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COMPOUND INTEREST FORMULAS

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 “Money is like an arm or leg, use it or lose”
-Henry Ford
Economic evaluation of investment alternative requires that the alternatives be evaluated on the same
basis and that the time value of money be accounted for properly. when alternate source of loan money are
available with different payment schedules that make it difficult or impossible to determine intuitively the
source that is least expensive, it is necessary to convert the alternatives to an "equivalent" basis that
permits comparison the alternatives. this necessitates correct accounting for the time value of money.

for example:
o would you rather have $100 now or $102 a year from now? A majority of people would take $100 now
because they intuitively know that putting the $100 in a bank at 4% or 5% interest will give them more
than $102 a year from now.
o would you rather have $100 now or $150 a year from now? A majority of people would probably take
$150 a year from now because they intuitively know that they probably do not have other places to
invest $100 where it will earn $50 profit or a $50 rate of return in one year.

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Compound Interest Formula Derivations and Ilustrations

This section presents the derivation of the six basic compound interest
formulas commonly needed to apply engineering economy decision methods
for proper comparison of investment alternatives. the develop general formulas,
the following letter symbols will be used throughout the remainder of this text:

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P: Present single sum of money. Normally “P” refers to a sum of money at time zero, but may
represent a sum of money at any point from which we choose to measure time.
F: A future single sum of money at some designated future date.
A: The amount of each payment in a uniform series of equal payments made at each period. when
the periods are years a refers to annual payments or value.
n: The number of interest compounding periods in the project evaluation life.
i: The period compound interest rate. depending on the situation "i" may refer to either the cost of
borrowed money, the rate of return on invested capital, or the minimum rate of return
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To assist in understanding these letter symbols and their relationship to investment evaluation
problems, refer to the horizontal time lime diagram shown in Figure 1:

A A A A A A
P F
0 1 2 3 4 n-1 n

The interest compounding periods are designated 1, 2, 3, ……n, below the horizontal line. At
the time zero “P” designated a present single sum of money.
“A” designated a uniform series of equal payments at each compounding period. And “F”
designated a future sum of money at the end of period “n”.

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There are six different two variable relationships that can be developed between
“P”, “F”, and “A”, as follows:

Calculated Quantity = Given Quantity X Appropriate Factor

F = P X F/Pi.n
F = A X F/Ai.n
P = F X P/Fi.n
P = A X P/Ai.n
A = F X A/Fi.n
A = P X A/Pi.n

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Example 1. Single Payment Compound –Amount Factor

Calculate the future worth that $1,000 today will have six years from now if
interest is 10% per year compounded annually.
Solution:
- - - - -
P=
$1,000 F?
0 1 2 3 4 5 6

F = $1,000 (F/Pi,n)
= $1,000 (F/P10%,6) = $1,000 (1.7716) = $1,771.6

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Example 2. Single Payment Present–Worth Factor

Calculate the present value of a $1,000 payment to be received six years from
now if interest is 10% per year compounded annually.
Solution:
- - - - -
P?
F = $1,000
0 1 2 3 4 5 6

P = $1,000 (P/Fi,n)
= $1,000 (P/F10%,6) = $1,000 (0,5645) = $564,50

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Example 3. Uniform Series Compound–Amount Factor

Calculate the future value six years from now of a uniform series of $1,000
investments made at the end of each year for the next six years if interest is 10%
per year compounded annually.
Solution: -
A=$1,000 A=$1,000 …………………… A=$1,000
F?
0 1 2 3 4 5 6

F = $1,000 (F/Ai,n)
= $1,000 (F/A10%,6) = $1,000 (7.716) = $7,716
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Example 4. Sinking–Fund Deposit Factor
Calculate the uniform series of equal payments made at the end of each year for
the next six years that are equivalent to a $1,000 payment six from now if
interest is 10% per year compounded annually.
Solution:

A? A? A? A? A? A?
F = $1,000
0 1 2 3 4 5 6

A = $1,000 (A/Fi,n)
= $1,000 (A/F10%,6) = $1,000 (0,12961) = $129,61
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Example 5. Capital-Recovery Factor
Calculate the uniform series of payments at the end of each year for six years
that are equivalent to a present sum of $1,000 if interest is 10% per year
compounded annually.
Solution:

A? A? A? A? A? A?
P = $1,000
0 1 2 3 4 5 6

A = $1,000 (A/Pi,n)
= $1,000 (A/P10%,6) = $1,000 (0,22961) = $229.61
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Example 6. Uniform Series Present-Worth Factor
Calculate the present value of a series of $1,000 payments to be made at the end
of each year for six years if interest is 10% per year compounded annually.
Solution:

A=$1,000 A=$1,000 …………………… A=$1,000

P?
0 1 2 3 4 5 6

P = $1,000 (P/Ai,n)
= $1,000 (P/A10%,6) = $1,000 (4.355) = $4,355

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