CHAPTER FOUR

MATHEMATICS OF FINANCE

People generally earn money because they want to spend it. If they save it, rather than
spend it in the period in which it was earned, it is usually because they want it to spend
in the future. However, for most people present consumption is more desirable than
future consumption if only because the future is so uncertain. "Live and be merry, for
tomorrow we may die," is a rationale used over the ages to justify the urge to buy now
rather than deferring gratification to the future. For this reason, most of us would rather
have a dollar today than a dollar a year from today, and must be given something extra
to get us to defer gratification.

Looking at the transaction from the borrower's perspective, there are consumers and
businesses (not to mention the deficit-ridden government) who really need that dollar
today and who are willing to promise to pay back more than that dollar in the future.
Businesses can invest borrowed funds in capital to create profits which are (hopefully)
more than sufficient to repay the borrowed funds (principal) plus INTEREST.
Consumers and governments borrow for various reasons but are expected to have
income in the future sufficient to repay principal and interest. Simply put, the basic
concept of mathematics of finance is that money has time value. That is, a bird at hand
worth two in the forest.

Interest is the price paid for the use of a sum of money over a period of time. It is the
charge for exchanging money now for money later.

A savings institution pays interest to a depositor on the money in the savings account
since the institution has use of those funds while they are on deposit. Or, a borrower
pays interest to a lending agent for use of that agent’s fund over the term of loan.

Interest - Simple interest.

- Compound interest.

SIMPLE INTEREST-

When we borrow money the money borrowed or the original sum of money lent
(borrowed or invested) is called the principal. (The principal remains fixed during the
entire interest period). Interest is usually expressed as a percentage of the principal for a
specified period of time which is generally a year. This percentage is termed the

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 interest rate. If interest is paid on the initial amount only and not on subsequently
accrued interest, it is called simple interest.

However, if the interest for each period is added to the principal in computing the
interest for the next period, the interest is called compound interest.

The sum of the original amount (principal) and the total interest is the future amount or
maturity value or Amount. A = P + I

Simple interest is generally used only on short term notes often of duration less than
one year. The concept of simple interest, however, forms the basis for compound
interest concepts.

Simple interest is given by the formula:

I = Prt
Where P= principal amount/ original amount borrowed or invested
r = Simple interest rate per year (expressed in decimal)
t= duration of the loan or investment in years
I = amount of interest in Birr.

If a sum of money, P is invested at a simple interest its value increases by the same
amount each year. Therefore, there is a linear relationship between amount and time.
Taking P= principal, r = rate of interest, t = time in years and A = amount, their
relationship is as follows:

I = Prt --------------------------- 1
A=P+I
= P + Prt
A = P (1+rt) ----------------------2
P = I --------------------------- 3
rt
P= A
1  rt            4
r = I              5
Pt
t= I
pr                6

Example:
1. Mr. X wanted to buy a leather sofa for his new family room. The cost of the sofa was
Birr 10,000. He was short of cash and went to his local bank and borrowed Birr 10,000

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 for 6 months at an annual interest rate of 12%. Find the total simple interest and the
maturity value of the loan.
Solution
I = Prt A = P+I
 10,000x012
. x 12 = 10,000 + 600
= Birr 600 = Birr 10,600 or

A = P (1+rt)
 10,000(1  .12 x 1 )
2
= 10,000 (1.06) = Birr 10,600

2. How long will it take if Birr 20,000 is invested at 5% simple interest to double in value?
Solution. I=A-p
I = 40,000 - 20,000
t=
P = 10,000 BIRR = 20,000
rp
r = 5%
A = Birr 40,000 20,000
t=? 105x 20,000
 20 years

3. At what interest rate will Birr 6,000 yield 900 Birr in 5 years time?
Solution.
t= I
rP
P = Birr 6,000
= 900
r = Birr 900 6000 x 5
t = 5 years = 3% annual rate
r =?

4. How much money must Mr. Z has to invest today at 6% simple interest if he is to receive
Birr 3,100 as an amount in 4 years?

Solution. A
P
P = Birr? 1  rt
A = 3,100 Br 3,100
=
t = 4 years 1 .06x 4
r = 6%  Birr 2,500

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 When time over which interest is paid is given in months, t is simply the number of
month divided by 12. If time is given as a number of days, then one of two methods of
computing t may be used:
# ofdays
 Ordinary interest year - uses a 360 - day year - t 
360
When time is determined in this way, the interest is called ordinary simple interest.
#ofdays
 Exact time- uses a 365-day year = t = t  or a 366 for leap year. Interest
365
computed in this way (using exact time) is called exact simple interest.

5. Find the interest on Birr 1,000 at 5% for 45 days.

Solution
1. Using ordinary Interest year:
p = Birr 1,000 I = prt
r = 5% 45
= 1,000 x .05 x
t = 45 days 360
I= Birr 6.25

2. Using exact time:

I = Prt Always ordinary simple
45 interest is grater than exact
= 1,000 x .05 x
360 simple interest.
= Birr 6.16

Compound Interest

If the interest which is due is added to the principal at the end of each interest period,
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. The result of compounding interest
is that starting with the second compounding the account earns interest on interest in
addition to earning interest on principal.

The sum of the original principal and all the interest earned is the Compound Amount.
The difference between compound amount and the original principal is the Compound
interest.

The compound interest method is generally used in long-term borrowing. There is

usually more than one period for computing interests during the borrowing time. The
time interval between successive conversions of interest in to principal is called the

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 interest period or conversion period or compounding period, and may be any
convenient length of time. The interest rates are always given as annual percentages; no
matter how many times the interest is compounded per year. Hence, interest rate must
be converted in to or adjusted to the appropriate interest rate per conversion period (i)
for computational purposes; and we use the number of conversion periods as time.

The i is equal to the stated annual interest rate /nominal rate (r) divided by the number
r
of conversion periods in one year (m) = i = .
m
Conversion # of conversions per year, m

Daily 365
Monthly 12
Quarterly 4
Semi annually 2
Annually 1

Example:

1. What are the compound amount and compound interest at the end of one year if Birr
10,000 is borrowed at 8% compound quarterly?
Solution
P = Birr 10,000 total # of conversions = 4
r = 8% t = one year
Total number of conversion periods (m) = 4 times = quarter
r 8%
i= . = = 2%
m 4

Original principal Birr 10,000

Add: interest for the first quarter, I = 10,000
x .02 200
Principal at the end of first quarter 10,200=10,000(1.02)1
Add: Interest for the second quarter, 10,200
x .02 204
Principal at the end of second quarter 10,404 = 10,000 (1.02)2
Add: Interest for the third quarter,
10,404x.02 208.08
Principal at the end of third quarter 10,612.08=10,000(1.02)3

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 Add: Interest for the fourth quarter,
10,612.08 x .02 212.2416
Principal at the end of fourth quarter Birr 10,824.3216 = 10,000(1.02)4
(Amount at the end of the year)

If we summarize the above computations, we will discern a pattern that leads to a

general formula for computing compound interest:
1st quarter: S = 10,000 (1.02)1
2nd quarter: S = 10,000 (1.02) (1.02) = 10,000 (1.02)2
3rd quarter: S = 10,000 (1.02) (1.02) (1.02) = 10,000 (1.02)3
4th quarter: S = 10,000 (1.02) (1.02) (1.02) (1.02) = 10,000 (1.02)4

In general, the compound amount can be found by multiplying the principal by (1+i) n
where i is the interest rate per conversion period and n is the total number of
conversion periods.

In Short, Amount with compound interest is calculated as:

r
A = P (1 +  tm
= P (1 + i) n
m
Where:
A = compound amount, after n conversion periods.
P = principal
r = stated annual rate of interest
m = number of conversion periods a year
t = total number of years
i = r/m = interest rate per conversion period
n = mt = Total number of conversion periods.
So, for the above question, the amount is equal to
A = P (1 + I) n
= 10,000 (1.02)4
= 10,824.3216 Birr

Compound interest = compound amount - original principal

= 10,824.3216 - 10,000
= Birr 824.3216

using logarithm Rules of log

A = 10,000 (1.02)4 1. log aa = 1

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 log A = log 10,000 + log (1.02)4 2. logmp = p logm
= log 10,000 + 4 log 1.02 3. logmn = logm + logn
= 4 + 4 (0.0086) 4. logm/n = logm - logn
= 4+ 0.0344
log A = 4.0344
A = antilog 4.0344
= 10,824.30

Logarithms and Anti Logarithms for the Solutions of Equations.

1. ax = b 2x = 5
logax = logb log2x = 5
xloga = logb xlog2 = log5
log b log
5
x= x=
log a log 2

2. abx + c = d 4(3x) + 10 = 17
abx = d-c 4(3x) = 17-10
dc 4(3x) = 7
bx =
a 3x = 1.75
dc log3x = log1.75
logbx = log --- k
a xlog3 = log1.75
xlogb = logk
log1.75
logb x=
x= log3
logb
x3 = 1,000
3. x3 = a logx3 = log1000
logx3 = loga 3logx = log1000
3 log x log a log1000
 log 
x
3 3 3
a k
log 3 3
logx = logx =
3 3
x = antilogk log x = 1

x = antilog1
4. a = b(c+x)d = 10

(c+x)d = a/b 100 = 25(1+x)4

log(c+x)d = loga/b (1+x)4 = 100/25
dlogc+x = loga-logb log(1+x)4 = log4

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  loga  logb  4log1+x = log4
logc+x =  k
 d  log1+x = log 4/4
log = k
c+x log1+x = 0/150515
c+x = antilogk 1+x = antilog0.150515
x = antilogk-c 1+x = 1.4142
x=0.4142

2. Find the compound amount compound interest resulting from the investment of Birr
1000 at 6% for 10 years,
2.1. Compounded annually.

Solution
P = Birr 1,000 A = p(1+i)n
t = 10 years = 1,000 (1.06)10
m=1 = Birr 1,790.85
r = 6%
A =? Compound interest = Compound amount - principal
i = 6% = 1,790.85 - 1000
n = 10 = 790.85 Birr

2.2. Compounded semiannually.

Solution
P = Birr 1,000 A = p(1+i)n
r = 6% = 1,000 (1.03)20
m=2 = Birr 1,806.11
t = 10 years Compound interest = compound amount - principal
i = 3% = 1,806.11 - 1000
n = 20 = Birr 806.11

2.3 compounded quarterly.

Solution
P = Birr 1,000 A = 1,000 (1.06)40
r = 6% = Birr 1,814.02
m=4
t = 10 years Compound interest = compound amount - principal
i = .015 = 1814.02 - 1000
n = 40 = Birr 814.02

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2.4. Compounded monthly.

Solution
P = Birr 1000 A = 1,000 (1.005) 120
r = 6% = 1,819.40 Birr
t = 10 years
m=12 Compound interest = compound amount - principal
i = .005 = 1,819.40 - 1000
n = 120 = 819.40 Birr

2.5. If compounded weekly

Solution
P = Birr 1000 A = 1,000 (1.0012)520
r = 6% = 1,821.49 Birr
t = 10 years
m=52 Compound interest = compound amount - principal
i = .0012 = 1821.49 - 1000
n = 520 = Birr 821.49

2.6. Compounded daily

P = Birr 1000 A = 1,000 (1.0001644)3650
r = 6% = 1,822.03
t = 10 years
m=365 Compound interest = compound amount - principal
i = .01644% = 1,822.03 - 1000
n = 3650 = Birr 822.03

2.7. Compounded hourly

P = Birr 1000 A = 1,000 (1.00000685)687,600
r = 6% = 1,822.12 Birr
t = 10 years
m= 8760 Compound interest =compound amount - principal
i = .000685% = 1,822.12 - 1000
n = 87600 = Birr 822.12 Birr

2.8. Compounded continuously (instantaneously).

(1+i) n = (1+r/m) mt

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  1 x  1 x
f(x) =  1   if x approaches infinity 1   becomes closer to 2.71828 = e
 x  x

Let m/r = x as m x 
mt mt
 r  1
1    1  
 m  x
rxt
 1
 1  
r/m = 1/x = m = rx  x
rt
 1  x 
 1  
 x  
 e rt
P = Birr 1000 A = Pert
r = 6% = 1,000 e.06x10 = 1000 e.6
t = 10 years = Birr 1,822.12
m=infinite compound interest = compound amount - principal
1,822.12 - 1000 = Birr 822.12
3. How long will it take to accumulate Birr 650 if Birr 500 is invested at 10% compound
quarterly?
Solution
P = 500 A = p(1+i)n
A = 650 650 = 500 (1.025)n
r = 10% 1.3 = (1.025)n
i=2.5% log1.3= log(1.025)n
m=4
10.625 2 log13. log1.025
t=? n/m =  2 years n
4 3 log13. log1.025
n =? 10.625 quarters log 1.3
n=
log 1.025
= 10.625 quarters

4. Birr 2000 is deposited in an account. After one year of monthly compounding, the
balance in the account is Birr 2,166. What is the annual percentage rate for this account?

Solution
P = Birr 2,000 A = p(1+i)n
A = Birr 2,166 2166 = 2000 (1+i)12
r =? 1.083 = (1+i)12
i=r/12 log1.083= log(1+i)12

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 t=1 =12log1+i
log 1.083
m = 12  log 1  i
12
0.0028857 = log1+i
anti log .0028857 = 1+i
1.0066667 = 1+i
.0066667 = i
.006667 x 12 = r = i x m
= 8% = r
5. A person deposits Birr 10,000 in a savings account that pays 6% compounded semi-
annually. Three years later, this person deposits an additional Birr 8,000 in the savings
account. Also, at this time, the interest rates changes to 8% compounded quarterly. How
much money is in the account 5 years after the original Birr 10,000 is deposited?
Solution

3 years 2 years

P= Birr 10,000

10,000(1.03)6 Birr 11,940.52

8,000.00
Birr 19,940.52

19,940.52(1.02)8
Birr 23,363.49
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 be
accumulated at the end of n conversion periods. This process is called discounting and
the principal is now a discounted value of a future income A.

A = P (1+i) n dividing both sides by (1+i) n leads to

A
P= = p = A (1+i)-n
(1  i ) n
Present values of a compound amount:

P = A (1+i)-n
Where:

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 p = principal / present value
A = compound amount (or future value)
i = interest rate per conversion period
n = total number of conversion periods
Example:
1. Find the present value of a loan that will amount to Birr 5,000 in four years if money is
worth 10% compounded semi annually.
Solution.
A = 5,000 Birr P = A (1+i)-n
t = 4 years = 5,000 (1.05)-8
m=2 = Birr 3,384.20
r = 10%
P =?
2. How much must be deposited now in an account paying 6% compounded monthly in
order to have just 20,000 Birr in the account 4 years from now?

A = 20,000 Birr P = A (1+i)-n

t = 4 years = 20,000 (1.005)-48
m = 12 = Birr 15,742
r = 6%
P =?

3. If money worth 14% compounded semi-annually, would it be better to discharge a debt

by paying Birr 500 now or Birr 600 eighteen months from now?
Solution:
We can solve this problem in two ways:
1) By finding the PV of 600 and compare it with 500
2) By finding the FV of 500 and compare it with 600.

1) A = 600 2) P = 500
t = 18 months = 1.5years t = 1.5 years
m=2 m=2
r = 14% r = 14%
p =? A =?
P = A(1+i) -n
A = P(1+i)n
= 600 (1.07)-3 = 500 (1.07)3
= Birr 489.78 = Birr 612.52
Since 489.78 < 500, it is better to pay Since 612.52 > 600, it is better to pay
the debt after 18 months. the debt after 18 months.

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4. How much should be deposited in an account paying 8% compounded quarterly in
order to have a balance of Birr 8,000 nine years from now?
Solution:
A = Birr 8,000 P = A (1+i)-n
t = 9 years = 8,000(1.02)-36
n = 36 = 3,921.79 Birr
m=4
i=2%
r = 8%
P =?

Present value with continuous compounding

A Pert
  P  A rt
ert ert e
 Ae rt

Equivalent Rates

Sometimes it is helpful to convert interest rates from, for example, a compounded

quarterly basis to a compounded annually basis, from a compounded quarterly basis to
compounded monthly basis, etc. this is easily accomplished as long as we understand
the concept of equivalent interest rates, which is defined as follows:
If at the beginning of a specified time period, the same amount of money is
invested at various rates so that the resulting compound amounts are equal at the
end of the time period, then the interest rates are equivalent rates.

Although we can use any length time period, we usually use a 1-year time interval.
Thus, if Birr P is invested at annual rate r compounded m times a year, and another Birr
P is invested at annual rate s compounded k times a year, then the rates are equivalent
as long as
P (1 +r/m) m = P (1 +s/k) k

Dividing both sides of the above equation by P gives the equivalent rates equation
which can be solved for either r or s, depending on which the unknown.
Use this equation to find equivalent rates: (1 +r/m) m = (1 +s/k) k

1. What rate compounded monthly is equivalent to 8% compounded quarterly?

Solution
(1+r/12)12 = (1+.08/4)4

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 = (1.02)4, solving for r, we take the 12th root of each side to obtain,
(1+r/12) = ((1.02)4)1/12
= (1.02)3
r/12 = (1.02)3 -1
= 1.006622 -1
r/12 = .006622
r = 12(.006622)
r = .079476
= 7.95%

2. What nominal annual rate of interest converted monthly corresponds to 16% converted
quarterly?
Solution

(1+r/12)12 = (1+.16/4)4
= (1.04)4, solving for r, we take the 12th root of each side to obtain, (1+r/12) =
[(1.04)4]1/12
= (1.04)1/3
r/12 = (1.04)1/3 -1
= 1.013159404 -1
r/12 =. 013159404
r = 12(013159404)
r = .157912845
= 15.79%

Or, using logarithms

(1.04) = (1+i)
4 12

Log (1.04)4 = log (1+ i) 12

4 log (1.04) = 12 log (1+i)
4 (0.017033339) = 12 log (1+ i)
0.068133357 = 12 log (1 + i)
0.0056778 = log 1+ i
Antilog .0056778 = (1+ i)
1.0131594 = 1+i
.1031594 = i
r=mxi
= 12 x .0131594
= 15.79%

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A stated rate of 15.79% compounded monthly would earn interest equivalent to that
earned with a stated rate of 16% compounded quarterly.

Effective Rate
Obviously, for a stated annual interest rate, the amount of interest accumulated
depends upon the frequency of conversion. This is because interest which has been
earned subsequently earns interest it self. When interest is compounded more than
once a year, the stated annual rate is called a Nominal Rate. The effective rate
corresponding to a given nominal rate r converted m times a year is the simple interest
rate that would produce an equivalent amount of interest in one year. Effective rates
are, therefore, the simple interest rates that would produce the same return in one year
had the same principal been invested at simple interest without compounding.
If P = Principal, A = Amount, r = nominal rate, m = number of conversion periods per
year, the compound interest for one year on principal p is,
I=A-P
= p (1 + r/m) m - p

Compound int erest I

The effective rate of interest is (re)=  . From the above statement:
principal P
I = p (1 + r/m) m - p
= P [(1+r/m) m - 1) Divide both sides by p
 r m 
I/p = P 1  1
 m  
m
 r
re = 1   1
 m
= (1+i) m - 1

In continuous compounding case:

A = Pert for one year A = Per
I=A-P
= Per - p, multiplying both sides by 1/p
1/p x I = P (er-1) x 1/p
re = er-1

Effective rates are used to compare competing interest rates offered by banks and other
financial institutions.

Example:

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1. What is the effective rate of money invested at 6% compounded quarterly?
Solution.
R = 6% re = (1+r/m)m-1
m=4 .06 4
= (1+ ) -1
4
= (1.015)4 -1
= 6.14%

2. An investor has two opportunities to invest his money. The first investment opportunity
(opp A) pays 15% compounded monthly and the second investment opportunity (opp
B) pays 15.2%% compounded semiannually. Which is the better investment, assuming
all else is equal.

Solution
Nominal rates with different compounding periods cannot be compared directly. We
must first find the effective rate of each nominal rate and then compare the effective
rates to determine which investment will yield the larger return.
:
Effective rate for inv. opp. A Effective rate for inv. opp. B
re= (1+r/m) - 1
m
re= (1+r/m)m - 1
12 2
 115  115
1   1 1   1
 12   12 
= (1.0125)12  1 = (1.076) 2  1
16.075% 15.778%

Since the effective rate for A is greater than the effective rate for B, Investment
opportunity A is the preferred investment.

3. A bank states that the effective interest on savings accounts that earn continuous interest
is 10%. Find the nominal rate.
Solution.
re = er-1
.10 = er-1
1.1 = er
ln 1.1 = lner
ln1.1 = rlne
ln1.1 = r (1)
9.531% = r

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ANNUITIES

An annuity is a sequence of EQUAL, PERIODIC PAYMENTS. The payments may be

made weekly, monthly, quarterly, semi-annually, annually or for any fixed period of
time. The time between successive payments is called the PAYMENT PERIOD for an
annuity. Each payment is called PERIODIC PAYMENT or PERIODIC RENT, and it is
denoted by R. The time from the beginning of the first payment period to the end of the
last period is called the TERM of an annuity. If payments are made at the end of each
time interval, then the annuity is called an ORDINARY ANNUITY. If payments are
made at the beginning of the payment period, it is called an ANNUITY DUE.

Geometric Series and Annuities

Geometric Series
A geometric progression is a sequence of numbers where each term after the first term
is found by multiplying the previous term by a fixed number called the Common ratio,
r. It has the form
a + ar + ar2 + ar3 +...+ arn-1.

Each term is a constant multiple, r, of the preceding term. If Sn denotes the sum of the
first n terms of a geometric series, then
Sn = a + ar + ar2 + ar3 +...+ arn-1.

An alternative formula for evaluating Sn is derived as follows. Take the equation Sn = a +

ar + ar2 + ar3 +...+ arn-1 and multiply both sides by r to obtain rSn = ar + ar2 + ar3 +...+ arn-1

Now consider both equations:

Sn = a + ar + ar2 + ar3 +...+ arn-1

rSn = ar + ar2 + ar3 +...+ arn-1 + arn
Subtracting the second equation from the first, we would get
Sn - rSn = a - arn

Factoring both sides of this last equation gives us

Sn (1 – r) = a (1- rn)
Hence,

Sn 

a 1 r n  (Valid only if r ≠ 1.)
1 r

17 | P a g e
 If r = 1, then Sn = arn. If the common ratio in a geometric progression is less than 1 in
modulus, (that is -1 < r <1), the sum of an infinite number of terms can be calculated.
This is known as the sum to infinity,  
a
  , Provided -1 < r < 1
1 r

ORDINARY ANNUITY

An ordinary annuity is a series of equal periodic payments in which each payment is

made at the end of the period.
In an ordinary annuity 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) and the last payment doesn’t qualify for interest at all since the value of the
annuity’s computed immediately after this last payment is received.
AMOUNT (FUTURE VALUE) OF AN ORDINARY ANNUITY
The amount (future value) of an ordinary annuity is the sum of all payments plus all
interests earned.

EXAMPLE

1. What is the amount of an annuity if the size of each payment is Birr 100 payable at the
end of each quarter for one year at an interest rate of 4% compounded quarterly?

Solution
Periodic payment (R) = Birr 100
Payment interval = conversion period = quarter
Nominal (annual rate), r, = 4%
Interest rate per conversion period (i) = r/m = 4%/4 = 1%
Future value of (sum of) an annuity =?
Term one year

18 | P a g e
1,2,3,4 - End of the quarter

Now 1 2 3 4
0 100Birr 100 Birr 100 Birr 100 Birr

Birr 100

Birr 100 (1.01)1

Birr 100 (1.01)2

Birr 100 (1.01)3

Birr 100 (1.01)4

A = Birr 406.04

Compound interest = Amount - R (n)

= 406.04 - 100(4)
= Birr 6.04

Taking
R = amount of periodic payment
I = interest rate per payment period
n = total number of payment periods
A = Future value (Amount) of an O. Annuity at the end of its term.

Last payment R
The second payment from the last R(1+i)1
The third payment from the last- R(1+i)2
|
The second payment R(1+i)n-2
The first payment R(1+i)n-1

A = R + R (1 + i) 1 + R (1+i) 2 + ------ + R (1+i) n-2 + R (1+i) n-1 -------- (1)

Multiplying each side of the equation by 1+i, we obtain

A (1+i) = R (1+i) + R (1+i) 2 + R (1+i) 3 + ---- + R (1+i) n-1 + R (1+i) n --- (2)

Then subtracting the first equation from the second equation, we have

19 | P a g e
 A (1+i) = R (1+i) + R (1+i) 2 + ------ + R (1 + i) n-1 + R (1+i) n
- A = R + R (1+I) 1 + R (+i) 2 + ---- + R (1+i) n-1
A (1+i) - A = R (1+i) n-R
A [1+i-1] = R [(1+i) n-1]
 (1  i)n  1
A (i) = R [(1+i) n-1] dividing both sides by i, we have, A = R  
 i 
1  (1  i) n  (1 + i) n -1]
P  R  = future value factor.
 i  i

[(1.01) 4 - 1]
For the above example: A = 100 = Birr 406.04
0.01

2. A newly married couple are both working and decide to have Birr 1000 at the end of a
month for a down payment on a home. The account earns 12% compound monthly.
How large a down payment will they have saved in three years?

Solution
R = Birr 1000 [(1  i) n  1] Compound interest = A - R(n)
A
t = 3 years. i = 43,076.88 - 36,000
m = 12 1000[(1.01)36  1] = 7,076,88 Birr

n = 36 0.01
r = 12%  Birr 43,076.88
i=1%
A =?

3. A person deposits Birr 200 a month for four years in to 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?
Solution

R = Birr 200 A4 = 200 [(1 + .07)48 – 1]

t = 4years 0.07/12
m = 12 = 200 (55.20924)10
r = 7% = 11,041.85 Birr

After the end of the fourth year, we calculate compound interest rate taking Birr
11,041.85 as principal compounded monthly for 6 years.

20 | P a g e
 P = 11,041.85 Birr A10 = 11,041.85 (1 + .07)72
t = 6years 12
m = 12 = 11,401.85 (1.5201)
I = 7% = Birr 16,784.77
A10 =?
4. A person deposits Birr 500 a year for 10 years in to an account that pays 6% compounded
annually. After 10 years the person transfers the money into another account that pays
8% compounded quarterly. The money is left in the second account for 8 years. What is
the balance after the 18-year period?

Solution.

For the first 10 years:

R = Birr 500 A10 = 500 [(1.06)10 – 1]
t = 10years .06
m=1 = 500 (13.180795)
r = 6% = Birr 6590.40
A10 =?

For the next 8 years, Birr 6590.40 is taken as single deposit (Principal) in an account
which pays 8% compounded quarterly.

P8 = A10 = Birr 6950.40

t = 8years A18 = A10 (1 +i) n
m=4 = 6950.40 (1.02)32
r = 8% = 6950.40 (1.88454)
A18 =? A18 = Birr 12,419.87

The balance after 18 years is Birr 12,419.87 out of which Birr 7,419.87 (Birr 12,419.87 –
Birr 5000) is interest earned.

Sinking Fund- Increasing Annuity

A Sinking fund is a fund in to which equal periodic payments are made in order to
accumulate a specified amount at some point in the future. Sinking funds are generally
established in order to satisfy some financial obligation 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 a mount of an ordinary annuity. That is, if

21 | P a g e
 A = R [(1+i) n –1]
i
Then A____
R = [(1+i) n - 1]
i

 i 
R = A 
 1 i   1
n

Example:
1. What monthly deposit will produce a balance of Birr 100,000 after 10 years? Assume
that the annual percentage rate is 6% compounded monthly. What is the total amount
deposited over the 10-year period?
Solution.

A = Birr 100,000 R=A[ i ]

(1+i)n – 1
t = 10years
m = 12 = 100,000 [ .005 ]
(1.005)120 – 1
r = 6% = 100,000 (0.006102)
R =? = Birr 610.21

The total amount deposited over the 10-yr period is 120 (610.21) = Birr 73,225.

2. Mrs. X has a saving goal of Birr 25,000 which she would like to reach 10 years from
now. During the first five years she is financially able to deposit only Birr 100 each
month into the savings account. What must her monthly deposits over the last five
years be if she is to reach the goal? The account pays 12% interest compounded
monthly.

Solution.

For the first five years

R = 100 A60 = 100 [(1.01)60 - 1]
t = 5years 0.01
m = 12 = 100 (81.6697)
r = 12% = Birr 8166.97
A60 =?

22 | P a g e
 For the last five years:

The amount at the end of the first 5 years (Birr 8,166.97) serves as single principal and it
earns interest for the next five years.

A = 8,166.97 (1.01)60
= Birr 14,836.90

To determine the periodic payment we subtract 14,836.90 Birr from Birr 25,000 to obtain
the amount of an ordinary annuity for the last five years.

A60 = Birr 25,000 – Birr 14,836.90

= 10,163.10

R2 = 10,163.120 X .01___
(1.01)60 – 1
= Birr 124.44

The proper R is (if normally deposited the same amounts)

R = 25,000 [ .01 ]
(1.01)120 – 1
= Birr 108.68

3. XYZ Company purchased a tract of land under a purchase agreement which requires a
payment of Birr 500,000 plus 5% interest compounded annually at the end of 10 years.
The company plans to setup a sinking fund to accumulate the amount required to settle
the land purchase debt. What should the quarterly deposit into the fund be if the
account pays 15% interest, compounded quarterly?

Solution.
First we have to find the total debt at the end of five years as

A = P (1+i) n i = 5%
= 500, 000 (1+0.05)10
= Birr 814,447.31

The amount is taken as Future Value of an Ordinary annuity with r = 15% Compounded
quarterly for 10 years

23 | P a g e
  .0375 
A40 = Birr 814,447.31 R = 814,447.31  
 1.0375 1
40

t = 10 years
m=4 = 9,088.80 Birr
r = 15%
i= 3.75%
R =?
Sinking Fund Schedule

The accumulation of value in a sinking fund is illustrated by a sinking fund schedule.

Example: A business man wishes to set aside semiannual payments to purchase
machinery after two years (two years from now). The machinery's estimated cost is Birr
5000. Each payment earns interest at 12%compounded semiannually.
a) Find the semiannual payment
b) Find the total interest earned
c) Prepare a sinking fund schedule

Solution
 i 
A = Birr5000 a) R= A  
 1 i   1
n

 .06 
t = 2 years = 5000  
 1.06 1
4

m=2 = Birr 1,142.96

r = 12% b) Interest = Amount - R (n)
i= 6% = 5000 - 1,142.96(4)
n= 4 = Birr 428.16
R=?
c)
Payment Payment (R) Interest* Total
number
1 Birr 1,142.96 Birr 0 Birr 1,142.96
2 Birr 1,142.96 Birr 68.58 Birr 2,354.50
3 Birr 1,142.96 Birr 141.27 Birr 3,638.73
4 Birr 1,142.96 Birr 218.32 Birr 5000.01
Birr 428.16
* Interest = balance x i

24 | P a g e
 Present Value of an Ordinary Annuity

The present value of an ordinary annuity is the amount of money today, which is
equivalent to the sum of a series of equal payment in the future. It is the sum of the
present values of the periodic payments of an annuity, each discounted to the beginning
of an annuity. The present value represents the amount that must be invested now to
purchase the payment due in the future.
In short, PV of an ordinary annuity can be computed in two ways:

(1) Discounting all periodic payment to the beginning of the term individually.
(2) Discounting the amount of an ordinary annuity to the beginning of the term.
Example

1. What is the PV of an annuity if the size of each payment is Birr 200 payable at the end of
each quarter for one year and the interest rate is 8% compounded quarterly?

Solution.

R = Birr 200 r = 8%
m=4 t = 1yr
P =?

P______________________________________________________A

0 1 2 3 4
196.10 = 200 (1.02) _ _ _ 200
-1

192.23 = 200 (1.02)-2 _ _ _ _ _ _ _ _ _ _ 200

188.46 = 200 (1.02)-3 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 200
184.77 = 200 (1.02) _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _
-4

Birr 761.56

Equivalently: Find the FV of the ordinary annuity using the formula A = R [(1+i)n - 1]

A = 200 [(1.02)4 - 1]
.02
= Birr 824.32

Discount this future value to the present value taking it as single FV.

P = 824.32 (1.02)-4

25 | P a g e
 = 761.56

We have seen that the future value of an ordinary annuity after n payment periods is A
= R [(1+i) n - 1], and also we have seen that the PV of a lamp sum investment after n
periods with interest rate i per period is: P (1+i) n

The future value of an annuity and the future value of the lamp sum payment should be
equal at the end of n periods; thus,

P (1+i) n = R [(1+i) n -1] Dividing both sides by (1+i) n gives

i
P = R [1 – (1+i) ]
-n

i
Or

If we multiply the FV of an O. annuity by the compound discount factor we have the

present value of an annuity.

P = R [(1+i) n -1] (1+i)-n

i
= R [(1+i) n (1+i)-n –1 (1+i)-n]
i
= R [(1+i) 0 – 1 (1+i)-n]
i
1  (1  i) n 
P  R 
 i 
Using the above formula; the PV of the former example is computed as:

R = Birr 200 P = R [1 – (1+i)-n]

r = 8% i
m=4 = 200 [1 – (1.02)-4]
t = 1yr .02
P =? = 200 (3.08773)
= Birr 761.55

2. What is the cash value of a car that can be bought for Birr 200 down payment and Birr
82 a month for 18 months, if money is worth 12% interest compounded monthly?
Solution.

26 | P a g e
 Cash Value = down payment + PV of an O. annuity
= 200 + 82[1 – (1.01)-18]
.01
= 200 + 82(16.39827)
= 200 + 1,344.658
= Birr 1,544.658

3. How much should you deposit in an account paying 6% compounded quarterly in

order to be able to withdraw Birr 1000 every 3 months for the next 3 years?
Solution.
R = Birr 1000 PV = 1000[1 – (1.015)12]
t = 3years .015
m=4 = 1000(10.9075)
r = 6% = Birr 10, 907.50
PV =?

4. What is the present value of an annuity of seven payments of Birr 1000 each made at the
end of each quarter with an interest rate of 12% compounded monthly?
Solution

Since we have quarterly payment periods and monthly interest periods, we must
change the interest rate to coincide with the quarterly payment periods. Specifically, we
must find the equivalent interest rate compounded quarterly corresponding to 12%
compounded monthly and use it as r (i). Using the equivalent rate formula, we have
(1 +r/4)4 = (1 +.12/12)12
(1+ r/4)4 = (1.01)12
r/4 = (1.03)3 - 1  i = .030301

R = Birr 1000
i = .030301
n=7
P =?
1  (1  i) n  1  (1.030301)7 
P  R  = 1000  = Birr 6,223.22
 i   .030301 

5. A business person's debt is payable as follows: Birr 2,000 1 year from now and Birr 5,000
5 years from now. The business person wants to repay the debt as follows: a Birr 1,000
payment now, a Birr 2,000 payment 2 years from now, a Birr 1,000 payment 3 years from

27 | P a g e
 now, and the last payment 4 years from now. If the interest rate is 12% compounded
annually, find the amount of the last payment.

Amortization- Decreasing Annuity

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 payments.

In amortization our interest is to determine the periodic payment, R, so as to amortize

(retire) a debt at the end of the last payment. Solving the PV of ordinary annuity
formula for R in terms of the other variables, we obtain the following amortization
formula:

 i 
R  P n 
1 1 i  
Where:
R = periodic payment
P = PV of loan
i= interest rate per period
n = number of payment periods

Example

1. Suppose you borrow Birr 5000 from a bank and agree to repay the loan in five equal
installments including all interests due. The bank’s interest charges are 5%
compounded annually. How much should each annual payment be in order to retire
the debt including the interest in 5 years?
Solution.
PV = Birr 5000 R = 5000[ .05 ]
t = 5years 1 – (1.05)-5

m=1 = 5000(.230975)
r = 5% = Birr 1,154.87
R =? Interest = (1,154.87 X 5) – 5000
= Birr 774.35

2. At the time of retirement, a person has Birr 200,000 in an account that pays 12%
compounded monthly. If he decides to withdraw equal monthly payments for 10 years,

28 | P a g e
 at the end of which time the account will have a zero balance, how much should he
withdraw each month?
Solution.

PV = Birr 200,000 R = 200,000 [ .01 ]

t = 10years 1 – (1.01)-120

m = 12 = 200,000(0.014347)
r = 12% = Birr 2,869.42
R =?

3. An employee has contributed with her employer to a retirement program for 20 years a
certain amount twice a year. The contribution earns an interest rate of 10% compounded
semi annually. At the date of her retirement the total retirement benefit is Birr 300,000.
The retirement program provides for investment of this amount at an interest rate of
10% compounded semi annually. Semi-annual payments will be made for 20 years to
the employee or her family in the event of her death.
1. What semi-annual payment should she make?
2. What semi-annual payment should be made for her?
3. How much interest will be earned on Birr 300,000 over the 40 years?
Solution.

Retirement plan

Employment period Retirement period

Pay Receive
0 20 40
R =? A = Birr 300,000
A = 300,000 PV = 300,000
t = 20 years t = 20 years
m=2 m=2
r = 10% r = 10%
R1 =? R2 =?

R = A[ i ] R2 = P20 [ i ]
(1+i) –1
n
1 – (1+i)-n

= 300,000 ( .05 ) = 300,000 ( .05 )

(1.05)40 – 1 1 – (1.05)-40
= Birr 2483.45 = Birr 17,483.45

29 | P a g e
 Interest earned = (R2 x 40) - (R1 x 40)
= (17,483.45 x 40) - (2483.45 x 40)
= (15,000 x 40)
= Birr 600,000

4. Eden signed a loan for Birr 10,000. The loan is to be repaid with equal yearly payments
for the first three years and equal yearly payments twice as large for the next four years.
If the interest rate is 12% compounded annually, find the yearly payments. Assume each
payment is made at the end of each year.

Solution
Draw the time line as follows.

0 1 2 3 4 5 6 7
x x x 2x 2x 2x 2x

Observe that x denotes the first three annual payments and 2x denotes the remaining
payments. Then we choose a comparison payment. If the comparison point chosen is
to be the end of the third year, then the annuity consisting of three payments of x Birr
each must be brought forward to the comparison point. This done by multiplying x by
the future value factor of an ordinary annuity. Also, the annuity consisting of four
payments of 2x Birr each must be brought back to the comparison point. This done by
multiplying 2x by the present value factor of an ordinary annuity. Finally, Birr 10,000
must be brought forward to the comparison point by multiplying it by future value
factor of a single deposit. Hence, the equation of value is,

 (1  i)n  1 1  (1  i) n 
x   2 x    10,000(1  i)
n

 i   i 
 (1  12)3  1 1  (1  .12)4 
x   2 x    10,000(1  .12)3
 .12   .12 

x(3.374400) + 2x(3.037349) = 10,000(1.404928)

Solving for x, we have
3.3744x + 6.074698x = 14,049.28
x = Birr 1,486.84

30 | P a g e
AMORTIZATION SCHEDULE

Ato Abebe borrowed Birr 7000. The loan plus the interest is to be repaid in equal
quarterly installments made at the end of each quarter during a 2 year interval. The
interest rate is 16% compounded quarterly.
a) Find the quarterly payment
b) Find the interest accumulated
c) Prepare an amortization schedule

Solution

 i 
P = Birr 7000 a) R  P  n 
1 1 i  
r = 16%, i = 4%
 .04 
m=4 R  7000 8 
1  1 .04 
t = 2 years, n = 8 R = Birr 1,039.69
R =?
b) Interest accumulated = R (n) - A
= 1,039.69(8) - 7,000
= Birr 1317.52

c) Amortization schedule
Payment payment Interest Principal Balance
No. reduction
0 Birr 7,000.00
1 Birr 1,039.69 Birr 280.00 Birr 759.69 6,420.31
2 1,039.69 249.61 790.08 5,450.23
3 1,039.69 218.01 821.68 4628.55
4 1,039.69 185.14 854.55 3774.00
5 1,039.69 150.96 888.73 2885.27
6 1,039.69 115.41 924.28 1960.99
7 1,039.69 78.44 961.25 999.74
8 1,039.69 39.99 999.74 0.00
Birr 1,317.56

Mortgage Payments

31 | P a g e
 In atypical house purchase transaction, the home-buyer pays part of the cost in cash and
borrows the remained needed, usually from a bank or a savings and loan association.
The buyer amortizes the indebtedness by periodic payments over a period of time.
Typically, payments are monthly and the time period is long-30 years is not unusual.

Mortgage payment and amortization are similar. The only differences are
- The time period in which the debt/loan is amortized/repaid
- The amount borrowed.
- In mortgage payments m is equal to 12 because the loan is repaid from monthly
salary, but in amortization m may take other values.

In Mortgage payments we are interested in the determination of monthly payments.

Taking A = total debt

R = monthly mortgage payment
r = stated nominal rate per annum
n = 12 x t

R can be determined as follows:

 r / 12   i 
R A  n 
Or R A  n 
1 1 r / 12  1 1 i  

1 1 i  n 
Similarly A  R  
 i 

Example:

1. Mr. X purchased a house for Birr 115,000. He made a 20% down payment with the
balance amortized by a 30 yr mortgage at an annual interest of 12% compounded
monthly.

a) What is the amount that Mr. X should pay monthly so as to retire the debt at
the end of the 30th yr?
b) Find the interest charged.

Solution

32 | P a g e
 Selling price = Birr 115,000 r = 12% i= 1%
Down payment (20%) 23,000 m = 12
Mortgage (A) Birr 92,000 t = 30yrs n= 360
R =?

 i 
R A  n 
1 1 i  

 .01 
R  92,000  360 
1 1.01 
= 92,000 (.010286125)
= Birr 946.32

Interest = Actual payment – Mortgage (loan)

= (946.32 X 360) - 92000
= Birr 340,675.20 – 92,000
= Birr 248,675.20

2. Mrs. Y purchased a house for Birr 50,000. She made an amount of down payment and
pay monthly Birr 600 to retire the mortgage for 20 years at an annual interest rate of
24% compounded monthly.

Required: Find the mortgage, down payment, interest charged, and the percentage of the
down payment to the selling price.

Solution.

Selling price = Birr 50,000 Mortgage (A) = R [1- (1+i)-n]

Down payment =? i
Mortgage (A) =? = 600 [1- (1.02)-240]
R = Birr 600 0.02
r = 24% i = 2% = Birr 29,741.13
m = 12 Down payment = Selling price – mortgage
t = 20 n = 240 = 50,000 – 29,741.13
= Birr 20,258.87
Interest charged = actual payment- mortgage
= 600 x 240 - 29,741.13
= 144,000 - 29741.13
= Birr 114,258.87

33 | P a g e
 Down payment
Percentage of down payment = x100
Selling Pr ice
20,258.87
= x100
50,000
= 40.52%
3. Mr. Z has taken out a Birr 60,000, 20 year, 24% mortgage on his home.
a. How much will he pay each month to discharge this mortgage?
b. How much of the first payment is for interest and by how much does it reduce
the balance owed?
c. How much of the second payment is for interest and by how much does it
reduce the balance owed?

Solution.
a.  i 
R A  n 
1 1 i  
Mortgage (A) Birr 60,000
r = 24% i = 2%
 .02 
m = 12 R  60,000  240 
t = 20 years n = 240 1 1.02 
= 60,000(.020174
= Birr 1,210.44
b. Interest = 60,000 X .02
= Birr 1,200
Reduction from the balance owed = Monthly payment – Interest
= 1210.44 – 1200
= Birr 10.44

c. Interest = (60,000 – 10.44) x .02

= Birr 1199.79

Reduction from Balance owed = 1210.44 – 1199.79

= Birr 10.65

4. Ato Tefera purchased a house for Birr 250,000. He made a 20% down payment, with a
balance to be amortized by a 30-year mortgage at annual interest rate of 12%
compounded monthly.

a. Determine the amount of his monthly mortgage payment

b. What is the total amount of interest Ato Tefera will pay over the life of the
mortgage?

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 c. Determine the amount of the mortgage Ato Tefera will have paid after 10 years.
d. What will be Ato Tefera's equity in the house at the end of 10 years?

Solution
Selling price = Birr 250,000 b. Interest=?
Down payment(20%)= 50,000 = total payment - mortgage
Mortgage Birr 200,000 = 2,057.23 x 360 - 200,000
r = 12% i = 1% = 740,602.80 - 200,000
m = 12 = Birr 540,602.80
t = 30 years n = 360
c. After 10 years there will remain (20 x
a. R =? 12) = 240 monthly payments of Birr
 i  2,057.23 to be made. The amount of the
R A  
1 1 i  
n mortgage that is still unpaid at this time
is the PV of this series of payments, that
 .01 
R  200,000  240  is;
1 1.01  1 1.01240 
= Birr 2,057.23 A  2,057.23  
 .01 
d. Equity in house = down = Birr 186,836.43.
payment + paid amount Thus after 10 years Ato Tefera will have
= Birr 50,000 + 13,163.57 paid Birr 13,163.57 (Birr 200,000 -
= Birr 63,163.57 186,836.43) against the principal amount
of the mortgage.

5. Andinet and Florence are looking to purchase a home. They found one that they like that
costs Birr 150,000. They can get a 30-year mortgage at 9% and plan to make a down
payment of 20% of the selling price.
a. What will be their monthly mortgage payment?
b. When Andinet and Florence go to the bank, they are offered an annual percent rate
of 6% if they take a 15-year loan rather than one for 30 years. Andinet and Florence
are skeptical because they can't afford to make twice the payment calculated for 30
years. In actual fact, how much would their payment be if they repaid the mortgage
in 15 years?
c. Andinet is 25 years old and wants to be a millionaire by the time he is 50. He is
planning to put aside a sum of money at the end of each year sufficient to
accumulate a million Birr in 25 years using an interest rate of 10%. How much must
he put aside?
d. Considering your answer in part c above, suppose Andinet can only put aside Birr
10,000 per year. How high a rate of return must he realize to achieve his goal?

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