CHAPTER 4:

MATHEMATICS OF FINANCE
TIME VALUE OF MONEY (TVM)

 Money received in the present

is more valuable than the same
sum received in the future.
 Present value is the value of money today;
 future value is the value of money at some
point in the future.
 Difference – interest - price paid for the use
of a sum of money over a period of time.
 Interest –fee paid for the use of another’s
money
INTEREST

 Computed as percentage of the

principal over a given period of time.
 % - interest rate.
 Interest rate - rate at which interest
accumulates per year throughout the
term of the loan.
 The original sum - principal.
INTERESTS

1. Simple interest and

2. compound interest.
SIMPLE INTEREST
 Interest paid on the initial amount of money
not on subsequently accumulated interest.
 Used only on short-term investments –less than
one year.

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).
 Principal and total interest = future
amount / maturity value /
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.
2 . How long will it take if Br. 10, 000 is
invested at 5% simple interest to double
in value?
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

 Interest due is added to the

principal at the end of each interest
period and this interest as well as
the principal will earn interest
during the next period.
 The interest is said to be
compounded.
COMPOUND INTEREST
 Starts with the second compounding period
 Interest paid on interest reinvested is called
compound interest.
 Original principal + interest earned = compound
amount.
 Compound amount - original principal =
compound interest.
 COMPOUND ….
 Used in long-term borrowing unlike simple interest.
 Time interval between successive conversions of
interest into principal - interest period/conversion
period/ compounding period
 Interest rate is usually quoted as an annual rate -
converted to appropriate rate per conversion period
 The rate per compound period (i) = annual
Nominal Rate (r) divided 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
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
 PRESENT VALUE:
 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?
EFFECTIVE RATE
 Simple interest rates that produce the same return
in one year had the same principal been invested
at simple interest without compounding.
 Or it is 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.
 Time between successive payments
-payment period for the annuity.
 Payments = at the end of each
payment period - ordinary annuity.
ANNUITY ….

 Payment at the beginning - annuity

due.
 Amount = All payments + interest during
the term of the annuity.
 Term of an annuity - time from the
begging of the first payment period to
the end of the last payment period.
 ORDINARY ANNUITY
 First payment is not considered in interest calculation for
the first period.
 Last payment does not qualify for interest - value of 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
 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.
 Established 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?
AMORTIZATION
 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.
 Examples of amortization - 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 annual payment be in
order to retire the debt including the interest
in 10 years?
 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
 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
 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