(1) If you have a $100,000 left as an inheritance by your beloved Aunt Lacy, what would the future value of that $100,000 be when you retire? You have to determine for yourself when you are going to retire and the number of years until that age. You will also have to assume an interest rate to use in your calculation. Now add 2% to the interest rate you assumed; redo the calculation. (2) If you decide that you need $1,000,000 to retire in luxury, how much "capital" would you have to have today to achieve that goal. Use the number of years and the interest rates from (1) above. (3) What other factors are you "holding constant" in doing these calculations? (4) What is the connection between the "interest rates and the "opportunity cost of capital"? Simple and Compound Interest Simple interest is an interest rate calculation only on the principal amount. Step 1. Learn the formula for simple interest: Principal x Rate x Time = Interest Step 2. Practice using the simple interest formula. Example 1: $100 Deposit at a simple interest rate of 5% held for one year is: $100 x 0.05 x 1 = $5 Simple interest in this example is $15. Example 2: $100 Deposit at a simple interest rate of 5% held for three years is: $100 x 0.05 x 3 = $15 Simple interest in this example is $5. Step 3. Calculate the total future amount using this formula: Total future amount = principal + interest Step 4. Put the two simple interest formulas together. Total future amount (with simple interest) = Principal + (Principal * Rate Time) Step 5. Apply the simple interest formula to our three year example. Total future amount (with simple interest) = $100 + ($100 x 0.05 x 3) = $115 Compound interest is an interest rate calculation on the principal plus the accumulated interest. Step 6. To find the compound interest, we determine the difference between the future value and the present value of the principal. This is accomplished as follows: Future Value = Principal x (1 + interest rate) lime Compound interest = Future Value - Present Valve Step 7. Apply this formula to our three-year scenario. Follow the calculations in Table 17.4 Year 1 Amount in Bank $100 Bank Interest Rate 5% Total $105 $100 + ($100 x 0.5) Year 2 Amount in Bank $105 Bank Interest Rate 5% Total $110.25 $105 + ($105 x .05) Year 3 Amount in Bank $110.25 Bank Interest Rate 5% Total $115.75 $110.25 + ($110.25 x .05) $115.75 - $100 = $15.75 Compound interest Table 17.4