Compound 8-1

8
Interest

Compound

Chapter 8

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 Compound 8-2

8
Interest
Learning Objectives
After completing this chapter, you will be able to:
Calculate the…
LO-1 …Maturity Value(MV), Future Value (FV), and Present
Value(PV) in
compound interest applications,
by both the algebraic method and the
pre-programmed financial calculator
…Maturity Value of compound
method interest for
Guaranteed Investment Certificates (GICs)

…Price of "strip" bonds

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 Compound 8-3

8
Interest
Learning Objectives
Calculate the…
LO-2 … Redemption Value of a compound interest
bearing Canada Savings Bond

…Payment on any date that is equivalent to one or

more payments on other dates

…Economic Value of a payment stream

And be able to…
…Adapt the concepts and equations of compound
interest to cases of compound growth
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 Compound 8-4

8
Interest

LO-1

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 Compound 8-5
To better understand how Compound Interest
8
Interest is calculated, let’s review how we calculate
Simple Interest!

The formula on which we base our

calculation is…

Formula I = Prt
Here we have an amount, the Principal, which is
multiplied by the Interest Rate and the Time over
which the Interest is earned!

As we will now see, Compound Interest uses

the Sum of P & I as a base on which to calculate
new Interest!
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 Compound 8-6
Compound Interest
8
Interest - Future Value

…the interest on the principal

plus the
interest of prior periods
e.g. Principal + prior period interest = $1100.00
$1000.00 $100.00
Interest for the next period is calculated on $1100.00.
This method will continue over the life of the
loan or investment. (See later example)

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 Compound 8-7
Compound Interest
8
Interest - Future Value

…is the compounded amount and

is the FINAL amount of the loan
or investment at the
end of the last period!

Contrast this with…

...is the value of a loan or
investment TODAY!

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 Compound 8-8
Compound Interest
8
Interest - Future Value

…the calculation of interest over

the life of the loan or investment
Let’s assume that the interest rate is 10% pa.
Example: Principal + prior period interest = $1100.00
Interest is now calculated on $1100.00
Principal(Compounded) * 0.10 = $110.00
New P $1210.00 to start next period

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Graphically…
 Compound 8-9
Compound Interest
8
Interest - Future Value
Interest Interest Interest Interest
Amount $1000
133.1
1331
121 121
1210
110 110 110
1100
100 100 100 100
1000

Compounding Compounding Compounding Compounding

Period Period Period Period
0 1 2 3 4
Time(Years)
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 Compound 8 - 10
Compound Interest
8
Interest - Future Value

What happens if the interest

rate changes during the life of
an investment?

Example…
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 Compound 8 - 11
Compound Interest
8
Interest - Future Value

You hold an investment for a period of 4 years.

Rates of return for each year are 4%, 8%,
-10% and 9% respectively.
If you invested
$1000 at the beginning of the term, how much
will you have at the end of the
last year?

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 Compound 8 - 12
Compound Interest
8
Interest - Future Value

You hold an investment for a period of 4 years.

Rates of return for each year are 4%, 8%, -10% and 9%
respectively. If you invested $1000 at the beginning of the
term, how much will you have at the end of the last year?

Year 1 Year 2 Year 3 Year 4

$1000 $1040 $1123.20 $1010.88
$1000 * $1040 * $1123.20 * $1010.88 *
(1 + .04) (1 + .08) (1 - .10) (1 +.09)
= $1040 = $1123.20 = $1010.88 = $1101.86
…Alternative
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 Compound 8 - 13
Compound Interest
8
Interest - Future Value

You hold an investment for a period of 4 years.

Rates of return for each year are 4%, 8%, -10%
and 9% respectively. If you invested $1000 at
the beginning of the term, how much will you
have at the end
of the last year?
Solving 1000(1.04)(1.08)(.90)(1.09) = $1101.86
Alternative
Solve for all 1 -10%
4 years at
once! It is rare for interest to be
compounded only once per year!
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 Compound 8 - 14

8
Interest

Compounding Frequencies and Periods

Frequency No. per Year Period
Annually 1 1 year
Semiannually 2 6 months
Quarterly 4 3 months
Monthly 12 1 month
Daily 365 1 day
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8
Interest
Development of a Formula

Nominal or Annual Rate (j)

Number of compoundings per year m
Periodic Rate per period (i)
Total Number of Periods n

Determining values for n and i

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 Compound 8 - 16

8 Formulae
Interest

To Determine n

Time(Years) * # of Compounding Frequencies p.a.(m)

To Determine i
Annual Interest Rate(j)
# of Compounding Frequencies p.a. (m)
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 Compound 8 - 17

8 Determining values for n

Interest

If you compounded $100 for 3 years at 6%

annually, semiannually, or quarterly,
what are the values for n and i ?

Time(Years) *
# of Compounding
Formula Frequencies per year (m)
No. n
Annually 3* 1 = 3
Semiannually 3 * 2 = 6
Quarterly 3 * 4 = 12
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8
Interest
Determining values for i

If you compounded $100 for 3 years at

6% annually, semiannually, or quarterly,
what are the values for n and i ?

Annual Interest Rate (j)

Formula
# of Compounding
Frequencies per year(m) No. Rate - i
Annually 6% / 1 = 6%
Semiannually 6% / 2 = 3%
Quarterly 6% / 4 = 1.5%
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8
Interest

Development of a Formula for Future Value

FV = PV(1 + i)n
Where…

PV= Present Value(Principal)

i = rate per period
n = number of periods

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 Compound 8 - 20
Compound Interest
8
Interest - Future Value

Formula FV = PV(1 + i) n

Steve Smith deposited $1,000 in a savings account for

4 years at a rate of 8%
compounded semiannually.
What is Steve’s interest and compounded
amount?
Extract necessary data...
PV = $1000
n = 4X2=8
i = .08/2 = .04
Solve…
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 Compound 8 - 21
Compound Interest
8
Interest - Future Value

Formula FV = PV(1 + i) n

Solve… Using PV = $1000 n = 8 i= .04

FV = $1000(1 + .04)8
= $1000(1.368569)
= $1,368.57

Principal $1,000.00
+ Interest 368.57
Compounded $1,368.57

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 Compound 8 - 22

8
Interest

What is the effect on the

Future Value
of
different
Compounding Periods
of
Interest?
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 Compound 8 - 23
Compound Interest
8
Interest - Future Value

If you compounded $100 for 3 years at 6%

annually, semiannually, or quarterly,
what are the final amounts that you would have at
the end of the three (3) years ?
Annual $119.10
FVA = 100(1.06)3
Semi- FVS = 100(1.03)6 $119.41
Semi = 6%/2
Quarterly $119.56
FVQ = 100(1.015)12
Quarterly = 6%/4
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 Compound 8 - 24
Compound Interest
8
Interest - Future Value
The Components of the Future Value of $100
250
Interest
on
FV=PV(1+i)n
Future Value
S or FV

200 Interest

Interest on
150 Original
Principal
S=P(1+rt)
100

50 Original Principal

Time(Years)
0
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 Compound 8 - 25

8
Interest

Comparisons

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 Compound 8 - 26

8 Simple Vs Compound Interest

Interest

Al Jones deposited $1,000 in a savings account

for 5 years at 10% p.a..

Annual Simple Interest Annual Compound

Rate of 10% Rate of 10%
What is Al’s What is Al’s
Simple Interest and Interest and
Maturity Value? Compounded Value?
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 Compound 8 - 27

8 Simple Vs Compound Interest

Interest

Al Jones deposited $1,000 in a savings account for 5 years at 10%

n = 5 * 1 = 5 i = .10
Simple Compound
Formulae
I = Prt FV = PV(1 + i)n
I = FV – PV
I = $1,000 * .10 * 5 = $1610.51 - $1000
Compare
= $500 = $610.51
FV = $1000(1.1)5
FV = $1,000 + $500 = $1,000 *1.6105
Compare
= $1,500
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= $1,610.51
 Compound 8 - 28

8
InterestFuture Values of $100 at
1800 Various Rates of Interest Compounded
1600
Annually 12%
FV

1400
Future Value

1200

1000
10%

800

8%
600

400 6%

200

100
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

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 Compound 8 - 29

8
Interest
Nominal Rates of Interest Compared

Beginning Nominal Compounding Ending

Rate Period Balance
Balance
Annual $1,060.00
Semiannual $1,060.90
$1,000 + 6%
Quarterly $1,061.36
Daily $1,061.83

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8
Interest
Future Values of $100 at the same Nominal Rate but
2500 Different Compounding Frequencies
FV

2000

12% Compounded
Future Value

1500
monthly
1000
e d
nd
pou
500
om lly
C u a
100 12% Ann
0 5 10 15 20 25

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Time (years)
 Compound 8 - 31

8 Compounding Daily Interest

Interest

Calculate the Future Value of $2,000

compounded daily for 4 years
at 4.5%.

Formula FV = PV(1 + i) n

n = 4 * 365 = 1460 i= .045 /365 = 0.0001232

FV = $2000(1+ .045/365)1460
= $2,000 * 1.1972 = $2,394.41

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 Compound 8 - 32

8
Interest

You invested $6000 at 4.5% compounded quarterly.

After 2 years, the rate changed to 5.2%
compounded monthly.
What amount will you have 41/2 years after the initial
investment?

Prepare a ‘time-line’ as part of the solution

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 Compound 8 - 33

8
Interest

You invested $6000 at 4.5% compounded quarterly.

After 2 years, the rate changed to 5.2%
compounded monthly.
What amount will you have 41/2 years after the
initial investment?
0 2 years 4.5 years

$6000 FV1 = PV2 FV2

i = .045/4 n = (2*4) = 8
i = .052/12 n = 2.5*12 = 30
FV1 = 6000(1+.045/4)8 FV2 = 6561.75(1+.052/12)30
= 6000(1.0936) = 6561.75(1.1385)
= 6561.75 = $7470.61
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 Compound 8 - 34

8
Interest

You borrowed $5000 at 7% compounded monthly.

On the first and second anniversaries of the loan,
you made payments of $2500.
What is the balance outstanding
immediately following the second payment?

Prepare a ‘time-line’ as part of the solution

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 Compound 8 - 35

8
Interest

You borrowed $5000 at 7% compounded monthly.

On the first and second anniversaries of the
loan, you made payments of $2500. What is the
balance outstanding immediately following the second
payment?
1 year 2 years
0
$5000 FV1 - $2500 = PV2 FV2
i = .07/12 n = 12 i = .07/12 n = 12
FV1 = 5000(1+.07/12) 12
FV2 = 2861.45 (1+.07/12)12
= 5000(1.072290) = 2861.45(1.072290)
= 5361.45 = $3068.30
PV2 = 5361.45 – 2500.00 = $3068.30 – 2500.00
= 2861.45
New Balance = $568.30
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8
Interest

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 Compound 8 - 37

8 Formula for Present Value

Interest

Formula PV = FV(1 + i)-n

i
1
Keys
This is the only
change to the
usual
sequence!

$PV
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 Compound 8 - 38

8 Calculating Present Value

Interest

You expect to need $1,500 in 3 years.

Your bank offers 4% interest
compounded semiannually.
How much money must
you put in the bank today (PV) to reach your goal in
3 years?

Prepare the solution…(a) algebraically, and

(b) by financial calculator

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 Compound 8 - 39

8 Calculating Present Value

Interest
Formula PV = FV(1 + i)-n
You expect to need $1,500 in 3 years.
Your bank offers 4% interest compounded
semiannually. How much money must you put in the
bank today (PV) to reach your goal in 3 years?
i = .04/2 = .02
n=3*2=6
1,331.96
0.88797
(a) PV = $1500(1+.02)-6 1.02
= $1500 * .8880
6
= $1,331.96

1500
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 Compound 8 - 40

8 Calculating Present Value

Interest

Formula PV = FV(1 + i)-n

What amount must you invest now at 5% compounded
daily to accumulate to $6000 after 1 year?

j = 5% PV = $6000(1+.05/365)-365 5,707.40
0.0001
0.9512
1.001
m = 365 = $6000 * .9512
.05
i = .05/365 = $5,707.40 365
n = 1*365 = 365
1
FV = $6000 6000
365
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 Compound 8 - 41

8 Calculating Present Value

Interest

What amount must you invest now at 5% compounded

daily to accumulate to $6000 after 1 year?
1 * 365
6000
5 PV= - 5,707.40
0

365

$5707.40
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 Compound 8 - 42

8
Interest

This completes Chapter 8

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