This preview shows pages 1–3. Sign up to view the full content.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
Unformatted text preview: MGNT 3125 Fall 2010 Dr. Amine Khayati Chapter 5 Notes I Future Value and Compounding: 1 Simple interest : Interest earned only on the original principal amount invested; that is, the interest received each year does not earn interest during any subsequent year. * Suppose you invest $1,000 for 2 years at a 5% interest rate per year using simple interest . At the end of year 1, you earn: 1,000 0.05 = 50 At the end of year 2, you earn: 1,000 0.05 = 50 At the end of year 2, your total value = 1,000 + 50 + 50 = 1,100 Future value (FV) : is the amount of money an investment will grow to over some period of time at some given interest rate. In the earlier example the future value is 1,100. 2 Compound interest : Interest earned on both the initial principal and the interest reinvested from prior periods. * Suppose you invest $1,000 for 2 years at a 5% interest rate per year using compound interest . At the end of year 1, you earn: 1,000 0.05 = 50 You reinvest the $50 interest you earned in year 1 At the end of year 2, you earn: 1,000 0.05 = 50 And 50 0.05 = 2.5 At the end of year 2, your total value = 1,000 + 50 + 50 + 2.5 = 1,102.5 The $2.5 comes from the interest you earned in year 2 from reinvesting the interest you earned in year 1. The process of leaving your money and any accumulated interest in an investment and thereby reinvesting the interest is called compounding . It also means earning interest on interest. The future value at year 1 = 1,000 (1.05) = 1,050 The future value at year 2 = 1,000 (1.05) (1.05) = 1,102.5 = 1,000 (1.05) = 1,102.5 The General formula for Future Value (FV): Where: FV: future value 1 PV: present value r: period interest rate, expressed as decimal t : number of periods * Suppose you invest the $1,000 from the previous example for 5 years, how much would you have using the simple interest and using compound interest? Determine the effect of compounding. Simple interest: 1,000 + (1,000 0.05 5) = 1,250 Compound interest: 1,000 (1.05) = 1,276.28 The effect of compounding = 1,250 – 1,276.28 = 26.28 Compounding added 26.28 to the value of the investment. Repeat the same example for an investment period of 10 years: Simple interest: 1,000 + (1,000 0.05 10) = 1,500 Compound interest: 1,000 (1.05) = 1,628.89 The effect of compounding = 1,500 – 1,628.89= 128.89 Compounding added 128.89 to the value of the investment. The effect of compounding increases as the number of periods increases. II Present Value and Discounting: The present value (PV) is the amount of money that you need to invest today at certain interest rate in order to reach some amount in the future (future value)....
View
Full
Document
This note was uploaded on 11/06/2010 for the course MGNT 3125 taught by Professor Warsi during the Spring '08 term at SPSU.
 Spring '08
 Warsi
 Compounding, Future Value, Interest

Click to edit the document details