Chapter 12
Compound Interest
and Present Value
Practical Business Math Procedures
Jeffrey Slater and Sharon Wittry
McGraw-Hill/Irwin Copyright © 2017 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning unit objectives
LU 12-1 Compound Interest (Future Value) – The Big Picture
1. Compare simple interest with compound interest.
2. Calculate the compound amount and interest manually and by
table lookup.
3. Explain and compute the effective rate (APY).
LU 12-2 Present Value -- The Big Picture
1. Compare present value (PV) with compound interest (FV).
2. Compute present value by table lookup.
3. Check the present value answer by compounding.
Compounding Interest
(Future Value)
Compounding – Compound Interest –
Involves the calculation of interest The interest on the principal plus the
periodically over the life of the loan or interest of prior periods
investment
Present Value –
Future Value (compound amount) –
The value of a
The final amount of the loan or loan or investment today
investment at 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 multiplied Annual interest rate divided
by the number of times the by the number of times the
interest is compounded per interest is compounded per
year year
If you compounded $100 for 4 years at 8% annually,
semiannually, or quarterly, what is N and R?
Periods Rate
Annually: 4x1=4 Annually: 8% / 1 = 8%
Semiannually: 4x2=8 Semiannually: 8% / 2 = 4%
Quarterly: 4 x 4 = 16 Quarterly: 8% / 4 = 2%
Simple Versus Compound
Interest
Simple Compounded
Bill Smith deposited $80 in a savings Bill Smith deposited $80 in a savings
account for 4 years at an annual account for 4 years at an annual
interest rate of 8%. What is Bill’s interest rate of 8%. What is Bill’s
simple interest and maturity value? interest and compounded amount?
I=PxRxT
Year 1 Year 2 Year 3 Year 4
I = $80 x .08 x 4 $ 80.00 $ 86.40 $ 93.31 $ 100.77
I = $25.60 x .08 x .08 x .08 x .08
MV = $80 + $25.60
Interest $ 6.40 $ 6.91 $ 7.46 $ 8.06
Beg. bal 80.00 86.40 93.31 100.77
MV = $105.60 End of year $ 86.40 $ 93.31 $ 100.77 $ 108.83
Interest: $108.83 -- $80.00 = $28.83
COMPOUND INTEREST CALCULATOR
https://www.investor.gov/additional-resources/free-financial-planning-
tools/compound-interest-calculator
https://www.thecalculatorsite.com/articles/finance/compound-
interest-formula.php
7
If an amount of $5,000 is deposited into a savings account at an annual
interest rate of 5%, compounded monthly, the value of the investment
after 10 years can be calculated as follows...
P = 5000.
r = 5/100 = 0.05 (decimal).
n = 12.
t = 10.
If we plug those figures into the formula, we get the following:
A = 5000 (1 + 0.05 / 12) (12 * 10) = 8235.05. 8
Bill Smith deposited $80 in a savings account for 4
years at an annual interest rate of 8%. What is Bill’s
interest and compounded amount?
P = 80
r = 8/100 = 0.08 (decimal).
n = 1.
t = 4.
If we plug those figures into the formula, we get the following:
9
A = 80 (1 + 0.08 / 1) (1 * 4) = $108.84.
Calculating Compound Amount
by Table Lookup
Pam Donahue deposits $8,000 in her savings account that pays 6% interest
compounded quarterly. What will be the balance of her account at the
end of 5 years?
Periods (N) =?
Rate (R) =?
Table Factor = ?
Compounded Amount:
?
Calculating Compound Amount
by Table Lookup
Pam Donahue deposits $8,000 in her savings account that pays 6% interest
compounded quarterly. What will be the balance of her account at the
end of 5 years?
Periods (N) = 4 x 5 = 20
Rate (R) = 6%/4 = 1.5%
Table Factor = 1.3469
Compounded Amount:
$8,000 x 1.3469 = $10,775.20
Nominal and Effective Rates (APY)
of Interest
Nominal Rate (stated rate) –
The rate on which the bank calculates interest
Effective rate (APY) = Interest for 1 year
Principal
Calculating Effective Rate APY
=Interest
Nominal and Effective Rates (APY)
of Interest Compared (Figure 12.3)
Period=1
percent = 6% = 6% Table: 6% ,1 =1.060
1
1000 X 1.060= $ 1,060 Interest=1060-1000=60
Effective rate (APY) = Interest for 1 year = 60
Principal 1000
Compounding Interest Daily
Use Table 12.2 to calculate what $1,500 compounded daily for
5 years will grow to at 7%.
N=5
R = 7%
Factor, 1.4190
$1,500 x 1.4190 = $2,128.50
Comparing Compound Interest (FV)
(Table 12.1) with
Present Value (PV) (Table 12.3)
Compound value Table 12.1 Present value Table 12.3
Table Present Future Table Future Present
12.1 Value Value 12.3 Value Value
1.3605 x $80 = $108.84 .7350 x $108.84 = $80.00
(N = 4, R = 8%) (N = 4, R = 8%)
We know the present We know the future
dollar amount and find dollar amount and
what the dollar amount find what the dollar
is worth in the future. amount is worth in the
present.
Problem 12-13
Lynn Ally, owner of a local Subway shop, loaned $40,000 to Pete Hall to help him
open a Subway franchise. Pete plans to repay Lynn at the end of 8 years with 6%
interest compounded semiannually. How much will Lynn receive at the end of 8
years? LU 12-1(2)
Solution:
8 years x 2 = 16 periods 6% = 3% $40,000 x 1.6047 = $64,188
2
Problem 12-15
Melvin Indecision has difficulty deciding whether to put his savings in Mystic Bank or
Four Rivers Bank. Mystic offers 10% interest compounded semiannually. Four Rivers
offers 8% interest compounded quarterly. Melvin has $10,000
to invest. He expects to withdraw the money at the end of 4 years. Which bank gives
Melvin the better deal? Check your answer. LU 12-1(3)
Solution:
Mystic Four Rivers
4 years x 2 = 8 periods 4 years x 4 = 16 periods
10% = 5% 8% = 2%
2 4
$10,000 x 1.4775 = $14,775 $10,000 X 1.3728 = $13,728
-- 10,000 -- 10,000
$ 4,775 $ 3,728
Problem 12-16
Lee Holmes deposited $15,000 in a new savings account at 9% interest compounded
semiannually. At the beginning of year 4, Lee deposits an additional $40,000 at 9%
interest compounded semiannually. At the end of 6 years, what is the balance in Lee’s
account? LU 12-1(2)
Solution:
3 years x 2 = 6 periods
9%
2 = 4.5%
$15,000 x 1.3023 = $19,534.50
+ 40,000.00
$ 59,534.50
$59,534.50 x 1.3023 = $77,531.78
Problem 12-27
Paul Havlik promised his grandson Jamie that he would give him $6,000 8 years
from today for graduating from high school. Assume money is worth 6% interest
compounded semiannually. What is the present value of this $6,000?
LU 12-2(2)
Solution:
8 years x 2 = 16 periods
6% = 3%
2
$6,000 x .6232 = $3,739.20
