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Reinvesting both the 1,000 dollar principal and the 40 dollars of interest means year two earns interest on:
A40 dollars only
B960 dollars only
C1,040 dollars
D1,000 dollars
Answer & Solution
Correct answer: C. 1,040 dollars
1. Compounding means the base grows each period.
2. In the second year the friend leaves the principal of 1,000 dollars in the account.
3. The earned interest of 40 dollars is also left in.
4. The entire account balance is reinvested for another year.
5. So year two earns interest on 1,040 dollars.
_Source: OpenStax Principles of Finance (CC BY 4.0), Ch 7 'Time Value of Money I: Single Payment Value'_
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