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BAEL

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13 views2 pages

BAEL

Uploaded by

bugaspearl0
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Example: The Power of Compounding

What if you could invest your $5,000 at As a result of compounding, an amount


an interest rate of 9% instead of 4%? of savings can grow substantially. Exhibit
Assuming a period of twenty years (like in 3.1 illustrates how a deposit of $1,000
the previous example), the future value grows over time. Notice that your initial
(FV ) will be: $1,000 deposit almost doubles in seven
years when considering the compoun-
Present Value (PV) = $5,000.00
ding effect (you earn interest on your
Interest Rate (i) = 9% (0.09)
initial deposit and on any interest that
Time period (n)= 20 years
has already accumulated).
FV = PV (1 + i)ⁿ
= 5,000 (1 + 0.09)²⁰ With the assumed interest rate of 10%, it
= 5,000 (1.09)²⁰ would take ten years for your deposit to
= 5,000 (5.6044) double if you only earned interest on the
FV = 28,022.00 initial deposit and not on the
accumulated interest as well.
Thus, your $5,000 will be worth $28,020 in
20 years if you can earn 9% interest, Exhibit 3.1 How an Initial Deposit of $1,000
versus only $10,955 in 20 years if you only Grows Over Time Due to Compounding
earn 4% interest. This comparison (assume annual interest rate = 10%)
illustrates the benefit of investing your
money at a higher interest rate.

More example:
Luis wants to know how much he will
have available to spend on his trip to
Belize in three years if he deposits $3,000
today at an annual interest rate of 2%
FV = PV (1 + i)ⁿ
= 3,000 (1 + 0.02)³
= 3,000 (1.02)³
Future Value of Debt
= 3,000 (1.0612)
Just as compounding can expand your
FV = 3,183.60
savings, it can also expand your debt.
Compounded Period For example, if you had debt today of
Example: $1,000 and were charged 10% on the debt
You deposit $1,500 in a bank account with per year, and you did not pay off any of
an annual interest rate of 4%, com- your debt, Notice how the debt would
pounded quarterly. How much will you grow because you would pay interest not
have after 5 years? only on your initial debt amount but also
on the interest that accumulates over
Present Value (PV) = $1,500
time.
Interest Rate (i) = 4%
Time Period (t)= 5 years Deferring Student Loan Debt
Compounded Period (n) = 4 Students who obtain student loans to
fund their education sometimes have
FV = PV (1 + i/n)ⁿˣᵗ
difficulty paying off their loans after they
= 1,500 (1 + 0.04/4)⁴ˣ⁵
graduate, especially when they are
= 1,500 (1.01)²⁰
allowed to defer (postpone) making any
= 1,500 (1.2202)
payments on their student loan debt for
PV = 1,830.30
a specific period.
Twisted Logic About Long-Term Debt future value to determine the present
Some consumers use twisted logic when value of that amount.
assessing their long-term debt. They
believe that avoiding the payment of It is dependent on the interest rate and
debt for as long as possible is advan- the number of years the money is
tageous because it allows them to spend invested.
money on other purchases instead of Formula:
paying off the debt. PV = FV × PVIFᵢ,ₙ
PV = FV / (1 + i)ⁿ
They can easily justify their decision to
PV = FV / (1 + i/n)ⁿˣᵗ -Compounded Period
spend excessively today without consi-
dering how difficult it may be to pay off PVIF is lower as the number of years
the debt in the future. They might not increases. This means that less money is
recognize how debt can accumulate needed to achieve a specific future value
over a long period. Instead, they are when the money is invested for a greater
more comfortable with long-term debt number of years. Similarly, less money is
because there is much time before they needed to achieve a specific future value
must face the reality of paying off the when the money is invested at a higher
debt. rate of return.
Example:
Present Value of a Dollar Amount
You would like to accumulate $50,000 in
Discounting
five years by making a single investment
It refers to the process of obtaining pre-
today. You believe you can achieve a
sent value.
return from your investment of 7%
To determine the present value of an annually. What is the dollar amount that
amount of money expected in the future, you need to invest today to achieve your
you need to know: goal?
• The future amount of money
Future Value (FV) = $50,000
• The interest rate to be earned on your
Term period (n) = 5 years
deposit
Interest Rate (i) = 7%
• The number of years the money will be
invested PV = FV / (1 + i)ⁿ
= 50,000 / (1 + 0.07)⁵
Example: = 50,000 / (1.07)⁵
Suppose that you want to have $20,000 = 50,000 / 1.4026
for a down payment on a house in three PV = 35,648.08
years. You want to know how much
money you need to invest today to reach Example:
a total of $20,000 in three years. That is, John is planning for his retirement. He
you want to know the present value of wants to save up enough money to have
$20,000 that will be needed in three ₱1,000,000 available for his retirement in
years, based on an interest rate that you 30 years. Assuming an annual interest
could earn over that period. rate of 5%, how much should he invest
PV = FV / (1 + i)ⁿ today to reach his retirement goal?
= 20,000 / (1 + 0.05)³ Future Value (FV) = ₱1,000,000
= 20,000 / (1.05)³ Term period (n) = 30 years
= 20,000 / 1.1576 Interest Rate (i) = 5%
PV = 17,277.14 PV = FV / (1 + i)ⁿ
Present Value Interest Factor (PVIF) = 1,000,000 / (1 + 0.05)³⁰
This refers to a factor multiplied by the = 1,000,000 / (1.05)³⁰

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