B) Compound Interest – the interest earned by the principal is not paid at the end of each

interest period, but is considered as added to the principal and therefore will also earn
interest for the succeeding periods.

Nominal Rate of Interest – specifies the rate of interest and the number of interest periods per
year.
Example: 12% compounded monthly

Effective Rate of Interest – is the actual rate of interest on the principal for one year.
Example: 14% compounded annually/ yearly or 14% effective.

ERI = [ ( 1 + i )n - 1 ] x 100%

Where i is the nominal rate of interest and n is the number of interest period.

Cash Flow:

0 1 2 …………. n

P = F ( 1 + i ) –n and F = P(1+i)n

Where: P is the present value of the said amount.

F is the future value of the said amount.
Continuous Compounding – if r is the nominal annual interest and m is the number of interest
period each year, then the interest rate per interest period is i = r/m and the number of
interest periods in n years is mn. Thus:

F = P ( 1 + r/m )mn

Increasing m, the number of interest periods per year without limit, it becomes very large and
approaches infinity and r/m approaches zero.

F = P lim ( 1 + r/m ) ; m approaches infinity

Set r/m = x; then m = ( 1/x )r and mn = ( 1/x )rn. As m approaches infinity, x approaches zero,
thus;

F = P [ lim ( 1 + x )1/x ]rn ; x approaches zero.

From Calculus, lim( 1 + x ) 1/x = 2.71828……….. = e

Thus, F = Pern

Discount – on a negotiable paper, is the difference between what is worth in the future and its
present worth, thus;

Discount = Future value - Present value

Rate of Discount – is the discount on one unit of principal per unit of time.

d = and i =

where i is an effective rate of interest.

Examples:

1) If the rate of interest of a certain amount deposited on an account is 14% compounded

quarterly, what is the effective rate of interest?
Solution:
.
ERI = [ ( 1 + )4 - 1 ] x 100% = 14.75%

2) What equivalent rate compounded quarterly is equivalent to 12% compounded semi-

annually?
Solution:
.
( 1 + )2 - 1 = ( 1 + )4 - 1

( 1 + )2 = 1.12550881 ; 1 + = 1.0609

i = .1218 or 12.18% compounded quarterly

3) How long will an amount be doubled if invested on a fund earning 12% compounded
quarterly?
Solution:
.
F = P ( 1 + i )n ; 2P = P ( 1 + )n ; 2 = ( 1.03 )n

ln ( 2) = n ln( 1.03 ) ; n = 23.45 quarters or 5.86 years

4) A P150,000.00 loan is to be paid in three instalments for a period of one year earning an
interest rate of 10% effective. The first payment happens three months after the said
loan was released amounting to P75,000.00. The second payment happens five months
after the first payment amounting to P 52,000.00. Last payment happens a year after
the loan was released. Find the amount of the last payment.
Solution:
Cash Flow Diagram:

150,000.00

3 8 12
52,000.00
75,000.00 X
Using n in years and using the effective rate of interest:

Let the present worth be your focal point ( reference point ) , thus:

P150,000.00 = P75,000.00 ( 1 + 0.10 ) + P52,000.00 ( 1 + 0.10 ) + X ( 1 + 0.10 )

P150,000.00 = P73,234.06 + P48,798.70 + 0.9091X
X = P30, 763.66

Let the future worth be your focal point, thus:

P150,000.00 ( 1 + 0.1 ) = P75,000.00 ( 1 + 0.1 ) + P52,000.00 ( 1 + 0.1 ) + X

P165,000.00 = P80,557.46 + P53,678.57 + X
X = P30,763.97

Using n in months and interest is nominally at compounded monthly:

0.10 = ( 1 + )12 - 1 ; i = 9.57 compounded monthly

Let the present worth be the focal point, thus:

. . .
P150,000.00 = P75,000 ( 1 + )-3 + P52,000 ( 1 + )-8 + X ( 1 + )-12

P150,000.00 = P73,233,87 + 48,798.36 + 0.9091X

X = P30,764.24

Let the future worth be the focal point, thus:

, . .
P150,000 ( 1 + )12 = P75,000 ( 1 + )9 + P52,000 ( 1 + )4 + X

P165,001.69 = P80,558.08 + P53,678.75 + X

X = P30,764.86
 5) A business loan was approved amounted to P 2.5 million by a Credit Agency in which it is
discounted at 8%. This loan needs to be paid in four instalment payments in different
amounts within a period of one year. First payment happens two months after the
release of the loan. Second payment is P50,000.00 greater than the first payment and
happens four months after the first payment. Third payment is P75,000 larger than the
second payment and happens three months after the second payment. Fourth and last
payment is P25,000 lesser than the first payment and happens a year after the said loan
was released. Find the amount of the third payment.
Solution:
Find first the effective rate of interest:
.
i = x 100% ; i = .
x 100% = 8.7%

Cash Flow Diagram:

P 2.5M

n in years i = 8.7%

2 6 9 12

X – P25,000
X
X + P50,000
( X + P50,000 ) + P75,000

Using Present worth as focal point:

P2,500,000 = X ( 1 + 0.087 ) + ( X + P50,000 ) ( 1 + 0.087 ) +

( X + P125,000 ) ( 1 + 0.087 ) + ( X - P25,000 ) ( 1 + 0.087 )

P2,500,000.00 = 0.9862X + 0.9591X + P47,957.36 + 0.9394X + P117,418.86

+ 0.92X - P22,999.08
X = P2,357,622.86 / 3.8047 = P619,660.65
Thus; third payment = P619,660.65 + P125,000.00 = P744,660.65