Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Chapter 5 Mathematics of Finance Compound Interest Annuities Amortization and Sinking Funds Arithmetic and Geometric Progressions (optional) Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Section 5.1 Compound Interest Simple Interest Formula Simple Interest - interest that is compounded on the original principal only. Interest: I = Prt Accumulated amount: A = P(1 + rt) A = Accumulated amount P = Principal r = Interest rate per year t = Number of years Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. $800 is invested for 9 years in an account that pays 12% annual simple interest. How much interest is earned? What is the accumulated amount in the account? Solution: note P = $800, r = 12%, and t = 9 years. Interest: I = Prt = (800)(0.12)(9) = 864 or $864 Accumulated amount = principal + interest = 800 + 864 = 1664 or $1664 Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Compound Interest Compound Interest – Interest is added to the original principal and then earns interest at the same rate. A = Accumulated amount after n periods P = Principal r = Nominal interest rate per year m = Number of conversion periods per year t = Term (number of years) Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. Find the accumulated amount A, if $4000 is invested at 3% per year for 6 years, compounded monthly. Solution: note P = $4000, r = 3%, t = 6, and m = 12. So or $4787.79 Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Effective Rate of Interest Effective Rate – the simple interest rate that would produce the same accumulated amount in 1 year as the nominal rate compounded m times per year. where reff = Effective rate of interest r = Nominal interest rate per year m = Number of conversion periods per year Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. Find the effective rate that corresponds to a nominal rate of 6% per year compounded quarterly. Solution: note r = 6% and m = 4. So about 6.136% per year. Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Present Value (Compound Interest) Present Value (principal) – the amount required now to reach the desired future value. Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. Jackson invested a sum of money 10 years ago in an account that paid interest at a rate of 8% per year compounded monthly. His investment has grown to $5682.28. How much was his original investment? A = $5682.28, r = 8%, t = 10, and m = 12 or $2560 Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Section 5.2 Annuities Annuity Annuity – a sequence of payments made at regular time intervals. Ordinary Annuity – payments made at the end of each payment period. Simple Annuity – payment period coincides with the interest conversion period. Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Future Value of an Annuity The future value S of an annuity of n payments of R dollars each, paid at the end of each investment period into an account that earns interest at the rate of i per period is Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. Find the amount of an ordinary annuity of 36 monthly payments of $250 that earns interest at a rate of 9% per year compounded monthly. R = 250, n = 36, and or $10,288.18 Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Present Value of an Annuity The present value P of an annuity of n payments of R dollars each, paid at the end of each investment period into an account that earns interest at the rate of i per period is Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. Paige’s parents loaned her the money to buy a car. They required that she pays $150 per month, for 60 months, with interest charged at 2% per year compounded monthly on the unpaid balance. What was the original amount that Paige borrowed? or $8557.85 Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Section 5.3 Amortization and Sinking Funds Amortization Formula The periodic payment R on a loan of P dollars to be amortized over n periods with interest charged at a rate of i per period is Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. The Kastners borrowed $83,000 from a credit union to finance the purchase of a house. The credit union charges interest at a rate of 7.75% per year on the unpaid balance, with interest computations made at the end of each month. The Kastners have agreed to repay the loan in equal monthly installments over 30 years. How much should each payment be if the loan is to be amortized at the end of the term? Solution: P = 83000, n = (30)(12) = 360, and So the monthly installment is $594.62. Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. A bank has determined that the Radlers can afford monthly house payments of at most $750. The bank charges interest at a rate of 8% per year on the unpaid balance, with interest computations made at the end of each month. If the loan is to be amortized in equal monthly installments over 15 years, what is the maximum amount that the Radlers can borrow from the bank? Solution: note R = 750, n = (15)(12) = 180, and So they can borrow up to about $78480.44. Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Sinking Fund Payment The periodic payment R required to accumulate S dollars over n periods with interest charged at a rate of i per period is Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.

Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc. Example Ex. Max has decided to set up a sinking fund for the purpose of purchasing a new car in 4 years. He estimates that he will need $25,000. If the fund earns 8.5% interest per year compounded semi-annually, determine the size of each (equal) semi-annual installment that Max should pay into the fund. Solution: note S = 25000, n = 4(2) = 8, and So the semi-annual payment is about $2689.12. Copyright © 2006 Brooks/Cole, a division of Thomson Learning, Inc.