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Compound Interest

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9 views

Compound Interest

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PTX PH
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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COMPOUND

INTEREST
Compound Interest is a
kind of interest that follows
the principle “interest on
top of interest”, that is both
the principal amount and
the interest earned
interest. It can be denoted
as:
F = P (1 + i) n

Where:
F = Future Amount
P = Principal Amount
i = Interest Period
n = period of time
PERIOD PRINCIPAL FUTURE WORTH
1 P P + PI = P(1 + I)
2 P(1 + i) P(1 +i) * P(1 + i) = P(1 + i)2
3 P(1 + i)2 P(1 + i)2 * P(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 Php 100 for the last 118 years. Neither
he nor your previous family members paid it
ever since. Today, how much money do you
have to pay for his ( grandfather ) debt if it has a
simple interest rate of 10% per year? Compare
the results if the rate of interest is compounded
annually.
N P F
1 P P(1+in)
2 P P(1+2n)
3 P P(1+3n)

SIMPLE:
COMPOUND:
Example: What is the future worth of Php
1000 if it was invested in the year 1904 at :
a.) simple interest rate of 12% per year
b.) compound interest of 12% compounded
annually?
A) SIMPLE:
B) COMPOUND:
Cash Flow Diagram

I = 12% per year (compounded annually)


F5 = (1,000,000)(1.12)5 + (200,000)(1.12)2 – (500,000)
(1.12)3
F5 = 1,310,757.768
Example:

B3 = 1,000,000 (1+0.10)3 – 500,000 = 831,000


B5 = 831,000 (1+ 0.1)2 – 300,000 = 705,510
B7 = 705,510 (1+0.1)2 = 853,667.10
EFFECTIVE
RATE VS.
NOMINAL
RATE
RATE OF INTEREST
A. Effective rate – Specifies the exact
rate of interest on the principal during a
year; involves problems with interests
that are compounded yearly

Feff = P
B. 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-
annually.

Fn = P
Example
If i = 10% per year compounded quarterly,
i will be iQ = = = 2.5%
in = 2.5 % per quarter compounded Quarterly

Quarters P F
1 100 100(1+0.025)= 102.5
2 102.5 102.5(1+0.025)= 105.0625
3 105.0625 105.0625(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:
Solve the future worth of Php 100 with an interest
of 12% per year compounded quarterly.
Solution:

(Using nominal rate) (Using effective rate)


Ieff =
F = 100 x Ieff = 12.55%
F = 112.55
F = 100 x F = 112.55
Note:
12% comp. Monthly >12% comp. Quarterly>12% comp. Semi-annually > 12% comp.
Annually

Ieff = - 1
Ieff = ) - 1
12% compounded monthly =12.68% compounded yearly
12% compounded quarterly =12.55% compounded yearly
12% compounded Semi-annually =12.38% compounded yearly
12% compounded annually =12% compounded yearly
Example:
What is the equivalent of 12% per year
compounded quarterly if converted to compounded
monthly?
Solution:
Fq = Fm
P(1+)q*4 = P(1+)3
(1+) = (1+ )3
=

12% per year compounded Quarterly = 11.88% per


year compounded monthly
Example:
Solve for the future worth of Php 1,000,000 invested
today after 10 years at interest of :
A.24% per year compounded monthly
B.24% per year compounded annually

Solution
A. B.
F= (1,000,00010*12 F = (1,000,000) (1 +
F = 10,765,163 0.24)10
F = 8,594,425
21

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?
22
GIVEN:
rate of interest compound quarterly: 4%
Principal Amount = 20,000 deposited
SOLUTION:
A = P(1+ r/n)nt

First quarter deposit, t = 1 year:


A1 = (20,000(1 = 0.04/4))4x1 = 20,812.08
Second quarter deposit, t = ¾ of 1 year:
A2 = (20,000(1 = 0.04/4))4x(3/4) = 20,606.02
Third quarter deposit, t = ½ of 1 year:
A3 = (20,000(1 = 0.04/4))4x(1/2) = 20,402
Fourth quarter deposit, t = ¼ of 1 year:
A4 = (20,000(1 = 0.04/4))4x(1/4) = 20,200
23

TOTAL = 20,812.08 + 20,


606.02 + 20,402 + 20,200

= 82,020.04
CONTINUOUS
COMPOUNDING
Continuous compounding is the mathematical limit
that compound interest can reach if its 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.

F = Pe in
Example: A person invested 800,000.00
in an account offering 4% compounded
continuously. He also invested 500,00.00
in a separate account offering 10%
compounded continuously. When will the
total amounts in both accounts be equal?
When will the total amount in the second
account be 50% more than the amount in
the first account?
SOLUTION:

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

F1 = F2 F2 is 50% more than F1


800,000e0.04t = 500,000e0.1t
(800,000/500,000) e0.04t = e0.1t F2 = 1.5 F1
1.6 = e0.1t-0.04t 500,000e0.1t = (1.5) 800,000 e0.04t
ln(1.6) = 0.06t 2.4 = e0.1t-0.04t
t = ln(1.6/0.06) ln(2.4) = 0.06t
t = 7.8 years t = ln(2.4/0.06)
t = 14.6 years
Example: What will be the final payment after 5 years if a loan ₱
1,000,000 at an interest rate of 18% compounded semi-annually was
paid on instalment basis as shown on the cash flow diagram below .

1M
i= 18%

100K
200K
300K 400K
B=?
SOLUTION:
= 933,972.91 = 1,000,000 = 1,818,100 – 100,000
= 1,088,100

= 1,088,100 = 1,092,771.61 – 200,000

= 1,092,771.61

= 1,092,771.61 = 1,298,321.95 – 300,000


= 998,321.9498

= 998,321.9498 = 1,186,106.309 – 400,000


= 786,106.3086

= 786,106.3086
= 933,972.71
5M

1M 1M
2M 2M

B=?

Example: Determine the value of B, if


a. i=12% compounded monthly
b. i= 12% compounded quarterly
c. i= 12% compounded semi-annually
4
SOLUTION:
12% COMPOUNDED MONTHLY 2,000,000
2,253,650.06
F= 5,000,000
F= 9,083,483.493 B= F – ( + )

= 1,000,000 B = 9,083,483.493 – (1,612,226.078 +


= 1,612,226.078 2,861,537.567 + 1,269,734.649 +
2,253,335.06)
2,000,000
2,861,537.567 B = 1,086,335.139
1,000,000
1,269,734.649
12% COMPOUNDED QUARTERLY 2,000,000
2,251,017.62
F= 5,000,000
F= 9,030,556.173 B= F – ( + )

= 1,000,000 B = 9,030,556.173 – (1,604,706.439 +


= 1,604,706.439 2,861,521.774 + 1,266,770.081 +
2,251,017.62)
2,000,000
2,861,521.774
B = 1,056,540.259
1,000,000
1,266,770.081
6

12% COMPOUNDED SEMI-ANUALLY 2,000,000


2,247,200
F= 5,000,000
F= 8,954,238.483 B= F – ( + )

= 1,000,000 B = 8,954,238.483 – (1,593,848.075 +


= 1,593,848.075 2,837,038.225 + 1,262,476.96 +
2,247,200)
2,000,000
2,837,038.225 B =1,013,675.223
1,000,000
1,262,476.96
i=10% i=10% i=10% i=10% i=10%

Compounded Compounded Compounded Compounded Compounded


annually monthly quarterly Semi- monthly
annually

1 2 3 4 5 6 7 8 9 ……………..
Years 20

10,000 10,000 10,000 10,000 10,000 F=?


Solution:
F= P( F4= 55,045.13(1+
F1=10,000( =66,907.70+10000
=12,100+10,000 =76,907.70
=22,100

F2= 22,100 (1+ F5= 76,907.70 (1+


=26,970.64+10000 F5= 254,076.06
=36,970.64

F3= 36,970.64(1+
=45,045.13+10000
=55,045.13
What will be the future worth after 10 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?
SEATWORK
First year Fourth year
F=20,000( F=127,539.13 (
= 22,400 = 143,302.96

Second year Fifth to


Tenth year
F=42,400( F=193,302.96 (
=47,777.38
= 388,963.53

Third year
F=77,777.38(
=87,539.13

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