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At the beginning of year 1, $10,000 is invested at 8% interest, compounded annually. What amount of interest is earned for year 2?
Choice 'c' is correct. This question is a compound interest question because the interest is to be determined at the end of the second year. The calculation is as follows and uses different symbols than the SI = PIN formula in the text to show candidates the PRT formula as well (the CPA exam often uses different terminology):
Interest = PRT (for the first year)
Interest = $1,000 x .08 x 1 = $800 and adding the $800 to the beginning principal
Interest = PRT (for the second year)
Interest = $1,800 x .08 x 1 = $864
It is obvious from the answer that the interest earned in year 2 is interest earned on the original principal ($10,000 x .08 = $800) plus interest on the year 1 interest ($800 x .08 = $64).
Choice 'a' is incorrect. This answer is interest only on the original principal, and not on the year 1 interest.
Choice 'b' is incorrect. This answer has a decimal point error in calculating the year 2 interest on year 1 interest.
Choice 'd' is incorrect. This answer is apparently made up. It is sometimes difficult to come up with 3 decent wrong answers, especially with simple questions.