Compound Interest-Time Value Of Money

INTRODUCTION AND SCOPE This chapter is intended as a brief review of the mathematics of compound interest and of the meaning of time equivalent money. In order to make valid economic evaluations of various investment alternatives, it is important that they be analyzed on an equivalent basis, taking into account the time value of money. Compound interest has been said to be one of the eighth wonders of the world. Certainly compound interest is a fact of life in today's economy. Whenever we deal with money over time-investments, earnings, savings, loans, etc.-we are immediately confronted with the principles and effects of compound interest. In such an environment it is necessary to be able to determine time value equivalence of various sums of money received or paid at different dates. It follows that all future payments or series of payments that would repay a present sum with interest at a stated rate can be said to be equivalent with each other. Equivalence, then, is a function of the interest rate. MATHEMATICS OF COMPOUND INTEREST FACTORS In order to develop mathematical formulas for various time value equivalence of compound interest we will use symbol designations: P is Present or principal sum of money; usually refers to value at time zero. F is a single sum of money at some designated future date. R is The amount of each payment in a uniform series of equal payments made at the end of each period. n is Number of interest compounding periods (may represent annual, semiannual, quarterly, or even daily periods). i is the period compound interest rate. Figure 20-1 illustrates the increase of princi-