Financial Management: Principles and Applications, 13/e

5.2 Compounding and Future Value

If we assume that an investment will earn interest only on the original principal, we call this simple interest. Suppose that you put $100 in a savings account earning 6 percent interest annually. How much will your savings grow after one year? If you invest for one year at an interest rate of 6 percent, you will earn 6 percent simple interest on your initial deposit of $100, giving you a total of $106 in your account. What if you leave your $100 in the bank for two years? In this case, you will earn interest not only on your original $100 deposit but also on the $6 in interest you earned during the first year. This process of accumulating interest on an investment over multiple time periods is called compounding ...