8-1

Compound
Compound

Interest
Interest

Compound
Chapter 8
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8-2
To better understand how Compound Interest
is calculated, lets review how we calculate
Simple Interest!
The formula on which we base our
calculation is

Formula
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!
McGraw-Hill Ryerson

Compound
Compound

Compound Interest

8-3

- Future Value

Interest
Interest

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)
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Compound Interest

8-4

- 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!

McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Compound Interest

8-5

- 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

McGraw-Hill Ryerson

Graphically

Compound
Compound

8-6

Compound Interest

- Future Value

Interest
Interest

Interest
Interest

Interest
Interest

Interest
Interest

Interest
Interest

Amount$1000
$1000
Amount
133.1

1331
1210
1100
1000

100

110
100

121

121

11
0
100

11
0
100

Compoundin Compoundin Compoundin

g Period
g Period
g Period

0
McGraw-Hill Ryerson

2
Time(Years)

Compoundin
g Period

Compound
Compound

Interest
Interest

Compound Interest

8-7

- Future Value

What happens if the interest

rate changes during the life of
an investment?

Example
Example
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Compound
Compound

Interest
Interest

Compound Interest

8-8

- 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?

McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Compound Interest

8-9

- 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 *
(1 + .04)
= $1040
McGraw-Hill Ryerson

$1040 *
$1123.20 *
(1 + .08)
(1 - .10)
= $1123.20 = $1010.88

$1010.88 *
(1 +.09)
= $1101.86
Alternative
Alternative

Compound
Compound

Interest
Interest

Compound Interest

8 - 10

- 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?

1000(1.04)(1.08)(.90)(1.09) = $1101.86
Solving
Solving
Alternative
Alternative
1
-10%
Solve
for
all
Solve for all
years at
at
44 years
It isis rare
rare for
forinterest
interest to
to be
be
It
once!
once!
compounded only once per year!
compounded only once per year!

McGraw-Hill Ryerson

8 - 11

Compound
Compound

Interest
Interest

Compounding Frequencies and Periods

Frequency
Frequency

McGraw-Hill Ryerson

No. per
per Year
Year
No.

Period
Period

Annually

1 year

Semiannually

6 months

Quarterly

3 months

Monthly

12

1 month

Daily

365

1 day

Compound
Compound

Interest
Interest

8 - 12

Development of a Formula
Formula

Nominal or Annual Rate

Number of compoundings per year
Periodic Rate per period

Total Number of

Periods
Periods

(j)

m
(i)

Determining values for n and i

McGraw-Hill Ryerson

Compound
Compound

8 - 13

Formulae
Formulae

Interest
Interest

To Determine
Determine
To

Time(Years)

n
n

# of Compounding Frequencies p.a.(m)

To Determine
Determine
To

ii

Annual Interest Rate(j)

# of Compounding Frequencies p.a. (m)
McGraw-Hill Ryerson

Compound
Compound

Determining values for n

Interest
Interest

If you compounded $100 for 3 years at 6%

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

Formula

Time(Years) *

# of Compounding
Frequencies per year (m)

Annually
3*
Semiannually 3 *
Quarterly 3 *
McGraw-Hill Ryerson

No.

= 3
= 6
= 12

2
4

8 - 14

Compound
Compound

Interest
Interest

Determining values for

8 - 15

If you compounded $100 for 3 years at

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

Formula
Formula

Annual Interest

Rate (j)

# of Compounding
Frequencies per
year(m)

6% /
Annually
Semiannually 6% /
Quarterly 6% /

McGraw-Hill Ryerson

No.
1
2
4

Rate -- ii
Rate
= 6%
= 3%
= 1.5%

8 - 16

Compound
Compound

Interest
Interest

Development of a Formula
Formula for Future Value
FV = PV(1 + i)n
Where

PV= Present Value(Principal)

i = rate per period
n = number of periods
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Compound Interest

8 - 17

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

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
McGraw-Hill Ryerson

Solve

Compound
Compound

Interest
Interest

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

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
McGraw-Hill Ryerson

8 - 18

Compound
Compound

Interest
Interest

What is the effect on the

Future Value
of
different
Compounding Periods
of
Interest?
McGraw-Hill Ryerson

8 - 19

Compound
Compound

Interest
Interest

Compound Interest

8 - 20

- 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
Annual

FVA = 100(1.06)3

SemiSemi-

FVS = 100(1.03)6

$119.10
$119.10
$119.41
$119.41

Semi = 6%/2
Quarterly
Quarterly

FVQ = 100(1.015)12
Quarterly = 6%/4

McGraw-Hill Ryerson

$119.56
$119.56

Compound
Compound

Interest
Interest

Simple Vs Compound
Interest

8 - 21

AlJones
Jonesdeposited
deposited$1,000
$1,000in
inaasavings
savingsaccount
account
Al
for55years
yearsat
at10%
10%p.a..
p.a..
for

AnnualSSimple
impleIInterest
nterest
Annual
Rateof
of10%
10%
Rate

AnnualC
Compound
ompound
Annual
Rateof
of10%
10%
Rate

WhatisisAls
Als
What
impleIInterest
nterestand
and
SSimple

WhatisisAls
Als
What
nterestand
and
IInterest

Maturity
aturityV
Value?
alue?
M

McGraw-Hill Ryerson

Compounded
ompoundedV
Value?
alue?
C

Compound
Compound

Interest
Interest

Simple Vs Compound
Interest

8 - 22

AlJones
Jonesdeposited
deposited$1,000
$1,000in
inaasavings
savingsaccount
accountfor
for55years
yearsat
at10%
10%
Al
Simple
Simple

n = 5 * 1 = 5 i = .10

I = Prt
I = $1,000 * .10 * 5
= $500
FV = $1,000 + $500

= $1,500
McGraw-Hill Ryerson

Formulae
Formulae

Compound
Compound

FV = PV(1 + i)n
I = FV PV

Compare

= $1610.51 - $1000

Compare

FV = $1000(1.1)5
= $1,000 *1.6105

= $610.51

Compound
Compound

Interest
Interest

Beginning
Beginning
Balance
Balance

$1,000
$1,000

McGraw-Hill Ryerson

Nominal Rates of Interest

Compared
Nominal
Nominal
Rate
Rate

6%
++6%

8 - 23

Compounding
Compounding
Period
Period

Ending
Ending
Balance
Balance

Annual
Semiannual

$1,060.00
$1,060.90

Quarterly

$1,061.36

Daily

$1,061.83

Compound
Compound

Interest
Interest

Compounding Daily Interest

8 - 24

Calculate the Future Value of $2,000

compounded daily for 4 years
at 4.5%.

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

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

Compound
Compound

8 - 25

Interest
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

McGraw-Hill Ryerson

8 - 26

Compound
Compound

Interest
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
$6000

2 years

FV1 = PV2
i = .045/4 n = (2*4) = 8

FV1 = 6000(1+.045/4)8
= 6000(1.0936)
= 6561.75
McGraw-Hill Ryerson

4.5 years

FV2
i = .052/12 n = 2.5*12 = 30
FV2 = 6561.75(1+.052/12)30
= 6561.75(1.1385)
= $7470.61

8 - 27

Compound
Compound

Interest
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

McGraw-Hill Ryerson

Compound
Compound

8 - 28

Interest
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?
1 year
2 years
0
$5000 FV1 - $2500 = PV2
FV2
i = .07/12 n = 12
i = .07/12 n = 12
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
NewBalance
Balance = $568.30
New
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

McGraw-Hill Ryerson

8 - 29

Compound
Compound

Interest
Interest

8 - 30

Calculating Present
Present Value
Value
Calculating

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

McGraw-Hill Ryerson

8 - 31

Compound
Compound

Calculating Present
Present Value
Value
Calculating

Interest
Interest

-n
Formula
PV
=
FV(1
+
i)
Formula

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

(a) PV = $1500(1+.02)-6
= $1500 * .8880

1,331.96
0.88797
1.02
6

= $1,331.96
1500
McGraw-Hill Ryerson

8 - 32

Compound
Compound

Calculating Present
Present Value
Value
Calculating

Interest
Interest

-n
Formula
PV
=
FV(1
+
i)
Formula

What amount must you invest now at 5% compounded

daily to accumulate to $6000 after 1 year?
j = 5%
m = 365

PV = $6000(1+.05/365)-365
= $6000 * .9512

i = .05/365
n = 1*365 = 365
FV = $6000

= $5,707.40

5,707.40
0.0001
0.9512
1.001
.05
365
1
365

McGraw-Hill Ryerson

6000

Compound
Compound

Interest
Interest

8 - 33

Equivalent Payments
Payments
Equivalent

Two payments of $2200 each must be made 1 and 4 years

from now. If money can earn 5% compounded monthly,
what single
payment 3 years from now
would be
equivalent
to
the two
scheduled
payments?
Step
1
Draw
a
Time-line
Draw a Time-line
Step 1
Step 22 Find
Findthe
theFV
FVof
ofthe
thepayment
paymentthat
that
Step
movedfrom
fromYear
Year11to
toYear
Year33
isismoved
Step 33 Find
Findthe
thePV
PVof
ofthe
thepayment
paymentthat
that
Step
movedfrom
fromYear
Year44to
toYear
Year33
isismoved
Prepare the solution(a) algebraically, and
(b) by financial calculator
McGraw-Hill Ryerson

Compound
Compound

8 - 34

Equivalent Payments
Payments
Equivalent

Interest
Interest

Step 11
DrawaaTime-line
Time-line
Draw
Step
Two payments of $2200 each must be made 1 and 4 years
from now. If money can earn 5% compounded
monthly,
what single payment 3 years from now
would
be equivalent
to the two3scheduled
payments?
0
1 year
2 years
years
4 years
PV1 $2200
$2200 FV2
FV
i = .05/12
Step 22
Step

Findthe
theFV
FVof
of
Find
thepayment
payment
the
thatisismoved
moved
that
fromYear
Year11to
to
from
Year33
Year
McGraw-Hill Ryerson

n = 2*12 = 24 PV
2

(a) FV1
= 2200(1+.05/12)24
= 2200(1.1049)
= 2430.87

2430.87
Now

Compound
Compound

Interest
Interest

Making aa choice!
choice!
Making

8 - 35

Suppose a bank quotes nominal annual interest rates

of
6.6% compounded annually,
6.5% compounded semi-annually,
and
6.4% compounded monthly
on five-year GICs.
Which rate should an investor choose
for an investment of $1,000?

McGraw-Hill Ryerson

Compound
Compound

Comparisons

Interest
Interest

8 - 36

Results
Results
j = 6.6%
compounded
annually
j = 6.5%

1376.53
1376.53

compounded
semi-annually
j = 6.4%

1376.89
1376.89

compounded
monthly

1375.96
1375.96

the 6.5%
6.5% compounded
compounded semi-annually
semi-annually
the

provides for
forthe
the best
best
provides
rate of
of return
return on
on investment!
investment!
rate
McGraw-Hill Ryerson