Math For Business

Unit # 6
Further Topics:
Compound Interest
Compound Interest: Further
aspects
Further aspects of compound interest are considered
here.

We will explore finding the number of conversion

periods, and computing equated dates, and effective and
equivalent rates of interest.

Use of pre-programmed financial calculators such as the

Texas Instruments BA II PLUS financial calculator will be
expanded.
Finding n and Related Problems

Finding the time using n The derivation of n

 The formula for n is

derived from the future
value formula,
 FV = PV(1 + i)n
 n is used to find the
total number of
compounding periods We can solve for
the exponent
given a PV, FV using a rule of
and a periodic interest (natural)
logarithms
rate.
Solving for n (1 of 2)

 In how many years will $1000 grow to $1600 if

money can earn 5% compounded quarterly?

Year 0 Year ?

$1000 $1600
Solving for n (2 of 2)

 The future value (FV) is $1600

 The present value (PV) is $1000
 The periodic interest rate i is 5%/4 = 1.25% every 3
months (every quarter)

 37.834806 quarters × 3 months per quarter =

113.504417 months = 9.458701 years (9.46 years)
 9 years and approximately 6 months (0.458701 years ×
12 months per year = 5.5 months)
Using your Calculator
KEY
CE/C
DISPLAY
0
KEY
×
DISPLAY
Blank
𝑛=
𝑙𝑛 (
16 00
1 0 00 ) =
𝑙𝑛 ( 1.6 )
1600 Blank 3 Blank 𝑙𝑛 (1+ 0.01 25 ) 𝑙𝑛 (1 .01 25 )
÷ Blank = 113.50441
7
1000 Blank ÷ Blank
= 1.6 12 9.458701
(years)
LN 0.47000362 Blank Blank
9
÷ Blank Blank Blank
1.012 Blank Blank Blank
5
LN 0.0124225 Note: The answer Blank
is displayed in
quarters since the
compounding
time was in
quarters.
= 37.8348056 Blank Blank
Using the Calculator Financial
Functions
KEY DISPLAY KEY DISPLAY
2nd
Blank −1000 Blank
𝑛=
𝑙𝑛 (
16 00
1 0 00 ) =
𝑙𝑛 ( 1.6 )
CLR TVM 0 PV PV = −1000 𝑙𝑛 (1+ 0.01 25 ) 𝑙𝑛 (1 .01 25 )
2nd Blank = 113.5044168
P/Y Blank 0 Blank
4 ENTER P/Y = 4 PMT PMT = 0
↓ (optional C/Y = 4 1600 Blank
*)
2nd Blank FV FV = 1600
QUIT 0 CPT Blank
5 Blank N N=
37.8348056
quarters
(since P/Y and
C/Y is set to 4)
I/Y I/Y = 5 * When P/Y Blank
is set, C/Y
will
automaticall
y be set to
the same
Equated Date
 The equated date is the date on which a single sum of
money is equal to the sum of two or more dated sums
of money.

 To find a specific date to solve the problem, solve for n,

and then use the DATE worksheet within the calculator.
Calculating the Equated Date (1 of
4)
 A payment of $500 is due today, $1000 in one year and
another payment of $3000 is due in five years. Find the date
at which a single payment of $5000 will settle the debt if
interest is set at 4% p.a. compounded annually.

 Note 4% p.a. compounded annually is a periodic rate of

4%/1 = 4% every year
Calculating the Equated Date (2 of
4)

 Use “now” as the focal date (t = 0)

 Compute the equivalent value of all scheduled
payments now.
 “Equate” the value of the payments “now” with the
payment of $5000 sometime in the future from “now”.
Calculating the Equated Date (3 of 4)

 The time line looks like

this:
0 1 5 years

$500 $1000 $3,000

n=1

n=5

 We need to find the sum of the PVs of all scheduled

payments at time 0.

= 500 + 961.153846 + 2465.78132 = $3,927.319782

Calculating the Equated Date (4 of
4)
 Redraw the time line.

0 ?

$3927.319782 $5000
?

𝑛
3927.319782 ( 1+0.04 ) =50 00
.156969 years = 73.88 months
Using the Calculator Financial
Functions
KEY DISPLAY KEY DISPLAY

2nd

CLR TVM

2nd
Blank

Blank
−3927.31978
2
PV

=
Blank

PV = −3927.319782

113.5044168 𝑛=
𝑙𝑛( ) 5000
3927.319782 𝑙𝑛 ( 1.273132)
=
P/Y Blank 0 Blank 𝑙𝑛 ( 1+0.04 ) 𝑙𝑛 ( 1 .04)
1 ENTER P/Y = 1 PMT PMT = 0
↓ (optional C/Y = 1 5000 Blank
*)
2nd Blank FV FV = 5000
QUIT 0 CPT Blank
4 Blank N N = 6.156969 years
(since P/Y and C/Y is
set to 1)
I/Y I/Y = 4 * When P/Y is Blank
set, C/Y will
automatically
be set to the
same value.
Finding i (1 of 3)

 The formula is derived from FV = PV(1 + i)n

Finding i (2 of 3)

 Find the nominal rate of interest compounded semi-

annually if $3,000 accumulates to $5,201.96 in 8 years.
Finding i (3 of 3)

 n = 8 × 2 = 16 periods
 PV = 3,000
 FV = 5,201.96

 0.035 = 3.5% every semi-annual compounding period

 3.5% × 2 = 7% p.a. compounded semi-annually
Using the Calculator Financial
Functions
( )
1
KEY DISPLAY KEY DISPLAY
5,201.96
2nd Blank −3000 Blank
𝑖= 16
−1=0.035(𝑝𝑒𝑟𝑖𝑜𝑑𝑖𝑐)
CLR TVM
2nd
0
Blank
PV
0
PV = −3,000
Blank
3,000
P/Y Blank PMT PMT = 0
2 ENTER P/Y = 2 5201.96 Blank
↓ (optional C/Y = 2 FV FV =
*) 5,201.96
2nd Blank CPT Blank
QUIT 0 I/Y I/Y =
7.000004677
*
16 Blank Blank Blank
N N = 16 * The interest rate is Blank
displayed as nominal
(per year). If you use
the formula, the rate
that results is periodic.
Effective and Equivalent
Interest Rates
 Interest rates that increase a given principal to the
same future value over the same period of time are
called equivalent rates.
 9.381% p.a. compounded annually and 9% p.a.
compounded monthly are equivalent rates.

 The annually compounded rate of 9.381% p.a. is called

the effective rate of interest.
Finding Effective Rate:(1 of 2)
 Formula:
 Let the nominal rate of interest be computed CY times
per year and let the interest rate per conversion period
be i.
 Then the accumulated amount after 1 year is
 Let the corresponding effective rate is f
 Then the accumulated amount after 1 year is
 The amounts are equal by definition:

 =
 -1
Finding Effective Rate:(2 of 2)
 Determine the effective rate of interest corresponding to 9% p.a.
compounded (i) annually, (ii) semi annually, (iii) quarterly, (iv) Monthly.

Step Annually Semi-annually Quarterly Monthly

s

I/Y 9.0 9.0 9.0 9.0

P/Y 1 2 4 12

i .09=9.0% .09/2=4.5% .09/4=2.25% .09/12=.75%

CY 1 2 4 12

f f= f= f= f=
= 1.09-1 = 1.092025-1 = 1.093083-1 = 1.092025-1
= 9% = 9.2025% = 9.3083% = 9.3807%
Finding an Equivalent Rate (1 of
2)
 What nominal annual rate compounded quarterly is
equivalent to 7.5% compounded monthly?
 7.5%/12 = 0.625% every month.
 In one year there are 12 monthly periods.
Finding an Equivalent Rate (2 of
2)
 Set up the equation and solve

 1.886743% × 4 = 7.546973% p.a. compounded

quarterly is equivalent to 7.5% p.a. compounded
monthly
Using the Calculator Financial Functions

 What nominal annual rate compounded quarterly is

equivalent to 7.5% compounded monthly?
KEY DISPLAY KEY DISPLAY
2nd Blank ↓ C/Y = 12
INCONV Blank 4 ENTER C/Y = 4 (changes conversion
periods to 4x per year)

2nd Blank ↓ NOM = 7.5

CLR WORK NOM = 0 CPT NOM = 7.546972656*

7.5 ENTER NOM = 7.5 Blank Blank

↑ C/Y = 4 (default) Blank * This is the equivalent
annual rate compounded
quarterly.
12 ENTER C/Y = 12 Blank Blank
↑ EFF = 0 (default) Blank Blank
CPT EFF = 7.76325988 (Effective Annual Blank Blank
Rate)
Finding an Effective Rate

 Converting nominal rates of interest

(compounded a number of times per year
other than one) to effective rates is the
method used for comparing different interest
rates.
Converting Using ICONV Function (1 of
2)
Effective Rates Using the BA II PLUS: Interest Rate
Conversion
The BA II PLUS is programmed in the 2nd function to quickly and
efficiently calculate effective interest rates by inputting the
nominal rate and the number of compounding periods. You can
also calculate the nominal rate if you know the effective rate.
To go from nominal rate to effective rate the process is as follows:
1. 2nd (ICONV) (2-key).
2. Enter the nominal rate, NOM = and press Enter.
3. Arrow down to C/Y = and enter the number of times
interest compounds in a year. Press Enter.
4. Arrow up to EFF = and press CPT.
Converting Using ICONV Function (2 of
2)
To go from effective rate to nominal rate the process is as follows:

1. 2nd (ICONV).
2. Arrow down to EFF = and enter the effective rate. Press Enter.
3. Arrow down to C/Y = and enter the compounding number
relating to the nominal rate you are converting to. Press Enter.
4. Arrow down to NOM = and press CPT.
Equivalent payment: (using compound
interest)
 Tylor wishes to replace payments of $1900 due today and $1500 due in 22
months by a single equivalent payment 18 months from now. If money is
worth 4.8% compounded monthly, what should that payment be?
Ans: We pick 18 months from now as the focal date since that is the single
payment date.
Periodic interest rate i = nominal rate/ compounding periods = IY/CY=4.8%/12 =
0.4%
Evaluate the FV of the first payment: (18 months from now (after due
date)=18/12 years=1.5 years)
Number of conversion periods from now: n = 1.5x12 = 18
FV = $1900(1.004)^(18) = $2041.55

Evaluate the PV, in 18 months, of the $1500 due in 22 months: (4 months before
the due date)
n = (4/12)*12= 4
PV = $1500(1.004)^(-4) = $1476.24
Equivalent rate:
 A company pays investors 8% compounded annually on its five-year
GICs. For you to be indifferent as to which compounding option you
choose, what would the nominal rates have to be on GICs with
quarterly compounding?
 Given: 8% compounded annually
 Accumulated value of $1 after 1 year: FV1 = (1+i)^(1) = (1.08)

 We need to determine the equivalent rate with quarterly

compounding.
 Accumulated value of $1 after 1 year: FV2 = (1+i)^(4)

 To maintain the same yield the rates must be equal:

 (1+i)^4 = (1.08)

 Solve for i:
 (1+i)^4 = (1.08) => 1+i=(1.08)^(1/4) => i = =((1.08)^(1/4))-1=
Summary
 By finding the number of conversion periods n, it is
possible to calculate the time and therefore the date
when a sum of money is due.
 The equated date is the date on which a single sum of
money is equal to the sum of two or more dated sums
of money.
 The effective rate of interest is the annual rate of
interest that yields the same amount of interest per
year as a nominal rate compounded a number of times
per year.
 Equivalent rates accumulate a given principal to the
same future value over the same period.