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ISD 151: BUSINESS MATHEMATICS

COMPOUND INTEREST AND

PRESENT VALUE
OUTLINE
Definitionof Compound Interest
Determining Compound Periods
Computing Present Values
Daily and Continuous Compounding
 Compound Interest
Compound interest is a kind of interest that is
calculated on both principal and interest accrued
once or more than once in a specified period.
Unlike simple interest that is calculated once a
year (p. a.) and only the principal, compound
interest is calculated on both the principal and the
interest any number of times agreed upon in a
given period.
This means that under compound interest, the
interest from the previous period is treated as part
of principal and interest is calculated on the total
sum in the next period.
If an investment is compounded annually for 2
years,
First, the simple interest on the principal is
calculated at the end of the first year.
Second, the interest earned at the end of the first
year is added to the principal to serve as the
principal at the beginning of the second year. At
the end of the 2nd year, interest is calculated on
this new principal and not the old.
The total value of an investment is hence the
principal plus all the compound interest and this
is called the future value or compound amount
The principal is called the present value
 Example
Robert invests Ȼ2000 for 2 years in an account that pays
6% interest compounded annually. Compute the total
compound interest and future value of the investment.
Solution
1st year interest = Ȼ2000 x 0.06 x 1 = Ȼ120
2nd year principal = Ȼ2000 + Ȼ120 = Ȼ2120
So 2nd year interest = Ȼ2120 x 0.06 x 1
= Ȼ127.20
Total compound interest = Ȼ120 + Ȼ127.20
= Ȼ247.20
Future value = Ȼ2000 + 120 + Ȼ127.20
=Ȼ2,247.20
 Computing Future Value (FV)
The future value of an investment can be
determined using the formula:
FV = Principal (PV) x Future value factor
(FVF)
The FVF can be read from the interest table or
computed using the formula: (1 + r)n
 r = interest rate/ cost of capital
n = number of compounding periods
Determining the Number of Compounding
Periods and Periodic Rates
Compound interest can be charged daily
(everyday), monthly (every month), quarterly
(every quarter), semiannually (every half-year),
or annually (once a year)
The “period” is the unit of time of the
compounding, and the periodic rate is the rate of
interest corresponding to the periods.
 To obtain the periodic rate, we:
1. Determine the number of corresponding periods
in 1 year. (i.e. m = 1 for annually; m=2 for
semiannually – 12months/6months) etc.
2. Divide the stated annual rate (r) by the number of
periods in 1 year (m). The quotient is the periodic is rate
(i). r/m = r

3. Multiply the number of periods in 1 year (m) by the

number of years (t). The product is the total number of
compounding periods n.

NB: The annual rate is called the “nominal rate” and the
“effective rate” is the true annual yield an investment
makes if the interest is compounded more than once.

FINANCIAL OTABIL