Day 97 Compound interest

Compound interest

The time value of money specifies that the money today will not be worth at the same value tomorrow. Technically speaking, this hypothesis is created to outline the importance of investments and other financial activities. Actually, the value of our investment can be quite different after a long-term. And what stimulates our return is the power of compound interest. As a financial participant, it is the fundamental knowledge for us to comprehend, since it determines the benefit carried out by our investment. Therefore, it is one of the most important figures that would affect out investment decisions.

Application of the compound interest method is pretty straight-forward. We have to accumulate the interest earned in each period along with the principal amount, and the interest revenue for the next period is calculated on this value. The common pitfall we need to avoid is that we have to calculate the value on the same time frame. For instance, if the deposit is compounding monthly, then the annually interest rate is required to be transformed into monthly interest rate. In addition, if the cash are invested repeatedly in a series manner, it becomes multiple cash flow investments. Because of the time value of money, we cannot simply collectively work out the expected return. Hence, we must define the future value of every single transaction and add them up. Distinguished by their features, there are four main categories of multiple cash flow investments. To illustrate, the ordinary annuity is with series of standard cash flow investment over a fixed period, and based at the end of a solid interval; On the other hand, the only different on the annuity due is the cash flow appears at the beginning of the interval; The infinite or perpetuity cash flow deposit will continue forever, thus it has an unlimited time period; At last, the varying compounding investment has the characteristic of the erratic amount of cash flow occurs in each interval.

To understand the calculation process of this compounding interest investment is critical. Due to financial decision makers must assess the present value and future value of the investment. Typical issues include taking the cash now and invest it for the return, or accept an offer to be paid in the future. Besides that, evaluations of financial assets such as bond price will rely on the present value as well. Nonetheless, it is rather simple mathematic knowledge, but like I said, it is the keystone of many other profound financial problems.