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7 - Compound Interest and Present Value (1)

The document explains the concept of compound interest, detailing how it is calculated on both principal and accumulated interest over various compounding periods. It includes examples comparing simple and compound interest, as well as formulas for calculating future and present values. Additionally, it discusses nominal and effective interest rates, providing methods for calculating these rates based on different compounding frequencies.

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Altaire Clemente
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3 views

7 - Compound Interest and Present Value (1)

The document explains the concept of compound interest, detailing how it is calculated on both principal and accumulated interest over various compounding periods. It includes examples comparing simple and compound interest, as well as formulas for calculating future and present values. Additionally, it discusses nominal and effective interest rates, providing methods for calculating these rates based on different compounding frequencies.

Uploaded by

Altaire Clemente
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Compound Interest

Compounding Interest (Future Value)


Compounding - involves the
Compound interest - the
calculation of interest
interest on the principal plus
periodically over the life of
the interest of prior periods
the loan or investment

Future value (compound


amount) - is the final amount Present value - the value of a
of the loan or investment at loan or investment today
the end of the last period
Compounding Terms
Compounding Periods Interest Calculated
Compounding Annually Once a year
Compounding Semiannually Every 6 months
Compounding Quarterly Every 3 months
Compounding Monthly Every month
Compounding Daily Every day
Tools for Calculating Compound Interest
Number of periods (N) Rate for each period (R)
Number of years Annual interest rate divided
multiplied the number of by the number of times the
times the interest is interest is compounded per
compounded per year year

If you compounded $100 for 3 years at 6% annually,


semiannually, or quarterly What is N and R?

Periods Rate
Annually: 3 x 1 = 3 Annually: 6% / 1 = 6%
Semiannually: 3 x 2 = 6 Semiannually: 6% / 2 = 3%
Quarterly: 3 x 4 = 12 Quarterly: 6% / 4 = 1.5%
Simple Versus Compound Interest
Simple Compounded
Al Jones deposited $1,000 in a savings Al Jones deposited $1,000 in a savings
account for 5 years at an annual account for 5 years at an annual
interest rate of 10%. What is Al’s compounded rate of 10%. What is Al’s
simple interest and maturity value? interest and compounded amount?

I=PxRxT Year 1 Year 2 Year 3 Year 4 Year 5


1,000.00 1,100.00 1,210.00 1,331.00 1,464.10
I = $1,000 x .10 x 5 Rate 0.10 0.10 0.10 0.10 0.10
Interest 100.00 110.00 121.00 133.10 146.41
I = $500
Beg. Bal. 1,000.00 1,100.00 1,210.00 1,331.00 1,464.10
MV = $1,000 + $500 End of Year 1,100.00 1,210.00 1,331.00 1,464.10 1,610.51

MV = $1,500
Interest: $1,610.51 - $1,000 = $610.51
Future Value
Future Value of $1 at 8% for Four Periods
Compounding goes from present value to future value

$5.00
$4.50 Future
$4.00 Value
After 3 After 4
$3.50 After 2
After 1 periods $1 periods $1
$3.00 periods $1
period $1 is worth is worth
is worth
$2.50 is worth $1.26 $1.36
Present $1.17
$2.00 $1.08
value $1.3605
$1.1664 $1.2597
$1.50 $1.00 $1.08
$1.00
$0.50
$0.00
0 1 2 3 4

Number of periods
Future Value of $1 at 8% for Four Periods
Manual Calculation
Year 1 Year 2 Year 3 Year 4
1.00 1.08 1.17 1.26
Rate 0.08 0.08 0.08 0.08
Interest 0.08 0.09 0.09 0.10
Beg. Bal. 1.00 1.08 1.17 1.26
End of Year 1.08 1.17 1.26 1.36

Manual Calculation (using exponents)


= $1.00 X (1 + 0.08) X (1 + 0.08) X (1 + 0.08) X (1 + 0.08)
= $1.00 X (1 + 0.08)4
= $1.00 X (1.08) 4
= $1.00 X 1.36048896
= ~ 1.36
Formula for Future Value
FV =
Nominal and Effective Rates (APY) of Interest

Nominal Rate (Stated Rate) - The rate on


which the bank calculates interest.

Effective Rate = Interest for 1 year


(APY) Principal
Calculating Effective Rate APY
Blue, 8% compounded quarterly Sun, 8% compounded semiannually
Periods (n) = 4 (4 x 1) Periods (n) = 2 (2 x 1)
Rate (r) = 8% = 2% Rate (r) = 8% = 4%
4 2
Principal = $8,000 Principal = $8,000
FV = 8,000 (1.02)4 FV = 8,000 (1.04)2
$8,659.20 $8,652.80
$8,000.00 $8,000.00
652.80
659.20
APY 652.80 = .0816
APY 659.20 = .0824
$8,000
$8,000
= 8.16%
= 8.24%
Nominal and Effective Rates (APY) of Interest Compared

Beginning Nominal rate Compounding End Effective rate


balance of interest period balance (APY) of interest

Annual $1,060.00 6.00%


Semiannual $1,060.90 6.09%
$1,000 + 6%
Quarterly $1,061.40 6.14%
Daily $1,061.80 6.18%
Compounding Interest Daily
Calculate what $2,000 compounded daily for 7 years will grow to at 6%

Formula:
N = 360 * 7 years = 2,520
R = 6% / 360 = 0.0001666666666
=$2,000 x (1.0001666666)2,520
=$2,000 x 1.5219
= $3,043.80
Present Value
Present Value of $1 at 8% for Four Periods
Present value goes from the future value to the present value

$1.20 Future Value


$1.10 $1.0000
$1.00 $.9259
Present value $.8573
$0.90 $.7938
$.7350
$0.80
$0.70
$0.60
$0.50
$0.40
$0.30
$0.20
$0.10
$0.00
0 1 2 3 4

Number of periods
Present Value of $1 at 8% for Four Periods
Manual Calculation
Year 0 Year 1 Year 2 Year 3 Year 4
Rate 0.0800 0.0800 0.0800 0.0800
Interest 0.0635 0.0686 0.0741 0.0741
Beg. Bal. 0.7350 0.7938 0.8573 0.9259
End of Year 0.7350 0.7938 0.8573 0.9259 1.0000

Manual Calculation (using exponents)


= _______________$1.00_________________
(1 + 0.08) X (1 + 0.08) X (1 + 0.08) X (1 + 0.08)
= $1.00 / (1 + 0.08)4
= $1.00 / (1.08) 4
= $1.00 / 1.36048896
= ~ 0.735029
Formula for Present Value
PV =
Compounded Interest - Formula

•PV =

•FV =

•Number of Periods =

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