INTRODUCTORY MATHEMATICAL ANALYSIS

For Business, Economics, and the Life and Social Sciences

Chapter 5
Mathematics of Finance

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Chapter 5: Mathematics of Finance

Chapter Outline

Compound Interest
Present Value
Interest Compounded Continuously
Annuities

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Chapter 5: Mathematics of Finance

Compound Interest
• Compound amount S at the end of n interest
periods at the periodic rate of r is as
S  P 1  r 
n

Example 1 – Compound Interest

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.

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Chapter 5: Mathematics of Finance
5.1 Compound Interest
Example 1 – Compound Interest

Solution:
There are 2 × 3 = 6 interest periods.
5001  r   588.38
6

1  r 6  588.38
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.

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Chapter 5: Mathematics of Finance
5.1 Compound Interest

Example 3 – Compound Interest

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.
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
4
 6.8083  6 years, 9 21 months .

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 Effective Rate or Annual Percentage
Yield (APY)

If principal P is invested at the annual

(nominal) rate r compounded m times a
year, then the annual percentage yields
is
m
 r
APY  re  1    1
 m
n
 r
re  1    1
 n

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Chapter 5: Mathematics of Finance
5.1 Compound Interest

Example 7 – Comparing Interest Rates

If an investor has a choice of investing money at 6%
1
compounded daily or 6 % compounded quarterly,
8
which is the better choice?
Solution:
Respective effective rates of interest are
365
 0.06 
re  1    1  6.18% and
 365 
4
 0.06125 
re  1    1  6.27%
 4 

The 2nd choice gives a higher effective rate.

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Exercises
1. Southern Pacific Bank recently offered a 1-year
CD that paid 6.8% compounded daily and
Washington Savings Bank offered one that
paid 6.85% compounded quarterly. Find the
APY (expressed as a percentage, correct to
three decimal places) for each CD. Which has
the higher return ?
2. A savings and loan wants to offer a CD with a
monthly compounding rate that has an
effective rate of 7.5%. What annual nominal
rate compounded monthly should they use ?

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 The Time Value of Money

Money NOW
is worth more than
money LATER!

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To simplify this material as much as
possible, you should understand that
there are only a few basic types of
problems, though each has several
variations.
• Future value or present value
• Future value of an annuity
• Present value of an annuity

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A sum of money today is called a
present value.

• We designate it mathematically with a

subscript, as occurring in time period 0

• For example: P0 = 1,000 refers to $1,000

today

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A sum of money at a future time is
termed a future value

• We designate it mathematically with a

subscript showing that it occurs in time period
n.

• For example: Sn = 2,000 refers to $2,000

after n periods from now.

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As already noted, the number of
time periods in a time value problem
is designated by n.

• n may be a number of years

• n may be a number of months
• n may be a number of quarters
• n may be a number of any defined time
periods

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The interest rate or growth rate in a
time value problem is designated by
i
• i must be expressed as the interest rate per
period.
• For example if n is a number of years, i must
be the interest rate per year.
• If n is a number of months, i must be the
interest rate per month.

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Chapter 5: Mathematics of Finance

Annuities
Sequences and Geometric Series
• A geometric sequence with first term a and
common ratio r is defined as
a,ar ,ar 2,ar 3,..., ar n1 where a  0
Example 1 – Geometric Sequences
a. The geometric sequence with a = 3, common
ratio 1/2 , and n = 5 is
2 3 4
 1  1  1  1
3, 3 , 3  , 3  , 3 
2 2 2 2

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Chapter 5: Mathematics of Finance
5.4 Annuities
Example 1 – Geometric Sequences

b. Geometric sequence with a = 1, r = 0.1, and

n = 4.
1, 0.1, 0.01, 0.001

Sum of Geometric Series

• The sum of a geometric series of n terms, with
first term a, is given by
n 1
s   ar i 
a 1  
r n
 for r  1
i 0 1 r

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Chapter 5: Mathematics of Finance
5.4 Annuities

Example 3 – Sum of Geometric Series

2 6
1  1  1
Find the sum of the geometric  
series: 2  2 
1    ...   
2
Solution: For a = 1, r = 1/2, and n = 7
  1 7 
11    
S
a 1 r n   2 
  
127
128

127
1 r 1
1 1
2 64
2
Present Value of an Annuity
• The present value of an annuity (P) is the sum
of the present values of all the payments.
P  R1  r   R1  r   ...  R1  r 
1 2 n

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Chapter 5: Mathematics of Finance
5.4 Annuities

Example 5 – Present Value of Annuity

Find the present value of an annuity of $100 per
1
month for 3 years at an interest rate of 6%
2
compounded monthly.

Solution:
For R = 100, r = 0.06/12 = 0.005, n = ( 3 1 )(12) = 42
2
P  100a __
42 0.005

From Appendix A, a  37.798300.

__
42 0.005
Hence,
P  10037.798300  $3779.83

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Chapter 5: Mathematics of Finance
5.4 Annuities

Example 7 – Periodic Payment of Annuity

If $10,000 is used to purchase an annuity consisting
of equal payments at the end of each year for the
next four years and the interest rate is 6%
compounded annually, find the amount of each
payment.

Solution:
For P = $10,000, n = 4, r = 0.06,
10,000  Ra __
4 0.06

P 10,000 10,000
R    $2885.91
a__ a__ 3.465106
n r 4 0.06

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The first of the general type of time
value problems is called future value
and present value problems. The
formula for these problems is:

• Sn = P0(1+i)n

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An example problem:

• If you invest $1,000 today at an interest

rate of 10 percent, how much will it grow
to be after 5 years?

• Sn = P0(1+i)n
• Sn = 1,000(1.10)5
• Sn = $1,610.51

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Another example problem:
• Assume you will receive an inheritance of
$100,000, six years from now. How much
could you borrow from a bank today and
spend now, such that the inheritance money
will be exactly enough to pay off the loan plus
interest when it is received? Assume the
bank charges an interest rate of 12 percent?

• How long will it take for $10,000 to grow to

$20,000 at an interest rate of 15% per year?

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One more example problem:

• If you invest $11,000 in a mutual fund today,

and it grows to be $50,000 after 8 years, what
compounded, annualized rate of return did
you earn?

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 The next two general types of time
value problems involve annuities

• An annuity is an amount of money that occurs

(received or paid) in equal amounts at equally
spaced time intervals.
• These occur so frequently in business that
special calculation methods are generally
used.

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 For example:

• If you make payments of $2,000 per year into

a retirement fund, it is an annuity.
• If you receive pension checks of $1,500 per
month, it is an annuity.
• If an investment provides you with a return of
$20,000 per year, it is an annuity.

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A common mathematical symbol for
an annuity amount is PMT

• A financial calculator usually has a key

labeled PMT
• Time value tables for future value of annuities
and for present value of annuities can also be
used to simplify calculations.

• OR, the following formulas can be used:

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For the future value of an annuity:

• FV = PMT[(1+i)n - 1]/i

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Chapter 5: Mathematics of Finance
5.4 Annuities

Amount /Future Value of an Annuity

• The amount S of ordinary annuity of R for n
periods at r per period is
S R
1 r   1
n

r
Example 9 – Amount of Annuity
Find S consisting of payments of $50 at the end of
every 3 months for 3 years at 6% compounded
quarterly.

Solution: For R=50, n=4(3)=12, r=0.06/4=0.015,

S  50 __  5013.041211  $652.06
12 0.015

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Chapter 5: Mathematics of Finance

Present Value
• P that must be invested at r for n interest periods
so that the present value, S is given by
P  S 1  r 
n

Example 1 – 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.
 36
Principle value is P  1000 1.0075  $764.15 .

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Exercises

1. Suppose you decide to deposit $100 every 6

months into an account that pays 6%
compounded semiannually. If you make six
deposits, one at the end of each interest
payment period, over 3 years, how much
money will be in the account after the last
deposit is made ?
2. How much should you deposit in an account
paying 6% compounded semiannually in order
to be able to withdraw $1,000 every 6 months
for the next 3 years ?

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3. If you want to save $500,000 for retirement
after 30 years, and you earn 10 percent per
annum, how much must you save each year ?

4. If you save $50 per month at 12 percent per

annum, how much will you have at the end of
20 years ?

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