Contemporary Business Mathematics

With Canadian Applications

Eighth Edition S. A. Hummelbrunner/K. Suzanne Coombs

PowerPoint: D. Johnston

Chapter 9

Compound Interest
Future Value and Present Value

Copyright 2008 Pearson Education Canada

9-1
 Objectives
After completing chapter nine, the student will
be able to:
Calculate interest rates and number of
compounding periods
Compute future (maturity) value.
Compute the present value of future sums of
money.
Discount long-term promissory notes.
Solve equivalent value problems.

Copyright 2008 Pearson Education Canada Inc. 9-2

 Compound Interest
Interest for a specified time period is added
to the original principal.
The sum of the principal and interest
becomes the new principal for the next time
period.
The amount of compound interest for the
first period is the same as for simple interest
but is greater for the following periods.

Copyright 2008 Pearson Education Canada Inc. 9-3

 Compounding of Interest
Principal = 10000, Rate = 10% p.a.
Term = 4 years
Year Principal Interest Amount
1 10000 1000 11000
2 11000 1100 12100
3 12100 1210 13310
4 13310 1331 14641

Copyright 2008 Pearson Education Canada Inc. 9-4

 Formula for Future Value
n n
FV = PV(1 + i) or S = P(1 + i)
FV = S = Future or Maturity Value
PV = P = Original Principal
i Periodic Interest Rate
n Number of compounding periods
over term of loan
Copyright 2008 Pearson Education Canada Inc. 9-5
Compounding Frequencies
Compounding Length of Number of
Frequency period annual periods

Annual 12 months 1
Semi-annual 6 months 2
Quarterly 3 months 4
Monthly 1 month 12
Copyright 2008 Pearson Education Canada Inc. 9-6
Determining Periodic Rate of
Interest i
The nominal rate of interest is the stated
annual rate of interest.

In the equations we will use we need to

periodic rate of interest i.e. i. To calculate I
we use this formula.

Nominal (Annual) Rate

i
Number of Compounding Periods Per Year

Copyright 2008 Pearson Education Canada Inc. 9-7

Finding Periodic Rate of Interest
i= j/m
j = nominal or annual rate of interest
m = number of yearly compounding periods

Compound interval Periodic rate i

Annual 8%

Semi-annual 8% =4%
2
Quarterly 8% = 2%
4
Copyright 2008 Pearson Education Canada Inc. 9-8
Determining Compounding
Factor (1+i)n
12% compounded (1.01)36
monthly for 3 years
n=12x3=36

7% compounded (1.035)16
semi-annually for 8
n=2X8=16
years

10% compounded (1.025)20

quarterly for 5 years
n=4X5=20

Copyright 2008 Pearson Education Canada Inc. 9-9

 Calculation of Future Value
A principal of $10,000 is invested at an annual
rate of 10% for four years. Find the FV.
n
FV = P(1+i)
4
FV =10000(1.10) = $14641

Interest earned = 14641 10000 = $4641

Copyright 2008 Pearson Education Canada Inc. 9-10

Simple Interest vs. Compound
Interest

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 Comparison of Simple and
Compound Interest
Principal $10000 Rate 6% compounded
Term 5 years annually
Simple Interest Compound Interest
5
FV = 10000(1+.06x5) FV=10000(1+.06)
= $13000 =$13382.26

Note the difference of $382.26.

Copyright 2008 Pearson Education Canada Inc. 9-12

 Future Value of an Investment
FV = PV(1+i)n

Find the future value (accumulated or maturity

value) of a savings certificate with a principal
of $5000 earning interest at 4% compounded
quarterly for five years at the end of the five-
year term.
20
FV = $5000(1.01) = 5000(1.22019004) =
$6100.95
Copyright 2008 Pearson Education Canada Inc. 9-13
 Finding FV When n Is a
Fraction
Find the future or accumulated value of $6000
invested for 4 years, 5 months at 4%
compounded quarterly.
17.666667
FV = 6000(1.01) = 7153.12

Note : There are 4x4 or 16 quarters in 4 years.

There are 1 and 2/3 quarters in 5 months (5/3).

Copyright 2008 Pearson Education Canada Inc. 9-14

 Computing Present Value
(Discounting)
Find the principal that will amount to $10,000
in 6 years at 4% compounded semi-annually.

FV = PV(1+i)n 10000 = PV(1.02)12

PV = 10000 = 10000(1.02) 12 = $7884.93

(1.02)12
(continued)

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 Compound Discount
(continued)
Compound Discount = FV PV

Compound Discount = 10000 7884.93

= $2115.07

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 Formula for Present Value
FV = PV(1+i)n
n
Divide both sides by (1+i) .
-n
PV = FV = FV(1+i)
n
(1+i)

Copyright 2008 Pearson Education Canada Inc. 9-17

 Calculating Present Value
Find the present value of an amount of $10000
due four years from today if the interest rate is
8% compounded semi-annually.

PV = 10000 = 10000(1.04) 8
8
(1.04)

PV = $7306.90

Copyright 2008 Pearson Education Canada Inc. 9-18

 Long-term Promissory Notes
Term of note longer than one year.
Can be bought and sold at any time before
maturity.
Subject to compound interest.
No requirement to add the 3 days of grace
in determining legal due date.

Copyright 2008 Pearson Education Canada Inc. 9-19

 Proceeds of Long-term
Promissory Note

The discounted value (or proceeds) is the

PRESENT VALUE of the MATURITY
VALUE at the date of discount.

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D
Promissory Note Diagram
Discount Period

issue discount maturity

date date date

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Calculating Proceeds of a Non-
Interest-bearing Note
Find the proceeds of a non-interest bearing
note for $3000 discounted 2 years before
maturity. The interest rate is 9% compounded
monthly.

Since this is a non-interest bearing note, the

maturity value is equal to the face value.
36
PV = Proceeds =3000(1.0075) = $2292.45

Copyright 2008 Pearson Education Canada Inc. 9-22

 Discounting an Interest-
bearing Note

Step 1 -- Find the maturity value of the

note.

Step 2 -- Find the present value at the

discount date of the maturity value.

Copyright 2008 Pearson Education Canada Inc. 9-23

 Finding the Proceeds for an
Interest-bearing Note
On April 1, 2004, a three-year promissory note for $5000 is
issued with an interest rate of 8% compounded semi-annually.
The note is discounted on April 1, 2006 at 9% compounded
quarterly. Find the proceeds of the note.

Step 1 Calculate the Maturity value = 5000(1.04)6 = $6326.60

Step 2- Calculate the Proceeds = 6326.60(1.0225) 4 = $5787.85

Copyright 2008 Pearson Education Canada Inc. 9-24

 Equivalent Values
Equivalent values are the dated values of an
original sum of money.

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 Finding Equivalent Values
Select a focal date. The focal date is a
specific date chosen to compare the time
values of one or more dated sums of money.
If the due date of the payment falls before
the focal date, use the FV formula.
If the due date of the payment falls after the
focal date, use the PV formula.

Copyright 2008 Pearson Education Canada Inc. 9-26

Calculating Equivalent Values
A payment of $7000 is due 5 years from now.
Money is worth 4% compounded annually.
The focal date is 5 years.
t=0 5 years 8 years

7000
Find the equivalent value today (t=0).
5
7000(1.04) = 5753.49
Find the equivalent value 8 years from today.
3
7000(1.04) = 7874.05
Copyright 2008 Pearson Education Canada Inc. 9-27
 Summary
With compound interest, earned interest is
added to the principal and thus interest is
earned on interest resulting in exponential
growth.
The future value of an investment at
compound interest can be expressed by the
formula FV = P(1+i)n .
(continued)
Copyright 2008 Pearson Education Canada Inc. 9-28
 Summary
(continued)
The present value of a future amount at
compound interest can be expressed by the
formula PV = FV(1+i) -n .

Copyright 2008 Pearson Education Canada Inc. 9-29