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Money Terms

Table of Contents
Interest (An Introduction) ......................................................................................................................................... 6
Money is Not Free to Borrow ........................................................................................................................................... 6
How Much does it Cost to Borrow Money? .................................................................................................................... 6
As a percent (per year) of the amount borrowed ....................................................................................................... 6
Example: Borrow $1,000 from the Bank .................................................................................................................... 6
This is the idea of Interest ... paying for the use of the money. ................................................................................. 6
Words ................................................................................................................................................................................. 7
More Than One Year ....................................................................................................................................................... 7
Simple Interest............................................................................................................................................................... 7
Example: Alex borrows $1,000 for 5 Years, at 10% simple interest: ....................................................................... 7
Example: Jan borrowed $3,000 for 4 Years at 5% interest rate, how much interest is that? ............................... 8
Compound Interest ....................................................................................................................................................... 8
What is Year 0? ............................................................................................................................................................. 9
Why Borrow? .................................................................................................................................................................... 9
Example: Chicken Business ....................................................................................................................................... 10
Investment ....................................................................................................................................................................... 10
Less Than One Year ... ................................................................................................................................................... 11

Compound Interest .................................................................................................................................................... 12


Make A Formula ............................................................................................................................................................. 13
The Formula .................................................................................................................................................................... 14
Examples ...................................................................................................................................................................... 14
Going "Backwards" to Work Out the Present Value.................................................................................................. 15
Compounding Periods .................................................................................................................................................... 15
APR .................................................................................................................................................................................. 16
Break Time! ..................................................................................................................................................................... 16
Working Out The Interest Rate ..................................................................................................................................... 16
Working Out How Many Periods .................................................................................................................................. 17
Calculator ........................................................................................................................................................................ 18
Summary.......................................................................................................................................................................... 18
Annuities .......................................................................................................................................................................... 18

Compound Interest: Periodic Compounding ............................................................................................... 19


Quick Explanation of Compound Interest.................................................................................................................... 19
The Formula .................................................................................................................................................................... 19
Example: $1,000 invested at 10% for 5 Years:......................................................................................................... 19
Example: $1,000 invested at 6% for 5 Years:........................................................................................................... 20
Periodic Compounding (Within The Year) .................................................................................................................. 20
Two Annual Interest Rates?....................................................................................................................................... 20
Working It Out ............................................................................................................................................................ 21
Example: what rate do you get when the ad says "6% compounded monthly"? ................................................. 22
Example: 7% interest, compounded 4 times a year. ................................................................................................ 22
Table of Values ................................................................................................................................................................ 22
Continuously? .............................................................................................................................................................. 23
Example: ...................................................................................................................................................................... 23
Using It ............................................................................................................................................................................. 23
Example: Continuous Compounding of $10,000 for 2 years at 8% ....................................................................... 23
Conclusion ....................................................................................................................................................................... 23

Compound Interest Formula Derivations ................................................................................ 24


Make A Formula ............................................................................................................................................................. 24
And that formula works for any year: ...................................................................................................................... 24
In fact we could go straight from the start to Year 5 if we multiply 5 times: ........................................................ 24
The Formula .................................................................................................................................................................... 25
Examples ...................................................................................................................................................................... 25
The Four Formulas ......................................................................................................................................................... 25
Working Out the Present Value .................................................................................................................................... 26
Example: Sam wants to reach $2,000 in 5 Years at 10% annual interest. How much should Sam start with? . 26
Example (continued):.................................................................................................................................................. 26
Another Example: How much do you need to invest now, to get $10,000 in 10 years at 8% interest rate? ....... 27
Working Out The Interest Rate ..................................................................................................................................... 27
Example: Sam has only $1,000, and wants it to grow to $2,000 in 5 Years, what interest rate should Sam be
looking for? .................................................................................................................................................................. 27
Example (continued):.................................................................................................................................................. 27
Another Example: What interest rate do you need to turn $1,000 into $5,000 in 20 Years? ............................... 27
Working Out How Many Periods .................................................................................................................................. 28
Example: Sam can only get a 10% interest rate. How many years will it take Sam to get $2,000? .................... 28
Example (continued): .................................................................................................................................................. 28
Another Example: How many years to turn $1,000 into $10,000 at 5% interest? ................................................ 28
Conclusion ....................................................................................................................................................................... 28

Present Value (PV) ..................................................................................................................................................... 29


Example: You can get 10% interest on your money. ............................................................................................... 29
Present Value ................................................................................................................................................................... 29
How to Calculate Future Payments ............................................................................................................................... 29
Easier Calculation ........................................................................................................................................................... 30
Future Back to Now ........................................................................................................................................................ 30
Example: Sam promises you $500 next year, what is the Present Value? ............................................................. 30
Example: Alex promises you $900 in 3 years, what is the Present Value? ............................................................ 30
Better With Exponents ................................................................................................................................................... 30
Example: (continued) .................................................................................................................................................. 31
Example: (continued) .................................................................................................................................................. 31
Example: What is $570 next year worth now, at an interest Rate of 10% ? ......................................................... 31
Example: What is $570 next year worth now, at an interest Rate of 15% ? ......................................................... 31
Example: What is $570 in 3 years time worth now, at an interest Rate of 10% ? ................................................ 31
Example: You are promised $800 in 10 years time. What is its Present Value at an interest rate of 6% ? ....... 31

Net Present Value (NPV) ........................................................................................................................................ 32


Example: Let us say you can get 10% interest on your money............................................................................... 32
How to Calculate Future Payments ............................................................................................................................... 32
Easier Calculation ........................................................................................................................................................... 33
Future Back to Now ........................................................................................................................................................ 33
Example: Sam promises you $500 next year, what is the Present Value? ............................................................. 33
Example: Alex promises you $900 in 3 years, what is the Present Value? ............................................................ 33
Better With Exponents ................................................................................................................................................... 34
Example: (continued) .................................................................................................................................................. 34
Example: (continued) .................................................................................................................................................. 34
Net Present Value (NPV) ................................................................................................................................................ 34
Example: A friend needs $500 now, and will pay you back $570 in a year. Is that a good investment when you
can get 10% elsewhere? .............................................................................................................................................. 34
Example: Same investment, but try it at 15%. ......................................................................................................... 35
Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the 3rd year. Use 10%
Interest Rate. ............................................................................................................................................................... 35
Example: (continued) at a 6% Interest Rate. ........................................................................................................... 36

Internal Rate of Return (IRR) ............................................................................................................................. 37


Example: Sam is going to start a small bakery! ....................................................................................................... 37
Present Value ................................................................................................................................................................... 38
Example: Alex promises you $900 in 3 years, what is the Present Value (using a 10% interest rate)? .............. 38
Example: try that again, but use an interest rate of 6% ......................................................................................... 39
Net Present Value (NPV) ................................................................................................................................................ 39
Example: You invest $500 now, and get back $570 next year. Use an Interest Rate of 10% to work out the
NPV. ............................................................................................................................................................................. 39
Example: Same investment, but work out the NPV using an Interest Rate of 15% ............................................. 39
Example: Try again, but the interest Rate is 14% ................................................................................................... 40
Internal Rate of Return .................................................................................................................................................. 40
Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the 3rd year.................... 41
Example: (continued) at 12% interest rate ............................................................................................................... 41
Example: (continued) at 12.4% interest rate ............................................................................................................ 41
Using the Internal Rate of Return (IRR) ...................................................................................................................... 41

Investing (Introduction) .......................................................................................................................................... 43


Investing: ......................................................................................................................................................................... 43
Risk and Reward ............................................................................................................................................................. 43
Comparing Investments ................................................................................................................................................. 44
Example: A bank pays 10% interest on your money. .............................................................................................. 44
Example: Two investments that both cost $200:one pays $220 next year, the other pays $230 in 2 years time 44
Example: you run a Bakery, and want to improve its income. You could: ........................................................... 45
Diversify! .......................................................................................................................................................................... 45
Example: the whole economy goes bad! .................................................................................................................... 45

Personal Budget ........................................................................................................................................................... 47


Where Does My Money Go? ................................................................................................................................. 47
Example: Sam's needs for last month were:....................................................................................................... 47
Example: Sam has these "wants": ..................................................................................................................... 48
Example: Sam earned $2500 last month, ........................................................................................................... 48
Budget for the Whole Year ................................................................................................................................... 48
Reducing Expenses ............................................................................................................................................... 49
Keep Your Money Under Control .......................................................................................................................... 50
Envelopes ............................................................................................................................................................ 50
Putting your Money To Good Use ......................................................................................................................... 51
Pay Off High Interest Debt .................................................................................................................................... 51
Emergency Fund ................................................................................................................................................... 51
Investments ......................................................................................................................................................... 51
Annuities.......................................................................................................................................................................... 52
Example: You get $200 a week for 10 years. ...................................................................................................... 52
Example: You buy an annuity ............................................................................................................................ 52
Example (continued): ........................................................................................................................................ 52
Value of an Annuity .............................................................................................................................................. 52
Example: 10% interest on $1,000 ...................................................................................................................... 52
Example: An annuity of $400 a month for 5 years. ............................................................................................. 53
Use a Monthly interest rate of 1%. .................................................................................................................... 53
First, let's try it on our $500 for 4 years example. .............................................................................................. 54
Now let's try it on our $400 for 60 months example:.......................................................................................... 54
Going the Other Way............................................................................................................................................ 54
Say you have $10,000 and want to get a monthly income for 6 years out of it, how much could you get each
month (assume a monthly interest rate of 0.5%) ............................................................................................... 55
Footnote: ......................................................................................................................................................... 55
Interest (An Introduction)
Interest: how much is paid for the use of money (as a percent, or an amount)

Money is Not Free to Borrow


People can always find a use for money, so it costs to borrow money.

How Much does it Cost to Borrow Money?


Different places charge different amounts at different times!

But they usually charge this way:

As a percent (per year) of the amount borrowed

It is called Interest

Example: Borrow $1,000 from the Bank


Alex wants to borrow $1,000. The local bank says "10% Interest". So to borrow the
$1,000 for 1 year will cost:

$1,000 × 10% = $100

In this case the "Interest" is $100, and the "Interest Rate" is 10% (but people often say "10% Interest" without
saying "Rate")

Of course, Alex will have to pay back the original $1,000 after one year, so this is what happens:

Alex Borrows $1,000, but has to pay back $1,100

This is the idea of Interest ... paying for the use of the money.

Note: I am showing a full year loan, but banks often want you to pay back the loan in
small monthly amounts, and they also charge extra fees too!
Words
There are special words used when borrowing money, as shown here:

Alex is the Borrower, the Bank is the Lender

The Principal of the Loan is $1,000

The Interest is $100

The important part of the word "Interest" is Inter- meaning between (we see inter- in words like interior and
interval), because the interest happens between the start and end of the loan.

More Than One Year ...


What if Alex wanted to borrow the money for 2 Years?

Simple Interest

If the bank charges "Simple Interest" then Alex just pays another 10% for the extra year.

Alex pays Interest of ($1,000 × 10%) x 2 Years = $200

That is how simple interest works ... pay the same amount of interest every year.

Example: Alex borrows $1,000 for 5 Years, at 10% simple interest:

• Interest = $1,000 × 10% x 5 Years = $500


• Plus the Principal of $1,000 means Alex needs to pay $1,500 after 5 Years

There is a formula for simple interest

I = Prt
where

 I = interest
 P = amount borrowed (called "Principal")
 r = interest rate
 t = time

Like this:

Example: Jan borrowed $3,000 for 4 Years at 5% interest rate, how much interest is that?

I = Prt
I = $3,000 × 5% × 4 years
I = 3000 × 0.05 × 4
I = $600

Compound Interest

But the bank says "If you paid me everything back after one year, and then I loaned it to you again ... I would be
loaning you $1,100 for the second year!"

And Alex pays $110 interest in the second year, not just $100.

Because Alex is paying 10% on $1,100 not just $1,000

This may seem unfair ... but imagine YOU lend the money to Alex. After a year you think "Alex owes me
$1,100 now, and is still using my money, I should get more interest!"

And so this is the normal way of calculating interest. It is called compounding.

With compounding we work out the interest for the first period, add it the total, and then calculate the interest
for the next period, and so on ..., like this:
It is like paying interest on interest: after a year Alex owed $100 interest, the Bank thinks of that as another loan
and charges interest on it, too.

After a few years it can get really large. This is what happens on a 5 Year Loan:

Year Loan at Start Interest Loan at End


0 (Now) $1,000.00 ($1,000.00 × 10% = ) $100.00 $1,100.00
1 $1,100.00 ($1,100.00 × 10% = ) $110.00 $1,210.00
2 $1,210.00 ($1,210.00 × 10% = ) $121.00 $1,331.00
3 $1,331.00 ($1,331.00 × 10% = ) $133.10 $1,464.10
4 $1,464.10 ($1,464.10 × 10% = ) $146.41 $1,610.51
5 $1,610.51

So, after 5 Years Alex has to pay back $1,610.51

And the Interest for the last year was $146.41 ... it sure grew quickly!

(Compare that to the Simple Interest of only $100 each year)

What is Year 0?

Year 0 is the year that starts with the "Birth" of the Loan, and ends just before the 1st Birthday.

Just like when a baby is born its age is zero, and will not be 1 year old until the first birthday.

So the start of Year 1 is the "1st Birthday". And the start of Year 5 is exactly when the loan is 5 years old.

In Summary:

To calculate compound interest, work out the interest for the first period, add it on, and then calculate the
interest for the next period, etc.

(There are quicker methods, see Compound Interest)

Why Borrow?
Well ... you may want to buy something you like. Paying it back will end up costing you more though.

But a business may be able to use the money to make even more money.
Example: Chicken Business

You borrow $1,000 to start a chicken business (to buy chicks, chicken food and so on).

A year later you sell all the grown chickens for $1,200.

You pay back the bank $1,100 (the original $1,000 plus 10% interest) and you are left with $100 profit.

And you used someone else's money to do it!

But be careful! What if you only sold the chickens for $800? ... the bank still wants $1,100 and you end up with
a $300 loss.

Investment
Compound Interest can work for you!

Investment is when you put money where it can grow, such as a bank, or a business.

If you invest your money at a good interest rate it can grow very nicely.

This is what 15% interest on $1,000 can do:

Year Loan at Start Interest Loan at End


0 (Now) $1,000.00 ($1,000.00 × 15% = ) $150.00 $1,150.00
1 $1,150.00 ($1,150.00 × 15% = ) $172.50 $1,322.50
2 $1,322.50 ($1,322.50 × 15% = ) $198.38 $1,520.88
3 $1,520.88 ($1,520.88 × 15% = ) $228.13 $1,749.01
4 $1,749.01 ($1,749.01 × 15% = ) $262.35 $2,011.36
5 $2,011.36

It more than doubles in 5 Years!

An investment at 15% is not likely to be safe (see Investing introduction) ... but it does show us the power of
compounding.

The graph of that investment looks like this:


Maybe you don't have $1,000? Here is what saving $200 every year for 10 Years at 10% interest can do:

$3,506.23 after 10 Years!


For 10 Years of $200 each year.

Less Than One Year ...


Interest is not always charged yearly. It can be charged Semi-annually (every 6 months), Monthly, even Daily!

But the same rules apply:

 For simple interest: work out the interest for one period, and multiply by the number of periods.
 For compound interest: work out the interest for the first period, add it on and then calculate the interest
for the next period, etc.
Compound Interest
You may wish to read Introduction to Interest first

With Compound Interest, you work out the interest for the first period, add it to the total, and then calculate the
interest for the next period, and so on ..., like this:

It grows faster and faster like this:

Here are the calculations for 5 Years at 10%:

Year Loan at Start Interest Loan at End


0 (Now) $1,000.00 ($1,000.00 × 10% = ) $100.00 $1,100.00
1 $1,100.00 ($1,100.00 × 10% = ) $110.00 $1,210.00
2 $1,210.00 ($1,210.00 × 10% = ) $121.00 $1,331.00
3 $1,331.00 ($1,331.00 × 10% = ) $133.10 $1,464.10
4 $1,464.10 ($1,464.10 × 10% = ) $146.41 $1,610.51
5 $1,610.51

We can calculate it one step at a time:

1. Calculate the Interest (= "Loan at Start" × Interest Rate)


2. Add the Interest to the "Loan at Start" to get the "Loan at End" of the year
3. The "Loan at End" of the year is the "Loan at Start" of the next year

A simple job, with lots of calculations.

But there are quicker ways, using some clever mathematics.


Make A Formula
Let us make a formula for the above ... just looking at the first year to begin with:

$1,000.00 + ($1,000.00 × 10%) = $1,100.00

We can rearrange it like this:

So, adding 10% interest is the same as multiplying by 1.10

so this: $1,000 + ($1,000 x 10%) = $1,000 + $100 = $1,100


is the same as: $1,000 × 1.10 = $1,100

Note: the Interest Rate was turned into a decimal by dividing by 100:

10% = 10/100 = 0.10

Read Percentages to learn more, but in practice just move the decimal point 2 places, like these examples:

 10% ⇒ 1.0 ⇒ 0.10


 12% ⇒ 1.2 ⇒ 0.12
 6% ⇒ 0.6 ⇒ 0.06

The result is that we can do a year in one step:

1. Multiply the "Loan at Start" by (1 + Interest Rate) to get "Loan at End"

Now, here is the magic ...

... the same formula works for any year!

 We could do the next year like this: $1,100 × 1.10 = $1,210


 And then continue to the following year: $1,210 × 1.10 = $1,331
 etc...

So it works like this:


In fact we could go straight from the start to Year 5, if we multiply 5 times:

$1,000 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10 = $1,610.51

But it is easier to write down a series of multiplies using Exponents (or Powers) like this:

This does all the calculations in the top table in one go.

The Formula
We have been using a real example, but let's be more general by using letters instead of numbers, like this:

(Can you see it is the same? Just with PV = $1,000, r = 0.10, n = 5, and FV = $1,610.51)

Here is is written with "FV" first:

FV = PV × (1+r)n

where FV = Future Value


PV = Present Value
r = annual interest rate
n = number of periods

This is the basic formula for Compound Interest.

Remember it, because it is very useful.

Examples

How about some examples ...


... what if the loan went for 15 Years? ... just change the "n" value:

... and what if the loan was for 5 years, but the interest rate was only 6%? Here:
Did you see how we just put the
6% into its place like this:

... and what if the loan was for 20 years at 8%? ... you work it out!

Going "Backwards" to Work Out the Present Value


Let's say your goal is to have $2,000 in 5 Years. You can get 10%, so how much should you start with?

In other words, you know a Future Value, and want to know a Present Value.

We know that multiplying a Present Value (PV) by (1+r)n gives us the Future Value (FV), so we can go
backwards by dividing, like this:

So the Formula is:

PV = FV / (1+r)n

And now we can calculate the answer:

PV = $2,000 / (1+0.10)5 = $2,000 / 1.61051 = $1,241.84

In other words, $1,241.84 will grow to $2,000 if you invest it at 10% for 5 years.

Another Example: How much do you need to invest now, to get $10,000 in 10 years at 8% interest rate?

PV = $10,000 / (1+0.08)10 = $10,000 / 2.1589 = $4,631.93

So, $4,631.93 invested at 8% for 10 Years grows to $10,000

Compounding Periods
Compound Interest is not always calculated per year, it could be per month, per day, etc. But if it is not per
year it should say so!

Example: you take out a $1,000 loan for 12 months and it says "1% per month", how much do you pay back?

Just use the Future Value formula with "n" being the number of months:

FV = PV × (1+r)n = $1,000 × (1.01)12 = $1,000 × 1.12683 = $1,126.83 to pay back


And it is also possible to have yearly interest but with several compoundings within the year, which is called
Periodic Compounding.

Example, 6% interest with "monthly compounding" does not mean 6% per month, it means 0.5% per month
(6% divided by 12 months), and is worked out like this:

FV = PV × (1+r/n)n = $1,000 × (1 + 6%/12)12 = $1,000 × (1.005)12 = $1,000 × 1.06168... = $1,061.68 to pay


back

This is equal to a 6.168% ($1,000 grew to $1,061.68) for the whole year.

So be careful to understand what is meant!

APR
Because it is easy for loan ads to be confusing (sometimes on purpose!), the "APR" is often
used.

APR means "Annual Percentage Rate" ... it shows how much you will actually be paying
for the year (including compounding, fees, etc).
This ad looks like 6.25%, but is really 6.335%

Here are some examples:

Example 1: "1% per month" actually works out to be 12.683% APR (if no fees).

And:

Example 2: "6% interest with monthly compounding" works out to be 6.168% APR (if no fees).

If you are shopping around, ask for the APR.

Break Time!
So far we have looked at using (1+r)n to go from a Present Value (PV) to a Future Value (FV) and back again,
plus some of the tricky things that can happen to a loan.

Now is a good time to have a break before we look at two more topics:

 How to work out the Interest Rate if you know PV, FV and the Number of Periods.
 How to work out the Number of Periods if you know PV, FV and the Interest Rate

Working Out The Interest Rate


You can calculate the Interest Rate if you know a Present Value, a Future Value and how many Periods.
Example: you have $1,000, and want it to grow to $2,000 in 5 Years, what interest rate do you need?

The formula is:

r = ( FV / PV )1/n - 1

Note: the little "1/n" is a Fractional Exponent, first calculate 1/n, then use that as the
exponent on your calculator.

For example 20.2 is entered as 2, "x^y", 0, ., 2, =

Now we just "plug in" the values to get the result:

r = ( $2,000 / $1,000 )1/5 - 1 = ( 2 )0.2 - 1 = 1.1487 - 1 = 0.1487

And 0.1487 as a percentage is 14.87%,

So you need 14.87% interest rate to turn $1,000 into $2,000 in 5 years.

Another Example: What interest rate do you need to turn $1,000 into $5,000 in 20 Years?

r = ( $5,000 / $1,000 )1/20 - 1 = ( 5 )0.05 - 1 = 1.0838 - 1 = 0.0838

And 0.0838 as a percentage is 8.38%.

So 8.38% will turn $1,000 into $5,000 in 20 Years.

Working Out How Many Periods


You can calculate how many Periods if you know a Future Value, a Present Value and the Interest Rate.

Example: you want to know how many periods it will take to turn $1,000 into $2,000 at 10% interest.

This is the formula (note: it uses the natural logarithm function ln):

n = ln(FV / PV) / ln(1 + r)

The "ln" function should be on a good calculator.

You could also use log, just don't mix the two.

Anyway, let's "plug in" the values:

n = ln( $2,000 / $1,000 ) / ln( 1 + 0.10 ) = ln(2)/ln(1.10) = 0.69315/0.09531 = 7.27

Magic! It will need 7.27 years to turn $1,000 into $2,000 at 10% interest.
Another Example: How many years to turn $1,000 into $10,000 at 5% interest?

n = ln( $10,000 / $1,000 ) / ln( 1 + 0.05 ) = ln(10)/ln(1.05) = 2.3026/0.04879 = 47.19

47 Years! But we are talking about a 10-fold increase, at only 5% interest.

Calculator
I also made a Compound Interest Calculator that uses these formulas.

Summary
The basic formula for Compound Interest is:

FV = PV (1+r)n To find the Future Value, where:

 FV = Future Value,
 PV = Present Value,
 r = Interest Rate (as a decimal value), and
 n = Number of Periods

And by rearranging that formula (see Compound Interest Formula Derivation) we can find any value when we
know the other three:

Find the Present Value when you know a Future


PV = FV / (1+r)n
Value, the Interest Rate and number of Periods.

Find the Interest Rate when you know the Present


r = ( FV / PV )1/n - 1
Value, Future Value and number of Periods.

Find the number of Periods when you know the


n = ln(FV / PV) / ln(1 + r)
Present Value, Future Value and Interest Rate

Annuities
So far we have talked about what happens to a value as time goes by ... but what if you have a series of values,
like regular loan payments or yearly investments? That is covered in Annuities, coming soon.
Compound Interest: Periodic Compounding
You may like to read about Compound Interest first.
You can skip straight down to Periodic Compounding.

Quick Explanation of Compound Interest


With Compound Interest, you work out the interest for the first period, add it to the total, and then calculate the
interest for the next period, and so on ..., like this:

But adding 10% interest is the same as multiplying by 1.10


(explained here)

So it also works like this:

In fact we can go from the Start to Year 5 if we multiply 5 times using Exponents (or Powers):

The Formula
This is the formula for Compound Interest (like above but using letters instead of numbers):

Example: $1,000 invested at 10% for 5 Years:

Present Value PV = $1,000

Interest Rate is 10%, which as a decimal r = 0.10

Number of Periods n = 5

PV × (1 + r)n = FV
$1,000 × (1 + 0.10)5 = FV
$1,000 × 1.105 = $1,610.51
Now we can choose different values, such as an interest rate of 6%:

Example: $1,000 invested at 6% for 5 Years:

Present Value PV = $1,000

Interest Rate is 6%, which as a decimal r = 0.06

Number of Periods n = 5

PV × (1 + r)n = FV
$1,000 × (1 + 0.06)5 = FV
$1,000 × 1.065 = $1,338.23

Periodic Compounding (Within The Year)


But sometimes interest is charged Yearly ...

... but it is calculated more than once within the year, with the interest added each time ...

... so there are compoundings within the Year.

Example: "10%, Compounded Semiannually"

Semiannual means twice a year. So the 10% is split into two:

 5% halfway through the year,


 and another 5% at the end of the year,

but each time it is compounded (meaning the interest is added to the total):

10%, Compounded Semiannually

This results in $1,102.50, which is equal to 10.25%, not 10%

Two Annual Interest Rates?

Yes, there are two annual interest rates:

Example
10% The Nominal Rate (the rate they mention)

10.25% The Effective Annual Rate (the rate after compounding)


The Effective Annual Rate is what actually gets paid!

When interest is compounded within the year, the Effective Annual Rate is higher than the rate mentioned.

How much higher depends on the interest rate, and how many times it is compounded within the year.

Working It Out

Let's come up with a formula to work out the Effective Annual Rate if we know:

 the rate mentioned (the Nominal Rate, "r")


 how many times it is compounded ("n").

Our task is to take an interest rate (like 10%) and chop it up into "n" periods, compounding each time.

From the Compound Interest formula (shown above) we can compound "n" periods using

FV = PV (1+r)n

But the interest rate won't be "r", because it has to be chopped into "n" periods like this:

r/n

So we change the compounding formula into:

This is the formula for Periodic Compounding:

FV = PV (1+(r/n))n

where FV = Future Value


PV = Present Value
r = annual interest rate
n = number of periods

Let's try it on our "10%, Compounded Semiannually" example:

FV = $1,000 (1+(0.10/2))2 = $1,000(1.05)2 = $1,000 × 1.1025 = $1,102.50

That worked! But we want to know what the new interest rate is, we don't want the dollar values in there, so
let's remove them:

(1+(r/n))n = (1.05)2 = 1.1025

That has the interest rate in there (0.1025 = 10.25%), but we should subtract the extra 1:

(1+(r/n))n − 1 = 0.1025 = 10.25%

And so the formula is:

Effective Annual Rate = (1+(r/n))n − 1


Example: what rate do you get when the ad says "6% compounded monthly"?

r = 0.06 (which is 6% as a decimal)


n = 12

Effective Annual Rate = (1+(r/n))n − 1

= (1+(0.06/12))12 − 1

= (1.005)12 − 1 = 0.06168 = 6.168%

So you actually get 6.168%

Example: 7% interest, compounded 4 times a year.

r = 0.07 (which is 7% as a decimal)


n=4

So:

FV = PV (1+(0.07/4))4

FV = PV (1+(0.07/4))4

FV = PV (1.0719...)

The effective annual rate is 7.19%

So remember:

Chop the interest rate into "n" periods r/n

Compound that "n" times: (1+(r/n))n

Don't forget to subtract the "1" (1+(r/n))n − 1

Table of Values
Here are some example values. Notice that compounding has a very small effect when the interest rate is small,
but a large effect for high interest rates.

Compounding Periods 1.00% 5.00% 10.00% 20.00% 100.00%


Yearly 1 1.00% 5.00% 10.00% 20.00% 100.00%
Semiannually 2 1.00% 5.06% 10.25% 21.00% 125.00%
Quarterly 4 1.00% 5.09% 10.38% 21.55% 144.14%
Monthly 12 1.00% 5.12% 10.47% 21.94% 161.30%
Daily 365 1.01% 5.13% 10.52% 22.13% 171.46%
... ...
Continuously Infinite 1.01% 5.13% 10.52% 22.14% 171.83%

Continuously?

Yes, if you have smaller and smaller periods (hourly, minutely, etc) you eventually reach a limit, and we even

have a formula for it:

Continuous Compounding Formula


Note: e=2.71828..., which is Euler's number.

Example:

Continuous Compounding for 20% is: e0.20 − 1 = 1.2214... − 1 = 0.2214...

Using It
Now that you can calculate the Effective Annual Rate (for specific periods, or continuous), we can use it in any
normal compound interest calculations.

Example: Continuous Compounding of $10,000 for 2 years at 8%

Continuous Compounding for 8% is: e0.08 − 1 = 1.08329... − 1 = 0.08329...

That is 8.329%

Now we want that over 2 years (see Compound Interest):

FV = PV × (1+r)n

FV = $10,000 × (1+0.08329)2

FV = $10,000 × 1.173511... = $11,735.11

Conclusion
Effective Annual Rate = (1+(r/n))n − 1

Where:

 r = Nominal Rate (the rate they mention)


 n = number of periods that are compounded (example: monthly=12)
Compound Interest Formula Derivations
Showing how the formulas are worked out, with Examples!

With Compound Interest we work out the interest for the first period, add it to the total, and then calculate the
interest for the next period, and so on ..., like this:

Make A Formula
Let's look at the first year to begin with:

$1,000.00 + ($1,000.00 × 10%) = $1,100.00

We can rearrange it like this:

So, adding 10% interest is the same as multiplying by 1.10

(Note: the Interest Rate was turned into a decimal by dividing by 100: 10% = 10/100 = 0.10, read Percentages
to learn more.)

And that formula works for any year:

 We could do the next year like this: $1,100 × 1.10 = $1,210


 And then continue to the following year: $1,210 × 1.10 = $1,331
 etc...

So it works like this:

In fact we could go straight from the start to Year 5 if we multiply 5 times:

$1,000 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10 = $1,610.51

But it is easier to write down a series of multiplies using Exponents (or Powers) like this:
The Formula
We have been using a real example, but let us make it more general by using letters instead of numbers, like
this:

(Can you see it is the same? Just with PV = $1,000, r = 0.10, n = 5, and FV = $1,610.51)

 When the interest rate is annual, then n is the number of years


 When the interest rate is monthly, then n is the number of months
 etc

Examples

How about some examples ...


... what if the loan went for 15 Years? ... just change the "n" value:

... and what if the loan was for 5 years, but the interest rate was only 6%? Here:

The Four Formulas


So, the basic formula for Compound Interest is:

FV = PV (1+r)n

 FV = Future Value,
 PV = Present Value,
 r = Interest Rate (as a decimal value), and
 n = Number of Periods

With that we can work out the Future Value FV when we know the Present Value PV, the Interest Rate r and
Number of Periods n
And we can rearrange that formula to find FV, the Interest Rate or the Number of Periods when we know the
other three.

Here are all four furmulas:

Find the Future Value when we know a Present Value, the Interest
FV = PV (1+r)n
Rate and number of Periods.

Find the Present Value when we know a Future Value, the Interest
PV = FV / (1+r)n
Rate and number of Periods.

Find the Interest Rate when we know the Present Value, Future Value
r = ( FV / PV )1/n - 1
and number of Periods.

Find the number of Periods when we know the Present Value, Future
n = ln(FV / PV) ln(1 + r)
Value and Interest Rate

How did we get those other three formulas? Read On!

Working Out the Present Value


Example: Sam wants to reach $2,000 in 5 Years at 10% annual interest. How much should
Sam start with?

In other words, we know a Future Value, and want to know a Present Value.

We can just rearrange the formula to suit ... dividing both sides by (1+r)n to give us:

Start with: FV = PV (1+r)n


Swap sides: PV (1+r)n = FV
Divide both sides by (1+r)n: PV = FV (1+r)n

So now we can calculate the answer:

Example (continued):

PV = $2,000 / (1+0.10)5 = $2,000 / 1.61051 = $1,241.84

So Sam should start with $1,241.84

It works like this:


Another Example: How much do you need to invest now, to get $10,000 in 10 years at 8%
interest rate?

PV = $10,000 / (1+0.08)10 = $10,000 / 2.1589 = $4,631.93

So, $4,631.93 invested at 8% for 10 Years grows to $10,000

Working Out The Interest Rate


Example: Sam has only $1,000, and wants it to grow to $2,000 in 5 Years, what interest rate
should Sam be looking for?

We need a rearrangement of the first formula to work it out:

Start with: FV = PV (1+r)n


Swap sides: PV (1+r)n = FV
Divide both sides by PV: (1+r)n = FV PV
Take nth root of both sides: 1+r = ( FV PV )1/n
Subtract 1 from both sides: r = ( FV PV )1/n − 1

(Note: to understand the step "take nth root" please read Fractional Exponents)

The result is:

r = ( FV / PV )1/n − 1

Now we have the formula, it is just a matter of "plugging in" the values to get the result:

Example (continued):

r = ( $2,000 / $1,000 )1/5 − 1


= ( 2 )0.2 − 1
= 1.1487 − 1
= 0.1487

And 0.1487 as a percentage is 14.87%

So Sam needs 14.87% to turn $1,000 into $2,000 in 5 years.

Another Example: What interest rate do you need to turn $1,000 into $5,000 in 20 Years?

r = ( $5,000 / $1,000 )1/20 − 1 = ( 5 )0.05 − 1 = 1.0838 − 1 = 0.0838

And 0.0838 as a percentage is 8.38%. So 8.38% will turn $1,000 into $5,000 in 20 Years.
Working Out How Many Periods
Example: Sam can only get a 10% interest rate. How many years will it take Sam to get
$2,000?

When we want to know how many periods it takes to turn $1,000 into $2,000 at 10% interest, we can rearrange
the basic formula.

But we need to use the natural logarithm function ln() to do it.

Start with: FV = PV (1+r)n


Swap sides: PV (1+r)n = FV
Divide both sides by PV: (1+r)n = FV / PV
Use logarithms: ln(1+r) × n = ln( FV / PV )
Divide both sides by ln(1+r): n = ln( FV / PV ) ln(1+r)

(Note: to understand the step "use logarithms" please read Working with Exponents and Logarithms).

Now let's "plug in" the values:

Example (continued):

n = ln( $2,000 / $1,000 ) / ln( 1 + 0.10 ) = ln(2)/ln(1.10) = 0.69315/0.09531 = 7.27

Magic! It will need 7.27 years to turn $1,000 into $2,000 at 10% interest.

Poor Sam will have to wait over 7 years.

Another Example: How many years to turn $1,000 into $10,000 at 5% interest?

n = ln( $10,000 / $1,000 ) / ln( 1 + 0.05 ) = ln(10)/ln(1.05) = 2.3026/0.04879 = 47.19

47 Years! But we are talking about a 10-fold increase, at only 5% interest.

Conclusion
Knowing how the formulas are derived and used makes it easier for you to remember them, and to use them in
different situations.
Present Value (PV)
Money now is more valuable than money later on.

Why? Because you can use money to make more money!

You could run a business, or buy something now and sell it later for more, or simply put the money in the bank
to earn interest.

Example: You can get 10% interest on your money.

So $1,000 now can earn $1,000 x 10% = $100 in a year.

Your $1,000 now can become $1,100 in a year's time.

Present Value

So $1,000 now is the same as $1,100 next year (at 10% interest).

We say the Present Value of $1,100 next year is $1,000

Because we could turn $1,000 into $1,100 (if we could earn 10% interest).

Now let us extend this idea further into the future ...

How to Calculate Future Payments


Let us stay with 10% Interest. That means that money grows by 10% every year, like this:

So:

 $1,100 next year is the same as $1,000 now.


 And $1,210 in 2 years is the same as $1,000 now.
 etc
In fact all those amounts are the same (considering when they occur and the 10% interest).

Easier Calculation
But instead of "adding 10%" to each year it is easier to multiply by 1.10 (explained at Compound Interest):

So we get this (same result as above):

Future Back to Now


And to see what money in the future is worth now, go backwards (dividing by 1.10 each year instead of
multiplying):

Example: Sam promises you $500 next year, what is the Present Value?

To take a future payment backwards one year divide by 1.10

So $500 next year is $500 ÷ 1.10 = $454.55 now (to nearest cent).

The Present Value is $454.55

Example: Alex promises you $900 in 3 years, what is the Present Value?

To take a future payment backwards three years divide by 1.10 three times

So $900 in 3 years is:

$900 ÷ 1.10 ÷ 1.10 ÷ 1.10


$900 ÷ (1.10 × 1.10 × 1.10)
$900 ÷ 1.331
$676.18 now (to nearest cent).

Better With Exponents


But instead of $900 ÷ (1.10 × 1.10 × 1.10) it is better to use exponents (the exponent says how many times to
use the number in a multiplication).
Example: (continued)

The Present Value of $900 in 3 years (in one go):

$900 ÷ 1.103 = $676.18 now (to nearest cent).

As a formula it is:

PV = FV / (1+r)n

 PV is Present Value
 FV is Future Value
 r is the interest rate (as a decimal, so 0.10, not 10%)
 n is the number of years

Example: (continued)

Use the formula to calculate Present Value of $900 in 3 years:

PV = FV / (1+r)n
PV = $900 / (1 + 0.10)3 = $900 / 1.103 = $676.18 (to nearest cent).

Exponents are easier to use, particularly with a calculator.

For example 1.106 is quicker than 1.10 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10

Let us use the formula a little more:

Example: What is $570 next year worth now, at an interest Rate of 10% ?

PV = $570 / (1+0.10)1 = $570 / 1.10 = $518.18 (to nearest cent)

But your choice of interest rate can change things!

Example: What is $570 next year worth now, at an interest Rate of 15% ?

PV = $570 / (1+0.15)1 = $570 / 1.15 = $495.65 (to nearest cent)

Or what if you don't get the money for 3 years

Example: What is $570 in 3 years time worth now, at an interest Rate of 10% ?

PV = $570 / (1+0.10)3 = $570 / 1.331 = $428.25 (to nearest cent)

One last example:

Example: You are promised $800 in 10 years time. What is its Present Value at an interest
rate of 6% ?

PV = $800 / (1+0.06)10 = $800 / 1.7908... = $446.72 (to nearest cent)


Net Present Value (NPV)

Money now is more valuable than money later on.

Why? Because you can use money to make more money!

You could run a business, or buy something now and sell it later for more, or simply put the money in the bank
to earn interest.

Example: Let us say you can get 10% interest on your money.

So $1,000 now can earn $1,000 x 10% = $100 in a year.

Your $1,000 now becomes $1,100 next year.

So $1,000 now is the same as $1,100 next year (at 10% interest):

We say that $1,100 next year has a Present Value of $1,000.

Because $1,000 can become $1,100 in one year (at 10% interest).

If you understand Present Value, you can skip straight to Net Present Value.

Now let us extend this idea further into the future ...

How to Calculate Future Payments


Let us stay with 10% Interest , which means money grows by 10% every year, like this:
So:

 $1,100 next year is the same as $1,000 now.


 And $1,210 in 2 years is the same as $1,000 now.
 etc

In fact all those amounts are the same (considering when they occur and the 10% interest).

Easier Calculation
But instead of "adding 10%" to each year it is easier to multiply by 1.10 (explained at Compound Interest):

So we get this (same result as above):

Future Back to Now


And to see what money in the future is worth now, go backwards (dividing by 1.10 each year instead of
multiplying):

Example: Sam promises you $500 next year, what is the Present Value?

To take a future payment backwards one year divide by 1.10

So $500 next year is $500 ÷ 1.10 = $454.55 now (to nearest cent).

The Present Value is $454.55

Example: Alex promises you $900 in 3 years, what is the Present Value?

To take a future payment backwards three years divide by 1.10 three times

So $900 in 3 years is:


$900 ÷ 1.10 ÷ 1.10 ÷ 1.10
$900 ÷ (1.10 × 1.10 × 1.10)
$900 ÷ 1.331
$676.18 now (to nearest cent).

Better With Exponents


But instead of $900 ÷ (1.10 × 1.10 × 1.10) it is better to use exponents (the exponent says how many times to
use the number in a multiplication).

Example: (continued)

The Present Value of $900 in 3 years (in one go):

$900 ÷ 1.103 = $676.18 now (to nearest cent).

And we have in fact just used the formula for Present Value:

PV = FV / (1+r)n

 PV is Present Value
 FV is Future Value
 r is the interest rate (as a decimal, so 0.10, not 10%)
 n is the number of years

Example: (continued)

Use the formula to calculate Present Value of $900 in 3 years:

PV = FV / (1+r)n
PV = $900 / (1 + 0.10)3 = $900 / 1.103 = $676.18 (to nearest cent).

Exponents are easier to use, particularly with a calculator.

For example 1.106 is quicker than 1.10 × 1.10 × 1.10 × 1.10 × 1.10 × 1.10

Net Present Value (NPV)


To be a Net Present Value you also need to subtract money that went out (the money you invested or spent):

 Add the Present Values you receive


 Subtract the Present Values you pay

Example: A friend needs $500 now, and will pay you back $570 in a year. Is that a good
investment when you can get 10% elsewhere?

Money Out: $500 now


You invested $500 now, so PV = -$500.00

Money In: $570 next year

PV = $570 / (1+0.10)1 = $570 / 1.10 = $518.18 (to nearest cent)

The Net Amount is:

Net Present Value = $518.18 - $500.00 = $18.18

So, at 10% interest, that investment is worth $18.18

(In other words it is $18.18 better than a 10% investment, in today's money.)

A Net Present Value (NPV) that is positive is good (and negative is bad).

But your choice of interest rate can change things!

Example: Same investment, but try it at 15%.

Money Out: $500

You invested $500 now, so PV = -$500.00

Money In: $570 next year:

PV = $570 / (1+0.15)1 = $570 / 1.15 = = $495.65 (to nearest cent)

Work out the Net Amount:

Net Present Value = $495.65 - $500.00 = -$4.35

So, at 15% interest, that investment is worth -$4.35

It is a bad investment. But only because you are demanding it earn 15% (maybe you can get 15% somewhere
else at similar risk).

Side Note: the interest rate that makes the NPV zero (in the previous example it is about 14%) is called the
Internal Rate of Return.

Let us try a bigger example.

Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the 3rd
year. Use 10% Interest Rate.

Let us work year by year (remembering to subtract what you pay out):

 Now: PV = -$2,000
 Year 1: PV = $100 / 1.10 = $90.91
 Year 2: PV = $100 / 1.102 = $82.64
 Year 3: PV = $100 / 1.103 = $75.13
 Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29

Adding those up gets: NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97

Looks like a good investment.

And again, but an interest rate of 6%

Example: (continued) at a 6% Interest Rate.

 Now: PV = -$2,000
 Year 1: PV = $100 / 1.06 = $94.34
 Year 2: PV = $100 / 1.062 = $89.00
 Year 3: PV = $100 / 1.063 = $83.96
 Year 3 (final payment): PV = $2,500 / 1.063 = $2,099.05

Adding those up gets: NPV = -$2,000 + $94.34 + $89.00 + $83.96 + $2,099.05 = $366.35

Looks even better at 6%

Why is the NPV bigger when the interest rate is lower?

Because the interest rate is like the team you are playing against, play an easy
team (like a 6% interest rate) and you look good, a tougher team (like a 10%
interest) and you don't look so good!

You can actually use the interest rate as a "test" or "hurdle" for your investments: demand that an investment
have a positive NPV with, say, 6% interest.

So there you have it: work out the PV (Present Value) of each item, then total them up to get the NPV (Net
Present Value), being careful to subtract amounts that go out and add amounts that come in.

And a final note: when comparing investments by NPV, make sure to use the same interest rate for each.
Internal Rate of Return (IRR)
The Internal Rate of Return is a good way of judging an investment. The bigger the better!

The Internal Rate of Return is the interest rate that makes the Net Present Value zero.

OK, that needs some explaining, right?

It is an Interest Rate.

You find it by first guessing what it might be (say 10%), then work out the Net Present Value (I will show
you how).

Then keep guessing (maybe 8%? 9%?) and calculating until you get a Net Present Value of zero.

Example: Sam is going to start a small bakery!

Sam estimates all the costs and earnings for the next 2 years, and calculates the Net Present Value:

At 6% Sam gets a Net Present Value of $2000

But the Net Present Value should be zero, so Sam tries 8% interest:

At 8% Sam gets a Net Present Value of −$1600

Now it's negative! So Sam tries once more, but with 7% interest:

At 7% Sam gets a Net Present Value of $15

Close enough to zero, Sam doesn't want to calculate any more.

The Internal Rate of Return (IRR) is about 7%

So the key to the whole thing is ... calculating the Net Present Value!

Read Net Present Value ... or this quick summary:


An investment has money going out (invested or spent), and money coming in (profits,
dividends etc). You hope more comes in than goes out, and you make a profit!

But before adding it all up you should calculate the time value of money.

Money now is more valuable than money later on.

Example: Let us say you can get 10% interest on your money.

So $1,000 now earns $1,000 x 10% = $100 in a year.

Your $1,000 now becomes $1,100 in a year's time.

Present Value

So $1,000 now is the same as $1,100 next year (at 10% interest).

The Present Value of $1,100 next year is $1,000

Present Value has a detailed explanation, but let's skip straight to the formula:

PV = FV / (1+r)n

 PV is Present Value
 FV is Future Value
 r is the interest rate (as a decimal, so 0.10, not 10%)
 n is the number of years

And let's use the formula:

Example: Alex promises you $900 in 3 years, what is the Present Value (using a 10% interest
rate)?

 The Future Value (FV) is $900,


 The interest rate (r) is 10%, which is 0.10 as a decimal, and
 The number of years (n) is 3.

So the Present Value of $900 in 3 years is:

PV = FV / (1+r)n
PV = $900 / (1 + 0.10)3
PV = $900 / 1.103
PV = $676.18 (to nearest cent)
Notice that $676.18 is a lot less than $900.

It is saying that $676.18 now is as valuable as $900 in 3 years (at 10%).

Example: try that again, but use an interest rate of 6%

The interest rate (r) is now 6%, which is 0.06 as a decimal:

PV = FV / (1+r)n
PV = $900 / (1 + 0.06)3
PV = $900 / 1.063
PV = $755.66 (to nearest cent)

When we only get 6% interest, then $755.66 now is as valuable as $900 in 3 years.

Net Present Value (NPV)


Now we are equipped to calculate the Net Present Value.

For each amount (either coming in, or going out) work out its Present Value, then:

 Add the Present Values you receive


 Subtract the Present Values you pay

Like this:

Example: You invest $500 now, and get back $570 next year. Use an Interest Rate of 10% to
work out the NPV.

Money Out: $500 now

You invest $500 now, so PV = −$500.00

Money In: $570 next year

PV = $570 / (1+0.10)1 = $570 / 1.10


PV = $518.18 (to nearest cent)

And the Net Amount is:

Net Present Value = $518.18 − $500.00 = $18.18

So, at 10% interest, that investment has NPV = $18.18

But your choice of interest rate can change things!

Example: Same investment, but work out the NPV using an Interest Rate of 15%

Money Out: $500 now


You invest $500 now, so PV = -$500.00

Money In: $570 next year:

PV = $570 / (1+0.15)1 = $570 / 1.15


PV = $495.65 (to nearest cent)

Work out the Net Amount:

Net Present Value = $495.65 - $500.00 = -$4.35

So, at 15% interest, that investment has NPV = -$4.35

It has gone negative!

Now it gets interesting ... what Interest Rate can make the NPV exactly zero? Let's try 14%:

Example: Try again, but the interest Rate is 14%

Money Out: $500 now

You invest $500 now, so PV = -$500.00

Money In: $570 next year:

PV = $570 / (1+0.14)1 = $570 / 1.14


PV = $500 (exactly)

Work out the Net Amount:

Net Present Value = $500 − $500.00 = $0

Exactly zero!

At 14% interest NPV = $0

And we have discovered the Internal Rate of Return ... it is 14% for that investment.

Because 14% made the NPV zero.

Internal Rate of Return


So the Internal Rate of Return is the interest rate that makes the Net Present Value zero.

And that "guess and check" method is the common way to find it (though in that simple case it could have been
worked out directly).

Let's try a bigger example:


Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the 3rd
year.

Let us try 10% interest:

 Now: PV = -$2,000
 Year 1: PV = $100 / 1.10 = $90.91
 Year 2: PV = $100 / 1.102 = $82.64
 Year 3: PV = $100 / 1.103 = $75.13
 Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29

Adding those up gets: NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97

Let's try a better guess, say 12% interest rate:

Example: (continued) at 12% interest rate

 Now: PV = -$2,000
 Year 1: PV = $100 / 1.12 = $89.29
 Year 2: PV = $100 / 1.122 = $79.72
 Year 3: PV = $100 / 1.123 = $71.18
 Year 3 (final payment): PV = $2,500 / 1.123 = $1,779.45

Adding those up gets: NPV = -$2,000 + $89.29 + $79.72 + $71.18 + $1,779.45 = $19.64

Ooh .. so close. Maybe 12.4% ?

Example: (continued) at 12.4% interest rate

 Now: PV = -$2,000
 Year 1: PV = $100 / 1.124 = $88.97
 Year 2: PV = $100 / 1.1242 = $79.15
 Year 3: PV = $100 / 1.1243 = $70.42
 Year 3 (final payment): PV = $2,500 / 1.1243 = $1,760.52

Adding those up gets: NPV = -$2,000 + $88.97 + $79.15 + $70.42 + $1,760.52 = -$0.94

That is good enough! Let us stop there and say the Internal Rate of Return is 12.4%

In a way it is saying "this investment could earn 12.4%" (assuming it all goes according to plan!).

Using the Internal Rate of Return (IRR)


The IRR is a good way of judging different investments.

First of all, the IRR should be higher than the cost of funds. If it costs you 8% to borrow money, then an IRR of
only 6% is not good enough!

It is also useful when investments are quite different.


 Maybe the amounts involved are quite different.
 Or maybe one has high costs at the start, and another has many small costs over time.
 etc...

Example: instead of investing $2,000 like above, you could also invest 3 yearly sums of $1,000 to gain $4,000
in the 4th year ... should you do that instead?

I did this one in a spreadsheet, and found that 10% was pretty close:

At 10% interest rate NPV = -$3.48

So the Internal Rate of Return is about 10%

And so the other investment (where the IRR was 12.4%) is better.

Doing your calculations in a spreadsheet is great as you can easily change the interest rate until the NPV is zero.

You also get to see the influence of all the values, and how sensitive the results are to changes (which is called
"sensitivity analysis").
Investing (Introduction)

Investing:
Investing is where you use money to (hopefully) make more money.

You can run a business.

You can put the money in the bank to earn interest.

You can buy something valuable, such as an antique or a rare coin, and sell it later.

You can buy a share in a company (such as on the stock exchange):

 They can pay dividends (regular payments to you based on their profit).
 AND you can sell the stock later, maybe for a higher price.

You can ... well there are LOTS of choices for investing money.

But how do you tell which are good and bad investments?

Risk and Reward


Unfortunately there is always RISK when investing.

 The company you put your money in might go bankrupt.


 When you try to sell that rare coin, you may find no one wants to buy it, except at a very low price.
 And that wonderful business might suddenly face big competition.

Often the investments that promise the biggest profits are also the ones with the biggest risk.

As Reward goes up, Risk usually increases too.

Example: banks pay low interest, but they are also low risk.

And that wonderful investment in a gold mine that promises 30% profit? It may work out well, or it may not!

And remember: risk is risky! The more risk you take, the higher the chance that you will end up losing.

How can you tell how risky an investment is? Ah! That is the million dollar question.
Do research! Find out all you can about how previous investments have worked out. Think about the future of
the investment (things that are good now can turn bad), and also ... can you trust the people involved?

Before you hand over any money, stop being excited by the idea of profits and think what might go wrong. A
wise friend once said it was the investments he didn't make that led to him being rich.

Comparing Investments
OK, you have some possible investments. The risks are about the same. How to tell which is best?

The basic idea is to add up all the money you receive, and subtract all the money you spend.

But you also need to think when you spend or receive the money.

Money now is more valuable than money later on.

Why? Because you can use money to make more money!

Example: A bank pays 10% interest on your money.

So $200 now can earn $200 x 10% = $20 in a year.

Your $200 now can become $220 in a year's time.

In fact, at 10% interest, $200 now is the same as $220 next year!

Learn more at Present Value

So money is not as valuable in the future, so we reduce the value of future payments.

Example: Two investments that both cost $200: one pays $220 next year, the other pays $230
in 2 years time.

Even though the $230 looks better, it is in 2 Years time.

The first investment pays $220 in 1 year. Reinvesting that $220 for another year might get you more than $230
by the 2nd year.

There are many ways to compare investments, but two of the most popular ways are:

Net Present Value

Internal Rate of Return


When you have compared the possible investments, and thought about the risks, you are better prepared to
make a decision.

Example: you run a Bakery, and want to improve its income. You could:

 Move the bakery to a busier street nearby (more customers)


 Renovate the kitchen (bake better things at less cost)

You estimate the costs and benefits, and then calculate the "Internal Rate of Return" of each to be:

 Move: IRR = 12%


 Renovate: IRR = 9%

So "Move" is best.

But hang on ... there are different risks!

 Move is more risky: will you really get more customers? What about the customers you lose? What if
someone opens a bakery at your old location, they will take business away from you.
 Renovate is much less risky, you know it will save money for your present operation.

If the Move goes bad you could lose your whole business.

So choose carefully!

Diversify!
To "diversify" means to have different types of investments ("diverse" means "different").

Why diversify? It reduces the risk of losing everything!

Example: the whole economy goes bad!

Your business and stock market investments are in trouble.

But (hopefully) your money in the bank or with government bonds is still OK.
There is an old saying: don't put all your eggs in one basket.

Some people recommend:

 one-third of your money into cash investments like a bank account or bonds,
 one-third into property, and
 one-third into the stock market.

But that is only a guide, you should decide for yourself what the best "spread of investments" is (and it can
change, depending on how the economy is going).

One last thing ... good luck and good fortune!


Personal Budget
Spending too much?

A Budget can help!

Spending less than you earn is Happiness.

To help you get your money under control, make a budget.

You can plan your whole year this way, and have money left over to save for big things like a new car, house,
holidays, etc.

Let's start!

Where Does My Money Go?


Your first step is to work out where you spend your money now. If you don't know, then start keeping careful
notes on every thing you spend money on for one month. Do the best you can to separate needs from wants.

List the things you need and what you spend on them per month.

Example: Sam's needs for last month were:

 $420 at the supermarket


 $150 on electricity
 $100 on gas
 $160 on phone and internet
 $115 on insurance (car, house)
 $650 on rent

That is a total of $1,595

Your Turn: List all your expenses for last month. If you are still at school, ask to do the family budget.

Type the numbers into a spreadsheet (like Open Office Calc or Microsoft Excel).

Now list your wants (not needs) and how much you'd like to spend on them per month.
Example: Sam has these "wants":

 $200 eating out


 $100 hair
 $60 movies
 $60 clothes
 $50 fun things

That is a total of $470

And then find out what is left over from what you earned.

Example: Sam earned $2500 last month,

Now let's see what is left over:

$2500 − $1,595 − $460 = $435

Great! Sam has $435 left over. It is important to have some left over here, as we will need it for other things

Your Turn: Complete your list of wants and needs, and compare it to your income, hopefully there is some left
too.

How did you go? You might need to cut your amounts back a little. We will look at that soon.

Budget for the Whole Year


Now let's make it a yearly budget.

First copy your single month to every month of the year:

then include budgets for Christmas, birthdays, annual bills, any need or want that is not monthly:
Now do totals, put in your income and find what is left each month:

Also, your first budget may not be very realistic. Expenses are going to come along that you didn't think of.
That is OK, it is part of your learning experience.

What if you don't have money left over? Well, you can:

 increase your income (if you can), or


 reduce expenses

Reducing Expenses
Go over your budget and think carefully how you can reduce each item.

 Look around for cheaper housing.


 Relocate closer to work to save transport costs.
 Own a house? Buy another near work, rent out other one to cover mortgage.
 A more fuel-efficient car can help.
 Is it cheaper to use public transport or to drive?
 Walk rather than drive short distances, cheaper and healthier.
 Review your smart phone and home phone plans. Do you really need all the services?
 Get quotes for replacing your insurance policies.
 Look for bargains at supermarkets.
 Cut back monthly subscriptions.
 If you have high credit card interest, shop around for better rates.
 Drink water, it is cheaper and healthier than sugary drinks.
 Stop eating out so much, home cooked meals are healthier anyway
 Buy healthy snacks to replace junk food.
 Own your own home? Install solar to save on electricity.

Keep Your Money Under Control

Keeping track of your expenses is very important!

When you spend money, put it in the "Actual" column for that month. Try to discipline yourself not to go over
your budget.

But also be gentle with yourself.

Think of your budget as a strict but kind friend.

Wrong way: I just got paid $2500. After all expenses I should have $500 left, so I can spend $500 on a new
game console!

Right way: I have spent $40 of my $100 "fun" budget, so I can spend $60 on games.

Wrong: those $200 shoes are on sale for $120. If I buy them I am saving $80

Right: the shoes cost $120, I am spending $120

Also remember that the excitement of buying often leads to a let down feeling later. Stay within your budget to
always feel good about yourself.

Envelopes
This helps some people:
Take out cash from the bank and put it in individual budget envelopes.
You can only spend from the envelopes.

Putting your Money To Good Use


Now you get to decide what to do with your left-over money.

Pay Off High Interest Debt


If you have any high-interest debt (such as credit cards), pay those off first!

Emergency Fund
Next, put money aside for emergencies. Things break down and need replacing or repair (plumbers are
expensive). Your pet might need a vet. A friend might need help.

At least $2,000. More if you can (some people suggest 3 months salary worth).

It must be easy to get at (cash or bank account).

Having emergency money also gives you a good sense of confidence in life.

Investments
When you have paid off your high interest debt, and have money in an emergency fund it is time to think about
investing Learn more about investing.
Annuities
An annuity is a fixed income over a period of time.

Example: You get $200 a week for 10 years.

How do you get such an income? You buy it!

So:

 you pay them one large amount, then


 they pay you back a series of small payments over time

Example: You buy an annuity

It costs you $20,000

And in return you get $400 a month for 5 years

Is that a good deal?

Example (continued):

$400 a month for 5 years = $400 × 12 × 5 = $24,000

Seems like a good deal ... you get back more than you put in.

Why do you get more income ($24,000) than the annuity originally cost ($20,000)?

Because money now is more valuable than money later.

The people you give the $20,000 to could invest it and earn interest, or do other clever things to make more
money.

So how much should an annuity cost?

Value of an Annuity
First: let's see the effect of an interest rate of 10% (imagine a bank account that earns 10% interest):

Example: 10% interest on $1,000

$1,000 now could earn $1,000 x 10% = $100 in a year.

$1,000 now becomes $1,100 in a year's time.


So $1,100 next year is the same as $1,000 now (at 10% interest).

The Present Value of $1,100 next year is $1,000

So, at 10% interest:

 to go from now to next year: multiply by 1.10


 to go from next year to now: divide by 1.10

Now let's imagine an annuity of 4 yearly payments of $500.

Your first payment of $500 is next year ... how much is that worth now?

$500 ÷ 1.10 = $454.55 now (to nearest cent)

Your second payment is 2 years from now. How do we calculate that? Bring it back one year, then bring it back
another year:

$500 ÷ 1.10 ÷ 1.10 = $413.22 now

The third and 4th payment can also be brought back to today's values:

$500 ÷ 1.10 ÷ 1.10 ÷ 1.10 = $375.66 now

$500 ÷ 1.10 ÷ 1.10 ÷ 1.10 ÷ 1.10 = $341.51 now

Finally we add up the 4 payments (in today's value):

Annuity Value = $454.55 + $413.22 + $375.66 + $341.51

Annuity Value = $1,584.94

We have done our first annuity calculation!

4 annual payments of $500 at 10% interest is worth $1,584.94 now

How about another example:

Example: An annuity of $400 a month for 5 years.

Use a Monthly interest rate of 1%.

12 months a year, 5 years, that is 60 payments ... and a LOT of calculations.

We need an easier method. Luckily there is a neat formula:

Present Value of Annuity: PV = P × 1 − (1+r)−n r


 P is the value of each payment
 r is the interest rate as a decimal, so 10% is 0.10
 n is the number of periods

First, let's try it on our $500 for 4 years example.

The interest rate is 10%, so r = 0.10

There are 4 payments, so n=4, and each payment is $500, so P = $500

PV = $500 × 1 − (1.10)−4 /0.10

PV = $500 × 1 − 0.68301.../ 0.10

PV = $500 × 3.169865...

PV = $1584.93

It matches our answer above (and is 1 cent more accurate)

Now let's try it on our $400 for 60 months example:

The monthly interest rate is 1%, so r = 0.01

There are 60 monthly payments, so n=60, and each payment is $400, so P = $400

PV = $400 × 1 − (1.01)−60 /0.01

PV = $400 × 1 − 0.55045.../ 0.01

PV = $400 × 44.95504...

PV = $17,982.02

Certainly easier than 60 separate calculations.

Going the Other Way


What if you know the annuity value and want to work out the payments?

Say you have $10,000 and want to get a monthly income for 6 years, how much do you get each month (assume
a monthly interest rate of 0.5%)

We need to change the subject of the formula above

Start with: PV = P × 1 − (1+r)−n /r

Swap sides: P × 1 − (1+r)−n /r = PV

Multiply both sides by r: P × (1 − (1+r)−n) = PV × r


Divide both sides by 1 − (1+r)−n : P = PV × r/ 1 − (1+r)−n

And we get this:

P = PV × r/ 1 − (1+r)−n

 P is the value of each payment


 PV is the Present Value of Annuity
 r is the interest rate as a decimal, so 10% is 0.10
 n is the number of periods

Say you have $10,000 and want to get a monthly income for 6 years out of it, how much could
you get each month (assume a monthly interest rate of 0.5%)

The monthly interest rate is 0.5%, so r = 0.005

There are 6x12=72 monthly payments, so n=72, and PV = $10,000

P = PV × r/ 1 − (1+r)−n

P = $10,000 × 0.005/ 1 − (1.005)−72

P = $10,000 × 0.016572888...

P = $165.73

What do you prefer? $10,000 now or 6 years of $165.73 a month

Footnote:

You don't need to remember this, but you may be curious how the formula comes about:

With n payments of P, and an interest rate of r we add up like this:

P × 1/ 1+r + P × 1/ (1+r)×(1+r) + P × 1/ (1+r)×(1+r)×(1+r) + ... (n terms)

We can use exponents to help. 1/ 1+r is actually (1+r)−1 and 1/ (1+r)×(1+r) is (1+r)−2 etc:

P × (1+r)−1 + P × (1+r)−2 + P × (1+r)−3 + ... (n terms)

And we can bring the "P" to the front of all terms:

P × [ (1+r)−1 + (1+r)−2 + (1+r)−3 + ... (n terms) ]

To simplify that further is a little harder! We need some clever work using Geometric Sequences and Sums but
trust me, it can be done ... and we get this:

PV = P × 1 − (1+r)−n /r

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