CHAPTER 4: COMPOUND INTEREST

LEARNING OBJECTIVES

• Differentiate between the concepts of compound interest and simple

interest
• Calculate the future value and present value of investments and loans
in compound interest applications
• Calculate equivalent payments that replace another payment or a set
of payments
• Calculate periodic and nominal interest rates
• Calculate the number of compounding periods and time period of an
investment or loan
• Calculate the effective and equivalent interest rates for nominal
interest rates
CHAPTER OUTLINE

4.1 Compound Interest Terms

4.2 Calculating Future Value (FV)

4.3 Calculating Present Value (PV)

4.4 Calculating Equivalent Payments

4.5 Calculating Periodic Interest Rate (i) and Nominal Interest Rate (j)

4.6 Calculating Number of Compounding Periods (n) and Time Period (t)

4.7 Calculating Equivalent Interest Rate

INTRODUCTION

• In the previous chapter, you learned that money grows linearly when
invested over a period of time at a simple interest rate
• Have you ever wondered if money can grow exponentially?
• Compound interest is a procedure where interest is calculated
periodically at regular intervals, known as compounding periods) and
reinvested to earn interest at the end of each compounding period
during the term; i.e. interest is added to the principal to earn interest
• This is different from simple interest where interest is calculated only
on the original amount (principal) for the entire term
INTRODUCTION
4.1 COMPOUND INTEREST TERMS

• In compound interest, the interest earned in the previous

compounding period also earns interest in subsequent compounding
periods
• For any given interest rate, the shorter the compounding period, the
greater the interest earned, because the number of compoundings
during the term will be greater
• Generally, the compounding period can be one year (annually), six
months (semi-annually), three months (quarterly), one month (monthly),
or one day (daily)
4.1 COMPOUND INTEREST TERMS
4.1 COMPOUND INTEREST TERMS

• Future Value:
𝐹𝑉 = 𝑃𝑉(1 + 𝑖)!
• Present Value:
𝐹𝑉 "!
𝑃𝑉 = = 𝐹𝑉(1 + 𝑖)
(1 + 𝑖)!
• Amount of Compound Interest:
𝐼 = 𝐹𝑉 − 𝑃𝑉

n: total number of compounding periods during the term

i: interest rate per compounding period
4.1 COMPOUND INTEREST TERMS

• Compounding period is the period of time between the compounding

of interest
• Length of compounding period is the time interval between successive
interest calculation dates
• For example, if the interest is compounded monthly, then the length of the
compounding period is every month.
• m = Compounding frequency is the number of times interest is
compounded every year
• For example, if the interest is compounded quarterly, then m = 4
4.1 COMPOUND INTEREST TERMS

• j = Nominal interest rate is the quoted or stated interest rate per annum
on which the compound interest calculaXon is based for a given
compounding period. It is the rate (expressed as a percent) that usually
precedes the word 'compounding' or 'compounded’
• For example, 6% compounded monthly: j= 6% = 0.06
• i = Periodic interest rate is the interest rate for a given compounding
period and is calculated as follows:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 (𝑗)
𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒(𝑖) =
𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝐹𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 (𝑚)
• For example, 6% compounded monthly: i = 6%/12 = 0.005
4.1 COMPOUND INTEREST TERMS

• t = Time period is the period of time (in years) during which interest is
calculated.
• For example, 5% compounded quarterly for 18 months: t = 1.5 years
• n = Total number of compounding periods during the term is calculated
as follows:
𝑇𝑜𝑡𝑎𝑙 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑃𝑒𝑟𝑖𝑜𝑑𝑠 = 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝐹𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 × 𝑇𝑖𝑚𝑒 𝑖𝑛 𝑌𝑒𝑎𝑟𝑠
• Therefore, the formula for the total number of compounding periods
during the term is:
𝑛 =𝑚×𝑡
• For example, 6% compounded semi-annually for 4 years: n = 4 x 2 = 8
EXAMPLES

1. An investment is growing at 6% compounded monthly for ten years.

a. Identify the nominal interest rate, compounding frequency, and time period.
b. Calculate the periodic interest rate and number of compounding periods.
2. A loan is issued at 4.32% compounded quarterly for nine months.
a. Identify the nominal interest rate, compounding frequency, and time period in
years.
b. Calculate the periodic interest rate and number of compounding periods.
3. An investment is earning 8.2% compounded semi-annually for 5
years and 6 months.
a. Identify the nominal interest rate, compounding frequency, and time period in
years.
b. Calculate the periodic interest rate and number of compounding periods.
4.2 CALCULATING FUTURE VALUE (FV)

1. An investment is earning 8.2% compounded semi-annually for 5 years and 6

months.
a. Identify the nominal interest rate, compounding frequency, and time period
in years.
b. Calculate the periodic interest rate and number of compounding periods.
2. Executive Wealth Inc. invested $80,000 in an investment fund at 8%
compounded quarterly for 3 years and 5 months.
a. Calculate the accumulated value of this amount for this period.
b. Calculate the compound interest earned.
3. The bank lent Ramona $10,000 on August 11, 2018 at 4.25% compounded daily
to assist her in starting her baking business.
a. How much money did Ramona pay the bank on May 29, 2019 to settle her
entire loan?
b. How much did she pay in interest?
4.2 CALCULATING FUTURE VALUE (FV)

4. Amanda's consulXng company deposited $50,000 in a growth fund at

8% compounded semi-annually. A_er two years, the interest rate
changed to 6% compounded annually. What is the value of the fund
at the end of 5.5 years? Calculate the total interest her company
earned over the enXre period.
5. Smart Build Inc. borrowed $280,000 from the bank at 6.3%
compounded monthly. It repaid $120,000 at the end of the first year
and another $100,000 at the end of the second year. What amount at
the end of the third year will sedle this loan?
4.3 CALCULATING PRESENT VALUE (PV)

1. Calculate the present value of $5000 due in three years at 5%

compounded semi-annually.
2. Zion Apparel wants $275,000 in 4 years and 7 months. How much
should it invest now to meet this goal if the interest rate for the first
year is 4% compounded semi-annually and 4% compounded
quarterly thereafter?
3. RC Printers had the following two options to pay for printing
supplies:
a. Option A: A single payment of $650 at the beginning of the year.
b. Option B: $200 at the beginning of the year and $480 at the end of the year.
If money can earn 8% compounded daily, which option is
economically better (in current value).
4.4 CALCULATING EQUIVALENT PAYMENTS

1. What single payment in three years would be equivalent to $1000 due one year ago (but not
paid) and $2000 in six years? Assume a rate of 5% compounded semi-annually during this period.
2. A scheduled payment of $5000 due in three months is to be replaced by two equal payments.
The first payment is due in one month and the second payment in six months. Calculate the size
of each of the equal payments if money can earn 6% compounded monthly.
3. You are given two options to settle a loan:
a. Option 1: $2000 now and $3000 in two years.
b. Option 2: $2500 in six months and the balance in three years.
Calculate the payment required in three years under Option 2 if money earns 8% compounded
quarterly.
4. Danny, an entrepreneur, obtained a $12,000 loan from the bank at a rate of 5% compounded
daily to start her own business. She plans to settle her loan in three annual payments, starting one
year for now. Danny predicts that as her business grows, she will make a greater revenue, and as
such she will be able to make larger loan payments; therefore, her second payment is to be one-
and-a-half times the amount of her first payment, and her third payment is to be two times the
amount of her first payment. Calculate the size of the three payments Danny must make under
this payment schedule to settle her loan.
4.5 CALCULATING PERIODIC AND NOMINAL INTEREST RATE

• Periodic interest rate:

#
𝐹𝑉 !
𝑖= −1
𝑃𝑉

• Nominal interest rate:

𝑗 =𝑚×𝑖
EXAMPLES

1. At what rate compounded monthly will an investment of $4500 grow

to $10,000 in four years?
2. The interest on a three-year GIC is $8269.17. If the GIC is purchased
for $180,000, what is the nominal interest rate of the GIC if interest
is compounded quarterly?
3. At what nominal interest rate compounded semi-annually will an
investment double in 12 years?
4.6 CALCULATING NUMBER OF COMPOUNDING PERIODS AND TIME PERIOD

• Number of Compounding Periods:

𝐹𝑉
ln( )
𝑛= 𝑃𝑉
ln(1 + 𝑖)

• Time Period in Years:

𝑛
𝑡=
𝑚
EXAMPLES

1. How long will it take for an investment of $32,000 in a mutual fund

to mature to at least $100,000 if it is growing at the rate of 12%
compounded semi-annually? Express your answer in:
a. years, rounded to two decimal places
b. years and months
c. years and days
2. What is the term of an investment of $8000 that earns interest of at
least $2000 at 4.80% compounded monthly? Express your answer in:
a. years, rounded to two decimal places
b. years and months
c. years and days.
4.7 CALCULATING EQUIVALENT INTEREST RATE

• Equivalent interest rates are nominal interest rates with different

compounding periods that result in the same future value of a given
principal for any fixed period of time
• Equivalent interest rates are used to compare the interest rates
between loans and investments that have different compounding
periods
• Calculating the equivalent interest rate is a 2-step approach:
• Step 1: Calculate the equivalent periodic interest rate
• Step 2: Calculate the equivalent nominal interest rate
4.7 CALCULATING EQUIVALENT INTEREST RATE

• Step 1: calculate the equivalent periodic interest rate

𝑃𝑉(1 + 𝑖$ )%! = 𝑃𝑉(1 + 𝑖# )%"
(1 + 𝑖$ )%! = (1 + 𝑖# )%"
%"
⇒ 𝑖$ = (1 + 𝑖# )% ! −1

• Step 2: We can multiply the equivalent periodic interest rate by the

compounding frequency to calculate the equivalent nominal interest
rate
𝑗$ = 𝑚$ ×𝑖$
EXAMPLES

Calculating the Equivalent Nominal Interest Rate

a. 8% compounded annually is equivalent to what nominal interest rate
compounded semi-annually?
b. 16% compounded monthly is equivalent to what nominal interest
rate compounded quarterly?
CALCULATING EFFECTIVE INTEREST RATE (f)

• The effective interest is a special case of equivalent interest rates,

where the nominal compounding frequency is annual
• When the nominal interest rate is compounded annually it is called the
effective interest rate
• The effective interest rate is used to compare the annual interest rate
between loans and investments that have different compounding
periods.
• By definition, the effective interest rate f results in the same future
value as a nominal rate with a given compounding frequency

𝑓 = (1 + 𝑖)% −1
EXAMPLES

1. What is the effective interest rate that corresponds to:

a. 9% compounded semi-annually?
b. 9% compounded quarterly?
c. 9% compounded monthly?
d. 9% compounded daily?
2. If an interest rate of 1.2% per month is charged by a credit card
company, what effective interest rate should be disclosed to the
borrower?
3. At what effective interest rate would $8000 grow to $13,663.19 in
six years?
THANK YOU !