Return required to achieve Future Value using Compound Interest Formula with annual contributions

42 Views Asked by At

Referring to the same formula from this question (Compound Interest Formula adding annual contributions).

$$ F=P(1+i)^n+A\frac{(1+i)^n-1}{i}=\left(P+\frac{A}{i}\right)(1+i)^n-\frac{A}{i} $$

where

P = Principle value
i = interest rate, annually
A = Annual amount contribution
n = duration in years
F = Future value

If all of the variables above is known, except i. How do we get the formula of i? I'm having trouble in getting the formula of i.

$$ i=? $$

1

There are 1 best solutions below

1
On

For this kind of problem, as soon as $n>4$, there is no analytical solution since the problem would be to find the roots of a polynomial of degree $n$ on $i$.

So, either numerical methods or approximations.

For approximations, since $i$ is known to be small, use for example a series expansion, which would give $$F-(P+A n)=\sum_{k=1}^\infty \Bigg(A \binom{n}{k+1}+P \binom{n}{k}\Bigg)\,i^k$$

Using only the first term,it will provide a starting point for any numerical method such as Newton $$i_0=\frac 2n\,\frac{F-(P+A n) }{(n-1)A+2P }$$

Using, for illustration : $F=2500$, $P=1000$, $A=100$ and $n=10$, this would give $i_0=\frac 1{29}=0.0344828$ while the solution is $i=0.0305279$.

Newton iterates would be $$\left( \begin{array}{cc} k & i_k \\ 0 & 0.0344828 \\ 1 & 0.0305879 \\ 2 & 0.0305280 \\ 3 & 0.0305279 \\ \end{array} \right)$$

which is a quite fast convergence.

If you do not want to use numerical methods, let $$B=F-(P+A n) \qquad \text{and} \qquad a_k=A \binom{n}{k+1}+P \binom{n}{k}$$ which make $$B=\sum_{k=1}^\infty a_k\, i^k$$ Truncate to some order and use power series reversion.

This would give $$i \sim \frac 1{a_1}B-\frac {a_2}{a_1^3}B^2+\frac{2a_2^2 -a_1a_3}{a_1^5} B^3+\cdots$$ and you can use as many terms as you want.

Using the same numbers and the above very truncated series would give $$i \sim \frac{629221}{20511149}=0.030677$$ Adding the next term would give $i=0.0304949$.