Category: Finance

Understanding ROCE: A Key Metric for Business Efficiency

What is Return on Capital Emplyed (ROCE)?

ROCE is a crucial metric to assess how efficiently a company is utilizing its capital employed to generate profits. It provides insight into how well the company is using both equity and debt to generate returns for it’s stakeholders.

Here’s a quick breakdown of the formula and its components:

  • ROCE = EBIT / Capital Employed

Where:

  • EBIT (Earnings Before Interest and Taxes): This measures the operating profitability of a company before considering interest and taxes.
  • Capital Employed: This represents the total funds employed in the business, calculated as Total Assets – Current Liabilities. Alternatively, it can be understood as the sum of Equity capital + Non-current liabilities (long-term debt).

Why is ROCE important?

  1. Measures Efficiency: ROCE indicates how much return is generated for each dollar of capital employed, making it a critical efficiency metric.
  2. Importance in Capital-Intensive Industries: It’s especially useful for comparing companies in industries that require significant investments in assets, such as manufacturing or utilities.
  3. Comparison Across Firms: A higher ROCE signifies more efficient use of capital and can be a key differentiator when evaluating companies with similar operations.

ROCE – Limitations

  • Unutilized Cash: If a company has large reserves of unutilized cash, it might distort the ROCE figure, making it less meaningful.
  • Fluctuations in Capital: Since capital employed can change over time, the timing of the calculation can affect the accuracy of the ROCE.
  • Some analysts may choose to calculate ROCE based on the average capital employed based on the average of opening and closing capital employed.

Example: Hindustan Unilever Ltd (HUL) ROCE Calculation

₹ in Crores Mar-24 Mar-23 Mar-22 Mar-21
EBIT 14,264 13,460 11,980 10,723
Total Assets (A) 78,499 73,087 70,517 68,757
Current Liabilities (B)12,876 12,028 11,280 11,103
Capital Employed (A – B)65,623 61,059 59,237 57,654
ROCE (%)22%22%20%19%
ROCE Calculation – Hindustan Unilever (HUL)

Note: 1 Crore =10 Mn

HUL Data source: Moneycontrol

Observation:

Hindustan Unilever’s ROCE improved from 19% in March 2021 to 22% in March 2024, indicating increased efficiency in utilizing its capital to generate profits.

Conclusion

In essence, ROCE provides a holistic view of how well a company is generating profits from its long-term funding sources (both equity and debt).

Investing ideas:

Companies with rising or stable ROCE tend to be attractive to investors, as they reflect efficient capital management and potential for long-term growth. On the other hand, companies with declining or volatile ROCE might signal inefficiency or difficulties in maintaining profitability.

Impact of Interest Rate Changes on Bond Prices and Debt Fund Returns

Understanding the Inverse Relationship Between Bond Prices and Interest Rates

Bonds pay a fixed interest, known as the coupon rate. When market interest rates change, the value of existing bonds adjusts to align with newly issued bonds at the current rates, leading to an inverse relationship between bond prices and interest rates.

Impact of Interest Rate Movements on Bonds and Debt Funds

1. Rising Interest Rates:

  • Effect on Bonds: When interest rates rise, new bonds are issued with higher coupon rates (e.g., 6%). This makes existing bonds with lower coupon rates (e.g., 5%) less attractive. To compensate for the lower yield, the price of these bonds must fall to offer a comparable yield to new bonds.
  • Example:
    If you hold a bond with a face value of ₹1000 and a coupon rate of 5% (₹50 interest annually), when new bonds are issued at 6%, investors will demand a lower price for your bond. To match the 6% yield, the bond’s price must fall below ₹1000.
  • Effect on Debt Funds: Since the prices of existing bonds fall, the Net Asset Value (NAV) of debt mutual funds also decreases, resulting in lower returns.

2. Falling Interest Rates:

  • Effect on Bonds: When interest rates fall, new bonds are issued with lower coupon rates (e.g., 4%). Existing bonds with higher coupon rates (e.g., 5%) become more attractive, increasing their market value.
  • Example:
    If interest rates drop and new bonds are issued at 4%, your bond with a 5% coupon rate becomes more desirable. Investors would pay more than ₹1000 for your bond, boosting its price.
  • Effect on Debt Funds: The increase in bond prices leads to capital gains for bondholders, resulting in higher returns for debt mutual funds.

Investment Strategies for Managing Interest Rate Risk in Debt Funds

Rising Interest Rate Scenarios:

  • Short-Duration Funds:
    In a rising interest rate environment, short-duration bonds or debt funds are preferable. These bonds mature quickly, allowing reinvestment at higher rates without significant price depreciation.
    • Why? Short-term bonds are less sensitive to interest rate changes, reducing the impact of rising rates on bond prices.
    • Funds to Consider: Liquid funds, ultra-short-term bond funds.

Falling Interest Rate Scenarios:

  • Long-Duration Funds:
    Long-duration bonds gain the most during falling interest rates because their prices increase more with the decline in interest rates.
      • Why? Longer-duration bonds lock in higher coupon rates, and their prices rise as newer bonds are issued at lower rates.
      • Funds to Consider: Gilt funds, long-duration debt funds.
    • Dynamic Bond Funds:
      These funds adjust the portfolio’s duration based on the interest rate outlook. Fund managers switch between long and short-term bonds depending on market expectations, allowing investors to gain in both rising and falling interest rate environments.

    Other Strategies:

    • Fixed Maturity Plans (FMPs):
      FMPs lock in yields for a fixed term, offering stable returns. They may not be as attractive in a rising interest rate environment, but in stable or falling rate periods, they provide predictable returns, insulating investors from market fluctuations.

    Key Takeaways for Investors:

    • Monitor the Interest Rate Environment: Investors should keep an eye on interest rate trends to adjust their portfolio allocations accordingly.
    • In Rising Rate Scenarios: Focus on short-duration funds or strategies that reduce interest rate risk.
    • In Falling Rate Scenarios: Consider long-duration funds or dynamic bond funds to capture gains from rising bond prices.
    • Use FMPs for Stability: In stable or falling rate environments, FMPs offer predictable returns with lower risk.

    By following these strategies, investors can improve their returns while managing the risk associated with fluctuating interest rates in debt mutual funds.

    Understanding Exchange-Traded Funds (ETF): Advantages, Limitations, and Popular Uses

    What is Exchange-Traded Fund (ETF)?

    An Exchange-Traded Fund (ETF) is a type of investment fund that is traded on stock exchanges, much like stocks. ETFs are designed to track the performance of a specific index (such as the S&P 500), sector, commodity (like gold or silver or oil), or a collection of assets like stocks or bonds.

    Advantages of ETFs:

    1. Lower Costs: ETFs often have a lower expense ratio compared to actively managed mutual funds.
    2. Liquidity: They can be traded throughout the day on the stock exchange, allowing for quick buy and sell decisions.
    3. Diversification: Although a single ETF may focus on a specific sector, many ETFs offer broad exposure across different industries, asset classes, or regions.
    4. Exposure to Commodities: Investors can get exposure to commodities like gold, silver or oil without needing to physically hold the commodity.
    5. Ease of Trading:
      • Intraday Trading: ETFs combine the best of both stocks and mutual funds by allowing intraday trading, so investors can take advantage of market movements as they happen.
      • Real-Time Pricing: Unlike mutual funds, which are priced at the end of the day, ETF prices fluctuate throughout the day based on supply and demand.

    Limitations of ETFs:

    1. Concentration Risk: ETFs that track a specific sector, commodity, or a small number of securities may have concentrated exposure, which can increase risk if that area underperforms.
    2. Trading Costs:
      • Brokerage Fees: While ETFs have lower expense ratios, frequent trading can lead to significant brokerage fees, which can erode returns over time.
      • Bid-Ask Spread: The difference between the buying price (ask) and selling price (bid) can impact the overall cost, especially in less liquid ETFs.
    3. Intraday fluctuations: Due to intraday fluctuations, some trades may be carried out at higher price.

    ETFs are popular among both individual and institutional investors due to their flexibility, cost efficiency, and ease of access to diverse markets and assets. But, like all investments, they need careful consideration of their structure, associated costs, and the specific exposure they offer.

    Understanding Debt Mutual Funds: Risks and Benefits Explained

    A Common Investor Story

    Ramesh is a 45-year-old salaried professional. He doesn’t like the ups and downs of the stock market, but fixed deposits no longer give him the returns he wants. His bank relationship manager suggests debt mutual funds, calling them “safe,” “stable,” and “better than FDs.”

    Reassured by words like bonds, fixed income, and low risk, Ramesh invests a part of his savings in a debt mutual fund, expecting steady returns and easy liquidity.

    But is a debt mutual fund really risk-free?

    What Are Debt Mutual Funds?

    Debt mutual funds invest your money in instruments such as:

    • Government securities
    • Corporate bonds and debentures
    • Treasury bills and money market instruments

    These investments pay interest, which is why debt funds are often seen as safer and more predictable than equity mutual funds.

    Why Debt Mutual Funds Feel Safer Than Equity Funds

    1. Regular Income from Bonds

    Unlike shares, bonds promise interest payments and repayment of principal at maturity. This makes debt funds feel more secure than equity funds, where returns depend entirely on market prices.

    2. Lower Day-to-Day Fluctuations

    Debt fund NAVs usually move slowly compared to equity funds. This lower volatility attracts investors who want stability or are investing for short- to medium-term goals.

    The Risks Most Retail Investors Overlook

    Despite their conservative image, debt mutual funds carry risks that often surface only during difficult times.

    1. Credit Risk – When the Borrower Doesn’t Pay

    Credit risk arises when the company or institution that issued the bond fails to pay interest or return the principal.

    Why it matters:
    To earn higher returns, some debt funds invest in bonds issued by weaker or lower-rated companies. If such a borrower defaults, the fund’s value can fall sharply—sometimes overnight.

    Real-life reminder:
    In 2018, IL&FS, a company rated AAA, suddenly defaulted on its debt. Several debt mutual funds had exposure to its bonds and commercial paper. Investors who expected “safe” returns were shocked to see losses and write-downs. The event also triggered panic across NBFC and housing finance stocks, proving that credit risk can appear without warning.

    2. Interest Rate Risk – When Rates Move Against You

    Bond prices and interest rates move in opposite directions.

    What this means for you:

    • If interest rates rise, existing bonds lose value, pulling down the fund’s NAV.
    • If interest rates fall, bond prices rise, benefiting the fund’s NAV.

    Debt funds that hold long-term bonds are more sensitive to interest rate changes and can show noticeable ups and downs, even without any default.

    3. Liquidity Risk – Getting Your Money When You Need It

    Liquidity risk occurs when many investors try to exit the fund at the same time.

    What can go wrong:
    During market stress, a fund may struggle to sell its bonds quickly. This can force the fund to sell at poor prices or, in extreme cases, restrict withdrawals—something many retail investors assume can never happen.

    What This Means for Investors Like Ramesh

    Debt mutual funds are not the same as fixed deposits. They:

    • Do not guarantee returns
    • Can fall in value
    • Are exposed to market events and credit quality

    They can be useful tools—but only when chosen carefully and matched to the right goal and time horizon.

    A Practical Investment Tip for Retail Investors

    Before investing in any debt mutual fund, look at the monthly fact sheet. Focus on:

    • How much of the portfolio is in AAA-rated bonds
    • Exposure to lower-rated or unrated instruments
    • Average maturity and duration compared to the benchmark

    If the fund is taking extra credit risk to show higher returns, make sure you are comfortable with that risk.

    Understanding Index Funds: Advantages, Disadvantages and Suitability

    What are Index funds?

    Index funds are mutual funds or exchange-traded funds (ETFs) designed to replicate the performance of a specific market index, such as the S&P 500, Nifty 50, or S&P BSE Sensex. They follow passive investment strategy, meaning they do not require frequent trading or active management.

    The goal of an index fund is to match the returns of the index it tracks by holding all or a representative sample of the securities in that index.

    John Bogle, Vanguard founder, is credited with pioneering the concept of Index funds by creating the first-ever index fund Vanguard 500 fund in 1976. This fund was designed to passively track the returns of the S&P 500, an index representing the 500 largest publicly traded companies in the U.S. His innovation democratized investing, particularly in an era dominated by costly brokerage services, and shifted the focus toward long-term growth over short-term trading. This strategy has had a profound and lasting impact on the investment landscape.

    Advantages of Index Funds:

    1. Low Expense Ratios: Since index funds follow a passive investing approach, they tend to have lower management fees compared to actively managed funds. This is because they do not require portfolio managers to make decisions about which securities to buy and sell.
    2. Diversified Portfolio: By tracking an index, these funds automatically spread investments across a large number of securities (stocks or bonds), which helps reduce the risk associated with investing in individual securities.
    3. Simplicity: Index funds are straightforward and easy to understand for most investors. The goal is simply to match the performance of the index, and no active management decisions are needed.
    4. Lower Turnover: Because the funds only buy or sell securities when the composition of the index changes, they tend to have lower transaction costs and capital gains taxes.

    Disadvantages of Index Funds:

    1. No Flexibility in Portfolio Management: Index funds follow a rigid structure by adhering to the composition of the index, leaving no room for managers to make decisions to potentially outperform the market.
    2. Market Downturns: Index funds offer no protection from overall market declines. Since they are designed to mirror the index, if the market goes down, the fund’s value will decrease as well.
    3. Average Returns: Since index funds are designed to match the market, they will typically offer average returns compared to the market as a whole. Index funds will not suit investors looking for above-market returns .

    In summary, index funds are suitable for investors seeking a low-cost, diversified, and long-term investment strategy that tracks the broader market’s performance. They are ideal for investors who prefer not to engage in active trading and market timing.

    Understanding Mutual Funds: Advantages, Disadvantages, and Considerations

    Mutual Funds: An Ideal Passive Investment Option for Investors

    For individuals who lack expertise in analyzing stocks, understanding financial statements, or simply don’t have the time to conduct in-depth research into individual investments, mutual funds offer an accessible and relatively stress-free investment avenue. Mutual funds provide a way to enter the market with the guidance of professional fund managers and a diversified portfolio that helps mitigate some of the inherent risks of investing.

    What are mutual funds?

    Mutual funds pool together capital from multiple investors, which is then managed by professional fund managers. These managers allocate the pooled funds into a diversified portfolio, which may include a mix of stocks, bonds, money market instruments, and other assets, depending on the specific objectives of the mutual fund. The fund’s performance, therefore, reflects the performance of the assets it invests in, and each investor shares in the gains or losses proportionally based on their investment.

    Advantages of Investing in Mutual Funds:

    1. Diversification:
      Mutual funds inherently offer diversification, which reduces risk by spreading investments across a range of assets such as different stocks, industries, or even asset classes like bonds. This diversification helps shield investors from the full impact of losses in any one particular asset or sector.
    2. Professional Management:
      One of the most significant advantages of mutual funds is that the investment decisions are made by professional fund managers who have experience and expertise in the market. These managers continuously monitor the portfolio and make adjustments based on market conditions, ensuring that the fund’s objectives are met.
    3. Flexibility of Investment Amounts:
      Mutual funds provide flexibility for investors to contribute based on their financial capacity. One can either invest a lump sum or choose a Systematic Investment Plan (SIP) where a fixed amount is invested at regular intervals (e.g., monthly or quarterly). This makes mutual funds accessible to investors with different income levels.
    4. Systematic Investment Planning (SIP):
      SIPs allow investors to invest regularly in small amounts rather than making a large one-time investment. This not only makes investing more manageable for those on a budget but also helps investors take advantage of cost averaging. By investing regularly over time, investors can average the cost of their investments, especially in a volatile market.
    5. Tailored to Risk Appetite:
      Mutual funds cater to a wide range of risk appetites, from conservative investors looking for capital preservation in low-risk debt funds to aggressive investors seeking higher returns in equity funds. Investors can choose mutual funds based on their risk tolerance, financial goals, and investment horizon.

    Disadvantages of Mutual Funds:

    1. Costs and Fees:
      Mutual funds charge management fees to cover the costs of running the fund. These fees include the remuneration of the fund manager, administrative expenses, and other operational costs. These expenses, known as the expense ratio, are deducted from the fund’s returns, which can reduce the overall return on investment (profit), particularly in actively managed funds.
    2. Lack of Control:
      Investors in mutual funds do not have control over the individual stocks or bonds that the fund invests in. All investment decisions are made by the fund manager. While this can be advantageous for those who prefer professional management, some investors might feel uneasy about not having a say in which assets the fund invests in.
    3. Market Risk:
      Like all market-linked investments, mutual funds are subject to market risks. The value of the mutual fund can fluctuate based on the performance of the underlying assets. While diversification can reduce risk, it cannot eliminate it entirely, and investors can still experience losses, particularly in periods of market downturns or crash.
    4. Limited Transparency:
      Although mutual funds are required to disclose their holdings, they do so at periodic intervals (usually monthly or quarterly). As a result, investors may not always have real-time information about the specific securities in the fund’s portfolio.
    5. Potential for Over-Diversification:
      While diversification reduces risk, excessive diversification can dilute returns. If a mutual fund is too broadly diversified, the strong performance of a few assets may not significantly impact the overall fund performance. This can lead to lower returns, especially in equity funds.

    Overall, mutual funds are an appealing option for investors seeking a hands-off approach with a built-in safety net of diversification and professional oversight. However, investors should be aware of the associated costs and risks, as well as their lack of control over individual investment decisions. As with any investment, it’s important to choose mutual funds that align with your financial goals, risk tolerance, and investment time horizon.

    Effective Interest Rate

    Effective Interest Rate (EIR) is an important tool to understand your actual return on investment against a stated annual interest rate (also known as the nominal rate) and it can be different from stated interest rate due to the effect of compounding.

    It’s fascinating how the stated annual interest rate can differ from the actual return due to compounding. The Effective Interest Rate (EIR) or Annual Equivalent Rate (AER) takes into account the impact of compounding periods, which can lead to a higher return than the nominal rate suggests.

    When interest compounds more frequently than annually—like monthly or quarterly—the actual return on your investment increases. The EIR provides a clearer picture of this, showing how much interest you’ll effectively earn in a year considering the frequency of compounding.

    For instance, if your bank manager says you’re getting a 10% return compounded monthly, the EIR will be higher than 10% because interest is being added to your balance each month, and you then earn interest on the interest.

    Formula

    Effective Interest Rate = (1+i/n)^n-1

    Where

    i = stated interest rate

    n = Number of compounding periods

    Example:

    Bank is offering interest @ 10% compounded monthly on an investment of $ 1000.

    Required: Calculate Effective Interest Rate

    Effective Interest Rate = [(1+10%/12)^12]-1 = 10.47%

    Let’s verify this will actual calculation table below:

    Month Opening Balance ($)Monthly Interest @ 10% Closing Balance ($)
    110008.31008.3
    21008.38.41016.7
    31016.78.51025.2
    41025.28.51033.8
    51033.88.61042.4
    61042.48.71051.1
    71051.18.81059.8
    81059.88.81068.6
    91068.68.91077.5
    101077.591086.5
    111086.59.11095.6
    121095.69.11104.7
    Total Interest104.7
    Interest compounded monthly @ 10%

    It is evident that actual return is 10.47% with interest of $104.7 on monthly compounding against the stated interest rate of 10%.

    Diluted Earnings per share

    Contents:

    1. Diluted EPS
    2. Calculation of Diluted EPS
      • Diluted EPS using if converted method
      • Diluted EPS using Treasury stock method
    3. Antidilutive security

    Diluted EPS

    Diluted EPS reflects the effect of all the company’s securities whose conversion / exercise would result in a dilution (reduction) of basic EPS.

    Dilutive securities includes:

    1. convertible debt,
    2. convertible preferred shares,
    3. warrants,
    4. Options
    5. Employee stock options

    Calculation of Diluted EPS

    Diluted EPS =

    (Net income available for common stockholders + Income adjustments due to dilutive financial instruments) / (Weighted average number of shares outstanding + Newly issuable shares due to dilutive financial instruments)

    Diluted EPS on Convertible Preference shares using if converted method:

    The conversion of preference shares has two effects on diluted EPS formula:

    1. Increase in denominator of outstanding shares on conversion of preference shares
    2. Increase in the numerator (Net income available for common stockholders) by dividends on convertible preferred stock.

    Let’s understand this with the help of below example:

    Net income$11,800
    Ordinary shares 5,000 shares outstanding
    Preferred shares ($2 dividend per share each year)
    900 shares outstanding convertible into 2 ordinary shares
    Total Preference dividends for the year $1,800
    Basic EPS ($11,800 − $1,800) / 5,000 $2.00

    Adjusted net income attributable to ordinary shareholders =

    =11,800 + 1,800 ( Preference shares dividend no longer payable on conversion)

    = $13,600

    Number of shares outstanding on conversion of preference shares = 2000+ 1,800 = 3,800

    Diluted EPS = 13,600 / 3,800 = $3.58 per share

    Diluted EPS on Stock options using Treasury stock method

    An option or warrant gives the holder the right to buy shares at some time in the future at a predetermined price.

    Treasury-stock method assumes that proceeds received on exercise of the options is used to buy back shares at the average market price.

    To calculate diluted EPS with an option, you need to work out the number of ‘free’ shares that will be issued if the options are exercised, and add that to the weighted average number of shares

    Diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase shares of common stock at the average market price of common stock during the period.

    The weighted average number of shares outstanding for diluted EPS is thus increased by the number of shares that would be issued upon exercise net of the number of shares that would have been purchased with the proceeds.

    We will understand this with the help of below example:

    Net income$12,000
    Ordinary shares shares outstanding2,000
    Basic EPS ($12,000) / 2,000) $6
    Stock options (200 options with exercise
    price of $80), 200 shares to be issued on exercise
    Average market price per ordinary share during
    the year     		$100

    Proceeds from exercise of options = 200 x $ 80 = $ 16,000

    No. of shares purchased from proceeds of exercise =$ 16,000 / 100 (average market price) =160 shares

    Total number of shares outstanding = 2000 + 200 – 160 = 2040 shares

    Diluted EPS = 12,000/2,040 shares = $5.88

    Antidilutive security

    Antidilutive security is a potentially convertible securities whose inclusion in the computation results in an increase in EPS than the basic EPS or a reduction in loss per share.

    Under IFRS and US GAAP, antidilutive securities are not included in the calculation of diluted EPS.

    Summary

    Diluted EPS is an important metric for investors to know how much will be the potential dilution in earning per share if all convertible securities were exercised.

    Related articles:

    What is Earning per share (EPS)

    What is PE Ratio?

    What is Earnings per share (EPS)?

    Earnings per share (EPS) is the company’s net profit available to equity shareholders (common stockholders) divided by the number of outstanding common shares.

    EPS is reported on the face of the income statement / profit & loss statement.

    How EPS is calculated?

    Earnings per share (EPS) (also known as Basic EPS) is calculated as under:

    Basic EPS  =   (Net income – Preferred dividends) / Weighted average  number of shares outstanding

    The weighted average number of shares outstanding is calculated by the length of time each quantity of shares was outstanding during the year.

    Example: A company has reported following numbers on 31.12.20X1:

    Particulars$
    Net income (PAT)1,300,000
    Preference shares 10%, 2,000,000 shares of $1 each2,000,000
    Common stock outstanding on 01.01.20X1 400,000 of $1 each
    Common stock issued on 01.07.20X1 400,000
    Common stock repurchased on 01.10.20X1 200,000
    Common stock outstanding on 31.12.20X1 600,000
    EPS llustration

    Step 1: Calculation of weighted average number of shares outstanding:

    400,000 shares * 6/12200000
    8,00,000 shares * 3/12 i.e. (400,000+400,000)2,00,000
    6,00,000 shares * 3/12 i.e. (800,000-200,000)1,50,000
    weighted average number of shares outstanding5,50,000

    Step 2: Net profit available to equity shareholders = PAT – Preference shares dividend

    = 1,300,000 – 200,000* = 1,100,000

    Step 3: Basic EPS = 1,100,000 / 550,000 = $ 2

    *10% of $ 2,000,000 Preference shares capital

    Utility of EPS

    • A comparison of year on year EPS growth indicates that profit per share is increasing which is positive for investor and vice versa.
    • From investor perspective, EPS indicates how much profit is earned on each share.
    • EPS is used an input into the price/earnings ratio.

    Related articles:

    Diluted EPS

    What is PE Ratio?

    How Compound interest  works to grow wealth?

    My wealth has come from a combination of living in America, some lucky genes, and compound interest“

    – Warren Buffett

    Compound interest means interest on interest. It is the result of reinvesting interest, rather than taking it out.

    To understand the concept, let us assume $10,000 is invested @ 5% interest which is withdrawn at the end of each year. Total simple interest earned will be $ 1500 at the end of 3 years

    YearPrincipalInterest @ 5% p.a.
    110,000500
    210,000500
    310,000500
    Total interest1500
    Table 1: Simple interest

    Let us assume $10,000 is invested @ 5% interest which is reinvested at the end of each year. This means at the end of year 1, interest earned $ 500 will be added to $ 10,000 principal and interest will be calculated for year 2 on $ 10,500 amounting to $ 525. Total cumulative interest earned will be $ 1576 at the end of 3 years

    YearPrincipalInterest @ 5% p.a.
    110,000500
    210,500 (10000+500)525
    311025 (10500+525)551
    Total interest 1576
    Table 2: Compound interest

    We can see that compound interest results in interest of $1576 at the end of 3 years compared to simple interest of $ 1500, i.e. an extra interest of $ 76 by just keeping interest reinvested.

    One can see, how power of compounding can help grow your wealth much faster.