Unit Four: Mathematics of Finance

Section One: Simple Interest and Discounts

In business, we usually pay some money for using services and goods. Such payments go by various names.
For instance, the money we pay for hiring a taxi is known as fair. The amount we pay for education is called
tuition fee. Likewise, the cost we pay for electric consumption commonly called electric charge. Back to our
case, we also incur cost in using money for a certain period. This cost is referred to as interest. Thus, interest
is the payment made for use of the principal (money) or a fee, which is paid for having the use of money.
The amount of money that is borrowed or lent or invested or money available at hand at the beginning is
called the principal and denoted by P. Interest is usually paid in proportion to the principal and the period of
time over which the money is used. The percent of the principal that is charged for the use of the principal
for a unit of time is called the rate of interest (interest rate, i). The length of time for which the principal is
borrowed, lent or invested is called the time or term of the loan and commonly how symbolized by n. The
future or maturity value, which is also denoted by F, is the sum of the principal and all the interest earned.

Based on computation of the respective interest, there are two types of interests. These are,
i. Simple interest: it is the return on a principal amount for one time period.
ii. Compound interest: it is the return on a principal amount for two or more time period, assuming that
the interest for each time period is added to the principal amount at the end of each period and earns
interest on all subsequent periods.

Simple Interest
Interest that is paid solely on the amount of the principal P is called simple interest. Simple interest is
usually associated with loans or investments that are short term in nature. In addition, it is always computed
based on the original principal.

Simple interest formula:

The computation of simple interest is based on the following formula.
I = pin
Where, I = Simple interest (in dollars or birr)
P = Principal (in dollar, or birr) and it is the amount
i = Rate of interest per period (the annual simple interest rate)
n = Number of years or fraction of one year
In computing simple interest, any stated time period such as months, weeks or days should be expressed in
terms of years. Accordingly, if the time period is given in terms of,
i. Months, then
n= Number of months
12
ii. Weeks, then
n= Number of Weeks
52
iii. Days, then
a. Exact interest
n= Number of days
365
b. Ordinary simple interest
n= Number of days
360
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Maturity value (future value) represents the accumulated amount or value at the end of the time periods
given. Thus,
Future value (F) = Principal (P) + Interest (I)

Example: A credit union has issued a 3 year loan of Birr 5,000. Simple interest is charged at a rate of 10%
per year. The principal plus interest is to be repaid at the end of the third year.
a. Compute the interest for the 3-year period.
b. What amount will be repaid at the end of the third year?
Solution
Given values in the problem
3 – Years loan = Principal = Birr 5,000
Interest rate = i = 10% = 0.1
Number of years (n) = 3 years
a) I = p i n
I = 5,000 x 0.1 x 3
I = Birr 1,500
b) The amount to be repaid at the end of the third year is the maturity (future) value of the specified
money (Birr 5,000). Accordingly, F = P + I
F = 5,000 + 1,500
F = Birr 6,500
Or, using alternative approach,
F=P+I
Then, substitute I = P i n in the expression to obtain
F = P + Pin
F = P (1 + in)
Consequently, using this formula we can obtain
F = 5,000 (1+ (0.1x3))
F = 5,000 x 1.3
F = Birr 6,500

Solution for P, i, and n

In the computation of simple interest in some cases we will be required to find out the value of the principal,
interest rate and the time period. Such computation for P, i and n is simply made by driving the formula for
the unknown values from the formula we have used for simple interest.

Example:
1. How long must one leave Birr 300 invested in order to earn Birr 36 interest at 3% per year?
2. At what rate will Birr 150 produce interest of Birr 20.25 in 4.5 years?
3. What principal is required to produce interest of Birr 38.50 in two year at 3.5% per year?

Solution

1. The question involves determining the time period which is enough to earn an interest of Birr 36 on Birr
300.
The given values in the problem are P = Birr 300 I = Birr 36 i = 3% and n =?
I = Pin, now solve for n in this formula.
n = I = ___36 = 36 = 4 years
Pi 300 x 0.03 9

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2. Given values in the problem
P=Birr 150
I=Birr 20.25
n=4.5 years
The required value is the rate of interest.
I = pin, Solve for i
i=I = 20.25 = 20.25 = 0.03 or 3%
Pn 150x4.5 675
3. Given values in the problem
I = Birr 38.50
n =2 years
i = 3.5% per year
Required: Principal (P)

We can find out the value of P In the same manner with the above examples a follows.
I = pin, solve for P

P I  38.5
0.07
i n  38.5
0.035  2

P = Birr 550
Thus, Birr 550 is required to produce interest of Birr 38.5 in 2 years at 3.5% rate.

Ordinary and Exact Interest

In computing simple interest, the number of years or time, n, can be measured in days. In such case, there
are two ways of computing the interest.
i. The Exact Method: if a year is considered as 365 days, the interest is called exact simple interest. If
the exact method is used to calculate interest, then the time is
n = number of days / 365
ii. The Ordinary Method (Banker’s Rule): if a year is considered as 360 days, the interest is called
ordinary simple interest. The time n, is calculated as
n = number of days/ 360

Simple Discount: Present Value

The principal that must be invested at a given rate for a given time in order to produce a definite amount or
accumulated value is called present value. The present value is analogous to a principal P. It involves
discounting the maturity or future value of a sum of money to a present time. Hence, the simple present
value formula is derived from the future value (F) formula as follows.

Future Value = Principal + Interest

F = P + I but I = Pin
Thus, F = P + Pin
F = P (1+ in)

Then from this, solve for P.

PF
1  in

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If P is found by the above formula, we say that F has been discounted. The difference between F and P is
called the simple discount and is the same as the simple interest on P.

Example: 90 days after borrowing money a person repaid exactly Birr 870.19. How much money was
borrowed if the payment includes principal and ordinary simple interest at 9 ½ %?
Solution
1. Given values in the problem,
n in ordinary method = Number of days / 360
= 90 /360
n = 0.25
F = the amount repaid = Birr 870.19
i = 9 ½% = 9.5% = 0.095

Required: The amount borrowed which is the same as simple present value, P.

PF
1  in
= 870.19 / (1+ (0.095 x 0.25))
P = 870.19 ÷ 1.0238
P = Birr 850

Exercise: Solve for the missing quantities

Question Present Simple Future Rate (i) Time

Value (P) discount (I) value (F) (n)
1 Birr 400 Birr 18 ? ? ½ years
2 Birr 600 Birr 60 ? 4% ?
3 ? Birr 126 Birr 1026 ? 3½ years
4 Birr 474.81 ? Birr 481,93 ? ¼ years
5 Birr 2510.14 ? Birr 2566.62 4 ½% ?

Section Two: Compound Interest

As it has been highlighted earlier, compound interest refers for the case where interest earned during the
earlier periods also earns interest during the later period. If, instead of being paid when due, the interest an
investment is added to the principal and the sum is used as new principal, we say that compound interest is
being used. Under this procedure, the interest for each period is added to the principal for purpose of
computing interest for the next period. The sum to which the principal and interest on it grow during the
period is called the maturity or accumulated value of the principal. The difference between the compound
amount and the principal is called compound interest. The sum that is invested is called the present value or
the principal. The time interval between the date on which the principal was invested and the date on which
it is repaid is called the term of the investment (loan).

The Compound Interest Formula

If an amount of money, P, earns interest compounded at a rate of I percent per period it will grow after n
periods to the compound amount F, and it is computed by the formula:
Compound amount formula: Fn = P (1 + i) n
Where, P = Principal
i = Interest rate per compounding periods
n = Number of compounding periods
F = Compound amount
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A period, for this purpose, can be any unit of time. If interest is compounded annually, a year is the
appropriate compounding or conversion or interest period. If it is compounded monthly, a month is the
appropriate period. It is important to know that the number of compounding period/s within a year is/are
used in order to find the interest rate per compounding periods and it is denoted by i in the above formula.
Consequently, when the interest rate is stated as annual interest rate and is compounded more than once a
year, the interest rate per compounding period is computed by the formula:
i = j / m, where j is annual quoted or nominal interest rate
m number of conversation periods per year or the
compounding periods per year
n = m x t, where t is the number of years

Example 1: Assume that we have deposited Birr 6,000 at commercial Bank of Ethiopia which pays interest
of 6% per year compounded yearly. Assume that we want to determine the amount of money we will have
on deposit (our account) at the end of 2 years (the first and second year) if all interest is left in the savings
account.

Solution
Give values in the problem, P = Birr 6,000, j = 6% = 0.06, t = 2 years
m = compounded annually = i.e. only once
n=mxt =1x2 = 2
i = j / m = 0.06 / 1 = 0.06
Then, the required value is the maturity or future value
F = P(1 + i )n
= 6,000 (1 + 0.06)2
= Birr 6,000 (1.06)2
= Birr 6,741.6

Example 2: An individual accumulated Birr 30,000 ten years before his retirement in order to buy a house
after he is retried. If the person invests this money at 12% compounded monthly, how much will be the
balance immediately after his retirement?

Solution
Given values, P = Birr 30,000 , t = 10 years , i = 12% = 0.12
m = compounded monthly = 12
i = j / m = 0.12 / 12 = 0.01
n = m x t = 12 x 10 = 120 and what is required is the Future Value F.
Then, F = P (1 + i) n
= 30,000 (1.01)120
= 30,000 (1.01)120
F = Birr 99,011.61

Having the understanding of how compound interest works and computation of future value, in subsequent
example, we will consider how to determine the number of periods it will take for P birr deposited now at i
percent to grow to an amount of F birr.

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Present Value of a Compound Amount
As we have considered in the simple interest case and as extended in the compound amount as well, future
(maturity) value is the value of the present sum of money at some future date (time). Conversely, present
value (or simply principal) is the current birr or dollar value equivalent of the future amount. It is the sum of
money that is invested initially and that is expected to grow to some amount in the future at a specified rate.
If we put the present and future (maturity) values on a continuum as shown below, we can observe that they
are inverse to one another. And, future value is always greater than the present value or the principal since it
adds/earns interest over specified time-period.

0 1 2 3 . . . n
Present Value (P) Future Value
(Compound Amount)

Fn
P  Fn (1  i) n Fn  P(1  i) n
(1  i) n

Future value is obtained by compounding technique and the expression (1 + i) n is called compound factor.
On the other hand, present value is obtained by discounting techniques and the expression (1 + i)-n is
referred to as the compound discount factor. The formula for present value of compound amount is simply
derived from compound amount formula by solving for P.

Examples: Suppose that a person can invest money in a saving account at a rate of 6% per year
compounded quarterly. Assume that the person wishes to deposit a lump sum at the beginning of the year
and have that some grow to Birr 20,000 over the next 10 years. How much money should be deposited at the
beginning of the year?

Solution:
Given the values, i = 6% = 0.06 , m = quarter = 4 times a year
i = j ÷ m = 0.06 ÷ 4 = 0.015
F = Birr 20,000 shall be accumulated
t = 10 years
n = m x t = 10 x 4 = 40 interest periods
P = how much should be deposited now?
P = Fn (1 + i)-n
= 20,000 (1+0.015)-40 = 20,000(1.015)-40
P = Birr 11,025.25

SECTION 3: ANNUITIES
Annuity refers to a sequence or series of equal periodic payments, deposits, withdrawals, or receipts made at
equal intervals for a specified number of periods. For instance, regular deposits to a saving account, monthly
expenditures for car rent, insurance, house rent expenses, and periodic payments to a person from a
retirement plan fund are some of particular examples of annuity.

Payments of any type are considered as annuities if all of the following conditions are present:
i. The periodic payments are equal in amount
ii. The time between payments is constant such as a year, half a year, a quarter of a year, a month
etc.
iii. The interest rate per period remains constant.
iv. The interest is compounded at the end of every time.
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Annuities are classified according to the time the payment is made. Accordingly, we have two basic types of
annuities.
i. Ordinary annuity: is a series of equal periodic payment is made at the end of each interval or
period. In this case, the last payment does not earn interest.
ii. Annuity due: is a type of annuity for which a payment is made of the beginning of each interval
or period.
It is only for ordinary annuity that we have a formula to compute the present as well as future values. Yet,
for annuity due case, we may drive it from the ordinary annuity formula. To proceed, let us first consider
some important terminologies that we are going to use in dealing with annuities.
i. Payment interval or period: it is the time between successive payments of an annuity.
ii. Term of annuity: it is the period or time interval between the beginning of the first payment
period and the end of the last one.
iii. Conversion or interest period: it is the interval between consecutive conversions of interest.
iv. Periodic payment/rent: it is the amount paid at the end or the beginning or each payment period.
v. Simple annuity: is the one in which the payment period and the conversion periods coincides
each other.
Following the above basic overview about annuities, we shall progress to deal with practical business
problems, which relate with determining the maturity and present values of annuities with specific
application cases.

Sum of Ordinary Annuity: Maturity Value

Maturity value of ordinary annuity is the sum of all payments made and all the interest earned therefrom. It
is an accumulated value of a series of equal payments at some point of time in the future. Suppose you
started to deposit Birr 1,000 into a saving account at the end of every year for four years. How much will be
in the account immediately after the last deposit if interest is 10% compounded annually?

In attempting this problem, we should understand that the phrase at the end of every year implies an
ordinary annuity case. Likewise, we are required to find out the accumulated money immediately after the
last deposit which also indicates the type of annuity. Further, the term of the annuity is four years with
annual interest rate of 10%. Thus, we can show the pattern of deposits diagrammatically as follows.

The Present The Future

st nd rd
0 1 2 3 4th
1,000 1,000 1,000 1,000

Birr 1,000
Birr 1,100

Birr 1,210
Birr 1,331
Total Future Value = Birr 4,641

The first payment earns interest for the remaining 3 periods. Therefore, the compound amount of it at the
end of the term of annuity is given by,
F = P (1 + i) n = 1,000 (1 + 0.1)3 = Birr 1,331
In the same manner, the second payment earns interest for two periods (years). So,
F= 1,000 (1+0.1)2 = Br. 1,210
rd
The 3 payment earns interest for only one period. So,
F=1,000 (1+0.1)1 = Br. 1,100

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No interest for the fourth payment since it is made at the end of the term. Thus, its value is 1,000 itself. In
total, the maturity value amounts to Birr 4,641. This approach of computing future value of ordinary
annuity is complex and may be tiresome in case the term is somewhat longer. Thus, in simple approach we
can use the following formula for sum of ordinary annuity (Future Value).

 (1  i)n - 1
Fn  R  
 i 

Where, n = the number of payment periods

i = interest rate per period
R = payment per period
Fn = future value of the Annuity or sum of the annuity after n periods

Now, let us consider the above example. That is,

R = Birr 1,000
i = 0.1 and n=4

 (1  0.1) 4 - 1
F4  1,000 
 0.1 

Future Value = Birr 4,641

Example 2: A 12-year-old student wants to begin saving for college. She plans to deposit Birr 50 in a saving
account at the end of each quarter for the next 6 years. Interest is earned at a rate of 6% per year
compounded quarterly. What should be her account balance 6 years from now? How much interest will she
earn?

Solution
R = Birr 50
t = 6 years
m = quarterly = 4 times a year
n = t x m = 6 x 4 = 24 quarters
j = 6% = 0.06
i = j ÷ m = 0.06 ÷ 4 = 0.015
 (1  0.015) 24  1
F 24 = 50  
 0.015 

= 50 (1.01524  1)  0.015 
F24 = Birr 1,431.68
Interest = Maturity Value - Sum of Deposits
= Maturity value - (24*50)
= F24 -1,200 = 1,431.68 – 1,200
= Birr 231.68

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Ordinary Annuities: Sinking Fund Payments
A sinking fund is a fund into which periodic payments or deposits are made at regular interval to accumulate
a specified amount (sum) of money in the future to meet financial goals and/or obligations. The equal
periodic payment to be made constitute an ordinary annuity and our interest is to determine the equal
periodic payments that should be made to meet future obligations. Accordingly, we will be given the Future
Amount, F, in n period and our interest is to determine the periodic payment, R. Then we can drive the
formula for R as follows.

 (1  i ) n  1
Fn  R  
 i 
Multiply both sides by

i
(1  i ) n  1

That is,

i  (1  i) n  1 i
Fn   R   
(1  i)  1
n
 i  (1  i)  1
n

Then, the sinking fund formula is:

 i 
R  Fn  
 (1  i )  1
n

Where, R = Periodic payment amount of an annuity

i = Interest per period which is given by j ÷ m
j = Annual nominal interest rate
m = Number of conversion periods per year
n = Number of annuity payment or deposits (also, the number of compounding periods)
Fn= Future value of ordinary annuity

In general, a sinking fund can be established for expanding business, buying a new building, vehicles,
settling mortgage payment, financing educational expenses etc.

Example: A firm wishes to establish a sinking fund for the purpose of expanding the production facilities at
one of its plants. The company needs to accumulate 500,000 birr over the next five years that earn interest at
6% compounded semi-annually.
a. How much should the firm contribute to the fund at the end of each semi-annual period in order to
achieve the goal?
b. Calculate the compound interest.
c. Prepare the fund accumulation schedule.

Solution
Future financial goal of the firm = Fn = Birr 500,000
t = term of the annuity = 5 years
j = annual interest rate = 0.06
m = Conversion period = Semi-annually = 2 times a year
i = j ÷ m = 0.06 ÷ 2 = 0.03
n = t x m = 5 x 2 = 10 semi-annuals
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a. R=?
 0.03 
R  500,000  
 (1  0.03)  1
10

= 500,000 (0.08723050506)
R = Birr 43,615.25

b. Compound Interest = Fn – (n x R)
= Fn - (R*10)
= 500,000 – (43,615.25*10)
= 500,000 - 436,152.5
Interest = Birr 63,847.5

c. Fund Accumulation Schedule

Period Balance Interest (Beginning Bal. x Periodic Payment Ending Balance (Beg.
(Beginning) 0.03) Bal.+ Interest + R)
1st 0 0 43,615.25 43,615.25
2nd 43,615.25 1,308.46 43,615.25 88,538.95
3rd 88,538.95 2,656.17 43,615.25 134,810.37
4th 134,810.37 4,044. 31 43,615.25 182,469.93
5th 182,469.93 5,474.09 43,615.25 231,559.28
6th 231,559.28 6,946.78 43,615.25 282,121.31
7th 282,121.31 8,463.64 43,615.25 334,200.20
8th 334,200.20 10,026.01 43,615.25 387,841.46
9th 387,841.46 11,635.24 43,615.25 443,091.95
10th 443,091.95 13,292.76 43,615.25 500,000

Present Value of Ordinary Annuity

The present value of annuity is an amount of money today, which is equivalent to a series of equal payments
in the future. It is the value at the beginning of the term of the annuity. The present value of annuity
calculation arise when we wish to determine what lump sum must be deposited in an account now if this
sum and the interest it earns will provide equal periodic payment over a defined period of time, with the
last payment making the balance in account zero.

Present value of ordinary annuity is given by the formula:

1  (1  i )  n 
P  R 
 i 

Where, R= Periodic amount of an annuity

i = Interest per period which is given by j ÷ m
j = Annual nominal interest rate
m = Interest/ conversion periods per year
n = Number of annuity payments / deposits (also, the number of compounding periods)
P = Present value of ordinary annuity

Example: A woman would like to borrow money from local microfinance institution which charges interest
at 4% compounded quarterly. If the woman is able to pay Birr 100 at the end of each quarter for one year,
a. How much should she receive from the institution at the time of borrowing?
b. How much interest will the woman be charged?
c. Prepare the debt repayment schedule (Amortization schedule).
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Solution
Interest charge rate = j = 4% = 0.04
Periodic payment by the woman = Birr 100
Term of the annuity (debt) = t = 1 year
Conversion period per year = quarterly = m = 4
Number of periods = n = t x m = 1 x 4 = 4 periods
Interest rate per conversion periods = j ÷ m = 0.04 ÷ 4 = 0.01

a. How much to receive now? That is, the present value of the annuities, p.

1  (1  i)  n 
P  R 
 i 

1  (1  0.01) 4  1  (1.01) 4 
P  100   100 
 0.01   0.01 

= 100 (3.902)

Present Value = Birr 390.20

Given the woman’s potential to pay Birr 100 at the end of each quarter for one year, she can borrow Birr
390.2 at the beginning.

b. Interest charge = Total amount paid – Present value

= (R x n) – P
= (100 x 4) - 390.2 = 400 – 390.2
= Birr 9.8
c. The debt repayment schedule is a table that shows a periodic status of payments that gradually make the
debt account balance zero. This table is also called amortization schedule. Now let us proceed with
preparing the schedule.

Period Beginning Balance Interest (I) Periodic Payment Ending Balance

(Debt) (Debt x 0.01) (Debt + I – R)
1st Birr 390.2 Birr 3.902 Birr 100 Birr 294.102
2nd Birr 294.102 Birr 2.941 Birr 100 Birr 197.043
3rd Birr 197.043 Birr 1.97043 Birr 100 Birr 99.013
4th Birr 99.013 Birr 0.99013 Birr 100 Birr 0

As you observe in the above amortization schedule, in ordinary annuity periodic payment the last balance
becomes zero.

Mortgage Payments and Amortization

Another main area of application of annuities in to real world business situations in general and financial
management practices in particular is mortgage amortization or payment. Mortgage payment is an
arrangement where by regular payments are made in order to settle an initial sum of money borrowed from
any source of finance. Such payments are made until the outstanding debt gets down to zero. An individual
or a firm, for instance, may borrow a given sum of money from a bank to construct a building or undertake
something else. Then the borrower (debtor) may repay the loan by effecting (making) a monthly payment to
the lender (creditor) with the last payment settling the debt totally.

In mortgage payment, initial sum of money borrowed and regular payments made to settle the respective
debt relate to the idea of present value of an ordinary annuity. Along this line, the expression for mortgage
payment computation is derived from the present value of ordinary annuity formula. Our intention in this

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case is to determine the periodic payments to be made in order to settle the debt over a specified time –
period.

Hence, we know that

1  (1  i )  n 
P  R 
 i 

Now, we progress to isolate R on one side. It involves solving for R in the above present value of ordinary
annuity formula. Hence, multiply both sides by the interest rate i to obtain:
P i = R [1 – (1 + i) –n]

Further, we divide both sides by [1 – (1 + i) –n] and the result will be the mathematical expression or
formula for computing mortgage periodic payments as follows.
 i 
R  P n 
1  (1  i ) 

Where, R = Periodic amount of an annuity

i = Interest per conversion period which is given by j ÷ m
j = Annual nominal interest rate
m = Interest or conversion periods per year
n = the number of annuity payments/deposits (number of compounding periods)
P = Present value of an ordinary annuity

Example: Assume you have borrowed Birr 11,500 from a bank to finance construction of a swimming pool
and agreed to repay the loan in 5 years mortgage at annual interest rate of 18% compounded monthly.

a. How much is the monthly payment?

b. How much interest will be paid over the term of the loan?

Solution: Amount borrowed = Birr 11,500 = P

n = 5*12 = 60 months
i = 0.18/12 = 0.015

a. Monthly Installment Payment R =?

 i 
R  P n 
1  (1  i ) 

 0.015 
R  11,500  60 
 11,500 (0.025393)
1  (1  0.015) 

R = Birr 292.02 per month

b. Total interest paid (I) = (R x n) – P

I = (292.02 x 60) – 11,500
I = Birr 6,021.20

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