8-1

Compound
Compound

Interest
Interest

Compound
Chapter 8
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Learning Objectives

After completing this chapter, you will be able to:

Calculate the
LO-1 Maturity Value(MV), Future Value (FV), and Present
Value(PV) in

compound interest applications,

by both the algebraic method and the

pre-programmed financial calculator method

Maturity Value of compound interest for
Guaranteed Investment Certificates (GICs)
Price of "strip" bonds
McGraw-Hill Ryerson

8-2

Compound
Compound

Learning Objectives

8-3

Interest
Interest

Calculate the
LO-2 Redemption Value of a compound interest
bearing Canada Savings Bond

Payment on any date that is equivalent to one or

more payments on other dates

Economic Value of a payment stream

And be able to
Adapt the concepts and equations of compound
interest to cases of compound growth
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

LO-1

McGraw-Hill Ryerson

8-4

Compound
Compound

Interest
Interest

8-5

To better understand how Compound Interest

is calculated, lets review how we calculate
Simple Interest!
The formula on which we base our
calculation is

Formula
Formula

I = Prt

Here we have an amount, the Principal, which is

multiplied by the Interest Rate and the Time over
which the Interest is earned!
As we will now see, Compound Interest uses
the Sum of P & I as a base on which to calculate

new Interest!
McGraw-Hill Ryerson

Compound
Compound

Compound Interest

8-6

- Future Value

Interest
Interest

the interest on the principal

plus the

interest of prior periods

e.g. Principal + prior period interest = $1100.00
$1000.00

$100.00

Interest for the next period is calculated on $1100.00.

This method will continue over the life of the
loan or investment. (See later example)
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Compound Interest
- Future Value

is the compounded amount and

is the FINAL amount of the loan
or investment at the
end of the last period!
Contrast this with
...is the value of a loan or
investment TODAY!

McGraw-Hill Ryerson

8-7

Compound
Compound

Interest
Interest

Compound Interest

8-8

- Future Value

the calculation of interest over

the life of the loan or investment
Lets assume that the interest rate is 10% pa.

Example: Principal + prior period interest = $1100.00

Interest is now calculated on $1100.00
Principal(Compounded) * 0.10 = $110.00
New P $1210.00 to start next period

McGraw-Hill Ryerson

Graphically

Compound
Compound

8-9

Compound Interest

- Future Value

Interest
Interest

Interest
Interest

Interest
Interest

Interest
Interest

Interest
Interest

Amount$1000
$1000
Amount
133.1

1331
1210
1100
1000

100

110
100

121

121

11
0
100

11
0
100

Compoundin Compoundin Compoundin

g Period
g Period
g Period

0
McGraw-Hill Ryerson

2
Time(Years)

Compoundin
g Period

Compound
Compound

Interest
Interest

Compound Interest

8 - 10

- Future Value

What happens if the interest

rate changes during the life of
an investment?

Example
Example
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Compound Interest

8 - 11

- Future Value

You hold an investment for a period of 4 years.

Rates of return for each year are 4%, 8%,
-10% and 9% respectively.
If you invested $1000
at the beginning of the term, how much will you
have at the
end of the last
year?

McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Compound Interest

8 - 12

- Future Value

You hold an investment for a period of 4 years.

Rates of return for each year are 4%, 8%, -10% and 9%
respectively. If you invested $1000 at the beginning of the
term, how much will you have at the end of the last year?

Year 1

Year 2

Year 3

Year 4

$1000

$1040

$1123.20

$1010.88

$1000 *
(1 + .04)
= $1040
McGraw-Hill Ryerson

$1040 *
$1123.20 *
(1 + .08)
(1 - .10)
= $1123.20 = $1010.88

$1010.88 *
(1 +.09)
= $1101.86
Alternative
Alternative

Compound
Compound

Interest
Interest

Compound Interest

8 - 13

- Future Value
You hold an investment for a period of 4 years.
Rates of return for each year are 4%, 8%, -10%
and
9% respectively. If you invested $1000 at
the beginning
of the term, how much will you
have
at the end
of the last year?

1000(1.04)(1.08)(.90)(1.09) = $1101.86
Solving
Solving
Alternative
Alternative
1
-10%
Solve
for
all
Solve for all
years at
at
44 years
It isis rare
rare for
forinterest
interest to
to be
be
It
once!
once!
compounded only once per year!
compounded only once per year!

McGraw-Hill Ryerson

8 - 14

Compound
Compound

Interest
Interest

Compounding Frequencies and Periods

Frequency
Frequency

McGraw-Hill Ryerson

No. per
per Year
Year
No.

Period
Period

Annually

1 year

Semiannually

6 months

Quarterly

3 months

Monthly

12

1 month

Daily

365

1 day

Compound
Compound

Interest
Interest

8 - 15

Development of a Formula
Formula

Nominal or Annual Rate

Number of compoundings per year
Periodic Rate per period

Total Number of

Periods
Periods

(j)

m
(i)

Determining values for n and i

McGraw-Hill Ryerson

8 - 16

Compound
Compound

Formulae
Formulae

Interest
Interest

To Determine
Determine
To

Time(Years)

n
n

# of Compounding Frequencies p.a.(m)

To Determine
Determine
To

ii

Annual Interest Rate(j)

# of Compounding Frequencies p.a. (m)
McGraw-Hill Ryerson

8 - 17

Compound
Compound

Determining values for n

Interest
Interest

If you compounded $100 for 3 years at 6%

annually, semiannually, or quarterly,
what are the values for n and i ?

Formula

Time(Years) *

# of Compounding
Frequencies per year (m)

Annually
3*
Semiannually 3 *
Quarterly 3 *
McGraw-Hill Ryerson

No.

= 3
= 6
= 12

2
4

8 - 18

Compound
Compound

Interest
Interest

Determining values for

If you compounded $100 for 3 years at

6% annually, semiannually, or quarterly,
what are the values for n and i ?

Formula
Formula

Annual Interest

Rate (j)

# of Compounding
Frequencies per
year(m)

6% /
Annually
Semiannually 6% /
Quarterly 6% /

McGraw-Hill Ryerson

No.
1
2
4

Rate -- ii
Rate
= 6%
= 3%
= 1.5%

8 - 19

Compound
Compound

Interest
Interest

Development of a Formula
Formula for Future Value
FV = PV(1 + i)n
Where

PV= Present Value(Principal)

i = rate per period
n = number of periods
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Compound Interest

8 - 20

- Future Value
n
FV
=
PV(1
+
i)
Formula
Formula

Steve Smith deposited $1,000 in a savings account for

4 years at a rate of 8%
compounded semiannually.
What is Steves interest and compounded amount?

Extract necessary data...

PV = $1000
n = 4X2=8
i = .08/2 = .04
McGraw-Hill Ryerson

Solve

Compound
Compound

Interest
Interest

Compound Interest
- Future Value
n
FV
=
PV(1
+
i)
Formula
Formula

Solve Using PV = $1000 n = 8 i= .04

FV = $1000(1 + .04)8
= $1000(1.368569)
= $1,368.57
Principal
$1,000.00
+ Interest
368.57
Compounded $1,368.57
McGraw-Hill Ryerson

8 - 21

Compound
Compound

Interest
Interest

BOTH
BOTH
wayswill
will
ways
bebe
shown!
shown!

McGraw-Hill Ryerson

There are two methods

that can be used to

calculate compound interest:

Use a calculator and

algebraic
sequencing
Use the TI BAII Plus
financial calculator!

8 - 22

8 - 23

Compound
Compound

Interest
Interest

Useaacalculator
calculatorand
andalgebraic
algebraicsequencing
sequencing
Use
Solve $1000(1 + .04)8

1368.57

.04
1

$1,368.57
$1,368.57
8

1000
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8 - 24

Useaacalculator
calculatorand
andalgebraic
algebraicsequencing
sequencing
Use
Find the
the following
following KEYS:
KEYS:
Find
The Power function Key.
Used to calculate the
value of exponents.
Used to access symbols located
above
another key,
i.e. its acts like the
SHIFT key on a
computer keyboard.
Changes the sign of the
data value of the number
being displayed.

McGraw-Hill Ryerson

8 - 25

Compound
Compound

Interest
Interest

Useaacalculator
calculatorand
andalgebraic
algebraicsequencing
sequencing
Use
Find the
the following
following KEYS:
KEYS:
Find

Some calculators have the yx symbol

above the calculator key.
The key stroke sequence to evaluate
an EXPONENT that is
8
(1.04)
is1.04
Positive
Positive

1.368569
Negative (1.04)-8 is1.04
Negative

0.73069
McGraw-Hill Ryerson

8 - 26

Compound
Compound

Interest
Interest

Useaacalculator
calculatorand
andalgebraic
algebraicsequencing
sequencing
Use
Find the
the following
following KEYS:
KEYS:
Find
Used to Store or save
displayed values.
Used to Recall the
saved values.
This calculator can store up to

McGraw-Hill Ryerson

10 values. the calculator must be

Therefore,
informed as to
where the values are to be
stored. Lets
Lets Practise
Practise

8 - 27

Compound
Compound

Interest
Interest

Useaacalculator
calculatorand
andalgebraic
algebraicsequencing
sequencing
Use
Using the
the
Using

key
key

e.g. you want to store the value 45.

The key stroke sequence to store is:
45
..choose
from 0 - 9
clear display
The key stroke sequence to recall is:
where you
stored the value!
McGraw-Hill Ryerson

8 - 28

Compound
Compound

Interest
Interest

Some key
key Keys!
Keys!
Some

McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8 - 29

Find the
the following
following KEYS:
KEYS:
Find
1. Number of compoundings
(for lump
payments)
2. Number of payments
(for
annuities)
The nominal
interest
rate
(Interest/Year)
Present Value or
initial(first) lump sum
Represents the
Periodic Annuity Payment
(used in chapter 10)
Future Value or
terminal(last) lump sum

McGraw-Hill Ryerson

Tells the calculator

to compute (CPT)

Compound
Compound

8 - 30

Find the
the following
following KEYS:
KEYS:
Find

Interest
Interest

Previously, it was noted that

it isis rare
rare for
forinterest
interest to
to be
be
it
compounded only
only once
once per
per year!
year!
compounded
However, we can now input the
number of compoundings per year
into the financial calculator.
This can be performed by using
the symbol
To access this symbol use:

and you will see

McGraw-Hill Ryerson

8 - 31

Compound
Compound

Interest
Interest

This display is referred to as the worksheet.

The12
12
The
isisaa
default
default
setting
setting

represents the number of Payments per Year

represents the number of Compoundings per Year
To access
use:

Appears
Appears
automatically
automatically

Note: You can override these values by entering

McGraw-Hill Ryerson

new ones!

more
more

8 - 32

Compound
Compound

Interest
Interest

If
the calculation
does not
involve
more
than
payment
must be
given
theone
same
value as

Illustration
Illustration
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8 - 33

Illustration
Illustration

represents the number of Compoundings per Year

InCompound
CompoundInterest,
Interest,P/Y
P/Y must
mustbe
be
In
giventhe
thesame
samevalue
valueas
asC/Y.
C/Y.
given
Settingaanew
newvalue
valuefor
forP/Y
P/Y
Setting

will
will

automaticallychange
changethe
theentry
entryfor
forC/Y
C/Y
automatically
tothe
thesame
samevalue
value
to
Wemust
mustkey
keyin
in
this
We
this
as
thedefault,
default,i.e.
i.e.P/Y
P/Y to scroll
as the
sequence
sequence
toclose
closeany
anyworksheet
worksheet
to
youhave
haveopened.
opened.
you
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

There are two methods

that can be used to

calculate compound interest:

Using the TI BAII Plus

financial calculator!

McGraw-Hill Ryerson

8 - 34

8 - 35

Compound
Compound

Interest
Interest

Usingthe
theTI
TIBAII
BAIIPlus
Plusfinancial
financialcalculator
calculator
Using

Steve Smith deposited $1,000 in a savings account for

4 years at a rate of 8% compounded semiannually.
What is Steves interest and
compounded amount?
Step 11
Step
Setthe
the
Set

frequency
frequency
of
of
interest
interest
compounding
compounding

Step 22
Step

Input values
values
Input
into the
the
into
financial keys
keys
financial

Using
McGraw-Hill Ryerson

8 - 36

Compound
Compound

Interest
Interest

Usingthe
theTI
TIBAII
BAIIPlus
Plusfinancial
financialcalculator
calculator
Using

Setthe
the
Step 11 Set
Step

frequency
frequency
of
of
interest
interest
compounding
compounding
SteveSmith
Smith
Steve
deposited$1,000
$1,000
deposited
inaasavings
savings
in
accountfor
for
account
yearsat
ataa
44years
rateof
of 8%
8%
rate
compounded
compounded
semiannually.
semiannually.

WhatisisSteves
Steves
What
interestand
and
interest
compounded
compounded
amount?
amount?
McGraw-Hill Ryerson

Inputvalues
values
Step 22 Input
Step
intothe
the
into
8.0
financial
FV=

1368.57

1000

financial
keys
keys

4*2
0

$1,368.57
$1,368.57

8 - 37

Compound
Compound

Interest
Interest

there is no need to keep inputting

each time!

The calculator remembers this step!

You only need to input the values that have changed!

McGraw-Hill Ryerson

8 - 38

Compound
Compound

Interest
Interest

CashFlows
Flows
Cash
..a term
term that
that refers
refers to
to payments
payments
..a
that can
can be
be either
either

that
payments received
e.g. receipts

Positives
Positives
McGraw-Hill Ryerson

++

Treated as:
as:
Treated

payments made
e.g. cheques

Negatives
Negatives

--

Compound
Compound

Interest
Interest

What is the effect on the

Future Value
of
different
Compounding Periods
of
Interest?
McGraw-Hill Ryerson

8 - 39

Compound
Compound

Interest
Interest

Compound Interest

8 - 40

- Future Value

If you compounded $100 for 3 years at 6%

annually, semiannually, or quarterly,
what are the final amounts that you would have at
the end of the three (3) years ?

Annual
Annual

FVA = 100(1.06)3

SemiSemi-

FVS = 100(1.03)6

$119.10
$119.10
$119.41
$119.41

Semi = 6%/2
Quarterly
Quarterly

FVQ = 100(1.015)12
Quarterly = 6%/4

McGraw-Hill Ryerson

$119.56
$119.56

Compound
Compound

8 - 41

Compound Interest

- Future Value

Interest
Interest

The Components of the Future Value of $100

SS or
or FV
FV

Future
FutureValue
Value

250

Interest
on

FV=PV(1+i)n

Interest

200

Interest on
Original
Principal

150

S=P(1+rt)
100

Original Principal

50

0
McGraw-Hill Ryerson

Time(Years)
1

10

11

Compound
Compound

Interest
Interest

Comparisons
McGraw-Hill Ryerson

8 - 42

Compound
Compound

Interest
Interest

Simple Vs Compound
Interest

AlJones
Jonesdeposited
deposited$1,000
$1,000in
inaasavings
savingsaccount
account
Al
for55years
yearsat
at10%
10%p.a..
p.a..
for

AnnualSSimple
impleIInterest
nterest
Annual
Rateof
of10%
10%
Rate

AnnualC
Compound
ompound
Annual
Rateof
of10%
10%
Rate

WhatisisAls
Als
What
impleIInterest
nterestand
and
SSimple

WhatisisAls
Als
What
nterestand
and
IInterest

Maturity
aturityV
Value?
alue?
M

McGraw-Hill Ryerson

Compounded
ompoundedV
Value?
alue?
C

8 - 43

Compound
Compound

Interest
Interest

Simple Vs Compound
Interest

8 - 44

AlJones
Jonesdeposited
deposited$1,000
$1,000in
inaasavings
savingsaccount
accountfor
for55years
yearsat
at10%
10%
Al
Simple
Simple

n = 5 * 1 = 5 i = .10

I = Prt
I = $1,000 * .10 * 5
= $500
FV = $1,000 + $500

= $1,500
McGraw-Hill Ryerson

Formulae
Formulae

Compound
Compound

FV = PV(1 + i)n
I = FV PV

Compare

= $1610.51 - $1000

Compare

FV = $1000(1.1)5
= $1,000 *1.6105

= $610.51

8 - 45

Compound
Compound

8 Future Values of $100 at

Interest
Interest

Various Rates of Interest Compounded

Annually
12%

Future
FutureValue
Value FV
FV

1800

1600

1400

1200

10%

1000

800

8%
600

6%

400

200

100
0
1

McGraw-Hill Ryerson

10

11

12

13

14

15

Years to Maturity,

16

17

18

19

20

21

22

23

24

25

26

Compound
Compound

Interest
Interest

Beginning
Beginning
Balance
Balance

$1,000
$1,000

McGraw-Hill Ryerson

Nominal Rates of Interest

Compared
Nominal
Nominal
Rate
Rate

6%
++6%

8 - 46

Compounding
Compounding
Period
Period

Ending
Ending
Balance
Balance

Annual
Semiannual

$1,060.00
$1,060.90

Quarterly

$1,061.36

Daily

$1,061.83

Compound
Compound

8 - 47

Future Values of $100 at the same Nominal Rate but

Future
FutureValue
Value FV
FV

Interest
Interest
2500

Different Compounding Frequencies

2000

12% Compounded

1500

monthly

1000

d
e
d
n
ou
p
m lly
o
a
C
u
12% Ann

500

100
0
McGraw-Hill Ryerson

10

15

Time (years)

20

25

Compound
Compound

Interest
Interest

8 - 48

Compounding Daily Interest

Calculate the Future Value of $2,000
compounded daily for 4 years
at 4.5%.

n
FV
=
PV(1
+
i)
Formula
Formula
n = 4 * 365 = 1460 i = .045 /365 = 0.0001232

FV = $2000(1+ .045/365)1460
$2,000 ** 1.1972
1.1972 == $2,394.41
$2,394.41
== $2,000
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8 - 49

Compounding Daily Interest

Solve FV =

2394.41

$2000(1+ .045/365)1460
.045
365
1
1460

2000
McGraw-Hill Ryerson

$2,394.41
== $2,394.41

Compound
Compound

8 - 50

Compounding Daily Interest

Interest
Interest

Setthe
the
Step 11 Set
Step

frequency
frequency
of
of
interest
interest
compounding
compounding
Calculate
the
Calculate the
FutureValue
Value
Future
of$2,000
$2,000
of
compounded
compounded
dailyfor
for44
daily
yearsat
at4.5%.
4.5%.
years

365

FV= - 2394.41

Inputvalues
values
Step 22 Input
Step
intothe
the
into
4.5
financialkeys
keys
financial

2000
4 * 365
0

$2,394.41
$2,394.41
McGraw-Hill Ryerson

Compound
Compound

8 - 51

Interest
Interest

You invested $6000 at 4.5% compounded quarterly.

After 2 years, the rate changed to 5.2%
compounded monthly.
What amount will you have 41/2 years after the initial
investment?

Prepare a time-line as part of the solution

McGraw-Hill Ryerson

8 - 52

Compound
Compound

Interest
Interest

You invested $6000 at 4.5% compounded quarterly.

After 2 years, the rate changed to 5.2%
compounded monthly.
What amount will you have 41/2 years after the
initial investment?

0
$6000

2 years

FV1 = PV2
i = .045/4 n = (2*4) = 8

FV1 = 6000(1+.045/4)8
= 6000(1.0936)
= 6561.75
McGraw-Hill Ryerson

4.5 years

FV2
i = .052/12 n = 2.5*12 = 30
FV2 = 6561.75(1+.052/12)30
= 6561.75(1.1385)
= $7470.61

8 - 53

Compound
Compound

Interest
Interest

Usingthe
theTI
TIBAII
BAIIPlus
Plusfinancial
financialcalculator
calculator
Using

Setthe
the
Step 11 Set
Step

frequency
frequency
of
of
interest
interest
compounding
compounding
You invested
$6000 at 4.5%
compounded
quarterly.
After 2 years,
the rate
changed to
4
5.2%
compounded
monthly.
What amount
will you have
41/2 years after
the initial
investment?
McGraw-Hill Ryerson

FV11==PV
PV22
FV

Inputvalues
values
Step 22 Input
Step
intothe
the
into
6000
financial
financial
keys
keys

6,571.75
4*2
4.5

$6,561.75
$6,561.75
FV2

8 - 54

Compound
Compound

Interest
Interest

Usingthe
theTI
TIBAII
BAIIPlus
Plusfinancial
financialcalculator
calculator
Using

Setthe
the
Step 11 Set
Step

frequency
frequency
of
of
interest
interest
compounding
compounding
You invested
$6000 at 4.5%
compounded
quarterly.
After 2 years,
the rate
changed to
12
5.2%
compounded
monthly.
What amount
will you have
41/2 years after
the initial
investment?
McGraw-Hill Ryerson

FV22
FV

Inputvalues
values
Step 22 Input
Step
intothe
the
into
financial
financial
keys
keys

7470.61
2.5*12
5.2

$7,470.61
$7,470.61

8 - 55

Compound
Compound

Interest
Interest

You borrowed $5000 at 7% compounded monthly.

On the first and second anniversaries of the loan,
you made payments of $2500.
What is the balance outstanding
immediately following the second payment?

Prepare a time-line as part of the solution

McGraw-Hill Ryerson

Compound
Compound

8 - 56

Interest
Interest

You borrowed $5000 at 7% compounded monthly.

On the first and second anniversaries of the loan,
you made payments of $2500. What is the balance
outstanding immediately following the second payment?
1 year
2 years
0
$5000 FV1 - $2500 = PV2
FV2
i = .07/12 n = 12
i = .07/12 n = 12
12
FV1 = 5000(1+.07/12)
FV2 = 2861.45 (1+.07/12)12
= 5000(1.072290)
= 2861.45(1.072290)
= 5361.45
= $3068.30
PV2 = 5361.45 2500.00
= $3068.30 2500.00
= 2861.45
NewBalance
Balance = $568.30
New
McGraw-Hill Ryerson

8 - 57

Compound
Compound

Interest
Interest

Usingthe
theTI
TIBAII
BAIIPlus
Plusfinancial
financialcalculator
calculator
Using
FV112500
2500==PV
PV22
FV

Step 11
Step
You borrowed
$5000 at 7%
compounded
monthly.
On the 1st. and 2nd
anniversaries of
the loan, you made
payments of $2500.
What is the
balance
outstanding
immediately after
the 2nd payment?
McGraw-Hill Ryerson

5000

FV= -5361.45
-2861.45

7.0
12

12
2500

$2,861.45
$2,861.45
FV2

8 - 58

Compound
Compound

Interest
Interest

Usingthe
theTI
TIBAII
BAIIPlus
Plusfinancial
financialcalculator
calculator
Using

Step 22
Step

You borrowed
$5000 at 7%
compounded
monthly.
On the 1st. and 2nd
anniversaries of
the loan, you made
payments of $2500.
What is the
balance
outstanding
immediately after
the 2nd payment?
McGraw-Hill Ryerson

FV22
FV

-2861.45

- 2,861.45
3068.30
568.30

2500

$568.30
$568.30

Compound
Compound

Interest
Interest

McGraw-Hill Ryerson

8 - 59

Compound
Compound

Interest
Interest

8 - 60

Formula for Present Value

-n
Formula
PV
=
FV(1
+
i)
Formula

Keys

1
This is the only
change to the
usual
sequence!

$PV
$PV
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8 - 61

Calculating Present
Present Value
Value
Calculating

You expect to need $1,500 in 3 years.

Your bank offers 4% interest
compounded semiannually.
How much money must
you put in the bank today (PV) to reach your goal in
3 years?

Prepare the solution(a) algebraically, and

(b) by financial calculator

McGraw-Hill Ryerson

8 - 62

Compound
Compound

Calculating Present
Present Value
Value
Calculating

Interest
Interest

-n
Formula
PV
=
FV(1
+
i)
Formula

You expect to need $1,500 in 3 years.

Your bank offers 4% interest compounded
semiannually. How much money must you put in the
bank today (PV) to reach your goal in 3 years?
n=3*2=6

i = .04/2 = .02

(a) PV = $1500(1+.02)-6
= $1500 * .8880

1,331.96
0.88797
1.02
6

= $1,331.96
1500
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8 - 63

Calculating Present
Present Value
Value
Calculating

You expect to need $1,500 in 3 years.

Your bank offers 4% interest compounded
semiannually. How much money must you put in the
bank today (PV) to reach your goal in 3 years?
3*2
1500

(b)

PV=

-1,331.96

$1331.96
$1331.96
McGraw-Hill Ryerson

8 - 64

Compound
Compound

Calculating Present
Present Value
Value
Calculating

Interest
Interest

-n
Formula
PV
=
FV(1
+
i)
Formula

What amount must you invest now at 5% compounded

daily to accumulate to $6000 after 1 year?
j = 5%
m = 365

PV = $6000(1+.05/365)-365
= $6000 * .9512

i = .05/365
n = 1*365 = 365
FV = $6000

= $5,707.40

5,707.40
0.0001
0.9512
1.001
.05
365
1
365

McGraw-Hill Ryerson

6000

8 - 65

Compound
Compound

Calculating Present
Present Value
Value
Calculating

Interest
Interest

What amount must you invest now at 5% compounded

daily to accumulate to $6000 after 1 year?
1 * 365
5

6000
PV= - 5,707.40
0

365

$5707.40
$5707.40
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8 - 66

Equivalent Payments
Payments
Equivalent

Two payments of $2200 each must be made 1 and 4 years

from now. If money can earn 5% compounded monthly,
what single
payment 3 years from now
would be
equivalent
to
the two
scheduled
payments?
Step
1
Draw
a
Time-line
Draw a Time-line
Step 1
Step 22 Find
Findthe
theFV
FVof
ofthe
thepayment
paymentthat
that
Step
movedfrom
fromYear
Year11to
toYear
Year33
isismoved
Step 33 Find
Findthe
thePV
PVof
ofthe
thepayment
paymentthat
that
Step
movedfrom
fromYear
Year44to
toYear
Year33
isismoved
Prepare the solution(a) algebraically, and
(b) by financial calculator
McGraw-Hill Ryerson

Compound
Compound

8 - 67

Equivalent Payments
Payments
Equivalent

Interest
Interest

Step 11
DrawaaTime-line
Time-line
Draw
Step
Two payments of $2200 each must be made 1 and 4 years
from now. If money can earn 5% compounded
monthly,
what single payment 3 years from now
would
be equivalent
to the two3scheduled
payments?
0
1 year
2 years
years
4 years
PV1 $2200
$2200 FV2
FV
i = .05/12
Step 22
Step

Findthe
theFV
FVof
of
Find
thepayment
payment
the
thatisismoved
moved
that
fromYear
Year11to
to
from
Year33
Year
McGraw-Hill Ryerson

n = 2*12 = 24 PV
2

(a) FV1
= 2200(1+.05/12)24
= 2200(1.1049)
= 2430.87

2430.87
Now

8 - 68

Compound
Compound

(b)

Interest
Interest

1 year

2 years

3 years

PV1 $2200

FV1
i = .05/12 n = 2*12 = 24 PV2
2*12
2200

Step 22
Step
Findthe
theFV
FVof
of
Find
thepayment
payment
the
thatisismoved
moved
that
fromYear
Year11to
to
from
Year33
Year

4 years
$2200 FV2

2430.87
0

12
Now

McGraw-Hill Ryerson

Compound
Compound

Equivalent Payments
Payments
Equivalent

Interest
Interest

8 - 69

1 year

2 years

PV1$2200

3 years
FV1

4 years
$2200

PV2
Step 33
Step
i = .05/12 n =1*12=12
Findthe
thePV
PVof
of
Find
(a) PV2 = 2200(1+.06/12)-12
the
payment
the payment
thatisismoved
moved
that
= 2200(0.9513)
fromYear
Year44to
to
from
Year33
Year
= 2092.92
Finally, this PV amount can be added to that put into memory
$4523.79
0
2430.87
McGraw-Hill Ryerson

8 - 70

Compound
Compound

(b)

Interest
Interest

1 year

2 years

PV1$2200
2,092.92
4,523.79
1*12
2200

McGraw-Hill Ryerson

3 years
FV1

4 years
$2200

PV2
n =1*12=12

Finally, this PV amount can be added

to that put into memory

Some of
of the
the
Some
values
values
have not
not
have
changed so
so
changed
there isis no
no
there
need to
to
need
enterthem
them
enter
again!
again!

0
2430.87

$4523.79

8 - 71

Compound
Compound

Interest
Interest

What regular payment will an investor receive

from a $10,000, 3 year, monthly payment GIC
earning a nominal rate of 4.8%
compounded monthly?
Interest rate per payment interval is:

i = j/m = .
= 0.0040
themonthly
monthly
PV *048/12
I = $10000 * 0.0040
the
paymentwill
willbe:
be:
payment

= $40.00

Makingaachoice!
choice!
Making
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

8 - 72

Making aa choice!
choice!
Making

Suppose a bank quotes nominal annual interest rates

of
6.6% compounded annually,
6.5% compounded semi-annually,
and
6.4% compounded monthly
on five-year GICs.
Which rate should an investor choose
for an investment of $1,000?

McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

j = 6.6%
compounded
annually

Supposeaabank
bank
Suppose
quotesnominal
nominal
quotes
annualinterest
interest
annual
ratesofof
rates
6.6%
6.6%
compounded
compounded
annually,
annually,
6.5%compounded
compounded
6.5%
semi-annually,
semi-annually,
and
and
6.4%compounded
compounded
6.4%
monthly
monthly
onfivefiveon
yearGICs.
GICs.
year
McGraw-Hill Ryerson

Which
Which

5*1
6.6

j = 6.5%

j = 6.4%

compounded
semi-annually
5*2

compounded
monthly
5 * 12

6.5

6.4

12

1376.89

1375.96

1000

8 - 73

1376.53

Comparisons

8 - 74

Compound
Compound

Comparisons

Interest
Interest

Results
Results
j = 6.6%
compounded
annually
j = 6.5%

1376.53
1376.53

compounded
semi-annually
j = 6.4%

1376.89
1376.89

compounded
monthly

1375.96
1375.96

the 6.5%
6.5% compounded
compounded semi-annually
semi-annually
the

provides for
forthe
the best
best
provides
rate of
of return
return on
on investment!
investment!
rate
McGraw-Hill Ryerson

8 - 75

Compound
Compound

Interest
Interest

of Interest Rates
McGraw-Hill Ryerson

8 - 76

Compound
Compound

Interest
Interest

of Interest Rates
An investment in a GIC might have a

FixedRate
Rate
Fixed

Step-upRate
Rate
Step-up

Variable Rate
Rate
Variable

theinterest
interest
the
ratedoes
doesnot
not
rate
changeover
overthe
the
change
termof
ofthe
theGIC.
GIC.
term

theinterest
interestrate
rateisis
the
increasedevery
every66
increased
monthsor
orevery
everyyear
year
months
accordingto
toaaprepreaccording
determinedschedule.
schedule.
determined

... is
is adjusted
adjusted every
every
...
year or
or every
every 66
year
months to
to reflect
reflect
months
market rates
rates
market
may be
be aa minimum
minimum
may
floor
floor
below which
which rates
rates
below
cannot drop
drop
cannot

McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Payment of
of
Payment
Interest
Interest

RegularInterest
Interest
Regular
version
version
Interest
Interestisispaid
paid

totothe
theinvestor
investor
every
everyyear
yearor
orevery
every66
months
months
McGraw-Hill Ryerson

8 - 77

Compound Interest
Interest
Compound
version
version
Interest
Interestisisperiodically
periodically

converted
convertedtotoprincipal
principal
and
and
paid
paidatatmaturity
maturity

8 - 78

Compound
Compound

Interest
Interest

Canadian
Savings
Bonds
McGraw-Hill Ryerson

Compound
Compound

Interest
Interest

Canadian
Savings
Bonds

- Can be purchased from financial institutions but

funds go to federal government to help finance its debt
- usual term is 10 or 12 years
- variable interest rates
- interest rate is changed on each anniversary,
with minimum rates for subsequent 2 years
To view current rates of interest and redemption values

Go to http://www.cis-pec.gc.ca/
McGraw-Hill Ryerson

8 - 79

Compound
Compound

Interest
Interest

McGraw-Hill Ryerson

8 - 80

Compound
Compound

Interest
Interest

Canadian
Savings
Bonds

All CSBs
CSBsissued
issuedup
upto
to 1988
1988 (Series
(Series 11to
to 43)
43)have
have matured
maturedand
andare
areno
no
All
longerearning
earninginterest.
interest.
longer
The rates
ratesof
of interest
interestfor
forSeries
Series45
45 to
to70
70 for
forsubsequent
subsequent years
yearsto
to maturity
maturity
The
will be
be announced
announcedat
at future
futuredates.
dates.
will
McGraw-Hill Ryerson

8 - 81

Compound
Compound

Interest
Interest

McGraw-Hill Ryerson

8 - 82

8 - 83

Compound
Compound

Interest
Interest

Concepts
The fair market value of
an investment
is the
sum of the Present
Values of the
expected cash flows.

McGraw-Hill Ryerson

The discount rate used

should be
the prevailing market
determined rate of return
required
on this type of
investment.

Compound
Compound

Interest
Interest

McGraw-Hill Ryerson

8 - 84

Compound
Compound

8 - 85

Interest
Interest

owner
ownerwill
willreceive
receiveaasingle
single

payment(called
(calledthe
theface
facevalue
value
payment
thebond)
bond)on
onthe
the
ofofthe
bondsmaturity
maturitydate
date
bonds

McGraw-Hill Ryerson

the
thematurity
maturitydate
date

couldbe
beas
asmuch
muchas
as30
30
could
yearsin
inthe
thefuture.
future.
years
Nointerest
interestwill
willbe
bereceived
received
No
inthe
theinterim!
interim!
in

8 - 86

Compound
Compound

Interest
Interest

Suppose a $10,000 face value strip bond

matures 18 years from now.
The owner of this bond will receive a payment of $10,000
in 18 years.
What is the appropriate price to pay for the bond today
if the prevailing rate of return is 5.75%,
compounded semi-annually?

FV = $10000

= .0575/2
n = 18 * 2 = 36

McGraw-Hill Ryerson

PV = 10000(1+.0575/2)-36
= 10000(0.3605)
= $3604.50

8 - 87

Compound
Compound

Interest
Interest

j = 5.75%
m=2
n = 18*2 = 36
FV = $10000

Suppose a $10,000 face value strip bond

matures 18 years from now. The owner of this
bond will receive a payment of $10,000 in 18
years.What is the appropriate price to pay for
the bond today if the prevailing rate of return is
5.75%, compounded semi-annually?
18 * 2
10000
5.75

PV = -3,604.50
0

2
$3604.50
$3604.50

McGraw-Hill Ryerson

8 - 88

Compound
Compound

Interest
Interest

This completes Chapter 8

McGraw-Hill Ryerson