CHAPTER FOUR

MATHEMATICS FOR FINANCE

People generally earn money because they want to spend it. If they save it, rather than spend it
in the period in which it was earned, it is usually because they want it to spend in the future.
However, for most people present consumption is more desirable than future consumption if
only because the future is so uncertain. "Live and be merry, for tomorrow we may die," is a
rationale used over the ages to justify the urge to buy now rather than deferring gratification to
the future. For this reason, most of us would rather have a dollar today than a dollar a year
from today, and must be given something extra to get us to defer gratification.

Looking at the transaction from the borrower's perspective, there are consumers and
businesses (not to mention the deficit-ridden government) who really need that dollar today
and who are willing to promise to pay back more than that dollar in the future. Businesses can
invest borrowed funds in capital to create profits which are (hopefully) more than sufficient to
repay the borrowed funds (principal) plus INTEREST. Consumers and governments borrow
for various reasons but are expected to have income in the future sufficient to repay principal
and interest. Simply put, the basic concept of mathematics of finance is that money has time
value. That is, a bird at hand worth two in the forest.

Interest is the price paid for the use of a sum of money over a period of time. It is the charge
for exchanging money now for money later.
A savings institution pays interest to a depositor on the money in the savings account since the
institution has use of those funds while they are on deposit. Or, a borrower pays interest to a
lending agent for use of that agent’s fund over the term of loan.
Interest can be:
1. Simple interest.
2. Compound interest.
Simple Interest
When we borrow money, the money borrowed or the original sum of money lent (borrowed or
invested) is called the principal. (The principal remains fixed during the entire interest
period). Interest is usually expressed as a percentage of the principal for a specified period of
time which is generally a year. This percentage is termed the interest rate. If interest is paid
on the initial amount only and not on subsequently accrued interest, it is called simple
interest.

1 Chapter Four – Mathematics for Finance

 However, if the interest for each period is added to the principal in computing the interest for
the next period, the interest is called compound interest.
The sum of the original amount (principal) and the total interest is the future amount or
maturity value or Amount. A = P + I
Simple interest is generally used only on short term notes often of duration less than one
year.
Simple interest is given by the formula:
I = Prt

Where P= principal amount/ original amount borrowed or invested

r = Simple interest rate per year (expressed in decimal)
t= duration of the loan or investment in years
I = amount of interest in Birr.
If a sum of money, P is invested at a simple interest its value increases by the same amount
each year. Therefore, there is a linear relationship between amount and time.
1. I = Prt
2. A = P + I 4. r = I Pt
A = P + Prt
A = P (1+rt) 5. t = I
pr
3. P = I rt or P = A1 + rt
Example:
1. Mr. X wanted to buy a leather sofa for his new family room. The cost of the sofa was Birr
10,000. He had short of cash and went to his local bank and borrowed Birr 10,000 for 6
months at an annual interest rate of 12%. Find the total simple interest and the maturity value
of the loan.
Solution
I = Prt A = P+I
= 10,000x 012
. x 12 = 10,000 + 600
= Birr 600 = Birr 10,600 or

A = P (1+rt)
= 10,000 (1.06) = Birr 10,600
2. How long will it take if Birr 20,000 is invested at 5% simple interest to double in value?

Solution. I=A-p
= 40,000 - 20,000
P = 20,000 BIRR = 20,000
A = Birr 40,000
r = 5%
t =?
2 Chapter Four – Mathematics for Finance
 A =2p =20,000x2 = 40,000 I
t=
pr
20,000
20,000x0.05
= 20 years
3. At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?
Solution
P = Birr 6,000 t = I rP
r = Birr 900
t = 5 years = 900
6000 x 5
r =?
= 3% annual rate

4. How much money must Mr. Z has to invest today at 6% simple interest if he is to receive Birr
3,100 as an amount in 4 years?

Solution. A
P=
P = Birr? 1 + rt
A = 3,100 3,100
t = 4 years =
1 + .06x 4
r = 6%
= Birr 2,500
When time over which interest is paid is given in months, t is simply the number of month
divided by 12. If time is given as a number of days, then one of two methods of computing t
may be used:
# ofdays
• Ordinary interest year - uses a 360 - day year - t =
360
When time is determined in this way, the interest is called ordinary simple interest.
#ofdays
• Exact time- uses a 365-day year = t = t = or a 366 for leap year. Interest
365
computed in this way (using exact time) is called exact simple interest.
5. Find the interest on Birr 1,000 at 5% for 45 days.
Solution
1. Using ordinary Interest year:
p = Birr 1,000 I = prt
r = 5% 45
= 1,000 x .05 x
t = 45 days 360
I= Birr 6.25

2. Using exact time:

I = Prt Always ordinary simple interest
45 is grater than exact simple
= 1,000 x .05 x
360 interest.

3 Chapter Four – Mathematics for Finance

= Birr 6.16

Compound Interest
If the interest which is due is added to the principal at the end of each interest period, then this
interest as well as the principal will earn interest during the next period. In such a case the
interest is said to be compounded. The result of compounding interest is that starting with the
second compounding the account earns interest on interest in addition to earning interest
on principal.
The sum of the original principal and all the interest earned is the Compound Amount. The
difference between compound amount and the original principal is the Compound interest.
The compound interest method is generally used in long-term borrowing. There is usually
more than one period for computing interests during the borrowing time. The time interval
between successive conversions of interest in to principal is called the interest period or
conversion period or compounding period, and may be any convenient length of time. The
interest rates are always given as annual percentages; no matter how many times the interest is
compounded per year. Hence, interest rate must be converted in to or adjusted to the
appropriate interest rate per conversion period (i) for computational purposes; and we use the
number of conversion periods as time.
The i is equal to the stated annual interest rate/nominal rate (r) divided by the number of
r
conversion periods in one year (m) = i = .
m
Conversion # of conversions per year, m

Daily 365
Monthly 12
Quarterly 4
Semi annually 2
Annually 1

A= P (1 + i) n
n = mt
Where:
A = compound amount, after n conversion
periods.
P = principal
r = stated annual rate of interest

4 Chapter Four – Mathematics for Finance

 m = number of conversion periods a year
t = total number of years
i = interest rate per conversion period
n =total number of conversion periods
Example:
1. What are the compound amount and compound interest at the end of one year if Birr 10,000 is
borrowed at 8% compound quarterly?
Solution
P = Birr 10,000 total # of conversions = 4
r = 8% t = one year

Total number of conversion periods (m) = 4 times = quarter

r 8%
i= . = = 2% n = mt = 1x4 = 4
m 4
A = P (1 + i) n
= 10,000 (1.02)4
= 10,824.3216 Birr
Compound interest = compound amount - original principal
= 10,824.3216 - 10,000
= Birr 824.3216
Using logarithm Rules of log
4
A = 10,000 (1.02) 1. log aa = 1
(1.02)4
log A = log 10,000 + log 2. logmp = plogm
= log 10,000 + 4 log 1.02 3. logmn = logm + logn
= 4 + 4 (0.0086) 4. logm/n = logm - logn
= 4+ 0.0344
log A = 4.0344
A = antilog 4.0344
A = 10,824.30
2. Find the compound amount compound interest resulting from the investment of Birr 1000 at
6% for 10 years,
2.1. Compounded annually.
Solution
P = Birr 1,000 A = p(1+i)n
t = 10 years = 1,000 (1.06)10
m=1 = Birr 1,790.85
r = 6%
A =? Compound interest = Compound amount - principal
i = 6% = 1,790.85 - 1000
n = 10 = 790.85 Birr
2.2. Compounded semiannually.
Solution
P = Birr 1,000 A = p(1+i)n
r = 6% = 1,000 (1.03)20
m=2 = Birr 1,806.11
t = 10 years Compound interest = compound amount - principal

5 Chapter Four – Mathematics for Finance

 i = 3% = 1,806.11 - 1000
n = 20 = Birr 806.11
2.3 compounded quarterly.
Solution
P = Birr 1,000 A = 1,000 (1.015)40
r = 6% = Birr 1,814.02
m=4
t = 10 years Compound interest = compound amount - principal
i = .015 = 1814.02 - 1000
n = 40 = Birr 814.02
2.4 Compounded monthly.
Solution
P = Birr 1000 A = 1,000 (1.005) 120
r = 6% = 1,819.40 Birr
t = 10 years
m=12 Compound interest = compound amount - principal
i = .005 = 1,819.40 - 1000
n = 120 = 819.40 Birr

2.5. If compounded weekly

Solution
P = Birr 1000 A = 1,000 (1.0012)520
r = 6% = 1,821.49 Birr
t = 10 years
m=52 Compound interest = compound amount - principal
i = .0012 = 1821.49 - 1000
n = 520 = Birr 821.49

2.6. Compounded continuously (instantaneously).

(1+i) n = (1+r/m) mt
 1  1
f(x) =  1 +  x if x approaches infinity 1 +  x becomes closer to 2.71828 = e
 x  x

Let m/r = x as m x 

6 Chapter Four – Mathematics for Finance

 r/m = 1/x = m = rx

mt mt
 r   1
1 +  = 1 + 
 m  x
rxt
 1
= 1 + 
 x
rt
 1 
x

= 1 +  

 x 
=e rt

P = Birr 1000 A = Pert

r = 6% = 1,000 e.06x10 = 1000 e.6
t = 10 years = Birr 1,822.12
m=infinite compound interest = compound amount - principal
1,822.12 - 1000 = Birr 822.12
3. How long will it take to accumulate Birr 650 if Birr 500 is invested at 10% compound
quarterly?
Solution
P = 500 A = p(1+i)n
A = 650 650 = 500 (1.025)n
r = 10% 1.3 = (1.025)n 10.625 2
i=2.5% log1.3= log (1.025)n = = 2 years or
4 3
m=4
i.e. 2.66 years
t=? log 1.3 log1.025
=n
log 1.025 log1.025
log 1.3
n=
log 1.025
= 10.625 quarters
4. Birr 2000 is deposited in an account. After one year of monthly compounding, the balance in
the account is Birr 2,166. What is the annual percentage rate for this account?
Solution
P = Birr 2,000 A = p(1+i)n
A = Birr 2,166 2166 = 2000 (1+i)12
r =? 1.083 = (1+i)12
i=r/12 log1.083= log(1+i)12
t=1 log1.083=12log1+i
log 1.083
m = 12 = log 1 + i
12
0.0028857 = log1+i
anti log .0028857 = 1+i
1.0066667 = 1+i
.0066667 = i

7 Chapter Four – Mathematics for Finance

 .006667 x 12 = r = i x m = r = 8%

5. A person deposits Birr 10,000 in a savings account that pays 6% compounded semi-annually.
Three years later, this person deposits an additional Birr 8,000 in the savings account. Also, at
this time, the interest rates change to 8% compounded quarterly. How much money is in the
account 5 years after the original Birr 10,000 is deposited?
Solution

3 years 2 years

P= Birr 10,000

10,000(1.03)6 Birr 11,940.52

8,000.00
Birr 19,940.52

19,940.52(1.02)8
Birr 23,363.49

Present Value
Frequently it is necessary to determine the principal P which must be invested now at a given
rate of interest per conversion period in order that the compound amount “A” to be
accumulated at the end of n conversion periods. This process is called discounting and the
principal is now a discounted value of a future income A.
A = P (1+i) n dividing both sides by (1+i) n leads to
A
P= = p = A (1+i)-n
(1 + i ) n
Present values of a compound amount:
P = A (1+i)-n
Where:
p = principal / present value
A = compound amount (or future value)
i = interest rate per conversion period
n = total number of conversion periods
Example:
1. Find the present value of a loan that will amount to Birr 5,000 in four years if money is worth
10% compounded semi annually.

8 Chapter Four – Mathematics for Finance

 Solution.
A = 5,000 Birr P = A (1+i)-n
t = 4 years = 5,000 (1.05)-8
m=2 = Birr 3,384.20
r = 10%
P =?
3. If money worth 14% compounded semi-annually, would it be better to discharge a debt by
paying Birr 500 now or Birr 600 eighteen months from now?
Solution:
We can solve this problem in two ways:
1) By finding the PV of 600 and compare it with 500
2) By finding the FV of 500 and compare it with 600.

1) A = 600 2) P = 500
t = 18 months = 1.5years t = 1.5 years
m=2 m=2
r = 14% r = 14%
p =? A =?
P = A(1+i)-n A = P(1+i)n
= 600 (1.07)-3 = 500 (1.07)3
= Birr 489.78 = Birr 612.52

Since 489.78 < 500, it is better to pay the Since 612.52 > 600, it is better to pay the
debt after 18 months. debt after 18 months.

Present value with continuous compounding

A Pe rt
=  P = A rt
ert ert e
= Ae − rt
Equivalent Rates
Sometimes it is helpful to convert interest rates from, for example, a compounded quarterly
basis to a compounded annually basis, from a compounded quarterly basis to compounded
monthly basis, etc. this is easily accomplished as long as we understand the concept of
equivalent interest rates, which is defined as follows:
If at the beginning of a specified time period, the same amount of money is invested at various
rates so that the resulting compound amounts are equal at the end of the time period, then the
interest rates are equivalent rates.

9 Chapter Four – Mathematics for Finance

 Although we can use any length time period, we usually use a 1-year time interval. Thus, if
Birr P is invested at annual rate r compounded m times a year, and another Birr P is invested
at annual rate s compounded k times a year, then the rates are equivalent as long as
P (1 +r/m) m = P (1 +s/k) k
Dividing both sides of the above equation by P gives the equivalent rates equation which can
be solved for either r or s, depending on which the unknown.
Use this equation to find equivalent rates: (1 +r/m) m = (1 +s/k) k

1. What rate compounded monthly is equivalent to 8% compounded quarterly?

Solution
(1+r/12)12 = (1+.08/4)4
(1+r/12)12 = (1.02)4, solving for r, we take the 12th root of each side to obtain,
(1+r/12) = ((1.02)4)1/12
1+ r/12= (1.02)1/3
r/12= (1.02)1/3 -1
= 1.006622 -1
r/12 = .006622
r = 12(.006622)
r = .079464
= 7.95%
3. What nominal annual rate of interest converted monthly corresponds to 16% converted
quarterly?

Solution
(1+r/12)12 = (1+.16/4)4
= (1.04)4, solving for r, we take the 12th root of each side to obtain,
(1+r/12) = [(1.04)4]1/12
= (1.04)1/3
r/12 = (1.04)1/3 -1
= 1.013159404 -1
r/12 =. 013159404
r = 12(013159404)
r = .157912845
= 15.79%

10 Chapter Four – Mathematics for Finance

 Or, using logarithms
(1.04)4 = (1+i) 12
Log (1.04)4 = log (1+ i) 12
4 log (1.04) = 12 log (1+i)
4 (0.017033339) = 12 log (1+ i)
0.068133357 = 12 log (1 + i)
0.0056778 = log 1+ i
Antilog .0056778 = (1+ i)
1.0131594 = 1+i
.1031594 = i
r=mxi
= 12 x .0131594
= 15.79%
A stated rate of 15.79% compounded monthly would earn interest equivalent to that earned
with a stated rate of 16% compounded quarterly.

Effective Rate

Obviously, for a stated annual interest rate, the amount of interest accumulated depends upon
the frequency of conversion. This is because interest which has been earned subsequently
earns interest it self. When interest is compounded more than once a year, the stated annual
rate is called a Nominal Rate. The effective rate corresponding to a given nominal rate r
converted m times a year is the simple interest rate that would produce an equivalent amount
of interest in one year. Effective rates are, therefore, the simple interest rates that would
produce the same return in one year had the same principal been invested at simple interest
without compounding.
If P = Principal, A = Amount, r = nominal rate, m = number of conversion periods per year,
the compound interest for one year on principal p is,
I=A-P
= p (1 + r/m) m - p
Compound int erest I
The effective rate of interest is (re)= = . From the above statement:
principal P
I = p (1 + r/m) m - p
= P [(1+r/m) m - 1) Divide both sides by p

11 Chapter Four – Mathematics for Finance

  r  m 
I/p = P 1+  −1
 m  
m
 r
re = 1+  −1
 m
= (1+i) m - 1

In continuous compounding case:

A = Pert for one-year A = Per
I=A-P
= Per - p, multiplying both sides by 1/p
1/p x I = P (er-1) x 1/p
re = er-1
Effective rates are used to compare competing interest rates offered by banks and other
financial institutions.

Example:
1. An investor has two opportunities to invest his money. The first investment opportunity (opp
A) pays 15% compounded monthly and the second investment opportunity (opp B) pays
15.2%% compounded semiannually. Which is the better investment, assuming all else is
equal.
Solution
Nominal rates with different compounding periods cannot be compared directly. We must
first find the effective rate of each nominal rate and then compare the effective rates to
determine which investment will yield the larger return.
Effective rate for inv. opp. A Effective rate for inv. opp. B
re= (1+r/m)m - 1 re= (1+r/m)m - 1

= (1.0125)12 − 1 = (1.076) 2 − 1
16.075% 15.778%

Since the effective rate for A is greater than the effective rate for B, Investment opportunity A
is the preferred investment.
3. A bank states that the effective interest on savings accounts that earn continuous interest is
10%. Find the nominal rate.

12 Chapter Four – Mathematics for Finance

Solution
re = er-1 re = er-1
.10 = er-1 .10 = er-1
1.1 = er 1.1 = er
log1.1 = loger Or ln 1.1 = lner
log1.1 = rloge ln1.1 = rlne
ln1.1 = r (1)
=r
9.531% = r
9.531% = r

Annuities
An annuity is a sequence of equal, periodic payments. The payments may be made weekly,
monthly, quarterly, semi-annually, annually or for any fixed period of time. The time between
successive payments is called the payment period for an annuity. Each payment is called
periodic payment or periodic rent, and it is denoted by R. The time from the beginning of
the first payment period to the end of the last period is called the term of an annuity. If
payments are made at the end of each time interval, then the annuity is called an ordinary
annuity. If payments are made at the beginning of the payment period, it is called an annuity
due.
Ordinary Annuity
An ordinary annuity is a series of equal periodic payments in which each payment is made at
the end of the period. In an ordinary annuity the first payment is not considered in interest
calculation for the first period (because it is paid at the end of the first period for which
interest is calculated) and the last payment doesn’t qualify for interest at all since the value of
the annuity’s computed immediately after this last payment is received.
The amount (future value) of an ordinary annuity is the sum of all payments plus all
interests earned.
 (1 + i ) n − 1
A = R 
 i 
Example
1. What is the amount of an annuity if the size of each payment is Birr 100 payable at the end of
each quarter for one year at an interest rate of 4% compounded quarterly?
Solution
Periodic payment (R) = Birr 100
Payment interval = conversion period = quarter
Nominal (annual rate), r, = 4%

13 Chapter Four – Mathematics for Finance

 Interest rate per conversion period (i) = r/m = 4%/4 = 1%
Future value of (sum of an annuity) =?
Term one year
[(1.01)4 - 1]
For the above example: A = 100 = Birr 406.04
0.01
Compound interest = Amount - R (n)
= 406.04 - 100(4) existence
= Birr 6.04
2. A newly married couple are both working and decide to have Birr 1000 at the end of a month
for a down payment on a home. The account earns 12% compound monthly. How large a
down payment will they have saved in three years?
Solution
R = Birr 1000 (1 + i ) n − 1] Compound interest = A - R(n)
t = 3 years. A = R   = 43,076.88 - 36,000
i
m = 12 = 7,076,88 Birr
[(1.01)36 − 1]
n = 36 = 1000
r = 12% 0.01
i=1% = Birr 43,076.88
A =?
3. A person deposits Birr 200 a month for four years in to an account that pays 7% compounded
monthly. After the four years, the person leaves the account untouched for an additional six
years. What is the balance after the 10-year period?
Solution
R = Birr 200 A4 = 200 [(1 + 0.00583)48 – 1]
t = 4years 0.00583
m = 12 = 200 (55.209)
r = 7% + = 11,041.80 Birr
After the end of the fourth year, we calculate compound interest rate taking Birr 11,041.85 as
principal compounded monthly for 6 years.
P = 11,041.85 Birr A10 = P (1+i) n
=11,041.80 (1 + .00583)72
t = 6years
m = 12 = 11,401.80 (1.5201)
r = 7% = Birr 16,780.70
A10 =?
Sinking Fund- Increasing Annuity
A Sinking fund is a fund in to which equal periodic payments are made in order to accumulate
a specified amount at some point in the future. Sinking funds are generally established in
order to satisfy some financial obligation or to reach some financial goal.

14 Chapter Four – Mathematics for Finance

 If the payments are to be made in the form of an ordinary annuity, then the required periodic
payment into the sinking fund can be determined by reference to the formula for a mount of
an ordinary annuity. That is, if
A = R [(1+i) n –1]
i
Then A____
R = [(1+i) n - 1]
i
 i 
R = A 
 (1+ i ) − 1
n

Example:
1. What monthly deposit will produce a balance of Birr 100,000 after 10 years? Assume that the
annual percentage rate is 6% compounded monthly. What is the total amount deposited over
the 10-year period?

Solution
 i 
A = Birr 100,000 R = A 
 (1+ i ) − 1
n

 0.005 
t = 10years R = 100,000  
 (1.005) −1
120

m = 12
r = 6% = 100,000 (0.006102)
R =? = Birr 610.21
The total amount deposited over the 10-yr period is 120 (610.21) = Birr 73,225. The
remaining Birr 26,775 an interest.
2. XYZ Company purchased a tract of land under a purchase agreement which requires a
payment of Birr 500,000 plus 5% interest compounded annually at the end of 10 years. The
company plans to setup a sinking fund to accumulate the amount required to settle the land
purchase debt. What should the quarterly deposit into the fund be if the account pays 15%
interest, compounded quarterly?
Solution
First, we have to find the total debt (future value) at the end of ten years as
A = P (1+i) n i = mt=1x5% = 5%
= 500, 000 (1+0.05)10
= Birr 814,447.31
The amount is taken as Future Value of an Ordinary annuity with r = 15% Compounded
quarterly for 10 years
 .0375 
A40 = Birr 814,447.31 R = 814,447.31  
 (1.0375) −1
40

15 Chapter Four – Mathematics for Finance

 t = 10 years
m=4 = 9,088.80 Birr
r = 15%
i= 3.75%
R =?
Present Value of an Ordinary Annuity
The present value of an ordinary annuity is the amount of money today, which is equivalent to
the sum of a series of equal payment in the future. It is the sum of the present values of the
periodic payments of an annuity, each discounted to the beginning of an annuity. The
present value represents the amount that must be invested now to purchase the payment due in
the future.
In short, PV of an ordinary annuity can be computed in two ways:
(1) Discounting all periodic payment to the beginning of the term individually.
(2) Discounting the amount of an ordinary annuity to the beginning of the term.
1 − (1 + i ) − n 
P = R 
 i 
Example
1. What is the PV of an annuity if the size of each payment is Birr 200 payable at the end of each
quarter for one year and the interest rate is 8% compounded quarterly?
Solution
R = Birr 200 r = 8%
m=4 t = 1yr
P =?
Using the above formula; the PV of the former example is computed as:

R = Birr 200 P = R [1 – (1+i)-n]

r = 8% i
m=4 = 200 [1 – (1.02)-4]
t = 1yr .02
P =? = 200 (3.08773)
= Birr 761.55
Equivalently: Find the FV of the ordinary annuity using the formula A = R [(1+i)n - 1]
i
4
A = 200 [(1.02) - 1]
.02
= Birr 824.32
2. What is the cash value of a TV that can be bought for Birr 200 down payment and Birr 82 a
month for 18 months, if money is worth 12% interest compounded monthly?
Solution
Cash Value = down payment + PV of an ordinary annuity

16 Chapter Four – Mathematics for Finance

 = 200 + 82[1 – (1.01)-18]
.01
= 200 + 82(16.39827)
= 200 + 1,344.658
= Birr 1,544.658
3. How much should you deposit in an account paying 6% compounded quarterly in order to be
able to withdraw Birr 1000 for the next 3 years?
Solution
R = Birr 1000 PV = 1000[1 – (1.015)-12]
t = 3years .015
m=4 = 1000(10.9075)
r = 6% = Birr 10, 907.50
PV =?
Amortization- Decreasing Annuity
Amortization means retiring a debt in a given length of time by equal periodic payments that
include compound interest. After the last payment, the obligation ceases to exist-it is dead-and it
is said to have been amortized by the payments.
In amortization our interest is to determine the periodic payment, R, so as to amortize (retire) a
debt at the end of the last payment. Solving the PV of ordinary annuity formula for R in terms of
the other variables, we obtain the following amortization formula:
 i 
R = P −n 
1− (1+ i ) 
Where:
R = periodic payment
P = PV of loan
i= interest rate per period
n = number of payment periods
Example
1. Suppose you borrow Birr 5000 from a bank and agree to repay the loan in five equal
installments including all interests due. The bank’s interest charges are 5% compounded
annually. How much should each annual payment be in order to retire the debt including the
interest in 5 years?
Solution
PV = Birr 5000 R = 5000[ .05 ]
t = 5years 1 – (1.05)-5
m=1 = 5000(.230975)

17 Chapter Four – Mathematics for Finance

 r = 5% = Birr 1,154.87 must be paid per year to amortize the debt
R =? Interest = (1,154.87 X 5) – 5000
= Birr 774.35
2. At the time of retirement, a person has Birr 200,000 in an account that pays 12% compounded
monthly. If he decides to withdraw equal monthly payments for 10 years, at the end of which
time the account will have a zero balance, how much should he withdraw each month?
Solution
PV = Birr 200,000 R = 200,000 [ .01 ]
t = 10years 1 – (1.01)-120
m = 12 = 200,000(0.014347)
r = 12% = Birr 2,869.42
R =?
3. An employee has contributed with her employer to a retirement program for 20 years a certain
amount twice a year. The contribution earns an interest rate of 10% compounded semi
annually. At the date of her retirement the total retirement benefit is Birr 300,000. The
retirement program provides for investment of this amount at an interest rate of 10%
compounded semi annually. Semi-annual payments will be made for 20 years to the employee
or her family in the event of her death.
1. What semi-annual payment should she make?
2. What semi-annual payment should be made for her?
3. How much interest will be earned on Birr 300,000 over the 40 years?
Solution
Retirement plan
A = 300,000 PV = 300,000
t = 20 years t = 20 years
m=2 m=2
r = 10% r = 10%
R1 =? R2 =?
R = A[ i ] R2 = P20 [ i ]
(1+i) n –1 1 – (1+i)-n
= 300,000 ( .05 ) = 300,000 ( .05 )
(1.05)40 – 1 1 – (1.05)-40
= Birr 2483.45 = Birr 17,483.45

Interest earned = (R2 x 40) - (R1 x 40)

18 Chapter Four – Mathematics for Finance

 = (17,483.45 x 40) - (2483.45 x 40)
= (15,000 x 40)
= Birr 600,000
Mortgage Payments
In atypical house purchase transaction, the home-buyer pays part of the cost in cash and
borrows the remained needed, usually from a bank or a savings and loan association. The
buyer amortizes the indebtedness by periodic payments over a period of time. Typically,
payments are monthly and the time period is long-30 years is not unusual.
Mortgage payment and amortization are similar. The only differences are
- The time period in which the debt/loan is amortized/repaid
- The amount borrowed.
- In mortgage payments m is equal to 12 because the loan is repaid from monthly salary,
but in amortization m may take other values.
In Mortgage payments we are interested in the determination of monthly payments.
Taking A = total debt
R = monthly mortgage payment
r = stated nominal rate per annum
n = 12 x t
R can be determined as follows:
 i   i 
R= A  −n 
Or R= A  −n 
1 − (1 + i )  1− (1+ i ) 

1− (1+ i )− n 
Similarly, A = R  
 i 
Example:
1. Mr. X purchased a house for Birr 115,000. He made a 20% down payment with the balance
amortized by a 30 yr mortgage at an annual interest of 12% compounded monthly.

a) What is the amount that Mr. X should pay monthly so as to retire the debt at the end
of the 30th yr?
b) Find the interest charged.
Solution
Selling price = Birr 115,000 r = 12% i= 1%
Down payment (20%) 23,000 m = 12
Mortgage (A) Birr 92,000 t = 30yrs n= 360
R =?

19 Chapter Four – Mathematics for Finance

  i 
R= A  −n 
1− (1+ i ) 
 .01 
R = 92,000  −360 
1− (1.01) 
= 92,000 (.010286125)
= Birr 946.32
Interest = Actual payment – Mortgage (loan)
= (946.32 X 360) - 92000
= Birr 340,675.20 – 92,000
= Birr 248,675.20
2. Mrs. Y purchased a house for Birr 50,000. She made an amount of down payment and pay
monthly Birr 600 to retire the mortgage for 20 years at an annual interest rate of 24%
compounded monthly.
Required: Find the mortgage, down payment, interest charged, and the percentage of the down
payment to the selling price.
Solution
Selling price = Birr 50,000 Mortgage (A) = R [1- (1+i)-n]
Down payment =? i
Mortgage (A) =? = 600 [1- (1.02)-240]
R = Birr 600 0.02
r = 24% i = 2% = Birr 29,741.13
m = 12 Down payment = Selling price – mortgage
t = 20 n = 240 = 50,000 – 29,741.13
= Birr 20,258.87
Interest charged = actual payment- mortgage
= 600 x 240 - 29,741.13
= 144,000 - 29741.13
= Birr 114,258.87
Down payment
Percentage of down payment = x100
Selling Pr ice
20,258.87
= x100
50,000
= 40.52%
3. Mr. Z has taken out a Birr 60,000, 20-year, 24% mortgage on his home.
a. How much will he pay each month to discharge this mortgage?
b. How much of the first payment is for interest and by how much does it reduce the
balance owed?
c. How much of the second payment is for interest and by how much does it reduce the
balance owed?
Solution

20 Chapter Four – Mathematics for Finance

 a)  i 
R= A  −n 
1− (1+ i ) 
Mortgage (A) Birr 60,000
r = 24% i = 2%
m = 12  .02 
R = 60,000  −240 
1 − (1.02) 
t = 20 years n = 240
= 60,000(.020174
= Birr 1,210.44
b). Interest = 60,000 X .02
= Birr 1,200
Reduction from the balance owed = Monthly payment – Interest
= 1210.44 – 1200
= Birr 10.44
c). Interest = (60,000 – 10.44) x .02
= Birr 1199.79

Reduction from Balance owed = 1210.44 – 1199.79

= Birr 10.65

21 Chapter Four – Mathematics for Finance