WELCOME TO UNIT 6

 Compound Interest, Future and Present Values

 Learning outcomes
 Calculate the future value and the compound interest amount by compounding
manually
 Calculate the future value and the compound interest amount using a $1.00
future value table
 Calculate the future value and the compound interest amount using a formula
 Find the effective interest rate ( APY)
 Calculate the interest compounded daily using a table
 Some loans may use compounding formula to calculate the
interest amount. In this case, the interest is calculated more
than one time during the term of the loan or investment and the
interest of a period is added to the principal before the interest
of the next period is calculated. So, the interest of one period
also earns some interest in the next period.
 The process of adding interest to the principal before calculating
the interest amount for the next period is called compounding
interest.
 There are two or more interest periods when the interest is
compounded. The interest period can be one day, one week,
one month, one quarter, one year, or any portion of the year.
 The more the number of interest periods, the higher the
amount of total interest will be because the interest of more
interest periods contribute to the total interest amount.
 future value or maturity value or compound amount is the
sum of compound interest and the original principal.
CALCULATE THE FUTURE VALUE AND THE COMPOUND INTEREST
AMOUNT BY COMPOUNDING MANUALLY

 The simple interest formula can be used to calculate

the future value of principal when annual number of
interest periods and the annual interest rate are
known.
 First, we need to find the period interest rate or
interest rate per period. This can be done by dividing
the annual interest rate by the total number of
annual interest periods.
 Period interest rate = annual interest rate / number
of interest periods per year
 STEPS TO FIND THE FUTURE VALUE USING THE SIMPLE INTEREST
FORMULA
 Calculate the principal at the end of the first period:
  
 Principal at the end of first period = original principal x (1 + period interest rate)
  
 If original principal = P; principal at the end of the first period = A; period interest rate = R then
  
 A = P(1 + R)
  
 For each remaining period,
  
 End-of-period principal = previous end-of-period principal x (1 + period interest rate)
  
 The last end-of-period principal is the future value.
 Example 1:
 Susan secured a loan of $8000 for three years compounded annually. If the
interest rate was9%,find:
 Future value
 Total compound interest paid
 Compare the total compound interest with total simple interest over the same
loan period, original principle, and annual interest rate.
  
 Solution:
 9% = 0.09
 Principal at the end of first period = $8,000 (1 + 0.09)
 = $8,000 (1.09)
 = $8,720
  
 Second end-of-period principal = $8,720 (1 + 0.09)
 = $8,720 (1.09)
 = $9,504.80
 Third end-of-period principal = $9,504.80 (1 + 0.09)
 = $9,504.80 (1.09)
 = $10,360.23
 So, the future value of the loan is $10,360.23
  
 Total compound interest = A–P
 = $10,360.23 - $8,000 = $2,360.23
 The compound interest is $2,360.23
  
 To find the simple interest:
  
 I = PRT
 I = $8,000 * 0.09 * 3 = $2,160
 Total Simple Interest = $2,160
 Different between total compound and total simple interests = 2,360.23 -
$2,160 = $200.23
 Example 2:
 Find the future value of a $10,000 investment at 8% annual interest compounded
semiannually for three years.
 Solution:
 8% = 0.08 ;
 Interest per period = annual interest rate / number of periods
 = 0.08 / 2 = 0.04
 Total number of periods = 3 years * 2 periods per year
 =3*2
 =6
 Principal at the end of the first period = $10,000 (1+ 0.04)
 = $10,000 (1.04) = $10,400
  
 Principal at the end of the second period = $10,400 (1+ 0.04)
 = $10,400 (1.04) = $10,816
 Principal at the end of the third period = $10,816 (1+ 0.04)
 = $10,816 (1.04) = $11,248.64
  
 Principal at the end of the fourth period = $11,248.64 (1+ 0.04)
 = $11,248.64 (1.04) = $11,698.59
  
 Principal at the end of the fifth period = $11,698.59 (1+ 0.04)
 = $11,698.59 (1.04) = $12,166.53
  
 Principal at the end of the fifth period = $12,166.53 (1+ 0.04)
 = $12,166.53 (1.04) = $12,653.19
 Calculate the future value and the compound interest amount using a $1.00 future value table
  
 We can also find the amount of compound interest using Table. Here is the steps involve in this process.
 Find total number of interest periods
  
 Total number of interest periods = number of years x number of interest periods per year
  
 Find interest rate per period
  
 Interest rate per period = annual interest rate / number of interest periods per year
  
 Select the row that corresponds to the number of periods and the column that corresponds to the interest rate per period from
Table
  
 Locate the value in the table at the intersection of the row and column mentioned in step 3.
  
 Multiply the original principal by the value from step 4 to find the future value .
  
 Future value = principal x table value
  
 Total compound interest = future value – original principal
 Example 1:

 Use table to find the compound interest on a $5000 loan for six years at 8%, compounded
annually.
 Solution:
 8% = 0.08
 Total interest periods = number of years x number of interest periods per year
 = 6x1=6
 Interest rate per period = 0.08 / 1 = 0.08
 The table 10-1 value for row = 6 and column = 8% is 1.58687
 Future value = principal x table value
 = $5,000 x 1.58687 = $7,934.35
  
 Total compound interest = $7,934.35 - $5,000 = $2,934.35
 Example 2:

 A loan of $3,000 at 8% annual interest is compounded quarterly (4 times a year) for

three years. Find the future value and the total compound interest.
 Solution:
 8% = 0.08
 Total interest periods = number of years x number of interest periods per year
 = 3 x 4 = 12
 Interest rate per period = 0.08 / 4 = 0.02
 The table 10-1 value for row = 12 and column = 2% is 1.26824
 Future value = principal x table value
 = $3,000 x 1.26824= $3,804.72
  
 Total compound interest = $3,804.72 - $3,000 = $804.72
CALCULATE THE FUTURE VALUE AND THE COMPOUND INTEREST AMOUNT USING A FORMULA

 
 The following formula can be used to find the future value (FV).
 FV = P(1 + R)N
 Where FV is the future value; R is interest rate per period ; n is the total number of periods.
  
 Example 1:
 Find the future value and total interest amount of a $5,000 investment that earns 6% compounded monthly after 3 years.
 Solution:
 6% = 0.06 ; R = Interest rate per period
 Total interest periods = number of years x number of interest periods per year
 = 3 x 12 = 36
  
 R = 0.06 / 12 = 0.005
 FV = $5,000 (1 + 0.005)36
 = $5,000 (1.005)36
 = $5,000 x 1.19668
 = $5,983.40
 Total interest amount = FV - Original principal
 = $5,983.40 - $5,000
 = $983.40
 How can we compare two loans with different interest rates and number of periods
compounded a year? To make such comparison we need to convert both to a rate of
interest called, effective rate.
 The effective rate equates the compound interest rates to equivalent simple interest
rates so that a comparison can be made. The effective rate is also referred to as the
annual percentage yield (APY).
 Here is how to find the effective interest rate of a compound interest rate
 Effective annual interest rate = compound interest for first year / principal
 We can also find the effective interest rate by using table 13-1 by using the formula
formula.
 Effective annual interest rate = [ (future value of $1.00 after 1 year - $1.00) / $1.00 ]
* 100%
FOUR
 FORMULAS
Example 1: TO DETERMINE PROPERTY TAX VALUES
 John borrowed $6,000 at 10% compounded semiannually. What is the effective rate?
  
 Solution:
 10% = 0.10
 Interest rate per period = 0.10 / 2 = 0.05
 First end-of-period principal = $6,000 (1 + 0.05)
 = $6,000 (1.05) = $6,300
  
 Second end-of- period principal = $6,000 (1 + 0.05)
 = $6,300 (1.05) = $6,615
  
 Compound interest after first year = $6,615 - $6,000 = $615
  
 Effective interest after first year = ($615 / $6,000) * 100%
 = 0.1025 * 100% = 10.25%
 To use Table, we go to the row of 2 (for two periods) and the column
of 5% and read the value at the intersection of the row and column.
This value is 1.10250.
  
 Effective annual interest rate = [ (future value of $1.00 after 1 year -
$1.00) / $1.00 ] * 100%
 Effective annual interest rate = [ (1.10250 – 1) / 1 ] * 100%
 = [ 0.10250 / 1 ] * 100%
 = 0.10250 * 100% = 10.25%
 Calculate the interest compounded daily using a table
 To find the compounded daily interest using a table we follow the steps below:
 We first determine the amount of money the table uses as the principal ($1, $100, or $1000).
 Then, divide the loan principal by table principal.
 Then, using Table 10-2 find the days row and interest rate column corresponding to the interest
rate of the loan and find the value at the intersection of this row and column.
 Finally, multiply the value from the resul t of step 2 by step 3.
  
 Example:
 Find the interest on $800 at 7.5% annually, compounded daily, for 28 days.
  
 Solution:
 First we find the number of $100 units in the principal. $800 / $100 = 8
 The Table 13-2 value is 0.576941. So,
 $8 ( 0.576941) = $4.615528 rounded to two digits after the decimal = $.62
PRESENT VALUE
Learning outcomes
 Calculate the present value bases on annual compounding for one year
 Calculate the present value using a $1.00 present value table
 Calculate the present value using a formula
  
 Present Value tells us how much to invest at present value in order to yield a certain amount at
some specified future date.
  
 Calculate the present value bases on annual compounding for one year
 Calculating present value manually is time consuming. When there are many interest periods out
there. We find the Present Value formula by adjusting the Future value formula.
 Future Value = principal (1 + annual interest rate) so to find for Principal we need to divide the
equation by (1 + annual interest rate). So,
  
 Present value = future value / (1 + annual interest rate)
 Example :
 Find the amount of money that Mary needs to set aside today to
ensure that $10,000 will be available in her account to buy a new
TV in one year if the annual interest rate is 4% compounded
annually.
 

 Solution:

 1 +0.04 = 1.04

 $10,000 / 1.04 = $9,615.38

CALCULATE THE PRESENT VALUE USING A $1.00 PRESENT VALUE TABLE
 To calculate the present value based on using the $1.00 present value table we use the following
formula:
 Interest per period = annual interest rate / number of interest periods per year
 We can also follow the Table 10-3 to find the days row and interest rate column corresponding to
the interest rate of the loan and find the value at the intersection of this row and column.
 Finally, multiply the value from the result of step 1 by the loan amount .
  
 Example:
 AZZ company needs $20,000 in five years to buy a new machine. How much must the firm invest at
the present if it is received 5% interest compounded annually?
  
 Solution:
 Going to table 10-3 row of 5 and rate of 5% column, the table value would be 0.78353.
  
 Present value = $20,000 * 0.78353 = $15,670.60
 The following is the present value formula where P is present value, R is the annual interest rate, and FV is the
future value.
 PV = FV / (1 + R)N
  
 Example:
 Hotel Victoria would like to put away some of the holiday profits to save for a planned expansion. A total of
$8,000 is needed in three years. How much money in a 5.2% three-year certificate of deposit that is compounded
monthly must be invested now to have the $8,000 in three years?
  
 Solution:
 5.2% = 0.052
 Interest rate per period = 0.052 / 12 = 0.00433
 Number of periods = 3 * 12 = 36
 PV = FV / (1 + R)N
 PV = $8,000 / (1 + 0.00433)36
 PV = $8,000 / (1.00433)36
 PV = $8,000 / 1.16829
 PV = $6,847.61
Discussion?