PPT5-Mathematics of Finance

MATH6102
Business Mathematics
Week 5
Mathematics of Finance
Chapter Outline
 Compound Interest
 Present Value
 Interest Compounded
Continuously
 Annuities
 Amortization of Loans
COMPOUND INTEREST
• The compound amount is also called the accumulated amount,
and the difference between the compound amount and the
original principal, S-P, is called the compound interest.
• Compound interest Formula:
S  P 1  r 
n
P  S 1  r 
n
where:
S = compound amount (future value)
P = principal (present value)
r = nominal rate
n = number of interest periods
Example: Nominal Rate
Suppose that $500 amounted to $588.38 in a savings account after three years. If interest was
compounded semiannually, find the nominal rate of interest, compounded semiannually, that was
earned by the money.
Solution:
There are n = 2 × 3 = 6 interest periods.
S  P 1  r 
n
588.38  5001  r 
6
588.38
1  r  6 
500
588.38
1 r  6
500
588.38
r6  1  0.0275
500
The semiannual rate was 2.75%, so the nominal rate was 5.5 % compounded semiannually.
Example: Number of interest periods
How long will it take for $600 to amount to $900 at an annual rate of 6% compounded
quarterly?
Solution:
• The periodic rate is r = 0.06/4 = 0.015.
S  P 1  r 
n
900  6001.015
n
1.015 n  1.5
ln 1.015  ln 1.5
n
n ln 1.015  ln 1.5
ln 1.5
n  27.233
ln 1.015
• It will take 27.233
 6.8083  6 years, 9 12 months
4
• Effective Rate Formula:
n
 r
re  1    1
 n
where:
re = effective rate
r = nominal rate
n = number of interest periods
Example: Effective Rate
If an investor has a choice of investing money at 6% compounded daily
1
or 6 % compounded quarterly, which is the better choice?
8
Solution:
Respective effective rates of interest are
365
 0.06 
re  1    1  6.18%(daily )
 365 
4
 0.06125 
re  1    1  6.27%(quarterly)
 4 
Quarterly is choice gives a higher effective rate.
PRESENT VALUE
• Present Value Formula:
P = S(1 + r)-n
• Net Present Value Formula:
Net Present Value (NPV) = Sum of present values – Initial investment
Example – Present Value
Find the present value of $1000 due after three years if the
interest rate is 9% compounded monthly.
Solution:
For interest rate, r  0.09 / 12  0.0075
P  S 1  r 
n
P  1.0001  0.0075
36
P  1.0001.0075
36
P  764.15
Example – Net Present Value
You can invest $20,000 in a business that guarantees you cash flows at the end of
years 2, 3, and 5 as indicated in the table.
Year Cash Flow
2 $10,000
3 8000
5 6000
Assume an interest rate of 7% compounded annually and find the net present value
of the cash flows.
Solution:
NPV  10,0001.07   80001.07   60001.07 
2 3 5
 20,000
NPV  $457.31
If NPV < 0, the business is not profitable
INTEREST COMPOUNDED
CONTINUOUSLY
Compound Amount under Continuous Interest
• The compound amount S is defined as
S = Pe rt
where:
S = compound amount (future value)
P = principal (present value)
r = nominal rate
t = years
e = 2,72
Example: Compound Amount
If $100 is invested at an annual rate of 5% compounded
continuously, find the compound amount at the end of
Solution:
a. 1 year.
S  Pe rt  100e  0.05  1  $105.13
b. 5 years.
S  100e  0.05  5   100e 0.25  $128.40
ANNUITIES
• Present Value of an Annuity
• The present value of an annuity (A) is the sum
of the present values of all the payments.
A  R 1  r   R 1  r   ...  R 1  r 
1 2 n
• The amount S of ordinary annuity of R for n

periods at r per period is
S R
 1 r   1
n
r
Example: Annuities
Find the present value of an annuity of $100 per month for

1
3 years at an interest rate of 6% compounded monthly.
2
Solution:
• For R = 100, r = 0.06/12 = 0.005, n = ( )(12)
1 = 42
3
2
A  100a __
• From Appendix B, 42 0.005
.
a __  37.798300
42 0.005
• Hence,
A  100 37.798300   $3779.83
Example: Future Value of an Annuity
Find S consisting of payments of $50 at the end of every

3 months for 3 years at 6% compounded quarterly. Also,
find the compound interest.
Solution:
For R=50, n=4(3)=12, r=0.06/4=0.015,
S  50 __  5013.041211  $652.06
12 0.015
Compund Interest  652.06  12 50   $52.06
AMORTIZATION OF LOANS
Amortization Formulas
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MATH6102

• The amount S of ordinary annuity of R for n

Find the present value of an annuity of $100 per month for

Find S consisting of payments of $50 at the end of every

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