Chapter 2

Describe the nature of compound interest;

and define the terms related to compound interest computation;

Discuss how a compound interest is computed;

Calculate compound amount(F), time (t), rate (r) and Present Value(P)
in compound interest applications,

discuss equivalent rates and calculate rate equivalent to a given rate;

 Identify the relationship between nominal and effective
interest rates;

calculate payment on any date that is equivalent to one or more

payments on other dates
 Last meeting , we discussed about

How to compute equivalent

❑Equivalent nominal and effective rates

❑Equivalent nominal rates with different conversion periods
❑Equivalent simple interest to a given nominal rates.

8-5
 VALUES OF OBLIGATIONS AND THEIR
COMPARISON

Dated transactions yield different present values and amounts. However,

points of references can be established to serve as dates of comparisons. Using
a common date of comparison can help us assess which financial transaction
will yield higher incomes or lower interests.

This section will help us make good decisions.

VALUES OF OBLIGATIONS AND THEIR
COMPARISON

Which would you like to have?

1 million next year?
1,080,000 next 2 years?
Or 925,925.93 today?
 VALUES OF OBLIGATIONS AND THEIR
COMPARISON
At compound interest rate of 8% compounded annually

At compound
considered to be In some ways the equivalent
interest rate of
equivalent to sum of money today is
8% compounded
1,080,000 pesos
annually, 1 million
in 2 years
due in one year is
 In general

we compare dated values by the following equivalence: X pesos due on a given date
is equivalent at a given compound interest rate i of Y pesos due in n periods later if

Y = X (1 + i ) X = Y (1 + i )
n −n
or
The following time diagram illustrates dated values equivalent to a dated value X.
Note: Based on the time diagram above the following simple rules can be stated:
When we value money at a later date, we multiply the sum by the compound
interest factor (1 + i)n .

When we value money at an earlier date, we divide the sum by the compound
interest factor or multiply it by
(1 + i) – n
 Example 1

NOTE 1
Roberts promises to pay ₱100,000 to Hartmann or order 5 years after
June 1, 2008 without interest

Note 1 is sold by Hartmann to Jones on June 1, 2011. If money is worth

4% compounded quarterly in his transaction, how much does Jones pay?

Solution
Amount that Jones pay
= ₱100 000(1+(.04/4))-8
= ₱92,348.32
 Example 2

NOTE 1
Roberts promises to pay ₱100,000 to Hartmann or order 5
years after June 1, 2008 without interest

In regard to promissory Note 1, Roberts gets permission to

delay his payment until June 1, 2015; under the assumption
that money is worth {4%, m = 4}after the note matures. What
final payment is Roberts required to make?
Solution
Amount that Roberts pay
=₱100 000(1+(.04/4))8
= ₱108 285.67
 Example 3
₱20,000 is due on May 1,2012. If money is worth 5% compounded
semiannually, find the value of this obligation on a) May 1,2007?
B) on May 1, 2015 if payment is deferred until then? ₱20,000(1 + (.05/2))-10
= ₱15 623.97

₱20,000(1 + (.05/2))6
Solution
= ₱23, 193.87
₱20,000

May 1,2007 May 1,2012 May 1,2015

To compare two obligations due on different dates, the values of the
obligations must be compared on some common date, which we shall call
the comparison date.
Example 3

If money is worth 4 ½ % compounded semiannually, which

obligation is the more valuable:
(a) ₱ 7,000 due at the end of two years or
(b) ₱ 7,500 due at the end of three years? ₱ 7,500(1+( .045/2))-2
= ₱7,173.56

Solution ₱ 7,000

₱ 7,000 ₱ 7,500

Since ₱7,173.56 at the end of two years is

greater than ₱7,000 then ₱7,500 at the end
End of two years End of three years of three years is more valuable than ₱7,000 at
the end of two years.
If money is worth 4 ½ % compounded semiannually, which
obligation is the more valuable:
(a) ₱ 7,000 due at the end of two years or
(b) ₱ 7,500 due at the end of three years?

Step 2
0 1 year 2 years 3 years 4 years
Calculate the value of each
obligation in the comparison
date

PV1
= 7000(1+.045/2)-2
= ₱ 6695.32 PV2 Therefore, ₱ 7,500 due at the end of three years is more
= 7500(1+.045/2)-4 valuable.
= ₱ 6861.33
Two TWO SETS of Payments ARE EQUIVALENT AT A GIVEN
COMPOUND INTEREST IF THE DATED VALUES OF THE
SETS OR ANY COMMON DATE ARE EQUAL.

An equation of value is a mathematical statement

which shows that the dated values on a
comparison date( focal date) of two sets of
payments are equal. The focal date or point is the
point where all obligations are brought through
the process of accumulation or discounting
If money is worth 5% compounded quarterly, what single payment at Solution
the end of 4 years will equitably replace the following set of obligations?
A) ₱ 30,000 due at the end of 2 years Solve for: Amount of the single
B)₱ 40,000 due at the end of 3 years with 7.5% simple interest. payment that will replace the four
C) ₱ 15,000 due at the end of 6 years with interest at 4% compounded obligations
semiannually.
D) ₱ 2,800 due at the end of 8 years with interest at 3% compounded
quarterly. Step 1. Let x pesos
represent the new payment

Step 2. Compute the

maturity value of the
obligations.
 Solution
If money is worth 5% compounded quarterly, what single payment at the end of 4
years will equitably replace the following set of obligations?
A)₱ 30,000 due at the end of 2 years
Maturity Values of Obligations
B)₱ 40,000 due at the end of 3 years with 7.5% simple interest. MV1 = ₱30 000 at the end of 2 years
C) ₱ 15,000 due at the end of 6 years with interest at 4% compounded semiannually. MV2 = ₱40 000(1 + (.075)(3))
D) ₱ 2,800 due at the end of 8 years with interest at 3% compounded quarterly. = ₱49 000 at the end of 3 years

MV3 = ₱15 000(1 + (.04/2))12

= ₱19 023.63 at the end of 6 years

MV4 = ₱2 800(1 + (.03/4))32

= ₱3 556.31 at the end of 8 years
Step 3

Place all obligations and payment

along the time diagram
30 000 49 000 x 19023.62692 3556.311428
Solution
Transfer all the values to the focal point. Values before the focal point will
Step 4
be transferred by accumulation process, while value after the focal point
will be transferred by discounting.

30 000 49 000 x 19023.62692 3556.311428

Solution
Equation:
Form the equation by separating
Step 5
the payment from the obligations,
X = 30,000 (1+ (.05/4))8 + 49,000 (1+ (.05/4))4 +
and for the unknown in the resulting 19,023.63 (1+ (.05/4))-8 + 3 556.31(1+ (.05/4))- 16
equation. = 33,134.58 + 51,496.32 + 17,223.97 +2,915.27
= ₱ 104,770.14

30 000 49 000 x 19023.62692 3556.311428

 John Puruntong owes Kevin Cosme, ₱ 22, 000 due now, and ₱ 50, 000 due in 6 years with
interest at 5 % compounded semiannually. He will be allowed to settle these obligations by paying two
equal payments in 3 and 4 years respectively. Find the size of the payments if money is worth 4.5%
compounded semiannually.

Solution

MV1= ₱ 22 000 due now.

Step 1: Let x be the payments to be Calculate the maturity MV2= 50,000 (1+(.05/2))12
made in 3 and 4 years values of the obligations. = 67 244.44
John Puruntong owes Kevin Cosme, ₱ 22, 000 due now, and ₱ 50, 000 due in 6 years with interest at 5 %
compounded semiannually. He will be allowed to settle these obligations by paying two equal payments in 3 and 4
years respectively. Find the size of the payments if money is worth 4.5% compounded semiannually.

Solution

Step 4: Place all obligations and payment along the

Transfer all the values to the focal point.
time diagram
John Puruntong owes Kevin Cosme, ₱ 22, 000 due now, and ₱ 50, 000 due in 6 years with interest at 5 %
compounded semiannually. He will be allowed to settle these obligations by paying two equal payments in 3 and 4
years respectively. Find the size of the payments if money is worth 4.5% compounded semiannually.

Solution

Step 5: Form the equation by

separating the payment from the x + x(1+(.045/2))—2 = 22 000 (1+(.045/2))6 + 47,244.44(1+(.045/2))--6
obligations, and for the unknown in the
resulting equation.
A loan of P80,000 will be discharged by a cash payment of P32,000 now; P18,000 at the end of 4 years; P6,000 at the
end of 6 years and the last payment at the end of 7 years. If money is worth 4% compounded annually, what is the size of the
last payment?