loan association pays 7% effective on deposits at the end of each year.
At the end of every three years a 2% bonusis paid on the balanceat that time. Find the
effective rate of interest earned by an investor if the moneyis left on deposit:
a) Twoyears.
b) Three years.
c) Fouryears.
 Solution ofproblemsin interest 71

27. A bank offers the following certificates of deposit (CDs):

. Nominal annual interestrate

Term in years . .
(convertible semiannually)
1 5%
2 6%
3 1%
4 8%

The bank does not permit early withdrawal, and all CDs matureat the end of the term.
During the next six years the bank will continue to offer these CDs. An investor
deposits $1000 in the bank. Calculate the maximum amountthat can be withdrawnat
the end ofsix years.

Miscellaneous problems

28. A store is running a promotion during which customers have two options for payment.
Option One is to pay 90% of the purchase price two monthsafter the date of sale.
Option Twois to deduct X % off the purchase price and pay cash on the date ofsale.
Determine X such that a customer wouldbeindifferent between the two options when
valuing them using an effective annual interest rate of 8%.

29. A manufacturersells a productto a retailer who has the option of paying 30% below the
retail price immediately, or 25% below theretail price in six months. Find the annual
effective rate of interest at which the retailer would be indifferent between the two
options.

30. You deposit $1000 into a bank account. The bank credits interest at a nominal annual
rate of i convertible semiannually for the first 7 years and a nominal annual of 2i
convertible quarterly for all years thereafter. The accumulated amountin the accountat
the end of 5 years is X. The accumulated amountin the accountat the end of 10.5 years
is 1980. Calculate X to the nearest dollar.

31. Fund A accumulates at 6% effective and Fund B accumulates at 8% effective. At the

end of 20 years the total of the two funds is $2000. At the end of 10 years the amount
in Fund A is half that in Fund B. Whatis the total of the two funds at the end of 5
years? Answerto the nearestdollar.
72 The theory of interest

32. An investor deposits $10,000 in a bank. During the first year, the bank credits an
annual effective rate of interest i. During the second year, the bank credits an annual
effective rate of interest i—.05. At the end of two years the account balance is
$12,093.75. What would the accountbalance have beenat the end ofthree years,if the
annual effective rate of interest were i + .09 for each of the three years? Answerto the
nearestdollar.

33. A signs a one-year note for $1000 and receives $920 from the bank. At the end ofsix
months A makes a payment of $288. Assuming simple discount, to what amount does
this reduce the face amountof the note?