Course : MATH6135-Business

Mathematics
Effective Period: September 2020

Mathematics of Finance

Session 5-6
Thank you
 Acknowledgement

These slides have been adapted from:

Haeussler, Jr. E.F., Paul, R. S., Wood, R. J. (2019).

Introductory Mathematical Analysis for Business,
Economics, and the Life and Social Sciences. 14th.
Ontario: Pearson.

Chapter 5
 Learning Outcomes

After studying this chapter, the students should

be able to :
• LO 1: Identify the concept of mathematics in
business decision making
• LO 2: Explain the mathematics analysis concept
properly in business decision making
• LO 3: Apply mathematics concept and critical
thinking to solve economics and business problem
in business decision making
Introductory Mathematical Analysis
For Business, Economics, and The Life and Social Sciences
Fourteenth Canadian Edition

Chapter 5
Mathematics of Finance

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Chapter Outline
5.1) Compound Interest
5.2) Present Value
5.4) Annuities
5.5) Amortization of Loans

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5.1 Compound Interest (1 of 6)
For an original principal of P, the formula S  P  1  r  gives the
n

compound amount S at the end of n interest periods at the

periodic rate of r.

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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5.1 Compound Interest (2 of 6)
Example 1 – Continued
Solution: Let r be the semiannual rate.
There are 2  3  6 interest periods.
500  1  r   588.38
6

588.38
1 r 
6

500
588.38
1 r  6
500
588.38
r6  1  0.0275
500
Thus, the semiannual rate was 2.75%, so the nominal rate was
5 12 % compounded semiannually.
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5.1 Compound Interest (3 of 6)
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. Let n be the
number of interest periods it takes for a principal of P  600 to
amount to S  900.
900  600  1.015 
n

900
 1.015 
n

600
   1.5
n
1.015

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5.1 Compound Interest (4 of 6)
Example 3 – Continued
Solution, continued
ln  1.015   ln1.5
n

n ln1.015  ln1.5
ln1.5
n  27.233. The number of years corresponding to
ln1.015
27.233 quarterly interest periods is 27.233 / 4  6.8083, about 6
years, 9 12 months. Therefore it will take 7 years to realize a
compound amount in excess of $900.

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5.1 Compound Interest (5 of 6)
Effective Rate
The effective rate re that is equivalent to a nominal rate of r
n
 r
compounded n times a year is given by re  1    1.
 n
Example 5 – Effective Rate
To what amount will $12,000 accumulate in 15 years if it is
invested at an effective rate of 5%?
Solution:
Since an effective rate is the rate that is compounded annually,
we have S  12,000  1.05 
15
 $24,947.14

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5.1 Compound Interest (6 of 6)
Example 7 – Comparing Interest Rates
If an investor has a choice of investing money at 6%
compounded daily or 6⅛ % compounded quarterly, which is
the better choice?

Solution: The 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 second choice is therefore the better choice.
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Exercise
1) Suppose that $700 amounted to $801.06 in a savings
account after two years. If interest was compounded
quarterly, find the nominal rate of interest, compounded
quarterly, that was earned by the money.
2) Over a five-year period, an original principal of $2000
accumulated to $2950 in an account in which interest
was compounded quarterly. Determine the effective rate
of interest, rounded to two decimal places.

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5.2 Present Value (1 of 6)
The principal P that must be invested at the periodic rate of r
for n interest periods so that the compound amount is S
is given by P  S  1  r 
n
and is called the present value of S .

Example 1 – Present Value

Find the present value of $1000 due after three years if the
interest rate is 9% compounded monthly.

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5.2 Present Value (2 of 6)
Example 1 – Continued
Solution: S  1000, r  0.09 / 12  0.0075, and n  3(12)  36.
P  1000  1.0075   764.15
36

$764.15 must be invested at 9% compounded monthly to have

$1000 in three years.
Example 3 – Equation of Value
A debt of $3000 due six years from now is instead to be paid
off by three payments: $500 now, $1500 in three years, and
a final payment at the end of five years. What would this
payment be if an interest rate of 6% compounded annually is
assumed?
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5.2 Present Value (3 of 6)
Example 3 – Continued
Solution: Let x be the final payment due in five years. Note
that at year 5 we compute the future values of $500 and $1500,
and the present value of $3000. The equation of value is
500(1.06)5  1500(1.06) 2  x
 3000(1.06) 1
x  3000(1.06) 1  500(1.06)5
 1500(1.06) 2  475.68
Thus, the final payment
should be $475.68

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5.2 Present Value (4 of 6)
• If an initial investment will bring in payments at future
times, the payments are called cash flows.
• The net present value, denoted NPV, of the cash flows is
defined to be the sum of the present values of the cash
flows, minus the initial investment.
• If NPV > 0, then the investment is profitable; if NPV < 0,
the investment is not profitable.

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5.2 Present Value (5 of 6)
Example 5 – 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 below. Assume an interest rate of 7% compounded
annually and find the net present value of the cash flows.

Year Cash Flow

2 10,000
3 8000
5 6000

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5.2 Present Value (6 of 6)
Example 5 – Continued

Solution: Subtracting the initial investment from the sum

of the present values of the cash flow gives
-2 -3 -5
NPV =10,000 ( 1.07 ) + 8000 ( 1.07 ) + 6000 ( 1.07 ) - 20,000
» - 457.31

Since NPV < 0, the business venture is not profitable if

one considers the time value of the money.

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Exercise
1) A bank account pays the nominal rate of 7.1%
compounded semiannually. How much must be
deposited now so that the account contains exactly
$12,000 at the end of one year?
2) Suppose that a person has the following choices of
investing $10,000:
a) placing the money in a savings account paying 6%
compounded semiannually;
b) investing in a business such that the value of the
investment after 8 years is $16,000.
Which is the better choice?
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5.4 Annuities (1 of 6)
• An annuity is any finite sequence of payments made at
fixed periods of time, of equal length, over a given interval.
• The fixed periods of time are referred to as the payment
period.
• The given interval is the term of the annuity.

1  (1  r )  n
The formula A  R  gives the present value A of an
r
ordinary annuity of R per payment period for n periods at the
1  (1  r )  n
interest rate of r per period. We write a n | r for .
r

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5.4 Annuities (2 of 6)
Example 1 – Present Value of Annuity

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

3½ years at an interest rate of 6% compounded monthly.

Solution: We set R  100, r  0.06 / 12  0.005, and

n  (3 12 )(12)  42.
Thus, A  100a __
42 0.005

From Appendix A, a __  37.798300. Hence,

42 0.005

A  100(37.798300)  3779.83
Thus, the present value of the annuity is $3779.83.

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5.4 Annuities (3 of 6)
Example 3 – 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: Here, A =10,000, n =4, r =0.06, and we want to find R.
10,000 =Ra__
4 0.06

Solving for r gives

10,000 10,000
R= » =2885.91
a__ 3.465106
4 0.06

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5.4 Annuities (4 of 6)
 1 r
n
1
The formula S  R  gives the future value S of an ordinary
r
annuity of R (dollars) per payment period for n periods at the
interest rate of r per period.
Example 5 – Future Value of an Annuity
Find the future value of an annuity consisting of payments of
$50 at the end of every three months for three years at the
rate of 6% compounded quarterly. Also, find the compound
interest.
Solution: R  50, n  4(3)  12, and r  0.06 / 4  0.015.
S  50 s __  50  13.041211  652.06
12 0.015

The compound interest is 652.06  12(50)  652.06  600  52.06

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5.4 Annuities (5 of 6)
Example 7 – Sinking Fund
A sinking fund is a fund into which periodic payments are
made in order to satisfy a future obligation. Suppose a
machine costing $7000 is to be replaced at the end of eight
years, at which time it will have a salvage value of $700. In
order to provide money at that time for a new machine
costing the same amount, a sinking fund is set up. The
amount in the fund at the end of eight years is to be the
difference between the replacement cost and the salvage
value. If equal payments are placed in the fund at the end of
each quarter and the fund earns 8% compounded quarterly,
what should each payment be?
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5.4 Annuities (6 of 6)
Example 7 – Continued
Solution: The amount needed after eight years is
$(7000 - 700) =$6300. Let R be the quarterly payment.
The payments into the sinking fund form an annuity with
n =4(8) =312, r =0.08 / 4 =0.02, and S =6300.
6300 =Rs____
32 0.02

6300
R= » 142.45
s____
32 0.02

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Exercise
1) Find the present value of an annuity of $150 per month
for 15 months at the rate of 9% compounded monthly
2) Find the future value of an annuity consisting of
payments of $2500 every month for four years at the rate
of 6% compounded montly. Also, find the compound
interest.

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5.5 Amortization of Loans (1 of 3)
• The formulas below describe the amortization of the
general loan:

Table 5.2 Amortization Formulas

A r
1. Periodic payment: R   A
an|r 1  (1  r )  n
2. Principal outstanding at beginning of k th period:
1  (1  r )  n  k 1
Ran  k 1|r  R 
r
3. Interest in kth payment: Ran  k 1|r
4. Principal contained in k th payment: R (1  ran  k 1|r )
5. Total interest paid:R (n  an|r )  nR  A
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5.5 Amortization of Loans (2 of 3)
Example 1 – Amortizing a Loan
A person amortizes a loan of $170,000 by obtaining a 20-
year mortgage at 7.5% compounded monthly. Find (a) the
monthly payment, (b) the total interest charges, and (c) the
principal remaining after five years.
Solution:
a. n  12(20)  240; r  0.075 / 12  0.00625; and A  170,000.
The monthly payment R is 170,000 / a 240 |0.00625 .
 0.00625 
We use the formula R  170,000   and a
 1   0.00625  240

 
calculator: R  1369.51
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5.5 Amortization of Loans (3 of 3)
Example 1 – Amortizing a Loan
Solution, continued
b. The total interest charges are
240  1369.51  170,000  328,682.40  170,000  158,682.40

c. After five years, we are at the beginning of the 61st

period. n  k  1  240  61  1  180; we find that the principal
 1  (1.00625) 180 
remaining is 1369.51   147,733.74
 0.00625 

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Exercise
A loan of $2000 is being amortized over 48 months at an
interest rate of 12% compounded monthly. Find the monthly
payment;
a) the principal outstanding at the beginning of the 36th
month;
b) the interest in the 36th payment;
c) the principal in the 36th payment;
d) the total interest paid.

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 References

Haeussler, Jr. E.F., Paul, R. S., Wood, R. J. (2019).

Introductory Mathematical Analysis for
Business, Economics, and the Life and Social
Sciences. 14th. Ontario: Pearson.