PRINCIPLES OF MONEY-TIME RELATIONSHIPS

(ES 21 LECTURE NOTE 2: 16 SEPT 2022)

COMPOUND INTEREST

I = P(1 + i)n – P,

Where, P(1 + i)n = F;

Hence, I = F – P = Interest Earned

Whenever the interest charge for any interest period is based on the remaining principal amount plus any
accumulated interest chargers up to the beginning of that period, the interest is said to be compound.

Compound interest calculations apply to investments where the amount of interest is calculated on the
present balance of the account.

Sample Problem.

For instance, if you invested $100 in a bank with an interest rate of 10% compounded annually ( once per
year), then in the first year of your investment you would earn $10. If this were simple interest, you would
continue to earn $10 per year for the period of your investment. However, since the interest is
compounded, you earn interest on your interest . The amount of compound interest for the first interest
period is the same as for simple interest. However, for further interest periods, the amount of compound
interest increases to an amount greater than simple interest.

To illustrate:

Simple Interest Compound Interest

Year 1 ($100)(1)(10%) = $10 ($100)(1)(10%) = $10

Year 2 ($100)(1)(10%) = $10 ($100 + $10)(1)(10%) = $11

Year 3 ($100)(1)(10%) = $10 ($100 + $10 +$11)(1)(10%) = $12.10

Total Interest $30 $33.10

From the illustration above, you can see that under simple interest payments, a yearly sum of $10 is
gained through interest. For each year of the loan period, $10 is earned. However, under compound
interest payments, the yearly interest is added to the principal for the next period. This has the effect of
increasing interest earned each year for the duration of the period (note: in example above, $33.10
earned from compound interest versus $30 earned from simple interest).

The Formula(s) Developed From the Illustration:

Beginning of Amount Lent + Amount Owed

Period at Period End
Interest Amount
1 P + Pi = P + Pi = P(1 +i)
2 P(1 + i) + P(1 + i)i = P(1 + i) + P(1 + i)i = P(1 + i)2
3 P(1 + i)2 + P(1 + i)2i = P(1 + i)2 + P(1 + i)2i = P(1 + i)3
. .
. .
. .
n P(1+i)n-1 +[P(1 + i)n-1]i =P(1 + i)n

NOTATIONS USED IN FORMULAS FOR COMPOUND INTEREST FORMULAS

I = P(1 + i)n – P

Where:

I = interest earned after a predetermined period (in dollars/pesos/etc.)

i = interest rate per interest period (usually in percentage form & subsequently converted to decimal form

for computation purposes)

n = number of compounding periods (usually in number of years)

P = present sum of money; the equivalent worth of one or more cash flows at a reference point in time
called the present

F = P(1 + i)n ( future sum of money; the equivalent worth of one or more cash flows at a reference point in
 time called the future.

IF THE COMPOUNDING INTEREST IS APPLIED MORE THAN ONCE A YEAR, then

i = r/m

Where,

r = nominal interest rate, and

m varies according to the number of compounding made in a year.

m = 1 if the interest rate is only applied once a year (annually)

m = 2 if the interest rate is applied twice a year (semi-annually)

m = 4 if the interest rate is applied four times a year (quarterly)

m = 12 if the interest rate is applied every month (monthly)

m = 52 if the interest rate is applied every week (weekly)

m = 365 if the interest rate is applied every day (daily)

m = may be any value depending on the number of compounding made in a year.

Hence;

F = P (1 + r/m)mn

FOR CONTINOUS COMPOUNDING

F = P e in