Mathematics of Finance
Simple and Compound Interest
1. Interest
• Interest is the cost for the use of money.
• The amount deposited in a bank or borrowed from a bank is called the principal,
the percent used to determine the amount of interest is called the interest rate,
and the duration of deposit or loan is called the time.
2. Simple Interest
• It is the interest earned only on the original principal invested.
• In calculating simple interest, we use the formula:
𝑰 = 𝑷𝒓𝒕
where,
I is the interest,
P is the principal,
r is the rate, and
t is the time period.
• If time is given in months or days, convert this to year using these formulas:
𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒎𝒐𝒏𝒕𝒉𝒔
𝐭=
𝟏𝟐
𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒅𝒂𝒚𝒔
𝐭=
𝟑𝟔𝟎 ∗
*360 could be changed to 365 if indicated.
• The final amount or maturity value at the end of t years can be solved using:
𝑭=𝑷+𝑰
Derived formulas from I = Prt and F = P + I:
𝑰 𝑰 𝑰
𝑷= 𝒓= 𝒙 𝟏𝟎𝟎% 𝒕=
𝒓𝒕 𝑷𝒕 𝑷𝒓
𝐹
𝐹 = 𝑃 + 𝐼 , 𝑤ℎ𝑒𝑟𝑒 𝐼 = 𝑃𝑟𝑡 𝑃= 1 +𝑟𝑡
𝐹 = 𝑃 + 𝑃𝑟𝑡
𝑭 = 𝑷(𝟏 + 𝒓𝒕) 𝐼 =𝐹 −𝑃
Illustrative Examples:
1. Find the interest on P2,500 at 6% simple interest for 5 years.
Given:
P = P2,500
t = 5 years
r = 6% = 0.06
Required:
Interest, I = ?
Solution:
𝐼 = 𝑃𝑟𝑡
= (𝑃2,500)(0.06)(5)
I = P750
The interest after 5 years is P750.
2. What is the simple interest rate on P30,000 for 6 ½ years if money earns P6,500?
Given:
P = P30,000
t = 6 ½ years = 6.5 years
I = P6,500
Required:
Simple interest rate, r = ?
Solution:
𝑰
𝒓= 𝒙 𝟏𝟎𝟎%
𝑷𝒕
𝑷𝟔,𝟓𝟎𝟎
= 𝒙 𝟏𝟎𝟎%
(𝑷𝟑𝟎,𝟎𝟎𝟎)(𝟔.𝟓)
r = 3.33%
The simple interest rate should be 3.33%.
3. If P4,500 is the interest at 10% after 3 months, how much was borrowed?
Given:
I = P4,500
r = 10% = 0.10
𝟑
t = 3 months = 𝟏𝟐 = 𝟎. 𝟐𝟓 𝒚𝒆𝒂𝒓𝒔
Required:
Principal, P = ?
Solution:
𝑰
𝑷=
𝒓𝒕
𝑷𝟒,𝟓𝟎𝟎
=
(𝟎.𝟏𝟎)(𝟎.𝟐𝟓)
P = P180,000
The amount borrowed is P180,000.
4. How long will it take for P5,000 to become P6,500 at 6% simple interest?
Given:
P = P5,000
F = P6,500
r = 6% = 0.06
Required:
time, t = ?
Solution:
Solve for I,
I=F–P
= P6,500 – P5,000
I = P1,500
Solve for t,
𝑰
𝒕=
𝑷𝒓
𝑷𝟏,𝟓𝟎𝟎
=
(𝑷𝟓,𝟎𝟎𝟎)(𝟎.𝟎𝟔)
t = 5 years
It will take 5 years to achieve the desired amount.
5. Accumulate P5,000 at 9% for 7 years.
Given:
P = P5,000
r = 9% = 0.09
t = 7 years
Required:
Future value, F = ?
Solution:
𝑭 = 𝑷(𝟏 + 𝒓𝒕)
= 𝑷𝟓, 𝟎𝟎𝟎(𝟏 + (𝟎. 𝟎𝟗)(𝟕))
F = P8,150
The accumulated amount after 7 years is P8,150.
3. Repayment
• Whenever money is borrowed, the total amount to be paid back equals the
principal plus the interest charged.
Total repayments = principal + interest
• Normally, the money paid back in regular installment is either monthly or weekly.
To compute the regular payment amount, we divide the total amount to be
repaid by the number of months (weeks) of the loan, therefore:
𝒑𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍+𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝒎𝒐𝒏𝒕𝒉𝒍𝒚 𝒑𝒂𝒚𝒎𝒆𝒏𝒕 𝒂𝒎𝒐𝒖𝒏𝒕 = or:
𝒍𝒐𝒂𝒏 𝒑𝒆𝒓𝒊𝒐𝒅, 𝑻, 𝒊𝒏 𝒎𝒐𝒏𝒕𝒉𝒔
𝒑𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍 + 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝒘𝒆𝒆𝒌𝒍𝒚 𝒑𝒂𝒚𝒎𝒆𝒏𝒕 𝒂𝒎𝒐𝒖𝒏𝒕 =
𝒍𝒐𝒂𝒏 𝒑𝒆𝒓𝒊𝒐𝒅, 𝑻, 𝒊𝒏 𝒘𝒆𝒆𝒌𝒔
There are 12 months or 52 weeks in a year.
Illustrative Example:
1. Carla purchased an iPod by obtaining a simple interest loan. The iPod costs P40,000,
and the interest rate on the loan is 7%. If the loan is to be paid back in weekly installments
over 2 years, calculate:
a. The amount of interest paid over 2 years;
b. The total amount to be paid back; and
c. The weekly payment amount.
Given:
P = P40,000
r = 7% = 0.07
t = 2 years, 2 x 52 weeks = 104 weeks
repayment term = weekly
Required:
a. interest, I = ?
b. Future value, F = ?
c. Weekly payment amount = ?
Solution:
a. I = Prt
=(P40,000)(0.07)(2)
I = P5,600
b. F = P + I
= P40,000 + P5,600
F = P45,600
𝒑𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍+𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
c. 𝒘𝒆𝒆𝒌𝒍𝒚 𝒑𝒂𝒚𝒎𝒆𝒏𝒕 𝒂𝒎𝒐𝒖𝒏𝒕 =
𝒍𝒐𝒂𝒏 𝒑𝒆𝒓𝒊𝒐𝒅, 𝑻, 𝒊𝒏 𝒘𝒆𝒆𝒌𝒔
𝑷𝟒𝟓,𝟔𝟎𝟎
=
𝟏𝟎𝟒
𝒘𝒆𝒆𝒌𝒍𝒚 𝒑𝒂𝒚𝒎𝒆𝒏𝒕 𝒂𝒎𝒐𝒖𝒏𝒕 = 𝑷𝟒𝟑𝟖. 𝟒𝟔
4. Ordinary and Exact Interest
• If the time is in terms of days and the interest rate is in percent per year, two types
of interest may be used, ordinary and exact interest.
• Ordinary interest assumes 360 days in a year
• Exact interest, 365 days in a year
• Io denotes ordinary interest
• Ie denotes exact interest
• Io > Ie
𝑫
𝑰𝒐 = 𝑷𝒓 ( )
𝟑𝟔𝟎
𝑫
𝑰𝒆 = 𝑷𝒓 ( )
𝟑𝟔𝟓
D denotes days
Illustrative Example
1. Find the ordinary and exact interest on P12,000 at 5% for 120 days.
Given: P = P12,000
r = 5% = 0.05
t = 120 days
Required:
a. Io
b. Ie
Solution:
𝑫
a. 𝑰𝒐 = 𝑷𝒓 ( )
𝟑𝟔𝟎
𝟏𝟐𝟎
= 𝑷𝟏𝟐, 𝟎𝟎𝟎(𝟎. 𝟎𝟓) ( )
𝟑𝟔𝟎
Io = P200
𝑫
b. 𝑰e = 𝑷𝒓 ( )
𝟑𝟔5
𝟏𝟐𝟎
= 𝑷𝟏𝟐, 𝟎𝟎𝟎(𝟎. 𝟎𝟓) ( )
𝟑𝟔𝟓
Io = P197.26
5. COMPOUND INTEREST
• Compound interest works over time because it allows individuals to earn interest
not only on the original amount that they invested, but earn interest also on the
interest they earned from that original investment.
• Compound interest is defined as interest on interest.
• The accumulated amount at the end of the period, the original principal and the
compound interest, is called the final amount or maturity value.
𝑭 = 𝑷 (𝟏 + 𝒊)𝒏
where,
F = maturity value or final amount
P = Principal
i = rate of interest per conversion period
n = frequency of interest conversion for the whole term
𝑗
• The rate of interest per conversion period, i, is computed as , where j is the
𝑚
compound interest rate and m is the frequency of interest conversion per year.
• Interest may be compounded annually, m=1; semi-annually, m=2; quarterly, m=4;
and monthly, m=12.
• The frequency of the conversion period for the whole term is n = mt, where t is the
time or term of transaction.
Illustrative Examples
1. If P100,000 is deposited in a bank that pays 4% compounded quarterly, what is the
maturity value after 3 years?
Given:
P = P100,000
t = 4 years
j = 4% = 0.04
m=4
𝑗 0.04
i= = = 0.01
𝑚 4
n = mt=4(3) = 12
Required:
Maturity value, F = ?
Solution:
𝑭 = 𝑷 (𝟏 + 𝒊)𝒏
= P100,000 (𝟏 + 0.01)12
F = P112,682.50
2. Amiel invested P210,000 in a time deposit account at 7.5% compounded semi –
annually. How much is the value of the fund if it is withdrawn after 2 years and 3 months?
Given:
P = P210,000
t = 2 years and 3 months = 2.25 years
j = 7.5% = 0.075
m=2
𝑗 0.075
i= = = 0.0375
𝑚 2
n = mt=2(2.25) = 4.5
Required:
Maturity value, F = ?
Solution:
𝑭 = 𝑷 (𝟏 + 𝒊)𝒏
= P210,000 (𝟏 + 0.0375)4.5
F = P247,836.79
6. Present Value (Compound Interest)
• Present value (PV) is the current worth of future sums of money.
• In accounting, this measures how much money needs to be invested today in
order to finance future business, initiatives, projects, and obligations.
• In order to determine the present value of future costs, accountants use formulas
based on the time value of money.
• The process of calculating the present value is usually the opposite of finding the
compound future value.
𝑃 = 𝐹 (1 + 𝑖)−𝑛
Illustrative Example:
1. Find the present value of P245,000, which is due in 2 years and 9 months with interest
at 8% compounded quarterly.
Given:
P = P245,000
t = 2 years and 9 months = 2.75 years
j = 8% = 0.08
m=4
𝑗 0.08
i= = = 0.02
𝑚 4
n = mt=4(2.75) = 11
Required:
Present value, P = ?
Solution:
P = F (𝟏 + 𝒊)-𝒏
= P245,000 (𝟏 + 0.02)-11
P = 197,044.44
7. The Rate at Compound Interest
• An interest rate is the amount borrowers pay for the use of money they do not
own. Interest rates are normally expressed as a percentage rate over the period
of one year.
1
𝐹 𝑛
𝑗 = 𝑚 [( ) − 1]
𝑃
Illustrative Example:
1. The bank granted a P350,000 loan to Rico Allen for him to start a small business. He
agreed to repay it in the amount of P420,000 after 2 years and 9 months. At what rate-
compounded quarterly is he paying the interest?
Given:
P = P350,000
F = P420,000
t = 2 years and 9 months = 2.75 years
m=4
n = mt=4(2.75) = 11
Required:
Interest rate, j = ?
Solution:
1
𝐹 𝑛
𝑗 = 𝑚 [( ) − 1]
𝑃
1
P420,000 11
= 4[( ) − 1]
P350,000
j = 0.0669 = 6.69%
Activity - Simple and Compound Interest
Directions: Solve the following problems systematically. Show all pertinent solution.
1. Find the simple interest on a loan of P70,000 if the loan is given at a rate of 20%
and is due in 3 years.
2. Cynthia invested a certain amount at 10% simple interest per year. After 2 years,
the interest she received amounted to P5,000. How much did she invest?
3. How long will an amount of money triple at a simple interest rate of 1% per
annum?
4. At what simple interest rate per annum will P20,000 accumulate to P30,000 in 3
years?
5. Zian lends P50,000 for 3 years at 5% compounded semi-annually. Find the future
value and interest of this amount?
6. How much should you set aside and invest in a fund earning 9% compounded
quarterly if you want to accumulate P250,000 in 3 years and 3 months?
7. Carla invested an amount of P 450,000 at 5% compounded quarterly. How long
should she let the investment stay if she wants to earn P 50,000?
8. At what rate compounded semi-annually will P10,000 accumulate to P18,000 in
10 years?
