Derivation of Compound Interest Formulas

There is some logic to the creation of the compound interest formulas (shown in Illustration 10-1 of the text).
The next few pages offer an explanation. The explanations require a basic understanding of exponents,
compound fractions, factoring, roots, and equation-solving skills. We will derive each of the formulas except
Formula 5; the derivation of Formula 5 is beyond the scope of the material you are covering. The derivations
will be done in the following order: Formula 1A, 2A, 1B, 2B, 3, 4A, and 4B.

Derivation of Formula 1A

Suppose you deposit $100 in a savings account earning 3% compounded annually. At the end of the first
year you will earn 3% (or $3), ending up with a balance of $103. Stated another way, your ending balance will
be 1.03 times as great as what you started with ($100 1.03 = $103). At the end of the second year you will
earn 3% on the $103 beginning balance (or $3.09), ending up with a balance of $106.09. This is compound
interest because you are earning interest on interest. Each year the balance increases by a multiple of 1.03:

(Yr 1) $100 (1.03)

(Yr 2) $100 (1.03) (1.03) = $100 (1.03)2
(Yr 3) $100 (1.03) (1.03) (1.03) = $100 (1.03)3
(Yr 4) $100 (1.03) (1.03) (1.03) (1.03) = $100 (1.03)4

Lets use symbols to represent the process. The ending balance is a future value (FV), the initial deposit is
a present value (PV), the 1.03 is 1 + i (1 + .03 = 1.03), and the exponent is the n-value. We end up with
Formula 1A:

FV = PV(1 + i) n

Derivation of Formula 2A

The Golden Rule of Equation Solving (see Unit 3.2 of the text) states that we can Do unto one side of an
equation as we do unto the other and the equation will still be in balance. Lets start with Formula 1A:

FV = PV(1 + i) n

If we want a formula that is designed to solve for PV, we can manipulate Formula 1A. By dividing both
sides of Formula 1A by (1 + i)n we get:
FV
' PV
(1 % i) n

If the left side of the above equation equals the right side, then it follows that the right side equals the left
side, so it is okay to put the variable PV on the left side, giving us Formula 2A:

FV
PV '
(1 % i)n
Derivation of Formula 1B

Suppose you deposit $100 at the end of each year and earn 3% compounded annually. At the end of 1 year,
your balance will be $100 (you will earn no interest the first year). Here is one way to calculate the balance at
the end of year 2:

Deposit at the end of year 2 $100.00

Deposit at the end of year 1, plus interest for next year: $100.00 (1.03) 103.00
Balance, year 2 $203.00

Lets use the same procedure to figure the balance at the end of year 4:

Deposit at the end of year 4 $100.00

Deposit at the end of year 3, plus interest for the next year: $100 (1.03) 103.00
Deposit at the end of year 2, plus interest for the next 2 years: $100 (1.03) (1.03) 106.09
Deposit at the end of year 1, plus interest for the next 3 years: $100 (1.03) (1.03) (1.03) 109.27
Balance, year 4 $418.36

You might notice a pattern developing. The ending balance that results from making periodic deposits of
$100 at the end of each period for 4 years, earning 3% compounded annually can be written as:

Ending Balance = $100 + $100 (1.03) + $100 (1.03)2 + $100 (1.03)3

Lets use symbols to represent the process. The ending balance is a future value (FV), the annual deposits
are periodic payments (PMT), and the 1.03 is 1 + i (1 + .03 = 1.03). Each exponent represents the number
of periods each deposit will earn interest; notice, the first deposit earns interest for one period less than the total
n-value. We end up with:

FV = PMT + PMT (1 + i) + PMT (1 + i)2 + PMT (1 + i)3 + ..... PMT (1 + i)n - 2 + PMT (1 + i)n - 1

The process of deriving Formula 1B gets a bit tricky from here. The next step is to divide each side of the
above equation by (1 + i):
FV PMT
' % PMT % PMT (1 % i) % PMT (1 % i)2 % ..... PMT (1%i)n & 2
(1 % i) (1 % i)

Now we will subtract the second equation from the first equation. That is, we will subtract the left side of
the second equation from the left side of the first equation, and subtract the right side of the second equation
from the right side of the first equation. You may wonder if doing so is mathematically sound. Remember,
since the left and right sides of the second equation are equal we are, in effect, subtracting equal values from
both sides of the first equation. By following this procedure most of the terms on the right side are canceled out.
We are left with:
FV PMT
FV & ' PMT (1 % i) n & 1 &
(1 % i) (1 % i)

Now lets factor out FV on the left and PMT on the right:

1 1
FV 1 & ' PMT (1 % i) n & 1 &
(1 % i) (1 % i)
 Next lets get common denominators inside each set of brackets:

(1 % i) 1 (1 % i) n 1
FV & ' PMT &
(1 % i) (1 % i) (1 % i) (1 % i)

i (1 % i) n & 1
Lets combine terms inside of each set of brackets: FV ' PMT
(1 % i) (1 % i)

(1 % i)
Finally, we will multiply each side by . We get Formula 2B:
i

(1 % i)n & 1
FV ' PMT
i

Derivation of Formula 2B

(1 % i)n & 1
Lets start out with Formula 1B: FV ' PMT
i

In Formula 1A, FV = PV(1 + i)n . Lets substitute PV (1 + i)n for FV in the above formula:

(1 % i)n & 1
PV (1 + i)n = PMT
i

(1 % i) n & 1
Now, lets divide each side of the equation by (1 + i) n : PV = PMT
i (1 % i) n

Move the i from the denominator inside of the brackets to create a denominator for PMT outside of the
brackets. Doing so does not change the value:
PMT (1 % i) n & 1
PV =
i (1 % i) n

The numerator inside of the brackets is a binomial (two terms) and the denominator is a monomial (one
term). Lets create two separate fractions inside of the brackets (this is the opposite of combining fractions with
the same denominator):
PMT (1 % i) n 1
PV = &
n
i (1 % i) (1 % i) n

PMT 1
Now we will simplify: PV = 1 &
i (1 % i) n
 Finally, divide the value inside of the brackets by the i outside the brackets (doing so does not change the
value):

1
1 &
(1 % i)n
PV ' PMT
i

Derivation of Formula 3

Lets start with Formula 1A: FV = PV(1 + i)n

FV
Now, lets divide both sides by PV: ' (1 % i) n
PV

Next, we want to take the nth root of both sides. Before we do that, lets consider what taking a root
means. To illustrate, taking the third root of 64" is the same as finding what value to the third power is 64?
The answer is 4, because 43 = 64. Mathematically, we can write the third root of 64" as either:
1
3
64 OR (64) 3
1
th FV n
By taking the n root of both sides of the equation shown above, we end up with: ' 1 % i
PV
1
FV n
Subtract 1" from both sides of the equation: & 1 ' i
PV
Finally, rewrite with i on the left:

1
FV n
i ' & 1
PV

Derivation of Formula 4A

(1 % i)n & 1
Lets start with Formula 1B: FV ' PMT
i

i FV ( i )
Multiply both sides by . We end up with: ' PMT
(1 % i) n & 1 (1 % i) n & 1

Rewrite the equation with PMT on the left:

FV ( i )
PMT '
(1 % i) n & 1
Derivation of Formula 4B

1
1 &
(1 % i)n
Lets start with Formula 2B: PV ' PMT
i

i PV ( i )
Next, multiply both sides of the equation by . We get ' PMT
1 1
1 & 1 &
(1 % i)n (1 % i)n

Rewrite the equation with PMT on the left:

PV ( i )
PMT '
1
1 &
(1 % i)n