CHAPTER 2: COMPOUND INTEREST

2.1

The compound interest formula

1)

In Chapter 1, simple interest was added to the investment at the maturity date. However,
if the interest is added to the investment at the end of each period, and there after also
earns interest, the investment earns compound interest.

2)

The future value is the sum of the original investment (or principal) and the compound
interest.

3)

The time period between two successive interest rate calculations is the interest period.

4)

The future value (FV) S at the end of n years is given by the compound interest formula:

S P(1 i)
where

(1
i)

is the compound interest factor or

Future Value Interest Factor = (FVIFi,n) = (1 i)

Example 1
Calculate the future value of $100 at 12% p.a. in a) 5 years; and b) 30 years.

5)

However, the interest period need not be a year and there are many situations where
interest is compounded half-yearly or payable quarterly. These rates, when expressed
as rates per annum, are known as nominal rates.

6)

Notation:
P

the original principal, or the present value of S.

the future value of P

the number of interest periods involved

the number of interest periods per year, or the frequency of compounding.

jm

the nominal interest rate p.a., which is compounded (payable, convertible) m

times per year.

the effective interest rate perperiod =

jm
m

Example 2
A person deposits $1000 into a savings account that earns interest at 12.5% p.a. payable
quarterly. How much interest will be earned (a) during the first year? and (b) during the second
year?

2.2

Equivalent rates

1)

The yearly nominal rate is meaningless until we specify the frequency of conversion m.

2)

At the same nominal rate, the future value depends on the frequency of compounding,
increasing in value with increased compounding.

3)

For a given nominal rate

jm compounded m times per year, the corresponding annual

effective rate of interest is defined as the rate which will produce the same amount of
interest per year.
4)

To find the annual effective rate j corresponding to a given nominal rate jm

1 j (1 i)

where i

j (1 i)

jm
m

1
Example 1
Find the annual effective rate of interest (to two decimal places when expressed as a %)
equivalent to the following rates:
a)

j2 7%

b)

j4 16%

d)

j365

e)

j12

12%

18%

c)

j4 7%

Example 2

j2
What simple interest rate p.a. is equivalent to 9%
Present Value at compound interest
1)

Present Value or (discounted value),

where (1
n

if money is invested for 3 years?

(1
n
i)

S(1 i)

is called the present value compound interest factor

i)

Therefore, the Present Value Interest Factor (PVIFi,n) = (1 i)

j12 12%

Example 1
Find the present value of $1000 due in 15 years at

Example 2
Let us suppose you can buy goods for $18000 cash or payments of $10 000 now, $5000 in 1
year and $5000 in 2 years. If money is worth

j12 15% , which option is better for you?

j12 16% 3 years

Example 3
A note for $2000 dated 1 September 2003 is due with compound interest at

after issue. On 1 December 2004 the holder of the note has it discounted by a lender who
charges

j 4 17.25%. Find the price paid at 1 December 2004.

2.4 Future or present value for a fractional time period

Example 1

j4 18%. .

Find the future value and the present value of $ 1500 for 16 months at

1)

Example 1 above is using Exact method of valuing a compound interest. This exact
method is not always used in practice.

2)

Instead, compound interest is used for the full number of interest periods and simple
interest for the fractional part of the interest period remaining this method is called the
approximate method.

Example 2
Find the future value and the present value of $ 1500 for 16 months for 16 months at
, using the approximate method and compare the results with those of example 1.

j4 18%

2.5

Finding the interest rate or the time period

P(1 i)
S

1/ n
i S
1
P

Example 1

j12

At what nominal rate

will money triple itself in 12 years?

j12 12% ? Assume the a) the exact

Example 2
How long will it take $500 to accumulate to $850 at

method of accumulation

b) the approximate method of accumulation.

2.6

Equations of value

Example 1
A person owes $200 due in 6 months and $300 due in 15 months. What single payment a) now;
and b) in 12 months will liquidate these debts if money is worth

Example 2
A debt of $1000 with interest at

j4
12%

j12 15% ?

will be repaid by a payment of $300 at the end of

3 months and 3 equal payments at the end of 6, 9 and 12 months?

Example 3

j12 12% . At the time of his death,

A man leaves an estate of $50 000 which is invested at

he has two children aged 12 and 16. Each child is to receive an equal amount from the estate
when they reach 21. How much does each child get?

2.7

Changing interest rates

In previous sections, we have assumed that the rate of compound interest relevant to any
particular problem remains unchanged throughout the term of the problem. However, this need
not be the case and, in practice interest rates vary with considerable frequency.
Example 1
How much will $1000 accumulate to in 8 years if it earns 10% p.a. effective for 6 years and 8%
p.a. effective for 2 years?

Example 2
A student owes $200 due in 6 months and $300 due in 15 months. What single payment now
will repay these debts if the interest rate is

j4
12%

for 9 months and j4 8% thereafter?

2.8

Other applications of compound interest theory

Example 1
The population of City A in June 1947 was 7.58 million. In June 1976 it was 13.92 million.
a) What was the annual growth rate from 1947 to 1976?
b) At this rate of growth, when will the population reach 20 million people?