COMPOUND

INTEREST
P R E PA R E D B Y F A D H I L A H C H E J A M I L
LEARNING OUTCOME
1. Explain the concept of time value of money.
2. Derive the compound amount formula.
3. Use the compound amount formula to find the future value, compound interest, and
present value of investments and loans.
4. Determine the effective interest rate and nominal rate.
5. Establish the relationship between effective rates and nominal rates.
6. Establish the relationship between two nominal rates.
7. Use the equation of value to solve problems relating to investments and loans.
CONTENT

6.1 INTRODUCTION
6.2 COMPOUND INTEREST FORMULA
6.3 EFFECTIVE AND NOMINAL RATES
6.4 PRESENT VALUE
6.4.1 NET PRESENT VALUE
6.5 EQUATION OF VALUE
6.1 INTRODUCTION

• Compound interest is calculated on the original and on the accumulated past interest.
• Concepts of compound interest are used in financial planning, investment, budgeting and
financial control.
• Money has time value that is a ringgit today is worth more than a ringgit tomorrow.
• It is because of its investment opportunities.
• Time value of money should not be confused with inflation which tends to reduce the
purchasing power of money.
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COMPOUND INTEREST

Computation based on the principal

which changes from time to time

Interest that is earned is

compounded/converted into principal
and earns interest thereafter

Principal changes from time to time

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SIMPLE INTEREST VS COMPOUND
INTEREST

SIMPLE INTEREST COMPOUND INTEREST

- Computation based on
- Computation based on principal which grows
original principal from one interest
- Simple amount function interval to another
linear function - Compound amount
function : exponential
function
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Example 1
RM1000 is invested for three years. Find the amount and interest received at the end of three
years if the investment earns 8% compounded annually.
6.2 COMPOUND INTEREST FORMULA
Future value, S after n interest periods

S = P (1 + i )
n
Where,
S= Future Value/Compound Amount

k
i = = Periodic Interest Rate
m
m = Annual nominal rate (Interest rate for a year together with the frequency in which interest
is calculated in a year)

n = mt = number of interest period in the investment period

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Example 1
State the value for k and m for each of the following
a) 7% compounded annually
b) 13% compounded semi annually
c) 9.5% compounded quarterly
d) 15% compounded monthly
e) 4.5% compounded every two months

3
f) 3 % compounded daily
4

1
g) 6 % compounded weekly
8
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Example 2
Katty Perry invested RM50,000 in an account for 3 years which pays 6.5% interest compounded
semi-annually. Calculate the future value of the investment?
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Example 3
Deco Company invest RM12,000 in an account for 3 years at 4.5% compounded annually. Find
a) the amount to which it will accumulate
b) the compound interest earned
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Example 4
At what rate of interest for the principal of RM12,120 become RM16,420 due for 3 years
compounded semi-annually.
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Example 6
Gina saved RM7,000 in a savings account which pays 7.25% interest compounded monthly. Eight
months later she saved another RM4,000. Find the amount in the account two years after her
first saving.
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Example 7
RMX was deposited in a savings account at 4.25% interest compounded monthly. Forty months
later, RM4,200 was withdrawn from the account and the balance was RM4,212.39. Find the value
of X.
6.3 EFFECTIVE AND NOMINAL RATES
Effective & Nominal
Rates

Effective/Annual
Nominal rate, k%
Effective rate, r%

Interest is calculated
Actual rate that is
more than once a
earned in a year
year

Equivalent Rates Can also be defined

When they yield the SAME FUTURE as the simple
VALUE at the end of one year interest rate
earned in a year
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Example 8
RM100 is invested for one year. If the interest is
a) 9.04% compounded annually
b) 8.75% compounded quarterly
Find the amount after one year.
6.3.1 RELATIONSHIP BETWEEN
EFFECTIVE AND NOMINAL RATES
Assume a sum of RMP is invested for one year. Then the future value after one year
a) At r% effective = P (1 + r )
m
 k
b) At k% compounded m times a year = P 1 + 
 m

Equating the future values in a) and b), we obtain

m
 k
(1 + r ) = 1 + 
 m
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Example 9
Find effective rate which is equivalent to 12.45% compounded semi-annually
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Example 10
Find the nominal rate, compounded monthly which is equivalent to 8% effective rate.
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Example 11
Find the annual effective rate that is equivalent to 5.25% compounded daily (assume 360 days in a
year)
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Example 12
South Bank offers two interest rates for personal loan:
Offer 1: 12% compounded quarterly
Offer 2: 13.55% simple interest
If you want to have the personal lean, which offer would you choose and why?
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Example 13
Bank XYZ offers two interest rates for fixed deposits.
Offer 1: 15.2% compounded quarterly
Offer 2: 14.5% compounded monthly
If you want to invest for one year, which offer would you choose and why?
6.3.2 RELATIONSHIP BETWEEN
TWO NOMINAL RATES
The relationship between two nominal rates is given as follows

m M
 k  K
1 +  = 1 + 
 m  M
where,
K and k = two different annual rates
M and m = two different frequencies of conversions
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Example 14
Find the nominal rate of interest compounded monthly that is equivalent to 13% compounded
every 3 months.
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Example 15
Find k% compounded quarterly which is equivalent to 7.5% compounded monthly.
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Example 16
Find the nominal rate, compounded monthly that is equivalent to
3
a) 5 % compounded quarterly
4

1
b) 8 % compounded semi-annually
2
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c) 15% compounded monthly

d) 7.35% compounded weekly

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e) 12.5% compounded daily
6.4 PRESENT VALUE
The present value (or discounted value) at i% per interest period of an amount S due in n
interest periods is that value P which will yield the sum S at the same interest rate after n
interest periods. Hence, from

S=P(1+i)n

P=S/(1+i)n

P=S(1+i)-n
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Example 17
Mr. Smith invested a certain sum of money in an account that pays 3¼% compounded monthly.
The account will amount to RM20,000 in 27 months’ time. Calculate the original principal that
was invested.
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Example 18
At what amount to be invested in order to get the due amount of RM25,000 at the given rate of
6% compounded semi-annually for a period of seven years.
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Example 19
A debt of Rm9,000 will mature in four years’ time. Find
a) the present value of this debt
b) the value of this debt at the end of the two year
c) the value of this debt at the end of five years
assuming money is worth 12% compounded quarterly.
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Example 20
A home theatre set is estimated to cost of RM7,000 in two years’ time. If Fariz wishes to buy this
home theatre set in two years’ time, how much he save now in an account that pays 12%
compounded every four months?
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Example 21
How much should you invest today at 15.25% compounded quarterly in order to have RM25,000
in four years?
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Example 22
A sum of money RMX was deposited in a savings account with interest 7% compounded monthly
on 1 June 2019. On 1 September 2019, RM500 was withdrawn and balance as of 1 April 2020 was
RM6,464.40. Find the value of X.
6.4.1 NET PRESENT VALUE
Net present value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to analyse the profitability of an
investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.
The present value of
The investments’
NPV = its annual net cash - Initial Outlay
flow (After tax)

Present value of Present value of

NPV = -
inflows outflows

The accept – Reject Criterion

If NPV ≥ 0 → Accept
NPV ≤ 0 → Reject
NPV = 0 → Should be accepted because it returns require rate of return
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Example 23
Given the cost of money is 11.5% per annum, and if RM90,000 is available for investment,
determine the Net Present Value (NPV) of the following investment opportunities if the project
yearly cash flows are RM35,000, RM40,000 and RM45,000 respectively from first year until third
year. State whether the investment should be accepted or not.
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Example 24
OTOBOT Company is considering an important proposal with the following cash flows.

Period Cost (Initial Outlay) Net Cash Flow

0 RM60,000
1 RM24,000
2 RM25,000
3 RM30,000

Find the net present value using a discount rate of 9%. Should the proposal be given the green
light?
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Example 25
Shaun Company is considering two important proposals with the following cash flows.

Project A Project B
Period
(Year) Cost Net cash Cost Net cash
(Initial Outlay) flow (Initial Outlay) flow
0 RM45,000 RM60,000
1 RM25,000 RM24,000
2 RM20,000 RM25,000
3 RM15,000 RM30,000

Find each project, compute its net present value using a discount rate 15%. Which project should
be accepted if the projects are mutually exclusive?
6.5 EQUATION OF VALUE

In computing of value using the compound interest rate, the two sets of obligations are the
same no matter where we put the focal point,
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Example 26
A debt of RM8,000 matures at the end of the second year and another of RM9,500 at the end six
years. If the debtor wishes to pay his debts by making one payment at the end of the fifth year,
find the amount he must pay if money is worth 6.25% compounded semi-annually using
a) the present as the focal date
b) the end of the fifth year as the focal date
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Example 27
A debt of RM3,000 matures at the end of the second year and another of RM7,000 at the end six
years. If the debtor wishes to pay his debts by making one payment at the end of the fourth year
and the seventh year, what are these payments assuming money is worth 5% compounded semi-
annually?
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Example 28
Mr. Jack invested RM30,000 at 7% compounded [Link] investment will be given to his
three children when they reach 20 years old. Now his three children are 15, 16 and 19 years old.
If his three children will receive equal amounts, find the amount each will receive.