CHAPTER 2 (PART II – COMPOUND INTEREST)

2.8 Compound Interest

Simple interest computation is based on the original principal, which does not change from time to time.
Interest calculation remains unchanged throughout the transaction period. However, compound interest
computation is based on the principal which changes from time to time. Interest that is earned is
compounded or converted into principal and earns interest thereafter. Hence, the principal increases
from time to time.

In general, there are two differences between simple interest and compound interest:

Simple interest is based on the original principal; Compound interest is based on the principal
that is, the total amount in each period grows by which grows from one interest interval to
some definite fraction of the original principal. another, that is, the total amount grows by some
fraction of the sum of the principal and the
interest paid on all previous periods.

Example 14
RM1000 is invested for three years. Find the interest received at the end of the three years if the
investments earns 8% compounded annually.

Answers
Interest for first year =
Amount at the end of the first year =

Interest for second year =

Amount at the end of the second year =

Interest for third year =

Amount at the end of the third year =

Compound interest earned =

2.9 Compound Interest Formula

The formula to calculate compound interest, 𝐼 is 𝐼 = 𝑀 − 𝑃 where future value, 𝑀 = 𝑃(1 + 𝑖)𝑛

𝑃 = original principal
𝑖 = interest rate per period
𝑛 = number of interest periods in the investment period.

Example 15
Repeat Example 14 by using the compound interest formula.

Answers

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Example 16
In 4 years, Tony and Lynn will need RM8000 for a down payment on a second-hand house. They have
RM5500 that they put in an investment earning 5% per year compounded annually. Determine
(a) the future amount in 4 years.
(b) the amount of compound interest earned;
(c) the excess compound interest over simple interest for the 4 years;
(d) the additional amount needed to achieve their goal.
Answers

2.10 Determine the Number of Periods and Rate per Period

Interest is often credited to an account more than once a year when calculating compound interest. For
example, interest on an investment may be compounded monthly. This means that interest is calculated
and credited to the account each month. That interest will then earn interest in future months. Compound
interest, unlike simple interest, pays interest on principal plus any previously credited interest.

Compound Interest Number of Times Rate per

Period Credited at the Interest Is Compounding Period
End of Each Credited per Year if 𝒓 Is Rate per year
Annual Year 1 𝑟
Semiannual 6 months 𝑟
2
2
Quarterly Quarter 𝑟
4
4
Monthly Month 𝑟
12
12

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Example 17
Find the future value of RM1000 which was invested for
(a) 4 years at 4% compounded annually
(b) 5 years 6 months at 14% compounded semi-annually
(c) 2 years 3 months at 4% compounded quarterly
(d) 5 years 7 months at 5% compounded monthly
(e) 2 years 8 months at 9% compounded every 2 months
(f) 250 days at 10% compounded daily

Answers

Example 18
Simon invests RM2500 in an investment paying 4% compounded semi-annually for 5 years.
(a) Estimate the future value by using simple interest.
(b) Estimate the compound amount.
(c) Hence, calculate the amount of interest earn for your answer in (a) and (b).

Answers

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Example 19
RM9000 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.

Answers

Example 20
How long does it take for a sum of money to double itself at 14% compounded annually?

Answers

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2.11 Effective and Nominal Rates
Two rates are equivalent if they yield the same future value at the end of one year. A nominal rate is
one in which interest is calculated more than once a year. An annual effective rate or effective rate in
short is the actual rate that is earned in a year. It can also be defined as the simple interest rate earned
in a year. The effective rate is useful when an investor wants to compare investments with different
compounding periods but he needs to put them on a common basis.

Example 21
What is the nominal rate compounded monthly that will make RM1000 become RM2000 in five years?

Answers

Effective rate of interest can be found from the nominal rate of interest using the following formula:

(1  i)n  1

Example 22
John has been offered two different 1 year loan for his business. Find the effective rate of interest for
each and decide on the better deal.

Loan A: nominal rate of 10% compounded quarterly

Loan B: nominal rate of 9% compounded monthly

Answers

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2.12 Present Value
The present value (or discounted value) at 𝑖% per interest period of an amount 𝑀 due in 𝑛 interest
periods is that value 𝑃 at which will yield the sum 𝑀 at the same interest rate after 𝑛 interest periods.
Hence, from 𝑀 = 𝑃(1 + 𝑖)𝑛 , we get

M
P
(1  i ) n

Example 23
Eric signs a note with an interest maturity value of RM17291.52 to purchase 0.5 acres located in a small
town. The note has an interest rate of 9% compounded semi-annually and a period of 2 years. Calculate
the present value that he receives.

Answers

Example 24
A debt of RM3000 will mature in three years’ time. Find
(a) the present value of this debt
(b) the value of this debt at the end of the first year
(c) the value of this debt at the end of four years
assuming the money is worth 14% compounded semi-annually.

Answers

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2.13 Equation of Value
An equation of value is an equation that expresses the equivalence of two sets of obligations at a focal
date. When we discussed the equation of value using simple interest, we found out that the value or
values to be determined will differ for different focal dates. However, in computing equation of value
using the compound interest rate, the two sets of obligations are the same no matter where we put the
focal point.

Example 25
A debt of RM7000 matures at the end of the second year and another of RM8000 at the end of six years.
If the debtor wishes to pay his dents by making one payment at the end of the fifth year, find the amount
he must pay if money is worth 6% compounded semi-annually using
(a) the present as the focal date
(b) the end of the fifth year as the focal date

Answers (the solution steps are the same with equation of value in simple interest)

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 TUTORIAL 3 (PART B)

1. Calculate the compound amount (or future value) and the amount of interest earned for the
following.
(a) RM20000 at 5% compounded annually for 5 years
(b) RM30000 at 6% compounded semi-annually for 5 years 6 months
(c) RM11500 at 8% compounded quarterly for 2.75 years
(d) RM120000 at 5% compounded monthly for 3.25 years
(e) RM120000 at 9% compounded daily for 270 days
(f) RM40000 at 12% compounded every 4 months for 6 years

2. Suppose RM1000 is invested at an annual interest rate of 5%. Compute the amount accumulated
after 20 years if the interest is
(a) simple interest
(b) compounded monthly
Hence, calculate the difference between the accumulated values in (a) and (b).
3. Find the interest earned if RM7500 is invested for 6 years at 6.4% compounded quarterly.

4. Aris saved RM25000 at 8% compounded monthly. Two years later, he withdrew RM14000 from
the savings. Find the amount left in the account.

5. Which yields more interest, 5% compounded monthly or 5.2% compounded annually?

6. Chow Fah deposited RM1000 in a saving account at 3% compounded monthly. Find the number
of months required is he wanted the amount in the account to become RM1498.54.

7. One of the pension funds that Jessica Walters manages must have RM3450,000 in 2 years. The
fund currently has RM2600,000 and it earns 5% compounded monthly. Calculate the expected
shortage in the pension in 2 years.

8. Peter has RM20,000 to invest for 1 year. He can lend to his brother, who agreed to pay 7% simple
interest or to a bank paying 4% compounded quarterly. Calculate the extra interest earned if he
lends the funds to his brother.

9. James Thompson needs RM45,000 to start a small music store but only has RM29,000. How long
must he wait to start the business if he believes he can earn 10% compounded annually?

10. Raj needs to borrow RM8000 for 1 year. He has been offered a loan with interest compounded
monthly and a compound amount of RM8493.42. Determine the rate.

11. Find the effective rate that is equivalent to

(a) 4.5% compounded semi-annually
(b) 16% compounded quarterly
(c) 15% compounded monthly
(d) 8% compounded weekly
(e) 12% compounded daily

12. Jennie deposits RM2500 in a fund paying 6% compounded quarterly. After 4 years, the rate drops
5% compounded semi-annually. Calculate the amount in her account at the end of 7 years.

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13. A sum of money, 𝑋, is deposited in a saving account at 10% compounded daily on 25 July 2015.
On 13 August 2015, RM600 is withdrawn and the balance as 31 December 2015 is RM8900.
Calculate the value of 𝑋 using exact time and 360-day year.

14. RM65000 is invested for 6 years and 9 months. If the investment is offered 5% compounded semi-
annually for the first 2 years, 6% compounded monthly for the next 18 months and 7%
compounded daily for the rest of the period, find the future value of this investment.

15. On 16 April 2013, RM2000 was invested at 5% compounded semi-annually. Find the amount
accumulated on 16 October 2016 if the rate was changed to 8% compounded quarterly beginning
16 April 2014.

16. Tom is a private investor. On 10th January, he deposited RM2463 in a savings account paying 3.5%
compounded daily. He deposits an additional RM1320 on 18th February and RM840 on 3rd March.
Calculate the interest earned on 10th April.

17. A debt of RM8000 will mature in four years’ time. Find

(a) the present value of this debt,
(b) the value of this debt at the end of two years
(c) the value of this debt at the end of five years
assuming the money is worth 9% compounded quarterly.
18. Green Company will receive RM185,000 in 3 years as part of a lawsuit settlement. Find the present
value if money can be invested at 5% compounded quarterly.

19. Tom owns a men’s clothing store worth RM125,000. The business is in a great location and is
growing rapidly. Tom is confident that the value of the business will increase at the rate of 16%
per year, compounded semi-annually, for the next 4 years. If he sells the business, he will invest
the proceeds at 8% compounded quarterly. What sale price should he insist on?

20. Five years ago, Paul had saved RM10000 in an account that pays 6% compounded monthly. Now,
he intends to add another 𝑋 ringgit into the account. Find the value of 𝑋 if the account will amount
to RM30000 in 10 years’ time.

21. A debt of RM30000 is due in two years and another of RM40000 in five years. If the debtor wants
to settle these two debts by making a single payment after three years, what is this single payment,
assuming the money is worth 8% compounded annually?

22. A debt of RM5000 matures in two years and another of RM10000 in five years. If the debtor wants
to settle his debts by making two equal payments, one now and another in three years’ time, find
these payments, assuming money is worth 5% compounded monthly.

23. Roland invested RM10000 at 12% compounded monthly. This 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.

24. A debt of RM7000 matures at the end of the second year and another of RM8000 at the end of six
years. If the debtor wishes to pay his debts by making two equal payments at the end of the fourth
year and the seventh year, what are these payments assuming money is worth 6% compounded
semi-annually?

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