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section 3.2
Compound interest
Objectives

At the end of this section you should be able to:

Understand the difference between simple and compound interest.

Calculate the future value of a principal under annual compounding.

Calculate the future value of a principal under continuous compounding.

Determine the annual percentage rate of interest given a nominal rate of interest.

Today, businesses and individuals are faced with a bewildering array of loan facilities and
investment opportunities. In this section we explain how these financial calculations are car-
ried out to enable an informed choice to be made between the various possibilities available.
We begin by considering what happens when a single lump sum is invested and show how to
calculate the amount accumulated over a period of time.
Suppose that someone gives you the option of receiving $500 now or $500 in 3 years’ time.
Which of these alternatives would you accept? Most people would take the money now, partly
because they may have an immediate need for it, but also because they recognize that $500 is
worth more today than in 3 years’ time. Even if we ignore the effects of inflation, it is still
better to take the money now, since it can be invested and will increase in value over the 3-year
period. In order to work out this value we need to know the rate of interest and the basis
on which it is calculated. Let us begin by assuming that the $500 is invested for 3 years at
10% interest compounded annually. What exactly do we mean by ‘10% interest compounded
annually’? Well, at the end of each year, the interest is calculated and is added on to the amount
currently invested. If the original amount is $500 then after 1 year the interest is 10% of $500,
which is
10 1
× $500 = × $500 = $50
100 10
so the amount rises by $50 to $550.
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3.2 • Compound interest 195

What happens to this amount at the end of the second year? Is the interest also $50? This
would actually be the case with simple interest, when the amount of interest received is the
same for all years. However, with compound interest, we get ‘interest on the interest’. Nearly
all financial investments use compound rather than simple interest, because investors need
to be rewarded for not taking the interest payment out of the fund each year. Under annual
compounding the interest obtained at the end of the second year is 10% of the amount invested
at the start of that year. This not only consists of the original $500, but also the $50 already
received as interest on the first year’s investment. Consequently, we get an additional
1
× $550 = $55
10
raising the sum to $605. Finally, at the end of the third year, the interest is
1
× $605 = $60.50
10
so the investment is $665.50. You are therefore $165.50 better off by taking the $500 now and
investing it for 3 years. The calculations are summarized in Table 3.16.

Table 3.16

End of year Interest ($) Investment ($)

1 50 550
2 55 605
3 60.50 665.50

Example

Find the value, in 4 years’ time, of $10 000 invested at 5% interest compounded annually.

Solution

At the end of year 1 the interest is 0.05 × 10 000 = 500, so the investment is 10 500.

At the end of year 2 the interest is 0.05 × 10 500 = 525, so the investment is 11 025.

At the end of year 3 the interest is 0.05 × 11 025 = 551.25, so the investment is 11 576.25.

At the end of year 4 the interest is 0.05 × 11 576.25 = 578.81 rounded to 2 decimal places, so the final
investment is $12 155.06 to the nearest cent.

Practice Problem

1 Find the value, in 10 years’ time, of $1000 invested at 8% interest compounded annually.

The previous calculations were performed by finding the interest earned each year and
adding it on to the amount accumulated at the beginning of the year. As you may have discovered
in Practice Problem 1, this can be rather laborious, particularly if the money is invested over a
long period of time. What is really needed is a method of calculating the investment after, say,
10 years without having to determine the amount for the 9 intermediate years. This can be
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196 Mathematics of Finance

done using the scale factor approach discussed in the previous section. To illustrate this, let us
return to the problem of investing $500 at 10% interest compounded annually. The original
sum of money is called the principal and is denoted by P, and the final sum is called the future
value and is denoted by S. The scale factor associated with an increase of 10% is
10
1+ = 1.1
100
so at the end of 1 year the total amount invested is P(1.1).
After 2 years we get
P(1.1) × (1.1) = P(1.1)2
and after 3 years the future value is
S = P(1.1)2 × (1.1) = P(1.1)3
Setting P = 500, we see that
S = 500(1.1)3 = $665.50
which is, of course, the same as the amount calculated previously.
In general, if the interest rate is r% compounded annually then the scale factor is
r
1+
100
so, after n years,
n
S = P AC 1 +
r D
100 F

Given the values of r, P and n it is trivial to evaluate S using the power key x y on a calculator.
To see this let us rework the previous example using this formula.

Example

Find the value, in 4 years’ time, of $10 000 invested at 5% interest compounded annually.

Solution
n
In this problem, P = 10 000, r = 5 and n = 4, so the formula S = P AC 1 +
r D
gives
100 F
4
S = 10 000 A 1 +
5 D
= 10 000(1.05)4 = 12 155.06
C 100 F
which is, of course, the same answer as before.

Practice Problem

2 Use the formula

n
S = PA1 +
r D
C 100 F
to find the value, in 10 years’ time, of $1000 invested at 8% interest compounded annually. [You
might like to compare your answer with that obtained in Practice Problem 1.]
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3.2 • Compound interest 197

The compound interest formula derived above involves four variables, r, n, P and S.
Provided that we know any three of these, we can use the formula to determine the remaining
variable. This is illustrated in the following example.

Example

A principal of $25 000 is invested at 12% interest compounded annually. After how many years will the
investment first exceed $250 000?

Solution
We want to save a total of $250 000 starting with an initial investment of $25 000. The problem is to deter-
mine the number of years required for this on the assumption that the interest is fixed at 12% throughout
this time. The formula for compound interest is
n
S = PA1 +
r D
C 100 F
We are given that
P = 25 000, S = 250 000, r = 12
so we need to solve the equation
n
250 000 = 25 000 AC 1 +
12 D
100 F
for n.
One way of doing this would just be to keep on guessing values of n until we find the one that works.
However, a more mathematical approach is to use logarithms, because we are being asked to solve an equa-
tion in which the unknown occurs as a power. Following the method described in Section 2.3, we first divide
both sides by 25 000 to get
10 = (1.12)n
Taking logarithms of both sides gives
log(10) = log(1.12)n
and if you apply rule 3 of logarithms you get

log(10) = n log(1.12)

Hence
log(10)
n=
log(1.12)
1
= (taking logarithms to base 10)
0.049 218 023

= 20.3 (to 1 decimal place)

Now we know that n must be a whole number because interest is only added on at the end of each year.
We assume that the first interest payment occurs exactly 12 months after the initial investment and every

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198 Mathematics of Finance

12 months thereafter. The answer, 20.3, tells us that after only 20 years the amount is less than $250 000, so
we need to wait until 21 years have elapsed before it exceeds this amount. In fact, after 20 years
S = $25 000(1.12)20 = $241 157.33
and after 21 years
S = $25 000(1.12)21 = $270 096.21

In this example we calculated the time taken for $25 000 to increase by a factor of 10. It can
be shown that this time depends only on the interest rate and not on the actual value of the
principal. To see this, note that if a general principal, P, increases tenfold then its future value
is 10P. If the interest rate is 12%, then we need to solve
n
10P = P AC 1 +
12 D
100 F
for n. The Ps cancel (indicating that the answer is independent of P) to produce the equation
10 = (1.12)n
This is identical to the equation obtained in the previous example and, as we have just seen, has
the solution n = 20.3.

Practice Problem

3 A firm estimates that its sales will rise by 3% each year and that it needs to sell at least 10 000 goods
each year in order to make a profit. Given that its current annual sales are only 9000, how many years
will it take before the firm breaks even?

You may have noticed that in all of the previous problems it is assumed that the interest is
compounded annually. It is possible for interest to be added to the investment more frequently
than this. For example, suppose that a principal of $500 is invested for 3 years at 10% interest
compounded quarterly. What do we mean by ‘10% interest compounded quarterly’? Well, it
does not mean that we get 10% interest every 3 months. Instead, the 10% is split into four equal
portions, one for each quarter. Every 3 months the interest accrued is
10%
= 2.5%
4
so after the first quarter the investment gets multiplied by 1.025 to give
500(1.025)
and after the second quarter it gets multiplied by another 1.025 to give
500(1.025)2
and so on. Moreover, since there are exactly 12 three-month periods in 3 years we deduce that
the future value is
500(1.025)12 = $672.44
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3.2 • Compound interest 199

Notice that this is greater than the sum obtained at the start of this section under annual com-
pounding. (Why is this?)
This example highlights the fact that the compound interest formula
n
S = P AC 1 +
r D
100 F
derived earlier for annual compounding can also be used for other types of compounding.
All that is needed is to reinterpret the symbols r and n. The variable r now represents the rate
of interest per time period and n represents the total number of periods.

Example

A principal of $10 is invested at 12% interest for 1 year. Determine the future value if the interest is
compounded
(a) annually (b) semi-annually (c) quarterly (d) monthly (e) weekly

Solution
The formula for compound interest gives
n
S = 10 AC 1 +
r D
100 F
(a) If the interest is compounded annually then r = 12, n = 1, so
S = $10(1.12)1 = $11.20
(b) If the interest is compounded semi-annually then an interest of 12/2 = 6% is added on every 6 months
and, since there are two 6-month periods in a year,
S = $10(1.06)2 = $11.24
(c) If the interest is compounded quarterly then an interest of 12/4 = 3% is added on every 3 months and,
since there are four 3-month periods in a year,
S = $10(1.03)4 = $11.26
(d) If the interest is compounded monthly then an interest of 12/12 = 1% is added on every month and,
since there are 12 months in a year,
S = $10(1.01)12 = $11.27
(e) If the interest is compounded weekly then an interest of 12/52 = 0.23% is added on every week and,
since there are 52 weeks in a year,
S = $10(1.0023)52 = $11.27

In the above example we see that the future value rises as the frequency of compounding
rises. This is to be expected because the basic feature of compound interest is that we get ‘inter-
est on the interest’. However, one important observation that you might not have expected is
that, although the future values increase, they appear to be approaching a fixed value. It can be
shown that this always occurs. The type of compounding in which the interest is added on with
increasing frequency is called continuous compounding. In theory, we can find the future
value of a principal under continuous compounding using the approach taken in the previous
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200 Mathematics of Finance

example. We work with smaller and smaller time periods until the numbers settle down to a
fixed value. However, it turns out that there is a special formula that can be used to compute
this directly. The future value, S, of a principal, P, compounded continuously for t years at an
annual rate of r% is

S = Pert/100

where e is the number

2.718 281 828 459 045 235 36 (to 20 decimal places)
If r = 12, t = 1 and P = 10 then this formula gives

S = $10e12×1/100 = $10e0.12 = $11.27

which is in agreement with the limiting value obtained in the previous example.

Advice

The number e and the related natural logarithm function were first introduced in Section
2.4. If you missed this section out, you should go back and read through this work now
before proceeding. The link between the number e and the above formula for continuous
compounding is given in Practice Problem 23 at the end of this section. However, you may
prefer to accept it without justification and concentrate on the applications.

Example

A principal of $2000 is invested at 10% interest compounded continuously. After how many days will the
investment first exceed $2100?

Solution
We want to save a total of $2100 starting with an initial investment of $2000. The problem is to determine
the number of days required for this on the assumption that the interest rate is 10% compounded con-
tinuously. The formula for continuous compounding is
S = Pert/100
We are given that
S = 2100, P = 2000, r = 10
so we need to solve the equation
2100 = 2000e10t/100
for t. Dividing through by 2000 gives
1.05 = e0.1t
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3.2 • Compound interest 201

As explained in Section 2.4, equations such as this can be solved using natural logarithms. Recall that
if M = en then n = ln M
If we apply this definition to the equation
1.05 = e0.1t
with M = 1.05 and n = 0.1t then
0.1t = ln(1.05)
= 0.048 790 2
and so t = 0.488 to three decimal places.
The variable t which appears in the formula for continuous compounding is measured in years, so to
convert it to days we multiply by 365 (assuming that there are 365 days in a year). Hence
t = 365 × 0.488 = 178.1 days
We deduce that the amount invested first exceeds $2100 some time during the 179th day.

Practice Problems

4 (1) A principal, $30, is invested at 6% interest for 2 years. Determine the future value if the interest is
compounded

(a) annually (b) semi-annually (c) quarterly

(d) monthly (e) weekly (f) daily

(2) Use the formula

S = Pert/100
to determine the future value of $30 invested at 6% interest compounded continuously for
2 years. Confirm that it is in agreement with the results of part (1).
5 Determine the rate of interest required for a principal of $1000 to produce a future value of $4000
after 10 years compounded continuously.

Example EXCEL

A principal of $10 000 is invested at one of the following banks:

(a) Bank A offers 4.75% interest, compounded annually.
(b) Bank B offers 4.70% interest, compounded semi-annually.
(c) Bank C offers 4.65% interest, compounded quarterly.
(d) Bank D offers 4.6% interest, compounded continuously.
For each bank, tabulate the value of the investment at the end of every year, for the next 10 years. Which of
these banks would you recommend?

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202 Mathematics of Finance

Figure 3.2

Solution
In Figure 3.2 the numbers 0 to 10 have been entered in the first column, together with appropriate head-
ings. The initial investment is the same for each bank, so the value 10 000 is typed into cells B4 to E4.
For banks A, B and C, the future values can be worked out using the formula
n
10 000 AC 1 +
r D
100 F
for appropriate values of r and n.
(a) In Bank A, the interest rate is 4.75% compounded annually, so at the end of year 1, the investment is
10 000(1 + 0.0475)1
The reason for writing it to the power of 1 is so that when we enter it into Excel, and copy down the
first column, the power will automatically increase in accordance with the changing years. We type
=10000*(1+0.0475)^A5
in cell B5, and then click and drag down to cell B14.
(b) Bank B offers a return of 4.7% compounded semi-annually, so that at the end of year 1, the investment is
10 000(1 + 0.047/2)2×1
In general, after t years, the investment is
10 000(1 + 0.0475/2)2×t
so in Excel, we type
=10000*(1+0.0475/2)^(2*A5)
in cell C5, and copy down this column in the usual way.
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3.2 • Compound interest 203

Figure 3.3

(c) Bank C offers a return of 4.65% compounded quarterly, so we type

=10000*(1+0.0465/4)^(4*A5)
in cell D5, and copy down the column.
(d) Bank D offers a return of 4.6% compounded continuously, so after t years the future value is given by
10 000e4.6t/100 = 10 000e0.046t
The corresponding values are calculated in column E by typing
=10000*EXP(0.046*A5) in cell E5 and copying down the column.
The completed spreadsheet is shown in Figure 3.3. The amounts have been rounded to 2 decimal places
by highlighting cells B5 through to E14, and using the Decrease Decimal icon on the toolbar.
Figure 3.3 shows that there is very little to choose between these banks and that, in practice, other issues
(such as any conditions or penalties attached to future withdrawals from the account) may well influence
our recommendation. However, from a purely monetary point of view, we should advise the investor to put
the money into Bank B, as this offers the greatest return. Notice that Bank B is not the one with the highest
rate of interest. This example highlights the importance of taking into account the frequency of com-
pounding, as well as the actual rate of interest.

Given that there are so many ways of calculating compound interest, people often find it
difficult to appraise different investment opportunities. What is needed is a standard ‘bench-
mark’ that enables an individual to compare different forms of savings or credit schemes on an
equal basis. The one that is commonly used is annual compounding. All firms offering invest-
ment or loan facilities are required to provide the effective annual rate. This is often referred to
as the annual percentage rate, which is abbreviated to APR. The APR is the rate of interest
which, when compounded annually, produces the same yield as the nominal (that is, the
stated) rate of interest. The phrase ‘annual equivalent rate’ (AER) is frequently used when
applied to savings. However, in this book we shall use APR for both savings and loans.
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204 Mathematics of Finance

Example

Determine the annual percentage rate of interest of a deposit account that has a nominal rate of 8% com-
pounded monthly.

Solution
The APR is the overall rate of interest, which can be calculated using scale factors. If the account offers a
return of 8% compounded monthly then each month the interest is
8 2
= = 0.67%
12 3
of the amount invested at the beginning of that month. The monthly scale factor is
0.67
1+ = 1.0067
100
so in a whole year the principal gets multiplied by
(1.0067)12 = 1.0834
which can be written as
8.34
1+
100
so the APR is 8.34%.

Practice Problem

6 Determine the annual percentage rate of interest if the nominal rate is 12% compounded quarterly.

Although the aim of this chapter is to investigate the mathematics of finance, the mathem-
atical techniques themselves are more widely applicable. We conclude this section with two
examples to illustrate this.

Example

A country’s annual GNP (gross national product), currently at $25 000 million, is predicted to grow by 3.5%
each year. The population is expected to increase by 2% a year from its current level of 40 million. After how
many years will GNP per capita (that is, GNP per head of population) reach $700?

Solution
The per capita value of GNP is worked out by dividing GNP by the size of the population. Initially, this is
25 000 000 000
= $625
40 000 000
During the next few years, GNP is forecast to grow at a faster rate than the population so this value will
increase.
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3.2 • Compound interest 205

The scale factor associated with a 3.5% increase is 1.035, so after n years GNP (in millions of dollars) will be
GNP = 25 000 × (1.035)n
Similarly, the population (also in millions) will be
population = 40 × (1.02)n
Hence GNP per capita is
25 000 × (1.035)n 25 000 (1.035)n
n
= 625 × AC
1.035 D
= ×
40 × (1.02)n 40 (1.02)n 1.02 F
We want to find the number of years required for this to reach 700, so we need to solve the equation
n
625 × AC
1.035 D
= 700
1.02 F
for n. Dividing both sides by 625 gives
n
A 1.035 D = 1.12
C 1.02 F
and after taking logs of both sides we get
n
log AC
1.035 D
= log(1.12)
1.02 F

n log AC
1.035 D
= log(1.12) (rule 3 of logs)
1.02 F
so that
log(1.12)
n= = 7.76
log(1.035/1.02)
We deduce that the target figure of $700 per capita will be achieved after 8 years.

Example

A firm decides to increase output at a constant rate from its current level of 50 000 to 60 000 during the next
5 years. Calculate the annual rate of increase required to achieve this growth.

Solution
r
If the rate of increase is r% then the scale factor is 1 + so after 5 years, output will be
100
5
50 000 AC 1 +
r D
100 F
To achieve a final output of 60 000, the value of r is chosen to satisfy the equation
5
50 000 AC 1 +
r D
= 60 000
100 F
Dividing both sides by 50 000 gives
5
A 1 + r D = 1.2
C 100 F 
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206 Mathematics of Finance

The difficulty in solving this equation is that the unknown, r, is trapped inside the brackets, which are raised
to the power of 5. This is analogous to the problem of solving an equation such as
x2 = 5.23
which we would solve by taking square roots of both sides to find x. This suggests that we can find r by
taking fifth roots of both sides of
5
A 1 + r D = 1.2
C 100 F
to get
r
1+ = (1.2)1/ 5 = 1.037
100
Hence r = 3.7%.

Practice Problem

7 The turnover of a leading supermarket chain, A, is currently $560 million and is expected to increase
at a constant rate of 1.5% a year. Its nearest rival, supermarket B, has a current turnover of $480 mil-
lion and plans to increase this at a constant rate of 3.4% a year. After how many years will supermar-
ket B overtake supermarket A?

Key Terms

Annual percentage rate The equivalent annual interest paid for a loan, taking into
account the compounding over a variety of time periods.
Compound interest The interest which is added on to the initial investment, so that this
will itself gain interest in subsequent time periods.
Continuous compounding The limiting value when interest is compounded with ever-
increasing frequency.
Future value The final value of an investment after one or more time periods.
Principal The value of the original sum invested.
Simple interest The interest which is paid direct to the investor instead of being added to
the original amount.

Practice Problems

8 A bank offers a return of 7% interest compounded annually. Find the future value of a principal of
$4500 after 6 years. What is the overall percentage rise over this period?
9 Find the future value of $20 000 in 2 years’ time if compounded quarterly at 8% interest.
10 Midwest Bank offers a return of 5% compounded annually for each and every year. The rival BFB
offers a return of 3% for the first year and 7% in the second and subsequent years (both compounded
annually). Which bank would you choose to invest in if you decided to invest a principal for (a) 2 years;
(b) 3 years?
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3.2 • Compound interest 207

11 The value of an asset, currently priced at $100 000, is expected to increase by 20% a year.
(a) Find its value in 10 years’ time.
(b) After how many years will it be worth $1 million?
12 How long will it take for a sum of money to double if it is invested at 5% interest compounded
annually?
13 A piece of machinery depreciates in value by 5% a year. Determine its value in 3 years’ time if its
current value is $50 000.
14 A principal, $7000, is invested at 9% interest for 8 years. Determine its future value if the interest is
compounded
(a) annually (b) semi-annually (c) monthly (d) continuously
15 A car depreciates by 40% in the first year, 30% in the second year and 20% thereafter. I buy a car
for $14 700 when it is 2 years old.
(a) How much did it cost when new?
(b) After how many years will it be worth less than 25% of the amount that I paid for it?
16 Find the future value of $100 compounded continuously at an annual rate of 6% for 12 years.
17 How long will it take for a sum of money to triple in value if invested at an annual rate of 3% com-
pounded continuously?
18 If a piece of machinery depreciates continuously at an annual rate of 4%, how many years will it take
for the value of the machinery to halve?
19 A department store has its own credit card facilities, for which it charges interest at a rate of 2% each
month. Explain briefly why this is not the same as an annual rate of 24%. What is the annual
percentage rate?
20 Determine the APR if the nominal rate is 7% compounded continuously.
21 Current annual consumption of energy is 78 billion units and this is expected to rise at a fixed rate of
5.8% each year. The capacity of the industry to supply energy is currently 104 billion units.
(a) Assuming that the supply remains steady, after how many years will demand exceed supply?
(b) What constant rate of growth of energy production would be needed to satisfy demand for the
next 50 years?
22 The population of a country is currently at 56 million and is forecast to rise by 3.7% each year. It is
capable of producing 2500 million units of food each year, and it is estimated that each member of
the population requires a minimum of 65 units of food each year. At the moment, the extra food
needed to satisfy this requirement is imported, but the government decides to increase food produc-
tion at a constant rate each year, with the aim of making the country self-sufficient after 10 years.
Find the annual rate of growth required to achieve this.
23 If a principal, P, is invested at r% interest compounded annually then its future value, S, after n years
is given by
n
S = P AC 1 +
r D
100 F
(a) Use this formula to show that if an interest rate of r% is compounded k times a year then after
t years
kt
S = P AC 1 +
r D
100k F 
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208 Mathematics of Finance

(b) Show that if m = 100k/r then the formula in part (1) can be written as
m rt /100
S = P AC AC 1 + DF DF
1
m
(c) Use the definition
m
lim AC 1 + D
1
e = m→∞
mF
to deduce that if the interest is compounded with ever-increasing frequency (that is, continu-
ously) then
S = Pert/100
24 (Excel) The sum of $100 is invested at 12% interest for 20 years. Tabulate the value of the invest-
ment at the end of each year, if the interest is compounded
(a) annually (b) quarterly (c) monthly (d) continuously
Draw graphs of these values on the same diagram. Comment briefly on any similarities and differ-
ences between these graphs.
25 (Excel) A department store charges interest on any outstanding debt at the end of each month. It
decides to produce a simple table of APRs for its customers, based on a variety of monthly rates. Use
a spreadsheet to produce such a table for monthly interest rates of 0.5%, 0.6%, 0.7%, . . . , 3%. Plot
a graph of APR against monthly rate and comment briefly on its basic shape.