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SECTION 2.1 Fundamental Compound Interest Formula

If the interest due is added to the principal at the end of each interest period and thereafter earns interest, the
interest is said to be compounded. The sum of the original principal and total interest is called the compound
amount or accumulated value or future value. The difference between the accumulated value and the original
principal is called the compound interest. The time between two successive interest computations is called the
interest period, compounding period, or conversion period. This time period need not be a year. Many of you
will already be familiar with situations where interest is “payable quarterly,” or “compounded semi-annually” or
“convertible monthly.”

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EXAMPLE 1Determine the compound interest earned on $1000 for 2 years at 6% compounded semi-annually
and compare it with the simple interest earned on $1000 for 2 years at 6% per annum.

SolutionSince the compounding period is 6 months, interest is earned at the rate of 3% per period, and there are
4 interest periods in 2 years.

The compound interest earned on $1000 for 2 years at 6% compounded semi-annually is $125.51, whereas the
simple interest on $1000 for 2 years at 6% is I = $1000 × 0.06 × 2 = $120. The extra $5.51 is due to the
compounding of interest.

In this section the following notation will be used:

Note 1:Commonly used frequencies of compounding are m = 1 for annual compounding, m = 2 for semi-annual
compounding, m = 4 for quarterly compounding, m = 12 for monthly compounding, m = 52 for weekly
compounding, and m = 365 for daily compounding (leap year or not). Continuous compounding that uses
compounding intervals shorter than one day is covered in section 2.10.

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Note 2:The rate i equals and is always used in the compound interest calculation. For example, j12 = 9%
means that a yearly rate of 9% is compounded (converted, payable) 12 times per year and that
is the interest rate per month.

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Let P represent the principal at the beginning of the first interest period and i the interest rate per compounding
period. We shall calculate the accumulated values at the ends of the successive interest periods for n periods.

Continuing in this manner for n periods the accumulated value S at the end of n periods is given by the
fundamental compound interest formula.

(7)

The factor (1 + i)n is called the accumulation factor or the accumulated value of $1. The process of
calculating S from P is called accumulation. To obtain the accumulated value S of P for n periods at rate i, we
multiply P by the corresponding accumulation factor (1 + i)n.

EXAMPLE 2Accumulate $10 000 at j12 = 6% for a) 5 years; b) 25 years.

Solution aWe have P = 10 000, i = 0.06/12 = 0.005 per month, n = 5 years × 12 = 60 months, and calculate:

The compound interest on $10 000 at j12 = 6% for 5 years is $3488.50.

Solution bWe have P = 10 000, i = 0.005 per month, n = 25 × 12 = 300 months, and calculate:

The compound interest on $10 000 at j12 = 12% for 25 years is $34 649.70, which is almost 3.5 times the
original investment. If the $10 000 had been invested at 6% simple interest (r = 0.06 and t = 25 years), the
interest earned would have been only $10 000(0.06)(25) = $15 000. This illustrates the power of compound
interest over a long period of time.

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If we graph the accumulated values of $10 000 at 6% simple interest and 6% compounded monthly over a 25-
year period, we can see that money grows on a straight-line (linear) basis under simple interest, but grows
exponentially under compound interest.

CALCULATION TIP:

It is assumed that students will be using pocket calculators equipped with the functions yx and log x to solve the
problems in Mathematics of Finance. In the examples in this textbook, we have used all digits of the factors
provided by a pocket calculator and rounded off to the nearest cent only in the final answer.

The table and graph below show the effect of time and rate on the growth of money at compound interest.

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Using a Computer Spreadsheet

A computer spreadsheet is tailor made for many of the financial calculations that will be studied in this textbook.
There are several spreadsheets available (such as Excel, Calligra Sheets, Corel Quattro Pro, Mariner Calc,
ZCubes, Gnumeric, and Numbers) and all can generate the required calculations very well. In this text, we will
present Excel spreadsheets.

We will illustrate the formulas needed to perform the calculations of Example 2 on a spreadsheet. The entries in
an Excel spreadsheet are summarized below. It is assumed that the initial investment, $10 000, is entered in cell
B11 (typed in as 10 000, no commas or dollar sign).

In A2 to A9, type 5, 10, 15, 20, 25, 30, 35, and 40. In B2, we need to type the formula that will accumulate the
initial investment (given in B11) to the end of 5 years at the given interest rate. Remember that the given interest
rate needs to be divided by 12 (to obtain the monthly rate) and the exponent must be multiplied by 12 (to give
the term in months). In B2 we type,

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To generate the rest of the values, copy B2 into C2 to E2 and then copy into B3 to E9.

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Note that dollar signs before and after a letter ($B$11) mean the value in that cell will not change when you
copy the formula. A dollar sign after the letter (B$1) means the value in that cell will change when you copy
across a row, but not when you copy down a column. A dollar sign before the letter ($A2) means the value in
that cell will change when you copy down a column, but not when you copy across a row.

A copy of the resulting spreadsheet is given below.

EXAMPLE 3A person deposits $1000 into a savings account that earns interest at 4.25% compounded semi-
annually. How much interest will be earned: a) during the first year? b) during the second year? c) during the
tenth year?

Solution aWe have P = 1000, per half-year, n = 2 and calculate the accumulated value at the
end of 1 year

The compound interest earned during the first year is $42.95.

Solution bWe calculate the accumulated value at the end of 2 years

The compound interest earned during the second year is

Solution c

CALCULATION TIP:

When using the fundamental compound interest formula (7) in calculations, do not round off the value of i. Use
all digits provided by your calculator.
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EXAMPLE 4Juliana invests $3500 in a fund that pays interest at j4 = 5%. How much has been accumulated in
the fund a) at the end of 33 months; b) at the end of six and a half years?

Solution aWe have P = 3500, i = 0.05/4 = 0.0125 per quarter year. To calculate n, we observe that 33 months is
equal to years. Thus, n = 2.75 × 4 = 11 quarterly interest periods. We then calculate:

Solution bWe have P = 3500, i = 0.0125, n = 6.5 × 4 = 26 and we calculate

OBSERVATION:

For interest rates that are compounded quarterly, m = 4. Sometimes m = 3 is mistakenly used, because one
quarter of a year equals 3 months. But m represents the number of interest periods per year (which is 4), not the
number of months in the interest period.

EXAMPLE 5Gustav opens a savings account by depositing $5000 on May 17. The account pays interest at 4%
per annum. How much is in the account on December 31 if

1. the interest is compounded daily?

2. the interest is calculated daily and paid into the account at the end of each month?

Solution aWe have P = 5000, i = 0.04/365 per day, n = 365 − 137 = 228 days (Note: Gustav would not earn any
interest on his $5000 on the first day, May 17, but would earn one day's worth of interest on December 31), and
we calculate:

Total interest earned during the year is

Solution bMost daily interest savings accounts calculate interest on the minimum daily balance using simple
interest (in this case, r = 0.04), with the interest added to the account at the end of each month.

Total interest earned during the year = $126.30.

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Note how the account with interest compounded daily earns more interest during the year than the account with
interest calculated daily, but credited monthly.

EXERCISE 2.1
Part A

Problems 1 to 8 make use of the following table. In each case calculate the accumulated value and the compound
interest earned.

Answers Answers Answers Answers

9. Accumulate $500 for one year at a) j12 = 4%, b) j12 = 8%, c) j12 = 12%.

Answers

10. How much money will be required on December 31, 2016, to repay a loan of $2000 made December 31,
2013, if j4 = 7%?

11. Determine the accumulated value of $100 over 5 years at an 8% nominal rate compounded: a) annually; b)
semi-annually; c) quarterly; d) monthly; e) daily.

Answers

12. Parents put $1000 into a savings account at the birth of their daughter. If the account earns interest at 6%
compounded monthly, how much money will be in the account when their daughter is 18 years old?

13. In 1492, Queen Isabella sponsored Christopher Columbus' journey by giving him $10 000. If she had
placed this money in a bank account at j1 = 3%, how much money would be in the account in 2014? If the
bank account earned a simple interest rate of 3%, how much money would be in the account in 2014?

Answers

14. Determine the accumulated value of $1000 at the end of 1 year at a) j1 = 6.136%; b) j2 = 6.045%; c) j4 =
6%; d) j12 = 5.970%.

15. Ying deposited $8000 into a GIC (guaranteed investment certificate) that paid interest at j2 = 3.5% for 5
years. At the end of 5 years, she reinvested the accumulated amount into another 5-year GIC that paid
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interest at j2 = 4%. How much interest did she earn on her investment in the 6th year?

Answers

Part B

1. Melinda has a savings account that earns interest at 6% per annum. She opened her account with $1000 on
December 31. How much interest will she earn during the first year if

1. the interest is compounded daily;

2. the interest is calculated daily and paid into the account on June 30 and December 31;

3. the interest is calculated daily and paid into the account at the end of each month?

Answers

2. Using a computer spreadsheet, set up a table and plot the graph showing the growth of $1000 at compound
interest rates j365 = 4%, 7%, 10% and time = 5, 10, 15, 20, and 25 years.

3. Determine the compound interest earned on an investment of $10 000 for 10 years at a nominal rate of
5.4% compounded with frequencies m = 1, 2, 4, 12, 52, and 365.

Answers

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