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Compounding Techniques
Compounding concept
Year 1 2 3
means the interest
Beginning
earned on the initial Amount 1000 1050 1102.5
principal sum becomes
a part of the principal Interest rate 5% 5% 5%
or initial sum at the end Amount of
of the compounded interest 50 52.5 55.125
period. Beginning
Principal 1000 1050 1102.5
Ending 1157.6
Principal 1050 1102.5 25
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Future Value
The compounding technique is used to find out the
FUTURE VALUE of a present money.
It can further be explained with reference to:
PV is Present Value
r is the interest rate
n is time period
If you deposited Rs 55,650 in a bank, which was
paying a 15 per cent rate of interest on a ten-year time
deposit, how much would the deposit grow at the end
of ten years?
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FVn = PV x CVFr,n
Non-Annual Compounding
Compounding is not always annually it may be half- yearly,
quarterly, monthly. So in this case compounding can be done
be using the following formula.
FV = PV(1+r/m)mn
m is the number of time compounding is done in a year
n is the time period.
Compounding Period No of period (m)
Annually 1
Half- Yearly 2
Quarterly 4
Monthly 12
Note: More frequently the compounding is made, the faster is the growth
in the FV
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Examples of Annuities
Student Loan Payments
Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings
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PARTS OF ANNUITY
(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3
0 1 2 3
(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3
0 1 2 3
Note
The future value of an ordinary annuity
can be viewed as occurring at the end
of the last cash flow period,
whereas the future value of an annuity
due can be viewed as occurring at the
beginning of the last cash flow period
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(1 i) 1 n
Fn A
(1+i)
i
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Cash flows occur at the beginning of the period
0 1 2 3 4
7%
$1,000 $1,000 $1,000 $1,070
$1,145
$1,225
FVAD3 = $1,000(1.07)3 +
$1,000(1.07)2 + $1,000(1.07)1
$3,440 = FVAD3
= $1,225 + $1,145 + $1,070
= $3,440
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Sinking Fund
Sinking fund is a fund, which is created out of fixed
payments each period to accumulate to a future sum
after a specified period. For example, companies
generally create sinking funds to retire bonds
(debentures) on maturity.
The factor used to calculate the annuity for a given
future sum is called the sinking fund factor (SFF).