P5-39

Compounding frequency and time value You plan to invest $2,000 in an individual

retirement arrangement (IRA) today at a nominal annual rate of 8%, which is expected

to apply to all future years.

a. How much will you have in the account at the end of 10 years if interest is compounded

(1) annually, (2) semiannually, (3) daily (assume a 365-day year), and

(4) continuously?

b. What is the effective annual rate (EAR) for each compounding period in part a?

c. How much greater will your IRA balance be at the end of 10 years if interest is

compounded continuously rather than annually?

d. How does the compounding frequency affect the future value and effective annual

rate for a given deposit? Explain in terms of your findings in parts a through c.