Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know

By William G. Droms | Go to book overview

11
Mathematics
of Compound Interest

In the next two chapters, we will explore various techniques employed in making long-term investment decisions. This area of financial management is referred to as capital budgeting -- the process of determining the amount of money to be budgeted for capital expenditure projects. In order to understand and use these techniques, it is first necessary to master the mathematics of compound interest. This chapter will discuss the mathematics necessary to deal with compound interest and the time value of money.


COMPOUND INTEREST

The familiar compound interest formula is the basis for all time value of money calculations. This equation expresses the value of a principal sum of money left on deposit (or invested) for a given number of years at a given rate of interest. The formula is as follows:

Vn = P(1 + i)n
whereVn = value at the end of n years
P = principal amount deposited or invested
i = interest rate per year
n = number of years

The derivation of the compound interest formula is actually quite simple. Exhibit 11.1 shows the value of $100, invested at the beginning of year 1 earning interest at 6 percent compounded annually, at the end

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