Mathematics for Economics

and Business

Chapter 3
Mathematics of Finance
 Contents
1. Percentages
2. Compound Interest
3. Geometric Series
4. Mathematics of Finance Applications: Investment
appraisal
 3.1

Percentages
 Objectives
1. Understand what a percentage is.
2. Solve problems involving a percentage increase or
decrease.
3. Write down scale factors associated with percentage
changes.
4. Work out overall percentage changes.
5. Calculate and interpret index numbers.
6. Adjust value data for inflation.
The word ‘percentage’ literally means ‘per cent’, i.e. per
hundredth
Whenever any numerical quantity increases or decreases, it is
customary to refer to this change in percentage terms.
In general, if the percentage rise is r% then the final value
consists of the original (100%) together with the increase
(r%), giving a total of
In general, the scale factor for an r% decrease is
We consider the calculation of overall percentage changes.
Applications of percentages in macroeconomics:

1. Index numbers
2. Inflation
 Index numbers

Economic data often take the form of a time series.

Values of economic indicators are available on an annual,

quarterly or monthly basis

We are interested in analysing the rise and fall of these numbers

over time.

Index numbers enable us to identify trends and relationships in the

data.
When finding index numbers, a base year is chosen and the
value of 100 is allocated to that year.
We take 2000 as the base year, so the index number of 2000 is
100.
To find the index number of the year 2001 we work out the
scale factor associated with the change in household spending
from the base year, 2000 to 2001, and then multiply the
answer by 100.
The following example shows the rise and fall of two share
prices during an 8-month period.

Notice that both shares are given the same index number of
100 in April, which is the base month. This creates ‘a level
playing-field’, enabling to monitor the relative performance of
the two shares.

The index numbers show quite clearly that share A has

outperformed share B during this period.
The index numbers of the output of a particular firm for the
years 2004 and 2005.
Table

The percentage from quarter 04Q2 to 05Q2:

The index number has increased by

which corresponds to an 8.4% increase.

The index numbers of the output of a particular firm for the
years 2004 and 2005.
Table

Similarly, the scale factor of the change from 04Q3 to 05Q1

is

which shows that the percentage decrease is 4.8%.

or 100-105=-5 and 5/105=0.04762 meaning a 4.762% decrease.
Table shows the unit costs of labour, energy, communications and
raw materials during a 3-year period.
In year 0, a firm used 70 units of labour, 25 units of energy, 10
units of communication and 140 units of raw materials.
Taking year 0 as the base year, we calculate an appropriate index
number for years 1 and 2.
Index numbers that are weighted according to the quantity
consumed in the base year are called L aspeyre indices.

Spreadsheets provide an easy way of presenting the

calculations.
 Inflation

Over a period of time, the prices of many goods and services

usually increase.

The annual rate of inflation is the average percentage change in a

given selection of these goods and services, over the previous year.

Seasonal variations are taken into account.

The presence of inflation is particularly irritating when trying to
interpret a time series that involves a monetary value.
Economists deal with this by distinguishing between nominal and
real data.

Nominal data are the original, raw data. These are based on the
prices that prevailed at the time.

Real data are the values that have been adjusted to take inflation
into account.
The price (in thousands of dollars) of an average house

1991 as the base year

At the end of 1992, the house is worth $93 000. However,
during that year inflation was 7.1%.
To adjust the price of the house in 1993 we first need to divide
by 1.035 to backtrack to the year 1992, and then divide again by
1.071 to reach 1991.

For the 1994 price, the adjusted value is

and, for 1990, the adjusted value is

The nominal and the ‘constant 1991’ values of the house
(rounded to the nearest thousand)

It shows quite clearly that, apart from the gain during

1991, the increase in value has, in fact, been quite modest.
 3.2

Compound Interest
 Objectives
1. Understand the difference between simple and
compound interest.
2. Calculate the future value of a principal under
annual compounding.
3. Calculate the future value of a principal under
continuous compounding.
4. Determine the annual percentage rate of interest
given a nominal rate of interest.
Suppose that someone gives you the option of receiving $500
now or $500 in 3 years’ time.
Which of these alternatives would you accept?

$500 is worth more today than in 3 years’ time.

Assume that the $500 is invested for 3 years at 10% interest

compounded annually.

At the end of each year, the interest is calculated and is

added on to the amount currently invested.

After 1 year, the amount rises by $50 to $550.

In general, if the interest rate is r% compounded annually
then the scale factor is

so, after n years,

A principal of $25 000 is invested at 12% interest compounded
annually. After how many years will the investment first exceed
$250 000?

We need to solve the equation

 taking logarithms to base 10

We need to wait until 21 years

Suppose that a principal of $500 is invested for 3 years at 10%
interest compounded quarterly.

It does not mean that we get 10% interest every 3 months.

Instead, the 10% is split into four equal portions, one for each
quarter.
Every 3 months the interest accrued is

so after the first quarter the investment gets multiplied by

1.025 to give

In 3 years
The type of compounding in which the interest is added on
with increasing frequency is called continuous com pounding.

The future value, S, of a principal, P, compounded

continuously for t years at an annual rate of r% is
A principal of $2000 is invested at 10% interest compounded
continuously. After how many days will the investment first
exceed $2100?

The amount
invested first
exceeds $2100 some
time during the
179th day.
For banks A, B and C, the future values can be worked out
using the formula

Bank D offers a return of 4.6% compounded continuously, so

after t years the future value is given by
Compound Interest

Year Bank A Bank B Bank C Bank D

0 10000 10000 10000 10000
1 10475 10480.64063 10473.17146 10470.74411
2 10972.5625 10984.38279 10968.73204 10963.64822
3 11493.75922 11512.33685 11487.74114 11479.7555
4 12039.71278 12065.66653 12031.30827 12020.15823
5 12611.59914 12645.59148 12600.59544 12586.0001
6 13210.6501 13253.38998 13196.81965 13178.47864
7 13838.15598 13890.40174 13821.25549 13798.84776
8 14495.46839 14558.03088 14475.23786 14448.42039
9 15184.00313 15257.74899 15160.1648 15128.57127
10 15905.24328 15991.09839 15877.50053 15840.73985
Compound Interest

Year Bank A Bank B Bank C Bank D

0 10000 10000 10000 10000
1 10475 10475.5225 10473.17146 10470.74411
2 10972.5625 10973.65716 10968.73204 10963.64822
3 11493.75922 11495.47925 11487.74114 11479.7555
4 12039.71278 12042.11516 12031.30827 12020.15823
5 12611.59914 12614.74483 12600.59544 12586.0001
6 13210.6501 13214.60433 13196.81965 13178.47864
7 13838.15598 13842.9885 13821.25549 13798.84776
8 14495.46839 14501.25375 14475.23786 14448.42039
9 15184.00313 15190.82099 15160.1648 15128.57127
10 15905.24328 15913.17871 15877.50053 15840.73985
It is difficult to appraise different investment opportunities.
What is needed is a standard ‘benchmark’. The one that is
commonly used is annual compounding.
All firms offering investment or loan facilities are required to
provide the effective annual rate.
This is often referred to as the annual percentage rate, which is
abbreviated to A PR .
The A PR is the rate of interest which, when compounded
annually, produces the same yield as the nominal (that is, the
stated) rate of interest.
The phrase ‘annual equivalent rate’ (AER) is frequently used when
applied to savings.
Determine the annual percentage rate of interest of a deposit
account that has a nominal rate of 8% compounded monthly.
A country’s annual GNP (gross national product), currently at
$25 000 million, is predicted to grow by 3.5% each year. The
population is expected to increase by 2% a year from its current
level of 40 million. After how many years will GNP per capita
(that is, GNP per head of population) reach $700?
A firm decides to increase output at a constant rate from its
current level of 50 000 to 60 000 during the next 5 years.
Calculate the annual rate of increase required to achieve this
growth.
 3.3

Geometric Series
 Objectives
1. Recognize a geometric progression.
2. Evaluate a geometric series.
3. Calculate the total investment obtained from a
regular savings plan.
4. Calculate the instalments needed to repay a loan.
Consider the following sequence of numbers:
2, 6, 18, 54, . . .

What is the next term in the sequence?

54 × 3 = 162 162 × 3 = 486 ... and so on.

Any sequence in which terms are calculated by multiplying their

predecessor by a fixed number is called a
geom etric progression and the multiplicative factor itself is
called a geom etric ratio.

The sequence above is a geometric progression with geometric

ratio 3.
For example, if a principal, $500, is invested at 10% interest
compounded annually, then the future values in successive
years are
2 3
500(1.1), 500(1.1), 500(1.1), . . .
which we recognize as a geometric progression with geometric
ratio 1.1.
The consecutive terms of a geometric progression added together
form what is called a geom etric series.

2 + 6 + 18 + 54 + 162 + 486 + ...

The sum of the first n terms of a geometric progression in which

the first term is a, and the geometric ratio is r, is equal to

2 + 6 + 18 + 54 + 162 + 486 =
 Application of geometric series involving savings

a sink ing fund

an equal amount of money is put into a savings account

at the same time each year (or month).

assume that the interest rate does not change

 Application of geometric series involving loans

Many businesses finance their expansion by obtaining loans from

a bank or other financial institution.

Banks are keen to do this provided that they receive interest as a

reward for lending money.

Businesses pay back loans by monthly or annual repayments.

Suppose interest is calculated on a monthly basis and that the firm repays the
debt by fixed monthly instalments at the end of each month.

The bank calculates the interest charged during the first month based on the
original loan.

At the end of the month, this interest is added on to the original loan and the
repayment is simultaneously deducted to determine the amount owed.

The bank then charges interest in the second month based on this new amount
and the process is repeated.

Provided that the monthly repayment is greater than the interest charged each
month, the amount owed decreases and eventually the debt is cleared.
Determine the monthly repayments needed to repay a $100 000
loan which is paid back over 25 years when the interest rate is
8% compounded annually.
The monthly repayment on a 25-year loan of $100 000 is
$780.66, assuming that the interest rate remains fixed at 8%
throughout this period.
The debt only falls by about $1500 to begin with, in
spite of the fact that over $9000 is being repaid each
year!
Total reserves of a non-renewable resource are 250 million
tonnes. Annual consumption, currently at 20 million tonnes
per year, is expected to rise by 2% a year. After how many
years will stocks be exhausted?
Current annual extraction of a non-renewable resource is 40 billion
units and this is expected to fall at a rate of 5% each year. Estimate
the current minimum level of reserves if this resource is to last in
perpetuity (that is, for ever).
 3.4

Mathematics of Finance
Applications:
Investment appraisal
 Objectives
1. Calculate present values under discrete and
continuous compounding.
2. Use net present values to appraise investment
projects.
3. Calculate the internal rate of return.
4. Calculate the present value of an annuity.
5. Use discounting to compare investment projects.
6. Calculate the present value of government
securities.
The following two formulas were used to solve compound interest
problems

P = principal
S = future value
r = interest rate
t = time
Of particular interest is the case where S, r and t are given, and P
is the unknown to be determined.
In this situation we know the future value, and we want to work
backwards to calculate the original principal.
This process is called discounting and the principal, P, is called
the present value.
The rate of interest is sometimes referred to as the discount rate.
Equations are rearranged to produce explicit formulas for the
present value under discrete and continuous compounding:
Find the present value of $1000 in 4 years’ time if the discount
rate is 10% compounded
(a) semi-annually
(b) continuously
The difference between the present value of the revenue and the
present value of the costs, is known as the net present value
(NPV ).

The internal rate of return (IR R ) is the annual rate which,

when applied to the initial outlay, yields the same return as the
project after the same number of years.
A project requiring an initial outlay of $15 000 is guaranteed to
produce a return of $20 000 in 3 years’ time.
Use the
(a) net present value
(b) internal rate of return
methods to decide whether this investment is worthwhile if the
prevailing market rate is 5% compounded annually. Would your
decision be affected if the interest rate were 12%?
Suppose that it is possible to invest in only one of two different
projects. Project A requires an initial outlay of $1000 and yields
$1200 in 4 years’ time. Project B requires an outlay of $30 000 and
yields $35 000 after 4 years.
Which of these projects would you choose to invest in when the
market rate is 3% compounded annually?
The results of this example show that the IRR method is an
unreliable way of comparing investment opportunities when
there are significant differences between the amounts
involved.

This is because the IRR method compares percentages, and

obviously a large percentage of a small sum could give a
smaller profit than a small percentage of a larger sum.
An annuity is a sequence of regular equal payments.
It can be thought of as the opposite of a sinking fund.
A lump sum is invested and, subsequently, equal amounts of
money are withdrawn at fixed time intervals.
Provided that the payments themselves exceed the amount of
interest gained during the time interval between payments, the
fund will decrease and eventually become zero.
At this point the payments cease.

In practice, we are interested in the value of the original lump sum

needed to secure a regular income over a known period of time.
Find the present value of an annuity that yields an income of
$10 000 at the end of each year for 10 years, assuming that the
interest rate is 7% compounded annually.
What would the present value be if the annuity yields this income in
perpetuity?
This represents the amount of money that needs to be invested
now so that a regular annual income of $10 000 can be
withdrawn from the fund for the next 10 years.
The argument used in the previous example can be used to
calculate the net present value.

For instance, suppose that a business requires an initial

investment of $60 000, which is guaranteed to return a regular
payment of $10 000 at the end of each year for the next 10 years.

If the discount rate is 7% compounded annually then the previous

example shows that the present value is $70 235.82.

The net present value of the investment is therefore

$70 235.82 − $60 000 = $10 235.82
A similar procedure can be used when the payments are
irregular, although not using the formula for the sum of a
geometric progression.

A small business has a choice of investing $20 000 in one

of two projects. The revenue flows from the two projects
during the next 4 years are listed in. If the interest rate is
11% compounded annually, which of these two projects
would you advise the company to invest in?
To compare these projects we need to discount the revenue
stream to the present value. The present values obtained depend
on the discount rate. Table shows the present values based on the
given rate of 11% compounded annually.
The net present values for Project A and Project B are given
by
$20 422.67 − $20 000 = $422.67

and
$21 109.19 − $20 000 = $1109.19
respectively.

Consequently, if it is possible to invest in only one of these

projects, the preferred choice is Project B.
(a) Calculate the IRR of a project which requires an initial outlay
of $20 000 and produces a return of $8000 at the end of year 1
and $15 000 at the end of year 2.
(b) Calculate the IRR of a project which requires an initial outlay
of $5000 and produces returns of $1000, $2000 and $3000 at the
end of years 1, 2 and 3, respectively.
We merely substitute likely solutions into the right-hand side of
the equation until we find the one that works. For example,
putting r = 5 gives
To obtain a more accurate estimate of IRR, we return to the
spreadsheet and add more columns for interest rates near 7%.
A 10-year bond is originally offered by the government at
$5000 with an annual return of 9%. Assuming that the bond
has 4 years left before redemption, calculate its present value
assuming that the prevailing interest rate is
(a) 5% (b) 7% (c) 9% (d) 11%

(e) 13%
Let us suppose that the interest rate is high at, say, 13%. The
price of the bond is relatively low.
Moreover, one might reasonably expect that, in the future,
interest rates are likely to fall, thereby increasing the present
value of the bond. In this situation an investor would be
encouraged to buy this bond in the expectation of not only
receiving the cash flow from holding the bond but also
receiving a capital gain on its present value.

Speculative balances therefore decrease as a result of high

interest rates because money is converted into securities.
Exactly the opposite happens when interest rates are low.
The corresponding present value is relatively high, and, with an
expectation of a rise in interest rates and a possible capital loss,
investors are reluctant to invest in securities, so speculative
balances are high.