Chapter 2:

Compound Interest and Compound Discount

Selim MANKAÏ
Université d’Auvergne
Semester 2, 2019

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 Learning objectives

- Compare simple interest with compound interest

- Calculate the compound amount and interest
- Explain and compute the effective rate
- Apply compound interest to financial operations

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 Simple Interest

The formula for simple interest:

I = P×r×t

Where,
I is the interest earned;
P is the principal or the amount invested;
r is the interest rate;
t is the time in years.

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 Compound Interest

Compound interest is interest calculated on the initial

principal and also on the accumulated interest of previous
periods of a deposit or loan.

Compound interest can be thought of as “interest on

interest”.

Compound interest is generally used for financial

operations with a duration greater than one year.

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 Getting to Compound Interest

Suppose we have an account where the interest is added

in each year and then that money also earns interest. This is
called compound interest.

1st year: A(1) = P(1+rt) The A(1) denotes the amount

after 1 year, etc…

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 Getting to Compound Interest

Suppose we have an account where the interest is added

in each year and then that money also earns interest. This is
called compound interest.

1st year: A(1) = P(1+rt) The A(1) denotes the

amount after 1 year, etc…

2nd year: A(2) = A(1) (1+rt) But A(1) = P(1+rt), so

A(2) = P(1+rt) (1+rt)
A(2) = P(1+rt)²

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 Getting to Compound Interest
Suppose we have an account where the interest is added in
each year and then that money also earns interest. This is called
compound interest.

1st year: A(1) = P(1+rt) The A(1) denotes the amount

after 1 year, etc…

2nd year: A(2) = A(1) (1+rt) But A(1) = P(1+rt), so

A(2) = P(1+rt) (1+rt)
A(2) = P(1+rt)²

3rd year: A(3) = A(2) (1+rt)

A(3) = P(1+rt)² (1+rt)
A(3) = P(1+rt)³

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 Compound interest formula

Vn  V0 (1  i) n

V0 = principal amount (the initial amount you borrow or deposit)

i = annual rate of interest (as a decimal)
n = number of years the amount is deposited or borrowed for.
Vn = amount of money accumulated after n years, including
interest.

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 Example 1

Bill deposited $ 100 in a savings account at an interest rate

of 4% per annum, compounded annually.

Determine the amount of money accumulated after one

year and six months.
Determine the amount of money accumulated after three
years.

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 Example 1

Bill deposited $ 100 in a savings account at an interest rate

of 4% per annum, compounded annually.

The amount of money accumulated after one year and six

months :

V1,5  100  (1  0.04)1,5  106.05

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 Example 1

Bill deposited $ 100 in a savings account at an interest rate

of 4% per annum, compounded annually.

The amount of money accumulated after one year and six

months :

V1,5  100  (1  0.04)1,5  106.05

The amount of money accumulated after three years :

V3  100  (1  0.04)3  112.49

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 Example 2

You make a deposit of $ 15000 in a savings account at an

interest rate of 4% per annum, compounded annually.
Let’s V1 the amount of money accumulated after 1 years,
V2 the amount of money accumulated after 2 years,
Vn the amount of money accumulated after n years,

Determine V1, V2 and V3

What is the nature of the progression Vi?
What are the common ratio and the first term?

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Example 2

V1  V0 (1  i)  15000(1  4%)  15600

V2  V0 (1  i)2  15000(1  4%)2  16224

V3  V0 (1  i)3  15000(1  4%)3  16872.9

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Example 2

V1  V0 (1  i)  15000(1  4%)  15600

V2  V0 (1  i)2  15000(1  4%)2  16224

V3  V0 (1  i)3  15000(1  4%)3  16872.9

The set of values represent a geometric progression.

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Example 2

V1  V0 (1  i)  15000(1  4%)  15600

V2  V0 (1  i)2  15000(1  4%)2  16224

V3  V0 (1  i)3  15000(1  4%)3  16872.9

The set of values represent a geometric progression.

The first term is 15000 and the common ratio is 1.04

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 Computing interest

The amount of the interest acquired after n periods is the

difference between the amount money accumulated after n
years and the initial capital:

Interest[0:n )  Vn  V0

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Example

Interpret the following amounts :

V1  V0  ;
V2  V0  ;
V2  V1 

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Example

Interpret the following amounts :

V1  V0  : Interest earned in the first year

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Example

Interpret the following amounts :

V1  V0  : Interest earned in the first year

V2  V0  : Interest earned in the first two years

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Example

Interpret the following amounts :

V1  V0  : Interest earned in the first year

V2  V0  : Interest earned in the first two years

V2  V1  : Interest earned in the second year

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 Future value

The value of an asset or cash at a specified date in the

future that is equivalent in value to a specified sum today.

Vn  V0 (1  i) n

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Example

Use the compound interest formula to find how much

$5,000 will grow to in 50 years at 8% annual compound
interest.

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Example

Use the compound interest formula to find how much

$5,000 will grow to in 50 years at 8% annual compound
interest.

FV = PV(1 + i)n
FV = $5,000(1 + 0.08)50
FV = $5,000(46.9016125132)
FV = $234,508.06

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Accumulation factors

Both simple and compound rate give the same interest for
the first period (year). Beyond the first year, interests are
higher when using a compound rate.

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Compound interest vs simple interest

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 Discounting and Present value

Discounting is the process of finding the present value of

an amount of cash at some future date.
By the present value we mean the principal V0 that must
be invested now in order to achieve a desired accumulated
value Vn over a specified period of time.

Vn
V0 
1  i 
n

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Example

How much money should I deposit today into an account

earning 7.375% annually compounded interest in order to
have $2,000 in the account 5 years from now?

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 Example

Before beginning with the formula, it is important to

notice that in this case the $2,000 is the FV, not the PV.

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 Solving for the Unknown Time

If any three of the four basic quantities: principal(s),

investment period length(s), interest rate(s), accumulated
value(s) are given, then the fourth can be determined.

Let’s consider the situation in which the length of the

investment period is the unknown.

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 Example

Find the length of time (in years) necessary for $12,000 to

accumulate to $17,631.94 if invested with 8% interest rate
of 8% compounded annually?

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 Example

Find the length of time (in years) necessary for $12,000 to

accumulate to $17,631.94 if invested with 8% interest rate
of 8% compounded annually?

M  P (1  i ) n
$17, 631.94  $12, 000(1  8%) n
17631.94
 1.469328  (1.08) n
12000

ln(1.469328)  ln(1.08) n
ln(1.469328)
n 5
ln(1.08)

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 Solving for the Unknown Interest Rate

Given an investment of $13200, compound amount of

$22680.06 invested for 8 years, what is the interest rate if
interest is compounded annually?

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 Solving for the Unknown Interest Rate

Given an investment of $13200, compound amount of

$22680.06 invested for 8 years, what is the interest rate if
interest is compounded annually?

V8  P (1  i ) n
22680.06  13200(1  i )8
22680.06
 1.71818  (1  i )8
13200

i  8 1.71818  1  6.95%

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 Nominal Rates of Interest and Discount

Effective "rate of interest” refers to a situation when

interest is paid once per measurement period (1 year),
either at the end of the period( in the case of interest rate)
or at the beginning of the period(in the case of discount
rate).

When interest is paid more than once per measurement

period. Rates of interest in these cases are called nominal.

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 Nominal Rates of Interest

A nominal rate of interest im payable m times per period,

where m, a positive integer, is the periodic interest rate
multiplied by the number of periods per year.

The yearly nominal rate is meaningless until we specify the

frequency of conversion m.

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 Example 1
The table below illustrates the effect of the frequency of
conversion on the amount to which $10 000 will accumulate
in 10 years at a nominal rate of 8% compounded with
frequencies in = 1, 2, 4, 12, and 365.

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 Example 1
The table below illustrates the effect of the frequency of
conversion on the amount to which $10 000 will accumulate
in 10 years at a nominal rate of 8% compounded with
frequencies in = 1, 2, 4, 12, and 365.

For m=2
Nominal rate convertible semi-annually i2 : 8%
Rate per period : (i2 /2)=4%
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 Example 2
Find the accumulated value of $3,000 to be paid at the end
of 8 years with a rate of compound interest of 5%:
(a) per annum;
(b) convertible quarterly;
(c) convertible monthly.

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 Example 2
Find the accumulated value of $3,000 to be paid at the end
of 8 years with a rate of compound interest of 5%:
(a) per annum;
(b) convertible quarterly;
(c) convertible monthly.

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Equivalent rates

Two rates of interest are said to be equivalent if a given

amount of principal invested over the same period of time
at each of the rates produces the same accumulated value.

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Equivalent rates

If i denotes the annual effective rate of interest per one

measurement period equivalent to im then :

m
 im 
1  i   1  
 m

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Example

(a) Find the annual effective interest rate i which is

equivalent to a rate of 8% convertible quarterly.
(b) Find the nominal interest rate i2 which is equivalent to
an annual effective interest rate of 8%.
(c) Find the nominal interest rate i4 which is equivalent to
a nominal rate of 8% convertible semi-annually.

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Example

Compound

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Continuous Compounded Interest (δ)

What would happen if we let the frequency of

compounding get very large. That is we would compound
not just every hour, or every minute or every second but
for every millisecond.
The continuous compounded interest (δ) can be defined
as:

  lim im
m 

  ln(1  i )

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 Continuous Compounded Interest (δ)

 
m

.

1  i   mlim  1 

 m

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 Continuous Compounded Interest (δ)

 
m

.

1  i   mlim  1 

 m
   
m
 
ln 1  i   lim ln 1    lim  m  ln 1   
m 
 m m 
  m 

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 Continuous Compounded Interest (δ)

 
m

.

1  i   mlim  1 

 m
   
m
 
ln 1  i   lim ln 1    lim  m  ln 1   
m 
 m m 
  m 
 m   
 lim   ln 1   
m 
   m 

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 Continuous Compounded Interest (δ)

 
m

.

1  i   mlim  1 

 m
   
m
 
ln 1  i   lim ln 1    lim  m  ln 1   
m 
 m m 
  m 
 m   
 lim   ln 1   
m 
   m 

   
 ln 1  m  
  lim     
m 
  
 m  48
 Continuous Compounded Interest (δ)

 
m

.

1  i   mlim  1 

 m
   
m
 
ln 1  i   lim ln 1    lim  m  ln 1   
m 
 m m 
  m 
 m   
 lim   ln 1   
m 
   m 

   
 ln 1  m  
  lim     
m 
  
 m  49
Example

Given the nominal interest rate of 12%, compounded

monthly.
Find the Continuous Compounded Interest (δ)

50
 Exemple

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