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Topic 3 Compound Interest

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Topic 3 Compound Interest

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marissanagu06
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
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TOPIC 3

COMPOUND INTEREST

Lecturer : Muhammad Shahimi Bin Ariffin


Introduction
 Compound interest is another method of interest calculation.
 Compound interest is calculated based on the original principal plus the interest
accumulated from the previous period .
 This adjusted principal (old principal + interest) becomes the principal for the next calculation
of interest.
 Compound interest is sometimes referred to as “earn interest on interest”.
Simple interest vs Compound interest
Situation : RM100 is invested for three years in Account A and Account B. Account A uses
simple interest concept while Account B uses compound interest concept in calculating the
interest. Suppose the rate of interest is 10% p.a for both accounts. Calculate the total interest
earned at the end of investment period for both accounts.
IMPORTANT TERMS IN COMPOUND INTEREST

TERM NOTATION DESCRIPTION


Original Principal P Initial value of investment/loan
Nominal l interest rate k The interest/dividend for a year
Frequency of conversion m The number of times interest is calculated/paid in a
year
Term of investment/loan t Time period of investment/loan (year)
Periodic interest rate i 𝑘
Interest rate for each interest period (𝑖 = )
𝑚
The total number of interest n number of times interest is calculated during the
period. term of the loan or investment.
𝑛 = 𝑚𝑡
Frequency of conversion (m)
Term Definition
Compounded annually interest is calculated on balance once a year. 𝑚=1
Compounded semi-annually interest is calculated on balance every 6 months. 𝑚=2

Compounded quarterly interest calculated on balance every 3 months. 𝑚=4


Compounded monthly interest calculated on balance every month. 𝑚 = 12
Compounded every 2 months interest calculated on balance every 2 months. 𝑚=6
Compounded every 4 months interest calculated on balance every 4 months. 𝑚=3
Let’s try ……….
Determine the value of 𝑃, 𝑚, 𝑘, 𝑡, 𝑖, 𝑎𝑛𝑑 𝑛 for the following.
1. RM7,500 is invested at 12% compounded quarterly for two years and three months.
2. RM7,500 is invested at 12% compounded quarterly for two years and three months.
3. RM10,00 is invested for 3% compounded monthly for four years and nine months.
4. RM20,000 is invested for 7.5% compounded annually for six years.
THE FORMULA

1) Future value/Compound amount/Accumulated value ( S )

𝑆 = 𝑃(1 + 𝑖)𝑛

2) Present value/ Principal (P)


𝑆
𝑃=
(1 + 𝑖)𝑛

3) Amount of interest ( I )
𝐼 =𝑆−𝑃
Example 1

RM5,000 is invested for 3 years. Find the compound amount and interest received at the
end of 3 years if the investment earns 8% compounded annually.
Example 2

Sue deposited RM3,500 in a saving account. The interest rate is 12% compounded quarterly
for 4 ½ years. Find the future value and interest that she earned.
Example 3

Amir deposited RM500 in a saving account for eleven years. The interest rate is 6%
compounded semiannually for the first 5 years and 8% compounded quarterly for the next 6
years. What is the amount in his saving account at the end of the 11th year.
Example 4

RM9,000 is invested for 7 years 3 months. This investment is offered 12% compounded
monthly for the first 4 years and 12% compounded quarterly for the rest of the period.
Calculate the future value of this investment.
Example 5

Kamariah saved RM5,000 in a saving account which pays 12% compounded monthly.
Eight months later she saved another RM4,000. Find the amount in the account 2 years after
her first savings.
Example 6

Roslan invested RM4,500 into an account that pays 6% compounded quarterly. He intended
to keep the saving untouched for 4 years. However, he withdrew RM2,200 after 2 years of
investment. Find the amount left in his account 4 years from the time he made his
investment.
Example 7

A sum of money was deposited in a savings account that earned interest at 4%


compounded quarterly. If the accumulated amount at the end of 5 years was RM6,083.26,
find
a) The amount deposited
b) The accumulated amount at the end of 10 years
c) The total interest at the end of 10 years
Example 8

A debt of RM3,000 will mature in 3 years’ time. Find the future value of this debt, assuming money is
worth 14% compounded annually.
Example 9

Find the present value of RM2,479.27 due at the end of 4 ½ years if money is worth 12%
compounded quarterly.
Example 10

Idayu invested RM B in Bank Z that pays 5.5% compounded quarterly. The amount will be
accumulated to RM12,000 in 27 months’ time. Calculate the value of B.
Example 11

A certain sum of money was invested in an account that pays 3% interest compounded every 3 months.
The amount at the end of 3 years was RM10,500. Calculate the original principal that was invested.
EFFECTIVE RATE AND NOMINAL RATE

• When interest is computed annually (once a year), it is called effective rate.


• When interest is calculated more than once a year, it is called nominal rate.
• The effective rate is used as a common basis for comparing an investment with different
compounding period.

EFFECTIVE RATE
Relationship between E.R and N.R
𝑖
𝑘
=
𝑚
𝒓 = (𝟏 + 𝒊)𝒎 − 𝟏
where : r = effective rate
i = nominal rate
Example 12
Find the effective rate which is equivalent to 14.5% compounded monthly.
12
0.145
𝑟 = 1+ −1
12
𝑟 = 0.1550
𝑟 = 15.50%
The end….

THANK YOU

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