# Archive for October 20th, 2012

### Compounding, Discounting and Effective Annual Rate

Posted by Awais Ahmad in ACADEMIC on October 20, 2012

*Author: Awais Ahmad (comsian027@gmail.com)*

**Compounding:**

The process of going from today’s value (Present Value; denoted by PV) to Future Value (denoted by FV) is called Compounding. If *i *is the Interest Rate, then Interest Amount (INT) can be calculated as:

INT ($) = PV x *i*

The Future Value will be the Present Value plus the amount of Interest, so:

FV = PV + INT

FV = PV + PV x *i*

FV = PV (1 + *i*)

If the amount is deposited or invested for *n* periods, the same formula can be written as:

FV_{n} = PV_{n} (1 + *i*) ^{n}

The term (1 + *i*)^{n} is known as *Future Value Interest Factor* and is denoted by FVIF_{i,n}, so:

FV_{n} = PV_{n} (1 + *i*)^{n} = PV (FVIF_{i,n})

In some cases, Interest is paid semiannually, which means Interest is paid twice a year. Similarly Interest payment 4 times a year means Interest is paid quarterly. For such cases, the above formula can be more generalized:

Where *m *is the number of times Interest Payment is made in a year. However, in such case, *i* is taken as *Nominal Rate of Interest*.

**Discounting:**

The process of calculating Present Value (PV) from Future Value (FV) is called Discounting. As we know:

FV_{n} = PV_{n} (1 + *i*) ^{n}

Solving for PV, we have:

Or we can write it as under:

PV_{n} = FV_{n} (1 + *i*)^{-n}

The term (1 + *i*)-^{n} is called *Present Value Interest Factor*, and is denoted by PVIF_{i,n}; therefore:

PV_{n} = FV_{n} (1 + *i*)^{-n} = FV (PVIF_{i,n})

Same as previous case, if the Interest is paid semiannually or quarterly, a more general formula is applicable:

Where *i* is taken as *Nominal Rate of Interest*.

**Effective Annual Rate (EAR):**

Effective Annual Rate is defined as the rate which would produce the same Future Value, if annual Compounding had been used. It is also called *Equivalent Annual Rate*, and can be calculated as:

As we have taken Annual Compounding, therefore n is not shown in the formula, and *i* will be taken as *Nominal Rate of Interest*.

**References:**

Financial Management – Theory & Practice by *Eugene F. Brigham & Michael C. Ehrhardt*

Investment Analysis & Portfolio Management – Lectures