CHAPTER 4

MATHEMATICS OF FINANCE

Introduction
The basic concept of mathematics of finance is that money has time value which is
described either as present value or future. Present value is the value of money today;
future value is the value of money at some point in the future. The different between money
now and the same money in the future is called interest. Interest have a wide spread
influence over decisions made by businesses and every of us in our personal lives.
Therefore, the basic objective of this unit is to discuss interest rates and their effects on the
value of money. Specifically, it covers simple interest, compound interest, annuity and
mortgage problems.

4.1 Interest

Interest is the price paid for the use of a sum of money over a period of time. It is a fee paid
for the use of another’s money, just rent is paid for the use of another’s house. A savings
institution (Banks) pays interest to depositors on the money in the savings account since the
institutions have use of those funds while they are on deposit. On the other hand, a borrower
pays interest to a lending agent (bank or individual) for use of the agent’s fund over the term
of the loan.

Interest is usually computed as percentage of the principal over a given period of time. This
is called interest rate.
rate. Interest rate specifies the rate at which interest accumulates per year
through out the term of the loan. The original sum of money that is lent or invested/
borrowed is called the principal.

Interests are of two types: simple interest and compound interest. In the first part of this unit
we shall explore these two concepts.

4.1.1 Simple Interest

If interest is paid on the initial amount of money invested or borrowed only and not on
subsequently accrued interest, it is called simple interest.
interest. The sum of the original amount
(principal) and the total interest is the future amount or maturity value or in short
amount.
amount. Simple interest generally used only on short-term loans or investments –offen of
duration less than one year. Simple interest is given by the following formula.
I = prt ….. ---------------------------------- (1)
Where: I = Simple interest
P = principal amount
r = Annual simple interest rate
t = time in years, for which the interest is paid
1
If any three of the four variables are given, you can solve for the fourth (unknown variable)
and their relationship is as follows:
Amount (A) = P + I
= P + Prt. factor out the common term P
= P (1 + rt) ……………………………………… (2)
P = I/rt or P = …………… (3)
r = I/pt…………………………. (4)
t = I/pr ………………………… (5)

Example 1
Ato Kassahun wanted to buy TV which costs Br. 10, 000. He was short of cash and went to
Commercial Bank of Ethiopia (CBE) and borrowed the required sum of money for 9 months
at an annual interest rate of 6%. Find the total simple interest and the maturity value of the
loan.

Solution:
p = Br. 10,000 A=P+I
**
t = 9 months = 9/12 = ¾ year = P (1 + rt)
r = 6% per year = 0.06 = 10, 000 (1 + 0.06 x ¾)
I =? A =? = 10, 000 x 1.045
Interest (I) = Prt = Br. 10, 450
= 10, 000 x 0.06 x ¾
= Br. 450
The total amount which will have to be repaid to CBE at the end of the 9 th month is Br. 10,
450 (the original borrowed amount plus Br. 450 Interest).
** Note: It is essential that the time period t and r be consistent with each other. That is if r
is expressed as a percentage per year, t also should be expressed in number of years
(number of months divided by 12 if time is given as a number of months). If time is
given as a number of days, then t = . this approach is known as ordinary
interest year method which uses a 360 day years, whereas if we use 365 days years
the approach is called exact time method.
method.

Example 2
How long will it take if Br. 10, 000 is invested at 10% simple interest to double in value?
Solution
Given: p = Br.10, 000 I = prt Divide both sides of the
r = 10% = 0.10 equation by pr and solve for t.
*
A = Br.20, 000 (2 x 10, 000) t = I /pr
t =? A=

2
 = 10 Years
I* = Amount (A) – principal (p)
= 20, 000 – 10, 000
= 10,000
Therefore it will take 10 years for the principal (Br. 10, 000) to double itself in value if it is
invested at 10% annual interest rate.

Example 3
How much money you have to deposit in an account today at 3% simple interest rate if you
are to receive Br. 5, 000 as an amount in 10 years?

Solution

A = Br. 5, 000 P=
t = 10 Years
=
r = 3% = 0.03
= Br. 3, 846.15
P =?
In order to have Br. 5, 000 at the end of the 10 th year, you have to deposit Br. 3846.15 in an
account that pays 3% per year.

Example 4. 4.
At what interest rate wills Br. 5, 000 yields Br. 2, 000 in 8 years time.
Solution:
P = Br. 5, 000 r = I/pt
I = Br. 2, 000 =
t = 8 years = 0.05 = 5%
r =?
Example 5.
Find the Interest on Br. 5, 000 at 10% for 45 days.
Solution:
P = Br. 5, 000 I = Prt
t = 45 days = 45/360 years = 5, 000 x 0.1 x 45/360
r = 10% = 62.50 Br.
I =?

4.1.2 Compound Interest

If the interest, which is due, is added to the principal at the end of each interest period (such
as a month, quarter, and year), then this interest as well as the principal will earn interest

3
during the next period. In such a case, the interest is said to be compounded.
compounded. The result of
compounding interest is that starting with the second compounding period; the account earns
interest on interest in addition to earning interest on principal during the next payment
period. Interest paid on interest reinvested is called compound interest.
interest.

The sum of the original principal and all the interest earned is the compound amount.
amount. The
difference between the compound amount and the original principal is the compound
interest.

The compound interest method is generally used in long-term borrowing unlike that of the
simple interest used only for short-term borrowings. The time interval between successive
conversions of interest into principal is called the interest period, or conversion period,
period, or
Compounding period,
period, and may be any convenient length of time. The interest rate is
usually quoted as an annual rate and must be converted to appropriate rate per conversion
period for computational purposes. Hence, the rate per compound period (i) is found by
dividing the annual nominal rate (r) by the number of compounding periods per year (m):
i = r/m

Example if r = 12%, i is calculated as follows:

Conversion period (m) Rate per compound period (i)
1. Annually (once a year) -------------------------------- i = r/1 = 0.12/1 = 0.12
2. Semi annually (every 6 months) --------------------- i = r/2 = 0.12/2 = 0.06
3. Quarterly (every 3 months) -------------------------- i = r/4 = 0.12/4 = 0.03
4. Monthly ------------------------------------------------- i = r/12 = 0.12/12 = 0.01

Example 1
Assume that Br. 10, 000 is deposited in an account that pays interest of 12% per year,
compounded quarterly. What are the compound amount and compound interest at the end of
one year?

Solution
P = Br. 10, 000
r = 12%
t = 1 year
m = No. of conversion periods = 4 times per quarter. This means interest will be
computed at the end of each three month period and added in to the principal.
i = r/m 12%/4 = 3%

In general, if p is the principal earning interest compounded m times a year at an annual rate
of r, then (by repeated use of the simple interest formula, using i = r/m, the rate per period,
the amount A at the end of each period is:
(1) A = p (1 + i)………………compound amount at the end of first period.

4
 If we are interested in determining the compound amount after two periods, it may
be computed using the equation:
(2) Compound amount = Compound amount + Interest earned during
after two periods after one period the 2nd period
A = p (1 + i) + [P (1 + i)] (i)
Factoring P and (1 + i) from both terms of the right side of the equation gives us:
A = P (1 + i) (1 + i)
= P (1 + i)2
(3) Compound amount = Compound amount + Interest earned
after three periods after two period during the 3rd period
A = P(1 + i)2 + [P (1 + i)2] (i)

Factor out p and (1 + i)2 from the terms on the right side of the equation and it gives
you:
A= P (1 + i)2 (1 + i)
= P (1 + i)3
(4) Compound amount
after nth period = P (1 + i)n

The compound amount formulas developed so far are summarized below:

1. Compound amount after one period = p (1 + i)1
2. Compound amount after two periods = p (1 + i)2
3. Compound amount after three periods = p (1 + i)3
4. Compound amount after nth periods = p (1 + i)n

………….* Compound amount formula.

A = P (1 + i)n
Where: A = amount (future value) at the end of n periods.
P = Principal (present value)
i = r/m = Rate per compounding period.
n = mt = total number of conversion periods
t = total number of years

m = number of compounding/ conversion periods per

Year
r = annual nominal rate of interest
Now let us solve the above problem.
A = 10, 000 (1.03)1 = Br. 10, 300……..1st quarter
A = [10, 000 (1.03)] (1.03) = 10, 000 (1.03)2 = 10, 609 …….2nd quarter.
A = [10, 000 (1.03)2] (1.03) = 10, 000 (1.03)3 = 10, 927.27 …….3rd quarter.
A = [(10, 000) (1.03)3] (1.03) = 10, 000 (1.03)4 = 11, 255.088 ……..4th quarter.

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In general, the compound amount can be found by multiplying the principal by (1 + i) n. So
for the above problem the amount at the end of the year, using the general formula, is equal
to:
A = P (1 + i)n n = mt = 4 x 1 = 4
4
= 10, 000 (1.03) i = r/m = 12%/4 = 3%
= Br. 11, 255.088

Compound Interest = Compound amount – original principal

= 11, 225.088 – 10, 000
= Br. 1, 255.088

We may evaluate “A” in several different ways. Among the possible alternatives are:
1. Use a hand-held calculator with a Yx function key. This is the procedure most often used.

2. Using Logarithms
Restate the equation by finding for log A (or In A) and then finding the antilog, using
either a hand-held calculator with logarithmic functions or a table of logarithms. Let
us illustrate this alternative.
A = 10, 000 (1.03)4
log A = log 10, 000 + log (1.03)4
= log 10,000 + 4 log 1.03
= log 104 + 4 log 1.03
= 4 log 10 + 4 log1.03
= 4 + 4(0.01284)
= 4 + 0.05135
log A = 4.05135
A = Antilog 4.05135
= Br. 11255.117

Basic rules of logarithm

1. ax = b Eg. 2x = 5
log ax = log b log 2x = log 5
x log a = log b x log 2 = log 5
x = log b/ log a x = log 5/ log2
x = 2.322
2. abx + c = d
abx = d – c
bx =

log bx = log let: =K

6
 X log b = log K divide both side of the equality by log b.
X=
Eg. 4 (3x) + 10 = 18 find the value of X
4 (3x) = 18 – 10
4 (3x) = 8 (Divide by 4)
x
3 =2
x
log 3 = log 2
X log 3 = log 2
X=
= 0.63093

3. X3 = a Eg. X3 = 1, 000
logX3 = log a log X3 = log 1, 000
3 log x = log a 3 log X = log 103
log x = ; Let =K log X = 3/3
X = Antilog K log X = 1
X = Antilog 1
X = 10

4. a = b (c + x)d find the value of X

d
(c + x) = a/b
log (c + X)d = log a – log b
d log c + X = log a = log b
log c + X = Let: =K
log c + x = K
c + x = Antilog K
X = Antilog K - C
Eg. 1, 000 = 250 (5 + X)5
(5 + X)5 = =4
log (5 + x)5 = log 4
5 log 5 + x = log 4
log 5 + X =
log 5 + X = 0.120412
X = antilog 0.120412 – 5
= 1.319508 – 5

7
 = -3.6805

3. The third way of finding the compound amount is using specially prepared tables which
provide values of (1 + i)n for selected values of i and n.

Therefore, to calculate the value of “A” or other variables in the compound interest formula,
you can use any of these three approaches which ever convenient to you.

Example 2. Find the compound amount and compound interest after 10 years if Br. 15, 000
were invested at 8% interest;
a) If compounded annually
Compounding annually means that there is one interest payment period per year. Thus
t = 10 years
m=1
n = mt = 1 x 10 = 10
i = r/m = 8 %/1 = 8% = 0.08
The compound amount will be:
A = 15, 000 (1.08)10
= 15, 000 (2.158925)
= Br. 32, 383.875
 Compound Interest = compound amount (A) – Principal (P)
= 32, 383.875 – 15, 000
= Br. 17, 383.875

b) If compounded semiannually
Compounding semiannually means that there are two interest payment periods per year.
Thus, the number of payment periods in 10 years n = 2 x 10 = 20 and the interest rate per
conversion period will be i = r/m = 8%/2 = 4%. The compound amount then will be:
A = P (1 + i)n
= 15, 000 (1.04)20
= 15, 000 (2.191123
= Br. 32, 866.85
Compound Interest = A – P
= 32, 8666.85 – 15, 000
= Br. 17, 866.85

c) If Compounded quarterly
If compounding takes place quarterly (four times a year), then an 8% annual interest rate, the
interest rate per conversion period will be i = 0.08/4 = 0.02, there will be a total of n = 4 x
10 = 40 conversion periods over the 10 years. The compound amount will be:
A = 15, 000 (1.02)40
= 15, 000 (2.208039)

8
 = Br. 33, 120.60

d) If compound monthly
p = 15, 000
t = 10 years
m = 12 (12 payment periods per year)
n = 12 x 10 = 120 payment periods over the 10 years
i = r/m = 8%/12 = 0.667% = 0.00667
Under these conditions:
A = 15, 000 (1. 00667)120
= 15, 000 (2.220522)
= Br. 33, 307.84
Interest = Br. 18, 307.84 (33,307.84 – 15,000)
e) If compounded weekly
m = 52
n = 10 x 52 = 520
i = 8%/52 = 0.154% = 0.00154, then
A = 15, 000 (1.00154)520
= Br. 33, 362.60
Interest = 33,362.60 – 15,000
= 18362.60

f) Try your self: if Compounded daily, and hourly, what will be the compound
amount respectively? Answer = Br. 33,380.19 and Br. 33, 382.99 respectively.

g) If compounded continuously (Instantaneously),

(Instantaneously), what happens to the compound
amount if interest is compounded continuously? To drive a formula for continuous
compound interest, we begin by writing:
(1 + i)n = (1 + r/m) mt
Then, by inserting 1 = r/r in the exponent, we obtain
(1 + r/m)mt (r/r) = (1 + r/m) (m/r). (rt)
Then, letting m/r = X, we have
[(1 + 1/x)x] rt
As X increases indefinitely, the term (1 + 1/x) x approaches the value of the familiar
mathematical constant e = 2.7182818……. This means that the factor
(1 + i)n = [(1 + 1/x)x]rt approaches
ert as n increases indefinitely. The resulting formula for the amount under continuous
compounding of interest is given by:
A = P ert ………………..**
Where: A= amount at the end of time t under continuous compounding
p = principal

9
 r = annual rate, compounded continuously
t= time, in years
Note: the value of ert may be found using a calculator.
Solution:
p = br. 15, 000 A = P ert
t = 10 years = 15, 000 (e0.08 x 10)
A=? = 15, 000 x e0.8
= 15, 000 x 2.22554
= Br. 33, 383.11
Compound Interest = 33, 383.11 – 15, 000
= Br. 18, 383.11
What can you observe from the above discussion? When a number of conversion period
within a year increases, the interest earned also increases continuously toward an upper
limit. The limiting case occurs where interest is compounded continuously.

Example 3.
How long it takes to accumulate Br. 8, 000 if you invest Br. 6, 000 at 12% compounded
monthly?

Solution:
P = Br. 6, 000 A = P (1 + i) n
A = Br. 8, 000 8000 = 6000 (1.01) n
r = 12% we can use logarithm to solve this problem
i = r/m = 1%= 0.01 = (1.01)n
t =?, n? Log 1.3 = log (1.01)n
Log 1.3 = n log 1.01
n=
n = 28.92 29 months
It takes 29 months for Br. 6000 invested at 12% to grow to Br. 8000

The 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 be
accumulated at the end of n conversion periods. Under these conditions, p is called the
present value of A. This process is called discounting and the principal is now a discounted
value of future income A. If:
A = P (1 + i)n then dividing both sides by (1 + i)n leads to

P= = A (1 + i)-n

P = A (1 + i) -n
10
 ……… ………* Present value of compound amount.

Example 4. How much should you invest now at 8% compounded semiannually to have
Br. 10, 000 toward your brother’s college education in 10 years?
Solution
A = Br. 10, 000 P = A (1 + i)-n
t = 10 years = 10, 000 (1.04)-20
m=2 = 10, 000 (0.456387)
n = mt = 20 = Br. 4563.87
r = 8%
i = r/m = 4% = 0.04
p =?
4.2 Effective Rate

An effective rate is the simple interest rates that would produce the same return in one year
had the same principal been invested at simple interest without compounding. In other
words, the effective rate r converted m times a year is the simple interest rate that would
produce an equivalent amount of interest in one year. It is denoted by re.

If principal p is invested at an annual rate r, compounded m times a year, then in one year,
A = P (1 + r/m)m
What simple interest rate will produce the same amount A in one year? We call this simple
interest rate the effective rate. To find re we proceed as follows:

(Amount at simple interest after 1 year) = (Amount at compound interest after 1 year)
P (1 + re) = p (1 + r/m)m ……….Divide both sides by p
1 + re = (1 + r/m)m …………..isolate re on the left side and gives you:

re = (1 + r/m)m - 1 ………..* effective interest rate formula.

Where: r = nominal annual rate of interest
m = no. of conversion periods per year.

re = e r - 1 …………..** effective interest rate in continuous compounding.

Example 5. An investor has an opportunity to invest in two investment alternatives A and B

which pays 15% compounded monthly, and 15.2% compounded semi-annually
respectively. Which investment is better investment, assuming all else equal?
Solution
Nominal rate with different compounding periods cannot be compared directly. We must
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 investment A Effective rate for Investment B

11
 r = 15% r = 15.2%
m = 12 m=2
i = 1.25% = 0.0125 i = 7.6% = 0.076
m
reA = (1 + i) – 1 reB = (1.076)2 - 1
= (1.0125)12 – 1 = 15.778%
= 16.076%
Since the effective rate for investment A (16.076%) is greater than the effective rate for
investment B (15.778%), A is the preferred investment alternative.

Example 6. What is the effective rate corresponding to a nominal rate of 16% compounded
quarterly?
re = (1 + 0.16/4)4 -1
= (1.04)4 –1
= 1.169859 – 1
= 16.99%
4.3 Annuities

An annuity is any sequence of equal periodic payments. The payments may be made
weekly, monthly, quarterly, annually, semiannually or for any fixed period of time. The time
between successive payments is called payment period for the annuity. If payments are
made at the end of each payment period, the annuity is called an ordinary annuity.
annuity. If
payment is made at the beginning of the payment period, it is called annuity due.due. In this
course we will discuss only ordinary annuities. The amount, or future value, of an annuity is
the sum of all payments plus the interest earned during the term of the annuity.

The term annuity refers to the time from the begging of the first payment period to the end
of the last payment period.

4.3.1 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. Similarly, the last payment does not qualify for interest at all since the
value of the annuity is computed immediately after the last payment is received.

Future value (Amount) of an ordinary annuity.

Example1.
Example1. What is the amount of an annuity if the size of each payment is Br. 100 payable
at the end of each quarter for one year at an interest rate of 4% compounded quarterly?

Solution
Periodic payment (R) = Br. 100
Payment interval (Conversion period) = quarter
Nominal (annual rate) = r = 4%
12
Interest per conversion period (i) = r/m = 4%/4 = 1%
Future value of an annuity = ?
  Periods (quarter)
Now 1 2 3 4
Br. 0 Br.100 Br. 100 Br. 100 Br. 100 Amount
Br. 100 =100
1
Br. 100 (1.01) =101
Br. 100 (1.01)2 =102.01
Br. 100 (1.01)3 =103.03
Future value (sum) = 406.04 Br.

Compound interest = Amount – R(n)

= 406.04 – 100 (4)
= Br. 6.04
If R represents the amount of the periodic payment, i represents the interest rate per payment
period, and n represents the number of payment periods, then
R R R -------- R R
0 1 2 3 ------- n-1 n Periods
The first payment of R accumulates interest for n-1 periods, the second payment R for n – 2
periods etc. The last payment accumulate no interest, the next to last payment accumulates
one period for interest. So using the future value for compound interest we see the future
value of the annuity:
A = R (1 + i) n-1 + R (1 + i)n-2 + ………..+ R (1 + i)1 + R….Equation 1
Multiplying each side of the equation by (1 + i), we obtain
A (1 + i) = R (1 + i)n + R (1 + i)n-1 + ……….+ R(1 + i)2 + R (1 + i) …… Eq. 2.
Then subtracting the first equation (eq. 1) from the second equation (eq. 2), gives you:
A (1 + i) = R (1 + i)n + R (1 + i)n-1 + …….+ R (1 + i)2 + R (1 + i)
A = R (1 + i)n-1 + ……..R (1 + i)2 + R(1 + i) + R
A (1 + i) – A = R (1 + i) n – R
A [(1 + i)] = R [(1 + i)n –1]
A (i) = R[(1 + i)n –1] Dividing both sides by i, we have

A=
………………..* Amount of an ordinary annuity

Where: A = Amount (future value) of an

ordinary annuity at the end of its
term
R = Amount of periodic payment
i = interest rate per payment period
13
 n = (mt) total no. of payment periods

Solve the above problem (example 1) using the annuity formula:

A=

= Br. 406.04

Example 2.2. Mr X. Deposits Br. 100 in a special savings account at the end of each month. If
the account pays 12%, compounded monthly, how much money, will Mr. X have
accumulated just after 15th deposit?
R = Br. 100
n = 15 A=R
r = 12%
= 100
m = 12
i = r/m = 12%/12 = 1% = 100 (16.096896)
= Br. 1609. 69
A=?
Example 3.3. A person deposits Br. 200 a month for four years into 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:
Solution:
R = Br. 200 Amount after
t = 4 years
m = 12 4 years (A4)= 200
n = mt = 4 x 12 = 48 = 200 (55.20924)
r = 7%
= Br. 11, 041.85
i = 7%/12 = 0.07/12

After the end of the fourth year, we calculate compound interest rate taking Br. 11, 041.85
as principal compounded monthly for the coming 6 years.
p = 11, 041.85 A10 = 11, 041.85 (1 + 0.07/12)72
t = 6 years = 11, 041.85 (1.5201
m = 12 = Br. 16, 784.77
n = 6 x 12 = 72
r = 7%
i = r/m = 7%/12 = 0.07/12
A10 = ?
Therefore, the balance after 10 years is Br. 16, 784.77.

14
4.3.2 Sinking Fund
A sinking fund is a fund into which equal periodic payments are made in order to
accumulate a definite amount of money up on a specific date. Sinking funds are generally
established in order to satisfy some financial obligations or to reach some financial goal.

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 the amount
of an ordinary annuity. That is, if:

A=R then,

R=

R=A

Example 4.4. How much will have to be deposited in a fund at the end of each year at 8%
compounded annually, to pay off a debt of Br. 50, 000 in five years?
Solution:
A = Br. 50, 000
t = 5 years R=A
m = 1, n = 5 (5 x 1)
r = 8% = 50, 000
i = r = 8%
R=? = 50, 000 (o.174056)
= Br. 8, 522.80
The total amount of deposit over the 5 year period is
equal to 5 x 8, 522.80 = Br.42, 614
Example 5. 5. Ato Ayalkebet has a savings goal of Br. 100, 000 which he would like to reach
15 years from now. During the first 5 years he is financially able to deposit only
Br. 1000 each quarter into the savings account. What must his quarterly deposit
over the last 10 (ten) years be if he is to reach his goal? The account pays 10%
interest, compounded quarterly.
Solution:
Solution:
For the first 5 years
A5 = 1, 000
R = Br. 1, 000
t = 5 years
= 1000 (25.544657)
m=4
n = 20 = Br. 25,544.66
r = 10 %
i = 2.5%
15
A5 = ?

This sum (Br. 25,544.66) will continue to draw interest at the rate of 10%; compounded
quarterly, over the next 10 years; and the amount at the end of the 10th year will be:
t = 10 years A10 = 25,544.66 (1.025)40
m=4 = 25,544.66 (2.6851)
n = 40 = Br. 68,589.043
i = 2.5%

To determine the periodic payment for the remaining 10 years, we subtract Br. 68,589.043
from Br. 100, 000 to obtain the amount of an ordinary annuity for the last 10 years which is
equal to Br. 31,410.957 (100, 000 – 68,589.043)

R = 31,410.957

= 31,410.957 (0.014836)
= Br. 466.013

Thus, if Ayalkebete makes quarterly payments of Br. 1000 into a savings account over the
first five years and then quarterly payments of Br. 466.013 over the next 10 years, he will
reach his savings goal of Br. 100, 000 at the end of 15 years.

4.3.2 Present value of an ordinary annuity

The present value of an ordinary annuity is the sum of the present values of all the
payments, each discounted to the beginning of the term of the annuity. It represents the
amount that must be invested now to purchase the payments due in the future.

The present value of an annuity can be computed in two ways:

 Discounting all periodic payments to the present (beginning of the term individually)
or
 Discounting the future value (amount) of an annuity to the beginning of the term

Example 6. What is the present value of an annuity if the size of each payment is Br. 200
payable at the end of each quarter for one year and the interest rate is 8%
compounded quarterly?
Solution:
R = Br. 200
r = 8%, i = 2%
m=4
n=4
p=?
Using the first approach (discounting each payment individually), the present value will be:
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 0 1 2 3 4 Periods (quarter)
Br. 200 200 200 200
Present value
196.1 = 200(1.02)-1
192.23 = 200(1.02)-2
188.46 = 200(1.02)-3
200(1.02)-4
184.77 = 200(1.02)
761.56 Br = Present value.

Equivalently we may find the future value of the ordinary annuity using the formula and
then discount it to the present taking it as a single future value.

A=R

= 200

= Br. 824.32
P = A (1 + i)-n
= 824.32 (1.02)-4
Br = 761.56

If we multiply the future value of an ordinary annuity by the compounding discounting

factor, we get the present value of an annuity as follows:

P=R ((1 + i)-n)

=R

…………………..* Present value of an ordinary annuity.

P=R

Using the formula, the present value of the above example is computed as:
R = Br. 200
r = 8%, i = 2%
P=R
m=4
t=4
= 200

= 200 (3.80773)
= Br.
17 761.55
Example 7. What is the present value of an annuity that pays Br. 400 a month for the next
five years if money is worth 12% compounded monthly?
Solution:
R = Br. 400
t = 5 years P=R
m = 12
n = 12 x 5 = 60
= 400
r = 12%
i = 12%/12 = 1% = 0.01
= 400 (44.955037)
p=?
= Br. 17, 982.01
4.3.3 Amortization
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 side to have been amortized by the periodic payments. Prominent examples of
amortization are loans taken to buy a car or a home amortized over periods such as 5, 10, 20
or 30 years.

In amortization the interest is to determine the periodic payment, R, so as to amortize (retire)

a debt at the end of the last payment. Solving the present value of ordinary annuity formula
for R in terms of the other variable, we obtain the following amortization formula:

R=P
…………………………………** Amortization formula

Where: R = Periodic payment

P = Present value of a loan
i = Rate per period
n = Number of payment periods
Example:1
1. Ato Elias borrowed Br. 15, 000 from Commercial Band of Ethiopia and agree to
repay the loan in 10 equal installments including all interests due. The banks interest
charges are 6% compounded Quarterly. How much should each annual payment be
in order to retire the debt including the interest in 10 years.
Solution R = 15, 000
Pv = Br. 15, 000
t = 10 years = 15, 000 (0.033427)
n = 10 x 4 = 40
m=4
= Br. 501.4
18 = [501.4 x 40] – 15, 000
Interest
= 20056 – 15,000
= Br. 5056
 r = 6% i= 6%/4 = 15%
R=?

4.3.4 Mortgage Payments

In a typical home purchase transaction, the home buyer pays part of the cost in cash and
borrows the remaining needed, usually from a bank or a savings and loan associations. The
buyer amortizes the indebtedness by periodic payments over a period of time. Typically
payments are monthly and the time period is long such as 30 years, 25 years and 20 years.
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 or
Income, but in amortization may take other values. Similarly stated mortgage payments are
of amortization in nature involving the repayment of loan monthly over an extended period
of time.

Therefore, in mortgage payments we are interested in the determination of monthly

payments.
Taking:
A = total debt
R = monthly mortgage payments
r = stated nominal rate per annum
n = 12 x number of years (period of the loan)
R can be determined as follows:

R=A or R=A

A=R

Example: 1
Ato Assefa purchased a house for Br. 115, 000. He made a 20% down payment with the
balance amortized by a 30 year mortgage at an annual interest of 12% compounded monthly
so as to amortize/ retire the debt at the end of the 30th year.
Required:
1. Find the periodic payment
2. Find the interest charged.
Find the interest charged.

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Solution:
Selling price = Br. 115, 000 r = 12%, i = 0.01
Less: Down payment = 23, 000 (20% x 115,000) m = 12, n = 360
Mortgage (A) = Br. 92, 000 t = 30 years
R=?

R=A = 92, 000

= 92, 000 (0.010286125)

= Br. 946.32
Ato Assefa should pay Br. 946.32 every month to
retire the debt within 30 years or 360 monthly
payments.
Interest = Actual payment – mortgage (loan)
= (946.32 x 360) – 92, 000
= Br. 340, 675.20 – 92, 000
= Br. 248, 675.20
Throughout the 30 years period the loan earns an interest of Br, 284,675.20
Example: 2
Ato Amare purchased a house for Br. 50, 000. He made an amount of down payment and
pay monthly Br. 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 percentage of the down
payment to the selling price.
Solution:
Selling price = Br. 50, 000
Down payment = ?
Mortgage (A) = ?
R = Br. 600
r = 24%, i = 2%
m = 12, n = 240
t = 20 years

* Mortgage (A) = R

= 600

= 600 (49.56855)
= Br. 29, 741.13
* Down payment = Selling price – mortgage.

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 = 50, 000 – 29741.13
= Br. 20, 288.87
* Interest charged = Actual payment – mortgage]
= 600 x 240 – 29, 741.13
= 144000 – 29741.13
= Br. 114, 258.87

* Percentage of down payment =

= 100%
= 40.52 %

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