Chapter 12

Compound Interest and

Present Value

McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved

#12 Compound Interest and Present Value

Learning Unit Objectives

LU12.1
Compound Interest (Future Value) –
The Big Picture
• Compare simple interest with compound
interest
• Calculate the compound amount and
interest manually and by table lookup
• Explain and compute the effective rate

12-2
#12 Compound Interest and Present Value

Learning Unit Objectives

LU12.2 Present Value -- The Big Picture

• Compare present value (PV) with

compound interest (FV)
• Compute present value by table lookup
• Check the present value answer by
compounding

12-3
 Compounding Interest (Future Value)

Compounding - involves the Compound interest - the interest

on the principal plus the interest
calculation of interest
of prior periods
periodically over the life of
the loan or investment

Future value (compound amount)

- is the final amount of the loan or Present value - the value of a
investment at the end of the last loan or investment today
period
12-4
 Compounding Terms

Compounding Periods Interested Calculated

Compounding Annually Once a year
Compounding Semiannually Every 6 months
Compounding Quarterly Every 3 months
Compounding Monthly Every month
Compounding Daily Every day

12-5
 Figure 12.1 Future Value of $1 at 8%
for Four Periods
Compounding goes from present value to future value
$5.00 Future
$4.50 Value

$4.00 After 3 After 4

After 2 periods periods
$3.50 After 1 periods $1 is
$1 is
period worth
$3.00 $1 is
$1 is worth
worth $1.26 $1.36
$2.50 Present worth $1.17
value $1.08
$2.00
$1.166 $1.259 $1.360
$1.50 $1.00 $1.08 7 5
4
$1.00
$0.50
$0.00
0 1 2 3 4
Number of periods

12-6
 Figure 12.1 Future Value of $1 at 8%
for Four Periods

Manual Calculation

Year 1 Year 2 Year 3 Year 4

$ 1.00 $ 1.08 $ 1.17 $ 1.26
0.08 x .10 x .10 x .10
Interest $ 0.08 $ 0.09 $ 0.09 $ 0.10
Beg. Bal 1.00 1.08 1.17 1.26
End of year $ 1.08 $ 1.17 $ 1.26 $ 1.36

12-7
 Tools for Calculating Compound Interest

Number of periods (N) Rate for each period

Number of years (R) Annual interest rate
multiplied the number divided by the number
of times the interest is of times the interest is
compounded per year compounded per year

If you compounded $100 for 3 years at 6% annually,

semiannually, or quarterly What is N and R?

Periods Rate
Annually: 3x1=3 Annually: 6% / 1 = 6%
Semiannually: 3 x 2 = 6 Semiannually: 6% / 2 = 3%
Quarterly: 3 x 4 = 12 Quarterly: 6% / 4 = 1.5%
12-8
 Simple Versus Compound Interest
Simple Compounded
Al Jones deposited $1,000 in a Al Jones deposited $1,000 in
savings account for 5 years at a savings account for 5 years
an annual interest rate of 10%. at an annual compounded rate
What is Al’s simple interest of 10%. What is Al’s interest
and maturity value? and compounded amount?

II==PPxxRRxxTT
Year 1 Year 2 Year 3 Year 4 Year 5
II==$1,000
$1,000xx.10
.10xx55 $ 1,000.00 $ 1,100.00 $ 1,210.00 $ 1,331.00 $ 1,464.10
x .10 x .10 x .10 x .10 x .10
II==$500
$500 Interest $ 100.00 $ 110.00 $ 121.00 $ 133.10 $ 146.41
MV
MV==$1,000 $500 Beg. Bal
$1,000++$500 1000.00 1100.00 1210.00 1331.00 1464.10
End of year $ 1,100.00 $ 1,210.00 $ 1,331.00 $ 1,464.10 $ 1,610.51
MV
MV==$1,500
$1,500 Interest: $1,610.51 - $1,000 = $610.51

12-9
 Calculating Compound Amount
by Table Lookup
Step 4. Multiply the table factor
by the amount of the loan.
Step 3. Go down the period column of the
table to the number desired; look across the
row to find the rate. At the intersection is
the table factor
Step 2. Find the rate: Annual rate
divided by number of times interest is
compounded in 1 year
Step 1. Find the periods: Years multiplied by
number of times interest is compounded in 1 year

12-10
 Table 12.1 - Future Value of $1
at Compound Interest

Future value of $1 at compound interest (Partial)

Period 1% 1.50% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.0100 1.0150 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.0900 1.1000
2 1.0201 1.0302 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.2100

3 1.0300 1.0457 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250 1.2597 1.2950 1.3310

4 1.0406 1.0614 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641
5 1.0510 1.0773 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105
6 1.0615 1.0934 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716

7 1.0721 1.1098 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.8280 1.9487
8 1.0829 1.1265 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436

9 1.0937 1.1434 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.1719 2.3579
10 1.1046 1.1605 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.3674 2.5937
11 1.1157 1.1780 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531

12 1.1260 1.1960 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384
13 1.1381 1.2135 1.2936 1.4685 1.6651 1.8856 2.1329 2.4098 2.7196 3.0658 3.4523

14 1.1495 1.2318 1.3195 1.5126 1.7317 1.9799 2.2609 2.5785 2.9372 3.3417 3.7975
15 1.1610 1.2502 1.3459 1.5580 1.8009 2.0789 2.3966 2.7590 3.1722 3.6425 4.1772

12-11
 Calculating Compound Amount
by Table Lookup

Steve Smith deposited $80 in a savings account for 4

years at an annual compounded rate of 8%. What is
Steve’s interest and compounded amount?
N=4x1=4 120

R = 8% = 8% 100

1 80

Table Factor = 1.3605 60

Investment

Compounded Amount: 40

20
$80 x 1.3605 = $108.84
0
I = $108.84 - $80 = $28.84 2007 2008 2009 2010

12-12
 Nominal and Effective Rates (APY) of Interest

Truth in Nominal Rate (Stated Rate) - The

Savings rate on which the bank calculates
Law interest.
Annual
e r c en t a ge
P
Yield Effective Rate = Interest for 1 year
(APY) Principal

12-13
 Calculating Effective Rate APY
Blue, 8% compounded quarterly Sun, 8% compounded semiannually
Periods = 4 (4 x 1) Periods = 2 (2 x 1)
Percent = 8% = 2% Percent = 8% = 4%
4 2
Principal = $8,000 Principal = $8,000
Table 12.1 lookup: 4 periods, 2% Table 12.1 lookup: 2 periods, 4%
1.0824 1.0816
x $8,000 x $8,000
Less $8,659.20 Less $8,652.80
$8,000.00 $8,000.00
659.20 652.80
APY 659.20 = .0824 APY 652.80 = .0816
$8,000 $8,000
= 8.24% = 8.16%

12-14
 Figure 12.3 - Nominal and Effective Rates
(APY) of Interest Compared

Beginning Nominal rate Compounding End Effective rate

balance of interest period balance (APY) of interest

Annual $1,060.00 6.00

Semiannual $1,060.90 6.09%
$1,000 + 6%
Quarterly $1,061.40 6.14%
Daily $1,061.80 6.18%

12-15
 Table 12.2 - Compounding Interest Daily

Interest on a 1% deposit compounded daily -360 day basis

Period 6.00% 6.50% 7.00% 7.50% 8.00% 8.50% 9.00% 9.50% 10.00%
1 1.0618 1.0672 1.0725 1.0779 1.0833 1.0887 1.0942 1.0996 1.1052
2 1.1275 1.1388 1.1503 1.1618 1.1735 1.1853 1.1972 1.2092 1.2214
3 1.1972 1.2153 1.2337 1.2523 1.2712 1.2904 1.3099 1.3297 1.3498
4 1.2712 1.2969 1.3231 1.3498 1.3771 1.4049 1.4333 1.4622 1.4917
5 1.3498 1.3840 1.4190 1.4549 1.4917 1.5295 1.5862 1.6079 1.6486
6 1.4333 1.4769 1.5219 1.5682 1.6160 1.6652 1.7159 1.7681 1.8220
7 1.5219 1.5761 1.6322 1.6904 1.7506 1.8129 1.8775 1.9443 2.0136
8 1.6160 1.6819 1.7506 1.8220 1.8963 1.9737 2.0543 2.1381 2.2253
9 1.7159 1.7949 1.8775 1.9639 2.0543 2.1488 2.2477 2.3511 2.4593
10 1.8220 1.9154 2.0136 2.1168 2.2253 2.3394 2.4593 2.5854 2.7179
15 2.4594 2.6509 2.8574 3.0799 3.3197 3.5782 3.8568 4.1571 4.4808
20 3.3198 3.6689 4.0546 4.4810 4.9522 5.4728 6.0482 6.6842 7.3870
25 4.4811 5.0777 5.7536 6.5195 7.3874 8.3708 9.4851 10.7477 12.1782
30 6.0487 7.0275 8.1645 9.4855 11.0202 12.8032 14.8747 17.2813 20.0772

12-16
 Compounding Interest Daily

Calculate what $2,000 compounded daily for 7 years will

grow to at 6%

N=7
R = 6%
Factor 1.5219
$2,000 x 1.5219 = $3,043.80

12-17
 Figure 12.4 Present Value of $1 at 8%
for Four Periods
Present value goes from the future value to the present value
Future
$1.20 Value
$1.10 $1.000
$.9259 0
$1.00 Present $.8573
$0.90 value $.7938
$.7350
$0.80
$0.70
$0.60
$0.50
$0.40
$0.30
$0.20
$0.10
$0.00
0 1 2 3 4

Number of periods

12-18
 Calculating Present Value by Table Lookup
Step 4. Multiply the table factor
by the future value. This is the
present value.
Step 3. Go down the period column of the
table to the number desired; look across the
row to find the rate. At the intersection is
the table factor.
Step 2. Find the rate: Annual rate
divided by number of times interest is
compounded in 1 year
Step 1. Find the periods: Years multiplied by
number of times interest is compounded in 1 year

12-19
 Table 12.3 - Present Value of $1 at End Period

Present value of $1 at end period (Partial)

Period 1% 1.50% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.9901 0.9852 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091

2 0.9803 0.9707 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264

3 0.9706 0.9563 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513

4 0.9610 0.9422 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830

5 0.9515 0.9283 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209

6 0.9420 0.9145 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645

7 0.9327 0.9010 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5470 0.5132

8 0.9235 0.8877 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.5019 0.4665

9 0.9143 0.8746 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241

10 0.9053 0.8617 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855

11 0.8963 0.8489 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505

12 0.8874 0.8364 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3555 0.3186

13 0.8787 0.8240 0.7730 0.6810 0.6006 0.5303 0.4688 0.4150 0.3677 0.3262 0.2897

14 0.8700 0.8119 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633

15 0.8613 0.7999 0.7430 0.6419 0.5553 0.4810 0.4173 0.3624 0.3152 0.2745 0.2394

12-20
 Calculating Present Value Amount
by Table Lookup
Steve Smith needs $108.84 in 4 years. His bank offers 8% interest
compounded annually. How much money must Steve put in the
bank today (present) to reach his goal in 4 years?

120
N=4x1=4 Invest 100
R = 8% = 8% Today 80
1
60
Investment
Table Factor = .7350
40
Compounded Amount: 20
$108.84 x .7350 = $80.00 0
2007 2008 2009 2010

12-21
 Comparing Compound Interest (FV)
Table 12.1 with Present Value (PV) Table 12.3

Compound value Table 12.1 Present value Table 12.3

Table Present Future Table Future Present
12.1 Value Value 12.3 Value Value
1.3605 x $80 = $108.84 .7350 x $108.84 = $80.00
(N = 4, R = 8) (N = 4, R = 8)

We know the We know the

present dollar future dollar
amount and find amount and find
what the dollar what the dollar
amount is worth in amount is worth
the future in the present

12-22
 Problem 12-13:

Solution:

4% = 2%
7 years x 2 = 14 periods 2

$25,000.00 x 1.3195 = $32,987.50

12-23
 Problem 12-15:

Solution:
Mystic Four Rivers

4 years x 2 = 8 periods 4 years x 4 = 16 periods

10% = 5% 8% = 2%
2 4
$10,000 x 1.4775 = $14,775 $10,000 X 1.3728 = $13,728
- 10,000 -10,000
$ 4,775 $ 3,728

12-24
 Problem 12-16:

Solution:
3 years x 2 = 6 periods $20,000 x 1.4185 = $28,370
12% = 6% +30,000
2 $58,370

$58,370 x 1.4185 = $82,797.85

12-25
 Problem 12-25:

Solution:

Compounding OR
Present value
5 years x 2 = 10 periods 10 periods
$10,000 x 1.7908 = $17,908 $15,000 x .55
12% = 6% 6%
2
Yes.

12-26
 Problem 12-27:

Solution:
8 years x 2 = 16 periods 6% = 3%
2

$6,000 x .6232 = $3,739.20

12-27