GEC 104 Mathematics in the Modern World

Unit III The Mathematics of Finance

Lesson 7 Compound Interest

At the end of this lesson, you should be able to:

a. Define and discuss compound interest; and
b. Calculate the compound amount by using the compound interest formula.

COMPOUND INTEREST
Consider an investment whose time frame is divided into equal intervals. If an interest is
computed after an interval and is being added to the principal and thereafter earns an interest, then
the difference between the original principal and the total amount after the whole time frame is called
compound interest.

The compound amount or the accumulated value of the principal is the sum of the
principal and the compound interest. In this situation, we see that the interest is being converted into
a principal and thus we use the phrase “interest is compounded” or “interest is converted”.

Consider an investment amount place on a financial institution that gives a compound interest
where the interest rate per conversion period is i. After one conversion, the total amount due to the
investor is P + Pi. The new principal at the end of the first conversion is now P + Pi = P (1 + i). At the
end of the second period, the accumulated value now becomes, P + Pi + (P + Pi) i which is
equivalent to P + Pi + Pi + Pi2 = P (1 + i)2. Thus, the new principal after the second conversion is P (1
+ i)2.

In a similar manner, at the end of the third period or third conversion, the accumulated value
becomes P (1 + i)2 + P (1 + i)2 i = P (1 + i) 2 (1 + i)2 = P (1 + i)3. Now, following the patterns that we
see, after the nth conversion, the accumulated value becomes P (1 + i)n. Thus we have the following
formula:

COMPOUND INTEREST

F = P(1 + i)n
Where,
F = compound amount or accumulated value of P at the end of the term
P = present value or original principal
j = interest rate per year
i = interest rate per period j
n = total number of conversion periods
i=m n = tm
m = number of conversions per year
t = term
 In the context of compound interest, the interest rate per annum or per year is called the
nominal rate of interest. Thus, when a given nominal rate is said to be compounded quarterly, that
means in a given year there will be 4 conversions. Similarly, when we say compounded monthly, the
conversions are made every month therefore in a given year, there will be 12 conversions.

EXAMPLE 1 If Php 2,500 is invested at 13% compounded quarterly for 12 years, find the
compound amount and interest.
Solution:
Given: P = ₱ 2,500; j = 13% = 0.13; t = 12; m=4

n = tm = 12 • 4 = 48
j 0.13
i = m = 3
= 0.0325
F = P(1 + i)n = 2,500(1.0325)48 = Php 11,605.47

EXAMPLE 2 If Php 3,700 is invested at 12% compounded semi-annually for 5 years, find the
compound amount and interest.
Solution:
Given: P = ₱ 3,700; j = 12% = 0.12; t = 5; m=2

n = tm = 5 • 2 = 10
j 0.12
i = m = 2
= 0.06
F = P(1 + i)n = 3,700(1.06)10 = Php 6,626.14

EXAMPLE 3 Find the present value of Php 2,850 due in 5 years if money is worth 10%
compounded quarterly.
Solution:
Given: F = ₱ 2,850; j = 10% = 0.10; t = 5; m=4

n = tm = 5 • 4 = 20
j 0.10
i = m = 4
= 0.025
F 2,850 2,850
P = (1+i)
n =
1.025 20 =
1.6386 = Php 1,739.29

EXAMPLE 4 How much must be invested today in a savings account to realize Php 9,000 in
4 years, if money earns at the rate of 4% compounded quarterly?
Solution:
Given: F = ₱ 9,000; j = 4% = 0.04; t = 4; m=4

n = tm = 4 • 4 = 16
j 0.04
i = m = 4
= 0.01
F 9,000 9,000
P = (1+i)
n =
1.01 16 =
1.1726 = Php 7,675.25
EXAMPLE 5 What rate compounded annually will double any amount principal if it is invested
in 6 years?
Solution:
Given: Let x be the amount to be invested. m = 1; t = 6 ⟹n = 6. We want to find j.

( )
6
j
F = P(1 + i) n ⟹ 2x = x 1+
1
⟹ 2 = ( 1+ j )6 j = √6 2 −¿1
⟹
⟹ j = 0.1225 = 12.25%

EXAMPLE 6 What nominal rate converted semi-annually will make Php 20,000 amount to
Php 50,000 in 8.5 years?
Solution:
Given: m = 2; t = 8.5 ⟹n = 17. We want to find j.

( )
17
j
F = P(1 + i)n ⟹ 50,000 = 20,000 1+
2

( )
17
j
⟹ 2.5 = 1+ 2
⟹ j = 217√ 2.5 −¿2 ⟹ j = 2.1108 −¿2
⟹ j = 0.1108 = 11.08%

EXAMPLE 7 When will Php 30,000 earn interest of Php 15,000 if it is invested at the rate of
7.5% converted annually?
Solution:
Given: F = 45,000; P = 30,000; j = 7.5% = 0.075; m = 1. We want to find t.

( )
n
0.075
F = P(1 + i)n ⟹ 45,000 = 30,000 1+
1
⟹ 1.5 = ( 1+0.075 )n ⟹ 1.5 = 1.075n
⟹ log 1.5 = n log (1.075)
log 1.5 0.176091
⟹ n = log (1.075) = 0.031408 = 5.6065
n 5.6065
⟹ t = m= = 5.6065
1

EXAMPLE 8 When will a principal double itself if the interest rate is 14% compounded
quarterly?
Solution:
Given: F = 2P; j = 14% = 0.14; m = 4. We want to find t.

( )
n
0.14
F = P(1 + i) n ⟹ 2P = P 1+ 4
⟹ 2 = ( 1+0.035 )n ⟹ 2 = ( 1.035 )n
⟹ log 2 = n log (1.035)
log 2 0.301030
⟹ n = log (1.035) = 0.014940 = 20.1493
n 20.1493
⟹ t = m= = 5.0373
4
 The effective rate of interest of compounded times a year can be computed as

r = (1 + i)m −¿ 1

EXAMPLE Determine the effective rate of interest for each of the following nominal interest
rate compounded times a year.

j
j m i = m r = (1 + i)m −¿ 1
2% 4 0.5% (1 + 0.5%)4 −¿1 = 4.0625%
3% 3 1% (1 + 1%)3 −¿1 = 7%
1.5% 12 0.125% (1 + 0.125%)12 −¿1 = 3.10989%
5% 4 1.25% (1 + 1.25%)4 −¿1 = 24.6289%

Present Value at Compound Interest

The present value of an amount F due in n interest periods is the value P, which when
invested now at a given rate will accumulate to F at the end of n periods. From the compound amount
formula F = P (1 + i)n, we solve for the present value P as follows:

F -n
P = n or P = F(1 + i)
(1+i)

The value of (1 + i)-n can also be obtained using scientific calculator.

“To discount an amount F due in n interest periods” means to find its present value P at n
periods before F is due. The factor (1 + i)-n is called the discount factor.

EXAMPLE 1 Find the present value of ₱5,000 due in 8 years if money is worth 12%
compounded semiannually.
Solution:
Given: F = ₱ 5,000; j = 12% = 0.12; t = 8 years; m=2
n = tm = 8 • 2 = 16 periods
j 0.12
i = = = 0.06
m 2
Find P.
-n
P = F(1 + i) = 5,000 (1 + 0.06)-16 = 5,000 (1.06)-16
= 5,000 (0.393646)
= Php 1,968.23

EXAMPLE 2 A piece of property is purchased on installment basis. The buyer makes a down
payment of ₱100,000 and owes a balance of ₱350,000 to be paid in 2 years.
Find the cash value of the property if money is worth 14% compounded quarterly.
Solution:
Cash Value = down payment (if any) + present value of the installment payment
Given: F = ₱ 350,000; j = 14% = 0.14; t = 2 years; m=4
n = tm = 2 • 4 = 8 periods
j 0.14
i = = = 0.035
m 4
Find Cash Value.
 The present value of the installment payment is computed is computed as:
-n
P = F(1 + i) = 350,000 (1 + 0.035)-8
= 350,000 (1.035)-8
= 350,000 (0.759412)
= Php 265,794.20
Cash Value = down payment + P
= ₱ 100,000 + ₱ 265,794.20
= ₱ 365,794.20

Finding the Time

In formula F = P(1 + i)n, if F, P, and i are given, the value of n can be determined by
using logarithms. Once n is obtained, we can solve for the time t from the formula t = n/m. This is
illustrated in the following example.

EXAMPLE 1 How long will it take ₱25,000 to amount to ₱58,000 if it is invested at 12%
compounded quarterly?
Solution:
Given: P = ₱ 25,000; j = 12% = 0.12; F = ₱ 58,000; m=4
j 0.12
i = = = 0.03
m 4
Find t.
n
F = P (1 + i)
58,000 = 25,000 (1 + 0.03)n
(1 + 0.03)n = 2.32
(1.03)n = 2.32

Taking the logarithms of both sides, we get

n log 1.03 = log 2.32

log 2.32 0.365488
n = log 1.03
= 0.012837
= 28.4714
n
From n = tm, we get t = .
m
n
t = m
28.4714
= 4
= 7.12 years

GEC 104 – MATHEMATICS IN THE MODERN WORLD WEEK 14

NAME: ___________________________ COURSE/YEAR/BLOC.: ___________

Activities Lesson 14 COMPOUND INTEREST

ACTIVITY 1 (2 points each)

Solve the following problems. Write your answer in the space provided before each number.

For numbers 1 to 3, refer to the situation below.

Find the future amount and the interest if ₱4,000 is invested for 2 years at the rate of 10%
compounded
____________ 1. annually.
____________ 2. semi-annually.
____________ 3. quarterly.

For numbers 4 to 6, refer to the situation below.

Find the present value of ₱6,800 due in 5 years if money is worth

____________ 4. 12% compounded annually.

____________ 5. 12% compounded semi-annually.
____________ 6. 12% compounded monthly.

____________ 7. On November 8, 2008, Anna deposited ₱25,000 in a fund earning interest at

6.5% compounded semiannually. How much money will she have in the fund on
May 8, 2015?
____________ 8. Find the present value of ₱10,400 due in 3 years and 8 months if money is
worth 10% compounded semiannually.
____________ 9. At what nominal rate compounded semiannually will ₱15,000 accumulate to
₱37,500 in 10 years?
____________ 10. How long will it take ₱5,000 to accumulate to ₱20,000 at 12% compounded
semiannually?