Engineering Economics | Econ 121

MODULE 4: COMPOUND INTEREST AND

INTEREST RATES

Engr. Laurence A. Adviento

Instructor
Overview
Welcome! to the fourth module of this course.

For this lesson, we will be discussing what is compound interest and its applications.
Learning Objectives
By the end of this module, you should be able to:
✓ Understand interest rate and compound interest;
✓ Solve interest problems.
 Compound Interest
Interest
In calculations of compound interest, the interest for an
1. Simple interest interest period is calculated on the principal plus total
2. Compound amount of interest accumulated in previous periods.
Interest Thus, compound interest means “interest on top of
interest.”
 Future Worth

𝑭 = 𝑷(𝟏 + 𝒊)𝒏

Present Worth

𝑷 = 𝑭(𝟏 + 𝒊)−𝒏
 F = P (1 + i)n

The quantity (1 + i)n is commonly called the “single payment compound factor” and is
designated by the functional symbol F/P, i%, n. Thus,

F = P (F/P, i%, n)

The symbol F/P, i%, n is read as “F given P at i per cent in n interest periods.”
 P = F (1 + i)-n

The quantity (1 + I)-n is called the “single payment present worth factor” and is
designated by the functional symbol P/F, i%, n. Thus,

P = F (P/F, i%, n)

The symbol F/P, i%, n is read as “P given F at i per cent in n interest periods.”
⚫ For 8% compounded annually for 5 years
i = 0.08 n = 5 periods

⚫ For 8% compounded semi-annually for 5 years

0.08
i = = 0.04 n = 5(2) = 10 periods
2

⚫ For 8% compounded quarterly for 5 years

0.08
i = = 0.02 n = 5(4) = 20 periods
4
⚫ For 8% compounded monthly for 5 years
0.08
i = = 0.00667 n = 5(12) = 60 periods
12

⚫ For 8% compounded bi-monthly for 5 years

0.08
i = = 0.013 n = 5(6) = 30 periods
6
Rate of Interest
A) Nominal Rate of Interest - specifies the rate of interest and a number of interest a
number of interest periods in one year.

𝒓
𝒊 = 𝒎

where: i = rate of interest per interest period

r = nominal interest rate
m = number of compounding periods per year
If the nominal rate of interest is 10% compounded quarterly, then i = 10%/4 = 2.5%, the
rate of interest per interest period.
B) Effective Rate of Interest - is the actual or exact rate of interest on the principal during
one year.

If P1.00 is invested at a nominal rate of 15% compounded quarterly, after one year this
will become,

0.15 4
P1 1 + 4
= P1.1586

The actual interest earned is P0.1586, therefore, the rate of interest after one year is
15.86%. Hence,
 𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝐑𝐚𝐭𝐞 = 𝐅𝟏 − 𝟏 = 𝟏 + 𝒊 𝒎 − 𝟏

where: F1 = the future amount P1.00 will be, after one year
Illustrative Problems
Problem 1: Find the nominal rate which is converted quarterly could be
used instead of 12% compounded monthly. What is the corresponding
effective rate?
Problem 2: Find the amount at the end of two years and seven months if
P1,000 is invested at 8% compounded quarterly using simple interest for
anytime less that a year interest period.
Problem 3: A P2,000 loan was originally made at 8% simple interest for 4
years. At the end of this period the loan was extended for 3 years, without
the interest being paid, but the new interest rate was made 10%
compounded semi-annually. How much should the borrower pay at the end
of 7 years?
Equation of Value
An equation of value is obtained by setting the sum of the values on a certain
comparison or focal date of one set of obligations equal to the sum of the values on the
same date of another set of obligations.
Problem 4: A man bought a lot worth P1,000,000 if paid in cash. On the
installment basis, he paid a down payment of P200,000; P300,000 at the end
of one year; P400,000 at the end of three years and a final payment at the
end of five years. What was the final payment if interest was 20%.
Continuous Compounding and Discrete Payments
In discrete compounding, the interest is compounded at the end of each finite – length
period, such as a month, a quarter or a year.

In continuous compounding, it is assumed that the cash payments occur once per year,
but the compounding is continuous throughout the year.

𝑭 = 𝑷𝒆𝒓𝒏

𝑷 = 𝑭𝒆−𝒓𝒏
Problem 5: Compare the accumulated amounts after 5 years of P1,000 at
the rate of 10% per year compounded (a) annually, (b) semiannually, (c)
quarterly, (d) monthly, (e) daily, and (f) continuously.
Inflation
Inflation is the increase in the prices for goods and services from one year to another, thus
decreasing the purchasing power of money.
• For Commodity
𝑭𝑪 = 𝑷𝑪 𝟏 + 𝒇 𝒏

where PC = present cost of commodity

FC = future cost of commodity
f = annual inflation rate
n = number of years
Problem 6: An item presently cost P1,000. if inflation is at the rate of 8% per
year, what will be the cost of the item in two years?
In an inflationary economy, the buying power of money decreases as cost increase. Thus,
• For Purchasing Power of Money
𝑷
𝑭= 𝒏
𝟏+𝒇

Where F is the future worth, measured in today’s pesos, of a present amount P.

Problem 7: An economy is experiencing inflation at an annual rate of 8%. If
this continues, what will P1,000 be worth two years from now, in terms of
today’s pesos?
In interest is being compounded (If money is invested with compounding interest) at the
same time that inflation is occurring, the future worth will be,

𝑷 𝟏+𝒊 𝒏
𝑭=
𝟏+𝒇 𝒏
Problem 8: A man invested P10,000 at an interest rate of 10% compounded
annually. What will be the final amount of his investment, in terms of today’s
pesos, after five years, if inflation remains the same at the rate of 8% per
year?
Problem 8: A man invested P10,000 at an interest rate of 5% compounded
annually. What will be the final amount of his investment, in terms of today’s
pesos, after five years, if inflation remains the same at the rate of 8% per
year?
Assessment Question
References
1. Chan S. Park, Fundamentals of Engineering Economy, 3rd ed. Pearson Limited, 2013.
2. W.G. Sullivan, E.M. Wicks and C.P. Koelling, Engineering Economy, 6th ed., Pearson
Higher Education, Inc., 2015
3. L. Blank and A. Tarquin, Engineering Economy, 7th ed., McGraw-hill Companies, Inc.,
2012
4. Hipolito B. Sta. Maria; Engineering Economy; 3rd Edition
5. Nhour R. Dibangkitun, Instructor, Presentation, CE-edu
End of Module 4
Thank you!

UTAK, TIWALA at DASAL