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Time Value of Money: Compound Interest

The document discusses time value of money concepts like compound interest. It explains that compound interest is earned on both the principal amount and previously accrued interest, resulting in higher returns than simple interest which is earned only on the principal. The effects of varying the compounding period are demonstrated, showing that more frequent compounding leads to greater overall interest. Formulas for calculating future and present value under simple and compound interest are also provided.

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62 views28 pages

Time Value of Money: Compound Interest

The document discusses time value of money concepts like compound interest. It explains that compound interest is earned on both the principal amount and previously accrued interest, resulting in higher returns than simple interest which is earned only on the principal. The effects of varying the compounding period are demonstrated, showing that more frequent compounding leads to greater overall interest. Formulas for calculating future and present value under simple and compound interest are also provided.

Uploaded by

kate
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Time Value of Money:

Compound Interest
Learning Objectives
Upon completing this assignment, students will:

• Learn about basic time value of money concepts

• Understand compounding and the effects of the


frequency of compounding
Time Value of Money

• Time value of money is the principle that money


received now is worth more than the expectation
of the same amount to be received in the future.
Time Value of Money: 3
Reasons
• Why is money received now valued more than the same
amount expected in the future?

1. Money can be invested to earn interest.

2. Purchasing power of money can be worth less over


time due to inflation.

3. The receipt of the money in the future can be


uncertain.
Interest Rate
• The interest rate is a percentage of the principal
paid by a borrower to a lender in exchange for the
use of the money.

• For example, a bank will pay you interest for


depositing money into the bank and keeping it
there for a certain amount of time.

• Interest rates are typically noted on an annual


basis, but can also be quarterly, monthly, or even
daily.
Simple or Compound Interest?

• Simple interest is interest on only the original


amount of the principal.

• Compound interest is interest on the initial


principal as well as upon the interest that has
already accrued.
Present Value and Future Value
• Present value (PV) = the current value of a future
sum of money.

• Future value (FV) = the initial payment +


accumulated interest.

• Present value decreases as interest rates


increase.

• Future values increase as the interest rate


increases.
Present Value and Future Value
Time Line: Simple Interest
• Present value and future value can be illustrated on
a timeline. In this case, PV = $100 and the annual
simple interest rate (r) = 5%. Every year, for four
years, $5 of interest is gained.

+$5

0 Year 1 Year 2 Year 3 Year 4


PV =$100 FV = $120
Simple Interest Formula

FV= Future
FV = PV(1 + rt)
value (at
the end of
n years)
PV = Present
value r = Annual t = Number of
(beginning Interest rate years the
amount) account will
earn interest
Simple Interest Formula (cont.)
FV = PV(1 + rt)
= $100(1 + .05×4)
= $120
+$5

0 Year 1 Year 2 Year 3 Year 4


PV =$100 FV = $120
Present Value and Future Value
Time Line: Compound Interest
• We can look at the same 4 year timeline, with the
same $100 principal and 5% interest rate.

• This time, instead of simple interest, we will use an


annually compounded interest rate.

0 Year 1 Year 2 Year 3 Year 4


PV =$100
Present Value and Future Value Time
Line: Compound Interest (cont.)
• At the end of the first year, just as with simple
interest, $5 is gained.

+$5

0 Year 1 Year 2 Year 3 Year 4


PV =$100
Present Value and Future Value Time
Line: Compound Interest (cont.)
• With compound interest, the interest is added to
the principal. So, by the end of the first year the
principal has increased from $100 to $105.

+$5

0 Year 1 Year 2 Year 3 Year 4


PV =$100 $105
Present Value and Future Value Time
Line: Compound Interest (cont.)

• 5% interest on $105 = $5.25.

+$5 +$5.25

0 Year 1 Year 2 Year 3 Year 4


PV =$100 $105
Present Value and Future Value Time
Line: Compound Interest (cont.)
• At the end of the second year, that new interest is
added to the principal, making the new principal
amount $110.25.

+$5 +$5.25

0 Year 1 Year 2 Year 3 Year 4


PV =$100 $105 $110.25
Present Value and Future Value Time
Line: Compound Interest (cont.)
• Each year the interest compounds. At the end of
the 4 years, the resulting $121.55 is greater than
the $120 that would have been achieved during the
same time period with a simple interest rate.

+$5 +$5.25 +$5.51 +$5.79

0 Year 1 Year 2 Year 3 Year 4


PV =$100 $105 $110.25 $115.76 FV= $121.55
Compound Interest Formula
• This compound interest formula takes into account
the number of times that the interest is
compounded per year.
FV= PV(1 + r/m)mt
r = annual interest rate
m = number of times interest is compounded per year
t = number of years

• This is easy to calculate for an annually


compounded interest rate, since “m” would be
equal to 1.
Compound Interest Formula
(cont.)
FV= PV(1+r/m)mt
= $100(1+.05/1)1×4 = $100(1.05)4
= $121.55
+$5 +$5.25 +$5.51 +$5.79

0 Year 1 Year 2 Year 3 Year 4


PV =$100 $105 $110.25 $115.76 FV= $121.55
Frequency of Compounding
• While interest rates are typically stated in the form
of an annual percentage rate (APR), the frequency
of compounding may not necessarily be annual. For
example, frequency of compounding could be
quarterly, monthly, daily or even continuous.

Compounding Frequency m
PV(1 + r/m)mt
Quarterly 4
Monthly 12
Daily 365
Frequency of Compounding:
Compound Interest Formula
• Consider our earlier problem of calculating
the future value of $100 at a 5% annual
interest rate after 4 years. This time we will
change the annual compounding interest to a
quarterly compounding interest.

• A quarterly compounding interest means the


interest will compound 4 times per year.
Frequency of Compounding:
Compound Interest Formula (cont.)
FV = PV(1 + r/m)mt
= $100(1 + .05/4) 4×4

= $100(1 +.0125)16
= $121.99
• With an initial deposit of $100, at a 5% annual
interest compounded quarterly, the future value
in four years will be $121.99.
Rule of 72 for Compound
Interest
•With annually compounded interest, the rule of 72 is a
quick formula to approximate how many years it will
take to double your initial investment:

Number of Years = 72
Interest rate %

•For example, at 8% annual interest, it would take 9


years (72 ÷ 8) to double the initial investment.

•This approximation technique becomes less accurate if


the interest rate is > 20%.
Link to Assignment

• Click the Link to Platform button or use the


following link to directly access the assignment:

https://wrds-www.wharton.upenn.edu/classroom
/compound-interest/
Assignment: Compound
Interest Graph
• Select loan parameters and generate a graph to
illustrate the compounding effect.

1. Enter an amount for the principal.

2. Enter an interest rate.

3. Enter the time period for the loan in


number of years.
Assignment: Compound
Interest Graph (cont.)

4. Select a compounding period.

5. Click Calculate to generate the graph.


Conclusion
• Time value of money is the principle that money
received now is valued higher than the same
amount of money expected to be received in the
future. This is due to potential interest to be gained
if the money is invested, possible devaluation due
to inflation, and uncertainty.

• The interest rate is a percentage of the principal


paid by a borrower to a lender in exchange for the
use of the money.
Conclusion (cont.)
• Simple interest is interest on only the original
amount of the principal.

• Compound interest is interest on the initial


principal as well as upon the interest that has
already accrued.
Conclusion (cont.)

• As interest is compounded more frequently, the


amount of interest earned over the entire time
period becomes greater, resulting in a higher future
value.

• When interest is compounded annually, the rule of


72 is an easy way to approximate how many years it
will take to double the initial investment.

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