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Mathematics of Finance
Compound Interest
Annuities
Amortization and Sinking Funds
Arithmetic and Geometric
Progressions
4.1
Compound Interest
Simple Interest Formulas
or $1240.
Example
A bank pays simple interest at the rate of 8% per year for
certain deposits.
If a customer deposits $1000 and makes no withdrawals
for 3 years, what is the total amount on deposit at the end
of three years?
What is the interest earned in that period?
Solution
The interest earned over the three year period is given by
I Prt
1000(0.08)(3) 240
or $240.
Applied Example: Trust Funds
An amount of $2000 is invested in a 10-year trust fund
that pays 6% annual simple interest.
What is the total amount of the trust fund at the end of 10
years?
Solution
The total amount is given by
A P (1 rt )
2000[1 (0.06)(10)] 3200
or $3200.
Compound Interest
Frequently, interest earned is periodically added to the
principal and thereafter earns interest itself at the same
rate. This is called compound interest.
Suppose $1000 (the principal) is deposited in a bank for a
term of 3 years, earning interest at the rate of 8% per year
compounded annually.
Using the simple interest formula we see that the
accumulated amount after the first year is
A1 P (1 rt )
1000[1 0.08(1)]
1000(1.08) 1080
or $1080.
Compound Interest
To find the accumulated amount A2 at the end of the
second year, we use the simple interest formula again, this
time with P = A1, obtaining:
A2 P (1 rt ) A1 (1 rt )
1000[1 0.08(1)][1 0.08(1)]
1000(1 0.08)2 1000(1.08) 2 1166.40
or approximately $1166.40.
Compound Interest
We can use the simple interest formula yet again to find
the accumulated amount A3 at the end of the third year:
A3 P(1 rt ) A2 (1 rt )
1000[1 0.08(1)]2 [1 0.08(1)]
1000(1 0.08)3 1000(1.08)3 1259.71
or approximately $1259.71.
Compound Interest
Note that the accumulated amounts at the end of each year
have the following form:
A1 1000(1.08) A1 P (1 r )
A2 1000(1.08)2 or: A2 P(1 r ) 2
A3 1000(1.08)3 A3 P (1 r )3
These observations suggest the following general rule:
If P dollars are invested over a term of t years earning
interest at the rate of r per year compounded annually,
then the accumulated amount is
A P(1 r )t
Compounding More Than Once a Year
The formula
A P (1 r )t
r 0.08
i 0.02
m 4
or 2% per period.
Compounding More Than Once a Year
First Period: A1 P (1 i )
Second Period: A2 A1 (1 i ) [ P (1 i )](1 i ) P (1 i )
2
nth Period: An An 1 (1 i ) [ P (1 i ) n 1 ](1 i ) P(1 i ) n
Compound Interest Formula
There are n = mt periods in t years, so the accumulated
amount at the end of t years is given by
n
r
A P 1
m
Where n = mt, and
A = Accumulated amount at the end of t years
P = Principal
r = Nominal interest rate per year
m = Number of conversion periods per year
t = Term (number of years)
Example
Find the accumulated amount after 3 years if $1000 is
invested at 8% per year compounded
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily
Example
Solution
a. Annually.
Here, P = 1000, r = 0.08, and m = 1.
Thus, i = r = 0.08 and n = 3, so
n
r
A P 1
m
3
0.08
1000 1
1
1000(1.08)3
1259.71
or $1259.71.
Example
Solution
b. Semiannually.
Here, P = 1000, r = 0.08, and m = 2.
Thus, i 0.08
2 and n = (3)(2) = 6, so
n
r
A P 1
m
6
0.08
1000 1
2
1000(1.04)6
1265.32
or $1265.32.
Example
Solution
c. Quarterly.
Here, P = 1000, r = 0.08, and m = 4.
Thus, i 0.08
4 and n = (3)(4) = 12, so
n
r
A P 1
m
12
0.08
1000 1
4
1000(1.02)12
1268.24
or $1268.24.
Example
Solution
d. Monthly.
Here, P = 1000, r = 0.08, and m = 12.
Thus, i 0.08
12 and n = (3)(12) = 36, so
n
r
A P 1
m
36
0.08
1000 1
12
36
0.08
1000 1
12
1270.24
or $1270.24.
Example
Solution
e. Daily.
Here, P = 1000, r = 0.08, and m = 365.
Thus, i 0.08
365 and n = (3)(365) = 1095, so
n
r
A P 1
m
1095
0.08
1000 1
365
1095
0.08
1000 1
365
1271.22
or $1271.22.
Continuous Compounding of Interest
One question arises on compound interest:
What happens to the accumulated amount over a
fixed period of time if the interest is compounded
more and more frequently?
Weve seen that the more often interest is
compounded, the larger the accumulated amount.
But does the accumulated amount approach a limit
when interest is computed more and more
frequently?
Continuous Compounding of Interest
mt
r
A P 1
m
A = Pert
where
P = Principal
r = Annual interest rate compounded
continuously
t = Time in years
A = Accumulated amount at the end
of t years
Examples
Find the accumulated amount after 3 years if $1000 is
invested at 8% per year compounded (a) daily, and
(b) continuously.
Solution
a. Using the compound interest formula with P = 1000,
r = 0.08, m = 365, and t = 3, we find
mt (365)(3)
r
0.08
A P 1 1000 1 1271.22
m 365
m
r
reff 1 1
m
where
reff = Effective rate of interest
r = Nominal interest rate per year
m = Number of conversion periods per year
Example
Find the effective rate of interest corresponding to a
nominal rate of 8% per year compounded
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily
Example
Solution
a. Annually.
Let r = 0.08 and m = 1. Then
1
0.08
reff 1 1
1
1.08 1
0.08
or 8%.
Example
Solution
b. Semiannually.
Let r = 0.08 and m = 2. Then
2
0.08
reff 1 1
2
1.0816 1
0.0816
or 8.16%.
Example
Solution
c. Quarterly.
Let r = 0.08 and m = 4. Then
4
0.08
reff 1 1
4
1.08243 1
0.08243
or 8.243%.
Example
Solution
d. Monthly.
Let r = 0.08 and m = 12. Then
12
0.08
reff 1 1
12
1.08300 1
0.08300
or 8.300%.
Example
Solution
e. Daily.
Let r = 0.08 and m = 365. Then
365
0.08
reff 1 1
365
1.08328 1
0.08328
or 8.328%.
Effective Rate Over Several Years
A P (1 reff )t
Present Value
Consider the compound interest formula:
mt
r
A P 1
m
P A 1 i
n
r n mt
Where i and
m
Examples
How much money should be deposited in a bank paying a
yearly interest rate of 6% compounded monthly so that
after 3 years the accumulated amount will be $20,000?
Solution
Here, A = 20,000, r = 0.06, m = 12, and t = 3.
Using the present value formula we get
mt
r
P A 1
m
(12)(3)
0.06
20,000 1
12
16,713
Examples
Find the present value of $49,158.60 due in 5 years at an
interest rate of 10% per year compounded quarterly.
Solution
Here, A = 49,158.60, r = 0.1, m = 4, and t = 5.
Using the present value formula we get
mt
r
P A 1
m
(4)(5)
0.1
49,158.60 1
4
30, 000
Present Value
with Continuously Compounded Interest
A = Pert
for P, we get
P = Aert
This formula gives the present value in terms of the future
(accumulated) value for the case of continuous
compounding.
Applied Example: Real Estate Investment
Blakely Investment Company owns an office building
located in the commercial district of a city.
As a result of the continued success of an urban renewal
program, local business is enjoying a mini-boom.
The market value of Blakelys property is
V (t ) 300,000e t /2
or $599,837.
Applied Example: Real Estate Investment
Solution
Using the present value formula for continuous
compounding
P = Aert
with A = V(t) and r = 0.09, we find that the present value of
the market price of the property t years from now is
P (t ) V (t )e 0.09t
300, 000e 0.09t t /2
(0 t 10)
Letting t = 8, we find that
or $600,640.
Applied Example: Real Estate Investment
Solution
Using the present value formula for continuous
compounding
P = Aert
with A = V(t) and r = 0.09, we find that the present value of
the market price of the property t years from now is
P (t ) V (t )e 0.09t
300, 000e 0.09t t /2
(0 t 10)
Letting t = 9, we find that
or $598,115.
Applied Example: Real Estate Investment
Solution
From these results, we see that the present value of the
propertys market price seems to decrease after a certain
period of growth.
This suggests that there is an optimal time for the owners
to sell.
You can show that the highest present value of the
propertys market value is $600,779, and that it occurs
at time t 7.72 years, by sketching the graph of the
function P.
Example: Using Logarithms in Financial Problems
How long will it take $10,000 to grow to $15,000 if the
investment earns an interest rate of 12% per year
compounded quarterly?
Solution
Using the compound interest formula
n
r
A P 1
m
ln1.5
4t
ln1.03
So, it will take about 3.4
years for the investment ln1.5
t 3.43
to grow from $10,000 to 4 ln1.03
$15,000.
4.2
Annuities
Future Value of an Annuity
(1 i ) n 1
S R
i
Example
Find the amount of an ordinary annuity consisting of 12
monthly payments of $100 that earn interest at 12% per
year compounded monthly.
Solution
Since i is the interest rate per period and since interest is
compounded monthly in this case, we have
0.12
i 0.01
12
Using the future value of an annuity formula, with
R = 100, n = 12, and i = 0.01, we have
(1 i ) n 1 (1 0.01)12
1
S R 100 1268.25
i 0.01
or $1268.25.
Present Value of an Annuity
1 (1 i ) n
P R
i
Example
Find the present value of an ordinary annuity consisting of
24 monthly payments of $100 each and earning interest of
9% per year compounded monthly.
Solution
Here, R = 100, i = r/m = 0.09/12 = 0.0075, and n = 24, so
1 (1 i ) n 1 (1 0.0075) 24
P R 100 2188.91
i 0.0075
or $2188.91.
Applied Example: Saving for a College Education
As a savings program towards Albertos college education,
his parents decide to deposit $100 at the end of every
month into a bank account paying interest at the rate of
6% per year compounded monthly.
If the savings program began when Alberto was 6 years
old, how much money would have accumulated by the
time he turns 18?
Applied Example: Saving for a College Education
Solution
By the time the child turns 18, the parents would have
made
(18 6) 12 144
deposits into the account, so n = 144.
Furthermore, we have R = 100, r = 0.06, and m = 12, so
0.06
i 0.005
12
Using the future value of an annuity formula, we get
(1 i ) n 1 (1 0.005)144
1
S R 100 21,015
i 0.005
or $21,015.
Applied Example: Financing a Car
After making a down payment of $4000 for an automobile,
Murphy paid $400 per month for 36 months with interest
charged at 12% per year compounded monthly on the
unpaid balance.
What was the original cost of the car?
What portion of Murphys total car payments went
toward interest charges?
Applied Example: Financing a Car
Solution
The loan taken up by Murphy is given by the present
value of the annuity formula
1 (1 i ) n 1 (1 0.01) 36
P R 400 12,043
i 0.01
or $12,043.
Therefore, the original cost of the automobile is $16,043
($12,043 plus the $4000 down payment).
The interest charges paid by Murphy are given by
n = (30)(12) = 360.
Using the amortization formula we find that the size of
each monthly installment required is given by
Pi (120,000)(0.0075)
R n
360
965.55
1 (1 i ) 1 (1 0.0075)
or $965.55.
Applied Example: Home Affordability
The Jacksons have determined that, after making a down
payment, they could afford at most $2000 for a monthly
house payment.
The bank charges interest at a rate of 7.2% per year on the
unpaid balance, with interest computations made at the
end of each month.
If the loan is to be amortized in equal monthly
installments over 30 years, what is the maximum amount
that the Jacksons can borrow from the bank?
Applied Example: Home Affordability
Solution
We are required to find P, given i = r/m = 0.072/12 = 0.006, n
= (30)(12) = 360, and R = 2000.
We first solve for P in the amortization formula
R 1 (1 i ) n
P
i
Substituting the numerical values for R, n, and i we obtain
iS (0.025)(30,000)
R 3434.02
(1 i ) 1 (1 0.025) 1
n 8
or $3434.02.
4.4
Arithmetic and Geometric Progressions
20
S20 [2 2 (20 1)5] 990
2
1,000,000(1 (1.1)5 )
S5 6,105,100
1 1.1
Arithmetic Progressions
An arithmetic progression is a sequence of numbers in
which each term after the first is obtained by adding a
constant d to the preceding term.
The constant d is called the common difference.
An arithmetic progression is completely determined if the
first term and the common difference are known.
nth Term of an Arithmetic Progression
a5 = 200,000 + (5 1)30,000
= 320,000
or $320,000.
Applied Example: Company Sales
Madison Electric Company had sales of $200,000 in its
first year of operation.
If the sales increased by $30,000 per year thereafter, find
Madisons sales in the fifth year and its total sales over the
first 5 years of operation.
Solution
Madisons total sales over the first 5 years of operation are
found by using the sum of terms formula.
Thus,
n
Sn [2a ( n 1)d ]
2
5
[2(200,000) (5 1)30,000]
2
1,300,000
or $1,300,000.
Geometric Progressions
A geometric progression is a sequence of numbers in
which each term after the first is obtained by multiplying
the preceding term by a constant.
The constant is called the common ratio.
A geometric progression is completely determined if the
first term a and the common ratio r are given.
nth Term of a Geometric Progression
a (1 r n )
if r 1
Sn 1 r
na if r 1
Example
Find the sum of the first six terms of the geometric
progression 3, 6, 12, 24,
Solution
Using the sum of terms formula
a (1 r n )
if r 1
Sn 1 r
na if r 1
3(1 26 )
S6 189
1 2
Applied Example: Company Sales
Michaelson Land Development Company had sales of
$1 million in its first year of operation.
If sales increased by 10% per year thereafter, find
Michaelsons sales in the fifth year and its total sales
over the first 5 years of operation.
Solution
The sales follow a geometric progression, with first term
a = 1,000,000 and common ratio r = 1.1.
The sales in the fifth year are thus
a5 1,000,000(1.1) 4 1, 464,100
or $1, 464,100.
Applied Example: Company Sales
Michaelson Land Development Company had sales of
$1 million in its first year of operation.
If sales increased by 10% per year thereafter, find
Michaelsons sales in the fifth year and its total sales
over the first 5 years of operation.
Solution
The sales follow a geometric progression, with first term
a = 100,000,000 and common ratio r = 1.1.
The total sales over the first 5 years of operation are