Financial Mathimatics

Dr. Islam Siam

Copyright © 2024 Islam Siam

P UBLISHED BY P UBLISHER

IASEAM @ COMMERCE . ZU . EDU . EG

You may not use this file except in compliance with the License.

First printing, October 2021

 Contents

1 Interest and Discount Rate . . . . . . . . . . . . . . . . . . . . . . . . . . 7

1.1 Interest 8
1.1.1 Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

1.1.2 Compound (effective) interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

1.2 Accumulation factors 16

1.3 The principle of consistency 19

1.4 Present values 20

1.5 Discount rates 21

1.5.1 Simple discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

1.5.2 Compound (effective) discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

1.6 Equivalent rates 27

1.7 More Exercises 32

1.8 Try to Solve These Questions by Yourself ! 42

2 Nominal interest and discount . . . . . . . . . . . . . . . . . . . . . 47

2.1 Nominal rates of interest 47

2.2 Nominal rates of discount 52

2.3 convert a nominal discount rate into an effective interest rate

and vice versa. 55

2.4 Accumulating and discounting using nominal discount rates57

2.5 More Exercises 60

2.6 Try to Solve These Questions by Yourself ! 64

3 The force of interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

3.1 Derivation force of interest from nominal interest convertible

pthly 70

3.2 Accumulating and discounting using the force of interest 71

3.3 Derivation force of interest from nominal discount convertible

pthly 73

3.4 Force of interest as a function of time 78

3.4.1 Accumulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

3.4.2 Present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

3.5 The continuous cashflow 86

3.6 Try to Solve These Questions by Yourself ! 93

3.7 More Exercises 95

4 Level annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.1 Present Value 99
4.1.1 Payments made in arrear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.1.2 Payments made in advance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
4.1.3 Relationship between a n and ä n . . . . . . . . . . . . . . . . . . . . . . . . . . 103

4.2 Accumulation for payments made in arrear and in advance

103

4.3 Continuously payable annuities 105

4.4 Annuities payable pthly 106

4.5 Perpetuities 110

4.6 Deferred annuities 111

4.6.1 Annual payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4.6.2 Annuities payable pthly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

5 Equations of value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

5.1 The Equation of Value 113

5.2 Loan schedules 116

5.3 Project appraisal 121

I Compound Interest Tables

 1. Interest and Discount Rate

Programming Language Usage

Some exercises this Chapter utilize the R programming language. Familiariz-
ing yourself with R will not only enhance your understanding of the theoretical
concepts but also equip you with valuable programming skills for real world appli-
cations. If you are new to R, don’t worry, I provided a step-by-step guide on how
to install R and RStudio. You can find the tutorial at this link.
https://www.youtube.com/watch?v=TFGYlKvQEQ4

1.1 Interest
1.1.1 Simple Interest

The essential feature of simple interest is that interest, once credited to an account,
does not itself earn further interest.
Suppose an amount C is deposited in an account that pays simple interest at the
rate of i × 100% per annum. Then after n years the deposit will have accumulated
 8 Chapter 1. Interest and Discount Rate

to:
AC = C(1 + in)
Where AC is the accumulated value, C is a principal or the present value (PV), I is
simple interest rate, and n is investment period.
Exercise 1.1 An investor deposits 10, 000 in a bank account that pays simple
interest at a rate of 5%pa. What will the deposit have accumulated to after 3
years?
Solution

C or P.V = 10000 i = .05 n = 3 years

AC =?

AC = 10000(1 + .05 × 3) = 11500

I(simple interest) = AC −C = 11500 − 10000 = 1500

1 # R code solution
2 # Define the variables
3 P <- 10000 # Principal amount
4 r <- 0.05 # Annual interest rate
5 t <- 3 # Time in years
6

7 # Calculate the accumulated amount

8 A <- P * (1 + r * t)
9

10 # Calculate the simple interest

11 I <- A - P
12

13 # Output the results

14 cat (" Accumulated Amount (A ):" , A , " \n")
15 cat (" Simple Interest (I):" , I , "\n")
1.1 Interest 9

Exercise 1.2 An investor puts 5, 000 in a savings account that pays 10% simple
interest at the end of each year. Compare how much the investor would have
after 6 years if the money was:
(i) invested for 6 years
(ii) invested for 3 years, then immediately reinvested for a further 3 years.
Solution
(i)

AC = C(1 + in)

= 5000(1 + .1 × 6) = 8000

I = AC −C = 8000 − 5000 = 3000

(ii)

AC after the first three Years

= c(1 + in) = 5000(1 + 1 × 3) = 6500

AC after another three xears

= c(1 + in) = 6500(1 + .1 × 3) = 8450

1 # R code solution
2 # Define the principal amount and interest rate
3 P <- 5000
4 r <- 0.1
5

6 # Scenario ( i) - Invested for 6 years

7 t1 <- 6
8 AC1 <- P * (1 + r * t1 )
9 I1 <- AC1 - P
10

11 # Scenario ( ii ) - Invested for 3 years , then reinvested for another 3 years

12 t2 <- 3
 10 Chapter 1. Interest and Discount Rate

13 AC2 _ first <- P * (1 + r * t2 )

14 AC2 _ total <- AC2 _ first * (1 + r * t2 )
15 I2 <- AC2 _ total - P
16

17 # Output the results

18 cat (" Scenario (i ) - 6 Years \n" )
19 cat (" Accumulated Amount :" , AC1 , "\n" )
20 cat (" Simple Interest :" , I1 , "\n \n")
21

22 cat (" Scenario ( ii ) - 3 Years then Reinvested for 3 Years \n ")

23 cat (" Accumulated Amount after First 3 Years :" , AC2 _ first , "\ n")
24 cat (" Total Accumulated Amount after 6 Years :" , AC2 _ total , "\ n")
25 cat (" Total Simple Interest :" , I2 , " \n")

1.1.2 Compound (effective) interest

The essential feature of compound interest is that interest itself earns interest.
Suppose an amount C is deposited in an account that pays compound interest at the
rate of i × 100% per annum. Then after n years the deposit will have accumulated
to:

AC = C(1 + i)n
1 1 n
C or p.v = AC n
= AC( ) = AC vn
(1 + i) 1+i
1
so, v=
1+i

Where AC is the accumulated value, C is a principal or the present value (PV), I is

compound interest rate, and n is investment period.
Exercise 1.3 An investor deposits 10, 000 in a bank account that pays com-
pound interest at a rate of 5%pa. What will the deposit have accumulated to
after 3 years?
Solution
1.1 Interest 11

AC = C(1 + i)n = C × A(0, 3)

AC = 10000(1 + .05)3 = 11576.25

I = AC −C

= 11576.25 − 10000 = 1576.25

1 # Define the variables

2 P <- 10000 # Principal amount
3 r <- 0.05 # Annual interest rate
4 n <- 3 # Time in years
5

6 # Calculate the accumulated amount with compound interest

7 A <- P * (1 + r)^n
8

9 # Calculate the interest

10 I <- A - P
11

12 # Output the results

13 cat (" Accumulated Amount (A ):" , A , " \n")
14 cat (" Interest (I ):" , I , "\ n")

Exercise 1.4 A woman who has won a prize is offered a lump sum of 100, 000
to invest now or 55, 000 to invest at the end of this year and another 55, 000 to
invest at the end of the following year. If all investments are assumed to earn
7% pa, which should she choose if she intends to withdraw the money after:
(i) 4 years
(ii) 2 years
Solution
She should choose the option with the biggest present value of the payments.
(The time which she will withdraw the money is not important.)
The PV of the lump sum option is 100, 000.
 12 Chapter 1. Interest and Discount Rate

1 1
v= 1+i = 1+.07 = 1.80802
1 1 2
) = 55, 000 v + v2 =



The PV of the two-payment option is 55, 000 1+i + ( 1+i
55, 000 × 1.80802 = 99, 441.
So she should choose the lump sum in either case. (Alternatively, you could
compare the accumulated values at the end of the periods.)
■

1 # R code solution
2 # Define the interest rate
3 r <- 0.07
4

5 # Lump Sum Option

6 PV _ lump _ sum <- 100000
7

8 # Two - Payment Option

9 # First payment at the end of the first year
10 PV _ first _ payment <- 55000 / (1 + r ) ^1
11

12 # Second payment at the end of the second year

13 PV _ second _ payment <- 55000 / (1 + r) ^2
14

15 # Total present value of the two - payment option

16 PV _ two _ payments <- PV _ first _ payment + PV _ second _ payment
17

18 # Output the results

19 cat (" Present Value of Lump Sum Option :" , PV _ lump _ sum , "\n")
20 cat (" Present Value of Two - Payment Option : " , PV _ two _ payments , "\n")
21

22 # Decision
23 if ( PV _ lump _ sum > PV _ two _ payments ) {
24 cat (" She should choose the lump sum option .\ n")
25 } else {
26 cat (" She should choose the two - payment option .\ n")
27 }

Exercise 1.5 Calculate the effective annual rate of interest for:

(i) a transaction in which 200 is invested for 18 months to give 350.
(ii) a transaction in which 100 is invested for 24 months and another 100 for 12
1.1 Interest 13

months (starting 12 months after the first investment) to give a total of 350.
Note that:
Given a general quadratic equation of the form

ax2 + bx + c = 0

with x representing an unknown, a, b and c representing constants with a ̸= 0,

the quadratic formula is:
√
−b ± b2 − 4ac
x=
2a

Solution
(i) Find i that make:

200(1 + i)18/12 = 350

i = 0.4522 = 45.22%.
(ii) Find i that make:

100(1 + i)2 + 100(1 + i) = 350

Dividing by 100 and rearranging:

(1 + i)2 + (1 + i) − 3.5 = 0

Applying the quadratic formula:

p
−1 ± 1 − 4(−3.5)
1+i = = 1.4365( or − 2.4365)
2
 14 Chapter 1. Interest and Discount Rate

Therefore i = 43.65%.
■

1 # R code solution
2 # Transaction (i)
3 # Define the variables for Transaction (i )
4 P1 <- 200
5 FV1 <- 350
6 t1 <- 18 / 12 # Time in years
7

8 # Calculate the interest rate for Transaction (i)

9 i1 <- ( FV1 / P1 ) ^(1 / t1 ) - 1
10

11 # Convert to percentage
12 i1 _ percent <- i1 * 100
13

14 # Output the result for Transaction (i)

15 cat (" Effective Annual Interest Rate for Transaction (i) :" , i1 _ percent , " %\ n "
)
16 # Transaction ( ii )
17 # Define the coefficients for the quadratic equation
18 a <- 1
19 b <- 1
20 c <- -3.5
21

22 # Calculate the roots using the quadratic formula

23 root1 <- (-b + sqrt (b ^2 - 4 * a * c)) / (2 * a)
24 root2 <- (-b - sqrt (b ^2 - 4 * a * c)) / (2 * a)
25

26 # Choose the positive root as the interest rate

27 i2 <- ifelse ( root1 > 0, root1 - 1 , root2 - 1)
28

29 # Convert to percentage
30 i2 _ percent <- i2 * 100
31

32 # Output the result for Transaction ( ii )

33 cat (" Effective Annual Interest Rate for Transaction ( ii ):" , i2 _ percent , " %\ n
")
1.2 Accumulation factors 15

1.2 Accumulation factors

For t1 ≤ t2 we define A (t1 ,t2 ) to be the accumulation at time t2 of an investment of
1 at time t1 .
The number A (t1 ,t2 ) is often called an accumulation factor, since the accumu-
lation at time t2 of an investment of C at time t1 is, by proportion: c × A(t1 ,t2 ) A(n)
is often used as an abbreviation for the accumulation factor A(0, n).
Exercise 1.6 An investment of 1, 000 in an account accumulated to 2, 500 after
5 years. (i) State the accumulation factor A(0, 5).
(ii) (a) Find the simple annual interest rate which would give the accumulation
factor in part (i).
(b) Find the annual compound interest rate which would give the accumulation
factor in part (i).
Solution

2500
(i) A(0, 5) = = 2.5
1000
(a) Find i that make (1 + in) = 2.5
2.5 − 1
(1 + i × 5) = 2.5 ⇒ i = = 30%
5
(b) Find i that make (1 + i)n = 2.5
√5
(1 + i)5 = 2.5 ⇒ 1 + i = 2.5
√5
i = 2.5 − 1 = 20%

1 # R code solution
2 # Part (i) - Accumulation Factor A (0 ,5)
3 A05 <- 2500 / 1000
4

5 # Part ( ii )( a) - Simple Annual Interest Rate

6 n <- 5
 16 Chapter 1. Interest and Discount Rate

7 i_ simple <- ( A05 - 1) / n

8

9 # Convert to percentage
10 i_ simple _ percent <- i_ simple * 100
11

12 # Part ( ii )( b) - Annual Compound Interest Rate

13 i_ compound <- ( A05 ^(1 /n )) - 1
14

15 # Convert to percentage
16 i_ compound _ percent <- i _ compound * 100
17

18 # Output the results

19 cat (" Accumulation Factor A (0 ,5) : " , A05 , " \n")
20 cat (" Simple Annual Interest Rate :" , i_ simple _ percent , " %\ n")
21 cat (" Annual Compound Interest Rate :" , i_ compound _ percent , " %\ n ")

Exercise 1.7 An account pays interest at an effective annual rate of interest of:
15% on Mondays, Tuesdays and Fridays 12% on Wednesdays and Thursdays
10% at weekends Calculate the equivalent level effective annual rate of interest
(for transactions that last for a whole number of weeks).
Solution
The accumulation factor for a 7 year period:

1.153 × 1.122 × 1.102 = 2.30842

The annual accumulation factor is:

2.308421/7 = 1.12694

So the equivalent effective annual interest rate is 12.69%

■

1 # R code solution
2 # Weekly accumulation factor
3 weekly _ accumulation <- 1.15^3 * 1.12^2 * 1.10^2
1.3 The principle of consistency 17

5 # Annual accumulation factor

6 annual _ accumulation <- weekly _ accumulation ^(1 / 7)
7

8 # Equivalent effective annual interest rate

9 equivalent _ annual _ rate <- ( annual _ accumulation - 1) * 100
10

11 # Output the result

12 cat (" Equivalent Effective Annual Interest Rate :" , equivalent _ annual _ rate , "
%\ n")

1.3 The principle of consistency

A (t0 ,tn ) = A (t0 ,t1 ) A (t1 ,t2 ) . . . A (tn−1 ,tn )
Exercise 1.8 4, 600 is invested at time 0 and the proceeds at time 10 are 8, 200.
Calculate A(7.10) if A(0.9) = 1.8, A(2, 4) = 1.1, A(2, 7) = 1.32, A(4, 9) = 1.45
Solution

8200
A(0, 10) = = 1.783
4600
A(0, 9) = A(0, 2), A(2, 4)A(4, 9)
A(0, 10) 1.8
A(0, 2) = = = 1.129
A(2, 4)A(4, 9) 1.1 × 1.45
A(0, 10) = A(0, 2)A(2, 7)A(7, 10)
A(0, 10) 1.783
A(7, 10) = = = 1.196
A(0, 2) · A(2, 7) 1.129 × 1.32

1 # R code solution
2 # Define the given accumulation factors
3 A_ 09 <- 1.8
4 A_ 24 <- 1.1
5 A_ 27 <- 1.32
6 A_ 49 <- 1.45
 18 Chapter 1. Interest and Discount Rate

8 # Calculate A (0 ,10)
9 A_ 010 <- 8200 / 4600
10

11 # Calculate A (0 ,2)
12 A_ 02 <- A_ 09 / ( A_ 24 * A_ 49)
13

14 # Calculate A (7 ,10)
15 A_ 710 <- A_ 010 / (A_ 02 * A_ 27)
16

17 # Output the result

18 cat (" Accumulation Factor A (7 ,10) :" , A_ 710 , "\n ")

1.4 Present values

How much do we need to invest now to provide payments at a later time? This
amount is called the present value (PV) or discounted value of the payments.

Exercise 1.9 An investor must make a payment of 5, 000 in 5 years’ time. The
investor wishes to make provision for this payment by investing a single sum
now in a deposit account that pays 10% per annum compound interest. How
much should the initial investment be?
Solution
1.5 Discount rates 19

AC = p.v(1 + i)n
 n
AC 1 1
P.V = = AC = AC
(1 + i)n (1 + i)n 1+i
1
if V =
1+i
P.V = AC ×V n
1 1
V= = = .909090
1 + i 1 + .1
P.V = 5000(.909090)5 = 3104.61

1 # R code solution
2 # Define the variables
3 AC <- 5000 # Future value
4 i <- 0.10 # Annual interest rate
5 n <- 5 # Number of years
6

7 # Calculate the present value

8 V <- 1 / (1 + i)
9 PV <- AC * V^n
10

11 # Output the present value

12 cat (" The present value ( initial investment needed ) is :" , PV , "\n" )

1.5 Discount rates

1.5.1 Simple discount

Suppose an amount C is due after n years and a rate of simple discount of d per
annum applies. Then the sum of money required to be invested now to amount to
C after n years (ie the present value of C) is:

p.v = AC(1 − nd)

 20 Chapter 1. Interest and Discount Rate

Where AC is the accumulated value, p.v is present value (PV), d is simple discount
rate, and n is investment period.
Exercise 1.10 Discount 10, 000 for 3 years using a simple discount rate of 5%
pa.
Solution

AC = 10000 n = 3 years d = .05

p.v = 10000(1 − .05 × 3) = 8500

1 # R code solution
2 # Define the variables
3 AC <- 10000 # Future value
4 d <- 0.05 # Discount rate per annum
5 n <- 3 # Number of years
6

7 # Calculate the present value using simple discount

8 PV <- AC * (1 - d * n )
9

10 # Output the present value

11 cat (" The present value is :" , PV , " \n")

1.5.2 Compound (effective) discount

Suppose an amount C is due after n years and a rate of compound (or effective)
discount of d per annum applies. Then the sum of money required to be invested
now to accumulate to C after n years (ie the present value of C) is:

p.v = AC(1 − d)n

Where AC is the accumulated value, p.v is present value (PV), d is compound

discount rate, and n is investment period.
1.5 Discount rates 21

Exercise 1.11 Discount 10, 000 for 3 years using a compound discount rate of
5%pa.
Solution

AC = 10000 n = 3 Years d = 5%

p.v = AC(1 − d)n

P.V = 10000(1 − .05)3 = 8573.75

1 # R code solution
2 # Define the variables
3 AC <- 10000 # Future value
4 d <- 0.05 # Compound discount rate per annum
5 n <- 3 # Number of years
6

7 # Calculate the present value using compound discount

8 PV <- AC * (1 - d) ^n
9

10 # Output the present value

11 cat (" The present value is :" , PV , "\ n")

Important Formulas:

AC = C(1 + i n) = C A(n) = C × simple accumulation factor → simple interest rate

AC = C(1 + i)n = C A(n) = C × compound accumulation factor → compound interest rate

P.V = AC(1 − d n) = AC v(n) = AC × simple discount factor → simple discount rate

P.V = AC(1 − d)n = AC v(n) = AC × compound discount factor → compound discount rate

C(a prenciple) = p.v (present value)

I = AC − p.v
22 Chapter 1. Interest and Discount Rate

Exercise 1.12 (i) Given an investment of 1, 000 find the accumulation after 5
years using a,b, and c rates:
(a) simple discount of 8%pa
(b) compound discount of 8%pa
(c) compound interest of 8%pa.
(ii) Given a payment of 2, 000 due in 4 years’ time, calculate the present value
using a,b, and c rates:
(a) simple interest of 3% pa.
(b) simple discount of 3% pa.
(c) compound interest of 3% pa.
Solution

(i)(a)P.V = AC(1 − dn)

P.V 1000
∴ AC = = = 1666.67
1 − d × n 1 − .08 × 5
(b) P.V = AC(1 − d)n
P.V 1000
AC = = = 1517.26
(1 − d)n (1 − .08)5
(C) AC = c(1 + i)n

= 1000(1 + .08)5 = 1469.33

1.5 Discount rates 23

(ii)

(a)

AC = p.v(1 + i n)
AC 2000
p.v = = = 1785.71
1 + in 1 + .03 × 4
(b) p.v = AC(1 − d n) = 2000(1 − .03 × 4) = 1760

(c) AC = p.v(1 + i)n

AC 2000
p.v = = = 1776.97
(1 + i)n
(1 + .03)4

1 # R code solution
2 # Part (i)
3 # Given investment
4 investment <- 1000
5

6 # (a) Simple discount rate of 8% per annum

7 d_a <- 0.08
8 n_a <- 5
9 AC _a <- investment / (1 - d_a * n_a)
10

11 # (b) Compound discount rate of 8% per annum

12 d_b <- 0.08
13 n_b <- 5
14 AC _b <- investment / (1 - d_b )^n_b
15

16 # (c) Compound interest rate of 8% per annum

17 i_c <- 0.08
18 n_c <- 5
19 AC _c <- investment * (1 + i_c )^n_c
20

21 # Part ( ii )
22 # Given payment due
23 payment _ due <- 2000
24

25 # (a) Simple interest rate of 3% per annum

26 i_a <- 0.03
27 n_a <- 4
 24 Chapter 1. Interest and Discount Rate

28 PV _a <- payment _ due / (1 + i_ a * n_a)

29

30 # (b) Simple discount rate of 3% per annum

31 d_b <- 0.03
32 n_b <- 4
33 PV _b <- payment _ due * (1 - d_ b * n_b)
34

35 # (c) Compound interest rate of 3% per annum

36 i_c <- 0.03
37 n_c <- 4
38 PV _c <- payment _ due / (1 + i_ c)^n_ c
39

40 # Output the results

41 cat ("( i) Accumulation after 5 years :\ n")
42 cat ("( a) Simple discount rate of 8% pa : " , AC _a , "\n")
43 cat ("( b) Compound discount rate of 8% pa :" , AC _b , "\n" )
44 cat ("( c) Compound interest rate of 8% pa :" , AC _c , "\n\ n")
45

46 cat ("( ii ) Present value of payment due in 4 years :\ n")

47 cat ("( a) Simple interest rate of 3% pa : " , PV _a , "\n")
48 cat ("( b) Simple discount rate of 3% pa : " , PV _b , "\n")
49 cat ("( c) Compound interest rate of 3% pa :" , PV _c , "\n" )

1.6 Equivalent rates

Two rates of interest and/or discount are equivalent if a given amount of principal
invested for the same length of time produces the same accumulated value under
each of the rates.

Exercise 1.13 Find the effective annual interest rate that is equivalent to a
simple interest rate of 3% pa over 4 years.
Solution
1.6 Equivalent rates 25

Find i that make

simple accumulation f actor = compound accumulation f actor

1 + in = (1 + i)n

1 + .03 × 4 = (1 + i)4
√
4
i = 1.12 − 1 = .029 = 2.9%

1 # R code solution
2 # Given simple interest rate over 4 years
3 in _ simple <- 0.03 * 4
4

5 # Number of years
6 n <- 4
7

8 # Calculate the effective annual interest rate

9 i_ effective <- (1 + in _ simple ) ^(1 /n) - 1
10

11 # Convert to percentage
12 i_ effective _ percent <- i_ effective * 100
13

14 # Output the effective annual interest rate

15 cat (" The effective annual interest rate is :" , i_ effective _ percent , " %\ n ")

Exercise 1.14 A bank account pays 10% effective annual interest rate over 5
years. Find the equivalent:
(i) simple annual interest rate.
(ii) effective monthly interest rate.
(iii) effective biennial interest rate.
(iv) effective annual discount rate.
(v) simple annual discount rate.
26 Chapter 1. Interest and Discount Rate

Solution
(i)
Find i that make

compound accumulation f actor = simple accumulation f actor

(1 + i)n = (1 + in)

(1 + .1)5 = 1 + i × 5
1.15 − 1
i= = .122 = 12.2%
5

(ii)
Find i that make

Compound accumulation f actor = Compound accumulation f actor

(1 + i)n = (1 + i)n

(1 + .1)5 = (1 + i)60

(1 + i)12 = 1.1
√
12
i = 1.1 − 1 = .00797 = .797%

(iii)
Find i that make
1.6 Equivalent rates 27

compound accumulation f actor = compound accumulation f actor

(1 + i)n = (1 + i)n

(1 + .1)5 = (1 + i)2.5

1 + i = (1, 1)2

i = (1.1)2 − 1 = .21 = 21%

(iv)
Find d that make

1
compound accumulation f actor =
compound discount f actor
1
A(n) =
v(n)
1
(1 + i)n =
(1 − d)n
1
1.15 =
(1 − d)5
1.15 = (1 − d)−5

1.1 = (1 − d)−1
1
1.1 =
1−d
1
1−d =
1.1
1
d=− + 1 = 9.09%
1.1

(v)
Find d that make
 28 Chapter 1. Interest and Discount Rate

1
compound accumulation f actor =
simple discount f actor
1
(1 + i)n =
1−d ×n
1
1.15 =
1 − 5d
1
1 − 5d =
1.15
1 − 1.11 5
d= = 7.58%
5
■

1 # R code solution
2 # Given effective annual interest rate
3 i_ effective <- 0.10
4

5 # (i) Simple annual interest rate

6 n_i <- 5
7 i_ simple <- ((1 + i_ effective ) ^( n_i) - 1) / n _i * 100
8

9 # ( ii ) Effective monthly interest rate

10 n_ ii <- 12 # 5 years * 12 months per year
11 i_ monthly <- ((1 + i_ effective ) ^(1 /n_ ii ) - 1) * 100
12

13 # ( iii ) Effective biennial interest rate

14 n_ iii <- 2.5 # 5 years / 2 years per period
15 i_ biennial <- ((1 + i _ effective ) ^( n_ iii -.5) - 1) * 100
16

17 # ( iv ) Effective annual discount rate

18 d_ iv <- ( -1 / (1 + i_ effective ) + 1) * 100
19

20 # (v) Simple annual discount rate

21 n_v <- 5
22 d_ simple <- ((1 - (1 / (1 + i _ effective )^n_v) )/n_v ) * 100
23

24 # Output the results

25 cat ("( i) Simple annual interest rate :" , i_ simple , " %\ n" )
26 cat ("( ii ) Effective monthly interest rate :" , i_ monthly , " %\ n" )
27 cat ("( iii ) Effective biennial interest rate :" , i_ biennial , " %\ n")
1.7 More Exercises 29

28 cat ("( iv ) Effective annual discount rate : " , d_ iv , " %\ n")

29 cat ("( v) Simple annual discount rate :" , d_ simple , " %\ n" )

1.7 More Exercises

Exercise 1.15 Find the rate of compound interest at which 1 will accumulate
to the same amount in five years as it will at 8% simple interest.
Solution

(1 + i)5 = 1 + (5 × .08)
√
1 + i = 5 1.4 = 1.06961

i = 1 − 1.06961 = 6.96%

1 # R code solution
2 # Load the rootSolve package
3 library ( rootSolve )
4

5 # Define the equation as a function of i

6 equation <- function (i) {
7 ((1 + i) ^5) - (1 + (5 * 0.08) )
8 }
9

10 # Find the root of the equation

11 root <- uniroot ( equation , interval = c (0 , 1) )
12

13 # Extract the root (i )

14 i_ root <- root $ root
15

16 cat (" The root of i is :" , i_ root , " \n")

 30 Chapter 1. Interest and Discount Rate

Exercise 1.16 You have 500 on deposit earning 8.2% annual compound interest.
How long will it be before your account balance is 856?.
Solution

AC = c(1 + i)n

856 = 500(1 + .082)n

856
ln = n[ln[(1 + .082)]
500
n = 6.82

1 # R code solution
2 library ( FinancialMath )
3 TVM ( pv =500 , fv =856 , n =NA , i =0.082 , ic =1 , plot = FALSE )
4

5 > TVM ( pv =500 , fv =856 , n=NA , i =0.082 , ic =1 , plot = FALSE )

6 TVM
7 PV 500.000000
8 FV 856.000000
9 Periods 6.822157
10 Eff Rate 0.082000

Exercise 1.17 After eleven years an account earning 4.5% annual compound
interest has accumulated to 4, 500. What was the value of the original deposit?
Solution

AC = PV (1 + i)n
AC 4500
PV = =
(1 + i)n (1 + .045)11
= 2772.89
1.7 More Exercises 31

1 # R code solution
2 TVM ( pv =NA , fv =4500 , n =11 , i =0.045 , ic =1 , plot = FALSE )
3 > TVM ( pv =NA , fv =4500 , n =11 , i =0.045 , ic =1 , plot = FALSE )
4 TVM
5 PV 2772.894
6 FV 4500.000
7 Periods 11.000
8 Eff Rate 0.045

Exercise 1.18 500 is deposited in an account earning annual compound interest

of 5.7%. At the end of two years the accumulated amount is transferred to
an account which pays an unknown annual compound interest. At the end of
three additional years the account shows a balance of 600. What was the rate of
annual compound interest during the final three years?
Solution

AC = 500(1 + .057)2 (1 + i)3 = 600

s
600
i= 3 −1
500(1 + .057)2

= 2.4%

1 # R code solution
2 # First stage calculation
3 result <- TVM ( pv =500 , fv =NA , n =2 , i =0.057 , ic =1 , plot = FALSE )
4 # Second stage calculation ( replace ` first _ stage _fv ` with the actual value
from the first stage )
5 Futurt _ value = result [2]
6

7 TVM ( pv = Futurt _ value , fv =600 , n =3 , i= NA , ic =1 , plot = FALSE )

8

9 > Futurt _ value

10 [1] 558.6245
 32 Chapter 1. Interest and Discount Rate

11 > TVM ( pv = Futurt _ value , fv =600 , n =3 , i=NA , ic =1 , plot = FALSE )

12 TVM
13 PV 558.62450000
14 FV 600.00000000
15 Periods 3.00000000
16 Eff Rate 0.02410328

Exercise 1.19 Suppose that A(t) = .1t 2 +1 represents an accumulation function.

you have an investment of 300 made at time t = 1. What is the accumulated
value of the investment at time t = 10?
Solution

.1(102 )−1
300 A(10)
A(1) = 300 .1(12 )−1
11
= 300 1.1 = 3000

1 # R code solution
2 # Define the accumulation function
3 A <- function (t) {
4 return (0.1 * t ^2 + 1)
5 }
6

7 # Initial investment
8 initial _ investment <- 300
9

10 # Calculate the accumulated value

11 accumulated _ value <- initial _ investment * (A (10) / A (1) )
12

13 # Print the accumulated value

14 accumulated _ value

Exercise 1.20 Suppose that the accumulation function is given by A(t) =

at 2 + 1. Further assume that 100 invested at time 0 accumulates to 280 by time
6 . Find the accumulated value at time t = 20 of 500 invested at time 5 .
1.7 More Exercises 33

Solution

AC = C(1 + i)n
AC = CA(n)
AC
A(n) = C
280
A(6) = 100 = 2.8
And since A(t) = at 2 + 1
∴ a62 + 1 = 2.8
∴ a = [2.8 − 1] ÷ 62 = .05

The alcumulated value at 20 :

A(20) .05(20)2 + 1
AC = 500 = 500
A(5) .05(5)2 + 1
= 4666.67

1 # R code solution
2 # Given values
3 investment _ time _ 0 = 100
4 accumulated _ value _ time _6 = 280
5 time _6 = 6
6

7 # Calculate 'a '

8 a = ( accumulated _ value _ time _6 / investment _ time _0 - 1) / ( time _6 ^ 2)
9 a
10

11 # Given values
12 investment _ time _ 5 = 500
13 time _ 20 = 20
14 time _5 = 5
15

16 # Accumulation function
17 A <- function (t) {
18 a * t ^2 + 1
 34 Chapter 1. Interest and Discount Rate

19 }
20

21 # Calculate accumulated value at time 20

22 accumulated _ value _ time _ 20 = investment _ time _5 * (A ( time _ 20) / A( time _ 5) )
23 accumulated _ value _ time _ 20

Exercise 1.21 Suppose a(t) = a t 2 + 1 and that an investment of 500 at t = 1

accumulates to 1, 500 at t = 5. What will be the accumulated value at t = 9 of
an investment of 200 at t = 3?
Solution

A(5) 1500
A(1) = 500
a52 +1
a12 +1
=3
3a + 3 = 25a + 1
22a = 2
1
a= 11

1 2
∴ A(t) = 11 t + 1
The accumulated value:
1
92 +1
= 200 A(9) 11
A(3) = 200 1 32 +1
11

= 920

Exercise 1.22 An investment is earning compound interest. If 100 invested in

year 2 accumulates to 105 by year 4 , how much will 500 invested in year 5 be
worth in vear 10?
Solution
1.7 More Exercises 35

AC = ((1 + i)n
105 = 100(1 + i)2
√
i = ( 1.05) − 1 = .0247 = 2.47%
∴ 500 A(5, 10)
= 500(1 + .0247)5 = 564.86

Exercise 1.23 An account is earning interest at an effective annual interest rate

of 6.5%. The account balance is 450 at t = 4.
a) What will the balance be at time t = 7 ?
b) What was the original balance in the account?
Solution

a)

AC = C(1 + i)n

= 450(1 + .065)3

= 543.58

b)
AC 450
PV = =
(1 + i)n (1 + .065)4
= 349.795

Exercise 1.24 An investor is saving to pay off an obligation of 50, 000 which
will be due in seven years. If the investor is earning 7.5% effective annual
36 Chapter 1. Interest and Discount Rate

interest rate, how much must be deposited as a single deposit now to meet this
obligation?
a) If we use simple interest.
b) If we use compound interest.

Solution

# simple interest
AC 50000
PV = =
(1 + in) (1 + .075(7))
= 32786.89
# Compound interest
AC 50000
PV = =
(1 + i)n (1 + .075)7
= 30137.75

Exercise 1.25 A deposit of 456 accumulates to 600 in five years what is the
rate of
a) Simple interest.
b) Compound interest.

Solution
1.7 More Exercises 37

a) simple
600 = 456(1 + 5i)
h i
600
i = 456 −1 ÷ 5
= 6.316%

b) Compound
600 = 456(1 + i)5
q 
i = 5 600
456 − 1 = 5.64%

Exercise 1.26 What deposit is required to accumulate $5, 600 in six years at
5.6% simple interest? How much is required in the case of compound interest?
Solution

#Simple
AC 5600
PV = (1+in) = (1+.056(6))
= 4191.62
#Compound

AC 5600
PV = =
(1 + i)n (1 + .056)6
= 4038.36

■
 38 Chapter 1. Interest and Discount Rate

1.8 Try to Solve These Questions by Yourself !

Exercise 1.27 An ınvestor deposits $5000 in a bank account that pays simple
interest at a rate of 3.5% pa. What will the deposit have accumulated to after
2.5 years?
Solution
5437.5
■

Exercise 1.28 An investor puts $4000 in a savings account that pays 9% simple
interest at the end of each year. How much the investor would have after 5 years
if the money was invested for 3 years, then immediately reinvested for a further
2 years.
Solution
5994.4 ■

Exercise 1.29 An investor deposits $8000 in a bank account that pays com-
pound interest at a rate of 4% pa. What will the deposit have accumulated to
after 5 vears?
Solution
9733.2 ■

Exercise 1.30 An investment of $1500 in an account accumulated to $3500

after 5 years. State the accumulation factor A(0, 5).
Solution
2.33 ■

Exercise 1.31 An investor must make a payment of $7000 in 3 years’ time.

The investor wishes to make provision for this payment by investing a single
sum now in a deposit account that pays 10% per annum compound interest.
1.8 Try to Solve These Questions by Yourself ! 39

How much should the initial investment be?

Solution
5259.2 ■

Exercise 1.32 Discount $4000 for 4 years using a simple discount rate of 10%
pa.
Solution
2400 ■

Exercise 1.33 Discount 15000 for 5 years using a compound discount rate of
8% pa.
Solution
9886.2 ■

Exercise 1.34 Given an investment of $3000 find the accumulation after 10

years using Simple discount of 6% pa
Solution
7500
■

Exercise 1.35 Given an investment of $4000 find the accumulation after 5

years using Compound discount of 4% pa.
Solution
4905.73 ■

Exercise 1.36 Given a payment of $2000 due in 5 years’ time, calculate the
present value using simple interest of 5% pa.
Solution
1600 ■
40 Chapter 1. Interest and Discount Rate

Exercise 1.37 Given a payment of $6000 due in 5 years’ time, calculate the
present value using compound interest of 8% pa.
Solution
4083.5 ■

Exercise 1.38 A bank account pays 5% effective annual interest rate over 5
years. Find the equivalent simple annual interest rate.
Solution
5.53% ■

Exercise 1.39 A bank account pays 6% effective annual interest rate over 6
years. Find the equivalent effective monthly interest rate.
Solution
0.49% ■

Exercise 1.40 A bank account pays 7% effective annual interest rate over 7
years. Find the equivalent effective biennial interest rate.
Solution
14.49% ■

Exercise 1.41 A bank account pays 8% effective annual interest rate over 8
years. Find the equivalent effective annual discount rate.
Solution
7.41% ■

Exercise 1.42 A bank account pays 9% effective annual interest rate over 9
years. Find the equivalent simple annual discount rate.
Solution
5.99% ■
 2. Nominal interest and discount

2.1 Nominal rates of interest

We denote the nominal rate of interest payable p times per period by i(p) . This
is also referred to as the rate of interest convertible pthly or compounded pthly.
Therefore, working in years, i(12) is referred to as a nominal interest rate convertible
monthly and i(4) as a nominal interest rate convertible quarterly, etc.
A nominal rate of interest per period, payable pthly, i(p) , is defined to be a rate
of interest of i(p) /p applied for each pth of a period. For example, a nominal rate
of interest of 6% pa convertible quarterly means an interest rate of 6/4 = 1.5% per
quarter.
!p
i(p)
1+i = 1+ (2.1)
p

 p h √
i(p)
i = 1+ p −1 , and i(p) = p · p 1 + i −1]
42 Chapter 2. Nominal interest and discount

Exercise 2.1 (i) Express a monthly effective interest of 2% as a nominal annual

interest rate convertible monthly.
(ii) (a) What is the corresponding two-monthly effective interest rate for a
nominal interest rate of 3% pa convertible two-monthly. (b) Hence, calculate
the equivalent annual effective interest rate.
Solution
i(12)
(i) i [effective monthly ] = 12 = 2% i(12) =? i(12) = 12 × 2% = 24%
(6)
(ii) (a) i[effective two monthly] = i 6 = .03
6 = .5%
 (p)
ρ
6
(b) i = 1 + i p − 1 Question 3.2 = 1 + .03
6 − 1 = 3.03% ■

Exercise 2.2 (i) Express 5% per quarter effective interest as a nominal annual
interest rate convertible quarterly. (ii) Find the annual effective interest rate
equivalent to a nominal interest rate of 12% pa convertible monthly.
Solution
(i)

i(4)
i[ effictivequarterly ] = = 5%
4
i(4) = 4 × 5% = 20%
2.1 Nominal rates of interest 43

(ii)

i(12) = 12%
ip ρ .12 12
   
i = 1+ −1 = 1+ −1
p 12
= 12.68%

Exercise 2.3 (i) Express 5% pa effective interest as a nominal annual interest

rate convertible quarterly. (ii) Find the annual effective interest rate equivalent
to a nominal interest rate of 12% pa convertible four-monthly.
Solution
(i)

i = 105 i(4) = 2
!p
iβ )
1+i = 1+
p
!4
i(4) i(4) √
4
1 + .05 = 1 + ⇒ = 1.05 − 1
4 4
√
i(4) = 4 · [ 1.05 − 1] = 4.9%
4

or dirertly ase
√
i(p) = p · [ p 1 + i − 1]

(ii)
44 Chapter 2. Nominal interest and discount

i =? i(3) = 12%
.12 3
 
i = 1+ − 1 = 12.49%
3
!
i(p)
we used, i = 1 + −1
p

Exercise 2.4 (i) $500 is invested in an account which pays nominal interest of
8% pa convertible half-yearly. Find the amount in the account after 3 years. (ii)
A payment of $800 is due in 5 years’ time. Calculate the present value of this
payment at an interest rate of 9% pa convertible monthly.
Solution
(i)

c = 500 i(2) = 8%

Method 1: 500(1 + .04)6 = 632.66

Method 2 : Find the equivalent annual effective interest rate

.08 2
 
i = 1+ − 1 = 8.16%
2
Then → 500(1 + .0816)3 = 632.66

(ii) Using the effective annual interest rate:

2.1 Nominal rates of interest 45

AC = 800 i(12) = .09 n = 5 years

AC = c(1 + i)n
.09 12
 
i = 1+ − 1 = 9.38%
12
AC 800
∴C = = = 510.96
(1 + i)n (1 + .0938)5

Using the effective monthly interest rate:

AC = c(1 + i)n
.09 60
800 = c(1 + )
12
c = 510.96

Exercise 2.5 The constant nominal rate of interest convertible quarterly is 15%
pa. Calculate the accumulated value after 7 years of a payment of $300.
Solution

i(4) = 15%
.15 28
 
AC = 300 1 + = 840.98
4

■
 46 Chapter 2. Nominal interest and discount

2.2 Nominal rates of discount

We denote the nominal rate of discount payable p times per period by d (p) . This
is also referred to as the rate of discount convertible p thly or compounded pthly.
Therefore, working in years, d (12) is referred to as a nominal discount rate convert-
ible monthly and d (4) as a nominal discount rate convertible quarterly, etc.

A nominal rate of discount per period payable p thly, d (p) , is defined as a rate
of discount of d (p) /p applied for each pth of a period.
 (P) P
  (P) P
 √
1 − d = 1 − dp ⇒ d = 1 − 1 − dp , and d (p) = [1 − p 1 − d]p

Exercise 2.6 (i) Express a monthly effective discount of 2% as a nominal annual

discount rate convertible monthly. (ii) Calculate the equivalent effective annual
discount rate to a nominal discount rate of 3% pa convertible two-monthly.
Solution
(i)

d (12)
= 2% ∴ d (1) = 12 × .02 = 24%
12

(ii)

d =? d (6) = 3%
!p
d (p)
1−d = 1−
p
!p
d (p) .03 6
 
d = 1− 1− = 1− 1− = 2.96%
p 6

■
2.2 Nominal rates of discount 47

Exercise 2.7 (i) Express 5% per quarter effective discount as a nominal annual
discount rate convertible quarterly. (ii) Find the annual effective discount rate
equivalent to a nominal discount rate of 12% pa convertible monthly.
Solution
d4
(i) 4 = .05
d (4) = 4 × .05 = 20%
(ii)

(ii) d =? d (12) = 12%

!p
d (p)
1−d = 1−
p
.12 12
 
d = 1− 1− = 11.36%
12

Exercise 2.8 (i) Express 5% pa effective discount as a nominal annual discount

rate convertible quarterly. (ii) Find the annual effective discount rate equivalent
to a nominal discount rate of 12% pa convertible four-monthly.
Solution
(i)
d = 5% d (4) =?
!ρ !4
d (p) d (4)
1−d = 1− ⇒ 1 − .05 = 1−
p 4
(4) √
1 − d 4 = 4 .95
√
d (4) = [1 − 4 .95] · 4 = 5.09%
√
or directly: d (p) = [1 − p 1 − d] p
(ii)
 48 Chapter 2. Nominal interest and discount

d =? d (3) = .12
(3) 3
 
3
1 − d = 1 − d3 ⇒ 1 − d = 1 − .12
3
d = 1 − (1.04)3 = 11.53% ■

2.3 convert a nominal discount rate into an effective interest

rate and vice versa.
!−p
d (p)
1+i = 1−
p

Rearranging the previos equation would result in:

!−p (2.2)
d (p)
i = 1− −1
p
− 1p
h i
(p)
d = 1 − (1 + i) .P

Exercise 2.9 (i) Find the nominal annual discount rate convertible monthly
equivalent to an effective annual interest rate of 10%. (ii) Find the annual effec-
tive interest rate equivalent to a discount rate of 8% pa convertible quarterly.
Solution
(i)

d (12) =? i = 10%
!−p
d (p)
1+i = 1−
p
1 d (12)
(1, 1)− 12 = 1 −
12
2.4 Accumulating and discounting using nominal discount rates 49

  −12
d (12)
1 + .1 = 1 − 
12
h 1
i
(12) − 12
d = 1 − (1.1) 12 = 9.49%
1
h i
Or directly d (p) = 1 − (1 + i)− p P

(ii)

i =? d (4) = .08
!−p !−4
d (p) d (4) .08 −4
 
i = 1− −1 = 1− −1 = 1− − 1 = 8.42%
p 4 4

2.4 Accumulating and discounting using nominal discount

rates
Exercise 2.10 (i) 500 is invested in an account which pays interest equivalent to
a nominal discount rate of 8% pa convertible half-yearly. Find the amount in the
account after 3 years. (ii) A payment of 800 is due in 5 years’ time. Calculate the
present value of this payment at a discount rate of 9% pa convertible monthly.
Solution
(i)
50 Chapter 2. Nominal interest and discount

c = 500 d (2) = .08

!−2
d (2) .08 −2
 
i = 1− −1 = 1− −1
2 2

= 8.51%

AC = C(1 + i)n = 500(1 + .0851)3 = 638.77

(ii)

AC = 800 C =? d (12) = .09

.09 60
 
Method 1: c = 800 1 − = 509.24
12
.09 −12
 
Method 2: i = 1 − − 1 = 9.45%
12
AC = c(1 + i)n
AC 800
c= = = 509.24
(1 + i)n (1 + .0945)5

Exercise 2.11 250 is invested at a discount rate of 18% pa convertible monthly

for the first 3 months followed by an interest rate of 20% pa convertible quarterly
for the next 9 months. Calculate the accumulated sum at the end of the year.
Solution

c = 250 d (12) = 18% → The first 3 months

i(4) = 20% → for the next 9 months
2.4 Accumulating and discounting using nominal discount rates 51

After 3 months:[Method 1]

.18 −12
 
i = 1− − 1 = 19.89%
12

After one Year:

9
.2 12 ·4

3
AC = 250(1 + .1989) 1+ 12 = 302.83
4

OR alternatively:[Method 2 ]

!p
i(p) .2 4
 
1+i = 1+ ⇒ i = 1+ − 1 = 21.55%
p 4

Then,
3 9
AC = 250(1 + .1989) 12 (1 + .2155) 12 = 302.83

Important formulas:
 (p) p
  (p) p
 h √ i
1+i = 1+ ip ⇒ i = 1+ ip −1 , and i(p) = p · p
1 + i −1

 (P) P
  (P) P
 √
1 − d = 1 − dp ⇒ d = 1 − 1 − dp , and d (p) = p · 1 − p 1 − d
 

(p) −p (p) −p 1
    h i
1 + i = 1 − dp ⇒ i = 1 − dp −1 , and d (p) = p · 1 − (1 + i)− p

1 d
(1 + i) = 1−d ⇒i= 1−d

 −p  p
d (p) i(p)
1− p = 1+ p
 52 Chapter 2. Nominal interest and discount

2.5 More Exercises

Exercise 2.12 At what rate of interest per quarter will $4, 500 invested at an
effective interest rate of i per quarter compounded quarterly accumulate to
$10, 000 in ten years?
Solution

AC = P ∨ (1 + i)n
10000 = 4500(1 + i)40
√
i = 40 .45 − 1 = 2.16%

Exercise 2.13 Bank A offers a credit card with a monthly interest rate of
1.9%.Bank B offers a card with an annual rate of 23%. Which card is the better
to buy?
Solution

Bank A :
(P) p
 
i = 1+ ip −1
= (1 + .019)12 − 1 = 25.34%
Bank B :
i = 23%
So bank B is a better credit.

■
2.5 More Exercises 53

Exercise 2.14 What quarterly rate of interest is equal to an effective annual

rate of 1.45%?
Solution

1
   1

i(p) = p (1 + i) p − 1 = 4 1.0145 4 − 1 = .014421816

.014421816
The quartely rate is 4 = .003605454 = .3605% ■

Exercise 2.15 What nominal monthly rate of interest is equivalent to a nominal

quarterly rate of 3.4% ?
Solution

i(12) =? i(4) = .034

(P) P (p) P
   
1+ ip = 1+ ip
(12) 12
 
4
1 + i 12 = 1 + .034
4
q
i(12) = 3 1 + .0344 − 1 12

= 3.39%

Exercise 2.16 Given that i(3) = .0013, find i(7) so that the two interest rates are
equivalent.
Solution
54 Chapter 2. Nominal interest and discount

i(7) =? i(3) = .0013

 P  P
i(P) i(p)
1+ p = 1+ p
 (7)
 7
3
1 + i7 = 1 + .0013
3 
q
3
i(7) = 7 1 + .00133 −1 7

= .0071

Exercise 2.17 Find the accumulated amount if 4, 500 is invested at an effective

monthly rate of .175% monthly for three years.
Solution
(12)
We have p = 12, i 12 = .00175 and n = 3

!n
i(p)
AC = PV 1+ = 4500(1.00175)36 = 4, 792.36
p

Exercise 2.18 X is placed in an account which carries a nominal annual interest

of 2.5% compounded monthly. After five years the accumulated value is placed
in an account which earns a nominal annual interest of 3.2% compounded quar-
terly. The value of this account eight years after inception is 10, 000. Find X
Solution

.025 60 .032 12
   
AC = 10000 = X · 1 + · 1+
12 4
10, 000
Solving for X yields X =
60
= 8021.27
032 12
1 + 025
12 1 + 4
2.5 More Exercises 55

Exercise 2.19 Compute the accumulated amount (FV) of $560 deposited for
one year at
a) An effective annual rate of interest of 5.6%.
b) An effective annual rate of discount of 5.6%.
c) What is the effective annual rate of interest for part b)?
d) What is the effective annual rate of discount for part a)?

Solution
a) AC = PV (1 + i)n = 560(1 + .056) = 591.36
PV 560
b) AC = (1−i)n = (1−.056) = 593.22
1
c) 1 + i = 1−d
1
1 + i = 1−.056
i = .05932
1
d) 1 − d = 1+i
1 1
d = 1 − 1+i = 1 − 1+.056
d = .05303 ■

Exercise 2.20 Compute the nominal rate of discount compounded quarterly

which is equivalent to a nominal rate of interest of 5.6% annually compounded
monthly.
Solution
 −p  p
d (p) i(p)
1− p = 1+ p

!−4
d (4) .056 12
 
1− = 1+
4 12
 56 Chapter 2. Nominal interest and discount

This gives us

d (4) .056 −3
 
= 1− 1+ = .01387034
4 12

As a result d (4) = .0554813746 = 5.548%. ■

2.6 Try to Solve These Questions by Yourself !

Exercise 2.21 Express a monthly effective interest of 3% as a nominal annual
interest rate convertible monthly.
Solution
36% ■

Exercise 2.22 What is the corresponding two-monthly effective interest rate

for a nominal interest rate of 5% pa convertible two-monthly.
Solution
.83% ■

Exercise 2.23 Find the annual effective interest rate equivalent to a nominal
interest rate of 6% pa convertible monthly.
Solution
6.17% ■

Exercise 2.24 Express 7% pa effective interest as a nominal annual interest

rate convertible quarterly.
Solution
6.82% ■

Exercise 2.25 $1000 is invested in an account, which pays nominal interest of

15% pa convertible half-yearly. Find the amount in the account after 3 years.
Solution
2.6 Try to Solve These Questions by Yourself ! 57

1543.3 ■

Exercise 2.26 A payment of $8000 is due in 3 years’ time. Calculate the

present value of this payment at an interest rate of 10% pa convertible monthly.
Solution
5933.92 ■

Exercise 2.27 Express a monthly effective discount of 3% as a nominal annual

discount rate convertible monthly.
Solution
36% ■

Exercise 2.28 Calculate the equivalent effective annual discount rate to a

nominal discount rate of 4% pa convertible two-monthly.
Solution
3.93% ■

Exercise 2.29 Express 7% pa effective discount as a nominal annual discount

rate convertible quarterly.
Solution
7.19% ■

Exercise 2.30 Find the annual effective discount rate equivalent to a nominal
discount rate of 10% pa convertible four-monthly.
Solution
9.67% ■

Exercise 2.31 Find the nominal annual discount rate convertible monthly equiv-
alent to an effective annual interest rate of 12%
Solution
58 Chapter 2. Nominal interest and discount

11.28% ■

Exercise 2.32 $5000 is invested in an account which pays interest equivalent

to a nominal discount rate of 10% pa convertible half-yearly. Find the amount
in the account after 3 years.
Solution
6801.87 ■

Exercise 2.33 $3500 is invested at a discount rate of 15% pa convertible

monthly for the first 3 months followed by an interest rate of 18% pa con-
vertible quarterly for the next 9 months. Calculate the accumulated sum at the
end of the year.
Solution
4147.605 ■
 3. The force of interest

An effective rate of interest is the amount of interest a single initial investment will
earn at the end of the time period. So you can think of the interest being paid at
the end of the time period. We now move on to the case where the interest is paid
continuously throughout the time period.

If we consider a nominal interest rate convertible very frequently (eg. every

second), we are no longer thinking of a fund that suddenly acquires an interest
payment at the end of each interval, but of a fund that steadily accumulates over
the period as interest is earned and added. In the limiting case, the amount of the
fund can be considered to be subject to a constant "force" causing it to grow. This
leads us to the concept of a force of interest, which is the easiest way to model
continuously paid interest rates mathematically.
 60 Chapter 3. The force of interest

3.1 Derivation force of interest from nominal interest convert-

ible pthly

Euler’s rule states that:

 x n
lim 1 + = ex
n→∞ n

So as p approaching infinity (∞) in equation 2.1

!p
i(p) (∞)
1 + i = lim 1+ = ei
p→∞ p

But we defined i(∞) to be δ . Hence:

1 + i = eδ

The rearrangement of eδ = 1 + i is:

δ = ln(1 + i)

So, the accumulated value can be calculated using this formula:

 n
AC = PV (1 + i)n = p ∨ eδ

AC = PVenδ
3.2 Accumulating and discounting using the force of interest 61

And the present value from:

AC
PV = = AC(1 + i)−n
(1 + i)n
= ACe−nδ

The next graph illustrates that the force of interest equals i(p) as p = ∞ using
i = .05.

Figure 3.1: The force of interest equals i(p) as p = ∞.

3.2 Accumulating and discounting using the force of interest

Exercise 3.1 500 is invested in an account which pays a force of interest of
8%pa. Find the amount in the account after 3 years.
Solution
62 Chapter 3. The force of interest

c = 500 δ = 8% n = 3 years

i = eδ − 1 = e.08 − 1 = 8.33%

AC = c(1 + i)n = 500(1 + .0833)3 = 635.62

Or you can get Ac as follows:

AC = cenδ = 500e3×.0833 = 635.62

Exercise 3.2 A payment of $800 is due in 5 years’ time. Calculate the present
value of this payment at a force of interest of 9%pa.
Solution

AC = 800 δ = 9% n = 5 years

i = eδ − 1 = e.09 − 1 = 9.42%
AC 800
ρ ·V = = = 510.1
(1 + i)n (1 + .0942)5
Or you can get Ac as follows:

ρ ·V = ACe−nδ = 800e−5×.09 = 510.1

■
3.3 Derivation force of interest from nominal discount convertible pthly 63

3.3 Derivation force of interest from nominal discount convert-

ible pthly

Using Euler’s Rule as p approaching infinity (∞) in equation 2.2

!−p
d (p)
1 + i = lim 1−
p→∞ p

1 1 d (∞)
1+i =   p = (∞)
= e
(p)
lim p→∞ 1 − d p e−d

(∞)
1 + i = ed = eδ

δ = ln(1 + i)

The next graph illustrates that the force of interest equals i(p) as p = ∞ using
i = .05.

Figure 3.2: The force of interest equals d (p) as p = ∞.

64 Chapter 3. The force of interest

We can see that d (p) is approaching the same limit of δ = ln 1.05 = 0.0488 as
before. However, d (p) tends to this limit from below whereas i(p) tends to this limit
from above as illustrated in the next graph when we combine figure 3.1 and 3.2.

Figure 3.3: The force of interest.

Hence, we have:

d < d (2) < d (3) < · · · < δ < · · · < i(3) < i(2) < i

Exercise 3.3 Arrange the following quantities in increasing order of numerical

value (assuming that they all correspond to the same effective interest rate):

i, i(4) , i(365) , d, d (12) , δ

3.3 Derivation force of interest from nominal discount convertible pthly 65

Solution

d < d (12) < δ < i(365) < i(4) < i

These relationships can be proved:

Value of...
In terems of δ i v d
δ δ eδ − 1 e−δ 1 − e−δ
1 i
i ln(1 + i) i 1+i 1+i
1−v
v − ln v v v 1−v
d
d − ln(1 − d) 1−d 1−d d

Exercise 3.4 (i) Given δ = 8%, calculate i, i(4) and d (12) .

(ii) Given i = 7%, calculate d, d (4) , i(2) and δ .
(iii) Given d = 9%, calculate i, d (2) , i(12) and δ .
Solution
(i)

i = eδ − 1 = e.08 − 1 = 8.33%
  1   
(4)
h 1
i
δ p .08

41
i = p (1 + i) p − 1 = p e −1 = 4 e − 1 = 8.08%
  − 1  

1

− 1p .08 − 12
h i
(12) δ p
d = p 1 − (1 + i) = p 1− e = 12 1 − e = 7.97%

(ii)
 66 Chapter 3. The force of interest

i .07
d= = = 6.54%
1 + i 1.07
1
h i h 1
i
d 4) = p 1 − (1 + i)− p = 4 1 − (1 + .07)− 4 = 6.71%
1
h i h 1
i
i(2) = P (1 + i) p − 1 = 2 (1 + .07) 2 − 1 = 6.88%

δ = ln(1 + i) = ln 1.07 = 6.77%

(iii)

d .09
i= = = 9.89%
1 − d 1 − .09
1
h i h 1
i
d (2) = P 1 − (1 − d) p = 2 1 − (1 − .09) 2 = 9.21%
1
h i h 1
i
i(12) = P (1 + i) p − 1 = 12 (1 + .0989) 2 − 1 = 9.47%

δ = ln(1 + i) = ln(1 + .0989) = 9.43%

3.4 Force of interest as a function of time

3.4.1 Accumulation

R t2
δ (t)dt
A (t1 ,t2 ) = e t1

This formula gives us an accumulation factor between times t1 and t2 when we

have a variable force of interest.
Exercise 3.5 If the force of interest at time t is δ (t) = 0.02 + 0.01t find the
accumulated value at time 8 of an investment of 1, 000 at time:
(i) 0
(ii) 5
3.4 Force of interest as a function of time 67

Solution
(i)

AC = C × A(0, 8)
R8 .01 2 8
= 1000 e 0 ,02+.01 dt dt
= 1000e[.02t+ 2 t ]0
.01 2
= 1000e.02×8+ 2 8 = 1000e.48 = 1616.07

(ii)

R8
AC = C × A(5, 8) = 1000e 5 .02 + .01t dt
.01 2 8
= 1000e[.02t+ 2 t ]5
.01 2 .01 2
= 1000e[(.02×8+ 2 8 )−(.02×5+ 2 5 )]

= 1000e.48−.225 = 1290.46

Exercise 3.6 If the force of interest is:


 0.08 0≤t <5
δ (t) =
 0.13 − 0.01t 5≤t

Find the accumulated value at time 10 of an investment of $500 at time 2 .

Solution
68 Chapter 3. The force of interest

AC = CA(2, 10)

= 500 A(2, 5)A(5, 10)

R5 R 10
= 500e 2 .08 dt
e 5 .13−.01t dt

2 10
= 500e[1.08t]2 e[.13t−.005t ]5
5

= 500e.4−.16 e.8−.525

= 500e.515 = 836.82

Exercise 3.7 If the force of interest is:


 0.04 0≤t <6
δ (t) =
 0.2 − 0.02t 6≤t

find the accumulated value at time 8 of a payment of $400 at time 3 .

Solution

AC = CA(3, 8)

= 400A(3, 6)A(6, 8)
R5 R8
= 400e 6 .04t dt
e 6 .2−.02t dt

2 8
= 400e[.04t]3 e[.2t−.01t ]6
6

= 400e.24−.12 e.96−.84

= 400e.24 = 508.5

■
3.4 Force of interest as a function of time 69

3.4.2 Present value

Rn
v(n) = e− 0 δ (t)dt

We’ll now calculate a present values when the force of interest changes over time.
We’ll apply the same principles as when we were accumulating, but just put a
negative in the power of the exponential.
Exercise 3.8 If the force of interest is

 0.08 0≤t <5
δ (t) =
 0.13 − 0.01t 5≤t

Find the value at time 3 of a payment of $500 at time 10 .

Solution

AC 1 1
p·v = = 500
A(3, 10) A(3, 5) A(5, 10)
R5 R 10
= 500e− 6 .08 dt e− 5 .13−.01t dt

2 10
= 500e−[.08t]3 e−[.13t−.005t ]5
5

= 500e−(.4−.24) e−(.8−.525)

= 500e−.435 = 323.63

■
70 Chapter 3. The force of interest

Exercise 3.9 The force of interest is given by:




 0.08 − 0.001t 0 ≤ t < 3

δ (t) = 0.025t − 0.04 3 ≤ t < 5


5≤t

 0.03

Calculate the present value at time 2 of a payment of 1, 000 at time 10.

Solution

R3 R5 R 10
.0125t 2 −.04dt −
P.v = 1000e− 2 .08−.001t dt −
e 3 e 5 .03 dt

2 3 2 5
= 1000e−[.08t−.0005t ]2 e−[10125t −104t ]3 e−[.03t]5
10

= 1000e−(.2355−.158) e−(.1125+.0075) e−(.3−.15)

= 1000e−.3475 = 706.45

Note that:

1
e−.3475 = .70645 =
A(2, 10)
A(2, 10) = 1.416

Exercise 3.10 Calculate the annual effective rate of interest from time 2 to 10
equivalent to the force of interest function in previous exercise.
Solution
3.4 Force of interest as a function of time 71

(1 + i)8 = A(2, 10)

(1 + i)8 = 1.416
√
8
i = 1.416 − 1 = 4.44%

Exercise 3.11 If the force of interest is:


 0.08 0≤t <5
δ (t) =
 0.13 − 0.01t 5≤t

find expressions for the accumulation factor from time 0 to time t.

Solution

When 0 ⩽ t < 5
Rt t
A(0,t) = e 0 .08 dt = e[.08t]0 = e.08t

When 5 ⩽ t

A(0,t) = A(0, 5)A(5,t)

R5 Rt
.08dt 5 .13−.01t dt
=e 0 e
2 t
e[.13t−.005t ]5
5
= e[.08t]0
2 −.525
= e.4 e.13t−.005t
2 −.125
= e.13t−.005t

Hence,
72 Chapter 3. The force of interest


 e.08t 0⩽t <5
A(0,t) = 2
 e.13t−.005t −.25 5⩽t

Exercise 3.12 The force of interest is given by:




 0.04 + 0.002t 0 ≤ t < 10

δ (t) = 0.015t − 0.08 10 ≤ t < 12


12 ≤ t

 0.07

Find expressions for the present value at time 0 of 1 unit due at time t.
Solution

When 0 ⩽ t < 10
4 +1002tdt
v(t) = e−2510
2 t
= e−[104t+1001t ]0 = e−904t−1001t
2

v(t) = e.04+.002t dt
2 t
= e−[.04t+.001t ]0 = e−.04t−.001t
2
3.5 The continuous cashflow 73

10 ⩽ t < 12
1 1
V (t) = = V (0, 10)V (10,t)
A(0, 10) A(10,t)
R 10 Rt
= e− 0 .04+.002t dt −
e 10 −.015t−.08 dt

2 10 2 t
= e−[.04t+.001t ]0 e−[.0075t −.08t ]10
2 +.08t−.05
= e−.5 e−.0075t
2 +.08t−.55
= e−.0075t

W hen 12 ⩽ t
1
V (t) =
A(0, 10)A(10, 12)A(12,t)
R 10 R 12 R 10
= e− 0 .04+.002t dt −
e 10 .015t−108dt −
e 0 .07 dt

2 10 2 12
= e−[.04t+.001t ]0 e−[.0075t −.08t ]10 e−[.07t]12
t

= e−.5 e−(.12+.05) e−.07t+.84

= e−.67 e−.07t+.84

= e−.07t+.17

Hence:


2
e−.04t−.001t



 0 ⩽ t < 10


V (t) = e−.0075t 2 +.08t−.55 10 ⩽ t < 12



e−.07t+.17

12 ⩽ t


3.5 The continuous cashflow

74 Chapter 3. The force of interest

Exercise 3.13

Find the value at time t = 0 of $250 due at time t = 6 and $600 due at time t = 8 if

δ (t) = 3%pa for all t.

Solution

v(n) = e−nσ

The present value = 250e−6×.03 + 600e−8×.03

= 680.79

Exercise 3.14 A company expects to receive for the next five years a continuous
cashflow with a rate of payment of 100 × 0.8t at time t (years). Calculate the
present value of this cashflow assuming a constant force of interest of 8% pa.
Solution

present value for continuous cashflow

Z ∞
= ρ(t)e−tδ dt
0
Z 5 Z 5
t
t −.08t
∴ P.V. = 100 × .8 e = 100. .8e−.08 dt
0 0
" t
#5
.8e−.08


= 100
ln(.8e−.08 )
0
"
−.08

5 #
.8e
= 100 = 257.42
ln(.8e−.08 )
3.5 The continuous cashflow 75

Note that:
ax
Z
ax dx = ; x → variable , a → constant
ln a
■

Accumulation factors:

1 Rt
A(t) = = (1 + i)n = enδ = e 0 δ (t) dt
v(t)

Discounting factors:

Rt
v(t) = (i + i)−n = vn = e−nδ = e− 0 δ (t) dt

Exercise 3.15 A company expects to receive for the next five years a continuous
cashflow of 350 pa. It also expects to have to pay out 600 at the end of the first
year and 400 at the end of the third year. Calculate the net present value of these
t
cashflows if v(t) = 1 − 100 for 0 ≤ t ≤ 5
Solution

Z ∞
present Value for continuous payment = ρ(t)v(t)dt
Z ∞ 0

= ρ(t)e−tδ dt
0
76 Chapter 3. The force of interest

∴ present value of the income

Z 5 Z 5 h t i
= 350v(t)dt = 350 1 − dt
0 0 100
5
t2
Z 5 
t
=350 1− dt = 350 t −
0 100 200 0
52
 
= 350 5 − = 1706.25
200
∴ present value of the outgo

= 600 V(1) + 400 V(3) = 600 × .99 + 400 × .97

= 982

So, the net present value

= P.V. of the income - P.V. of the outgo

= 1706.25 − 982 = 724.25

Exercise 3.16 The force of interest is:

δ (t) = 0.01t + 0.04 0≤t ≤5

Find the present value at time 0 of the payment stream ρ(t) = 0.5t + 2, which
is received between time 0 and 5 .
Solution
3.5 The continuous cashflow 77

The present value is :

Z b Rt Z 5 Rt
−
ρ(t)e a δ (s)ds dt = .5t + 2e− 0 (.01s+.04)ds dt
a 0
Z 5 t
.01 2
= .5t + 2e−[ 2 s +.045 0 ] dt
0
Z 5
2 −.04t
= .5t + 2e−.005t dt
0
 5
5t + 2 −.005t 2 −.04t
= e
−.005t − .04 0
−50(−.01t − .04) −.005t 2 −.04t 5
 
= e
−.01t − .04 0
h 2
i5
= −50 e−.005t −.04t
0
h 2
i
= −50 e−(.005×5 +.04×5) − e0

= 13.87

Exercise 3.17 Find the accumulated value of a payment stream of 0.3 + 1.5t
that is received continuously from time 4 to time 8 during which time the force
of interest is 0.01 + 0.05t
Solution
78 Chapter 3. The force of interest

The alcumulated value is:

Z b Rb Z 8 R8
δ (s)ds .01+.055s ds
ρ(t)e t dt = .3 + 1.5t e t dt
a 4
Z 8 8
.05 2
= .3 + 1.5te[.1s+ 2 s ]t dt
4
Z 8
.05 2 .05 2
= .3 + 1.5t e.08+ 2 8 −.01t− 2 t dt
4
Z 8
2
= .3 + 1.5t e1.68−.01t−.025t dt
4
.3 + 1.5t 1.68−.01t−.025t 2 8
 
= e
−.01 − .05t 4
−30(−.01 − .05t) 1.68−.01t−.025t 2 8
 
= e
−.01 − .05t 4
h 2
i8
= −30 e1.68−.01t−.025t
4
h 2 2
i
= −30 e1.68−(.01×8)−(.025×8 ) − e1.68−(.01×4)−(.025×4 )

= −30 e0 − e1.24 = 73.67

 

Exercise 3.18 Calculate the present values as at 1 January 2005 of the following
payments:
(i) a single payment of 2000 payable on 1 July 2009.
(ii) a single payment of 5000 payable on 31 December 2016 .
Assume effective rates of interest of 8% per annum until 31 December 2011 and
6% per thereafter.
Solution
3.6 Try to Solve These Questions by Yourself ! 79

1
V=
1+i
(i) 2000V 4.5@8%
 4.5
1
= 2000 = 1415
1 + .08
(ii) 5000v5@6% v7@8%
 5  7
1 1
= 5000 = 2180
1 + .06 1 + .08

A(0,t )
Exercise 3.19 True or false: (i) A (t1 ,t2 ) = A(0,t2 ) (ii) A (0,t2 ) = A (0,t1 ) +
1
1
A (t1 ,t2 ) (iii) v (t2 ) = v (t1 ) v (t2 − t1 ) (iv) v(t2 ) = A (0,t1 ) A (t1 ,t2 )
Solution

(i) A (0,t2 ) = A (0,t1 ) A (t1 ,t2 ) ⇒ True

(ii) False ⇒ must be A (0,t2 ) = A (0,t1 ) · A (t1 ,t2 )

(iii) False ⇒ must be

v (t2 ) = v (t1 ) v (t1 ,t2 ) ⇒ v (0,t2 ) = v (0,t1 ) v (t1 ,t2 )

(iv) A (t2 ) = A (0,t1 ) A (t1 ,t2 ) ⇒ True

3.6 Try to Solve These Questions by Yourself !

Exercise 3.20 $3000 is invested in an account which pays a force of interest of
10% pa. Find the amount in the account after 3 years.
Solution
80 Chapter 3. The force of interest

4049.58
■

Exercise 3.21 A payment of $9000 is due in 5 years’ time. Calculate the

present value of this payment at a force of interest of 5% pa.
Solution
7009.21
■

Exercise 3.22 If the force of interest is:


 0.03 0≤t <8
δ (t) =
 0.24 − 0.01t 8≤t

Find the accumulated value at time 10 of an investment of $750 at time 5

Solution
1107.74
■

Exercise 3.23 1) Given δ = 10%, calculate i.

2) Given δ = 8%, calculate i(3) .
3) Given δ = 7%, calculate d (24) .
4) Given i = 12%, calculate d.
5) Given i = 10%, calculate d (3) .
6) Given i = 5%, calculate δ .
Solution
1)10.52
2)8.11
3)6.99
3.7 More Exercises 81

4)10.72
5)9.38
6)4.88
■

Exercise 3.24 Calculate the present values as at 1 January 2005 of the following
payments: a single payment of 2000 payable on 31 December 2016. Assume
effective rates of interest of 10% per annum until 31 December 2011 and 15%
per annum thereafter.
Solution
510.26 ■

Exercise 3.25 A company expects to receive for the next five years a continuous
cashflow of 500 pa. It also expects to have to pay out 400 at the end of the first
year and 800 at the end of the third year. Calculate the net present value of these
 2 
t
cashflows if v(t) = 1 − 100 for 0 ≤ t ≤ 5
Solution
1167.67 ■

3.7 More Exercises

Exercise 3.26 Bank A offers a savings account paying a nominal annual rate
(APR) of 3.2% compounded monthly. Bank B offers the same rate, but com-
pounds continuously. If you deposit $4500 for a period of five years how much
more will you earn with Bank B?
Solution
82 Chapter 3. The force of interest

Babk A:
!12(5)
i(2)
AC = PV 1 +
12
.032 60
 
= 4500 1 + = 5279.67
12

Bank B:

AC = PVenδ = 4500e5(.032)

= 5280.8

The differrence = 5280.8 − 5279.67

= 1.13

Exercise 3.27

1
Given that δ = , find an expression for A(t) .
1+t

Solution

Rt
A(t) = e 0 δ (t)dt

Rt 1
=e 0 1+t dt

= eln(1+t) = 1 + t

■
3.7 More Exercises 83

Exercise 3.28

Find an expression for A(t) if the force of interest is given by

δ (t) = t 2

Solution

Rt
A(t) = e 0 δ (t)dt

Rt 2
=e 0 t dt

h 3 it
t t3
3 0
=e =e3

Exercise 3.29 The force of interest is t 22t+1 and the accumulated amount at t = 3
is 10, what is the accumulated amount at time t = 4?
Solution

R t 2t
dt 2 +1
A(t) = e 0 2 t +1 = eln(t )

= t2 + 1

A(4)
A(4) = AC(3)
A(3)
2
4 +1
= 10 2 = 17
3 +1

■
84 Chapter 3. The force of interest

Exercise 3.30 A deposit of $5, 500 earns interest i1 = .04, i2 = .05, i3 = .02
ik = .03 if k ≥ 4.
(i) What is the accumulated value of this deposit after ten periods?
(ii)What rate of interest, paid over the entire period would yield the same accu-
mulated value? This is called the average rate of return.
Solution
(i)

AC = 5, 500(1.04)(1.05)(1.02)(1.03)7

= 7534.35

(ii)

(1 + i)10 = (1.04)(1.05)(1.02)(1.03)7
q
10
1+i = (1.04)(1.05)(1.02)(1.03)7 = 1.031973

i = 3.2%

■
 4. Level annuities

4.1 Present Value

4.1.1 Payments made in arrear

The symbol an (pronounced "A.N.") represents the PV of an annuity consisting of

n payments of 1 unit made at the end of each of the next n time periods. This is
called an annuity paid in arrear.

a n = v + v2 + v3 + · · · + vn
v (1 − vn )
=
1−v
1 − vn
= −1
v −1
1 − vn
=
i
86 Chapter 4. Level annuities

Exercise 4.1 Calculate the present value as at 1 March 2005 of a series of

payments of 1.000 payable on the first day of each month from April 2005 to
December 2005 inclusive. assuming a rate of interest of 6% pa convertible
monthly.
Solution

i(P) .06
= = .005 ⇒ .5%
p 12
1

9
@1% 1− 1+.005
1000a 9 2 = 1000 = 1000(8.7791) = 8779.1
.005
■

Exercise 4.2 You are given that vn = .6139133 and that the present value of an
annuity-immediate of 1 for n periods is 7.72. What is the interest rate?
Solution

1 − vn .3860867
7.72 = =
i i
.380867
i= = .05001
7.72
i = 5%

Exercise 4.3 A person has 10, 000 to invest and wishes to purchase an annuity
which will provide constant monthly payments for a period of ten years. If the
interest rate used to price the annuity is a nominal rate of annual interest of 12%
compounded monthly, what will the monthly payment be?
Solution
4.1 Present Value 87

.12
We have i(mounthly) = 12 = .01, n = 120, and PV = 10000. Assume that the
annuity = AN, then,
10000 10000
PV = AN(a n ) ⇒ AN = a = 1 120 = 143.47 ■
120 (
1− 1+.01)
.01

4.1.2 Payments made in advance

Thus ä n is the value at the start of any given period of length n of a series of n
payments, each of amount 1, to be made in advance at unit time intervals over the
period. It is common to refer to such a series of payments, made in advance, as an
annuity-due and to call ä n the present value of the annuity-due.

ä n = 1 + v + v2 + · · · + vn−1
1 − vn
=
1−v
1 − vn
=
d

Exercise 4.4

Calculate a 25 and ä 15 at 13.5% pa effective.

Solution

1

25
1 − vn 1 − 1+.135
a 25 = = = 7.095
i .135
1 − vn 1 − (1.135)−15
ä 15 = = .135
= 7.149
d 1.135

■
 88 Chapter 4. Level annuities

4.1.3 Relationship between a n and ä n

ä n = (1 + i)a n .

ä n = a n−1 + 1

So
1 − vn 1 − vn i
an = , ä n = = a n = a n−1 + 1
i d d

4.2 Accumulation for payments made in arrear and in ad-

vance

(1 + i)n − 1
sn =
i
(1 + i)n − 1 i
s̈ n = = s n = s n+1 − 1
d d

Exercise 4.5 Calculate s 10 and s̈ 13 = at 3.5% pa effective.

Solution

(1 + i)n − 1 (1.035)10 − 1
s 10 = = = 11.731
i .035
(1 + i)n − 1 (1.035)13 − 1
s̈ 13 = = .035
= 16.677
d 1.035

Exercise 4.6 An annuity-immediate has a present value of 12. If the interest

rate is i = .05 what is the accumulated value of this annuity just after the final
payment is made?
Solution
4.2 Accumulation for payments made in arrear and in advance 89

Immediate means that there is no deferred period.

1 n
1 − vn 1 − ( 1+.05 )
an = ⇒ 12 = ⇒ n = 18.78
i .05
(1 + .05)18.78 − 1
s 18.78 = = 29.999 ≃ 30
.05
■

Exercise 4.7 Maria will retire in ten years and is saving 300 every month to
purchase a thirty-year monthly annuity to provide income in retirement. Her
savings account pays a nominal rate of 8% annual interest converted monthly
while the annuity is priced based on a nominal annual interest rate of 15%
compounded monthly. What will Maria’s monthly payment be?
Solution
The accumulated value after 10 years using n = 12 · 10 = 120, i = .08
12 = .006667
is
120 −1
AC = 300s 120 = 300 (1+.006667)
.006667 = 54885.03527
This number now becomes the present value of the annuity Maria will purchase.
Assume that the annuity = AN, then,
PV = AN(a n )
We now have n = 12 × 30 = 360 and i = .15/12 = .0125.
54885.03527 54885.03527
AN = a = 1 360 = 693.99 ≃ 694 ■
360 (
1− 1+.0125)
.0125

Exercise 4.8 Ahmed is saving up for college and needs to have 20, 000 in
twelve years. he plans to make an equal deposit at the end of each year with
the final payment to be made one year prior to entering college (the end of the
investment period). What is the size of the payment he needs to make each year
if the interest earned on his account is 5% per year?
Solution
 90 Chapter 4. Level annuities

Assume that the annuity = AN, then,

AC = AN( s̈ n )
We now have n = 11(he will make eleven payments at the start of each of years
2 through 12) and i = .05.
20000 20000
AN = s̈
= (1+.05)11 −1
= 1340.74 ■
12 .05
1+.05

4.3 Continuously payable annuities

Let n be a non-negative number. The value at time 0 of an annuity payable

continuously between time 0 and time n, where the rate of payment per unit time is
constant and equal to 1 , is denoted by ā n .

The accumulated amount of such an annuity at the time the payments cease is
denoted by s̄ n .

1 − vn i
ā n = = an
δ δ
n
(1 + i) − 1 i
s̄ n = = sn
δ δ

R Notice the similarity between the formulae for the present and accumulated
values of annuities:

1−vn 1−vn 1−vn

an = i ä n = d ā n = δ
(1+i)n −1 (1+i)n −1 (1+i)n −1
sn = i s̈ n = d s̄ n = δ

The numerators are the always consistent. the only difference between the
formulae are the denominators.
4.4 Annuities payable pthly 91

4.4 Annuities payable pthly

(p) 1 − vn i (p) (1 + i)n − 1 i

an = (p)
= (p) a n sn = (p)
= (p) s n
i i i i
1 − v n i (1 + i) n −1 i
(p) (p)
ä n = (p) = (p) a n s̈ n = = sn
d d d (p) d (p)

Exercise 4.9 Find the present and accumulated value of an annuity which pays
450 at the end of each quarter for ten years. The rate of interest is 4.5% per
quarter.
Solution
Method 1:

!40
1
1− (p) 1

40
1 − vn 1+ i p 1−
@.5% 1.045
PV = 450 · a 40 = 450 · = 450 · = 450 ·
i i(p) .045
p

= 8, 280.713

Method 2:

!p
i(p)
i= 1+ − 1 = (1 + .045)4 − 1 = 0.1925186
p
1

10
(4) 1 − vn 1 − 1.1925186
PV = 1800 · a 40 = 1800 · (p) = 1800 · = 8, 280.713
i .045(4)

Exercise 4.10 Find the present value as at 1 January 2004 of a series of pay-
ments of 100 payable on the first day of each month during 2005, 2006 and 2007
92 Chapter 4. Level annuities

. assuming an effective rate of interest of 8% per annum.

Solution

− 1p
h h 1
i
(p) 12 − 12
d = 1 − (1 + i) ]P ⇒ d = 1 + (1 + .08) 12 = .07671

V = 1 ÷ 1.08 = .92593
1 − v3 1 − .925933
 
The present value = 1200 V (12) = 1200(.92593) = 2986
d .076714

Exercise 4.11 Find the present value as at 1 June 2004 of payments of 1.000
payable on the first day of each month from July 2004 to December 2004 inclu-
sive. assuming a rate of interest of 8% per annum convertible quarterly.
Solution

!p !p !12
i(P) i(p) .08 4 i(12)
 
1+ = 1+ ⇒ 1+ = 1+
p p 4 12

i(12) = .07947
!p
i(P)
 
.07947
i = 1+ −1 = 1+ − 1 = .0824
p 12
1

2
(12) 1 − 1+.0824
a .5 = 12000 = 5861.37
.07947
■

Exercise 4.12 You have just invested 1, 000 in a fixed interest security. In
return you will receive 40 at the end of each half year plus your money back
on redemption in 12 years. You intend to deposit all of the proceeds in a bank
account that will pay an effective rate of interest of 8% pa. How much money
4.5 Perpetuities 93

do you expect there to be in the bank account after 10 years?

Solution

h√ i √
i = P 1 + i − 1 ⇒ i(2) = 2[ 1.08 − 1] = .07846
(P) p 2

(1 + .08)10 − 1
 
(2)
s 10 = 80 = 80(14.77) = 1181.6
.07846

Exercise 4.13 The present value at 6%pa of the following series of payments
is $245.32 $1 at time 1, $4 at time 2, $9 at time 3 . . . .$100 at time 10. What is
the present value of the series of payments if, instead of being paid at the end of
each year, the payments are made in three equal instalments at the end of each
third of a year?
Solution

√
i(P) ⇒ i(3) = 3[ 1.06 − 1] = .05884
3

(3) i .06
a 10 = a = 245.32 = 250.16
i(p) 10 .05884
■

4.5 Perpetuities
1 1 (p) 1 (p) 1
a∞ = i ä ∞ = d a∞ = i(p)
ä ∞ = d (p)

Exercise 4.14 Calculate the present value of an annuity that pays 150 pa annu-
ally in arrears forerer using an annual effective rate of interest of 8%.
Solution
94 Chapter 4. Level annuities

1
150a ∞ = 150 = 1.875
.08

Exercise 4.15

Calculate the present value of payments of 2, 000 at times 0.1.2 . . . using i = 7.6% pa

effective.

Solution

2000 2000
2000 ä ∞ = = = 28315.79
d .076 ÷ 1.076

Exercise 4.16 Calculate the present value of an annuity that pays 300pa
monthly in arrears forever using an annual effective rate of interest of 6%.
Solution

√
j(12) = 12[
12
1.06 − 1] = .05841
(12) 300 300
300 a∞ = = = 5136.05
i(12) .05841
■
4.6 Deferred annuities 95

4.6 Deferred annuities

4.6.1 Annual payments

m| a n = a m+n − a m = vm a n

m| ä n = ä m+n − ä m = vm ä n

4.6.2 Annuities payable pthly

(p) (p)
m| a n = vm a n
(p) (p)
m| ä n = vm ä n

Exercise 4.17 An annuity immediate will consist of ten years of monthly pay-
ments of 500 each. What is the value of this annuity seven months prior to its
first payment if the nominal annual interest rate is 6% compounded quarterly?
Solution
Method 1:
Find the effective monthly interest rate i(mounthly):
(p) p (p) p
   
1+ ip [mounthly] = 1 + i p [quarterly]
(12) 12
 
4 (12)
1 + i 12 = 1 + .06
4 ⇒ i(mounthly) = i 12 = .004975
Hence,

m| a n = vm a n
@.49% @.49%
7| a 120 = v7 a 120 @.49%
120
 1

1

7 1−( 1+.004975 )
7| a 120 = 1+.004975 .004975 = 87.116
PV = 500(7| [email protected]%
n ) = 500 × 87.116 = 43558
Method 2:
Find i(12) = 12 × .004975 = .0597
,and i(annually)
96 Chapter 4. Level annuities

(p) p
 
(1 + i)[annually] = 1 + i p [quarterly]
4 (12)
(1 + i) = 1 + .06 ⇒ i(annually) = i 12 = .06136


4
Hence,
(p) m (p)
m| a n = v a n
1 10
1+.06136 )
(12) 7 (12) 1 7 10 7 1−(
7 a = v 12 a 10 = ( 1+.06136 ) 12 ( 1−v(12) ) = ( 1
1+.06136 ) 12 (
.0597 ) = 7.2596
12 | 10 i
(12)
PV = 6000 × 7 a = 6000 × 7.2596 = 43557.6 ≃ 43558 ■
12 | 10
 5. Equations of value

5.1 The Equation of Value

The Equation of Value can be expressed as an equality between the present value
of money received and the present value of money paid out. The general form of
this equation is:

PVreceived = PVpaid out

This equation asserts that the present value of cash inflows (money received) is
equal to the present value of cash outflows (money paid out). The present value is
calculated by discounting future cash flows at a specified interest rate to reflect the
time value of money.
The formula for present value is commonly used in various financial calcu-
lations, such as net present value (NPV) analysis, which compares the present
value of inflows (revenues or benefits) with the present value of outflows (costs or
98 Chapter 5. Equations of value

investments). The equality in the Equation of Value represents a balance between

the values at the present time, considering the time value of money.
Consider a security S where an investor pays a price P to receive a series of
interest payments D at the end of each of the next n years, along with a final
redemption payment R at the end of the n years. The investor earns an annual
effective rate of return i.
The equation of value for this investment is expressed as:

P = Da n + Rvn , calculated at the interest rate i

Throughout the following section, we will explore methods to solve this equa-
tion when any of the quantities P, D or R, n, and i are unknown.
Exercise 5.1 Consider a security S where an investor pays a price P to receive
a series of interest payments D at the end of each of the next n years, along with
a final redemption payment R at the end of the n years. The investor earns an
annual effective rate of return i.
Calculate D , given that P=127.12, R=125, i=7.75 % and n=10 .
Solution
The equation of value for this investment is expressed as:

P = Da n + Rvn , calculated at the interest rate i

The equation of value is:

127.12 = Da 10 + 125v10

−10
127.12 = D × 1−1.0775
0.0775 + 125 × 1.0775−10
127.12 = D × 6.7864 + 125 × 0.47405
5.2 Loan schedules 99

127.12 − 125 × 0.47405

D= = 10.00
6.7864

Exercise 5.2 In the previous exercise if you have the following information for
security S: P = 78.92, D = 5, R = 125 and i = 0.10. Calculate n
Solution
The equation of value is:

78.92 = 5a n + 125vn
1 − vn
78.92 = 5 × + 125vn
0.10

78.92 = 50 (1 − vn ) + 125vn = 50 + 75vn

78.92 − 50
vn = = 0.38560
75

1.10−n = 0.38560

−n log 1.10 = log 0.38560

log 0.38560
n=− = 10.00
log 1.10

5.2 Loan schedules

The equation PVreceived = PVpaid out is fundamentally related to loan schedules
through the concept of present value and the time value of money. In the context
of loans, this equation can be applied to understand the relationship between the
100 Chapter 5. Equations of value

present value of loan payments received and the present value of loan payments
paid out.
Loan Payments as Cash Flows:
- The money received represents the present value of future loan payments that a
borrower is expected to make to the lender.
- The money paid out represents the present value of the loan amount disbursed by
the lender to the borrower.
Exercise 5.3 IA bank lends a company 5, 000 at a fixed rate of interest of 10%
pa effective. The loan is to be repaid by five level annual payments.
Calculate the interest and capital payments of each repayment.
Solution
The value of each repayment Y as following

Y a 5 = 5, 000
5, 000
Y= = 1, 318.98
3.7908

Interest due at Loan

Loan outstanding Capital repaid at the
the end of the outstanding at
Year at start of the end of the year
year end of the year
year (L) (C = 1, 318.98 − I)
(I = 10% of L) (L −C)
1 5,000 500 818.98 4, 181.02
2 4, 181.02 418.10 900.88 3, 280.14
3 3, 280.14 328.01 990.97 2, 289.17
4 2, 289.17 228.92 1, 090.06 1, 199.11
5 1, 199.11 119.91 1, 199.07 0.04
■

There are two more efficient approaches for determining the outstanding
5.2 Loan schedules 101

capital right after a repayment:

(a) Through the retrospective method, by computing the accumulated value of the
initial loan minus the accumulated value of the payments made up to that point.
(b) Through the prospective method, by determining the present value of future
repayments.
Exercise 5.4 A loan of 50, 000 is repayable by level annual payments at the
end of each of the next 5 years. Interest is 8% pa effective for the first three
years and 12% pa effective thereafter.
Calculate the loan outstanding immediately after the second repayment.
Solution
Firstly we calculate
 the amount of each repayment Y :
50, 000 = Y a 3 + v38% a 2
8% 12%
50, 000
Y=
2.5771 + 1.08−3 × 1.6901
Y = $12759.287

Interest due at Loan

Loan outstanding Capital repaid at the
the end of the outstanding at
Year at start of the end of the year
year end of the year
year (L) (C = 12759.287 − I)
(I = % of L) (L −C)
1 50000 4000 8759.287 41240.71
2 41240.71 3299.257 9460.03 31780.68
3 31780.68 2542.455 10216.83 21563.85
4 21563.85 2587.662 10171.62 11392.23
5 11392.23 1367.067 11392.22 0.005857
102 Chapter 5. Equations of value

Using the prospective approach:

 
12759.287v8% 1 + a 2 = 12759.287 × 1.08−1 × (1 + 1.6901) = 31, 781.26
12%

 
12759.287v8% 1 + a 2
12%

= 12759.287 × 1.08−1 × (1 + ((1.12−1 ) + (1.12−2 ))) = 31, 780.68

using the retrospective approach:

50, 000(1.08)2 − 12759.287((1.08) + 1) = 31, 780.68

Exercise 5.5 A loan of 16,000 is repayable by ten level payments, made an-
nually in arrears. The annual effective rate of interest is 4%. Calculate: (i) the
interest element of the 4th payment (ii) the capital element of the 7th payment
(iii) the capital repaid in the last five years of the loan (iv) the total interest paid
over the whole loan.
Solution

16, 000 16, 000

X a 10 = 16, 000 X= = = 1, 972.66
a 10 8.1109

(i) The outstanding capital after the 3rd payment (computed prospectively)
is determined by:

1, 972.66a7 = 1, 972.66 × 6.0021 = 11, 840.01

5.2 Loan schedules 103

The interest component of the 4th payment is calculated as:

0.04 × 11, 840.01 = 473.60

(ii) The outstanding capital after the 6th payment (calculated prospectively)
is found using:

1, 972.66a4 = 1, 972.66 × 3.6299 = 7, 160.55

The interest component of the 7th payment is determined by:

0.04 × 7, 160.55 = 286.42

Hence, the capital portion of the 7th payment is given by:

1, 972.66 − 286.42 = 1, 686.24

(iii) The capital repaid over the last five years of the loan equals the out-
standing capital after the 5th payment, i.e.:

1, 972.66a5 = 1, 972.66 × 4.4518 = 8, 781.93

(iv) The total interest payable over the whole loan is the total payment made
less the capital borrowed, i.e.:

10 × 1, 972.66 − 16, 000 = 3, 726.60

■
 104 Chapter 5. Equations of value

5.3 Project appraisal

Net Present Value (NPV) is a crucial metric in project appraisal, and it plays a
central role in evaluating the financial feasibility and attractiveness of a project.
Generally, if the NPV is positive, the project is considered financially viable and
acceptable. A negative NPV might indicate that the project may not meet the
required rate of return and could be rejected.
Net Present Value (NPV) is a financial metric used to evaluate the profitability of
an investment or project. It represents the difference between the present value
of cash inflows and the present value of cash outflows over a specific period of time.

NPV = The present value of cash inflows−The present value of cash outflows

The accumulated profit over a specific period can be represented using the
cumulative sum of net profits or retained earnings. If we denote the net profit in
each period as Pt , where t is the period, the accumulated profit (AP) at the end of a
given period is calculated as:

t
APt = ∑ Pi
i=1

Exercise 5.6 Let the cashflow at time t be denoted Ct . The cashflows for two
business ventures are as follows:

Venture 1: C0 = −100,C1 = −40,C2 = +50,C3 = +120

Venture 2: C1 = −45,C3 = +25,C4 = +25,C5 = +25
Calculate the accumulated profit at time 5 and the net present value for each of
these ventures using a risk discount rate of 15% pa.
Solution
5.3 Project appraisal 105

The accumulated profit for Venture 1 at time 5 is:

AP1 = −100(1 + i)5 − 40(1 + i)4 + 50(1 + i)3 + 120(1 + i)2 @15% = −36.352

The accumulated profit for Venture 2 at time 5 is:

AP2 = −45(1 + i)4 + 25(1 + i)2 + 25(1 + i) + 25@15% = 8.107

So the accumulated profits are −36, 352 (ie a loss) for Venture 1 and 8, 107
for Venture 2. The net present values are:

NPV1 = −100 − 40v + 50v2 + 120v3 @15% = −18.073

NPV2 = −45v + 25v3 + 25v4 + 25v5 @15% = 4.031

So the NPVs are −18, 073 for Venture 1 and 4, 031 for Venture 2 . ■

Exercise 5.7 A company must choose between Project C and Project D, both of
which would be financed by a loan, repayable only at the end of the project. The
company must pay interest at a rate of 6.25%pa effective on money borrowed,
but can only earn interest at a rate of 4%pa effective on money invested in its
deposit account.
The cashflows for Project C, which has a term of 5 years, are:
Outgo Income
(start of year 1) 140, 000 (end of year 5)
The cashflows for Project D, which has a term of 3 years, are:
Outgo Income
80, 000 (start of year 1) 10, 000 (end of year 1)
20, 000 (start of year 2) 30, 000 (end of year 2)
5, 000 (start of year 3) 87, 000 (end of year 3)
Calculate the accumulated profit at the end of 5 years for each project.
106 Chapter 5. Equations of value

Solution
Project C Since Project C does not generate any income, the company will be
relying on the loan throughout the 5 -year term. So only the borrowing rate of
6.25% will be relevant here.
The accumulated profit at time 5 years will be:

140, 000 − 100, 000 × 1.06255 = 4, 592

Project D Since Project D does generate income during the project’s term,
we need to consider the company’s net assets at the end of each year to see
whether there are any excess funds available to invest.
At the end of year 1 , there is an income payment of 10, 000. However, at
that time the company needs to pay interest of 80, 000 × 0.0625 = 5, 000 on the
initial loan and it also has further outgo of 20, 000 at the start of year 2 . The
net outgo at this time is therefore:

5, 000 + 20, 000 − 10, 000 = 15, 000

So further borrowing of 15, 000 is required. This takes the total borrowing
to:

80, 000 + 15, 000 = 95, 000

At the end of year 2, there is an income payment of 30, 000. However, at

that time the company needs to pay interest of 95, 000 × 0.0625 = 5, 937.5 on
its borrowing and it also has further outgo of 5, 000 at the start of year 3 . The
5.3 Project appraisal 107

net income at this time is therefore:

30, 000 − 5, 937.5 − 5, 000 = 19, 062.5

Since the loan can only be repaid at the end of the project, this money cannot
be used to reduce the loan outstanding. Instead, the company has 19, 062.5
available for investment.
So, just after the outgo of 5, 000 at the start of year 3, the company has: -
loans totalling 95, 000 - investments of 19, 062.5.
At the end of the project (ie time 3 years), the company receives income of
87, 000. The money invested at the start of year 3 has grown to:

19, 062.5 × 1.04 = 19, 825

So the total amount at the company’s disposal is 87, 000+19, 825 = 106, 825.
From this, the company must repay the loan of 95, 000 plus the interest accrued
on this loan over the year. This leaves an amount at time 3 years of:

106, 825 − 95, 000 × 1.0625 = 5, 887.5

To obtain the accumulated profit at time 5 , we take this money at time 3 and
accumulate it for 2 years to time 5 (using the investment rate of interest of 4% ):

5, 887.5 × 1.042 = 6, 368

Exercise 5.8 The business plan for a new company that has obtained a 5 -year
lease for operating a local bus service is shown in the table below. Items marked
108 Chapter 5. Equations of value

with an asterisk represent continuous cashflows.

Cashflow item Timing Amount
Initial set up costs Immediate -250
Fees from advertising contracts 1 month +200
Purchase of vehicles 3 months −2, 000
Fares from passengers* From 3 months onwards +1, 000pa
Staff costs & other operating costs* From 3 months onwards −400pa
Resale value of assets 5 years +500
Determine the discounted payback period for this project assuming that it
will be financed by a loan based on an effective annual interest rate of 10%, and
that the loan can be repaid at any time.
Solution
If the DPP exists for this project, it will be at some point after 3 months, as the
income from fares is needed to recoup the initial expenditure.
Remembering that the starred cashflows are continuous, the accumulated
value of cashflows up to time t (where 3 months < t < 5 years) is:

AV (t) = −250 × 1.10t + 200 × 1.10t−1/12 − 2, 000 × 1.10t−3/12 + (1, 000 − 400) s̄t−3/12
 
= −250 × 1.103/12 + 200 × 1.102/12 − 2, 000 × 1.10t−3/12 + 600 s̄t−3/12

= −2, 052.83 × 1.10t−3/12 + 600 s̄t−3/12

To determine the DPP, we need to find the value of t for which the accumu-
lated value of the cashflows up to that time is 0 . This occurs when:

2, 052.83 × 1.10t−3/12 = 600 s̄t−3/12

Since s̄ n = (1 + i)n ā n , we can divide through by 1.10t−3/12 and rearrange

5.3 Project appraisal 109

to obtain:

2, 052.83
āt−3/12 = = 3.42138
600

Now:

1 − 1.10−(t−3/12)
= 3.42138 ⇒ 1.10−(t−3/12) = 0.67391
ln 1.10

Taking logs and solving, we find:

ln 0.67391 3
−(t − 3/12) ln 1.10 = ln 0.67391 ⇒ t = − + = 4.39
ln 1.10 12

So the discounted payback period is 4.39 years.

Instead of working with accumulated values, we could work with present
values. The DPP is the time t when NPVup to = 0. The equation to solve is:

NPV = −250 + 200v1/12 − 2, 000v3/12 + 600v3/12 āt−3/12 = 0

This gives the same answer as above. ■

I
Compound Interest Tables
 Compound
Interest Tables