Math For Business

Unit # 5
 Compound Interest I:
Future and Present Value

Objectives

1. Calculate interest rates and the number of

compounding periods.

2. Compute future (maturity) values of investments.

3. Compute present values of future sums of money.

4. Discount long-term promissory notes.

5. Solve problems involving equivalent values.

Introduction

Compound interest calculations are

used extensively in banking, investing,
and business transactions. This type of
interest is much more commonly used
than simple interest in everyday life, in
car loans, mortgages, and long-term
planning.
 Compound Interest
Basic Concepts and

Calculations
Interest in earlier periods earns interest in future periods
(compounded).
 Interest for a specified time period is calculated using
the original principal plus all the interest earned in prior
periods.
 Note that the amount of interest for the first period is the
same as the amount of interest computed using simple
interest
 In later periods, the amount of interest for compound
interest becomes increasingly greater than the amount
for simple interest.
 Compound interest is generally used for long-term
investments and loans.
 Compounding periods per year are the number of times
per year interest is “compounded” i.e. interest is
charged on interest.
 Comparison of Principal of $10,000
Invested for a Term of 5 Years at 10% Per
Annum (P.A.) (1 of 2)
Blan At Simple At Compound
k Interest Blank Blank Interest Blank
Interest Interest
Year Calculation Amount Balance Calculation Amount Balance
Blan Blank $10000.0 $10 Blank Blank $10
k 0 000.00 000.00
1 (0.10)(10 1 000.00 11 (0.10)(10 000.00) 1 11
000.00) 000.00 000.00 000.00
2 (0.10)(10 1 000.00 12 (0.10)(11 000.00) 1 12
000.00) 000.00 100.00 100.00
3 (0.10)(10 1 000.00 13 (0.10)(12 100.00) 1 13
000.00) 000.00 210.00 310.00
4 (0.10)(10 1 000.00 14 (0.10)(13 310.00) 1 14
000.00) 000.00 331.00 641.00
5 (0.10)(10 1 000.00 $15 (0.10)(14 641.00) 1 $16
000.00) 000.00 464.10 105.10
Comparison of Principal of $10,000 Invested
for a Term of 5 Years at 10% Per Annum (P.A.)
(2 of 2)
Periodic Rate of Interest
Versus Nominal Rate of
Interest
 Periodic interest is the interest rate per
period, not to be confused with the nominal
annual rate of interest.
 “5% p.a. compounded semi-annually” is an
example of a nominal annual rate of
interest.
 p.a. indicates “per annum”.
 Compounded semi-annually indicates interest
is compounded twice per year.
 2.5% (every six months or twice per year) is
the corresponding periodic rate of interest.
Determining the Periodic
Rate of Interest
 Nominal rate of interest IY
– rate of interest expressed Compoundi Length of Number of
annually. ng Compoun Compoundin
 Periodic rate of interest i – Frequency ding g Periods
the interest rate per period. Period per Year (m)
 Periods can be days (365x
per year), months (12x per Annual 12 months 1
year), quarters (4x per year (1 year)
- 3-month periods), semi-
Semi-annual 6 months 2
annual (2x per year – every
6 months) or years (same
Quarterly 3 months 4
as nominal).
 Number of compounding
Monthly 12 months 12
periods per year CY :
1. Daily – 365
Daily 1 day 365
2. Monthly – 12
3. Quarterly – 4
4. Semi-annually – 2
5. Annually – 1
 Periodic Rate of
Interest
 Nominal rates (IY) can be expressed as
periodic rates of interest by dividing
the nominal annual rate by the number
of compounding periods per year (CY).

𝐈𝐘 ( 𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐫𝐚𝐭𝐞 )
𝒊 ( 𝒑𝒆𝒓𝒊𝒐𝒅𝒊𝒄 𝒓𝒂𝒕𝒆 ) =
𝐂𝐘 ( 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐜𝐨𝐦𝐩𝐨𝐮𝐧𝐝𝐢𝐧𝐠 𝐩𝐞𝐫𝐢𝐨𝐝𝐬 𝐩𝐞𝐫 𝐲𝐞𝐚𝐫 )
Periodic Rate

 The formula converts the nominal rate into

the periodic rate.

 The periodic interest rate that corresponds

to 5% p.a. compounded semi-annually
(nominal rate) is computed by: every 6
months (2.5% twice a year).
Number of Compounding Periods
(1 of 2)

 Number of compounding periods for the duration of the loan is

represented by “n” and is computed by

CY
Ask yourself “If I do something m times per year for x years,
how many times will I have done it?”
 Example: A loan is provided at 4% compounded
semi-annually for 5 years. Calculate n.
 Semi-annually is 2x per year.
 The loan lasts 5 years.
 In total the loan is compounded, n = 2 × 5 = 10
times
Number of Compounding
Periods (2 of 2)
 Alternatively, n can be computed by changing
the term length of the loan to months and
dividing by the number of months per period.
 Example: A loan is provided for five years at a
nominal rate of 6% per year compounded
quarterly.
 There are 5 × 12 = 60 months in the term of
the loan.
 Quarterly means every three months per
period (per quarter).
 n = 60/3 = 20 times
The Future Value Formula for
Compound Interest

compounding factor

 PV is the Principal Value

 i is the periodic rate of interest
 n is the total number of compounding periods in the
term
Using the Formula Putting it
All Together
Blank At
Compound
Interest
Interest
Calculation Amount Balance
Blank Blank $10 000.00
Manual key steps (0.10)(10 1 000.00 11 000.00
10,000 × (1.10 yx 5) = 000.00)
(0.10)(11 1 100.00 12 100.00
 Compare the result 000.00)
with the table
(0.10)(12 1 210.00 13 310.00
calculations to the 100.00)
right.
(0.10)(13 1 331.00 14 641.00
310.00)
(0.10)(14 1 464.10 $16 105.10
641.00)
Applying the Formula
 i = 7.75%/2 = 3.875% =
 A loan for $5000 with 0.03875
interest at 7.75%  5 years + 10/12 years =
compounded semi- years
annually is repaid  n = × 2 = periods
after 5 years, 10
months. What is the
amount of interest
 Interest paid = $2791.10
paid?

Manual key steps

5000 × (1.03875 yx ) =
 Using the Texas Instruments BA II
PLUS
KEY DISPLAY KEY DISPLAY
2nd Blank 7.75 Blank
P/Y Blank I/Y I/Y = 7.75
2 ENTER P/Y= 2 −5000 Blank
↓ (can C/Y= 2 PV PV = −5000
skip)
2nd Blank 0 Blank
QUIT Blank PMT PMT = 0
2nd Blank CPT Blank
CLR TVM 0 FV FV =
7,791.10
Blank Note: The negative in the Blank
5000 indicates money
flowing out.

N N= Note: There are alternative Blank

methods to enter values as
per the formula.
Applying the FV Formula (1
of 2)

 A deposit of $5,000 earns interest at 7% p.a.

compounded quarterly for four years and
five months. At that time, the interest rate
changes to 6% p.a. compounded monthly.
What is the value of the deposit three years
after the change in the rate of interest?
Applying the FV Formula
(2 of 2)

 There are two major calculations, FV1 and FV2

 FV1
 i = 7%/4 = 1.75% (0.0175) every three months
 n = 4 years × 4 = 17 periods
 FV1 = 5,000 = $6,793.257139

 FV2
 i = 6%/12 = 0.5% (0.005) every month
 n = 3 years × 12 = 36 periods
 FV2 = $6,793.257139(1 + 0.005)36 = $8,129.36
 A Timeline of the Event
Now 4y 5m (4.416667y) 7.416667y
3y
i = 7%/4 = 1.75% = 0.0175
n = 4 years × 4 times per year i = 6%/12 = 0.5% = 0.005
= 17 periods (quarters) periods
n = 3 years × 12 times per
year
= 36 periods (months)
$5,000
$6,793.257139
$8,129.36
The Present Value Formula

 The principal that will grow to the given amount if

compounded at a given periodic rate of interest over a
specified number of conversion periods is the Present
Value.
 Present Value Formula:

 which can also be expressed as:

Applying the PV Formula
• Find the principal that will amount to $10,000 in 6
years at 4% p.a. compounded quarterly.
– i = 4%/4 = 1% (0.01) every three months (4x per
year)
– n = 6 years × 4 times per year = 24 three-month
periods
Using the Texas
Instruments BA II PLUS
KEY DISPLA KEY DISPLAY
Y
2nd Blank 4 Blank

P/Y Blank I/Y I/Y = 4

4 ENTER P/Y = 4 10000 Blank

↓ (can C/Y = 4 FV FV = 10000

skip)
2nd Blank 0 Blank

QUIT Blank PMT PMT = 0

2nd Blank CPT Blank

CLR TVM 0 PV PV =
−7,875.66
24 Blank Note: The negative in Blank
7875.66 indicates money
flowing out.

N N = 24 Note: There are alternative Blank

methods to enter values as
per the formula.
Compound Discount
 The difference between the known future
amount and the computed present value
(principal) is the compound discount and
represents the compound interest
accumulating on the computed present
value.
– Compound Discount = FV − PV
– In the previous example, the compound
discount is
$10,000 − 7,875.66 = $2,124.34
Application of
Compound Interest
Discounting negotiable financial instruments at
compound interest
Discounting Long-term
Promissory Notes
 Long-term promissory notes are
negotiable.
 They can be bought and sold
(discounted) at any time before
maturity.
 The principals involved are similar to
those used in discounting short-term
promissory notes by the simple
discount method.
 No grace period is considered in
determining the legal due date.
 Non-Interest Bearing
Promissory Notes (1 of 2)
 For non-interest-bearing notes:
 Face value is the maturity value.
 The discounted value is determined in one
step—calculating the present value of the
discount period.
 The proceeds of a non-interest-bearing note
are the present value of its face value at the
date of discount. face value = maturity value
issue date discount date maturity date

discount period
Non-Interest Bearing
Promissory Notes (2 of 2)
 Find the proceeds of a non-interest bearing
note for $3,000 discounted 2 years before
maturity. The interest rate is 9%
compounded monthly.
 The maturity value is equal to the face
value.
 i = 9%/12 = 0.75% = 0.0075 per period
(month)
 n = 2 years × 12 times per year = 24
periods

 Key strokes: ( 1 + 0.0075 ) 24 +/− = x 3000

Using the Texas Instruments BA II PLUS

KEY DISPLAY KEY DISPLAY

2nd Blank 9 Blank
P/Y Blank I/Y I/Y = 9
12 ENTER P/Y = 3000 Blank
12
↓ (can C/Y = FV FV = 3000
skip) 12
2nd Blank 0 Blank
QUIT Blank PMT PMT = 0
2nd Blank CPT Blank
CLR TVM 0 PV PV =
−2,507.49
24 Blank Note: The negative in Blank
2507.49 indicates money
flowing out.

N N = 24 Note: There are Blank

alternative methods to
enter values as per
formula.
Discounting Interest-
Bearing Promissory
Notes (1 of 4)
Determine the maturity value of the note.
1.
 Use the future value formula.
2. Determine the proceeds by discounting the
maturity value found in step 1.
 The calculation of present value is
required, using the prevailing interest
rate and the time between the discount
date and the maturity date.
Discounting Interest-
Bearing Promissory
Notes

(2 of 4)
Find the proceeds of a six-year, $900
note bearing interest at 10%
compounded quarterly, issued June 1,
2013, discounted on December 1, 2018,
to yield 8.5% compounded semi-annually.
Discounting Interest-
Bearing Promissory Notes
(3 of 4) December 1, 2018 June 1, 2019
June 1, 2013 discount date maturity date

$900 discount period

 Referring to the timeline, the maturity date is 6 years in

the future on June 1, 2019.
 The discount period is 6 months from the discount date to
the maturity date.
 Step 1: Maturity value (FV) on June 1 is computed by:
FV = 900(1 + 0.025)24 = $1627.853355
 10% compounded quarterly is 2.5% per quarter (10%/4).
 Four compounds per year for six years is n = 4 × 6 = 24
 Discounting Interest-
Bearing Promissory
Notes (4 of 4) December 1, 2018
discount date
June 1, 2019
maturity date
June 1, 2013

discount period
$1561.49 $1627.85
6 months
$900

 Step 2: Proceeds (PV) on December 1 is computed by:

PV = 1627.853355(1 + 0.0425)−1 = $1561.49
 8.5% compounded semi-annually is 4.25% per semi-annual
period (every 6 months) (8.5%/2).
 Discounted 6 months or 1 semi-annual period
Using the Texas Instruments BA II PLUS
(1 of 2)

KEY DISPLA KEY DISPLAY

Y
2nd Blank 10 Blank
P/Y Blank I/Y I/Y = 10
4 ENTER P/Y = 4 −90 Blank
0
↓ (can C/Y = 4 PV PV = −900
skip)
2nd Blank 0 Blank
QUIT Blank PMT PMT = 0
2nd Blank CPT Blank
CLR TVM 0 FV FV = 1627.853355
24 Blank Blank
N N = 24 Note: There are alternative methods to enter
values as per formula.
Using the Texas Instruments
BA II PLUS (2 of 2)

KEY DISPLA KEY DISPLAY

Y
2nd Blank CPT Blank
P/Y Blank PV PV = −1561.49
2 ENTER P/Y = 2 Blan Blank
k
↓ (can C/Y = 2 Blan Blank
skip) k
2nd Blank Blan Blank
k
QUIT Blank Blan Blank
k
1 Blank Blan Blank
k
N N =1 Blan Blank
k
8.5 Blank Blan Note 1: There are alternative methods to enter
k values as per the formula.
Equivalent Values
 Amounts of money have  If the due date of the
different values at payment falls before
different times (Time the focal date, use the
Value of Money). FV formula
 When sums of money fall  FV = PV(1 + i)n
due or are payable at
different times, they are
not directly comparable.  If the due date of the
 To make such sums of payment falls after the
money comparable, a focal date, use the PV
point in time
formula
(comparison/focal date)
must be chosen for the  PV = FV(1 + i)−n
comparison.
Note on Equivalent
Payments
 When calculating equivalent values for more
than one payment:
 Each payment is a separate transaction. (One
could make each payment separate from any
other payment).
 Therefore, any equivalent value is rounded to
two decimals before summing multiple
payments.
 Equivalent Payments (1 of 3)

 Debt payments of $500 due three months ago, $1,000 due

today, and $2,000 due in fifteen months are to be
combined into one payment due six months from today at
12% p.a. compounded monthly.
 Find the size of that payment.

Equivalent Payment? $2,000

$500 due $1,000 6 months 15 months
3 months ago today from today from today
 Equivalent Payments (2 of 3)

i = 12%/12 = 1% per period (month) Equivalent Payment?

6 months $2,000
from today 15 months
$500 due $1,000
Focal date from today
3 months ago Today (0)

n = 6 periods (months) E2
n = 15 − 6 = 9 periods
6
𝐹𝑉 =1,000 (1+0.01 ) =$ 1,061.52 (months)

n = 3 + 6 = 9 periods (months)
E3
9
𝐹𝑉 =500 (1+ 0.01 ) =$ 546.84 E1
Equivalent Payments (3 of 3)

 From the graph we can Summary Blank

see that the equivalent
Equivalent Amount
payment at month six is
Payment
calculated as
E1 + E2 + E3 E1 $546.84
E2 $1,061.52
E3 $1,828.68
Total $3,437.04
Two or More Equivalent
Replacement Payments (1 of 3)

 Joel is due to make a payment of $2,500

now. Instead, he has negotiated to
make two equal payments, one year
and two years from now. Determine the
size of the equal payments if money is
worth 7.5% compounded quarterly.
 The focal date can be arbitrary;
however, it should be chosen to
reduce the number and complexity of
the calculations.
 Choose today as the focal date for
convenience.
Two or More Equivalent
Replacement Payments (2 of 3)

i = 7.5%/4 = 1.875% per period (quarter) We represent the unknown replacement payments
both ‘x’ because they are equivalent
$2,500 x x
Today = 1 year 2 years
now
Focal date

n = 1 × 4 = 4 periods
E1 −𝟒
𝑷𝑽 = 𝒙 ( 𝟏+𝟎. 𝟎𝟏𝟖𝟕𝟓 ) =𝟎. 𝟗𝟐𝟖𝟑𝟖𝟖 𝒙

n = 2 × 4 = 8 periods
E2 −𝟖
𝑷𝑽 = 𝒙 ( 𝟏+𝟎. 𝟎𝟏𝟖𝟕𝟓 ) =𝟎.𝟖𝟔𝟏𝟗𝟎𝟒 𝒙
 Two or More Equivalent
Replacement Payments
(3 of 3)
 From the graphic we can see that the equivalent
payment at the focal date is calculated as E1 + E2 =
1.790292x
Blank Replacement
payments
E1 0.928388x
E2 0.861904x
Total 1.790292x

 1.790292x = 2,500
 x = $1,396.42 is the size of each replacement
payment
 Effective Interest Rates

 Interest rates that increase a given principal to the same future

value over the same period of time are called equivalent rates.
 9.381% p.a. compounded annually, and 9% p.a. compounded
monthly are equivalent rates.

 The annually compounded rate of 9.381% p.a. is called the effective

rate of interest.

https://www.youtube.com/watch?
v=aIxkIPUWiBw&t=187s&ab_channel=LimorMarkmanLimorMarkma
n
 Finding Effective Rate:(1 of

2)
Formula:
 Let the nominal rate of interest be computed CY times
per year and let the interest rate per conversion
period be i.
 Then the accumulated amount after 1 year is
 Let the corresponding effective rate is f
 Then the accumulated amount after 1 year is
 The amounts are equal by definition:

 =
 -1
 Finding Effective Rate:(2
 of 2)
Determine the effective rate of interest corresponding
to 9% p.a. compounded (i) annually, (ii) semi-annually,
(iii) quarterly, (iv) Monthly.

Step Annually Semi-annually Quarterly Monthly

s

I/Y 9.0 9.0 9.0 9.0

P/Y 1 2 4 12

i .09=9.0% .09/2=4.5% .09/4=2.25% .09/12=.75%

CY 1 2 4 12

f f= f= f= f=
= 1.09-1 = 1.092025-1 = 1.093083-1 = 1.092025-1
= 9% = 9.2025% = 9.3083% = 9.3807%
Summary
With compound interest, earned interest is
added to the principal and thus “interest is
earned on interest” resulting in exponential
growth.
The Future Value (maturity value) of an
investment using compound interest can be
expressed by the formula FV = PV(1 + i)n
The Present Value (discount) of an
investment using compound interest can be
expressed by the formula PV = FV(1 + i)−n