Compound 8-1

8
Interest

Compound

Chapter 8

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 Compound 8-2

8
Interest
Learning Objectives
After completing this chapter, you will be able to:
Calculate the
LO-1 Maturity Value(MV), Future Value (FV), and Present
Value(PV) in
compound interest applications,
by both the algebraic method and the
pre-programmed financial calculator method
Maturity Value of compound interest for
Guaranteed Investment Certificates (GICs)

Price of "strip" bonds

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 8-3

Learning Objectives
Compound

8
Interest

Calculate the
LO-2 Redemption Value of a compound interest
bearing Canada Savings Bond

Payment on any date that is equivalent to one or

more payments on other dates

Economic Value of a payment stream

And be able to
Adapt the concepts and equations of compound
interest to cases of compound growth
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 Compound 8-4

8
Interest

LO-1

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 Compound 8-5
To better understand how Compound Interest
8
Interest is calculated, lets review how we calculate
Simple Interest!

The formula on which we base our

calculation is

Formula I = Prt
Here we have an amount, the Principal, which is
multiplied by the Interest Rate and the Time over
which the Interest is earned!

As we will now see, Compound Interest uses

the Sum of P & I as a base on which to calculate
new Interest!
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 8-6
Compound Interest
Compound

8
Interest - Future Value

the interest on the principal

plus the interest of prior periods
e.g. Principal + prior period interest = $1100.00
$1000.00 $100.00
Interest for the next period is calculated on $1100.00.
This method will continue over the life of the
loan or investment. (See later example)

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Compound Interest
Compound

8
Interest - Future Value

is the compounded amount and

is the FINAL amount of the loan
or investment at the
end of the last period!

Contrast this with

...is the value of a loan or
investment TODAY!

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 8-8
Compound Interest
Compound

8
Interest - Future Value

the calculation of interest over

the life of the loan or investment
Lets assume that the interest rate is 10% pa.
Example: Principal + prior period interest = $1100.00
Interest is now calculated on $1100.00
Principal(Compounded) * 0.10 = $110.00
New P $1210.00 to start next period

Graphically
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 8-9
Compound Interest
Compound

8
Interest - Future Value
Interest Interest Interest Interest
Amount $1000

133.1
1331
121 121
1210
110 110 110
1100
100 100 100 100
1000

Compounding Compounding Compounding Compounding

Period Period Period Period
0 1 2 3 4
Time(Years)
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 8 - 10
Compound Interest
Compound

8
Interest - Future Value

What happens if the interest

rate changes during the life of
an investment?

Example
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Compound Interest
Compound

8
Interest - Future Value

You hold an investment for a period of 4 years.

Rates of return for each year are 4%, 8%,
-10% and 9% respectively.
If you invested $1000 at the beginning of the
term, how much will you have at the
end of the last year?

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 8 - 12
Compound Interest
Compound

8
Interest - Future Value

You hold an investment for a period of 4 years.

Rates of return for each year are 4%, 8%, -10% and 9%
respectively. If you invested $1000 at the beginning of the
term, how much will you have at the end of the last year?

Year 1 Year 2 Year 3 Year 4

$1000 $1040 $1123.20 $1010.88
$1000 * $1040 * $1123.20 * $1010.88 *
(1 + .04) (1 + .08) (1 - .10) (1 +.09)
= $1040 = $1123.20 = $1010.88 = $1101.86
Alternative
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 8 - 13
Compound Interest
Compound

8
Interest - Future Value

You hold an investment for a period of 4 years.

Rates of return for each year are 4%, 8%, -10% and
9% respectively. If you invested $1000 at the beginning
of the term, how much will you have
at the end of the last year?

Solving 1000(1.04)(1.08)(.90)(1.09) = $1101.86

Alternative
Solve for all 1 -10%
4 years at
once! It is rare for interest to be
compounded only once per year!
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 Compound 8 - 14

8
Interest

Compounding Frequencies and Periods

Frequency No. per Year Period

Annually 1 1 year
Semiannually 2 6 months
Quarterly 4 3 months
Monthly 12 1 month
Daily 365 1 day

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 Compound 8 - 15

8
Interest
Development of a Formula

Nominal or Annual Rate (j)

Number of compoundings per year m
Periodic Rate per period (i)
Total Number of Periods n

Determining values for n and i

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 Compound 8 - 16

8
Interest
Formulae

To Determine n

Time(Years) * # of Compounding Frequencies p.a.(m)

To Determine i
Annual Interest Rate(j)
# of Compounding Frequencies p.a. (m)
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 Compound 8 - 17

8 Determining values for n

Interest

If you compounded $100 for 3 years at 6%

annually, semiannually, or quarterly,
what are the values for n and i ?

# of Compounding
Formula Time(Years) * Frequencies per year (m)
No. n
Annually 3* 1 = 3
Semiannually 3 * 2 = 6
Quarterly 3 * 4 = 12
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 Compound 8 - 18

8
Interest
Determining values for i

If you compounded $100 for 3 years at

6% annually, semiannually, or quarterly,
what are the values for n and i ?

Annual Interest Rate (j)

Formula
# of Compounding
Frequencies per year(m) No. Rate - i
Annually 6% / 1 = 6%
Semiannually 6% / 2 = 3%
Quarterly 6% / 4 = 1.5%
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 Compound 8 - 19

8
Interest

Development of a Formula for Future Value

FV = PV(1 + i)n
Where

PV= Present Value(Principal)

i = rate per period
n = number of periods

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 8 - 20
Compound Interest
Compound

8
Interest - Future Value
n
Formula FV = PV(1 + i)

Steve Smith deposited $1,000 in a savings account for

4 years at a rate of 8%
compounded semiannually.
What is Steves interest and compounded amount?
Extract necessary data...
PV = $1000
n = 4X2=8
i = .08/2 = .04
Solve
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Compound Interest
Compound

8
Interest - Future Value
n
Formula FV = PV(1 + i)

Solve Using PV = $1000 n = 8 i= .04

FV = $1000(1 + .04)8
= $1000(1.368569)
= $1,368.57

Principal $1,000.00
+ Interest 368.57
Compounded $1,368.57

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 Compound 8 - 22

8
Interest

What is the effect on the

Future Value
of
different Compounding Periods
of
Interest?
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 8 - 23
Compound Interest
Compound

8
Interest - Future Value

If you compounded $100 for 3 years at 6%

annually, semiannually, or quarterly,
what are the final amounts that you would have at
the end of the three (3) years ?
Annual FVA = 100(1.06)3 $119.10
Semi- FV = 100(1.03)6
S $119.41
Semi = 6%/2
Quarterly FVQ = 100(1.015)12 $119.56
Quarterly = 6%/4
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 8 - 24
Compound Interest
Compound

8
Interest - Future Value
The Components of the Future Value of $100
250
Interest
on
FV=PV(1+i)n
Future Value

Interest
S or FV

200

Interest on
150 Original
Principal
S=P(1+rt)
100

50 Original Principal

Time(Years)
0
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 Compound 8 - 25

8
Interest

Comparisons

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 Compound 8 - 26

8 Simple Vs Compound Interest

Interest

Al Jones deposited $1,000 in a savings account

for 5 years at 10% p.a..

Annual Simple Interest Annual Compound

Rate of 10% Rate of 10%
What is Als What is Als
Simple Interest and Interest and
Maturity Value? Compounded Value?
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 Compound 8 - 27

8 Simple Vs Compound Interest

Interest

Al Jones deposited $1,000 in a savings account for 5 years at 10%

n = 5 * 1 = 5 i = .10
Simple Compound
Formulae
I = Prt FV = PV(1 + i)n
I = FV PV
I = $1,000 * .10 * 5 = $1610.51 - $1000
Compare
= $500 = $610.51
FV = $1000(1.1)5
FV = $1,000 + $500 = $1,000 *1.6105
Compare
= $1,500 = $1,610.51
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 Compound 8 - 28

8
Interest Future Values of $100 at
1800 Various Rates of Interest Compounded Annually
1600 12%
FV

1400
Future Value

1200

1000
10%

800

8%
600

400 6%

200

100
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

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 Compound 8 - 29

8
Interest
Nominal Rates of Interest Compared

Beginning Nominal Compounding Ending

Balance Rate Period Balance

Annual $1,060.00
Semiannual $1,060.90
$1,000 + 6%
Quarterly $1,061.36
Daily $1,061.83

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 Compound 8 - 30

8
Interest
Future Values of $100 at the same Nominal Rate but
2500 Different Compounding Frequencies
FV

2000

12% Compounded
Future Value

1500
monthly
1000

500

100
0 5 10 15 20 25

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Time (years)
 Compound 8 - 31

8
Interest
Compounding Daily Interest

Calculate the Future Value of $2,000

compounded daily for 4 years at 4.5%.

n
Formula FV = PV(1 + i)
n = 4 * 365 = 1460 i= .045 /365 = 0.0001232

FV = $2000(1+ .045/365)1460
= $2,000 * 1.1972 = $2,394.41

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 Compound 8 - 32

8
Interest

You invested $6000 at 4.5% compounded quarterly.

After 2 years, the rate changed to 5.2%
compounded monthly.
What amount will you have 41/2 years after the initial
investment?

Prepare a time-line as part of the solution

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 Compound 8 - 33

8
Interest

You invested $6000 at 4.5% compounded quarterly.

After 2 years, the rate changed to 5.2%
compounded monthly.
What amount will you have 41/2 years after the
initial investment?
0 2 years 4.5 years

$6000 FV1 = PV2 FV2

i = .045/4 n = (2*4) = 8
i = .052/12 n = 2.5*12 = 30
FV1 = 6000(1+.045/4)8 FV2 = 6561.75(1+.052/12)30
= 6000(1.0936) = 6561.75(1.1385)
= 6561.75 = $7470.61
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 Compound 8 - 34

8
Interest

You borrowed $5000 at 7% compounded monthly.

On the first and second anniversaries of the loan,
you made payments of $2500.
What is the balance outstanding
immediately following the second payment?

Prepare a time-line as part of the solution

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 Compound 8 - 35

8
Interest

You borrowed $5000 at 7% compounded monthly.

On the first and second anniversaries of the loan, you
made payments of $2500. What is the balance
outstanding immediately following the second payment?
0 1 year 2 years

$5000 FV1 - $2500 = PV2 FV2

i = .07/12 n = 12
12
i = .07/12 n = 12
FV1 = 5000(1+.07/12) FV2 = 2861.45 (1+.07/12)12
= 5000(1.072290) = 2861.45(1.072290)
= 5361.45 = $3068.30
PV2 = 5361.45 2500.00 = $3068.30 2500.00
= 2861.45
New Balance = $568.30
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Interest

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 Compound 8 - 37

8
Interest
Formula for Present Value
- n
Formula PV = FV(1 + i)
i
1
Keys
This is the only
change to the
usual
sequence!

$PV
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 Compound 8 - 38

8
Interest
Calculating Present Value

You expect to need $1,500 in 3 years.

Your bank offers 4% interest
compounded semiannually.
How much money must you put in the bank today
(PV) to reach your goal in 3 years?

Prepare the solution(a) algebraically, and

(b) by financial calculator

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 Compound 8 - 39

8
Interest
Calculating Present Value
- n
Formula PV = FV(1 + i)
You expect to need $1,500 in 3 years.
Your bank offers 4% interest compounded
semiannually. How much money must you put in the
bank today (PV) to reach your goal in 3 years?

n = 3 * 2 = 6 i = .04/2 = .02
1,331.96
0.88797
(a) PV = $1500(1+.02)-6
1.02
= $1500 * .8880
= $1,331.96 6

1500
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 Compound 8 - 40

8
Interest
Calculating Present Value

Formula PV = FV(1 + i)-n

What amount must you invest now at 5% compounded

daily to accumulate to $6000 after 1 year?

j = 5% PV = $6000(1+.05/365)-365 5,707.40
0.0001
0.9512
1.001
m = 365 = $6000 * .9512
= $5,707.40 .05
i = .05/365 365
n = 1*365 = 365
1
FV = $6000 6000
365
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 Compound 8 - 41

8
Interest
Calculating Present Value

What amount must you invest now at 5% compounded

daily to accumulate to $6000 after 1 year?
1 * 365
6000
5 PV= - 5,707.40
0

365

$5707.40
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 Compound 8 - 42

8
Interest

This completes Chapter 8

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