1.

0 COMPOUND INTEREST, ORDINARY ANNUITIES, AMORTIZATION

AND SINKING FUND.
1.1 COMPOUND INTEREST

There are two types of interest:

 Simple interest
 Compound interest

Simple Interest

Simple interest refers to the interest earned only on the principal amount,
usually denoted as a specified percentage of the principal. To determine an
interest payment, simply multiply principal by the interest rate and the
number of periods for which the loan remains active. For example, if one
person borrowed $100 from a bank at a simple interest rate of 10% per year
for two years, at the end of the two years, the interest would come out to:

$100 × 10% × 2 years = $20

For example, suppose the bank has given a loan of $6000 to Jack to
purchase a tractor. After three years Jack returns back the loan along with
10% interest charged by the bank. The money borrowed loan is called

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principal and the extra money to be paid is called the interest. The interest
is only a fair payment for using another person’s money.

Terminologies used in simple interest:

 PRINCIPAL (P): is the money deposited or borrowed in the

bank.
 INTEREST (I): The extra money obtained from the bank after
depositing is called the Interest.
 TIME (T): Is the number of years for which the money is
deposited or borrowed in the bank.
 Interest rate (R %): is the amount a lender charges a borrower
and is a percentage of the principal (the amount loaned). This
is R % p.a. (per annum or per year)
 AMOUNT (A): The total money obtained ( Principal + Interest
you get after a fix time.)

Therefore:

AMOUNT (A) = PRINCIPAL (P) + INTEREST (I)

A=P+I

Formula for calculating simple interest is given by

PRT
S . I =P ( R % ) T =
100

Compound Interest

Compound interest: Is when the interest on a loan or deposit is calculated

based on both the initial principal and any accumulated interest from
previous periods.

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Compound period: Is the span of time between when interest is calculated
and when it will be calculated again.

Compound amount: Is the total amount of principal and accumulated interest

at the end of a loan or investment period.

The compound interest is calculated at regular intervals like annually

(yearly), semi-annually, quarterly, monthly, etc. Banks or any financial
organization calculate the amount based on compound interest only.

Compound Interest Formula

nt
r
The basic formula for compound interest is: A = P(1+ )
n

In this formula:

 A = Ending balance
 P = Principal balance
 r = the interest rate (expressed as a decimal)
 n = the number of times interest compounds in a year
 t = time (expressed in years).

Compound Interest formula

The compound interest formula is given by:

nt
r
C . I =P(1+ ) – P
n

Where: C . I −¿ is the compound interest and the rest is the same as named
above.

It is to be noted that the above given formula is the general formula when
the principal is compounded n number of times in a year. If the given

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principal is compounded annually (n=1), the formula of ending amount and
compound interest becomes:

A = P(1+r )t while; C . I =P(1+r )t – P

DERIVATION OF COMPOUND INTEREST FORMULA

Let the principal be P and the rate of interest be R% per annum. Since the
interest is compounded annually, so the compounding period is 1 year. It is
to be noted that the principal (P) will change after every 1 year. So, let us
calculate the interest for numbery of years.
The interest for the first year will be as follows:
 Let the interest for the first year be I 1

. Now the amount at the end of the first year will be:
PR
I 1=PR %=
100
R
A1 = P + I1 = P + PR %. This will give A1 = P (1 + ) = New
100
principal ( P2)
Interest for the 2nd year ( I 2), we have:
R
P2 = P (1 + )
100
r = R % and
t= 1
Therefore;
R R
I 2=P R %=¿P (1 + ).
100 100

= P (1 +
R R R R R
A2 = P2 + I 2 = P (1 + ) + P (1 + ). ) (1 + ¿
100 100 100 100 100
2
R
A2=P (1+ ) = New principal for the 3rd year ( P3)
100

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Interest for the 3rd year ( I 3), we have:
2
R
I 3=P3 R %=¿ P(1+ R ) .
100 100
2 2
R
A3 = P3 + I 3 = P(1+ R ) + P(1+ R ) .
100 100 100
2 3
A3 = P(1+ R ) (1+ R ) = P(1+ R )
100 100 100
Continuing in this manner for n compounding periods, the amount at the end
R n
of the nth compounding period can be expressed as: A = P(1 + ) .
100
From the above formulas and computations, you can observe that the
compound interest is the same as simple interest for the first interval. But,
over a period of time, there is a remarkable difference in returns.

The simple interest value for each of the years is the same, as the
principal on which it is calculated is constant. But the compound
interest is varying and increasing across the years. Because the principal on
which the compound interest is calculated is increasing. The principal for a
particular year is equal to the sum of the initial principal value, and
the accumulated interest of the past years.

EXAMPLE 01

For example, a sum of $10,000 is deposited at a rate of 10%. The below

table explains the difference between simple interest and compound interest
computation on this principal for the period of 5 years per annum.

SIMPLE INTEREST COMPOUND INTEREST (r=10%)

(r=10%)

For 1st year For 1st year

P = 10,000 P = 10,000

r = 10% r = 10%

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T = 1 year T = 1 year

PRT 10,000× 10 ×1 PRT 10,000× 10 ×1

I = = = I= = = $1000
100 100 100 100
$1000

For 2st year For 2st year

P = 10,000 A1=P 1+ I 1=P2(New principal)

r = 10% A1=$ 10,000 + $1000

T = 1 year A1=$ 11,000=P2

PRT 10,000× 10 ×1
I = = = I 2= PRT = 11000 × 10 ×1
100 100 100 100
$1000
I 2= $1100

3rd year

A2=P 2+ I 2=P3(New principal)

3 rd
year
A2=$ 11,000 +$ 1100
P = 10,000
A2=$ 12100 = P3
r = 10%
PRT 12100 ×10 ×1
I 3= =
T = 1 year 100 100

PRT 10,000× 10 ×1 I 3= $1210

I = = =
100 100
$1000

4th
year 4th
year
A3 =P 3+ I 3=P 4(New principal)
P = 10,000
A3 =$ 12100+ $ 1100

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r = 10% A3 =12100+$ 1210 =$13,310 = P4

T = 1 year PRT $ 13,310 ×10 ×1

I 4= =
100 100
PRT 10,000× 10 ×1
I = = =
100 100 I 4= $1331
$1000

5th
year 5th
year
A 4=P4 + I 4 =P5(New principal)
P = 10,000
A 4=$ 13,310+ $1331
r = 10%
A 4=$ 14,641 = P5
T = 1 year
PRT $ 14,641 ×10 ×1
PRT 10,000× 10 ×1 I 5= =
I = = = 100 100
100 100
I 5= $1464.1
$1000

Total simple interest = Total compound interest = $6105.1

$5000

Total amount = $10,000+ Total amount¿ $ 14,641+$ 1464.1=

$5000 $16,105.1

= $15,000 OR

Total amount = $10,000+ $6105.1

= $16,105.1

Computing compound interest by using formula:

Given:

P = $10,000

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R = 10%

t = 5 years

Required:

C.I = ?

From

nt
r
C . I =P(1+ ) – P But n = 1 since the interest rate is compounded per
n
annually

t
r
C . I =P(1+ ) −P
100

5
10
C . I =$ 10,000(1+ ) −$ 10,000 = $ 10,000 ( 1.61051 )−$ 10,000
100

= $16105.1 - $ 10,000

C.I = $6,105.1

Compound Interest Formula for Different Time Periods

Compound interest for a given principal can be calculated for different time
periods using different formulas.

Compound Interest Formula - Half Yearly

The interest in the case of compound interest varies based on the period of
computation. If the time period for the calculation of interest is half-yearly,
the interest is calculated every six months, and the amount is compounded
twice a year.

The formula to calculate the compound interest when the principal is

compounded semi-annually or half-yearly is given as:

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COMPOUND INTEREST – HALF YEARLY FORMULA

2t
r /2
C . I =P(1+ ) −P
100

Here the compound interest is calculated for the half-yearly period, and
hence the rate of interest r, is divided by 2 and the time period is
doubled. The formula to calculate the amount when the principal is
compounded semi-annually or half-yearly is given by:

2t
r /2
A=P(1+ )
100
In the above expression,

 A is the amount at the end of the time period

 P is the initial principal value, r is the rate of interest per annum
 t is the time period
 C.I. is the compound interest.
Compound Interest Formula - Quarterly

If the time period for the calculation of interest is quarterly, the interest is
calculated for every three months, and the amount is compounded 4 times a
year. The formula to calculate the compound interest when the principal is
compounded quarterly is given as:

4t
r /4
C . I =P(1+ ) −P
100

Here the compound interest is calculated for the quarterly time period, and
hence the rate of interest r, is divided by 4 and the time period is
quadrupled. The formula to calculate the amount when the principal
is compounded quarterly is given by:

4t
r/ 4
A=P(1+ )
100
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In the above expression,

 A is the amount at the end of the time period

 P is the initial principal value, r is the rate of interest per annum
 t is the time period
 C.I. is the compound interest.

Monthly Compound Interest Formula

The monthly compound interest formula is also known as the interest

calculated per month i.e., n = 12. Total compound interest is the final
amount excluding the principal amount. The monthly compound interest
formula is expressed as:
12 t
r /12
C . I =P(1+ ) −P
100

Daily Compound Interest Formula

When the amount compounds daily, it means that the amount compounds
365 times in a year. i.e., n = 365. The daily compound interest formula is
expressed as:
365 t
r /365
C . I =P(1+ ) −P
100

EXAMPLE 01

John lends $4000 to Emma at an interest rate of 10% per annum,

compounded half-yearly for a period of 2 years. Calculate the amount he
gets after a period of 2 years from Emma.

Solution:

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Let us identify the data given to us: The principal amount 'P' is $4000. The
rate of interest, r' is 10% per annum. Conversion period = Half-year, Rate of
interest per half-year = 10/2 % = 5%. The time period 't' is 2 years.

Time
Amount Calculation
Period

Principal = $4000

1st half Interest = 5% × $4000 = (5/100) × 4000 =

year $200

Amount = $4000 + $200 = $4200

Principal = $4200

2nd half Interest = 5% × $4200 = 5/100 × 4200 =

year $210

Amount = $4200 + $210 = $4410

Principal = $4410
3rd half
Interest = 5% × $4410 = $220.5
year
Amount = $4410 + $220.5 = $4630.5

Principal = $4630.5
4 half
th

Interest = 5% × $4630.5 = $231.53

year
Amount = $4630.5 + $231.53 = $4862.03

The total interest to be paid over 2 years 200 + $210 + $220.5 +

$231.53 = $862.03. Total Amount = P + I=$4000 + $862.03 = $4862.03.
Therefore the total amount is $4862.03.

Example 02:
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Solve the above-given problem using the compound interest formula.

Solution:

The principal amount 'P' is $4000. The rate of interest 'r' is 10% per annum.
Conversion period = Half-year, Rate of interest per half-year = 10/2% =
5%. The time period 't' is 2 years. The compounding frequency 'n' is 2.

Let us substitute the given data in the compound interest formula: A = P(1+
{r / 2}/100)2t= 4000(1+{10 / 2}/100)2(2)= $4862.03

Therefore the final amount is $4862.03, and the compound interest formula
makes the solution simple.

QUESTIONS TO DISCUSS ON SIMPLE AND COMPOUND INTEREST

1. With examples, discuss the following terms as used in business context

a) Interest, simple interest, interest rate, principal and amount
b) Formula for computing simple interest
c) Compound interest, formula for computing compound interest
and amount
n
r
2. Show that amount (A) = P(1+ )
100

3. A man takes a loan of $ 10,000 at a compound interest rate of 10% per

annum.

a) Find the amount after 1 year.

b) Find the compound interest for 2 years
c) Find the sum of money required to clear the debt at the end of 2
years
d) Find the difference between the compound interest and simple
interest at the same rate for 2 years.

4. Find the compound interest on $25000 for 3 years at 6% per annum,

compounded semi-annually.

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5. Find the compound interest on $5000 for 1 year at 10% per annum,
compounded quarterly.
6. John borrowed $ 10,000 and agreed to pay interest at the rate of 8%
and 10% for the first and second year respectively. Find the total
amount he had to pay after 2 years.

7. At 4% per annum, the difference between compound and simple

interest for 2 years on a certain sum of money is Tshs.2596.30. Find
the sum
8. Find the compound interest on $30,000 at 8% per annum compounded
half-yearly.
9. Sultan borrows $ 10,000 at a compound interest rate of 8% per annum.
If he repays $ 2000 at the end of each year, find the sum outstanding
at the end of the third year.
10. Erick invests $ 20,000 at the beginning of every year in a bank
and earns 10 % annual interest compounded annually. What will be his
balance in the bank at the end of three years?.

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