Chapter 2

COMPOUND INTEREST
COMPOUND INTEREST
An interest is said to be
compounded or converted when it
(the interest) is added to the principal
at regular intervals, and the sum
becomes the new principal.
• Interest may be compounded:

annually - once a year

semi-annually - twice a year
quarterly - four times a year
monthly - twelve times a year
• The final amount (the sum of the
interest and the principal ) is called the
compound amount.

• The difference between the compound

amount and the principal is called the
compound interest.
Example:
Find the compound amount
and interest if P1,000 is invested at
an interest rate of 9% compounded
annually for 3 years.
*the term “compounded annually means that the
interest earned in 1 year is added to the principal to
earn additional interest for the next year.
 If the investment term is long,
the computation of the compound
amount would be very lengthy and
tedious. For that reason, formulas
have been derived to shorten the
process.
The Compound Amount
Formula
n
F  P (1  i )
where:
P = original principal
F = compound amount or accumulated value of P at the
end of n periods
i = interest rate per period,{ i = j/m}
j = nominal rate of the interest (annual rate)
m = frequency of conversion
n = total number of conversion periods in the
investment term, { n = mt }
t = term of investment in years
Example:
Find the compound amount
and interest if P1,000 is invested at
an interest rate of 9% compounded
annually for 3 years.
Solution:
F = 1000 (1 + 0.09)3
F = 1000 (1.09)3
F = 1,295.03
Therefore the compound amount is P 1,295.03
The Compound Amount (F)
n
F  P (1  i )
Where:
j n  mt
i and
m
Therefore:
mt
 j
F  P 1  
 m
Examples
1. Find the compound amount if
P23,000 is invested for 4 years at
the rate of 12% compounded:
a. annually
b. semi – annually
c. quarterly
2. Accumulate P15,500 for 17 months at
12.6% compounded monthly. Also,
compute the compound interest.
3. Regina bought a designer bag on terms.
She made a down payment of P100,000
and the remaining balance to be paid 1
year after at 8.24% converted quarterly.
How much did she pay after 1 year if the
bag’s cash price was P150,000?
 The values of m
(frequency of conversion)
annually once a year m=1

semi-annually twice a year m=2

quarterly four times a m=3

year
monthly twelve times a m=4
year
The Present Value (P) at
Compound Interest
From the formula:
n
F  P (1  i )
The present value P is:

F n
P n
or P  F(1  i )
(1  i )
Examples:
1. Find the present value of P1,200
due in 3 ½ years if money is invested
at 12% compounded monthly.

2. Discount P35,700 for 2 years and 3

months at 8.4% compounded
quarterly.
3. If P3,000 was due on December 5,
2009, find its present value on June
5, 2007, if money was invested at
10% compounded semi-annually.
4. A computer was bought on installment:
P65,000 down payment and the balance
of P45,000 in 15 months. What was its
cash price if the interest rate was 14%
compounded quarterly? How much
would have been saved if the computer
was bought in cash?
6. A man purchased a piece of lot by
making an initial partial payment of
P600,000 and another payment
amounting to P400,000 one year later.
How much would have he paid if he
bought that lot in cash? Interest for
payment by installment was at 20%
compounded semi-annually.
*Compound Amount and Present
Value at a Fraction of a Period

When n is a fraction, we will

still use the same formulas as we
will assume compound interest
throughout the term.
*Compound Amount and Present
Value at a Fraction of a Period

Examples:
1. Find the compound amount if P10,300 is
invested for 2 years and 10 months at 11%
compounded semi-annually.

2. Discount P32,000 for 3 years and 7 months

at 10% compounded quarterly.
Finding the Interest Rate (j)

n
In the formulaF  P (1  i )
, the interest rate can be
determined if F, P, and n are
known.
The formula for interest rate (j) is:

 1
  
 F  n
j  m    1
 P  
 
P = original principal
F = compound amount or accumulated value of P
at the end of n periods
I = interest rate per period,
j = nominal rate of the interest (annual rate)
m = frequency of conversion
n = total number of conversion periods in the
investment term,
t = term of investment in years
Examples

1. At what nominal rate compounded

quarterly will P7,500 amount to
P8,100 in 1 year and 9 months?

2. What nominal rate converted semi-

annually will make P29,700 amount
to P50,000 in 7 years and 6 months?
Examples

3. If P25,000 earned an interest of

P3,000 in 2 years, at what rate
compounded annually was the money
invested?
Finding the Time/Term (t)

The formula for finding the term is:

F
log  
 P
t
m  log( 1  i )
Examples
1. How long will it take for P4,300 to
accumulate to P5,250 at 9.4% compounded
semi-annually?
2. When will a principal double itself if the
interest rate is 11.4% compounded
quarterly?
3. How long will it take P37,700 to earn P2,100
interest if the money is earning at 12.48%
converted monthly?
Examples
4. On March 27, 2007, Martin deposited
P82,074.66 in a fund that paid 10%
compounded quarterly. On what date
would his investment amount to
P100,000?
Nominal, Effective, and
Equivalent Rates

Two annual rates of interest

with different conversion periods are
said to be equivalent if they produce
the same compound amount for the
same time.
• When an interest is compounded more
than once a year, the given rate is called
the nominal rate.

• The effective rate is the rate that, when

compounded annually, produces the
same compound amount each year as
the nominal rate j compounded m times
a year.
Example:

For a period of 1 year, the compound

amount of P10.00 invested:
a. at 12% compounded semi-annually is:
2
 0.12 
F  P10.001    P11.236
 2 
b. at 12.36% compounded annually is:
F  P10.001  0.1236  P11.236
Equivalent Rates
Two nominal rates are said to be
equivalent if they yield the same
maturity value for the same term.

The following formulas give the value

of an unknown rate given some other
rate.
1. FORMULA FOR FINDING THE SIMPLE
INTEREST RATE EQUIVALENT TO A DISCOUNT
INTEREST RATE

d
r
( 1  dt )
Example:
What simple interest rate is equivalent
to 12% simple discount for a period of
2 ¼ years?
2. FORMULA FOR FINDING THE DISCOUNT
INTEREST RATE EQUIVALENT TO A SIMPLE
INTEREST RATE

r
d 
( 1  rt )
Example:
Find the equivalent discount rate of
7.5% simple interest in a 5-year
transaction.
3. FORMULA FOR FINDING THE EFFECTIVE
INTEREST RATE EQUIVALENT TO A
NOMINAL INTEREST RATE

u  1  i   1
m

Example:
Find the effective rate equivalent to
10.5% compounded semi-annually.
4. FORMULA FOR FINDING NOMINAL INTEREST
RATE EQUIVALENT TO AN EFFECTIVE
INTEREST RATE


j  m 1  u  (1/ m )
1 
Example:
What nominal rate compounded
quarterly is equivalent to 11% effective
rate?
5. FORMULA FOR FINDING THE NOMINAL RATE
EQUIVALENT TO ANOTHER NOMINAL INTEREST
RATE

 (m /m ) 
j2 
2 1

j1  m1 1    1
 m2  
Example:
What rate compounded quarterly is
equivalent to 16.25% compounded
monthly?
6. FORMULA FOR FINDING THE SIMPLE INTEREST
RATE EQUIVALENT TO A NOMINAL INTEREST
RATE

r

(1  i ) n
1 
t
Example:
What simple interest rate is equivalent to
7.85% compounded quarterly in a 4-year
transaction?
7. FORMULA FOR FINDING THE NOMINAL
INTEREST RATE EQUIVALENT TO A SIMPLE
INTEREST RATE


j  m (1  rt ) (1 / n )

1
Example:
What nominal rate converted monthly is
equivalent to 10% simple interest for a
25-month transaction?
Comparison of Two Rates

To compare two rates of interest,

is to compare their effective rates.

u  1  i   1 m
Examples
1. Which is better, to invest money at
7.5% compounded semi-annually or at
7.4% compounded monthly?

2. BANK A offers 6.45% (m=12) on a

loan while BANK B offers 6.5 %
(m=4). Which bank will you borrow
money from?
3. Which investment yields a higher
interest: 9.50% effective or 9.40%
compounded semi-annually?
VARYING INTERESTS

If the interest rate changes

during an investment term, the
amount at the previous rate is first
obtained before applying the new
rate.
Examples
1. Find the amount in 15 years if P500
is invested at 18% compounded
semi-annually in the first 5 years,
15% compounded semi-annually in
the next 4 years and 18%
compounded quarterly in the last 6
years.
2. A principal of P8000 was invested for
14 years. For the first 6 years, the
rate was 9% (m=4), and then
dropped to 8% (m=4) in the
remaining time. Find the amount in 14
years.
3. On March 14, 1989, Jing deposited
P15,320 in a bank. How much did he
have after 10 years if the 9%
interest payable quarterly was in
effect until September 14, 1992, and
if 10% was payable semi-annually
thereafter?
4. Discount P12,000 at 5% simple
interest for 8 months, 6%
compounded monthly for the
following year, and at 7%
compounded quarterly for 27
months.
CONTINUOUS COMPOUNDING

Interest may be converted very

frequently: weekly, daily, or hourly.
When interest is converted very
frequently, the frequency of
conversion becomes infinite.
As m increases, the compound
amount increases marginally. Frequent
compounding thus will increase the
interest, but only slightly.
Value of P100 at the End of One Year as m
Becomes Infinite

Nominal Rate Frequency of Amount of P100 at

7% Converted Conversion the End of 1 Year
(m)
annually 1 Php 107
semi-annually 2 107.1225
quarterly 4 107.1859
monthly 12 107.22901
weekly 52 107.24576
daily 365 107.25006
 At the nominal rate j compounded
continuously, the amount of principal P
invested for t years is:

jt
F  Pe
 Solving for P, the present value
of F due at the end of t years at the
nominal rate j compounded
continuously is:

 jt
P  Fe
Examples
1. Find the amount if P4,000 was invested
for 10 years at 12% converted:
a. quarterly
b. monthly
c. continuously
2. Find the present value of P4,800 due
in 8 years at 9% compounded
continuously.

3. Find the accumulated value of

P9,000 at the end 5 years if it is
invested at 9% converted
continuously.
4. Find the accumulated value of
P8,700 at the end of 10 years if it
earns effective interest of 7% in
the first 3 years and 10%
converted continuously in the
remaining years.
EQUATION OF VALUES

This is used when there is a

need to replace a set of debts by
another set of different amounts
due at different times.
 For instance, a single payment
on the 6th year can settle these two
debts:
• P10,000 due in 4 years
• P15,000 due in 8 years
In order to find that single
payment, an equation of value should
be set up.
STEPS IN SOLVING AN
EQUATION OF VALUES:
1. Make a time diagram. Write all debts
above the line and the payments
below the line.
2. Choose a comparison date. Any time
can be used as comparison date, but
to simplify computation, a payment
date is used.
3. Bring all values to the comparison date by
either accumulating or discounting. Write
down the equation of value which can be
briefly stated as:
all payments = all debts

4. Solve the resulting equation.

Examples
1. What single payment on the 6th
year will settle debts of P10,000
due in 4 years, and P15,000 due
in 8 years, if money is worth 8%
compounded quarterly?
2. If money is worth 7.5% effective rate,
what single payment at the end of 5 years
would replace the following debts?
a. P900 due in 1 year without interest
b. P1,000 due in 9 years with accumulated
interest from today at 14% (m = 2)
3. What equal payments at the end of 2 years and 5
years will equitably replace these obligations,
assuming that the settlement rate is 10%
compounded quarterly?
– P2,000 due at the end of 1 year
– P3,000 due at the end of 3 years, at 5% simple
interest
– P4,000 due at the end of 7 years with interest of
9% converted semi-annually.
4. Sonny owes Jeffrey the following debts:
a. P500 due in 1 year
b. P700 due in 9 months with accumulated
simple interest from today at 9%
c. P400 due in 18 months with accumulated
interest from today at 15% (m=2)
Sonny wishes to replace these debts with two
equal payments at the end of 10 months and 2
years, respectively. Find how much each
payment is if money is worth 12% compounded
monthly.
5. Edgar owes Jimmy P12,000 at the end of 3
years and P18,000 due at the end of 7 years
with accumulated interest from today at 10%
compounded quarterly. Edgar decided to
settle his obligations by making a payment of
P8,000 at the end of 1 year, P5,000 at the
end of 5 years, and another payment at the
end of 9 years. If they agree that money is
worth 14% compounded semi-annually, find
the size of the payment at the end of 9 years.
Reference:
Ong & Gabriel (2008). Fundamentals of
Investment Mathematics 3rd Edition, 27-65.