MODULE 4

INTEREST COMPOUNDING, PRESENT VALUE, DISCOUNTING

Introduction

Today the economic global economy is so diverse, challenging and busy. To stay
competitive, the business portfolio must always provide capital for investment. This is
the reason why commercial loan takes a higher interest rates commercially that is to
provide a stable recovery factor for the investor. One financial tool to realize this is
through interest compounding.

Compounding is a process of growing. If you’re familiar with the “snowball

effect,” you already know how something can build upon itself. Compound
interest is interest earned on money that was previously earned as interest. This
cycle leads to increasing interest and results to account balances at an
increasing rate, mathematically known as exponential growth.

COMPOUND INTEREST

Compound interest is the addition of interest to the principal sum of a loan or

deposit, or in other words, interest on interest. It is the result of reinvesting interest,
rather than paying it out, so that interest in the next period is then earned on the
principal sum plus previously accumulated interest.

F = P (1 + i )n

In accounting, it is expressed as, ( F/P, i , n) read as, F given P in i interest

rate at n interest period

The quantity (𝟏 + 𝐢 )𝐧 is the “ single payment compound amount factor of P” .

It is the recovery factor on P.

r%
i=
m

F – is the compound amount in the future

P- is the present worth of F, or the principal (amount) of loan at the beginning
r – is the nominal rate of interest per year “as quoted”
m – is the number of interest period per year;
ex., monthly is equivalent to 12 interest period per year
quarterly (≈ 4); semi-annualy (≈2 ) ; annually (≈1)
daily, continuous compounding

Example:

You have $1,000 earning at 5% compounded monthly. How much will you
have after 15 years?

F = P (1 + i )n

5% 12∗15
𝐹 = $1000 (1 + ) = $ 2113.00
12

Student Assessment Question and Answer

How long for $1,000 to become $2,000 invested at 7.8% compounded

annually? Semi-annually? Quarterly? Monthly? Daily?

Answers: 9.23 ; 9.06 ; 8.97 ; 8.92 ; 8.89 (years)

Nominal Rate of Interest

Nominal rate of interest is the interest rate as quoted and is explicitly

express in the loan contract and policies.

Let us say,

ἱ = 8% compounded quarterly; the nominal rate r = 8%

8%
Hence, 𝑖 = = 2% this means that the rate of interest per
4
interest period is 2%

Furthermore, if we assume a principal value of ₱ 1.0 (one peso), the

compound amount for one year would be
 8% −4
𝐹 = ₱ 1.0 (1 + )
4

= 1.0824

Hence the interest earned, I = 1.0824 − ₱ 1.0 = ₱ 0.0824 , which means

that in effect the actual rate of interest is 8.24%. This is the effective rate of
interest.

Effective Rate of Interest

Effective rate of interest is the actual or exact interest rate on P in one year.
In our illustration, it is 8.24%

Equivalent Rates

Illustrative Problem:

1. Find the nominal rate which if converted quarterly could be used instead of 12%
compounded monthly. What is the corresponding effective rate?

Solution:

Let r = the unknown nominal rate

For two or more nominal rates to be equivalent, their corresponding effective

rates must be equal.

Nominal rate Effective rate

𝑟 4
r% compounded quarterly [1 + (4)] −1

0.12 12
12% compounded monthly [1 + ( 12 )] −1

𝑟 4
[1 + ( )] − 1 = [1 + (. 01)]12 − 1
4
𝑟
1+ = [1.1268]1/4 = 1.0303
4
 𝑟 = 0.1212 𝑜𝑟 12.12% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦

2. Find the amount at the end of two years and seven months if ₱1,000 is
invested at 8% compounded quarterly using simple interest for anytime less than a year
interest period.

Solution
8%
For compound interest: 𝑖= = 2%, 𝑛 = (2)(4) = 8 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑠
4

7 7
For simple interest: 𝑖 = 8%, 𝑛 = 2 12 𝑦𝑒𝑎𝑟𝑠; 𝑛1 = 2 ; 𝑛2 =12

𝑛
8% 8
𝐹1 = 𝑃 (1 + 𝑖) = ₱1000 (1 + ) = ₱1171.66
4
Computation for less than a year period

7
𝐹2 = 𝐹1 (1 + 𝑛𝑖) = ₱1171.66 (1 + ( ) (0.08)) = ₱1226.34
12

Student Assessment Questions and Answer

1. What effective interest rate is equivalent to 14 % per year, compounded semi-

annually? 𝐴𝑛𝑠𝑤𝑒𝑟: 𝔦 = 14.49%

2. What is the corresponding nominal rate, compounded monthly for an effective rate of
16.5%? Answer: 𝑟 = 15.37%

Present Value

Present Value refers to the value of the compound amount F at present.

Mathematically, the value of the principal is equal to the value of the present worth of F
at year 0. And it should be noted that, the present worth of F after sometime within the
period of loan is not equal anymore with the principal. It has earned interest after year
zero. The difference can be accounted as the time value of money.

𝐏 = 𝐅 (𝟏 + 𝐢 )−𝐧
The quantity (1 + 𝑖 )−𝑛 in accounting, is referred to as “single payment present
worth factor.

The present worth P is said to be the discounted value of F.

Example:

What is the present worth of ₱50,000.00 invested at 12% compounded

quarterly, 3 years ago?

P = F (1 + i )−n using this formula

.12 −3∗4
P = ₱50,000.00 (1 + ) = ₱35,068.99
4

Student Assessment Question

Answer the problem. Show your solution.

1. A construction company has an option to purchase a certain bulldozer for $61,000 at

any time between now and 4 years from now. If the company plans to purchase the
dozer 4 years from now, the equivalent present amount that the company is paying
for the dozer at 6% per year interest is closest to

(a) $41,230
(b) $46,710
(c) $48,320
(d) Over $49,000
2. The cost of tuition at a certain public university was $160 per credit-hour 5 years ago.
The cost today (exactly 5 years later) is $235. The annual rate of increase is closest to
(a) 4%
(b) 6%
(c) 8%
(d) 10%

Answers: 1. C 2. C
DISCOUNT

Discount is the difference between the money’s future worth and present worth.
Cash discount (or amount of discount) is a deduction to the future value of the loan
granted. Normally, it is given as incentive for advance payment for advance payment.

D =F−P

The formula being presented provides idea to the borrower how much is the value
of his earlier payment. However, the amount of cash discount that the debtor may
receive is still dependent upon how much the creditor wants to give for the early
payment.

In reality, the additional professional services and its expenses, like, preparation
and acquisition of legal documents to process the execution of advance payment, is
shouldered by the borrower. Hence it increases the net of the present value and in
effect, decreases the cash discount.

If the creditor is the one who encourages the debtor for early payment, then the
discount amount is offered at the utmost value.

Example

A teacher gets a loan of ₱10,000.00 for 18 months from a bank. The bank
discounted the loan and gave her ₱9,000.00. What was the rate of discount? the rate of
interest? rate of interests for one year?
₱1000
 Rate of discount (d) 𝑑 = ₱10000 = 10%

The rate of discount takes into account the point of view of the bank who
applies the discounting
₱1000
 Rate of interest (r) 𝑟 = = 11.11%
₱9000

The rate of interest considers the point of view of the borrower

 18
 The rate of interest per year: ₱1,000 = (₱9000) r ( )
12

𝑟 = 7.4%

The rate of interest consider the time value of money, significantly, the
money’s worth for the complete term of the loan

Example:

What is the future worth of ₱10,000 invested at 8% compounded-quarterly

for 3 years? after one year?

8% 12
𝐹 = ₱10,000 (1 + )
4

= ₱12,682.42

8% −8
𝑃 = 12,682.42 (1 + )
4

= ₱10,824.32 future worth after the first one year

Let us put more meaning to the problem, say, the borrower wants to terminate
the loan after two years, how much discount should be given to him? How much will be
the borrower’s total payment?

8% −4
Amount to be discounted = ₱12,682.42 [1 − (1 + ) ]
4

= ₱965.83

8% −4
Discount = ₱965.83 [1 − (1 + ) ]
4
= ₱ 73.55

Payment = ₱12,682.42 - ₱73.55

= ₱12,608.87

Rate of discount (𝑑) is the discount on one unit of principal per unit time
8% 𝑑
ἱ = = 2% 𝑖 = 1−𝑑 ; 𝑑 = 1 − (1 + 𝑖)−1
4

Base on the formula: d = 1.96%

Discount rate is normally lower than effective rate
Student Assessment Question

If money’s worth is 7% today and you are looking for a property worth ₱1M. How
much is the discount when it was sold to you, after 8 months, for only ₱975,000.00. What
was the rate of discount? the rate interest?

Answer:

D= ___________ (Answer is not provided; when you got d and r correctly, it follows
that your answer is correct)

d = 6.8% ; r = 7.3%

References:

Blank L.T., Tarquin A., Engineering Economy,6th edition, McGraw-Hill, 2010.

Engineering Economy, 3rd edition. Matias Arreola
Engineering Economy, 4th edition. Sta Maria and Matias