LESSON 11 (SEC. 9.

2) COMPOUND INTEREST FUTURE VALUE

𝑆 = 𝑃(1 + 𝑖)𝑛

Chapter 9 Compound Interest – Future Value and Present Value

Lessons 11-15

Learning Objectives page 336

Upon completing this chapter, you will be able to do the following

1 Compute future (maturity) values of investments.

2 Compute present values of future sums of money.
3 Solve problems involving equivalent values.

Compound Interest

The interest for a specified period is added to the principal and the resulting
amount becomes the new principal for the next period.

Conversion Period

Interest may be converted or compounded into principal at any regular

periods of time.

Period Converted or Compounded

1 year annually

6 months semi-annually

3 months quarterly

1 month monthly

1 week weekly

1 day daily

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 LESSON 11 (SEC. 9.2) COMPOUND INTEREST FUTURE VALUE
𝑆 = 𝑃(1 + 𝑖)𝑛

Example

Invest $1000 for two years at 10% p.a. where interest is converted into
principal every six months.

Find the balance in the account at the end of

6
6 months 𝑆 = 1000 (1 + 0.1 × ) = $1050 the new P
12

6
1 year 𝑆 = 1050 (1 + 0.1 × ) = $1102.50 the new P
12

6
1 ½ years 𝑆 = 1102.50 (1 + 0.1 × ) = $1157.63 the new P
12

6
2 years 𝑆 = 1157.63 (1 + 0.1 × ) = $1215.51
12

6 6 6 6
Note 𝑆 = 1000 (1 + 0.1 × ) (1 + 0.1 × 12) (1 + 0.1 × 12) (1 + 0.1 × 12)
12
𝑆 = $1215.51

There are four factors which can be expressed with an exponent

0.1 4
𝑆 = 1000 (1 + ) = $1215.51
2
Compare to simple interest 𝑆 = 1000(1 + 0.1 × 2) = $1200

In simple interest, only the original principal earns interest, while in

compound interest, the interest earns interest.

The extra $15.51 is the interest earned by the interest.

2
 LESSON 11 (SEC. 9.2) COMPOUND INTEREST FUTURE VALUE
𝑆 = 𝑃(1 + 𝑖)𝑛

The interest rate must coincide with the conversion (compounding) period.

𝑖 = 𝑡ℎ𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛(𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔) 𝑝𝑒𝑟𝑖𝑜𝑑

The number of periods in one year is called the frequency of conversion

𝑚 = 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 𝑜𝑟 𝑡ℎ𝑒 𝑓𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 𝑜𝑓 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛

𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 𝑟
𝑖= =
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 𝑚

We also need to determine the total number of periods

𝑛 = 𝑡ℎ𝑒 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

𝑛 = 𝑡𝑖𝑚𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠 × 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟

𝑛=𝑡×𝑚

Example

Determine 𝑖 and 𝑛 if the nominal rate is 4.5% p.a. and the term is 3 years
and interest is compounded
0.045
a) Monthly 𝑚 = 12 𝑖= 𝑛 = 3 × 12 = 36
12
0.045
b) Quarterly 𝑚=4 𝑖= 𝑛 = 3 × 4 = 12
4
0.045
c) Semi-annually 𝑚=2 𝑖= 𝑛 =3×2=6
2
d) Annually 𝑚=1 𝑖 = 0.045 𝑛=3

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 LESSON 11 (SEC. 9.2) COMPOUND INTEREST FUTURE VALUE
𝑆 = 𝑃(1 + 𝑖)𝑛

Traditional Future Value Formula for Compound Interest

𝑆 = 𝑃(1 + 𝑖)𝑛
In the textbook, you will find another version of the formula

𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛
We will be using the traditional formula in this course.

𝑆 = 𝑃(1 + 𝑖)𝑛

Exercise 9.2 page 355

#2 How much will a registered retirement savings deposit of $1500 be

worth in 15 years at 3.45% compounded quarterly? How much of the
amount is interest?

Solution

Find the value of the deposit 15 years from now,

0.0345
Find 𝑆, given 𝑃 = 1500 𝑖 = 𝑛 = 15 × 4 = 60
4

0.0345 60
𝑆 = 1500 (1 + ) = $2511.16
4
The registered retirement savings deposit will be worth
$2511.16 in 15 years.
How much of the amount is interest?
𝐼 = 𝑆 − 𝑃 = 2511.16 − 1500 = $1011.16
The interest portion is $1011.16

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 LESSON 11 (SEC. 9.2) COMPOUND INTEREST FUTURE VALUE
𝑆 = 𝑃(1 + 𝑖)𝑛

Example

You made a registered retirement savings deposit of $1000 on December

1, 2014, at a fixed rate of 3% compounded monthly. If you withdraw the
accumulated amount on August 1, 2021, how much will you receive?

Solution

The interest period is from December 1, 2014 to August 1, 2021.

When you are given dates in compound interest, you do not count the
number of days. You count the number of years and the number of
months.
8
It is six years and eight months 𝑡=6
12

0.03 8
Given 𝑃 = 1000, 𝑖 = , 𝑛=6 × 12 = 80
12 12

0.03 80
𝑆 = 𝑃(1 + 𝑖)𝑛 = 1000(1 + ) = $1221.10
12

You will receive $1221.10 on August 1, 2021.

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 LESSON 11 (SEC. 9.2) COMPOUND INTEREST FUTURE VALUE
𝑆 = 𝑃(1 + 𝑖)𝑛

Fractional Conversion Periods

Example

A $6000 investment matures in three years, eleven months. Find the

maturity value if interest is 9% p.a. compounded quarterly.

Solution
0.09 11 2 47
Given 𝑃 = 6000, 𝑖 = , 𝑛=3 × 4 = 15 =
4 12 3 3

note that 𝑛 must be in exact form and not expressed as a decimal.

0.09 47
Find 𝑆, 𝑆 = 𝑃(1 + 𝑖)𝑛 = 6000(1 + ) 3 = $8502.43
4

The maturity value of the investment is $8502.43

Example

Find the maturity value of a promissory note for $3200 dated March 31,
2014, and due on August 31, 2020 if interest is 7% compounded quarterly.

Solution
0.07
Given 𝑃 = 3200, 𝑖 =
4

and the interest period is from March 31, 2014 to August 31, 2020
5 5 2 77
𝑡=6 which means that 𝑛 = 6 × 4 = 25 =
12 12 3 3

A promissory note is the note that you sign when you obtain a loan in
which you promise to repay a loan with or without interest on a
specific date.
0.07 77
𝑆 = 3200(1 + ) 3 = $4994.98
4
The maturity value of the promissory note is $4994.98.

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 LESSON 11 (SEC. 9.2) COMPOUND INTEREST FUTURE VALUE
𝑆 = 𝑃(1 + 𝑖)𝑛

Comparison

Example

The Continental Bank advertises capital savings at 4.25% compounded

semi-annually while TD Canada Trust offers premium savings at 4%
compounded monthly. Suppose you have $1000 to invest for two years.

Which deposit will earn more interest and what is the difference in the
amount of interest?

Solution

Find the accumulated values of each investment.

Find the accumulated value at the Continental Bank

where 𝑛 = 2 × 2 = 4
0.0425 4
𝑆 = 𝑃(1 + 𝑖)𝑛 = 1000(1 + ) = $1087.75
2
The interest earned at the Continental Bank is $87.75.

Find the accumulated value at TD Canada Trust

where 𝑛 = 2 × 12 = 24
0.04 24
𝑆 = 𝑃(1 + 𝑖)𝑛 = 1000(1 + ) = $1083.14
12
The interest earned at TD Canada Trust is $83.14.

Therefore, the deposit at Continental Bank earns more interest.

The difference in the interest is 87.75 – 83.14 = $4.61.