UNIT 3 FINANCIAL MATHEMATICS

LESSON 1

UNIT 3 LESSON 1

Financial Mathematics Simple and Compound Interest Study Time: 21/2 Hours INTRODUCTION: In many small and large businesses money is constantly being paid out or received at regular and non-regular intervals forming patterns at times. Some of these payments or receivals form a series. One of the main patterns observed is the geometric progression. A knowledge of the geometric progression will help you with the derivation of some of the formulae in this and other lessons. At the end of the lesson the student should be able to
State the simple interest formula Derive the compound interest formula Make all the variables in the compound interest formula the subject of the formula Distinguish between effective and nominal interest rate

1. Simple Interest If you were about to borrow some money from a financial institution, questions which may be asked are, how much money ? (Principal); for how long ? (Time); what rate of interest per annum is affordable ? (Simple interest per annum). So simple interest is related to all of these variables. SI P R T SI = PRT .. eqn (1) Where SI is the simple interest P is the principal R is the simple interest rate per annum T is the time in years Let A represent the amount repaid at the end of the period, then A = P + SI A = P + PRT A = P(1 + RT) ..eqn (2) A is also called the amount accumulated, so it is seen where with simple interest, interest is paid only on the amount deposited and not on past interest. Example 1

Marsha borrowed $65,000 from a bank for 14 years at a simple interest rate of 24% per annum (i) How much money will Marsha repay the bank after 14 years? (ii) How much interest did she pay ? Solution Given P =$65,000, T = 14 years, R = 24% = 24/100 = 0.24, A = ? Substitute in the formula below A = P(1 + RT) A = $65,000( 1 + 0.24*14) A = $65,000(1 + 3.36) A = $65,000(4.36) A = $283,400.00 Interest* ( I ) = A - P I = $283,400 - $65,000 I = 218,400 *Here interest is simple interest We in turn can make P, R, T and SI the subject of the formula. 1. EXERCISE 1.1 How long will it take for Miss Johnsons investment of $120,000 to accumulate to $600,000 given that 15% simple interest rate per annum was applied ? P = $120,000, T =?, R = 15%, A = $600,000 Substituting in the formula A = P(1 + RT) 600,000 = 120,000(1 + 0.15T) Dividing by 120,000; 5 = 1 + 0.15T Subtracting 1; 4 = 0.15T Dividing by 0.15; T = 26.66 years 1.2 What simple interest rate per annum was applied if an investment of $250,000 accumulated to $750,000 after 8 years ? Given A = $750,000, P = $250,000, T = 8 years, R = ? A = P(1 + RT) 750,000 = 250,000(1 + 8R) 3 = 1 + 8R 2 = 8R R = 0.25 = 25% 1.3 How much money was invested in a certificate of deposit, if after 18 months the maturity value was $247,000 and the simple interest rate applied was 20% per annum? Given A = $247,000, P = ?, T = 18 months = 1.5 years, R = 20% = 0.2 A = P(1 + RT)

247,000 = P( 1 + 0.2*1.5) 247,000 = P( 1 + 0.3) 247,000 = P(1.3) P = 247,000/1.3 = $190,000 2. COMPOUND INTEREST Compound interest occurs where interest is earned not only on the principal but also on the past interest. Derivation of the compound interest formula by induction Let P dollars be invested at a compound rate of interest per annum i for n years. Determine the amount accumulated at the end of n years. A table is useful here. Year 1 2 3
: :

Principal at start of year P P(1 + i ) P(1 + i )2

Interest Pi *1 P(1 + i )*i*1 P(1 + i)2 *i*1

Amount accumulated at the end of the year P + Pi = P(1 + i ) P(1 + i ) + P(1 + i )*i = P(1 + i )2 P(1 + i )2 + P(1 + i )2*i = P(1 + i)3
: :

P(1 + i)n-1

P(1 + i)n-1*i*1

P(1 + i)n

A = P(1 + i)n . eqn (3) Where A is the amount accumulated P is the principal or present value i is the compound interest rate per annum n is the number of years

Example 2 Let us return to the problem Marsha borrowed $65,000 from a bank for 14 years at 24% compound interest per annum. (i) How much money will Marsha repay the bank after 14 years ? (ii) How much interest did she pay ? Solution

P = $65,000, n = 14 years, i = 24%, A = ?, I = ? Using the formula A = P(1 + i)n = 65,000(1 + 0.24)14 = 65,000(1.24)14 = 65,000(20.31905905) = $1,320,738.84 to the nearest cent NB Compound interest tables could also be used to look up (1.24)14
i.

ii. I = A - P = $1,320,784.84 - $65,000 = $1,255,738.84 Compare this compound interest value with $218,400 simple interest 3. Compound Interest Formula when the period of compounding is less than a year If a financial institution offers a compound interest rate of 24% per annum and you had only had your money invested for three months then the interest rate for the period would be (3/12)*24% = 6%. Notice that there are four three month periods in any one year. If it were for a six month period then the interest rate for the period would have been (6/12)*24% = 12%. Notice that there are two six month periods in any one year. It can be shown in all instances, that the interest rate for the year is divided by the number of compounding periods for the year to obtain the interest rate for the period. In general the Compound Interest formula when the period of compounding is less than a year is A = P(1 + i/m)mn .eqn (4) Where A is the accumulated amount P is the principal i is the compound interest rate per annum m is the number of compounding periods per annum n is the number of years Example 3 Returning to the Marsha problem Marsha borrowed $65,000 from a bank for 14 years at a compound interest rate of 24% per annum compounded monthly. (i) How much money will Marsha repay the bank after 14 years ? (ii) How much interest did she pay ? Solution P = $65,000, n = 14 years, i = 24%, m = 12, A = ?, I = ? Using the formula

i.

A = P(1 + i/m)mn = $65,000( 1 + 0.24/12)12*14 = $65,000(1.02)168 = $65,000(27.85023448) = $1,810,265.24 I=A-P = $1,810,265.24 - $65,000 = $1,745,265.24

ii.

Note that if this situation was a savings instead of a loan then the same formula would apply. Here the interest would be earned instead of being paid out. Exercise 3.1 Complete the table below if $65,000 was invested for 14 years at 24% interest per annum when the compounding period is as indicated in the table. Compounded how Not at all (simple interest) Yearly Semi annually Quarterly (every three months) Monthly Daily Value of m
Not applicable

Interest obtained $218,400 $1,255,738.84 $__________ $___________ $1,745,265.24 $1,804,232.34

1 2 4 12 365

What happens to the interest as the value of m increases ? What if you were borrowing money, would this be beneficial ? 4. There is a continuous compounding given by the formula A = Peni Where A is the accumulated amount P is the principal i is the compound interest rate per annum e is a constant which is equal to 2.718281 Exercise 4.1 Invest $65,000 for 14 years at 24% compound interest per annum compounded continuously. i. Determine the amount accumulated

ii. The interest Solution i. Using the formula A = Peni = $65,000(2.718281)14*0.24 = $65,000(2.718281)3.36 = $1,871,297.41 to the nearest cent ii. I = A - P = $1,871,297.41 - $65,000 = $1,806,297.41 5. Making P the subject of the formula Present Value The principal is often referred to as the Present Value as this is the amount required now to obtain a target or future sum down the road. The diagram below illustrates

How much is now P = ? to obtain the target sum

Target sum A Known

Given A = P(1 + i)n then P = A /(1 + i)n = A(1 + i)-n When the period of compounding is less than a year, A = P(1 + i/m)mn and P = A /(1 + i/m)mn = A(1 + i/m)-mn Exercise Sharon would like to purchase an Intel Pentium 133MHz computer system 4 years from now. She anticipates that it will cost her $210,000 then. How much money should she invest now in a financial institution which offers an interest rate of 20% per annum compounded every three months ? Solution

A = $210,000, n = 4 years, i = 20% = 0.2, m = 4, P = ? P = A(1 + i/m)-mn = $210,000(1 + 0.2/4)-4*4 = $210,000(1.05)-16 = $210000(0.458111522) =$96,203.42 Sometimes the process is referred to as discounting a future sum to present value and the interest rate here is called the discount rate. Notice that the amount required now, to obtain the future sum is less than the future sum due to interest earned and the time value of money. 6. Making i the Interest Rate the subject of the formula Recall Solve the following problem for x (3 + x)4 = 12 Taking the fourth root of both sides [(3 + x)4]1/4 = 121/4 3 + x = 1.8612 x = 1.8612 - 3 x = -1.14 (2 dp) We will use the same technique to solve for i, If A = P(1 + i)n then (A/P) = (1 + i)n (A/P)1/n = 1 + i (A/P)1/n - 1 = i So i = (A/P)1/n - 1 Similarly, when the period of compounding is less than a year, A = P(1 + i/m)mn i = m[(A/P)1/mn - 1] Exercise What compound interest rate was applied given that a sum of $150,000 was invested for eight years and accumulated to $750,000 after eight years ? Also given that interest is compounded every four months P = $150,000, n = 8 years, A = $750,000, m = 3, i = ? To solve this problem one can substitute directly in the i formula or go from the base formula A = P(1 + i/m)mn using A = P(1 + i/m)mn 750,000 = 150,000(1 + i/3)3*8 5 = (1 + i/3)24 51/24 = 1 + i/3

1.069359 - 1 = i/3 i = 0.069359 * 3 i = 0.208078 = 20.8% per annum 7. Making n time the subject of the formula Recall Solve the equation for x 3x = 5 Taking logs of both sides log 3x = log 5 xlog 3 = log 5 x = log 5 / log 3 = 1.46 (2 dp) We will be using a similar technique to obtain n. Given A = P(1 + i)n make n the subject (A/P) = (1 + i)n Taking logs of both sides log (A/P) = log (1 + i)n log (A/P) = nlog (1 + i) n = log (A/P) / log (1 + i) Similarly when the period of compounding is less than a year n = log (A/P) / mlog (1 + i/m) Exercise 7.1 How long will it take Marcia to save $4,000,000 if she deposits $500,000 now into a financial institution which offers an interest rate of 24% per annum compounded daily ? Solution A = $4,000,000, P = $500,000, i = 24%, m = 365, n = ? using the formula n = log (A/P) / mlog (1 + i/m) = log (4,000,000/500,000) / 365log (1 + 0.24/365) = log 8 / 365log (1.000657) = 0.90308 / 365*0.00028 = 0.90308 / 0.104196 = 8.667 years or 8years 10 months 8. Effective Interest rate and Nominal Interest rate Introduction An example will be used to demonstrate the effective interest rate. a) Determine the interest obtained if $100 is invested for one year at 20% per annum compounded every three months. b) From your result in part (a) determine the equivalent simple interest rate

Solution A = P(1 + i/m)mn = 100(1 + 0.2/4)4*1 = 100(1.05)4 =$121.55 Thus I = A - P = $121.55 - $100 = $21.55
a)

b) To determine the simple interest rate P = $100, SI = $21.55, T = 1 year, R = ? Using the formula SI = PRT $21.55 = $100*R*1 R = 0.2155 = 21.55% Note that this equivalent simple interest is higher than the compound interest rate for the same period. The compound interest rate is called the nominal rate of interest while the simple interest rate is called the effective interest rate. Effective and Nominal Interest Rate Definitions The nominal rate of interest is the annual rate of interest quoted by financial institutions. It does not take into account that sometimes interest is added to the principal during the course of the year. The effective rate of interest is the equivalent simple interest rate due to the compounding effect of the sum invested. Let P dollars be invested for 1 year at i% compound interest per annum compounded m times per year. Let the equivalent simple interest rate be E. Amount accumulated Simple interest A = P + PET = P(1 +E1) = (1 +E) = Thus E = Compound interest P(1 + i/m)mn P(1 + i/m)m1 (1 + i/m)m ( 1 + i/m)m - 1

Where E is the effective rate of interest i is the nominal rate of interest m is the number of compounding periods per annum Note that neither the Effective or Nominal interest rates are affected by the amount invested P.

EXERCISE 8.1 Determine the effective rate of interest if the nominal rate of interest is 28% compounded every 3 months. Solution i = 28%, m = 4 using the formula E = ( 1 + i/m)m - 1 = ( 1 + 0.28/4)4 - 1 = (1 + 0.07)4 - 1 = (1.07)4 - 1 = 0.31078 = 31.10%

Exercise 8.2 Calculate the nominal interest rate given that the effective interest rate is 40% per annum and interest is compounded monthly. Solution m = 12, E = 40% Using the formula

E = (1 + i/m)m - 1 0.4 = (1 + i/12)12 - 1 0.5 = (1 + i/12)12 1.41/12 = 1 + i/12 1.41/12 - 1 = i/12 1.0284362 - 1 = i/12 0.0284362*12 = i 0.3412338 = i i = 34.12%

SELF TEST WITH ANSWERS

How much money should Mr. Black repay Mr. Brown if he borrowed $25,000.00 for 41/2 years at 18% per annum compounded every four months ?

Solution P = $25,000, n = 41/2 years, i = 18%, m = 3 Using the formula A = P(1+ i/m)mn = $25,000(1 + 0.18/3)3*4.5 = $25,000(1.06)13.5 = $25,000 * 2.19598

= $54,899.60 Mr. Black should repay Mr. Brown $54,899.60 2. How long will it take for a sum of money to triple at 20% per annum compounded quarterly. Solution Let P = x , m = 4, A = 3x, i = 20% A = P(1 + i/m)mn 3x = x(1 + 0.20/4)4n 3 = 1.054n log3 = 4nlog(1.05) n = log 3/4log(1.05) n = 5.6 years n = 5 years and 8 months

3.

What should be invested now in order to purchase a component set five years from now if the projected cost then is $42,000 and also given that money can be invested at 24% per annum compounded monthly ?

Solution A = $42,000, n = 5 years, i = 24%, m = 12 A = P(1 + i/m)mn P = A(1 + i/m)-mn = $42,000(1 + 0.24/12)-12*5 = $42,000(1.02)-60 = $42,000* 0.30478 = $12,800.86 4. What compound rate of interest, compounded every three months is necessary to triple your money in 5 years ? Solution Let P = x, A = 3x, m = 4, n = 5 years A = P(1 + i/m)mn 3x = x(1 + i/4)4*5 3 = (1 + i/4)20 31/20 = 1 + i/4 1.0564 - 1 = i/4 i = 0.22586 i = 22.6% ( 1 dp)
5.

Marcia can invest $200,000 with institution A at an effective interest rate of 28% per annum. She also can invest her $200,000 with institution B at a nominal rate of 26%. If both institutions compound interest on a monthly basis what should she do ?

Solution: Note that the amount to be invested P = $200,000 will not affect the final results. One has to convert the effective interest rate to the nominal interest rate or vice versa. When i = 26%, (institution B) EB = (1 + i/m)m - 1 = ( 1 + 0.26/12)12 - 1 = (1.0216)12 - 1 = 1.2933 - 1 = 0.2933 or 29.33%

and EA = 28%

It is better to invest with institution B. SELF TEST WITHOUT WORKING SOLUTION

How many years are required for $2,158 to earn an interest of $357, if interest is at 61/4% per annum compounded semi-annually ? Answer: 2.49 years Starting on her 18th birthday, Phyllis Pharsight invests $500 on each of her birthdays for three consecutive birthdays. The first $500 is at 6% per annum compounded semi-annually, the second $500 is at 71/2% per annum compounded every 4 months, and the last $500 is at 8% per annum compounded quarterly. What is the value of Phyllis Pharsights investments on her 25th birthday ? Answer: $2,279.11 What compound rate of interest, compounded every 4 months is necessary to triple your money in 10 years ? Answer: 11.2%

2.

3.

4. A bank advertises that they offer 28% per annum as an effective rate of interest for sums exceeding $200,000. Determine the nominal rate of interest.