CHAPTER FOUR

MATHEMATICS OF FINANCE

4.1 Introduction to Mathematics of Finance

If you borrow money from lending agents or Banks, then when you return back the money you
have to pay additional money for the use of the money. The price paid for the use of a sum of
money over a period of time is called Interest. It is a fee paid for the use of another’s money, just
the same as a rent is paid for the use of another’s house. Savings institutions (Banks) pay interest
to depositors on the money in their savings accounts; since the institutions have use of those
funds while they are on deposit. On the other hand, a borrower pays interest to a lending agent
(Bank or individual) for use of the agent’s fund over the term of the loan.

Interest is usually computed as percentage of the principal over a given period of time. This is
called interest rate. Interest rate specifies the rate at which interest accumulates per year
throughout the term of the loan. The original sum of money that is lent or invested/or borrowed
is called the principal or present value. The sum of money deposited or invested and the amount
of interest together are called the amount or future value.

Interests are of two types: simple interest and compound interest. In the next subsections of this
section you will explore these two concepts.

4.2 Simple Interest and its Future Value

If interest is paid only on the initial amount of money invested or borrowed, and not on
subsequently accrued interest, it is called simple interest. The sum of the original amount
(principal) and the total interest is the future amount or maturity value or in-short amount.
Simple interest is generally used only on short-term loans or investments –often of duration less
than one year. The simple interest is given by the following formula.

I  Pr t  (4.1)
Where: I  amount of simple interest;
P  the amount of principal;
r  the simple interest rate per year (annual or nominal simple interest rate); and
t  the time in years, for which the interest is paid

If any three of the four variables are given, you can solve for the fourth (unknown) variable.
The amount of simple interest or future value of the simple interest ( A ) is the sum of the
principal and the simple interest, given by:
A PI
 P  Pr t if you factor out P , then you have

A  P(1  rt ) (4.2)
From (4.2) we can obtain the present value of the simple interest if the amount of simple
interest, time and interest rate per year is given as follows:
A
P
1  rt
Example 4.1 Ato Kassahun wanted to buy a TV set which costs Birr 10, 000. He was short of cash
so he went to Commercial Bank of Ethiopia (CBE) and borrowed the required sum of money for

1
9 months at an annual interest rate of 6%. Find the total simple interest and the maturity value
of the loan.
Solution:
Given P  10,000 Birr
9 3
t  9 months   years (In computing interest time has to be in years, always)
12 4
r  0.06 (In computing interest, interest rates have to be in decimal or fraction)
Required I  ? and A  ?
 3
The simple interest obtained is I  Pr t  10,000 (0.06)    450 Birr.
 4
The amount of interest obtained is: A  P  I  10,000  450  10,450 Birr or equivalently
 3
A  P(1  rt )  10,000 1  0.06    10,000(1.045)  10,450 Birr.
 4
The total amount that will have to be repaid to CBE at the end of the 9th month will be Birr 10,
450 (the original borrowed amount plus Birr 450 Interest).

Note It is essential that the time period t and r be consistent with each other. That is if r is
expressed as a percentage per year, t also should be expressed in number of years (number
of months divided by 12 if time is given as a number of months). If time is given as a
Number of days
number of days, then t = . This approach is known as ordinary interest
360
year method, which uses a 360-day year, whereas if we use 365 days year the approach is
called exact time method.

4.3 Compound Interest

If the interest which is due is added to the principal at the end of each interest period (such as a
month, quarter, and year), then this interest as well as the principal will earn interest during the
next period. In such a case, the interest is said to be compounded. The result of compounding
interest starts with the second compounding period; the account earns interest on interest in
addition to earning interest on principal during the next payment period. Interest paid on interest
reinvested is called compound interest.

The sum of the original principal and all the interest earned on the entire time is called the
compound amount (or the future value of a compound interest). The difference between the
compound amount and the original principal is the compound interest.

The compound interest method is generally used for long-term borrowings unlike the simple
interest which is used only for short-term borrowings. The time interval between successive
conversions of interest into principal is called the interest period, or conversion period, or
compounding period, and it may be any convenient length of time. The interest rate is usually
quoted as an annual interest rate (r ) and must be converted to appropriate rate per conversion
period (i ) for computational purposes. Hence, the rate per compound period (i ) is found by
dividing the annual nominal rate (r ) by the number of compounding periods per year (m) , that
is

2
 r
i
m
For example, if the interest rate per year is r  12% , then interest rate per period (i ) is
calculated as follows:

Conversion period (m) Rate per compound period (i )

r 0.12
1. Annually (once a year, m  1 ) i    0.12
m 1
r 0.12
2. Semiannually (every 6 months, m  2 )  i    0.06
m 2
r 0.12
3. Quarterly (every 3 months, m  4 ) i    0.03
m 4
r 0.12
4. Monthly ( m  12) i    0.01
m 12

Example 4.6 Assume that Birr 10, 000 is deposited in an account that pays an interest of 12% per
year, compounded quarterly. What are the compound amount and compound interest at the
end of one year?

Solution
Given: P  10,000 Birr, r  12%  0.12 , t  1 year , m  4 and this means interest will be
computed at the end of each three-month period and added in to the principal.
Required: A  ? and I  ?

To find the interest rate per period and the number of period interest is compounded:
r 0.12
i   0.03 and n  mt  4  1  4
m 4
In general, if P is the principal earning interest compounded m times a year at an annual rate of
r , then (by repeated use of the simple interest formula, using i  r m , the rate per period), the
amount Ai at the end of i period is:
th

The compound amount at the end of first period ( A1 ) will be:

A1  P1  i (1)   P1  i 
The amount at the end of the first period will serve as a principal to the second period. Hence,
the compound amount ( A2 ) at the end of the second period will be:
A2  A1 1  i(1)  A1 1  i   P(1  i)(1  i)  P(1  i) 2
Again, the amount at the end of the second period will serve as a principal to the third period.
Hence, the compound amount ( A3 ) at the end of the third period will be:
A3  A2 1  i(1)   A2 1  i   P(1  i) 2 (1  i)  P(1  i) 3
In, this process you observe that the compound amount ( An ) at the end of the n period
th

depends on the amount at the end of the (n  1) th period and thus be given as:
An  An1 1  i(1)  An1 1  i   P(1  i) n1 (1  i)  P(1  i) n

3
The compound amount formulae developed so far are summarized below:
1. Compound amount after one period A1  P1  i  .
1

2. Compound amount after two periods A2  P1  i  .

2

3. Compound amount after three periods A3  P1  i  .

3

n. Compound amount after nth periods An  P1  i  .

n

Therefore, the compound amount formula will be given by:

A  P1  i  (4.3)
n

Where: A  amount (future value) of a compound interest at the end of nth periods,
P  the principal (present value)of a compound interest,
i  interest rate per compounding period,
n  the total number of conversion periods,
m  number of compounding or conversion periods per year,
t  total number of years money saved or deposited, and
r  interest rate per year or annual rate of interest.
r
You can also express equation (4.3) differently using i  and n  mt (since if interest is
m
compounded m times per year, then in t years it will be compounded mt -times) as follows:
mt
 r
A  P1    (4.4)
 m
The compound interest (I ) is given by the difference between compound amount and the
principal, that is:
I  A  P (4.5)
Now if you go back to solve the above problem, then
A1  P1  i   10,000(1.03)1  10,300.00 Birr, at the end of the 1st quarter
1

A2  P1  i   10,000(1.03) 2  10,609.00 Birr, at the end of the 2nd quarter

2

A3  P1  i   10,000(1.03) 3  10,927.27 Birr, at the end of the 3rd quarter

3

A4  P1  i   10,000(1.03) 4  11255.08 Birr, at the end of the 4th quarter

4

In general, the compound amount can be found by multiplying the principal by (1 + i)nusing
equation (4.3) above. Hence, the amount at the end of the year,
A  P(1  i) n  10,0001  0.03  10,000(1.03) 4  11,255.08 Birr.
4

mt 41
 r  0.12 
or A  P 1    10,000 1    10,000(1.03) 4  11,255.08 Birr.
 m  4 
The amount of interest is obtained from (4.4) hence:
I  A  p  11,255.08  10,000  1,255.08 Birr.

Example 4.7 Find the compound amount and compound interest after 10 years if Birr 15,000
were invested at 8% interest, if compounded
a) Annually? b) Semi-annually? c) Quarterly?
d) Monthly? e) Weekly? f) Daily? Hourly?

4
Solution
a) Annually: compounding annually means that there is one interest payment period per year.
Given: P  15,000 Birr, t  10 year , r  8%  0.08 , m  1 .
r 0.08
Hence, n  mt  1(10)  10 , and i    0.08
m 1
Required: A  ? and I  ?
The compound amount will be:
A  P(1  i) n  15,0001.08  10,000(2.158925)  32,383.87 Birr.
10

The compound interest is:

I  A  P  32,385.87  15,000  17,383.87 Birr
b) Semiannually (m  2)
Compounding semiannually means that there are two interest payment periods per year.
Thus, the number of payment periods in 10 years is n  mt  2(10)  20 , and
r 0.08
i   0.04 . The compound amount then will be:
m 2
A  P(1  i) n  15,0001.04  10,000(2.191123)  32,866.84 Birr.
20

The compound interest is:

I  A  P  32,866.84  15,000  17,866.84 Birr
c) Quarterly (m  4)
Compounding quarterly means that there is four interest payment periods per year.
Thus, the number of payment periods in 10 years is n  mt  4(10)  40 , and
r 0.08
i   0.02 . The compound amount then will be:
m 4
A  P(1  i) n  15,0001.02  15,000(2.208039)  33,120.59 Birr
40

The compound interest is:

I  A  P  33,120.59  15,000  18,120.59 Birr
d) Monthly (m  12)
Compounding monthly means that there is twelve interest payment periods per year. Thus,
the number of payment periods in 10 years is n  mt  12(10)  120 , and
r 0.08
i   0.00667 . The compound amount then will be:
m 12
A  P(1  i) n  15,0001.00667  15,000(2.220522)  33,307.83 Birr
120

The compound interest is:

I  A  P  33,307.83  15,000  18,304.83 Birr
e) Weekly (m  52)
r 0.08
n  mt  52(10)  520 , and i    0.001538 . The compound amount will be:
m 52
A  P(1  i) n  15,0001.001538  15,000(2.22364)  33,354.60 Birr
520

The compound interest is:

I  A  P  33,354.60  15,000  18,354.83 Birr

5
f) Try yourself: if Compounded daily, and hourly, what will be the compound amount
respectively?
Answer: Birr 33,380.19 and Birr 33, 382.99, respectively.

Present Value
Frequently it is necessary to determine the principal P , which must be invested now at a given
rate of interest per conversion period i in order that the compound amount A be accumulated
at the end of n conversion periods. Under these conditions, P is called the present value of A .
This process is called discounting and the principal is now a discounted value of future income A .
If A  P(1  i) n then dividing both sides by (1  i) n leads you to:
A
P  A(1  i) n
(1  i) n

Therefore, the present value of a compound interest is given by:

P  A(1  i)  n (4.7)

Example 4.10 How much should you invest now at 8% compounded semiannually to have Birr
10, 000 toward your brother’s college education in 10 years?
Solution
Given: A  10,000 Birr, r  8%  0.08 , m  2 , t  10 years.
Required: P  ?
r 0.08
First you need to find observe i    0.04 and n  mt  2(10)  20 .
m 2
Therefore P  A(1  i) n  10,000(1.04) 20  4563.86 Birr

4.4 An Ordinary Annuity

An annuity is any sequence of equal periodic payments. The payments may be made weekly,
monthly, quarterly, annually, semiannually or any fixed period of time. The time between
successive payments is called payment period for the annuity. If payments are made at the end of
each payment period, the annuity is called an ordinary annuity. If payment is made at the
beginning of the payment period, it is called annuity due. In this course we will discuss only
ordinary annuities. The amount or future value, of an annuity is the sum of all payments plus the
interest earned during the term of the annuity.

The term of an annuity refers to the time from the beginning of the first payment period to the
end of the last payment period.

An ordinary annuity is a series of equal periodic payments in which each payment is made at the
end of the period. In an ordinary annuity the first payment is not considered in interest
calculation for the first period because it is paid at the end of the first period for which interest is
calculated. Similarly, the last payment does not qualify for interest at all since the value of the
annuity is computed immediately after the last payment is received.

In this section you will learn future value and present value of an ordinary annuity computation.
Furthermore, you will observe how much to deposit periodically that is, sinking fund and how
do you pay your dept that is amortization.

6
 1. Future value (Amount) of an ordinary annuity
If you make equal payments at the end of each period, which coincide, with the corresponding
period of time interest compounded, then you are contributing to the future value of an ordinary
annuity. Hence you will develop a formula that will give you the cumulated amount you have at
some specified time in the future using the following example.

Example 4.13 What is the amount of an ordinary annuity if the size of each payment is Birr 100
payable at the end of each quarter for one year at an interest rate of 4% compounded quarterly?

Solution
Observe that you are given;
Periodic payment R  100 Birr
Payment interval or conversion period m  4
Annual interest rate r  4%  0.04
r 0.04
Interest per period i    0.01 and look for
m 4
Future value of an ordinary annuity = ?
The first payment of Birr100 accumulates interest for three periods, the second payment Birr
100accumulats for 2 periods etc. The last payment accumulate no interest, the next to last
payment accumulates one period for interest.

Periods 0 1 2 3 4

Payment Birr 100 Birr 100 Birr 100 Birr 100

100(1.01)1

100(1.01)2

100(1.01)3

Future value of the annuity = 406.04 Birr

The future value of the ordinary annuity or amount of the annuity ( A) is the sum you have on
the right hand side of the chart shown, hence
A  100  100(1.01)1  100(1.01) 2  100(1.01) 3 ()
If you multiply with 1.01 both sides of the equation, you have
1.01A  100(1.01)  100(1.01) 2  100(1.01) 3  100(1.01) 4 ()
Now, if you subtract () from () , on the right hand side of the equations most of the terms will
cancel each other out and you remain with the last term of () and the first term of () .
 
(1.01  1) A  100 (1.01) 4  1
 (1.01) 4  1
Which implies that the future value is, A  100    406.04 Birr.
 0.01 

7
Therefore, the amount of interest (I ) for future value of an ordinary annuity obtained will be
the difference of the future value of the ordinary annuity and the total amount of payment
made.
I  406.04  100(4)  6.04 Birr
If R represents the amount of the periodic payment, i represents the interest rate per payment
period, and n represents the number of payment periods, then the first payment of R
accumulates interest for (n  1) periods, the second payment R for (n  2) periods etc. The last
payment accumulates no interest; the next to last payment accumulates one period of interest. So
using the future value for compound interest we see the future value of the ordinary annuity:

R RR  R R
Payment
0 2 3 4  (n-1) n
Periods
n 1 n2
A  R(1  i)  R(1  i)    R(1  i)  R(1  i)  R (  )
2

Multiplying each side of the equation (  ) by (1  i ) , you obtain

A(1  i)  R(1  i) n  R(1  i) n1    R(1  i) 3  R(1  i) 2  R(1  i)(  )
Now, subtracting the first equation (  ) from the second equation (  ) gives you:
 n n 1
 A(1  i )  R(1  i)  R(1  i )    R(1  i )  R(1  i)  R(1  i)
3 2


 
 A  R(1  i) n 1  R(1  i) n 2    R(1  i) 2  R(1  i )  R
A(1  i)  A  R(1  i ) n  R

Hence A(1  i  1)  R (1  i) n  1 

iA  R (1  i)  1
n
 (Divide both sides of the equation by i )
 (1  i) n  1
A  R  (4.10)
 i 
Where A  the future value (or amount) of an ordinary annuity at the end of its term,
R  the amount of periodic payment,
 r
i  the interest rate per payment period  i   , and
 m
n  the total number of periodic payments made n  mt  .

If you solve the above problem using the future value of an ordinary annuity formula given by
equation (9):
 (1  i) n  1 100 1.04 4 1
A  R    406.04 Birr
 i   0.04 
The amount of interest of the future value of an ordinary annuity is given by:

I  A  nR  (4.11)

8
Example 4.14 Mr. X deposits Birr 100 in a special savings account at the end of each month. If
the account pays 12%, compounded monthly, how much money will Mr. X have accumulated
just after the 15th deposit?
Solution
Given: R  100 Birr, r  12%  0.12 , m  12 , n  15
Required: A  ?
r 0.12
You need to look for i    0.01 .
m 12
Using the future value of an ordinary annuity formula given by equation (9):
 (1  i) n  1 100 1.0115 1
A  R    100(16.096896)  1609.68 Birr
 i   0.01 

Example 4.15 A person deposits Birr 200 a month for four years into an account that pays 7%
compounded monthly. After the four years, the person leaves the account untouched for an
additional six years. What is the balance after the 10 years period?

Solution
Given: R  200 Birr, t  4 Years, r  7%  0.07 , m  12
Required: The future value of an ordinary annuity after four years A  ? and then what is the
compound amount after six period?
r 0.07
You need to look for i    0.005833 and n  mt  12(4)  48 .
m 12
Using the future value of an ordinary annuity formula:
 (1  i) n  1  1.00583348 1
A  R   200    200(55.0878585)  11,041.75 Birr.
 i   0.005833 
At the end of the fourth year, we calculate compound interest rate taking Birr 11, 041.75 as
principal compounded monthly for the coming 6 years.
Now, P  11, 041.85 Birr, t  6 Years, r  7%  0.07 , m  12 , then
r 0.07
i   0.005833 and n  mt  12(4)  48
m 12
Hence, from compound interest formula we have:
A  P(1  i) n  11,041.75(1.005833) 72  16,784.22 Birr.
Therefore, the balance after 10 years is Birr 16, 784.22.

2. Sinking Fund
A sinking fund is a fund into which equal periodic payments are made in order to accumulate a
definite amount of money up on a specific date. Sinking funds are generally established in order
to satisfy some financial obligations or to reach some financial goal..

If the payments are to be made in the form of an ordinary annuity, then the required periodic
payment into the sinking fund can be determined by reference to the formula for the amount of
an ordinary annuity. That is, from equation (9) we have:

9
  (1  i) n 1 A
A  R  , then R 
 i  (1  i ) n 1
i
Therefore, the periodic payment made will be:
 i 
R  A 
 (1  i) 1
n

Example 4.16 How much will have to be deposited in a fund at the end of each year at 8%
compounded annually, to pay off a debt of Birr 50, 000 in five years?

Solution
Given: A  50,000 Birr, t  5 Years, r  8%  0.08 , m  1
Required: R  ?
r 0.08
You need to look for i    0.08 and n  mt  1(5)  5 .
m 1
Therefore the periodic payment will be:
 i   0.08 
R  A   50,00    50,000 (0.170456454 )  8,522.82 Birr.
 (1  i)  1  1.08 1
n 5

The total amount of deposit over the 5 year period is equal to 5 x 8, 522.80 = Birr 42, 614

Example 4.17 Ato Ayalkebet has a savings goal of Birr 100, 000 that he would like to reach 15
years from now. During the first five years he is financially able to deposit only Birr 1000 each
quarter into the savings account. What must his quarterly deposit over the last 10 (ten) years if he
is to reach his goal? The account pays 10% interest compounded quarterly.

Solution
Given: A  100,000 Birr, t  5 Years, R  1000 Birr, r  10%  0.10 , m  4
Required: For the last 10 years, the periodic payment R  ?
r 0.10
You need to look for i    0.025 and n  mt  4(5)  20 .
m 4
Therefore, the future value of the ordinary annuity at the end of 5 years will be:
 (1  i) n 1  (1.025) 20 1
A  R   1,000    1,000 (25.54465761)  25,544.65 Birr.
 i   0.025 
This sum (Birr 25,544.65) will continue to draw interest at the rate of 10%; compounded
quarterly, over the next 10 years; and the compound amount at the end of the 10 th year will be
obtained by taking:
P  25,544.65 Birr
t  10 Years
r  2.5%  0.025
m4
Hence, n  mt  4(10)  40 . The compound amount at the end of 10 years will be:
A  P(1  i) n  25,544.65(1.025) 40  68,589.01Birr.

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To determine the periodic payment for the remaining 10 years, we subtract Birr 68,589.01 from
Birr 100, 000 to obtain the amount of an ordinary annuity for the last 10 years, which is equal to
Birr 31,410.99 (that is: 100, 000 – 68,589.01).
 i   0.025 
R  A   31,410.99    31,410.99(0.014836233)  466.02 Birr.
 (1  i) 1  (1.025) 1
n 40

Thus, if Ayalkebete makes quarterly payments of Birr 1000 into a savings account over the first
five years and then quarterly payments of Birr 466.02 over the last 10 years, he will reach his
savings goal of Birr 100, 000 at the end of 15 years.

3. Present Value of an Ordinary Annuity

The present value of an ordinary annuity is the sum of the present values of all the payments
made, each discounted to the beginning of the term of the annuity. It represents the amount that
must be invested now to purchase the payments due in the future.The present value of an
ordinary annuity ( An ) is the lump sum of money you may deposit in an account now so that at
the end of each period you will be able to withdraw equal amount of money for a fixed number
of periods (n) .

The present value of an ordinary annuity can be computed in two ways:

 Discounting all periodic payments to the present (beginning of the term individually) or
 Discounting the future value (amount) of an annuity to the beginning of the term

Example 4.18 What is the present value of an annuity if the size of each payment is Birr 200
payable at the end of each quarter for one year and the interest rate is 8% compounded
quarterly?

Solution
Given: R  200 Birr, t  1 Years, r  8%  0.08 , m  4
Required: the present value of an ordinary annuity An  ?
r 0.08
You need to look for i    0.02 and n  mt  4(1)  4 .
m 4
Using the first approach (discounting each payment individually), the present value will be:
Periods 0 1 2 3 4

Birr 200 Birr 200 Birr 200 Birr 200

Present value
196.10 = 200(1.02)1
192.23 = 200(1.02)2
188.46 = 200(1.02)3
184.77 = 200(1.02)4
761.56 Birr = Present value of the ordinary annuity

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Similarly we may find the future value of the ordinary annuity using the formula and then
discount it to the present taking it as a single future value.
 (1  i) n 1  (1.02) 4 1
A  R   200   824.32 Birr.
 i   0.02 
Let’s now find the present value of the compound interest that will result the accumulated
amount of the future value of the ordinary annuity Birr 824.32.
P  A(1  i) n  824.32(1.02) 4  761.55 Birr.
If you equate the future value of an ordinary annuity with the future value of a compound
interest, from this you can solve for the present value of the ordinary annuity denoted by ( An )
you as follows: (Where An is the present value of a compound interest P )
 (1  i) n  1
  An (1  i) (Solving for An )
n
R
 i 
 (1  i) n  1 1
An  R  
 (1  i)
n
 i
 (1  i) n  1 1  (1  i)  n 
An  R  n 
 R  
 i(1  i)   i 
Therefore, the present value of the ordinary annuity An is given by:
1  (1  i)  n 
An  R   (4.12)
 i 
Where An  the present value of an ordinary annuity,
R  the amount of periodic payment,
 r
i  the interest rate per payment period  i   , and
 m
n  the total number of periodic payments made n  mt  .

The amount of interest obtained from a present value of an ordinary annuity will be given by:
I  nR  An (4.13)

Using the formula, the present value of the above example is computed as follows using
equation (11):
1  (1  i)  n  1  (1.02) 4 
An  R    200   200 (3.807728699)  761.54 Birr.
 i   0 .02 

4. Amortization
Amortization means retiring a debt in a given length of time by equal periodic payments that
include compound interest. After the last payment, the obligation ceases to exist it is dead and it
is said to have been amortized by the periodic payments. Prominent examples of amortization
are loans taken to buy a car or a home amortized over long period of time such as 5 years, 10
years, 15 years, 20 years, or 30 years.

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In amortization the interest is to determine the periodic payment R , so as to amortize (retire) a
debt at the end of the last payment. Solving the present value of ordinary annuity formula for R
in terms of the other variable, we obtain the periodic payment to amortize the loan by the
amortization formula:
 i 
R  An  n 
(4.14)
 1  (1  i) 
Where An  the present value of an ordinary annuity,
R  the amount of periodic payment,
 r
i  the interest rate per payment period  i   , and
 m
n  the total number of periodic payments made n  mt  .
The amount of interest paid for a present value of an ordinary annuity will be given by:
I  nR  An (4.15)

Example: 4.19 Ato Elias borrowed Birr 15, 000 from Commercial Bank of Ethiopia and agreed to
repay the loan in 10 years. The bank’s interest charges are 6% compounded Quarterly. How
much should each quarter payment be in order to retire the debt, including the interest, in 10
years?

Solution
Given: An  15,000 Birr, t  10 Years, r  6%  0.06 , m  4
Required: the periodic payment R  ?
Now, to find the periodic payment you need to find:
r 0.06
i   0.015 and n  mt  4(10)  40 .
m 4
Hence using the formula in equation (4.14),
 i   0.015 
R  An   40 
 15,000   40 
 15,000(0.033427101)  501.41 Birr.
 1  (1  i)   1  (1.015) 
The periodic payment Ato Elias has to pay every three-month is Birr 501.41.

5. Mortgage Payments
In a typical home purchase transaction, the home buyer pays part of the cost in cash and borrows
the remaining, usually from a bank or savings and loan associations. The buyer amortizes the
indebtedness by periodic payments over a period of time. Typically; payments are monthly and
the time period is long such as 30 years, 25 years and 20 years. Mortgage payment and
amortization are similar. The only differences between the two are:
 the time period in which the debt/ loan is amortized /repaid/
 the amount borrowed.
In mortgage payments m is equal to 12 because the loan is repaid from monthly salary or
income, but in amortization money takes other values. Similarly stated mortgage payments are of
amortization in nature involving the repayment of loan monthly over an extended period of
time.

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Therefore, in mortgage payments we are interested in the determination of monthly payments
that is R given by.
 i 
R  An  n 
 1  (1  i) 
Where An  the present value of an ordinary annuity as the amount of loan or total debt,
R  the amount of periodic payment,
 r
i  the interest rate per payment period  i   , and
 m
n  the total number of periodic payments made n  mt  12t  .
The amount of interest charged is computed using equation (14).

Example 4.20 Ato Assefa purchased a house for Birr 115, 000. He made a 20% down payment
with the balance amortized by a 30 year mortgage at an annual interest of 12% compounded
monthly so as to amortize/ retire the debt at the end of the 30th year.

Required:
1. Find the periodic payment
2. Find the interest charged.

Solution
Given: Price of the house = Birr 115,000
Down payment = 20% of the Price of the house.
t  30 Years, r  12%  0.12 , and m  12 .

Required: the periodic payment R  ? andthe amount of interest paid I  ?

Amount of down payment = Selling price  percentage rate of down payment
= 115,000  0.20 = 23,000 Birr
The mortgage or amount of loan An  Selling price  Down payment
An  115,000  23,000  92,000 Birr
Now, to find the periodic payment you need to look for:
r 0.12
i   0.01 and n  mt  12(30)  360 .
m 12
The monthly payment is given by.
 i   0.12 
R  An  n 
 92,000  360 
 1  (1  i)   1  (1.12) 
 92,000 (0.010286125 )  946.32 Birr
Ato Assefa should pay Birr 946.32 every month to retire the debt within 30 years or 360
monthly payments.
The amount of interest is obtained by taking the difference between the actual payment and the
amount of loan or from equation (14) as follows:
I  nR  An  360(946.32)  92,000  248,675.20 Birr
Throughout the 30 years period the loan earns an interest of Br, 284,675.20

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Example 4.21 Ato Amare purchased a house for Birr 50, 000. He made an amount of down
payment and pay monthly Birr 600 to retire the mortgage for 20 years at an annual interest rate
of 24% compounded monthly.
Required:
Find the mortgage, down payment, interest charged and percentage of the down payment to the
selling price.
Solution:
Given: Selling price = Birr 50, 000, R  600 Birr , t  20 Years, r  24%  0.24 , m  12
Required: Mortgage An  ? Down payment =?, I  ? , and percentage of down payment?
To compute the mortgage or the amount of loan:
1  (1  i)  n   1  (1.02) 240 
An  R    600 
 i   0.02 
 600(49.56855168)  29,741.13 Birr.
To compute the amount of down payment:
Down payment = Selling price – mortgage
= 50, 000 – 29741.13 = 20, 258.87Birr
To compute the amount of interest paid:
Interest charged = Actual payment – mortgage]
= 600 (240) – 29, 741.13
= 144000 – 29741.13 = 114, 258.87 Birr
The percentage of the down payment is:
Down payment
Percentage of down payment = 100%
Selling price
20258.87
=  100%  40.52 %
50,000

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 GROUP ASSIGNMENT (15%)

NB. Form a group of five students and answer the following questions
The submission date will be a week before final exam.
1. The ABC Electrical Appliances Company produces two products: refrigerators and ranges.
Production takes place in two separate departments. Refrigerators are produced in
department-I and ranges produced in department-II. The weekly production cannot exceed
25 refrigerators in department-I and 35 ranges in department –II, because of limited available
facilities in the two departments. The company regularly employs a total of 60 workers in the
two departments. A refrigerator requires 2 man-weeks of labor while a range requires 1 man-
week of labor. A refrigerator contributes a profit of Birr 600 and a range contributes a profit
of Birr 400. Formulate the problem as a Linear Programming Model (LPM).
2. A steel company has two mills. Mill 1 costs $70,000 per day to operate, and it can produce
400 tons of high-grade steel, 500 tons of medium-grade steel, and 450 tons of low-grade
steel each day. Mill 2 costs $60,000 per day to operate, and it can produce 350 tons of high-
grade steel, 600 tons of medium-grade steel, and 400 tons of low-grade steel each day. The
company has orders totaling 100,000 tons of high-grade steel, 150,000 tons of medium-grade
steel, and 124,500 tons of low-grade steel. How many days should the company run each
mill to minimize its costs and still fill the orders?(Use graphical methods)
3. A farmer has 100 acres of land on which she plans to grow wheat and corn. Each acre of
wheat requires 4 hours of labor and $20 of capital, and each acre of corn requires 16 hours of
labor and $40 of capital. The farmer has at most 800 hours of labor and $2400 of capital
available. If the profit from an acre of wheat is $80 and from an acre of corn is $100, how
many acres of each crop should she plant to maximize her profit?(Use graphical method)
4. If you invest Birr 4200 in a commercial Bank of Ethiopia at 4% compounded semi-annually
for 2 years, what is the future value? What is the amount of interest earned?
5. Suppose you borrowed Birr 5, 000 from Commercial Bank of Ethiopia for 1 year to pay at
6% interest rate. Find the simple interest and the maturity value of the loan.
6. What is the present value of a loan that will amount to Birr 9, 000 in 5 years if money is
worth 3% compounded semi-annually?
7. How much should you deposit in a saving account today so that you would be able to
withdraw Birr 5000 after 3 years, if interest rate per year is 5% compounded monthly?
8. How much must be deposited at the end of each month if the objective is to accumulate Birr
12,000 after 5 years? Assume interest is earned at the rate of 8% compounded monthly.
How Much interest is earned?
9. A family wants to begin saving for a trip to Asia. The trip is planned after three years from
now, and the family wants to accumulate $5,000 for the trip. If 12 deposits are made
quarterly to an account, which earns interest rate of 5% per year compounded quarterly,
how much should each quarterly deposit be? How much interest will be earned on their
deposit?
10. What is the present value of an annuity that pays Birr 400 a month for the next five years if
money worth’s 12% compounded monthly?
11. If you have Birr 100,000 in an account that pays 6% compounded monthly and if you decide
to withdraw equal amount monthly for 10 years at the end of which time the account will
have a zero balance, how much should be withdrawn each month?
12. Ato Liku purchased a house for Birr 250, 000. He made a 20% down payment, with a
balance amortized by a 30-year mortgage at an annual interest rate of 12% compounded
monthly.
a. Determine the amount of the monthly mortgage payment.

16
b. What is the total amount of interest Ato Liku will pay over the life of the mortgage?
c. Determine the amount of the mortgage Ato Liku will have paid after 10 years?
d. Develop an amortization table for the first 6 months

17