Compounding and different types of

compounding
• Increasing value of an asset due to the interest earned on both a principal and accumulated interest.

• Direct realization of time value of money concept is also known as the compound interest.

• Interest is credited to an existing principal amount as well as to interest already paid.

• Works on both assets and liabilities.

• Compounding period:annual, monthly, daily.

To illustrate how compounding works,

Suppose $10000 is held an account that pays 5% interest annually.

After the first year or compounding period , the total in the account has risen to $10500 a simple reflection of $500 in interest
being added to the $10000 principal. In year two, the account realises 5% growth on both the original principal and the $500
of first year interest, resulting in second year gain of $525 and a balance of $11 , 025 . After 10 years, assuming no
withdrawals and a steady 5% interest rate the account would grow to $16, 288.95
Calculation of compound interest
 Compound interest schedules

Daily
• Used for savings account at banks. Yearly
• Investment.
• Money market accounts.

Monthly
• Mortgage loans.

• Home equity loans.

• Personal business loans

Take a three year loan of $10000 at an interest rate of 5% that compounds annually. What would be the
amount of interest?

$10, 000[(1+0.05) ^3-1]= $10, 000[1.157625-1]

=$1576.25
 Types of compounding

Multi period compounding

• Cash flows occurs more than once a year

• Financial institutions may require corporate borrowers to pay interest quarterly/half yearly.

• Half yearly compounding.

• Quaterly compounding.
• Monthly compounding.
• Weekly compounding.
• Annual compounding.

Continuous compounding

• Compounding done continuously.

• Banks pay interest continuously:daily compounding.