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CHAPTER 3

1. Compound interest
2. Effective rate
3. Odd periods and fractional compounding
4. Continuous compounding
5. Conversions
6. Time value of money
7. Equation of value

1. COMPOUND INTEREST

 Only one principle value

 Interest calculations are done more than once according to the number of compounding
periods in one year, specified.
 Earn interest on interest

Formula:
tm
 j 
S  P  1  m  or S  P  1  i 
n

 m
jm – nominal interest rate per year
m – number of compound periods in 1 year
t – years or fraction of year!!!
tm – also known as N on your calculator

ID: compound interest + one principle

Calculator: financial or normal mode

Calculator example 1

Susan deposits R15 000 into a new savings account. The amount of money that she will have in
the bank after three years, if interest is compounded monthly at 8% per year, equals?

ID: compounded interest/one principle.

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tm
 j 
S  P 1  m 
 m
with P  15 000 ; jm  0,08
m  12 ; t  3

312
 0,08 
S  15 000  1 
 12 
 R19 053,56

Using your calculator’s financial keys we enter the values as follows:

FV I/Y or I/YR enter as a %

𝟎,𝟎𝟖 𝟑 𝟏𝟐
``𝑺 𝟏𝟓 𝟎𝟎𝟎
`` 𝟏
𝟏𝟐

PV P/Y or N
P/YR
SHARP:
2ndF CA
2ndF P/Y 12 ENT ON/C
3 × 12 = N or 3 2ndf ×P/Y N
± 15000 PV
8 I/Y
COMP FV

HP:
ORANGE C ALL
12 ORANGE P/YR
3 × 12 = N or 3 ORANGE ×P/YR N
15000 ± PV
8 I/YR
FV
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Calculator example 2

Harry’s parents think that they will need R170 000 to pay for his university fees in 15 years'
time. They invest money at 7,71% per year, compounded quarterly. Determine the amount that
they need to invest now.

ID: compounded interest/one principle

tm
 j 
S  P 1 m 
 m

154
 0,0771 
170 000  P  1 
 4 

R54 071,27 must be invested.

Using your calculator’s financial keys we enter the values as follows:

Do not change the formula – your calculator financial mode can solve it as it
is!!!!!!! Enter the known values then press the unknown last.

FV I/Y or I/YR enter as a %

𝟎,𝟎𝟕𝟕𝟏 𝟏𝟓 𝟒
𝟏𝟕𝟎𝟎𝟎𝟎
`` 𝑷` 𝟏
` 𝟒

PV P/Y or N
P/YR
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SHARP:
2ndF CA
2ndF P/Y 4 ENT ON/C
15 × 4 = N or 15 2ndf ×P/Y N
± 170000 FV
7.71 I/Y
COMP PV

HP:
ORANGE C ALL
4 ORANGE P/YR
15 × 4 = N or 15 ORANGE ×P/YR N
170000 ± FV
7.71 I/YR
PV
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2. EFFECTIVE RATE

 Effective interest rate is the rate that you in effect will receive in one year.
 You actually earn more as the specified compound interest rate because of the compounding
effect.
 To illustrate:

If you invest R100 for 3 months at 12% per year, compounded monthly:
tm
 j 
S  P 1 m 
 m
3 12

 ,12  12 1
 100  1 
 12 
 103,03

Thus the interest earned is

R100 – R103,03 = R3,03

Now if you calculate the interest rate earning of R3,03 it is

I  Pr t
3
3,03  100  r 
12
r  12,12%

Thus although the rate is 12% you earn 12,12% effectively.

Formula:

 jm 
m

J eff  100   1    1 
 m 
 
ID: effective interest rate
Calculator: financial or normal mode
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Calculator example 1

Determine the effective rate for a nominal rate of 18,75% per year, compounded every three
months.

ID: effective interest rate

 jm 
m

J eff  100   1    1
 m 
 
 0,1875 
4

 100   1    1 
 4 
 
 20,11%

The effective rate is 20,11%.

Using your calculator’s financial keys we enter the values as follows:

EFF (x,y) or NOM%

, ``
𝐽 `` 100 1 1
(x,y) or P/YR

SHARP:
2ndF CA
4 (x,y) 18,75
2ndF EFF

HP:
ORANGE C ALL
4 ORANGE P/YR
18,75 ORANGE NOM%
ORANGE EFF%
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Calculator example 2

Determine the nominal rate per year, compounded monthly for an effective rate of 20,75%.

ID: effective interest rate

 jm 
m

J eff  100   1    1 
 m 
 
𝑗
20,75 100 1 1
12

The nominal rate is 19,00%

Using your calculator’s financial keys we enter the values as follows:

Do not change the formula – your calculator financial mode can solve it as it
is!!!!!!! Enter the known values then press the unknown last.

SHARP:
2ndF CA
12 (x,y) 20,75
2ndF APR

HP:
ORANGE C ALL
12 ORANGE P/YR
20,75 ORANGE EFF%
ORANGE NOM%
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3. ODD PERIODS AND FRACTIONAL COMPOUNDING

 Odd period: Time period is not a full compounding period but smaller

 Different methods to deal with it:

1. Use simple interest for odd periods and compound interest for full periods -Important is
to draw a time line.

2. Fractional compounding
Use compounding formula but the time period is calculated as the full period plus the odd
period expressed as a fraction of the compounding period. – Page 37 MO001

 See notes on odd periods under Announcements on myUnisa for an

example.

ID: odd periods or method given

Calculator: financial or normal mode

Fractional compounding:

FV I/Y or I/YR enter as a %

𝟐𝟔 𝟔 𝟐𝟎
𝟎,𝟎𝟖𝟑𝟕 𝟏𝟐
``𝑺 𝟕𝟓 𝟎𝟎𝟎
`` 𝟏 𝟑𝟔𝟓 𝟏𝟐 𝟑𝟔𝟓
𝟏𝟐

PV P/Y or N
P/YR
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4. CONTINUOUS COMPOUNDING

 Number of compounding periods almost an infinite number of times

 Formula:
S  Pe ct
c – continuous compounding rate
t – must be yearly, if not change!

Note: The mathematical constant e is a unique real number. The number e is of considerable
importance in mathematics. The numerical value of e truncated to 20 decimal places is
2,71828182845904523536. Some calculators have a specific key (for example ex) to calculate
the value of the power of e. You should be able to call up the specified value of e by entering e1
into your calculator.

ID: continuous compounding or continuous rate

Calculator: normal mode

Calculator example 1

An amount of R5000 was invested at a continuous compounding interest rate of 10%. The
accumulated amount after 5 years is?

ID: continuous compounding rate

𝑺 𝑷 𝒆𝒄𝒕
𝑺 𝟓𝟎𝟎𝟎𝒆 𝟎,𝟏𝟎 𝟓

𝑺 𝟖𝟐𝟒𝟑, 𝟔𝟏

SHARP:
2ndF CA
5000 × 2ndF ex ( 0.10 × 5) =
Please remember to put the brackets round the power of the e!!!!

HP:
ORANGE C ALL
Note you start from the back to the front!
0.10 × 5 = ORANGE ex × 5000 =
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Calculator example 2

If R2 800 accumulates to R3 798 in 42 months, determine the continuous compounding rate.

ID: continuous compounding

S  Pe ct
42
c
3798  2800e 12

We need to solve c. We can’t solve thus using our financial mode. We need to manually
manipulate the formula till c is the subject of the formula.
42
3798 c
e 12
2800
But c in the power – use a ln rule to bring it “down”. We take ln on both sides of the equation:
42
 3798  c
ln    ln e 12

 2800 

Now ln a x  x ln a is a ln rule . Thus

 3798   42 
ln     c   ln e
 2800   12 
But ln e  1

 3798  42
ln   c
 2800  12
c  8,7%
SHARP:
2ndF CA
2ndF ln ( 3798 ÷ 2800 ) ÷ (42 ÷ 12 ) =

HP:
ORANGE C ALL
3798 ÷ 2800 = ORANGE LN × 12 ÷ 42 =
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5. CONVERSIONS BETWEEN DIFFERENT TYPES OF INTEREST

RATES

 Between nominal rate jm and continuous compounding rate c

Formulas

 j 
c  m ln  1  m 
 m
OR
𝒄
𝒋𝒎 𝒎 𝒆𝒎 𝟏

ID: continuous compounding rate AND compounding rate (nominal rate)

Calculator: normal mode

Calculator example 1

Determine the continuous compounding rate for a 12% nominal rate per year, compounded every
three months.

 j 
c  m ln  1  m 
 m
 0,12 
 4ln  1 
 4 
 11,824%

SHARP:
2ndF CA
4 × 2ndF ln ( 1 + 0.12 ÷ 4) =

HP:
ORANGE C ALL
0.12 ÷ 4 = + 1 = ORANGE LN × 4 =
Note you start from the back to the front!
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 Between continuous compounding rate and effective rate


J   100 e c  1 
ID: continuous compounding rate AND effective rate
Calculator: normal mode

Calculator example 1

Determine the effective rate for a 9% continuous compounding rate.


J   100 e c  1 
 100  e 0,09
1 
 9, 42%

SHARP:
2ndF CA
100 × ( 2ndF ex 0.09 – 1 ) =

HP:
ORANGE C ALL
0.09 ORANGE ex – 1 = × 100 =

 Ordinary compounding rate to an equivalent compounding rate but with

different compounding periods

Sometime we need to convert a given compounding period to another compounding period and
still get the same return – see example 3.5 in study guide. This is normally necessary in the case
of annuities if we have for example monthly payments but the compounding rate is quarterly.
𝒎
𝒋𝒎 𝒏
𝒋𝒏 𝒏 𝟏 𝟏
𝒎

Tip: Remember n stands for new compounding periods and m the old compounding periods

ID: old compounding rate AND new compounding rate

Calculator: normal mode
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Calculator example 1

An interest rate of 15,25% per year compounded half-yearly is equivalent to a quarterly

compounded interest rate of?

 j 
mn

i  n  1  m   1
 m 
 
 0,1525 
2 4

 4  1    1
 2  
 
 14,97%

SHARP:
2ndF CA
4 ( ( 1 + 0.1525 ÷ 2)
2ndF yx ( 2 ÷ 4 ) – 1 )=

HP:
ORANGE C ALL
Note you start from the back to the front!
0.1525 ÷ 2 = + 1 =
ORANGE y x
ORANGE ( 2 ÷ 4 ORANGE ) =
– 1 = × 4 =

6. TIME VALUE OF MONEY

 An amount of money has a different value at different time periods because of interest.
 Moving money forward in time or calculating a FV value, we multiply the present value by
an interest component. Thus the present value increases over time if we move money forward
in time. Thus
j
S  P (1  m )tm
m
 If we have a future value and we need to determine the present value of that amount we
divide by an interest component or multiply by interest component to the power of –1 . Thus
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the future value becomes less as we move it back in time. Moving money back in time or
calculating a PV value is

S
P
j
(1  m )tm
m
or
jm  tm
P  S (1  )
m
 Always draw a time line of the situation.
 The value t is from where to where you are moving the money.

Calculator: financial mode or normal

ID: Rescheduling someone’s debt and compound interest

Calculator example 1

R35 000 must be paid back in three years’ time from now. Interest is calculated at 8,4% per
year, compounded half yearly. Calculate the amount that must be paid if the debt is paid
(a) six months from now.
(b) five years from now.

ID: Rescheduling his debt and compound interest

(a) Drawing a time line:

t = 2,5 years

? R35 000

now 6 months 3 years

We need to move the R35 000 from time period three years to time period six months. We move
it two and a half years in total back in time. When we move money back in time we calculate a
PV thus we divide by the interest component or multiply with the negative power of the interest
component. Thus
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tm
 j 
S  P 1  m 
 m
S  35 000
jm  0, 084
m2
t  2, 5
 tm
 j 
P  S 1  m 
 m
2,52
 0, 084 
 35 000  1 
 2 
 28492, 43

The amount that must be paid back six months from now is R28 492,43.

Do not change the formula – your calculator financial mode can solve it as it
is!!!!!!! Enter the known values then press the unknown last.

Remember the 35 000 is FV because we have the negative in the power which
mean we are dividing or calculating a PV.

FV I/Y or I/YR enter as a %

𝟎,𝟎𝟖𝟒 𝟐,𝟓 𝟐
``𝑷 𝟑𝟓 ``𝟎𝟎𝟎 𝟏
𝟐

PV P/Y or N Don’t enter the negative

P/YR
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SHARP:
2ndF CA
2ndF P/Y 2 ENT ON/C
2.5 × 2 = N or 2.5 2ndf ×P/Y N
± 35000 FV
8.4 I/Y
COMP PV

HP:
ORANGE C ALL
2 ORANGE P/YR
2.5 × 2 = N or 2.5 ORANGE ×P/YR N
35000 ± FV
8.4 I/YR
PV

(b) Drawing a time line:

t =2 years

? R35 000

now 6 months 3 years 5 years

We need to move the R35 000 from time period three years to time period five years. Thus we
need to move it forward in time. In total two years forward. When we move money forward in
time we calculate a FV thus we multiply with the interest component. Thus
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tm
 j 
S  P 1  m 
 m
P  35 000
jm  0, 084
m2
t2
22
 0, 084 
S  35 000  1 
 2 
 41 260, 92

The amount that must be paid back five years from now is R41 260,92.

SHARP:
2ndF CA
2ndF P/Y 2 ENT ON/C
2 × 2 = N or 2 2ndf ×P/Y N
± 35000 PV
8.4 I/Y
COMP FV

HP:
ORANGE C ALL
2 ORANGE P/YR
2 × 2 =N or 2 ORANGE ×P/YR N
35000 ± PV
8.4 I/YR
FV

7. EQUATION OF VALUE

 Sometimes we want to reschedule the payments of our debts.

 To calculate the new payments the

sum of the obligations must be equal to the sum of the payments.

 We can only add amounts that are at the same time period because of the time value of
money. Thus we need to move all the moneys to the same date before we can add or subtract.
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 Moving money forward we × by interest component (1+jm/m)tm thus calculating a FV value.

 Moving money back we ÷ interest component (1+jm/m)tm or × by interest component to the
power of –1 (1+jm/m)–tm calculating a PV value.
 Always draw a time line of the situation.
 The value t is from where to where you are moving the money.

 See notes on Equation of value under Announcements on myUnisa for an

example.

ID: Compound interest and more than one payment and debts and rescheduling of debts

A summary of the steps to follow is:

1. Draw a time line.
2. Determine the comparison date.
3. Move all the loan moneys and X’s of the payments to the date the answer is asked or
comparison date, due to time value of money.
a. If you move money forward multiply by (1+jm/m)tm.
b. If you move money backward you divide by (1+jm/m)tm or multiply with
(1+jm/m)–tm.
c. Remember the value of t is from where to where you are moving the money.
4. Now add all the loans together.
5. Add all the payments together.
6. Now according to the equation of value the sum of the loans = sum of the payments.
7. Now solve for X.
8. Answer the question.