1. 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)
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2. 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
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3. 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
= = 1664
or $1664
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4. 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)
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5. 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 $
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6. 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
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7. 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.
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8. Present Value (Compound Interest)
Present Value (principal) – the amount required now to reach the desired future value.
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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 $ How much was his original investment?
A = $ , r = 8%, t = 10, and m = 12
or $2560
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10. 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.
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11. 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
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12. 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
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13. 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
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14. 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 $
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15. 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
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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 $
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17. 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 $
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18. 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
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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 $
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