Introduction to Corporate Finance:

Fifth Canadian Edition

Booth, Cleary, Rakita

Chapter 5

TIME VALUE OF MONEY

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Learning Objective 3

5.3 Define compound interest and explain how it works.

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5.3 COMPOUND INTEREST

• Compound interest is interest that is earned on the

principal amount and on the future interest payments.

• Calculations are done to determine how much you will

have in the future with compound interest (known as the
future value)

• Calculations are done to determine how much you would

have today if the compound interest was removed (known
as the present value)
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5.3 COMPOUND INTEREST

• The future value of a single cash flow at any time ‘n’ is

calculated using Equation 5.2.

FVn  PV0 (1  k ) n [5.2]

Where:
FVn = Future value at compounding period n
PV0 = Present value at time zero
k = Discount or interest rate

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EXAMPLE: Computing Future Values
(Compounding)
FVn  PV0 (1  k ) n [5.2]

Example 5 -2 Compound Interest

You invest $500 today for five years and receive 10 percent annual compound interest.

Year Beginning Amount Interest Ending Amount

1 $500 $500 × 0.1 = $50 $550
2 $550 $550 × 0.1 = $55 $605
3 $605 $605 × 0.1 = $60.50 $666
4 $666 $666 × 0.1 = $66.66 $732
5 $732 $732 × 0.1 = $73.20 $805

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EXAMPLE: Computing Future Values
(Compounding) FV  PV (1  k ) [5.2] n 0
n

Example 5 -2 Compound Inte re st

You invest $500 today for five years and receive 10 percent annual compound interest.

Ye ar Beginning Amount Inte re st Ending Amount

1 $500.00 $500 × 0.1 = $50 $550.00
2 $550.00 $550 × 0.1 = $55 $605.00
3 $605.00 $605 × 0.1 = $60.50 $665.50
4 $665.50 $665.50 × 0.1 = $66.55 $732.05
5 $732.05 $732.05 × 0.1 = $73.20 $805.25

Solve with the formula: FVn = $500*(1+.10)5

= $500*1.610510
= $805.25
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COMPOUND VERSUS SIMPLE INTEREST

• Simple interest grows principal in a linear manner.

• Compound interest grows exponentially over time.

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FUTURE VALUE INTEREST FACTOR (FVIF)

• A term that represents the future value of an investment at a

given rate of interest and for a stated number of periods.
FVIFn ?,k ?  (1  k ) n

• The FVIF for 10 years at 8% would be:

FVIFn 10,k  0.08  (1  0.08)10  2.1589

• $100 invested for 10 years at 8% would equal:

FV10  $100  (1  0.08)10  $100  2.1589  $215.89

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EXAMPLE: Using the FVIF

Find the FV20 of $3,500 invested at 3.25%.

FV20  P0   FVIFn  20,k  3.5% 

 $3,500  (1  0.035) 20
 $3,500  1.99
 $6,964.26

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COMPUTING PRESENT VALUES (DISCOUNTING)

• The inverse of compounding is known as discounting.

• Discounting is essentially removing all compound interest from
some future amount
• You can find the present value of any future single cash flow
using equation 5.3.

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PRESENT VALUE INTEREST FACTOR (PVIF)

PVIF is the inverse of the FVIF.

1
PVIFn ?,k ? 
(1  k ) n

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EXAMPLE: Using the PVIF

Find the PV0 of receiving $100,000 in 10 years time if the

opportunity cost is 5%.
PV0  FV10   PVIFn 10,k 5% 
1
 $100,000 
(1  0.05)10
1
 $100,000 
1.629
 $100,000  0.6139
 $61,391.33

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USING EQUATION 5.2

• Given three known values, you can solve for the one unknown in
equation 5.2

• Solve for:
• FV - given PV, k, n (finding a future value)
• PV - given FV, k, n (finding a present value)
• k - given PV, FV, n (finding a compound rate)
• n - given PV, FV, k (find holding periods)
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SOLVING FOR ‘n’ OR “COMPOUNDING PERIODS”

Equation 5.3 is reorganized to solve for n:

FV0
PV0  [5-3]
(1  k ) n

ln  FVn / PV0 
n
ln 1  k 

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EXAMPLE: Solving for ‘n’

How many years will it take $8,500 to grow to $10,000 at a 7%

rate of interest?

ln  FVn / PV0 
n
ln 1  k 
ln  $10,000 / $8,500 ln[1.17647 ]
n 
ln 1  .07 ln[1.07]
0.1625
n  2.4 years
0.06766

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SOLVING FOR COMPOUND RATE OF RETURN

Equation 5.3 is reorganized to solve for k:

FV0
PV0  [5-3]
(1  k ) n

1/ n
 FVn 
k  1
PV
 0

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EXAMPLE: Solving for ‘k’

Your investment of $10,000 grew to $12,500 after 12 years.

What compound rate of return (k) did you earn on your money?

1/ n
 FVn 
k  1
PV
 0
1
 $12,500  12
k   1  1. 25 0.083
1
 $10,000 
k  0.01877  1.88%

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USING FINANCIAL CALCULATOR

• Examples are based on using a BAII Plus by

Texas Instruments
• The key variables are individually inputted into
the calculator
• So long as at least 3 variables are known,
you can solve for the remaining variable

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EXAMPLE: Solving for ‘n’

How many years will it take $8,500 to grow to

$10,000 at a 7% rate of interest?
Variable Inputs:
8500 +/- PV
10000 FV
7.0 I/Y
CPT n = 2.40 years

When you have both PV and FV, the PV must be made to be negative

© 2015 John Wiley & Sons, Inc. All rights reserved. 19

EXAMPLE: Solving for ‘k’

Your investment of $10,000 grew to $12,500 after

12 years. What compound rate of return (k) did
you earn on your money?
Variable Inputs:
10000 +/- PV
12500 FV
12 n
CPT I/Y = 1.88%

© 2015 John Wiley & Sons, Inc. All rights reserved. 20

Copyright

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