Mathematics of Finance

Compound Interest
For an original principal of P, the formula:
S = P (1 + r)n
Gives the compound amount S at the end of n interest
periods at the periodic rate of r.
Example:
1. Suppose you leave an initial amount of $518 in a savings
account for three years. If interest is compounded daily
(365 times per year), find the nominal rate of interest so
that there is $600 after three years?
2. Suppose you leave an initial amount of $520 in a savings
account at an annual rate of 5.2% compounded daily.
Find how long it takes for the amount to accumulate to
$570!
3. How long will it take for $600 to amount to $900 at an
annual rate of 6% compounded quarterly?

Effective Rate
Def : just the rate of simple interest earned over a
period of one year.
n

r
re 1
n

Example:
a. What effective rate is equivalent to a nominal rate of
6% compounded (a) semiannually, (b) quarterly?
b. Suppose you have two investment opportunities. You
can invest $10,000 at 11% compounded monthly or
you can invest $97,000 at 11.25% compounded
quarterly. Which has the better effective rate of
interest? Which is the better investment over 20
years?
c. How many years will it take for money to double at
the effective rate of r?

Present Value
The principal P that must be invested at the
periodic rate of r for n interest period so
that the compound amount is S is given by:
P= S (1+r)-n
Example:
A trust fund for a childs education is being
set up by a single payment so that at the
end of 15 years there will be $50,000. if the
fun earns interest at 7% compounded
semiannually, how much money should be
paid into the fund?

Equations of Value
Example 1:
1.Suppose that Mr. Smith owes Mr. Jones two
sums of money: $1,000 due in two years, and
$6,000 due in five years. If Mr. Smith wishes to
pay off the total debt now by a single payment,
how much should the payment be? (Assume:
interest rate 8% compounded quarterly)
2.A debt of $3,000 due in 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 year 5. what this payment be if
an interest rate of 6% compounded annually?

Comparing Investments
Suppose that you had the
opportunity of investing $5000 in a
business such that the value of the
investment after five years would be
$6300. On the other hand, you could
instead put the $5000 in a savings
account that pays 6% compounded
semiannually. Which investment is
better ?

NET PRESENT VALUE

The net present value, denoted NPV, of
the cash flows is defined to be the sum of
the present value of the cash flow, minus
the initial investment.
Example :
Suppose that 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 t below. Assume an
interest rate of 7% compounded annually,
and find the net present value of the cash
flows.
Year

Cash Flow

10,000

8,000

6,000

Interest Compounded
Continuously
S = Pert
Gives the compound amount S of a
principal of P dollars after t years at
an
annual
interest
rate
r
compounded continuously

Annuities
Def : any finite sequence of payments made
at fixed periods of time over a given interval.
Present Value of an Annuity
Def : is the sum of the present values of all n
payments. It represents the amount that
must be invested now to purchase all n of
them.

Gives the present value A of an ordinary

annuity of R per payment period for n
periods at the interest rate of r period

Annuities
Present Value of an Annuity
Periodic payment of an Annuity :

An Annuity Due ( payment at the

beginning of the year)

Annuities
Future Value of An Annuity
Def: the sum of the future value of all n
payments.

Periodic payment of an Annuity

Future Value of An Annuity Due

Examples of Annuities
1. Suppose a man purchase a house with an initial
down payment of $20000 and then makes
quarterly payments: $2000 at the end of each
quarter for six years and $3500 at the end of
each quarter for eight more years. Given an
interest rate of 6% compounded quarterly. Find
the amount the mans debt and the houses
price!
2. A man makes house payment of $1200 at the
beginning of every month. If the man wishes to
pay one years worth of payment in advance,
how much should he pay, provided that r=
6.8%?

Examples of Annuities
3. Suppose you invest in an IRA by
depositing $2000 at the end of every year
for the next 15 years. If the interest rate is
5.7% compounded annually, how much
will you have at the end of the year?
4. Suppose you invest in an IRA by
depositing $2000 at the beginning of the
year for the next 15 years. If the interest
rate is 5.7% compounded annually, how
much will you have at the end of the year?

Amortization of Loans
Amortization Schedule
Suppose that a bank lends a borrower
$1500 and charges interest at the
nominal rate of 12% compounded
period
Principal
Interest
Payment
Principal
monthly.
outstandin for period at the end repaid at
g at the
beginning
of period

of period

the end of
period

$1500

$15

$510.03

$495.03

1004.97

10.05

510.03

499.98

504.99

5.05

510.03

504.99

30.10

1530.10

1500

Total

Amortization of Loans
Amortization Formula
1.Periodic Payment :
2.Principal outstanding at the beginning of
the kth period :
3.Interest in kth period : i * Sk-1
log A log( A i * JNS )
4. jumlah periode (n)
n
log(1 i )