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COMPOUND INTEREST
ENGINEERING ECONOMY

BRAZAL | CASEM | ROSELLO

COMPOUND INTEREST
Compound interest is a kind of
interest that follows the principle, “interest
on the top of an interest”, that is both the
principal amount and the interest earned
interest. It can be denoted as:

Where
F  P (1  i ) n F = Future Amount
P = Principal Amount
i = interest rate
n = period of Time
Period Principal Future Worth
1 P P+Pi = P(1+i)
2 P(1+i) P(1+i) * (1+i) = P(1+i)2
3 P(1+i)2 P(1+i)2 (1+i) = P(1+i)3

n P(1+i)n-1 P(1+i)n

So,
• F = P(1+i)n - single payment compounded
amount factor
• P = F(1+i)-n - single payment present worth
factor
 SIMPLE INTEREST VS.
COMPOUND INTEREST
Example: You have a grandfather who
owned a debt of P100 for thee last 118
years. Neither he nor his family members
payed it ever since. Today, how much
money do you have topay for his own debt,
if it has a simple interest rate of 10% per
year? Compare the results if the rate of
interest is compounded annually.
 Simple Interest
Period Principal Future Worth
1 P P+Pi = P(1+i)
2 P(1+i) P(1+i) * (1+i) = P(1+i)2
3 P(1+i)2 P(1+i)2 (1+i) = P(1+i)3

F = P(1 + in)
10
F = 100 *{1  [ (118 yrs )]}
100 yrs
F  P1,280
Compound Interest

F  P(1  i ) n

0.10 118
F  100 *[1  ( )]
100
F  P7,661,906,514
Example

What is the future worth of

P1000, if it was borrowed on the
year 1980 at: (a) simple interest
of 12% per year compared to (b)
compound interest of 12%
compounded annually
Example
F = P(1 + in)
F = 100 *[1  0.12(119)]
F  P15,280

F  P(1  i) n

F  100 * (1  i) 119

F  P719,357,370.50
EFFECTIVE RATE
VS.
NOMINAL RATE
EFFECTIVE RATE VS.
NOMINAL RATE
Rate of Interests
Effective rate – specifies the exact
rate of interest on the principal during a
year; involves problems with interests that
are compounded yearly.

Feff = P(1+ieff)n
EFFECTIVE RATE VS.
NOMINAL RATE

Nominal rate – specified the rate of

interest and a number of interest periods in
one year; involves problems with interests
that are compounded monthly, quarterly
and semi-anually.

Fn = P[1+(in/m)]n*m
 EFFECTIVE RATE VS.
NOMINAL RATE

Example,
If i=10% per year compounded yearly, i will be

iQ = i/4 = 10%/4 = 2.5%.

in = 2.5% per quarter compounded quarterly

EFFECTIVE RATE VS.
NOMINAL RATE
Quarters P F
1 100 100(1+0.025)=102.5
2 102.5 102.5(1+0.025)=105.0625
3 105.0625 105(1+0.025)=107.689
4 107.689 107.69(1+0.025)=110.38
The effective rate of 10% compounded quarterly is 10.38%.
Example: What is the equivalent of
12% per year compounded quarterly if
converted to compounded monthly?
12% Compounded Monthly = 12.68%
Compounded Annually
12% Compounded Quarterly = 12.55%
Compounded Annually
12% Compounded Semi-Annually = 12.36%
Compounded Annually
12% Compounded Annually = 12%
Compounded Annually
Example: What is the equivalent of
12% per year compounded quarterly if
converted to compounded monthly?
Example: Solve for the future worth of
Php 1,000,000.000 invested today after 10
years at interest of:
(a) 24% per year compounded monthly
(b) 24% per year compounded annually
Example
A bank saving account offers 4%
compounded on a quarterly basis. A
customer deposit 20,000.00, in this
type of account, at the start of each
quarter starting with the first deposit
on the first of January and the fourth
deposit on the first of October. What
is the total amount in his account at
the end of the year?
First quarter deposit, 𝑡 = 1 𝑦𝑒𝑎𝑟:
0.04 (4×1)
𝐴1 = [20,000 1 + ]
4
= 20,812.08
3
Second quarter deposit, 𝑡 = 𝑜𝑓 1 𝑦𝑒𝑎𝑟:
4

0.04 (4×3)
𝐴2 = [20,000 1 + ] 4
4
= 20,606.02
 1
Third quarter deposit, 𝑡 = 𝑜𝑓 1 𝑦𝑒𝑎𝑟:
2

0.04 (4×1)
𝐴3 = [20,000 1 + ] 2 = 20,402
4
1
Fourth quarter deposit, 𝑡 = 𝑜𝑓 1 𝑦𝑒𝑎𝑟:
4

0.04 (4×1)
𝐴4 = [20,000 1 + ] 4 = 20,200
4
 1
Third quarter deposit, 𝑡 = 𝑜𝑓 1 𝑦𝑒𝑎𝑟:
2

0.04 (4×1)
𝐴3 = [20,000 1 + ] 2 = 20,402
4
1
Fourth quarter deposit, 𝑡 = 𝑜𝑓 1 𝑦𝑒𝑎𝑟:
4

0.04 (4×1)
𝐴4 = [20,000 1 + ] 4 = 20,200
4
Example
The first credit card that you got charges
12.49% interest to its customers and
compounds that interest monthly. Within
one day of getting your first credit card, you
max out the credit card limit by spending
12,000.00. If you do not buy anything else
on the card and you do not make any
payments, how much money would you
owe the company after 6 months?
Given:
P = 12,000.00
i = 12.49 %
n = 6 months
0.1249 (6)
𝐹 = 1200(1 + )
12
 CONTINUOUS
COMPOUNDING
 CONTINUOUS
COMPOUNDING
Continuous compounding is the
mathematical limit that compound interest
can reach if it’s calculated and reinvested
into an account’s balance over a
theoretically infinite number of periods.
While this is not possible in practice, the
concept of continuously compounded
interest is important in finance.
Example
A person deposited 800,000.00 in a
5% account compounded continuously. In a
second account, he deposited 500,000.00
in a 10% account compounded
continuously. When will the total amount in
the second accounts be 50% more than the
total amount in the first account?
F1 = 800,000e0.04t
F2 = 500,000e0.1t

F1 = F2
800,000e0.04t = 500,000e0.1t

F1 = (800,000/500,000)e0.04t = e0.1t
1.6 = 𝑒 (0.1𝑡−0.04𝑡)
ln 1.6 = 0.06t
t = ln (1.6/0.06)
T = 7.8 years

F2 is 50% more than F1

F2 = 1.5F1
0.04𝑡 0.1𝑡
(1.5)800,000𝑒 = 500,000𝑒
𝑒^(0.1𝑡−0.04𝑡)=2.4
0.06t = ln 2.4
t = ln(2.4/0.06)
t = 14.6 years
Cash Flow Diagram
i = 12% per year
(compounded annually)

Fs = (1,000,000)(1.12)5 +
(200,000)(1.12)2 -
3
(500,000)(1.12)

Fs= 1,310,757.768
Cash Flow Diagram
B3 = 1,000,000 (1 + 0.10)3 -
500,000 = 831,000

B5 = 831,000 (1 + 0.10)2 -
300,000 = 705,510

B7 = 705,510 (1 + 0.10)2 =
853,667.10
Example
What will be the final
payment after 5 years if a loan of
1,000,000 at an interest rate of
18% compounded semi-annually
was paid on installment basis as
shown on the cash flow diagram
below.
Cash Flow Diagram
 0.18 2
𝐵1 = 1,000,000 (1 + ) =
2
1,188,100 – 100,000
𝐵1 = 1,088,100
0.18 2
𝐵2 = 1,088,100 (1 + ) =
2
1292771.61 – 200,000
𝐵2 = 1,092,771.61
0.18 2
𝐵3 = 1,092,771.61 (1 + ) =
2
1,298,321.95 – 300,000
𝐵3 = 998,321.9498
 0.18 2
𝐵4 = 998,321.9498 (1 + ) =
2
1,186,106.309 – 400,000
𝐵4 = 786,106.3086
0.18 2
𝐵𝑁 = 786,106.3086 (1 + )
2
𝐵𝑁 = 933,972.91
Example
Determine the value of B, if

a. i = 12% compounded monthly

b. i = 12% compounded quarterly
C. i = 12% compounded semi-
annually
Cash Flow Diagram
(1) 12% COMPOUNDED
MONTHLY
0.12 5(12)
F = 5,000,000 (1 + )
12
F = 9,083,483.493
0.12 4(12)
F1 = 1,000,000 (1 + )
12
F1 = 1,612,226.078
0.12 3(12)
F2 = 2,000,000 (1 + )
12
F2 = 2,861,537.567
0.12 2(12)
F3 = 1,000,000 (1 + )
12
F3 = 1,269,734.649
 0.12 1(12)
F4 = 2,000,000 (1 + )
12
F4 = 2,253,650.06
B = F – (F1 + F2 + F3 + F4)

B = 9,083,483.493 –
(1,612,226.078 + 2,861,537.567 +
1,269,734.649 + 2,253,650.06)

B = 1,086,335.139
(2) 12% COMPOUNDED
QUARTERLY
0.12 5(4)
F = 5,000,000 (1 + )
4
F = 9,030,556.173
0.12 4(4)
F1 = 1,000,000 (1 + )
4
F1 = 1,604,706.439
0.12 3(4)
F2 = 2,000,000 (1 + )
4
F2 = 2,851,521.774
0.12 2(4)
F3 = 1,000,000 (1 + )
4
F3 = 1,266,770.081
 0.12 1(4)
F4 = 2,000,000 (1 + )
4
F4 = 2,251,017.62

B = F – (F1 + F2 + F3 +F4)

B = 9,030,556.173 –
(1,604,706.439 + 2,851,521.774 +
1,266,770.081 + 2,251,017.62)

B = 1,056,540.259
3.) 12% COMPOUNDED SEMI-
ANNUALLY
0.12 5(2)
F = 5,000,000(1+ )
2
F= 8,954,238.483
0.12 4(2)
F1 = 1,000,000(1+ )
2
F1 = 1,593,848.075
0.12 3(2)
F2 = 2, 000,000(1+ )
2
F2= 2, 837, 038.225
0.12 2(2)
F3 = 1, 000,000(1+ )
2
F3 = 1,262,476.96
 0.12 1(2)
F4 = 2, 000,000(1+ )
2
F4 = 2,247,200

B = F-(F1 + F2 + F3 + F4)
B = 8,954,238.483 -
(1,593,848.075 +
2,837, 038.225 + 1,262,476.96 +
2,247,200)
B = 1,013,675.223
Example
F= P(1+i)𝑛
F1 = 10,000(1+0.1)2
= 12,100 + 10,000
= 22,100
0.1 2𝑥12
F2 = 22,100(1+ )
12
= 26,970.64 + 10000
= 36,970.64
0.1 2𝑥4
F3 = 36,970.64 (1+ )
4
= 45,045.13 + 10,000
= 55,045.13
 0.1
F4 = 55,045.13 (1+ ) 2𝑥2
4
= 66,907.70 + 10,000
= 76,907.70
0.1 12𝑥12
F5 = 76,907.70 (1+ )
2
F5 = 254,076.06
Example
What will be the future worth after ten
years if interest on the first year is 12%
compounded annually, 12% compounded
monthly on the second year, 12%
compounded quarterly on the third year,
12% compounded semi-annually on the
fourth and 12% compounded semi-annually
on the fifth up to tenth year?
CASH FLOW DIAGRAM
F = P(1+i)𝑛
F1 = 20,000(1+0.12)
= 22400 + 20,000
= 42,400
0.1 12
F2 = 42400(1+ )
12
= 46839.834 + 30000
= 76839.83
0.12 4
F3 = 76839.83 (1+ )
4
= 86483.90 + 40,000
= 126483.90
 0.12
F4 = 126483.90 (1+ )2
2
= 142117.31 + 50,000
= 192,117.31
0.12 2𝑥6
F5 = 192,117.31 (1+ )
2
F5 = 386,577.77
Example
An E-Vehicle Company manufactures
high-performance battery electric vehicles.
An engineer evaluates bids for new-
generation machinery to be directly linked
to the automated manufacturing of high-
precision vehicle components. Three bids
include the interest rates that vendors will
charge on unpaid balances. To get a clear
understanding of finance cost, the
management asked the engineer to
determine the effective semiannual and
annual interest rates for each bid.
The bids are as follows:
Bid 1: 9% per year, compounded quarterly
Bid 2: 3% per quarter, compounded quarterly
Bid 3: 8% per year, compounded monthly

Which bid has the lowest effective

annual rate?
 0.09 4
𝑖𝑒𝑓𝑓 1 = (1 + ) − 1 = 0.09308
4
𝑖𝑒𝑓𝑓(1) = 9.31%
0.12 4
𝑖𝑒𝑓𝑓 2 = (1 + ) − 1 = 0.1255
4
𝑖𝑒𝑓𝑓(2) = 12.55%
0.088 12
𝑖𝑒𝑓𝑓 3 = (1 + ) −1
12
= 0.0916
𝑖𝑒𝑓𝑓(3) = 9.16%

Therefore, Bid 3 has the lowest

annual rate.
Example
At a certain interest rate
compounded quarterly, Php 1,000 will
amount to Php 4,500 in 15 years.
What is the amount at the end of 10
years?
Given:
For 15 years: n= 4(15) = 60 periods
P= Php 1000
Formula: F = P 1 + 𝑖 𝑛
F= Php 4500

Find: interest rate

4500 = 1000(1 + 𝑖)60
(1 + 𝑖)60 = 4.5
1
1+𝑖 = 4.560
𝑖 = 𝟎. 𝟎𝟐𝟓𝟑𝟖 = 𝟐. 𝟓𝟑𝟖%
Given:
For 10 years: n= 4(10) = 40 periods
P= Php 1000
Formula: F = P 1 + 𝑖 𝑛
F= Php 4500

Find: amount at the end of 10 years

F = 1000(1 + 0.25382)60
F = 1000(1.2538)60
F = 1000(2.72568)
F = 𝑷𝒉𝒑 𝟐, 𝟕𝟐𝟓. 𝟔𝟖