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Amity Business School

Compounding Techniques
Compounding concept
Year 1 2 3
means the interest
earned on the initial Beginning
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:

The future value of a single cash flow (Lump sum


amount)

The Future value of a series of Cash Flows


(Annuity)
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(i) The FV of Single Cash Flow


Formula
FV = PV (1+r)n
FV is Future Value

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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The general form of equation for calculating the


future value of a lump sum after n periods
may, therefore, be written as follows:

FVn = PV x CVFr,n

The term (1 + r)n is the compound


value factor (CVF) of a lump sum of Re
1, and it always has a value greater than 1 for
positive i, indicating that CVF increases as r and
n increase.
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We will first find out the compound value factor


at 15 per cent for 10 years which is 4.046.
Multiplying 4.046 by Rs.55,650, we get Rs
225,159.90 as the compound value:

FV= 55,650 X CVF 10, .15


= 55,650 X 4.046
= Rs. 225159.90
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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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(ii) Future Value of series of cash flow


(Annuity)
An Annuity represents a series of payments (or
receipts) occurring over a specified number of
equidistant periods
Types of Annuities
Ordinary Annuity:
Annuity Payments or receipts
occur at the end of each period.
Annuity Due:
Due Payments or receipts occur
at the beginning of each period
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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

$100 $100 $100

Today Equal Cash Flows


Each 1 Period Apart
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PARTS OF ANNUITY DUE

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows


Each 1 Period Apart
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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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Formula for ordinary Annuity


As it is clear now that Annuity is a fixed payment (or
receipt) each year for a specified number of years. If
you rent a flat and promise to make a series of
payments over an agreed period, you have created an
annuity.
(1 + i ) - 1
n

Fn = A
i
The term within brackets is the compound value factor
for an annuity of Re 1, which we shall refer as CVAF.
Fn = A x CVAFn,r
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Example of ordinary Annuity

Cash flows occur at the end of the period


0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000 $3,215 = FVA3
= $1,145 + $1,070 + $1,000
= $3,215
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Formula For Annuity Due

(1 + i ) - 1 (1+i)
n
Fn = A
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).