CH 06

Finite Mathematics: An Applied Approach by Michael Sullivan
Copyright 2011 by John Wiley & Sons. All rights reserved.

CHAPTER
6
Finance
Chapter 6 p1
6.1 Interest
Section 6.1 p2
Section 6.1 p3
Definition
Simple Interest
Simple interest is interest computed on the principal for
the entire period it is borrowed.
6.1 Interest
Section 6.1 p4
Theorem
Simple Interest Formula
If a principal P is borrowed at a simple interest rate of R%
per annum (where R% is expressed as the decimal r = R/100
for a period of t years, the interest I is
I = Prt (1)

6.1 Interest
Section 6.1 p5
Theorem
The amount A owed at the end of t years is the sum of the
principal P borrowed and the interest I charged. That is,
A = P + I = P + Prt = P(1 + rt) (2)

6.1 Interest
Section 6.1 p6
Theorem
Discounted Loans
Let r be the per annum rate of interest, t the time in years,
and L the amount of the loan. Then the proceeds R is given
by
R = L Lrt = L(1 rt) (3)
where Lrt is the discount, the interest deducted from the
amount of the loan.
6.1 Interest
6.2 Compound Interest
Section 6.2 p7
Section 6.2 p8
Determine the Future Value of a Lump Sum of Money
In working with problems involving interest, we use the term
payment period as follows:
Annually Once per year
Semiannually Twice per year
Quarterly 4 times per year
Monthly 12 times per year
Daily 365 times per year*
If the interest due at the end of each payment period is added to
the principal, so that the interest computed for the next payment
period is based on this new amount of the old principal plus
interest, then the interest is said to have been compounded.
That is, compound interest is interest paid on the initial principal
and previously earned interest.
* Some banks use 360 times per year.
Section 6.2 p9
Theorem
Compound Interest Formula
The amount A after t years due to a principal P invested at
an annual interest rate r compounded n times per year is

(1)

The amount A is typically referred to as the future value of
the account, while P is called the present value.
1
nt
r
A P
n
| |
= +
|
\ .
Section 6.2 p10
Now suppose that the number n of times that the interest is
compounded per year gets larger and larger.
This is equivalent to h = n/r getting larger and larger.
Table 2 (see next slide) illustrates what happens to the
expression (1 + 1/h)
h
as h takes on increasingly larger values;
notice it is getting closer to a particular number, which we
designate as e.
Section 6.2 p11
TABLE 2

The bottom number in the right column is the number e correct to eight decimal
places and is the same as the entry given for e on your calculator (if expressed
correctly to eight decimal places). The number e is an irrational number, so its
decimal equivalent is a nonrepeating, nonterminating decimal.
Section 6.2 p12
Definition
The number e is defined as the number that the expression

(3)

approaches as h gets larger and larger.
1
1
h
h
| |
+
|
\ .
Section 6.2 p13
Definition
When interest at per annum rate, r, is compounded on a
principal P so that the amount after 1 year is Pe
r
, we say the
interest is compounded continuously.
Section 6.2 p14
Theorem
Continuous Compounding
The amount A after t years due to a principal P invested at
an annual interest rate r compounded continuously is
A = Pe
rt
(4)

Section 6.2 p15
When people engaged in finance speak of the time value of
money, they are usually referring to the present value of
money.
The present value of A dollars to be received at a future
date is the principal that you would need to invest now so
that it will grow to A dollars in the specified time period.
The present value of money to be received at a future date is
always less than the amount to be received, since the
amount to be received will equal the present value (money
invested now) plus the interest accrued over the time
period.
Section 6.2 p16
Theorem
Present Value Formulas
The present value P of A dollars to be received after t years,
assuming a per annum interest rate r compounded n times
per year, is
(5)

If the interest is compounded continuously,
P = Ae
rt
(6)

1
nt
r
P A
n
| |
= +
|
\ .
6.3 Annuities; Sinking Funds
Section 6.3 p17
Section 6.3 p18
An annuity is a sequence of equal periodic deposits. The
periodic deposits can be annual, semiannual, quarterly,
monthly, or any other fixed length of time.
When the deposits are made at the same time the interest is
credited, the annuity is termed ordinary*.
The amount of an annuity is the sum of all deposits made
plus all interest accumulated.

*We shall concern ourselves only with ordinary annuities in this book.
Section 6.3 p19
Theorem
Amount of an Annuity
Suppose P is the deposit made at the end of each payment
period for an annuity paying an interest rate of i per
payment period.
The amount A of the annuity after n deposits is

(1)

(1 ) 1
n
i
A P
i
| |
+
=
|
\ .
Section 6.3 p20
A person with a debt may decide to accumulate sufficient
funds to pay off the debt by agreeing to set aside enough
money each month (or quarter, or year) so that when the
debt becomes payable, the money set aside each month plus
the interest earned will equal the debt.
The fund created by such a plan is called a sinking fund.
6.4 Present Value of an Annuity;
Amortization
Section 6.4 p21
Section 6.4 p22
The present value of an annuity is the sum of the present
values of the withdrawals.
In other words, the present value of an annuity is the
amount of money needed now so that if it is invested at a
rate of i per payment period, n equal dollar amounts can be
withdrawn without any money left over.
6.4 Present Value of an Annuity; Amortization
Section 6.4 p23
Theorem
Present Value of an Annuity
Suppose an annuity earns interest at the rate of i per
payment period. If n withdrawals of $P are made at each
payment period, the amount V required is

(1)

Here V is called the present value of the annuity.
1 (1 )
n
i
V P
i
| |
+
=
|
\ .
Section 6.4 p24
A loan with a fixed rate of interest is said to be amortized if
both principal and interest are paid by a sequence of equal
payments made over equal periods of time.
(The Latin word mort means death. Paying off a loan is
regarded as killing it.)
Section 6.4 p25
Theorem
Amortization
The payment P required to pay off a loan of V dollars
borrowed for n payment periods at a rate of interest i per
payment period is

(2)

1 (1 )
n
i
P V
i

| |
=
|
+
\ .
Section 6.4 p26
Definition
Face Amount (Face Value or Par Value)
The face amount or denomination of a bond (normally
$1000) is the amount paid to the bondholder at maturity.
It is also the amount usually paid by the bondholder when
the bond is originally issued.
Section 6.4 p27
Definition
Nominal Interest (Coupon Rate)
The nominal interest or coupon rate is the contractual interest
paid on the bond.
Section 6.4 p28
Nominal interest is normally quoted as an annual
percentage of the face amount.
Nominal interest payments are conventionally made
semiannually, so semiannual periods are used for
compound interest calculations.
Section 6.4 p29
When the bond price is higher than the face amount, it is
trading at a premium;
when it is lower, it is trading at a discount.
For example, a bond with a face amount of $1000 and a
coupon rate of 8% may trade in the marketplace at a price of
$1100, which means the true yield is less than 8%.
To obtain the true interest rate of a bond, we view the bond
as a combination of an annuity of semiannual interest
payments plus a single future amount payable at maturity.
The price of a bond is therefore the sum of the present value
of the annuity of semiannual interest payments plus the
present value of the single future payment at maturity.
This present value is calculated by discounting at the true
interest rate and assuming semiannual payment periods.
6.5 Annuities and Amortization
Using Recursive Sequences
Section 6.5 p30
Section 6.5 p31
Often, though, money is invested in equal amounts at
periodic intervals. An annuity is a sequence of equal
periodic deposits. The periodic deposits may be made
annually, quarterly, monthly, or daily.
When deposits are made at the same time that the interest is
credited, the annuity is called ordinary. We will only deal
with ordinary annuities here.
The amount of an annuity is the sum of all deposits made
plus all interest paid.
6.5 Annuities and Amortization Using Recursive Sequences
Section 6.5 p32
Theorem
Annuity Formula
If A
0
= M represents the initial amount deposited in an
annuity that earns a rate of r per annum compounded N
times per year, and if P is the periodic deposit made at each
payment period, then the amount A
n
of the annuity after n
deposits is given by the recursive sequence

A
0
= M, (1)

*We use N to represent the number of times interest is compounded per annum instead
of n, since n is the traditional symbol used with sequences to denote the term of the
sequence.
1
1 , 1
n n
r
A A P n
N

| |
= + + >
|
\ .
Section 6.5 p33
Theorem
Amortization Formula
If $B is borrowed at an interest rate of r per annum
compounded monthly, the balance A
n
due after n monthly
payments of $P is given by the recursive sequence

(2)

Formula (2) may be explained as follows: The initial loan balance is $B.
The balance due after n payments will equal the balance due previously,
plus the interest charged on that amount reduced by the periodic
payment P.
0 1
, 1 , 1
12
n n
r
A B A A P n
| |
= = + >
|
\ .
Chapter 6 p34
IMPORTANT FORMULAS
Simple Interest Formula I = Prt
Discounted Loans R = L Lrt
Compound Interest Formula
A = Pe
rt

Amount of an Annuity

Present Value of an Annuity

Amortization

6 Summary
Summary
| |
= +
|
\ .
1
nt
r
A P
n
| |
+
=
|
\ .
(1 ) 1
n
i
A P
i
| |
+
=
|
\ .
1 (1 )
n
i
V P
i
| |
=
|
+
\ .
1 (1 )
n
i
P V
i
Select the best answer
for each of the following
multiple choice questions.
Section 6.MC p35
6.Extra Multiple Choice Questions
Section 6.MC p36
1. If $15,000 is deposited in an account
that earns interest at a 5.25% annual
rate, compounded monthly, find the
amount in this account after seven
years.
A. $21,610.07
B. $21,460.80
C. $21,644.44
D. $6,644.44
Section 6.MC p37
2. If $235 is deposited at the end of each
month for five years in an account earning
interest at an annual interest rate of 7.15%,
compounded monthly, find the amount in
this account at the end of five years.
A. $16,265.69
B. $15,108.15
C. $14,100.00
D. $16,889.81
Section 6.MC p38
3. If an automobile loan of $28,500 is to be
repaid in equal monthly payments over
five years, at an annual interest rate of
3.75%, compounded monthly, find the
monthly payment for this loan.
A. $521.66
B. $475.00
C. $432.60
D. $476.48
Section 6.MC p39
4. What is the principal amount of a 30-year,
fixed-rate home loan, if the monthly
mortgage payment for this loan is $1800
and the annual interest rate for this loan is
6.125%, compounded monthly?
A. $312,700.30
B. $296,242.39
C. $288,013.44
D. $279,784.48
Section 6.MC p40
Answers for the Multiple Choice Questions
1. C. $21,644.44
2. D. $16,889.81
3. A. $521.66
4. B. $296,242.39

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Finite Mathematics: An Applied Approach by Michael Sullivan

Copyright 2011 by John Wiley & Sons. All rights reserved.

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