,

Let’s Dig Deeper!

In economics, we always come across variables that grow or decline over a

period of time. One example of which is a sum of money which when invested
properly will grow as the interests accumulates. The amount of oil in an oilfield
will decline as production continues over the years. This chapter will explain
how mathematics can be used to help answer the problems which involves
these variables that change over a period of time, and will mainly focus in the
area of finance including different forms of investment.

After this lesson, you will be able to:

Calculate the final sum, the initial sum, the time period and the
interest rate for an investment.
Calculate the Net Present Value and Internal Rate of Return on
an investment, constructing relevant spreadsheets when required.

Interest
Time plays an important role in an investment. If you invest money in a deposit
account, expect to earn interest. If you borrowed money, then you have to pay
a specified amount of interest. From an investor’s point of view, “interest rate”,
can be considered as the “opportunity cost of capital”. If you opted to save your
money in a piggy bank, then you somehow lose the interest that could have
been earned by investing your money in a deposit account.
Simple interest as defined in Investopedia, is the quick and easy method in
calculating the interest charge on a loan. It is determined by multiplying the
interest rate by the principal amount by the number of days that elapse between
payments.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 × 𝑡𝑖𝑚𝑒
𝐼 = 𝑃𝑟𝑡
Example 1.1
Dyan Sabitsana borrowed ₱20, 000 and repaid the loan after a year with
interest at 10 ¼ % simple interest. Find the total amount paid by Dyan.
Solution:
Transform any interest rate specified in percentage terms into decimal fraction.
10.25
10 ¼ % = = 0.1025
100

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 × 𝑡𝑖𝑚𝑒

= 20,000 × 0.1025 × 1
= 2,050
𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝐴𝑚𝑜𝑢𝑛𝑡 (𝐴) = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
= 20,000 + 2,050
= 22,500
Example 1.2
Mrs. Majait issued a check for ₱16, 800 to settle a loan of ₱12, 750 she got two
years ago. How much simple interest rate was she charged?
Solution:
Manipulate the formula for Interest to derive a formula for Interest rate.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 × 𝑡𝑖𝑚𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 × 𝑡𝑖𝑚𝑒
=
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑡𝑖𝑚𝑒 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑡𝑖𝑚𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 =
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑡𝑖𝑚𝑒

Identify the interest paid within that 2 years.

𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝐴𝑚𝑜𝑢𝑛𝑡 (𝐴) = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
16,800 = 12,750 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
16,800 − 12,750 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 4,050
Thus,
4,050
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 =
12,750 × 2
= 0.158824
= 0.158824 × 100
= 15.8824%
Example 1.3
How long will it take P60, 000 to grow to ₱80, 000 if the simple interest is 15%?
Solution:
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 × 𝑡𝑖𝑚𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 × 𝑡𝑖𝑚𝑒
=
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑇𝑖𝑚𝑒 =
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝑇𝑜𝑡𝑎𝑙 𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝐴𝑚𝑜𝑢𝑛𝑡 (𝐴) = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
80,000 = 60,000 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
80,000 − 60,000 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 20,000
Therefore,
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑇𝑖𝑚𝑒 =
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
20,000
=
60,000 × 0.15
= 2.22 𝑦𝑒𝑎𝑟𝑠 (about 2 years and 3 months)

Check Your Progress 1

1. Ms. De la Cruz needs ₱18, 000 today. How much should she borrow from
Muller’s Bank charging 16 1/2% interest-in-advance payable in 2 years?
2. Determine the term of a loan with proceeds and amount of ₱22, 000 and
₱25, 000 respectively, at a discount rate of 14%?

Compound interest is when the interest is added to the principal amount every
time it accrues. The interest added every period will also earn interest the
following period.
𝑟 𝑛𝑡
𝐴 = 𝑃 (1 + 𝑛) Compound Interest Formula
where
A = Total Accrued Amount
P = Principal
r = interest rate
n = number of times the interest is compounded
t = time
Example 1.4
If an amount of ₱100,00 is deposited into a savings account with an annual
interest rate of 5%, compounded monthly, what would be the value of the
investment after 10 years?
Solution:
P = 100,000
5
r = 100 = 0.05

t = 10
n = 12, since there are 12 months in a year
If we plug in these figures in the formula, we get the following:

0.05 12×10
𝐴 = 100,000 (1 + )
12
= 100,000(1.00416667)120
= 164,700.95
So, the investment balance after 10 years is ₱164,700.95.
Example 1.5
Find the amount on ₱128,000 for 1 year at 7¹/₂ % per annum, compounded
semi-annually.
Solution:
P = ₱128,000
7.5
r = 100 = 0.075

t=1
n=2
Plugging on the given values to the formula, we have

0.075 2×1
𝐴 = 128,000 (1 + )
2
= 128,000(1.0375)2
= 137,780
Example 1.6
Joshua built a house from a bank on credit. If the whole construction and
furnishing of the house amounted to ₱1,250,000 and the bank charges interest
at 12% per annum compounded quarterly, find the amount paid by Joshua after
a year and a half.
Solution:
P = 1,250,000
12
r = 100 = 0.12

t = 1.5 years
n = 4, since there are four (4) quarters in a year
Using the formula for compound interest we have,

0.12 4×1.5
𝐴 = 1,250,000 (1 + )
4
 = 1,250,000(1.03)6
= 1,492,565.37
Example 1.7
How much money it needs to be invested in 2 years in order to get an amount
of ₱350,000 at 6.5% per annum compounded annually?
Solution:
Derive first a formula for principal, we have
𝑟 𝑛𝑡
𝐴 = 𝑃 (1 + )
𝑛
𝑟 𝑛𝑡
𝐴 𝑃 (1 + )
= 𝑛
𝑟 𝑛𝑡 𝑟 𝑛𝑡
(1 + 𝑛) (1 + 𝑛)

𝐴
𝑃=
𝑟 𝑛𝑡
(1 + 𝑛)

Using the newly found formula, we have

350,000
𝑃=
0.065 1×2
(1 + 1 )
350,000
=
(1.134225)
= 308,580.75
Thus, you have to invest an amount of ₱308,580.75 to get ₱350,000 in two
years.
Example 1.8
What monthly rate of interest must be paid on a sum of ₱20,800 if it is to
accumulate to ₱30,000 after 3 years?

Solution:
𝑟 𝑛𝑡
𝐴 = 𝑃 (1 + )
𝑛
𝑟 𝑛𝑡
𝐴 𝑃 (1 + 𝑛)
=
𝑃 𝑃
𝐴 𝑟 𝑛𝑡
= (1 + )
𝑃 𝑛
 1
𝐴 𝑟 𝑛𝑡 𝑛𝑡
[ = (1 + ) ]
𝑃 𝑛
1
𝐴 𝑛𝑡 𝑟
( ) = 1+
𝑃 𝑛
1
𝐴 𝑛𝑡 𝑟
( ) −1=
𝑃 𝑛
1
𝐴 𝑛𝑡
𝑟 = 𝑛 [( ) − 1]
𝑃

Using the formula for interest rate, we have

1
30,000 12×3
𝑟 = 12 [( ) − 1]
20,800

= 12[(1.44230769)0.027778 − 1]
= 12(0.01022546)
= 0.12270556 × 100
= 12.27%
Example 1.9
For how long must ₱50,000 be kept in a deposit account paying 8% interest
annually, compounded quarterly, before it accumulates to ₱75,000?
Solution:
Using the compound interest formula, we have
𝑟 𝑛𝑡
𝐴 = 𝑃 (1 + 𝑛)

0.08 4𝑡
75,000 = 50,000 (1 + )
4
0.08 4𝑡
75,000 50,000 (1 + 4 )
=
50,000 50,000
0.08 4𝑡
1.5 = (1 + )
4
1.5 = (1.02)4𝑡
log1.02 1.5 = 4𝑡
 log1.02 1.5
𝑡=
4
log 1.5
( )
log 1.02
=
4
𝑡 = 5.119 years

Check Your Progress 2

1. Shelly deposited ₱20,000 in a bank where the interest is credited half-
yearly. If the rate of interest paid by the bank is 6% per annum, what
amount will she get after 1 year?
2. Nik lent ₱65,536 for 2 years at 12¹/₂ % per annum. How much could he
get if the interest were compounded quarterly?
3. What rate of interest when compounded semi-annually would turn
₱30,000 into ₱80,000 in 10 years?
4. How long will ₱70,000 take to accumulate to ₱100,000 if it is invested at
11% compounded annually?
Using Excel to Create a Compound Interest Schedule
Interest can be compounded on any given frequency schedule, from
continuous to daily to annually. One may use spreadsheet to create such
schedule.
Example 1.10
If ₱40,000 is invested at an interest rate of 5% per annum, what will it be worth
after 9 months?
Solution:

Download the Excel file on the link below for the complete solution of the Example.
https://drive.google.com/file/d/1jOixMtxTK4biEPPrAnLBWezZZ-3mZnQa/view?usp=sharing

First is to compute the monthly interest rate:

𝑟
𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 =
12
0.05
=
12
= 0.0042 or 0.42%
To calculate the monthly compound interest, you can start a formula based on
the starting balance and the monthly interest rate.

= start + (start*rate)
Example 1.11
A parent invests ₱26,000 for a 7-year-old child in a fixed interest scheme which
guarantees 8% interest annually. How much will the child have at the age of
21?

Solution:

Download the Excel file on the link below for the complete solution of the Example.
https://drive.google.com/file/d/1g1nPErw4QuahrVrWHeEmfw-mQN8eOtNO/view?usp=sharing

After 14 years, the invested money will be ₱76,367.03.

Check Your Progress 3

1. If ₱52,500 is invested in a deposit account that pays 6% interest per
annum,
(a) what will the final sum be after 6 years when the interest is
compounded semi-annually?
(b) what will the value of the investment after the first half of the 5th year?
Investment Appraisal: Net Present Value
Did you know that Warren Buffett, the CEO of Berkshire Hathaway which owns
more that 60 companies which include Duracell, first bought stock at age 11
and first filed taxes at 13? As of August 21, 2020, his net worth is amounted to
$78.3 billion. How does Buffett evaluate a possible investment opportunity? He
uses net present value.
Net present value (NPV) is the value of projected cash flows, discounted to the
present. It's a financial modeling method used by accountants for capital
budgeting, and by analysts and investors to evaluate the profitability of
proposed investments and projects. The net present value method is used to
evaluate current or potential investments and allows you to calculated the
expected return on investment (ROI) you'll receive.
Net present value (NPV) is calculated using the formula:
𝑛
𝑅𝑡
𝑁𝑃𝑉 = ∑
(1 + 𝑖)𝑡
𝑡=1

where
𝑅𝑡 = Net cash inflow-outflows during a single period t
i = Discount rate or return that could be earned in alternative investments
t = Number of timer periods

The concept of NPV is represented by

𝑁𝑃𝑉 = 𝑇𝑉𝐸𝐶𝐹 − 𝑇𝑉𝐼𝐶
where
TVECF = Today’s value of the expected cash flow
TVIC = Today’s value of invested cash
A positive result for NPV indicates that the projected earnings generated by the
investment will be profitable and an investment with negative NPV will result to
net losses. Thus, only investments with positive NPV values should be
considered.
Example 1.12
Pet Supply Company is comparing two projects to invest in. The discount rate
for both projects is 10%.

Project 1 Project 2
Initial Investment ₱10,000 ₱5,000
Year 1 ₱5,000 ₱8,000
Year 2 ₱15,000 ₱16,000
Year 3 ₱9,000 -
Year 4 ₱18,000 -

Calculate the present values for each year of the project:

Project 1 Project 2
5000 8000
Year 1 : = 4,545 Year 1 : = 7,273
(1+0.10)1 (1+0.10)1

15000 16000
Year 2 : = 12,397 Year 2 : = 13,223
(1+0.10)2 (1+0.10)2

9000
Year 3 : (1+0.10)3 = 6,762

18000
Year 4 : (1+0.10)4 = 12,294

Get the summation of these present values and subtract the initial investment
amount to find the net present value.
Project 1
𝑁𝑃𝑉 = (4,545 + 12,397 + 6,762 + 12,294) − 10,000
= 35,998 − 10,000
= 25,998
Project 2
𝑁𝑃𝑉 = (7,273 + 13,223) − 5,000
= 20,496 − 5,000
= 15,496
The NPV for Project 1 is ₱25,998 and Project 2 is ₱15,496. Pet Supply
Company should invest in Project 1 since it has a higher NPV value.
Example 1.13
An investor can put money into any one of the following three ventures:
Project A costs ₱20,000 now and pays back ₱30,000 in 4 years
Project B costs ₱20,000 now and pays back ₱40,000 in 6 years

Project C costs ₱30,000 now and pays back ₱48,000 in 5 years

The current interest rate is 10%. Which project should be chosen?
Solution:
30,000
NPV for Project A = − 20,000
(1+0.10)4

= 20,490.40 − 20,000
= 490.04
40,000
NPV for Project B = (1+0.10)6 − 20,000

= 22,578.96 − 20,000
= 2,578.96
48,000
NPV for Project C = (1+0.10)5 − 30,000

= 29,804.22 − 30,000
= −195.78
Project B has the largest PNV and thus, that is the best option for investment.
Project C has a negative PNV, so it is not worthwhile to invest on.
Example 1.14
An investment proposal involves an initial payment now of ₱400,000 and then
returns of ₱100,000, ₱300,000 and ₱200,000 respectively in 1, 2, and 3 years’
time. If money can be invested at 10% is this a worthwhile investment?
Solution:
Calculate the present values for each year.
100,000
Year 1 : (1+0.10)1 = 90,909.09

300,000
Year 2 : (1+0.10)2 = 247,933.88

200,000
Year 3 : (1+0.10)3 = 150,262.96
𝑁𝑃𝑉 = (90,909.09 + 247,933.88 + 150,262.96) − 400,000
= 489,105.27 − 400,000
= 89,105.27
The NPV is greater than 0 and so the project is worthwhile.
Example 1.15
An investor has to choose between two projects A and B whose outlay and
returns are set out in table below. Which is the better investment if the going
rate of interest is 10%?

All values are in ₱. Project A Project B

Initial outlay 30,000 30,000
Return in 1 years’ time 6,000 8,000
Return in 2 years’ time 10,000 8,000
Return in 3 years’ time 10,000 8,000
Return in 4 years’ time 10,000 8,000
Return in 5 years’ time 8,000 8,000

Solution:
You may use spreadsheet for easier and quick calculations for the PNV.

Download the Excel file on the link below for the complete solution of this example.
https://drive.google.com/file/d/1UoROaVnPmvZtoORV8YbGLxBiDlOQzYfc/view?usp=sharing
The formula used in this example is

=return/(1+rate) ^year

To get the value in cell C5, you have to input the following formula:
=B5/(1+$C$1) ^A5
Then, you can just use the fill handle to fill the other cells with the similar
formula.
For the total, you only have to use the sum function to get the summation. Lastly
for the NPV, you only have to subtract the initial outlay from the total value.

=A11 - B4

Check Your Progress 4

1. An investment project requires an initial outlay of ₱75,000 and will pay
back ₱20,000 at the end of the next 5 years. Is it worthwhile if capital
can be invested elsewhere at 12%?
2. An investor has to choose between the following three projects:

Project A requires an outlay of ₱35,000 and returns ₱60,000 after 4 years

Project B requires an outlay of ₱40,000 and returns ₱75,000 after 5 years
Project C requires an outlay of ₱25,000 and returns ₱50,000 after 6 years

Which project would you advise this investor to put money into if the cost
of capital is 10%?

The Internal Rate of Return

The IRR method of investment appraisal involves finding the rate of return (r)
on a project and comparing it with the market rate of interest (i). If 𝑟 > 𝑖 then
the project is viable. Alternative projects can be ranked according to the
magnitude of the different rates of return.
Example 1.16
Find the IRR for the three projects in the table below, decide whether they are
viable if the market rate of interest is 7%, and then rank them in order of
profitability according to the IRR method.
Project A Project B Project C
Initial outlay ₱50,000 ₱40,000 ₱80,000

Return after one year ₱57,500 ₱43,000 ₱85,000

Solution:

7,500
IRR for A = = 0.15 𝑜𝑟 15%
50,000

4,300
IRR for B = 40,000 = 0.1075 𝑜𝑟 10.75%
5,000
IRR for C = = 0.0625 𝑜𝑟 6.25%
80,000

Only projects A and B produce an IRR of more than the market rate of interest
of 7% and so C is not viable.
A is preferred to B because 𝑟𝐴 > 𝑟𝐵 .
Example 1.17
Use the IRR method to evaluate the following project given a market rate of
interest of 11%.
Initial outlay £75,000
Return at end of year 1 £15,000
Return at end of year 2 £20,000
Return at end of year 3 £20,000
Return at end of year 4 £25,000
Return at end of year 5 £25,000
Return at end of year 6 £12,000

Solution:
One needs to find the value of r for which
0 = −75,000 + 15,000(1 + 𝑟)−1 + 20,000(1 + 𝑟)−2 + 20,000(1 + 𝑟)−3 + 25,000(1 + 𝑟)−4
+ 25,000(1 + 𝑟)−5 + 12,000(1 + 𝑟)−6
The manual calculation for this is far too complex and time consuming, hence
we use spreadsheet in solving.

Download the Excel file on the link below for the complete solution of this example.
https://drive.google.com/file/d/1fpBM0--OQDEG56UYLzOewBB9uCuBxf0W/view?usp=sharing

The resulting spreadsheet should look like in the table above. This shows that
the rate of interest that corresponds to an NPV of zero will lie somewhere
between 14% and 15%, which checks out with the precise value for the IRR of
14.14% computed in cell B12. The market rate of interest given in the question
is 11% and so, as the calculated IRR of 14.14% exceeds this, the project is
worthwhile according to the IRR criterion.

Check Your Progress 5

1. Using a spreadsheet, find the IRR and show that the NPV of the following
project is zero when the discount rate used is approximately equal to this
IRR.

Outlay now: ₱25,000

Annual returns: (1) ₱4,000 (2) ₱6,000 (3) ₱7,500

(4) ₱7,500 (5) ₱10,000 (6) ₱10,000
 2. Two projects A and B each involve an initial outlay of ₱40,000 and
guarantee the returns (in £) given in table below. The market rate of
interest is 18%. Which is the better investment according to (a) the IRR
criterion, (b) the NPV criterion?
Project A Project B
Year 1 15,000 10,000
Year 2 20,000 12,000
Year 3 25,000 12,000
Year 4 0 12,000
Year 5 0 15,000
Year 6 0 15,000

Geometric Series and Annuities

You may have observed on previous examples that there are tendencies that
the return of the investment was the same in some period of time. These forms
of financial investment which is designed like that is called as annuities. For
example, someone might pay a fixed sum for a guaranteed pension payment
of ₱140,000 a year for the next 5 years.
The present value of a steady stream of a fixed return of ₱𝑎 per year for the
next 𝑛 years
when interest rates are 𝑖% will be
𝑃𝑉 = 𝑎(1 + 𝑖)−1 + 𝑎(1 + 𝑖)−2 +· · · +𝑎(1 + 𝑖)−𝑛
This sequence of terms is a special case of what is known as a geometric
series.
Geometric Series
A geometric series is a sequence of terms where each successive term is the
previous term multiplied by a common ratio. The series starts with a given initial
term. Any number of terms may be in a series.
Example 1.18
A firm’s sales revenue is initially ₱60,000 and then grows by 20% each
successive year. What is the pattern of sales revenue over 5 years?
Solution:
Each year’s sales are 120% of the previous years. The time profile of sales
revenue is therefore a geometric series with an initial term of £40,000 and a
common ratio of 1.2. Thus (in ₱) the series is
60,000 60,000 × 1.2 60,000 × 1.22 60,000 × 1.23 60,000 × 1.24
Sum of a Geometric Series
The sum of a geometric series can be found by simply adding all the terms
together. By using a calculator, you may get the sum, however, there are
complex series that are difficult to sum up, so we derive a formula for summing
them.
The formula for the sum of a geometric series is

𝑎(1 − 𝑘 𝑛 )
𝐺𝑃𝑛 =
1−𝑘
where
a = initial term
k = common ratio
n = number of terms
Example 1.19
Use the geometric series sum formula to sum the geometric series
15 45 135 405 1,215 3,645
Solution:
a = 15 k=3 n=6
Substituting these values to the formula, we have
𝑎(1 − 𝑘 𝑛 ) 15(1 − 36 )
𝐺𝑃𝑛 = =
1−𝑘 1−3
15(1 − 729)
=
−2
15(−728)
=
−2
−10,920
=
−2
= 5,460
Example 1.20
A firm expects its sales to grow by 12% per month. If its January sales figure is
₱92,000 per month what will its expected total annual sales be?

Solution:
The firm’s total annual sales will be the sum of the geometric series
𝑎(1 − 𝑘 𝑛 ) 92,000(1 − 1.1212 )
𝐺𝑃𝑛 = =
1−𝑘 1 − 1.12
 92,000(1 − 3.895976)
=
0.12
92,000(−2.895976)
=
− 0.12
− 266,429.79
=
− 0.12
= 2,220,249.25
Example 1.21
An annuity will pay ₱80,000 at the end of each year for 5 successive years, the
first payment being 12 months from the initial purchase date. What is the
maximum price any rational investor would pay for such an annuity if the
opportunity cost of capital is 10%?
Solution:
The present value (PV) of the stream of returns is the maximum purchase price.
Thus,
80,000 80,000 80,000 80,000 80,000
𝑃𝑉 = 1
+ 2
+ 3
+ 4
+
(1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10) (1 + 0.10)5
80,000 80,000 80,000 80,000 80,000
= + + + +
1.101 1.102 1.103 1.104 1.105
This is an example of a geometric series; therefore, we may use the formula for
the sum of geometric series. Thus, we have

80,000 1 5
(1 −
1.10 1.10 ) 72,727.27(0.37907868)
𝑃𝑉 = =
1 0.0909091
1−
1.10
27,569.357289
= = 303,262.90
0.0909091

A more simplified general formula for the PV of the annuity can be derived
from the given example above. Assuming R as the annual payment for n
years and an interest rate of i, then
𝑅 𝑅 𝑅
𝑃𝑉 = + 2
+⋯+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛

With this geometric series, the initial term is

𝑅
𝑎=
(1 + 𝑖)
and the constant term is
1
𝑘=
1+𝑖
When these values be substituted to the formula for the sum of the geometric
series, we have
𝑅 1 𝑛
𝑎(1 − 𝑘 𝑛 ) (1 + 𝑖 ) (1 − )
1+𝑖
𝑃𝑉 = =
1−𝑘 1
1−1+𝑖

𝑅 1 𝑛
(1 − ) 𝑅 1 𝑛 1+𝑖 𝑅 1 𝑛 1+𝑖
(1 + 𝑖 ) 1+𝑖
= (1 − )× = (1 − )×
1−𝑖−1 (1 + 𝑖 ) 1+𝑖 1−𝑖−1 (1 + 𝑖 ) 1+𝑖 1−𝑖−1
1+𝑖
1
𝑅 [1 − ] 𝑅[1 − (1 + 𝑖)−𝑛 ]
(1 + 𝑖 )𝑛
= =
1−𝑖−1 𝑖

We can use this formula to check the answer from the above example. Given
R= 80,000, i = 0.10, and n = 5, we have
80,000[1 − (1 + 0.10)−5 ]
𝑃𝑉 = = 303,262.90
0.10
This derived the same answer as that of the first solution.

Check Your Progress 6

1. A 5-year saving scheme requires investors to pay in ₱50,000 now
followed by ₱50,000 at 12- month intervals. Interest is credited at 14%
at the end of each year of the investment. What will the final sum be at
the end of the fifth year?
2. An annuity will pay ₱20,000 a year for the next 5 years, with the first
payment in 12 months’ time. Capital can be invested elsewhere at an
interest rate of 14%. Is ₱60,000 a reasonable price to pay for this
annuity?
Loan Repayments

If someone takes out a loan now, to be paid off in regular equal instalments
over a given time period, how can these payments be calculated? The following
example shows how the formula for calculating the PV of an annuity can be
adapted for this type of problem. As most loans are paid off monthly, we shall
mainly use monthly rates of interest in this section.

Example 1.22
If a £2,000 loan is taken out now to be paid back over the next 12 months at a
monthly interest rate of 2% what will the monthly payments be?
Solution:
From the lender’s viewpoint the repayments can be viewed as a monthly
annuity which pays £R per month for the following 12 months, where R is the
monthly repayment. If the lender is willing to exchange the loan of £2,000 for
this stream of payments then this must be the PV of this ‘annuity’. Therefore,
for a loan of amount L we can adapt the formula for the PV of an annuity as
𝑅[1 − (1 + 𝑖)−𝑛 ]
𝑃𝑉 = =𝐿
𝑖
However, instead of calculating PV we need to find the value of R for a given
size of loan L. Since

𝑅[1 − (1 + 𝑖)−𝑛 ]
=𝐿
𝑖
𝑅[1 − (1 + 𝑖)−𝑛 ] = 𝑖𝐿
𝑖𝐿
𝑅=
[1 − (1 + 𝑖)−𝑛 ]

which is the general formula for calculating loan repayments.

The known values for this example are L = 2,000, i = 2%= 0.02 and n = 12.
Substituting these into the loan repayment formula gives
0.02 × 2000
𝑅=
[1 − (1 + 0.02)−12 ]
40
=
1 − 0.7884934
= £189.12 per month
Example 1.23
What will be the monthly repayments on a loan of £6,000 taken out for 5 years
at a monthly interest rate of 0.7%?

Solution:
𝐿 = £6,000 𝑖 = 0.7% = 0.007 𝑛 = 5 × 12 = 60
𝑖𝐿
𝑅=
[1 − (1 + 𝑖)−𝑛 ]
0.007 × 6000
=
[1 − (1 + 0.007)−60 ]
0.007 × 6000
=
1 − 0.658008
42
=
0.342
= £122.82 monthly loan repayment
Example 1.24
What are the monthly payments on a repayment mortgage of £60,000 taken
out for 25 years if the monthly rate of interest is 0.75%?

Solution:

𝐿 = 60,000 𝑖 = 0.75% = 0.0075 𝑛 = 25 × 12 = 300 months

𝑖𝐿
𝑅=
[1 − (1 + 𝑖)−𝑛 ]
0.0075 × 60000
=
[1 − (1 + 0.0075)−300 ]
450
=
1 − 0.106287
= £503.32 monthly loan repayment

If only the annual percentage rate (APR) for a loan is quoted, then it will be
necessary to calculate the equivalent monthly interest rate before working out
monthly repayments.
Example 1.25

If a loan of £4,200 is taken out over a period of 3 years at an APR of 6.8% what
will the monthly repayments be?

Solution:
𝐴𝑃𝑅 = (1 + 𝑖𝑚 )12 – 1
1 + 𝐴𝑃𝑅 = (1 + 𝑖𝑚 )12
12
√(1 + 𝐴𝑃𝑅) = 1 + 𝑖𝑚
12
√(1 + 𝐴𝑃𝑅) − 1 = 𝑖𝑚
Substituting in the value of APR = 6.8% = 0.068

𝑖𝑚 = 12√(1 + 𝐴𝑃𝑅) − 1

= 12√(1 + 0.068) − 1
12
= √1.068 − 1
= 1.0054974 − 1
= 0.0055 = 0.55%
The values to be entered into the loan repayment formula are therefore

𝐿 = 4,200 𝑖 = 0.0055 𝑛 = 3 × 12 = 36

𝑖𝐿 0.0055 × 4200
𝑅= =
[1 − (1 + 𝑖) ] [1 − (1 + 0.0055)−36 ]
−𝑛

23.1
= = £128.92
1 − 0.820815
Example 1.26
A car dealer offers you a £12,000 car for a £4,000 deposit now followed by 24
monthly payments of £400. What is the APR on this effective loan of £8,000?

Solution:

The quickest way to solve this is to use a spreadsheet. Instructions for

constructing an appropriate Excel format is shown below, which should give the
actual spreadsheet shown in the next page.

CELL Enter Explanation

Ex. Solution to Example
A1 Label to remind you what example this is
1.26
Label to tell you loan value goes in next
B1 LOAN =
cell.
C1 8000 Loan value for this example.
Label to tell you the number of months for
D1 n MONTHS=
repayment goes in next cell.
E1 24 Number of months for this example.
A3 APR
B3 MONTHLY i Column heading labels
C3 REPAYMENT
Start of (guessed) interest rate for APR
A4 15.00%
range
A5 =A4+0.0025 Gives increment of 0.25%
A6 to Copy cell A5 formula down Gives a range of values for APR in 0.25%
A24 column A increments. (Format to 2 d.p. )
Formula calculates monthly interest rate
B4 =(1+A4)^(1/12)-1
corresponding to APR in cell A4.
B5 to Copy cell B4 formula down Calculates monthly interest rates
B24 column B corresponding to APR in column A.

Formula calculates repayment

corresponding to value of total loan in cell
C4 =B4*C$1/(1-(1+B4)^-E$1) C1, number of months in cell E1 and the
monthly interest rate in cell B4, which is
determined by APR in column A.

C5 to Copy cell C4 formula down Calculates repayment corresponding to

C24 column C different APR values.
Download the Excel file on the link below for the complete solution of this example.
https://drive.google.com/file/d/1FAmAphc3dcKfHT_CvUrKFszh6JSXyOj3/view?usp=sharing

Example 1.27
A loan company will require 36 monthly payments of £438.25 in return for a
loan of £12,500. What APR is it charging?
Solution:
Using the same spreadsheet constructed in the previous example, enter the
new values for the loan and time period in cells C1 and E1. In row 12 you should
then be able then read off the values:

APR MONTHLY i REPAYMENT

17.00% 1.32% 438.25

The APR this company charges is therefore 17%.

 Check Your Progress 7
1. What will be the monthly repayments on a loan of £6,500 taken out over
5 years at a monthly interest rate of 1.2%? 1
2. A loan company will lend you £5,000, repayable over the next 3 years in
monthly payments. What will these payments be if the APR on the loan
is 24.6%? 3
3. A loan of £800 is taken out. What APR is being charged if the monthly
payments are 5
(a) £27.00 over 36 months?
(b) £31.13 over 36 months?
(c) £25.00 over 48 months?
(d) £21.78 over 48 months?