Republic of the Philippines

SORSOGON STATE COLLEGE

SORSOGON CITY CAMPUS
A.Y. 2019-2020
Name: Mathew B. Esparrago
Alexis D. Mangarin
Section: BSED 2A-MATH
Subject: Mathematics of Investments

COMPOUND INTEREST

 According to English dictionary, it is an interest, as on a loan or a bank account, that is

calculated on the total on the principal plus accumulated unpaid interest.
 Another definition is, “it is an interest computed on the sum of an original principal and
accrued interest.
 Compounding is a process of continuously re-investing the present value and its interest
without withdrawing, thus the interest earned is called compound interest.

Important concepts

 In compound interest, interest is compounded either annually, semiannually, quarterly,

monthly or continuously as the case may be.
 If the interest is compounded semiannually, it is computed twice a year. If it is
compounded quarterly, it is computed four times a year. If it is compounded monthly, it
is computed twelve times a year.

Compound Amount (Interest) Formula

F = P (1 + i)n
 In the compound amount formula, P is the present value and F is the compound amount
where (1 + i)n is called the accumulation factor.
 The time between two successive conversions is called the interest period. The number of
conversion periods in one year is called the frequency of conversion. This is denoted by
variable, m. The annual interest rate is called the nominal rate. It is denoted by the variable, j.
 The interest rate per period is denoted by i. It is given by the formula,

nominal rate, 𝐣
Interest rate per period, 𝒊 =
frequency of conversion, 𝐦
 To determine the number of conversions, n, we have the following formula,
 number of conversions, n = the time ,t, is given in years multiplied by frequency of
conversion, m.

𝐣
i= and n = tm
𝐦
Table 1

Frequencies of Conversion

Annually i = (1 + rt)1/n m=1

𝐓𝐰𝐢𝐜𝐞 𝐚 𝐘𝐞𝐚𝐫
Semi-annually m=2
𝐄𝐯𝐞𝐫𝐲 𝟔 𝐦𝐨𝐧𝐭𝐡𝐬
𝐅𝐨𝐮𝐫 𝐭𝐢𝐦𝐞𝐬 𝐚 𝐘𝐞𝐚𝐫
Quarterly m=4
𝐄𝐯𝐞𝐫𝐲 𝟑 𝐦𝐨𝐧𝐭𝐡𝐬
𝐓𝐰𝐞𝐥𝐯𝐞 𝐭𝐢𝐦𝐞𝐬 𝐚 𝐘𝐞𝐚𝐫
Monthly m = 12
𝐄𝐯𝐞𝐫𝐲 𝐦𝐨𝐧𝐭𝐡
Example:

1. Find the compound amount if Php50, 000.00 is invested at 8% compounded quarterly for
4 years?

𝐣 .𝟎𝟖
Given: P = 50,000 t = 4 years where: i = = =. 𝟎𝟐
𝐦 𝟒

j = .08 F=? n = tm = 4(4) = 16

m=4

F = P (1 + i)n

= 50000 (1 + .02)16

= Php68, 639.29 (compound amount)

We shall say that P, due now, and F due at the end of n periods, are equivalent values when
money is worth the rate i per period, if P and F satisfy. We call P the present value of F.
The sums P and F, due as stated, are equally desirable because P grows to the value F by the
end of n periods. If I is the compound interest earned by P in n periods, then

I=F–P

To accumulate a principal P for n conversion periods means to find the compound amount
F resulting at the end of n periods if P is invested at the specified interest rate. The
accumulation problem is solved by the use of (1 + i)n.
 2. Same given above, “Find the compound amount if Php50, 000.00 is invested at 8%
compounded quarterly for 4 years? And the compound interest earned?
a) The compound amount is
F = P (1 + i)n

= 50000 (1 + .02)16

= Php68, 639.29 (compound amount)

b) The compound interest earned is

I=F–P

= 68, 639.29 – 50, 000

= Php18, 639.29 (compound interest)

Compound Present Value Formula

P = F (1 +i)-n

In the compound present value formula, P is the present value and F is the compound amount
where (1 +i)-n is called the discount factor. Take note that interest can be compounded annually,
semi-annually, quarterly, monthly, or continuously.

To discount and amount F for n conversion periods means to find its present value P on a day
which is n periods before F is due. If we let I be the discount on F, then I = F – P. For
convenience in solving discount problems, we alter F = P (1 + i)n by solving for P.

Derivations of Formula:

F = P (1 + i)n
𝐅
» P = (𝟏+𝒊)^𝐧

𝟏
» = F(𝟏 + 𝐢)^𝐧

» P = F (1 + i)-n
Examples:

1. Ferdinand wants to have Php85, 000 in his account by the end of 3 years. How much
should he invest today in a bank that pays 9% compounded monthly? And find the
discount?
Sol’n: P = F (1 + i)-n

Given: F = 85, 000 m = 12 = 85, 000 (1 + .0075)-36 » Php64, 952.66

j = .09 t = 3 years P = ??? the discount on the 85, 000 is I= F - P

where: i=j/m » .09/12 » .0075 I= 85, 000 – 64, 952.66

n=tm » 3(12) » 36 I= 20047.34

Compound Amount with a Fractional Time Period

Approximation Method

In the compound amount formula, F = P (1 + i)n the number, n, has been expressed as a
whole number. However, there are times when number, n, is expressed in fraction. Consider this
example.

Examples:

1. Seelyn deposited Php450,000.00 in a bank paying 14% compounded quarterly. After 4

years and 2 months, she decided to close her account. How much would she be able to
withdraw from the bank?
Solution
Given: P = 450,000 j = .14 m=4 t = 4 yrs and 2 months F= ?

F = P (1 + i)n

= 450,000 (1 + .035)16.66667

= Php 798,395.98 (compound amount)

𝒋 .𝟏𝟒 𝟐
Where: i= = = .035 n=tm = [4 and ](4) = 16.66667
𝒎 𝟒 𝟏𝟐

This method is called the approximation method. On the other hand, banks and other
financial institutions use another method. This method is the theoretical method.

Theoretical Method

Step 1: Find the compound amount using the largest whole number of n.

F1 = P (1 + i)n
 = 450,000 (1 + .035)16

= 780,293.7179

Step 2: Using the computed compound amount as the present value, use simple interest on
the fractional time period.

F = F1 (1 + rt)

2
= 780,293.7179 [1 + .14 (12)]

= Php 798,500.57 (compound amount)

Compound Present Value with a Fractional Time Period

In the compound present value formula, P = F (1 + i)n the number, n, has been expressed
as a whole number. However, there are times when number, n, is expressed in fraction. Consider
this example.

Example:

1. Cindy wants to have Php 1, 500, 000.00 in 5 years and 2 months. If the bank’s interest is
12% compounded quarterly, how much should she deposit in the bank now?
Solution:

Given: F = Php1, 500 ,000.00 j = .12 m=4

t = 5 yrs and 2 months P= ?

P= F (1 + i)-n

= 1, 500 ,000.00 (1 + .03)-20.6666667

= PHP 814, 307.84 (compound present value)

Where:
𝒋 .𝟏𝟐 𝟐
i= = = .03 n=tm = [5 and ](4) = 20.66667
𝒎 𝟒 𝟏𝟐

Continuous Compounding
 Investments are generally compounded annually, semi-annually, quarterly, and monthly.
At times, interests are being paid every day. This kind of conversion is referred to as continuous
compounding. Here m is equal to 365 or 366 days. Consider the following examples.

Examples:

1. Cristy makes it a practice to save a part of her allowance. She deposited savings to the
bank. Her savings amounted to Php 10, 500.00. How much would she have in3 years if
the bank’s interest is 4.5% compounded daily?
Solution:

Given: P = Php10, 500.00 j = .04 m = 365 t = 3 yrs F= ?

F= P(1 + i)n
.045 1095
= 10, 500 (1 + )
365

= PHP 12, 017.54 (compound amount)

Where:
𝒋 .𝟎𝟒𝟓
i= = = .0001232 n=tm = (3)(365) = 1095
𝒎 𝟑𝟔𝟓

2. Arlyn wants to have Php 75, 000.00 at the end of 2 years. How much should she deposit
in a savings today if the bank pays interest at 10% converted continuously.

Solution:

Given: F = Php75, 000.00 j = .10 m = 365 t = 2 yrs P= ?

P= F(1 + i)-n
.10
= 75, 000.00 (1 + 365)-730

= PHP 61, 406.49 (compound present value)

Where:
𝒋 .𝟏𝟎
i= = = .0002739 n=tm = (2)(365) = 730
𝒎 𝟑𝟔𝟓
To simplify problems on continuous compounding, we can apply easier and more convenient
formulas. These formulas are for the present value and amount of “moneys” that are
compounded continuously. In these formulas, the symbol e, is used. It is approximately equal to
2.71828. The respective formulas are as follows:
 CONTINUOUS COMPOUNDING

Compound Amount Formula: F = Pejt Compound Present Value Formula: P = Fe-jt

In the formulas above for continuous compounding, P is the compound present value, F
is the compound amount, e is equal to 2.71828, j is the nominal rate, and t is the time period.
Referring to the above examples, let us compute for both the compound amount and
compound present value for continuous compounding.

#1 Solutions:

Given: P = Php10, 500.00 j = .04 t = 3 yrs F= ?

F = Pejt

= 10, 500e(.045)(3)
= Php 12, 017.64 (Compound amount)

#2 Solutions:

Given: F = Php75, 000.00 j = .10 t = 2 yrs P= ?

P = Fe-jt
= 75, 000.00e(-.10)(2)

= PHP 61, 404.81 (compound present value)

Take not that in both cases, the answers were not exactly the same.

References:

Young, F. (2010). Mathematics of Investment Made Simple. Rex Book Store, INC. 856 Nicanor

Reyes, Sr. St., Sampaloc, Manila.