Compound Interest and Depreciation

Compound Interest and Depreciation

  • Compound interest is a way in which an amount of money grows over time. It increases exponentially, meaning it grows faster as time goes on. This is because the interest is calculated on the initial amount (the principal) plus any previously earned interest.

  • The formula for compound interest is A = P (1 + r/n)^(nt). Where:
    • A represents the total amount of money accumulated after n years, including interest.
    • P represents the principal amount (the initial amount you borrow or deposit).
    • r stands for the annual interest rate (in decimal form).
    • n stands for the annual compounding frequency (number of times that interest is compounded per unit t).
    • t represents the time the money is invested or borrowed for, in years.
  • Remember to convert all rates to a consistent time period before inputting them into the formula. For example, convert annual rates to monthly if the compounding period is monthly.

  • Depreciation represents the decrease in the value of an asset over time, often due to wear and tear.

  • A common method of calculating depreciation is the straight-line method or linear depreciation, which assumes the asset loses an equal value each year. The formula for this method is ((Initial Value - Salvage Value) / Useful Life of Asset).

  • Another method is the reducing-balance method or compound depreciation. This assumes the asset loses a certain percentage of its value each year. The formula is (Book Value at Beginning of Year x Depreciation rate/100).

  • Compound depreciation will lead to a faster decline in value compared to straight-line depreciation, as the depreciation is a percentage of a reducing amount.

  • It’s useful to know both compound interest and depreciation when planning and predicting future situations, such as saving, investing or purchasing assets.

  • Practice is essential when mastering these concepts. Try different practice questions and real-life scenarios to get a better understanding. Make sure your understanding of percentages is strong as it’s highly integral to these topics. Make use of calculators effectively where needed.