Chapter Four: Mathematics of Finance 1

CHAPTER FOUR
MATHEMATICS OF 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 - Simple interest.

- 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.

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 2

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. The concept of simple interest, however,
forms the basis for compound interest concepts.

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.
Taking P= principal, r = rate of interest, t = time in years and A =
amount, their relationship is as follows:

I = Prt --------------------------- 1
A=P+I
= P + Prt
A = P (1+rt) ----------------------2

P= --------------------------- 3

P=

r=

t=

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 was 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

= 10,000 + 600
= Birr 600 = Birr 10,600 or

A = P (1+rt)

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 3

1
=10 , 000 (1+. 12 x )
2
= 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 = 10,000 BIRR = 20,000
r = 5%
A = Birr 40,000
t=?

t=
3. At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?
Solution.
I
P = Birr 6,000 t= rP
r = Birr 900 900
t = 5 years = 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.
P = Birr?
A = 3,100
t = 4 years
=
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:

 Ordinary interest year - uses a 360 - day year -

When time is determined in this way, the interest is called ordinary
simple interest.
¿ ofdays
t=
 Exact time- uses a 365-day year = t = 365 or a 366 for leap
year. Interest 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%

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 4

t = 45 days
I= = 1,000 x .05 x
Birr 6.25

2. Using exact time:

I = Prt Always ordinary simple
interest is grater than
= 1,000 x .05 x exact simple interest.
= 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 conversion periods in one year (m) = i =

Conversion # of conversions per year, m

Daily 365
Monthly 12
Quarterly 4
Semi annually 2
Annually 1

Example:

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 5

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

i= = = 2%
Original principal Birr 10,000
Add: interest for the first quarter, I =
10,000 x .02 200
Principal at the end of first quarter 10,200=10,000(1.02)1
Add: Interest for the second quarter,
10,200 x .02 204
Principal at the end of second quarter 10,404 = 10,000 (1.02)2
Add: Interest for the third quarter,
208.08
10,404x.02
10,612.08=10,000(1.02)3
Principal at the end of third quarter
Add: Interest for the fourth quarter, 212.2416
10,612.08 x .02 Birr 10,824.3216 = 10,000(1.02)4
Principal at the end of fourth quarter
(Amount at the end of the year)

If we summarize the above computations, we will discern a pattern

that leads to a general formula for computing compound interest:
1st quarter: S = 10,000 (1.02)1
2nd quarter: S = 10,000 (1.02) (1.02) = 10,000 (1.02) 2
3rd quarter: S = 10,000 (1.02) (1.02) (1.02) = 10,000 (1.02) 3
4th quarter: S = 10,000 (1.02) (1.02) (1.02) (1.02) = 10,000 (1.02) 4

In general, the compound amount can be found by multiplying the

principal by (1+i) n where i is the interest rate per conversion period
and n is the total number of conversion periods.

In Short, Amount with compound interest is calculated as:

A = P (1 + tm
= P (1 + i) n

Where:
A = compound amount, after n conversion periods.
P = principal

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 6

r = stated annual rate of interest

m = number of conversion periods a year
t = total number of years
I = r/m = interest rate per conversion period
n = mt = Total number of conversion periods.
So, for the above question, the amount is equal to
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

A = 10,000 (1.02)4 1. log aa = 1
log A = log 10,000 + log (1.02)4 2. logmp = p logm
= 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
= 10,824.30
Logarithms and Anti Logarithms for the Solutions of Equations.

1. ax = b 2x = 5
logax = logb log2x = 5
xloga = logb xlog2 = log5

x= x=

2. abx + c = d 4(3x) + 10 = 17
abx = d-c 4(3x) = 17-10
4(3x) = 7
bx = 3x = 1.75
log3x = log1.75
xlog3 = log1.75
logbx = log --- k
xlogb = logk
x=
x=
x3 = 1,000
logx3 = log1000
3. x3 = a
3logx = log1000
logx3 = loga

logx

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 7

logx = logx =
x = antilogk logx = 1
x = antilog1
= 10
4. a = b(c+x)d
(c+x)d = a/b 100 = 25(1+x)4
log(c+x)d = loga/b (1+x)4 = 100/25
dlogc+x = loga-logb log(1+x)4 = log4
4log1+x = log4
log1+x = log 4/4
logc+x = log1+x = 0/150515
logc+x = k 1+x = antilog0.150515
c+x = antilogk 1+x = 1.4142
x = antilogk-c x=0.4142

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
i = 3% = 1,806.11 - 1000
n = 20 = Birr 806.11

2.3 compounded quarterly.

Solution
P = Birr 1,000 A = 1,000 (1.06)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

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 8

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 daily

P = Birr 1000 A = 1,000 (1.0001644)3650
r = 6% = 1,822.03
t = 10 years
m=365 Compound interest = compound amount - principal
i = .01644% = 1,822.03 - 1000
n = 3650 = Birr 822.03

2.7. Compounded hourly

P = Birr 1000 A = 1,000 (1.00000685)687,600
r = 6% = 1,822.12 Birr
t = 10 years
m= 8760 Compound interest =compound amount - principal
i = .000685% = 1,822.12 - 1000
n = 87600 = Birr 822.12 Birr

2.8. Compounded continuously (instantaneously).

(1+i) n = (1+r/m) mt

x x
f(x) = if x approaches infinitely becomes closer to
2.71828 = e
Let m/r = x as m x 

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 9

( ) ( )
mt mt
r 1
1+ = 1+
m x
= (1 + )
rxt
1
x

= [( 1 + ) ]
x rt
1
x
rt
r/m = 1/x = m = rx =e
rt
P = Birr 1000 A = Pe
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
i=2.5% log1.3= log(1.025)n
m=4
10 . 625 2
= 2 years
t=? n/m = 4 3
n =? 10.625 quarters
n=
= 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 =12log1+i
m = 12

0.0028857 = log1+i
anti log .0028857 = 1+i
1.0066667 = 1+i
.0066667 = i
.006667 x 12 = r = i x m
= 8% = r
5. A person deposits Birr 10,000 in a savings account that pays 6%
compounded semi-annually. Three years later, this person deposits an

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 10

additional Birr 8,000 in the savings account. Also, at this time, the
interest rates changes 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 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

P= = p = A (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.
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 =?
2. How much must be deposited now in an account paying 6%
compounded monthly in order to have just 20,000 Birr in the account
4 years from now?

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 11

A = 20,000 Birr P = A (1+i)-n

t = 4 years = 20,000 (1.005)-48
m = 12 = Birr 15,742
r = 6%
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 Since 612.52 > 600, it is better to
pay the debt after 18 months. pay the debt after 18 months.

4. How much should be deposited in an account paying 8% compounded

quarterly in order to have a balance of Birr 8,000 nine years from
now?
Solution:
A = Birr 8,000 P = A (1+i)-n
t = 9 years = 8,000(1.02)-36
n = 36 = 3,921.79 Birr
m=4
i=2%
r = 8%
P =?

Present value with continuous compounding

A Pert A
= ⇒ P=
ert ert e rt
= Ae−rt

Equivalent Rates
Some times 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:

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 12

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.
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
= (1.02)4, solving for r, we take the 12th root of each
side to obtain, (1+r/12) = ((1.02)4)1/12
= (1.02)3
r/12 = (1.02)3 -1
= 1.006622 -1
r/12 = .006622
r = 12(.006622)
r = .079476
= 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%

Or, using logarithms

4 12
(1.04) = (1+i)
Log (1.04)4 = log (1+ i) 12

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 13

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

The effective rate of interest is (re)= . From the

above statement:
I = p (1 + r/m) m - p
= P [(1+r/m) m - 1) Divide both sides by p

I/p =
[( ) ]
P 1+
r m
m
−1

re = ( )
1+
r m
m
−1

= (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

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 14

re = er-1
Effective rates are used to compare competing interest
rates offered by banks and other financial institutions.

Example:
1. What is the effective rate of money invested at 6% compounded
quarterly?
Solution.
R = 6% re = (1+r/m)m-1
m=4
= (1+ ) 4- 1
= (1.015)4 -1
= 6.14%

2. 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

= =

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.

Solution.
re = er-1
.10 = er-1
1.1 = er
ln 1.1 = lner

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 15

ln1.1 = rlne
ln1.1 = r (1)
9.531% = r

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 16

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.

Geometric Series and Annuities

Geometric Series
A geometric progression is a sequence of numbers where each term
after the first term is found by multiplying the previous term by a
fixed number called the Common ratio, r. It has the form
a + ar + ar2 + ar3 +...+ arn-1.

Each term is a constant multiple, r, of the preceding term. If S n

denotes the sum of the first n terms of a geometric series, then
Sn = a + ar + ar2 + ar3 +...+ arn-1.

An alternative formula for evaluating Sn is derived as follows. Take the

equation Sn = a + ar + ar2 + ar3 +...+ arn-1 and multiply both sides by r
to obtain rSn = ar + ar2 + ar3 +...+ arn-1

Now consider both equations:

Sn = a + ar + ar2 + ar3 +...+ arn-1

rSn = ar + ar2 + ar3 +...+ arn-1 + arn
Subtracting the second equation from the first, we would get
Sn - rSn = a - arn

Factoring both sides of this last equation gives us

Sn (1 – r) = a (1- rn)
Hence,

a (1 − rn )
Sn =
1−r (Valid only if r ≠ 1.)

If r = 1, then Sn = arn. If the common ratio in a geometric progression

is less than 1 in modulus, (that is -1 < r <1), the sum of an infinite
number of terms can be calculated. This is known as the sum to
infinity,∫∞ ¿¿

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 17

a
∫∞ ¿ 1 − r ,
Provided -1 < r < 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) 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.

AMOUNT (FUTURE VALUE) OF AN ORDINARY ANNUITY

The amount (future value) of an ordinary annuity is the sum of all
payments plus all interests earned.

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%
Interest rate per conversion period (i) = r/m = 4%/4 = 1%
Future value of (sum of) an annuity =?
Term one year

1,2,3,4 - End of the quarter

Now 1 2 3 4
0 100Birr 100 Birr 100 Birr 100 Birr

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 18

Birr 100

Birr 100 (1.01)1

Birr 100 (1.01)2

Birr 100 (1.01)3

Birr 0 (1.01)4
A = Birr 406.04

Compound interest = Amount - R (n)

= 406.04 - 100(4)
= Birr 6.04
Taking
R = amount of periodic payment
I = interest rate per payment period
n = total number of payment periods
A = Future value (Amount) of an O. Annuity at the end of its term.

Last payment R
The second payment from the last R(1+i)1
The third payment from the last- R(1+i)2
|
The second payment R(1+i)n-2
The first payment R(1+i)n-1

A = R + R (1 + i) 1 + R (1+i) 2 + ------ + R (1+i) n-2 + R (1+i) n-1 -------- (1)

Multiplying each side of the equation by 1+i, we obtain

A (1+i) = R (1+i) + R (1+i) 2 + R (1+i) 3 + ---- + R (1+i) n-1 + R (1+i) n --- (2)

Then subtracting the first equation from the second equation, we have
A (1+i) = R (1+i) + R (1+i) 2 + ------ + R (1 + i) n-1 + R (1+i) n
- A = R + R (1+I) 1 + R (+i) 2 + ---- + R (1+i) n-1
A (1+i) - A = R (1+i) n-R
A [1+i-1] = R [(1+i) n-1]

A (i) = R [(1+i) n-1] dividing both sides by i, we have, A =

R
i [
(1+i)n −1
]
P=R [
1−(1+i)−n
i ] = future value factor.

[(1 .01 )4 -1 ]
For the above example: A = 100 0 . 01 = Birr 406.04

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 19

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= = 43,076.88 - 36,000
i
m = 12 = 7,076,88 Birr
n = 36 1000[(1 .01 )36−1 ]
=
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 + .07/12)48 – 1]
t = 4years 0.07/12
m = 12 = 200 (55.20924)
r = 7% = 11,041.85 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 = 11,041.85 (1 + .07)72
t = 6years 12
m = 12 = 11,041.85 (1.5201)
I = 7% = Birr 16,784.77
A10 =?
4. A person deposits Birr 500 a year for 10 years in to an account that
pays 6% compounded annually. After 10 years the person transfers
the money into another account that pays 8% compounded quarterly.
The money is left in the second account for 8 years. What is the
balance after the 18-year period?

Solution.
For the first 10 years:
R = Birr 500 A10 = 500 [(1.06)10 – 1]
t = 10years .06
m=1 = 500 (13.180795)
r = 6% = Birr 6590.40
A10 =?

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 20

For the next 8 years, Birr 6590.40 is taken as single deposit

(Principal) in an account which pays 8% compounded quarterly.

P8 = A10 = Birr 6950.40

t = 8years A18 = A10 (1 +i) n
m=4 = 6950.40 (1.02)32
r = 8% = 6950.40 (1.88454)
A18 =? A18 = Birr 12,419.87

The balance after 18 years is Birr 12,419.87 out of which Birr

7,419.87 (Birr 12,419.87 – Birr 5000) is interest earned.

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.
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 a mount of an ordinary
annuity. That is, if
A = R [(1+i) n –1]
i
Then A____
R = [(1+i) n - 1]
i

R=
A
[ i
( 1 + i )n −1 ]
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.

A = Birr 100,000 R=A[ i ]

(1+i)n – 1
t = 10years
m = 12 = 100,000 [ .005 ]
120
(1.005) – 1
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.

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 21

2. Mrs. X has a saving goal of Birr 25,000 which she would like to reach
10 years from now. During the first five years she is financially able to
deposit only Birr 100 each month into the savings account. What
must her monthly deposits over the last five years be if she is to reach
the goal? The account pays 12% interest compounded monthly.

Solution.

For the first five years

R = 100 A60 = 100 [(1.01)60 - 1]
t = 5years 0.01
m = 12 = 100 (81.6697)
r = 12% = Birr 8166.97
A60 =?

For the last five years:

The amount at the end of the first 5 years (Birr 8,166.97) serves as
single principal and it earns interest for the next five years.

A = 8,166.97 (1.01)60
= Birr 14,836.90

To determine the periodic payment we subtract 14,836.90 Birr from

Birr 25,000 to obtain the amount of an ordinary annuity for the last
five years.

A60 = Birr 25,000 – Birr 14,836.90

= 10,163.10

R2 = 10,163.120 X .01___
(1.01)60 – 1
= Birr 124.44

The proper R is (if normally deposited the same amounts)

R = 25,000 [ .01 ]
(1.01)120 – 1
= Birr 108.68

3. 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?

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 22

Solution.
First we have to find the total debt at the end of five years as

A = P (1+i) n i = 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

A40 = Birr 814,447.31

.0375
40
R = 814,447.31 ( 1 . 0375 ) − 1
[ ]
t = 10 years
m=4 = 9,088.80 Birr
r = 15%
i= 3.75%
R =?
Sinking Fund Schedule
The accumulation of value in a sinking fund is illustrated by a sinking
fund schedule.
Example: A business man wishes to set aside semiannual payments
to purchase machinery after two years (two years from now). The
machinery's estimated cost is Birr 5000. Each payment earns interest
at 12%compounded semiannually.
a) Find the semiannual payment
b) Find the total interest earned
c) Prepare a sinking fund schedule

Solution

A = Birr5000 a) R=
A
[ i
( 1 + i )n −1 ]
t = 2 years =
5000
[ . 06
( 1. 06 )4 −1 ]
m=2 = Birr 1,142.96
r = 12% b) Interest = Amount - R (n)
i= 6% = 5000 - 1,142.96(4)
n= 4 = Birr 428.16
R=?
c)
Payment Payment (R) Interest* Total
number
1 Birr 1,142.96 Birr 0 Birr 1,142.96
2 Birr 1,142.96 Birr 68.58 Birr 2,354.50
3 Birr 1,142.96 Birr 141.27 Birr 3,638.73
4 Birr 1,142.96 Birr 218.32 Birr 5000.01
Birr 428.16

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 23

* Interest = balance x i

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.
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 =?

P______________________________________________________A

0 1 2 3 4
196.10 = 200 (1.02)-1 _ _ _ 200
192.23 = 200 (1.02)-2 _ _ _ _ _ _ _ _ _ _ 200
188.46 = 200 (1.02)-3 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 200
184.77 = 200 (1.02)-4 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 200
Birr 761.56

Equivalently: Find the FV of the ordinary annuity using the formula A

= R [(1+i)n - 1]

A = 200 [(1.02)4 - 1]
.02
= Birr 824.32

Discount this future value to the present value taking it as single FV.

P = 824.32 (1.02)-4

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 24

= 761.56

We have seen that the future value of an ordinary annuity after n

payment periods is A = R [(1+i) n - 1], and also we have seen that the
PV of a lamp sum investment after n periods with interest rate i per
period is: P (1+i) n

The future value of an annuity and the future value of the lamp sum
payment should be equal at the end of n periods; thus,

P (1+i) n = R [(1+i) n -1] Dividing both sides by (1+i) n gives

i
P = R [1 – (1+i)-n]
i
Or
If we multiply the FV of an O. annuity by the compound discount
factor we have the present value of an annuity.

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

i
= R [(1+i) (1+i)-n –1 (1+i)-n]
n

i
= R [(1+i) – 1 (1+i)-n]
0

P=R [ 1−(1+i)−n
i ]
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

2. What is the cash value of a car 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 O. annuity
= 200 + 82[1 – (1.01)-18]
.01
= 200 + 82(16.39827)
= 200 + 1,344.658
= Birr 1,544.658

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 25

3. How much should you deposit in an account paying 6% compounded

quarterly in order to be able to withdraw Birr 1000 every 3 months 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 =?

4. What is the present value of an annuity of seven payments of Birr

1000 each made at the end of each quarter with an interest rate of
12% compounded monthly?
Solution

Since we have quarterly payment periods and monthly interest

periods, we must change the interest rate to coincide with the
quarterly payment periods. Specifically, we must find the equivalent
interest rate compounded quarterly corresponding to 12%
compounded monthly and use it as r (i). Using the equivalent rate
formula, we have
(1 +r/4)4 = (1 +.12/12)12
(1+ r/4)4 = (1.01)12
r/4 = (1.03)3 - 1  i = .030301

R = Birr 1000
i = .030301
n=7
P =?

P=R [
1−(1+i)−n
i =
]
1000 [
1−(1 . 030301)−7
. 030301 ]
= Birr 6,223.22

5. A business person's debt is payable as follows: Birr 2,000 1 year

from now and Birr 5,000 5 years from now. The business person
wants to repay the debt as follows: a Birr 1,000 payment now, a
Birr 2,000 payment 2 years from now, a Birr 1,000 payment 3
years from now, and the last payment 4 years from now. If the
interest rate is 12% compounded annually, find the amount of the
last payment.

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.

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 26

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:

R=P
[ i
1 − ( 1 + i )− n ]
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 ]
-5
t = 5years 1 – (1.05)
m=1 = 5000(.230975)
r = 5% = Birr 1,154.87
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?

፩፪፫፬

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

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 27

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

Employment period Retirement period

Pay Receive
0 20 40
R =? A = Birr 300,000
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)

= (17,483.45 x 40) - (2483.45 x 40)
= (15,000 x 40)
= Birr 600,000

4. Eden signed a loan for Birr 10,000. The loan is to be repaid with equal
yearly payments for the first three years and equal yearly payments
twice as large for the next four years. If the interest rate is 12%
compounded annually, find the yearly payments. Assume each
payment is made at the end of each year.

Solution
Draw the time line as follows.

0 1 2 3 4 5 6 7
x x x 2x 2x 2x 2x

Observe that x denotes the first three annual payments and 2x

denotes the remaining payments. Then we choose a comparison
payment. If the comparison point chosen is to be the end of the third
year, then the annuity consisting of three payments of x Birr each

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 28

must be brought forward to the comparison point. This done by

multiplying x by the future value factor of an ordinary annuity. Also,
the annuity consisting of four payments of 2x Birr each must be
brought back to the comparison point. This done by multiplying 2x by
the present value factor of an ordinary annuity. Finally, Birr 10,000
must be brought forward to the comparison point by multiplying it by
future value factor of a single deposit. Hence, the equation of value is,

x [
(1+i)n −1
i
+2 x ] [
1−(1+i)−n
i ]
= 10 ,000 (1+i )n

x [ (1+12)3−1
.12 ] [
+2 x
1−(1+. 12)−4
. 12 ]
= 10 , 000(1+. 12)3

x(3.374400) + 2x(3.037349) = 10,000(1.404928)

Solving for x, we have
3.3744x + 6.074698x = 14,049.28
x = Birr 1,486.84

AMORTIZATION SCHEDULE
Ato Abebe borrowed Birr 7000. The loan plus the interest is to be
repaid in equal quarterly installments made at the end of each quarter
during a 2 year interval. The interest rate is 16% compounded
quarterly.
a) Find the quarterly payment
b) Find the interest accumulated
c) Prepare an amortization schedule

Solution

P = Birr 7000 a)
R=P
[ i
1 − ( 1 + i )−n ]
r = 16%, i = 4%

m=4
R = 7000
[ . 04
1 − ( 1 . 04 )−8 ]
t = 2 years, n = 8 R = Birr 1,039.69
R =?
b) Interest accumulated = R (n) - A
= 1,039.69(8) - 7,000
= Birr 1317.52

c) Amortization schedule
Payment payment Interest Principal Balance
No. reduction
0 Birr 7,000.00
1 Birr Birr 280.00 Birr 759.69 6,240.31

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 29

1,039.69
2 1,039.6 249.61 790.08 5,450.23
9
3 1,039.6 218.01 821.68 4628.55
9
4 1,039.6 185.14 854.55 3774.00
9
5 1,039.6 150.96 888.73 2885.27
9
6 1,039.6 115.41 924.28 1960.99
9
7 1,039.6 78.44 961.25 999.74
9
8 1,039.6 39.99 999.74 0.00
9
Birr
1,317.56

* Interest = balance x i

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:

R=A
[ r/12
]
1 − ( 1 + r/12 )−n Or
R=A
[ i
1 − ( 1 + i )−n ]
Mathematics For Management (MGMT 2131)
 Chapter Four: Mathematics of Finance 30

Similarly
A=R [ 1 −( 1 + i )−n
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 =?

R=A
[ i
1 − ( 1 + i )−n ]
R = 92 ,000
[ .01
1 − ( 1 .01 )−360 ]
= 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

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 31

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
x 100
Percentage of down payment = Selling Price
20,258.87
x 100
= 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.

[ ]
a. i
Mortgage (A) Birr 60,000 R=A
1 − ( 1 + i )−n
r = 24% i = 2%
m = 12
t = 20 years n = 240
R = 60 ,000
[.02
1 − ( 1 .02 )−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

4. Ato Tefera purchased a house for Birr 250,000. He made a 20% down
payment, with a balance to be amortized by a 30-year mortgage at
annual interest rate of 12% compounded monthly.

a. Determine the amount of his monthly mortgage payment

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 32

b. What is the total amount of interest Ato Tefera will pay over the
life of the mortgage?
c. Determine the amount of the mortgage Ato Tefera will have paid
after 10 years.
d. What will be Ato Tefera's equity in the house at the end of 10
years?

Solution
Selling price = Birr 250,000 b. Interest=?
Down payment(20%)= 50,000 = total payment - mortgage
Mortgage Birr 200,000 = 2,057.23 x 360 - 200,000
r = 12% i = 1% = 740,602.80 - 200,000
m = 12 = Birr 540,602.80
t = 30 years n = 360
c. After 10 years there will remain
a. R =? (20 x 12) = 240 monthly payments of

[ ]
i Birr 2,057.23 to be made. The
R=A amount of the mortgage that is still
1 − ( 1 + i )−n
unpaid at this time is the PV of this
R = 200 ,000
[
.01
]
series of payments, that is;

= Birr 2,057.23
1 − ( 1.01 )−240
A = 2,057.23 [ 1 − (1 .01 )−240
.01 ]
= Birr 186,836.43.
d. Equity in house = down Thus after 10 years Ato Tefera will
payment + paid amount have paid Birr 13,163.57 (Birr
= Birr 50,000 + 13,163.57 200,000 - 186,836.43) against the
= Birr 63,163.57 principal amount of the mortgage.

5. Andinet and Florence are looking to purchase a home. They found one
that they like that costs Birr 150,000. They can get a 30-year
mortgage at 9% and plan to make a down payment of 20% of the
selling price.
a. What will be their monthly mortgage payment?
b. When Andinet and Florence go to the bank, they are offered an
annual percent rate of 6% if they take a 15-year loan rather than
one for 30 years. Andinet and Florence are skeptical because they
can't afford to make twice the payment calculated for 30 years. In
actual fact, how much would their payment be if they repaid the
mortgage in 15 years?
c. Andinet is 25 years old and wants to be a millionaire by the time he
is 50. He is planning to put aside a sum of money at the end of
each year sufficient to accumulate a million Birr in 25 years using
an interest rate of 10%. How much must he put aside?
d. Considering your answer in part c above, suppose Andinet can only
put aside Birr 10,000 per year. How high a rate of return must he
realize to achieve his goal?

Mathematics For Management (MGMT 2131)

 Chapter Four: Mathematics of Finance 33

Mathematics For Management (MGMT 2131)