Teaching and Learning

Guide 5: Finance and Growth

Section 3: Simple and Compound Interest

1. The concept of simple and compound Interest
As noted earlier, students will benefit from clear and cogent definitions at the beginning of the topic or module.

Definition of Simple Interest Simple interest is a fixed percentage of the principal, P, that is paid to an investor each year, irrespective of the number of years the principal has been left on deposit. Consequently an amount of money invested at simple interest will increase in value by the same amount each year.

Algebraically, the amount of simple interest, I, earned on a deposit, P0, invested at r% for t years is:

I = P0 x r x t Hence the total amount of money after t years is the principal plus the accrued interest:

P0 + P0 x r x t = P0(1 + rt) Definition of compound interest The view above of only the principal earning interest is a very simplistic one and normally the interest on money borrowed is usually compounded. Compound interest pays interest on the principal plus on any interest accumulated in previous years.

The total value after t years when a principal, P0, is compounded at r% per annum is: Pt = P0(1+r)t

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2. Presenting the concept of simple and compound Interest

Worked examples are a good way for students to understand and apply the concepts and mathematical techniques. They also provide a reference for students to return if they need to when they are working independently on problem sets. Two worked examples are provided below to help colleagues present these two concepts. Presenting the calculation of simple interest If you borrow 1000 for five years at a simple interest rate of 10% p.a., the amount of interest you pay is:

I = P0 x r x t = 1000 x 0.1 x 5 = 500 Thus the cost of borrowing 1000 for five years at 10% p.a. simple interest is 500. The total amount due after five years would be:

P0(1 + rt) = 1000 x (1 + 0.1 x 5) = 1500. Presenting the calculation of compound interest In order to demonstrate the fundamentals of compound interest consider a deposit of 1000 over 5 years at 10% per annum with interest compounded annually.

Principal at start of year 1000 1100 1210 1331 1464.10

Interest paid each year 100 110 121 133.10 146.41

Total at end of year 1100 1210 1331 1464.10 1610.51

Note the 1610.51 could have been obtained directly as: 1000 x (1 + 0.1)5 = 1000 x 1.61051 = 1610.51

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Repeating the above example but using algebraic notation rather than numbers:

Principal at start of year P0

Interest earned each year r x P0

Total at end of year

P0 + rP0 = P0(1 + r) = P1

P1

r x P1

P1+rP1=P0(1 + r)+ rP0(1 + r) = P0(1+r)(1+r) = P0(1+r)2 = P2 P2+rP2=P0(1 + r)2+ rP0(1 + r)2 = P0(1+r)2(1+r) = P0(1+r)3 = P3

P2

r x P2

Pt-1

r x Pt-1

... P0(1+r)t = Pt

Notice that the totals at the end of each year form a geometric progression (including the initial amount): P0, P0(1+r), P0(1+r)2, P0(1+r)3, , P0(1+r)t Hence as stated previously the total value after t years when a principal, P0, is compounded at r% per annum is:

Pt = P0(1+r)t
3. Delivering the concept of simple and compound Interest to small and larger groups Students will need an initial and formal overview of simple and compound interest. This could be complemented by a more practical exercise where students visit banks and building societies in person or online to consider the different rates of interest offered by different financial products and to consider how the total return they would receive would be significantly affected by compounding.

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Links to the online question bank There are questions on investment appraisal including simple and compound interest at http://www.metalproject.co.uk/METAL/Resources/Question_bank/Economics%20applications/in dex.html

Video clips The video clips for this Guide can be found at http://www.metalproject.co.uk/Resources/Films/Mathematics_of_finance/index.html Clips 3.01 to 3.03 (inclusive) offer good practical illustrations of compounding starting with an applied example of a student calculating how long it will take for them to save for a round the world trip.

4. Discussion
A simple competition and discussion could be created where students are paired and given a notional 1000 and a 10 year investment time frame and asked to select a savings account which would maximise their compounded interest. Higher ability students could look at foreign savings products and could factor in exchange rates when arriving at the Sterling figure.

5. Activities
Learning Objectives LO1: Students learn the meaning of key financial terms- bond, coupon, interest, simple and compound interest LO2: Students learn how to calculate simple and compound interest LO3: Students learn the distinction between simple and compound interest LO4: Students learn the impact which the frequency of compounding has upon the size of the total return

Task One A bond's coupon is the annual interest rate paid on the issuer's borrowed money, generally paid out semi-annually. The coupon is always tied to a bond's face or par value, and is quoted as a percentage of par. For instance, a bond with a par value of 1,000 and an annual interest rate of 4.5% has a coupon rate of 4.5% (45).

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Say you invest in a six-year bond paying 5% per year, annually. Assuming you hold the bond to maturity, you will receive 6 interest payments of 250 each, or a total of 1,500. Plus the par value of 1000.This coupon payment is simple interest.

You can do two things with that simple interestspend it or reinvest it. Determine the total amount of money you will have after six years, assuming you can reinvest the interest at 5% per annum.

Task Two So far, it has been assumed that compound interest is compounded once a year. In reality interest may be compounded several times a year, e.g. daily, weekly, monthly, quarterly, semiannually or even continuously.

The value of an investment at the end of m compounding periods is: Pt = P0[1 + r/m]m x t Where m is the number of compounding periods per year and t is the number of years.

Using this information, solve the following problem:

(a)

1,000 is invested for three years at 6% per annum compounded semi-annually. Calculate

the total return after three years.

(b) What would the answer be if the interest was compounded annually?

(c) If the interest was compounded monthly is it true that the total amount after three years would be less than 1195.00?

(d) Using your answers to (a) (c) what can you infer about the frequency of compounding and the size of the total return?

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rt

Task Three (Using the formula Pt = P0e ) It follows that when we compound interest continuously the value of the investment at the end of the period becomes Pt = P0ert. Worked example A financial consultant advises you to invest 1,000 at 6% continuously compounded for three years. Find the total value of your investment. Pt = P0ert = 1,000 x e(0.06 x 3) = 1,000 x 2.71830.18 = 1,197.22 In Excel to raise e to the power of another number you use the EXP function.

(a) Use Excel to set up a table comparing the growth of 1 invested for 25 years at 20% assuming interest is compounded (i) annually; (ii) quarterly; (iii) monthly and (iv) continuously. (b) Graph the outcome. (c) What conclusion can be drawn regarding the frequency of compounding?

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ANSWERS Task One Time (years) 1 2 3 4 5 6 Totals Cash Flow received 250 250 250 250 250 1,250 2,500 Interest Earned at 5% 69.07 53.88 39.41 25.63 12.50 0.00 200.48

When you reinvest a coupon, however, you allow the interest to earn interest. The precise term is "interest-on-interest," (i.e. compounding). Assuming you reinvest the interest at the same 5% rate and add this to the 1,500 you made, you would earn a cumulative total of 2,700.48, or an extra 200.48 (of course, if the interest rate at which you reinvest your coupons is higher or lower, your total returns will be more or less).

Task Two (a) P3 = 1,000 x (1 + 0.06/2)2 x 3 = 1,000 x (1.03)6 = 1194.05 (b) Time (years) 1 2 3 Principal 1,000.00 1,060.00 1,123.60 Interest Earned 60.00 63.60 67.42 Total at End of Period 1,060.00 1,123.60 1,191.02

Which is the same as 1,000 x (1+0.06)3 = 1,191.02.

(c) FALSE since we would get Time (months) 1 2 Principal 1,000.00 1,005.00 Interest Earned 5.00 5.03 Total at End of Period 1,005.00 1,010.03

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3 .. .. 35 36

1,010.03 .. .. 1,184.83 1,190.75

5.05 .. .. 5.92 5.95

1,015.08 .. .. 1,190.75 1,196.70

or 1,000 x (1 + 0.06/12)12 x 3 = 1,000 x (1.005)36 = 1,196.68 (note difference is due to rounding errors)

(d) Hence

the greater the compounding frequency the greater the total return. Thus if we

compound daily the total return would be: 1,000 x (1 + 0.06/365)365 x 3 = 1,197.20. To illustrate what happens as the compounding frequency is increased, consider the table below.

Compounding Frequency 1 2 4 8 12 52 365 730 1460 5000 10000 50000

Total at End of Period 1,191.02 1,194.05 1,195.62 1,196.41 1,196.68 1,197.09 1,197.20 1,197.21 1,197.21 1,197.22 1,197.22 1,197.22

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As the value of m (the compounding frequency) increases the value of the investment becomes larger, but never exceeds 1.197.22

Note the final value is arrived at from: 1,000 x (1 + 0.06/50000)50000 x 3 = 1,197.22. Note: Higher ability students might want to consider the following explanation: By allowing m to approach infinity interest is being added to the investment more and more frequently and can be regarded as being added continuously, such that:

0.06 lim 1000 x 1 + m m

mx 3

= 1,197.22

Here we applied this formula: Pt = P0[1 + r/m]m x t

with P0 set at 1,000, r set at 0.06 and t set at 3 and varying m. If we now set P0 at 1, r at 100% (i.e. 1) and t set at 1 year we arrive at the following answer for m set at 50,000: Pt = 1x [1 + 1/50,000]50,000 = 2.7183 Thus we can say that:

1 lim 1 + m m

= 2.7183

You may recognise this number, 2.7183, the natural logarithm, e. Note log to the base e of 2.7183 (denoted loge(2.7183) = 1).

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Task Three
(a) and (b)
The Growth of 1 at r = 20% using different compounding frequencies 160.00 140.00 120.00 100.00 80.00 60.00 40.00 20.00 0.00 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Year

Value ('s)

Annually Quarterly Monthly Continuously

(c) We can observe from the chart that the continuous method of compounding leads to the greatest cumulative total after 20 years, while the annual method gives the smallest sum. Furthermore, the longer the investment is left on deposit the wider the differences when compounded by the different methods.

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6. Top Tips
Remind students that the interest rate is always quoted as a percentage, i.e. r%. Many students erroneously enter interest rates into a variety of financial problems. As a good check it is useful to ask students to undertake a simple commonsense check: look at the answer and ask if its reasonable. For example if I invest 100 for one year at 10% would I really expect to get 1100 back at the end of the year (100 x (1+10)) or is 110 more realistic (100 x (1+0.01))? This intuition is impossible to teach but students can acquire and develop it if they practise stopping and reflecting on their answers rather than accepting whatever appears on their calculator screens.

Students appreciate real examples rather than made up examples. You will find a huge wealth of examples at http://www.nsandi.com/products/frsb/calculator.jsp

Section 4: Investment Appraisal

1. The concept of investment appraisal
It would be helpful to start by explaining what is meant by the term, Investment Appraisal and also that it is necessary to first consider the time value of money and the concept of present value.

2. Presenting the concept of investment appraisal

A good way to get students thinking about investment appraisal is to ask the group of students would you rather have 100 now or 100 in a years time?. One would expect everyone to respond with 100 now!. Then repeat the question at 85, 90, 95, 96, 97, 98 and 99. One would be surprised if anyone said yes at 85, 90 or even 95.

But if they do you can question their logic. They may choose to take the money now because they favour present consumption over future consumption. But if they argue that they could the

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