Introduction to the Mathematics of Finance

Simple Interest: When interest is calculated only on the original principal, then it is called simple
interest (S.I.). Mathematically, S.I. = Pin. Where p is the principal, 𝑖 is the rate of interest per year
and 𝑛 is the number of years.

Compound Interest: When interest is calculated on both principal and successive interests then it is
called compound interest (C.I.). Mathematically, C.I. = 𝐴 − 𝑃, 𝐴 = 𝑃(1 + 𝑖)! , Where 𝑃 is the
principal, 𝑖 is the rate of interest per year and 𝑛 is the number of years.

Nominal Interest: The annual compound interest rate is called nominal rate of interest.

Effective Interest: When interest is compounded more than once in a year, then the actual
percentage of interest rate per year is called effective rate of interest.

Annuity: A sequence of equal payments made at equal time intervals is called an annuity.

Annuity Certain: An annuity payable for a fixed number of years is called annuity certain.

Annuity Due: An annuity, in which all payments are made at the beginning of each period, is called
annuity due. Examples: saving schemes, life insurance payments, etc.

Immediate Annuity: An annuity, in which all payments are made at the end of each period, is called
immediate annuity or ordinary annuity. Examples: car loan, repayment of housing loan etc.

Annuity Contingent: In case the term of payment depends on some uncertain event, the annuity is
called annuity contingent.

Deferred Annuity: If the payments are deferred or delayed for a certain number of years, then it is
called deferred annuity. For ex.: pension plan etc. Many financial organizations give loan amount
immediately and regular installments may start after specified time period.

Perpetual annuity: An annuity whose payments are continue forever is called perpetual annuity or
a
perpetuity. In this case, PV = ; where a = payment of each installment, i= rate of interest.
i
Present value of an annuity: The present value of an annuity is the sum of the present values of all
the payments of annuity at the beginning of the annuity.

Future value of an annuity: The future value of an annuity is the sum of all payments made and
interest earned on them at the end of the term of annuities.

Sinking Fund: A type of savings fund, in which deposits are made regularly, with compound interest
earned, to be used later for a specific purpose, such as purchasing equipment or buildings, is called
sinking fund.

1
Amortization: A loan with fixed rate of interest is said to be amortized if both principal and interest
are paid by a sequence of equal payments with equal time periods. Purchasing a car by making a
series of periodic payments is an example of a loan that is amortized.

Formulae:

1. 𝑆. 𝐼. = 𝑃𝑖𝑛
!"#$
(for (i) exact method 𝑛 = and for ordinary method [or Banker’s rule]
%&'
!"#$
𝑛= %&(
)
2. 𝐶. 𝐼. = 𝐹 − 𝑃= Future value – Present value
3. (i) 𝐹 = 𝑃(1 + 𝑖)) , when interest is compounded yearly
(ii) 𝐹 = 𝑃(1 + 𝑖/2)*) , when interest is compounded semi-annually or
half yearly
(iii) 𝐹 = 𝑃(1 + 𝑖/4)+) , when interest is compounded quarterly
(iv) 𝐹 = 𝑃(1 + 𝑖/12),*) , when interest is compounded monthly
where P indicates present value, F indicates future value, 𝑖 indicates rate
of interest per year and 𝑛 is the number of years.
4. Nominal rate = rate per year = 𝑗
- /0123"4 6"78 986 #8"6
5. 𝑖 = . = /:1;86 0< =03>86$203$ 986 #8"6
6. The effecter rate is the equivalent annual simple interested rate. It is
denoted by 𝑟? .
- .
7. 𝑟? = (1 + 𝑖 ). − 1 = 41 + .5 − 1.

Annuity (Ordinary Annuity) [payments are made at the end of

each period]
! #
8. 𝑃𝑉 = $1 − (#%")!',
"
[we use this formula in case of amortization, loan, debt, borrow
because PV is the amount of amortization, loan, debt, borrow]
!
9. 𝐹𝑉 = [(1 + 𝑖)' − 1]
"
[we use this formula in case of sinking fund, any kind of fund,
because FV is the amount of sinking fund or any kind of fund]
where 𝑎 = payment of each installment

2
 𝑛 = number of installments
(
𝑖=
)
𝑗 = nominal rate per year
𝑚 = number of conversions per year

Question: Find the interest on $𝟏𝟒𝟔𝟎 for 72 days at 10 percent interest using (a) the exact
method and (b) the ordinary method.

Solution: Given that, 𝑷 = $𝟏𝟒𝟔𝟎, 𝒊 = 𝟏𝟎% = 𝟎. 𝟏.

!" !"
(a) For exact method, 𝑛 = #$%. So, the simple interest (S.I) = 𝑃𝑛𝑖 = 1460 × #$% × 0.10 =
$28.80.
!" !"
(b) For ordinary method, 𝑛 = #$&. So, the S.I = 𝑃𝑛𝑖 = 1460 × #$& × 0.10 = $29.90.

Exercise. Find the future value of $5000 at 10% for 9 months.

Answer. $5375. [Try yourself]

Example. Jan received $50 for a diamond at a pawnshop and a month later paid $53.50 to
get the diamond back. Find the percent interest rate.
!
Solution: Given that, P= $50, F=$53.50 and 𝑛 = year, 𝑖 =?
!"
We know, 𝐹 = 𝑃 + 𝑃𝑛𝑖
!
⇒ 53.50 = 50 + (50 × × 𝑖)
!"
#$%
⇒ !"
= 3.50
#.%&×)"
⇒𝑖= %&
= 0.84 = 0.84 × 100% = 84% (Answer)

Page 393
Exercise. Fran has placed $500 in an employees’ savings account that pays 8 percent simple
interest. How long will it be, in months, until the investment amounts to $530?

Solution: Given that, P= $500, F=$530, 𝑖 = 8% or 0.08, 𝑛 =?

We know, 𝐹 = 𝑃 + 𝑃𝑛𝑖
* +&* * #&
⇒ 530 = 500 + (500 × )" × 0.08) ⇒ )"
= 30 ⇒ )" = +& ⇒ 𝑛 =9 months [Ans.]

3
 Question: At what interest rate compounded annually will a sum of money double in 10
years?

Solution: Let, PV= $𝑥, so according to the question, FV= $2𝑥, 𝑛 = 10 years, 𝑖 =?
We know, 𝐹 = 𝑃(1 + 𝑖)* ⇒ 2𝑥 = 𝑥(1 + 𝑖))& ⇒ 2 = (1 + 𝑖))&
⇒ 𝑙𝑜𝑔2 = 𝑙𝑜𝑔(1 + 𝑖))& ⇒ 𝑙𝑜𝑔2 = 10log (1 + 𝑖) ⇒ 10 log(1 + 𝑖) = 𝑙𝑜𝑔2
,-."
⇒ log (1 + 𝑖) = )&
⇒ log (1 + 𝑖) = 0.0301 ⇒ (1 + 𝑖) = 10&.&#&)

⇒ 1 + 𝑖 = 1.071766 ⇒ 𝑖 = 1.071766 − 1 ⇒ 𝑖 = 0.071766

⇒ 𝑖 = 0.071766X100% ⇒ 𝑖 =7.17% (Answer)

Question no. 9
How many years will it take at 7 percent compounded annually for $5,000 to amount to
$20,000?

Solution: Here, P = $5000, F = $20000, 𝑖 = 7% = 0.07, 𝑛 =?

We know, 𝐹 = 𝑃(1 + 𝑖)*
⇒ 20,000 = 5000(1 + 0.07)*

⇒ 5000(1 + 0.07)* = 20,000

⇒ (1 + 0.07)* = 4

⇒ 𝑙𝑜𝑔(1 + 0.07)* = 𝑙𝑜𝑔4 (Taking log on both sides)

⇒ nlog (1 + 0.07) = 𝑙𝑜𝑔4

,-.+
⇒ 𝑛 = ,-.).&! ⇒ 𝑛 = 20.49 years. (Answer)

Question no. 10
How many years will it take for a sum of money to double at 10 percent compounded
annually?

)&
Solution: Suppose, PV= $𝑥, FV= $2𝑥, 𝑖 = 10% = )&& = 0.1, 𝑛 =?
We know, 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)*
⇒ 2𝑥 = 𝑥(1 + 0.10)* ⇒ 2 = (1 + 0.10)*

⇒ 𝑙𝑜𝑔2 = 𝑙𝑜𝑔(1 + 0.10)* (Taking log on both sides)

,-."
⇒ 𝑛 log(1 + 0.10) = 𝑙𝑜𝑔2 ⇒ n = /01 ().)&) ⇒ 𝑛 = 7.27 𝑦𝑒𝑎𝑟𝑠

4
Question no. 11
Find the rate of interest compounded annually at which a sum of money will double in 20
years?

Solution: Suppose, PV= $𝑥, FV= $2𝑥, 𝑛 =20 years, 𝑖 =?

We know, 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)*
⇒ 2𝑥 = 𝑥(1 + 𝑖)"& ⇒ 2 = (1 + 𝑖)"&
⇒ 𝑙𝑜𝑔2 = 𝑙𝑜𝑔(1 + 𝑖)"& (Taking log on both sides)
⇒ 𝑙𝑜𝑔2 = 20log (1 + 𝑖) ⇒ 20 log(1 + 𝑖) = 𝑙𝑜𝑔2
,-."
⇒ log (1 + 𝑖) = "&
⇒ log (1 + 𝑖) = 0.01505
&.&)%&%
⇒ (1 + 𝑖) = 10
⇒ 1 + 𝑖 = 1.03526 ⇒ 𝑖 = 1.03526 − 1 ⇒ 𝑖 = 0.03526
⇒ 𝑖 = 0.03526X100% ⇒ 𝑖 = 3.526% (Answer).

Question no. 12
Find the rate of interest compounded semiannually at which $𝟓𝟎𝟎𝟎 will grow to $𝟏𝟐𝟎𝟎𝟎
in 8 years.

Solution: Here, we are given PV = $5,000, FV= $12,000, 𝑛 = 8 years, 𝑖 =?

We know, 𝐹 = 𝑃(1 + 𝑖/2)"* , when interests are compounded semiannually
5
⇒ 12,000 = 5,000(1 + ")67"
5
⇒ 12,000 = 5,000(1 + "))$
5
⇒ (1 + "))$ = 2.4
5
⇒ 𝑙𝑜𝑔(1 + "))$ = 𝑙𝑜𝑔2.4
5
⇒ 16 log S1 + "T = 𝑙𝑜𝑔2.4
5 ,-.".+
⇒ log (1 + ") = )$
5
⇒ log (1 + ") = 0.02376
5
⇒ (1 + ") = 10&.&"#!$
5
⇒ " = 0.0562 ⇒ 𝑖 = 0.112467 ⇒ 𝑖 = 11.246%. (Answer)

Question no. 13
A bank pays 5.25 percent compounded daily on certificate accounts running for 6 years.
Using 365 days per year compute the future value of a deposit of $5,000 for 6years.

Solution: Given, PV= $5,000 , n=8 years, 𝑖 = 5.25% = 0.0525, 𝐹𝑉 =?

5
 5
We know, 𝐹𝑉 = 𝑃𝑉(1 + #$%)#$%*
⇒ 𝐹𝑉 = 5,000(1 + 0.000143835)$×#$%
⇒ 𝐹𝑉 = 5,000(1 + 0.000143835)")8& ⇒ 𝐹𝑉 = 6,851.14 (Answer)

Question no. 14
A bank pays 5.25 percent compounded daily on certain accounts. Find the future value of
a deposit of $2,000 for 45 days.

+%
Solution: PV= $2,000 ,𝑛 = #$% year, 𝑖 = 5.25% = 0.0525, FV=?
5
⇒ 𝐹𝑉 = 𝑃𝑉(1 + #$%)#$%*
&.&%"% +%
⇒ 𝐹𝑉 = 2,000(1 + #$%
) ⇒ 𝐹𝑉 = 2,000𝑋1.00649
⇒ 𝐹𝑉 = 2,012.986

Example problem
Find the effective rate of 24 percent compounded monthly.

Solution: Given that, 𝑗 = 24% = 0.24, 𝑚 = 12, 𝑟& =?

- .
We know, effective rate, 𝑟? = 41 + 5 − 1
.
$."( !"
⇒ 𝑟e = (1 + !"
) −1
⇒ 𝑟e = (1 + 0.02)!" − 1 = 0.268241795 ⇒ 𝑟e = 26.82 %

Exercise Problem
Find the effective rate of 16 percent compounded quarterly.

Solution: Given that, 𝑗 = 16% = 0.16 , 𝑚 = 4, 𝑟& =?

- .
We know, effective rate, 𝑟? = 41 + .5 − 1
$.!) (
⇒ 𝑟e = (1 + (
) −1
⇒ 𝑟e = (1 + 0.04)( − 1 = 0.1699 ⇒ 𝑟e = 16.99 %

Sinking Fund Payment example problem

Question: How much should be deposited in a sinking fund at the end of each quarter for
5 years to accumulate $𝟏𝟎𝟎𝟎𝟎 if the fund earns 8 percent compounded quarterly?

Solution: Given that, 𝐹𝑉 = $10,000,

6
 9 6% &.&6
𝑖=:= +
= +
= 0.02 ,
𝑛 = 5𝑚 = 5 × 4 = 20, 𝑎 =?

<
We know, 𝐹𝑉 = 5 [(1 + 𝑖)* − 1]
<
⇒ 10,000 = &.&" [(1 + 0.02)"& − 1]
< )&,&&&×&.&"
⇒ &.&" × 0.4859 = 10,000 ⇒ 𝑎 = &.+6%8
⇒ 𝑎 = $411.61

Thus, $411.61 should be deposited quarterly and the total sum of the deposits will be
411.61×20 = 8,232.15 dollar.

Question: A company wants to accumulate $100,000 to purchase replacement machinery

8 years from now. To accomplish this, equal semiannual payments are made to a fund
that earns 7% compounded semiannually. Find the amount of each payment.

Solution: Given that, 𝐹𝑉 = $100,000,

9 !% &.&!
𝑖=:= "
= "
= 0.035 ,
𝑛 = 8𝑚 = 8 × 2 = 16, 𝑎 =?

<
We know, 𝐹𝑉 = 5 [(1 + 𝑖)* − 1]
<
⇒ 10,0000 = &.&#% [(1 + 0.035))$ − 1]
⇒ 𝑎 = $4768.48 .

Question no.6
Greg has $100 deducted from his salary at the end of each month and invested in an
employees’ fund that, because of company contributions, pays 12 percent interest
compounded monthly. How much will Greg’s account amount to when he retires 3 years
from now after receiving his last salary check?

9 )"% &.)"
Solution: Given that, a = $100, 𝑖 = : = )"
= )"
= 0.01, 𝑛 = 12𝑚 = 12 × 3 = 36, 𝐹𝑉 =?

We know,
<
𝐹𝑉 = 5 [(1 + 𝑖)* − 1]
)&&
𝐹𝑉 = &.&) [(1 + 0.01)#$ − 1] ⇒ 𝐹𝑉 = 10,000 × 0.4307 ⇒ 𝐹𝑉 = $4,307 (Answer)

7
Question no. 7
What amount should be deposited at the end of each quarter in a sinking fund earning 8
percent compounded quarterly if the amount in the fund after 4 years is to be $90,000?

9 6% &.&6
Solution: We have, 𝑖 = : = +
= +
= 0.02 , 𝑛 = 4𝑚 = 4 × 4 = 16, FV= $90,000, 𝑎 =?

<
We know, 𝐹𝑉 = 5 [(1 + 𝑖)* − 1]

< <
⇒ 90,000 = &.&" [(1 + 0.02))$ − 1] ⇒ &.&" × 0.37278 = $90,000
8&,&&&×&.&"
⇒𝑎= &.#!"!6
⇒ 𝑎 = $4,828.58 (Answer)

Question no. 8
What amount should be deposited at the end of each 6-month period in a sinking fund
earning 6 percent compounded semiannually if the amount in the fund after 15 years is to
be $75,000?

&.&$
Solution: We have, 𝑖 = "
= 0.03 , n = 15×2 = 30, FV= $75,000, 𝑎 =?

We know,
<
𝐹𝑉 = 5 [(1 + 𝑖)* − 1]
<
⇒ 75,000 = &.&# [(1 + 0.03)#& − 1]
< 8&,&&&7&.&#
⇒ &.&# × 1.42726 = $90,000 ⇒ 𝑎 = ).+"!"$
⇒ 𝑎 = $1,576.45

Question no.9
New Venture Corporation has decided to transfer a sum of money to a reserve amount at
the end of each year to accumulate $1,00,000 to be used to replace machinery 10 years
from now. How much should be transferred each year if interest at 8 percent compound
annually if credited to the reserve?

Solution: Given that, FV= $1,00,000, n = 10, i = 8% or 0.08

<
We know, 𝐹𝑉 = 5 [(1 + 𝑖)* − 1]
<
⇒ 1,00,000 = &.&6 [(1 + 0.08))& − 1]
< 8&,&&&×&.&6
⇒ &.&6 × 1.1589 = $1,00,000 ⇒ 𝑎 = ).)%68
⇒ 𝑎 = $6,903.10

8
Question no. 10
In order to accumulate $15,000 for a down payment on a home 8 years from now, the
joneses are going to deposit a sum of money at the end of each 6-month period in an
account earning 8 percent compounded semiannually. What should be the amount of
each deposit?

&.&6
Solution: We have, 𝑖 = "
= 0.04 , n = 8×2 = 16
FV= $15,000
<
We know, 𝐹𝑉 = 5 [(1 + 𝑖)* − 1]
<
⇒ 15,000 = &.&+ [(1 + 0.04))$ − 1]
< )%,&&&×&.&+
⇒ &.&+ × 0.8729 = $15,000 ⇒ 𝑎 = &.6!"8
⇒ 𝑎 = $687.36

Question. What sum deposited now in an account earning 8% interest

compounded quarterly will provide quarterly payments of $1000 for 10
years, the first payment to be made 3 months from now?

9 6% &.&6
Solution: Given that, PV=?, 𝑖 = : = +
= +
= 0.02, 𝑛 = 10𝑚 = 10 × 4 = 40, 𝑎 =
$1000.

< )
We know, 𝑃𝑉 = 5 [1 − ()>5)! ]

)&&& )
⇒ 𝑃𝑉 = &.&"
Y1 − ()>&.&")"# Z = $27355.48 (Answer)

Amortization problem example

Question. Sam borrowed $5,000 to buy a car. He will amortize the loan by monthly
payments of $R each over a period of 3 years. a) Find the monthly payment if interest is 12
percent compounded monthly. b) Find the total amount Sam will pay.

9 )"% &.)"
Solution: Given that, PV=$5,000, 𝑖 = : = )"
= )"
= 0.01, 𝑛 = 3𝑚 = 3 × 12 = 36, 𝑎 =
𝑅 =?

< )
We know, 𝑃𝑉 = 5 [1 − ()>5)! ]

9
 ? )
⇒ 5,000 = &.&) [1 − ()>&.&))$% ]

? )
⇒ 5,000 = &.&) [1 − ).+#&!$]

? %,&&&×&.&)
⇒ 5,000 = &.&) × 0.30439 ⇒ 𝑅 = &.#&+#8
⇒ 𝑅 = $164.2629

(b) The total amount will be $164.2629 × 36 = $5,913.69

Question. A $70,000 condominium is to be purchased by paying $10,000 in cash and a

$60,000 mortgage for 30 years at 9.75 percent compounded monthly. a) Find the monthly
payment on the mortgage. b) What will be total amount of interest paid?

&.&8!%
Solution: Given that, PV=$60,000, 𝑖 = )"
= 0.008125, n=30m= 30X12=360

< )
We know, 𝑃𝑉 = 5 [1 − ()>5)! ]

< )
⇒ 60,000 = &.&&6)"% [1 − ()>&.&&6)"%)$%# ]

< )
⇒ 60,000 = &.&&6)"% [1 − )6.+)%"6]

< $&,&&&×&.&&6)"%
⇒ 60,000 = &.&&6)"% × 0.945697 ⇒ 𝑎 = &.8+%$8!
⇒ 𝑎 = $515.49

The total amount will be $515.49 × 360 = $1,85,576.40

Interest paid will be

= $1,85,576.40 − $60,000 = $1,25,576.40

Question no.5
A company offers its salespeople a bonus of $500 per quarter for 3 year. To win a
bonus, a salesperson must have sold at least $1 million worth of the company’s products
in the period January 1 through December 31, and the first bonus payment is made at
the end of the first quarter following. The company funds each bonus on December 31
by a lump-sum deposit in a bank account that pays 8 percent compounded quarterly,
and the bank sends out the bonus checks. a) What total sum is received by each bonus
winner? b) How much does it cost the company to fund each bonus?

Solution: (a) Total sum received by each bonus winner is ($500X12) = $6,000
(b) The cost the company to fund each bonus is calculated as follows:

10
 &.&6
Given that, a=$500, n=3x4=12, 𝑖 = +
= 0.02
< ) %&& )
⇒ 𝑃𝑉 = 5 [1 − ()>5)! ] ⇒ 𝑃𝑉 = &.&" [1 − ()>&.&")&' ]

%&& ) %&&
⇒ 𝑃𝑉 = &.&" [1 − )."$6"+] ⇒ 𝑃𝑉 = &.&" × 0.21151

⇒ 𝑃𝑉 = $5,287.75

Question no.6
A college alumni club has decided to establish a scholarship fund that will provide
grants of $5,000 a year for 25 years, with the first grants to be made a year from now. a)
What should be the sum placed in the fund if interest on it is earned at the rate of 8
percent compounded annually? b) What is the total amount of scholarship aid the fund
will provide over its life?

Solution: Given that, a=$5,000, n=25, 𝑖 = 8% 𝑜𝑟 0.08

We know,

< ) %,&&& )
⇒ 𝑃𝑉 = 5 [1 − ()>5)! ] ⇒ 𝑃𝑉 = &.&6
[1 − ()>&.&6)'( ]

%,&&& ) %,&&&
⇒ 𝑃𝑉 = &.&6
[1 − $.6+6+!%] ⇒ 𝑃𝑉 = &.&6
× 0.85398

⇒ 𝑃𝑉 = $53,373.75

(b) The total amount will be ($5,000×25) = $1,25,000

Question no. 7
What payment at the end of each month for 2 years will discharge a current debt of
$1000 if the interest charge on the debt balance at any time is 12 percent compounded
monthly?
&.)"
Solution: PV=$1,000, n=2x12=24 , 𝑖 = 12% = )"
= 0.01
We know,
< ) < )
𝑃𝑉 = 5 [1 − ()>5)! ] ⇒ 1,000 = &.&) [1 − ()>&.&))'" ]

< ),&&&×&.&)
⇒ 1,000 = &.&) × 0.2124 ⇒ 𝑎 = &.")"+
⇒ 𝑎 = $47.08

11