Chapter 06

6-1
Copyright 2010 McGraw-Hill Australia Pty Ltd

PowerPoint slides to accompany Croucher, Introductory Mathematics and Statistics, 5e

Chapter 6

Compound Interest
Introductory Mathematics
& Statistics

6-2

Learning Objectives
Distinguish between simple and compound interest

Calculate compound interest

Compare calculations of simple and compound interest

Calculate the present and accumulated values of a
principal of money

Solve problems that involve transposing the compound
interest formula
6-3

6.1 Introduction
We are now considering the case in which the interest
due is added to the principal at the end of each interest
period and this interest itself also earns interest from
that point onwards

In this case, the interest is said to be compounded, and
the sum of the original principal plus total interest
earned is called the accumulated value or maturity
value

The difference between the accumulated value and
original principal is called compound interest
6-4

6.1 Introduction (cont)
Compound interest formula

Where:
P = principal at the beginning
i = rate of interest per period (expressed as a fraction or
decimal)
n = number of periods for which interest is accumulated
S = accumulated value at the end of n periods
( )
n
i 1 P S + =
6-5


The accumulation factor is the factor by which
you multiply the original principal in order to
obtain the accumulated value

The value of the accumulation factor is independent of
the value of the beginning principal, P
( )
n
i + = 1 factor on Accumulati
6-6


The actual amount of compound interest earned after n
years is the difference between the accumulated value and
the original principal

( )
( ) | |
( ) 1 factor on accumulati P
1 i 1 P
P i 1 P
principal original value d accumulate interest compound of Amount
n
n
=
+ =
+ =
=
6-7

Comparison of the calculation of simple interest
and compound interest from first principles

For any given principal P, given the same interest rate i and
the same period of an investment or loan, compound
interest will always have a value greater than simple interest

From an investors point of view, compound interest is
preferable

From a borrowers point of view simple interest is preferable
6-8

The amount of simple interest earned each year is a
constant: P i = Pi
The amount of compound interest earned in the first year is
also Pi
However, the amount of compound interest earned in the
second year is Pi(1 + i), which is greater than Pi
The amount of compound interest earned in the third year
is Pi(1 + i)
2
, which is also greater than Pi

Amount of compound interest earned in the kth year

Amount of simple interest earned each year = Pi

( )
1 k
i 1 Pi

+ =
6-9

6.2 Calculation of compound interest
In many instances the interest may be compounded
using other time periods, such as semi-annually,
monthly, weekly or even daily

This rate, when expressed as a rate per annum, is
known as a nominal rate of interest

The interest rate is divided by the number of periods
per year for which the interest is compounded

The number of time periods (n) is now the total number
of time periods involved
6-10

(cont)
Example
Suppose $8000 is invested at a compound interest rate of
5% per annum. Find the accumulation factor, accumulated
value and amount of compound interest earned after 3
years.

Solution

3 n , 05 . 0 i , 8000 $ P = = =
( )
( )
157625 . 1
05 . 0 1
i 1 r facto on Accumulati
3
n
=
+ =
+ =
6-11

(cont)
Solution (cont)

( )
( )
9261 $
05 . 1 8000 $
i 1 P S value d Accumulate
3
n
=
=
+ = =
( )
( )
1261 $
1 157625 . 1 8000 $
1 factor on accumulati interest compound of Amount
=
=
= P
6-12

(cont)
Example

A company secretary has an investment opportunity in
which a lending institution offers her an interest rate of
4.0% compounded quarterly. She decides to invest an
amount of $6000 under the scheme for 8 years.
Calculate:
(a) the accumulation factor
(b) the accumulated value after 5 years
(c) the total compound interest earned
6-13

(cont)
Solution

(a)
32 8 4 n , 01 . 0
4
04 . 0
i , 6000 $ P = = = = =
( )
( )
37494068 . 1
01 . 0 1
i 1 r facto on Accumulati
32
n
=
+ =
+ =
6-14

(cont)
Solution (cont)

(b)

(c)

( )
( )
64 . 8249 $
01 . 1 6000 $
i 1 P S value d Accumulate
32
n
=
=
+ = =
( )
( )
64 . 2249 $
1 37494068 . 1 6000 $
1 factor on accumulati interest compound of Amount
=
=
= P
6-15

6.3 Present value
We would like to know how much we must invest today to
accumulate a specified amount at some future time

This is called the present value (or discounted value) at
compound interest

Where
P = present value
S = compound interest

( )
n
i 1 S P

+ =
6-16

6.3 Present value (cont)
The present value factor (factor or discount factor) is the
amount by which you multiply the specified amount in
order to obtain the original principal.

Example

A plumber wishes to have an amount of $30 000 at the end
of 10 years. The bank pays an interest rate of 8% per
annum compounded annually. How much money will the
plumber have to invest with the bank now?
n
) i 1 ( r facto value Present

+ =
6-17

Solution

So

Hence, the plumber must invest an amount of $13 895.80
now to accumulate the specified amount of $30 000 at the end
of 10 years.

10 n , 08 . 0 i , 30000 $ S = = =
( )
( )
46319349 . 0
08 . 0 1
i 1 factor value Present
10
n
=
+ =
+ =
( )
80 . 13895 $
46319349 . 0 30000 $
i 1 S P
n
=
=
+ =

6-18

Calculation of the interest rate

The compound interest formula can also be used to find the
interest rate charged when a principal of P has accumulated to an
amount S after n periods

Note that the value of i obtained is the interest rate per period. To
obtain the nominal rate of interest (per annum), multiply this value
of i by the number of periods in a year. E.g., if interest is
compounded quarterly, i should be multiplied by 4
1
P
S
i
n
1
|
.
|
\
|
=
6-19

Example
Suppose that $1000 has accumulated to $1460 in 20 years with
interest compounded quarterly. What annual rate of compound interest
was used?
Solution

Since the interest was compounded quarterly, multiply this value of i by
4 to obtain 0.004 74 4 = 0.018 96. This corresponds to an interest
rate of 1.896% per annum.

80 4 20 , 1460 $ , 1000 $ = = = = n S P
00474 . 0
1
1000
1460
1
P
S
i
80
1
n
1
=
|
.
|
\
|
=
|
.
|
\
|
=
6-20

Calculation of the number of periods

The compound interest formula can also be used to find the
number of periods (n) required for an amount P to
accumulate to an amount S when interest is at a rate of i per
period

That is, the value of i must be written as the interest rate per
period. Note also that the value of n obtained will not always
be a whole number and so we can only approximate the
actual number of periods required
( ) i 1 log
P
S
log
n
+
|
.
|
\
|
=
6-21

Example
Find how long it will take for $800 to accumulate to $1500 if
interest is at 5% per annum, compounded quarterly.

Solution

Hence, the number of periods required is 50.56. Since in this
case a period is a quarter, the amount of time is approximately
equal to 50 4 = 12.64 years.
0125 . 0
4
05 . 0
i , 1500 $ S , 800 $ P = = = =
( )
56 . 50
0125 . 0 1 log
800
1500
log
n
=
+
|
.
|
\
|
=
6-22

Summary
We have discussed the difference between simple and
compound interest

We calculated compound interest

We have also compared calculations of simple and
compound interest

We calculated the present and accumulated values of a
principal of money

We solved problems that involve transposing the compound
interest formula

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