Compounding Interest  Compounding

Define as : The ability of an asset to The process of determining the

generate earnings, from previous future value of a payment
earnings.
Application of Compounding
a. Compute terminal value of a single investment.

b. Time shifting of cash flows for addition and

comparison.

c. Prices escalations.

d. Ranking of investments on basis of terminal

values.
a. Terminal Value

Defined as THE PRESENT VALUE to  future point in time

Recall: Fn = P * [ 1 + i ] n [compounding equation]

It enables the terminal value (Fn) to be calculated when the initial

amount (P), the rate of interest (i), and the investment period (n) are
known.
Example:
If RM 100 is invested for 10 years at 12% interest per year, what is the terminal
value at year 10.

P = RM 100, i = 0.12, n = 10 years

F10 = P * [ 1 + i ] n
= 100 * [1 + 0.12 ]10
= 100 * 3.106
= RM 310.6 [terminal value]
b. Time Shifting of Cash Flows

 Cash flows associated with an investment commonly occur at different

points in time
 In order to compare these cash flows at different points in time, the cash
flows must be brought to a common point in time.

1. Cumulative method
CashFlow [C] is compounded forwarded by one time step
{ C4 + C3 [ 1 + i ] + C2 [ 1 + i ]2 + C1 [ 1 + i ]3 }
In general form:
Cn + Cn-1 [ 1 + i ] + . . . + C2 [ 1 + i ]n-2 + C1 [ 1 + i ]n-1

2. Direct method
Each CashFlow [C] is taken separately and is compounded
directly forward to an appropriate time period
C1 = C 1 * [ 1 + I ] 3
C2 = C 2 * [ 1 + I ] 2
C3 = C 3 * [ 1 + I ] 1
C4 = C 4
[time shift]
c. Price escalations.
• Supply Price projection as a function of time and interest rate
• Demand
• inflation
c. Price escalations.
1 US gallon = 3.78 Liter
d. Ranking of Investments

By Compounding
 Applied as a basis for comparing investment opportunities.

 Compare terminal values at the same point in time.

 Rank the values.

Option 2

(3)
(2)
(1)
Rank by Present value @ variation of Interest rate
Discounting Interest  Discounting
• The process of determining the present value of a
payment.
• Mathematically, discounting is the inverse of
compounding.

Recall, compounding equation: F = P * (1 + i ]n

Then,

Discounting equation would be:

P = F * (1 + i ]-n F = future value

P = present value
i = interest
(1+i)n = compound factor
(1+i)-n = discount factor
PRESENT VALUE
 Application of Discounting

a. Computation of present value of a single future

cash flow.

b. Computation of present value of a series of

future cash flows.

c. Ranking of investments on the basis of present

value.

d. Comparison of production profiles.

a. Present value of a single future cash flow
Recall  P = F * (1 + i ]-n Discounting equation

b. Present value of a series of future cash flows

a. Cumulative method

b. Direct method
Each cash flow is taken separately and
discounted directly backward in time
C1 = C 1
C2 = C2 * [ 1 + I ] -1
C3 = C3 * [ 1 + I ] -2
C4 = C4 * [ 1 + I ] -3
c. Ranking of investments

By Discounting
 Present value can be computed for any cash flows.

 It has intrinsic an advantage over compounding for

ranking of investments.

 The time origin is similar with other project compared to

that of compounding.
Case study….

Similar data
as it used for
Terminal
Value
Option 1: £1250 is placed on deposit for 10 years at 5%.
Regardless of when this investment is withdrawn, it will have a
discounted of present value of £1250.

Option 3: The direct payment of £3500 would be received after 10 years.

The present value is derived by discounting at 5% over 10
years:
P = 3500 * [1 + 0.05)-10
P = 3500 * 0.614
P = £2148.7

Option 2: This is more complex calculation as the investment returns 10

years payments of £250, each of which must be discounted
back to the present value by the appropriate number of years.
Case 2

(3)
(2)
(1)
Another Issues…..?
How if we change the Interest Rate? Lets say we change to 12%
d. Comparison of Production Profiles

Why decline?
3 reasons..

Example of
HUTTON Field
* Discount rate in North Sea
* Reservoir pressure
* Taxation
[oil price]
ANNUITY

Annuity is a series of payments made at fixed intervals of time

The present value of an annuity is the value of a stream of payments,

discounted by the interest rate to account for the fact that payments are
being made at various moments in the future.

(Annuity equation)

P = Present value of annuity

A = present value for payment
I = discount rate
N = number of cash flow
Example:

During years one and two, a company is spending RM 5000

each year on a new oil field. The company expects to save
(positive cash flow) RM 8000 each year for years 3, 4, 5, & 6. Is
the project worthy of consideration if the company expects a
15% interest on its investments?
 Solution:

The following are the cash flows: 15%

1 2 3 4 5 6 7

-RM5000 -RM5000 RM8000 RM8000 RM8000 RM8000

Present Value Calculation

PV of -RM5000 Annuity, 2 years, 15% = 1.62571 x -RM5000 = -RM8128.54

PV of RM8000 Annuity, 4 years, 15% = 2.85498 x RM8000 = RM22839.84

(The RM22839.84 is lands at the end of year 2 and must be treated as a lump sum)

PV of RM22839.84, end of year 2, 15% = 0.75614 x RM22839.84 = RM17270.12

Add up the results inside the boxes for the final total = RM9141.57

Since the end result is positive (greater than zero) the project passes the NPV test
and might be worthy of further consideration.
THANK YOU