GRACE MISSION COLLEGE

Catiningan, Socorro, Oriental Mindoro

Module 2 in MATHEMATICS OF INVESTMENT

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 𝑃 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 +
𝑃𝑖 2 = 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 =
2 3
P(1+i) (1 + 𝑖) = P(1+i) . Now, following the patterns that we see, after the 𝑛 𝑡ℎ conversion, the
accumulated value becomes P(1+i )n . Thus we have the following formula:

Compound Amount
F = P(1+i )n
Where,
F = compound amount or accumulated value of P at the end of the term
j
P = present value or original principal i=
m
j =interest rate per year
i = interest rate per period n = tm
n= total number of conversions periods
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. Find the compound amount and interest:
a. If Php 2,500 is invested at 13% compounded quarterly for 12 years
Solution:
Given: 𝑃 = 2,500; 𝑗 = 13%; 𝑡 = 12; 𝑚 = 4
 𝑛 = 𝑡𝑚 = 4 ∗ 12 = 48
j 0.13
i= = = 0.0325
m 3

𝐹 = P(1+i)n= 2,500( 1.0325 )48 = Php 11, 605.47

b. If Php 3,700 is invested at 12% compounded semi-annually for 5 years

𝐹 = P(1+i)n= 3,700(1+0.06)10=¿ 3,700(1.06)10 = Php 6, 626.14

Example 2. 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%; 𝑡 = 5; 𝑚 = 4
𝑛 = 𝑡𝑚 = 5 ∗ 4 = 20
j 0.1
i= = = 0.025
m 4
F 2,850 −20
P= n = 20 = 2,850(1.025) = Php 1, 739.27
(1+i) (1+0.025)

Example 3. 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%; 𝑡 = 4; 𝑚 = 4

𝑛 = 𝑡𝑚 = 4 ∗ 4 = 16
j 0.04
i= = = 0.01
m 4
F 9,000
P= n = = 9,000(1.01)−16 = Php 7, 675.39
(1+i) (1+0.01)16

Example 4. What rate compounded annually will double any amount principal if it is invested in 6 years?
Solution:
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Let 𝑥 be the amount to be invested. 𝑚 = 1; 𝑡 = 6 ⇒ 𝑛 = 6. We want to find j.

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

Example 5. What nominal rate converted semi-annually will make Php 20,000 amount to Php 50,000 in 8.5
years?
Solution:

We want to find j. Given: 𝑚 = 2; 𝑡 = 8.5 ⇒ 𝑛 = 17.

j 17 j 17
F = P(1+i)n ⇒ 50,000 = 20,000 (1+ ) ⇒ 2.5 = (1+ ) ⇒ 𝑗 = 2(17√2.5 – 1) ⇒ j = 11.08%
1 2

Example 6. When will Php 30,000 earn interest of Php 15,000 if it is invested at the rate of 7.5% converted
annually?
Solution:
We want to find t.

Given: 𝐹 = 45,000; 𝑃 = 30,000; 𝑗 = 7.5%; 𝑚 = 1

Example 7. When will a principal double itself if the interest rate is 14% compounded quarterly?
Solution:

We want to find j. Given: 𝐹 = 2𝑃; 𝑗 = 14%; 𝑚 = 4

0.14 n
F = P(1+i)n ⇒ 2𝑃 = P(1+ ) ⇒ 2 = (1.035)n ⇒ 𝑙𝑜𝑔2 = 𝑛𝑙𝑜𝑔(1.035)
4
log 2
n= ⇒ 𝑛 = 20.1488 ⇒ t = 5.0372
log (1.035)

Sometimes we may want to compare which interest rate would provide a higher interest when their
interest payments are not the same. We then have to resort to converting these interest rates to a common
interest payment. This is the notion of effective rates of interest. For instance, which interest rate gives a
higher interest for an investment of 1 Peso (Php1), an 8% compounded semi-annually or a 7.9%
compounded monthly. If 1 peso is invested at a rate of 8% compounded semi-annually, then at the end of the

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 2
0.08
year it accumulated to 𝑆 = 1(1+ ) = 1.0816. While an investment of 1 peso at a rate of 7.9%
2
0.08 12
compounded monthly accumulates to 𝑆 = 1(1+ ) = 1.082999507.
12
The effective rate of interest of 𝑖 compounded 𝑚 times a year can be computed as:

r = (1+i)m – 1

Example 8. Determine the effective rate of interest for each of the following nominal interest rate 𝑗
compounded 𝑚 times a year.

J m j r = (1+i)m – 1
i=
m
2% 4 0.5% 4
(1+0.5 %) – 1 = 4.0625%
3% 3 1% 3
(1+1 %) – 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%

EXERCISES
1. Mary Joy deposited P14,500 in a bank that pays interest at 2% compounded annually. If no
withdrawal is made, how much does she have in her account after 5 years?
2. If the principal invested by Anika is P50,000 and the interest rate given by Peso Financial Inc. is
2.5% compounded quarterly, how much did she earned at the end of 5 years?
3. Find the compound interest earned at the end of 2 years and 5 months of an investment fund
amounting to P24,500 if it is invested at 3.5% compounded monthly.
4. If money can be invested at 7% compounded monthly, find the present value of 55,300 which is due
after 2 years and 11 months from today.
5. Jamie wants to have P45,000 in 2 years to buy a new computer. How much money should he invest
today in a fund that earns 5% compounded quarterly to get this amount after 2 years?
6. A 35,000 principal earned an interest of P8,500 at the end of 7 years. At what nominal rate,
compounded annually, was it invested?
7. At what rate compounded monthly should P25,000 be deposited in a bank to gain an interest of
P4,500 in 3 years?
8. If P48,000 is invested at the rate of 2.5% compounded quarterly, when will the compound amount be
P70,000?
9. When will P80,000 grow to P95,000 if it is invested at 4.5% compounded quarterly?

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10. If P135,650 is the maturity value of a sum invested at 3.2% compounded semi-annually for 9 years
and 6 months, find the present value and the compound interest earned.

“The only thing that compounds faster than interest is learning.” - Orrin Woodward

Prepared by:
_________________
JEORGE O. HUGNO
Instructor