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CHAPTER 3

COMPOUND INTEREST

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3.1 TIME VALUE OF MONEY

 Money has time value, that is a ringgit today is worth
more than a ringgit tomorrow.
 Money has time value because of its investment
opportunities.

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3.2 COMPOUND INTEREST

 In compounding, after the interest is calculated, it is
then added to the principal and becomes an adjusted
principal.
 Processes are repeated until the end of the loan or
investment term.
 Normally used with long-term loan or investment, and
the interest is calculated more than once during the
loan or investment term.

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 The interest earned is called compound interest, and the

final sum at the end of the period of borrowing is called
the compound amount.

 Therefore, compound interest is the difference between

the original principal and the amount.

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3.3 SOME IMPORTANT TERMS

 Some of the common terms used in relation to
compound interest are:
1. Original principal
2. Nominal interest rate
3. Interest period or conversion period
4. Frequency of conversions
5. Periodic interest rate
6. Number of interest periods in the investment
period

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3.4 COMPOUND INTEREST FORMULA

 The method used in finding compound amount at the
end of the nth period is as follow:

S = P(1 + i)n
Where:
P = Principal / Present Value
S = Future Value
n = Number of Periods (number of
years multiplied by number of
times compounded per year)
i = Interest rate per compound period

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Example 1 pg 41
Find the future value of RM 1000 which was invested for
a) 4 years at 4% compounded annually,
b) 5 years 6 months at 14% compounded semi annually,
c) 2 years 3 months at 4% compounded quarterly
d0 5 years 7 months at 5% compounded monthly
e) 2 years 8 months at 9% compounded every 2 months
f) 250 days at 10% compounded daily.

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Example 2 pg 42
RM 9000 is invested for 7 years 3 months. This investment is offered
12% compounded monthly for the first 4 years and 12%
compounded quarterly for the rest of the period. Calculate the
future value of this investment.
Example 3 pg 42
Lolita saved RM 5000 in a saving account which pays 12% interest
compounded monthly. Eight months later she saved another RM
5000. Find he amount in the account two years after her first saving.
Example 4 pg 43
What is the nominal rate compounded monthly that will make RM
1000 become RM 2000 in five years?

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3.5 EFFECTIVE, NOMINAL AND EQUIVALENT

RATES
 Effective rate : Simple rate that will produce the same
accumulated amount as the nominal rate is compounded
each period after one year.

 Nominal rate : Stated annual interest rate at which

interest is compounding more than once a year.

 Equivalent rate : Two different rates that yield the same

value at the end of one year.

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3.6 RELATIONSHIP BETWEEN EFFECTIVE AND

NOMINAL RATES
 The relationship between the nominal rate and
effective rate is derived as follows:
 Assume a sum RM P is invested for one year. Then the
future value after one year:

(a) At r% effective = P(1 + r)

(b) At k% compounded m times a year = P(1 + k/m)m

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Example 1 pg 41
Find the effective rate which is equivalent to 16% compounded semi
annually.
Example 2 pg 45
Find the nominal rate, compounded monthly which is equivalent to 9%
effective rate.
Example 3 pg 45
Kang wishes to borrow some money to finance some business
expansion. He has received two difference quotes:
Bank A: Charged 15.2% compounded annually
Bank B: Charged 14.5% compounded monthly.
Which bank provides a better deal?

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3.7 RELATIONSHIP BETWEEN TWO NOMINAL

RATES
 The relationship between two nominal rates is given
as follows:

(1 + k/m)m + (1 + K/M)M
Where:
k and K are two different annual rates with
respectively two different frequencies of conversions,
m and M.

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Example 1 pg 46
Find K% compounded quarterly which is equivalent to 6%
compounded monthly.

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3.8 PRESENT VALUE

 Present value or discounted value is the value which

will yield the sum (S) after certain time and at a
specific interest rate.
 We can find present value by transposing the formula
as below:

S = P(1 + i)n

transpose

P = S / (1 + i)n or P = S(1 + i)-n

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Example 1 pg 47
A debts of RM 3000 will mature in three years’ time. Find
a) the present value of this debts
b) the value of this debt at the end of the first year
c) the value of this debts at the end if four years.
Assuming money is worth 14% compounded semi annually.
Example 2 pg 49
A debt of RM 7000 matures at the end of the second year and another
of RM 8000 at the end of six years. If the debtor wishes to pay his
debts by making one payment at the end of the fifth year, find the
amount he mist pay if money is worth 6% compounded semi
annually using
a) the present as the focal date
b) the end of the fifth year as the focal date.

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Example 3 pg 50
A debt of RM 7000 matures at the end of the second year and another
RM 8000 at the end of six years. If the debtor wishes to pay his debts
making two equal payments at the end of the fourth year and the
seven year, what are these payments assuming money is worth 6%
compounded semi annually.

Example 4 pg 51
Roland invested RM 10000 at 12% compounded monthly. This
investment will be given to his three children when they reach 20
years old. Now his three children are 15, 16 and 19 years old. If his three
children will receive equal amounts, find the amount each will receive.

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3.9 EQUATION OF VALUE

 An equation that expresses the equivalence of two sets
of obligations at a focal date.
 In other words, it expresses the following:

What is owed = What is owned at the focal date

or

What is given = What is received at the focal date

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3.10 CONTINUOUS COMPOUNDING
 We have been discussing compounding of interest
on discrete time intervals (daily, monthly, etc).
If compounding of interest is done on a continuous
basis, then we will have a different picture of the future
value as shown below:

Discrete compounding Continuous compounding

Future Future
value value

Time DDG 1113 Time

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