Compound Interest

​ Whenever the interest charge for any interest period is based on the remaining principal amount
plus any accumulated interest chargers up to the beginning of that period, the interest is said to
be compound.
​ Compound interest calculations apply to investments where the amount of interest is calculated
on the present balance of the account.

Sample Problem.

For instance, if you invested ₱10,000 in a bank with an interest rate of 10% compounded annually
(once per year), then in the first year of your investment you would earn ₱1,000. If this were simple
interest, you would continue to earn ₱1,000 per year for the period of your investment. However,
since the interest is compounded, you earn interest on your interest. The amount of compound
interest for the first interest period is the same as for simple interest. However, for further interest
periods, the amount of compound interest increases to an amount greater than simple interest.

To illustrate:

Simple Interest Compound Interest

Year 1 ₱100 x 10% =₱ 1000 ₱10000 x 10% = ₱ 1000
Year 2 ₱100 x 10% =₱ 1000 ₱11000 x10% = ₱ 1100
Year 3 ₱100 x 10% =₱1000 ₱12100 x 10% = ₱ 1210
Total Interest ₱3000 ₱3310

From the illustration above, you can see that under simple interest payments, a yearly sum of
₱1,000 is gained through interest. For each year of the loan period, ₱1,000 is earned. However,
under compound interest payments, the yearly interest is added to the principle for the next period.
This has the effect of increasing interest earned each year for the duration of the period (note: in
example above, ₱3310 earned from compound interest versus ₱3,000 earned from simple interest).

NOTATION AND CASH FLOW DIAGRAMS

Notations used in formulas for compound interest formulas

i = interest rate per interest period

N = number of compounding periods
present sum of money; the equivalent worth of one or more cash flows at
P = a
reference point in time called the present
F = future sum of money; the equivalent worth of one or more cash flows at a
reference point in time called the future
A =end-of-period cash flows in a uniform series continuing for a specified
number of periods; starting at the end of the first period and continuing
through the last period
Cash Flow Diagram

​ Cash flow is the difference between total cash coming (inflows or cash receipts) and total cash
going out (outflows or cash disbursements) for a given period of time. Cash flow provides a
means for planning the most effective use of your cash.
​ A cash flow diagram is a picture of a financial problem that shows all cash inflows and
outflows plotted along a horizontal time line. It is used to visualize cash flow: individual cash
flows are presented as vertical arrows along a horizontal time scale.

The cash flow diagram employs several conventions:

1. The horizontal line is a time scale, with progression of time moving from left to right
divided into equal periods such as days, months, or years.
2. The arrows signify cash flows and are placed at the end of the period. Funds that you pay out
such as savings deposits or lease payments are negative cash flows that are represented by
downward arrows Funds that you receive such as proceeds from a mortgage or withdrawals
from a saving account are positive cash flows represented by upward arrows.
3. The cash flow diagram is dependent on the point of view (e.g. lender versus borrower
viewpoint).

Example: You are 40 years old and have accumulated $50,000 in your savings account. You can
add $100 at the end of each month to your account which pays an annual interest rate of 6%
compounded monthly. Will you be able to retire in 20 years?

The time line is divided into 240 monthly periods (20 years times 12 payments per year) since the
payments are made monthly and the interest is also compounded monthly. The $50,000 that you
have now (present value) is a negative cash outflow since you will treat it as though you were just
now depositing it into the account. It is represented with a downward pointing arrow with its base at
the beginning of the first period. The 240 monthly $100 deposits are also negative outflows
represented with downward pointing arrows placed at the end of each period. Finally you will
withdraw some unknown amount (the future value) after 20 years. Represent this positive inflow
with an upward pointing arrow with its base at the very end of the last period.

This diagram was drawn from your point of view. From the bank's point of view, the present value
and the series of deposits are positive cash inflows, and the final withdrawal of the future value will
be a negative outflow.
 INTEREST FORMULAS FOR DISCRETE CASH FLOWS

Single Cash Flows / Payments

F = Future equivalent (Find)

i = interest rate per period

1 2 3 N-2 N-1 N

Period

P = Present equivalent (Given)

Figure shows a cash flow diagram involving a present single sum, P and a future single sum F,
separated by N periods with interest at i% per period. The dashed arrow indicates the quantity to be
determined.

Finding F When Given P

F = P(1 + i)N

The quantity (1+i)N is commonly called the single payment compound amount factor. The
functional symbol of (1+i)N is (F/P, i%, N). Therefore the equation can be expressed as
 F = P (F/P, i%, N)
where the factor in parentheses is read “find F given P at i% interest per period for N interest
periods.”

Problem. Find the compound amount of ₱ 1,000 in 4 years at 8% interest compounded annually.

F = P(1 + i)N
F = 1 000 × (1 + 0.08)4 = 1 000 × 1.3605 = ₱ 1,360.5

Finding P When Given F

P = F (1 / 1 + i)N = F(1+i%) -N

The quantity (1+i)-N is called the single payment present worth factor. The functional
symbol for this factor is (P/F, i%, N). Hence
P = F (P/F, i%, N)

Problem. How much should be invested now (at present time) at 8% compound interest per
year, in order to receive ₱1,360.5 within 4 years; or what is the present equivalent worth of US$
1 360.5 to be received four years in the future?

P = 1,360.5 x (1/1+.08)-4 = 1,360.5 × (1/1.3605) = 1,360.5 × 0.73503 = ₱ 1,000

Uniform Series

Uniform series mean uniform amount of money, A, occurring at the end of each period for n
periods with interest at i% per period. A uniform series is often called annuity.

Annuity - is a bunch of structured payments or equal payments made regularly, like every
month or every week.

Other assumptions:

1. P (present worth) occurs at one interest period before the first A.

2. F (future worth) occurs at the same time as the last and n interest periods after P.
3. A (annual worth) occurs at the end of periods 1 through N, inclusive.
 A A A A A

N
1 2 3 N -1

Perio
d
i = interest rate per period
P = Present equivalent F = Future equivalent
(FIND) (FIND)

Figure shows a general cash flow diagram relating uniform series (ordinary annuity) to the
present equivalent and future equivalent values.

Finding F When
Given A

(1 + i)N - 1
F= A
i

The quantity {[(1 + i)N – 1] / i} is called the uniform series compound amount factor.
The functional symbol for this factor is (F/A, i%, N). Hence,

F = A (F/A, i%, N)

Problem. Example: If you deposit ₱10,000 in a bank every year for 18 years at interest rate 8%.
Then this amount becomes

F = 10,000 x {[(1 + 0.08)18 – 1] / 0.08]} = ₱374; 502:

What this amount will be if the interest rate is 10%? What if N = 20?

Finding P When Given A

(1 + i)N - 1
P=A
i(1 + i)N

The equation in bracket is called the uniform series present worth factor. And the
functional symbol for this factor is (P/A, i%, N). Therefore:

P = A (P/A, i%, N)

Problem. If a certain machine undergoes a major overhaul now, its output can be increased by
20%
- which translates into additional cash flow of ₱20,000 at the end of each year for five
years. If i = 15% per year, how much can we afford to invest to overhaul this machine?

P = 20,000 x {[(1 + 0.15)5 – 1] / 0.15 (1 + 0.15)5 = ₱20,000 (3.3522) = ₱67,044

Problem. You are running a bank. A customer agrees to pay you ₱100,000 each year with annual
interest rate of 10% for 5 years. How much money will you lend to him?

P = 100,000 x (P/A, i%, N) = ₱379,080

Finding A When Given F

i
A= F
(1 + i)N - 1

This is the relation for finding the amount, A, of a uniform series of cash flows occurring
at the end of N interest periods that would be equivalent to its future equivalent value occurring
at the end of the last period. The quantity in bracket is called the sinking fund factor and the
functional symbol for this factor is (A/F, i%, N). Hence, A = F (A/F, i%, N)
Problem. How much do you need to invest every year in a bank with an interest rate of 8% in
order to yield $1 million in 30 year?

A = 1,000,000 x (A/F, 8%; 30) = $8,827

How much this will be if the interest rate is 10%?
Problem. An enterprising student is planning to have personal savings totaling ₱1,000,000
when she retires at age 65. She is now 20 years old. If the annual interest rate will average 7%
over the next 45 years on her savings account, what equal end-of-year amount must she save to
accomplish her goal.

A = ₱1,000,000 (A/F, 7%, 45) = $1,000,000 (0.0035) = ₱3,500

Finding A When Given P

i (1 + i)N
A=P
(1 + i)N - 1

The quantity in bracket is called the capital recovery factor and the functional symbol
for this factor is (A/P, i%, N). Therefore,

A = P (A/P, i%, N)

Exercise Problem: You want to buy an apartment at the price of 4 million Hong Kong dollars.
You will do this with a mortgage from a bank at the annual interest rate 8% for 30 years.
What is your annual payment?
 A = 4,000,000 (A/P, 8%, 30) = $355,200
($29,600 per month).

What if the interest rate is 6%?

What if the mortgage is for 20 years? 10 years?

Table 1. Discrete Compounding Interest Factors and Symbols

To Given: Factor by which to Factor Name Factor

Find: multiply “Given” Functional
Symbol
For Single Cash
Flow
F P (1 + i)N Single payment compound (F/P, i%, N)
amount
P F 1 / (1 + i)N Single payment present worth (P/F, i%, N)
For Uniform series (annuities)
F A [(1 + i)N – 1] / i Uniform series compound (F/A, i%, N)
amount
P A [(1 + i)N – 1] / i(1 + Uniform series present worth (P/A, i%, N)
i)N
A F i / [(1 + i)N – 1] Sinking Fund (A/F, i%, N)
i(1 + i)N / [(1 + i)N –
A P Capital recovery (A/P, i%, N)
1]
Discrete Compounding – it means that the interest is compounded at the end of each finite
length
INTEREST FORMULAS FOR DISCRETE COMPOUNDING AND DISCRETE CASH FLOWS
period, such as month or a year. The formulas also assume discrete (lump-sum) cash flows
spaced at the end of equal time intervals of a cash flow diagram.

Deferred Annuities (Uniform Series)

Ordinary Annuity – is one where the equal payments are made at the end of each payment
period starting from the first period.

Deferred Annuity – is one where the payment of the first amount is deferred a certain number
of periods after the first.
Time Present

0 1 2 J-1 J J+1 J+2 J+3 J+4 N-1 N

Period

i=%

If the annuity is deferred J periods (J<N), the entire framed ordinary annuity has been forward
from “time present”, or “time 0”, by J periods. Since the annuity deferred for J periods, the first
payment is made at the end of period (J + 1), assuming that all periods involved are equal in
length.

The present equivalent at the end of period J of an annuity with cash flow of amount A is A
(P/A, i%, N-J). The present equivalent of the single amount A (P/A, i%, N-J) as of time 0 will
then be
A (P/A, i%, N-J) (P/F, i%, J)

Problem. Suppose that a father, on the day his son is born wishes to determine what lump
amount would have to be paid into an account bearing interest of 12% per year to provide
withdrawals of ₱2,000 on each of the son‟s 18th, 19th, 20th, and 21st birthdays.
A = $2,000

1 2 17 18 19 20 21

i = 12%
P17 = F17
Po = ?

Solution: N = 21 ; J = 17

P17 = A (P/A, 12%, 4) = ₱2,000 (3.0373) = ₱6,074.60

P0 = F17(P/F, 12%, 17) = ₱6,074.60 (0.1456) = ₱884.46

NOMINAL AND EFFECTIVE INTEREST RATES

Nominal Interest Rate - Nominal means "in name only". This is sometimes called the quoted
rate or basic annual interest. It is the stated rate of interest applied to your investment.

Periodic Rate - The amount of interest you are charged each period, like every month.

Effective interest rate - the actual annual interest rate that accrues, after taking into
consideration the effects of compounding (when compounding occurs more than once per year).
The rate that you actually get charged on an annual basis. Remember you are paying interest on
interest.

To illustrate: Consider a principal amount of ₱1,000 to be invested for three years at a nominal
rate of 12% compounded semi-annually. The interest earned during the first six months would
be:

₱1,000 x (0.12/2) = ₱60

The interest earned during the second six months

would be ₱1,060 x (0.12/2) = ₱63.60

Then total interest earned during the year is

₱60.00 + ₱63.20 = ₱123.60

The effective annual interest rate for the entire

year is (₱123.60 / ₱1,000) X 100 =
12.36%

The relationship between effective annual interest, i, and nominal interest r, is

i = (1 + r/M)M – 1 where M is the number of compounding periods per year and r is

expressed in decimal.

Problem: A credit card company charges an interest rate of 1.375 per month on the unpaid
balance of all accounts. The annual interest rate they claim is 12 x 1.375% = 16.5%. What is the
effective rate of interest per year being charged by the company?

i = (1 + 0.165/12)12 – 1
= 0.1781 or 17.81% per year

Interest Problems with Compounding More Often Than Once Per Year

Single Amounts
If a nominal interest rate is quoted and the number of compounding periods per year and number
of years are known, any problem involving future amounts, annual, or present equivalent values
can be calculated by straightforward use of equations F = P(1 + i)N and i = (1 + r/M)M – 1
respectively.
Problem. Suppose that a $100 lump-sum amount is invested for 10 years at a nominal rate of 6%
compounded quarterly. How much is it worth at the end of the tenth year?
Solution: There are 4 compounding periods per year, or a total of 4 x 10 = 40 periods. The
interest rate per interest period is 6%/4 = 1.5%.

F = P (F/P, 1.5%, 40) = $100.00 (1.015)40 = $100.00 (1.814) = $181.40

Other solution: Using i = (1 + r/M)M – 1

i = (1 + 6/10)10 – 1 = 6.14%
F = P (F/P, 6.14%, 10) = $100.00 (1.0614)10 = $181.40

Problem. At a certain interest rate compounded semi-annually, P2,000 will amount to 6,500 in 10
years. What is the amount at the end of 15 years?

Solution: Solve first for the interest

For 10 years: F = P (1+i)N N = 10 (2) = 20 periods

6,500 = 2,000 (1+i)20
3.25 = (1+i)20
3.251/20 = 1+i
1.06 = 1+i
i = 1.06 – 1
i = 0.06 or 6%
For 15 years: F = 2,000 (1.06)30
F = 11,486.98

Uniform Series

Problem. Suppose that one has a bank loan for ₱10,000, which is to be repaid in equal
end-of-month installments for five years with a nominal interest rate of 12% compounded
monthly. What is the amount of each payment?

Solution: Number of installments = 5 x 12 = 60, interest rate per month is 12%/12 = 1%.

A = P(A/P, 1%, 60) = 10,000 (0.0222) = ₱222

Problem. A father wishes to provide ₱4,000 for his son on his 21st birthday. How much should
he deposit every 6 months in a savings bank which pay 3% compounded semi-annually, if the
first deposit is made when the son is 31/2 years old?
 N = 17.5 years (2) = 35 periods i = 3/2 = 1.5%

A = F(A/F, 1.5%, 35) = 4,000 [0.015 / (1+0.015)35 -1]

= 4,000 (0.015/0.684)
= 4,000 (0.022)
= ₱87.73

Interest Problems with Cash Flows Less Often Than Compounding Periods

Problem. Suppose that there exists a series of 10 end-of-year receipts of ₱1,000 each, and it is
desired to compute their equivalent worth as one of the tenth year is the nominal interest rate is
12% compounded quarterly.

Solution. Interest = 12/4 = 3% per quarter, but the uniform series cash flows do not occur at the
end of each quarter.

1st Procedure: Compute an equivalent cash flow for the time interval that corresponds to the
stated compounding frequency.

A = F(A/F,3%,4)
= ₱1,000 (0.2390)
= ₱239 at the end of each quarter is equivalent to $1,000 at the end of each year.

Therefore, the future equivalent at the end of 10th quarter is: N = 10(4) = 40 periods

F = A(F/A,3%,40)
= ₱239 (75.4012) = ₱18,021

2nd Procedure:

Get the effective interest rate: i = (1+r/M)M -1 = (1+12/4)4 – 1 = 0.1255 or 12.55%

F = A (F/A, 12.55%,10) = ₱1,000 (F/A, 12.55, 10) = ₱18,022

PLS. Answer the ff. on a separate sheet of paper thank you(show complete solution)
A person desires to accumulate $2,500 over a period of 7 years so that a cash payment can be
made for a new roof on a summer cottage. To have this amount when it is needed, annual
payments will be made to a savings account that earns 6% interest per year. How much must
each annual payment be? Draw a cash flow diagram.
It is estimated that a certain piece of equipment can save $6,000 per year in labor and material
costs. The equipment has an expected life of 5 years and no salvage value. If the company must
earn a 20% rate of return on such investments, how much could be justified for the purchase of
this piece of equipment? Draw a cash flow diagram.