Lecture 3:
Topic: Mathematics of Finance
Reading
H&P, Ch 5.
Reading for this lecture
H&P, Ch 5, Sect 5.1 - 5.2;
(also refer back to Ch 4, pp. 167-168)
Homework for Tutorial in Week 2
Ex 5.1, pp.200-201 , problems 1, 3, 9, 11.
Ex 5.2, pp. 204-205, problems 3, 11, 15, 19.
Compound Interest
End of Qtr 1: S = 100(1 + 0.02) = 102
End of Qtr 2: S = 102(1 + 0.02) = 104.04
=
End of Qtr 3: S = 104.04(1 + 0.02) = 106.12
= r
End of Qtr 4: S = 106.12(1 + 0.02) = 108.24
=
Find S, given P, r and n
Suppose $1,000 is invested at 5%. What is the
compound amount after 4 years if interest is
accumulated (a) annually, (b) semi-annually?
S = P(1 + r)n
P=
(a)
(b)
Compound Interest
Suppose $100 is invested at 8 percent per
annum. Interest is earned and reinvested
at the end of every quarter.
What is the compound amount after 1 year?
Principal =
Nominal interest rate =
Quarterly interest rate =
Number of quarters =
1 2
Compound Interest Formula
S = P(1 + r)n
where
P is the original principal
n is the number of conversion periods
is the rate of interest per conversion period
S is the compound amount after n periods
S – P is amount the compound interest earned
3 4
Find r, given S, P and n
Over a three-year period, an original principal of
$5,000 accumulated to $7,000 in an account in
which interest was compounded monthly.
Determine the nominal rate of interest.
S = P(1 + r)n
The periodic rate of interest is
The nominal rate of interest is
5 6
1
 Find n, given S, P and r The Effective Rate of Interest
How long will it take to double a principal at a What annual interest rate, re, would give the
rate of 10%? same compounded amount in 4 years as 5%
S = P(1 + r)n compounded 2 times per year?
Solve P(1 + re)4 = P(1 + 0.025)(4)(2)

The effective rate of interest is

It will take years to double a principal An interest rate of compounded annually
invested at 10% per annum. would give the same amount in 4 years as a
7 5% interest rate compounded semi-annually. 8

Definition: The Effective Rate of Interest, re ,

is the per annum equivalent of a periodic interest
rate (per annum rate/no. of conversion periods).
P(1 + re)n = P(1 + r/m)nm
∴ (1 + re)n = (1 + r/m)nm
∴ (1 + re) = (1 + r/m)m
∴ re = (1 + r/m)m – 1
where
r is the nominal rate of interest,
n is the number of years,
m is the number of conversion periods per year
(times per year that interest is compounded).
9 10
Discounting
Find P, given S, n and r
Discounting is the method of finding the
current value of a sum of money that will be
available at a future date.
e.g. How much is $1,000 payable in a year’s
time worth today? In other words, what sum,
invested at the current rate of interest, would
compound to $1,000 after one year?

The Present Value Trust Fund

S = P(1 + r)n Ex 5.2, p. 204, problem 13.

Find P, given S, r and n A trust fund for a 10-year-old child is being
P = S(1 + r)-n set up by a single payment so that by age 21
where the child will receive $27,000. Find how much
P is the present value of the future sum, S
the payment is if an interest rate of 6%
n is the number of conversion periods
compounded semiannually is assumed.
r is the rate of interest per conversion period
S is the future sum after n periods 11 12

2
 Trust Fund Equations of Value
Ex 5.2, p. 204, problem 13.
S= Ex 5.2, p. 205, problem 17.
r = A debt of $5,000 due five years from now and
n = $5,000 due ten years from now is to be
P = S(1 + r)-n repaid by a payment of $2,000 in two years,
= a payment of $4,000 in four years, and a final
=
payment at the end of six years. If the interest
=
rate is 2.5% compounded annually, how
invested now at 6% compounded semi-
annually will be worth $27,000 in 11 year’s time.13 much is the final payment?
14

Ex 5.2, p. 205, problem 17. Ex 5.2, p. 205, problem 17.

year debt repayment 1+r=
1
2 2000 Let x be the final payment at the end of 6 years.
3 Equate the PV of the payments with the PV of
4 4000
5 5000 the debt.
6 x
7
8
9
Isolate x by multiplying by
10 5000
15 16

Ex 5.2, p. 205, problem 17. Net Present Value

Example
An initial investment of $10,000 in a business
Solve for x
guarantees the following cash flows:
x =
Year 2 3 4
Cash Flow 2,500 5,000 7,500
= 5,125 + 4,529.75 – 2,207.63 – 4,202.5
Find the NPV at an interest rate of 10%
=
Is the investment profitable?
The final payment at the end of six years must be
17 18

3
 Net Present Value
1+r=
NPV =
=
=
The net present value of cash flows is
The investment is profitable because the NPV
of cash flows exceeds zero.

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