WELCOME TO UNIT 6 Compound Interest, Future and Present Values

Learning outcomes Calculate the future value and the compound interest amount by compounding

manually Calculate the future value and the compound interest amount using a $1.00

future value table Calculate the future value and the compound interest amount using a formula Find the effective interest rate ( APY) Calculate the interest compounded daily using a table

Some loans may use compounding formula to calculate the interest amount. In this case, the interest is calculated more than one time during the term of the loan or investment and the interest of a period is added to the principal before the interest of the next period is calculated. So, the interest of one period also earns some interest in the next period.

The process of adding interest to the principal before calculating the interest amount for the next period is called compounding interest.

There are two or more interest periods when the interest is compounded. The interest period can be one day, one week, one month, one quarter, one year, or any portion of the year.

The more the number of interest periods, the higher the amount of total interest will be because the interest of more interest periods contribute to the total interest amount.

future value or maturity value or compound amount is the sum of compound interest and the original principal.

CALCULATE THE FUTURE VALUE AND THE COMPOUND INTEREST AMOUNT BY COMPOUNDING MANUALLY

The simple interest formula can be used to calculate the future value of principal when annual number of interest periods and the annual interest rate are known.

First, we need to find the period interest rate or interest rate per period. This can be done by dividing the annual interest rate by the total number of annual interest periods.

Period interest rate = annual interest rate / number of interest periods per year

STEPS TO FIND THE FUTURE VALUE USING THE SIMPLE INTEREST FORMULA

Calculate the principal at the end of the first period: Principal at the end of first period = original principal x (1 + period interest rate) If original principal = P; principal at the end of the first period = A; period interest rate = R then A = P(1 + R) For each remaining period, End-of-period principal = previous end-of-period principal x (1 + period interest rate) The last end-of-period principal is the future value.

Example 1: Susan secured a loan of $8000 for three years compounded annually. If the

interest rate was9%,find: Future value Total compound interest paid Compare the total compound interest with total simple interest over the same

loan period, original principle, and annual interest rate. Solution: 9% = 0.09 Principal at the end of first period = $8,000 (1 + 0.09) = $8,000 (1.09) = $8,720 Second end-of-period principal = $8,720 (1 + 0.09) = $8,720 (1.09) = $9,504.80

Third end-of-period principal = $9,504.80 (1 + 0.09) = $9,504.80 (1.09) = $10,360.23 So, the future value of the loan is $10,360.23 Total compound interest = A – P = $10,360.23 - $8,000 = $2,360.23 The compound interest is $2,360.23 To find the simple interest: I = PRT I = $8,000 * 0.09 * 3 = $2,160 Total Simple Interest = $2,160 Different between total compound and total simple interests = 2,360.23 -

$2,160 = $200.23

Example 2: Find the future value of a $10,000 investment at 8% annual interest compounded

semiannually for three years. Solution: 8% = 0.08 ; Interest per period = annual interest rate / number of periods = 0.08 / 2 = 0.04 Total number of periods = 3 years * 2 periods per year = 3 * 2 = 6 Principal at the end of the first period = $10,000 (1+ 0.04) = $10,000 (1.04) = $10,400 Principal at the end of the second period = $10,400 (1+ 0.04) = $10,400 (1.04) = $10,816

Principal at the end of the third period = $10,816 (1+ 0.04) = $10,816 (1.04) = $11,248.64 Principal at the end of the fourth period = $11,248.64 (1+ 0.04) = $11,248.64 (1.04) = $11,698.59 Principal at the end of the fifth period = $11,698.59 (1+ 0.04) = $11,698.59 (1.04) = $12,166.53 Principal at the end of the fifth period = $12,166.53 (1+ 0.04) = $12,166.53 (1.04) = $12,653.19

Calculate the future value and the compound interest amount using a $1.00 future value table We can also find the amount of compound interest using Table. Here is the steps involve in this process. Find total number of interest periods Total number of interest periods = number of years x number of interest periods per year Find interest rate per period Interest rate per period = annual interest rate / number of interest periods per year Select the row that corresponds to the number of periods and the column that corresponds to the interest rate per period from

Table Locate the value in the table at the intersection of the row and column mentioned in step 3. Multiply the original principal by the value from step 4 to find the future value . Future value = principal x table value Total compound interest = future value – original principal

Example 1:

Use table to find the compound interest on a $5000 loan for six years at 8%, compounded annually.

Solution: 8% = 0.08 Total interest periods = number of years x number of interest periods per year = 6 x 1 = 6 Interest rate per period = 0.08 / 1 = 0.08 The table 10-1 value for row = 6 and column = 8% is 1.58687 Future value = principal x table value = $5,000 x 1.58687 = $7,934.35 Total compound interest = $7,934.35 - $5,000 = $2,934.35

Example 2:

A loan of $3,000 at 8% annual interest is compounded quarterly (4 times a year) for three years. Find the future value and the total compound interest.

Solution: 8% = 0.08 Total interest periods = number of years x number of interest periods per

year = 3 x 4 = 12 Interest rate per period = 0.08 / 4 = 0.02 The table 10-1 value for row = 12 and column = 2% is 1.26824 Future value = principal x table value = $3,000 x 1.26824= $3,804.72 Total compound interest = $3,804.72 - $3,000 = $804.72

CALCULATE THE FUTURE VALUE AND THE COMPOUND INTEREST AMOUNT USING A FORMULA

The following formula can be used to find the future value (FV). FV = P(1 + R)N Where FV is the future value; R is interest rate per period ; n is the total number of periods. Example 1: Find the future value and total interest amount of a $5,000 investment that earns 6% compounded monthly after 3 years. Solution: 6% = 0.06 ; R = Interest rate per period Total interest periods = number of years x number of interest periods per year = 3 x 12 = 36 R = 0.06 / 12 = 0.005 FV = $5,000 (1 + 0.005)36 = $5,000 (1.005)36

= $5,000 x 1.19668 = $5,983.40 Total interest amount = FV - Original principal = $5,983.40 - $5,000 = $983.40

FINDING THE EFFECTIVE INTEREST RATE ( APY)

How can we compare two loans with different interest rates and number of periods compounded a year? To make such comparison we need to convert both to a rate of interest called, effective rate.

The effective rate equates the compound interest rates to equivalent simple interest rates so that a comparison can be made. The effective rate is also referred to as the annual percentage yield (APY).

Here is how to find the effective interest rate of a compound interest rate Effective annual interest rate = compound interest for first year / principal We can also find the effective interest rate by using table 13-1 by using the formula

formula. Effective annual interest rate = [ (future value of $1.00 after 1 year - $1.00) / $1.00 ]

* 100%

FOUR FORMULAS TO DETERMINE PROPERTY TAX VALUES Example 1: John borrowed $6,000 at 10% compounded semiannually. What is the effective rate? Solution: 10% = 0.10 Interest rate per period = 0.10 / 2 = 0.05 First end-of-period principal = $6,000 (1 + 0.05) = $6,000 (1.05) = $6,300 Second end-of- period principal = $6,000 (1 + 0.05) = $6,300 (1.05) = $6,615 Compound interest after first year = $6,615 - $6,000 = $615 Effective interest after first year = ($615 / $6,000) * 100% = 0.1025 * 100% = 10.25%

To use Table, we go to the row of 2 (for two periods) and the column of 5% and read the value at the intersection of the row and column. This value is 1.10250.

Effective annual interest rate = [ (future value of $1.00 after 1 year -

$1.00) / $1.00 ] * 100% Effective annual interest rate = [ (1.10250 – 1) / 1 ] * 100% = [ 0.10250 / 1 ] * 100% = 0.10250 * 100% = 10.25%

Calculate the interest compounded daily using a table To find the compounded daily interest using a table we follow the steps below: We first determine the amount of money the table uses as the principal ($1, $100, or $1000). Then, divide the loan principal by table principal. Then, using Table 10-2 find the days row and interest rate column corresponding to the interest

rate of the loan and find the value at the intersection of this row and column. Finally, multiply the value from the resul t of step 2 by step 3. Example: Find the interest on $800 at 7.5% annually, compounded daily, for 28 days. Solution: First we find the number of $100 units in the principal. $800 / $100 = 8 The Table 13-2 value is 0.576941. So, $8 ( 0.576941) = $4.615528 rounded to two digits after the decimal = $.62

PRESENT VALUELearning outcomes Calculate the present value bases on annual compounding for one year Calculate the present value using a $1.00 present value table Calculate the present value using a formula Present Value tells us how much to invest at present value in order to yield a certain amount at

some specified future date. Calculate the present value bases on annual compounding for one year Calculating present value manually is time consuming. When there are many interest periods out

there. We find the Present Value formula by adjusting the Future value formula. Future Value = principal (1 + annual interest rate) so to find for Principal we need to divide the

equation by (1 + annual interest rate). So, Present value = future value / (1 + annual interest rate)

Example : Find the amount of money that Mary needs to set aside today to

ensure that $10,000 will be available in her account to buy a new TV in one year if the annual interest rate is 4% compounded annually.

Solution: 1 +0.04 = 1.04 $10,000 / 1.04 = $9,615.38

CALCULATE THE PRESENT VALUE USING A $1.00 PRESENT VALUE TABLE To calculate the present value based on using the $1.00 present value table we use the following

formula: Interest per period = annual interest rate / number of interest periods per year We can also follow the Table 10-3 to find the days row and interest rate column corresponding to

the interest rate of the loan and find the value at the intersection of this row and column. Finally, multiply the value from the result of step 1 by the loan amount . Example: AZZ company needs $20,000 in five years to buy a new machine. How much must the firm invest at

the present if it is received 5% interest compounded annually? Solution: Going to table 10-3 row of 5 and rate of 5% column, the table value would be 0.78353. Present value = $20,000 * 0.78353 = $15,670.60

CALCULATE THE PRESENT VALUE USING A FORMULA

The following is the present value formula where P is present value, R is the annual interest rate, and FV is the future value.

PV = FV / (1 + R)N Example: Hotel Victoria would like to put away some of the holiday profits to save for a planned expansion. A total of

$8,000 is needed in three years. How much money in a 5.2% three-year certificate of deposit that is compounded monthly must be invested now to have the $8,000 in three years?

Solution: 5.2% = 0.052 Interest rate per period = 0.052 / 12 = 0.00433 Number of periods = 3 * 12 = 36 PV = FV / (1 + R)N PV = $8,000 / (1 + 0.00433)36 PV = $8,000 / (1.00433)36 PV = $8,000 / 1.16829 PV = $6,847.61

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