CHAPTER 4:

MATHEMATICS OF FINANCE
TIME VALUE OF MONEY (TVM)
 An important concept that money received in the present is
more valuable than the same sum received in the future.
 The basic concept of mathematics of finance is that money has
time value which is described either as present value or future.
 There are some basic reasons to support the time value theory:
 First, a dollar can be invested and earn interest over time, giving it
potential earning power.
 Also, money is subject to inflation, eating away at the
spending power of the currency over time, making it worth a
lesser amount in the future.
 Risks are also associated in the process.
 Present value is the value of money today;
 future value is the value of money at some point in
the future.
 The difference between money now and the same
money in the future is called interest.
 It is the price paid for the use of a sum of money
over a period of time.
 interest – is fee paid for the use of another’s money,
just rent is paid for the use of another’s house.
EXAMPLE:
 A savings institution (banks) pay interest to
depositors on the money in the savings
account,
 Since the institutions have use of those funds
while they are on deposit; also a borrower pays
interest to a lending agent (bank or individual)
for use of the agent’s fund over the term of the
loan.
INTEREST
 Interest is usually computed as percentage of the
principal over a given period of time.
 This is called interest rate.
 Interest rate specifies the rate at which interest
accumulates per year throughout the term of the
loan.
 The original sum of money that is lent or
invested/ borrowed is called the principal.
INTERESTS
are of two types: simple interest and compound
interest.
Areas to be covered
 Simple interest,
 compound interest,
 annuity,
 sinking fund and
 mortgage problems.
SIMPLE INTEREST
 Interest paid on the initial amount of money invested or
borrowed only, and not on subsequently accrued
(accumulated) interest.
 Used only on short-term loans or investments –often of
duration less than one year.
 Simple interest is given by the following formula:
 I= P*r*t
 Where: I = Simple interest; P = principal amount
 r = Annual simple interest rate; t = time in years, for which
the interest is paid
SIMPLE INTEREST

 Relationship of Variables is as follows:

 Amount (A) = P + I= P + Prt= P (1 + rt).
 The sum of the original amount
(principal) and the total interest is the
future amount or maturity value or in
short amount.
EXAMPLES ON SIMPLE INTEREST CASES
 Rahel wanted to buy TV which costs Br. 10, 000.
She was short of cash and went to Dashen Bank
and borrowed the required sum of money for 9
months at an annual interest rate of 6%.
 Find the total simple interest and the maturity
value of the loan.
 The total amount which will have to be repaid to
Dashen at the end of the 9th month is Br. 10, 450
(the original borrowed amount plus Br. 450 Interest).
 ** Note: It is essential that the time period t and r be
consistent with each other. That is if r is expressed as
a percentage per year, t also should be expressed in
number of years (number of months divided by 12 if
time is given as a number of months).
2 . How long will it take if Br. 10, 000 is
invested at 5% simple interest to double
in value?
 Therefore it will take 2 0 years for the
principal (Br. 10, 000) to double itself
in value if it is invested at 5% annual
interest rate.
EXAMPLE

3. How much money you have to deposit in an

account today at 3% simple interest rate if you are
to receive Br. 5, 000 as an amount in 10 years?
 In order to have Br. 5, 000 at the end of the
10th year, you have to deposit Br. 3846.15 in
an account that pays 3% per year.
COMPOUND INTEREST
 If the interest, which is due, is added to the
principal at the end of each interest period (such
as a month, quarter, and year), 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.
COMPOUND INTEREST
 The result of compounding interest is that starting with
the second compounding period; the account earns
interest on interest in addition to earning interest on
principal during the next payment period.
 Interest paid on interest reinvested is called compound
interest.
 The sum of the original principal and all the interest
earned is the compound amount.
 The difference between the compound amount and the
original principal is the compound interest.
 COMPOUND ….
 The compound interest method is generally used in long-
term borrowing unlike that of the simple interest used only
for short-term borrowings.
 The time interval between successive conversions of interest
into principal is called the interest period, or conversion
period, or compounding period, and may be any
convenient length of time.
 The interest rate is usually quoted as an annual rate and
must be converted to appropriate rate per conversion period
for computational purposes.
 Hence, the rate per compound period (i) is found by
dividing the annual nominal rate (r) by the number of
compounding periods per year (m): i = r/m
EXAMPLE …
 Example if r = 12%, i (rate per compound period) for
different conversion period (m) is calculated as
follows:
 Annually (once a year) i = r/1 = 0.12/1 =0.12;
 Semi annually (every 6 months), i = r/2 = 0.12/2 =0.06;
 Quarterly (every 3 months)= r/4=0.12/4 = 0.03;
 Monthly; i = r/12 = 0.12/12=0.01
 Therefore, to calculate the value of “A” or other
variables in the compound interest formula, you can
use one of the three approaches which ever
convenient to you, these are: calculators,
logarithmic rules, and readymade tables.
COMPOUND …
 Assume that Br. 10, 000 is deposited in an
account that pays interest of 12% per year,
compounded quarterly. What are the compound
amount and compound interest at the end of one
year?
 Find the compound amount and compound interest
after 10 years if Br. 15,000 were invested at 8%
interest if compounded:
 i) annually
 ii) semi-annually
 iii) quarterly
 iv) Monthly
 v) daily
 vi) hourly
 vii) instantaneously
 When a number of conversion period
within a year increases, the interest
earned also increases continuously
toward an upper limit.
 The limiting case occurs where interest
is compounded continuously.
 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 is accumulated at the end
of n conversion periods.
 Under these conditions, P is called the present
value of A.
 This process is called discounting and the
principal is now a discounted value of future value
A.
 How much should you invest now at 8%
compounded semiannually to have Br. 10, 000
toward your brother’s college education in 10
years?
EXAMPLE …
 How long it takes to accumulate Br. 8, 000 if you
invest Br. 6, 000 at 12% compounded monthly?
 Solution: Given: A=8,000, P=6,000, r=12%=0.12,
m=12, i=r/m=0.12/12=0.01, t=?,n=?
 A/P=(1+i)n =8,000/6000=1.01n
 =log8,000/6000=log1.01n
 =3log8/6=n.log1.01
n=log1.33/log1.01=28.66≈29months;
t=n/m=29/12=2.42 years
EFFECTIVE RATE
 is simple interest rates that would produce the
same return in one year had the same principal
been invested at simple interest without
compounding.
 In other words, the effective rate r converted m
times a year is the simple interest rate that would
produce an equivalent amount of interest in one
year.
 It is denoted by re. t=1 thus, P(1+re)=P(1+r/m)m;
1+ret=(1+r/m)m; Effective rate=re=(1+r/m)m-1
 What is the effective rate corresponding to a
nominal rate of 16% compounded
quarterly?
 An investor has an opportunity to invest in two
investment alternatives A and B which pays 15%
compounded monthly, and 15.2% compounded
semi-annually respectively. Which investment is
better investment, assuming all else equal?
ANNUITIES
 Any sequence of equal periodic payments.
 The payments may be made weekly, monthly,
quarterly, annually, semiannually or for any
fixed period of time.
 The time between successive payments is
called payment period for the annuity.
 If payments are made at the end of each
payment period, the annuity is called an
ordinary annuity.
ANNUITY ….
 If payment is made at the beginning of the payment
period, it is called annuity due.
 In this course we will discuss only ordinary annuities.
 The amount, or future value, of an annuity is the sum
of all payments plus the interest earned during the
term of the annuity.
 The term of an annuity refers to the time from the
begging of the first payment period to the end of the
last payment period.
 ORDINARY ANNUITY
 A series of equal periodic payments in which each payment
is made at the end of the period.
 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.
 The last payment does not qualify for interest at all since the
value of the annuity is computed immediately after the last
payment is received.

Where; R = Amount of periodic payment; i = interest rate per payment

period; n = (mt) total no. of payment periods
Example: Abebe deposits Br. 100 in a special
savings account at the end of each month. If the
account pays 12%, compounded monthly, how
much money, will Mr. X have accumulated just
after 15th deposit?
 A person deposits Br. 200 a month for four years
into 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?
PRESENT VALUE OF ANNUITY
 It represents the amount that must be invested
now to purchase the payments due in the future.

 What is the present value of an annuity that pays

Br. 400 a month for the next five years if money
is worth 12% compounded monthly?
 SINKING FUND:
 A fund into which equal periodic payments are made in
order to accumulate a definite amount of money up on a
specific date.
 Are generally established in order to satisfy some
financial obligations 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 amount of an ordinary annuity as
follows:
EXAMPLE
 How much will have to be deposited in a fund at
the end of each year at 8% compounded annually,
to pay off a debt of Br. 50, 000 in five years?
 Ato Chala has a savings goal of Br. 100,000 which
he would like to reach 15 years from now. During
the first 5 years he is financially able to deposit
only Br. 1000 each quarter into the savings
account. What must his quarterly deposit over the
last 10 (ten) years be if he is to reach his goal? The
account pays 10% interest, compounded quarterly.
 Thus, if Chala makes quarterly payments of Br.
1000 into a savings account over the first five
years and then quarterly payments of Br. 466.02
over the next 10 years, he will reach his savings
goal of Br. 100,000 at the end of 15 years.
AMORTIZATION
 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 periodic
payments.
 Prominent examples of amortization are loans taken to buy a
car or a home amortized over periods such as 5, 10, 20 or 30
years.
 Where: R = Periodic payment; P = Present value of a loan; i
= Rate per period n = Number of payment periods
 EXAMPLE
 Ato Elias borrowed Br. 15, 000 from Commercial
Bank of Ethiopia and agreed to repay the loan in
10 equal installments including all interests due.
The banks interest charges are 6% compounded
Quarterly. How much should each
 If you have Br. 100,000 in an account that pays
6% compounded monthly and you decide to
withdraw equal monthly payments for 10 years at
the end of which time the account will have a
zero balance, how much should be withdrawn
each month?
 MORTGAGE
 In a typical home purchase transaction, the home
buyer pays part of the cost in cash and borrows
the remaining needed, usually from a bank or
savings and loan associations.
 The buyer amortizes the indebtedness by periodic
payments over a period of time.
 Typically payments are monthly and the time
period is long such as 30 years, 25 years and 20
years.
MORTGAGE VS AMORTIZATION
 Mortgage payment and amortization are similar.
 The only differences are: the time period in which the
debt/ loan is amortized /repaid/ is equal 12; and
 The amount borrowed (the loan is repaid from
monthly salary or Income, but in amortization money
take other values).
 In sum, mortgage payments are of amortization in
nature involving the repayment of loan monthly over
an extended period of time.
 Therefore, in mortgage payments we are interested in
the determination of monthly payments.
EXAMPLE
 Ato Assefa purchased a house for Br. 115, 000.
He made a 20% down payment with the balance
amortized by a 30 year mortgage at an annual
interest of 12% compounded monthly so as to
amortize/ retire the debt at the end of the 30th
year.
 Required:
 i) Find the periodic payment
 ii) Find the interest charged.
EXAMPLE
 Ato Amare purchased a house for Br. 50, 000. He made
an amount of down payment and pay monthly Br. 600 to
retire the mortgage for 20 years at an annual interest rate
of 24% compounded monthly. Find the mortgage, down
payment, interest charged and percentage of the down
payment to the selling price.
 Ato Liku purchases a house for Br. 250, 000. He
makes a 20% down payment, with a balance
amortized by a 30 year mortgage at an annual
interest rate of 12% compounded monthly.
1) Determine the amount of the monthly mortgage
payment.
2) What is the total amount of interest Ato Liku will pay
over the life of the mortgage?
3) Determine the amount of the mortgage Ato Liku will
have paid after 10 years?
GOOD LUCK