CHAPTER 6

The Mathematics of Finance

(Reference: Chapter 11 of
Mathematical Excursions by
Aufmann)

1
OUTLINE
 6.1 Simple Interest
 6.2 Compound Interest
 6.3 Equation of Values
 6.4 Annuities
 6.5 Simple Annuities
 6.6 Amortization and Sinking Fund
Schedule
2
S E C T I O N 6.1
SIMPLE INTEREST

3
 Simple Interest
 When you deposit money in a bank—for
example, in a savings account—you are
permitting the bank to use your money.
 The bank pays you for the privilege of using
your money. The amount paid to you is called
interest.
 If you are the one borrowing money from a
bank, the amount you pay for the privilege of
using that money is also called interest. 4
 Simple Interest
 The amount deposited in a bank or borrowed
from a bank is called the principal.
 The amount of interest paid is usually given
as a percent of the principal. The percent
used to determine the amount of interest is
called the interest rate.

5
 Simple Interest
 If you deposit $1000 in a savings account
paying 5% interest per year,
- $1000 is the principal and
- the annual interest rate is 5%.

6
Simple Interest Formula
 The simple interest formula is
I = Prt
I is the interest,
P is the principal,
r is the interest rate, and
t is the time period.
7
 example 1 Calculate Simple
Interest
 Calculate the simple interest earned in 1
year on a deposit of $1000 if the interest
rate is 5%.
 P = 1000, r = 5% = 0.05, and t = 1.
 I = Prt
 I = (10000)(.05)(1)
 I =50
 The simple interest earned is $50.
8
 example 2 Calculate Simple
Interest
 Calculate the simple interest due on a 3-month
loan of $2000 if the interest rate is 6.5%.

9
 Remember that in the simple interest
formula, time t is measured in the same
period as the interest rate.
 Therefore, if the time period of a loan
with an annual interest rate is given in
days, it is necessary to convert the time
period of the loan to a fractional part of
a year.
10
 There are two methods for converting
time from days to years: the exact
method and the ordinary method.

The ordinary method is used by most

businesses. Therefore, unless otherwise
stated, the ordinary method will be used in
this text. 11
 example 4 Calculate Simple
Interest
 Calculate the simple interest due on a 45-day
loan of $3500 if the annual interest rate is 8%.

12
 example 5 Calculate the
Simple Interest Rate
 The simple interest charged on a 6-month loan of
$3000 is $150. Find the simple interest rate.

13
Future Value and Maturity
Value
 When you borrow money, the total
amount to be repaid to the lender is the
sum of the principal and interest.

14
 For an investment, such as a deposit in
a bank savings account, A is the total
amount on deposit after the interest
earned has been added to the principal.
This sum is called the future value of
the investment.

15
 example 6 Calculate a
Maturity Value
 Calculate the maturity value of a simple
interest, 8-month loan of $8000 if the
interest rate is 9.75%.

16
 Calculate the maturity value of a simple
interest, 8-month loan of $8000 if the
interest rate is 9.75%.

17
 Recall that the simple interest formula
states that I = Prt.
 A=P+I
 A = P + Prt
 A = P(1+ rt )
 A is the future value of an investment or
the maturity value of a loan, P is the
principal, r is the interest rate, and t is the
time period. 18
S E C T I O N 6.2 COMPOUND
INTEREST

19
20
21
22
23
24
Present Value
 The present value of an investment is the
original principal invested, or the value
of the investment before it earns any
interest. Therefore, it is the principal, P,
in the compound amount formula.
 Present value is used to determine how
much money must be invested today in
order for an investment to have a specific
value at a future date.
25
Present Value

26
1. Find the compound amount and interest if ₱1,000 is
invested at 2% compounded quarterly for 1 year and 6
months.
2. Find the compound amount and interest if P5, 500 is
invested at 1.6% compounded monthly for 5 years and 6
months.
3. Find the compound amount and interest on P12, 800 for 3
years and 6 months at 6% converted semi-annually.
4. A financial obligation of P25, 500 is due on January 6, 2020.
What is the value of this obligation on July 6, 2014 at 9%
compounded semi-annually?
5. An equipment is purchased on instalment by your
company. Your company makes a ₱205, 000 and owes a
balance of ₱500, 000 to be paid in seven years. Find the
cash value of the equipment if money is worth 1.02%
compounded quarterly.
27
S E C T I O N 6.3 EQUATIONS
OF VALUE

28
 EQUATION OF VALUE

 In business transactions, it is often needed to

exchange a set of obligations for another set of
different amounts due at different times. The
most effective method to solve investment
problems like these is the EQUATION OF VALUE
process.

29
 EQUATION OF VALUE

 An equation of value is a mathematical

statement, which shows that the dated values
on a comparison date (focal date) of two sets of
payments are equal. The focal date or point is
the point where all obligations and payments
are brought through the process of
accumulation or discounting. The location of
the focal point or date will not change or affect
the final answer.
30
 EQUATION OF VALUE

 An equation of values is a mathematical

statement stating that the sum of one set of
values on a certain comparison date (called the
Focal date) is equal to the sum of another set of
values on the same comparison date. Note: sum
of the values of old obligations = sum of the
values of new obligations

31
 Procedure

1. Identify the set of old and new obligations.

Represent the unknown with the letter x.
2. Construct the time diagram
3. Select the most convenient comparison or
focal date.
4. Write the equation of values then solve.
5. State the final answer.

32
 Exercises:

1. If money is worth 9% compounded quarterly,

what single payment at the end of 4 years will
equitably replace the following set of obligation:
a. ₱5, 500 due at the end of 2 years
b. ₱6, 600 due at the end of 3 ½ years with 11 ¼% simple
interest
c. ₱4, 400 due at the end of 6 years with interest at 5 ½%
converted semi – annually
d. ₱7, 700 due at the end of 7years with interest at 6%
compounded quarterly.
33
 Exercises:
2. Mr. Hae Y. Ram owes his creditor ₱1000 due without
interest at the end of 10 years, and ₱3000 due at the end of
4 years with accumulated interest from today at 4%
compounded annually. Mr. Hae Y. Ram will discharge his
obligations by two equal payments at the end of the 3rd and
6th years. If the creditor states that money is worth 6%
compounded semi – annually, find the new payments.
3. Mr. Aye borrowed ₱2000 from Mr. Yoo on June 1, 2012,
and ₱500 on June 1, 2014, agreeing that money is worth 5%
compounded annually. Mr. Aye paid ₱500 on June 1, 2015,
₱400 on June 1, 2016, and ₱700 on June 1, 2017. What
additional sum should Mr. Aye pay on June 1, 2020, to
discharge all remaining liability?

34
 Exercises:
4. Mr. Matt A. Kaw owes Whaley N. Fud, ₱3,300 due
now, and ₱4, 500 due in 6 years with interest at 5 ½%
compounded quarterly. He will be allowed to settle
these obligations by paying two equal payments in 3
and 4 years respectively. Find the size of the payments
if money is worth 5 ½% compounded semi-annually.
5. A housewife buys a dining set worth ₱42, 400. She
pays a down payment of ₱14, 600 and promise to settle
the balance in three equal payments in 3, 6 and 9
months, respectively. If interest is charged at 9%
compounded monthly, what will be the size of each
payment?

35
S E C T I O N 6.4 ANNUITIES

36
 SIMPLE ANNUITIES
 Annuity is a series of periodic payments
(usually equal) made at regular intervals of
time. Instalment payments, monthly rentals,
and life insurance premiums are familiar
examples of annuities.
 The period of time between consecutive
payments is called the payment interval
 Term of an annuity is the time from the
beginning of the first payment interval to the
end of the last payment interval.
 The interval maybe of any convenient length
like monthly

37
 TYPES OF ANNUITIES
 Annuity Certain – is an annuity payable for
a definite duration not dependent on some
outside contingency. It means that this
annuity begins and ends on a definite or
fixed date.
 Annuity Uncertain or Contingency Annuity –
is an annuity payable for an indefinite
duration in which the beginning or the
termination is dependent on some certain
event. It means that this annuity’s first or
last payment, or both, depends upon some
events.
38
KINDS OF ANNUITY CERTAIN
 Simple Annuity – an annuity whose interest conversion period

(m) is equal or the same as the payment interval (pi).

 General Annuity – an annuity whose interest conversion
period (m) is unequal or not the same as the payment interval

CLASSIFICATION OF SIMPLE ANNUITY

 Ordinary Annuity– is annuity in which the periodic payment is
made at the end of each payment interval.
 Annuity Due– is an annuity in which the periodic payment is

made at the beginning of each payment interval.

 Deferred Annuity– is an annuity in which the periodic payment
is not made at the beginning nor at the end of each payment
interval, but some later date.

39
PRESENT VALUE and AMOUNT of an
ANNUITY

 The PRESENT VALUE of an Annuity is the

value of the annuity at the beginning of
its term.
 The AMOUNT of an Annuity is the value
of the annuity at the end of its term.

40
 PRESENT VALUE and AMOUNT of an
ANNUITY

Present
value or
amount
loaned

41
 Formulas
𝑟 𝑛𝑡
(1+ ) − 1
𝑛
 𝐴=𝑅 𝑟
𝑛𝑟
𝐴
𝑛
𝑅= 𝑟 𝑛𝑡
1+ −1
𝑛

Where: 1−(1+ )
𝑟 −𝑛𝑡
𝑛
A – future value  𝑃=𝑅 𝑟
amount of annuity 𝑛𝑟
P – present value of the 𝑃
𝑛
annuity
𝑅= 𝑟 −𝑛𝑡
1− 1+
R – periodic payment 𝑛

42
Exercises:
 A man deposits ₱12,200 every end of 6 months in an
account paying 2% compounded semi – annually. What
amount is in the account at the end of 9 years and 6
months?
Unknown: 𝑨 𝑟 0.02
Given: 𝑅 = ₱12200
: = 0.01
𝑛 2
6
𝑟 = 2%, 𝑛 = 2 𝑛𝑡: 2 9 12 = 19
𝑡 = 9 𝑦𝑒𝑎𝑟𝑠 𝑎𝑛𝑑 6 𝑚𝑜𝑛𝑡ℎ𝑠
𝑟 𝑛𝑡
(1 + ) − 1
𝐴=𝑅 𝑛 (1.01)19 − 1
𝑟 𝐴 = 12200
𝑛 .01

𝑨 = ₱𝟐𝟓𝟑𝟖𝟗𝟐. 𝟗𝟐

43
Exercises:
 A home video entertainment set is offered for sale for ₱18,000 down
payment and ₱1,800 every three months for the balance, for 18
months. If interest is to be computed at 10% converted quarterly,
what is the cash price equivalent of the set?
Unknown: Cash price
Given: 𝑅 = ₱1800 𝑟 = 10%, 𝑛 = 4 𝑡 = 18 𝑚𝑜𝑛𝑡ℎ𝑠
𝑪𝒂𝒔𝒉 𝒑𝒓𝒊𝒄𝒆 = 𝒅𝒐𝒘𝒏 𝒑𝒂𝒚𝒎𝒆𝒏𝒕 + 𝑷

𝑟 𝑟 0.1
1 − (1 + 𝑛)−𝑛𝑡 : = 0.025
= 18000 + 𝑅 𝑟 𝑛 4
𝑛 18
𝑛𝑡: 4 =6
12
1 − (1.025)−6
= 18000 + 1800
0.025

𝐂𝐚𝐬𝐡 𝐩𝐫𝐢𝐜𝐞 = ₱𝟐𝟕𝟗𝟏𝟒. 𝟔𝟑

44
Exercises:
 How much monthly deposit must be made for 5 years and 5

months in order to accumulate ₱120,000 at 3% compounded

monthly?
Unknown: R
Given: 𝐴 = ₱120000
𝑟 = 3%, 𝑛 = 12 𝑡 = 5 𝑦𝑒𝑎𝑟𝑠 𝑎𝑛𝑑 5 𝑚𝑜𝑛𝑡ℎ𝑠

𝑟 𝑟 0.03
𝑨 𝑛 𝑛
:
12
= 0.0025
𝑹=
𝑟 𝒏𝒕
𝟏+𝑛 −𝟏 5
𝑛𝑡: 12 5
12
120000 0.0025 = 65
𝑅=
1.0025 65 − 1

45
𝑹 = ₱𝟏𝟕𝟎𝟐. 𝟓𝟐
Exercises:
 Bebong wants to buy a car worth ₱740,000. He can

pay 40% of the price as down payment and the

balance payable every end of the month for 60
months, how much must he pay monthly at 9%
compounded monthly?
Unknown: R
Given: 𝑪𝒂𝒔𝒉 𝒑𝒓𝒊𝒄𝒆 = ₱740,000
𝑫𝒐𝒘𝒏 𝒑𝒂𝒚𝒎𝒆𝒏𝒕: 740000(.4) = ₱296000
𝑷: 740000 − 296000 = ₱444000
𝒓 = 9%, 𝒏 = 12 𝒕 = 60 𝑚𝑜𝑛𝑡ℎ𝑠

46
Given: 𝑪𝒂𝒔𝒉 𝒑𝒓𝒊𝒄𝒆 = ₱740,000
𝑫𝒐𝒘𝒏 𝒑𝒂𝒚𝒎𝒆𝒏𝒕: 740000(.4) = ₱296000
𝑷: 740000 − 296000 = ₱444000
𝒓 = 9%, 𝒏 = 12 𝒕 = 60 𝑚𝑜𝑛𝑡ℎ𝑠

𝑟
𝑃 𝑛
𝑅= 𝑟 0.9
𝑟 −𝑛𝑡 : = 0.0075
1− 1+𝑛 𝑛 12

60
444000 0.0075 𝑛𝑡: 12 = 60
𝑅= 12
1 − 1.0075 −60

𝑹 = ₱𝟗𝟐𝟏𝟔. 𝟕𝟏

47
S E C T I O N 6.5 AMORTIZATION
AND SINKING FUND SCHEDULE

48
 Amortization is the gradual extinguishment of
any amount over a period of time, that is, the
extinction of a debt, principal and interest by
means of a sequence of equal periodic
payments or installment payments due at the
end of equal intervals of time. Usually the equal
payments from an annuity whose present value
is the original principal of the loan. Payments
made could either be by ordinary, due or
deferred annuity.
 Amortization schedule is the table, which
shows how much is applied to reduce the
principal and how much portion is paid for
interest to show the outstanding principal or
remaining liabilities after each payment period.

49
  Amortization Table
Periodi
Payment Unpaid Interest c Principal
Number Balance Paid Payme Repaid
nt
𝑟
1 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 = 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝑅 𝑅 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑
𝑛
𝑅
𝑁𝑒𝑤 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 = 𝑟
2 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 − 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑅𝑒𝑝𝑎𝑖𝑑
= 𝑁𝑒𝑤 𝐵𝑎𝑙𝑎𝑛𝑐𝑒
𝑛 𝑅 − 𝑛𝑒𝑤 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑

.
Repeat the process until you reach nth
.
period.

n
50
 Amortization Schedule
 Example:
 A loan of ₱40 000 is to be amortized by equal
payments at the end of each quarter for 18
months. If interest is 10% compounded
quarterly, find the periodic payment and
construct an amortization schedule.

U: 𝑹
G: 𝑷 = ₱𝟒𝟎, 𝟎𝟎𝟎
𝒕 = 𝟏𝟖 𝒎𝒐𝒏𝒕𝒉𝒔
𝒓 = 𝟏𝟎%, 𝒏 = 𝟒
51
 𝑟 𝑟
𝑷 𝑛 = 0.025
𝑹= 𝑛
𝑟 −𝒏𝒕
𝟏− 𝟏+𝑛 𝑛𝑡 = 6

40000(0.025)
𝑅=
1 − (1.025)−6

𝑅 = ₱7262.00 52
Payment Unpaid Interest Periodic Principal
number Balance Paid Payment Repaid
1 ₱40000.00 ₱1000.00 ₱7262.00 ₱6262.00
2 33738.00 843.45 7262.00 6418.55
3 27319.45 682.99 7262.00 6579.01
4 20740.44 518.51 7262.00 6743.49
5 13996.95 349.92 7262.00 6912.08
6 7084.87 177.12 7262.00 7084.88
3571.99 43572.00 40000.0153
ADDITIONAL REFERENCES
 https://www.mathsisfun.com/money/an
nuities.html

54
END OF CHAPTER 6

55