Intra-year Compounding
Interest is often compounded more than once a year. Banks and other financial
institutions accepting placements compounded interest quarterly, daily, or even
continuously. If interest is compounded many times a year, the general formula for
solving the future value is:
FV= PV (1+i/m) t x m
The number of conversion periods for 1 year is denoted by m while the total
number of conversion periods for the whole investment term is denoted by n.
Conversion periods are usually expressed by any convenient length of time and usually
taken as an exact division of the year, e.g., monthly, quarterly, semi-annually, and
annually. When the conversion periods are:
Annually, m=1
Semi-annually, m=2
Quarterly, m=4
Monthly, m=12
The total number of conversion periods for the whole term n can be found from
the relation:
n =time x number of conversion periods per year m
n =t x m
Thus, the term 5 years compounded:
Annually, 5x1 n=5
Semi-annually, 5x2 n=10
Quarterly, 5x4 n=20
Monthly, 5 x 12 n=60
The interest rate is usually expressed as an annual or yearly rate, and must be
changed to the interest rate per conversion period or periodic rate i and can be found
from the relation:
i = interest rate r________
conversion period per year m
i = r___
m
Thus, the interest rate at 9% compounded:
Annually, 9%/ 1 = 9.00%
Semi-annually, 9%/ 2 = 4.50%
Quarterly, 9%/ 4 = 2.25%
Monthly, 9%/ 12 = .75%
The formula reflects a more frequent compounding (t x m) at a smaller interest
rate per period (i/m). The future value increases as m increases. Thus continuous
compounding results in the maximum possible future value at the end of n periods for a
given rate of interest.
Example:
Assume that P = P1,000, i=12% and n=4 years. Thus:
Annual compounding (m=1): FV= P1,000 (1.12)4 x 1
= P1,000 (1.574)
= P1,574
Semi-annual compounding (m=2) FV= P1,000 (1.12/2)4 x 2
= P1,000 (1.06) 8
= P1,000 (1.594)
= P1,594
Quarterly compounding (m=4) FV= P1,000 (1.12/4)4 x 4
= P1,000 (1.03) 16
= P1,000 (1.605)
= P1,605
Monthly compounding (m=12) FV= P1,000 (1.12/12)4 x 12
= P1,000 (1.01) 48
= P1,000 (1.612)
= P1,612
Amortized Loans
Payments of obligations are made in equal installments which may be monthly quarterly
semi-annually or annually. Amortized loans include housing loans and auto loans.
Other loans are classified as long-term loans. The periodic payment can be computed
using the present value of an annuity of 1:
1-(1+i)-n
PVA= A i
Thus, by transition, the periodic payment is:
PVA
A= 1-(1+i)-n
i
Example:
Ferlie Shells has a 60-month auto loan of P650,000 at a 12% annual interest
rate. She wants to find out how much the monthly payment should be:
P650,000
A= 1-(1.01)-60
.01
A= P650,000
44.955
A=P14,458.90
To repay the principal and interest on a P650,000, 12%, 60-month auto loan,
Ferlie Shells has to P14,458.90 a month for the next 60 months.
Assume that a firm borrows P120,000 to be repaid annually for the next 5 years. The
creditor-bank stipulated as 12% interest. Compute the amount of each payment.
P120,000
A= 1-(1.12)-5
.12
A= P120,000
3.605
A=P33,287.10
Each loan payment made is distributed partly to the interest and partly to the
principal. The breakdown is often displayed in a loan amortization schedule. The
interest component is largest in the first period and subsequently declines, whereas the
principal portion is smallest in the first period and increases thereafter.
Example:
Using the same data in the above example, the amortization schedule is as
follows:
Year Payment Interest Principal Outstanding
Payment Balance
0 120,000.00
1 33,287.10 14,400.00 18,887.10 101,112.90
2 33,287.10 12,133.55 21,153.55 79,959.35
3 33,287.10 9,595.12 23,691.98 56,267.37
4 33,287.10 6,752.08 26,535.02 29,732.35
5 33,287.10 3,567.88 29,732.35 0.00
166,435.50 46,448.64 120,000.00
Annual Percentage Rate (APR)
The different types of financial instruments use various compounding periods.
Bonds, for instance, usually pay interest semi-annually; banks pay interest on deposits
quarterly; and firms offering credit cards pay interest monthly. If an investor wants to
compare financial instruments with different compounding periods, a mathematical tool
should be used to make the comparison possible. For this purpose, the effective annual
rate also known as the annual percentage rate (APR) is used.
APR is computed as follows:
APR= (1+r/m)m-1.0
Where:
r = nominal rate
m = number of compounded period in a year
Example:
If the nominal rate is 12% compounded quarterly, the APR is:
APR = (1+.12/4)4-1.0
= (1.03)4-1.0
= 1.1255-1.0
= .1255 or 12.55%
This means that if an investment offers 12% interest compounded quarterly, the
investor is actually receiving an APR or effective annual rate of 12.55%. That is to say, if
one investment offers a 12% interest compounded quarterly while the other one offers a
12.55% interest compounded annually, the same amount of money will be received at
the end of the year.
