CHAPTER

1
Mathematics of Finance

1.1. INTRODUCTION

In this chapter we will discuss mathematical methods and formulae which are helpful in business and personal finance. One of the fundamental concepts in the mathematics of finance is the time value of money, i.e., the value of a particular sum of money at different points of time. For example, if you have Rs. 100 today, what will it be worth at the end of one year?
1.1.1. Simple Interest (S.I.)

When we take loan from Bank for a certain period we pay off the loan and a certain sum of money to the Bank for the use of the money lent. The loan amount is called the Principal and the additional amount paid for the use of the loan is called Interest. The sum of the principal and the interest due at the end of the period is called the Amount, i.e., Amount = Principal + Interest. The borrower is called the Debtor and the lender is called the Creditor. If Rs. 10 is paid as interest on Rs. 100 for 1 year, the rate of interest is said to be 10% p.a. Simple Interest (S.I.) is the interest on the principal alone for the time for which it is used. S.I. on the principal P for N years at the rate of R% p.a. is given by: S.I. = P.N.
R R , where i = or R = 100i; and the amount (A) is given by: 100 100

A 1 + Ni Unless otherwise stated the interest is always calculated yearly. Example 1.1. (i) Find the simple interest on Rs. 1,000 for 10 years at 10% p.a.

A = P + S.I. = P + P.N. i = P (1 + Ni) or P =

(ii) At what rate percent will Rs. 1,000 amount to Rs. 1,500 in 2 years? (iii) What principal will amount to Rs. 3,000 in 5 years at 20% p.a. S.I.? (iv) In what time will Rs. 1,200 amount to Rs. 3,600 at 10% p.a. S.I.?
Answer: (i) Interest on Rs. 100 for 1 year Interest on Rs. 1 for 1 year Interest on Rs. 1,000 for 1 year = Rs. 10 = Rs. = Rs. 10 100 10 1,000 100

2 Financial Mathematics 10 1,000 10 = Rs. 1,000 100 Here P = Rs. 1,000, A = Rs. 1,500, N = 2 years Interest on Rs. 1,000 for 10 years = Rs. Now, A = P (1 + Ni) or, 1,500 = 1,000 (1 + 2i) or, 1+ 2i = 1.5 or i = Again, i = (iii) R 100 R = 100 0.25 = 25 20 = 0.2 100 or, P = 3,000 = Rs. 1,500 2 2 = 20 years. 0.1 0.5 = 0.25 . 2

(ii)

Here, A = Rs. 3,000, N = 5 years, i = Now, A = P (1+ Ni),

or, 3,000 = P (1+ 5 0.2),

(iv)

Here, P = Rs. 1,200, A = Rs. 3,600, i = 10% = 0.1 Now, A = P (1+ Ni), or, 3,600 = 1,200 (1+ N 0.1) or, 3 = 1+ 0.1N or N =

1.2. COMPOUND INTEREST (C.I.)

If the interest, as and when it becomes due, is added to the principal and the whole amount produces interest for the subsequent period, then it is called compound interest. The period after which the interest becomes due is known as interest period. Interest is compounded monthly, quarterly, half-yearly, yearly etc., if it is specifically mentioned. If this is not given in the problem we assume that the interest is payable yearly. Example 1.2. (i) Find the difference between Simple and Compound interests on Rs. 3,000 invested for 3 years at 6% p.a., interest payable annually. (ii) What is the present value of Rs. 1,000 due in 2 years at 6% p.a., compound interest payable half-yearly? (iii) What rate of interest p.a., does a man get who is paid @ 6% compound interest payable 1/2 yearly. (iv) Find the compound interest on Rs. 1,000 @ 4% for the first year, 5% for the second year and 6% for the third year.
Answer: (i) Simple Interest = PNi = Compound Interest: Principal (Original) Interest for 1st year Principal for 2nd year Interest for 2nd year Principal for 3rd year Interest for 3rd year Amount in 3 years Compound Interest Compound Interest Simple Interest = Rs. 3,000.00 = = = = = 180.00 3,180.00 190.80 3,370.80 202.25 = Rs. 3,573.05 = Rs. 3573.05 3000 = 573.05 PNR 3,000 3 6 = = Rs. 540 100 100

= Rs. (573.05 540) = Rs. 33.05

Mathematics of Finance (ii) Let, Principal (original) Interest for 1st 1/2 year Principal Interest for 2nd 1/2 year Principal Interest for 3rd 1/2 year Principal Interest for 4th 1/2 year Amount in 2 years = = = = = = = = = Rs. 100.00 3.00 103.00 3.09 106.09 3.18 109.27 3.28 Rs. 112.55
Rs. 100 1,000 112 .55 Rs. 888.49 Rs. 100.00 3.00 103.00 3.09 Rs. 106.09

The required principal or present value

= =

(iii)

Let, Principal (original) Interest for 1/2 year Principal Interest for 1/2 year

= = = =

(iv)

Compound interest = Rs. (106.09 100.00) = Rs. 6.09 The required rate of interest = 6.09% Principal (original) Interest for 1st year @ 4% Principal for 2nd year Interest for 2nd year @ 5% Principal for 3rd year Interest for 3rd year @ 6% Amount in 3 years = Rs. 1,000.00 40.00 1,040.00 52.00 1,092.00 65.52 1,157.52

The required compound interest = Rs. (1,157.52 1,000) = Rs. 157.52

1.3. FORMULA FOR COMPOUND INTEREST

Let, P = Principal, N = No. of years or interest periods, i = Interest on unit sum for 1 interest period or 1 year, A = Amount and I = Total interest. Now, Principal = P Interest in the 1st period Amount in 1st period, or Principal for 2nd period Interest for 2nd period = Pi = P (1+ i) = P (1+ i) i

4 Financial Mathematics

Amount in the 2nd period or Principal for 3rd period Interest for 3rd period Amount in the 3rd period A = Amount in N periods If R is the rate per cent, then A = P 1 +

= P (1+ i) + P (1+ i) i = P (1+ i)2i = P (1+ i)2+ P (1+ i)2 i

= P (1+ i) {1+ i} = P (1+ i)2

= P (1+ i)2 {1+ i} = P (1+ i)3 and so on. = P (1+ i)N ...(1)

FH

R 100

IK

, i.e., in compound interest the amounts at the

end of different years are in G.P. In formula (1), P is called the present value of the sum A due in N periods.
P= A = A (1 + i ) N N (1 + i )

...(2) ...(3)

I = Compound Interest = A P = P (1+ i)N P = P {(1+ i)N 1}

N N Cor. 1. If (1+ i) = I1, i.e., I1 = Amount of principal 1 in 1 period, then A = P I1 and I = P{I1 1}

Hence, for the compound interest, the amount increases in geometric progression. Cor. 2. From equation (1), log A = log P+ N log (1+ i). If we know any three of the four unknowns A, P, N, i, we can find the other. Cor 3. In case of uniform decrease, we use i instead of i in all the above formulae for compound interest. Hence, for depreciation at compound rate, we apply the formula, A = P (1 i)N Similarly, if P = Present population of a country and R% = Rate of decrease of population p.a., then population after N years = P 1

F H

R 100

I K

Cor. 4. We use the following formulae:

(iii) A = P 1 +

F iI H 12 K F iI (iv) A = P 1 + H 365 K

F iI H 2K i (ii) A = P F1 + I H K
(i) A = P 1 +

2N

, when interest is paid half-yearly.

4N

, when interest is paid quarterly.

12 N

, when interest is paid monthly.

365 N

, when interest is paid daily.

Mathematics of Finance

Cor. 5. If i is the normal rate of interest on Re. 1 for 1 year and the interest is convertible b times a year, then the effective rate of interest is

100

RF1 + i I 1U SH b K V T W
b

Note 1: In compound interest calculations, the principal and interest vary for each unit of time. The interest for any unit of time again earns interest at the same rate over subsequent units of time. Hence principal for any unit of time is the amount due at the end of previous unit of time. Unit of time is known as the conversion period. Note 2: The rate of interest R% p.a. compounded at given number of times per year is known as nominal rate. The rate of interest R% p.a. which if compounded yearly would yield the same amount of interest as r% rate compounded m times per year, then R% is called the effective rate. For example, if a man borrows Rs. 100 at 10% p.a. compounded half-yearly, then 10% p.a. is the nominal rate and 100 1 +

LM F NM H

10 200

I K

100 = 10.25% is

OP QP

the effective rate (here N = 1). If the nominal rate is compounded annually, then the nominal rate of interest becomes equal to the effective rate.

Cor. 6. If the rate of interest is different for each year, e.g., r1, r2, r3 for the first, second and third years respectively, then the amount after 3 years is given by:
A = P 1+
Note 3: The compound interest law A = P 1 +

F H

r1 100

I F1 + r I F1 + r I . K H 100 K H 100 K
2 3

F H

R 100

I K

applies to any quantity which increases or decreases so that

amount at the end of each period of constant length bears a constant ratio to the amount at the starting of that period. This ratio is known as growth factor if it is more than 1, and decay factor if less than 1. For example, if the population of a city steadily increases by 3% p.a. of the population at the beginning of each year, then the yearly growth factor will be 1.03 and the population after N years will be (1.03)N times the population at the beginning of the period. Again, if the value of the machinery depreciates steadily by 12% p.a. of its value at the beginning of each year, then the yearly decay factor will be (1 0.12) = 0.88 and the value after N years will be (0.88)N times its value when new.

Example 1.3. (i) The simple interest on a sum of money in one year is Rs. 50 and compound interest in two years is Rs. 102. Find the principal and the rate of interest. (ii) A machine is depreciated at the rate of 10% on reducing balance. The original cost was Rs. 10,000 and the ultimate scrap value was Rs. 3,750. Find the effective life of the machine.
[B.Com. (C.U.), 1966, B.Com. (B.U.), Hons. 1990]

(iii) Find in what time a sum of money will double itself at 5% interest compounded annually [log 2 = 0.3010; log 105 = 2.0212] (iv) The machinery in a factory is valued at Rs. 24,537 and it is decided to reduce the estimated value at the end of each year by 18% of the value at the beginning of that year. When will the value be Rs. 20,000? (v) A man left Rs. 18,000 with the direction that it should be divided in such a way that his 3 sons aged 9, 12, 15 years should each receive the same amount when they would reach the

6 Financial Mathematics

age of 25 years. If the rate of compound interest is 3.5% p.a., what should each son receive when he is 25 years old? (vi) When a boy is born, Rs. 500 is placed to his credit in an account that pays @ 6% compounded annually, (b) 6% compounded quarterly, (c) 6% compounded monthly. If the account is not distributed, what amount will there be to his credit on his twentieth birthday?
(ICWAI, Dec. 1979)

(vii) A truck purchased by a transport company at Rs. 60,000 depreciates at the rate of 10% p.a. and its maintenance cost for the first year is Rs. 2,000 which increases by 2% every year. If the scrap value realised when sold is Rs. 35,429.40, find the minimum average annual return from the truck the company should get so as not to sustain any loss.
[ICWAI, Jan. 1978]

(viii) A man borrowed Rs. 20,000 from a money-lender but he could not repay any amount for a period of 4 years. Accordingly, the money lenders demand showed Rs. 26,500 due from him. At what rate per cent p.a. C.I. did the money lender lend his money? [Given: log 2.65 = 0.4232, log 2 = 0.3010, log 1073 = 3.0306] [C.A. (Ent), Nov. 1991]
Answer: (i) S.I. = PNi, or, PNR , where P = Principal, N = Number of Years, 100 i = Interest on Re. 1 for one year Compound Interest for 2 years = P{(1+ i)2 1} = P {i2 + 2i} = Pi (2 + i) Now, Pi = 50 ...(1) and Pi (i + 2) = 102 ...(2) From (2), 50 (i + 2) = 102, or, i + 2 = From (1), P = 50 = Rs. 1,250 0.04 R 102 = 2.04 i = 2.04 2 = 0.04 = 100 50 R = 4%

The required principal and the rate of interest are Rs. 1,250 and 4% respectively. (ii) Let the effective life of the machine be N years. For depreciation at constant rate, A = P (1 i)N Here, P = Rs. 10,000, A = Rs. 3,750, i = 10 100 = 10,000 1 = (0.9)N = N log 0.9 = N 1.9542 = N (1 + 0.9542) = N 0.0458 N= 0.426 = 9.3 years 0.0458 ...(1)

From (1), 3,750 or, 0.375 or, log 0.375 or, 1.5740 or, (1 + 0.5740) or, 0.426 or,

F H

10 100

I K

Mathematics of Finance 5 100

(iii)

If P = Rs. 100, then A = Rs. 200, i =

Now, A = P (1 + i)N or, 200 = 100 (1 + 0.05)N or, 2 = (1.05)N, or, log 2 = N log 1.05 or, log 2 = N (log 105 log 100) or, 0.3010 = N (2.0212 2), or, N = (iv) Here, P = Rs. 24,537, A = Rs. 20,000, i = 0.18 Now, A = P (1 i)N or, 20,000 = 24,537 (1 0.18)N or, 0.8151 = 0.82N, or, log 0.8151 = N log 0.82 or, 1.9113 = N 1.9138 or, (1 + 0.9113) = N (1 + 0.9138) or, N = (v) 0.0887 = 1.03 years 0.0862 0.3010 = 14.2 years. 0.0212

Let the sons aged 9, 12 and 15 years receive Rs. P1, Rs. P2 and Rs. P3 respectively. Again, each of them receive Rs. P at the age of 25 years. P1+ P2+ P3 = 18,000 For the son aged 9 years, P = P1 1 + Similarly, " " ...(1)

F H

3.5 100

I K

25 9

= P1 (1.035)16

" 12 years, P = P2 (1.035)13 " 15 years, P = P3 (1.035)10 ...(2)

From (1), P(1.035)16 + P(1.035)13 + P(1.035)10 = 18,000 Now, (1.035)16 = x (say) or,16 log 1.035 = log x or, 16 0.0149 = log x or, 0.2384 = log x or, or, Similarly, using logarithm we get,

1.7616 = log x
x = 0.5776

(1.035)13 = 0.6401 (1.035)10 = 0.7096 From (2) P(0.5776 + 0.6401 + 0.7096) = 18,000 or, (vi) (a) Here Now or, or, P= 18,000 = Rs. 9,339.49. 1.9273

P = Rs. 500, i = 0.06, N = 20 A = P (1 + i)N A = 500 (1.06)20 log A = log 500 + 20 log 1.06 = 2.6990 + 20 0.0253 = 3.2050

(b) Now,

A = Antilog 3.2050 = Rs. 1,603. A = P 1+

F H

i 4

I K

4N

= 500 (1 + 0.015)80 or, log A = log 500 + 80 log 1.015 = 2.6990 + 80 0.0064 = 3.2110 A = Antilog 3.2110 = Rs. 1,626.

8 Financial Mathematics

(c)

Now

A = P 1+

F H

i 12

I K

12 N

= 500 (1 + 0.005)240 or, log A = log 500 + 240 log 1.005 = 2.6990 + 240 0.0021 = 3.2030 Now, or, or, or, or, or, or, or, The maintenance cost for 5 years: Minimum return required for no loss: A = Antilog 3.2030 = Rs. 1,596. A = P (1i)N 35,429.40 = 60,000 (10.1)N 0.5905 = 0.9N log 0.5905 = N log 0.9
1 .7713 = N 1 .9542

(vii) Here, P = Rs. 60,000, i = 0.1, A = Rs. 35,429.40, the truck is sold after N years.

(1+ 0.7713) = N (1 + 0.9542) 0.2287 = N (0.0458) N = 4.99 5 years = Rs. [2,000 + 2,040 + 2,080.8 + 2,122.42 + 2,164.86] = Rs. 10,408.08 = Rs. (60,000 + 10,408.08) Rs. 35,429.40 = Rs. 34,978.68.
Rs. 34,978.68 = Rs. 6,995,74. 5

Average minimum yearly return required for no loss =

(viii) If r% p.a. is the rate at which the money-lender lends his money, then 26,500 = 20,000 (1 + r/100)4; or log 26,500 r = log 20,000 + 4 log (1 + r/100) or, 4.4232 = 4.3010 + 4 log (1 + r/100); or, 4 log 1 + = 0.1222; or, log 100

F H

I K

(1 + r/100) = 0.0306; or (1 + r/100) = 1.073; or r/100 = 0.073, or r = 7.3%.

Example 1.4. (i) A sum of money put out at simple interest amounts to Rs. 690 in two years and to Rs. 757.50 in 3 years. Find the sum invested and the rate of simple interest.
[ICWAI (Prel.), June 1992, Dec. 1993]

(ii) Two equal sums are lent at 6.75% and 4.5% simple interest per annum respectively. If the former is recovered two years earlier than the later and the amount in each case is Rs. 1,905. Find the sum lent in each case. [B.Com. (Bangalore), Nov. 1992] (iii) A pressure cooker is available for Rs. 250 cash or Rs. 100 cash down payment followed by Rs. 165 after six months. Find the rate of interest charged under the instalment plan.
[ICWAI (Prel.), Dec. 1992, Dec. 1993]

(iv) Ram deposited a sum of Rs. 10,000 in a bank. After 2 years, he withdrew Rs. 4,000 and at the end of 5 years he received an amount of Rs. 7,520. Find the rate of simple interest.
[ICWAI (Prel.), June 1990]

(v) If I ask you for a loan and agree to repay you Rs. 300 after nine months from to-day, how much should you loan me if you are willing to make the loan at the rate of 6% p.a.?
[ICWAI (Prel.), June 1986]

Mathematics of Finance

(vi) A sum of Rs. 1,200 becomes Rs. 1,323 in 2 years at compound interest compounded annually. Find the rate per cent. [ICWAI (Prel.), Dec. 1990, June 1993] (vii) If the population of a town increases every year by 2 per cent of the population at the beginning of that year, in how many years will the total increase of population be 40%?
[B.Com. (C.U.), Hons. 1990]

(viii) A sum of Rs. 1,000 is invested for 5 years at 12% interest per year. What is the simple interest? If the same amount had been invested for the same period at 10% p.a. compound interest compounded per year, how much more interest would he get?
[ICWAI (Prel.), June 1987]

(ix) On what sum the difference between simple and compound interest for 3 years at the rate of [ICWAI (Prel.), Dec. 1993] 20% is Rs. 1,600? (x) A man deposits Rs. 5,000 in a Savings Bank which pays compound interest at the rate of 4 % for first two years and then at the rate of 5% p.a. for next three years. Find his amount after 5 years. [B.Com. (C.U.), 1981] (xi) A machine depreciates at the rate of 7% of its value at the beginning of a year. If the machine was purchased for Rs. 8,500, what is the minimum number of complete years at the end of which the worth of the machine will be less than or equal to half of its original cost price? [ICWAI, Dec. 1976] (xii) A man wishes to have Rs. 2,500 available in a bank account when his daughters first year college expenses begin. How much must he deposit now at 3.5% compounded annually, if the girl is to start in college six years from now? [ICWAI, Dec. 1982] (xiii) A machine, the life of which is estimated to be 10 years, costs Rs. 10,000. Calculate the scrap value at the end of its life, depreciation on the reducing instalment system being charged at 10% p.a. [Given: log 30 = 1.4771 and log 3.483 = 0.5420] [CA (Ent.), May 1991]
Answer: (i) Let, P = Principal and R = Rate of simple interest Rs. 690 = P (1 + 2i) Rs. 757.50 = P (1 + 3.5i) From (1) and (2), ...(1) ...(2)

690 757.50 = or, 690 + 2,415i = 757.50 + 1,515i or, 900i = 67.5, or, i = 0.075, i.e., 7.5%. 1 + 2i 1 + 3.5i
690 = Rs. 600. 115 .

From (1), 690 = P (1 + 2 0.075) or, P =

(ii) Let Rs. P = Two equal sums, and sums at 6.75% and 4.5% S.I. p.a. be recovered after n years and (n + 2) years respectively. P 1+ n

F H

P 1+ n + 2

LM b N

6.75 = Rs. 1,905 100

I K

...(1)

4.5 = Rs. 1,905 100

OP Q

...(2)

From (1) and (2), 1 +

6.75 n 4.5 n + 9 or, 100 + 6.75n = 100 + 4.5n + 9 or, 2.25n = 9 n = 4 years = 1+ 100 100

10 Financial Mathematics

From (1), P 1 +

F H

1,905 4 6.75 = Rs. 1,500. = 1,905 or, P = 1.27 100

I K

(iii) Interest on Rs. 150 [i.e., Rs. (250 100)] for 6 months = Rs. (165 150) = Rs. 15. S.I. on Rs. 150 for 1 year = Rs. (15 2) = Rs. 30. % of interest =

Rs. 30 100 = 20%. Rs. 150

(iv) Total interest received by Ram = Rs. (7,520 6,000) = Rs. 1,520. If R% p.a. = Rate of interest, then S.I. on Rs. 10,000 for 2 years =
10,000 2 R = Rs. 200 R 100

Again, principal after 2 years = Rs. (10,000 4,000) = Rs. 6,000 S.I. on Rs. 6,000 for 3 years =
6,000 3 R = Rs. 180 R 100

Total interest = Rs. (200 + 180) R = Rs. 1,520 or, R = 4%.

(v) Let Rs. P be the loan. Amount = Rs. P 1 +

F H

Rs. 300 400 3 6 = Rs. 300 or, P = = Rs. 287.08. 418 4 100

I K

LM N

N=

9 3 = year 12 4

OP Q

(vi) Here, P = Rs. 1,200, A = Rs. 1,323, N = 2, i = ? 1,323 = 1,200 (1+ i)2 or, (1 + i )2 =
1,323 = 11025 . 1,200

Taking logarithms of both sides, we get 2 log (1 + i) or, or, (vii) Let P log (1 + i) i = log 1.1025 = 0.0213 or, or, 2 log (1 + i) = 0.0426 (1 + i) = Antilog 0.0213 = 1.051

= 0.051 and R = 100 0.051 = 5.1%.

= Original population = 100 A = 100 + 0.4 100 = 140 Here, i =

2 2 , N = ? 140 = 100 1 + 100 100

F H

I K

or, 1 + or, N =

F H

2 100

I K

= 1.40 or, N log 1.02 = log 1.40 or, N 0.0086 = 0.1461

0.1461 = 16.99 17 years. 0.0086

(viii) S.I. on Rs. 1,000 for 5 years @ 12% p.a. = Rs.

1,000 5 12 = Rs. 600. 100

Compound interest on Rs. 1,000 for 5 years @ 10% p.a. = 1,000

RF1 + 10 I 1U = 1,000 n(11) 1s . SH 100 K V T W

5 5

Mathematics of Finance 11 [Let, x = 1,000 (1.1)5 or, log x = log 1,000 + 5 log 1.1 or, log x = 3 log 10 + 5 0.0414 = 3 + 0.2070 or, x = Rs. 1,611] Compound interest = Rs. {1,000 (1.1)5 1,000} = Rs. (1,611 1,000) = Rs. 611. Difference = Rs. (611 600) = Rs. 11.

(ix) Let, Rs. 100 = Sum of money S. I. = Rs. 100 3

I K R 20 I 1U Compound Interest (C.I.) = P n(1 + i ) 1s = Rs. 100 SF1 + W TH 100 K V RF 6 I U R 216 1U = Rs. 9,100 = Rs. 72.80 = Rs. 100 SH K 1V = Rs. 100 S 125 W T 125 V T5 W
20 = Rs. 60 100
3 N 3

F H

C.I. S.I. = Rs. (72.80 60) = Rs. 12.80 Difference is Rs. 12.80 when sum of money is Rs. 100 " " Re. 1 Rs. 1,600 " " " " Rs. 100 12.80 100 1,600 12.80

= Rs. 12,500. (x) Amount after 5 years = Rs. 5,000 1 +

LM NM

FG H

4.5 100

IJ OP FG1 + 5 IJ K QP H 100 K
2

= Rs. [5,000 (1.045)2] (1.05)3.

= Rs. [5,000 1.092025] 1.157625 = Rs. (5,460.125 1.157625) = Rs. 6,320. (xi) For depreciation at compound rate: A = P (1 i)N Here P = Rs. 8,500, i = 7% = 0.07, A Rs.

F 1 I 8,500, N = ? H 2K
1 8,500 2

N A = 8,500 (1 0.07)N = 8,500 (0.93)N. Again, 8,500 (0.93)

N or, ( 0.93)

1 or, N log 0.93 log 0.5 or, N 1 9685 1 6990 or, N (1 + 0 9685) ( 1 + 0.6990 ) 2 0.3010 = 9.56 10 years. 0.0315

or, N ( 0 0315) 0.3010 or, N

Minimum number of complete years = 10. (xii) Let P be the money deposited now. Here, A = Rs. 2,500, i = 3.5% = 0.035, N = 6, P = ? 2,500 = P (1+ 0.035)6 or, log 2,500 = log P + 6 log 1.035 or, log P = 6 log 1.035 + log 2,500 or, log P = 6 (0.0149) + 3.3979 or, log P = 3.3085 or, P = Antilog 3.3085 = Rs. 2,034.

12 Financial Mathematics (xiii) A = Scrap value = P (1 i)N = 10,000 (1 0.1)10 = 10,000 (0.9)10 Let x = 0.910; log x = 10 [log 9 log 10] = 10 [2 log 3 1] = 10 [2 0.4771 1] = 10 [0.9542 1] = 0.458 = 1 + 1 0.458 = T.542 = log 0.3483 x = 0.3483; A = Rs. (10,000 0.3483) = Rs. 3,483.

1.4. SOME RELATED TERMS

(i) Exact Time, Exact Interest, Ordinary Interest: In many transactions, the time may be given in months, weeks or days. But in the simple interest formula, N must be expressed in years. Thus, months, weeks or days are to be converted into years, e.g.,
4 1 13 1 = year, 13 weeks = = year. 12 3 52 4 When an annual simple interest rate and the time d in days are given, the following methods are used to convert days into years:

4 months =

(1) If N (in years) = (2) If N (in years) =

d ( in days) , then the interest is said to be exact. 365

d ( in days) , then the interest is said to be ordinary. 360

The exact number of days between the date of deposit and date of interest calculation is referred to as exact time. For example, the exact time in days from February 1, 2001 to March 10, 2001 is the exact number of days between the two dates. Since 2001 is not a leap year, the exact time will be as follows: No. of remaining days in February 28 1 = 27 No. of days in March = 10 Exact time 37 days Illustration 1.1. A borrows Rs. 2,000 on June 1, 2001, for 60 days. The simple interest rate is 5%. (1) Calculate the exact simple interest. (2) Calculate the ordinary simple interest.
Answer: (1) Here, P = Rs. 2,000, i = 0.055, N = (2) Here N = 60 60 = Rs. 18.08. year. Exact S.I. = Rs. 2,000 0.055 365 365

1 60 1 = year Ordinary S.I. = Rs. 2,000 0.055 = Rs. 18.33. 6 360 6

(ii) Equations of Value, Time Value of Money and S.I.: Consider a case when A borrows Rs. 100 from B at 5% S.I. and agrees to pay Rs. 50 on the loan in 6 months. What payment 1 year from now will settle the debt?

Mathematics of Finance 13

Set up the information on a time diagram as follows: Rs. 100 (Money borrowed) 6 months 12 months Rs. 50 x (Payment in 12 months) For this type of problem where payments are made at different dates, we need the following fundamental principle of mathematics of finance: Equation of Value; i.e., Value of loan at focal date = Value of payments at focal date Focal date is the particular date at which amounts of money payable at different times can only be compared. Focal date is fixed by the lender and the borrower. (a) In this problem, if the focal date is chosen 1 year from now, then the value of each sum of money must be calculated at the focal date as follows: Value of loan at focal date = Value of payments at focal date.
Value of Rs. 100 at focal date = Value of Rs. 50 at focal date + Value of x at focal date
Rs. 100 1+0.05 1 = Rs. 105.00 Rs. 50 1+0.05

LM N

FG 1 IJ OP = Rs. 51.25 H2KQ

+ x (No shift of time)

or, x = Rs. 53.75 [Focal date at 12 months]. (b) In this problem, if the focal date is chosen 6 months from now, then the equation of value will be as follows:
Value of Rs. 100 at focal date = Value of Rs. 50 at focal date + Value of x at focal date
A=P (1+Ni), Rs. 100 1+0.05

LM N

FG 1 IJ OP = Rs. 102.5 H2KQ

Rs. 50 (No shift of time)

x 1+ 0.05

FG 1 IJ , i.e. 1.025 H 2K

A x or, = 52.5 or, x = Rs. 53.8125 1.025 (1 + Ni) The time diagram will be as follows: Focal date 100 102.5 i. e. P =

6 (months) 50
x 1.025

12 (months) x

Thus, different focal dates give different values of x. This difference will exist in simple interest transactions and hence it is important for the parties concerned to agree on the focal date.

14 Financial Mathematics

Illustration 1.2. A borrows Rs. 200 now and agrees to pay Rs. 50 after 2 months and Rs. 70 after 6 months. What final payment should A make 18 months from now to settle this debt if the S.I. rate is 10% and the focal date is now?
Answer: Let Rs. x be the final payment in the following time diagram. The values of the loan and payments at the focal date are shown in Table 1.1. Value of money at focal date 200 Focal date Rs. 200 0 49.02 66.67 x 115 . 2 Rs. 50 6 Rs. 70 12 18 (months) Rs. x

(Time diagram) Table 1.1

Rs. 200 50

Formula to use No shift in time P= A 1 + Ni

Value at focal date (Rs.) 200

50 1 + 0.1

FG 2 IJ = 49.02 H 12 K FG 6 IJ = 66.67 H 12 K
x

70

P=

A 1 + Ni A 1 + Ni

70 1 + 0.1

P=

. F 18 I = 115 1 + 0.1 G J H 12 K

The equation of value at the focal date is 200 = 49.02 + 66.67 + x x = 84.31 or, x = Rs. 96.96. or, 115 . 115 .

(iii) Equations of Value and C.I.: Let us again consider transactions in which one or more debts are repaid with one or more payments due at various points of time. Illustration 1.3. A borrows Rs. 200 and agrees to pay Rs. 50 after 2 months and Rs. 70 after 6 months. What final payment should A make 18 months from now to settle the debt if interest is 6% compounded monthly?
Answer: This illustration is similar to illustration 1.2. The only difference is that C.I. is used here. With C.I., the focal date may be any date at which interest is compounded, and the resulting equations of value will give identical result for the quantity to be determined. (a) Let 18 months be the focal date and x be the amount of final payment.

Mathematics of Finance 15 Value of money at focal date Focal date Rs. 200 0 2 Rs. 50 6 Rs. 70 18 (months) x x 70 (1.005)12 50 (1.005)16 (Time Diagram) Table 1.2 shows the value of each amount of money at the focal date. Table 1.2 Rs. Formula used Value at focal date (Rs.) 200 (1.005)18

200

A = P 1+

F H

i 12

I K

12 N

200 1 +

F H F H F H

.06 12 .06 12 .06 12

I K I K I K

12

18 12

= 200 1.005

18

50

"

50 1 +

12

16 12

= 50 1.005

16

70 x

" No shift in time

70 1 +

12

12 12

= 70 1.005

12

Value of loan at focal date = Value of payments at focal date 200 (1.005)18 = 50 (1.005)16 + 70 (1.005)12 + x or, or, 200 (1.09392894) = 50 (1.083071151) + 70 (1.061677812) + x or, 218.79 = 54.15 + 74.32 + x x = Rs. 90.32 [Using Calculator]

(b) Let us solve this illustration by selecting focal date now. Table 1.3 shows the values of each amount of money at focal date (i.e., t = 0). The time diagram is shown below: Value of money at focal date Focal date 200 200 0 50 (1.005)2 70 (1.005)6 x (1.005)18 2 50 6 70 18 (months) x

16 Financial Mathematics Table 1.3 Rs. 200 50 Formula used No shift in time Value at focal date 200 50 (1.005)2

P = A 1+

F H

.06 12

I K

2 12 12

70

F .06 I P = A 1+ H 12 K
P = A 1+

12

6 12

70 (1.005)6

x The equation of value is:

F H

.06 12

I K

12

18 12

x (1.005)18

Value of loan at focal date = Value of payments at focal date 200 = 50 (1.005)2 + 70 (1.005)6 + x (1.005)18

200 = 50 (0.990074503) + 70 (0.970518078 ) + x (0.914136159 )

or, 200 = 49.50 + 67.94 + 0.914136159 x or, 0.914136159x = 82.56 or, x = Rs. 90.32 [using calculator] Thus values of x in (a) and (b) are equal. Also if we multiply both sides of equation of value of (b) by (1.005)18, we get the equation of value of (a), which shows that the two equations (for two different focal dates) are algebraically equivalent.

(iv) Continuous Compounding: The compound amount A for a deposit of Rs. P at interest rate R per year compounded continuously for N years is given by: A = P . eRN. (R in decimal form) To get Rs. A at the end of N years, an initial investment of P = A . eRN is required. The value of e is 2.7182818. The values of ex and ex can be obtained from tables or by using calculators. For a constant principal, time period and annual interest rate, the more frequent the compounding, the larger is the return on the investment. But there is a theoretical upper limit on the return that can be obtained in this way. If we imagine the number of yearly conversions to increase indefinitely, we arrive at a situation when interest is compounded continuously, i.e., at each instant of time the investment grows in proportion to its current value. This is known as continuous compounding.
EXERCISE 1(a)

1. Mr. Rama invested equal amountsone at 6% simple interest and the other at 5% compound interest. If the former earns Rs. 486.56 more as interest at the end of two years, find the total amount invested. [ICWAI (Prel.), Dec. 1985] 2. Mr. Ram borrowed Rs. 25,000 from a moneylender but he could not repay any amount in a period of 5 years. Accordingly the moneylender demands now Rs. 35,880 from him. At what rate per cent per annum compound interest did the latter lend his money?
[ICWAI, June 1987]

Mathematics of Finance 17

3. In how many years will the population of a village change from 2,500 to 2,601, if the rate of increase is 2% per annum? [ICWAI (Prel.), Dec. 1992] 4. Two partners A and B together lend Rs. 12,615 at 5% compounded annually. The amount A gets in 2 years is the same as B gets at the end of 4 years. Determine the share of each in the principal. [ICWAI (Prel.), June 1991] [Hints: If A lends Rs. P, then B lends Rs. (12,615 P). P (1+ 0.05)2 = (12,615 P) (1 + 0.05)4] 5. A sum of money invested at compound interest amounts to Rs. 10,816 at the end of second year and to Rs. 11,248.64 at the end of the third year. Find the rate of interest and the sum [B.Com. (C.U.), 1983] invested. 6. The population of a town is 1,25,000. If the annual birth rate is 3.3% and annual death rate is 1.3%, calculate the population of the town after 3 years. [ICWAI, June 1992] [Hints: Population increases each year by (3.3 1.3) = 2% A = 1,25,000 1 +

FH

2 100

IK

7. A man left for his three sons aged 10, 12 and 14 years Rs. 10,000, Rs. 8,000 and Rs. 6,000 respectively. The money is invested in 3%, 6% and 10% compound interest respectively. They will receive the amount when each of them attains the age of 21 years. Find, using a five-figure [B.Com. (C.U.), 1967] log-table, how much each would receive. 8. A borrower pays interest on his loan at the rate of 4% in quarterly instalments. He wishes to pay monthly in the future. What should be the new nominal rate so that the lender will receive an equivalent amount? [ICWAI (Prel.), Dec. 1989] 9. A machine depreciates 10% p.a. for first two years and then 7% p.a. for the next three years, depreciation being calculated on the diminishing value. If the value of the machine be Rs. 10,000 initially, find the average rate of depreciation and the depreciated value of the machine at the end of the fifth year. [B.Com. (C.U.), 1974] 10. The difference between the simple and the compound interests at the same rate for 2 years on a certain amount is 1/400 of amount. Find the rate of interest. [ICWAI (Prel.), June 1986] 11. The compound interest on a certain sum of money invested for two years at 5% is Rs. 238. What will be the simple interest on it at the same rate and for the same period?
[ICWAI (Prel.), Dec. 1986]

12. A sum of money invested now at x% per annum compound interest quadruples in 18 years. Find x. [ICWAI (Prel.), June 1984] 13. In how many years will the population of a village change from 15,625 to 17,576 if the rate of increase is 4% per year? [Given: 17576 = 263 and 15625 = 253] [ICWAI (Prel.), Dec. 1984] 14. A machine depreciates at the rate of 10 p.c. of its value at the beginning of a year. The machine was purchased for Rs. 44,000 and the scrap value realised when sold was Rs. 25,981.56. Find the number of years the machine was used. [ICWAI, Dec. 1983]

18 Financial Mathematics

15. A machine depreciates each year by 10% of its value at the beginning of the year. At the end of fourth year its value is Rs. 1,31,200. Find its original value. [Given: log 1312 = 3.1179, log 90 = 1.9542, Antilog 5.3011 = 20,000] [B.Com. (C.U.), 1982] 16. Mr. Needy borrowed money from the short-term loan company and promised to pay Rs. 200 at the end of the year. The interest rate is 2% per month on the first Rs. 100 and 2% on the second Rs. 100. How much does he receive? [ICWAI, Dec. 1979] 17. What is the effective rate of interest corresponding to a nominal rate of 5% p.a. if interest is [ICWAI, June 1991] compounded quarterly? 18. A lends B Rs. 320. B is to pay interest on whatever amount he has not paid back at the rate of 5% per annum for the first year, 6% for the second year and 7% for the third year. B pays Rs. 100 at the end of first year, Rs. 100 at the end of the second year and enough to pay off completely the debt and the interest at the end of the third year. How much is the last payment?
[ICWAI, 1971]

19. The population of a country increases every year by 2.4% of the population at the beginning of that year. In what time will the population double itself? Answer to the nearest year.
[ICWAI, June 1977]

20. The difference between simple and compound interest on a sum of money put out for 4 years at 5% p.a. is Rs. 150. Find the sum. [ICWAI, June 1989] 21. A machine depreciates in value each year at the rate of 10% of its value at the beginning of a year. The machine was purchased for Rs. 10,000. Obtain, to the nearest rupee, its value at the end of the tenth year. [ICWAI, June 1975] 22. A sum of money invested at compound interest, payable yearly, amounts to Rs. 2,704 at the end of the second year and to Rs. 2,812.16 at the end of the third year. Find the rate of interest and the sum. [B.Com. (C.U.), 1983] 23. In a certain population the annual birth and death rates per 1,000 are 39.4 and 19.4 respectively. Find the number of years in which the population will be doubled assuming that there is no immigration. [ICWAI, Dec. 1974] 24. Find the amount that Rs. 100 will become after 20 years at compound interest @ 5% calculated annually. [B.Com. (C.U.), 1966] 25. A man wants to invest Rs. 5,000 for four years. He may invest the amount at 10% p.a. compound interest, interest accruing at the end of each quarter of the year, or, he may invest it at 10% p.a. compound interest, interest accruing at the end of each year. Which investment will give him slightly better return? [ICWAI, June 1976] 26. The interest on a sum of money invested at compound interest are Rs. 832 for the second year and Rs. 865.28 for the third year. Find the rate of interest and the sum invested.
[ICWAI, June 1986 (old)]

27. Mr. Brown was given the choice of two payment plans on a piece of property. He may pay Rs. 10,000 at the end of 4 years, or, Rs. 12,000 at the end of 9 years. Assuming money can be invested annually at 4% p.a. converted annually, what plan should Mr. Brown choose?
[ICWAI, June 1983]

Mathematics of Finance 19

ANSWERS

(1) Rs. 27,800; (2) 7.5%; (3) 2 years; (4) Rs. 6,615, Rs. 6,000; (5) 4%, Rs. 10,000; (6) 1,32,651; (7) Rs. 13,843, Rs. 13,517; Rs. 11,691; (8) 3.6%; (9) 8.2%, Rs. 6,515; (10) 5% p.a.; (11) Rs. 232.20; (12) 8%; (13) 3 years; (14) 5 years; (15) Rs. 2,00,000; (16) Rs. 156.45; (17) 5.0945%; (18) Rs. 160.67; (19) 29 years; (20) Rs. 9,673.52; (21) Rs. 3,483; (22) 4% p.a., Rs. 2,500; (23) 35 years; (24) Rs. 265.50; (25) Second investment will give him better return; (26) 4%, Rs. 20,000; (27) Second plan.
1.5. ANNUITIES

An annuity is a fixed amount paid at regular intervals e.g., monthly, quarterly, yearly, etc., under certain conditions. When the interval is not given, we take it as one year. An annuity payable for a fixed number of periods, or, years is defined as Annuity Certain. When an annuity is to continue for ever, it is said to be a Perpetual Annuity or Perpetuity. If the payment of an annuity commences or ceases at the occurrence of a contingent event, it is said to be an Annuity Contingent. If the payments are made at the end of each period, the annuity is called Immediate or Ordinary Annuity. When the payments are made at the beginning of each period, the annuity is defined as Annuity Due. An annuity is taken as immediate unless otherwise stated. If the payments of an annuity are deferred or delayed for certain periods, or years, it is called a Deferred Annuity. If an annuity is deferred for n years, its first instalment will be paid at the end of (n + 1) years. For a Deferred Perpetuity, the payments commence after the deferred period and thereafter continue for ever. If we add the present values of all the payments of an annuity, we get its Present Value. A Free-hold Estate is that which generates a perpetual annuity, i.e., rent. A Lease-hold Estate generates rent for the fixed lease period. The value of a freehold estate is equal to the present value of the perpetuity (or rent). If an annuity remains unpaid for a certain period, it is said to be Unpaid Annuity for that period. The amount of the unpaid annuity is obtained by adding the instalments and the compound interest on each for the period during which it remained unpaid.
1.6. FORMULAE

(1) Amount of an annuity:

A= P (1 + i ) n 1 i A = Amount of an annuity or (immediate annuity) P = Annuity; n = Unpaid years

where,

i = Interest on unit sum for 1 year or period Proof: The first instalment P due at the end of the first year will earn compound interest for (n 1) years and the amount will be P (1+ i)n1. Similarly, the second instalment P will earn compound interest for (n 2) years and amount to P (1+ i)n2 and so on. The last instalment P will not earn any interest.

20 Financial Mathematics

A = P 1+ i

b g

n 1

+ P 1+i
n

b g

n 2

+....... + P

[This is a G.P. with C.R. 1/(1 + i)]

= P (1 + i) n 1

R1 F 1 I U S H1+ iK V W = P (1 + i) R(1 + i) 1U (1 + i) T S (1 + i) V 1 + i 1 1 T W 1 1+ i
n 1 n n

= P (1 + i) n 1

R(1 + i) 1U 1 = P n(1 + i) 1s S (1 + i) V i i T W
n n 1
n

Cor. If t = Times of payments made per year. Rs. P = Rent per year, Rs.
P = Rent per period t

i = Interest per unit sum per year, then A = Amount of the annuity P for n years

Pt it

RF1 + i I SH t K T
s

nt

1 =

U P RF1 + i I V i SH t K W T

nt

U V W

(2) Present value of an annuity:

V= P 1 (1 + i) n i

where, P = Annuity to continue for n years. V = Present value of the annuity (immediate). i = Interest on unit sum for 1 year. Proof: The present values of the first, second, third, ......., nth payments are:

a f a f a1 + if
2

P P , 1+ i 1+ i

,.........,

a1 + if

respectively.

V = Sum of the present values of all the payments.

a f a f a f
2

P P + 1+ i 1+ i

P 1+ i

++

a f

P 1+ i

R F IU | | b g S GH JK V | | T W =
1 P 1 1+ i 1+i 1 1 1+ i
n

P 1 1+ i i

{ b g }
n

Mathematics of Finance 21

Cor. If

t = Times of payments made per year Rs.

P t

Rs. P = Rent per year

= Rent per period

i = Interest on unit sum for 1 year, then

V=

Pt i 1 1+ it t

R F I U = P R1 F1 + i I U S H K V i S H tK V T W T W
nt nt

(3) Present value of a perpetuity:

V= P i

1 Proof: For perpetuity, n is indefinitely large. Hence the value of (1 + i ) n in (2) may be taken

as zero.
From ( 2), V =

P 1 P P 1 = (1 0) = n i (1 + i ) i i

R S T

U V W

(4) Present value of a deferred annuity:

V=

P (1 + i ) n 1 P P 1 1 = 1 1 m+n m+n i i (1 + i) (1 + i) m i (1 + i)

R S T

U V W

R S T

U R V S W T

U V W

Proof: Let P = Annuity, V = Present value, i = Interest on unit sum for 1 year. Payment starts at the end of m years and thereafter continues for n years. Hence, the first, second, third,...., last payments are due at the end of (m + 1), (m + 2), (m + 3),......, (m + n) years respectively. The present values of the successive payments are:

a1 + if

m +1

a1 + if
P

m +2

,...........,
P

a1 + if

m+n

respectively.

V=

a1 + if a1 + if P R (1 + i) 1 U = S V i T (1 + i) W PL 1 1 = M i M a1 + if a1 + if N
m +1

m+2

+...........+

a1 + if

m+n

m+ n

[Infinite geometric series]

m+n

OP = P L1 1 O P L1 1 O PQ i MN (1 + i) PQ i MN (1 + i) PQ
m+n m

= [Present value of an immediate annuity to continue for (m + n) years] [Present value of an immediate annuity to continue for m years.]

22 Financial Mathematics

(5) The present value of a deferred perpetuity:

V= 1 P i (1 + i) m

where, V = Present value of a deferred perpetuity P to begin after m years. Proof: In (4), putting
1 = 0, as ( m + n ) is indefinitely large, we get (1 + i ) m + n P P P P 1 1 + = . i i i (1 + i ) m i (1 + i ) m

LM N

OP Q

V=

(6) Sinking fund: It is a fund which is created by investing annually a fixed amount at compound interest to pay off a loan or a debenture stock or bond on a given date or to redeem certain liabilities or to provide for replacement of assets (i.e., capital expenditure), e.g., plant and machinery, etc. If A is the amount of loan to be paid off at the end of n years and P is the accumulations of the annual sum, then
A= P (1 + i) n 1 i

where, i = Interest on unit sum for 1 year [Same as formula (1)] (7) Present value of uneven cash inflows: If P1, P2 ,....., Pn be the unequal cash inflows received at the end of year 1, 2,...... n respectively, then the present value of these sums at interest rate i is given by:
V= P1 P2 Pn . + +.........+ 2 (1 + i ) (1 + i ) (1 + i ) n

Example 1.5. (i) A machine costs Rs. 97,000 and its effective life is estimated to be 12 years. A fund is created for replacing the machine at the end of its effective life time. If the scrap realises Rs. 2,000, what amount should be retained out of profits at the end of each year to accumulate at compound interest at 5% p.a.? [Given (1.05)12 = 1.797]. (ii) S. Roy borrows Rs. 20,000 at 4% compound interest and agrees to pay both the principal and the interest in 10 equal annual instalments at the end of each year. Find the amount of these instalments. [C.U., 1972] (iii) The annual rent of a free-hold estate is Rs. 1,000. What is its present value, if the compound interest rate is 4% p.a.? (iv) Which is better, an annuity of Rs. 100 to last for 12 years , or, the reversion of a free-hold estate of Rs. 80 p.a. to commence 6 years hence, the rate of interest being 6%? (v) A man buys an old piano for Rs. 500, agreeing to pay Rs. 100 down and the balance in equal monthly instalment of Rs. 20 with interest at 6%. How long will it take him to complete payment? [ICWAI, Dec. 1979]

Mathematics of Finance 23

(vi) The accumulations in a Provident Fund are invested at the end of every year to earn 10% p.a. A person contributes 12% of his salary to which his employer adds 10% every month. Find how much the accumulations will amount to at the end of 30 years of his service, for every 100 rupees of his monthly salary [Give the answer to the nearest rupee]. [ICWAI, June 1975] (vii) A wagon is purchased on instalment basis such that Rs. 5,000 is to be paid on the signing of the contract and four-yearly instalments of Rs. 3,000 each payable at the end of the first, second, third and fourth years. If interest is charged at 5% p.a., what would be the cash down price? [B.Com. (C.U.), C.A. (Ent.), Nov. 1991] (viii) For endowing an annual scholarship of Rs. 12,000 a man wishes to make three equal contributions. The first award of the scholarship is to be made 3 years after the last of his three contributions. What would be the value of each contribution, assuming interest at 2.5% p.a. compounded annually? (Assume that the first contribution is to be made now and the other two at an interval of one year thereafter.) [ICWAI, Dec. 1980] (ix) A sinking fund is created for redemption of debentures of Rs. 2,00,000 at the end of 20 years. How much money should be provided out of profit each year for the sinking fund if the investment can earn interest @ 4% p.a.?
Answer: (i) Here, A = Cost price of the machine Scrap value = Rs. (97,000 2,000) = Rs. 95,000 n = 12 years, i = 0.05 Now, Amount of an annuity = A =
P (1 + i )n 1 i

where, P = Amount to be retained out of profits at the end of each year = Annuity 95,000 = P 1.0512 1 0.05

s
4,750 = Rs. 5,960. 0.797

[Let x = 1.0512 log x = 12 log 1.05 = 12 0.0212 = 0.2544 x = Antilog 0.2544 = 1.797]

or, 4,750 = P (1.797 1) or, P =

(ii) Here, V = Rs. 20,000 = P.V. of an annuity of Rs. P to continue for 10 years at 4% p.a., n = 10, i = 0.04, P = Amount of each instalment or annuity. Now, Present value of annuity P =V= P 1 (1 + i ) n i

1 s or, 20,000 = 0.P LMN1 (1.04) OPQ 04

10

[Let, x = (1.04)10 log x = 10 log 1.04 = 10 0.0170 = 0.1700, x = 1.479] or,

800 = P 1

LM N

1 = P ( 0.3239) P = Rs. 2,469.90 Rs. 2,470 1.479

OP Q

(iii) A freehold estate yields a perpetual annuity P. If V = P.V. of the freehold estate, then V = P 1,000 = = Rs. 25,000. i 0.04

24 Financial Mathematics P = 1 (1 + i ) n = P.V. of an annuity P to continue for n years. i

100 1 - 1 + .06 0.06

(iv) First case: V =

Here, P = 100, i = 0.06, n = 12 or, V =

LM b N

g OQP
- 12

[Let x = 1.0612, log x = 12 log 1.06 = 12 0.0253 = 0.3036 x = Antilog 0.3036 = 2.0120] or, V = 1,666.67 (1 0.4970) = Rs. 838.34 Second case: It is a deferred perpetuity which commences after 6 years. Now, V = P (1 + i ) m = P.V. of a deferred perpetuity P to commence after m years. i 80 (1.06 )6 = 1,333.33 (1.06) 6 . 0.06

Here, P = Rs. 80, i = 0.06, m = 6 V =

[Let, x = (1.06)6, log x = 6 log 1.06 = 6 0.0253 = 0.1518 x = Antilog 0.1518 = 1.419] or, V = 1,333.33 0.7047 = Rs. 939.60 Since P.V. of the second case, i.e., Rs. 939.60 is greater than the P.V. of the first case, i.e., Rs. 838.34, the second case is better. (v) Amount paid in cash = Rs. 100. V = Rs. (500 100) = Rs. 400 = The balance amount. If n be the number of years, then V = P i 1 1+ i 12

LM F N H

I OP K Q
12 n

Here, P = Rs. 20 12 = Rs. 240, i = 0.06 400 = or, 400 = 4,000 {1 (1.005)12n} or, or, (1.005)12 n = 1

240 0.06 1 1+ 0.06 12

LM F N H

I OP K Q
12 n

1 = 1 (1.005)12 n 10

10 1 9 12 n or, (1.005) = = 9 10 10

or, 12n log 1.005 = log 1.1111 or, 12n 0.0021 = 0.0457 or, 12n = 21.76 Here, the required time = n years = 12n months = 21.76 22 months (vi) Total monthly contributions to P.F. = 12.5 + 10 = Rs. 22.5; if we assume the monthly salary of the person as Rs. 100. Total annual contribution to P.F. = 12 22.5 = Rs. 270. If A = Total accumulation at the end of 30 years, then 270 P (11)30 1 = 2,700 1130 1 . . (1 + i )n 1 . Here, P = Rs. 270, i = 0.1, n = 30 = 0.1 i [Let x = 1.130, or log x = 30 log 1.1 = 30 0.0414 = 1.242 A=

x = Antilog 1.2420 = 17.46] A = 2,700 16.46 = Rs. 44,442. (vii) If V = P.V. of the annuity of Rs. 3,000 for 4 years at 5% compound interest, then cash down price of the wagon will be Rs. (V + 5,000). Now, V =
P 1- 1+ i i

{ b g } = 30,000 n1 (1.05) s .05

-n

Here P = Rs. 3,000, n = 4, i = 0.05

Mathematics of Finance 25 [Let, x = 1.054, log x = 4 log 1.05 = 4 0.0212 = 0.0848 = 1+ 1 0.0848 = 1.9152 x = Antilog 1.9152 = 0.8226] or V = 60,000 (1 0.8226) = Rs. 10,644 The required cash down price = Rs. (10,644 + 5,000) = Rs. 15,644. (viii) The first scholarship is to be paid at the end of the 5th year and thereafter it will continue for ever. Hence we have a perpetuity of Rs. 12,000 deferred by 4 years. V = P.V. of the endowments = x + where, x = The annual contribution Here, n = 2, as the first contribution is made now, i = 0.025. V=x+ x 1 (1 + i ) n i

s x 0.0481 I =x+ 0.0481 = x F 1 + H 0.025 K 0.025

x 1 1.0252 0.025

= 2.924 x

...(1)

Again, for the P.V. of deferred perpetuity

V=
=

P 1 , Here, P = Rs. 12,000, i = 0.025, m = 4 i (1 + i) m

12,000 (1.025) 4 0.025

[Let, x = 1.0254, or log x = 4 log 1.025 = 4 0.0107 = 0.0428 = 1+ 1 0.0428 = 1.9572

x = Antilog 1.9572 = 0.9061] V = 4,80,000 0.9061 = Rs. 4,34,928

P 1+ i i

...(2)

From (1) and (2), 2.924x = Rs. 4,34,928 x = Rs. 1,48,744.18 (ix) Amount of annuity, A = or, P =
n

oa f 1t ; or 2,00,000 = 0.P04 oa1.04f

20

8,000 8,000 = = Rs. 6,734. (2.188 1) (1.04)20 1

[Let x =

(1.04)20;

log x = 20 log 1.04 = 20 0.0170 = 0.34, x = 2.188]

Example 1.6. (i) A government constructed housing flats costing Rs. 1,36,000; 40% to be paid at the time of possession and the balance reckoning C.I. @ 9% p.a. is to be paid in 12 equal annual instalments. Find the amount of each such instalment. Given:

LM 1 N (1.09)

12

= 0.3558

[B.Com. (C.U.), 1984]

OP Q

(ii) A loan of Rs. 10,000 is to be repaid in 30 equal annual instalments of Rs. P. Find P if the compound interest charged is at the rate of 4% p.a. (Annuity is an immediate annuity, i.e., first payment is made at the end of first year). [Given: (1.04)30 = 3.2434]
[B.Com. (C.U.), 1982]

(iii) A machine costs a company Rs. 52,000 and its effective life is estimated to be 25 years. A sinking fund is created for replacing the machine by a new model at the end of its life time, when its scrap realises a sum of Rs. 2,500 only. The price of the new model is estimated to

26 Financial Mathematics

be 25% higher than the price of the present one. Find what amount be set aside each year out of the profits for the sinking fund, if it accumulates at 3% per annum compound? [Given: log 10.35 = 1.01494, log 236.32 = 2.3735] [C.A. (Ent.), May 1992] (iv) An investor has a capital of Rs. 20,000 on which he earns interest @ 5% p.a. If he spends Rs. 1,800 per year, show that he will be ruined of his capital before the end of 17th year. (v) Determine the present value of a perpetual annuity of Rs. 100 payable at the end of 1st year, Rs. 200 at the end of 2nd year, and Rs. 300 at the end of 3rd year, and so on, increasing Rs. 100 payable at the end of each subsequent year. Assume a time preference rate of 5% p.a., compounded annually.
Answer: (i) Amount to be paid at the time of possession = Rs. (1,36,000 0.4) = Rs. 54,400 Balance to be paid in 12 instalments along with interest = Rs. (1,36,000 54,400) = Rs. 81,600. If Rs. P is the annual instalment, then 81,600 =

P 1 1 0.09 (1.09)12

LM N

OP Q

[Let x = (1.09)12; log x = 12 log 1.09 = 12 .0374 = 0.4488 x = Antilog 0.4488 = 2.810] or, 81,600 = 7344 P P = Rs. 11,402. 1 0.3559 = 0.6441 or, P = 0.6441 0.09 0.09

(ii)

10,000 =

P 1 1 0.04 (1 + 0.04)30

LM N

OP Q
P= 400 = Rs. 578.87. 0.691

[Let x = 1.0430; log x = 30 log 1.04 = 30 0.017 = 0.51 x = Antilog 0.51 = 3.236] or, 10,000 = (iii) P (1 0.3090 ) or, 400 = P 0.691 0.04

A = Cost of the machine Scrap value = Rs. (1.25 52,000 2,500) = Rs. (65,000 2,500) = Rs. 62,500 Amount of an annuity = A = P (1 + i )n 1 i

where, A = Amount to be retained out of profits at the end of each year 62,500 = P (1.035)25 1 0.035

[Let x = 1.03525; log x = 25 log 1.035 = 25 0.01494 = 0.3735 = log 2.3632 x = 2.3632] or, P (2.3632 1) = 2,187.5 or, P = Rs. (iv) V= P 1 (1 + i ) n i 2,187.5 = Rs. 1,604.68. 1.3632
n

s or, 20,000 = 10,800 n1 (1.05) s .05

or,

10 8 4 1,000 n = = or, n log 1.05 = log 4 log 9 = 1 (1.05) n or, (1.05) = 1 18 18 9 1,800

Mathematics of Finance 27 0.3521 = 16.61 17th year 0.0212

or, n 0.0212 = 0.6021 0.9542 or, n 0.0212 = 0.3521 n = (v) The present value of the perpetual annuity can be obtained as follows:

V=

P1 P2 P3 100 200 300 + + +.............+ = + + +............... 1.05 (1.05)2 (1.05)3 (1 + i) (1 + i )2 (1 + i)2

V 1 2 3 or, 100 = 1.05 + (1.05)2 + (1.05)3 +...............

or, A = x+ 2x2+ 3x3 +..........+ Multiplying both sides by x, we get Ax = x2+ 2x3+ 3x4+ ...... Now, A Ax = x+ x2+ x3 +........ or, A (1 x) = x (1+ x+ x2 +.......) = x (1 x)1
2 or, A = x (1 x ) =

LMPut 1 = x and N 1.05

V =A 100

OP Q

V or, V = 100x (1 x)2 100

= 100

100 (1.05)1

1 (1.05)1

05 s 1.05 FH 0..05 IK 1
2

100 1.05 105 = = Rs. 42,000. 0.0025 (0.05)2

1.7. AMORTIZATION

A loan is amortized if both the principal and interest are paid by a sequence of equal periodic payments. Amortization means removal of loan. Each payment consists of: (i) The interest on the loan outstanding at the beginning of the payment period. (ii) A part repayment of the loan or principal. To facilitate accounting, it is often required to split up each instalment paid into repayment of loan and payment of interest on the outstanding balances. With each payment, the actual loan or principal decreases, interest part in each payment successively decreases and loan repayment (i.e., amortization) increases.
1.7.1. To calculate the amortizations for the 1st, 2nd, 3rd, etc., years, of a loan repaid by fixed annual payments in n years, compound interest being allowed

Let A be the amount of each annual payment paid at the end of each year for n years. Hence the loan P is the present value of the n annual payments. Let i be the rate of interest per Re. p.a. The loan is given by:
P = P1 + P2 + P3 +...............+ Pn

a f + A a1 + if + A a1 + if +...........+ A a1 + if = A a1 + if {1 + a1 + if + a1 + if +...........+ a1 + i f a f }
= A 1+ i
1 1 2 3 1 2 n 1

28 Financial Mathematics

1 1 1 (1 + i ) n A (1 + i) n = A (1 + i) 1 = 1 (1 + i ) 1 (1 + i) 1 1 (1 + i )

a f a f a f

1+ i n 1 1+ i A A = n 1+ i 1+ i 1 i 1+ i

a f a f

Ra1 + if 1U Hence, A = Pi (1 + i) | S a1 + if | V (1 + i ) 1 | | T W
n
n

...(1)

Now, the annual payment A paid at the end of the 1st year contains the interest on P for 1 year, which is Pi and the rest of A is amortization. Amortization at the end of the 1st year
= A Pi = Pi (1 + i) n Pi (1 + i) n 1

...[From (1)]

Pi (1 + i) n Pi (1 + i) n + Pi Pi = n (1 + i) 1 (1 + i) n 1

After amortization the loan amount at the end of the 1st year = P Interest on (2) in 1 year = Pi
Pi 2 (1 + i ) n 1
n 2

Pi (1 + i) n 1

...(2)

Hence amortization at the end of the 2nd year

2 n n

R U = Pi a1 + if Pi + Pi Pi = A SPi T (1 + i) 1V (1 + i) 1 (1 + i) 1 W Pi (1 + i) Pi n(1 + i) 1s + Pi Pi (1 + i) Pi + Pi = . = =
n n n 2 2

[From (1)]

(1 + i) n 1

(1 + i) n 1

(1 + i) n 1

Similarly, amortization at the end of the 3rd year =

Pi (1 + i )2 and so on (1 + i ) n 1

Amortization at the end of the nth year = Total amortization in n years

=

Pi 1 + i n 1 1+ i n 1

a f a f

Pi 1 + i Pi 1 + i 2 Pi 1 + i n 1 Pi +.........+ + + (1 + i) n 1 (1 + i) n 1 (1 + i ) n 1 (1 + i) n 1

a f

a f

a f

Mathematics of Finance 29

Pi 1 + (1 + i) + (1 + i) 2 +.............+ (1 + i) n 1 n (1 + i) 1

Pi (1 + i) n 1 = P = Loan amount. (1 + i) n 1 (1 + i) 1

Example 1.7. A loan of Rs. 1,000 is to be paid in 5 equal annual payments, interest being at 6% p.a. compound interest and first payment being made after a year. Analyse the payments into those on account of interest and on account of amortization of the principal. [ICWAI, Jan. 1970]
Answer: Present value of an annuity, P 1 (1 + i ) n , i where P is the annuity (i.e., yearly payment) in rupees. V= Here, V = 1,000, i = 0.06, n = 5, P = ? 1,000 = or, 60 = P 1 (1.06 )5
P 1 (1 + .06) 5 , 0.06

t
60 Rs. 237.40 0.2527

...(1)

[Let x = (1.06)5, log x = 5 log 1.06 = 5 .0253 = 0.1265 = 1 + 1 0.1265 = 1 .8735 x = Antilog ( 1.8735) = 0.7473] From (1), 60 = P {1 0.7473} = P 0.2527 or, P =

Amortization Table End of year Yearly payment P (Rs) 237.40 237.40 237.40 237.40 237.40 1,187 Interest due (Rs) Amortization (Rs) Principal earning interest (Rs) 1,000.00 822.60 634.56 435.24 223.96

1st 2nd 3rd 4th 5th Total

60.00 49.36 38.08 26.12 13.44 187

177.40 188.04 199.32 211.28 223.96 1,000

1.8. PRESENT VALUE (P.V.) IN CAPITAL EXPENDITURE

The expenditures made for buying fixed assets like land, building, plant and machinery projects, etc. are called capital expenditure. We have already seen how present values of such assets can be calculated. P.V. concept in capital expenditure helps us to select the best out of alternatives. For example, suppose a pipe line is due for repairs. It will cost Rs. 10,000 and lasts for 3 years. Alternately, a new pipe line can be laid at a cost of Rs. 30,000 which will last for 10 years. Assume cost of capital is 10% and ignore salvage value.

30 Financial Mathematics

The present values of both the cases are to be calculated and compared. The project having lesser P.V. is to be selected.
1.8.1. Free-hold and Lease-hold Estates

1. A free-hold estate yields perpetual annuity, i.e., rent whereas a lease-hold estate held for a fixed period yields rent for that fixed period only. 2. The value of free-hold estate can be taken as the P.V. of the perpetuity having each payment equal to rent. The value of certain lease hold property is the P.V. of an annuity certain having each payment equal to rent, the status being the no. of years to the time the lease terminates. 3. Value of a free-hold estate = P.V. of the perpetuity of P (Annual rent) =

P 1 = Px (say), x = , i i

is the no. of years purchase. 4. If a man having purchased a lease yielding a rent of Rs. P yearly and lasting for n years, wants, after x years (n > x), to renew it for another period of y years, he must pay fine for the renewal. The fine is the P.V. of an annuity of P for y years deferred (n x) years. 5. To obtain the P.V. of a lease hold property with a rent P, we are to find the P.V. of the annuity of P for the remaining period of the lease. 6. A lease-hold property reverts to the original holder after termination of the lease. An estate worth X to be reverted after n years has the reversion value = P.V. of X = If the yearly rent is P, then from (3), X =
X . (1 + i) n

P P . . The value of reversion = i (1 + i ) n i

7. A company increases its capital by issuing loans, which are called Debentures. The debenture-holders get their fixed rate of interest whether the company earns profit or not. It is also issued by State or Central Govts., or, other public bodies, e.g., Improvement Trusts, Corporations, etc. Like debenture bond it is also a written promise to pay or do something.
1.9. PRESENT VALUE AND DISCOUNT

The P.V. of a given sum A due after a given period is that sum of money [P (say)] which becomes the sum A after the given period. (a) P. V. = P =
A 1 + Ni

(Simple interest)
A 1 = A 1 1 + Ni 1 + Ni

True Discount (T.D.) = A P = A (b) P.V. = P =

T. D. = A A (1 + i ) N

F H

I K

ANi 1 + Ni

(Compound interest)

A = A 1 (1 + i ) N (1 + i ) N

Mathematics of Finance 31

1.9.1. Bankers Discount and Present Value

If a sum of money is due after a given period, then the interest (simple or compound) on the sum of money for that period is called the Bankers Discount. It is the interest on the face value of the bill. [Face value = P.V. + T.D.]. True discount (T.D.) is the interest (simple or compound) on the present value of the sum due or present value of the amount of the bill. Bankers P.V. is the difference between the sum of money due and the Bankers Discount. Bankers Gain = Bankers Discount True Discount = Interest on Bill value Interest on Present value = Interest on (Bill value Present value) = Interest on True Discount Legal due date = Nominal due date + Three days of grace. Example 1.8. (i) The difference between true discount and bankers discount on a bill due after 6 months at 4% p.a. is Rs. 24. Find out true discount, bankers discount and bill amount.
[B.Com. (Bangalore), 1991]

(ii) If the difference between true discount and bankers discount on a sum due in 6 months at 5% p.a. is Rs. 100, find the amount of the bill. [B.Com. (Bangalore), 1990] (iii) The bankers gain for a sum due 10 months hence at 6% p.a. is Rs. 25. Find the sum due.
[ICWAI, June 1993]

(iv) A bill for Rs. 12,900 was drawn on 3rd February, 1988 at six months date and discounted on 13th March at the rate of 8% p.a. For what sum was the bill discounted and how much did the banker gain on this? [B. Com. (Bangalore), 1991]
Answer: (i) (Bankers discount True discount) for 6 months = Interest on true discount for 6 months True discount 0.04 24 1 = Rs. 1,200 = 24 or, True discount = 0.02 2 1 = 1,200 x = Rs. 60,000 2

If Rs. x is the P.V. of the bill, then x 0.04

Amount of the bill = Rs. (60,000 + 1,200) = Rs. 61,200. True discount = Rs. 1,200; Bankers discount = Rs. 1,224. (ii) Let the amount of the bill be Rs. x. Present value of the bill = P =
A x 200 = =x 1 + ni 1 + 5 1 205 100 2

T.D.=

200 5 1 x 1 x x = . Bankers discount = x 0.05 = 205 100 2 41 2 40

Bankers discount True discount = Amount of bill = Rs. 1,64,000.

F x x I = x = Rs. 100 H 40 41K 1640

(given)

32 Financial Mathematics (iii) Let Rs. x be the P.V. of the sum due Sum due = Rs. x + x 0.06

F H

10 x = Rs. x + 12 20

I K

F H

I T.D.= x + x x = x K 20 20

Bankers gain = Interest on T.D. =

x 10 0.06 = 25 (given) x = Rs. 10,000 20 12

(iv) Due date of the bill = 6th August (Includes 3 days of grace) No. of days for which Bankers discount is paid. = 18 + 30 + 31 + 30 + 31 + 6 = 146 days. Bankers discount = Rs. 12,900 146 0.08 = Rs. 412.8 365

Present value of the bill on the day of discounting: Present value + Present value or, Present value = Rs.
16 146 = 12,900 0.08 = 12,900 or, Present value 1 + 500 365

LM N

OP Q

12,900 500 = 12,500. T.D. = Rs. (12,900 12,500) = Rs. 400 516

Bankers gain = Rs. (412.8 400) = Rs. 12.8.

1.10. TYPICAL EXAMPLES

Example 1.9: (i) Machine A costs Rs. 10,000 and has useful life of 8 years. Machine B costs Rs. 8,000 and has useful life of 6 years. Suppose machine A generates an annual savings of Rs. 2,000 while machine B generates an annual saving of Rs. 1,800. Assuming the time value of money is 10% p.a., which machine is preferable? [D.U., B.Com. (Hons.), 1997] (ii) How much is needed to be saved each year in a savings account paying 6% p.a. compounded continuously in order to accumulate Rs. 6,000 in three years?
[D.U., B.Com. (Hons.), 1992]

(iii) A man retires at the age of 60 years and his employer gives him a pension of Rs. 1,200 a year for the rest of his life. Reckoning his expectations of life to be 13 years and that interest is at 4% p.a., what single sum is equivalent to his pension? [Given: log 104 = 2.0170 and log 6012 = 3.7790]. [C.A. (Ent.) May, 1991] (iv) A fixed royalty of Rs. 20,000 p.a. for 15 years is granted to an author by a publishing company. The right of receiving the royalty is sold after 10 years. Find to the nearest rupee the price at which it is sold, assuming money is worth 12% p.a. compounded annually. (v) Find the present value of Rs. 500 due 10 years hence when interest of 10% is compounded (i) half-yearly, (ii) continuously. [D.U., Eco. (Hons.), 1989] (vi) A money-lender charges interest at the rate of 10 paise per rupee per month, payable in advance. What effective rate of interest does he charge p.a.? [D.U., B.Com. (Hons.), 1996] (vii) Rs. 3,000 is invested at annual rate of interest of 10%. What is the amount after 3 years if the compounding is done: (a) Annually? (b) Semi-annually? (c) Monthly? (d) Daily?

Mathematics of Finance 33

(viii) An investor wants to buy a 3-year Rs. 1,000 per value bond having nominal interest rate of 10%. At what price the bond be purchased now if it matures at par and the investor requires a rate of return of 14%? (ix) What annual rate of interest compounded annually doubles an investment in 5 years? (x) A man opened an account on April, 2004 with a deposit of Rs. 900. The account paid 5% interest compounded quarterly. On October 1, 2004, he closed the account and added enough additional money to invest in a 6-month Time Deposit for Rs. 1,200 earning 5% compounded monthly. (a) How much extra amount did the man invest on October 1, 2004? (b) What was the maturity value of his Time Deposit on April 1, 2005? (c) How much total interest was earned? (xi) Rs. 10,000 is invested in a Term Deposit Scheme which yields interest 5% p.a. compounded quarterly. What will be the interest after 1 year? Work-out ab initio. What is the effective rate of interest? (xii) Mr. Y has made real estate investment for Rs. 15,000 which he expects will have a maturity value equivalent to interest at 12% compounded monthly for 5 years. If most of the savings institutions currently pay 6% compounded quarterly on a 5-year term, what is the least amount for which Mr. Y should sell his property? (xiii) Mr. X plans to receive an annuity of Rs. 8,000 semi-annually for 10 years after he retires in 15 years. Money is worth 10% compounded semi-annually. (a) How much amount is needed to finance the annuity? (b) What amount of single deposit made now would provide the funds for the annuity? (c) What amount will Mr. Y receive from the annuity? (xiv) Find the effective rate equivalent to nominal rate of 10% compounded (a) half-yearly; (b) quarterly; (c) monthly; (d) continuously. (xv) An N.S.C costs Rs. 20 and realises Rs. 25 after 10 years. Find the rate of interest involved when it is added (a) yearly; (b) continuously. (xvi) A bank issues Re-investment certificates for a period of 2 years. If Rs. 5,000 are invested in these certificates, their maturity value is Rs. 6,500. Assuming that the interest is compounded every year, what is the rate of interest?
Answer: (i) Machine A: P.V. of a sequence of annual savings of Rs. 2,000 for 8 years @ 10% p.a. is given by: V= P 1 1+ i i

o a f t = 2000 o1 a1 + 0.10f t = 20,000 b1 0.4665g = 20,000 0.5335 = Rs. 10,670 0.10

n 8

Net saving from Machine A = Rs. 10,670 Rs. 10,000 (cost of machine) = Rs. 670 1800 1 1 + 0.10 0.10

Machine B: P.V. of a sequence of annual savings of Rs. 1,800 for 6 years @ 10% p.a. is given by: V=

o a

f t = 18000 k1 0.56447p = 18000 0.43553 = Rs. 7,839.54.

6

Net savings from Machine B = Rs. (7,839.54 8,000) = Rs. 160.46.

Hence, Machine A is preferable.

34 Financial Mathematics (ii) Let Rs. P be saved per year for 3 years to get Rs. 6,000. Here, A = Rs. 6,000, R = 0.06, N = 3. A = P e RN dN = P
0

z
3

LM e OP NRQ

RN 3 0

6,000 =

P e18 e 0 0.06

6,000 =

P 6000 0.06 11972 1 P = . = Rs. 1,825.56. 0.06 0.1972

e18 From Table = 11972 .

Thus, Rs. 1,825.56 should be saved each year for 3 years. (iii) Here, P = Rs. 1,200, n = 13, i = 0.04 Using the formula: V=

Let x = 1.0413

o a f t we have, V = 1200 {1 b1.04g } = 30,000 l1 0.6012q = Rs. 11,964 0.04 , log x = 13 log b1.04g = 13 0.0170 = 0.221
P 1 1+ i i
n
13

or, log x = 1.7790 or, x = 0.6012, 1.04 13 = 0.6012 .

Hence the single sum equivalent to his pension is Rs. 11,964. (iv) Out of 15 years, 10 years have elapsed. Hence the author is entitled to only 5 yearly instalments of Rs. 20,000. Using the formula: V= V= P 1 1+ i i

o a f t, where P = Rs. 20,000, i = 0.12 and n = 5, we have,

n

20,000 1 112 . 0.12

{ a f } = 166666.67 k1 0.5674p = 166666.67 0.4326 = Rs. 72,100.

5

Thus, the price at which the author sold his royalty is Rs. 72,100. (v) (a) Here, A = 500, i = We know, P = A 1 + i (b) 10 = 0.05, N = 2 10 = 20 200

a f

= 500 1.05

a f

20

= 500 0.3769 = Rs. 188.45

The present value is Rs. 188.45. Here, A = 500, R = 0.10, N = 10.

A = P e RN or, P = A e RN

We know, or,

P = 500 e 0.10 10 =

500 500 = = Rs. 183.95 e 2.7182

Thus, the present value (P) is Rs. 183.95. (vi) As 10 paise/rupee/month is payable in advance, the interest rate p.m. will be

b100 10g = 9 per month, N = 12.

10

Now, Effective interest rate (E) = (1 + i)N 1 = 1 + Hence the effective rate of interest is 254.1%. (vii) (a) The annual compounding is given by;

F H

1 9

I K

12

1 = 3.541 1 = 2.541, i. e., 254.1%

A = P 1 + i , where i = 0.1, N = 2, P = 3000 = 3000 11 = 3000 1.21 = Rs. 3,630. .

a f

a f

Mathematics of Finance 35 0.1 = 0.05 2

(b) For semi-annual compounding, N = 2 2 = 4, i = A = 3000 1.05

a f

= 3000 1.2155 = Rs. 3,646.52

(c) For monthly compounding, N = 2 12 = 24, i =

A = 3000 1.00833

0.1 = 0.00833. 12

b b

g g

24

= 3000 1.22029 = Rs. 3,660.87.

(d) For daily compounding, N = 2 365 = 730, i = 0.1/365 = .00027.

A = 3000 1.00027
730

= 3000 1.21783 = Rs. 3,653.49.

(viii) P.V. of the bond =

1000 .1 1000 .1 1000 .1 1000 + 2 + 3 + 3 = 87.7193 + 76.9468 + 67.4972 + 674.9715 = 907.1348. 114 . 114 . 114 . 114 .

a f a f

a f a f
b g
5

Thus purchase value of the bond is Rs. 907.1348. (ix) or, 2P = P (1 + i)5
2 = 1+ i or, 21 5 = 1 + i or, 1148698 = 1 + i .

[ A = P (1 + i)N]

b g

or, i = 0.148698, Required rate of interest = 14.87% (x) (a) The initial investment earned interest for 2 quarters (i.e., April to June and July to September). Here, i =
5 1 = 1 %, N = 2, and the compounded amount 4 4

1 = 900 1 + 1 % 4

FG H

IJ K

= 900 1 + 1.25%

= 900 1.0125

= 900 1.02516 = Rs. 922.64.

The additional amount = Rs. (1,200 922.64) = Rs. 277.36. (b) Here, Time Deposit earned interest compounded monthly for 2 quarters, i.e., i =
5 %, N = 6, P = 1200 12

Maturity value = 1200 1 +

FG H

5 % 12

IJ K

= 1200 1 + 0.4167%

= 1200 1 + 0.004167

= 1200 1.02526 = Rs. 1,230.31

(c) Total interest earned = Rs. (22.64 + 30.31) = Rs. 52.95 (xi) Interest for first quarter = 10,000

g FGH 1 IJK b0.05g = Rs. 125 4

New principal at the end of 1st quarter = Rs. 10,125. Interest for second quarter = 10,125

g FGH 1 IJK b0.05g = Rs. 126.56 4

New principal at the end of 2nd quarter = Rs. 10,251.56 Interest for 3rd quarter = 10,251.56

fFH 1 IK a0.05f = 128.14 4

36 Financial Mathematics New principal at the end of 3rd quarter = Rs. 10,379.70 Interest for 4th quarter = 10379.70

g FGH 1 IJK b0.05g = Rs.129.75 4

Interest accrued after 1 year = Rs. (125 + 126.56 + 128.14 + 129.75) = Rs. 509.45 For effective rate of interest, use I = PRt. or, Alternative method:
E = 1+ i

509.45 = (10,000) R 1 or, R = 0.0509 Effective rate of interest is 5.09%

b g

1, where i =

1 4 5 1 % = 1 % and n = 4 = 1 + 1 % 1 = (1.0125) 1 = 0.0509, i.e., 5.09% 4 4 4

(xii) Maturity value of the investment, i.e, A N = P 1 + i , where

P = 15,000, i = 12 = 1%, N = 5 12 = 60 12

b g b

A N = 15,000 1 + 1%

60

= 15,000 1.01

b g

60

= 15,000 1.816696699

= Rs. 27,250.45. The present value P, of the amount AN due at the end of N interest periods @ 1% interest per period is given by,
P = AN 1 + i

b g

Here,

A N = Rs. 27,250.45, i =

6 1 = 1 %, N = 5 4 = 20 4 2

1 P = 27250.45 1 + 1 % 2

FG H

IJ K

20

= 27250.45 1 + 0.015

20

= 27250.45 1.015

20

= 27250.45 0.742470418 = Rs. 20,232.65.

Mr. Y should not sell the property for less than Rs. 20,232.65.

(xiii) (a) P.V. for the 10 year annuity (V)

= V= P 1 1+ i i

{ b g }, where P = 8000, i = 5%, n = 20

n

8000 1 1 + 0.05 0.05

{ b

g } = 1,60,000 n1 b0.376889482 gs
20

= 1,60,000 0.623110518 = Rs. 99,697.68. (b) We require the amount of single deposit which matures to Rs. 99,697.68 in 15 years at 10% compounded semiannually,
A N = P 1 + i , where A N = 99,697.68, N = 15 2 = 30 and i =

b g

10 = 5% 2

P = AN 1 + i

b g

= 99697.68 1 + 0.05

30

= 99697.68 0.231377448

= Rs. 23,067.79.

Mathematics of Finance 37 (c) Required amount = Rs. 8000 20 = Rs. 1,60,000. (xiv) (a) E (Effective rate) = (1 + i)n 1 Here, (b) Here, (c) Here,
i= 0.1 = 0.05, n = 2 2

E = 1 + 0.05

b b

1 = 11025 1 = 0.1025, i. e., 10.25% .

i=

0.1 = 0.025, n = 4 4

E = 1 + 0.025

1 = 11038 1 = 0.1038, i. e., 10.38% .

i=

0.1 , n = 12 12

E = 1+

FG H

0.1 12

IJ K

12

1 = 11047 1 = 0.1047, i. e., 10.47% .

(d) The effective rate equivalent nominal rate 10% converted continuously is given by,
E = e R 1 = e 0.1 1 = 11052 1 = 0.1052, i. e., 10.52% .

(xv) (a) or, or, or, or, or, or, (b) or, or,

A N = P 1 + i , where P = 20, A N = 25, N = 10

b g log 5 log 4 = 10 log b1 + i g log 5 log 4 0.6990 0.6021 log b1 + i g = = 10 10 log b1 + ig = 0.00969 1 + i = Antilog b0.00969g = 1.0226
10

b g 25 = 20 b1 + i g
N

or,

5 = 1+i 4

10

i = 0.0226, i. e., 2 .26%

A = P e RN 25 = 20 e10 R or, e10 R =

5 4

10 R log e = log 5 log 4 = 0.6990 0.6021 = 0.0969

R=

0.0969 0.0969 = 10 log e 10 0.4343

log e = 0.4343

= 0.0223, i. e., 2.23%

(xvi) If P be the principal, A be the amount, R% be the rate of interest and N be the number of years, then A = P 1 + Here A = Rs. 6,500, P = Rs., 5,000, N = 2

F H

R 100

I K

FG1 + R IJ H 100 K

6500 R 12 or, 1 + = 1.3 = 11402 . 5000 100

b g

or,

R = 0.1402, R = 14.02%. 100

38 Financial Mathematics

EXERCISE 1(b)

1. A man borrows Rs. 40,000 at 4% compound interest and agrees to pay both the principal and interest in 10 equal instalments at the end of each year. Find the amount of these instalments.
[B.Com. (Bangalore), 1991]

2. Find the amount of an immediate annuity of Rs. 100 p.a. left unpaid for 10 years allowing 5% [B.Com. (C.U.)] p.a. compound interest. 3. Shri Ajit bought a house paying Rs. 20,000 down payment and Rs. 4,000 at the end of each year 25 years. What amount he would have paid for house, if he had bought it cash down? Reckon interest at 5% p.a. C.I. [B.Com. (Bangalore), 1991] [Hints: A = 20,000 +

P 1 1+ i i

{ b g }
n

= 20,000 +

4,000 1 1.05 0.05

{ b g }]
25

4. A machine costs Rs. 65,000 and its effective life is estimated to be 25 years. A sinking fund is created for replacing the machine at the end of its life time when its scrap realises a sum of Rs. 2,500 only. Calculate what amount should be provided every year out of profits for the sinking fund if it accumulates at 3% p.a. compound. [ICWAI, Dec. 1992] 5. The cost of a machine is Rs. 1,00,000 and its effective life is 12 years. If the scrap realises only Rs. 5,000, what amount should be retained out of profits at the end of each year to accumulate at C.I. 5% p.a.? [Given: log10 1.05 = 0.0212, log10 1.797 = 0.2544] [C.A. (Ent.), Nov. 1988; ICWAI, Dec. 1990] 6. A man retires at the age of 60 years and his employer gives him a pension of Rs. 1,200 a year for the rest of his life. Reckoning his expectations of life to be 13 years and that interest is at 4% p.a., what single sum is equivalent to his pension? [Given: log 104 = 2.0170 and log 6012 = 3.7790] [C.A. (Ent.), May 1991] 7. A man decides to deposit Rs. 500 at the end of each year in a bank which pays 8% p.a. compound interest. If the instalments are allowed to accumulate, what will be the total accumulation at the end of 7 years? 8. Find the amount of an annuity of Rs. 100 in 20 years, allowing compound interest at 4%. [Given: log 1.045 = 0.191163 and log 24.117 = 1.3823260] [ICWAI] 9. A person desires to create an endowment fund to provide for a prize of Rs. 300 every year. If the fund can be invested at 10% p.a. compound interest, find the amount of the endowment.
[ICWAI, June 1976]

10. What sum should be invested every year at 5% p.a. compound interest for 20 years, to replace plant and machinery, which is expected to cost them 25% more over its present cost of Rs. 60,000? [B.Com. (C.U.), 1970] 11. A machine costs a company Rs. 80,000 and its effective life is estimated to be 20 years. A sinking fund is created for replacing the machine at the end of its effective life time when its scrap realises a sum of Rs. 5,000 only. Calculate to the nearest hundreds of rupees, the amount

Mathematics of Finance 39

which should be provided, every year, for the sinking fund if it accumulates at 9% p.a. compounded annually. [ICWAI, Dec. 1975] 12. A motor cycle is purchased on instalment basis such that Rs. 3,400 is to be paid on the signing of the contract and four yearly instalments of Rs. 2,400 each payable at the end of the first, second, third and fourth years. If interest is charged at 8% p.a., what would be the cash down [B.Com. (Hons.) (C.U.), 1983] price? [Given: (1.08)4 = 1.36.] 13. A person invests Rs. 1,000 every year with a company which pays interest at 10% p.a. He allows his deposits to accumulate with the company at compound rate. Find the amount standing to his credit one year after he has made his yearly investment for the tenth time.
[ICWAI, Dec. 1975]

14. Calculate the present value of an annuity of Rs. 5,000 p.a. for 12 years, the interest being 4% p.a. compounded annually. [ICWAI, Dec. 1974] 15. A person purchases a house worth Rs. 70,000 on a hire purchase scheme. At the time of gaining possession he has to pay 40% of the cost of the house and the rest amount is to be paid in 20 equal annual instalments. If compound interest is reckoned at 7% p.a., what should be [ICWAI, June 1980] the value of each instalment? 16. A person desires to endow a bed in a hospital the cost for which is Rs. 6,000 p.a. If the money is worth 10% p.a., how much should he provide in perpetuity? He further desires to provide for the building of a ward, at a cost of Rs. 1,00,000 and also to provide for periodical repairs thereto entailing 5% of the cost of the ward per year on the average. What should be the total value of the endowment? [ICWAI, June 1977] 17. A person retires at the age of 58 and earns a pension of Rs. 6,000 a year. He wants to commute one-fourth of his pension to ready money. If the expectation of life at this age be 12 years, find the amount he will receive when money is worth 4% p.a. compound. (It is assumed that pension for a year is due at the end of the year). [ICWAI, June 1981] 18. A loan of Rs. 8,000 is to be paid in 5 equal annual payments, interest being at 5% p.a. compound interest and first payment being made after a year. Find the amount of each of the payments. [ICWAI, Jan. 1971] 19. On his 48th birthday a man decides to make a gift of Rs. 5,000 to a hospital. He decides to save this amount by making equal annual payments upto and including his 60th birthday to a fund which gives 3% compound interest, the first payment being made at once. Calculate the amount of each annual payment. [ICWAI, July 1972] 20. A person borrows a sum of Rs. 5,000 at 4% compound interest. If the principal and interest are to be repaid in 10 equal annual instalments, find the amount of each instalment; first payment being made after 1 year. [ICWAI, Jan. 1969] 21. Find the sum of money received by a pensioner at 58 if he wants to commute his annual pension of Rs. 1,200 for a present payment when compound interest is reckoned at 4% p.a. and the expectation of his life is assessed as 10 years only. [ICWAI, July 1969] 22. A man purchases a house and takes a mortgage on it for Rs. 60,000 to be paid off in 12 years by equal annual payments. If the interest rate is 5% compounded annually, what amount will be required to pay each year? [ICWAI, Jan. 1966]

40 Financial Mathematics

23. A company sets aside for a reserve fund the sum of Rs. 20,000 annually to enable it to pay off a debenture issue of Rs. 2,39,000 at the end of 10 years. Assuming that the reserve accumulates at 4% p.a. compound, find the surplus after paying off the debenture stock.
[ICWAI, July 1970]

24. For endowing an annual scholarship of Rs. 10,000, Mr. Reddy wishes to make five equal annual contributions. The first award of the scholarship is to be made two years after the last of his five contributions. What would be the value of each contribution, assuming interest at 5% p.a. compounded annually? [Assume that the first contribution is to be made now and the other four at an interval of one year thereafter.] [ICWAI, Dec. 1977]
ANSWERS

(1) Rs. 4,932; (2) Rs. 1,258; (3) Rs. 76,373; (4) Rs. 1,600; (5) Rs. 5,960; (6) Rs. 11,964; (7) Rs. 4,456.25; (8) Rs. 3,137.12; (9) Rs. 3,000; (10) Rs. 2,266; (11) Rs. 1,500; (12) Rs. 11,341.18; (13) Rs. 17,534; (14) Rs. 46,850; (15) Rs. 4,120; (16) Rs. 60,000, Rs. 1,10,000; (17) Rs. 14,055; (18) Rs. 1,847; (19) Rs. 343.14; (20) Rs. 617.50; (21) Rs. 9,717; (22) Rs. 6,767; (23) Rs. 500 ( A = Rs. 2,39,500); (24) Rs. 34,440.
SUMMARY

The chapter begins with the discussion of simple and compound interests, time value of money, annuities, present values of annuity and perpetuity, etc and ends with the discussion of sinking fund, amortization, present value of capital expenditure, free-hold and lease-hold estates, bankers discount, etc. Each definition has been explained with adequate number of examples.
KEY-TERMS (a) Some Important Formulae

1. A = P + S.I., where A = amount, P = principal, N = No. of years. = P (1 + Ni), i =

R ; and R in % p.a. is rate of interest. 100

2. I = Compound interest = A P = P 1 + i

a f

P = P (1 + i ) N 1

where, P = principal, N = No. of years, i = interest on Rs. 1 for 1 year. 3. Amount of an annuity = A = on Rs. 1 for 1 year. 4. P.V. of an annuity = V =
P 1 (1 + i ) n , where P = Annuity to continue for n years. i
P . i

P (1 + i) n - 1 , where P = Annuity, n = unpaid years, i = interest i

5. P.V. of a perpetuity = V =

Mathematics of Finance 41

6. P.V. of a deferred annuity = V =

P i

R a1 + if 1 U, where P = Annuity, Payment starts at the S a1 + if V T W

n m+n

end of m years and thereafter continues for n years. 7. P.V. of a deferred perpetuity = V =
P i

LM 1 OP, P to begin after m years. N a1 + if Q

m

8. If A is the amount of loan to be paid off at the end of n years and P is the accumulations of the annual sum, then
A= P 1+ i i

a f

9. If P1, P2, ..., Pn be the unequal cash inflows received at the end of year 1, 2, ..., n respectively, then the present value of these sums at interest rate i is given by:

V=

P1 P2 + i 1+ i

a f

++

a f

Pn 1+ i

10. Bankers Gain = Bankers Discount True Discount. 11. (i) True Discount = A 1 1 + i (ii) True Discount =

o a f t.
N

(Compound Interest) (Simple Interest)

A Ni . 1 + Ni