CHAPTER 2

Financial
Mathematics

2.1 INTRODUCTION

What is financial math?

- field of appliedmathematics, concerned
withfinancial markets.

Procedures which used to answer questions

associated with major financial transactions

Example: Interest problem, annuity and

depreciation

2.2 SIMPLE INTEREST

The study of interest is very important and

fundamental to the understanding of the
economy of a country

Interest is money earned when money is

invested or interest is charge incurred
when a loan or credit is obtained.

If you deposit a sum of money P in a savings

account or if you borrow a sum of money P
from a lending agent such as financial agency
or bank, then P is call principal.

Usually we have to repay this amount P plus

an extra amount. These extra amounts,
which pay to the lender for the convenience
of using lender money is called interest.

In general, if the principal P is borrowed at a

rate r after t years, the borrower will owe
the lender an amount A that will include
the principal P plus interest I.

Since P is the amount that is borrowed now

and A is the amount that must be paid back
in the future, P is often referred to as the
present value and A as the future value.

Example 2.2.1
RM1000 is invested for two years in a
bank, earning a simple interest rate of 8%
per annum. Find the simple interest
earned

Exercise 1
RM5000 is invested for 6 years in a bank, earning
a simple interest rate of 5.7 % per annum. Find
the simple interest earned

Solution

Example 2.2.2
RM10000 is invested for 4 years 9 month in a
bank earning a simple interest rate of 10%
per annum. Find the simple amount at the
end of the investment period.

Solution

Exercise 2
If Bank A offers a simple interest rate of 8 %
per annum, Ahmad invested RM 9000 for 4
years 6 months in a bank earning. Find the
future value obtain by Ahmad at the end of
the investment period.

Anwer

Example 2.2.3
Find the present value at 8% simple interest of
a debt amount RM3000 due in ten months.

Solution

Example 3
Find the present value at 6% simple interest
with total amount of debt RM 40000 due in
15 years.

Solution

2.3 COMPOUND INTEREST

Based on the principal which interest

changes from time to time.
Interest that is earned is compounded or
converted into principal and earns
thereafter.
Hence the principal increases from time to
time.

Some important terms are best explained with the

following example.
Suppose RM9000 is invested for 7 years at 12%
compounded quarterly

Principal, P
The original principal, denoted by P is the original
amount invested. Here the principal is P = RM 9000
Annual nominal rate, r
The interest rate for a year together with the
frequency in which interest is calculated in a year.
Thus the annual nominal rate is given by r = 12%
compounded quarterly, that is four times a year.

Frequency of conversions/ number of

compounding periods per year, m
The number of times interest is calculated
in a year. The annual nominal rate is given by
r = 12% compounded quarterly, that is four
times a year. In this case, m=4

Interest period
Interest period is the length of time in which
interest is calculated. Thus, the interest
period is three month

Example 2.3.1
Find the accumulated amount after 3 years if
RM1000 is invested at 8% per year
compounded
A. Annually
B. Semi-annually
C. Quarterly
D. Monthly
E. Daily

Solution
t 3

t 3

Example 2.3.2

RM9000 is invested for 7 years 3 months. This

investment is offered 12% compounded monthly
for the first 4 years and 12% compounded
quarterly for the rest of the period. Calculate
the future value of this investment.

Solution
Amount of investment after 4 year
P 9000, r 0.12, m 12, i
A P 1 i 9000 1 0.01
n

48

r 0.12

0.01, t 4, n mt 12 4 48
m 12

14510.03

Amount of investment at the end of 7 years 3 month ( 3 year 3 month)

r 0.12
P 14510.03, r 0.12, m 4, t 3.25, n mt 4 3.25 13, i
0.03
m
4
A P 1 i

14510.03 1 0.03
21308.48

13

Example 2.3.3
What is the annual nominal rate compounded
monthly that will make RM1000 become
RM2000 in five years?
Solution

2.3.1 EFFECTIVE RATE OF

INTEREST

The effective rate is the simple interest rate

that would produce same accumulated
amount in 1 year as the nominal rate
compounded m times a year.

The effective rate also called the effective

annual yield.

Example 2.3.4

Solution

Example 2.3.5

Solution

BANK

Annual
Nominal
rate

Effective
rate

15.2%

15.2%

14.5%

15.5%

2.3.2 PRESENT VALUE

The process for finding the present value is called discounting.

Solution

RM 16713 should be invested so that we get accumulated RM

20000 after 3 years

Solution

2.3.3 CONTINUOUS COMPOUNDING OF INTEREST

Example
Find the accumulated value of RM1000 for six
months at 10% compounded continuously.
Solution

2.4 ANNUITIES

Sequence of equal payments made at equal

intervals of time.

Examples of annuity are shop rentals,

insurance policy premiums, instalment
payment, etc.

An annuity in which the payments are

made at the end of each payment period is
call ordinary annuity certain.

2.4.1 FUTURE VALUE OF ORDINARY ANNUITY

CERTAIN

Future value of an ordinary annuity certain is the

sum of all the future values of the periodic
payments.

If you know how much you can invest per period

for a certain time period, the future value of an
ordinary annuity formula is useful for finding out
how much you would have in the future by
investing at your given interest rate.

If you are making payments on a loan, the future

value is useful for determining the total cost of the
loan.

Example 2.4.1
Find the amount of an ordinary annuity
consisting of 12 monthly payments of RM100
that earn interest at 12% per year
compounded monthly.
Solution

Example 2.4.2
RM 100 is deposited every month for 2 years
7 month at 12% compounded monthly. What
is the future value of this annuity at the
end of the investment period?
Solution

Example
Lily invested RM100 every month for five
years in an investment scheme. She was
offered 5% compounded monthly for the first
three years and 9% compounded monthly for
the rest of the period. Determine the future
value of this annuity at the end of five
years and total amount money after 5
years.

Solution

2.4.2 PRESENT VALUE OF ORDINARY ANNUITY

CERTAIN

In certain instances, we may try to

determine the current value P of a sequence
of equal periodic payment that will be made
over a certain period of time.

After each payment is made, the new

balance continues to earn interest at some
nominal rate.

The amount P is referred to as the present

value of ordinary annuity certain.

Example 2.4.5
After making a down payment of RM4000 for
an automobile, Maidin paid RM400 per
month for 36 month with interest charged at
12% per year compounded monthly on the
unpaid balance. What was the original cost
of the car?

Solution

Original cost
= RM4000 + RM 12 043
= RM16 043

2.4.3 AMORTIZATION

An interest bearing debt is said to be

amortized when all the principal and interest
are discharged by a sequence of equal
payments at equal intervals of time.

Example 2.4.8
A sum of RM50000 is to be repaid over a 5 year
period through equal instalments made at the
end of each year. If an interest rate of 8% per
year is charged on the unpaid balance and
interest calculations are made at the end of
each year, determine the size of each
instalment so that the loan is amortized at
the end of 5 years.

Solution

Example
Andy borrowed RM120, 000 from a bank to
help finance the purchase of a house. The
bank charges interest at a rate 9% per year in
the unpaid balance, with interest
computations made at the end of each
month. Andy has agreed to repay the loan in
equal monthly instalments over 30 years.
How much should each payment be if the
loan is to be amortized at the end of the
term?

Solution

0.09
P 120000 ,i
0.0075,n mt 12 30 360
12
Pi
R
n
1 1 i

120000 0.0075

1 1 0.0075

360

965.55
Andy has to pay RM 965.55 per month within 30 years

2.4.4 SINKING FUND

A sinking fund is an account that is set up for

a specific purpose at some future date.

For example, an individual might establish a

sinking fund for the purpose of discharging
a debt at a future date.

A corporation might establish a sinking fund

in order to accumulate sufficient capital to
replace equipment that is expected to be
obsolete at some future date.

Example 2.4.10
A debt of RM1000 bearing interest at 10%
compounded annually is to be discharged by the
sinking fund method. If five annual deposits are
made into a fund which pays 8% compounded
annually,
A. Find the annual interest payment
B. Find the size of the annual deposit into the sinking
fund
C. What is the annual cost of this debt?

Solution

2.5 DEPRECIATION

Depreciation is an accounting procedure for

allocating the cost of capital assets, such as
buildings, machinery tools and vehicles over
their useful life.

It is important to note that depreciation

amount are estimates and no one can estimate
such amounts with certainty.

Depreciation expenses allow firms to recapture

the amount of money to provide for
replacement of the assets and to recover the
original investments.

Several terms are commonly used in calculation

relating to depreciation. The terms are

Original cost
The original cost of an asset is the amount of
money paid for an asset plus any sales taxes,
delivery charges, installation charges and other
cost.
Salvage value
The salvage value (scrap value or trade in value) is
the value of an asset at the end of its useful life. If
a company purchases a new machine and sells it for
RM600 at the end of its useful life, then the salvage
value is RM600. The salvage value of an asset is an
estimate that is usually based on previous salvage
value of a similar asset.

Useful life
The useful life an asset is the life expectancy
of the asset or the number of years the asset
is expected to last. For example, if a
company expects to use machinery for 10
years, then its useful life is 10 years.
Total depreciation
The total depreciation or the wearing value
of an asset is the difference between cost
and scrap value.

Annual depreciation
The annual depreciation is the amount of
depreciation in a year. It may or may not be
equal from year to year.
Accumulated depreciation
The accumulated depreciation is the total
depreciation to date. If the depreciation for
the first year is RM2000 and for the second
year RM1000 then the accumulated
depreciation at the end of the second year is
RM3000

Book value
The book value or carrying value of an asset
is the value of the asset as shown in the
accounting record. It is the difference
between the original cost and the
accumulated depreciation charged to that
date. For example a car which was
purchased for RM40000 two years ago, will
have a book value of RM34000 if its
accumulated depreciation for two years is
RM6000.

Three method of depreciation are commonly

used. These methods are
1. Straight line method
2. Declining balance method
3. Sum of years digits method

2.5.1 STRAIGHT LINE METHOD

Example 3.5.1
The book values of an asset after the third
year and fifth year using the straight line
method are RM7000 and RM5000 respectively.
What is the annual depreciation of the asset?
Solution

Example 2.5.2
John Company bought a lorry for RM38000.
The lorry is expected to last 5 years and its
salvage value at the end of 5 years is
RM8000. Using the straight line method to;
A. Calculate the annual depreciation
B. Calculate the annual rate of depreciation
C. Calculate the book value of the lorry at the
end of third year
D. Prepare a depreciation schedule

Solution

End of
Year
0
1
2
3
4
5

Annual
Accumulated Book value at
Depreciation( Depreciation
end
RM)
(RM)
Of year(RM)
0
0
38000
6000
6000
32000
6000
12000
26000
6000
18000
20000
6000
24000
14000
6000
30000
8000

2.5.2 DECLINING BALANCE

METHOD

Example 2.5.4
Given
Cost of the asset = RM15000
Useful life = 4 years
Scrap value = RM3000
a) Find the annual rate of depreciation
b) Construct the depreciation schedule
Using the declining balance method

Solution

Year

Annual
Accumulated Book Value
Depreciation Depreciation
(RM)
(RM)
(RM)

15000

4969.50

4969.50

10030.50

3323.10

8292.60

6707.40

2222.16

10514.76

4485.24

1485.24

12000

3000

2.5.3 SUM OF YEARS DIGITS

METHOD

The rate of depreciation is based on the sum

of the digits representing the number of
years of useful life of the asset. If an asset
has a useful life of 3 years, the sum of digits
is S = 1+2+3=6, while for an asset with a
useful life of 5 years, the sum of digits is S =
1+2+3+4+5=15. Since S is an arithmetic
progression, S can be calculated with the
formula

Example 2.5.5
A machine is purchased for RM45000. Its life
expectancy is 5 years with a zero trade in
value. Prepare a depreciation schedule using
the sum of the years digits method.
Solution

Amount of depreciation for each year is

calculated as follows

The depreciation schedule is as follows

Year

0
1
2
3
4
5

Annual
Accumulate Book Value
Depreciation
d
(RM)
(RM)
Depreciation
(RM)
0
0
45000
15000
15000
30000
12000
27000
18000
9000
36000
9000
6000
42000
3000
3000
45000
0

Example 2.5.6
A computer is purchased for RM3600. It is
estimated that its salvage value at the end of
8 years will be RM600. Find the depreciation
and the book value of the computer for third
year using the sum of the years digits
method.

Solution