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Compound
Compound
Interest
Interest
Compound
Chapter 8
McGraw-Hill Ryerson
Compound
Compound
Interest
Interest
8-2
To better understand how Compound Interest
is calculated, lets review how we calculate
Simple Interest!
The formula on which we base our
calculation is
Formula
Formula
I = Prt
new Interest!
McGraw-Hill Ryerson
Compound
Compound
Compound Interest
8-3
- Future Value
Interest
Interest
plus the
$100.00
Compound
Compound
Interest
Interest
Compound Interest
8-4
- Future Value
McGraw-Hill Ryerson
Compound
Compound
Interest
Interest
Compound Interest
8-5
- Future Value
McGraw-Hill Ryerson
Graphically
Compound
Compound
8-6
Compound Interest
- Future Value
Interest
Interest
Interest
Interest
Interest
Interest
Interest
Interest
Interest
Interest
Amount$1000
$1000
Amount
133.1
1331
1210
1100
1000
100
110
100
121
121
11
0
100
11
0
100
0
McGraw-Hill Ryerson
2
Time(Years)
Compoundin
g Period
Compound
Compound
Interest
Interest
Compound Interest
8-7
- Future Value
Example
Example
McGraw-Hill Ryerson
Compound
Compound
Interest
Interest
Compound Interest
8-8
- Future Value
McGraw-Hill Ryerson
Compound
Compound
Interest
Interest
Compound Interest
8-9
- Future Value
Year 1
Year 2
Year 3
Year 4
$1000
$1040
$1123.20
$1010.88
$1000 *
(1 + .04)
= $1040
McGraw-Hill Ryerson
$1040 *
$1123.20 *
(1 + .08)
(1 - .10)
= $1123.20 = $1010.88
$1010.88 *
(1 +.09)
= $1101.86
Alternative
Alternative
Compound
Compound
Interest
Interest
Compound Interest
8 - 10
- 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?
1000(1.04)(1.08)(.90)(1.09) = $1101.86
Solving
Solving
Alternative
Alternative
1
-10%
Solve
for
all
Solve for all
years at
at
44 years
It isis rare
rare for
forinterest
interest to
to be
be
It
once!
once!
compounded only once per year!
compounded only once per year!
McGraw-Hill Ryerson
8 - 11
Compound
Compound
Interest
Interest
McGraw-Hill Ryerson
No. per
per Year
Year
No.
Period
Period
Annually
1 year
Semiannually
6 months
Quarterly
3 months
Monthly
12
1 month
Daily
365
1 day
Compound
Compound
Interest
Interest
8 - 12
Development of a Formula
Formula
Total Number of
Periods
Periods
(j)
m
(i)
Compound
Compound
8 - 13
Formulae
Formulae
Interest
Interest
To Determine
Determine
To
Time(Years)
n
n
To Determine
Determine
To
ii
Compound
Compound
Interest
Interest
Formula
Time(Years) *
# of Compounding
Frequencies per year (m)
Annually
3*
Semiannually 3 *
Quarterly 3 *
McGraw-Hill Ryerson
No.
= 3
= 6
= 12
2
4
8 - 14
Compound
Compound
Interest
Interest
8 - 15
Formula
Formula
Annual Interest
Rate (j)
# of Compounding
Frequencies per
year(m)
6% /
Annually
Semiannually 6% /
Quarterly 6% /
McGraw-Hill Ryerson
No.
1
2
4
Rate -- ii
Rate
= 6%
= 3%
= 1.5%
8 - 16
Compound
Compound
Interest
Interest
Development of a Formula
Formula for Future Value
FV = PV(1 + i)n
Where
Compound
Compound
Interest
Interest
Compound Interest
8 - 17
- Future Value
n
FV
=
PV(1
+
i)
Formula
Formula
PV = $1000
n = 4X2=8
i = .08/2 = .04
McGraw-Hill Ryerson
Solve
Compound
Compound
Interest
Interest
Compound Interest
- Future Value
n
FV
=
PV(1
+
i)
Formula
Formula
FV = $1000(1 + .04)8
= $1000(1.368569)
= $1,368.57
Principal
$1,000.00
+ Interest
368.57
Compounded $1,368.57
McGraw-Hill Ryerson
8 - 18
Compound
Compound
Interest
Interest
8 - 19
Compound
Compound
Interest
Interest
Compound Interest
8 - 20
- Future Value
Annual
Annual
FVA = 100(1.06)3
SemiSemi-
FVS = 100(1.03)6
$119.10
$119.10
$119.41
$119.41
Semi = 6%/2
Quarterly
Quarterly
FVQ = 100(1.015)12
Quarterly = 6%/4
McGraw-Hill Ryerson
$119.56
$119.56
Compound
Compound
Interest
Interest
Simple Vs Compound
Interest
8 - 21
AlJones
Jonesdeposited
deposited$1,000
$1,000in
inaasavings
savingsaccount
account
Al
for55years
yearsat
at10%
10%p.a..
p.a..
for
AnnualSSimple
impleIInterest
nterest
Annual
Rateof
of10%
10%
Rate
AnnualC
Compound
ompound
Annual
Rateof
of10%
10%
Rate
WhatisisAls
Als
What
impleIInterest
nterestand
and
SSimple
WhatisisAls
Als
What
nterestand
and
IInterest
Maturity
aturityV
Value?
alue?
M
McGraw-Hill Ryerson
Compounded
ompoundedV
Value?
alue?
C
Compound
Compound
Interest
Interest
Simple Vs Compound
Interest
8 - 22
AlJones
Jonesdeposited
deposited$1,000
$1,000in
inaasavings
savingsaccount
accountfor
for55years
yearsat
at10%
10%
Al
Simple
Simple
n = 5 * 1 = 5 i = .10
I = Prt
I = $1,000 * .10 * 5
= $500
FV = $1,000 + $500
= $1,500
McGraw-Hill Ryerson
Formulae
Formulae
Compound
Compound
FV = PV(1 + i)n
I = FV PV
Compare
= $1610.51 - $1000
Compare
FV = $1000(1.1)5
= $1,000 *1.6105
= $610.51
Compound
Compound
Interest
Interest
Beginning
Beginning
Balance
Balance
$1,000
$1,000
McGraw-Hill Ryerson
6%
++6%
8 - 23
Compounding
Compounding
Period
Period
Ending
Ending
Balance
Balance
Annual
Semiannual
$1,060.00
$1,060.90
Quarterly
$1,061.36
Daily
$1,061.83
Compound
Compound
Interest
Interest
8 - 24
n
FV
=
PV(1
+
i)
Formula
Formula
n = 4 * 365 = 1460 i = .045 /365 = 0.0001232
FV = $2000(1+ .045/365)1460
$2,000 ** 1.1972
1.1972 == $2,394.41
$2,394.41
== $2,000
McGraw-Hill Ryerson
Compound
Compound
8 - 25
Interest
Interest
McGraw-Hill Ryerson
8 - 26
Compound
Compound
Interest
Interest
0
$6000
2 years
FV1 = PV2
i = .045/4 n = (2*4) = 8
FV1 = 6000(1+.045/4)8
= 6000(1.0936)
= 6561.75
McGraw-Hill Ryerson
4.5 years
FV2
i = .052/12 n = 2.5*12 = 30
FV2 = 6561.75(1+.052/12)30
= 6561.75(1.1385)
= $7470.61
8 - 27
Compound
Compound
Interest
Interest
McGraw-Hill Ryerson
Compound
Compound
8 - 28
Interest
Interest
Compound
Compound
Interest
Interest
McGraw-Hill Ryerson
8 - 29
Compound
Compound
Interest
Interest
8 - 30
Calculating Present
Present Value
Value
Calculating
McGraw-Hill Ryerson
8 - 31
Compound
Compound
Calculating Present
Present Value
Value
Calculating
Interest
Interest
-n
Formula
PV
=
FV(1
+
i)
Formula
i = .04/2 = .02
(a) PV = $1500(1+.02)-6
= $1500 * .8880
1,331.96
0.88797
1.02
6
= $1,331.96
1500
McGraw-Hill Ryerson
8 - 32
Compound
Compound
Calculating Present
Present Value
Value
Calculating
Interest
Interest
-n
Formula
PV
=
FV(1
+
i)
Formula
PV = $6000(1+.05/365)-365
= $6000 * .9512
i = .05/365
n = 1*365 = 365
FV = $6000
= $5,707.40
5,707.40
0.0001
0.9512
1.001
.05
365
1
365
McGraw-Hill Ryerson
6000
Compound
Compound
Interest
Interest
8 - 33
Equivalent Payments
Payments
Equivalent
Compound
Compound
8 - 34
Equivalent Payments
Payments
Equivalent
Interest
Interest
Step 11
DrawaaTime-line
Time-line
Draw
Step
Two payments of $2200 each must be made 1 and 4 years
from now. If money can earn 5% compounded
monthly,
what single payment 3 years from now
would
be equivalent
to the two3scheduled
payments?
0
1 year
2 years
years
4 years
PV1 $2200
$2200 FV2
FV
i = .05/12
Step 22
Step
Findthe
theFV
FVof
of
Find
thepayment
payment
the
thatisismoved
moved
that
fromYear
Year11to
to
from
Year33
Year
McGraw-Hill Ryerson
n = 2*12 = 24 PV
2
(a) FV1
= 2200(1+.05/12)24
= 2200(1.1049)
= 2430.87
2430.87
Now
Compound
Compound
Interest
Interest
Making aa choice!
choice!
Making
8 - 35
McGraw-Hill Ryerson
Compound
Compound
Comparisons
Interest
Interest
8 - 36
Results
Results
j = 6.6%
compounded
annually
j = 6.5%
1376.53
1376.53
compounded
semi-annually
j = 6.4%
1376.89
1376.89
compounded
monthly
1375.96
1375.96
the 6.5%
6.5% compounded
compounded semi-annually
semi-annually
the
provides for
forthe
the best
best
provides
rate of
of return
return on
on investment!
investment!
rate
McGraw-Hill Ryerson