Mathematics of Finance
Md. Aktar Kamal
Assistant Professor
Dept. of Management Studies
Faculty of Business Studies(FBS)
Bangladesh University of Professionals (BUP)
Course Contents
1. Introduction
2. Simple Interest
3. Compound Interest
4. Annuity
Terminology
• Present Value
• Future Value
• Interest
• Interest Rate
• Simple Interest
• Compound Interest
Terminology
Present Value: The amount of money initially
invested is called the and is denoted by P.
Future Value: The amount of money principal
has grown to after the time period is called
the and is denoted by FF.
Terminology
Interest: The amount of money charged
for the initial investment for a period of
time and is denoted by I.
Interest = Future value - Present Value
Or I = F - P
• Interest Rate : The percentage of the
amount of money charged for the initial
investment for a period of time and is
denoted by i.
Two Types of Interest
• Simple interest:
– only principal earns interest
– beneficial for short term (1 year)
– easy to describe
• Compound interest:
– interest earns interest
– beneficial for long term
– the most important type of accumulation
function
SIMPLE INTEREST
Finding Total Interest
I=Pin
Where,
I= Total interest
P = Present Value
i = Interest Rate
n= Number of years
SIMPLE INTEREST
Finding Total Interest
Example: Compute the interest on $480 at 6 ¼
percent for 9 months.
We know I=Pin, Where,
I= Total interest=?
P = Present Value=$480
i = Interest Rate=6 ¼ =25/4%=0.625
n= Number of years=9/12=.75
So, I = 4800.625 .75=$22.5 (ans.)
Simple Interest Future Value
F=P(1+in)
Where,
F = Future Value
P = Present Value
i = Interest Rate
n= Number of years
Simple Interest Future Value
F=P(1+in)
Example: Find the future value of $20,000 at
6% for 3 months.
Solution: We know, F=P(1+in)
Here, P=$20,000 I=6%=6/100=0.06
n=3 months=3/12 years=1/4=0.25
So, F=20,000(1+0.06 0.25)=$20,300 (ans.)
Simple Interest Time
I=Pin
Example: How many months will it take until the
interest on $9,00 at 12 percent will be $135?
Solution: We know, I=Pin
Here, P=$900 i=12%=12/100=0.12
I=$135 n=?
So, 135=900 0.12 n Hence n=15 months (ans.)
Home Work
Book: BOWEN
Problems: 11, 12 and 14 Page 399 - 400
Problems: 15 to 21 Page 400
Compound Interest
Compound Interest: Computing the interest on
interest is called compounding interest.
Let us consider P is the principal amount i% is the
interest rate and n is the number of years and the
period is one year.
Then, the interest of 1 taka for 1 year is i.
After 1 year
Taka one will grow to 1+i.
Taka P will grow to P(1+i).
So we can say that the future value of P after one year
is F1 =P(1+i)
13
Compound Interest
After 2 year
Taka one will grow to (1+i)2.
Taka P will grow to P(1+i)2.
So we can say that the future value of P after one
year is F2 =P(1+i)2
Similarly after 3 years P will grow to F3 =P(1+i)3
after 3 years P will grow to Fn =P(1+i)n
Or simply F=P(1+i)n
14
Compound Interest Future value
F=P(1+i) n
Where,
F = Future Value
P = Present Value
i = Interest per take
n= Number of years
15
Compound Interest Future value
F=P(1+i)n
Find the future value of $1,000 at 7% per year for
10 years.
We know F=P(1+i)n , Here P=$1,000
i =7%=7/100=0.07 and
n = 10 years
Hence F= 1,000(1+0.07)10
=1,000(1.07)10
=1,0001.96715=$1,967.15 (ans.)
16
Compound Interest
When interest is compounded more often than
once a year
• Nominal Rate: Quoted interest rates per year
if not accompanied by a qualifying statement
such as 1.5% per month. In the absence of a
qualifier the quoted annual rate is called the
nominal rate and is symbolized by j.
• Nominal rate = Rate per year=j
17
Compound Interest
When interest is compounded more often than
once a year
• Number of Conversions Per year = m
• If the number of conversions per year = m
• Then,
• n= (Number of year )(Number of conversion per year)
• And j
i
m
18
Compound Interest
When interest is compounded more often than
once a year
nm
F P( 1 j
m
)
Where,
F = Future Value
P = Present Value
j = Nominal Interest Rate per year
n= Number of years
m= number of conversion per year
19
Compound Interest (Future Value)
Find the future value of $1,500 at 8% compounded
quarterly for 10 years.
Solution: We know, F P ( 1 j ) nm
m
Where,
F = Future Value=?
P = Present Value=$1,500
j = Nominal Interest Rate per year=8%=8/100=0.08
n= Number of years=10
m= number of conversion per year=4
Hence,
104
0.08
F 500 1
4
500 1.02 500 2.208039665 $1,104.02
4
20
Compound Interest (Finding Time)
At 8% compounded annually, how many years will it take
for $2,000 to grow to $3,000?
Solution: We know,
Where,
F P( 1 i )n
F = Future Value=$3,000
P = Present Value=$2,000
i = Interest Rate per period=8%=8/100=0.08
n= Number of years=?
Hence,
3, 000 2 ,000 1 0.08 or ln 1.5 ln 1.08
n n
or
3, 000
1.08
n or ln 1.5 n ln 1.08
2 , 000 ln 1.5
or n 5.268 years
or 1.5 1.08
n
ln 1.08 21
Compound Interest (Finding Interest)
At what interest rate compounded annually will a
sum of money double in 10 years?
Solution: We know, F P( 1 i )
n
Where,
P = Present Value=P
F = Future Value=2P
i = Interest Rate per period=?
n= Number of years=10 1
Hence, or ( 1 i ) 210
2 P P( 1 i )10 or ( 1 i ) 1.071773463
or 2 ( 1 i )10 or i 1.071773463 1
or i 0.071773463
or ( 1 i )
10
2
or i 7.177% ans. 22
At what rate of interest will a sum of money be
double in 8 years? The difference between simple
and compound interest on a sum for 3 years at 5%
is $76.25. Find the sum.
Home Work
Book: Business Mathematics (V. K. Kapoor)
Page 226-229
Example:30-35
Page-235- 236:
Exercise: 2,3,4,8,9
24
Annuity: The Basic Theory
Definitions
• Annuity: An annuity is a series of periodic
payments.
• Usually the payments are made in equal
payments.
• Annuities are classified by
• When they begin and end
• When the payments are made
• Whether or not the payments interval coincide
with the interest intervals
Annuity: The Basic Theory
Definitions
• Annuity Certain: An annuity that begins and
end on designated dates is called an Annuity
Certain.
• Examples: Loan transactions, rent payments.
• Simple Annuity: An annuity whose payment
intervals coincide with the interest interval is
called Simple Annuity.
• Examples: a transaction whose payments are
made monthly and whose interest is charged
monthly.
Annuity: The Basic Theory
Definitions
• Complex Annuity: An annuity whose payment
intervals does not coincide with the interest
interval is called Complex Annuity.
• Examples: a transaction whose payments are
made yearly but whose interest is charged
monthly.
• Ordinary Annuity: An annuity whose payment
is made at the end of each payment interval is
called an Ordinary Annuity.
• Examples: Loan transactions are ordinary
annuity.
Annuity: The Basic Theory
• Annuity Due: An annuity whose payment
is made at the beginning of each payment
interval is called an Ann
• An annuity due may arise due to any recurring
obligation. Many monthly bills, such as rent, mortgages,
car payments and cellphone payments, are annuities
due if the payment is required at the beginning of the
billing period. Expenses for insurance are typically
annuities due as the payment is required at the start of
each period in which the individual or business is
covered.
• We will investigate Simple Ordinary
annuities certain.
• Usually just called Ordinary Annuity
Future Value of an Ordinary Annuity
F=R/i[(1+i) - 1] n
Where,
R= Payment made at the end of each period
i = Interest per period
n=Number of periods
F = Future value of the annuity after the last
payment made
Future Value of an Ordinary Annuity
F=R/i[(1+i) - 1] n
Example:
If $100 is deposited in an account each month for
10 years and the account earns 7% compounded
monthly, how much will be in the account after last
deposit is made?
If $100 is deposited in an account each month for 10 years
and the account earns 7% compounded monthly, how
much will be in the account after last deposit is made?
F=R/i[(1+i) - 1] n
Here,
R= $100
i = 0.07/12
n=10 years=10.12=120 periods
F = Future value of the annuity=?
R= $100 , i = 0.07/12, n=120 periods F =?
F=R/i[(1+i) - 1] n
100 0.07
120
F 1 1
0.07 12
12
F $17 ,308.48
Ordinary Annuity: Sinking Fund
Sinking Fund: A fund into which periodic
payments are made in order to accumulate a
specified amount at some point in the future.
Example: A company wants to accumulate
$100,000 to purchase replacement machinery 8
years from now.
Sinking Fund Payment
Fi
R
1 i n
1
We know the future value of the ordinary
annuity is
R
F [1 i 1]
n
i
Fi R [ 1 i 1 ]
n
R [ 1 i 1 ] Fi
n
Fi
R
[1 i 1]
n
Sinking Fund Payment
Fi
R
1 i 1
n
Example:
How much should be deposited in a sinking fund at
the end of each quarter for 5 years to accumulate
$10,000 if the fund earns 8% compounded
quarterly?
• How much should be deposited in a sinking fund at the end of
each quarter for 5 years to accumulate $10,000 if the fund earns
8% compounded quarterly?
Fi
R
1 i n
1
Here, F= $10,000 i= 0.08/4
n= 5 years= (5)(4)=20 periods and F=?
10 ,000 0.02
R
[ 1 0.02
20
1]
$411 .57
Ordinary Annuities: Present Value
Present value annuity calculations arise when we
wish to determine what lump sum must be
deposited in an account now if this sum and the
interest it earns are to provide equal payments
for a stated number of periods, with the last
payment making the account balance zero.
Example: What sum deposited now in an
account earning 8% compounded quarterly will
provide quarterly payments of $1,000 for 10
years, the 1st payment to be made 3 months from
Ordinary Annuities: Present Value
We use the formula
R
P 1 1 i
i
n
To calculate the present value of ordinary
annuity
Example: What sum deposited now in an
account earning 8% compounded quarterly will
provide quarterly payments of $1,000 for 10
years, the 1st payment to be made 3 months from
Example: What sum deposited now in an account
earning 8% compounded quarterly will provide
quarterly payments of $1,000 for 10 years, the 1st
payment to be made 3 months from now?
R
P 1 1 i
i
n
Solution: Here, R=$1,000 i=0.08/4=0.02
n=10years=(10)(4)=40 periods P=?
P
1 ,000
0.02
1 1 i
40
$27 ,355.48
Ordinary Annuities: Amortization
In many Financial transactions, a current
obligation is discharged by making a series of
payments in future. This situation is called
amortization
Example: Loans taken to buy a home or a car
and amortized over a period of 20 or 30 years.
Ordinary Annuities: Amortization
Pi
R
We use the formula
1 1 i
n
To calculate the amortization payment of
ordinary annuity
Example: A company has borrowed $ 50,000 at
10% compounded quarterly, the debt is to be
amortized by equal payments each quarter over
15 years. Find the quarterly payment.
A company has borrowed $ 50,000 at 10% compounded quarterly,
the debt is to be amortized by equal payments each quarter over
15 years. Find the quarterly payment.
Pi
R
1 1 i
n
Solution:
Here, P=$50,000, i=0.10/4
n= 15 years= (15)(4)=60 periods R=?
50 ,000 0.025
R
1 1 0.025 60
$1 ,617.67
A man borrows $6,000 at 6% and promises to pay
both principal amount and the interest in 20 annual
installments at the end of each year. What is the
annual payment necessary? (Answer: R = 523.16)
Here, P = $6000
i = 6% = 0.06
n=20
We know,
R
P 1 1 i
i
n
Home Work
Book: Business Mathematics (V. K. Kapoor)
Page 232-234
Example:38-42
Page-236:
Exercise: 14,17,22
44
Permutation and Combination
In permutations the objects are based on the order of the
arrangements where each change in order constitutes a
different arrangement, But, if order is not of any
consequence then it is a problem of combination.
Combinations, therefore, are the groups which can be made
by taking some or all of things at a time.
The number of combinations of ‘n’ different
things taken ‘r’ at a time are given by
n!
n
Cr , where r n
r!(n r )!
A cricket team of 11 players is to be formed from 16
players including 4 bowlers and 2 wicket keepers. In
how many different ways can a team be formed so
that the team contains
(i) exactly 3 bowlers and 1 wicket keeper?
(ii) at least 3 bowlers and at least 1wicket keeper?
(a) Here a cricket team of 11 is exactly to contain 3 bowlers
and a wicket keeper.
3 bowler can be selected out of 4 in 4C3 i.e. 4 ways.
1 wicket keeper can be selected out of 2 in 2C1, i.e. 2 ways.
Now the remaining 7 players to complete the team can be
selected from the remaining 10 players in 10C3, i.e.120 ways.
Hence by the fundamental principle,
the total number of ways in which the tam can be formed
= 4 2 120 = 960.
(b). In this case the cricket team of 11 can be formed
in the following ways:
(i) 3 bowlers, 1 wicket keeper and 7 other players.
(ii) 3 bowlers, 2 wicket keeper and 6 other players.
(iii) 4 bowlers, 1 wicket keeper and 6 other players.
(iv) 4 bowlers, 2 wicket keeper and 5 other players.
We now consider all these 4 cases
(i) 3 bowlers, 1 wicket keeper and 7 other players
can be selected in 4C3 2C1 10C7
= 4 2 120 = 960
(ii) 3 bowlers, 2 wicket keeper and 6 other players
can be selected in 4C3 2C2 10C6
= 4 1 210 = 840 ways
(iii) 4 bowlers, 1 wicket keeper and 6 other players
can be selected in 4C4 2C1 10C6
= 1 2 210 = 210 ways
(iv) 4 bowlers, 2 wicket keeper and 5 other players
can be selected in 4C4 2C2 10C5
= 1 2 252 = 252 ways
Home Work
Book: Business Mathematics (V. K. Kapoor)
Page 320-323
Example:33,35,37,38,43
52
