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Compounding Techniques

Compounding concept means the interest earned on the initial principal sum becomes a part of the principal or initial sum at the end of the compounded period.

Year

1

2

3

Beginning

     

Amount

1000

1050

1102.5

Interest rate

5%

5%

5%

Amount of interest

50

52.5

55.125

Beginning

     

Principal

1000

1050

1102.5

Ending

   

1157.6

Principal

1050

1102.5

25

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Future Value

The compounding technique is used to find out the FUTURE VALUE of a present money.

It can further be explained with reference to:

The future value of a single cash flow (Lump sum amount)

The Future value of a series of Cash Flows (Annuity)

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(i) The FV of Single Cash Flow

Formula

Amity Business School (i) The FV of Single Cash Flow Formula FV is Future Value PV

FV FV is Future Value PV is Present Value r is the interest rate n is time period

Amity Business School (i) The FV of Single Cash Flow Formula FV is Future Value PV

= PV (1+r) n

If you deposited Rs 55,650 in a bank, which was paying a 15 per cent rate of interest on a ten-year time deposit, how much would the deposit grow at the end of ten years?

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The general form of equation for calculating the future value of a lump sum after n periods may, therefore, be written as follows:

FV n = PV x CVF r,n

The term (1 + r) n is the compound value factor

(CVF) of a lump sum of Re 1, and it always has a value greater than 1 for positive i, indicating that CVF increases as r and n increase.

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We will first find out the compound value factor

at 15 per cent for 10 years which is 4.046.

Multiplying 4.046 by Rs.55,650, we get Rs

225,159.90 as the compound value:

FV=

55,650 X

CVF 10, .15

55,650 X 4.046 = Rs. 225159.90

=

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Non-Annual Compounding

Compounding is not always annually it may be half- yearly,

quarterly, monthly. So in this case compounding can be done

be using the following formula.

FV = PV(1+r/m) mn

m is the number of time compounding is done in a year

n

is the time period.

Compounding Period

No of period (m)

Annually

1

Half- Yearly

2

Quarterly

4

Monthly

12

Note: More frequently the compounding is made, the faster is the growth in the FV

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(ii) Future Value of series of cash flow

(Annuity)

Amity Business School (ii) Future Value of series of cash flow (Annuity) An Annuity represents a

An Annuity represents a series of payments (or receipts) occurring over a specified number of

equidistant periods

Types of Annuities

Amity Business School (ii) Future Value of series of cash flow (Annuity) An Annuity represents a

Ordinary Annuity: Payments or receipts occur at the end of each period.

• Ordinary Annuity : Payments or receipts occur at the end of each period.

Annuity Due: Payments or receipts occur

at the

beginning of each period

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Examples of Annuities

Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings

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PARTS OF ANNUITY

(Ordinary Annuity)

Amity Business School PARTS OF ANNUITY (Ordinary Annuity) End of Period 1 End of Period 2

End of

Period 1

Amity Business School PARTS OF ANNUITY (Ordinary Annuity) End of Period 1 End of Period 2

End of Period 2

Amity Business School PARTS OF ANNUITY (Ordinary Annuity) End of Period 1 End of Period 2

End of

Period 3

0 1 2 3
0
1
2
3
Amity Business School PARTS OF ANNUITY (Ordinary Annuity) End of Period 1 End of Period 2

Today

$100 $100 $100 Equal Cash Flows Each 1 Period Apart
$100
$100
$100
Equal Cash Flows
Each 1 Period Apart

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PARTS OF ANNUITY DUE

(Annuity Due)

Amity Business School PARTS OF ANNUITY DUE (Annuity Due) Beginning of Period 1 Beginning of Period

Beginning of Period 1

Amity Business School PARTS OF ANNUITY DUE (Annuity Due) Beginning of Period 1 Beginning of Period

Beginning of Period 2

Amity Business School PARTS OF ANNUITY DUE (Annuity Due) Beginning of Period 1 Beginning of Period

Period 3

Beginning of

0 1 2 3
0
1
2
3
$100 $100 $100 Today Equal Cash Flows Each 1 Period Apart
$100
$100
$100
Today
Equal Cash Flows
Each 1 Period Apart

Note

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The future value of an ordinary annuity can be viewed as occurring at the end of the last cash flow period,

Note Amity Business School The future value of an ordinary annuity can be viewed as occurring

whereas the future value of an annuity due can be viewed as occurring at the beginning of the last cash flow period

Note Amity Business School The future value of an ordinary annuity can be viewed as occurring

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Formula for ordinary Annuity

As it is clear now that Annuity is a fixed payment (or receipt) each year for a specified number of years. If you rent a flat and promise to make a series of payments over an agreed period, you have created an

annuity.

F

n

A

(1

1

i

)

n

i

The term within brackets is the compound value factor for an annuity of Re 1, which we shall refer as CVAF.

F n = A x CVAF n,r

Example of ordinary Annuity

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Cash flows occur at the end of the period 0 1 2 3 4 7%
Cash flows occur at the end of the period
0
1
2
3
4
7%
$1,000 $1,000 $1,000 $1,070 $1,145
$1,000
$1,000
$1,000
$1,070
$1,145
FVA 3 = $1,000(1.07) 2 + $1,000(1.07) 1 + $1,000 $3,215 = FVA 3 = $1,145
FVA 3 = $1,000(1.07) 2 +
$1,000(1.07) 1 + $1,000
$3,215 = FVA 3
= $1,145 + $1,070 + $1,000
= $3,215

Formula For Annuity Due

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F

n

A

(1

i

)

n

1

i

(1+i)

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Cash flows occur at the beginning of the period

0 1 2 3 4 7%
0
1
2
3
4
7%
$1,000 $1,000 $1,000 $1,070 $1,145 $1,225
$1,000
$1,000
$1,000
$1,070
$1,145
$1,225
FVAD 3 = $1,000(1.07) 3 + $1,000(1.07) 2 + $1,000(1.07) 1 $3,440 = FVAD 3 =
FVAD 3 = $1,000(1.07) 3 +
$1,000(1.07) 2 + $1,000(1.07) 1
$3,440 = FVAD 3
= $1,225 + $1,145 + $1,070
= $3,440

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Sinking Fund

Sinking fund is a fund, which is created out of fixed payments each period to accumulate to a future sum after a specified period. For example, companies generally create sinking funds to retire bonds

(debentures) on maturity.

The factor used to calculate the annuity for a given future sum is called the sinking fund factor (SFF).