Building Investment Formulas:

Working with interest rates (Understanding Compounding Interest; Nominal Vs Effective

The interest rate is the mechanism that transforms a present value into a future value…. (Or,
operating as a discount rate, it’s what transforms a future value into a present value.) Therefore,
when working with financial formulas, it’s important to know how to work with interest rates …
and to be comfortable with certain terminology.The next sections show you a few interest rate
techniques you should know.

ii) Understanding Compound Interest

An interest rate is described as simple if it pays the same amount each period. For example, if
you have $1,000 in an investment that pays a simple interest rate of 10% per year, you’ll receive
$100 each year.

Suppose, however, that you were able to add the interest payments to the investment. At the end
of the first year, you would have $1,100 in the account, which means you would earn $110 in
interest (10% of $1,100) the second year. Being able to add interest earned to an investment is
calledcompounding, and the total interest earned (the normal interest plus the extra interest on
the reinvested interest—the extra $10, in the example) is called compound interest.

iii) Nominal Versus Effective Interest

Interest can also be compounded within the year. For example, suppose that your $1,000
investment earns 10% compounded semiannually. At the end of the first six months, you receive
$50 in interest (5% of the original investment). This $50 is reinvested, and for the second half of
the year, you earn 5% of $1,050, or $52.50. Therefore, the total interest earned in the first year is
$102.50. In other words, the interest rate appears to actually be 10.25%. So which is the correct
interest rate, 10% or 10.25%?
To answer that question, you need to know about the two ways that most interest rates are most
often quoted:

 The nominal rate: This is the annual rate before compounding (the 10% rate, in the example).
The nominal rate is always quoted along with the compounding frequency for example, 10%
compoundedd semiannually.

Note that the nominal annual interest rate is often shortened to APR ( the annual percentage
rate).

The effective rate: This is the annual rate that an investment actually earns in the year after the
compounding is applied (the 10.25%, in the example).

In other words, both rates are “correct,” except that, with the nominal rate, you also need to
know the compounding frequency. If you know the nominal rate and the number of
compounding periods per year (for example, semiannually means 2 compounding periods per
year, and monthly means 12 compounding periods per year), you get the effective rate per
period by dividing the nominal rate by the number of periods:

= Nominal_rate/ npery

Here, npery is the number of compounding periods per year. To convert the nominal annual rate
into the effective annual rate, you use the following formula:

Effective annual rate = (1 + nominal_rate / npery) npery – 1

Conversely, if you know the effective rate per period, you can derive the nominal rate by
multiplying the effective rate by the number of periods:

Nominal rate =effective_rate * npery

To convert the effective annual rate to the nominal annual rate, you use the following
formularNominal annual rate:=npery * (effective_rate + 1) ^ (1 / npery) - npery
Fortunately, the next section shows you two functions that can handle the conversion between
the nominal and effective annual rates for you.

Converting Between the Nominal Rate and the Effective Rate

To convert a nominal annual interest rate to the effective annual rate, use the 

EFFECT() function:

EFFECT(nominal_rate, npery)

For example, the following formula returns the effective annual interest rate for an
investment with a nominal annual rate of 10% that compounds semiannually:

=EFFECT(0.1, 2) = 10.25%

Figure 19.1 shows a worksheet that applies the EFFECT() function to a 10% nominal annual

Figure 19.1 The formulas in column D use the EFFECT() function to convert the nominal rates
in column C to effective rates based on the compounding periods in column B.
If you already know the effective annual interest rate and the number of compounding periods,
you can convert the rate to the nominal annual interest rate by using the 

NOMINAL() function:

NOMINAL (effect_rate, npery)

For example, the following formula returns the nominal annual interest rate for an investment
with an effective annual rate of 10.52% that compounds daily:

=NOMINAL(0.1052, 365) = 10 %

iv) Calculating the Future Value of an investment

Just as the payment is usually the most important value for a loan calculation, the future value
is usually the most important value for an investment calculation. After all, the purpose of an
investment is to place a sum of money (the present value) in some instrument for a time, after
which you end up with some new (and hopefully greater) amount: the future value.

To calculate the future value of an investment, Excel offers the FV() function:

FV (rate, nper[, pmt][, pv][,  type])
 v) The Future Value of a Lump Sum

In the simplest future value scenario, you invest a lump sum and let it grow according to the
specified interest rate and term, without adding any deposits along the way. In this case, you use
the FV() function with the pmt argument set to 0:

FV(rate, nper, 0, pv, type)

For example, Figure 19.2 shows the future value of $10,000 invested at 5% over 10 years.

The Future Value of a Series of Deposits

Another common investment scenario is to make a series of deposits over the term of the
investment, without depositing an initial sum. In this case, you use the FV() function with
the  pv argument set to 0:

FV(rate, nper, pmt, 0, type)
 For example, Figure 19.3 shows the future value of $100 invested each month at 5% over 10
years. Notice that the interest rate and term are both converted to monthly amounts because the
deposit occurs monthly.

The Future Value of a Lump Sum Plus Deposits

For best investment results, you should invest an initial amount and then add to it with regular
deposits. In this scenario, you need to specify all the FV() function arguments (except type). For
example, Figure 19.4 shows the future value of an investment with a $10,000 initial deposit and
$100 monthly deposits at 5% over 10 years.
Working Toward an Investment Goal

Instead of just seeing where an investment will end up, it’s often desirable to have a specific
monetary goal in mind and then ask yourself, “What will it take to get me there?”

Answering this question means solving for one of the four main future value parameters—
interest rate, number of periods, regular deposit, and initial deposit—while holding the other
parameters (and, of course, your future value goal) constant. The next four sections take you
through this process.

Calculating the Required Interest Rate

Say that you know the future value that you want, when you want it, and the initial deposit and
periodic deposits you can afford. What interest rate do you require to meet your goal? You
answer this question by using the RATE() function, which you first encountered in Chapter 18.
Here’s the syntax for that function from the point of view of an investment:
 RATE(nper, pmt, pv, fv[, type][, guess])

For example, if you need $100,000 10 years from now, you are starting with $10,000, and you
can deposit $500 per month. What interest rate is required to meet your goal? Figure 19.5 shows
a worksheet that comes up with the answer: 6%.

Calculating the Required Number of Periods

Given your investment goal, if you have an initial deposit and an amount that you can afford to
deposit periodically, how long will it take to reach your goal at the prevailing market interest
rate? You answer this question by using the NPER() function (which was introduced in Chapter
18). Here’s the NPER() syntax from the point of view of an investment:
 NPER(rate, pmt, pv, fv[, type])

For example, suppose that you want to retire with $1,000,000. You have $50,000 to invest, you
can afford to deposit $1,000 per month, and you expect to earn 5% interest. How long will it take
to reach your goal? The worksheet in Figure 19.6 answers this question: 349.4 months, or 29.1
years.
Calculating the Required Regular Deposit

Suppose that you want to reach your future value goal by a certain date and that you have an
initial amount to invest. Given current interest rates, how much extra do you have to periodically
deposit into the investment to achieve your goal? The answer here lies in the PMT() function
fromChapter 18. Here are the PMT() function details from the point of view of an investment:

PMT(rate, nper, pv, fv[, type])

For example, suppose you want to end up with $50,000 in 15 years to finance your child’s
college education. If you have no initial deposit and you expect to get 7.5% interest over the term
of the investment, how much do you need to deposit each month to reach your target? Figure
19.7shows a worksheet that calculates the result using PMT(): $151.01 per month.
 Calculating the Required Initial Deposit

For the final standard future value calculation, suppose that you know when you want to reach
your goal, how much you can deposit each period, and how much the interest rate will be. What,
then, do you need to deposit initially to achieve your future value target? To find the answer, you
use the PV() function. Here are the PV() function details from the point of view of an
investment:PV(rate, nper, pmt, fv[, type])

For example, suppose your goal is to end up with $100,000 in three years to purchase new
equipment. If you expect to earn 6% interest and can deposit $2,000 monthly, what does your
initial deposit have to be to make your goal? The worksheet in Figure 19.8 uses PV() to calculate
the answer: $17,822.46.
 Calculating the Future Value with Varying Interest Rates

All the future value examples that you’ve worked with so far have assumed that the interest rate
remained constant over the term of the investment. This will always be true for fixed-rate
investments, but for other investments, such as mutual funds, stocks, and bonds, using a fixed
rate of interest is, at best, a guess about what the average rate will be over the term.

For investments that offer a variable rate over the term, or when the rate fluctuates over the
term, Excel offers the FVSCHEDULE() function, which returns the future value of some initial
amount, given a schedule of interest rates:

FVSCHEDULE(principal, schedule)

For example, the following formula returns the future value of an initial $10,000 deposit that
makes 5%, 6%, and 7% over three years:

=FVSCHEDULE(10000, {0.05, 0.06, 0.07})

Similarly, Figure 19.9 shows a worksheet that calculates the future value of an initial deposit of
$100,000 into an investment that earns 5%, 5.5%, 6%, 7%, and 6% over five years.